Opinion ID: 769343
Heading Depth: 1
Heading Rank: 6

Heading: R.C. S 1272(a)(1) states:

Text: For purposes of this title, there shall be included in the gross income of the holder of any debt instrument having original issue discount issued after July 1, 1982, an amount equal to the sum of the daily portions of the original issue discount for each day dur ing the taxable year on which such holder held such debt instru ment. 4 I.R.C. S 1275(a)(1) defines a debt instrument as a bond, debenture, note, or certificate or other evidence of indebtedness. 5 See Rev. Rul. 77-250, 1977-2 C.B. 309. 6 Custom Chrome relies on the following dicta in Computervision to support its argument: Petitioners, in an effort to bolster their argument that the second warrant was a capital asset of CV, suggest that the warrant repre sented partial compensation to Computervision for the below market interest rate on the loans CV made to Sun as part of the workstation purchase transaction. If in fact the net proceeds of the sale of the second warrant constituted additional interest income to CV with respect to its loan to Sun, the proceeds would be taxable as ordinary income and not long-term capital gain. 71 T.C.M. at 2466-67 n.19. That footnote, however, merely indicates that the character of the income would be ordinary, yet states nothing about the timing of when such a realization event would be valued. This is consistent with the OID rules, which provide that OID is treated as a deduction in ordinary income to the debtor and an increase in ordinary income to the creditor. See I.R.C. SS 163(e), 1272(a)(1). 7 In tandem, these sections provide that if a debt instrument is issued and subsequently repurchased at a price in excess of the issue price plus any amount of original issue discount deductible prior to the date of repurchase . . . the excess of the repurchase price over the issue price . . . is deductible as interest for the taxable year. Proposed Treas. Reg. 1.163 7(f)(1) (1986). 8 In this regard, the phrase rates that otherwise would have been applied is a bit of a misnomer, because borrowers that require a higher interest rate usually do not have sufficient cash flow to meet the high interest payments demanded by a higher interest rate. For example, Ken Jones, Vice-President, Commercial Lending Officer, 1989, Bank of America, testified that in these types of transactions, if you were to charge a higher rate of interest or charge a higher fee, given the amount of debt that this company was having to take on, it would probably not be able to service the debt and you'd immediately create a problem for yourself. Indeed, according to the testimony of Gregory C. Foy, Vice President, Acquisition Finance, 1989, BancBoston, probably because of Custom Chrome's tight cash flow, the Bank utilized options, as opposed to a higher interest rate, to increase its internal rate of return. Thus, Custom Chrome's lack of sufficient cash flow explains why no higher interest was actually negotiated. So when ascertaining what the interest rate would have been in the absence of the warrants, the factfinder should simply determine the rate of return (i.e., effective interest rate) required by the lender for the entire loan transaction to take place. 9 The Commissioner argues that, although the Monarch Cement approach was mandated by the Treasury Regulations in effect at the time Monarch Cement was decided, those regulations were not in effect at the time of the transaction in this case. The Commissioner also notes that, although proposed Treas. Reg. S 1.1273-2 (1986) -which was similar to the provisions governing Monarch Cement -would have applied during the time of the Custom Chrome buyout, the proposed regulation was later withdrawn and replaced with another, less specific regulation, see Treas. Reg. S 1.1272-2 (1994). Because the new regulation applies only to debt instruments issued on or after April 4, 1994, we are not bound by it in this case. In any event, although the new regulation may not provide specific rules for determining the value of the options, the factfinder must utilize some reliable method to determine the value of the options that are included as OID. Because the method of Monarch Cement is reliable and well-established, we conclude that that is one of several methods available to the courts for valuing options granted in return for OID. 10 Other well-established and reliable methods include but are not limited to: (1) estimating as a multiple of earnings before interest and taxes (EBIT) the present value of the portion of the company that may be purchased by exercise of the options; (2) comparing the value of the total debt instrument to the published values of comparable debt instruments of other issuers, taking into account the factors listed in former Treas. Reg. S 1.1232-3(b)(2)(ii)(a) (1986); and (3) the Black-Scholes method, see Snyder v. Commissioner, 93 T.C. 529, 540-42 (1989) (discussing that method). 11 The expert used the Black-Scholes method as well as the method of determining the value of additional interest that otherwise would have been charged in the absence of the warrants. 12 Originally, in his valuation report, the Commissioner's expert claimed that the value of the warrants was $630,000. Apparently, the expert neglected to take into account the $7 million loan provided by Mezzanine. At trial, the expert stated that he had revised his valuation to $45,000. 13 In the event that the warrants were not highly profitable, the Bank also benefitted from the put provision, which allowed it to sell a specified portion of the warrants back to Custom Chrome. 14 The Commissioner argues that, because of the heavy debt undertaken, the value of the equity of Custom Chrome was reasonably $500,000. While Custom Chrome's book value may have been close to $500,000, the relevant value for determining OID is the estimated market value of Custom Chrome -that is, the value the Bank took into account when discounting the loan. See Monarch Cement, 634 F.2d at 485. 15 The Bank appears to have been under pressure from federal regulators -in particular, the Office of the Controller of Currency -to state a low value on its books for the value of the warrants. In particular, Foy testified that, although it [was] unlikely that the bank regulators would have permitted the bank to put a value on the warrants,suffice to say . . . the bank assumed that they were quite valuable and obviously the shareholders of the new company viewed them as quite valuable and that's why they were the subject of obviously very heated negotiation over the amount. Mary Reilly, Vice President, 1989, Banc Boston Capital, also testified that one of the reasons for the low value booked for the warrants was because of the inter-company transfer of the warrants from FNBB to BancBoston. 16 Section 162(k) states in relevant part: [N]o deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred by a corporation in con nection with redemption of its stock. I.R.C. S 162(l) (1986). I.R.C. S 162(l) was redesignated as I.R.C. S 162(k) in 1988. See Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, S 3011(b)(3)(A), 102 Stat. 3342, 3625 (1988). 17 In United States v. Kroy (Europe) Ltd. (In re Kroy (Europe) Ltd.), 27 F.3d 367 (9th Cir. 1994), before the amendments toS 162(k), this court held that expenses relating to the borrowing of funds to redeem its stock were deductible. Custom Chrome's reliance on this case is misplaced, however, because the expenses at issue do not relate to finance charges. 18 Custom Chrome argues further that, at the time Jordan sold all its stock in Custom Chrome, the useful life of whatever intangible asset created by the leveraged buyout of Cruze was finished, such that the costs of creating that asset (i.e., the $650,000 in acquisition fees) should at least have been deductible as of then. As in the argument concerning whether the series of steps in acquiring Cruze's stock were a single transaction, any expenses incurred by Jordan were ultimately assumed by Custom Chrome. See Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-40 (1943) (noting that a corporation and its shareholders are distinct taxable entities). Thus, the focus must be on Custom Chrome, not Jordan. Custom Chrome seems to argue that the exit of Jordan somehow ceased all the benefit created by the original buyout. The control of Custom Chrome by members of Jordan, however, certainly had lasting effects on Custom Chrome's success. Thus, whatever benefit was created by the buyout will not cease until the corporation itself is dissolved or ends. See McCrory Corp. v. United States, 651 F.2d 828, 832 (2d Cir. 1981) (noting that organizational expenditures are only deductible upon dissolution or liquidation); Vulcan Materials Co. v. United States, 446 F.2d 690, 693-94 (5th Cir. 1971) (same). 19 Generally, for corporations,substantial understatement is defined under I.R.C. S 6662(d)(1) as the greater of 10 percent of the tax required or $10,000. 20 We note that any lessening of Custom Chrome's tax burden from the eventual deductions that it will realize from the value of the warrants should be used to reduce the amount of underpayment and, correspondingly, the penalty under S 6662. See I.R.C. S 6662(d)(2)(A) (noting that understatement of tax is with respect to total tax due for a given tax year).