Equity Classification Of Convertible Debt?: Tax And Cash Flows Considerations

The issue of debt versus equity classification for hybrid securities has been a source of continuing controversy for tax policy-makers and financial accounting standard setters. A large number of corporations have issued hybrid financial instruments which possess the characteristics of both debt and equity. One of the most common examples of hybrid financial instruments is convertible debt. Issuers of convertible debt were motivated by a desire to raise capital that would be attractive to the capital markets while at the same time exploit tax or reporting rules. For instance, the issuer of convertible debt is allowed a tax deduction for interest expense even though the convertible debt instrument may later be converted to equity, thus avoiding repayment of principal at maturity. The Internal Revenue Service (IRS) allows the issuer a tax deduction for interest expense, while requiring the holder to recognize taxable interest income. However, the IRS and the Financial Accounting Standards Board (FASB) have considered treating convertible debt according to its underlying economic substance and ultimate outcome as opposed to treating it strictly as debt. If the IRS, the FASB, or both were to move towards an economic substance approach with respect to convertible debt, what implications would this have on the issuers and holders of convertible debt? This article speculates on changes in tax and reporting rules for convertible debt and analyzes the potential impact of such changes on the treatment of distributions from convertible debt. Our analysis shows that if convertible debt were treated as equity and its distributions no longer eligible for interest expense deductions, issuers would experience a decrease in cash flow from operations due to the presumed increase in tax liability. Conversely, holders of convertible debt may be eligible for the dividends-received deduction.