Debt issued with warrants.
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)).
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 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. 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 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 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 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 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 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, 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 Custom Chrome, is on grant. Additionally, a literal reading of Sec. 1273(c) requires the investment unit's issue price to be allocated between the relative FMVs at issuance. The IRS supported this position in TAM 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 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 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, 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 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 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 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 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, MONTGOMERY COSCIA GREILICH LLP, DALLAS, TX (NOT AFFILIATED WITH PKF)
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|Publication:||The Tax Adviser|
|Date:||Nov 1, 2003|
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