Innovative financial products: tax aspects; a glossary of financial instruments.

Wall Street's new products departments were hard at work in 1990 developing financial instruments designed to meet the unique needs of their clients in a rapidly changing economic environment. In many cases, the tax treatment associated with the instrument determines its viability; thus, a high degree of certainty about tax consequences often is a prerequisite to launching a new product. This year's innovative instruments possess this characteristic, explored here.

Accrual debentures. In 1989, Congress created a category of instruments dubbed "applicable high-yield discount obligations" (HYDOs), on which substantial tax penalties are imposed. HYDOs, popularly known as junk bonds, exceeding five years.

1. A exceeding five years.

2. A yeild to maturity equal to or greater than 500 basis points over the applicable federal rate.

3. A significant original issue discount (OID).

In light of this last element, it is clear that Congress's specific target was the deferred interest instruments that figured so prominently in the leveraged buyout boom of the late 1980s. Thus, as was typically the case with these LBO instruments, significant OID exists when, as of the close of any accrual period ending more than five years after the bond's issuance date, the amount included in a holder's income (both stated interest and OID) exceeds the interest amount paid by more than the product of the bond's issue price and the bond's yield to maturity.

When HYDO status exists, the OID on the bond is bifurcated into qualified and disqualified portions. The latter segment is equal to the lesser of (1) the entire amount of OID or (2) an amount that bears the same ratio to the bond's total return as its disqualified yield bears to its total yield. Disqualified yield, in turn, is the excess of total yield over the applicable federal rate plus 600 basis points. The 1989 tax code revisions provide that no tax deduction is available for the disqualified portion of OID (and, for corporate holders of the instrument, the income attributable to such disqualified portion is eligible for a dividends-received deduction), whereas the qualified portion is not deductible as it accrues but, instead, only as it is paid in cash or property other than the issuer's stock or debt.

How, then, as an issuer achieve the seemingly incosistent goals of immediate tax deductions together with deferred payments of interest? The answer lies in the third prong of the HYDO definition, significant OID, which exists only if on a "testing date" the amounts included in income exceed the amount of interest actually paid. However, because the first testing date occurs no earlier than five years and six months after issuance, a bond that accrues interest through that date--with the accumulated interest paid on such date--avoids HYDO characterization.

Such bonds, known as accrual debentures, were used successfully by Container Corporation to avoid the strictures imposed by Congress on LBO debt paper.

Credit-sensitive debentures. These instruments are designed to protect the investor against a downgrading of the issuer's credit rating and reward the issuer when its rating improves. Thus, a base interest rate is provided, which is adjusted upward or downward periodically to reflect the movements in the issuer's creditworthiness.

For tax purposes, an investor includes as interest income, in accordance with its method of accounting, an amount equal to the stated bond interest. If adjustments are made to reflect an alteration in credit rating, the investor is governed by the rules dealing with contigent interest. The rules require the holder to include contingent interest (and the issuer to deduct an equivalent amount) in the year in which the payment amount becomes fixed. For cash-basis investors, these bonds impose accrual accounting principles when the credit-sensitive adjustment is fixed in a year that precedes the year in which the adjustment amount is remitted. Nevertheless, judging by their popularity, the downside to this instrument is outweighed by the fact that a holder will not suffer the erosion of principal usually resulting from a drop in the issuer's credit standing.

Exchangeable debentures. These debentures resemble convertible debentures but, instead of being convertible into issuer's stock, they are convertible into portfolio stock of an investee owned by the issuer. For the issuer, an interest savings is garnered by the "equity kicker" provided by the bond's option element. The best results are attained when the debt pertains to a stable issuer and the underlying stock can be characterized as volatile.

Although for tax purposes the conversion of a convertible debenture into the obligor's stock is not currently taxable, this rule does not apply to an exchangeable debenture conversion. The Internal Revenue Service concluded that gain or loss is recognized on such an exchange because the bonds and stock are issued by separate corporations. Thus, the investor will generate a taxable capital gain or loss on the conversion transaction. The issuer, in turn, will be treated--on delivery of the underlying stock--as satisfying a liability with appreciated property and viewed as though it sold the stock for an amount equal to its fair market value and then retired the debenture for an equivalent amount. The net result of these tax fictions is a capital gain from the sale of the investee stock together with a bond retirement premium deduction for the amount by which the fair value of the discarded stock exceeds the issue price of the bond.

Exchangeables are exceedingly popular for issuers holding portfolio investments, because an issuer receives an immediate cash infusion (the bond proceeds) and is able to defer the associated tax liability until the stock is delivered in satisfaction of the bond. In effect, an issuer achieves the benefits of an installment sale (together with monetization of the accompanying installments obligation) in contravention of the prohibitions on installment sale treatment for publicly traded stock.

An issuer also may receive more subtle benefits. If the portfolio stock has a holding period that began before July 19, 1984, the issuer may enjoy a full dividends-received deduction for investee dividends, even though under section 246A such stock has been converted to debt-financed portfolio stock. The dividends-received deduction normally is reduced by a percentage corresponding to the percentage of the stock basis considered debt financed. This rule, however, is inapplicable for stock with a holding period that precedes section 246A's enactment date. Further, it is possible to enhance interest deductions through the creation of an OID, which exists if the issuer is permitted to allocate a part of the debenture's issue price to the bond's exchange feature. The OID regulations appear to permit such a strategy in prohibiting such an allocation only when the bond is convertible into the issuer's own stock.

Contingent value rights. CVRs are price protection rights that often are issued to a target corporation's shareholders in a business combination. The most prominent example involves the CVRs issued by Dow Chemical in connection with its acqusition of Marion Laboratories. Such instruments, which trade seperately from the associated stock, provide for the payment of an amount geared to the amount by which the stock price falls below a specified level. For tax purposes, the principal question is whether CVRs are debt instruments or cash settlement put options.

If a CVR is a debt instrument (defined in the OID regulations as a right to deferred payments under a contract), the amount paid in its retirement, in excess of its issue price, is treated as interest income. This can be unfavorable for the holder because, if the CVR has appreciated in value, its associated stock probably has suffered a corresponding value decline. An investor may be saddled with interest income (from the CVR) and a capital loss (from the stock). Since such losses can be offset only against capital gains, an investor is not "made whole" (from the tax point of view) until he or she can generate capital gains to absorb the loss. Conversely, an issuer prefers debt instrument classification because such status provides it with an ordinary interest deduction for CVR payments in excess of issue price.

If, instead, put portion treatment prevails, a different tax regime applies. CVR payments will generate capital gain or loss for both the issuer and the holder. Here, however, a holder of both the stock and the associated CVR will find himself or herself governed by the tax laws' "straddle" rules. A straddle has been created because the investor possesses offsetting positions (whole values vary inversely) in actively traded personal property. Although straddle status is limited in the case of stock, this designation is imposed when, as here, the offsetting position is an option pertaining to such stock. The existence of straddle subjects the investor to a battery of restrictions. Interest and carrying charges allocable to a straddle position have to be capitalized rather than deducted. Also, each straddle component's holding period cannot begin until the straddle ceases to exist. Finally, a loss derived from a position cannot be deducted to the extent it exceeds the unrealized gain existing in the companion position. It seems clear in light of revenue ruling 88-31's conclusions, that the IRS regards a CVR as a case settlement put option. It therefore seems likely capital gain or loss will result from a CVR investment and the straddle rules will pertain to a CVR holder who has established a position in the associated stock.

Indexed debentures. The tax law prohibits a deduction for a premium paid to repurchase convertible debentures to the extent the premium exceeds a "normal" call premium on comparable nonconvertible instruments. For this purpose, a convertible instrument is one that is convertible to the issuer's stock or the stock of an 80%-or-more-owned subsidiary. Moreover, a normal call premium is a premium specified in dollars under the terms of a comparable nonconvertible instrument or of the convertible instrument, provided the latter figure does not exceed an amount equal to one year's interest. The rule's goal is to prevent a taxpayer from obtaining a deduction for payments attributable to the bond's conversion feature, as opposed to the cost of borrowing. Since deductions are not available for amounts paid in connection with a stock repurchase, Congress thought it appropriate to extend this prohibition to payments attributable to a "stock equivalent," the conversion feature of convertible debt.

However, an indexed debenture avoids these strictures. Such a debenture is nonconvertible and, instead, provides for cash payments on conversion equal to the value of the stock that serves as the index for such payments. An example is the Walt Disney Co. debentures that provide for payments equal to the U.S. dollar equivalent of the trading value of a specified number of shares of Disney's 49%-owned affiliate, Euro Disneyland. Quite clearly, these payments--to the extent they are in excess of the bond's adjusted issue price--will be eligible for a deduction because the bond simply is not a convertible instrument. Even though such premium payment is not strictly attributable to the borrowing cost, deductions are nevertheless available because the tax law mechanism designed to prevent them (the convertible bond retirement premium rule) is inapplicable.

Self-liquidating preferred stock. In an attempt to cure their capital impairment problem, banks have begun to issue a variety of preferred stock that possess a liquidation preference substantially below its issue price. The excess of such issue price over the liquidation preferences can be credited by the bank to its primary capital accounts.

For tax purposes, however, this type of equity (self-liquidating preferred stock), has penalties that are visited on the corporate investor. Thus, self-liquidating preferred is equity for which there is an excess of issue price over liquidation value (or redemption price) or that features a dividend rate that declines (or can reasonably be expected to decline, such as adjustable rate preferred) over the instrument's life. In these cases, all dividends remitted to the stock are characterized as extraordianry. This is true, moreover, even though the law usually carries an exception to the extraordinary dividend rules for qualified preferred dividends that often would be available to self-liquidating preferred holders. An extraordinary dividend characterization means the corporate stockholder will forfeit the benefit of the 70% dividends-received deduction, because the nontaxed portion of an extraordinary dividend (an amount equal to such deduction) must be applied to reduce the stock basis on which the dividend was paid. When the stock is sold, a larger gain (or smaller loss) results so that, as a practical matter, the benefit of the dividents-received deduction is recaptured. Typically, such stock trades at a higher pretax yield in recognition of this decidedly negative tax feature.

U.K. preferred. When a corporation in the United Kingdom pays a dividend, it also

U.K. PREFFERED MECHANICS
Nominal dividend:             $ 7.50
ACT                             2.50
                              $10.00     (Amount U.S. investor
                                          reports on tax return)
Witholding tax                -$1.50
Net receipt                   $ 8.50
Precredit tax liability       $ 2.80     (28% of $10)
Foreign tax credit           -  1.50
Net tax liability             $ 1.30
Aftertax receipt              $ 7.20     (Net receipt/net tax
                                          liability)
Effective tax rate                     4% (Aftertax receipt/
                                          nominal dividend)

must remit to the government a so-called advance corporation tax (ACT) currently assessed at a rate equal to one-third of the dividend amount. U.S. investors, however, are entitled to a refund of the ACT, net of a 15% withholding tax that constitutes an income tax eligible to be credited against the portion of the recipient's U.S. tax liability attributable to the dividends. In light of this feature, U.K. preferred generally provides an investor (who is able to credit the withholding tax fully) with an aftertax yield some 80 to 90 basis points over that available for comparable money market instruments. Moreover, to ensure that the stock trades at its par value and to ensure comparability vis-a-vis money market alternatives, the dividend rate for U.K. preferred generally is reset (through an auction or remarketing mechanism) every 28 days. The mechanics of U.K. preferred are shown in the sidebar at left.

"Buffer" debenture. Institutional investors are loathe to invest in master limited partnerships (MLPs) because of a 1987 tax law change providing that net income derived from a MLP unit would be considered (regardless of its source) unrelated business taxable income, a characterization resulting in a tax liability to the extent such income exceeds $1,000 in any year.

Nevertheless, such a unit can be sold effectively to an institution of it is wrapped in a different package. Accordingly, SFP Pipeline Holdings, Inc. recently sold variable coupon debentures to institutional investors. These debentures are exchangeable (at maturity) into Holdings' 44% interest in a MLP and--more important--pay interest at a variable rate that is premised (subject to a ceiling and floor) on the distributions Holdings receives from such MLP. Moreover, to ensure such debentures will trade in a manner equivalent to the underlying MLP units, no exchange premium was placed on the debentures. Thus, the institutional investor can indeed participate in the MLP market, provided such MLP units are encased within a buffer debenture package.

This sampling of 1990 innovations attests to Wall Street's ingenuity in tailoring instruments to the needs of clients and the investing public. Although taste tends to gravitate toward "plain vanilla" instruments in periolous economic environments, unique circumstances always will be served best by financial products geared to meeting specific needs.

ROBERT WILLENS, CPA, is senior vice-president of Lehman Brothers, New York City. He is a member of the American Institute of CPAs, the New York State Society of CPAs and the Wall Street Tax Association.