Although the issuance of securities has experienced a well-documented decline, one category that has help up well—and has in fact increased—is convertible securities. There are several well-known investment explanations for this divergence. However, the tax law seemingly served to fuel the issuance of a particularly popular variety of convertible—the contingent convertible.

Until recently, it was not entirely clear that the tax benefits envisioned by the issuers of these securities were legitimately claimed. Now, however, with the issuance of Revenue Ruling 2002-31, these intrepid issuers have been entirely vindicated. In fact, the tax benefits thought to be associated with these novel securities are fully available.

Indeed, the ruling confirms that these securities constitute contingent payment debt instruments—a characterization that allows the issuer to accrue and deduct interest on the securities at rates well in excess of the instrument’s stated yield. Accordingly, the issuers obtain what some refer to as “phantom” interest deduction, i.e., interest deductions that are unaccompanied by a concomitant outlay of cash or other resources.

The ruling describes a taxpayer that issues a “zero coupon” convertible debenture at a substantial discount to its stated principal amount. However, beginning some three years after issuance, interest will be payable on the security, but only if its “average market price” for a “measurement period” is more than 120 percent of the bond’s “accreted value.” The ruling tells us that this contingent interest is neither a “remote” or “incidental” contingency.

In addition, the holder of the instrument has a right to put such an instrument back to the issuer. If the put right is exercised, the holder receives an amount equal to the accreted value of the instrument. The issuer, in turn, has the right to honor such put using cash, its own stock, or a combination of the two mediums of payment.

As a legal matter, if a contingent payment debt instrument is issued for cash (or for publicly traded property), it is accounted for using the non-contingent bond method. This means that interest accrues on the instrument as if it was a fixed payment debt instrument that is constructed by using the so-called comparable yield and a projected payment schedule. The comparable yield is the yield at which the issuer would issue a fixed-rate instrument with terms similar to the contingent payment debt instrument that was actually issued.

The projected payment schedule, in turn, must produce the instrument’s comparable yield. And a contingent payment debt instrument, in turn, is simply a debt instrument that provides for contingent payments. It does not so provide, however, merely because it allows an option to convert into securities of the issuer or those of a party related to the issuer. Thus, a “straight” convertible is not, without more, a contingent payment debt instrument.

Therefore, the security at issue here is clearly a contingent payment debt instrument. (Although the debt instrument does provide for an option to convert, it also provides for contingent payments that are neither remote nor incidental.) Accordingly, the issuer of the security is entitled to “enhanced” interest deductions determined by reference to the instrument’s comparable yield—in this case, the comparable yield is determined by reference to comparable fixed-rate non-convertible debt instruments.

The IRS also concluded that no other provisions of the tax law would deprive the issuer of the interest deductions that the contingent payment debt instrument rules provided. Hence, Sec. 163(l) provides that no deduction is allowed for interest, otherwise deductible, on a disqualified debt instrument. In general, a disqualified debt instrument is one that is payable in equity. More specifically, it is an instrument with respect to which a substantial amount of principal, or interest, is required to be paid, or at the option of the issuer is payable inequity.

However, when the tax provision was enacted, Congress admonished overzealous regulators that “it is not expected that Sec. 163(l) will affect convertible debt in cases where the conversion price is significantly higher than the market price (of the issuer’s stock) on the date the securities are issued.”

As a result, Sec. 163(l) was not a factor here: The instrument will be paid in stock on conversion, and may be paid in stock if the holder of the security exercises its right to put. Nevertheless, the ruling says there is no substantial certainty that a significant amount of principle, or interest, will be required to be paid in stock, or will be payable in stock at the election of the issuer. What’s more, due entirely to the inherent uncertainties that always exist as to whether a convertible security will, in fact, be converted into equity, the security being evaluated was found to be disqualified debt instrument.

Finally, the IRS ruled, properly, that Sec. 249 does not apply to eliminate the interest deductions otherwise available here. That provision states that no deduction is permitted for a premium paid to repurchase a convertible to the extent that the repurchase price exceeds the sum of the instrument’s adjusted issue price—plus a “normal” call premium. However, Sec. 249 does not operate here because, by its terms, it only applies to the premium paid to the repurchase a convertible, and therefore, cannot affect the ability to deduct accruals of interest—with respect to a contingent payment debt instrument—based on the instrument’s comparable yield.

In summary, then, the classic contingent convertible security has a most felicitous tax profile. To be sure, it is a contingent payment debt instrument because it provides for contingent payments that are neither remote nor incidental. As a result, interest accrues on the basis of the instrument’s comparable yield—i.e., the yield at which the issuer would issue a fixed rate instrument (the issuer’s “straight” borrowing rate) with similar terms. Moreover, these interest deductions are in no way adversely affected by the rules that govern disqualified debt instruments, not those that address the deductibility of repurchase premiums paid with respect to the retirement of a convertible.

It must be admitted, however, that despite this seemingly unadulterated victory for issuers of these securities, the IRS may not, as policy matter, be entirely comfortable with this outcome.

More to the point, in concurrently issued Notice 2002-36, the IRS asks for comments designed to address the disparity in the treatment of straight convertibles—where the amount of interest that is deductible is based entirely on the instrument’s stated yield—and the tax treatment of contingent convertible, where as indicated, the issuer secures deductions based on the instrument’s comparable yield.

Moreover, the difference in tax treatment, as the ruling notes, is entirely a function of the presence, in the latter case, or contingencies (the provision for contingent interest) that, while not remote or incidental (in the technical tax sense), are, nonetheless, “relatively insignificant” in both amount and likelihood of occurrence. In other words, the IRS seems to be troubled by the fact that major tax consequences can turn on minor economic disparities. So in the name of market efficiency, if for no other reason, the IRS may someday seek to narrow the tax difference between the varieties of convertible securities that Revenue Ruling 2002-31 certifies.

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