Tax October 2007 ALBANY AMSTERDAM ATLANTA BOCA RATON BOSTON CHICAGO DALLAS DELAWARE DENVER FORT LAUDERDALE HOUSTON LAS VEGAS LOS ANGELES MIAMI NEW JERSEY NEW YORK ORANGE COUNTY ORLANDO PHILADELPHIA PHOENIX SACRAMENTO SILICON VALLEY TALLAHASSEE TAMPA TOKYO TYSONS CORNER WASHINGTON, D.C. WEST PALM BEACH ZURICH Strategic Alliances with Independent Law Firms BRUSSELS LONDON MILAN ROME TOKYO O IRS Provides Favorable Guidance on, and Parameters for, Convertible Bond Hedge Issuances On July 20, 2007, the Internal Revenue Service (IRS) released Associate Chief Counsel Advice Memorandum 2007-0014. AM 2007-0014 is the first federal income tax guidance that the IRS has released with respect to convertible bond hedge transactions. Although these transactions have been in the market for several years, the IRS noted several important elements that must be satisfied in order for the transactions to have their desired tax treatment. In certain instances, the new guidance differs from the market practice that we have seen. This GT Alert describes the elements of a convertible bond hedge transaction that will fall within the parameters specified by the IRS. Convertible bond hedge transactions are popular with issuers when the market favorably views their convertible debt, but the issuer does not desire to experience the dilution posed by the issuance of standard convertible notes. In a typical call spread convertible transaction, the issuer defeases the conversion feature in its convertible notes ( Notes ) with purchased call options on its common stock (the Hedges ). The cost of the Hedges is partially offset by the issuer writing out-ofthe-money cash-settled call options on its common stock (the Warrants ). By integrating the Notes with the Hedges in the manner discussed below, the issuer produces a synthetic fixed rate debt instrument, the initial issue price of which equals the Notes principal amount minus the cost paid for the Hedges. This creates deductible original issue discount ( OID ) for the issuer (but not taxable OID to the holders of the Notes). Additionally, any gain on the Warrants is not income to the issuer for federal income tax purposes. For example, a corporation issues Notes with a $1,000 face amount convertible into 20 shares of its stock, that is, the conversion price of the Notes is $50 per share. The Notes bear 1% stated interest per annum. The issuer purchases Hedges from an unrelated bank (the Bank ) allowing it to buy its own common stock at $50 per share, for an upfront cost of $100. The issuer writes Warrants to the Bank, allowing the Bank to purchase its common stock for $65 per share, for an upfront premium of $45. On these facts, the issuer deducts the 1% stated interest and has created OID on the Notes of $100, which is deductible over the term of the Notes. Holders of the Notes only include the 1% stated interest in income. The tax savings from the OID deductions will equal $35, at the maximum federal income tax marginal rate. The issuer has no income from the writing of the Warrants. In addition, if the Warrants expire worthless, the issuer should not have any income.
I. Detailed Description of the Transactions Described in AM 2007-0014 A corporation ( C ) issues mid-term Notes (i.e., five year convertible notes) with a zero interest rate. The issue price of the Notes is equal to their principal amount. Except in certain limited circumstances, 1 at no time before maturity may C call, or the holders put, the Notes; At any time, the holders may convert each Note into a number of shares of C s common stock and upon conversion elect for (i) physical settlement; (ii) net cash settlement; or (iii) net share settlement; On the issue date of the Notes, C purchases the Hedges from the Bank. Each Hedge entitles C to purchase a number of shares of C s common stock equal to the number of common shares at a strike price equal to the specified conversion price in the Notes. The Hedges settle in the same way as the converted Notes and, unless it is in connection with the conversion of the Notes, C has no right to purchase stock under the Hedges. The Hedges expire on the maturity date of the Notes and the Bank collects a premium from C for the Hedges based on their fair market value; On the issue date of the Notes, C sells Warrants to the Bank, which entitle the Bank to purchase a number of shares of C s common stock equal to the number of conversion shares at a strike price that is significantly higher than the strike price for the Hedges. The Warrants do not refer to the Notes or the Hedges; cannot be physically settled; are European-style options; and expire on the date that is at least several months after the final maturity of the Notes. The Bank pays a premium based on the fair market value of the Warrants. The Hedges and Warrants contain no rights of offset. II. U.S. Federal Income Tax Considerations In general, a corporation does not recognize gain or loss on dealings in its own stock or in options on its own stock. Section 1032(a) of the Internal Revenue Code of 1986, as amended (the Code ); Treas. Reg. 1.1032-3(d). AM 2007-0014 confirms, however, that when the Hedges are integrated with the Notes, the Hedges lose their stand-alone character as options governed by Code 1032 and instead meld into a term of the Notes. This melding of the Hedges into the Notes allows the issuer to obtain a deduction, over the duration of the Notes, for the premium paid on the Hedges. The integration election does not affect the holders of the Notes. Furthermore, the general rules of non-taxability continues to apply to the Warrants. Integration is generally permitted if a hedge (a Treasury Regulation 1.1275-6 hedge 2 ) or combination of Treasury Regulation 1.1275-6 hedges and a qualifying debt instrument together produce combined cash flows that are substantially equivalent to the cash flows on a fixed rate debt instrument or a variable rate debt instrument ( VRDI ). A Treasury Regulation 1.1275-6 hedge is defined as any financial instrument on which the combined cash flows of the financial instrument and the qualifying debt instrument either (1) permit the calculation of a yield to maturity under the principles of Code 1272 or (2) the right to the combined cash flows would qualify as a VRDI that pays interest at one or more qualified floating rates ( QFRs ), except for the requirement that the interest payments be stated as interest. Treas. Reg. 1.1275-6(b)(2)(i). A financial instrument is not a Treasury Regulation
1.1275-6 hedge, however, if the resulting synthetic debt instrument does not have the same duration as the remaining duration of the qualifying debt instrument. Finally, a financial instrument is defined as (1) a spot, forward, or futures contract, (2) an option, a notional principal contract, a debt instrument, or a similar instrument, or (3) a combination or series of financial instruments (stock is not a financial instrument for purposes of these integration rules and thus cannot operate as a Treas. Reg. 1.1275-6 hedge). Treas. Reg. 1.1275-6(b)(3). 3 A qualified debt instrument and a Treas. Reg. 1.1275-6 hedge constitute an integrated transaction under the following seven conditions: (1) the taxpayer must satisfy the identification requirements described below on or before the date the taxpayer enters into the hedge; (2) the parties must not be related or, if related, the party providing the hedge must use a mark-to-market method of accounting; (3) the same taxpayer must enter into both the qualifying debt instrument and the hedge; (4) if the taxpayer is a foreign person engaged in a U.S. trade or business that issues or acquires a qualifying debt instrument or that enters into a hedge through the trade or business, all items of income and expense associated therewith would be treated as effectively connected with the U.S. trade or business throughout the term of the synthetic debt instrument if integration treatment had not applied; (5) the qualifying debt instrument, any other debt instrument that is part of the same issue as the qualifying debt instrument, or the hedge must not have been part of an integrated transaction entered into by the taxpayer that has been terminated within thirty days immediately preceding the issue date of the synthetic instrument; (6) the qualifying debt instrument must be issued or acquired by the taxpayer on or before the date that the first payment on the hedge is made or received by the taxpayer; and (7) neither the hedge nor the qualifying debt instrument was, with respect to the taxpayer, part of a straddle as defined in Code 1092(c) prior to the issue date of the synthetic debt instrument. Treas. Reg. 1.1275-6(c)(1)(i)-(vii). The taxpayer cannot affirmatively obtain integration treatment if any of these requirements is not satisfied. Generally, in a typical convertible bond where the initial conversion price is at least 20% out-of-themoney (so that it is not certain that the Notes will be converted), the yield to maturity of the Notes will be considered to be its stated yield. See Treas. Reg. 1.1275-4(a)(4). Thus, when the Notes and the Hedges are treated as a single financial instrument, the resulting bond is a synthetic fixed rate discount debt instrument. The yield on the synthetic fixed rate discount debt instrument is a qualifying yield for integration purposes. Thus, the Notes should be treated as qualified debt instruments. 4 Options are within the categories of financial instruments treated as Treasury Regulation 1.1275-6 hedges. Therefore, the taxpayer may elect to integrate the Notes with the Hedges. 5 The IRS further concluded in AM 2007-0014 that, based on the principles set forth in Revenue Ruling 88-31, 1988-1 C.B. 302, the Hedges and Warrants should be treated as separate financial instruments for U.S. federal income tax purposes. Revenue Ruling 88-31 holds that a share of common stock and a contingent payment right issued together as an investment unit are separate items of property because they are separately tradable on a national securities exchange. See also Rev. Rul. 2003-97, 2003-2 C.B. 380 (Debt issued with a forward contract). In the case of the Warrants and the Hedges, their terms, as described above, were considered to be sufficiently disparate so that they were treated separately. It is worth noting that Treasury Regulation 1.1275-2(g) provide for an anti-abuse rule that, if applied by the IRS, could disallow the integration of the Notes and Hedges if the principal purpose is to achieve a result that is unreasonable under certain provisions of the Code. The IRS, however, has ruled in AM
2007-0014 that this anti-abuse rule should not apply to these type of transactions provided that the following conditions are satisfied: 1) The Warrants and the Hedges do not contain a right of offset. This helps in ensuring that the Warrants and Hedges are separate financial instruments. 2) The strike price of the Warrants is significantly greater than the strike price of the Hedges. 3) The Warrants do not refer to either the Notes or the Hedges. 4) The Warrants may not be physically settled. 5) The Warrants expire no earlier than several months after the stated maturity of the of the Notes. 6) The Hedges and the Warrants are each priced at fair market value. (In other words, the issuer is not attempting to unreasonably increase its OID deductions by overpaying for the Hedges and receiving back such overpayment by way of receiving an above-market consideration for the Warrants.) 7) The premium paid for the Hedges must be meaningfully greater than the premium received for the Warrants (this condition is a derivative of condition #2 above). In addition, AM 2007-0014 implicitly cautions financial institutions who write the Hedges and purchasing the Warrants against also purchasing the Notes and not electing to integrate the Notes with the Hedges. The cautionary note stems from the position of the IRS that such a transaction would allow the financial institution to unreasonably defer the income on the resulting synthetic discount bond. Although no mention is made, this cautionary note should not apply if the financial institution is accounting for the Hedges and the Warrants on the mark-to-market method of accounting. In this case, income is actually accelerated, so the perceived abuse should not considered to be present. To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any US federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein. 1 E.g., Consolidations, mergers, etc are treated as fundamental changes that permit a holder to put the notes for their stated principal amount in cash. 2 Code Sections or refer to the Internal Revenue Code of 1986, as amended (the Code ) and Treasury regulations promulgated thereunder. 3 See, Legal Advice Issued by Chief Counsel, LAFA 2007-014 (July 20, 1007). 4 We note that this would continue to be true, even if the Notes paid interest at a qualifying variable rate. However, we have yet to see a convertible bond hedge transaction using VRDIs. 5 Legal Advice Issued by Chief Counsel, LAFA 2007-014 (July 20, 1007) at p. 5.
This GT Alert was written by Mark Leeds and Diana Davis in New York City. Mark Leeds is a shareholder with the New York office of Greenberg Traurig. Diana Davis is a senior associate at the same firm. Their professional practices focus on U.S. and foreign tax issues presented by financial products and strategies. Questions about the content of this Alert can be directed to: Mark Leeds at 212.801.6947 (leedsm@gtlaw.com) Diana Davis at 212.801.6706 (davisd@gtlaw.com) Yoram Keinan at 212.801.2826 (keinany@gtlaw.com) Or your GT attorney Albany 518.689.1400 Amsterdam + 31 20 301 7300 Atlanta 678.553.2100 Boca Raton 561.955.7600 Boston 617.310.6000 Chicago 312.456.8400 Dallas 214.665.3600 Delaware 302.661.7000 Denver 303.572.6500 Fort Lauderdale 954.765.0500 Houston 713.374.3500 Las Vegas 702.792.3773 Los Angeles 310.586.7700 Miami 305.579.0500 New Jersey 973.360.7900 New York 212.801.9200 Orange County 714.708.6500 Orlando 407.420.1000 Philadelphia 215.988.7800 Phoenix 602.445.8000 Sacramento 916.442.1111 Silicon Valley 650.328.8500 Tallahassee 850.222.6891 Tampa 813.318.5700 Tokyo + 81 3 3264 0671 Tysons Corner 703.749.1300 Washington, D.C. 202.331.3100 West Palm Beach 561.650.7900 Zurich + 41 44 224 22 44 This Greenberg Traurig Alert is issued for informational purposes only and is not intended to be construed or used as general legal advice. The hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer s legal qualifications and experience. Greenberg Traurig is a trade name of Greenberg Traurig, LLP and Greenberg Traurig, P.A. 2007 Greenberg Traurig, LLP. All rights reserved.