IRS Acts to Prop Up Some Debt Instruments in Slumping Markets

New guidance issued last month by the Internal Revenue Service addresses the current credit crisis and how it might affect a corporate debt instrument known as an “applicable high yield discount obligation” (AHYDO). In fact, the application of the new guidance will likely give corporate issuers more flexibility to deal with financial commitments that were made when the markets were in better shape.

Before examining the IRS bulletin, let’s examine the key feature of an AHYDO that is affected by the guidance. When a debt instrument is classified as an AHYDO, the issuer is stripped of its ability to deduct the accompanying original issue discount (OID), as it accrues. Instead, the discount may only be deducted when it is actually paid in cash or property (other than a debt instrument of the issuer or a related person). Moreover, if the instrument is categorized as a “super AHYDO” (because its yield to maturity exceeds certain thresholds), a portion of the OID — known as the “disqualified portion” — can never be deducted.

As a result, the IRS has taken steps to insure that certain debt instruments, issued in connection with financing commitments previously obtained by the issuer, will not inadvertently, fall within the definition of an AHYDO.

Financing Commitments

In the guidance issued on September 2, (Rev. Proc. 2008-51), the IRS recognizes that corporations frequently obtain financing commitments from lenders in advance of borrowing money. In some situations, the corporation will borrow on terms that were established in the commitment, and which remain fixed over the term of the resulting debt instrument. Alternatively, the corporation will borrow on terms that are temporary and that change to different, more permanent, terms after this temporary period.

Clearly, as we have recently witnessed, market conditions can worsen between the time a financial commitment is obtained and the time the corporation calls upon the lender to discharge its responsibilities under the commitment. In cases where a corporation issues debt with permanent terms, the lender (if market conditions have worsened) may be unable to sell the debt to third parties for a price equal to the money provided to the corporation.

In these situations, the “issue price” of the debt may be substantially less than the amount of money advanced to the corporation. 1 In cases in which a corporation issues debt with temporary terms, the company may be unable to refinance the debt with permanent debt that has more favorable terms that is embedded in the debt issued pursuant to the financial commitment. Thus, to allow the lender to sell the debt to third parties, the parties are permitted to amend the terms of the debt.

Such amendments may constitute a significant modification within the meaning of the tax code (Regulation Section 1.1001-3.) In those situations, once again, the issue price of the “new debt” (deemed issued as a result of the significant modification) may be substantially less than the amount of money initially advanced to the corporate borrower. 2

AHYDO

Under the tax code — specifically Section 163(e)(5) — and in the case of an AHYDO, a corporation is not allowed a deduction for the “disqualified portion” of the OID. What’s more, the corporation’s deduction for the remaining portion of the OID will be deferred until that deduction is paid in cash or property (other than debt of the issuer or a related person). For this purpose, Section 163(i) defines AHYDO as any debt instrument issued by a corporation if:
• The maturity date is more than five years from the date of issue;
• The yield-to-maturity equals or exceeds the Applicable Federal Rate (AFR) in effect for the month in which the instrument is issued plus 500 basis points, 3 and;
• The debt instrument features “significant OID — it does if the following applies. That is, the aggregate amount included in a holder’s gross income for periods before the close of any “accrual period” ending after the date five years after the date of issuance exceeds the sum of: (1) the aggregate amount of interest paid before the close of the accrual period, and (2) the product of the instrument’s issue price and yield to maturity.

According to Congress, in cases with significant OID, the accrued interest with respect to the instrument is “excessive” in comparison to the interest actually paid. Therefore, AHYDO penalties are properly exacted. The amount of OID associated with an instrument is the amount by which the instrument’s stated redemption price at maturity exceeds its issue price. (See Section 1273(a)(1) of the tax code.) Accordingly, if due to changes in market condition, the instrument’s issue price falls substantially below the amount of money advanced to the corporation, the instrument may bear significant OID. As a result, it would be classified as an AHYDO. So the IRS has taken steps to insure that, in many cases, this fate will not befall an unwitting issuer.

Therefore, the new IRS bulletin provides that if its terms apply to a debt instrument, the government will not treat the instrument as an AHYDO. The September bulletin applies to the following varieties of debt instruments:
• Issued by a corporation, for money, with terms that are consistent with the general terms of a binding financial commitment obtained from an unrelated party before January 1, 2009 — and which would not be an AHYDO if the issue price was set at the net cash proceeds actually received by the corporation for the debt instrument;
• Issued by a corporation in exchange for a debt instrument (Old Debt Instrument A— ODIA) which was (1) issued by the corporation, and (2) described in the immediately preceding category. In addition, the debt instrument (issued in exchange for the ODIA) must be issued within 15 months following the issuance of the ODIA, and the debt instrument would not be an AHYDO if the issue price was the net cash proceeds actually received by the corporation for the ODIA. Moreover, the maturity date of the debt instrument (issued in exchange for the ODIA) may not be more than one year later than the maturity date of the ODIA. Finally, the redemption price at maturity of the debt instrument may not be greater than the corresponding redemption price of the ODIA;
• Issued by a corporation in exchange for a debt instrument (Old Debt Instrument B — ODIB) which was issued by the corporation and described in the immediately preceding category. In addition, the debt instrument must be issued within 15 months following the issuance of the ODIB and the debt instrument would not be an AHYDO if the issue price was the net cash proceeds actually received by the corporation for ODIB. Moreover, the maturity date of the debt instrument must not be more than one year later than the maturity date of ODIB and the redemption price at maturity of the debt instrument must not be greater than the corresponding redemption of the ODIB.

If these detailed conditions are met, an instrument that normally would fall squarely within the Section 163(i) definition of an AHYDO, will not be so treated. This revenue procedure is effective on August 8, 2008.

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

Footnotes
1If a substantial amount of the debt instruments is issued for money, the issue price of each debt instrument is the first price at which a substantial amount of the debt instruments is sold. However, for this purpose, sales to bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters, placement agents, or wholesalers is ignored. Accordingly, in these cases, it is easy to see why the issue price of the debt (following a deterioration in market conditions) may be markedly less than the amount of money advanced to the corporation. See Reg. Sec. 1.1273-2(a) and (e).)
2 See Regulation Section 1.1273-2(b); if a substantial amount of the debt instruments in an issue is traded on an established market and the debt instrument is not issued for money, the issue price of each debt instrument in the issue is the fair market value of the debt instrument determined as of the issue date.
3 The AHYDO will be classified as a super AHYDO if the yield to maturity exceeds the AFR (in effect for the month in which the debenture is issued) plus 600 basis points. In these cases, the disqualified portion of the OID is an amount equal to the total yield for the taxable year multiplied by a fraction whose numerator is the “disqualified yield” (the excess of the yield over the AFR plus 600 basis points) and whose denominator is the instrument’s total yield.