Some convertible debt instruments have come under fire

Some convertible debt instruments have come under fire | Norton Rose Fulbright

December 01, 2001 | By Keith Martin in Washington, DC

Lee Sheppard, a writer read by many tax policymakers in Washington, urged the Treasury Department in November to prevent borrowers from deducting more than the stated interest rate on loans that the lender can convert into shares in the borrower.

Many corporations have been issuing zero coupon or other debt with a stated interest rate that is below the current market rate. The lender has a right to convert into common shares of the borrower, thereby making up for the lower interest. The loans are structured intentionally with contingent features that increase the stated interest paid in certain events. This has the effect of causing the instruments to be treated as having been issued at a discount for US tax purposes. The result is the borrower can deduct not just the stated interest it actually pays, but also deduct the discount as it accrues over time. Some borrowers also deduct the premium paid at conversion into shares as additional interest.

The loans go by such names as LYONs.

Sheppard suggested four ways the government can deny interest deductions on the instruments and urged the US Treasury to act quickly before corporate America is awash in such instruments.

According to Investment Dealer’s Digest, “$77.4 billion in new converts had priced as of October 17, a record-smashing number.” The number of convertible bonds issued in the first two weeks of October was $4.1 billion.

Keith Martin