A Frequently Overlooked Tax Issue for Private Equity Investors

By John T. Murray, CPA, Partner

A Frequently Overlooked Tax Issue for Private Equity Investors

Overview and tax considerations of contingent payment debt instruments

What are Contingent Payment Debt Instruments?

Contingent payment debt instruments (CPDIs) are financial instruments that involve debt arrangements with payments contingent upon specific events or variables. These instruments commonly include debt instruments such as:

  • Bonds
    • Convertible
    • Callable
    • Step-Up
  • Structured Notes
  • Variable Rate Demand Notes
  • Or other types of fixed-income securities.

Unlike traditional fixed payment instruments, CPDIs adjust their payments based on predetermined contingencies, such as changes in interest rates, the performance of an underlying asset, or a specified index. The specific terms and features of contingent payment debt instruments can vary significantly.

Private equity investor CPDI tax considerations and compliance

As frequent providers of capital with flexible payment terms, private equity investors are most likely to be impacted by CPDI tax compliance complexities. Regulation 26 CFR § 1.1275-4 specifically addresses CPDIs and attempts to ensure accurate reporting and compliance for businesses and taxpayers. The regulation outlines the rules for determining the issue price, original issue discount (OID), and interest accruals on these instruments.

Determining issue price, original issue discount, and interest accruals

  • Issue Price Determination
    The regulation establishes rules for determining the issue price of a contingent payment debt instrument at the time of issuance. This determination considers factors such as fixed payments, contingent payments, and the likelihood of those contingencies occurring. It also addresses the valuation of noncontingent payments and any embedded options.
  • Original Issue Discount
    Original Issue Discount (OID) represents the difference between the stated redemption price at maturity and the issue price of a debt instrument. Under 26 CFR § 1.1275-4 there are specific rules for calculating and reporting OID for contingent payment debt instruments. The regulation takes into consideration contingencies that could affect the timing or amount of payments and provides guidelines for determining accruals and adjustments.
  • Interest Accruals and Adjustments
    CPDIs often involve complex interest accruals and adjustments due to the contingencies tied to the payments. The regulation provides rules for determining the accrual periods, calculating the imputed interest, and making necessary adjustments to reflect the contingent nature of the instrument.

Leverage resources to stay tax compliant

Private equity investors and businesses should review debt agreements to know the charter and nature of its tax impacts. The taxable interest income resulting from a contingent payment debt instrument does not always follow investor expectations. There are cases where investors are reporting taxable interest income without having a corresponding cash payment to match the income or income tax.

If you need assistance interpreting your debt agreement to determine the character and nature of the loan payments and tax, contact your Keiter Opportunity Advisor or John Murray, CPA, Tax Partner, Financial Services industry team| jmurray@keitercpa.com or call 804.747.0000.


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About the Author

John T. Murray

John T. Murray, CPA, Partner

John is a member of the Firm’s Financial Services and Mergers & Acquisitions and Technology industry teams with over 20 years of experience in both the private and public accounting practice areas. He applies his experience to provide insights and identify opportunities for closely-held businesses in the real estate, healthcare, private equity, and government contracting industries. He provides ongoing budgeting, forecasting, cash management, and compensation planning for many of his clients. John also applies his expertise and knowledge in structuring transactions and reviewing proposed acquisitions in order to minimize the tax consequences for his clients that are located throughout the US as well as internationally.

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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.


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