Falling federal interest rates can precipitate interest disallowance.

Over the past year, the applicable Federal rate (AFR) published by the IRS has been decreasing. The AFR is used in a number of tax computations, including the calculation of original issue discount (OID) on debt instruments. Generally, OID is interest deductible to the issuer of a debt instrument based on a constant yield over the instrument's term. To the extent an instrument meets certain criteria and its yield to maturity (YTM) exceeds the AFR plus 5%, OID is deductible only when paid, creating a temporary difference between interest deducted for book and tax. However, any interest over the AFR plus 6% can be disal-lowed for Federal income tax purposes, creating a permanent difference between interest deducted for book and tax purposes. Therefore, as the AFR decreases, this threshold also decreases and the potential for disallowance of interest increases.

The determination of YTM and OID is made when an instrument is issued. If an instrument is substantially modified (as defined in proposed regulations), it is treated as if the original instrument were exchanged for a new instrument. In other words, the substantial modification of an instrument causes a redetermination of YTM and OID, and can result in a modified instrument that is over the threshold--even if the original instrument was not.

True Nature of Debt Instrument Payments

Taxpayers have exhibited considerable creativity over the years in developing debt instruments to provide the best tax consequences for all parties. Congress first attempted to require taxpayers to recognize the true nature of payments under a debt instrument as interest or principal in 1962 with the enactment of Sec. 483. These rules have been amended several times and new rules have been added as debt instruments and taxpayers became more sophisticated.

Currently, the issuer of a debt instrument may deduct an amount equal to the aggregate daily portions of OID on the instrument for the tax year. OID is defined as the excess of the stated redemption price at maturity (SRPM) of the instrument over its issue price (IP). The SRPM is the amount payable at maturity, including interest other than interest based on a fixed rate that is payable unconditionally at fixed periodic intervals of one year (or less) during the debt's entire term. (Note: Under this definition, all interest on an instrument is considered OID if its terms provide for an interest holiday of more than one year at any time between the issue and maturity dates.) In order to determine IP, an instrument must be analyzed to determine if all or a part of it is publicly traded and if it was issued for property that is publicly traded. (For this purpose, property does not include money.) If the debt instrument is part of an investment unit (i.e., has a property right attached), the IP must be allocated between the debt instrument and the property right based on their relative fair market values (FMVs).

Special Rule for AHYDO 

In 1989, Congress added an exception to the general OID rule that applies to an applicable high yield discount obligation (AHYDO). An AHYDO is defined as a debt instrument with (1) a maturity date more than five years from the date of issuance, (2) a YTM that equals or exceeds the sum of the AFR for the month the instrument was issued plus 5% and (3) significant OID (SOID). In the case of an AHYDO issued by a corporation, no deduction is allowed for the disqualified portion of OID on such obligation and the remainder of the OID is not deductible until paid. The disqualified portion of OID on an AHYDO is the lesser of the OID or the disqualified yield divided by the YTM multiplied by the total return on the obligation; the disqualified yield is the excess of the YTM over the AFR plus 6%. This rule was added as an attempt to identify debt instruments with characteristics that resembled equity (e.g., a high rate of return and a delay in payment are viewed as indicating that the return is dependent on the generation of corporate earnings).

An instrument is considered to have SOID if the aggregate amount to be included in the income of the holder for accrual periods through the period that ends after five years from the instrument's issue date (and at any accrual period thereafter) exceeds the sum of the amount of interest paid for the same accrual periods and the product of the IP multiplied by the YTM (i.e., one year accural of interest).

See the example on page 410 illustrating an AHYDO application.

Conclusion

Companies should monitor the tax consequences of the debt instruments they issue or restructure much more closely in the current environment. The mid-term AFR with annual compounding for March 1996 is 5.45%, which means that debt instruments have the potential for disqualified interest (i.e., permanently disallowed) if the YTM exceeds 11.45%.