New Publicly Traded Debt Tax Regulations

Overview

On September 13, 2012, the Treasury issued final regulations addressing when property, including a debt instrument, is considered to be traded on an established market (i.e., publicly traded). (T.D. 9599) . The final regulations will likely (1) result in more types of debt instruments, such as certain bank or private loans, to be classified as publicly traded, and (2) impose new reporting requirements on debt issuers, including issuers on debt that is deemed to be newly issued as a result of a significant modification. Any debt with an outstanding principal amount greater than $100 million is subject to the final regulations.

The effect of these new regulations is that more kinds of debt instruments, such as syndicated bank loans and revolvers, will be considered publicly traded, and holders will more likely realize a taxable gain or loss upon a significant modification than under the old rules.

The final regulations apply to debt issued on or after November 13, 2012, including debt that is deemed to be newly issued as a result of a "significant modification" occurring on or after that date.

General tax issues

The determination of whether a debt is considered publicly traded can dramatically affect the tax consequences of a debt-for-debt exchange. A debt-for-debt exchange occurs where issuer (debtor) and holder (creditor) agree to change debt terms by either modifying existing debt or replacing it with new debt with different terms. A modification is treated as a taxable debt-for-debt exchange if the modification to debt is "significant" under Treasury Regulation § 1.1001-3.

The new regulations redefine the classification of publicly traded debt, which affects the determination of issue price.

The issue price of a new debt determines (1) the amount of consideration transferred by the issuer to the holder and, thus, the holder's gain or loss, (2) the amount of issuer's cancellation of debt (COD) income or repurchase premium deduction, and (3) the amount of original issue discount (OID) on the new instrument. An instrument with OID may have deductions limited by the applicable high yield discount obligation (AHYDO) rules under IRC Section 163(i).

Generally, IRC § 1274, which governs debt that is not publicly traded, provides that the issue price is equal to the stated principal as long as the stated interest is equal to or greater than the Applicable Federal Rate (AFR). Often, an exchange of non-publicly traded debt, while a taxable event, results in no income or deduction to the issuer because the issue price and the adjusted issuer price (stated principal) are the same. Similarly, a holder whose basis equals the stated principal (adjusted issue price) will not have a gain or loss if the stated principal remains the same in the debt for debt exchange of non-publicly traded debt (and the stated interest is at or above the AFR). It is important to note that contingent payments are not considered for purposes of determining issue price, under IRC §1274.

In contrast, IRC § 1273, which governs the determination of issue price for publicly traded debt, provides that if the old debt before modification or new debt after modification qualifies as "publicly traded", then the issue price equals the fair market value ("FMV") of the new debt. This rule often creates COD income to the issuer and future OID deductions that are limited by the AHYDO rules.

The new regulations

Under new Treasury Regulation § 1.1273-2(f), a debt instrument is considered publicly traded if there is:

• An actual sales price,
• A firm quote, or
• An indicative quote period.

This occurs at any time during the 31-day period ending 15 days after the issue date of the new debt. It would appear that more debt than under the prior rules will fall into one of these three categories. Private placement debt, syndicated bank loans, and revolvers are examples of debt that are likely to have quotations available in the marketplace. For instance, syndicated bank loans appear on several loan pricing services.

If debt is considered to be publicly traded under these new rules, the trading price or quoted price will be used to determine the issue price of the new debt. If, however, only indicative quotes are available, the taxpayer may determine that the indicative quotes materially misrepresent FMV and can use another reasonable method to establish FMV.

Debt with a stated principal of not greater than $100M at time of determination is considered to be not publicly traded debt under the new safe harbor rules of Treasury Regulation. § 1.1273-2(f)(6).

The final regulations also added Treasury Regulation § 1.1274-3(b)(4)(i) which prohibits "recent sales transaction" treatment for new debt instruments issued in a debt-for-debt exchange, including a significant modification, even if the old debt was recently acquired. The "recent sales transaction" determination of issue price under IRC § 1274(b)(3) and Treasury Regulation § 1.1274-3 will no longer apply to new debts arising from a significant modification. The "potentially abusive situation" rules of IRC § 1274(b)(3) allowed taxpayers to use FMV, instead of stated principal for non- publicly traded debt instruments, where a debt instrument was recently acquired and then significantly modified under Treasury Regulation § 1.1001-3. This position allowed holders to avoid "phantom income" for the modification of recently acquired distressed debt.

Specific issues for asset managers

The new regulations require the debt issuer to determine whether the new debt is publicly traded and, if so, its FMV. The issuer can be subject to negligence penalties if they do not exercise reasonable diligence to determine and provide the requisite information. Issuers must make such information available to holders in a commercially reasonable fashion within 90 days of issuance. This can be done by electronic medium (e.g., the issuer's website) or by other reasonable ways.

An issuer's determination of issue price is binding on a holder unless the holder discloses a contrary position on its tax return. The holder has responsibility to verify the issue's determination, and the holder must perform due diligence should the issuer not supply the requisite information. For instance, a foreign issuer might not comply.

Once it is determined that a significant modification has occurred, and the issue price is established, the holder will have to compute its gain or loss, and potentially begin the accrual of OID based on the difference between the new issue price and the stated principal amount. Because these final regulations became effective for modifications occurring on or after November 13, 2012, the new rules should be considered in executing tax year 2012 compliance efforts.

Please see the Deloitte Dbriefs webcast, Amend and Extend: How New Regulations May Affect Refinancing Debt on this topic. For further questions or comments, please contact :

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