Issuing stock warrants or other property may produce additional interest deductions for borrower.

Corporate debt obligations frequently are issued with warrants, stock options or other property that provides the lender with a fixed return on the debt obligation along with the potential for sharing in the appreciation in the value of the borrower's stock. This type of arrangement typically is used by venture capitalists in mezzanine financing arrangements and by private lenders. From the borrower's perspective, issuing warrants or other property can reduce the loan's interest rate. Also, if the borrower's business is too risky, the use of warrants or other property may be necessary to obtain a loan at a reasonable interest rate. In addition, the use of warrants may provide an infusion of equity into the borrower's business when they are exercised.

When this combination of a debt instrument and a warrant, option, security or other property is issued together as an investment unit, the borrower may obtain greater interest expense deductions under the original issue discount (OID) rules.

(While the OID rules are not limited to lending transactions, the ensuing discussion is confined to the application of the OID rules to a lending transaction in which the lender also receives additional property or rights from the borrower.)

Sec. 1273(a) (1) defines OID as the excess of the stated redemption price at maturity over the issue price. Under Regs. Sec. 1.1273-2(h), an investment unit is treated as if the entire unit were a debt instrument, with the issue price allocated between the debt instrument and any other property (such as a warrant or option) based on their relative fair market values (FMVs); see also Sec. 1273(c) (2).

Example: X Corporation wishes to borrow $500,000 from Lender. The debt obligation requires X to pay 9% simple interest. During the loan's term, interest only is payable on the loan's anniversary date for five years ($45,000 annually) and the entire $500,000 principal is due at the end of five years. Additionally, Lender receives warrants to purchase 10,000 shares of X's common stock. Neither the debt instrument nor the warrants are traded publicly. Lender normally would require a 16% rate of return on the loan if the warrants were not issued with the debt instrument.

Together, the debt instrument and the warrants are an investment unit. For purposes of the OID rules, the issue price of the investment unit is allocated between the debt instrument and the warrants based on their relative FMVs.

If either component of the investment unit is publicly traded, the issue price may be allocated in a fairly straightforward manner by first allocating it to the publicly traded portion of the investment unit, with any remainder allocated to the nonpublicly traded portion.

Allocating the issue price becomes much more difficult if none of the investment unit's elements are publicly traded. In the example, allocating the $500,000 issue price between the debt instrument and the warrants might be made by discounting the cash flows required under the debt instrument, using the 16% interest rate that would have been demanded by Lender if it had not received the warrants. The present value (PV) of these cash flows is as follows:

PV of $45,000
 interest payments
 payable once a year
 for five years on
 the loan's
 anniversary date            $147,343.21

PV of $500,000
 principal payable
 at the end of five years     238,056.51

Total PV of the cash flows
 resulting from the
  debt instrument            $385,399.72

Therefore, the investment unit's $500,000 issue price might be allocated: $385,399.72 to the debt instrument and the remaining $114,600.28 to the warrants. Because the $500,000 stated redemption price of the debt instrument at maturity exceeds its issue price of $385,399.72, it contains $114,600.28 of OID. Consequently, X should be entitled to annual interest deductions for OID accruing on the debt instrument--as well as the $45,000 of interest paid each year.

Regs. Sec. 1.1273-2(h) (2) provides that the borrower's allocation of the issue price is binding on the lender unless the lender attaches a disclosure statement to its timely filed income tax return for the year of acquisition of the investment unit. The disclosure must explicitly indicate that the lender's allocation is different from the borrower's allocation.

In addition, Regs. Sec. 1.1275-2(e) requires the borrower to provide relevant information to the holder of the investment unit in a reasonable manner to enable the holder to comply with the OID rules. Regs. Sec. 1.1275-3 also prescribes information reporting requirements to facilitate OID reporting. Generally, the issuer/borrower must either:

* Set forth on the face of the debt instrument the issue price, the amount of OID, the issue date and the yield to maturity; or

* Provide the name or title and either the address or telephone number of a representative of the issuer who will make this information available on request.

In addition, if a debt instrument is not publicly offered, it must contain a written legend on its face stating that the debt instrument has been issued with OID. This legend is not required while the original holder owns the instrument. However, if the original holder disposes of the debt instrument, the legend is required at that time.

Temp. Regs. Sec. 1.1275-2T(g) contains an anti-abuse rule that allows the IRS to apply or depart from the regulations to achieve a reasonable result, if a principal purpose in structuring a debt instrument, engaging in a transaction or applying the regulations under Sec. 163(e) or Secs. 1271 through 1275 is to achieve a result unreasonable in light of the purpose of the applicable statutes.

Today's creative financing techniques require tax professionals to be aware of the regulation affecting investment units. More and more businesses are entering into these types of arrangements to lower their borrowing costs or to obtain loans that could not otherwise be procured due to the high risk involved with the venture. These rules generally allow the borrower to recognize greater interest expense deductions due to the OID resulting from allocating a portion of the issue price to the warrants or other property issued with the debt instrument.