Creative debt/equity financing: OID rules surface again.

Many businesses find it difficult to obtain growth capital because their financial needs are viewed as too risky by conventional banks or other traditional lending sources. As a result, these businesses may turn to alternative sources of financing, such as small business investment companies (SBICs), seed capital funds and venture capitalists. In many cases, these alternative sources will provide the necessary financing in exchange for an economic package that is flexibly structured to meet the borrower's needs. A typical financing arrangement may include a debt instrument such as a term note together with a separately issued equity interest, typically a warrant to purchase the stock of the issuer.

This hybrid form of financing can be attractive to lenders because of the potentially high return available if the borrower experiences significant growth and prosperity, and the lender exercises the stock warrants. Similarly, the financing has appeal to borrowers since they are provided with much needed growth capital at a time when their alternative sources of capital may be limited or nonexistent.

This hybrid form of financing is referred to as an "investment unit" and is addressed in the original issue discount (OID) rules. Because of the increasing popularity of these alternative forms of financing and the dramatically different (and often unexpected) tax consequences to the lender and the borrower, an overview of these rules is helpful.

In general, from a borrower's perspective, the OID rules treat certain items as deductible that would otherwise be treated as nondeductible capital

expenditures. From the lender's standpoint, however, the OID rules may effectively result in a portion of nontaxable debt repayments being treated as taxable interest income; this is particularly bad news to a lender that has just embarked on a highly speculative undertaking.

Sec. 1273(a)(1) generally defines OID as the amount by which a debt instrument's stated redemption price at maturity exceeds its issue price.

Example 1: A note is issued for $90,000. Its stated principal amount, payable at maturity in 10 years, is $100,000. The note also provides for quarterly interest payments at a 10% annual interest rate. All of the stated interest payments are deductible; in addition, the note contains OID of $10,000, which is deductible over the term of the note.

In Example 1, determination of OID is a relatively simple matter. The note's redemption price at maturity is provided by the terms of the debt instrument while the issue price is simply the amount paid for the debt instrument, in other words, the amount of cash actually loaned to the borrower.

Determining issue price for a debt instrument and equity (or other property) right issued together as an investment unit is far more complicated, and requires application of the special rules in Sec. 1273(c)(2) and Prop. Regs. Sec. 1.1273-2(d). Essentially, these rules provide that when an investment unit is issued for cash, some portion of the consideration received by the issuer is allocable to the equity right, with the balance allocable to the debt instrument. Under Prop. Regs. Sec. 1.1273-2(d)(2)(i), this allocation is based on the fair market value (FMV) of each element of the investment unit.

Example.2: On Jan. 1, 1991, V Co. (a venture company) provides U Inc. (a new company) with $500,000. V takes back a $500,000 note from U bearing interest at 10%. Under the agreement, U is required to make quarterly interest payments of $12,500 to V. U is also required to repay the entire $500,000 stated principal amount on Dec. 31, 1992. V also obtains stock warrants from U, which grant V the right to purchase 1,000 shares of U's stock on Dec. 31, 1994 for $25 per share.

Assume the FMV of the warrants on Jan. 1, 1991 is $100,000. Accordingly, under the OID rules, $100,000 of the total $500,000 loan is allocated to the warrants, with the remaining $400,000 allocated to the debt. Since the stated redemption price at maturity of $500,000 exceeds the debt issue price of $400,000, the lending transaction includes $100,000 of OID.

In this situation, U will deduct each of the $12,500 quarterly interest payments. Additionally, U will deduct $100,000 of OID over the term of the note. Over the same period, V will include in income the $12,500 quarterly interest payments as well as the $100,000 of OID.

The rules for determining the FMV of the components of an investment unit are set forth in Prop. Regs. Sec. 1.1273-2(d)(2)(ii)-(iv), and vary depending on whether or not the debt instrument and/or the equity right are publicly traded. In determining the issue price of the debt instrument, the following rules generally apply.

If the debt instrument issued as part of an investment unit is publicly traded, the debt instrument's issue price equals its initial trading price, with the balance of the total issue price allocated to the equity right. If the equity right issued as part of an investment unit is publicly traded and the debt instrument is not, the issue price of the debt instrument will equal the price paid for the investment unit less the initial trading price of the property right.

If neither the property right nor the debt instrument issued as part of an investment unit is publicly traded, the issue price allocated to the debt instrument equals the present value of all payments due under the debt instrument, discounted at a rate agreed to by the issuer (i.e., the borrower) and the holder (generally the lender), based on the original yields of other debt instruments with similar maturities and security issued within the previous six months by the issuer. In the absence of similar debt instruments, the parties must look to comparable debt instruments of other issuers, taking into consideration all of the applicable facts and circumstances.

Since the proposed regulations do not address how to allocate the issue price of a nonpublicly traded investment unit in the absence of an agreement between the parties, it is possible that the Service would take the position that no portion of the issue price is allocated to the equity rights and thus eliminate any OID deductions to the issuer. The holder of the investment unit, on the other hand, would benefit from this approach by recognizing less taxable income if the entire issue price is allocated to the debt instrument (rather than to OID).

The use of creative financing techniques, including a variety of debt/equity packages, is becoming commonplace as the economy continues to struggle. The income tax consequences associated with these so-called investment units can be significant (and complex when the OID rules are involved) and should be carefully considered by both parties when negotiating the terms of the debt instrument and equity right package.