IRS Revenue Ruling
2002-31

Code Secs. 1275, 163, 249

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Rules 26 CFR 1.1275-4: Contingent payment debt instruments.
(Also sections 163, 249; 1.249-1.)

Contingent convertible debt instruments. This ruling provides guidance
on the tax treatment of a debt instrument that is convertible into stock
of the issuer and that also provides for one or more cash contingent
payments.


REV. RUL. 2002-31

ISSUES

Does the noncontingent bond method described in section 1.1275-4(b) of
the Income Tax Regulations apply to a debt instrument that is convertible
into stock of the issuer and that also provides for one or more contingent
cash payments? If so, how is the comparable yield determined, and does
either section 163(l) or section 249 of the Internal Revenue Code affect
the issuer's ability to deduct the interest that accrues on the instrument
under the noncontingent bond method?


FACTS

On January 1, 2002, Corporation X issues for $625x a 20-year debt
instrument with a stated principal amount of $1,000x. Except for the
contingent interest payments described below, the debt instrument does not
provide for any stated interest. The debt instrument is convertible at any
time into a number of shares of Corporation X common stock having a value,
on the date of issue of the debt instrument, that is significantly less
than $625x. The debt instrument is part of an issue that is not marketed
or sold in substantial part to persons for whom the inclusion of interest
from the instruments in the issue is not expected to have a substantial
effect on their U.S. tax liability.

The debt instrument provides that, beginning after January 1, 2005,
interest ("contingent interest") is payable for any six-month period
ending on June 30 or December 31 if the average market price of the
instrument for a measurement period before the applicable six-month period
is greater than 120 percent of the instrument's accreted value. Under the
terms of the debt instrument, accreted value is defined as the issue price
of the instrument plus the economic accrual to any date of determination
of a portion of the difference between the issue price and the stated
principal amount at maturity. The amount of contingent interest that is
payable is equal to the greater of (1) the regular cash dividend per share
of Corporation X common stock for the six-month period multiplied by the
number of shares into which the debt instrument may be converted, or (2) y
percent of the average market price of the debt instrument for the
measurement period. The contingent interest is neither a remote nor an
incidental contingency within the meaning of section 1.1275-2(h).

On or after January 1, 2005, Corporation X has the option to redeem the
debt instrument for cash in an amount equal to the instrument's accreted
value as of the date the instrument is redeemed. In addition, the holder
of the debt instrument has the option to put the debt instrument to
Corporation X on January 1, 2005, or January 1, 2012, for an amount equal
to the instrument's accreted value as of each such date. If the holder
exercises this option, Corporation X can satisfy its obligation with cash,
shares of Corporation X common stock, or a combination of cash and shares
of Corporation X common stock, in each case having a total value equal to
the instrument's accreted value. Taking into account both the likelihood
of conversion of the debt instrument and the likelihood that the
instrument will be put by the holder, it is not substantially certain that
a substantial amount of the principal or interest on the debt instrument
will be required to be paid in stock or will be payable in stock at the
option of the issuer.

Corporation X takes the position that the noncontingent bond method
applies to the debt instrument and that the comparable yield for the
instrument is 7 percent, compounded semiannually. (To determine the
comparable yield under section 1.1275-4(b), Corporation X used the yield
at which it would issue a comparable fixed-rate, nonconvertible debt
instrument.) In preparing the projected payment schedule required by the
noncontingent bond method, Corporation X projects payments of contingent
interest and a payment at maturity (based on a projected exercise of the
conversion privilege) in an amount sufficient to cause the yield on the
debt instrument to equal 7 percent, compounded semiannually. When the debt
instrument was issued, the long-term applicable Federal rate (AFR) was
5.39 percent, compounded semiannually.


LAW AND ANALYSIS

Section 1.1275-4 provides rules for the treatment of contingent payment
debt instruments. In general, if a contingent payment debt instrument is
issued for cash or publicly traded property, the non-contingent bond
method applies to the instrument. See section 1.1275-4(b). Under the
noncontingent bond method, interest accrues on the debt instrument as if
it were a fixed-payment debt instrument. This fixed-payment debt
instrument is constructed by using the instrument's comparable yield and a
projected payment schedule.

In general, under section 1.1275-4(b)(4)(i), the comparable yield for a
contingent payment debt instrument is the yield at which the issuer would
issue a fixed rate debt instrument with terms and conditions similar to
those of the contingent payment debt instrument. Relevant terms and
conditions include the level of subordination, term, timing of payments,
and general market conditions. In determining the comparable yield, no
adjustments are made for the riskiness of the contingencies or the
liquidity of the debt instrument. In all cases, the yield must be a
reasonable yield for the issuer and may not be less than the AFR. In
certain situations, the comparable yield is presumed to be the AFR. See
section 1.1275-4(b)(4)(i)(B).

The projected payment schedule for a debt instrument includes each
noncontingent payment and a projected amount for each contingent payment.
See section 1.1275-4(b)(4)(ii). In general, if a contingent payment is
based on market information, the amount of the projected payment is the
forward price of the contingent payment. If a contingent payment is not
based on market information, the amount of the projected payment is the
expected value of the contingent payment as of the issue date. If the
projected payment schedule and the instrument's issue price do not produce
the comparable yield, then the schedule must be adjusted to produce the
comparable yield. In most cases, the issuer's determination of the
projected payment schedule will be respected unless it was set with a
principal purpose to overstate, understate, accelerate, or defer interest
accruals on the debt instrument. See section 1.1275-4(b)(4)(v).

If the actual amount of a contingent payment is different from the
projected payment, then the difference is taken into account as either a
positive or negative adjustment. A positive adjustment results when the
actual amount is greater than the projected amount. In general, a net
positive adjustment is treated as interest and is includible in income by
the holder and deductible by the issuer in the taxable year in which the
adjustment occurs. A negative adjustment results when the actual amount is
less than the projected amount. In general, a net negative adjustment (1)
reduces interest accruals on the debt instrument for the taxable year, (2)
to the extent of any excess, is treated as an ordinary loss by a holder
and ordinary income by the issuer, but only to the extent of prior
accruals on the debt instrument by the holder or issuer, and (3) to the
extent of any further excess, is a carryforward to the next taxable year.
See section 1.1275-4(b)(6) for the specific rules that apply to negative
and positive adjustments.

Except as provided in section 1.1275-4(a)(2), section 1.1275-4 applies
to any debt instrument that provides for one or more contingent payments.
A payment is not a contingent payment merely because of a contingency
that, as of the issue date, is either remote or incidental. See section
1.1275-2(h) for rules relating to remote and incidental contingencies.

In addition, a debt instrument does not provide for contingent payments
merely because it provides for an option to convert the instrument into
the stock of the issuer, into the stock or debt of a related party, or
into cash or other property in an amount equal to the approximate value of
such stock or debt. Section 1.1275-4(a)(4). However, this exception does
not apply when the debt instrument provides for contingent payments other
than the conversion feature and those contingent payments are neither
remote nor incidental.

Although the debt instrument issued by Corporation X provides for an
option described in section 1.1275-4(a)(4), the debt instrument also
provides for one or more contingent payments (the contingent interest)
that are neither remote nor incidental. As a result, the debt instrument
is a contingent payment debt instrument subject to the noncontingent bond
method described in section 1.1275-4(b). Although a conversion feature
alone does not cause a convertible debt instrument to be subject to the
noncontingent bond method, the possibility of a conversion is nevertheless
a contingency. Therefore, the comparable yield for a convertible debt
instrument subject to the noncontingent bond method is determined under
section 1.1275-4(b) by reference to comparable fixed-rate nonconvertible
debt instruments. Moreover, the projected payment schedule is determined
by treating the stock received upon a conversion of the debt instrument as
a contingent payment.

Under section 1.163-7, the amount of interest that is deductible each
year on a contingent payment debt instrument is determined under section
1.1275-4. Therefore, for purposes of section 163(a), Corporation X
computes its interest deductions for each year the debt instrument is
outstanding based on the comparable yield of 7 percent, compounded
semiannually. Based on the facts set forth above, the original issue
discount anti-abuse rule in section 1.1275-2(g) does not apply because the
result reached is not unreasonable in light of the purposes of section
163(e), sections 1271 through 1275, or any related section of the Code.
The anti-abuse rule, therefore, does not affect Corporation X's ability to
compute its interest deductions based on the comparable yield of 7
percent, compounded semiannually.

Certain provisions of the Internal Revenue Code, such as section 163(l)
and section 249, may affect an issuer's ability to deduct the interest
computed under the noncontingent bond method.

Section 163(l), which was added to the Internal Revenue Code by the
Taxpayer Relief Act of 1997, section 1005, 1997-4 (Vol. 1) C.B. 125,
provides that no deduction is allowed for any interest paid or accrued on
a disqualified debt instrument, which is any indebtedness of a corporation
that is payable in equity of the issuer or a related party. Under section
163(l), indebtedness is payable in equity only if (A) a substantial amount
of the principal or interest is required to be paid or converted, or at
the option of the issuer or a related party is payable in, or convertible
into, such equity, (B) a substantial amount of the principal or interest
is required to be determined, or at the option of the issuer or a related
party is determined, by reference to the value of such equity, or (C) the
indebtedness is part of an arrangement that is reasonably expected to
result in a transaction described in either (A) or (B) above. Principal or
interest is required to be so paid, converted, or determined if it may be
required at the option of the holder or a related party and there is a
substantial certainty the option will be exercised.

The conference report on the 1997 legislation indicates that an
instrument is treated as payable in stock if it is part of an arrangement
designed to result in payment with or by reference to such stock,
including certain issuances of a forward contract in connection with the
issuance of debt, nonrecourse debt that is secured principally by such
stock, or certain debt instruments that are convertible at the holder's
option when it is substantially certain that the right will be exercised.
The conference report further states that it is not expected that section
163(l) will affect debt with a conversion feature if the conversion price
is significantly higher than the market price of the stock on the issue
date of the debt. See H.R. Conf. Rep. No. 220, 105th Cong., 1st Sess.
523-24 (1997), 1997-4 (Vol. 2) C.B. 1993-94.

Under the terms of the debt instrument issued by Corporation X, none of
the instrument's principal or interest is required to be determined by
reference to the value of Corporation X's stock. Although the value of
Corporation X's stock is used in constructing the debt instrument's
projected payment schedule, this projected payment is not determinative in
applying section 163(l) to the instrument. Under the noncontingent bond
method, the projected payment schedule is a mechanism for comparing actual
payments to projected payments and then applying the rules for negative
and positive adjustments.

The debt instrument will be paid in stock on conversion and may be paid
in stock, at the option of Corporation X, if the holder exercises its put
option. Nevertheless, it is not substantially certain that a substantial
amount of the principal or interest on the debt instrument will be
required to be paid in stock or will be payable in stock at the option of
Corporation X. Therefore, the debt instrument is not a disqualified debt
instrument under section 163(l), and section 163(l) does not bar
Corporation X's accrual of interest deductions based on the comparable
yield of 7 percent, compounded semiannually.

Section 249 provides that no deduction is allowed to the issuing
corporation for any premium paid or incurred upon the repurchase of a
bond, debenture, note or certificate or other evidence of indebtedness
that is convertible into the stock of the issuing corporation, or a
corporation in control of, or controlled by, the issuing corporation, to
the extent the repurchase price exceeds an amount equal to the adjusted
issue price plus a normal call premium on bonds or other evidences of
indebtedness that are not convertible. However, section 249 does not apply
to the extent the corporation can demonstrate to the satisfaction of the
Secretary that such excess is attributable to the cost of borrowing and is
not attributable to the conversion feature. See section 1.249-1. For
purposes of section 249, a conversion is a repurchase. See Clark Equipment
Company v. United States, 912 F.2d 113 (6th Cir. 1990). See also sections
1.61-12(c)(2) and 1.163-7(c).

Section 249 was added to the Internal Revenue Code in 1969 because, in
the case of a premium paid upon a corporation's repurchase of its
convertible indebtedness, Congress believed that the amount of the premium
in excess of the cost of borrowing is not analogous to an interest expense
or deductible business expense. Instead, the amount is paid in a capital
transaction analogous to a corporation's repurchase of its common stock
and, therefore, is not deductible. H.R. Rep. No. 413 (Part 1), 91st Cong.,
1st Sess. 1, 110 (1969), 1969-3 C.B. 200, 269; S. Rep. No. 552, 91st
Cong., 1st Sess. 1, 149 (1969), 1969-3 C.B. 423, 518.

Section 249 applies only to a premium paid to repurchase a convertible
debt instrument. Therefore, section 249 does not affect Corporation X's
ability to deduct accruals of interest based on the comparable yield.
However, section 249 applies to a conversion of the debt instrument into
stock having a value in excess of the debt instrument's adjusted issue
price. See Clark Equipment; National Can Corp. v. United States, 687 F.2d
1107 (7th Cir. 1982); and section 1.249-1. Therefore, this excess is not
deductible by Corporation X, except to the extent the excess does not
exceed a normal call premium under section 1.249-1(d) or Corporation X can
demonstrate that the excess is attributable to the cost of borrowing and
not to the conversion feature.


HOLDINGS

The noncontingent bond method described in section 1.1275-4(b) applies
to the convertible debt instrument issued by Corporation X. The yield at
which Corporation X would issue a comparable fixed rate nonconvertible
debt instrument is used to determine the instrument's comparable yield
and, therefore, the accruals of interest on the instrument. In addition,
the debt instrument is not a disqualified debt instrument under section
163(l). Moreover, section 249 does not affect Corporation X's ability to
deduct periodic interest accruals on the debt instrument. However, if the
debt instrument is converted into Corporation X stock having a value in
excess of the debt instrument's adjusted issue price, Corporation X may
not be able to deduct this excess under section 249.


DRAFTING INFORMATION

The principal authors of this revenue ruling are William E. Blanchard
and Dale S. Collinson of the Office of Associate Chief Counsel (Financial
Institutions and Products). For further information regarding this revenue
ruling, contact Mr. Blanchard at (202) 622-3950 and Mr. Collinson at (202)
622-3900 (not toll-free calls).

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