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Tax Relief for Bond Interest Has a Hitch

Congress provided companies caught in the liquidity crunch a tax break for certain bond discount obligations — but payments of accrued interest must be timed correctly.
Robert Willens, CFO.com | US
July 13, 2009

During the 1980s, many deals were financed, at least in part, with "deferred interest" debt securities. Under the original issue discount (OID) rules, however, the interest was deductible for tax purposes as it accrued, even though its payment was delayed, sometimes quite far into the future. Congress felt that this convention was contributing to the proliferation of "uneconomic" deals then being closed, and in an effort to curtail the current deduction of accruing interest, created the concept of the AHYDO — the "Applicable High Yield Discount Obligation."

Section 163(i) of the U.S. Tax code defines AHYDO as any debt instrument issued by a corporation that demonstrates the following characteristics:

• The maturity date of the debt instrument is more than five years from the date of issue;

• The yield to maturity of the debt instrument is equal to, or greater than, the sum of (1) the "applicable federal rate" (AFR) in effect for the calendar month in which the obligation is issued, and (2) five percentage points,1and;

• There is, with respect to the obligation, significant OID.

Significant OID
This latter characteristic, without which a debt instrument cannot be characterized as an AHYDO, is by far the most inscrutable of the three AHYDO attributes. Indeed, OID is considered to be a form of interest, and that complicates tax issues. But breaking down the rules, especially with regard to OID, can help bond holders, and issuers, better understand the implications.

For example, there is a significant OID in cases where the aggregate amount that can be included in (the holder's) income2 exceeds the sum of: (1) the aggregate amount of interest to be paid before the close of such accrual period, and (2) the product of the obligation's issue price and its yield to maturity.

In these cases, according to Congress, the accrued interest with respect to the obligation is "excessive" in comparison to the interest actually paid. Therefore, a penalty is warranted.

Due to this "odd" definition of significant OID, a debenture can escape significant OID status, and therefore AHYDO designation as well, if certain criteria are met. Specifically, OID and AHYDO status can be avoided if the corporation pays no interest until immediately before the close of the first accrual period ending after the fifth anniversary of issuance. At that time, the corporation is required to pay all interest accrued, except an amount equal to the first 12 months' yield accrued after issuance. What's more, each accrual period thereafter, the corporation is required to pay the interest accrued during the accrual period.

In these cases, the instrument is not an AHYDO to begin with, with the result that the interest accrued during the period prior to the initial measurement date (the close of the first accrual period ending after the fifth anniversary of issuance) can be currently deducted.3

AHYDO Penalties
In the case of an AHYDO issued by a corporation, no deduction is allowed for the disqualified portion of the OID with respect to the obligation. Further, the remainder of the OID is not allowable as a deduction until it is paid in cash or property. (See Section 163(e)(5).)

Bob Willens 2
"However, no relief has been granted to those issuers who avoided AHYDO status by promising to make a "catch up" payment of the accrued [original interest discount] ... and now, due to liquidity or other problems, are unable to honor their commitment. — Robert Willens

In effect, the issuer — but not the holder — of an AHYDO is required to use the cash receipts and disbursements method of accounting with respect to OID4. For this purpose, the disqualified portion of OID is the lesser of, (1) the amount of such OID, or (2) the portion of the "total return" on such obligation which bears the same ratio to the total return as the disqualified yield bears to the obligation's yield to maturity.

To be clear, the precise definitions of these two elements are as follows: The disqualified yield is the excess of the yield to maturity over the sum of the applicable federal rate that is in effect for the calendar month in which the obligation was issued — plus 600 basis points. The total return, with respect to the obligation, is the amount which would have been the bond-related OID if the "qualified stated interest" of the obligation was included in the bond's redemption price at maturity. (However, the qualified stated interest would have to be so-called non-conforming interest for purposes of ascertaining the total return.)

In light of the credit crisis, Congress has granted some relief to potential issuers of AHYDOs through the stimulus package passed in April. Thus, the AHYDO penalties shall not apply to an AHYDO issued during the period beginning on Sept. 1, 2008, and ending on Dec. 31, 2009, in exchange for an obligation which is not an AHYDO — and the issuer of which is the same as the issuer of such AHYDO.


However, no relief has been granted to those issuers who avoided AHYDO status by promising to make a "catch up" payment of the accrued OID with respect to the instrument prior to the close of the first accrual ending after the fifth anniversary of the obligation's issuance — and now, due to liquidity or other problems, are unable to honor their commitment.

In those cases, the instrument would have to be characterized, nunc pro tunc, as an AHYDO, forcing the issuer to restate its prior tax returns to eliminate the deductions it claimed for the accruing OID. Such OID could only be deducted, now that the instrument has been conclusively classified as an AHYDO, when it is actually remitted in cash or other property. As a result, absent relief — which does not appear to be forthcoming — companies in this predicament might be called upon to pay an amount of "back taxes" stemming from the fact that such issuers claimed, prematurely as it turns out, deductions for OID.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com

Footnotes

1 By regulations, the Secretary may permit, on a temporary basis, a rate to be used with respect to any debt instrument which is higher than the AFR if the Secretary determines that "such rate is appropriate in light of distressed conditions in the debt capital markets." The Secretary has not, as of yet, exercised this privilege.

2 For periods before the close of any accrual period ending after the date, which is five years after the issue date.

3 See M. Ginsburg and J. Levin, Mergers, Acquisitions, and Buyouts, Paragraph 1303.

4Solely for purposes of Section 243 (dealing with the intercorporate dividends received deduction), the "dividend equivalent portion" of any amount includible in gross income of a corporation in respect of an AHYDO shall be treated as a dividend (eligible for the dividends received deduction). The dividend equivalent portion, in turn, is the portion of the amount includible in the corporate holder's gross income which is attributable to the disqualified portion of the OID.         




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