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Court decision entangles redemption transactions

A recent tax court decision raises interesting questions regarding the tax treatment of costs incurred in leveraged buyouts and other redemption transactions. The case is interesting in part simply as an illustration of the size, cost and complexity of the LBOs undertaken in the 1980s. However, the court’s opinion also creates disturbing implications for the tax treatment of expenses incurred in connection with any redemption.
The case, Fort Howard Corp. v. Commissioner, involved a classic 1980s LBO. A group led by inside management and outside investment bankers acquired the corporation. They did so by retaining or acquiring a very small amount of stock themselves, and causing the corporation to borrow $2.8 billion to redeem the shares of all other shareholders. After a convoluted series of transactions, the takeover group owned the business, subject to new debt of $2.8 billion.
Such a highly leveraged buyout typically involves substantial fees to the bankers involved in arranging the financing for the transaction, and this one was no exception. Fort Howard paid more than $169 million in loan-origination costs in the year of the takeover. These were merely the “soft” costs of arranging the transaction financing; the loans themselves, of course, created substantial additional interest costs.
The question in the Fort Howard case was the tax treatment of these loan-origination costs. Until fairly recently, this seemed an easy question. For many years it has been clear that loan-origination costs incurred in a trade or business are amortized over the life of the loan. For example, if a business incurred $100 in fees to obtain a five-year loan, it would deduct $20 in each of the five years in which the loan is outstanding.
The IRS, however, treated the loan-origination expenses in Fort Howard as neither deductible nor amortizable. It relied on a relatively new section of the Internal Revenue Code, S 162(k), which was aimed at a different aspect of corporate-raider transactions.
Section 162(k) was inserted in the code in 1986 to address the issue of corporate “greenmail.” Greenmail is another phenomenon of the wild and woolly takeover days of the 1980s. It occurs when a corporate raider acquires a substantial minority interest in a publicly traded corporation. Once he owns, for example, 20 percent of a publicly traded company, the raider has a very realistic threat of acquiring a larger percentage and taking control of the company. If management opposes the takeover, it often is tempted to offer to buy out the raider’s position.
Thus, by threatening to pursue a takeover, the raider might cause the corporation to repurchase its shares at a substantial premium and make a healthy “greenmail” profit.
The costs of redeeming a corporation’s stock have been understood for many years to be non-deductible. A corporation neither recognizes gain when it sells its stock, nor incurs a deductible expense when it purchases its stock. Such transactions merely add or subtract from its capital base.
However, some companies tried to make an argument that all or a portion of the payments made in a greenmail transaction were not really paid for the stock. Rather, such payments were made, it was argued, to protect the company from an unfriendly takeover attempt that would have been deleterious to the corporation’s interests.
Under this theory, then, the costs of a greenmail redemption were not really redemption costs, but rather ordinary expenses of protecting the corporation’s trade or business. On this rather imaginative theory, some corporations attempted to deduct the cost of greenmail payments.
Section 162(k) of the code sought to put an end to this creative argument. Instead of a narrow and well-placed bullet, however, Congress killed the argument with a blunderbuss. It provided that no deduction would be allowed for any amount paid “in connection with” a corporation’s redemption of its stock.
Using this broad language, the IRS made its attack on loan-origination fees in Fort Howard. Despite the longstanding law on amortization of loan-origination fees, the IRS argued that S 162(k) changed the rule when a loan was incurred “in connection with” a redemption. The facts in an LBO like Fort Howard make the connection quite strongly. Clearly, the transaction costs would not have been incurred but for the redemption. The sole purpose of the borrowing, and an express condition of the borrowing, was its use for the redemption transaction.
The tax court accepted the IRS’ argument. It ignored the taxpayer’s arguments on the purpose and legislative history of S 162(k) as relating solely to greenmail payments. Instead, it read the “plain words” of the statute. Since the loan and the loan origination fees were incurred “in connection with” a redemption, the court held that the fees were not deductible or amortizable.
At this point, Fort Howard appears to be a major victory for the IRS, although it is widely anticipated that the decision will be appealed. Its implications, however, are troublingly broad. Section 162(k) does not limit itself to loan-origination fees, but deals with any amount paid “in connection with” a redemption. One can imagine many otherwise deductible payments that might be trapped by this language.
For example, it is common to engage in a variety of transactions when a key executive leaves a corporation. A substantial aspect of the transaction may be a redemption of the executive’s stock, but other payments–such as severance, job relocation and related items–may be paid at the same time. How does one decide whether these payments are “in connection with” the termination of employment or are “in connection with” the redemption of the employee’s stock?
If the stock is valuable, it may represent the dominant economic aspect of the transaction. It seems unlikely that S 162(k) was intended to reach this type of expense, but it is difficult to find the logical limit to the court’s language.
Even if the Fort Howard decision is limited to loan-origination fees, substantial problems of interpretation remain. For example, suppose that a corporation incurs loan fees to have a line of credit available for five years for the general working capital needs of the business. Under existing law, it begins amortizing those loan costs over the five-year period. Suppose that in year three it draws substantially on the line in order to obtain the funds necessary to redeem a dissident shareholder. Are the loan-origination fees now “connected with” the redemption? Must the corporation now recapture some of the amortization already taken?
Similar questions are raised by the simple notion that money is fungible. Suppose that on the same day: 1) a redemption for $1 million occurs, 2) the corporation obtains $1 million in cash from operations, and 3) the company incurs $1 million in new debt. Which $1 million was used to redeem the stock? Can the corporation protect itself from the implications of Fort Howard simply by using the operating cash for the redemption and placing the borrowed cash in a segregated account to demonstrate that it was not used “in connection with” the redemption?
Unfortunately, there are no answers to these questions; the Fort Howard decision raises far more questions than it answers. These questions may be clarified if an appeals court reverses Fort Howard and limits S 162(k) to greenmail payments, as many believe was intended. Unless that occurs, however, corporations will need to carefully plan all redemption transactions.
An effort should be made to disassociate costs from the redemption transaction to the maximum extent possible. They should be tied to some other corporate need or event. In short, the planning should seek to minimize the costs incurred “in connection with” a redemption.
(Michael McEvoy is a partner in the law firm of Harter, Secrest & Emery, where he concentrates his practice on tax matters.)

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