I. Intention of the parties
The intention of the parties is frequently highlighted by the courts as being important in determining whether an instrument is a debt or equity. As intent is not an objective factor, all facts and circumstances giving rise to the instrument are usually examined. For example, how the issuer and investor treat the instrument for tax and book purposes may indicate the intentions of the parties. It should be noted that some commentators, particularly Professor Plumb, argue that intent of the parties should not be gleaned from an examination of all other factors.
J. Thin or inadequate capitalization
An issuer with a high debt-to-equity ratio could be at risk of having an instrument denominated as debt actually treated as stock. Thin capitalization may create the presumption that an instrument is so at risk of the business that it may be regarded as venture capital. Some courts have disregarded the thin capitalization of an issuer where there the facts indicate a reasonably assured cash flow sufficient to service the purported debt.
III. TAXATION OF SPECIFIED HYBRIDS
A. Convertible bonds, debts, loans, notes and debentures
Convertible debt is generally treated as a debt instrument until conversion, after which it becomes equity. If an instrument is issued at a premium (i.e in excess of the face amount) for cash, the holder may amortize the premium over the life of the bond using a compounded-interest method. The issuer must include any amount attributable to the bond’s conversion features. Furthermore, the bond premium does not include any difference between the fair market value of securities received in the conversion and the value of converted bonds.
If an instrument is issued at a discount (i.e at a price below its face amount) for cash, the holder must accrue what is called the “original issue discount” (hereinafter: OID) in income over the life of debt. OID is defined as the excess of the debt instruments “stated redemption price at maturity” (hereinafter SRPM) over its “issue price”. The SRPM is defined as the
amount fixed by the last modification of the purchase agreement and includes interest and other amounts payable at that time (other than any interest based on a fixed rate, and payable unconditionally at fixed periodic intervals of one year or less during the entire term of the debt instrument).
The issuer may deduct the OID amount as additional interest over the life of the debt. It should be noted that in computing the OID, no adjustments are made for the value of the conversion privilege. When a bond is retired for cash, the amount by which the repurchase price exceeds the bond’s “adjusted issue price” is treated like a premium. This premium is deductible to the extent that it is not greater than a call premium on comparable non-convertible debt. The portion that is no deductible is treated as attributable to the repurchase of the bond’s conversion featured. In the situation, the holder’s gain will generally constitute capital gain.
In the case where a bond is retired for less than its face amount, the issuer may have to recognize “cancellation-of-debt” (hereinafter: COF) income. COF income is measured by the spread between the amount paid to discharge the debt and the debt’s “adjusted issue price”. The exercise of an option to convert a bond into the stock of the issuer is not a taxable exchange. Gain or loss on the conversion is recognized only when the taxpayer disposes of the stock. This rule applies only if the conversion feature is provided for in the bond and only where the stock received in the conversion is the same stock of the issuer of the bond.