Certain Debt Obligations Not Subject to AHYDO Restrictions

Editor: Michael D. Koppel, CPA, PFS

As a result of the recent deteriorating market conditions for debt obligations, the IRS has indicated that it will not regard specific debt obligations as applicable high-yield discount obligations (AHYDO) for purposes of Secs. 163(e)(5) and 163(i).

Generally, when a corporation issues a debt obligation subject to the AHYDO rules, the disqualified portion of the original issue discount (OID) is considered to be a distribution akin to a dividend, rendering that portion nondeductible for tax purposes. The corporation defers the deduction for the remaining amount of OID until it is actually paid. Original issue discount is the discount from par value at the time a bond or other debt obligation is issued; it is the difference between the stated redemption price at maturity and the issue price (Sec. 1273(a)(1)).

Many tax professionals may be confused by the AHYDO rules or even unaware of the provisions. The recent market collapse for debt obligations makes having a working knowledge in this area more important than ever.

Rev. Proc. 2008-51

The IRS recently provided guidance on AHYDO in Rev. Proc. 2008-51, which is effective for debt obligations issued on or after August 8, 2008. This revenue procedure was issued to provide assurance to those who may have obtained financing commitments and, as a result of the recent deteriorating market conditions, discovered that the related debt obligation issue price may be significantly less than the monies advanced to the company under the financing commitment. In addition, certain mitigating actions may be necessary to reduce the impact of the reduced market price for debt obligations that, without this guidance, might lead one to conclude that the AHYDO rules do apply to the modified or exchanged obligation.

The new guidance provides more certainty with respect to certain potential AHYDO tax issues that may be affected by the issuance of specific debt obligations. The new guidance applies to debt obligations issued for money under a financing commitment and debt obligations issued in exchange for debt obligations issued under a financing commitment.

In anticipation of its needs, a company may seek to obtain a financing commitment from its lender in advance of borrowing the needed funds. These commitments guarantee that the company will have adequate debt financing at an upcoming date. When the company calls upon the commitment and the lender extends credit under terms previously negotiated, the company will borrow on those terms that were established in the commitment.

These terms may remain fixed over the term of the debt obligation. Fixed terms may allow the debt to be quickly sold by the lender. On the other hand, the company may borrow on terms that are temporary but that change to fixed terms after this temporary period. If the terms are temporary, the company may refinance the loan during the bridge period on terms that are more favorable than the fixed terms.

As recent market actions have shown, conditions can worsen between the time a company obtains a binding commitment and the time the company calls upon the lender to perform. This can have a number of consequences that may result in situations in which the issue price of a debt obligation is significantly less than the amount of money actually received by the company. For example, the lender may be unable to sell the debt to third parties for a price near the amount provided to the company under the commitment. In these situations, the issue price of the debt may be significantly less than the amount of money advanced to the company.

The issuance of a debt obligation under a commitment or under the significant modification of a debt obligation could subject the borrower to adverse income tax consequences in situations in which the issue price of the debt obligation is less than the cash actually received by the company. For example, interest deductions on the debt obligation may be disallowed under Sec. 163(e)(5) (i.e., the AHYDO rules could be applicable).

Under Sec. 163(e)(5), in the case of an AHYDO, a company is not allowed a deduction for the disqualified portion of the OID on the obligation, and the company’s deduction for the remaining portion of the OID is deferred until the OID is paid in cash or in property. A debt obligation is an AHYDO if:

1. The maturity date of the debt obligation is more than five years from the date of issue;
2. The yield to maturity of the debt obligation equals or exceeds the sum of the applicable federal rate in effect under Sec. 1274(d) for the calendar month in which the obligation is issued, plus five percentage points; and
3. The debt obligation has significant OID (Sec. 163(i)).

Under Sec. 163(i)(2), a debt obligation has significant OID if:

1. The aggregate amount that would be includible in gross income with respect to the debt obligation for periods before the close of any accrual period (as defined in Sec. 1275(a)(5)) ending after the date five years after the date of issue exceeds
2. The sum of the aggregate amount of interest to be paid under the debt obligation, before the close of the accrual period, and the product of the issue price of the debt obligation (as defined in Secs. 1273(b) and 1274(a)) and its yield to maturity.

Three Scenarios Addressed

Rev. Proc. 2008-51 applies to three scenarios. In the first, a debt obligation is issued for money under a financing commitment. If the following conditions are satisfied, the IRS will not treat the debt obligation as an AHYDO for purposes of Secs. 163(e)(5) and 163(i):

1. The debt obligation is issued by a corporation;
2. The debt obligation is issued for money and the terms of the debt obligation are consistent with the general terms of a binding financing commitment obtained by the company from an unrelated party before January 1, 2009; and
3. The debt obligation would not be an AHYDO within the meaning of Sec. 163(i) if, solely for purposes of making a determination if it is an AHYDO, the issue price of the debt obligation were the net cash proceeds actually received by the company for the debt obligation.

In the second scenario, a debt obligation is issued in exchange for another debt obligation issued under a financing commitment. The IRS will not treat the debt obligation as AHYDO if:

1. A corporation issues a debt obligation and the debt obligation is issued in exchange for a previous debt obligation that meets the requirements described in Scenario 1 above issued by the corporation;
2. The new debt obligation is issued within 15 months following the issuance of a previous debt obligation, and the debt obligation would not be an AHYDO within the meaning of Sec. 163(i) if, solely for purposes of making a determination of whether the debt obligation is an AHYDO, the issue price of the debt obligation were the net cash proceeds actually received by the company for the previous debt obligation; and
3. The maturity date of the debt obligation may not be more than one year later than the maturity date of the previous debt obligation, and the stated redemption price at maturity of the debt obligation is not greater than the stated redemption price at maturity of previous debt obligation.

The third scenario applies to a debt obligation indirectly exchanged for a debt obligation issued under a financing commitment. This scenario will not result in an AHYDO if:

1. A corporation issues a debt obligation;
2. The debt obligation is issued in exchange for a previous debt obligation (old debt B) issued by the corporation that meets the requirements described in Scenario 2;
3. The new debt obligation is issued within 15 months following the issuance of another debt obligation (old debt A);
4. The new debt obligation would not be an AHYDO within the meaning of Sec. 163(i) if, solely for the purpose of determining whether it is an AHYDO, the issue price of the debt obligation were the net cash proceeds actually received by the company for A;
5. The maturity date of the debt obligation is not more than one year later than the maturity date of A; and
6. The stated redemption price at maturity of the debt obligation is not greater than the stated redemption price at maturity of A.

Conclusion

In the current and recent market environment of commercial debt obligations, the AHYDO rules are certain to generate confusion among taxpayers. Advisers should be aware of the application of the AHYDO rules, including the new rules in Rev. Proc. 2008-51.

EditorNotes

Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

The Tax Adviser would like to acknowledge the special contribution to the December Tax Clinic of Singer Lewak LLP; Mark G. Cook, tax partner in the Irvine, CA, office; and Steve Cupingood, the partner in charge of that firm’s tax practice.

For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.