The factors applied by the courts and the IRS may differ slightly from case to case, but those most commonly considered are the following:
(1) the label or name given to the instrument;
(2) the presence or absence of a fixed maturity date;
(3) 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;
(4) the source of payments on the instrument;
(5) the right to enforce payment of principal and interest;
(6) the extent to which the rights of the holder are subordinated to the general creditors of the issuer;
(7) whether there is identity of interest between holders
of the instrument and stockholders of the issuer;
(8) the extent to which the holder has the right to participate in the management of the issuer;
(9) the intent of the parties;
(10) whether the issuer is thinly or adequately capitalized;
(11) the ability of the corporation to obtain loans from
outside lending institutions; and
(12) whether the instrument is intended to be treated as
debt or equity for non-tax purposes, including regulatory, rating agency or financial accounting purposes.
2.1.2. Relevant classification factors
The following discussion applies the factors listed in Notice 94-47 and other debt/equity factors to CoCos. Below, each of these factors is applied to the characteristics of the CoCos considered in this comparative survey, to determine whether such CoCos should be classified as debt or equity. This determination is also central to whether interest deductions may be taken by the issuer and how the payments under the instrument must be treated by the holder.
The label the parties attach to an instrument may be a relevant factor in determining the classification of that instrument as debt or equity. As the CoCos are referenced as debt instruments in the offering documents, that is one factor that supports debt classification.
184.108.40.206. Unconditional promise to pay a sum certain on-demand or a fixed maturity date that is in the reasonably foreseeable future
An important factor used in classifying an instrument as either debt or equity is whether the instrument has a definite maturity date on which the creditor is entitled to an unconditional repayment of principal. The presence of a fixed maturity date indicates a definite obligation to repay (a debt characteristic), and the absence of a fixed maturity date indicates that the repayment may depend on the fortunes of the issuer (an equity characteristic).
In addition, although the presence of a fixed maturity date to repay the principal is one of the indicia of debt, the date on which payment is due must be a date that is in the reasonably foreseeable future. In determining whether a maturity date for a particular instrument is a reasonable date, the courts have considered a number of factors, including the nature of the issuer’s business, the financial condition of the issuer, the length of time the issuer has been in existence and how likely it is that the issuer will be in existence when the instrument matures.
The IRS has stated that the “presence of a sum certain payable at maturity is a sine qua non of debt treatment under the Code”. In Rev. Rul. 83-98, the IRS concluded that notes payable at maturity in a predetermined number of
shares of stock must be treated as equity for tax purposes, but in contrast, in Rev. Rul. 85-119, the IRS found that debt that would be retired at maturity either with shares of stock then-equal in value to the principal amount of
the debt or with the proceeds from the sale of stock yielding an amount sufficient to retire the full amount of the debt, constituted true debt for tax purposes. As discussed above, Notice 94-47 warned that certain instruments
treated as debt in Rev. Rul. 85-119 would not be classified as debt if the holders of the instruments were required in all events to accept payment of principal solely in the stock of the issuer.
The principle underlying these rulings is that the holder of the debt instrument cannot be put at risk for the fortunes of the issuer with respect to the recovery of its investment. Put differently, there must be a sum certain to retire the debt investment in order for the instrument to
be treated as debt for tax purposes. This sum certain cannot exist if it is pegged to a set amount of stock the future value of which cannot be determined at the issuance date.
Whether this factor supports the classification of the CoCos as equity depends on the likelihood the conversion will be triggered, which is based on the capital position of the issuer. The conversion will be triggered only if the issuer’s capital ratio falls or threatens to fall below a certain level, and absent a significant deterioration in this capital ratio, the CoCos will be paid in full at maturity. If the possibility of conversion is remote, the conversion
feature might be ignored. The authors assume that none of the issuing banks contemplate a forced conversion of the CoCos when they are issued. Nevertheless, at the time of issuance of the CoCos, it is difficult to ascertain the likelihood that the conversion will be triggered prior to maturity.
Conventional convertible debt that will be converted into equity once a trigger price significantly in excess of the price of the issuer’s stock on the date of issuance of the debt is reached, is typically viewed as a debt instrument. In the case of the CoCos considered in this survey, the
conversion feature is triggered by the worsening condition of the issuer, which is a cause for greater concern as that undermines the requirement for certainty of return on the debt