D. Debt exchangeable for common stock
Debt exchangeable for common stock (hereinafter: DECS) is a security that is used by issuers as means to monetize their appreciated investment in other corporations without recognizing the gain at the time the DECS securities are issued. Although no IRS rulings or technical advise memoranda have been specifically issued with respect to DECS, based on other authorities, issuers have been treating the security as debt.
A DECS transition is generally structured as follows. An issuer borrows funds by using stock as collateral for the debt that is convertible into the reference stock. The principal amount of the stock. At maturity, the principal amount of the debt will be exchanged into a number of shares of stock based upon a formula that fluctuates with the value of the stock. DECS securities are generally subject to a conversion cap, thereby shifting the downside risk on the stock to the holder of the debt instrument (i.e. DECS instrument) while retaining the upside in excess of the cap. The issuer and holder of the DECS security agree in the indenture that, for tax purposes, the DECS will be treated as an investment unit consisting of a debt instrument in the principal amounts of the DECS and a forward purchase contract to acquire the stock with the principal that is payable to maturity. Thus, allowing the DECS issuer to claim current interest expense deductions (as interest is paid on the debt) and avoid recognition of gain on the referenced stock until the date the debt is exchanged for stock.
As the financial engineers of Wall Street continue to test the boundaries of the debt/equity distinction with increasingly aggressive hybrid products, it is likely that more guidance on the issue will be seen.