Ground Zero?

But the boom has also heightened interest in the securities on the part of the U.S. Treasury, which has long viewed them as a tax dodge. This year, for the third time since 1995, the Clinton Administration budget proposes to curb the ability of issuers to deduct interest on the bonds. The government argues that because issuers don't pay any interest until maturity, they should get a tax deduction for interest only at that time. "There's always been a cloud over the product from a tax point of view," says Willens.

Critics of the Treasury proposal contend that the difficulty in converting these bonds to stock undermines that argument. Merrill's Patrick also claims that the Treasury's proposal "is at odds with the tax law's general treatment of expenses paid in stock," which are deductible. And finally, he claims that the proposal would "destroy the symmetry between issuers and holders of debt with original issue discount, which has been the pillar of tax policy regarding [zero-coupon convertibles]."

But that pillar looks increasingly shaky. Theoretically, buyers pay tax each year on a portion of the income they eventually receive from the zeros--creating the symmetry. But Willens notes that "the reality is that for zero coupons, the principal purchasers are tax- exempt organizations, deferred tax accounts, and foreigners." As a result, he says, "it's a revenue loss to the IRS." Since the product's inception, he says, the loss has clearly been "substantial."

Willens's point is borne out by Calamos, who says he buys zero-coupon converts primarily for tax-exempt accounts. And while the Treasury's past efforts to curb the tax break have failed, the bigger the drain on IRS coffers, the harder the Administration is likely to push to eliminate the tax break, and the harder it will be for Congress to push back. Granted, the IRS issued a private-letter ruling that okayed the product's tax status in 1991, but the service has been backtracking ever since. In 1995, the Treasury stated in its budget proposal that "the line between debt and equity is uncertain, and taxpayers have exploited this lack of guidance."

This February, its proposal added that "in many cases, the issuance of convertible debt instruments is viewed by market participants as a de facto issuance of equity," and that allowing issuers to deduct accrued interest and the original issue discount is "inconsistent with the market view." So now the IRS wants to defer the deduction until actual payment.

It's impossible to predict, of course, whether the proposal will in fact become law. But the longer the zero-convert boom lasts, the likelier that prospect becomes. And issuers who want to take fresh advantage clearly have reason to make hay while the making is good.

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