Favorable Rev. Rul. on contingent convertible bonds.

• Author: Sair, Edward A.

In Rev. Rul. 2002-31, the IRS concluded that a convertible debt instrument issued with contingent interest that is neither "remote nor incidental" is subject to the Regs. Sec. 1.1275-4(b) contingent-payment-debt-instrument (CPDI) rules. This regulation, known as the "noncontingent bond method" allows an issuer to accrue an original issue discount (OID) deduction at a yield "comparable" to that of a fixed-rate instrument with similar terms and conditions, but without contingencies. As a result, the interest deduction on a contingent convertible is much higher than that of a regular convertible instrument. Better still, the tax deduction is much higher than the interest expense accrued for financial statement purposes.

Holders of a contingent convertible debt instrument, however, must accrue OID into income at the higher yield without receiving cash payments, regardless of their accounting method. On conversion, the holder must also include as ordinary income the excess of the fair market value (FMV) of the stock it receives, over the basis in the debt instrument (i.e., the amount paid for the debt, plus any accrued, but unpaid, OID).

Background

Corporations have long issued bonds convertible into an issuer's or a related-party's stock. Because of the conversion feature, holders accept a lower yield on the convertible bonds than on other bonds. For Federal income tax purposes, the debt's conversion feature is ignored; interest accrues at the debt instrument's overall yield based on the stated interest rate and any OID. At conversion, the holder does not recognize any income, and the issuer cannot deduct as interest the excess of the stock's FMV over the debt's adjusted issue price (i.e., original issue price plus accrued, but unpaid, OID). The holder's basis in the convertible debt becomes the stock's basis, even though the stock's FMV is higher at conversion. This difference will be taxed (generally at capital-gain rates) as income to the holder when the stock is sold.

The Regs. Sec. 1.1275-4 rules for contingent-payment debt instruments apply to instruments issued after Aug. 12, 1996. Such instruments issued for cash ate subject to the Reg. Sec. 1.1275-4(b) non-contingent-bond method, which allows an issuer to deduct, and requires a holder to include, potential contingent interest before it becomes fixed. The issuer has to determine a "comparable" yield (i.e., the yield on a similar, but non-contingent debt instrument), and construct a...