220.127.116.11. Voting and management rights
A right to vote and participate in the management of the issuer supports equity treatment.34 There is no indication that the holders of the CoCos here have voting or management rights, so long as the conversion feature is
18.104.22.168. Intent of the parties
The intent of the holder and the issuer of an instrument, at the time the instrument was entered into, is also a factor in deciding whether the instrument constitutes debt or equity
Here, the CoCos are referenced as debt instruments. However, CoCos are issued in part to enable “a fresh injection of capital into a distressed bank”, so there is an intention that the CoCos could turn into equity.
22.214.171.124. Thin capitalization of the issuer
In general, if a corporation has a nominal stock capitalization coupled with excessive debt, this fact would tend to indicate that an instrument labelled debt might constitute equity. As a result, the debt/equity ratio is another factor used to determine whether an instrument is debt or equity. The debt/equity ratio indicates to what extent a corporation may suffer losses without impairment of the interests of the corporation’s creditors. A high ratio lowers the protection afforded to the creditors against sudden business slumps. As a result, a high ratio of debt to equity indicates that the issuance of the instrument is a contribution to capital rather than a bona fide loan.
However, courts have recognized purported debt as debt in cases where a corporation’s debt/equity ratio was approximately 30:1, 300:1, 650:1, and in certain circumstances, approximately 20,000:1. Such courts appeared to have considered the debt/equity ratio in the context of determining the reasonableness of the debt holder’s expectation of timely repayment, which, by itself, is a significant factor in the debt/equity analysis.42 Thus,
even a finding that an issuer is thinly capitalized may not adversely affect debt classification if cash flows sufficient to service the debt can be demonstrated to be reasonably assured.
No facts have been included in the description as to the capitalization of the issuer, so no conclusion can be reached on this factor.
126.96.36.199. Availability of outside loans
The ability of an issuer to obtain loans from independent lenders is relevant to the characterization of a purported debt instrument because a loan that purports to be debt “is obviously a loan in name only” where such “advance is far more speculative than what an outsider would make” Here, it is likely that the issuers of the CoCos are able to obtain independent loans, outside of the CoCos.
188.8.131.52. Treatment of instrument for non-tax purposes
Whether an instrument is intended to be treated as debt or equity for non-tax purposes is also relevant to the tax characterization of the instrument.
CoCos qualify as Tier 1 capital for regulatory purposes. However, the underlying idea behind issuing CoCos could weigh in favour of treating the CoCos as debt. In the recent financial crisis, when some large financial
institutions essentially became insolvent, the common shareholders suffered a loss of most, if not all, of their investment. However, sovereign governments bailed out the senior creditors, fearing that if they failed to do so, the banks in question could not fund themselves and the financial system as a whole might falter. Regulators have sought a fashion to put at least some of the senior creditors at risk in order to put additional market discipline (so-called “moral hazard”) into the operation of the credit markets for systemically important banks. CoCos are viewed as one means of doing this. Accordingly, from a regulatory perspective, it appears that contingent capital instruments, such as CoCos, were intended to be treated as debt instruments in the credit markets.
On balance, a few of the factors that the IRS and courts have used to determine whether an instrument is debt or equity support the view that the CoCos here are debt, but other factors support the view that the CoCos are equity. In particular, the conversion feature and the lack of an unconditional promise to pay a sum certain, the payment of interest at the discretion of the issuer, the subordinated status of the instruments, and the lack of creditor rights upon conversion all weigh in favour of equity treatment. Further, if the term of the CoCos is perpetual, then that
factor, combined with the others, would strongly weigh in favour of equity treatment. Assuming that the term is 30 years, however, the ultimate conclusion the IRS or a court reaches will probably rest on the likelihood that the conversion will be triggered. This is because a novel feature of a CoCo is that it has a mandatory conversion feature, which unlike conventional convertible debts that are generally respected as debt for US federal income tax purposes, does not guarantee that the conversion will
give the holder stock having a value equal to or greater than the principal amount of the CoCo. This mandatory conversion feature, depending on the likelihood that it will be triggered, results in the lack of an unconditional
promise to pay a sum certain, which is perhaps the most important factor supporting the classification of an instrument as debt.
Absent a ruling from the IRS, the treatment of CoCos cannot be determined with certainty, and equity treatment may become the opinion standard followed by most issuers. However, given the proclivity of the tax authorities to be supportive of the debt treatment of hybrid-type instruments approved by banking authorities, the US tax authorities could still conclude that debt treatment is proper.