Recent IRS guidance has given comfort to corporate borrowers that certain financing commitments obtained before January 1, 2009 will not become subject to rules that limit the deductibility of interest on debt instruments.
On August 8, 2008, the IRS issued Revenue Procedure 2008-51, which specifically exempted three types of debt obligations from being treated as applicable high yield discount obligations (AHYDOs). Given the current shakiness of financial markets and the resultant increased likelihood that debt instruments will be sold at deep discounts by issuers, without this guidance certain corporate borrowers may have seen their debt instruments swept into the AHYDO rules due to circumstances beyond their control.
Original Issue Discount Rules
A detailed discussion of original issue discount (OID) is beyond the scope of this article. However, some discussion is necessary to understand how and why the IRS notice is a help to taxpayers.
OID is the excess of a debt instrument’s stated redemption price at maturity over its issue price. The stated redemption price at maturity generally is the total of all payments required to be made over the life of the debt instrument, other than stated interest required to be paid in cash or property other than debt instruments at least annually. For example if a bond is issued for $80, pays no interest prior to maturity and is redeemable at maturity for $100, the bond has $20 of OID. This OID accrues over the term of the instrument at the yield on the bond. The holder (even if otherwise on the cash method of accounting) must take the OID that accrues into income over the holder’s holding period. On the other hand, the issuer (even if otherwise on the cash method of accounting) of the bond generally is permitted to deduct, as an interest expense, the OID that accrues over the term of the bond, subject to some very complex rules.
Because OID is the excess of the stated redemption price at maturity of a debt instrument over its issue price, the determination of the issue price is critical. The OID rules contain specific rules for determining the issue price of a debt instrument. In the case of a publicly offered debt instrument issued for cash, the issue price is the offering price to the public (ignoring bond houses and brokers) that a substantial amount of the debt instruments was sold. In the case of a non-publicly issued debt instrument issued for cash, the issue price for each instrument is the price paid by the first buyer. The issue price of a debt instrument that is either publicly traded or that is issued for property that is publicly traded is the fair market value of the traded property.
Treasury Regulations provide that if the debt instrument is materially modified (e.g., the term or interest rate is changed more than an amount specified by the Treasury Regulations), the debt instrument is treated as being reissued for a new debt instrument. The issue price of the “new” debt instrument is determined under the OID rules described above. Accordingly, if the issue price of the new debt instrument is lower than the stated redemption price at maturity (e.g., because it is publicly traded and has dropped in value), the new debt instrument will have OID, which may be in excess of the OID on the original instrument.
The AHYDO rules limit a taxpayer’s ability to deduct OID as interest on certain corporate debt instruments. When the AHYDO rules apply, no deduction is allowed for the “disqualified portion” of the OID, which is treated as a corporate distribution for purposes of the dividends received deduction available to corporate holders. The disqualified portion is the portion of the yield in excess of the applicable federal rate plus 6 percentage points. The remaining OID on any AHYDO is deductible only when paid. This obviously raises issues for the borrower, which would like a deduction for what is, in essence, an interest expense. It also poses an issue for lenders, because more taxes mean less cash flow with which to pay debt service. Accordingly, it usually is important both to the borrower and lender to ensure that, consistent with economic terms to which the parties agreed, the AHYDO rules are not brought into play. In general, an AHYDO is a debt instrument that:
IRS Relief - Revenue Procedure 2008-51With the above background, you start to see some of the concerns created by current market conditions.
The IRS specifically highlighted two situations where worsening market conditions could dramatically affect the issue price of a financing commitment.
First, in a situation where a corporation issues debt with terms that are essentially permanent (i.e., not subject to renegotiation after the expiration of temporary “bridge” terms), the lender, acting as an underwriter, may be unable to sell the debt to third parties for a price that is equal to the amount the corporation received pursuant to the financing commitment. If this is the case, the result could be that the lender deeply discounts the debt obligations and causes a resultant drop in issue price (because the price paid by the lender in its capacity as an underwriter is ignored in determining issue price), compared to the money advanced to the corporation.
Second, in a situation in which a corporation issues debt that is subject to “bridge” terms established in the financing commitment, the corporation may be only be able to refinance this debt under less favorable “permanent” terms. Thus, the corporation and the lender may negotiate to amend the terms of the debt so that it can be marketed. In this case, certain amendments may end up constituting material modifications, and thus the debt would be treated as reissued for a new debt instrument. The issue price of the “new” debt instrument may, as discussed above, have an issue price lower than the amount initially advanced to the corporation. For example, if the debt instrument is publicly traded and the fair market has gone down. Each of these cases potentially results in the creation of OID as a result of adverse market conditions. If the OID is significant, the instrument may be an AHYDO. The IRS wanted to alleviate uncertainties generated by current market conditions. Revenue Procedure 2008-51 covers three specific types of debt instruments issued under a financing commitment, that are generally: (1) debt instruments issued for money; (2) debt instruments exchanged for debt instruments issued under a financing commitment; and (3) debt instruments indirectly exchanged for debt instruments issued under a financing commitment. Specifically, under the terms of Revenue Procedure 2008-51, the following debt instruments will not be treated as AHYDOs:
Revenue Procedure 2008-51 provides some relief and certainty for taxpayers against potentially adverse tax consequences arising solely as a result of current poor market conditions. It is encouraging to see the IRS take a more commercial, less technical view under these circumstances. Taxpayers must remember, however, that the IRS clearly marked the limited cases covered by the Revenue Procedure. Taxpayers are specifically instructed that they may not use this guidance to infer other rules regarding whether a debt instrument would be within the scope of the AHYDO rules. Moreover, the “fix” effected by the Revenue Procedure is temporary (as we hope the conditions necessitating the Revenue Procedure will be).
Corporate borrowers intending to modify debt instruments, or whose debt is being sold by brokers or other intermediaries, should closely consider (with their tax advisors) whether the conditions described herein apply to their debt instruments, in order to determine whether the relief set forth in Revenue Procedure 2008-51 may apply.
1 Once a debt instrument is determined to be an AHYDO, all OID is subject to the deductibility limitations, not just the portion of the OID representing yield in excess of the AFR plus five percentage points.
2 “Significant OID” is by far the most complex criterion. A debt instrument has “significant OID” if, at the end of an interest accrual period at least five years after the issue date, the cumulative accrual of interest and OID on the instrument exceeds the sum of: (i) the actual interest paid from the issue date until the end of that accrual period, and (ii) the product of the yield to maturity and the instrument’s issue price. In essence, this means that a debt instrument will have significant OID if following the first interest accrual period after the fifth anniversary of the debt instrument, unpaid interest and OID exceeds one year’s simple interest determined by multiplying the original issue price of the debt instrument by the yield to maturity thereon.
Steven D. Bortnick and Marc D. Nickel
The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.