Debt and Taxes

The Internal Revenue Service gives its blessing to contingent convertible bonds, or ''cocos.''
Tim ReasonJuly 1, 2002

Who dares, wins. Companies issuing contingent convertible bonds — or “cocos” — over the past two years took a risk that the very tax benefits that made these debt instruments so attractive might prompt the Internal Revenue Service to outlaw them. Instead, in a June ruling so favorable it surprised even coco developers, the IRS gave the hybrid securities its unconditional blessing.

Historically, the tax code has allowed companies to deduct only the stated interest rate of a convertible bond — which is low because investors reap a second payout when the bond converts to equity. The IRS excludes convertibles from other types of contingent debt, for which a much higher “comparable yield” can be deducted.

That exclusion was circumvented by coco developers like Merrill Lynch, which tacked on extra contingencies — such as additional interest payments triggered by certain price movements of the underlying stock — to traditional convertibles. Although these new contingencies can be “relatively insignificant in amount or in likelihood of occurrence,” says the IRS, the agency ruled that they changed the bond enough to let it qualify for the larger deduction.

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“I wasn’t expecting this [ruling],” says Dan Zucker, a partner at law firm McDermott, Will & Emery, which has advised on the issuance of cocos. “I was surprised not only that [the IRS] said something about it, but that what they said was so favorable.” In fact, the IRS also invited public comment on whether the comparable-yield calculation should also be allowed for straight convertible bonds.

Until that happens, newly approved cocos could be destined to completely replace less tax-friendly convertible bonds. But, notes Zucker, cocos don’t typically sell for a premium over convertibles. That means issuing companies must eat the risk of the added contingencies. In a down market, that’s already come back to bite some companies.

There’s another drawback to cocos: while issuing companies can deduct more interest than they pay, coco holders must also book an equal amount of phantom income and pay taxes on it. Fortunately, that phantom income is not a problem for the primary purchasers of cocos — tax-exempt institutional investors, as well as those that use the mark-to-market method of accounting.

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