Chapter 4C.
Extra Debt Materials
Edited December 31, 2010
Contents of next few slides
Background on Debt and Equity
Debt vs. Equity
Thin corporations
When you may have a debt vs. equity
argument with the IRS.
Criteria for Debt
Earnings Stripping
(Read on.)
Debt vs. Equity
Debt
Corporation pays interest to debt holder
which is deductible by corporation
Interest paid is taxable as ordinary
income to individual or corporate
recipient (Temporary law provides that
individuals use capital gains rates for
dividend income.)
Loan repayments are not taxable to
investors unless repayments exceed
basis
Debt vs. Equity
• Equity:
–Corporation pays dividends which
are not deductible
–Taxable as ordinary income to
recipient to extent corp has E & P
• Corporate shareholder may
receive dividends received
deduction
Reclassification of Debt As Equity
If corp is “thinly capitalized”, i.e., has
too much debt and too little equity
IRS may argue that debt is really
equity and deny tax advantages of
debt financing
If debt has too many features of
stock, principal and interest
payments may be treated as
dividends
Thin Capitalization Factors-1
• Debt instrument documentation
• Debt terms (e.g., reasonable rate
of interest and definite maturity
date)
• Timeliness of repayment of debt
• Whether payments are
contingent on earnings
Thin Capitalization Factors-2
• Subordination of debt to other
liabilities
• Whether debt and stock holdings
are proportionate
• Use of funds (if used to finance
initial operations or to acquire
capital assets, looks like equity)
• Debt to equity ratio
Reclassification of Debt As Equity
Four times for dispute:
• Investment of assets in a corporation
and receipt of stock or debt (351)
vs. sale (Rudolph A. Hardman)
• Does the investor receive dividends
or interest?
• Is corporation paying interest or
dividend?
• At the end, how is repayment or
worthlessness treated?
Debt or Equity?
There is no definition in Code or
regs for determining if an interest
in a corp. is debt or equity.
Characterization as debt or equity
is based on case law:
numerous factors identify
economic substance of an
investor's interest.
Sec. 1361(c)(5)(B) Straight debt
defined…
any written unconditional promise to
pay on demand or on a specified date
a sum certain in money if —
(i) the interest rate (and interest
payment dates) are not contingent on
profits, the borrower's discretion, or
similar factors,
(ii) there is no convertibility (directly
or indirectly) into stock…
Classification Criteria
Item
Stock
Debt
Interest or Dividends?
Div. if Declared
Interest must be paid
Principal Repayment?
No Maturity
Must be paid at Maturity
Payment Deductible?
No
Yes
Div- Low Rate
Int. - Ordinary Income
If from E&P
In all cases
Yes
No
Unlimited
Limited-Stated Interest
Elect Directors
Greater
Generally, None
Less
Type of Income?
Income Reported?
Count as Control-351?
Profit Potential
Control over Mgt
Risk of loss
Earnings Stripping.
Suppose a U.S. parent invests $1,000,000 in
stock of a foreign subsidiary. Then the parent
borrows that money from the subsidiary at an
interest rate of 25%.
Parent has interest expense of $250,000 per year
on a loan of money [that was the parent’s
money].
The foreign subsidiary has interest income of
$250,000, but that income is not subject to U.S.
taxes until the subsidiary pays a dividend to the
parent, which it will not do.
This is an aggressive form of earnings stripping,
and it is not allowed under the Internal Revenue
Code
Earnings Stripping
163(j) Limit on Deduction for Interest…
(1) Limit.
(A) .., no deduction shall be allowed … for
disqualified interest paid … by such corp.
during such year. Amount disallowed …
shall not exceed the corp's excess interest
expense for the year.
(B) Any amount disallowed … shall be treated
as disqualified interest paid or accrued in
the succeeding year (and clause (ii) of
paragraph (2)(A) shall not apply for ..
applying this subsection to the amount so
treated).
Earnings Stripping
163(j) Limit on Deduction for Interest...
(2) Corps to Which Subsection Applies.
(A) This subsection shall apply to any corp. for
any year if(i) corp. has excess interest expense for
such year, and
(ii) the ratio of debt to equity of such corp. as
of the close of such year (or on any other day
during the year as the Secretary may by regs
prescribe) exceeds 1.5 to 1.
(iii) …other adjustments prescribed by regs
Next Few Slides.
Review Compound Interest
Concepts and Procedures.
1. Future value of an investment made
today.
2. Present value (today) of an amount in
the future.
3. Future value of an annuity
(series of payments).
4. Present value of an annuity
(series of payments).
1. Make an Investment Today.
What is the value in the future
(Future value)?
I will invest $1,000 in a savings
account today (January 1, Year 1).
My savings account will earn interest
at the rate of 10% per year.
How much money will be in the
account in 3 years?
(December 31, Year 3)?
Compound Interest-Future Value of $1
Invest $1,000 on Jan. 1, Yr 1 (for 3 yrs)
Interest at 10% compounded annually
Given: present value (PV). Compute FV.
Jan 1
Dec 31
Dec 31
Dec 31
Yr. 1
Yr. 1
Yr. 2
Yr. 3
$1,000
$1,000
PV
Int.
100
$1,100
Int.
Int.
FV
Interest at 10% compounded annually
Given: present value (PV). Compute FV.
Jan 1
Dec 31
Dec 31
Dec 31
Yr. 1
Yr. 1
Yr. 2
Yr. 3
$1,000
$1,000
PV
Int.
100
$1,100
$1,100
Int.
110
$1,210
$1,210
Int.
121
FV
n
$1,331
Factor
(1+i)
1.331
Conclusion.
If you invest $1,000 today in a
savings account earning 10%
interest per year, your account
will have a balance of $1,331 in
three years.
2. Present value of a payment
to be made in the future.
I bought computer today. My price is
$1,000, payable in 3 years.
I do not pay interest on this debt.
Assume I normally pay 10% when
borrowing money.
What is present value (today) of
the $1,000 to be paid in 3 years?
Present Value (today) of $1 in Future
I need $1,000 on Dec. 31, Yr 3 (for 3 yrs).
Interest is 10% compounded annually
How much should I invest today (PV)?
Given: Future value (FV). Compute PV.
Jan 1
Dec 31
Dec 31
Dec 31
Yr. 1
Yr. 1
Yr. 2
Yr. 3
$1,000
÷ 1.10 or 110%
$909.09
÷ 1.10 or 110%
÷
1.10 or 110%
PV factor. Reciprocal of FV.
Present Value of $1 in the Future
I need $1,000 on Dec. 31, Yr 3 (for 3 yrs)
Interest is 10% compounded annually
How much should I invest today (PV)?
Given: Future value (FV). Compute PV.
Jan 1
Dec 31
Dec 31
Dec 31
Yr. 1
Yr. 1
Yr. 2
Yr. 3
$1,000
÷ 1.10 or 110%
$909.09
÷ 1.10 or 110%
$826.45
÷ 1.10 or 110%
$751.31
0.7513 PV factor. Reciprocal of FV.
Conclusion.
The seller of the computer should
be willing to accept $751.31 in full
payment of the computer today, if
the seller uses the same interest
rate.
If the seller invests $751.31 today
in a savings account earning 10%
interest, the balance in 3 years
will be $1,000.
3. Future value of an annuity
(periodic payments)
I will save $1,000 each year and
deposit that amount in a savings
account on the last day of each of the
next 3 years.
My savings account will earn 10% per
year.
How much money will be in my
account at the end of 3 years?
FV of "Ordinary" Annuity of $1
Invest $1,000 at end of each year (3 yrs)
Interest at 10% compounded annually
Jan 1
Dec 31
Dec 31
Dec 31
Yr. 1
Yr. 1
Yr. 2
Yr. 3
Dep. $1,000
Int.
$1,000
$1,000
Int.
100
Dep. 1,000
$2,100
Balance in 3 years.
FV of Annuity of $1.
10%
$2,100
Int.
210
Dep. 1,000
FV $3,310
3.310
Conclusion
If I invest $1,000 in a savings
account at the end of each year
(total deposits of $3,000) the
account balance will be $3,310 in
three years.
[Note this also applies for other
business transactions involving
periodic payments.]
4. Present value of an annuity
(series of payments).
I bought computer today. My price is
$3,000, payable in $1,000 at the end of
year 1, $1,000 at the end of year 2 and
$1,000 at the end of year 3.
I do not pay interest on this debt.
Assume I normally pay 10% on
borrowed money.
What is present value of the
payments?
Present Value (today) of annuity of $1
I will pay $1,000 each year on Dec. 31.
Interest is 10% compounded annually
What is the present value of those payments?
Given: Future value (FV). Compute PV.
Jan 1
Dec 31
Dec 31
Dec 31
Yr. 1
Yr. 1
Yr. 2
Yr. 3
$1,000
÷ 1.10 or 110%
$909.09
$1,000.00 Compute
PV for 1 Yr
÷
1.10 or 110%
$1,000.00
÷
1.10 or 110%
See PV tables
Present Value (today) of annuity of $1
I will pay $1,000 each year on Dec. 31.
Interest is 10% compounded annually
What is the present value of those payments?
Given: Future value (FV). Compute PV.
Jan 1
Dec 31
Dec 31
Dec 31
Yr. 1
Yr. 1
Yr. 2
Yr. 3
$1,000
÷ 1.10 or 110%
$909.09
Compute
$1,000.00
PV-1 Yr.
$1,909.09
÷ 1.10 or 110%
$1,735.54
$1,000.00
$2,735.54
÷ 1.10 or 110%
$2,486.85
See PV tables
Conclusion
The actual purchase price of the
computer is $2,486.85, if a discount
rate of 10% is used (with annual
compounding). A little over $500 is for
interest for deferred payment.
We use these approaches when
computing present values (PV) of
lease payments, PV of bonds, PV of
potential capital budgeting
investments, etc.
Next few slides: Bond Pricing
What is a discount or premium?
How do you compute the price of
a bond?
Study an illustration of issuing a
bond at a discount because its
interst rate is less than the market
requires.
Discount or Premium.
Bonds issued at discount or
premium.
How is the bond price computed?
How is the amount of the periodic
interest payment determined?
The amount of interest expense,
and amortization?
Discount or Premium.
Interest is generally stated as a
percent of the balance to be received
or paid each year.
The compounding period may be less
than a year.
A savings account that earns 10%
compounded semiannually will earn
5% each six months.
A bond that is issued for 2 years will
have 4 compounding periods if it pays
interest every six months.
Bond IIlustration – Slide 1 of 16
A corporation issues bonds with a
face value of $100,000 on 1-1-06.
The bonds mature 2 years later on
12-31-07.
The bonds pay interest of 10% per
year, payable twice per year
($5,000 each 6 months).
Bond IIlustration – Slide 2 of 16
If the market rate for
companies with similar
credit standing is 10%,
the bonds will sell for
$100,000 (plus any accrued
interest if sold between
interest dates).
Bond IIlustration – Slide 3 of 16
Assume the market insists on an
interest rate of 12% compounded
semiannually even though our
bonds actually pay only 10% per
year. The bonds will sell for less
than $100,000.
The bonds will sell at a discount
to provide additional earnings for
the investor beyond the $5,000
interest payments each 6 months.
Bond IIlustration – Slide 4 of 16
Both the borrower and the
investor (if held to maturity)
must amortize bond
discount using the constant
interest rate method (with
semiannual compounding).
Bond IIlustration – Slide 5 of 16
How would you compute
the amount to be paid for
these bonds, if yield is 12%,
compounded
semiannually?
Remember, these 2-year
bonds have 4 interest periods.
Bond IIlustration – Slide 6 of 16
Please discount the
interest payments and
principal payment, at
12%, compounded
semiannually.
Bond IIlustration – Slide 7 of 16
On 1-1-06, issue $100,000 of bonds.
On 12-31-07 the bonds will mature.
Bonds have stated interest of 10%.
Bonds pay interest of $5,000 each 6
months. Bob buys bonds at price to
yield 12%, with semi-annual
compounding. Compute price paid by
Bob by discounting cash flows at 6%
per interest period.
Bond IIlustration – Slide 8 of 16
Jan
PV
2006
June
Dec.
$5,000
PV
$5,000
PV
PV
PV
Total is Bond Price
2007
June
Dec
$5,000
$5,000
$100,000
Bonds – Slide 9 of 16.
PV of 4 interest payments
Interest Payments
PV Factor [Pg. 675]
=PV(0.06,4,-5000,,0)
PV of annuity of $5,000
$
5,000.00
$17,325.53
PV of $100,000
(4 periods, 6% per period)
Principal Payment
Factor
=1/(1+0.06)^4
PV of $100,000 payment
Price of Bond
$
100,000.00
0.792093663
$
79,209.37
$96,534.89
Bond IIlustration – Slide 10 of 16
Prepare amortization table.
Note: The PV factors on preceding
page were computed with Excel.
These factors are a little more
accurate than those taken from
tables in a book (because of
rounding in the textbook).
Bond IIlustration – Slide 11 of 16
On Jan. 1, 2006, issued $100,000, 10% , 2 year bonds.
Interest is paid on 6-30 and 12- 31. Mature 12-31-07.
Bonds were sold at a price to yield 12% per year.
Book
Interest Interest
Unamort
Book
Yr
Value
Received Income Amort.
Disc/Prm
Value
2006
96,535
2006
2007
2007
Bond IIlustration – Slide 12 of 16
On Jan. 1, 2006, issued $100,000, 10% , 2 year bonds.
Interest is paid on 6-30 and 12- 31. Mature 12-31-07.
Bonds were sold to Bob at a price to yield 12% per year.
Book
Interest Interest
Unamort
Book
Yr
Value
Received Income Amort. Disc/Prm
Value
2006
96,535
5,000 5,792
792
2,673 97,326.99
2006
97,327
5,000 5,840
840
1,833 98,166.61
2007
98,167
5,000 5,890
890
943
99,056.61
2007
99,057
5,000 5,943
943
(0)
100,000
Bond IIlustration – Slide 13 of 16
How much income is
recognized by Bob in
first year?
Bond IIlustration – Slide 14 of 16
How much income
is recognized by
Bob in first year?
$5,792.09 plus
$5,839.62.
Bond IIlustration – Slide 15 of 16
How much expense is
recognized by the
company in the first
year?
$5,792.09 plus $5,839.62.
Bond IIlustration – Slide 16 of 16
How much would the
bonds sell for if they
pay zero interest?
Answer:
$79,209.37 (Slide 9 of 16)
Bonds redeemed before maturity.
How do you record the retirement
of bonds prior to maturity?
How does it affect the financial
statements? Please work the
problem on the next page.
Charlotte Co. retires bonds. [1 of 4]
Charlotte company has $100,000 (par
value) of bonds outstanding. The
unamortized discount on these bonds
is $4,500.
The company redeemed these bonds
at 97 percent of par.
What is the gain (loss) on redemption?
a. $1,500 b. ($1,500)
c. $3,000 d. ($3,000) e. ($4,500)
Charlotte Corp. Bonds. [2 of 4]
Face value of bonds
$ 100,000
Unamortized discount
4,500
Book Value of Bonds
95,500
Redemption price
97,000
Loss on Redemption
$
1,500
Charlotte Co. . [3 of 4]
Cash
Bal.
????
Bonds Payable
Bal.
100,000
1
1
Bal.
Bond Discount
4,500 1
Bond Premium
Revenue and Expense
Loss or Gain on Redemption
1
Interest Expense
Charlotte Co. [4 of 4]
Cash
Bal.
????
1
97,000
1
Bal.
Bond Discount
4,500 1
4,500
Bonds Payable
Bal.
100,000
100,000
Bond Premium
Revenue and Expense
Loss or Gain on Redemption
1
1,500
Interest Expense
What is the market rate of interest for a
bond issue which sells for more than its
par value?
a. Less than rate stated on the bond.
b. Equal to rate stated on the bonds
c. Higher than rate stated on the bond.
d. Rate is independent of rate stated
on the bonds.
(Source: CPA)
On Jan. 1, 2006, Carr Corp purchased
Fay Corp. 9% bonds with a face amount
of $400,000 for $375,600, to yield 10%.
The bonds are dated January 1, 2006,
mature on December 31, 2015, and pay
interest annually on Dec. 31.
Carr uses the interest method of
amortizing discount.
What is Carr’s interest revenue for 2006?
$40,000 b. $37,560 c. $36,000 d. $34,440
(Source: CPA)
NTD Company issues bonds. [1 of 3]
NTD Company issues bonds with a face
value of $100,000 on Jan. 1, 2006.
These bonds pay interest twice per year
at the annual rate of 9%. (4-1/2 % pmts)
Interest is paid on 6-30 and 12- 31.
The bonds mature in 2 years [12-31-07].
The bonds were sold at a price to yield
10% per year.
Please compute the price of the bonds
and complete the amortization table on
the next slide.
Bonds – NTD
PV of 4 interest payments
Interest Payments
PV Factor [Pg. 675]
=PV(0.05,4,-45000,,0)
PV of annuity of $5,000
$4,500.00
$15,956.78
PV of $100,000
(4 periods, 6% per period)
Principal Payment
Factor
=1/(1+0.05)^4
PV of $100,000 payment
Price of Bond
$100,000.00
0.822702475
$82,270.25
$98,227.02
NTD Bond Amortization Schedule [2 of 3]
On Jan. 1, 2006, issued $100,000, 9% , 2 year bonds.
Interest is paid on 6-30 and 12- 31. Mature 12-31-07.
Bonds were sold at a price to yield 10% per year.
Book
Yr
2006
2006
2007
2007
Interest Interest
Value Paymnt
98,227
4,500
Exp.
Unamort
Amort. Disc/Prem
Book
Value
NTD Bond Amortization Schedule [3 of 3]
On Jan. 1, 2006, issued $100,000, 9% , 2 year bonds.
Interest is paid on 6-30 and 12-31. Mature 12-31-07.
Bonds were sold at a price to yield 10% per year.
Book
Yr
Interest Interest
Value Paymnt
Exp.
Unamort
Amort. Disc/Prem
Book
Value
2006
98,227
4,500 4,911
411
1,362
98,638
2006
98,638
4,500 4,932
432
930
99,070
2007
99,070
4,500 4,954
454
476
99,524
2007
99,524
4,500 4,976
476
0 100,000
Accounting for leases.
Off balance sheet financing.
What is the difference between an
operating lease and a capital
lease. If I rent an auto from Hertz
for a day, is that an operating or
capital lease?
Capital Lease
On Jan. 1, 2005, entered into a 5-year lease
Annual payments are $10,000, at end of year.
FMV is $39,928. Discount rate is 8% .
12-31
Lease
Lease
Interest
Lease
Yr
Debt
Payment
Expense
Debt
2006
39,927
10,000
3,194
33,121
2007
33,121
10,000
2,650
25,771
2008
25,771
10,000
2,062
17,833
2009
17,833
10,000
1,427
9,259
2010
9,259
10,000
741
(0)
Capital Lease
Cash
Bal.
Facility
???
Bal.
Lease Liability
???
Accumulated Depreciation
Revenue and Expense
Depreciation Expense
Interest Expense
Peerless Industries
The next few slides in this
PowerPoint file cover an
interesting case involving a
bond discount that was almost
large enough to make the
present value of the bond be
zero.
Peerless Industries
The president of Peerless Ind. helped a
college by selling it a zero interest, 50year $20,000,000. The present value of
the zero-coupon bond (discount rate
of 14%, compounded semiannually, for
50 years) was $23,066.
He made a gift to the college so that
the college could afford to buy the
bond.
Retirement of Debt
In exchange for $23,066, Peerless
sold LVC a promise to pay
$20,000,000 in fifty years.
The difference, or original issue
discount of $19,976,934 represents
the total interest that will accrue
over the fifty year Bond term.
The Appeals Court Noted:
The Code and regs in effect in 1981
permitted a straight-line deduction
method whereby the taxpayer allocates
the discount ratably over the term of the
Bond. Rather than deducting the interest
that would accrue on $23,066 at the 14%
annual interest rate--approximately
$3,500 per year--Peerless deducted onefiftieth of the $19,976,934 total discount-or $399,538--in each tax year.
The IRS and taxpayer agreed that
the interest deduction should be
allowed, unless the court ruled
that the debt should be
disregarded.
The court determined that there
was no business purpose for
issuing the debt, and no interest
deduction was allowed.
This is an extreme case, but the steps
used by the taxpayer to compute the
present value, the discount and the
discount amortization were all in
accordance with the law applicable to
bonds issued at a discount.
The next slide shows amortization
amounts for the Peerless Industries
under the straight-line method and under
the constant interest rate method
required by current tax law.
Zero Interest Bond - Peerless Ind.
Peerless Industries, Inc.
Maturity Value of Bonds
Discount -14%
Present Value (Issue Price)
Amortization - 6 months
Adjusted book value
Amortization - 6 months
Adjusted book value
Amortization-first year
Old Law
$20,000,000
$19,976,934
$23,066
$199,769
$222,835
$199,769
$422,605
$399,539
Current Law
$20,000,000
$19,976,934
$23,066
$1,615
$24,681
$1,728
$26,408
$3,342
Next few slides.
Some additional slides
on bond problems, first
showing the procedure
when straight-line
amortization is used.
Bond Discount
Big Co. issued $100,000 (par value), 9%, 3-year
bonds for $97,000 on 1-1-04. The bonds sold at a
discount because the market rate of interest was
higher than 9%.
Bonds payable
$100,000
Discount
(3,000)
Book Value
$97,000
Each year, Big will make interest payments of
$9,000, and will amortize discount of $1,000
(recognize additional interest expense), if the
straight-line amortization method is used.
Total interest expense will be $10,000 per year, or
$30,000 for 3 yrs. ($27,000 interest payments &
$3,000 discount.)
Bond Discount-Amort. Table
Three-Year Bonds, Face: $100,000, 9%.
Issued 1-1-04. Straight Line Amortization
Begin.
Annual Interest Discount Ending
Yr Bk Value
Pmt.
Expense Amort.
Bk Value
1
97,000
9,000
10,000
1,000
98,000
2
98,000
9,000
10,000
1,000
99,000
3
99,000
9,000
10,000
1,000
100,000
Bond Discount-Amort. Table
One investor purchased all of the bonds for
$97,000 on 1-1-2004.
Her interest income for 2004?
$10,000
Her basis in the bond at 1-1-05? $98,000
Interest rates go down and company calls
the bonds at 100 ($100,000) on 1-1-05.
What is the investor’s capital gain? $2,000
Bond Discount
To add reality, we must make two
changes.
1. The bonds are priced to yield an
interest rate in line with current market
rates. Price of bond is based on
present value computations.
2. Amortization of discount or premium
must be based on a method that
generates a constant rate of interest
(yield rate) each year.
Study next slide
Bond Discount Amortization
Three-Year Bonds, Face: $100,000, 9% . Yield 10%
Present value of bonds when sold
Beginning
Annual
Interest
Disc.
97,513.15
Ending
Yr
Bk Value Payment Expense Amort.
Bk Value
1
97,513.15 9,000.00
9,751.32 751.32
98,264.47
2
98,264.47 9,000.00
9,826.45 826.45
99,090.91
3
99,090.91 9,000.00
9,909.09 909.09 100,000.00
Bond Discount-Amort. Table
One investor purchased all of the bonds for
$97,000 on 1-1-2004.
Her interest income for 2004?
$9,751
Her basis in the bond at 1-1-05? $98,264
Interest rates go down and company calls
the bonds at 100 ($100,000) on 1-1-05.
What is the investor’s capital gain? $1,736
Bond Discount
M purchases for $620.92 on December 31,
2003, a zero coupon $1,000 bond. The
bond matures on December 31, 2008, and
the current market yield for the bond is
10% compounded annually. In 2005, M
must recognize interest income of
(rounded)
a. $62.09. b. $68.30. c. $117.
d. $140 e. None of these
Yr
1
2
3
4
5
Five-Year Bonds, Face: $1,000, 0%
Issued 1-1-04 at a price to yield 10% .
Unamort
Book Int.
Int.
Ending
Value Pmt Exp. Amort. Disc/Prm Bk Value
620.92
- 62.09 62.09 316.99
683.01
683.01
- 68.30 68.30 248.69
751.31
751.31
- 75.13 75.13 173.56
826.44
826.44
- 82.64 82.64 90.91
909.09
909.09
- 90.91 90.91
0.00 1,000.00
The
End