Debt issued with warrants.

With interest rates at historic lows, many companies are taking advantage of the low cost of capital and issuing debt Some closely held companies are "buying down" rates by issuing stock warrants with their debt. Alternatively some companies are replacing debt previously issued with warrants, to finance capital at a lower interest rate.

Stock warrants (which are essentially the same as stock options) allow a holder to purchase the issuer's stock at an exercise price within a defined period Warrants are an attractive way to allow lender to potentially increase its overall return on debt otherwise issued at lower interest rate. From the borrower" perspective, warrants lower the cost o capital, by obtaining debt at a lower rate than otherwise available. A question arises as to the tax treatment of the debt instrument and the warrants (i.e., the "investment unit" and the associated original issue discount (OID)).

Background

Sec. 163(e)(1) provides that in the case of any debt instrument issued after July 1, 1982, the portion of the OID on such debt instrument allowable as a deduction to the issuer for any tax year equals the aggregate daily portions of the OID for the days during such tax year. Sec. 1273(a)(1) provides that OID is the excess of the stated redemption price at maturity over the issue price. Sec. 1273(a)(2) defines the stated redemption price at maturity as the amount fixed by the last modification of the purchase agreement and includes interest and other amounts payable at that time (other than interest based on a fixed rate and payable unconditionally at fixed periodic intervals of one year or less during the debt instrument's entire term).

Sec. 1273(c)(2)(A) and (B) provide that (1) an investment unit's issue price is determined under Sec. 1273(b) as if it were a debt instrument and (2) the issue price should be allocated between the debt instrument and the warrant based on their relative fair market values (FMVs). Under Sec. 1273(c)(2), an investment unit includes a debt instrument and an option or other property issued together as an investment unit.

For publicly offered debt instruments not issued for property, Sec. 1273(b)(1) states that the issue price is the initial offering price to the public (excluding bond houses and brokers), at which price a substantial amount of such debt instruments was sold. For other debt instruments not issued for property and not publicly offered, Sec. 1273(b)(2) defines issue price as the...