United States: Final IRS Regulations And Revenue Procedure 2001-21 Affecting Fungibility Of Debt Securities

Co-written by Darren Eicken

1. Introduction.

On January 11, 2001, the U.S. Treasury Department and the Internal Revenue Service (the "IRS") issued final regulations that provide rules for determining which debt securities are part of the same "issue" as other debt securities or a "qualified reopening" of a prior issue of debt securities (which is treated as part of the original reopening). Debt securities that are part of a single issue or are part of a qualified reopening of a prior issue are treated as issued with the same amount of "original issue discount" ("OID") for U.S. federal income tax purposes as all of the other securities in the issue, and therefore generally bear the same CUSIP number and are fungible. On the other hand, a debt instrument issued with more than a de minimis amount of OID which is not part of the same issue or a qualified reopening of a prior issue of debt instruments generally will bear a different CUSIP number and will not be fungible with the other debt instruments. The regulations are generally effective for debt instruments issued on or after March 13, 2001 (with certain transition rules for debt instruments issued prior to March 13) and debt instruments that are part of a reopening with a reopening date on or after March 13, 2001.

In addition, on January 20, 2000, the IRS issued Revenue Procedure 2001-21,¹ which permits an issuer to facilitate the tax-free exchange of the original debt instruments that are the subject of a qualified reopening for the newly-issued debt instruments, and permits certain tax-free consolidations of outstanding issues of identical debt instruments to achieve greater fungibility and liquidity.

In general, the regulations provide bright-line guidance, remove some uncertainty that exists under current law, and simplify and liberalize some of the requirements under the prior proposed regulations; Revenue Procedure 2001-21 helpfully permits tax-free exchanges in certain limited situations. However, the qualified reopening requirements contained in the final regulations are more restrictive than market participants had requested and will limit the ability of issuers to achieve fungibility of newly-issued debt instruments with their economically-identical outstanding debt instruments. Nevertheless, the IRS has informally indicated that it may be amenable to unlimited fungibility of newly-issued debt with economically identical outstanding debt instruments if holders of the outstanding debt instruments elect to report all discount (including existing market discount) as currently includible OID. Following this election, all of the outstanding securities and the newly-issued securities would be fungible.

The balance of this memorandum describes the regulations and Revenue Procedure 2001-21 in greater detail. A chart appended to this memorandum summarizes the requirements for a single "issue" and a "qualified reopening".

2. OID, Market Discount, And The Fungibility Of Debt Securities.

U.S. taxpayers are required to currently accrue OID on a constant yield basis for any debt instrument that is issued with more than a "de minimis" amount of OID,² and issuers generally are permitted to deduct OID as it accrues on any debt instrument that is issued with OID. The amount of OID on an "issue" of debt instruments is fixed on the first day that a substantial amount of the issue is sold,³ and the amount and method of accruing the OID does not change over the term of the debt instrument, regardless of changes in the debt instrument’s market value (i.e., as a result of changes in market interest rates or the issuer’s creditworthiness).

In contrast to OID, which is currently taxable to holders as it accrues, "market discount" generally is not taxable currently as it accrues, unless the holder so elects.⁴ Market discount generally arises when a secondary-market investor purchases a debt instrument for an amount that is less than its "adjusted issue price" (i.e., its issue price plus accrued but unpaid OID less payments of principal and accrued OID).⁵ Accordingly, an investor may hold two debt instruments issued by the same issuer and which bear the same maturity date, payment schedule and yield, but if one instrument was issued with OID and the other was issued at par (without any OID) but was acquired with market discount, the taxpayer will be subject to current tax on the discount that accrues on the OID debt instrument, but not with respect to the market discount debt instrument.

Example. On January 1, 2000, a corporation issues a debt instrument at par for $100. The debt instrument matures on December 31, 2004 and bears interest at 10%, payable annually.

On January 1, 2001, interest rates have increased and the same corporation issues for $93.93 a debt instrument with a face amount of $100. The debt instrument matures on December 31, 2004 and bears interest at 10%, payable annually. (The yield of this instrument is 12%).

On January 1, 2001, a taxpayer purchases each note for $93.93.

In this case, although both notes represent economically identical investments for the taxpayer, the note issued in 2001 will have been issued with $6.07 of OID, and the note issued in 2000 will have no OID, but will have been acquired with market discount of $6.07. Accordingly, the taxpayer will be subject to current tax with respect to discount on the 2001 note, but not with respect to the 2000 note. ⁶

Because the tax treatment of the issuer and holders of debt instruments issued with OID is different than the treatment of holders of debt instruments with the same maturity date, payment schedule and yield that were not issued with OID (even if they were acquired with equivalent market discount), and because issuers are required to report to individuals and certain other holders the amount of accrued OID on debt instruments issued with OID, OID debt securities are not fungible with economically-identical debt securities that were issued with no (or differing amounts of) OID.

All of the debt securities in a single "issue" and in a qualified reopening of that issue are treated as issued at the same issue price, bear the same amount of OID, and therefore are fungible. The regulations define an "issue" and "qualified reopening" for purposes of these rules.

3. Definition Of An "Issue."

Under the final regulations, for debt instruments issued on or after March 13, 2001, an issue of debt instruments includes all debt instruments that:

• have the same credit and payment terms,
• are issued either pursuant to a common plan or as part of a single transaction or a series of related transactions, and
• are issued within a period of 13 days beginning with the date on which the first debt instrument that would be part of the issue is sold to a person other than a bond house, broker, or similar person or organization acting in the capacity of an underwriter, placement agent, or wholesaler.⁷

To satisfy the second requirement and to help establish that any subsequent offerings are issued either pursuant to a common plan or as part of a single transaction or series of related transactions with previously issued debt securities, issuers may wish to issue the additional debt instruments under the same shelf registration statements and/or include in their files at the time of an initial issuance contemporaneous written evidence to the effect that the offering may include sales subsequent to the initial offering and all such sales are intended to be included as part of the same issue for U.S. federal income tax purposes.

Under existing law, for debt instruments issued after April 4, 1994, and before March 13, 2001, an issue of debt instruments includes all debt instruments that:

• have the same credit and payment terms,
• are issued, either pursuant to a common plan or as part of a single transaction or a series of related transactions, and
• are sold "reasonably close in time".⁸

No guidance previously existed on the meaning of "reasonably close in time." The final regulations, by providing a bright-line 13-day test, represent a significant improvement over the "reasonably close in time" approach under prior law.

Under a transition rule contained in the final regulations, if any of the debt instruments that would be part of the same issue (determined as if each debt instrument were part of a separate issue) are issued on or after March 13, 2001, the new definition of an issue will apply, and all debt instruments issued with 13 days of the first debt instrument will generally be considered part of the same issue.

4. Qualified Reopenings Under The Final Regulations.

As mentioned above, the final regulations treat multiple debt securities as part of the same issue for purposes of calculating OID if either (i) the debt securities are part of the same "issue" (as described above), or (ii) the newly-issued debt securities are issued as part of a "qualified reopening" of the initial issuance.

The final regulations provide rules for two types of qualified reopenings.⁹ The first set of rules relates to reopenings under which the new debt instruments are issued with more than a de minimis amount of OID (i.e., OID that is more than ¼ of 1-percent of the stated redemption price, multiplied by the number of complete years to maturity) and the second relates to reopenings under which the new debt instruments are issued with no more than de minimis amount of OID.

An issuance of new debt instruments with more than a de minimis amount of OID will be a qualified reopening of outstanding debt instruments if the following four requirements are met:

• The original debt instruments are publicly traded,¹⁰
• The issue date of the new debt instruments (treated as a separate issue) is not more than six months after the issue date of the original debt instruments,¹¹
• The new debt instruments have terms that are in all respects identical to the terms of the original debt instruments (as of the reopening date),¹² and
• On the pricing date of the reopening (or, if earlier, the announcement date),¹³ the yield of the original debt instruments (based on their fair market value) is not more than 110% of the yield of the original debt instruments on their original issue date (or, if the original securities were issued with no more than a de minimis amount of OID, the coupon rate).¹⁴

An issuance of new debt instruments with no more than de minimis OID will be treated as a qualified reopening of outstanding debt instruments if the following three requirements are met:

• The original instruments are publicly traded,¹⁵
• The new debt instruments have terms that are in all respects identical to the terms of the original debt instruments (as of the reopening date),¹⁶ and
• The newly-issued instruments (treated as a separate issue) are issued with no more than a de minimis amount of OID.¹⁷

Debt instruments issued in a qualified reopening of a prior issuance have the same adjusted issue price as the original issuance, and therefore are fungible with the original debt instruments and may bear the original CUSIP number. Discount attributable to increases in market rates of interest or a deterioration of the issuer’s credit rating since the original issuance is treated as market discount in the hands of holders. Revenue Procedure 2001-21, described below, provides a procedure under which the holders of the original debt instruments may exchange their debt instruments for the debt instruments issued in the qualified reopening on a tax-free basis.

The issuer of the debt instrument treats the difference between the adjusted issue price of the original debt instruments and the price paid for the additional debt instruments as an adjustment to the issuer’s interest expense for the original and additional debt instruments.¹⁸ Accordingly, if a holder pays more than the adjusted issue price of the original debt instrument, the issuer increases the aggregate adjusted issue prices of all of the debt instruments in both the original and additional issues. If a holder pays less than the adjusted issue price of the original debt instruments, the issuer reduces the aggregate adjusted issue prices of all the debt instruments by that amount. The issuer then recomputes the yield of both the old and the new debt securities to determine its accruals of interest expense over the remaining term of all the debt instruments based on this readjusted aggregate issue price and the remaining payment schedule of the instruments.¹⁹

As discussed above, Revenue Procedure 2001-21 provides an election by which an issuer may permit any electing holder to exchange certain outstanding debt instruments for newly-issued debt instruments on a tax-free basis, and thereby achieve greater fungibility and liquidity. A holder may qualify for the tax-free exchange only if the following conditions are satisfied:

• Either (x) the original debt instruments were the subject of a qualified reopening and are exchanged for the debt instruments issued in the reopening, or (y) the original debt instruments are part of a consolidation of outstanding debt instruments from two or more outstanding issues (i.e., the issuer consolidates two or more issues into a single new issue);²⁰
• The outstanding debt instruments and the new-issued debt securities are not materially different (as determined under the existing regulations);²¹
• The outstanding debt instruments and the newly-issued debt instruments are both publicly traded;²²
• The outstanding debt instruments and the newly-issued debt instruments are each issued at par or with no more than a de minimis amount of OID or premium;²³
• Neither the new debt nor the old debt is (i) a "contingent payment debt instrument" (i.e., a debt instrument that provides for more than one contingent payment), (ii) a tax-exempt obligation, or (iii) a convertible debt instrument;
• All payments on the outstanding debt instruments and the newly-issued debt instruments are denominated in, or determined solely by reference to, U.S. dollars, and the functional currency of the business unit issuing the new debt is the U.S. dollar; and
• The issuer and at least one debt instrument holder enter into a written agreement to treat the exchange as a realization event no later than the last day of the month in which the substitution occurs.²⁴

An electing holder does not recognize gain or loss as a result of the deemed exchange. Instead, the holder’s basis in the new debt is the same as the holder’s adjusted basis in the outstanding debt instruments that were exchanged. In addition, the holder takes the same holding period in the new debt as it held in the old debt. If the stated redemption price at maturity of the new debt is greater than the holder’s basis in the new debt, the difference is treated as market discount if the amount of the market discount on the new debt is more than de minimis. In that case, the lesser of the market discount on the new debt and the accrued market discount on the old debt which has not been taken into account by the holder as ordinary income, is treated as accrued market discount on the new debt.

In general, the issuer must take into account over the term of the newly-issued debt instruments any difference between the (x) adjusted issue price of the original debt instruments at the time of the substitution, and (y) the issue price of the newly-issued debt instruments by either increasing (where the issue price of the new debt instruments is less than the adjusted issue price of the original debt instruments ) or decreasing (where the issue price of the new debt instruments is greater than the adjusted issue price of the original debt instruments) the aggregate issue price of the new debt. As a result, the difference is taken into account by the issuer over the term of the new debt as either increased or reduced OID or as bond issuance premium.²⁵

An issue of debt instruments includes all debt instruments that:

• have the same credit and payment terms,
• are issued either pursuant to a common plan or as part of a single transaction or a series of related transactions, and
• are issued within a period of 13 days beginning with the date on which the first debt instrument that would be part of the issue is sold to a person other than a bond house, broker, or similar person or organization acting in the capacity of an underwriter, placement agent, or wholesaler.

Qualified Reopenings Within Six Months for Debt Instruments Issued With More Than a De Minimis Amount of OID.

A reopening of debt instruments is treated as a qualified reopening if:

• the original debt instruments are publicly traded,
• the issue date of the new debt instruments (treated as a separate issue) is not more than six months after the issue date of the original debt instruments,
• the new debt instruments have terms that are in all respects identical to the terms of the original debt instruments (as of the reopening date), and
• on the pricing date of the reopening (or, if earlier, the announcement date), the yield of the original debt instruments (based on their fair market value) is not more than 110% percent of the yield of the original debt instruments on their issue date (or, if the original securities were issued with no more than a de minimis amount of OID, their coupon rate).

Qualified Reopenings At Any Time for New Issues of Debt Instruments With No More than De Minimis OID.

A reopening of debt instruments is treated as a qualified reopening if:

• The original instruments are publicly traded,
• the new debt instruments have terms that are in all respects identical to the terms of the original debt instruments (as of the reopening date), and
• The newly-issued instruments (treated as a separate issue) are issued with no more than a de minimis amount of OID.

Qualified Reopenings of Treasury Securities.

A reopening of Treasury securities is treated as a qualified reopening if:

• the newly-issued Treasury securities have the same terms as the original Treasury securities, and
• either the newly-issued Treasury securities are issued not more than one year after the original Treasury securities were first issued to the public, or the newly-issued Treasury securities have no more than a de minimis amount of OID.

1 2001-9 I.R.B. (expected to be published on February 26, 2001).

2 A de minimis amount of original issue discount is defined as ¼ of 1-percent of the stated redemption price at maturity, multiplied by the number of complete years to maturity. See section 1273(a)(3); Treasury regulations section 1.1273-1(d). The stated redemption price at maturity is the sum of all payments provided by the debt instrument other than qualified stated interest. See Treasury regulations section 1.1273-1(b). Qualified stated interest is stated interest that is unconditionally payable in cash or property at least annually at a single fixed rate. See Treasury regulations section 1.1273-1(c). If an issuance is considered to have de minimis OID, the amount of OID is treated as zero.

3 See Treasury regulations section 1.1273-2(a)(1).

4 Unless a taxpayer specifically elects to include market discount in income as it accrues, the taxpayer includes market discount in income (as ordinary income) as principal is received and/or when the debt instrument is sold or otherwise disposed of. See section 1276(a). In addition, unless a taxpayer elects to include market discount in income as it accrues, the taxpayer generally is required to defer deductions for interest paid on any indebtedness incurred to acquire the debt instrument until principal is received or the debt instrument is disposed of. See section 1277(a).

5 See section 1278(a)(2).

6 The amount of OID on the 2001 note in each accrual period will be $1.27 in 2001, $1.42 in 2002, $1.59 in 2003, and $1.79 in 2004, or $6.07 in the aggregate.

The issuer’s treatment is symmetric: it is permitted to currently deduct the accrued OID on the 2001 note but is not entitled to deduct discount on the 2000 note because the note was not issued at a discount.

7 See Treasury regulations section 1.1275-1(f)(1).

8 See Treasury regulations section 1.1275-1(f)(2).

9 A third special rule applies to qualified reopenings of Treasury securities. Under these rules newly-issued Treasury securities are issued in a qualified reopening of a prior issuance if (i) the newly-issued Treasury securities have the same term as the original Treasury securities, and (ii) either the newly-issued Treasury securities are issued not more than one year after the original Treasury securities were first issued to the public, or the newly-issued Treasury securities are issued at any subsequent time with no more than a de minimis amount of OID. See Treasury regulations section 1.1275-2(d).

10 See Treasury regulations section 1.1275-2(k)(3)(ii)(A). Generally, a publicly traded debt instrument is a debt instrument that is traded on an established market. See Treasury regulations section 1.1273-2(f).

11 See Treasury regulations section 1.1275-2(k)(3)(ii)(B).

12 See Treasury regulations section 1.1275-2(k)(2)(ii)(C).

13 The announcement date is the later of (i) seven days before the date on which the price of the new securities is established, or (ii) the date on which the issuer’s intent to reopen a security is publicly announced through one or more media, including an announcement reported on the standard electronic news services used by security broker-dealers (e.g., Reuters, Telerate or Bloomberg). See Treasury regulations section 1.1275-2(k).

14See Treasury regulations section 1.1275-2(k)(3)(ii)(C).

The 110% yield test represents a liberalization of the 107.5% yield test under the proposed regulations. In addition, under the proposed regulations, a reopening of debt instruments was a qualified reopening only if the yield of the additional debt instruments was (i) no more than 115% of the yield of the original debt instruments on the issue date, or (ii) issued with no more than a de minimis amount of OID. The 115% yield test was eliminated in the final regulations.

15 See Treasury regulations section 1.1275-2(k)(3)(iii)(A).

16 See Treasury regulations section 1.1275-2(k)(2)(ii)(C).

17 See Treasury regulations section 1.1275-2(k)(3)(iii)(B).

18 See Treasury regulations section 1.163-7(e)(1).

The adjusted issue price for any accrual period is generally the sum of the original issue price of a debt instrument plus the amount of previously accrued interest for all periods before the first day of such accrual period. See section 1272(a)(4).

19 See Treasury regulations section 1.163-7(e)(4).

20 The holder need not exchange debt instruments from each outstanding issuance to qualify. However, the issuer must receive debt instruments from two or more issues.

21 In other words, the exchange must not represent a "significant modification" of the outstanding debt instruments. See Treasury regulations section 1.1001-3.

This determination may be made either on (i) the date the substitution of the debt occurs, or (ii) the date that is two business days before the date on which the substitution offer commences, provided that date is no more than 30 business days before the date on which the substitution offer ends.

22 Generally, a publicly tracked debt instrument is a debt instrument that is traded on an established market (e.g., NASDAQ, NYSE). See Treasury regulations section 1.1273-2(f).

23 De minimis premium is determined using the same principles for determining de minimis OID. See footnote 2, above.

24 In addition, the issuer must attach a signed statement to its U.S. federal income tax return for the taxable year in which the exchange occurs. On the statement, the issuer must (i) identify both the old and new debt instruments, (ii) indicate the issue price of the new debt (or, if the new debt is issued in a qualified reopening, the adjusted issue price of the new debt immediately after the substitution), and (iii) indicate that the election was made under Revenue Procedure 2001-21.

25 If the new debt is issued in a qualified reopening, the issuer is required to use the remaining term of the new debt instead of the term of the new debt and must use the adjusted issue price of the new debt immediately after the substitution instead of the issue price of the new debt. See Revenue Procedure 2001-21, 2001- 9 I.R.B., Section 3(2) (expected to be published on February 26, 2001).