Cuckoo for Coco Puffs?

Contingent convertible bonds get a tax-treatment boost from a new IRS revenue ruling. But the window of opportunity may slam shut.

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.

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