Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 72-32

1972-1 C.B. 48

Sec. 163
Sec. 461
Sec. 483

IRS Headnote

Treatment of interest included in value of stock issued by a successor corporation under a section 368(a)(1)(A) merger agreement providing for issuance of additional stock in each of four succeeding years in which earnings exceed a stated amount.

Full Text

Rev. Rul. 72-32

Advice has been requested concerning the deductibility of interest under section 163 of the Internal Revenue Code of 1954 under the circumstances described below.

On December 1, 1970, M and X both domestic corporations, merged in a transaction that qualified as a statutory merger under the provisions of section 368(a)(1)(A) of the Code. X continued as the surviving corporation and uses a calendar year and an accrual method of accounting for Federal income tax purposes. On the effective date of the merger, the shareholders of M received one share of the common stock of X for each share they owned of M, with a total of 250x shares of X stock issued on that date. In addition, because of difficulties in valuing the M stock, the merger agreement provides for additional shares of common stock of X to be issued to the former shareholders of M in each of the four succeeding years, provided the earnings of the business formerly conducted by M exceed 100x dollars in any such years. The right to receive additional shares of X stock is not represented by negotiable certificates, is not readily marketable, and can only give rise to the receipt of additional shares of X common stock. The payment of additional stock will be according to a formula based on the year's earnings. The additional stock will be paid to the former M shareholders on the March 31st following the taxable year for which the earnings have reached the required level, and no additional shares will be issued after March 31, 1975. The total additional shares to be paid will not exceed 250x of shares.

The merger agreement also provided that, of any additional shares paid more than one year after the effective date of the merger, four percent per annum of the value (determined as of the payment date) of such additional shares will be considered simple interest. The simple interest of four percent per annum is to be computed from the effective date of the merger to the date of payment. The foregoing computation will produce a rate of simple interest somewhat in excess of four percent per annum.

Section 483 of the Code provides, in general, that in the case of a sale or exchange of property under a contract where payments are deferred more than one year after the date of the sale or exchange and no interest or an inadequate interest rate is stated, then a portion of the deferred payments represents "total unstated interest" and is to be treated as interest rather than part of the sale or exchange price. Under section 1.483-1(d)(2) of the Income Tax Regulations, section 483 of the Code will not apply to deferred payments where the contract provides for interest at a rate of at least four percent simple interest per annum, payable on each installment of principal at the time such installment is payable.

Section 483(d) of the Code and section 1.483-1(e)(1) of the regulations provide, in part, that where a payment is indefinite as to liability, amount or due date, section 483 of the Code shall be separately applied to such payment (and any interest attributable thereto) as if it were the only payment under the contract. In such a case, the determination as to whether there is total unstated interest (in accordance with section 1.483-1(d) of the regulations) shall be made separately with respect to each indefinite payment as of the time it is received. Similarly, under section 1.483-1(e)(2) of the regulations, contingent interest shall not be taken into account in determining whether there is unstated interest until it is actually paid.

Section 163(a) of the Code provides that there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness. Section 1.461-1(a)(2) of the regulations provides, in part, that where the taxpayer is using an accrual method of accounting for Federal income tax purposes an expense is deductible for the taxable year in which all the events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy.

Accordingly, under the facts of the instant case, since there is stated simple interest of more than four percent per annum on each contingent payment, there will be no "total unstated interest" on a particular payment of additional shares when and if such a payment is made. Four percent per annum (computed from the effective date of the merger) of the value at payment date of any additional shares paid more than one year after the effective date of the merger will be treated as interest within the meaning of section 163 of the Code.

No part of such interest will accrue as a deduction to X before the end of the taxable year in which it is determined, on the basis of earnings for such year, that under the merger agreement there is a fixed liability to pay such additional shares. See Pierce Estates v. Commissioner, 195 F. 2d 475 (1952). It is a question of fact whether, at the end of the taxable year in which the fixed liability arises, the value of such shares on the date of their payment, and thus the amount of the stated interest thereon (limited to such value multiplied by four percent per annum from the date of the merger to the end of such year), can be determined at that time with reasonable accuracy, within the meaning of section 1.461-1(a)(2) of the regulations. In the instant case, the amount of interest payable with respect to the additional shares of the common stock of X is dependent upon the value of such shares on March 31st--three months following the end of the preceding taxable year. Moreover, in the past the value of the X common stock has fluctuated significantly and it is expected that the value of such stock will continue to fluctuate significantly. Accordingly, under these circumstances a reasonably accurate determination of the amount of interest payable will not be possible at the end of the preceding taxable year, and thus the deduction to X for such interest will not accrue until the taxable year in which the March 31st payment becomes due and payable.

Revenue Ruling 70-300, C.B. 1970-1, 125 as clarified by Revenue Ruling 72-35, page 139, discusses the tax consequences to the recipient of the shares of the acquiring corporation under circumstances similar to those stated here and holds that the shares designated as interest shares will have a basis equal to fair market value.