7659 / How is the amount of amortizable bond premium determined in the case of a convertible bond?
On January 1, 2025, John Smith purchases for $1,100 a convertible bond maturing on January 1, 2028, with a stated principal amount of $1,000, payable at maturity. The bond provides for unconditional payments of interest of $20.00 on January 1 and July 1 of each year. In addition, the bond is convertible into 15 shares of the corporation’s stock at the option of the holder. On January 1, 2025, the corporation’s nonconvertible, publicly-traded, three-year debt with a similar credit rating trades at a price that reflects a yield of 4.50 percent, compounded semiannually.
Mr. Smith’s basis for determining loss on the sale or exchange of the bond is $1,100. As of January 1, 2025, discounting the remaining payments on the bond at the yield at which the corporation’s similar nonconvertible bonds trade (4.50 percent, compounded semiannually) results in a present value of $985. Thus, the value of the conversion option is $115. Mr. Smith’s basis is $985 ($1,100 - $115) for purposes of the rules and regulations of IRC Section 171. The sum of all amounts payable on the bond other than qualified stated interest is $1,000. Because Mr. Smith’s basis (under IRC Section 171) does not exceed $1,000, he does not acquire the bond at a premium.
Regulations in effect for bonds acquired before March 2, 1998 (or held before a taxable year containing March 2, 1998) provided that the value of the conversion features is determined as of the date of acquisition by adjusting the price of the bond to a yield determined by comparison with the yields of bonds of similar character without conversion features that are sold on the open market.3 The above language is not included in the regulations, as amended December 31, 1997.