Did You Know That If The Rate Of Deferred Interest (PIK Interest) On A Loan Is Too High That The Interest May Not Be Deductible?

Loans that have interest that is not currently paid each year are treated as having "original issue discount" or OID. These types of loans are common in mezzanine financing which can have rates ranging from 13-18% with 11-15% payable currently (typically monthly or quarterly)and the remaining interest (referred to a PIK interest) paid at a later date or at maturity. Borrowers can deduct the PIK interest ratably over the term of the note (even though not paid).

However, if the rate of interest is high enough and the loan has certain other characteristics, the loan may be considered an "Applicable High Yield Discount Obligation" or AHYDO for short. A borrower cannot deduct the "disqualified portion" of the PIK interest on an AHYDO, and the remaining PIK interest cannot be deducted by the borrower until paid. A loan is an AHYDO if

The term of the loan is more than 5 years;
The borrower is a C corporation (or partnership with corporate partners);
The interest rate is at least 5% higher than the midterm Applicable Federal Rate (currently 4.06%); and
The debt has accrued but unpaid interest as of any accrual period ending after the 5^th anniversary of the loan that exceeds one year's interest.

This potential limitation on the ability to deduct interest is commonly addressed by providing that the borrower is required to make a "catch up" payment of interest around the 5^th anniversary so that total accrued and unpaid interest does not exceed one year's worth of interest. That removes the 4^th element listed above.

Even if the note provides for payment of all the PIK interest as necessary to avoid
AHYDO treatment, sometimes subordination agreements with a senior lender prohibit the payment of any amount on the subordinate debt other than regular interest. This
could prevent a borrower from paying deferred interest to avoid AHYDO treatment.
While it appears that this should not impact the determination of whether the debt is
an AHYDO, there is no authority addressing whether this limitation could result
in the debt being recharacterized.

Bottom Line: As a borrower on mezzanine loan, it is important to be aware of the exceptions to AHYDO treatment and the potential impact of other agreements on the ability to comply with the 5-year payment safe harbor.

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Never reveal everything you know." – Roger H. Lincoln

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