Legal Insights
Debt instruments issued together with warrants or other equity kickers are becoming more common in the private credit market. Both issuers and holders, however, need to be concerned about the proper calculation and reporting of original issue discount (OID). Under the right circumstances, the instrument could even be a contingent payment debt instrument (CPDI), requiring even more detailed calculations.
OID Basics
Under section 1273(a)(1) of the Internal Revenue Code of 1986, as amended (the Code), OID is the difference between a debt instrument’s issue price and its stated redemption price at maturity. Many factors can cause a debt instrument to have OID. For example, a debt instrument with $100 million payable at maturity issued for only $95 million has $5 million of OID.
Now suppose the holder receives warrants together with the debt instrument. Under Code section 1273(c)(2) and Treas. Reg. § 1.1273-2(h), the issue price of an investment unit consisting of a debt instrument and options, securities, or other property is allocated among the components based on their relative fair market values. That allocation creates even more OID. For instance, if that $100 million debt instrument is worth only $90 million and is issued together with a warrant worth $20 million, the $95 million issue price is allocated 81.82% to the debt instrument and 18.18% to the warrant — meaning the debt instrument now has an issue price of only approximately $77.73 million ($95 million × 90/110 = $77,727,273), and roughly $22.27 million of OID.
PIK Notes Add Another Layer
Let’s take this one step further. If interest on the debt instrument may be paid with payment-in-kind (PIK) notes — that is, with additional debt instruments — two consequences follow. First, interest that the issuer may pay in kind is generally not unconditionally payable in cash at least annually, so it may not qualify as qualified stated interest; any interest that is not qualified stated interest is included in the stated redemption price at maturity and therefore becomes OID. Second, Treas. Reg. § 1.1275-2(c)(3) treats the PIK instruments as aggregated with the original debt. Payments made on the PIK instrument are treated as made on the original, and issuing the PIK instrument is not itself considered a payment. The result is an accrual of even more OID, as illustrated by the following example (adapted from Treas. Reg. § 1.1272-1(j), Example 8):
(i) Facts. On January 1, 2027, a private credit fund (the Lender) purchases at original issue, for $77,729,000 (approximately the issue price computed above, rounded as in the regulation example), a debt instrument of a portfolio company (the Borrower) maturing on January 1, 2032, with a stated principal amount of $100,000,000 payable on that date. The debt instrument provides for annual interest payments of $4,000,000 on January 1 of each year, beginning on January 1, 2028. The Borrower has the unconditional right to issue, in lieu of the first interest payment, a second debt instrument (the PIK instrument) maturing on January 1, 2032, with a stated principal amount of $4,000,000. The PIK instrument, if issued, would provide for annual interest payments of $160,000 on January 1 of each year, beginning on January 1, 2029.
(ii) Aggregation of PIK instrument with original debt instrument. Under Treas. Reg. § 1.1275-2(c)(3), the issuance of the PIK instrument is not considered a payment made on the original debt instrument, and the PIK instrument is aggregated with the original debt instrument. The PIK instrument is treated as having the same issue date as the original debt instrument.
(iii) Determination of yield and maturity. The Borrower’s right to issue the PIK instrument is treated as an option to defer the initial interest payment until maturity. Yield determined without regard to the option is 9.85%, compounded annually. Yield determined by assuming the Borrower exercises the option is 9.65%, compounded annually. Thus, under Treas. Reg. § 1.1272-1(c)(5), an issuer is assumed to exercise an unconditional option if doing so would decrease the yield of the debt, so the Borrower is assumed to issue the PIK instrument. For purposes of calculating OID, the debt instrument is therefore treated as a 5-year debt instrument with a single principal payment at maturity of $104,000,000 and four annual interest payments of $4,160,000, beginning on January 1, 2029. As a result, the yield is 9.65%, compounded annually.
The takeaway: the Lender must accrue at least the $26,271,000 difference between the $104,000,000 of principal and the $77,729,000 issue price — plus any interest that is not qualified stated interest — as OID over the life of the instrument, producing taxable income to the Lender (and deductions to the Borrower) before the corresponding cash is paid. The lower the issue price, the higher the yield to maturity — and the more OID that accrues.
When Contingencies Enter the Picture
The CPDI rules come into play if, as is common, the debt instrument calls for some kind of premium, such as a higher interest rate or a return based on equity-like considerations like multiple on invested capital (MOIC), that is contingent on events like bankruptcy or default. That said, not all contingencies make a debt instrument a CPDI. One important exception applies if the contingency is either remote or incidental. Treas. Reg. § 1.1275-4(a)(5).
A contingency is remote if there is only a remote likelihood that it will occur (or, conversely, only a remote likelihood that it will not occur). If the contingency is remote, it is simply assumed away for OID purposes — either treated as if it will not happen or as if it definitely will, depending on which outcome is remote. The debt instrument is then analyzed as a conventional OID instrument rather than a CPDI. If a contingency assumed away later does occur, the instrument is generally treated as retired and reissued for purposes of computing OID going forward.
A contingency is incidental if its economic impact is insignificant. For contingencies affecting payment amounts, the question is whether the potential contingent payment is trivial compared to the total expected payments on the debt instrument. For contingencies affecting payment timing, the question is whether the range of possible payment dates is narrow enough to be immaterial. In either case, the analysis must hold true “under all reasonably expected market conditions” — not just the base case. Treas. Reg. §§ 1.1275-2(h)(2), (3).
If the contingency is neither remote nor incidental, the debt instrument is a CPDI. For debt instruments issued for money, the parties must use the “noncontingent bond method.” This approach determines the amount of interest for each accrual period by calculating a “comparable yield” — the yield at which the issuer would issue a fixed-rate debt instrument with similar terms — and constructing a projected payment schedule. The OID rules then apply to that projected schedule. Treas. Reg. § 1.1275-4(b). Notably, any gain the holder recognizes on the sale, exchange, or retirement of a CPDI is generally ordinary interest income rather than capital gain.
Where the Rubber Meets the Road
Consider how these rules apply to common deal structures:
Default and Bankruptcy Premiums. Many debt instruments include a higher interest rate or make-whole payment triggered by issuer default or bankruptcy. For a financially healthy borrower, that contingency may well be remote — and if so, OID is calculated as though the premium will never be paid. But if the issuer is already in distress or the deal is structured around an anticipated restructuring, the contingency may not be remote at all, pushing the instrument into CPDI territory.
MOIC and Equity Kickers. Debt instruments with returns tied to MOIC or other equity-like metrics present a harder case. The whole point of an equity kicker is that the payment depends on how well the investment performs — which makes the amount inherently uncertain. MOIC protections in private credit typically guarantee the lender a minimum multiple, often triggered on a prepayment, change of control, or other exit. If the MOIC threshold is aggressive and unlikely to be achieved, the contingency might be remote or incidental. But in many private equity deals, the sponsor fully expects to hit (or exceed) the target multiple, meaning the contingent payment may be neither remote nor incidental. Result: likely a CPDI.
Call Rights and Prepayment Options. When the uncertainty is about when a payment will be made rather than how much, the analysis generally starts with the option rules of Treas. Reg. § 1.1272-1(c)(5), not the CPDI regulations, which generally do not apply to instruments covered by those rules. An unconditional issuer call right is assumed to be exercised if exercise would lower the instrument’s yield, and an unconditional holder put is assumed to be exercised if exercise would raise it. A call premium or make-whole that makes early redemption uneconomic for the issuer will often mean the call is assumed not to be exercised. Where prepayment depends on a contingency rather than an unconditional option (for example, a mandatory prepayment on a change of control at a premium), the remote and incidental tests discussed above become relevant again.
The Bottom Line
Debt instruments with equity-like features are here to stay — and so is the OID complexity that comes with them. The difference between a straightforward OID calculation and the more demanding CPDI regime often turns on whether a contingency is remote or incidental. Getting that analysis right at the outset can save issuers and holders from unexpected tax consequences down the road. Issuers and holders of such debt instruments should consult their tax advisors in order to fully understand the possible outcomes. In addition, when a lender is looking to structure one of these transactions, if the debtor is potentially troubled, the lender should also consider engaging experienced bankruptcy counsel to advise on enforceability under the Bankruptcy Code, including whether make-whole premiums and unamortized OID would be allowed or disallowed as unmatured interest in a bankruptcy case.
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