Taxing Convertible Debt

Abstract

There has been significant recent interest among tax policy experts about various possible reforms for the tax treatment of convertible debt. Potential reforms center on removing the deductibility by issuers of interest or original issue discount for these instruments either unconditionally or conditional upon conversion. This paper begins with a review of the role that callable convertible bonds play in corporate finance in order to gauge the impact of particular reforms. The most salient explanations for the issuance of substantial quantities of these bonds and for issuer call policy after issuance hinge on the ability of issuers to signal their prospects through issuance and call policy. After considering the impact of adding taxes to an appropriate signalling model, the paper concludes that the envisioned reforms of the tax treatment of convertible debt may have a very large impact on the utility of convertible debt as a signalling device. However, the direction of the impact is uncertain. In view of the apparent importance of convertible debt as a financing vehicle, these results suggest abstaining from potential reforms until a clearer picture emerges.