Convertible Bond Rule Targets Earnings

The verdict is in on "Instrument C" bonds, and all is not rosy.

A convertible debt instrument which is also a contingent payment debt instrument (CPDI), however, can provide the issuer with “enhanced” interest expense deductions. A CPDI, in turn, is defined as a debt instrument which provides for one or more contingent payments. (See Regulation Section 1.1275-4(a)(1).) For this purpose, a payment is not regarded as a contingent payment merely because of a contingency that, as of the issue date of the instrument, is either “remote or incidental.”

Furthermore, a debt instrument does not provide for contingent payments merely because it provides an option to convert the debt instrument into the stock of the issuer, into the stock or debt of a related party, or into cash or other property, in an amount equal to the approximate value of such stock or debt. Nevertheless, it has been ruled (see Revenue Ruling 2002-31, 2002-1 C.B. 1023) that a zero-coupon convertible debt instrument which provides for nominal payments in cases where, during specified periods, the debt trades at or above a certain multiple of its accreted value, does constitute a CPDI.

In those cased, the contingency — the occurrence of which would trigger such payments — was neither a remote nor incidental contingency. In cases where a CPDI is issued for cash or publicly-traded property, it is accounted for under the taxpayer-friendly non-contingent bond method (NCBM). See Regulation Section 1.1275-4(b)(1).

Under this method, the amount of interest expense which is taken into account for each accrual period is determined by first constructing a projected payment schedule for the debt instrument, and then applying rules similar to those for accruing original issue discount on a non-contingent debt instrument. Therefore, the amount of interest that accrues in each period is the product of the comparable yield of the debt instrument (the yield at which the issuer would issue a fixed rate debt instrument with terms and conditions similar to those of the CPDI), and the debt instrument’s adjusted issue price as of the beginning of the accrual period.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

*A broad reconsideration of the accounting for all convertible instruments is being undertaken in connection with FASB’s liabilities and equity project.

**The FSP does not affect the application of the guidance in FAS No. 128,Earnings per Share, with respect to the calculation of earnings per share. In the case of Instrument C, a “treasury stock” type method is employed, the same method that would be employed if the unitary CDI was, instead, a straight debt instrument which had been issued with warrants.

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