Capitalizing and amortizing debt issuance costs.
The regulations generally do not change which type of debt issuance costs must be capitalized, although they do allow a current deduction for certain de minimis debt issuance costs. However, they do alter the method of amortizing capitalized debt issuance costs to conform generally to the constant yield to maturity method for OID. The new method applies to issuance costs on debt instruments issued on or after Dec. 31, 2003. Because of these new rules, the issuance costs deductible each year for tax purposes will often differ from the amount expensed for financial statement purposes. Determining the correct amount may require additional calculations.
Costs Required to Be Capitalized (Regs. Sec. 1.263-5)
Regs. Sec. 1.263(a)-5(a) provides that debt issuance costs are costs incurred by an issuer of debt (i.e., a borrower) to "facilitate" a borrowing. According to Regs. Sec. 1.263(a)-5(a)(9), a borrowing is any debt issuance, including one in an acquisition of capital or a recapitalization. It also includes debt issued in a debt-for-debt exchange resulting from a significant modification under Regs. Sec. 1.1001-3.
Under Regs. Sec. 1.263(a)-5(b)(1), an amount paid to investigate or otherwise pursue a borrowing is also paid to facilitate a borrowing. Costs that facilitate a borrowing include payments to an investment bank to market a debt instrument to investors, and to attorneys to prepare offering documents. Prior to the regulations, case law had required capitalization of investment bank fees, attorneys' fees and similar costs; see, e.g., Helvering v. Union Pacific R.R. Co., 293 US 282 (1934).
Under Regs. Sec. 1.263 (a)-5 (c)(1), an amount paid to facilitate a borrowing does not facilitate another transaction. Thus, costs incurred in issuing debt to finance an asset or stock purchase are debt issuance costs and are not capitalized into the basis of the acquired assets.
Regs. Sec. 1.263(a)-5(d)(1) does not require capitalization of employee compensation and overhead. As most taxpayers probably do not capitalize these internal costs, the regulations will not change the current practice.
In addition, under a de minimis exception, Regs. Sec. 1.263(a)-5(d)(3) allows a deduction for third-party costs that do not total more than $5,000 per transaction. If this threshold is exceeded, all costs must be capitalized. Although the exception is a departure from prior law, it may have only limited usefulness for most corporate taxpayers.
Accounting Method to Amortize costs (Regs. Sec. 1.446-5)
In general: Previously, based on long-standing case law and IRS rulings, most taxpayers amortized debt issuance costs on a straight-line basis; see Rev. Ruls. 70-359 and 70-360. In contrast, under Regs. Sec. 1.446-5, costs exceeding a certain threshold must be amortized as if they increased the debt instrument's yield. For de minimis amounts determined in the manner discussed below, the costs may be amortized on a straight-line basis.
Regs. Sec. 1.446-5(h) adjusts the yield on a debt instrument by treating the issuance costs as if they reduced the debt instrument's issue price and create (or increase) OID. The costs are then spread over the debt's term based on a constant yield to maturity. The constant yield is the discount rate at which the sum of the present value of all payments (interest and principal) equals the issue price as calculated for Regs. Sec. 1.446-5 purposes; see Regs. Sec. 1.1272-1(b) for the constant yield method.
The following examples illustrate the new rules for amortizing debt issuance costs.
Example 1: On Jan. 1, 2005, X borrows $10 million. The principal is repayable on Dec. 31, 2009; interest payments of $500,000 are due on December 31 of each year the loan is outstanding. X incurs $130,000 of debt issuance costs.
Under Regs. Sec. 1.1273-2, the loan's issue price is $10 million. To amortize debt issuance costs, however, X reduces the issue price by the $130,000 of debt issuance costs, resulting in an issue price of $9.87 million. As a result, for purposes of calculating the amortization of debt issuance costs, X treats the loan as having $130,000 of OID ($10 million stated redemption price at maturity--$9.87 million issue price).
Because the OID under this calculation ($130,000) is more than the de minimis amount of OID for the loan, determined under Regs. Sec. 1.1273-1(d)(2) ($125,000 = $10 million X 0.0025 X 5 years), X must allocate the OID to each year based on the constant yield method described in Regs. Sec. 1.1272-1(b); see Regs. Sec. 1.163-7(a). Based on this method, the constant yield to maturity, with annual accrual periods, is 5.3%. The debt issuance costs allocable to each year are as follows: $23,385 for 2005, $24,625 for 2006, $25,931 for 2007, $27,306 for 2008 and $28,753 for 2009.
Example 2: The facts are the same as in Example 1, except X incurs debt issuance costs of $120,000, rather than $130,000.
Under Regs. Sec. 1.1273-2, the loan's issue price is $10 million. To determine the accrual of debt issuance costs, however, X reduces the issue price by the $120,000 of debt issuance costs, resulting in an issue price of $9.88 million. As a result, for purposes of calculating the amortization of debt issuance costs, X treats the loan as having $120,000 of OID ($10 million stated redemption price at maturity--$9.88 million issue price).
Because $120,000 is less than de minimis, as determined under Regs. Sec. 1.1273-1(d)(2) (i.e., $125,000, as described in Example 1 above), X is not required to use the Regs. Sec. 1.1272-1(b) constant yield method to allocate the debt issuance costs to each year. Instead, under Regs. Sec. 1.163-7(b)(2), X can choose to allocate the costs to each year on a straight-line basis over the loan's term or in proportion to the stated interest payments ($24,000 each year for either method). X also could choose to deduct the costs at maturity or use the constant yield method.
X makes a choice by reporting the costs in a manner consistent with the method chosen on its timely filed 2005 Federal income tax return. If X chooses to use the constant yield method, the yield would be 5.279%, compounded annually. The costs allocated to each year would be: $21,596 for 2005, $22,736 for 2006, $23,937 for 2007, $25,200 for 2008 and $26,531 for 2009.
No other guidance: Other than the two examples described above, the regulations do not provide detailed guidance for determining how to amortize debt issuance costs using a constant yield method. Applying this method is more complicated if the debt instrument has OID. To apply the constant yield method, it is necessary to construct two yield schedules, one based on the yield for the combined amount of interest and debt issuance costs and one based on the yield only for the interest. The difference between the two schedules provides the amount of debt issuance costs to be deducted each year. (If an issuer does not need to calculate the OID separately, only one amortization schedule is needed to determine the total deduction for interest and debt issuance costs, lf an issuer, however, must report OID to holders or must calculate OID to apply certain interest limits, it will have to construct both schedules, because debt issuance costs are not considered OID.)
To the extent that the sum of debt issuance costs and any OID on the debt does not exceed the de minimis OID threshold, Regs. Sec. 1.446-5(b)(2) states that a taxpayer may amortize the issuance costs using the de minimis OID rules. In general, de minimis OID is 0.0025 (0.25%) times the stated redemption price at maturity, times the number of complete years to maturity; see Regs. Sec. 1.1273-l(d)(2). For debt instruments with principal payments before maturity, the formula uses a factor of 0.00167 (0.167%) instead of 0.0025; see Regs. Sec. 1.1273-1 (d)(3). The OID rules must be applied to determine whether the sum of the OID on the debt instrument and the debt issuance costs results in an amount that is de minimis under the de minimis OID rules. For example, stated interest is considered OID unless it meets the definition of qualified stated interest; see Regs. Sec. 1.1273-1(c). Thus, a debt instrument issued at par can have more OID than a de minimis amount if the stated interest is not qualified stated interest.
If debt issuance costs are de minimis, taxpayers may deduct the costs (1) on a straight-line basis; (2) in proportion to the stated interest payments; or (3) in full at the maturity of the debt instrument; see Regs. Sec. 1.163-7(b)(2). Taxpayers may also use the constant yield method. For debt instruments with a single payment at maturity, the straight-line method results in a faster amortization than the constant yield method. The taxpayer makes its choice by reporting de minimis debt issuance costs in a manner consistent with the method chosen on a timely filed tax return for the year the debt is issued.
Debt Issuance Costs Are Not OID
Although Regs. Sec. 1.446-5 requires taxpayers to account for debt issuance costs under the OID rules and aggregates these costs with OID to determine whether the amounts are de minimis, debt issuance costs are not OID. Regs. Sec. 1.446-5 provides a method of accounting for debt issuance costs, but does not characterize such costs as interest.
Thus, debt issuance costs are not interest for purposes of applying various rules that disallow or limit interest deductions. For example, in applying the provisions under Sec. 163(e)(5) and (i) for applicable high-yield debt obligations, the debt issuance costs are not considered in determining the instrument's yield. They are not interest for purposes of the acquisition indebtedness rules under Sec. 279 and for the limits on the deduction of stated interest and OID paid to related foreign persons under Secs. 163(e)(3) and 267(a)(3), respectively.
To amortize debt issuance costs under the new regulations, the taxpayer must calculate an adjusted yield that takes into account both interest and debt issuance costs. For a fixed-rate debt instrument, this calculation is relatively straightforward. For instruments with variable or contingent interest payments, taxpayers must apply special OID rules for determining the adjusted yield.
For a variable-rate debt instrument based on the same interest index for the debt's entire term, the debt issuance costs are amortized by treating them as adjusting the yield, which is deter mined based on the index's initial value; see Regs. Sec. 1.1275-5(e)(2). Thus, even though the interest rate changes over the term, the amortization schedule of the debt issuance costs remains fixed.
For a contingent debt instrument that is not publicly traded and is issued in exchange for nontraded property, the issue price is determined based only on the debt's fixed components. Thus, the debt issuance costs would adjust the overall yield based only on the fixed payments under the debt; see Regs. Sec. 1.1275-4(c)(3).
For a contingent debt instrument issued for cash, the overall yield generally will be based on the projected payment schedule required under the contingent payment debt instrument rules; see Regs. Sec. 1.1275-4(b). Special rules also apply for determining the yield for debt instruments with alternate payment schedules (such as one arising from an option exercisable by the lender or the borrower); see Regs. Sec. 1.1272-1(c).
The new rules apply to debt issuance costs on debt instruments issued on or after Dec. 31, 2003. Instruments issued before that date are not affected by the new rules. A "significant modification" under Regs. Sec. 1.1001-3 to a debt instrument issued before the effective date results in the instrument becoming subject to the new rules, because the debt is treated as newly issued at the time of the modification.
Regs. Sec. 1.446-5(e) requires a tax-payer to implement the new amortization rules for debt issuance costs by attaching Form 3115, Application for Change in Accounting Method, to the return for the first tax year affected by the regulations. Taxpayers are granted automatic consent for this change for that first year. The change is made on a cut-off basis; thus, no items of income or deduction are omitted or duplicated, and no Sec. 481 adjustment is allowed.
FROM MICHAEL BLINDER, J.D., MBA, AND HELEN YACHISIN, J.D., WASHINGTON, DC.
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|Publication:||The Tax Adviser|
|Date:||Mar 1, 2005|
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