By Heléna Klumpp

A ruling by the Internal Revenue Service in May suggests that companies would be wise to look into doing their future borrowing using convertible debt instruments and then structuring the debt so that the amount of interest to be paid is “contingent”on future events.

The IRS said borrowers under such instruments can deduct substantially more interest than the stated rate. The extra deductions reduce the cost of borrowing.

A “convertible” debt is one where the lender may end up with shares in the borrower rather than cash.

IRS Ruling

The IRS ruled in May that borrowers under certain contingent convertible debt instruments may take bigger interest deductions than some critics had previously thought possible.

The IRS made its position known in Revenue Ruling 2002-31. The IRS said in the ruling that an issuer of a contingent convertible bond can compute its interest deductions based on the rate at which it would issue straight debt, instead of the rate at which the borrower would issue the same convertible debt without contingencies.

This is important because the interest rates on straight debt are typically much higher than the interest rates on non-contingent convertible debt. The difference is as much as 300 to 400 basis points, even considering the relatively shorter term expected of convertible bonds. The IRS also said that the borrower can deduct interest calculated on any premium it would have to pay if it repaid the debt in shares. Thus, by adding a contingent feature to a convertible debt instrument, a company may be able to increase the rate of its interest deductions significantly, as well as increase the principal amount on which such deductions are calculated.

Convertible Debt

Starting with the basics, a convertible debt instrument is a bond that may be converted into stock of the borrower, generally at set times or under set conditions. In a basic convertible, the conversion ratio is set upon issuance at a fixed amount of shares per bond. The interest will be typically much lower than that of a straight debt instrument because the conversion right adds value.

A contingent convertible debt instrument adds an additional wrinkle: instead of paying fixed, stated interest, a contingent convertible debt instrument provides for payment of interest only if certain conditions are met.

There are many variations in how contingent convertibles are structured. The IRS described one such instrument in its ruling. The instrument in the ruling was issued on January 1, 2002 at a discount from the stated principal amount of $1,000. The borrower pays no current interest. The lender loaned $625 and expects to be repaid $1,000 in 20 years. However, interest will be paid semi-annually beginning in 2005 if the average market price for the instrument measured over a six-month period is greater than 120% of the bond’s “accreted value” at the end of that period. The accreted value at the end of a period is the $625 originally lent plus the amount of the discount that has accrued to date. If interest is payable for any semi-annual period, then the amount of the interest will be the greater of two figures. One is the cash dividend that was paid on the borrower’s stock (multiplied by the number of shares into which the debt instrument could be converted). The other is X% of the average market price of the debt instrument for the six-month period.

On the same date that contingent interest might first be paid (January 1, 2005), the borrower has an open-ended right to redeem the debt instrument for cash equal to its then-accreted value. The lender also has the right, exercisable on two dates — January 1, 2005 or January 1, 2012 — to “put” the debt instrument back to the issuer for an amount equal to the instrument’s accreted value as of that date. If the lender exercises its put, then the borrower has the right to pay the lender in cash, stock, or a combination of the two.

Tax Benefits

The IRS ruling answered the question about the amount and timing of the interest the borrower is allowed to deduct.

The IRS said the borrower should compute its interest deductions using a 7% rate, which is roughly equivalent to the rate at which the issuer would have issued a straight debt instrument. It also said that interest could accrue on the premium the borrower would have to pay if it repaid the debt in shares, which could be significant. In other words, the agency said the borrower should deduct interest — and the lender should report it — at the same rate at which interest would have accrued on a straight debt instrument identical in all respects to the contingent convertible except that it contains no contingencies and is not convertible.

The IRS said this follows from a complicated rule in its “contingent payment debt regulations.”

In the case of a straight debt instrument with fixed interest, the parties accrue interest deductions and income at the stated interest rate, assuming that rate is a market rate. However, when a debt instrument provides for payments that are contingent in time or amount upon some future event, then the parties have a harder time figuring out how much interest to deduct (or, in the case of the lender, to report as income). The contingent payment debt regulations, adopted in 1996, address this issue.

They instruct taxpayers to accrue interest on debt instruments issued for cash using the “hypothetical noncontingent bond method.” This means that the parties must account for interest at the same rate as the yield on a hypothetical bond that does not include any contingencies. The hypothetical bond is deemed to be issued by the same borrower as the contingent bond and is identical in all respects to the contingent bond (except that it contains no contingencies). This hypothetical yield is applied to a projected payment schedule for the actual bond to calculate the amount of each payment that should be considered interest.

A borrower cannot use the contingent debt regulations to determine the amount of interest the borrower can deduct on a plain convertible debt. Thus, the key to getting larger interest deductions is to add contingencies that bring the instrument under the contingent debt regulations. Standing alone, the chance of convertibility is not considered a contingency. The contingency should relate to interest payments.

By pulling a convertible bond into the contingent debt regulations, a borrower could be entitled to take interest deductions that are based on higher-yield fixed obligations.

There is an additional benefit to contingent convertibles: the IRS said that the stock the lender receives upon conversion can be treated as a contingent principal payment that accrues interest.

The convertible debt market is booming. More than $119 billion in convertible debt was issued in 2001, up from $74 million in 2000. Its popularity may be attributable in part to the volatility of the stock market and the pressure that many companies are under from rating agencies to improve their balance sheets. They may be hoping for partial equity treatment on their books.

Of course, where there exists potential for phantom deductions, there is potential for phantom income. The borrower’s interest calculations must be disclosed to the lenders and are binding on any US lender unless the US lender can establish to the IRS that they are unreasonable. However, foreign lenders or certain US lenders who are not subject to US income taxation (tax-exempt organizations, for example) will not care about any phantom US income.

Reservations

The IRS issued a notice at the same time as the revenue ruling that suggests the agency is not entirely comfortable with its conclusions on contingent convertibles. The notice is Notice 2002-36. In it, the IRS expressed concern that “relatively insignificant changes in the investment economics of a convertible debt instrument can effect a dramatic change in the amount of interest accruals.” The IRS “invite[d] comments and suggestions for changes in the relative tax treatment of straight convertible debt instruments and contingent convertible debt instruments to eliminate or reduce the disparity in treatment of these instruments.”

The questions on which the IRS invited comments suggest it is looking at three possible options. First, the IRS asked whether it should also let taxpayers accrue interest on straight convertible debt under the contingent debt regulations. Second, it asked whether the regulations should be modified to provide that the yield on contingent convertibles must be computed by reference to plain convertible debt instead of straight debt. Third, the IRS asked whether it should shore up a rule that says remote or incidental contingencies are not enough to bring an instrument under the contingent debt regulations.

The IRS also urged commentators to address the effects of two sections of the US tax code that apply to convertible debt: section 249, which denies any deduction for excessive conversion premiums where the premium reflects more than the cost of the borrowing, and section 163(l), which denies a borrower any interest deductions on debt instruments that are substantially likely to be repaid in issuer shares. The section 163(l) issue was largely assumed away in the fact section of the May ruling.