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Favorable Rev. Rul. on contingent convertible bonds.

In Rev. Rul. 2002-31, the IRS concluded that a convertible debt instrument issued with contingent interest that is neither "remote nor incidental" is subject to the Regs. Sec. 1.1275-4(b) contingent-payment-debt-instrument (CPDI) rules. This regulation, known as the "noncontingent bond method" allows an issuer to accrue an original issue discount (OID) deduction at a yield "comparable" to that of a fixed-rate instrument with similar terms and conditions, but without contingencies. As a result, the interest deduction on a contingent convertible is much higher than that of a regular convertible instrument. Better still, the tax deduction is much higher than the interest expense accrued for financial statement purposes.

Holders of a contingent convertible debt instrument, however, must accrue OID into income at the higher yield without receiving cash payments, regardless of their accounting method. On conversion, the holder must also include as ordinary income the excess of the fair market value (FMV) of the stock it receives, over the basis in the debt instrument (i.e., the amount paid for the debt, plus any accrued, but unpaid, OID).


Corporations have long issued bonds convertible into an issuer's or a related-party's stock. Because of the conversion feature, holders accept a lower yield on the convertible bonds than on other bonds. For Federal income tax purposes, the debt's conversion feature is ignored; interest accrues at the debt instrument's overall yield based on the stated interest rate and any OID. At conversion, the holder does not recognize any income, and the issuer cannot deduct as interest the excess of the stock's FMV over the debt's adjusted issue price (i.e., original issue price plus accrued, but unpaid, OID). The holder's basis in the convertible debt becomes the stock's basis, even though the stock's FMV is higher at conversion. This difference will be taxed (generally at capital-gain rates) as income to the holder when the stock is sold.

The Regs. Sec. 1.1275-4 rules for contingent-payment debt instruments apply to instruments issued after Aug. 12, 1996. Such instruments issued for cash ate subject to the Reg. Sec. 1.1275-4(b) non-contingent-bond method, which allows an issuer to deduct, and requires a holder to include, potential contingent interest before it becomes fixed. The issuer has to determine a "comparable" yield (i.e., the yield on a similar, but non-contingent debt instrument), and construct a projected payment schedule that reflects that yield. The difference between actual and projected payments is an adjustment to interest income or expense. All interest on a debt instrument subject to this method is considered OID; any income to holders on disposition of the debt instrument is ordinary.

Traditional convertible debt is not subject to the CPDI; see Regs. Sec. 1.1275-4(a) (4). Recently, some taxpayers have issued convertible instruments that also pay contingent interest. Depending on the product, the contingent interest may be based on dividends on the underlying stock or on changes in the Treasury rate, the issuing corporation's nonconvertible borrowing rate of the convertible instrument's value.

Rev. Rul. 2002-31 confirms that the Regs. Sec. 1.1275-4(b) non-contingent-bond method applies to these instruments (at least under the regulation's particulars). It also offers guidance on how to determine comparable yield. Although not extensively addressed, the ruling does not apply the Regs. Sec. 1.1275-2(g) anti-abuse rules. Finally, it discusses the potential interest-deduction-disallowance rules of Secs. 163(1) and 249, finding these inapplicable under the ruling's facts.

Debt Instrument

Rev. Rul. 2002-31 describes a 20-year, zero-coupon bond that a corporation issued for cash at 62.5% of par. (The bond's effective annual yield was 4.75%, compounded semi-annually.) The holder may convert the bond at any time into a set number of shares of common stock, which on the issue date had a FMV significantly less than the bond's issue price. The ruling noted that the yield for a fixed-rate, nonconvertible debt issued by the corporation would have been 7%.

Starting in Year 4, the bond will pay contingent interest for the six-month period ending June 30 or December 31, if its average market price during a "measurement period" before the six-month period was greater than 120% of its accreted value. (The accreted value is the issue price plus the economic accrual of the discount.)The contingent interest is the greater of (1) the regular cash dividend for the six-month period multiplied by the number of shares into which the debt instrument may be converted or (2) a stated percent of the bond's average market price for the measurement period.

After three years, the issuer may redeem the bond for cash at its accreted value. Also, at the start of Years 4 and 11, the holder may put the bond to the corporation for an amount equal to the accreted value. If the holder exercises this option, the corporation could satisfy its obligation with cash, shares of its own common stock or a combination of these.

Treatment of Contingent Convertible Instruments

Rey. Rul. 2002-31 holds that the contingent-interest component subjects the convertible instrument to the Regs. Sec. 1.1275-4 CPDI rules. It specifically states that the contingent interest is neither a "remote nor incidental" contingency within the meaning of Regs. Sec. 1.1275-2(h). If a contingency is either of these, the rules would not apply; see Regs. Sec. 1.1275-4(a)(5). The ruling, however, does not discuss the likelihood or possible amounts of contingent interest. Thus, its characterization of the contingency as neither remote nor incidental offers little practical guidance.

The contingent debt is issued for cash; interest is accrued using the Regs. Sec. 1.1275-4(b) non-contingent-bond method, under which the issuer determines a comparable yield on a fixed-rate debt instrument. In general, interest will accrue on the debt instrument at this yield, with subsequent adjustments if the actual payments differ from the payment schedule.

Under Regs. Sec. 1.1275-4(b)(4)(i)(A), comparable yield is that at which the issuer would issue a fixed-rate debt instrument with terms and conditions similar to those of the contingent payment instrument (but not lower than the relevant applicable Federal rate). Relevant terms and conditions include the level of subordination, term, timing of payments and market conditions.

Rev. Rul. 2002-31 held that the comparable yield was based on the yield of a comparable fixed-rate, nonconvertible instrument. Thus, the exception to the CPDI rules for convertible bonds applies if the conversion feature is the only contingency If there are others, the conversion feature is treated as any other contingency. Moreover, the projected payment schedule is determined by including the stock to be received on conversion as a contingent payment.

Before the ruling, practitioners had debated whether the Regs. Sec. 1.1275-2(g) anti-abuse rules could apply to these instruments. The anti-abuse rule allows the Service to depart from or to modify the regulations under Secs. 163 and 1271-1275 if the result reached in applying the regulations is unreasonable in light of their purpose. Rev. Rul. 2002-31 concludes that subjecting a contingent-interest convertible debt to the Regs. Sec. 1.1275-4(b) non-contingent-bond method, and then subsequently applying the comparable-yield rule, is not unreasonable in light of Sec. 163. However, the ruling appears to be of little help in evaluating such products without knowing the specific facts.

Sec. 249

Sec. 249 will limit the deductibility of a payment made by the issuer to repurchase debt convertible into the issuer's stock (or that of certain controlled corporations) if the payment exceeds the adjusted issue price, plus a normal call premium for nonconvertible bonds. Regs. Sec. 1.249-1 (d) provides that, in general, a call premium is a normal call premium if it does not exceed the interest for a comparable nonconvertible obligation for the tax year of repurchase.

In Rev. Rul. 2002-31, Sec. 249 applied only to premiums paid to repurchase a convertible debt instrument, and thus did not affect the issuer's ability to deduct interest accruals under the debt, based on the comparable yield. Sec. 249, however, would apply on a conversion into stock having a FMV over the debt's adjusted issue price. Such excess would be allowed only to the extent it does not exceed a normal call premium under Regs. Sec. 1.249-1(d), or if the issuer can otherwise demonstrate that it is attributable to the cost of borrowing and not to the conversion feature.

Sec. 163(1)

Rev. Rul. 2002-31 also concluded that Sec. 163(1) did not apply to the contingent convertible debt, even though the debt instrument will be paid in stock on conversion or may be paid on exercise of a put by the holder (at the issuer's option).

Under Sec. 163(1), no deduction is allowed for interest paid or accrued on a disqualified debt instrument, which is any debt of a corporation payable in the issuer's or a related-party's equity. Debt is treated as payable in the issuer's equity if a substantial amount of the principal or interest must be determined by reference to that equity's value. Principal or interest is treated as required to be so determined if it may be required at the holder's option and there is a substantial certainty that the option will be exercised.

The ruling concludes that it is greatly uncertain whether a substantial amount of the principal or interest on the debt instrument will be required to be paid in stock or payable in stock at the corporation's option. This conclusion is consistent with the Sec. 163(1) legislative history, which states that it is not expected to affect debt with a conversion feature if the conversion price is significantly higher than the stock's FMV on the debt's issue date; see H. 1Kep't No. 105-220, 105th Cong., 1st Sess. 523-24 (1997), 1997-4 (Vol. 2) CB 1993-94.

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Author:Sair, Edward A.
Publication:The Tax Adviser
Date:Mar 1, 2003
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