B. Warrants, options, and rights
The cash or property that a corporation receives when it issues a warrant to purchase its own stock is not taxable (it is viewed as non-taxable capital receipts). The proceeds remain tax-exempt even when the warrant lapses without being exercised. However, if the corporation repurchases the warrant, the proceeds used to buy it back are not deductible. Often, warrants are issued as part of an “investment unit”. An investment unit generally consists of a debt obligation with a warrant attached. This issue’s price of the investment unit must be allocated between the debt and warrant in proportion to their relative fair market values. The bifurcation often results in the creation of OID.
The following example illustrated the investment unit bifurcation rules. Larry Lender purchased a bond from Tech Corp. Larry paid USD 100 for a 5 per cent, 20 year bond, with a principal amount of USD 100, together with a 5-year warrant entitling Larry to purchase 10 shares of Tech’s stock at USD 10 per share. On the date Tech issued the bond to Larry, the bond was worth USD 88, the warrant was worth USD 12, and Teach’s stock was worth USD 9 per share. In this example, Teach is treated as issuing and Larry is treated as purchasing the bond for USD 88 and the warrant for USD 12. The bifurcation creates USD 12 of OID on the bond, which Tech may deduct and Larry must report as ordinary income. If Larry exercises the warrants, he will not realize any gain or loss and his basis in the Tech stock will be USD 112 (USD 100 exercise price plus USD 12 basis in the warrants). IF Larry decided to sell the warrant instead of exercising them, he will realize a capital gain or loss on the difference between his USD 12 basis in the warrants and the amount realized on the sale. If Larry allows the warrants to lapse, he would incur a USD 12 capital loss. Furthermore, the issuer, Tech Corp., does recognize any gain or loss on the issue, exercise, repurchase or lapse of the warrants.
C. Preferred Shares/Stock
Preferred stock is a security where the blurred line between debt and equity is often tested. The type of preferred stock and how it is structured will determine its states as debt or equity. The most basic form of preferred stock, that which enjoys limited rights and privileges (i.e. with respect to dividends and liquidation rights) in relation to other outstanding stock but without participating in corporate growth to any significant extent, is generally treated as equity. Dividends are distributions that are treated as ordinary income and included in gross income by the recipient. When a distribution is in excess of current and accumulated earnings and profits, it is not considered a dividend and is not included in income. The distribution decreases the recipient shareholder’s basis in the stock to the extent of his or her basis, and thereafter it is usually related as capital gains.
Special rules apply to corporate shareholders that receive dividends. Generally, corporate shareholders can deduct dividends received from taxable domestic corporations. The amount that the recipient corporation can deduct depends upon the extent of its ownership interest in the issuing corporation. The recipient corporation can generally deducts:
- 70 per cent of the dividends if it owns less than 20 per cent of the voting power and value of the stock of the issuing corporation;
- 80 per cent of the dividend if it owns at least 20 per cent but less than 80 per cent of the voting power and value of the stock of the issuing corporation; and
- 100 per cent of the dividend if it is a small business investment company or if the recipient and issuer are members of the same affiliated group.
Dividends are included in income in the year in which the income is unqualifiedly made subject to the shareholder’s demand, which generally occurs at the time the dividends are received. The rule applies to both accrual- and cash-basis taxpayers. For instance, a dividend distributed on 31 December 1998 and received by an accrual-basis shareholder on 2 January 1999 is included in income in 1999. A recent example of preferred stock that has been treated as debt is monthly income preferred stock (hereinafter: MIPS). A MIPS transaction provides a borrower with an interest expense deduction for tax purposes while avoiding reporting the borrowing fro financial accounting purposes. Generally, a pass-through entity, such as a partnership (or an entity treated as a partnership for US federal income tax purposes), is set up by the borrower. The pass-through entity then issues equity interests (the MIPS) that have a debt-like return. The proceeds from the sale of the MIPS are lent to the borrower, thereby allowing the borrower to take an interest expense deduction. Commonly, the borrower and the pass-through entity are consolidated for financial accounting purposes, which result in the elimination of the debt and allows the issuer to treat the MIPS as a minority equity interest in a subsidiary resulting in an increase of its capital.
The IRS recently issued a technical advice memorandum in which it found a MIPS transaction to be debt. The IRS applied the factor discussed in a notice previously issued in response to MIPS and DECS (i.e. debt exchangeable for common stock) transactions. In this notice, the IRS stated that it would scrutinize certain instruments designed to be treated as debt for federal income tax purposes but as equity for regulatory, rating agency, or financial accounting purposes. The IRS stated that its characterization of an instrument as debt or equity will depend on the terms of the instrument and all surrounding facts and circumstances. The factors the IRS said it would consider are:
- whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future;
- whether holders of the instruments possess the right to enforce the payment of principal and interest;
- whether the rights of the holder of the instruments are subordinate to the rights of general creditors;
- whether the issuer is thinly capitalized;
- whether there is identify between holder of the instruments and stockholders of the issuer;
- the label placed on the instruments by the parties; and
- whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency or financial accounting purposes.