A tax provision included in the stimulus package passed by Congress earlier this year brought relief to issuers of debt instruments classified as applicable high yield debt obligations (AHYDOs). But the provision is set to expire at the end of the year, unless the Treasury Secretary deems it prudent to extend the tax break. As a result, some companies may want to reexamine their debt portfolios in light of the possible return to normalcy.
Consider that when a debt instrument is classified as an AHYDO, certain unattractive results ensue. Most notably, the original issue discount (OID) with respect to the instrument is not, as is normally the case, deductible from the issuer’s gross income as it accrues. Instead, the OID is only deductible much later when it is actually paid in cash or other property.
Moreover, if the instrument is found to be a “Super AHYDO” — because its yield to maturity is in excess of the applicable federal rate plus 600 basis points — a portion of the OID known as the “disqualified portion” is never deductible.
A debt instrument is an AHYDO if it meets a four-pronged test. The instrument must be issued by a corporation, have a maturity date that is more than five years from the date of issue, have a yield to maturity that is equal to or greater than the applicable federal rate (in effect for the month in which the debenture is issued) plus 500 basis points, and have “significant OID.”1
An instrument has significant OID if its accrued interest is “excessive” in comparison to the interest actually paid (in cash or other property) with respect to the debenture. In general, if the amount of interest accrued on any “testing date” exceeds the amount of interest actually paid by more than the product of the debenture’s issue price and its yield to maturity, the instrument has significant OID.
In this environment, if a troubled debtor seeks to execute a debt-for-debt exchange, it is entirely possible that the new instrument will constitute an AHYDO. This will almost certainly be the case if the new instrument pays interest “in kind” in the form of “bunny” debentures. A bunny debenture or bond is a fixed-rate instrument that gives the holder the option to reinvest coupon payments into additional bonds with the same coupon and maturity.
Such an instrument almost always features significant OID because the issuance of a bunny bond in lieu of cash or other property to the creditors does not constitute a payment of such interest. Accordingly, on any testing date, it is almost certain that the accrued interest will be found to be excessive in comparison to the interest actually paid.
“In this environment, if a troubled debtor seeks to execute a debt-for-debt exchange, it is entirely possible that the new instrument will constitute an AHYDO.” — Robert Willens
Fortunately, there is a rule that will expire shortly that takes the sting out of issuing — in a recapitalization — an instrument that is properly characterized as an AHYDO. Indeed, the tax code, specifically Section 163(e)(5)(F)(i), states that “this paragraph” (the paragraph that defers the deduction of OID with respect to an AHYDO) shall not apply to an AHYDO that is issued during the period beginning on September 1, 2008, and ending on December 31, 2009, in exchange for an obligation that is not an AHYDO, as long as the issuer (or obligor) is the same as the issuer (or obligor) of the AHYDO.
In short, if an AHYDO is issued in exchange for an instrument that is issued outside of the exemption period, the normal “penalties” associated with AHYDO status are waived. That means that the OID with respect to the AHYDO will, therefore, be deductible as it accrues.2 This dispensation may well encourage debtors to undertake recapitalizations before the year runs out, and investors will want to be attuned to the opportunities these recapitalizations will present.3
Robert Willens, founder and principal of Robert Willens LLC and contributing editor to CFO.com, writes a weekly tax column.
1 See Section 163(i).
2 If, however, as part of a reacquisition, any debt instrument is issued in exchange for an applicable debt instrument, and there is OID with respect to the debt instrument issued, then no deduction otherwise allowable to the issuer is permitted with respect to a portion of the OID. Instead, the OID is deductible only when the cancellation of indebtedness (COD) income that arose from the debt-for-debt exchange, and which was deferred by the issuer under Section 108(i), is included in the issuer’s gross income. Therefore, in cases in which the recapitalization gives rise to deferred COD income, some deferral of the attendant OID deductions will ensue. See Section 108(i)(2)(A).
3 The Secretary of the Treasury has been afforded the authority to extend this rule for an indefinite period, but only if the Secretary makes a determination that such an extension “is appropriate in light of distressed conditions in the debt capital markets.” See Section 163(e)(5)(F)(iii).