THE US TREASURY BELIEVES IT HAS AUTHORITY TO DISALLOW INTEREST DEDUCTIONS on new debt instruments like PHONES and DECS.

THE US TREASURY BELIEVES IT HAS AUTHORITY TO DISALLOW INTEREST DEDUCTIONS on new debt instruments like PHONES and DECS.

September 01, 1999

PHONES are a form of debt instrument a corporation might use to monetize shares it holds in another company. The acronym stands for “participating hybrid option note exchangeable securities.” For example, COMCAST issued $718 million in PHONES in March this year tied to shares it owned in AT&T. The interest COMCAST paid on the PHONES was a function of the dividends it received from AT&T, and the PHONES converted at maturity into the full cash value of the underlying AT&T shares. DECS are a similar form of debt instrument called “debt exchangeable into common shares.”

Section 263(g) of the US tax code requires that inter-est paid on one leg of a “straddle” must be capitalized and treated as tax basis in the other leg.

Jeffrey Maddrey, an attorney-adviser at Treasury, said at an American Bar Association meeting in August that the government believes it can use section 263(g) to disallow interest deductions on PHONES. He made the same statement about DECS earlier in the summer.

Maddrey believes the IRS would have trouble applying section 263(g) retroactively and favors having the IRS clarify its regulations first and then apply the statute prospectively.The Clinton administration asked Congress in the last two budgets to “clarify” application of the straddle rules to structured financial transactions involving corporate stock. Congress did not act on the proposal.

Keith Martin