Thin capitalisation: practical guidance: interest cover - debt servicing: discounted debt and convertible debt
Discounted debt - deep discount bonds or zero coupon bonds
Instead of making annual interest payments, lending may be rewarded by issuing the debt at a discount. For example, a borrower issues five year debt with a face value of £1,000 for an immediate cash receipt of £800. This means that upon issue of the debt, the borrower receives £800 for the £1,000 in face value taken up. When the debt matures at the end of five years, the investor receives the face value of £1,000.
The difference between a debt’s issue and redemption value is called “original issue discount”, and represents the cost to the borrower of borrowing money.
Alternatively, the debt may be redeemed at a premium. In this situation the amount borrowed is equivalent to the face value of the debt, but the debt is redeemed at a premium to face value. Issue at a discount or at a premium has the same effect; if the debt pays no interest then the return is built into the issue and redemption price.
For the issuer of the security, the borrower, the discount or premium is part of its finance cost, and this will be spread over the period to maturity of the security (as will the incidental costs of issuing the security). Further guidance about accounting for debt liabilities can be found in the Corporate Finance Manual - see CFM21640 where the issuer accounts for the security under IAS 39 (or a UK GAAP equivalent accounting standard), or CFM23010 onwards where the company accounts under the older standard, FRS 4.
Discounts and premiums are treated as interest for corporation tax purposes, but a discount or premium is not subject to the obligation to withhold income tax (ITA09/S874), since there is no interest payment.
A company may issue a security that on maturity may be redeemed for cash or converted into a fixed number of shares, either in the issuing company or in another specified company. For example, a subsidiary may issue a security exchangeable for shares in its quoted parent company.
The conversion right gives the holder of the security a chance to profit from increases in the company’s share price. Because of this additional opportunity for profit, convertible securities will carry a lower interest coupon than an equivalent security without the conversion feature. A convertible issue may therefore be attractive to a borrower with expectation of a low initial cash return, but good longer-term prospects.
Where the issuing company accounts for its financial instruments in accordance with IAS 39 (or UK GAAP equivalent), it will usually account for the conversion element as a separate financial instrument - known as a derivative - see CFM25000 onwards. The aggregate cost of these financial instruments is sometimes referred to as “notional finance costs”. It represents the true cost of borrowing the funds.
For convertible securities issued in periods of account beginning on or after 1 January 2005, the notional finance cost will normally be allowable for tax purposes. Nevertheless, in considering interest cover, it is important to bear in mind that these debits are not interest, nor any other cash outgoing of the company.
Payment-in-kind (“PIK”) Notes or Funding Bonds
These are mentioned at INTM519030 in relation to private equity financing, and represent a non-cash way of meeting obligations to pay interest where cash flow is a problem. For tax purposes they represent interest paid, but they are in fact further loans, themselves bearing interest. This can result in a steady increase in the amount of the principal and an ever increasing interest expense.