Debt issued with warrants.
With interest rates at historic lows, many companies are taking advantage of the low cost of capital and issuing debt Some closely held companies Closely held company
A company who has a small group of controlling shareholders. In contrast, a widely-held firm has many shareholders. It is difficult or impossible to wage a proxy battle for any closely-held firm. are "buying down" rates by issuing stock warrants with their debt. Alternatively some companies are replacing debt previously issued with warrants, to finance capital at a lower interest rate.
Stock warrants (which are essentially the same as stock options) allow a holder to purchase the issuer's stock at an exercise price within a defined period Warrants are an attractive way to allow lender to potentially increase its overall return on debt otherwise issued at lower interest rate. From the borrower" perspective, warrants lower the cost o capital, by obtaining debt at a lower rate than otherwise available. A question arises as to the tax treatment of the debt instrument and the warrants (i.e., the "investment unit" and the associated original issue discount (OID (1) (Object IDentifier) A permanent number assigned to an object for storage (persistence). It is typically a long integer, such as 128 bits, that can be computed using various methods to create a unique number. )).
Sec. 163(e)(1) provides that in the case of any debt instrument issued after July 1, 1982, the portion of the OID on such debt instrument allowable as a deduction to the issuer for any tax year equals the aggregate daily portions of the OID for the days during such tax year. Sec. 1273(a)(1) provides that OID is the excess of the stated redemption price Redemption price
See: Call price
1. The price at which an open-end investment company will buy back its shares from the owners. In most cases, the redemption price is the net asset value per share.
2. at maturity over the issue price. Sec. 1273(a)(2) defines the stated redemption price at maturity as the amount fixed by the last modification of the purchase agreement and includes interest and other amounts payable at that time (other than interest based on a fixed rate and payable unconditionally at fixed periodic intervals of one year or less during the debt instrument's entire term).
Sec. 1273(c)(2)(A) and (B) provide that (1) an investment unit's issue price is determined under Sec. 1273(b) as if it were a debt instrument and (2) the issue price should be allocated between the debt instrument and the warrant based on their relative fair market values (FMVs). Under Sec. 1273(c)(2), an investment unit includes a debt instrument and an option or other property issued together as an investment unit.
For publicly offered debt instruments not issued for property, Sec. 1273(b)(1) states that the issue price is the initial offering price to the public (excluding bond houses and brokers), at which price a substantial amount of such debt instruments was sold. For other debt instruments not issued for property and not publicly offered, Sec. 1273(b)(2) defines issue price as the price paid by the first buyer of such debt instrument. For debt instruments issued for property for which there is public trading, Sec. 1273(b)(3) defines the issue price as the property's FMV FMV - full-motion video . The issue price of all other debt not mentioned above is the stated redemption price at maturity, unless the debt instruments falls under Sec. 1274 (which generally applies to certain debt issued for property). Property includes services and the right to use property, but not money.
When a debt instrument is issued at a face amount greater than the amount loaned, the difference is deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). as OID over the loan's life, under Sec. 163, Because a portion of the issue price is allocated to the warrants, the debt's face amount will be higher than its allocable al·lo·ca·ble
Capable of being allocated.
Adj. 1. allocable - capable of being distributed
distributive - serving to distribute or allot or disperse share of the gross issue price. As such, the OID equals the value of the issue price allocated to the warrants.
Example: A Corp. issued debt with detachable warrants Detachable warrant
A warrant entitles the holder to buy a given number of shares of stock at a stipulated price. A detachable warrant is one that may be sold separately from the package it may have originally been issued with (usually a bond). to individual B for $1,000. The debt's face amount is $1,000. Because a portion of the issue price is allocable to the warrants, the debt will have OID (assuming the de minimis An abbreviated form of the Latin Maxim de minimis non curat lex, "the law cares not for small things." A legal doctrine by which a court refuses to consider trifling matters. rules do not apply).
A question arises as to when the warrants are valued for OID purposes--at the time of grant or exercise? Some tax advisers may conclude that they should be valued at exercise, as required under Sec. 83. They would argue that the (1) warrants' value is certain at that time and (2) Sec. 461 all-events test is otherwise met.
Cases: Custom Chrome, Inc., 217 F3d 1117 (9th Cir. 2000), explored this issue and concluded that warrants issued with debt should be valued when granted, for two reasons. First, the warrants were intended to compensate a bank for additional risk, thereby raising the loan's effective interest rate, and were not intended to compensate it for services. The general rule under Letter Ruling (TAM) 200043013 is that warrants issued in connection with an extension of credit compensate the lender for making a loan, rather than for services. Second, to deduct de·duct
v. de·duct·ed, de·duct·ing, de·ducts
1. To take away (a quantity) from another; subtract.
2. To derive by deduction; deduce.
v.intr. OID ratably over the loan's life, the warrants must be valued at grant.
The taxpayer in Custom Chrome argued that the warrants should be valued at exercise, when their value is certain. The Ninth Circuit concluded that, because the warrants were OID in an integral part of a loan package, they had to be valued at grant. The taxpayer also argued that Regs. Sec. 1.83-7 mandates that when the FMV of options granted is not readily ascertainable at grant, they must be valued at exercise. The court disagreed, concluding that Sec. 83 only applies to options granted in exchange for services, not warrants issued as part of an overall loan package,
In Centel Communications Co., Inc., 92 TC 612 (1989), the taxpayer issued warrants to individuals who guaranteed its debt. The taxpayer claimed a See. g3(h) deduction when the warrants were exercised, but the Tax Court disagreed; it held that the warrants did not fall under that provision, because they were not issued for services, but to compensate the individuals for additional risk.
Other court cases have concluded that the proper time for valuing warrants issued in a non-Sec. 83 context is at exercise. For example, in Convergent Technologies (company) Convergent Technologies - A company formed by a small group of people who left Intel Corporation in 1979. Convergent Technologies' first product was the IWS (Integrated Workstation) based on the Intel 8086, which ran Convergent Technologies Operating System - their first , Inc., TC Memo 1995-320, the taxpayer issued warrants to a customer to induce the latter to purchase products; for more detail, see Coscia, Tax Clinic, "Warrants Issued to Customers," p. 657, this issue. The warrants' value was held to be a sales discount. The court concluded that the warrants should be valued at exercise rather than when exercisable, as this is when the actual cost of issuance is known. Valuing the warrants when exercisable cannot be done with reasonable accuracy, a requirement of Sec. 461(h). Thus, the court reasoned, the all-events test is met on exercise.
The warrants issued in Convergent Technologies, Inc. are distinguishable from warrants issued in conjunction with debt, as the latter creates OID. Became OlD is deductible over the loan's life under Sec. 163, the proper time for valuing those warrants, according to according to
1. As stated or indicated by; on the authority of: according to historians.
2. In keeping with: according to instructions.
3. Custom Chrome, is on grant. Additionally, a literal In programming, any data typed in by the programmer that remains unchanged when translated into machine language. Examples are a constant value used for calculation purposes as well as text messages displayed on screen. In the following lines of code, the literals are 1 and VALUE IS ONE. reading of Sec. 1273(c) requires the investment unit's issue price to be allocated between the relative FMVs at issuance. The IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. supported this position in TAM In Tam (September 22, 1916 - April 1, 2006) is a former Prime Minister of Cambodia. He served in that position from May 6 1973 to December 9 1973, and had a long career in Cambodian politics. 200043013.
Valuing warrants can be difficult. In Monarch Cement Co., 634 F2d 484 (10th Cir. 1980), the court valued the warrants at issue for OID purposes by considering the difference between the interest rate required without the options and that actually used.
In Custom Chrome, the Ninth Circuit stated that,"[t]he problem in valuing the warrants stems from the combination of the general speculative nature of options aid the related difficulty of determining precisely what effect options granted for OID have on a core loan transaction." The court concluded that any well-established and reliable method for determining the value of options may be used in determining the warrants' value, such as (1) comparing the total debt instrument's value to the published values of comparable debt instruments of other issuers; (2) estimating as a multiple of earnings before interest and taxes In financial and business accounting, earnings before interest and taxes (EBIT) is a measure of a firm's profitability that excludes interest and income tax expenses.
EBIT = Operating Revenue – Operating Expenses + Non-operating Income the present value of the portion of the company that may be purchased by exercise of the options; and (3) using the Black-Scholes method.
While warrants may not have a readily ascertainable FMV at grant (a phrase used in Sec. 83(e)(3)), it is quite plausible that they will have a FMV at grant. The term "readily ascertainable FMV" is a higher threshold than FMV. Most property has an FMV, although deriving it with reasonable accuracy may prove difficult. Even warrants with an exercise price below the underlying stock's current market price can have an FMV, as warrants have two types of value intrinsic value Intrinsic Value
1. The value of a company or an asset based on an underlying perception of the value.
2. For call options, this is the difference between the underlying stock's price and the strike price. and time value. Intrinsic value is the difference between the underlying stock's actual price and the exercise price; time value refers to the value of the right to exercise the option in the future. Time value is difficult to determine.
Many nonpublic and closely held companies issue debt with an equity kicker Equity kicker
Stock warrants issued attached to a new debt, preferred or common stock issue to improve the salability of the issue.
equity kicker , such as a warrant. For these companies, valuing warrants may prove more difficult. A valuation expert may be needed to value the warrants at issuance, so that OID deductions may be claimed. Warrants with no value at the time of issuance will result in no deductible OID.
Once a value is determined, the amount should be deductible as OID under Sec. 163(e). The daily portions are determined under Sec. 1272(a), without regard to Secs. 1272(a)(7) and 1273(a). Accordingly, the OID created by the warrants is deductible over the loan's life. If the loan is repaid early or otherwise cancelled, the remaining OID is deductible in full in the year of payoff or cancellation. The lapse (language) LAPSE - A single assignment language for the Manchester dataflow machine.
["A Single Assignment Language for Data Flow Computing", J.R.W. Glauert, M.Sc Diss, Victoria U Manchester, 1978]. or failure to exercise warrants does not affect the amount of OID, which determined when the obligations are issued; see Rev. Rul. 72-46.
A borrower's repurchase re·pur·chase
tr.v. re·pur·chased, re·pur·chas·ing, re·pur·chas·es
To buy (something) again.
The act of buying something that one previously sold or owned.
Noun 1. of a warrant would more than likely result in no gain or loss under Sec. 1032(a), which provides that a corporation recognizes no gain or loss on a lapse or acquisition of an option to buy or sell its stock. Because OID is determined at issuance, a corporation's repurchase of a warrant results in a nondeductible non·de·duct·i·ble
Not deductible, especially for income-tax purposes.
Adj. 1. nondeductible - not allowable as a deduction
deductible - acceptable as a deduction (especially as a tax deduction) capital expenditure. The same is true when a warrant is ultimately exercised.
Given current interest rates, many companies are obtaining loans at relatively low cost. One common type of debt issued (especially by closely held A phrase used to describe the ownership, management, and operation of a corporation by a small group of people.
In a closely held corporation, the same people often act as shareholders, directors, and officers, and no outside investors exist. entities) is debt with an equity kicker, such as a warrant. Warrant should be valued at grant, so that the debtor-company can claim the proper OID deductions under Sec. 163. Valuing the warrants at zero will result in no OID and no deduction.
Some companies might want to consider issuing debt with warrants attached This would allow them to obtain lower interest rates than otherwise available. While the warrants represent a noncash transaction cost, their dilution effect should also be considered.
FROM MATTHEW COSCIA, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , MONTGOMERY COSCIA GREILICH LLP LLP - Lower Layer Protocol , DALLAS, TX (NOT AFFILIATED WITH PKF PKF Peace Keeping Force
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