Rev. Rul. 83-98

For federal income tax purposes, should the adjustable rate convertible notes (ARCN's) described below be treated as debt, so that amounts paid periodically with respect thereto are deductible as interest under section 163 of the Internal Revenue Code, or should they be treated as equity?

FACTS

X corporation has outstanding one class of common stock that is traded on a national securities exchange. This stock has traded recently at about $20 per share; its current dividend rate is $.78 per share, or about 3.9 percent, annually.

X proposes to issue $10 million worth of ARCN'S. An ARCN will be offered at a price of $1000 cash or 50 shares of X common stock (worth $1000). The terms of the ARCN's follow. The ARCN's will mature in 20 years, and on maturity the holder will be entitled to elect to receive either $600 cash or 50 shares of X common stock. Each ARCN will be convertible at any time into 50 shares of X common stock. X will have no right to compel redemption of ("call") an ARCN until 2 years after issuance, after which it will have the right to call any ARCN at a price of $600 cash. However, upon call, the holder may exercise his conversion right.

An amount designated as interest will be paid on the ARCNs quarterly at a rate based upon dividends paid on X common stock. More specifically, the annual amount payable with respect to an ARCN will be equal to the dividends paid on 50 shares of X common stock, plus an amount ($20) equal to 2 percent of the issue price ($1,000) of the note. However, such payments may not be less than $60, or more than $175, per ARCN. The current yield for nonconvertible, noncontingent debt instruments of corporations similar to X is 12 percent.

The ARCN's will be subordinated to all present and future senior and general creditors of X. In the event of bankruptcy, the holder of an ARCN will be treated as a creditor in the amount of $600.

LAW AND ANALYSIS

Whether an instrument represents indebtedness or an equity investment for federal income tax purposes depends on the facts and circumstances of each case. No particular fact is conclusive in making such a determination. John Kelley Co. v. Commissioner, 326 U.S. 521 (1946), 1946-1 C.B. 191. Among the factors that may be considered in making such a determination are: (a) whether there is a written unconditional promise to pay on demand or on a specific date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest; and (b) the intent of the parties in creating the instrument. See Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968); Dobkin v. Commissioner, 15 T.C. 31 (1950), AFF'D, 192 F.2d 392 (2d Cir. 1951).

The ARCNs in this case are structured so that under most likely eventualities they will be converted into X common stock. At maturity the holder of an ARCN will convert the ARCN to stock rather than take cash if the stock can be sold for more than $600 in the aggregate. Because the X stock is worth $1,000 when the ARCNs are issued, redemption for cash at maturity will occur only if the stock drops in price by more than 40 percent. Further, as long as the 50 shares of X common stock are trading at more than $600 in the aggregate (i.e., for more than $12 per share), it would be economically disadvantageous for the holder of an ARCN to permit X to redeem it for $600. Thus, in such a situation, X may in effect force conversion at any time beginning 2 years after issuance by calling the ARCN.

Moreover, in many circumstances it will be to X's advantage to force conversion because by doing so it would avoid having to pay out cash. Redemption for cash may cause it to recognize ordinary income in the amount of the difference between the issue price of the ARCN and the cash redemption price (less the amount, if any, already returned as income). Section 1.61-12(c)(3) of the Income Tax Regulations. But see sections 108 and 1017 of the Code, permitting deferral of recognition under some circumstances if the corporation foregoes certain tax benefits. Thus, there is a significant income tax cost that increases the net cost of a cash retirement well above $600. On the other hand, if X issues stock upon the conversion of an ARCN, it will recognize no gain or loss. See Rev. Rul. 59-222, 1959-1 C.B. 80. If the value of the stock into which ARCNs are convertible is less than the after-tax cost of a cash retirement, X benefits from conversion of ARCN's into stock. Conversion can be forced by X as long as the value of 50 shares of X stock exceeds $600.

Because of the very high probability that all of the ARCN's issued will be converted into stock, the ARCN's do not in reality represent a promise to pay a sum certain. Rather, the $600 face value is a figure calculated primarily to ensure conversion into stock; its only other function is to provide a floor for purposes of loss that will become material only if the price of X common stock declines by more than 40 percent from its price at the time the ARCN's are issued.

Other factors in this case that support a conclusion that the ARCNs constitute equity rather than debt include (i) the guaranteed annual return of $60 with respect to the $1,000 investment is unreasonably low in comparison to the annual return on comparable nonconvertible, noncontingent instruments at the time the ARCN's are issued, (ii) under the terms of the ARCN's, more than 65 percent of the future annual yield may be discretionary based on the level of discretionary dividends paid on X common stock, and (iii) the ARCN's are subordinated to X's general creditors.

The fixed principal and fixed minimum interest payable on the ARCN's are insufficient factors to support their classification as debt. It is apparent that neither X nor the purchasers of ARCN's ascribe any economic value or practical significance to the fixed debt features of the ARCN's since the ARCN's will be sold for a price approximately equal to the value of the common stock into which the ARCN's can be converted, rather than at a substantial premium.

The ARCN's in this case are fundamentally different from the instruments classified as debt in Rev. Rul. 68-54, 1968-1 C.B. 69, because the instruments considered there were intended to create and did create a fixed obligation to pay money on a given date; the interest rate, although to some extent dependent on earnings, was determinable according to a formula and did not float in tandem with discretionary common stock dividends; and the notes were not convertible into stock. These factors outweighed the subordination of the debentures.

Rev. Rul. 73-122, 1973-1 C.B. 66, is also distinguishable because the instruments considered there, although subordinated, gave rise to a right to be repaid a sum certain at some time within ten years; interest was to be paid at a fixed rate; and there was no conversion feature.

In both Rev. Rul. 68-54 and Rev. Rul. 73-122, unlike the present case, a consideration of the entire transaction revealed that true indebtedness was intended to be created; that is, unrelated parties dealing at arms length contemplated a cash repayment of the obligation within a fixed period of time. Here the parties contemplate that the ARCN's will not be redeemed for cash but will at some point be converted into stock of X.

HOLDING

The ARCN's constitute an equity interest in X and will be treated as stock for Federal income tax purposes. Accordingly, the periodic distributions with respect to the ARCN's, although denominated as interest, are distributions subject to section 301 of the Code, and are not deductible by X.

EFFECT ON OTHER REVENUE RULINGS.

Rev. Ruls. 68-54 and 73-122 are distinguished.

¹ Also released as News Release No. IR 83-87, dated June 24, 1983.