IRS Acts to Prop Up Some Debt Instruments in Slumping Markets

The tax agency will not rigorously apply the "AHYDO" rules.

New guidance issued last month by the Internal Revenue Service addresses the current credit crisis and how it might affect a corporate debt instrument known as an “applicable high yield discount obligation” (AHYDO). In fact, the application of the new guidance will likely give corporate issuers more flexibility to deal with financial commitments that were made when the markets were in better shape.

Before examining the IRS bulletin, let’s examine the key feature of an AHYDO that is affected by the guidance. When a debt instrument is classified as an AHYDO, the issuer is stripped of its ability to deduct the accompanying original issue discount (OID), as it accrues. Instead, the discount may only be deducted when it is actually paid in cash or property (other than a debt instrument of the issuer or a related person). Moreover, if the instrument is categorized as a “super AHYDO” (because its yield to maturity exceeds certain thresholds), a portion of the OID — known as the “disqualified portion” — can never be deducted.

As a result, the IRS has taken steps to insure that certain debt instruments, issued in connection with financing commitments previously obtained by the issuer, will not inadvertently, fall within the definition of an AHYDO.

Financing Commitments

In the guidance issued on September 2, (Rev. Proc. 2008-51), the IRS recognizes that corporations frequently obtain financing commitments from lenders in advance of borrowing money. In some situations, the corporation will borrow on terms that were established in the commitment, and which remain fixed over the term of the resulting debt instrument. Alternatively, the corporation will borrow on terms that are temporary and that change to different, more permanent, terms after this temporary period.

Clearly, as we have recently witnessed, market conditions can worsen between the time a financial commitment is obtained and the time the corporation calls upon the lender to discharge its responsibilities under the commitment. In cases where a corporation issues debt with permanent terms, the lender (if market conditions have worsened) may be unable to sell the debt to third parties for a price equal to the money provided to the corporation.

In these situations, the “issue price” of the debt may be substantially less than the amount of money advanced to the corporation. 1 In cases in which a corporation issues debt with temporary terms, the company may be unable to refinance the debt with permanent debt that has more favorable terms that is embedded in the debt issued pursuant to the financial commitment. Thus, to allow the lender to sell the debt to third parties, the parties are permitted to amend the terms of the debt.

Such amendments may constitute a significant modification within the meaning of the tax code (Regulation Section 1.1001-3.) In those situations, once again, the issue price of the “new debt” (deemed issued as a result of the significant modification) may be substantially less than the amount of money initially advanced to the corporate borrower. 2

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