Editor: Michael Dell, CPA
Gross Income
In September, the IRS issued final regulations (T.D. 9599) clarifying the circumstances in which property is traded on an established market (i.e., publicly traded) for purposes of determining the issue price of a debt instrument.
The issue price of a debt instrument has several important tax consequences. It determines the amount of original issue discount on a newly issued debt instrument and the amount of repurchase premium or cancellation of debt (COD) income for an issuer, and the gain or loss to the holder upon exchange of the debt. The IRS noted that these consequences have intensified in recent years because of the impact of the credit crisis on debt markets. The final regulations apply to debt instruments issued on or after Nov. 13, 2012.
Background
Under Sec. 1273(b)(3), the issue price of a debt instrument that is issued for property where there is public trading is its fair market value (FMV). Regs. Sec. 1.1273-2(f) defines when property (including a debt instrument) is publicly traded. Under the prior regulations, which were out of date and unclear, a debt instrument was publicly traded if, in the period 30 days before or after the exchange, either the debt instrument or the property for which the debt instrument is exchanged (1) is exchange listed; (2) is market traded; (3) appears on a quotation medium; or (4) is a readily quotable debt instrument or property. To update the prior regulations, the IRS issued proposed regulations (REG-131947-10) that prompted a number of comments from practitioners. In response, the IRS issued the revised final regulations.
The Final Regulations
The final regulations state that property is publicly traded if, at any time during the 31-day period ending 15 days after the debt’s issue date (about half of the current period), the property has (1) a sales price; (2) one or more firm quotes; or (3) one or more indicative quotes.
Under the final rules, property is publicly traded if a sales price for the property is reasonably available. A sales price is considered reasonably available if the sales price or information sufficient to calculate the sales price appears in a medium that is made available to issuers of debt instruments, persons that regularly purchase or sell debt instruments, or persons that broker purchases or sales of debt instruments. Property is also considered to be publicly traded when a firm quote to buy or sell the property is available. A price quote is firm when it is labeled as such or when it functions as a firm quote as a matter of law or industry practice (see the preamble to REG-131947-10). Finally, property is now also considered publicly traded when it has an indicative quote, i.e., when at least one broker, dealer, or pricing service quotes a price for the property and the quote is not a firm quote.
The final regulations allow an exception to public trading status for any “small debt issues” of $100 million or less of stated principal amount, an increase from the $50 million exemption in the proposed regulations. The new rules also dispense with the category of exchange-listed property found in both the prior and proposed regulations. According to the preamble, this category was unnecessary because the small amount of debt that is listed on an exchange rarely actually trades over the exchange.
Under the final rules, the FMV of publicly traded property is presumed to equal its sales or quoted (firm or indicative) price. The taxpayer may use any consistently applied, reasonable method to determine FMV when there are multiple competing prices or quotes. Additionally, if property has only an indicative quote that the taxpayer determines materially misrepresents its FMV, the taxpayer can use any method that provides a reasonable basis to determine the property’s FMV. However, in this situation, the taxpayer must establish that the method chosen more accurately reflects the property’s FMV than the quote or quotes that were not used. Even if a taxpayer establishes that the indicative quote materially misrepresents FMV, the new regulations suggest that the property is nevertheless publicly traded.
In a departure from the proposed regulations, the final regulations now require consistency between the issuer and holder in determining whether the property is publicly traded and the property’s FMV. The issuer must make these determinations and then make the information available to holders within 90 days of the issue date “in a commercially reasonable fashion” that may include electronic publication. This determination is binding on holders unless they explicitly disclose the rationale behind a different determination on a timely filed federal income tax return for the tax year in which the debt instrument was acquired.
As in the proposed regulations, the final regulations also contain guidance in other areas, such as clarifying and revising the rules to determine when an issuance of debt is eligible to be part of a qualified reopening under Regs. Sec. 1.1275-2(k) and clarifying that a debt instrument issued in a debt-for-debt exchange is not subject to the potentially abusive transaction rules in Sec. 1274(b)(3), even if it was purchased shortly before the exchange. The final regulations also adopt the proposed regulations’ clarification that annual payments on a debt instrument are qualified stated interest even if the interval between two payments can exceed one year because the later payment is postponed by a Saturday, Sunday, or federal holiday to the first business day following the date on which it would otherwise be due.
The regulations provided a 60-day window before the final regulations apply to new debt instruments. Thus, as stated above, these final regulations apply to debt instruments issued on or after Nov. 13, 2012.
Implications
The IRS should be commended for issuing new regulations that discard the parts of the existing and proposed regulations that did not conform to the pricing of securities in the internet age. The final regulations resolve several uncertainties regarding whether debt is publicly traded. This is particularly important for syndicated bank debt, the treatment of which under the old regulations was often uncertain. The broadened definition of public trading under these regulations will likely make these types of debt instruments publicly traded unless they meet the expanded small debt issues exception.
However, not all the news is good. For issuers whose debt is worth less than its face amount, the expanded definition of public trading means that a greater class of issuers will have to recognize COD income if and when their debt is significantly modified. On the other hand, while the expansion of the public trading universe generally benefits holders of distressed debt, in the event of a significant modification, the inability of such holders to use the Sec. 1274 rule to set an issue price at FMV in potentially abusive situations is unfortunate. While the preamble to these regulations says that potential distortions created by distressed debt is the subject of guidance currently in the works, there is no indication when such guidance may be released. Finally, because the small debt issues exception is not a safe harbor, it will prevent issuers within this exception from deducting repurchase premium in a debt-for-debt exchange, even if quotes are available for the debt, since the issue price in these cases will be determined under Sec. 1274.
EditorNotes
Michael Dell is a partner with Ernst & Young LLP in Washington, D.C.
For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
