Treatment of warrants issued in a debt restructuring
Refinancing versus retirement, does it matter?
INSIGHT ARTICLE |
While the economy is showing signs of recovery, many businesses continue to struggle with existing debt levels. As a result, the tax implications of debt modifications and restructurings represent a continuing issue for many businesses. This article addresses the impact of the issuance of equity options or warrants in connection with newly issued or restructured business debts.
Retirement versus refinancing - In situations where a debtor satisfies an existing debt by rolling the debt into a new debt instrument of a lesser, equal or greater amount, the question arises whether the old debt was refinanced or retired. The determination as a refinance or retirement may result in differing tax consequences. Critical to the analysis is whether the new debt is sufficiently separate, distinct and independent from the old debt.1
Factors to take into consideration when making a determination include, but are not limited to:
- the form of the transaction (i.e., whether the existing facilities are extinguished and replaced by new facilities or are amended and left in place; replacement favors retirement while amendment favors refinancing)
- the correlation in membership and participation percentages between the old and new syndication groups (greater correlation favors refinancing)
- whether new security interests are re-filed or amended (re-filing favors retirement)
Investment units - When a debt instrument and warrant instrument are issued for money or publicly traded property as a part of an investment unit, the issue price of the debt is based on the relationship of the fair market value of the debt instrument to the fair market value of the warrant at the time of issuance.2 The value of the warrant reduces the issue price of the debt and creates original issue discount (OID).
Redemption premiums - In general, barring disallowance by IRC section 249, a redemption premium paid by a debtor on a debt is deductible as interest in the year of the redemption.3However, where the debt is redeemed with a newly issued debt and the issue price of the new debt is determined under IRC section 1273(b)(4) or IRC section 1274, the redemption premium is amortized over the life of the new debt as if it were OID.4
Application to debt restructurings
Example 1: Corporation D issued a non-publicly traded debt instrument with a stated principal amount of $200. D issued warrants along with the debt, which, together with the debt, represent an investment unit. Upon issuance, the warrants were valued at $10 under the Black-Scholes methodology. D received $200 on the issuance of the investment unit. Pursuant to IRC section 1273(c)(2) the issue price of the debt is $190, and the $10 warrant value created $10 of OID.
Example 2: Under the same facts as Example 1, assume that D used $100 of the proceeds to extinguish $100 of existing debt from creditors unrelated to the holders of the new debt. The facts in this example support that the old debt was retired and the new debt was unrelated. As a result, the issue price of the new debt would again be $190, and the warrants would create $10 of OID.
Example 3: Under the same facts as Example 2, assume that holders of the $100 of extinguished debt acquired $100 of the new debt (the other $100 was acquired by unrelated holders). Assume further that the interest rate of the new debt is two percent higher than the old debt and that the maturity date extends two years past the maturity date of the old debt. In this case, the new debt is issued to a different mix of creditors, the old debt is extinguished and the new debt has significantly different terms from the old debt.
Assume further that the holders actually wired the full $200 of new debt to D followed by the extinguishment of the old debt. In this case, there appears to be a retirement rather than a refinancing of the old debt, and this would not appear to represent a debt-for-debt exchange but rather a separate borrowing by D and subsequent extinguishment. As a result, the issue price of the new debt would be $190 pursuant to IRC section 1273(c)(2) just as in Examples 1 and 2.
Example 4: Would the answer to the previous example change if, with respect to the $100 of new debt proceeds used to extinguish the old debt, D did not receive funds from the holders of the old debt, but rather the old debt was replaced with the new debt? In this situation, D needs to decide whether to treat the $100 old debt as satisfied and the new debt as reissued in a separate transaction, or to treat the $100 in new debt issued to the old debt holders as a debt-for-debt exchange. If the old debt is satisfied and the new debt reissued in a separate transaction, the conclusions in Example 3 would apply.
However, if this were a debt-for-debt exchange, IRC section 1273(c)(2) would not apply to the new debt issued in exchange for old debt, but rather the issue price of the debt portion of the investment unit would be determined pursuant to IRC sections 1273(b)(4) or 1274.5 Assuming the new debt meets the requirements of IRC section 1274(c) and has adequate stated interest, the issue price of the debt portion of the investment unit would be $195 ($95 for the new debt issued for cash and $100 for the exchanged debt). The debt would only appear to have $5 of OID. However, D issued warrants with a value of $5 to the old debt holders, which currently is not taken into account. It is reasonable to argue that the $5 value of the warrants represents a redemption premium as defined in Treas. Reg. §1.163-(7)(c), which would be recognized over the life of the new debt as OID under the constant yield method. If D had paid $5 in cash or other property there would have been little doubt that the cash or property represented a redemption premium.
However, questions arise as to the proper treatment of a warrant issued in a transaction outside the purview of IRC section 1273(c)(2). D could take the position that a redemption premium was paid and the corresponding OID is determined based upon the value of the warrants at the date of issuance under principles of IRC section 1273(c)(2) and Custom Chrome.6 In Custom Chrome, the Court held that the allocation of value between the warrants and debt was required even where the fair market value of the warrant was not readily ascertainable but where there was a well-established and reliable method for valuing the warrants.7
While it would appear reasonable for D to value the warrants on the date of grant and treat the value as a redemption premium amortized over the life of the new debt, treating the warrants under the redemption premium rules rather than under the investment unit rules leaves some uncertainty as to the proper timing for valuing the warrants. As IRC section 1273(c)(2) and Custom Chrome do not directly apply, it is possible that D might be able to take the position that the redemption premium is not taken into account until the all events test is satisfied. In the case of an accrual method taxpayer, the all events test applies to determine when a liability is incurred and generally is taken into account for Federal income tax purposes.8 Thus, the all-events test determines the timing of a cost’s deduction, capitalization, inclusion in basis or cost of goods sold.9 In which case, the Convergent Technologies10 decision could defer inclusion of the warrants until an actual exercise. In Convergent Technologies, the taxpayer issued warrants as a sales incentive to a customer. The court determined the value of the warrant was not determinable with reasonable accuracy on the date of grant, thus failing the all events test at grant. The court then stated that the “value we are seeking is the actual cost to petitioner of issuing the stock upon the exercise of the warrants.” This represented the actual cost to the taxpayer of issuing the stock. Computervision11 and Sun Microsystems12 also looked at a similar IRC section 461 requirement for warrants issued in connection with trade discounts and concluded that when the warrants were exercised, the fact of the liability and the amount of the liability became fixed under the all events test.13 A differentiating factor, however, between the warrants at issue in Convergent Technologies and those in Custom Chrome and those in Example 4 is that the warrants issued by the taxpayer in Convergent Technologies were not issued in connection with debt, but rather as a customer incentive.
Example 5: Assume that, rather than raising $100 of additional proceeds, D simply issued $200 of new debt and warrants to existing holders of $200 of D debt. In this case, without additional facts distinguishing the new debt from the old debt, it would appear that a debt-for-debt exchange has occurred and the issue price of the new debt would not be reduced by the $10 warrant value. Rather, it would appear that Treas. Reg. §1.163-7(c) would apply and the warrants would represent a redemption premium.
Valuation on grant and treatment of the warrants issued in a debt-for-debt exchange as OID is perhaps the most supportable position for a taxpayer, since the warrants are being issued as part of a debt transaction and not as part of a customer relationship. As a result, any value allocated to the warrants seemingly should be treated as a redemption premium that is properly amortized over the life of the new debt. If, using a well-established and reliable method for valuing the warrants, the warrants are determined to have no value as of the date of grant, then no OID would be associated with the new debt.
1 See, e.g., Buddy Schoelkopf Products v. Commissioner, 65 TC 640, 648-50 (1975) (no refinancing even though the new debt was with the same lender because the two loans were “separate and independent” with different (i) principal amounts, (ii) interest rates, and (iii) maturity dates; in addition, the terms of the second loan were “separately and newly bargained for”). Bridgeport Hydraulic Co. v. Commissioner, 22 TC 215 (1954) (no refinancing even though the old and new bonds had the same three lenders with like face amounts; the Tax Court determined that the taxpayer’s calling of its old bonds and sale of its new bonds were separate and independent transactions), nonacq., 1955-2 CB 10, aff’d, 223 F.2d 925 (2nd Cir. 1955). Cf., South Carolina Continental Tel. Co. v. Commissioner, 10 TC 164 (1948) (refinancing found where new debt issued in simultaneous exchange for old debt from same lender; the issuance of the new debt was “entirely dependent upon the simultaneous surrender” of the old debt, and the old and new debt were not “independent obligations existing at the same time, but instead evidenced the same indebtedness between the same parties without interruption, by virtue of the simultaneous exchange or substitution”)
2 Section 1273(c)(2);Custom Chrome v. Commissioner, TC Memo 1998-317 (the determination of whether any OID is associated with a loan issued with options should be done when the loan is issued and the options are granted, not when the options are subsequently exercised), aff’d in part, rev’d in part, and remanded 217 F.3d 1117 (9th Cir. 2000) (the Ninth Circuit affirmed the Tax Court’s holding that the options were part of the loan and should be valued at the date of issuance) See also, PLR 200043013 (June 30, 2000) (“The amount of OID is computed as of the date of issuance and equals the portion of the value of the investment unit allocated to the Warrants. If the Warrants have no value as of the date of issuance, then there is no OID associated with the financing provided by Bank”)
3 Treas. Reg. section 1.163-7(c)
4 Treas. Reg. section 1.163-7(c)
5 Treas. Reg. section 1.1273-2(h)(1). See also Kevin Keyes, Federal Taxation of Financial Instruments & Transactions section 4.02[b], Example 4-11 (2008)
6 Custom Chrome, Inc. v Commissioner, 217 F.3d 111 (9th Cir. 2000), aff’g in part, rev’g in part, and remanding Custom Chrome, Inc. v. Commissioner, T.C. Memo 1998-317. See also FSA 200115015 (April 13, 2001) (citing Custom Chrome, the IRS stated an allocation of value to the warrants was required even when the warrants do not have a readily ascertainable value and that the allocation must be done to close the transaction)
7 The Court in Custom Chrome noted that other “well-established and reliable methods include but are not limited to: (1) estimating as a multiple of earnings before interest and taxes (EBIT) the present value of the portion of the company that may be purchased by exercise of the options; (2) comparing the value of the total debt instrument to the published values of comparable debt instruments of other issuers, taking into account the factors listed in former Treas. Reg. section 1.1232-3(b)(2)(ii)(a) (1986); and (3) the Black-Scholes method, see Snyder v. Commissioner, 93 T.C. 529, 540-42 (1989) (discussing that method)” 217 F.3d at 1124, FN 10
8 Treas. Reg. section 1.446-1(c)(1)(ii)(A)
9 Treas. Reg. section 1.446-1(c)(1)(ii)(B)
10 Convergent Technologies v. Commissioner, 1995 T.C. Memo 320 (1995)
11 T.C. Memo 1996-131
12 T.C. Memo 1993-467
13 See also, FSA 1999-1168 (IRS determined that warrants issued by the taxpayer to customers under product purchase agreements were granted as part of “a transaction designed to obtain steady outlets for the taxpayer’s product” and as an “inducement to a continuing business relationship”; thus, because the customers could not exercise the warrants until they purchased specified quantities of the taxpayer’s goods, the IRS held that the warrants should be valued and capitalized when exercised by the customers)Compare TAM 9737001 (May 23, 1997) (in determining the proper treatment of a corporation’s issuance of warrants to obtain access to television channel space, the IRS required capitalization of the expenditure as a cost of obtaining an intangible asset not subject to IRC section 83; the IRS noted that under similar cases governed by the investment unit rules, the taxpayer should capitalize the warrants’ fair market value upon grant because the warrants did not represent compensation for the performance of services)