Creative debt/equity financing: OID rules surface again.

• Author: Jolley, Mark
• Position: Original issue discount

Many businesses find it difficult to obtain growth capital because their financial needs are viewed as too risky by conventional banks or other traditional lending sources. As a result, these businesses may turn to alternative sources of financing, such as small business investment companies (SBICs), seed capital funds and venture capitalists. In many cases, these alternative sources will provide the necessary financing in exchange for an economic package that is flexibly structured to meet the borrower's needs. A typical financing arrangement may include a debt instrument such as a term note together with a separately issued equity interest, typically a warrant to purchase the stock of the issuer.

This hybrid form of financing can be attractive to lenders because of the potentially high return available if the borrower experiences significant growth and prosperity, and the lender exercises the stock warrants. Similarly, the financing has appeal to borrowers since they are provided with much needed growth capital at a time when their alternative sources of capital may be limited or nonexistent.

This hybrid form of financing is referred to as an "investment unit" and is addressed in the original issue discount (OID) rules. Because of the increasing popularity of these alternative forms of financing and the dramatically different (and often unexpected) tax consequences to the lender and the borrower, an overview of these rules is helpful.

In general, from a borrower's perspective, the OID rules treat certain items as deductible that would otherwise be treated as nondeductible capital

expenditures. From the lender's standpoint, however, the OID rules may effectively result in a portion of nontaxable debt repayments being treated as taxable interest income; this is particularly bad news to a lender that has just embarked on a highly speculative undertaking.

Sec. 1273(a)(1) generally defines OID as the amount by which a debt instrument's stated redemption price at maturity exceeds its issue price.

Example 1: A note is issued for $90,000. Its stated principal amount, payable at maturity in 10 years, is $100,000. The note also provides for quarterly interest payments at a 10% annual interest rate. All of the stated interest payments are deductible; in addition, the note contains OID of $10,000, which is deductible over the term of the note.

In Example 1, determination of OID is a relatively simple matter. The note's redemption price at maturity is...