United States: IRS Finalizes Regulations Addressing The Issue Price Of Debt Issued For Property And In Reopenings

Introduction

On September 13, 2012, the IRS published final regulations (the "Final Regulations") addressing when property is "traded on an established securities market" for purposes of determining the issue price of a debt instrument.¹ The Final Regulations also modify the "qualified reopening" rules, providing two additional methods that permit an issuer and holders to treat two offerings of debt instruments as part of a single fungible issue for U.S. federal income tax purposes even where, if treated as separate issuances, the two offerings of debt instruments would have had different amounts of original issue discount ("OID") and otherwise would not have been fungible.

Background

Relevance of Issue Price

The "issue price" of a debt instrument determines many of the tax consequences of issuing and owning the instrument. For example, the difference between the "stated redemption price at maturity" of a debt instrument and its issue price is, unless de minimis, the amount of OID that a holder must accrue as ordinary income (and that an issuer may deduct as interest) over the life of the instrument. In a debt-for-debt exchange (or deemed debt-for-debt exchange resulting from a significant modification of debt terms), the issue price of the new instrument in the exchange not only determines the amount of OID, but also may affect cancellation of debt income (or "CODI") an issuer may recognize.

In general, the existing regulations, which are not changed by the Final Regulations, provide that where a substantial amount of a debt issue is issued for cash, the issue price is simply, "the first price at which a substantial amount of the debt instruments is sold for money,"² ignoring sales to, "bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters, placement agents, or wholesalers . . . ."³

Where a debt instrument is issued in exchange for property, however, the issue price of the debt instrument depends on whether the property received (i.e., the new debt) or the property surrendered (i.e., the original debt) was "traded on an established securities market." The issue price of new debt traded on an established securities market is its fair market value on the issue date.⁴ If a substantial portion of an issue of new debt is not traded, but a substantial portion of such debt is issued for property that is traded (including original debt), the issue price of the debt is the fair market value of the property surrendered as of the issue date.⁵ Debt that is neither traded nor issued for traded property will generally has an issue price equal to their stated principal amount.⁶

Prior Definition of Publicly Traded Property

Property was "traded on an established market" under the prior regulations, if, at any time during the 60-day period ending 30 days after the issue date, the property was: listed on an exchange, traded on a market, appeared on a quotation medium or was a readily quotable debt instrument.⁷ Property was considered "listed" on an exchange if it was listed on an a "national securities exchange registered under section 6 of the Securities Exchange Act of 1934", an interleader quotation system sponsored by a registered national securities exchange, or a foreign exchange enumerated in the Treasury Regulations.⁸ "Market traded property" was property traded on "a board of trade designated as a contract market by the Commodities Futures Trading Commission or on an interbank market."⁹ A "quotation medium" was a general circulation system that provided recent price quotations or pricing information of sales for which a fair market value can be discerned.¹⁰ Finally, a readily quotable debt instrument was, subject to certain "safe harbor" exceptions, a debt instrument for which "price quotations [were] readily available from dealers, brokers, or traders."¹¹

Qualified Reopenings

Whether a debt instrument is traded on an established securities market may, in practice, determine whether an issuer can reopen a series of debt. Unless the original debt and the additional debt issued in the reopening either have no OID or have precisely the same amount of OID, there will be different tax consequences to owning the original debt and the additional debt, and, thus, the two instruments would not be fungible from the perspective of U.S. holders. For example, if the original debt instruments were not issued with OID and the additional debt instruments were issued with OID, the original debt instruments and the additional debt instruments will generally need to be separately identifiable through the use of separate CUSIP numbers.

Subject to certain limitations, the current Treasury Regulations governing the treatment of reopenings permit an issuer to reopen debt in a "qualified reopening" and to treat the additional debt as part of the same issue as the original debt, with the same issue price, and amount of OID under one of three methods (assuming, of course, that the original debt and the additional debt otherwise have identical payment terms).

The first method requires that the additional debt be issued within thirteen days of the original debt. The second method requires that (i) the original debt instruments are traded on an established securities market, (ii) the additional debt instruments are not be issued more than six months after the issue date of the original debt instruments and (iii) the yield of the original debt instruments (based on their market value) is not more than 110 percent of their yield on the original issue date at the time of the issuance of the additional debt instruments.¹² The third method requires that (i) the original debt instruments are traded on an established securities market and (ii) the additional debt instruments, if treated as a separate issuance, would not be treated as issued with OID. In practice, even if the debt is not traded on an established securities market, the debt is fungible if neither the original nor new debt has OID.

Determining whether the original debt is traded on an established securities market therefore frequently is important to an issuer attempting a "qualified reopening" for the purpose of having two issuances of debt instruments in a single series be fungible for U.S. federal income tax purposes.

The Final Regulations

Determination of Public Trading

The Final Regulations make it considerably more likely that debt will be considered traded on an established securities market than prior law. The Final Regulations treat property, including debt, as "traded on an established market," i.e., publicly traded for U.S. federal income tax purposes, if, "at any time during the 31-day period ending 15 days after the issue date," (i) there is a "sales price" for the property, (ii) there are one or more "firm quotes" for the property, or (iii) there are one or more "indicative quotes" for the property.¹³

There is a sales price for property if the price for the purchase or sale of the property is "reasonably available" within a reasonable period of time after the sale.¹⁴ The sales price of property is "reasonably available" if the:

There is a firm quote for property if, "at least one broker, dealer or pricing service," is making a price quote and such quoted price is "substantially the same as the price for which the person receiving the quoted price could purchase or sell the property."¹⁶

There is an indicative quote for property if a price quote other than a "firm quote" is available.¹⁷

In general, the fair market value of property will be presumed to be the sales price or the quoted price.¹⁸ However, if there is more than one sales price, more than one firm quote or indicative quote, or both, more than one sales price and quoted price, a taxpayer can use "any reasonable method" to determine the fair market value of the property.¹⁹ The issuer, however, must determine whether property is publicly traded and the fair market value of the property on which the issue price of a debt instrument is based.²⁰ The issuer's determination will be binding on a holder unless that holder explicitly discloses that it has made a different determination as to the status or value of the property.²¹

The Final Regulations apply to debt instruments issued on or after November 12, 2012.²²

Qualified Reopenings

The Final Regulations retain the existing provisions relating to qualified reopenings and offer two new provisions under which a new issue of debt instruments can be considered to be part of a qualified reopening.

The first applies where (i) the additional debt instruments are issued for cash to persons unrelated²³ to the issuer for an arm's length price and (ii) either (a) the reopening is within six months of the issue date of the original debt instruments and the yield of the additional debt instruments is not more than 110 percent of the yield of the original debt instruments on their issue date or (b) the additional debt instruments, if treated as a separate issue, would not be treated as issued with OID.²⁴ This permits an issuer to issue additional debt instruments that are fungible for U.S. federal income tax purposes regardless of whether the original debt instruments are publicly traded, as long as the additional debt instruments are issued for cash to unrelated parties within six months of the issue date of the original debt instruments.

The second type of new qualified reopening applies where (i) the additional debt instruments are issued more than six months after the issue date of the original debt instruments and (ii) either (a) the original debt instruments are publicly traded for U.S. federal income tax purposes and the yield of the original debt instruments (based on their fair market value) is not more than 100 percent of the yield of the original debt instruments on their issue date or (b) the additional debt instruments are issued for cash to persons unrelated to the issuer for an arm's length price and the yield of the additional debt instruments is not more than 100 percent of the yield of the original debt instruments on their issue date.²⁵

Prior to the Final Regulations, it was not possible to have a qualified reopening more than six months after the issue date of the original debt instruments unless the additional debt instruments, analyzed separately, would not have been treated as issued with OID. The Final Regulations, thus, liberalize the rules of prior regulations and now permit an issuer to issue, at any time, additional debt instruments that are fungible for U.S. federal income tax purposes as long as either the original debt instruments are traded or the additional debt instruments are issued for cash to unrelated parties and the corresponding yield test is met.

These rules apply to reopenings on or after September 13, 2012.²⁶

Footnotes

1 T.D. 9599 (Sept. 13, 2012).

2 Treas. Reg. § 1.1273-2(a)(1).

3 Treas. Reg. § 1.1273-2(e).

4 Treas. Reg. § 1.1273-2(b)(1).

5 Treas. Reg. § 1.1273-2(c)(1).

6 Treas. Reg. § 1.1274-2(b)(1).

7 Prior Treas. Reg. § 1.1273-2(f ). Although the final Treasury Regulations are to become effective with respect to debt instruments on or after November 12, 2012, the current regulations are herein referred to as the prior regulations.

8 Prior Treas. Reg. § 1.1273(f )(2). The enumerated foreign exchanges included the International Stock Exchange of the United Kingdom and the Republic of Ireland, Limited, the Frankfurter Stock Exchange, and the Tokyo Stock Exchange.

9 Prior Treas. Reg. § 1.1273-2(f )(3).

10 Prior Treas. Reg. § 1.1273-2(f )(4).

11 Prior Treas. Reg. § 1.1273-2(f )(5).

12 Treas. Reg. § 1.1275-2(k)(3)(ii).

13 Treas. Reg. § 1.1273-2(f)(1).

14 Treas. Reg. § 1.1273-2(f)(2)(i).

15 Treas. Reg. § 1.1273-2(f)(2)(ii).

16 Treas. Reg. § 1.1273-2(f)(3).

17 Treas. Reg. § 1.1273-2(f)(4).

18 Treas. Reg. § 1.1273-2(f)(5)(i).

19 Id. Additional exceptions are provided, including for property with i) only a single indicative quote, ii) small debt issues, iii) temporary restrictions on trading on property in order to avoid these rules, or iv) artificial prices. Treas. Reg. §§ 1.1273-2(f)(5)(ii), (6) and (7).

20 Treas. Reg. § 1.1273-2(f)(9)(i)

21 Id. Such disclosure must describe how the holder made such a determination and be filed on a timely tax return for the taxable year in which the debt instrument was acquired.

22 Treas. Reg. § 1.1273-2(f)(10).

23 For this purpose a party is related to the issuer if they are related within the meaning of Section 267(b) or 707(b) of the Internal Revenue Code of 1986, as amended.

24 Treas. Reg. § 1.1275-2(k)(3)(iv).

25 Treas. Reg. § 1.1275-2(k)(3)(v).

26 Treas. Reg. § 1.1275-2(k)(5).

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