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IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by
the IRS, we inform you that any U.S. federal tax advice contained in this communication
(including any attachments) is not intended or written to be used or relied upon, and
cannot be used or relied upon, for the purpose of (i) avoiding penalties under the Internal
Revenue Code or (ii) promoting, marketing, or recommending to another party any
transaction or matter addressed herein. If you are not the original addressee of this
communication, you should seek advice based on your particular circumstances from an
independent adviser.
When a convertible debenture is redeemed, the transaction is treated as a § 1001
exchange. Accordingly, the holder will recognize capital gain to the extent the redemption price
exceeds the adjusted issue price (i.e. basis), which is increased by any OID income realized. IRC
§ 1273(a)(1). The capital gain treatment is generally meaningless because when a debenture is
retired at maturity, the adjusted issue price equals the redemption price. For example, if the issue
price is 800, the redemption price is 1000, and the maturity date is 5 years from issuance, the
holder’s basis at the time of redemption will be 1000 (800, plus 40 OID interest income for 5
years). Therefore, redemption at maturity is typically a tax free event.
However, when a debenture is redeemed for a “premium”, the premium would be capital
gain to the holder. § 1271(a)(1); § 1001. The problem with the “premium” analysis is that if the
premium is guaranteed or provided for in the agreement, the IRS will put substance over form
and treat the premium as a part of the redemption price. For example, if the issue price is 800
and the redemption price is 1000, with a 100 “premium,” the IRS will treat the true redemption
price as 1100. Mason v. U.S. 365 F. Supp. 670. To make matters worse, the IRS would assess a
deficiency against the holder for unreported OID income of 20 per year.
The only way to get capital gain treatment that would be respected by the IRS would be
to call the debenture before maturity for the full redemption price. § 1271(a)(1). Unfortunately,
you cannot get this treatment if you intend to call the debt before maturity. § 1271(a)(2). For
example, if a debenture is issued for 800 redeemable in 5 years for 1000, the holder will have
ordinary income at redemption if the agreement provides that the debenture will be redeemed
after 2 years, notwithstanding the 5 year maturity date. Treas. Reg. 1.271-1(a)(1). Thus, you
could not actually market this plan and get capital gain treatment for the premium.
Finally, the conversion of the debenture for stock (or a membership interest) is a
nontaxable even to the holder, even if the value of the stock is more than the basis of the
debenture. The holder will then take a basis in the stock (or membership interest) equal to its
basis in the debenture. Thus, the holder will get capital gain treatment when the shares are later
sold. For example, using the above facts, if the holder elects to convert after year 1, it will take a
840 basis in the stock, and will recognize capital gain (or loss) when the stock is later sold.
The only way that I can see how the holder can get capital gain treatment in a redemption
situation is if the transaction is seen not as true debt, but as equity. In this event, the “holder”
would be a shareholder, and would not have to recognize OID. When the “debt” is later
redeemed, it would be treated as the redemption of stock and the “holder” would have capital
gain. For example, if the debt is really an equity interest, and the holder’s basis is 800 and the
stock is later redeemed for 1000, the holder would have 200 of capital gain. This strategy suffers
from several major setbacks including (1) non-deductibility by the corporation, (2) the investor
will lose the flexibility of the conversion option, (3) the IRS is very reluctant to classify the
transaction as an equity not debt, and (4) the IRS may classify the “redemption” as a dividend,
not a redemption.