rr-02-31.pdf

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Part I

Section 1275.B-Other definitions and special rules

26 CFR 1.1275-4: Contingent payment debt instruments.
(Also '' 163, 249; 1.249-1.)

Rev. Rul. 2002-31

ISSUES
Does the noncontingent bond method described in
' 1.1275-4(b) of the Income Tax Regulations apply to a debt
instrument that is convertible into stock of the issuer and that
also provides for one or more contingent cash payments? If so,
how is the comparable yield determined, and does either ' 163(l)
or ' 249 of the Internal Revenue Code affect the issuer=s ability
to deduct the interest that accrues on the instrument under the
noncontingent bond method?
FACTS
On January 1, 2002, Corporation X
issues for $625x a 20-year
debt instrument with a stated principal amount of $1,000x
.
Except for the contingent interest payments described below, the
debt instrument does not provide for any stated interest. The

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debt instrument is convertible at any time into a number of
shares of Corporation X
common stock having a value, on the date
of issue of the debt instrument, that is significantly less than
$625x
. The debt instrument is part of an issue that is not
marketed or sold in substantial part to persons for whom the
inclusion of interest from the instruments in the issue is not
expected to have a substantial effect on their U.S. tax
liability.
The debt instrument provides that, beginning after January
1, 2005, interest (Acontingent interest@) is payable for any six-
month period ending on June 30 or December 31 if the average
market price of the instrument for a measurement period before
the applicable six-month period is greater than 120 percent of
the instrument=s accreted value. Under the terms of the debt
instrument, accreted value is defined as the issue price of the
instrument plus the economic accrual to any date of determination
of a portion of the difference between the issue price and the
stated principal amount at maturity. The amount of contingent
interest that is payable is equal to the greater of (1) the
regular cash dividend per share of Corporation X
common stock for
the six-month period multiplied by the number of shares into
which the debt instrument may be converted, or (2) y percent of
the average market price of the debt instrument for the
measurement period. The contingent interest is neither a remote

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nor an incidental contingency within the meaning of ' 1.1275-
2(h).
On or after January 1, 2005, Corporation X has the option to
redeem the debt instrument for cash in an amount equal to the
instrument=s accreted value as of the date the instrument is
redeemed. In addition, the holder of the debt instrument has the
option to put the debt instrument to Corporation X
on January 1,
2005, or January 1, 2012, for an amount equal to the instrument=s
accreted value as of each such date. If the holder exercises
this option, Corporation X
can satisfy its obligation with cash,
shares of Corporation X common stock, or a combination of cash
and shares of Corporation X
common stock, in each case having a
total value equal to the instrument=s accreted value. Taking
into account both the likelihood of conversion of the debt
instrument and the likelihood that the instrument will be put by
the holder, it is not substantially certain that a substantial
amount of the principal or interest on the debt instrument will
be required to be paid in stock or will be payable in stock at
the option of the issuer.
Corporation X
takes the position that the noncontingent bond
method applies to the debt instrument and that the comparable
yield for the instrument is 7 percent, compounded semiannually.
(To determine the comparable yield under ' 1.1275-4(b),
Corporation X used the yield at which it would issue a comparable

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fixed-rate, nonconvertible debt instrument.) In preparing the
projected payment schedule required by the noncontingent bond
method, Corporation X
projects payments of contingent interest
and a payment at maturity (based on a projected exercise of the
conversion privilege) in an amount sufficient to cause the yield
on the debt instrument to equal 7 percent, compounded
semiannually. When the debt instrument was issued, the long-term
applicable Federal rate (AFR) was 5.39 percent, compounded
semiannually.
LAW AND ANALYSIS
Section 1.1275-4 provides rules for the treatment of
contingent payment debt instruments. In general, if a contingent
payment debt instrument is issued for cash or publicly traded
property, the noncontingent bond method applies to the
instrument. See
' 1.1275-4(b). Under the noncontingent bond
method, interest accrues on the debt instrument as if it were a
fixed-payment debt instrument. This fixed-payment debt
instrument is constructed by using the instrument=s comparable
yield and a projected payment schedule.
In general, under ' 1.1275-4(b)(4)(i), the comparable yield
for a contingent payment debt instrument is the yield at which
the issuer would issue a fixed rate debt instrument with terms
and conditions similar to those of the contingent payment debt
instrument. Relevant terms and conditions include the level of

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subordination, term, timing of payments, and general market
conditions. In determining the comparable yield, no adjustments
are made for the riskiness of the contingencies or the liquidity
of the debt instrument. In all cases, the yield must be a
reasonable yield for the issuer and may not be less than the AFR.
In certain situations, the comparable yield is presumed to be
the AFR. See
' 1.1275-4(b)(4)(i)(B).
The projected payment schedule for a debt instrument
includes each noncontingent payment and a projected amount for
each contingent payment. See ' 1.1275-4(b)(4)(ii). In general,
if a contingent payment is based on market information, the
amount of the projected payment is the forward price of the
contingent payment. If a contingent payment is not based on
market information, the amount of the projected payment is the
expected value of the contingent payment as of the issue date.
If the projected payment schedule and the instrument=s issue
price do not produce the comparable yield, then the schedule must
be adjusted to produce the comparable yield. In most cases, the
issuer=s determination of the projected payment schedule will be
respected unless it was set with a principal purpose to
overstate, understate, accelerate, or defer interest accruals on
the debt instrument. See
' 1.1275-4(b)(4)(v).
If the actual amount of a contingent payment is different
from the projected payment, then the difference is taken into

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account as either a positive or negative adjustment. A positive
adjustment results when the actual amount is greater than the
projected amount. In general, a net positive adjustment is
treated as interest and is includible in income by the holder and
deductible by the issuer in the taxable year in which the
adjustment occurs. A negative adjustment results when the actual
amount is less than the projected amount. In general, a net
negative adjustment (1) reduces interest accruals on the debt
instrument for the taxable year, (2) to the extent of any excess,
is treated as an ordinary loss by a holder and ordinary income by
the issuer, but only to the extent of prior accruals on the debt
instrument by the holder or issuer, and (3) to the extent of any
further excess, is a carryforward to the next taxable year. See
' 1.1275-4(b)(6) for the specific rules that apply to negative
and positive adjustments.
Except as provided in ' 1.1275-4(a)(2), ' 1.1275-4 applies
to any debt instrument that provides for one or more contingent
payments. A payment is not a contingent payment merely because
of a contingency that, as of the issue date, is either remote or
incidental. See ' 1.1275-2(h) for rules relating to remote and
incidental contingencies.
In addition, a debt instrument does not provide for
contingent payments merely because it provides for an option to
convert the instrument into the stock of the issuer, into the

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stock or debt of a related party, or into cash or other property
in an amount equal to the approximate value of such stock or
debt. Section 1.1275-4(a)(4). However, this exception does not
apply when the debt instrument provides for contingent payments
other than the conversion feature and those contingent payments
are neither remote nor incidental.
Although the debt instrument issued by Corporation X

provides for an option described in ' 1.1275-4(a)(4), the debt
instrument also provides for one or more contingent payments (the
contingent interest) that are neither remote nor incidental. As
a result, the debt instrument is a contingent payment debt
instrument subject to the noncontingent bond method described in
' 1.1275-4(b). Although a conversion feature alone does not
cause a convertible debt instrument to be subject to the
noncontingent bond method, the possibility of a conversion is
nevertheless a contingency. Therefore, the comparable yield for
a convertible debt instrument subject to the noncontingent bond
method is determined under ' 1.1275-4(b) by reference to
comparable fixed-rate nonconvertible debt instruments. Moreover,
the projected payment schedule is determined by treating the
stock received upon a conversion of the debt instrument as a
contingent payment.
Under ' 1.163-7, the amount of interest that is deductible
each year on a contingent payment debt instrument is determined

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under ' 1.1275-4. Therefore, for purposes of ' 163(a),
Corporation X
computes its interest deductions for each year the
debt instrument is outstanding based on the comparable yield of 7
percent, compounded semiannually. Based on the facts set forth
above, the original issue discount anti-abuse rule in ' 1.1275-
2(g) does not apply because the result reached is not
unreasonable in light of the purposes of ' 163(e), '' 1271
through 1275, or any related section of the Code. The anti-abuse
rule, therefore, does not affect Corporation X
=s ability to
compute its interest deductions based on the comparable yield of
7 percent, compounded semiannually.
Certain provisions of the Internal Revenue Code, such as
' 163(l) and ' 249, may affect an issuer=s ability to deduct the
interest computed under the noncontingent bond method.
Section 163(l), which was added to the Internal Revenue Code
by the Taxpayer Relief Act of 1997, ' 1005, 1997-4 (Vol. 1) C.B.
125, provides that no deduction is allowed for any interest paid
or accrued on a disqualified debt instrument, which is any
indebtedness of a corporation that is payable in equity of the
issuer or a related party. Under ' 163(l), indebtedness is
payable in equity only if (A) a substantial amount of the
principal or interest is required to be paid or converted, or at
the option of the issuer or a related party is payable in, or
convertible into, such equity, (B) a substantial amount of the

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principal or interest is required to be determined, or at the
option of the issuer or a related party is determined, by
reference to the value of such equity, or (C) the indebtedness is
part of an arrangement that is reasonably expected to result in a
transaction described in either (A) or (B) above. Principal or
interest is required to be so paid, converted, or determined if
it may be required at the option of the holder or a related party
and there is a substantial certainty the option will be
exercised.
The conference report on the 1997 legislation indicates that
an instrument is treated as payable in stock if it is part of an
arrangement designed to result in payment with or by reference to
such stock, including certain issuances of a forward contract in
connection with the issuance of debt, nonrecourse debt that is
secured principally by such stock, or certain debt instruments
that are convertible at the holder=s option when it is
substantially certain that the right will be exercised. The
conference report further states that it is not expected that '
163(l) will affect debt with a conversion feature if the
conversion price is significantly higher than the market price of
the stock on the issue date of the debt. See
H.R. Conf. Rep. No.
220, 105th Cong., 1st Sess. 523-24 (1997), 1997-4 (Vol. 2) C.B.
1993-94.

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Under the terms of the debt instrument issued by Corporation
X
, none of the instrument=s principal or interest is required to
be determined by reference to the value of Corporation X=s stock.
Although the value of Corporation X
=s stock is used in
constructing the debt instrument=s projected payment schedule,
this projected payment is not determinative in applying ' 163(l)
to the instrument. Under the noncontingent bond method, the
projected payment schedule is a mechanism for comparing actual
payments to projected payments and then applying the rules for
negative and positive adjustments.
The debt instrument will be paid in stock on conversion and
may be paid in stock, at the option of Corporation X
, if the
holder exercises its put option. Nevertheless, it is not
substantially certain that a substantial amount of the principal
or interest on the debt instrument will be required to be paid in
stock or will be payable in stock at the option of Corporation X
.
Therefore, the debt instrument is not a disqualified debt
instrument under ' 163(l), and ' 163(l) does not bar Corporation
X
=s accrual of interest deductions based on the comparable yield
of 7 percent, compounded semiannually.
Section 249 provides that no deduction is allowed to the
issuing corporation for any premium paid or incurred upon the
repurchase of a bond, debenture, note or certificate or other
evidence of indebtedness that is convertible into the stock of

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the issuing corporation, or a corporation in control of, or
controlled by, the issuing corporation, to the extent the
repurchase price exceeds an amount equal to the adjusted issue
price plus a normal call premium on bonds or other evidences of
indebtedness that are not convertible. However, ' 249 does not
apply to the extent the corporation can demonstrate to the
satisfaction of the Secretary that such excess is attributable to
the cost of borrowing and is not attributable to the conversion
feature. See ' 1.249-1. For purposes of ' 249, a conversion is
a repurchase. See
Clark Equipment Company v. United States, 912
F.2d 113 (6th Cir. 1990). See also '' 1.61-12(c)(2) and 1.163-
7(c).
Section 249 was added to the Internal Revenue Code in 1969
because, in the case of a premium paid upon a corporation=s
repurchase of its convertible indebtedness, Congress believed
that the amount of the premium in excess of the cost of borrowing
is not analogous to an interest expense or deductible business
expense. Instead, the amount is paid in a capital transaction
analogous to a corporation=s repurchase of its common stock and,
therefore, is not deductible. H.R. Rep. No. 413 (Part 1), 91st
Cong., 1st Sess. 1, 110 (1969), 1969-3 C.B. 200, 269; S. Rep. No.
552, 91st Cong., 1st Sess. 1, 149 (1969), 1969-3 C.B. 423, 518.
Section 249 applies only to a premium paid to repurchase a
convertible debt instrument. Therefore, ' 249 does not affect

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Corporation X=s ability to deduct accruals of interest based on
the comparable yield. However, ' 249 applies to a conversion of
the debt instrument into stock having a value in excess of the
debt instrument=s adjusted issue price. See
Clark Equipment;
National Can Corp. v. United States, 687 F.2d 1107 (7th Cir.
1982); and ' 1.249-1. Therefore, this excess is not deductible
by Corporation X
, except to the extent the excess does not exceed
a normal call premium under ' 1.249-1(d) or Corporation X can
demonstrate that the excess is attributable to the cost of
borrowing and not to the conversion feature.
HOLDINGS
The noncontingent bond method described in ' 1.1275-4(b)
applies to the convertible debt instrument issued by Corporation
X
. The yield at which Corporation X would issue a comparable
fixed rate nonconvertible debt instrument is used to determine
the instrument's comparable yield and, therefore, the accruals of
interest on the instrument. In addition, the debt instrument is
not a disqualified debt instrument under ' 163(l). Moreover, '
249 does not affect Corporation X
=s ability to deduct periodic
interest accruals on the debt instrument. However, if the debt
instrument is converted into Corporation X
stock having a value
in excess of the debt instrument=s adjusted issue price,
Corporation X
may not be able to deduct this excess under ' 249.

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DRAFTING INFORMATION
The principal authors of this revenue ruling are William E.
Blanchard and Dale S. Collinson of the Office of Associate Chief
Counsel (Financial Institutions and Products). For further
information regarding this revenue ruling contact Mr. Blanchard
on (202) 622-3950 and Mr. Collinson on (202) 622-3900 (not toll-
free calls).