Section 279: Interest Limit on Corporate Acquisition Debt

Internal Revenue Code Section 279 is a targeted measure addressing corporate acquisitions financed heavily with debt. This provision can limit the amount of interest a corporation is permitted to deduct on debt used to acquire another company’s stock or assets. The rule was established to discourage takeovers that result in a high degree of leverage, where the debt carries features more commonly associated with equity.

The framework of Section 279 is aimed at situations where the financing structure suggests new debt holders are taking on a risk profile similar to that of stockholders. The tax code establishes a series of tests to identify these specific obligations. If the debt meets the definition of “corporate acquisition indebtedness” and the issuing corporation fails certain financial health checks, the interest deduction is capped.

Defining Corporate Acquisition Indebtedness

For a debt instrument to be categorized as corporate acquisition indebtedness under Section 279, it must satisfy three qualitative tests examining its purpose, priority, and equity-like features. All three conditions must be present for the debt to fall under this initial classification. This classification is based on the specific characteristics of the obligation itself, independent of the issuing corporation’s overall financial standing.

The Purpose Test

The first condition, the purpose test, focuses on how the funds from the debt issuance are used. The debt must be issued to provide consideration for acquiring either stock in another corporation or at least two-thirds of another corporation’s assets, excluding cash. For stock acquisitions, the issuing corporation must own 5% or more of the target company’s voting stock. For example, if Corporation A issues bonds and uses the cash proceeds to purchase 100% of the shares of Corporation B, the bonds meet the purpose test as ownership exceeds the 5% minimum. The rule targets transactions that represent a genuine change in control or ownership.

The Subordination Test

The second condition is the subordination test, which assesses the debt’s ranking in the company’s capital structure. This test is met if the debt instrument is subordinated to the claims of the issuing corporation’s general trade creditors. Alternatively, the test is also satisfied if the debt is expressly subordinated in right of payment to any substantial amount of the issuer’s unsecured debt, whether that unsecured debt is currently outstanding or issued in the future. For instance, if a company issues a debenture that, by its terms, will only be paid after all trade creditors are paid in a liquidation scenario, it meets the subordination test.

The Convertibility Test

The final qualitative condition is the convertibility test, which identifies the presence of an equity participation feature. This test is satisfied if the debt instrument is, either directly or indirectly, convertible into the stock of the issuing corporation. It is also met if the debt is issued as part of an investment unit that includes an option to acquire stock, such as a bond issued with detachable warrants. A common example is a convertible bond that gives the holder the right to exchange the bond for a predetermined number of shares of the issuing company’s common stock.

Applying Financial Threshold Tests

Once a debt instrument meets the purpose, subordination, and convertibility tests, the analysis shifts to the financial condition of the issuing corporation. Section 279 will only apply if the corporation fails at least one of two financial ratio tests. These tests are performed as of the last day of the taxable year in which the debt was issued.

The Debt-to-Equity Ratio Test

The first financial threshold is a debt-to-equity ratio test. For Section 279 to apply, the issuing corporation’s ratio of debt to equity must exceed 2-to-1. The “debt” in this calculation includes all of the corporation’s indebtedness, including the new acquisition debt. “Equity” is defined as the sum of money and the adjusted basis of other property, reduced by the corporation’s debt. This calculation uses the tax basis of assets, not fair market value. If a corporation has $15 million in total debt and its equity, calculated under these specific rules, is $6 million, its debt-to-equity ratio is 2.5-to-1. Since this exceeds the 2-to-1 threshold, the test is failed.

The Projected Earnings to Annual Interest Test

The second financial test compares the company’s earnings capacity to its interest burden. This test is failed if the corporation’s “projected earnings” do not exceed three times the “annual interest” to be paid or incurred. “Projected earnings” are the corporation’s average annual earnings and profits for the three-year period ending on the last day of the acquisition year. “Annual interest” refers to the total interest expense on all its debt, including the new acquisition indebtedness. For example, if projected earnings are $9 million and annual interest is $4 million, the earnings are only 2.25 times the interest, failing the test.

The Interest Deduction Limitation

When a debt instrument is classified as corporate acquisition indebtedness and the issuing corporation fails one of the financial threshold tests, the consequences are direct. The rule imposes a specific dollar-based limit on the amount of interest that can be deducted on that debt, increasing the corporation’s taxable income. The core of the limitation is a $5 million annual cap. A corporation is disallowed a deduction for interest paid on its corporate acquisition indebtedness to the extent that interest exceeds $5 million. For instance, if a company pays $7 million in annual interest on debt that falls under Section 279, the first $5 million is deductible, but the remaining $2 million is not.

This $5 million allowance is further reduced by interest paid on certain other types of acquisition debt. Specifically, the $5 million limit is decreased by the amount of interest paid on any debt used for acquisitions that meets the purpose test but is not classified as corporate acquisition indebtedness. This typically involves acquisition debt that does not meet the subordination or convertibility tests. For example, if a company pays $1 million in interest on such older acquisition debt, its available Section 279 limit for the year is reduced from $5 million to $4 million.

Special Considerations for Affiliated Groups

The rules of Section 279 become more complex when applied to an affiliated group of corporations that files a consolidated tax return. The principles of the purpose, financial, and limitation tests still apply, but their application is aggregated at the group level. This prevents companies from circumventing the rules by strategically placing debt and assets among different legal entities within the same corporate family.

When one member of an affiliated group acquires a target corporation, the tests are applied to the group as a whole. For instance, the purpose test is met if one member of the group issues debt and uses the proceeds to acquire the stock or assets of a target, even if a different member of the group ultimately holds the acquired assets.

The financial threshold tests—the debt-to-equity ratio and the earnings-to-interest coverage ratio—are also calculated on a consolidated basis. The total debt of all group members is aggregated and compared to the total equity of the group. Similarly, the projected earnings are based on the combined earnings and profits of the entire group, and this figure is compared against the total annual interest expense for all members.

Finally, the $5 million interest deduction limitation is applied to the affiliated group as a single entity. The group as a whole is entitled to one $5 million cap, not a separate $5 million for each corporation. This aggregate limit is then reduced by the group’s total interest on any other acquisition indebtedness. The disallowed interest is then allocated among the members of the group that paid or incurred the corporate acquisition indebtedness.