The debt instrument in Rev. Rul. 2002-31 provided that, beginning after five years following issuance, interest (“contingent interest”) was payable for any six-month period ending on 30 June or 31 December if the average market price of the instrument for a measurement period before the applicable six-month period was greater than 120% of the instrument’s accreted value. Under the terms of the debt instrument, accreted value was defined as the issue price of the instrument plus the economic accrual to
any date of determination of a portion of the difference between the issue price and the stated principal amount at maturity. The amount of contingent interest that was payable was equal to the greater of (1) the regular cash dividend per share of the issuer’s common stock for the six-month period multiplied by the number of shares into which the debt instrument may be converted or (2) y% of the average market price of the debt instrument for the measurement period. The contingent interest was neither a remote nor an incidental contingency within the meaning of Treas. Reg. Sec. 1.1275-2(h).
On or after five years following issuance, in Rev. Rul. 2002-31 the issuer had the option to redeem the debt instrument for cash in an amount equal to the instrument’s accreted value as of the date the instrument was redeemed. In addition, the holder of the debt instrument had the option to put the debt instrument to the issuer five years after issuance, or 10 years after issuance, for an amount equal to the instrument’s accreted value as of each such date. If the holder exercised this option, the issuer could satisfy its obligation with cash, shares of its own common stock, or a combination of cash and shares of its own common stock, in each case having a total value equal to the instrument’s accreted value. Taking into account both the likelihood of conversion of the debt instrument and the likelihood that the instrument will be put by the holder, the ruling provides that it was not substantially certain that a substantial amount of the principal or interest on the debt instrument would be required to be paid in stock or will be payable in stock at the option of the issuer.
Rev. Rul. 2002-31 concludes that the non-contingent bond method of Treas. Reg. Sec. 1.1275-4(b) applied to the instrument in consideration, which necessarily means that the instrument was treated as debt.
Although raising similar issues, the CoCo is not sufficient similar to the instrument considered in Rev. Rul. 2002-31 to be able to conclusively rely upon the ruling for a characterization as debt. Thus, the CoCo must be tested under the general rules for distinguishing debt and equity under US tax laws.
Under Sec. 385(a),7 the Treasury is authorized to prescribe regulations to determine whether an interest in a corporation is to be treated as stock or debt (or as in part stock and in part debt). Sec. 385(b) sets forth some of the
factors that the regulations should take into account to determine whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists. These factors include the following: (1) whether there is a written unconditional promise to pay on-demand or on a specified 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, (2) whether there is subordination to or preference over any indebtedness of the corporation, (3) the ratio of debt to equity of the corporation, (4) whether there is convertibility into the stock of the corporation and (5) the relationship between holdings of stock in the corporation and holdings of the interest in question.
Proposed regulations under Sec. 385(a) were issued on 24 March 1980, which set forth the factors to be considered in determining whether an instrument was stock or debt. Final regulations under Sec. 385(a) were then issued in December 1980 (with a delayed effective date that was
extended several times). The final regulations, however, were withdrawn in 1983.8 There currently are no regulations under Sec. 385.
The IRS has set forth its views on determining whether an instrument is debt or equity in several rulings and other guidance, including Rev. Rul. 85-1199 and Notice 94-47.