Practical tax issues related to qualified reopenings

Editor: Greg A. Fairbanks, J.D., LL.M.

A company that needs capital to fund operations or an acquisition, expand its business, or pay off existing debt will often look to issue new debt. Different types of borrowing arrangements can have particular tax implications. One common borrowing arrangement is a credit agreement that provides for an immediate “initial term loan” but also provides for one or more additional tranches of a “delayed draw term loan” (DDTL) that can be drawn as needed over a specified period.

Without applying the relevant tax rules covered below, a borrower may treat all loans issued under the initial term loan and the DDTL as a single loan or treat each borrowing as a separate loan. Either treatment can be an incorrect tax treatment, depending on the circumstances. Specifically, the rules under Regs. Sec. 1.1275–2(k) provide that debt issued subsequent to an original debt (an additional debt) that has identical terms as the original debt is treated as part of the same issue as the original debt if the additional debt is a “qualified reopening” of the original debt.

If the additional debt is a qualified reopening of the original debt, the original debt and the additional debt are regarded as fungible and treated as a single debt for tax purposes. If the additional debt is not a qualified reopening of the original debt, the original debt and the additional debt are treated separately for tax purposes.

Whether the original debt and the additional debt are fungible can have substantial ramifications for tax purposes, but this analysis is often overlooked. This item summarizes the rules governing whether debt is treated as a qualified reopening and some of the ramifications.

‘Issue’ of debt instruments

Two or more debt instruments that are part of the same issue will have the same issue price (as defined in Sec. 1273) and generally are accounted for as a single loan for tax purposes. The regulations under Regs. Sec. 1.1275–1(f)(1) define two or more debt instruments that have been issued on or after March 13, 2001, as part of the same issue if: (1) they have the same credit and payment terms; (2) they are issued pursuant to a common plan or as part of a single transaction or a series of related transactions; and (3) they are issued within a period of 13 days, beginning with the issue date of the first debt instrument that would be part of the issue.

Thus, if these criteria are met, debt issued within 13 days from an initial borrowing is automatically treated as part of the same issue.

Qualified reopening

An additional debt may also be treated as part of the same issue as the original debt if it meets one of three tests to constitute a “qualified reopening” as defined in Regs. Sec. 1.1275–2(k). If the additional debt is determined to be a qualified reopening, the additional debt is treated as having the same issue date, same issue price, and same adjusted issue price as the original debt with respect to the holders.

To potentially be treated as a qualified reopening, the following requirements must be met regarding the additional debt under Regs. Sec. 1.1275–2(k)(2)(ii): (1) The additional debt would be part of a single issue of debt as defined in Regs. Sec. 1.1275–1(f), without the application of Regs. Sec. 1.1275–2(k); (2) the additional debt is not part of the same issue as the initial debt issuance as defined in Regs. Sec. 1.1275–1(f); and (3) the additional debt has terms that are in all respects identical to the terms of the original debt instruments as of the reopening date.

To constitute a qualified reopening, an additional debt must meet the requirements in Regs. Sec. 1.1275–2(k)(2)(ii) and also meet the requirements of one of the tests under Regs. Sec. 1.1275–2(k)(3)(ii), (iii), (iv), or (v), which are discussed below.

For the reopening–within–six–months test (Regs. Sec. 1.1275–2(k)(3)(ii)), the requirements are:

• The original debt is publicly traded (within the meaning of Regs. Sec. 1.1273-2(f)) as of the date on which the price of the additional debt is established (or, if earlier, the announcement date of the additional debt) (Regs. Sec. 1.1275-2(k)(3)(ii)(A));
• The reopening date of the additional debt instruments is not more than six months after the issue date of the original debt instruments (Regs. Sec. 1.1275-2(k)(3)(ii)(B)); and
• On the date on which the price of the additional debt instruments is established (or, if earlier, the announcement date), the yield of the original debt instruments (based on their fair market value (FMV)) is not more than 110% of the yield of the original debt instruments on their issue date (or, if the original debt instruments were issued with no more than a de minimis amount of original issue discount (OID), the coupon rate) (Regs. Sec. 1.1275-2(k)(3)(ii)(C)).

For the reopening–with–de–minimis–OID test (Regs. Sec. 1.1275–2(k)(3)(iii)), the requirements are:

• The original debt is publicly traded (within the meaning of Regs. Sec. 1.1273-2(f)) as of the date on which the price of the additional debt is established (or, if earlier, the announcement date) (Regs. Sec. 1.1275-2(k)(3)(iii)(A)); and
• The additional debt instrument is issued with no more than a de minimis amount of OID. De minimis OID is defined under Regs. Sec. 1.1273-1(d) as an amount equal to 0.0025 (or 0.25%, or 25 basis points) multiplied by the product of the stated redemption price at maturity and the number of complete years to maturity from the issue date.

For the nonpublicly-traded-debt-issued-for-cash test (Regs. Sec. 1.1275-2(k)(3)(iv)), the requirements are that the additional debt is issued to persons unrelated to the issuer for cash for an arm’s-length price, and either:

1. The Regs. Secs. 1.275-2(k)(3)(ii)(B) and (C) requirements for a reopening within six months are satisfied, with the yield test (Regs. Sec. 1.275(k)(3)(ii)(C)) being satisfied if, on the date on which the price of the additional debt instruments is established (or, if earlier, the announcement date), the yield of the additional debt instruments (based on their cash purchase price) is not more than 110% of the yield of the original debt instruments on their issue date (or, if the original debt instruments were issued with no more than a de minimis amount of OID, the coupon rate); or
2. The additional debt instruments are issued with no more than a de minimis amount of OID.

For the 100%-yield test for reopening after six months (Regs. Sec. 1.1275–2(k)(3)(v)), the requirements are that the additional debt instrument is issued more than six months after the issue date of the original debt instruments, and:

1. The requirements in Regs. Secs. 1.1275-2(k)(3)(ii)(A) and (C) are satisfied, with the yield test in Regs. Sec. 1.1275-2(k)(3)(ii)(C) being satisfied if, on the date on which the price of the additional debt instruments is established (or, if earlier, the announcement date), the yield of the additional debt instruments (based on their FMV or cash purchase price, whichever is applicable) is not more than 100% of the yield of the original debt instruments on their issue date (or, if the original debt instruments were issued with no more than a de minimis amount of OID, the coupon rate); or
2. The additional debt instrument is issued for cash to persons unrelated to the issuer for an arm’s-length price and with no more than a de minimis amount of OID.

The following example illustrates the tax treatment of the rules described above:

Example: The taxpayer borrows an initial term loan on Feb. 1, 2024, which matures on Feb. 1, 2029. Also on Feb. 1, 2024, the taxpayer enters into a DDTL that can be drawn in the next two years. The terms of the DDTL are identical to the initial term loan. The taxpayer borrows under the DDTL on the following dates:

• DDTL No. 1 — Feb. 10, 2024;
• DDTL No. 2 — April 21, 2024; and
• DDTL No. 3 — Aug. 15, 2024.

After testing, the taxpayer’s issuer determines that:

1. DDTL No. 1 was drawn within 13 days of the initial term loan and is part of the same issue as the initial term loan under Regs. Sec. 1.1275-1(f).
2. DDTL No. 2 was determined to be a qualified reopening of the initial term loan under Regs. Sec. 1.1275-2(k) and thus treated as having the same issue date, same issue price, and same adjusted issue price as the initial term loan and DDTL No. 1 on April 21, 2024.
3. DDTL No. 3 was determined to be not a qualified reopening of the initial term loan under Regs. Sec. 1.1275-2(k) and is treated as a separate debt from the initial term loan, DDTL No. 1, and DDTL No. 2.

Tax considerations

The tax effects of a qualified reopening can seem inconsequential but can be important.

First, once it is determined that an additional debt was issued in a qualified reopening, the issuer must redetermine the yield of the aggregated original debt and additional debt (the aggregate debt) as of the reopening date under Regs. Sec. 1.163–7(e) to determine the accrual of interest expense, OID, and debt–issuance costs over the remaining term of the aggregate debt. In comparison, if the additional debt is determined to be not a qualified reopening, the issuer would create a separate schedule for the additional debt to accrue interest expense, OID, and debt–issuance costs.

Second, whether there is an aggregate debt or the original debt and additional debt are treated as separate tranches can have other meaningful differences for tax purposes. For example, when the terms of a debt are modified, taxpayers must analyze whether the modification is a “significant modification” under Regs. Sec. 1.1001-3. The most common tests that can result in a significant modification are a change in yield under Regs. Sec. 1.1001-3(e)(2) or a material deferral of payments under Regs. Sec. 1.1001-3(e)(3). The test under Regs. Sec. 1.1001-3(e)(2) could be affected by a qualified reopening because there could be different results under a single change-in-yield test treating the original debt and additional debt as an aggregate and more than one change-in-yield test treating the original debt and additional debts as separate loans. Similarly, the determination of a material deferral under Regs. Sec. 1.1001-3(e)(3) could be affected because that test is based on the timing of payments relative to a debt’s unmodified payment schedule. Thus, if the additional debt is a qualified reopening, it would have the same issue date and maturity term as the original debt; however, if the additional debt is not a qualified reopening, its issue date and maturity term would be determined separately based on its actual issue date. Therefore, the determination of whether there was a material deferral of a payment with respect to the additional debt could be different depending on whether it was a qualified reopening due to the different maturity terms.

Another aspect that can be important to consider is whether tranches of debt are aggregated appropriately to determine whether the small-debt issuance exception applies under Regs. Sec. 1.1273-2(f)(6). For background, when a debt is significantly modified under Regs. Sec. 1.1001-3, the modified debt is treated as a new debt for tax purposes, and the issue price of the new debt is determined under Sec. 1273 and the regulations thereunder. If a debt is publicly traded, as defined in Regs. Sec. 1.1273-2(f), the issue price of the new debt may be the fair market value of the publicly traded debt, which can be different than the stated principal of the new debt. However, Regs. Sec. 1.1273-2(f)(6) provides that a debt instrument is not publicly traded if at the time of the determination the outstanding stated principal amount of the issue does not exceed $100 million. Thus, if an original debt and the additional debt are treated as the same issue, the determination of issue price may be different if they exceed $100 million combined than if they are treated as separate loans and respectively do not exceed $100 million.

Whether an additional debt is a qualified reopening or a separate debt can also affect the timing of income inclusion for the holder. For example, when an additional debt is a qualified reopening of the original debt, a discount on the additional debt may be converted into market discount subject to Sec. 1276 to the extent the discount exceeds any discount reflected in the adjusted issue price of the original debt. In comparison, if the additional debt is treated as a separate loan from the original debt, the discount related to the additional debt may be OID subject to Sec. 1272.

Best practices

Performing a qualified reopening analysis under Regs. Sec. 1.1275–2(k) on every additional debt under a DDTL can be a tedious and time–consuming process if a taxpayer makes numerous draws. An issuer may be able to limit testing if a draw falls squarely within the definition of an issue, i.e., a draw within 13 days from the original debt; however, it is often the case that the issuance of an additional debt falls outside the 13–day period.

Before analyzing each additional debt, taxpayers must determine if the requisite criteria are met to treat an additional debt as part of the same issue or as a potential qualified reopening. In practice, the additional debt commonly does not have identical terms as the original debt because the regulations strictly provide that the additional debt must have terms that are “in all respects identical.”

A common difference between the terms of an original debt and the terms of an additional debt is the required principal payment schedules. For example, a DDTL may not require a principal payment upon the first accrual period after the borrowing date of the additional debt when the original debt requires such a payment upon the end of that accrual period. While the terms of an initial–term loan and DDTL may otherwise be identical, a slight difference in the required principal payment schedule may be sufficient to disqualify an additional debt from being a qualified reopening. Some debt agreements have precise terms that avoid this issue but may require that the required principal payments for the original debt be adjusted going forward.

Taxpayers and their advisers should be aware that even slight variations of terms between the original debt and the additional debt can disqualify the additional debt from being a qualified reopening; therefore, a granular review of the debt terms is warranted before any testing.

Editor

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 Fairbanks at greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.