A closer look at the costs of borrowing

Editors: Alexander J. Brosseau, CPA, and Greg A. Fairbanks, J.D., LL.M.

The rise of benchmark interest rates (e.g., the Secured Overnight Financing Rate, SOFR) in recent years has led to higher interest expense for many taxpayers. In addition, many taxpayers have been further restricted from deducting interest expense due to the change, beginning in 2022, that required a deduction of depreciation, amortization, and depletion in determining adjusted taxable income for Sec. 163(j) purposes. Based on these developments, it is more important than ever for taxpayers to compute interest expense for tax purposes accurately, given that the deduction of interest expense is more likely subject to a limitation.

In practice, taxpayers may use their interest expense for accounting purposes as a proxy for their interest expense for tax purposes. However, taxpayers who assume that their interest expense computed for accounting purposes is the same as their interest expense for tax purposes may be surprised to learn that there are distinct differences between the two. This item summarizes certain relevant tax provisions and accounting rules related to interest expense and then identifies some best practices for taxpayers to identify such differences.

Interest and original issue discount

Under Sec. 163(a) taxpayers may generally deduct interest paid or accrued within a tax year on indebtedness. Sec. 163(e)(1) also provides an allowable deduction to the issuer (i.e., the obligor) of a debt for the aggregate daily portions of original issue discount (OID) in a given tax year. While there are many limitations to a deduction under Sec. 163, businesses are commonly limited to a deduction under Sec. 163(j) to the extent that business interest expense does not exceed the following for a given tax year: (1) business interest income, (2) floor plan financing interest, and (3) 30% of adjusted taxable income.

For tax purposes, interest is commonly defined as “compensation for the use or forbearance of money,” based on the Supreme Court’s decision in Deputy v. du Pont, 308 U.S. 488 (1940). The Supreme Court further held in Midland–Ross Corp., 381 U.S. 54 (1965), that “earned [OID] serves the same function as stated interest” and thus should be treated akin to interest.

Interest may come in many forms. From a tax perspective, however, interest mostly comprises three categories: qualified stated interest (QSI), OID, and repurchase premium. QSI is stated interest that is unconditionally payable in cash or in property (other than debt instruments of the issuer) or that will be constructively received under Sec. 451 at least annually at a single fixed rate (Regs. Sec. 1.1273–1(c)).

OID and repurchase premium are described further below.

Original issue discount

Under Sec. 1273(a)(1), OID is the excess, if any, of the stated redemption price at maturity over the issue price. OID is generally taken into account by the borrower following rules in Regs. Sec. 1.163–7, which generally require the use of the constant–yield method (described in Regs. Sec. 1.1272–1(b)) to compute how much OID is deductible for a period. Special rules may apply if the total amount of OID on the debt is de minimis, which may allow the borrower to deduct OID over the term of the debt based on a straight–line amortization method.

In determining the amount of OID, the regulations contemplate payments incident to lending transactions that may impact the issue price of a debt and thus give rise to additional OID. Specifically, the regulations under Regs. Sec. 1.1273–2(g)(2) provide that a payment from the borrower to the lender in a cash transaction reduces the issue price of a loan, except if the payment is for property or services provided by the lender (e.g., commitment fees or loan processing costs). Example 1 of Regs. Sec. 1.1273–2(g)(5) illustrates this concept:

(i) Facts. A lends $100,000 to B for a term of 10 years. At the time the loan is made, B pays $4,000 in points to A. Assume that the points are not deductible by B under [Sec.] 461(g)(2) and that the stated redemption price at maturity of the debt instrument is $100,000.

(ii) Payment results in OID. Under [Regs. Sec. 1.1273–2(g)(2)(i)], the issue price of B’s debt instrument evidencing the loan is $96,000. Because the amount of OID on the debt instrument ($4,000) is more than a de minimis amount of OID, A accounts for the OID under [Regs. Sec.] 1.1272–1. B accounts for the OID under [Regs. Sec.] 1.163–7.

Due to the rule under Regs. Sec. 1.1273–2(g)(2), fees a borrower pays to a lender are commonly characterized as OID or as giving rise to OID. Such fees may be labeled as OID, discount, an upfront fee, a closing fee, a funding fee, or various other names.

Repurchase premium

Under Regs. Sec. 1.163–7(c), repurchase premium occurs when a debt instrument is repurchased by the issuer for a price in excess of the adjusted issue price. Repurchase premium is generally deductible as interest in the tax year in which the repurchase occurs. However, in the event of a repurchase of a debt instrument in a debt–for–debt exchange (e.g., a significant modification of a debt instrument under Regs. Sec. 1.1001–3), in which the issue price of the newly issued debt is determined under either Sec. 1273(b)(4) or 1274, the “repurchase premium is not deductible in the year of the repurchase, but is amortized over the term of the newly issued debt instrument in the same manner as if it were OID” (Regs. Sec. 1.163–7(c)).

Debt issuance costs

For tax purposes, the term “debt issuance costs” means transaction costs incurred by an issuer of debt that are required to be capitalized under Regs. Sec. 1.263(a)-5 (Regs. Sec. 1.446–5(a)). Pursuant to Regs. Sec. 1.263(a)-5(a)(9), a taxpayer must capitalize an amount paid to facilitate a borrowing as debt issuance costs. Debt issuance costs are generally capitalized and amortized over the term of the debt instrument to which the costs relate (Enoch, 57 T.C. 781 (1972)) and typically include underwriting costs, commissions, legal services, and other costs related to the issuance of a debt.

Prior to the issuance of Regs. Sec. 1.446–5, debt issuance costs were deductible over the term of the debt based on a straight–line amortization method. However, Regs. Sec. 1.446–5, while issued to conform the rules for debt issuance costs to the rules for OID, applies solely for purposes of determining the deduction of debt issuance costs in a given period. Under Regs. Sec. 1.446–5(b), the issuer treats debt issuance costs “as if they adjusted the yield on the debt” by treating the costs “as if they decreased the issue price of the debt.” If the aggregate of OID and debt issuance costs are de minimis, the borrower may deduct the debt issuance costs over the term of the debt based on a straight–line amortization method.

Importantly, debt issuance costs are deductible as ordinary and necessary expenses paid or incurred in carrying on a trade or business under Sec. 162, rather than under Sec. 163.

Hedging transactions

Sec. 1221 and Regs. Sec. 1.446–4 govern the treatment of hedging transactions. Sec. 1221(b)(2)(A) provides that the term “hedging transaction” includes a transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily to manage the risk of interest rate fluctuations with respect to borrowings. If properly identified, a hedging transaction under Sec. 1221 results in ordinary income, deduction, gain, or loss to a taxpayer because it would not constitute a capital asset.

Under Regs. Sec. 1.446–4(b), a taxpayer must account for income, deduction, gain, or loss on a tax hedging transaction by reference to the timing of income, deduction, gain, or loss on the item being hedged (a hedged item). For example, a taxpayer that enters into an interest rate swap to hedge the interest rate risk on debt may be generally required to account for the timing of any income, deduction, gain, or loss on the swap as the interest expense related to the debt is incurred.

Notwithstanding that a hedging transaction will be linked to the hedged item by Sec. 1221 and Regs. Sec. 1.446–4, the hedging transaction is generally considered to be a separate transaction from the hedged item.

Interest for Sec. 163(j)

The regulations under Sec. 163(j) provide their own definition of “interest” for Sec. 163(j) purposes. Specifically, Regs. Sec. 1.163(j)-1(b)(22) provides that interest consists of four categories of items for Sec. 163(j) purposes: (1) items that are compensation for the use or forbearance of money (the general category); (2) imputed interest from certain swaps with significant nonperiodic payments; (3) other items treated as interest, including premium, substitute interest payments, factoring income, and others (the other–items category); and (4) any expense or loss economically equivalent to interest if a principal purpose of structuring the transaction was to reduce interest (the anti–avoidance category).

For items listed in the general category, the regulations provide a nonexclusive list of items including QSI, OID, de minimis OID, and repurchase premium.

Notably, proposed regulations under Sec. 163(j) (REG–106089–18) had included in the other–items category both debt issuance costs (Prop. Regs. Sec. 1.163(j)-1(b)(20)(iii)(H)) and certain hedging income, deduction, gain, or loss (Prop. Regs. Sec. 1.163(j)-1(b)(20)(iii)(E)). However, the preamble to the final regulations (T.D. 9905) explicitly discusses the exclusion of both items from the definition of “interest” in the final regulations but left open the potential that the items could be included in the anti–avoidance category.

Accounting for interest

FASB ASC Topic 835, Interest, provides guidance for the accounting treatment of interest.

The FASB ASC Master Glossary definition of “interest cost” provides that “[i]nterest cost includes interest recognized on obligations having explicit interest rates, interest imputed on certain types of payables in accordance with Subtopic 835–30, and interest related to a finance lease determined in accordance with Topic 842.” Interest cost also includes amounts resulting from the periodic amortization of discount or premium and debt issuance costs.

When debt is issued in exchange for property (including money), goods, or a service in an arm’s–length transaction, it is presumed that the interest rate will be equal to the market rate and thus “fair and adequate compensation” (Paragraph 835–30–05–2). However, interest may include imputed interest under the accounting rules, despite the actual terms, when the transaction is viewed as not at arm’s length or the market rate materially differs from the stated interest rate.

Discount or premium is reported on the balance sheet as a direct deduction or addition, respectively, to the face amount of a debt. Similarly, debt issuance costs related to a debt are reported on the balance sheet as a direct deduction from the face amount.

GAAP requires discounts, premiums, and debt issuance costs to be amortized using the interest method. The interest method is used to derive a periodic interest cost (including amortization) that represents a level effective rate on the sum of the debt’s face amount plus or minus the unamortized premium or discount and produces a constant effective yield over the term of a debt. In practice, other methods are used if their results do not differ materially from the interest method, such as a straight–line amortization method.

Under Paragraph 835–30–45–3, a borrower reports the amortization of discount or premium related to a liability as interest expense in financial statement income. The amortization of debt issuance costs is also included in interest expense. Similarly, certain hedging gain or loss may be classified as interest expense under Topic 815, Derivatives and Hedging.

Upon an extinguishment of debt, a difference between the reacquisition price and the net carrying amount of the extinguished debt is recognized on the income statement as loss or gain under Subtopic 470–50. The net carrying amount of debt is defined as “the amount due at maturity, adjusted for unamortized premium, discount, and cost of issuance” (FASB ASC Master Glossary). For this reason, loss or gain on extinguishment of debt may include unamortized premium, discount, and debt issuance costs.

Best practices

Prudent taxpayers should carefully analyze differences between their interest expense for accounting purposes and their interest expense for tax purposes.

First, taxpayers should comprehensively analyze the composition of interest expense for accounting purposes to determine whether it is interest for tax purposes. As noted above, the items included as interest expense for accounting purposes may be inherently different from the items included as interest expense for tax purposes. Most notably, debt issuance costs and hedging gain or loss may be included as interest expense for accounting purposes but may not constitute interest expense for tax purposes. On the other hand, some fees paid to lenders may constitute OID for tax purposes and not debt issuance costs, despite being labeled as a fee.

Second, taxpayers should evaluate the methods for determining interest expense for accounting purposes to determine whether they are permissible methods for tax purposes. The timing of items classified as interest expense for accounting purposes may be different from the timing for tax purposes. For example, while the interest method for accounting purposes may be similar to the constant–yield method, the straight–line method for OID and debt issuance costs may be used for accounting purposes under certain circumstances. Similarly, the straight–line method or other methods may be permissible for tax purposes under certain circumstances. Given that alternative methods for amortizing OID and debt issuance costs may be permissible for tax purposes, depending on the circumstances, taxpayers should assess their circumstances for determining appropriate accounting methods for tax purposes.

Finally, while loss on extinguishment of debt for accounting purposes and repurchase premium for tax purposes are similar concepts, they are measured differently and may be taken into account differently. Taxpayers should analyze any loss or gain on the extinguishment of debt for accounting purposes to identify whether and the extent to which such loss or gain reflects unamortized OID and unamortized debt issuance costs. As noted above, any portion that should be characterized as interest under Sec. 163(j) should be identified and subject to the Sec. 163(j) limitation, while other portions of such loss or gain may not be subject to Sec. 163(j).

Editors

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office. Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with Deloitte Tax LLP or Grant Thornton LLP as noted in the byline.

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