During the 1980s, scores of deals were financed in part with “deferred interest” securities. But, despite its name, the interest on the securities was tax deductible as it accrued, even though payment of such interest was delayed – frequently quite far into the future.
The accrued tax deduction was a function of the tax law’s original issue discount (OID) rules, and at the time Congress didn’t like the mismatch. Lawmakers felt that the rule was partially responsible for the proliferation of “uneconomic” deals that characterized the later stages of that particular takeover era. Accordingly, in selected cases – and as a way to prevent the current deduction of accrued interest – Congress created the concept of the “applicable high yield discount obligation” (AHYDO) in 1989.
In a recent deal involving The New York Times Company, it seemed likely that the transaction would create an AHYDO and the Times would lose its associated tax deduction. But by shrinking its interest payments from one year to six months, the media company was able to avoid the tax hit. Here’s the rules and regulations behind the transaction.
On January 19, the Times announced that it had entered into a “private financing agreement” with entities affiliated with Mexican billionaire Carlos Slim Helu for an aggregate amount of $250 million in senior unsecured notes due 2015 with “detachable warrants.” These notes have a coupon of an astonishing 14.053 percent, of which the Times may elect to pay three percent “in kind” (i.e. in additional notes). The lenders also received detachable warrants for an aggregate amount of 15.9 million Class A (low vote) shares, at a strike price of $6.3572. Further, the warrants expire in 2015.
The notes described by the Times deals are considered to have been issued at a discount, which is important when determining what creates an original issue discount that, in turn, can create an AHYDO.
According to the tax code – specifically Section 1273(a)(1) -an original issue discount is the excess of a debt instrument’s “stated redemption at maturity” over its issue price. The instrument’s stated redemption at maturity is the sum of all payments provided by the debt, other than qualified stated interest. (See Reg. Sec. 1.1273-1(b).)
The portion of the interest that may be paid in kind is not qualified state interest and, therefore, is added to the stated redemption at maturity. In fact, by itself, the interest can lead to an excess of stated redemption at maturity over issue price and, hence, the original issue discount.
One more note about the Times the notes and the detachable warrants. They are part of an investment unit. That changes things a bit, because the purchase price for an investment unit must be allocated between the debenture and the warrants, which often increases the yield, creating or increasing the original issue discount. (See Ginsburg and Levin, Mergers, Acquisitions and Buyouts, Paragraph 13.031.)