Contingent Interest Convertible Bonds and the Economic Accrual Regime
Posted: 24 Jun 2002
This article discusses the policy issues relevant to the taxation of contingent interest convertible bonds and of conventional convertible bonds. The policy discussion is framed by reference to Revenue Ruling 2002-31, which addresses many of the central policy issues surrounding contingent interest convertibles. The article also responds to Notice 2002-36, in which the Treasury Department and the Internal Revenue Service express concern about the disparity in the treatment of contingent convertibles and conventional convertibles and invite comment on that issue.
The article discusses each of the main holdings of Revenue Ruling 2002-31 from a policy perspective and argues that the ruling is correct to hold that contingent interest convertibles are properly taxed under the rules applicable to contingent payment debt instruments rather than those applicable to conventional convertible debt. The article also considers issues raised by sections 163(l), 249 and 1032, and agrees with the policy choices made by the ruling, which generally allow an issuer of a contingent convertible bond to deduct interest expense to the extent of the comparable yield, as determined under the contingent payment debt instrument rules.
The article further offers some response to the issues raised by Notice 2002-36 by arguing that the rules for taxing conventional convertible bonds lead to a systematic underaccrual of income and that any tension between the taxation of contingent convertibles and conventional convertibles is best resolved by taxing conventional convertibles as contingent payment debt instruments.
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