Part III. Administrative, Procedural, and Miscellaneous

by requiring use of the nonconversion yield on a straight convertible debt instrument as the comparable yield for accruals on contingent convertible debt instruments under the noncontingent bond method.

Several commentators have focused attention on the rule that only remote and incidental contingencies are disregarded in determining whether a debt instrument is a contingent debt instrument. See §§ 1. 1275–4(a)(5) and 1.1275–2(h). To the extent that § 1.1275–4 takes into account contingent payments that are relatively unlikely to occur (but not so unlikely as to be remote) and relatively insignificant in amount (but not so insignificant as to be incidental), the narrow scope of the exception tends to make largely elective the exclusion of straight convertible debt from the noncontingent bond method. That is, through changes in the terms of debt instruments that result in relatively small economic differences, issuers can trigger the application of the comparable yield methodology. Critics of this result have suggested an expansion of the universe of contingent payments that are disregarded in determining whether debt is contingent debt.

As a policy matter, the Service and the Treasury are concerned whenever significantly different tax results obtain for economically similar financial instruments, such as (1) straight convertible debt and (2) convertible debt that provides for contingent payments that, while not remote or incidental, are relatively insignificant in amount or in likelihood of occurrence. Such inconsistencies create market inefficiencies and increased transactional expense.

Disparate tax treatment for economically similar financial instruments exists in other instances, however, and the means for achieving equivalent tax treatment may not be clear or acceptable. With respect to contingent convertible debt instruments, for example, differing considerations support competing answers to the question of whether the comparable yield used for interest accruals should be based on a comparable nonconvertible debt instrument or a comparable convertible debt instrument.

Contingent Convertible Debt Instruments—Request for Comments

Notice 2002–36

Rev. Rul. 2002–31, 2002–22 I.R.B., dated June 3, 2002, provides guidance on the tax treatment of a debt instrument that is convertible into stock of the issuer and that also provides for one or more contingent cash payments (contingent convertible debt instruments). The revenue ruling holds that, in the described circumstances, the noncontingent bond method described in § 1.1275–4(b) of the Income Tax Regulations applies to these debt instruments. In addition, the revenue ruling addresses how an issuer determines the comparable yield used to determine the interest accruals, the effect of § 163( l ) of the Internal Revenue Code on the accruals, and the consequences of a conversion of the instrument, including the application of § 249. See Rev. Rul. 2002–31 for a discussion of these issues. The Internal Revenue Service and the Treasury Department are aware that the contingent convertible debt instruments described in the revenue ruling have been the subject of considerable comment within the tax bar and the media regarding whether the applicable tax rules are those generally governing contingent debt instruments or those generally governing convertible debt instruments. Existing regulations dealing with contingent debt instruments establish a general rule that issuers of such instruments are required to accrue interest expense (and holders are required to accrue interest income) as if the debt instruments bore a yield equal to the rate at which an issuer would issue a comparable debt instrument. However, certain convertible debt instruments are generally excluded from the application of the noncontingent bond method.

Specifically, § 1.1275–4(a)(4) provides that 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 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. Because of this exclusion from the noncontingent bond method for straight convertible debt (that is, debt with no contingencies other than the conversion privilege described in § 1.1275– 4(a)(4)), issuers and holders of such instruments accrue interest expense and income at a yield that assumes the instrument will not be converted (the nonconversion yield). That yield generally is considerably less than the yield for a comparable nonconvertible debt instrument. By contrast, if a convertible debt instrument providing for the possible payment of additional interest upon the occurrence of particular contingencies is eligible for the application of the noncontingent bond method, relatively insignificant changes in the investment economics of a convertible debt instrument can effect a dramatic change in the amount of interest accruals.

Some commentators have argued that the general approach of the noncontingent bond method, which requires issuers and holders of contingent debt instruments to accrue interest income and expense based on the yield of comparable debt instruments, is economically sound. They argue that the exclusion of straight convertible debt from this general approach simply reflects the historical treatment of convertible debt instruments but is otherwise inconsistent with the economic rationale for the general rule. Accordingly, these commentators argue for limited application of the exclusion for straight convertible debt and assert that sound policy supports the application of the comparable yield methodology to contingent convertible debt instruments.

Other commentators support the exclusion for straight convertible debt (or have assumed its continued existence) and have questioned whether contingent convertible debt instruments should be subject to the comparable yield methodology, particularly if the result is to permit an issuer to deduct interest accruals based on the yield of comparable nonconvertible debt instruments. These commentators have suggested that the discontinuity between the treatment of straight convertible debt and the treatment of contingent convertible debt instruments could be eliminated, or substantially ameliorated,

2002–22 I.R.B. 1029 June 3, 2002

ments and suggestions may want to include a discussion of whether a suggested treatment of convertible debt instruments issued by corporations also should apply to similar instruments issued by partnerships.

Please submit all comments by August 30, 2002. Written comments should be sent to:

Internal Revenue Service Attn: CC:ITA:RU (Notice 2002–36) Room 5226 P.O. Box 7604 Ben Franklin Station Washington, D.C. 20044

or hand delivered between the hours of 8 a.m. and 5 p.m. to:

Courier’s Desk Internal Revenue Service Attn: CC:ITA:RU (Notice 2002–36) 1111 Constitution Avenue, N.W. Washington, D.C. 20224

Alternatively, comments may be submitted electronically via e-mail to the following address: Notice.Comments@ irscounsel.treas.gov . Please include “Notice 2002–36” in the subject line. All comments will be available for public inspection and copying in their entirety.

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

26 CFR 601.204: Changes in accounting periods and in methods of accounting. (Also Part I, §§ 442, 706, 898, 1502; 1.442–1, 1.706–1, 1.1502–76.)

Rev. Proc. 2002–37

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