Tax Relief for Bond Interest Has a Hitch

Congress provided companies caught in the liquidity crunch a tax break for certain bond discount obligations — but payments of accrued interest must be timed correctly.

During the 1980s, many deals were financed, at least in part, with “deferred interest” debt securities. Under the original issue discount (OID) rules, however, the interest was deductible for tax purposes as it accrued, even though its payment was delayed, sometimes quite far into the future. Congress felt that this convention was contributing to the proliferation of “uneconomic” deals then being closed, and in an effort to curtail the current deduction of accruing interest, created the concept of the AHYDO — the “Applicable High Yield Discount Obligation.”

Section 163(i) of the U.S. Tax code defines AHYDO as any debt instrument issued by a corporation that demonstrates the following characteristics:

• The maturity date of the debt instrument is more than five years from the date of issue;

• The yield to maturity of the debt instrument is equal to, or greater than, the sum of (1) the “applicable federal rate” (AFR) in effect for the calendar month in which the obligation is issued, and (2) five percentage points,1and;

• There is, with respect to the obligation, significant OID.

Significant OID

This latter characteristic, without which a debt instrument cannot be characterized as an AHYDO, is by far the most inscrutable of the three AHYDO attributes. Indeed, OID is considered to be a form of interest, and that complicates tax issues. But breaking down the rules, especially with regard to OID, can help bond holders, and issuers, better understand the implications.

For example, there is a significant OID in cases where the aggregate amount that can be included in (the holder’s) income2 exceeds the sum of: (1) the aggregate amount of interest to be paid before the close of such accrual period, and (2) the product of the obligation’s issue price and its yield to maturity.

In these cases, according to Congress, the accrued interest with respect to the obligation is “excessive” in comparison to the interest actually paid. Therefore, a penalty is warranted.

Due to this “odd” definition of significant OID, a debenture can escape significant OID status, and therefore AHYDO designation as well, if certain criteria are met. Specifically, OID and AHYDO status can be avoided if the corporation pays no interest until immediately before the close of the first accrual period ending after the fifth anniversary of issuance. At that time, the corporation is required to pay all interest accrued, except an amount equal to the first 12 months’ yield accrued after issuance. What’s more, each accrual period thereafter, the corporation is required to pay the interest accrued during the accrual period.

In these cases, the instrument is not an AHYDO to begin with, with the result that the interest accrued during the period prior to the initial measurement date (the close of the first accrual period ending after the fifth anniversary of issuance) can be currently deducted.3

AHYDO Penalties

In the case of an AHYDO issued by a corporation, no deduction is allowed for the disqualified portion of the OID with respect to the obligation. Further, the remainder of the OID is not allowable as a deduction until it is paid in cash or property. (See Section 163(e)(5).)

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