For companies with convertible debt (debt), there have been concerns about the tax deductibility interest expense on such debt. IRS Section 163(l) covers this issue and provides that when the issuer of the debt has an option to convert the debt into stock then the tax deduction for interest on the debt will be disallowed. If the holder of this debt has an option to convert the debt into stock then the interest deduction will be permitted if there was not “substantial certainty” that the option would be exercised.
On April 24, 2015, the IRS issued PLR 201517003 which concerned the issue of whether interest on a convertible debt to a foreign parent could be tax deductible by a US subsidiary. The IRS concluded that the interest is tax deductible because it was not “substantially certain” that the foreign parent (holder) would exercise the option to pay the debt with its stock.
In structuring a convertible debt, it is important to remember that if the arrangement is designed so that ultimately the company will make interest payments in equity rather than cash, such interest deductions may be disallowed on audit. It is best to follow the rules outlined in section 163(l) by providing that the holder of the debt has the option to elect to receive equity or cash to settle the debt provided that there was substantial uncertainty when the arrangement was made as to whether payment would be in cash or stock.