Warrants issued to customers.

During the 1980s and 1990s, some equity prices became severely inflated; consequently, many companies looked for ways to capitalize oil their increased share price by using their stock as currency. One idea was to issue customers warrants to motivate them to purchase a certain amount of product. This effectively gave the customer the potential to realize a significant discount on products purchased and provided a seller the means to offer a purchase incentive. The IRS and taxpayers have disputed the appropriate tax treatment of these warrants--while taxpayers argue they should be treated as sales discounts, the IRS claims they should be capitalized.

Purchase/Sales Discount

The primary issue is whether the issued warrants constitute (1) a sales discount or allowance excludible from gross sales; (2) an ordinary and necessary business expense deductible under Sec. 162; or (3) an investment by the customer that is neither excludible from income nor deductible. Clearly, amounts excludible from gross income or deductible as ordinary and necessary business expenses may be paid in terms other than cash. For example, warrants issued in connection with debt often create original issue discount deductible under Sec. 163; see Coscia, Tax Clinic, "Debt Issued with Warrants," p. 666, this issue. Employees are often offered stock options as compensation and third-party consultants are often paid via stock, which can be deductible depending on the services rendered.

Cases: Two court cases examined the deductibility of warrants issued to customers. In Sun Microsystems, Inc., TC Memo 1993-467, the taxpayer issued warrants to a customer that were grouped with a note and debentures representing capital transactions, mainly to comply with Federal and state securities laws. The warrants were contingent on the customer purchasing a certain level of product from the taxpayer.

The Tax Court concluded that the negotiations between the two parties clearly showed the warrants were included as an incentive to purchase product, not as a capital item. The court rejected the argument that the warrants were included in an agreement with a note and debentures, as this merely facilitated securities law requirements. Additionally, the customer did not ultimately own any stock; the warrants were sold to a third party who immediately exercised them. The court noted that the customer "did not intend to purchase or hold the stock of...[Sun]...if the Stock Warrants became exercisable and had value...."

In Convergent, Technologies, TC Memo 1995-320, the taxpayer also offered warrants as a customer incentive. Customers were required to purchase a significant amount of product and the warrants' terms varied according to each purchase. The taxpayer's counsel drafted the warrant agreements separately from the product purchase agreement, for three reasons. First, its counsel was familiar with the format in loan and warrant transactions. Second, the taxpayer wanted to be able to resist customer attempts to renege on the product purchase agreement if the taxpayer's stock did not increase in value. Third, the warrants were drafted to meet certain private-placement requirements.

The Convergent Technologies court followed the same analysis used in Sun and based a portion of its opinion on its reasoning. The two cases are similar, except that the warrants in Convergent Technologies were issued as separate agreements; the ones in Sun were issued together with other capital items.

The IRS argued that the warrant agreement's language, stating that the warrants were "entirely separate and independent" from the purchase agreement and did not "constitute additional consideration" for the purchase of product, showed that the warrants were not issued solely as a customer inducement. The court concluded that the warrant agreement made it more difficult for the two parties to refuse to carry out the purchase agreement on the basis that the warrants had not become valuable, providing further support for the direct relationship between the warrants and the purchases. Accordingly, the court concluded the warrants were excludible from income as a sales discount.

INDOPCO Issues

In Sun, the court considered whether the warrants should be attributed to the development of a long-term customer relationship and capitalized in accordance with INDOPCO, Inc., 503 US 79 (1992).The court concluded that the warrants were clearly included as an incentive to purchase a large amount of product.

IRS Positions

The IRS issued two undated Field Service Advices on the taxability of warrants issued to a customer. In FSA 1999-1166, it concluded that the stock warrant transactions resulted in capital expenditures, not deductible business expenses. The IRS stated there that the warrants were issued to induce a continuing business relationship, which, under INDOPCO, required capitalization. The FSA's facts are similar to those in Convergent Technologies (and probably relate to the same taxpayer).

In FSA 1999-1168, the IRS examined whether warrants issued to a customer represented sales discounts or were capital expenditures to establish a long-term business relationship and enable the taxpayer to represent itself as a credible supplier of product for large customers. The facts are' the same as those in Sun (and are more than likely the same taxpayer). The IRS stated that it was arguable whether the issuance of the warrants was a capital expenditure rather than a sales discount, but that further facts were needed.

Additionally, the IRS concluded that if the warrants are sales discounts, Sec. 1032 should not preclude a Sec. 61 adjustment to gross sales. Sec. 1032(a) states that a corporation does not recognize gain or loss on the receipt of money or other property in exchange for its stock. In 1984, Sec. 1032 was amended to provide that a corporation does not recognize gain or loss oil any lapse or acquisition of an option, or on a securities futures contract, to buy or sell its stock (including treasury stock). The warrants in both FSAs and court cases were issued before this amendment.

The IRS concluded in FSA 1999-1168 that Sec. 1032 does not prevent a taxpayer from claiming a deduction otherwise allowable. This followed the decision in Duncan Industries, Inc., 73 TC 266 (1979), in which the court held that Sec. 1032's enactment did not alter the well-settled rule that the fair market value (FMV) of stock is deductible as a business expense if the payment of cash would have resulted in a deduction. Further, the amendment to Sec. 1032 does not modify the longstanding position that it has no effect on business expenses otherwise deductible under Sec. 162.

Sec. 1032 bans a corporation from recognizing gain or loss on the receipt of money or other property in return for its stock, but does not consider the tax consequences of a corporation's payment of stock or options. Those situations are governed by other Code provisions.

Example: A provides accounting services to X Corp. valued at $1,000. X pays A by giving him 1,000 shares of X, with a $/0 par value. X would be allowed a $1,000 deduction if the services are not otherwise capitalizable under the Code (e.g., they do not relate to an acquisition). X does not recognize $990 gain, the amount by which its stock exceeds its par value.

Even though the courts say that the warrants should be considered sales discounts, the IRS may contend otherwise, depending on whether the taxpayer is the seller or the customer. In Computervision International Corp., TC Memo 1996-131, the IRS argued that the warrants the taxpayer received were in the nature of purchase discounts, the value of which should be treated as a reduction in cost of goods sold. The taxpayer argued the warrants generated a capital loss. The warrant transaction was the same transaction as in Sun (Computervision was Sun's customer). Of course, the court held for the IRS.

Value of Warrants

In Convergent Technologies, the court determined when the warrants should be valued, at exercise or when exercisable. In either case, the proper time for valuing the warrants under Sec. 461 is when all events have occurred that determine the fact of a liability and the amount can be determined with reasonable accuracy.

The taxpayer argued the warrants should be valued when exercisable, as that was when the liability became fixed. It further contended the value of the liability is the difference between the stock's FMV and the warrants' exercise price. The court stated that "the value we are seeking is the actual cost to petitioner of issuing the stock upon the exercise of the warrants, and this value can only be determined on the date of exercise." Accordingly, the court concluded the warrants had to be valued on exercise.

Cancellation

A seller may decide to pay a customer cash and cancel the warrants prior to vesting, or the customer may seek to have the vested warrants cancelled in exchange for cash. Cancellation should not affect whether the warrants are sales discounts or deductible expenses.

A customer's request to cancel the warrants is a mere formality to facilitate monetization and is basically an exercise and sale a the saute time. The customer could .just as easily exercise the warrants and sell the stock on the open market or back to the taxpayer. In that case, the taxpayer would deduct the cost of the warrants at the time of exercise, but not the cost of the stock repurchased.

Additionally, amended Sec. 1032 still does not apply; it has no effect on otherwise allowable deductions. See. 1032 was enacted to bar companies from recognizing income from other transactions in their own stock. The Committee Reports on Sec. 1032's amendment state "...a corporation does not recognize gain or loss on any lapse or repurchase of a warrant it issued to acquire its stock."

If the seller cancels a nonvested warrant in return for payment, it is fulfilling a pre-existing obligation that is otherwise deductible. The IRS may attempt to argue the amount paid to cancel the warrant is in excess of its FMV, thereby precluding a portion of the claimed deduction under Sec. 1032. However, warrants have both time value and intrinsic value. Time value is often difficult to determine. If the cancellation price is determined by two unrelated parties at arm's length, it should sustain scrutiny and be deductible in full.

Conclusion

Taxpayers that issue warrants to customers should review their agreements to determine if they can support exclusion as a sales discount or deductibility as a trade or business expense. Warrants primarily issued to induce a customer to purchase product are probably deductible. Vesting should be tied to the amount of product purchased.

Having separate warrant agreements should not taint deductibility, as a separate agreement will most likely be required for securities law purposes. Most often, specific language in the warrant agreement is needed to fulfill securities law obligations and should not override the parties' intent. Customers who receive warrants in return for a commitment to purchase a minimum amount of product have probably received an asset creating a purchase discount, rather than one creating capital gain.

FROM MATTHEW COSCIA, CPA, MONTGOMERY COSCIA GREILICH LLP DALLAS, TX (NOT AFFILIATED WITH PKF)