Issuing stock warrants or other property may produce additional interest deductions for borrower.

AuthorTaylor, David E.

Corporate debt obligations frequently are issued with warrants, stock options or other property that provides the lender with a fixed return on the debt obligation along with the potential for sharing in the appreciation in the value of the borrower's stock. This type of arrangement typically is used by venture capitalists in mezzanine financing arrangements and by private lenders. From the borrower's perspective, issuing warrants or other property can reduce the loan's interest rate. Also, if the borrower's business is too risky, the use of warrants or other property may be necessary to obtain a loan at a reasonable interest rate. In addition, the use of warrants may provide an infusion of equity into the borrower's business when they are exercised.

When this combination of a debt instrument and a warrant, option, security or other property is issued together as an investment unit, the borrower may obtain greater interest expense deductions under the original issue discount (OID) rules.

(While the OID rules are not limited to lending transactions, the ensuing discussion is confined to the application of the OID rules to a lending transaction in which the lender also receives additional property or rights from the borrower.)

Sec. 1273(a) (1) defines OID as the excess of the stated redemption price at maturity over the issue price. Under Regs. Sec. 1.1273-2(h), an investment unit is treated as if the entire unit were a debt instrument, with the issue price allocated between the debt instrument and any other property (such as a warrant or option) based on their relative fair market values (FMVs); see also Sec. 1273(c) (2).

Example: X Corporation wishes to borrow $500,000 from Lender. The debt obligation requires X to pay 9% simple interest. During the loan's term, interest only is payable on the loan's anniversary date for five years ($45,000 annually) and the entire $500,000 principal is due at the end of five years. Additionally, Lender receives warrants to purchase 10,000 shares of X's common stock. Neither the debt instrument nor the warrants are traded publicly. Lender normally would require a 16% rate of return on the loan if the warrants were not issued with the debt instrument.

Together, the debt instrument and the warrants are an investment unit. For purposes of the OID rules, the issue price of the investment unit is allocated between the debt instrument and the warrants based on their relative FMVs.

If either component of the...

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