Suspension of Applicable High-Yield Discount Obligation Regime for 2010

Interest Income & Expense

With the passage of the American Recovery and Reinvestment Act of 2009, P.L. 111-5 (ARRA), Congress suspended the applicable high-yield discount obligation (AHYDO) rules under Sec. 163(e)(5) for certain debt-for-debt exchanges occurring between September 1, 2008, and December 31, 2009. This temporary suspension was part of an effort to reduce obstacles within the financial system in order to foster increased liquidity in the wake of the financial crisis that erupted in 2008. Under Sec. 163(e)(5)(F)(iii), Treasury was granted authority to extend such suspension in the event it “is appropriate in light of distressed conditions in the debt capital markets.” On December 24, 2009, the IRS released Notice 2010-11, which extended the suspension of the AHYDO regime through December 31, 2010, but with additional requirements. Accordingly, practitioners who work in this area, especially those with private equity clients, should be aware of the temporary framework that can deliver favorable tax results while increasing liquidity and reduced cash outflows in the short term.

The AHYDO Rules

Generally speaking, an AHYDO is any debt instrument that is issued by a C corporation (including proportionate corporate ownership of a passthrough entity) for a term of more than five years and has a yield to maturity in excess of five percentage points over the applicable federal rate (AFR) for the month in which it is issued. To the extent a debenture is an AHYDO, accrued interest becomes deductible only when paid, while a portion is subject to permanent disallowance because it is considered to be equivalent to a dividend. On the other hand, interest is fully deductible on debt that remains outside the AHYDO rules as it accrues, consistent with the taxpayer’s method of accounting. In any case, the holder of a note that earns interest accrued but unpaid will recognize income under the original issue discount (OID) rules, with the exception of any dividend equivalent that is treated as dividend income. Moreover, it is important to highlight that a corporate note holder of an AHYDO is eligible for a dividends-received deduction under Secs. 243, 245, 246, and 246A for the dividend equivalent earned, concomitant with the holder’s equity interest in the borrower.

Under Sec. 163(e)(5)(C), the dividend equivalent is the disqualified portion of the OID of an AHYDO note that would be a dividend if it were a distribution of a corporation with respect to its stock. The disqualified portion of the OID on any AHYDO note is the lesser of (1) the amount of the OID or (2) the portion of the total return on the obligation that bears the same ratio to the total return as the obligation’s disqualified yield bears to the obligation’s yield to maturity. The note’s disqualified yield is defined under Sec. 163(e)(5)(C)(ii) as the excess of the yield to maturity over the sum of the AFR plus six percentage points.

A detailed review of the concept of significant OID, as defined under Sec. 163(i)(2), is beyond the scope of this item. While significant OID is one of the cornerstones of the AHYDO rules, it is important to note that many loan documents contain catch-up provisions that require payments in advance of the general structure of the note’s terms in order to avoid the AHYDO rules. To the extent the terms of a modified note can be engineered to avoid the AHYDO rules under the suspension provisions of Sec. 163(e)(5)(F) and Notice 2010-11, the notion of the catch-up provision becomes moot, thereby allowing the issuer to conserve cash by not having to make early payments, which are otherwise commonplace under notes with elevated rates of OID.

Notice 2010-11 Requirements

Under Sec. 163(e)(5)(F)(i), the AHYDO rules are suspended where a note that is not an AHYDO is exchanged for a note that would be an AHYDO if not for the temporary suspension. However, the suspension does not apply to contingent portfolio interest as defined under Sec. 871(h)(4) or to obligations issued to a related person within the meaning of Sec. 108(e)(4). Notice 2010-11 added the requirement that the AHYDO’s issue price must be determined under Sec. 1273(b) or 1274(b), as applicable. In addition, Notice 2010-11 requires that the exchanged note will qualify for the suspension only if “the AHYDO would not otherwise be an AHYDO if its issue price were increased by the amount of any discharge of indebtedness income realized by the issuer . . . upon the exchange.”

The Notice 2010-11 requirements can be illustrated by the following example.

Example: In May 2007, L Corp. issued debt with a $50 million face value, at an interest rate of 7%, for a 10-year term, payable quarterly. Due to financial difficulties as a result of the recession, L restructured its debt in May 2010, increasing the interest rate from 7%, payable quarterly, to 15%, with payment of interest deferred until maturity of the note in 2017. Because the new interest rate exceeds the May 2010 AFR of 4.47% by more than five percentage points, the note would be an AHYDO, with interest recharacterized as nondeductible dividend equivalent, if not for the temporary suspension under Sec. 163(e)(5)(F) and Notice 2010-11.

If instead the principal amount of the note were reduced from $50 million to $40 million, L would realize $10 million cancellation of debt (COD) income at the time of the exchange. In determining whether the modified note qualifies for suspension under Notice 2010-11, the face amount of the note is increased by the $10 million COD income realized on the exchange. Under this set of facts, the increased deemed issue price of $50 million is used to determine whether the note is an AHYDO under the revised terms. Because this obligation would be an AHYDO (as determined in the preceding example), the new note does not meet the requirements of Notice 2010-11 and therefore is not eligible for suspension of the AHYDO rules.

Alternatively, if the interest rate were increased to 9% as opposed to 15% and interest remained payable quarterly but with an extension of the maturity date by three additional years until May 2020, the note would meet the requirements of Notice 2010-11 and thus would allow suspension because the new interest rate is less than five percentage points over the long-term quarterly 4.40% AFR in May 2010.

Conclusion

As these examples illustrate, the recent guidance provides greater flexibility for increased interest rates as opposed to reductions in principal in avoiding AHYDO treatment for renegotiated obligations. Accordingly, notwithstanding the favorable provisions recently enacted as part of ARRA regarding deferral of recognition of COD income under Sec. 108(i), practitioners will need to weigh the relative impacts of these seemingly competing relief provisions in striking the optimal balance for both borrowers and lenders.

Editor: Frank J. O’Connell Jr., CPA, Esq.

EditorNotes

Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.