Debt vs. Equity

April 29, 2013

(This post will be updated from time to time, as needed.  Many of my readers are likely to have more and better insight into specific debt versus equity matters regarding bonds.  If you have any comments, please leave a comment using the “reply” feature below.)

General Information

debt-consolidation-funny-pictureWhether an obligation is considered debt for federal income tax purposes depends on the terms of the obligation instrument and all surrounding facts and circumstances.  In Notice 94-47, the Internal Revenue Service describes several factors listed below that may be considered in making this determination.  No particular factor is conclusive in making a determination of whether the obligation constitutes debt or equity, and the weight given to any factor depends on the facts and circumstances and the overall effect of an instrument’s debt and equity features.

  1. Whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future (“yes” indicates debt);
  2. Whether holders of the instruments possess the right to enforce the payment of principal and interest (“yes” indicates debt);
  3. Whether the rights of the holders of the instruments are subordinate to the rights of general creditors (“no” indicates debt);
  4. Whether the instruments give the holders the right to participate in the management of the issuer (“no” indicates debt);
  5. Whether the issuer is thinly capitalized (“no” indicates debt);
  6. Whether there is identity between holders of the obligations and stockholders of the issuer (“no” indicates debt);
  7. The labels placed upon the instruments by the parties;
  8. Whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency or financial accounting purposes.

Notice 94-47 was issued in part to address transactions being completed in which the obligations were structured to look like debt for federal income tax purposes but as equity for regulatory, rating agency or financial accounting purposes (see factor 8 above).  Rev. Rul. 85-119, 1985-2 C.B. 60 was used as authority or guidance in treating such obligations as debt.  The IRS cautions that the ruling should be analyzed narrowly and indicates that it does not feel bound by any arrangements that do not mirror the facts in the ruling.

See also L. Howard Adams, “What Role for Equity in Applying Factors for Distinguishing Debt?,” Tax Notes, March 4, 2013, for a good discussion of factors relevant to determining the debt/equity status of obligations.

Notice 94-84, Short-Term Bonds, Qualified Stated Interest

April 4, 2013

Stated redemption price at maturity under I.R.C. 1273(a)(2) means all payments on the obligation, including interest, except to the extent that a payment is considered “qualified stated interest” (QSI).  If all interest payable on the obligation is QSI, the stated redemption price to maturity is simply equal to the stated principal amount of the obligation.

In the case of an obligation with a fixed term of one year or less (e.g., certain TRANs and similar obligations), no payments of interest are considered QSI.  The means that all interest on short-term obligations is considered OID.  This rule prohibiting QSI on a short-term obligation does not have an exception for tax-exempt obligations.  Normally this wouldn’t matter because the difference between QSI and OID is generally of no consequence – both are considered “interest” that can be excludable from gross income for federal income tax purposes.  However, the distinction is relevant for subsequent purchasers of the bond, if the bond was originally issued at a price in excess of its stated principal amount.

Example:  N issues a one-year tax-exempt bond with a face amount of $10 million and a stated interest rate of 5%.  The price is 101% of the face amount – i.e., the bond is sold at a premium ($100,000), and that sale price is the purchaser’s basis in the bond.  The yield on the bond, due to the premium, is approximately 3.98% (interest is payable once at maturity).  Three months after the issuance of the bond, O purchases the bond at par (at $10 million – i.e. 100%) plus accrued interest of 1.25%.  If the stated interest (the $500,000 due on the bond at maturity) is QSI, O’s entire return to maturity is tax-exempt interest.  However, if the interest is treated as OID, O has acquired the bond for 101.25% (100% + 1.25% accrued interest) at a time when its adjusted issue price (daily compounding) is 101.9855%.  Thus, by the time the bond matures, O’s basis will have increased to only 104.2645% and O will have taxable gain of 0.7355 percent of the bond’s face amount.

The temporary regulations preceding Treas. Reg. 1.1273-1(c)(5) suggested that tax-exempt obligations would be excluded from the special rule for short-term obligations.  Due to the confusion created by the final regulations that do not make reference to the exclusion, the IRS issues Notice 94-84, which permits owners of tax-exempt bonds to treat the interest either as OID or as QSI.