A patchwork of federal income tax rules can create tax complexities
LANCE BEHNKE, BRACEWELL & GIULIANI LLP, SEATTLE AND HOUSTON
ALEXANDER JONES, BRACEWELL & GIULIANI LLP, NEW YORK
In the past several years, the record low yield on investment grade debt has prompted fixed income investors to seek out instruments that generate a greater economic return. As a result, there has been increased demand for convertible debt instruments that contain unconventional economic terms. In our prior article (OGFJ, April 2014, "Tax issues can unexpectedly complicate mezzanine financings"), we focused on the unexpected tax complications associated with mezzanine financings. In this article, we will discuss the tax complications involving another debt instrument, unconventional convertible debt.
Typical convertible debt provides a holder with a fixed rate of return and an embedded option to convert the principal of debt into an equivalent amount of stock of the issuer at the time of conversion. The tax rules involving such generic convertible debt are well understood and the conversion generally is nontaxable to both domestic and foreign holders of the debt. The tax rules, however, do not directly address convertible debt instruments that contain unconventional terms. Instead, the parties holding and issuing such convertible debt must analyze a patchwork of federal income tax rules and authorities that often provide for unexpected outcomes.
Exploration and production companies that do not yet have access to the public capital markets have been the primary issuer of these unconventional debt instruments. The debt instruments have allowed the issuers to acquire additional development acreage, repay existing mezzanine debt, and complete their capital structures. The instruments also provide companies with alternatives in structuring their contemplated initial public offerings.
Convertible debt functions similar to a mezzanine financing and the debt is subordinate to any first or second lien debt issued by the company. In exchange for accepting more repayment risk, the holder receives a scheduled interest payment and an embedded option that allows it to participate in the contemplated IPO of the issuer. Unlike plain-vanilla convertible debt instruments, these instruments provide a holder with a fixed interest payment and a targeted economic return that periodically increases over the term of the debt. The debt's conversion right usually provides that the debt will be converted into an amount of stock of the issuer at a discount to its fair market value at the time of the conversion.
To determine the correct tax treatment of the debt, the issuer must initially determine whether its convertible debt instrument is in fact treated as indebtedness for tax purposes. The bedrock principal of debt for tax purposes is the instrument contains an unconditional promise to pay a sum certain due at maturity. These nonconventional convertible debt instruments usually are issued at par, but the principal amount owed to a holder at maturity increases on each scheduled interest payment date by a fixed percentage. The difference between the amount paid for the debt and such increased principal amount is treated as original issue discount (OID) for tax purposes. If the issuer concludes that its convertible debt is likely to be outstanding for its entire term, a sum certain due upon maturity can be calculated but a significant amount of OID will accrue on the debt.
In certain situations a corporate issuer (or a partnership issuer with corporate partners) may not be entitled to deduct all of the interest expense on the debt. If the debt has a more than five year term and assuming that significant OID will accrue on the debt, the tax rules we discussed in our prior article involving applicable high yield discount obligations (AHYDO) could apply.
Additionally, the tax rules provide that if there is substantial certainty holders will exercise the conversion option contained in the debt instrument, the issuer cannot deduct the interest expense on the debt. Where the terms of the nonconventional debt provide for conversion into the issuer's stock at a discount, holders would likely be viewed as substantially certain to exercise their conversion right. However, the guidance pertaining to such rules generally provides that if the conversion right on the debt is out of the money upon issuance, the issuer can deduct the interest expense on the debt. The issuer should carefully review the terms associated with the conversion right and the contemplated economic return on the convertible debt to determine if the conversion option is out of the money upon issuance and the issuer's interest deduction potentially preserved.
The issuer must then determine whether its convertible debt instrument is treated as a contingent payment debt instrument (CPDI) for tax purposes. If the convertible debt is a treated as a CPDI, the parties will calculate their interest income or interest deduction by computing a complex projected payment schedule based on the yield the issuer would pay on a fixed rate debt instrument with similar terms. Those tax rules also provide that if the fair market value of the stock received upon conversion of the debt exceeds a holder's basis in the debt, such excess is taxed as ordinary interest income to the holder at the time of the conversion. Thus, if the CPDI rules apply and the debt converts into the issuer's stock at a discount to its market price at the time of the conversion, the holder of the debt could recognize ordinary income on the conversion.
However, the CPDI rules generally do not apply if all possible payments on the debt are known upon issuance and the issuer believes it is significantly more likely than not that the debt will remain outstanding until maturity. Instead, the debt instrument is subject to tax rules that require the issuer to compute a simplified payment schedule that reflects the holders' interest income and the issuer's interest deduction based on the total amount owed to a holder upon the maturity of the debt.
Consistent with such calculation, holders will be required to include OID in income without the corresponding receipt of a cash payment over the term of the debt. The holder will increase its tax basis in the convertible debt by such OID. If the debt is not viewed as a CPDI, a domestic holder generally is not taxed on the conversion of the debt into common stock of the issuer and receives a basis in the stock equal to its adjusted basis in the converted debt.
Foreign holders of the convertible debt may be subject to taxation upon the disposition of the debt or upon conversion regardless of how the debt is characterized. If the value of the issuer's real property interests in the United States (USRPI) constitutes more than 50% of the value of all of its worldwide real property interests and trade or business assets, the issuer is treated as a United States Real Property Holding Corporation (USRPHC) pursuant to the Foreign Investment in Real Property Act (FIRPTA). Most of the assets of companies that issue this form of convertible debt primarily consist of oil and gas properties located in the United States and are viewed (or will be viewed upon the IPO) as USRPHCs.
Certain interests in a USRPHC are also treated as a USRPI, including debt instruments that furnish a holder with an option, whether or not presently exercisable, to convert into the stock of a USRPHC. Foreign holders of debt instruments without such a conversion right generally are not subject to U.S. taxation upon the disposition of the debt. Foreign holders of debt convertible into the stock of a USRPHC, however, generally are subject to FIRPTA withholding tax on any gain realized upon the disposition of the debt. As a result, a purchaser of the debt would be required to withhold 10% of the gross proceeds provided to the foreign holder in exchange for the debt and the foreign holder would be required to file a US tax return.
Notwithstanding the general rule that the conversion of the debt into equity of the issuer is nontaxable, if the debt is treated as a USRPI and convertible into an interest that is not a USRPI, certain foreign holders are subject to tax upon the conversion. The amount of issuer stock a foreign holder will own upon conversion will determine whether the shares received on the conversion are also a USRPI and whether the holder is subject to FIRPTA taxation upon the conversion.
If the debt is convertible into a publicly traded class of stock of the issuer and the issuer is classified as a USRPHC, the tax rules provide that a 5% or less interest in such stock is not classified as a USRPI. A foreign holder that would own upon conversion 5% or less of the common stock of the issuer would likely be subject to US taxation upon the exchange and the FIRPTA rules require 10% of the fair market value of the common stock received be withheld. The foreign holder would receive a basis in the stock equal to the fair market value of the stock and the foreign holder's holding period with respect to the stock would commence on the day after the receipt of the stock.
On the other hand, an interest in more than 5% of the publicly traded stock of a USRPHC issuer is characterized as a USRPI. A foreign holder that would own more than 5% of the publicly traded stock of the issuer would not be subject to tax upon the conversion of the debt provided such holder filed certain documentation with the IRS that certifies the holder will be subject to FIRPTA taxation upon its disposition of the stock. Upon conversion, such foreign holder would receive a basis in the stock received equal to its adjusted basis in the debt exchanged (increased by any gain recognized) and would have a carryover holding period in the stock.
The convertible debt also provides the issuer with alternatives in structuring its IPO. Several issuers of this type of convertible debt are treated as partnerships for tax purposes. Such issuers have several options for structuring their IPOs. The issuer could simply elect to be treated as a corporation for tax purposes and offer equity to the public. Alternatively, the issuer could form a new corporation that would issue stock to the public and the new corporation could use the proceeds to purchase interests in the issuer (which continued to be treated as a partnership).
Under this structure, commonly referred to as an Up-C structure, the corporation generates additional depreciation and other tax attributes from the purchase that are used to reduce its income tax liability. As part of the purchase price for the partnership interests, the corporation pays the selling issuer a portion, typically 85%, of the tax benefits the corporation realizes. The terms of the partnership issuer's debt must address a conversion into the IPO corporation (an entity that did not issue the debt). Depending on the structure, such a conversion could be nontaxable to a domestic holder of debt but a foreign holder that owns 5% or less of the common stock of the corporation upon a conversion generally would be subject to U.S. taxation on account of FIRPTA.
Unconventional convertible debt offerings can be utilized to satisfy market demand for high yield fixed income products and provide investors and issuers with significant economic benefits. In exchange for those benefits, the debt may produce unique tax results for both parties. The tax considerations must be taken into account when issuers and investors are reviewing their expected economics with respect to the transaction. Investors and issuers must analyze whether the convertible debt is treated as debt for tax purposes and may be surprised that an instrument labeled and marketed as debt may not be characterized as debt of the issuer for tax purposes.
If the convertible debt is not characterized as debt for tax purposes, the issuer does not generate interest expense and investors would not receive interest income. An issuer should also determine whether the terms of the convertible debt potentially cause the interest expense on the debt to be nondeductible. Foreign investors in the debt may be especially surprised to discover that holding the convertible debt could subject the investor to FIRPTA and the conversion of the debt into equity of the issuer may be taxable. Accordingly, the parties must carefully review the terms of the debt and its tax consequences to ensure their financial models for the transaction are reflective of their economic expectations.
About the authors
Lance W. Behnke is a tax partner in Bracewell & Giuliani's Seattle and Houston offices. His practice focuses on federal and state tax issues relevant to both global and US clients.
Alexander W. Jones is counsel with Bracewell & Giuliani in New York. His practice focuses on the federal income taxation of corporations, partnerships and limited liability companies, including mergers and acquisitions, partnership transactions and state and local tax.
