Look Before You Lend: A Practical Discussion of Tax Issues to Consider When Lending to an Emerging Business

Private credit appears to be the dominating trend throughout emerging business markets.  Businesses seeking to raise capital are finding private investors who, unsurprisingly, are looking to maximize yield, while at the same time attempting to minimize their risks. And these investors are doing so through a variety of lending strategies, some of which involve adverse tax implications to the lender that are often times being ignored. 

Specifically, we’re talking about: (i) convertible loans in which interest accrues annually, but which is not payable until maturity, and (ii) loans issued together with an issuance of warrants.  Neither of these structures are novel, but for some reason, parties are failing to identify the potentially adverse tax implications that the lender will face in connection with such arrangements.  And when we say “adverse tax implications” we are specifically referring to phantom income that must be recognized annually by the lender, but for which no cash is actually received – forcing the lender to come out of pocket to pay taxes on such income. This article was written with the hope of providing a practical explanation to an overly technical tax issue – just enough for the reader to be able to identify the issue and seek out competent tax counsel to assist.    

I.          Tax Terms Worth Noting

Per the authors’ experience, Original Issue Discount (OID) appears to have at least two definitions. 

The first and most commonly known definition is “a tax term that often arises in lending transactions, which automatically causes the lender and borrower to want to quickly move on to the next issue on the list.” 

The second and more important definition, is the amount by which the loan’s stated redemption price at maturity exceeds the loan’s issue price. 

But when a term is defined with phrases such as, “stated redemption price at maturity”  and “issue price,” and the definitions of those words are further defined with terms like “qualified stated interest,” “daily portions” and “annual yield,” it is easy to understand why people quickly get overwhelmed.  And when some of these terms have different meanings depending on the situation¹, it’s no wonder why the first definition of OID is generally accepted at cocktail receptions across the nation.

In light of the above, Parts II and III of this article explain and illustrate how OID can arise in connection with certain loans.  And, importantly, once the existence of OID is confirmed, Part IV explains and illustrates what that means for the lender. 

II.        Loans Where Interest is Not Paid Until Maturity

Sometimes a loan will provide that although interest will accrue annually, an actual cash payment for the accrued interest will not be made until the loan matures.  This could be accomplished, for example, (i) by simply recording the accrued interest on the borrower’s and lender’s books, (ii) with the issuance of a second debt instrument each year in an amount equal to the interest that accrued during such year (sometimes referred to as a PIK, or “paid in kind”, instrument), or (iii) through some other kind of mechanism which essentially credits the lender, on paper, to the right to receive the interest, but defers the actual payment of such interest until maturity or some other later date.  There are many iterations, but the common theme of each scenario essentially involves a debt instrument for which interest is NOT payable, in cash, at least annually.  The examples below illustrate some of these scenarios. 

Example #1. Lender (“L”) lends Borrower (“B”) $100 in consideration of a debt instrument which provides as follows: (i) maturity date in 5 years, (ii) interest accrues at a simple rate of 8% per year, but is not payable until maturity, and (iii) principal of $100 is payable at maturity.  In such a case, the total amount of OID is $40 – comprised of the aggregate simple interest that accrues annually, but is not paid until maturity.²

Example #2.  A similar analysis would apply if, for example, L loans B $100 in consideration of a debt instrument, which provides as follows: (i) maturity date in 5 years, (ii) no interest accrues on the note, and (iii) an aggregate amount of $140 is payable at maturity.  In such a case, the amount of OID is $40, i.e., the excess of $140, over the original amount loaned of $100. 

Example #3.  Finally, a similar analysis would also apply if, for example, L loans B $100 in consideration of a debt instrument, which provides as follows: (i) maturity date in 5 years, (ii) interest accrues at a rate of 8% per year, and is payable, and paid, at least annually, and (iii), in addition to the interest paid annually, an aggregate amount of $120 is payable at maturity.  In such a case, the amount of OID is $20, i.e., the excess of $120 (the note’s stated redemption price at maturity), over the $100 original amount loaned (the note’s issue price).³

In each of the examples above, the gist of the OID problem hinges on the fact that, separate and apart from any adequate interest that is required to be and is paid at least annually, the amount paid at maturity is greater than the amount originally loaned – and, in general, that difference is OID. 

As mentioned, the implications for the lender of making a loan subject to OID is discussed in Part IV, below. 

III.       Debts and Warrants Issued Together

Often times a borrower will borrow cash in exchange for the issuance of both (i) a debt instrument, and (ii) a warrant to purchase the borrower’s stock.  In such a case, the debt instrument provides the lender with down-side protection by way of a creditor-position and a security interest, and the warrant provides the lender with up-side potential in the form of potential equity.   

Example #4.  L lends B $100 in consideration of:

• a debt instrument which provides as follows: (i) maturity date in 5 years, (ii) interest accrues at a rate of 8% per year and is required to be, and is, paid at least annually, and (iii) principal of $100 is payable at maturity, and
• a warrant which allows L to purchase B’s stock,

Similar to a purchase and sale situation in which a purchaser allocates a purchase price among two distinct assets acquired at the same time from the same seller, in this context the tax law requires L’s $100 advance to be allocated among (i) the debt instrument, and (ii) the warrant, in each instance based on their relative fair market values.  Steps should be taken to ensure that if the IRS challenged the agreed upon fair market values, then such determination would be respected in light of all applicable facts and circumstances. The fact that the lender and the borrower may be unrelated to one another may be helpful, but will not necessarily ensure that the agreed upon fair market values will be respected by the IRS or a court.  In this respect, although costly, it may be prudent to obtain an independent third party appraisal to determine such values. 

In terms of Example #4, assume that based on all applicable facts and circumstances the $100 advance is properly allocated as follows: (i) $90 to the debt instrument, and (ii) $10 to the warrant. 

In such a case, the debt instrument will be treated as (i) having an issue price of $90, and (ii), because $100 is required to be paid at maturity, having a stated redemption price at maturity of $100.  As a result, the determination of whether the debt instrument has been issued with OID in Example #4 is very similar to the analysis applied in Examples #3, above – that is, other than interest that is required to be, and is, paid at least annually, the note in Example #4 has OID equal to $10, calculated as the excess of $100 (the note’s stated redemption price at maturity), over $90 (the note’s issue price).

IV.       Lender Implications When a Debt Instrument is Issued with OID

In general, when a debt instrument is issued with OID, the lender must include, as ordinary income, a portion of the such OID each year throughout the term of the debt instrument.  In other words, each year, the lender must recognize and pay tax on some portion of the OID even though no cash is paid on the debt instrument until maturity. The yield and related concepts are nuanced, but in general, the note is treated as having a single compounding yield. In terms of Example #1, above, recall that the 5-year debt instrument accrued interest at a simple rate of 8% per year, but all such interest was payable at maturity – resulting in OID of $40. The $40 of OID would generally be recognized over the 5-year term of the note as set forth below in Table 1.

Table 1

Significantly, if the interest on the debt instrument was paid annually, then there would be no OID and the income inclusions each year would be as set forth below in Table 2.

Table 2

Table 1 and Table 2 are intended to illustrate the general purpose of the OID rules.  As you can see, the OID rules are not intended to require a lender to recognize more income than the lender would otherwise be required to recognize under a straight forward lending arrangement, i.e., one in which interest accrues and is paid at least annually.  Instead, the OID rules are intended to ensure that a lender does not improperly defer income until maturity or some other later date.  In other words, in the end, the OID rules are merely a “timing” rule that prevents lenders from deferring income taxes arising from their loans.

V.        Conclusion

As one could expect, there are various other rules and exceptions that may impact the results explained in each of the illustrations above – rules relating to contingent payment debt instruments, variable rate debt instruments, partial payments during the term of the note, de minimis and other exceptions, related-party rules, etc. Lenders should not take any of these issues for granted. More importantly, when determining whether a loan makes economic sense, a lender is strongly encouraged to consider the tax implications, including the OID rules, that may arise from the loan transaction.  The tax consequences for lenders can be significant, and lenders should be careful to ensure that their arrangements do not result in the recognition of phantom income, i.e., income on which they have to pay taxes, but for which they have yet to receive a corresponding amount of cash. 

This article is merely intended to introduce you to these rules and is not a substitute for careful tax planning. Before making a loan, lenders should consult with their own tax advisor.  Also, please be advised that any tax advice included in this article is not intended and cannot be used for the purpose of (i) avoiding any federal tax penalty or (ii) promoting, marketing, or recommending any transaction or matter to another person.  Furthermore, any examples included in this article are intended for illustration purposes only and the calculations are by no means precise.