On January 6, 2011, the IRS proposed new regulations for determining when property is considered to be “publicly traded” for purposes of calculating the issue price of a debt instrument. Although these proposed changes would affect the issue price of any debt instrument issued in exchange for property, they would also have a significant impact on instruments that are significantly modified, perhaps as a result of the borrower’s financial difficulty or as a result of the borrower seeking to change the terms of its indebtedness to obtain additional financial flexibility.
Relevance of “Issue Price” to the Modification of a Debt Instrument
When a sufficiently material modification is made to the terms of a debt instrument (e.g., a significant extension of its maturity, a sufficient change in its stated rate of interest), the unmodified debt instrument is treated for tax purposes as having been exchanged for the modified debt instrument. The consequences to holders and the issuer of the debt instruments depend on the issue price of the modified debt instrument compared to the adjusted issue price of the unmodified instrument in the case of the borrower or the tax basis in the case of the holders. For the borrower, an issue price on the modified debt instrument that is higher than the adjusted issue price on the unmodified debt instrument may result in an immediate deduction to the extent of such excess. Conversely, an issue price on the modified debt instrument that is lower than the adjusted issue price on the unmodified debt instrument can result in the recognition of cancellation of debt (“COD”) income. For a holder of a modified debt instrument, an issue price higher than that of a holder’s tax basis can result in immediate income. Similarly, a holder of a modified debt instrument may realize a loss if the issue price is lower than the holder’s tax basis.
The issue price of a debt instrument is affected by whether it is issued in exchange for “property” and, if so, by whether it or such property is publicly traded. In the case of a significant modification of a debt instrument, the unmodified instrument deemed exchanged would constitute “property.” Accordingly, if either the unmodified debt instrument or the modified debt instrument is publicly traded, the issue price of the modified debt instrument will be the fair market value of such instrument. If neither the unmodified debt instrument nor the modified debt instrument is publicly traded, then the issue price of the modified debt instrument generally would be par (assuming it provides for interest at a rate at least equal to the applicable federal rate, which in general is a rate based on comparable term U.S. Treasury obligations).
Changes to the Existing Regulations
Under existing regulations, although there is some uncertainty, relatively few debt obligations qualify as publicly traded. To be publicly traded or to be considered issued for publicly traded property under existing regulations, a debt instrument must fit in one of four categories within the 60-day period ending 30 days after its issue date: (i) it or the property for which it was issued is listed on a national securities exchange, an interdealer quotation system sponsored by a national securities association, or the London Stock Exchange, the Frankfurt Stock Exchange, the Tokyo Stock Exchange, or other foreign exchange designated by the Commissioner of the IRS, (ii) it or the property for which it was issued is of a kind that is traded on a board of trade designated as a contract market by the Commodities Futures Trading Commission or on an interbank market, (iii) the property for which it was issued appears in a quotation medium that provides a reasonable basis to determine fair market value by disseminating either recent price quotations of one or more identified brokers, dealers or traders or actual prices of recent sales transactions, or (iv) a price quotation is readily available from dealers, broker or traders if the debt is part of an issue that exceeds $25 million and the borrower has other debt that is publicly traded under one of the first three categories that does not have materially more restrictive covenants or a maturity more than three years earlier.
The preamble to the proposed regulations states that the IRS and Treasury feel that the phrase “traded on an established exchange” for purposes of setting a debt instrument’s issue price is intended to be interpreted broadly. Toward this end, the proposed regulations modify the regulations with respect to the four categories of public trading that will result in the debt or the property issued in exchange for it to be considered “traded on an established exchange” and, as a result, have an issue price equal to its fair market value. The four categories are (i) debt or property that is listed on a national securities exchange, a board of trade designated as a contract market by the CFTC, a foreign securities exchange that is officially recognized, sanctioned, regulated or supervised by the government of a foreign country in which the exchange is located or any other exchange identified by the IRS commissioner, (ii) debt or property for which a sales price for a recently executed purchase or sale is available, (iii) debt or property for which it is possible to get a firm quote from a broker, dealer or pricing service for the property or substantially similar property, or (iv) debt or property for which an indicative quote is available from at least one broker, dealer or pricing service. There is an overall de minimis trading exception if within a 31-day period ending 15 days after the issue date all sales of the debt instrument are for increments of $1 million or less and all such sales aggregate to $5 million or less. However, similar to the existing regulations, there is an anti-abuse rule if there is any temporary restriction on trading, a purpose of which is to avoid the characterization of property as one that is traded on an established market. There is also a small issuance exception for debt instruments in which the issue does not exceed $50 million.
The proposed regulations are proposed to become effective to debt instruments issued on or after the date of publication of the Treasury decision adopting the proposed rules as final regulations in the Federal Register. The IRS has requested comments on these proposed regulations and a public hearing on the proposed regulations has been scheduled for April 13, 2011.
Effect of the Proposed Regulations
The proposed regulations, if adopted in their current form, will make it far more likely that modifications of debt instruments in general, and syndicated bank loans in particular, will cause borrowers to realize COD income (and have higher future original issue discount (“OID”) deductions). Another potential consequence, which flows from the creation of OID in connection with a modification, is that the OID created may be large enough so that if the maturity of the modified debt instrument is long enough (over five years) the modified instrument will be subject to the applicable high yield debt obligation (“AHYDO”) rules, causing OID deductions to be delayed or even denied depending on the instrument’s yield. In a common fact pattern, a taxpayer will purchase distressed debt at a discount and modify the debt. In the absence of the debt being publicly traded, the taxpayer often is required to use the par amount of the debt as its issue price, resulting in a taxable gain for the buyer that does not correspond to an actual increase in value. The proposed regulations would change this result (effectively eliminating the artificial gain) for many types of debt instruments, but this would be irrelevant for holders that are mark-to-market taxpayers (e.g., dealers or traders), tax-exempt taxpayers (e.g., pension funds and foundations), or not subject to U.S. tax on gains (e.g., foreign investment funds). Eliminating the artificial gain means that borrowers will have COD income (subject to exclusion for insolvency and bankruptcy) and future OID deductions which may be limited under the AHYDO rules. The IRS has previously provided relief from the application of the AHYDO rules, but that relief expired at the end of 2010.
If you have any questions about these proposed regulations, please contact the following lawyers:
Will Cejudo, Partner, Structured Transactions Practice
william.cejudo@bingham.com, 202.373.6122
Anthony J. Carbone, Deputy Chair, Corporate Area and Co-Leader, Tax and Employee Benefits Practice
anthony.carbone@bingham.com, 212.705.7430
Charles R. Bogle, Partner, Tax and Employee Benefits Practice
charles.bogle@bingham.com, 212.705.7558
This article was originally published by Bingham McCutchen LLP.