Opinion ID: 769343
Heading Depth: 2
Heading Rank: 1

Heading: The Appropriate Time for Valuing the Warrants

Text: 15 When a loan is provided at a face value higher than the amount actually loaned, the debtor is allowed to deduct the difference over the life of the loan as original issue discount (OID), while the creditor realizes the OID as ordinary income. See I.R.C. SS 163(e)(1) & 1272(a)(1). 3 Under I.R.C. S 1273(c)(2), whenever any debt instrument and an option . . . [are] issued together as an investment unit . . . the issue price for such unit shall be determined . . . as if it were a debt instrument. 4 Under I.R.C.S 1273(b)(2), for non-publicly traded debt instruments, the issue price of each such instrument is the price paid by the first buyer of such debt instrument. 16 Here, the warrants (effectively equivalent to options 5 ) were granted at the same time the loan was provided to Custom Chrome. The most straightforward reading of S 1273 is that the value of the warrants should be considered as OID and should be valued at the time the warrants were granted. First, the warrants were clearly intended to compensate the Bank for its additional risk, thereby raisingthe effective interest rate of the loan and resulting in OID. Second, in order to deduct the OID ratably over the life of the loan, it is necessary to value the warrants at the time of grant. This is borne out by reading together SS 1273(b)(2) and (c)(2), which require that the warrants be valued as part of the price paid by the first buyer of such debt instrument. I.R.C. S 1273(c)(2) (emphasis added). The most sensible approach is that the first buyer's price must be determined at the time of that buyer's purchase of the debt instrument, which includes the warrants. For example, in Monarch Cement, the Tenth Circuit treated the equity kicker portion of a loan -which was comprised of warrants -as OID subject to valuation at the time of issuance. See 634 F.2d at 485-86. 17 Custom Chrome's argument that the warrants should be valued at the time of exercise -when the value of the warrants is certain -may be sensible from a policy perspective, but contradicts the terms of the statute. First, the cases that Custom Chrome cites are inapposite because all of them involve trade discounts implemented through warrants in long-term sales contracts. In Computervision International Corp. v. Commissioner, 71 T.C.M. (CCH) 2450, 2454-55, 1996 WL 116379 (1996), vacated on other grounds , 164 F.3d 73 (1st Cir. 1999), for instance, although a loan made via a debenture was part of the overall transaction, the warrants at issue were granted in exchange for high-volume sales, and not as OID. 6 See also Convergent Tech. v. Commissioner, 70 T.C.M. (CCH) 87, 89, 1995 WL 422677 (1995) (noting that warrants were only exercisable once sales volume hit a specified amount); Sun Microsystems, Inc. v. Commissioner, 66 T.C.M. (CCH) 997, 1993 WL 390471 (1993) (same underlying factual situation as Computervision). Here, the warrants were an integral part of the loan package and, hence, OID that must be valued at the date of grant. 18 Second, Custom Chrome's reliance on I.R.C. S 83 is misplaced, because that section deals only with stock options received for services rendered. In particular, Treas. Reg. S 1.83-7 mandates that, when the fair market value of options granted in exchange for warrants is not readily ascertainable at the time of grant, the value of the options must be valued at the date of exercise. See Pagel, Inc. v. Commissioner, 905 F.2d 1190 (8th Cir. 1990) (holding that valuation of options granted for services rendered should be at time of exercise when value was not readily ascertainable at time of grant). Here, because the warrants were issued as part of an entire loan transaction (as opposed to in return for services), they are considered OID and, under I.R.C. S 1273(b)(2) and (c)(2), must be valued at the time of grant. 19 Third, Custom Chrome's argument that the put options were equivalent to additional interest and were, therefore, a debt instrument subject to proposed Treas. Regs.S 1.163-7(a) and (f) (1986), 7 is misplaced. Even if we were to apply theproposed regulations, because the puts were exercisable at the discretion of FNBB, and it was not clear that it would have been in FNBB's interest to exercise the puts (indeed, FNBB did not), the puts were pure options and not a debt instrument. See I.R.C. S 1275(a)(1) (defining a debt instrument to mean a bond, debenture, note, or certificate or other evidence of indebtedness); Proposed Treas. Reg. 1.1272-1(j) (1986) (noting that puts should be included in the OID valuation but stating nothing about whether puts are debt instruments); cf. Foster v. Commissioner, 756 F.2d 1430, 1436-37 (9th Cir. 1985) (holding that, where a complex series of transactions clearly results in additional income to lender, that income should be characterized as interest income rather than capital gains). Thus, the puts should be valued as OID under I.R.C. S 1273(c)(2). 20 In sum, the Tax Court did not err in utilizing the time of issuance to determine the value of the warrants.