Final regs. on contingent payment debt instruments leave questions on nonmarket-based contingencies.

In June 1996, contingent payment debt instrument (CPDI) final regulations were issued under Regs. Sec. 1.1275-4.(1) Effective for CPDIs issued on or after Aug. 13, 1996, the regulations are the culmination of Treasury's repeated attempts to address original issue discount (OID) uncertainties created by debt instruments with contingent payments. The first set of proposed regulations, issued in 1986 and amended in 1991, were never finalized and were withdrawn in 1994.(2) A different set of proposed regulations (which would have significantly changed the 1986 proposed regulations) were scheduled to be issued in January 1993, but were delayed by the change in presidential administration and never issued. A third set of proposed regulations was issued in 1994 and finalized in 1996.(3)

Essentially, Regs. Sec. 1. 1275-4(a) divides debt instruments with one or more contingent payments into two major classes. The first applies to any debt instrument with one or more contingent payments whose issue price is determined under Sec. 1273 (other than Sec. 1273(b)(4)); this covers debt instruments issued for cash or publicly traded property, and publicly traded debt instruments. Such instruments are subject to the "noncontingent bond" method (NBM) of Regs. Sec. 1.1275-4(b). Debt instruments whose issue price is determined under Sec. 1274 are subject to the "wait and see" method of Regs. Sec. 1.1275-4(c); such instruments have OID, are not publicly traded and are issued for nonpublicly traded property. (The 1986 proposed regulations used this method for all CPDIs.)

The NBM represents a major change from prior law on the income inclusion and deduction of contingent interest. Under prior law, holders of debt instruments generally were not required to include in income or deduct any contingent amount until the contingency became either fixed or paid, depending on the taxpayer's method of accounting. The NBM can require an income inclusion and a corresponding deduction for a contingent amount prior to the occurrence of the contingency. The Preamble to the 1994 proposed regulations states that, in Treasury's view, this approach is consistent with congressional intent under the, OID provisions to require a current accrual of interest on a debt instrument. Debt instruments subject to the wait and see approach retain the prior-law approach to contingencies -- generally, there are no tax consequences until the contingency is paid.

The CPDI final regulations change the calculation of income or deduction (and gain or loss) for a CPDI subject to the NBM. Instead of waiting for the contingency to occur, both holders and issuers must now accrue income and deductions based on the debt instrument's yield as if all payments were noncontingent. Although not explicitly stated, the theory of the NBM could be that the parties to the transaction expect a certain approximate yield on the instrument, based on both the noncontingent payments and a reasonable expectation of the occurrence of the contingencies. Generally, this expected yield will approximate the yield on comparable debt instruments of the issuer that call for only noncontingent payments; thus, a "comparable yield" will now be reflected in the accrual of income and expense. When the contingency is based on the future price of traded property or on some market index, the facts and circumstances regarding the expected value of the contingency will be somewhat clearer; however, when the contingency is based on nonmarket information (e.g., cash flow, the issuer's sales or profits or an increase in the value of nonpublicly traded property securing the debt instrument), any valuation of the future contingency is much more problematic.

This article discusses the NBM, focusing on contingencies not based on the future value of traded property, an index or other objective financial information. A future article will examine the wait and see method for CPDIs not subject to the NBM and the regulations' unexpected effects when restructuring troubled debt.

General Rules

What Is a CPDI?

Regs. Sec. 1.1275-4 governs the character and timing of income, deductions, gains or losses from CPDIs. Regs. Sec. 1.1275-1(d) provides that Regs. Sec. 1.1275-4 does not apply if a contingent payment obligation is not actually a debt instrument under general Federal tax principles.(4) While Regs. Sec. 1.1275-4 does not define "contingent payments," it specifies several types of instruments treated elsewhere in the Code or regulations to which it does not apply: * A debt instrument with an issue price determined under Sec. 1273(b)(4) (e.g., a debt instrument subject to Sec. 483) (Regs. Sec. 1.1275-4(a)(2)(i)). * A variable rate debt instrument (as defined in Regs. Sec. 1.1275-5) (Regs. Sec. 1.1275-4(a)(2)(ii)). * A debt instrument with an alternative payment schedule(s) applicable on the occurrence of a contingency(ies) subject to Regs. Sec. 1.1272-1(c) (Regs. Sec. 1.1275-4(a)(2)(iii)). * A debt instrument with an indefinite maturity and a fixed yield (as defined in Regs. Sec. 1.1272-1(d)) (Regs. Sec. 1.1275-4(a)(2)(iii)). * A debt instrument subject to Sec. 988 (foreign currency loans) (Regs. Sec. 1.1275-4(a)(2)(iv)). * A debt instrument to which Sec. 1272(a)(6) applies (certain interests in or mortgages held by a real estate mortgage investment conduit (RF-MIC), and certain other debt instruments with payments subject to acceleration) (Regs. Sec. 1.1275-4(a)(2)(v)). * A debt instrument (other than a tax-exempt obligation) described in Sec. 1272(a)(2) (e.g., U.S. savings bonds, certain loans between natural persons and short-term taxable obligations) Regs. Sec. 1.1275-4(a)(2)(vi)). * An inflation-indexed debt instrument (as defined in Temp. Regs. Sec. 1.1275-7T) (Regs. Sec. 1.1275-4(a)(2)(vii)). * Certain state-sponsored prepaid tuition plans (Regs. Sec. 1.1275-4(a)(2)(viii)).

Further, according to Regs. Sec. 1. 1275-4(a) (3), payments are not contingent merely because of the possibility of impairment by insolvency, default or similar circumstances. In addition, under Regs. Sec. 1.1275-4(a) (4), a debt instrument does not provide for contingent payments merely because it is convertible into stock of the issuer or stock or debt of a related party (or its cash or property equivalent).

The exception to NBM treatment for debt instruments with alternative contingent payment schedules subject to Regs. Sec. 1.1272-1(c) reflects the regulations' attempt to give a taxpayer greater flexibility in structuring a debt instrument without becoming subject to the CPDI rules. When the timing and amount of each payment of each alternative schedule are known as of the issue date and, based on the facts and circumstances as of that date, a single payment schedule for a debt instrument (including the stated payment schedule) is significantly more likely than not to occur, Pegs. Sec. 1.1272-1(c)(2) requires the yield and maturity of such instrument to be computed based on that payment schedule. Regs. Sec. 1.1272-1(c)(1) provides that if no single payment schedule is significantly more likely than not to occur, the debt instrument is subject to the CPDI regulations.

A debt instrument does not provide for an alternative payment schedule merely because there is a possibility of impairment of payment by insolvency, default or similar circumstances; under Regs. Sec. 1.1272-1 (c) (5), if the alternative payment schedule is triggered by an unconditional option held by the issuer or holder, the option will be presumed exercised if it lowers (if held by the issuer) or raises (if held by the holder) the debt instrument's overall yield. An option includes a right to can, put or extend. Regs. Sec. 1.1272-1(c)(6) provides that if the presumed payment schedule does not occur because of a change in circumstances, the debt instrument is treated as if retired and reissued at its adjusted issue price (AIP) on the date of such change; the instrument is reexamined at that time under Regs. Sec. 1.1272-1(c).

Remote or Incidental Contingencies

Another exception to the CPDI regulations exists under Regs. Sec. 1.1275-2(h) for contingencies considered remote or incidental at the date of issuance. Regs. Sec. 1.1275-2(h)(2) provides that a contingency is remote if there is a remote likelihood either that the contingency will occur or will not occur. Regs. Sec. 1.1275-2(h)(3)(i) defines a contingency as incidental as to amount if the potential amount of the contingent payment, based on "all reasonably expected market conditions," is insignificant compared to the total amount of remaining payments on the debt instrument. According to Regs. Sec. 1. 1275-2 (h) (3) (ii), a contingency relating to timing of a payment is incidental if, under "all reasonably expected market conditions," the potential difference in the timing of a payment (from the earliest date to the latest date) is insignificant.

Regs. Sec. 1.1275-2(h)(4) provides that if there are several remote or incidental contingencies, but, when considered together, there is a greater-than-remote likelihood that at least one will occur, or the payments subject to such contingencies are not incidental, none of the contingencies are remote or incidental. (Neither "remote" nor "incidental" is defined.) The IRS has verbally indicated, as an example, that 90%-95% certainty that a contingency will occur makes the likelihood that it will not occur "remote." If the contingency is remote or incidental, it is ignored for purposes of Sec. 163(e) (other than Sec. 163(e)(5), regarding applicable high-yield discount obligations) and Secs. 1271-1275, according to Regs. Sec. 1.1275-2(h)(1). A contingency considered remote not to occur renders a contingent payment noncontingent. A consistency rule in Regs. Sec. 1.1275-2(h)(5) provides for consistent treatment between holder and issuer; Regs. Sec. 1.1275-2(h)(6) provides adjustments if the contingency occurs other than as presumed.

The NBM

Under Regs. Sec. 1.1275-4(b)(3), proper application of the NBM requires the taxpayer to: 1. Determine the comparable yield. 2. Determine the projected payment schedule. 3. Determine the daily portions of interest. 4. Adjust the amount of income/deductions for differences between the projected and actual contingent payments.

Comparable Yield

Regs. Sec. 1.1275-4(b)(4)(i)(a) defines the comparable yield of a CPDI as the yield at which the debt instrument would have been issued if there were only noncontingent payments. In determining the comparable yield, the fictitious fixed rate instrument is based on similar terms and conditions as those of the actual CPDI (including same level of subordination, term, timing of payments and general market conditions). If a Regs. Sec. 1.1275-6 hedge (or the substantial equivalent) is available, the comparable yield is the yield on the synthetic fixed rate debt instrument that would result if the issuer entered into the hedge.(5) If a Regs. Sec. 1.1275-6 hedge (or the substantial equivalent) is not available, but the issuer has previously issued a similar fixed rate debt instrument trading at a price that reflects a spread above a benchmark rate, the comparable yield is the sum of the value of the benchmark rate on the issue date and the spread. For example, if the issuer of a CPDI has a similar fixed rate instrument outstanding trading at a price that produces a yield of prime plus 400 basis points, the comparable yield of the CPDI would be the prime rate on the date of issuance plus 400 basis points.

Comparable yield is determined without regard to the riskiness of the contingency or the lack of liquidity of the debt instrument; moreover, the yield must not be less than the applicable Federal rate (AFR) for the CPDI's term and accrual period. The AFR is published monthly by the IRS and represents the average yield of outstanding marketable U.S. obligations of similar maturities during the prior month, according to Regs. Sec. 1.1274-4(b).

Under Regs. Sec. 1.1275-4(b)(4)(i)(b), if the US. tax liability effect to the holder is not substantial, and the contingent payment is nonmarket-based, the comparable yield is presumed to be the AFR. For example, if the holder is a foreign person and the income from the debt instrument is not effectively connected trade or business income, the holder may be indifferent as to the comparable yield. A taxpayer may, by clear and convincing evidence, overcome the presumption and establish that the comparable yield should be higher than the AFR; however, valuations (e.g., appraisals of nonpublicly traded property and evidence based on comparable issuers or general market conditions) will not rebut the presumption.

Projected Payment Schedule

After a comparable yield is determined, a projected payment schedule must be determined as of the issue date; the schedule includes each noncontingent payment and an amount for each contingent payment. (Whether the contingency is labeled as "principal" or "interest" is irrelevant.) The projected payment schedule is constructed to produce the comparable yield. Regs. Sec. 1.1275-4(b)(4)(iv) states that the issuer's projected payment schedule is used to determine the holder's interest accruals and adjustments, even though the actual amount of the contingent payment is not fixed or determinable at the time of accrual.

Under Regs. Sec. 1.1275-4(b)(4)(ii)(A), if the contingent payment is based on market information (a market-based payment), the amount of the projected payment is the forward price of the contingent payment. The forward price is the amount a party would agree to pay (as of the issue date) to an unrelated party for the right to the contingent payment on the date due. Regs. Sec. 1.1275-4(b)(4)(ii)(B) provides that if the contingency is not based on market information (a nonmarket-based payment), the projected payment amount is the expected value of the contingent payment on the issue date. According to Regs. Sec. 1.1275-4(b)(4)(ii)(C), if necessary, the expected payments should be adjusted to produce the comparable yield without undue front- or backloading of interest.

Generally, the projected payment schedule does not change based on whether or not the contingent payments are made; instead, differences between actual and projected contingent payments are treated as adjustments to income when paid.

Regs. Sec. 1.1275-4(b)(4) requires the determination of the comparable yield and projected payment schedule to be supported by contemporaneous documentation; they must be reasonable, made in good faith and based on reliable, complete and accurate data.

Daily Portions of Interest

The third step in applying the NBM is the determination of the interest for each day the debt instrument is held. This calculation is based on the comparable yield and the projected payment schedule and is generally the same as that for noncontingent OID instruments.(6) Under Regs. Sec. 1.1275-4(b)(3), the interest accruing in each accrual period equals the comparable yield of the debt instrument (adjusted for the length of the accrual period) multiplied by the instrument's AIP at the beginning of the accrual period. Thus, the initial calculation of interest for each accrual period is based on the hypothetical comparable yield when the debt instrument was originally issued. The AIP for each accrual period is based on the original projected payment schedule, as increased by the original comparable yield. Regs. Sec. 1.1275-4(b)(5) provides that none of the stated interest on a CPDI subject to the NBM is qualified stated interest, even if it is noncontingent and otherwise meets the definition of Regs. Sec. 1.1273-1(C)(1); thus, all of the interest on a CPDI is OID.

Adjustments for Differences Between Projected

and Actual Contingent Payments

According to Regs. Sec. 1.1275-4(b)(3)(iv), differences between actual and projected contingent payments are taken into account as adjustment to income when the contingent payment is made (earlier if the contingent payment becomes fixed six months or more before payment). Under Regs. Sec. 1.1275-4(b)(6)(1), if an actual contingent payment is greater than the amount projected, the adjustment is positive; the adjustment is negative if the contingent payment is less than the amount projected. A taxpayer takes into account only those adjustments that occur during a tax year in which he held the debt instrument (or was primarily liable on it). Regs. Sec. 1.1275-4(b)(6)(ii) provides that a net positive adjustment is additional interest income or a deduction for the tax year.

Under Regs. Sec. 1.1275-4(b)(6)(iii),a net negative adjustment is generally treated as follows:

1. Interest accrued for the tax year is reduced.

2. A net negative adjustment in excess of the interest accrued for the year (based on the original projected payment schedule) is an ordinary loss to the holder and ordinary income to the issuer. The holder's ordinary loss is limited to the excess of his total previous interest inclusions on the debt instrument over the total net negative adjustments he treated as ordinary loss in previous tax years. The issuer's ordinary income inclusion is limited to the amount by which his total interest deductions on the debt instrument exceed net negative adjustments he treated as ordinary income in previous tax years.

3. Any further excess net negative adjustment is treated as a carryforward to the succeeding tax year; the carryforward is treated as a negative adjustment on the first day of the succeeding tax year. If a holder sells, exchanges or retires a CPDI, any remaining carryforward reduces the amount realized. Query the logic here: the overstated interest accrual was ordinary income, but the reduction of the amount realized generally reduces capital gain (or creates a capital loss). The issuer must increase ordinary income by any carryforward in existence in the year the CPDI is retired.

AIP and Basis Calculations

Regs. Sec. 1.1275-4(b)(7)(ii) defines the AIP of a debt instrument as the issue price, plus the interest previously accrued under step #3 above, less any noncontingent payment (and the projected amount of any contingent payment) previously made on the debt instrument. Regs. Sec. 1.1275-4(b)(7)(iii) requires a holder's basis in a debt instrument to be increased by the interest previously accrued under step #3 above, and decreased by any noncontingent payment (and the projected amount of any contingent payment) previously made on the debt instrument.

On a scheduled retirement of a debt instrument, the issuer is treated as paying, and the holder is treated as receiving, the projected amount of any contingent payment due at maturity. If a different amount is paid because the actual contingent payment differs from the projected payment, the previously discussed adjustments must be made.

Regs. Sec. 1. 1275-4(b) (8) states that any gain on the retirement, sale or exchange of a CPDI is ordinary income to the holder; any loss is ordinary to the extent the holder's total previous interest inclusions exceed the total net negative adjustments on the debt previously taken into account as ordinary loss. Any excess loss is treated as a loss from the retirement, sale or exchange of a debt instrument.

Issuer/Holder Consistency

A critical component of the NBM is that the issuer and holder must report the interest accruals from the projected payment schedule and the associated adjustments in a consistent way. Regs. Sec. 1.1275-4(b)(4)(iv) requires the issuer to provide or otherwise make available to the holder the projected payment schedule (according to Regs. Sec. 1.1275-3(b)(1), either the actual schedule or the name, title and address or telephone number of the issuer's representative who will provide such information on request). If the holder disagrees with the issuer's projected payment schedule or the issuer does not provide such schedule, the holder must determine its own projected payment schedule and disclose on its return for the tax year in which the debt is acquired that it has determined such schedule and the reason therefor. Regs. Sec. 1.1275-3(e) states that if the issuer fails to comply with these reporting requirements, it is subject to Sec. 6706 penalties.

The consistency requirement will generally force debtors and creditors to agree on the comparable yield and projected payment schedule, once the parties become aware of the rules. When the comparable yield is based on the existence of a potential hedge under Regs. Sec. 1.1275-6 or the issuer has outstanding fixed rate instruments with similar terms and the projected payment schedule is based on market information, an agreement between holder and issuer should be fairly easy to accomplish. However, if the contingency is nonmarket-based (e.g., based on a percentage of the issuer's profits) and the issuer does not have similar outstanding debt, the calculation of comparable yield and the projected payment schedule may be more difficult and an agreement may be harder to achieve.

Regs. Sec. 1.1275-4(b)(4)(v) notes that if the issuer maintains appropriate contemporaneous records, its determination of comparable yield and the projected payment schedule will be respected unless either is unreasonable. A comparable yield or projected payment schedule is unreasonable if set with a purpose to overstate, understate, accelerate or defer interest accruals on the debt instrument. To determine an improper purpose, consideration will be given to whether the treatment of the debt instrument is expected to have a substantial effect on the issuer's or holder's US. tax liability. Thus, the issuer must completely document its reasons for computing a comparable yield and a projected payment schedule. Useful information for documentation purposes should include:

* Information documenting the yield on a fixed rate instrument of the issuer of similar terms.

* Information related to the issuer's other debt instruments or its general cost of borrowing.

* Availability of hedges for the contingent payment.

* Projections of possible values and probabilities of future contingencies.

Integration of QDIs

The CPDI final regulations introduce Regs. Sec. 1.1275-6, which allows a taxpayer to treat a QDI and a hedge (or a combination of hedges) as a single synthetic debt instrument. If a taxpayer enters into a financial instrument (defined in Regs. Sec. 1.1275-6(b) (3) as a spot, forward or futures contract, an option, a notional principal contract, a debt instrument or a similar instrument or combination or series of financial instruments) and the combined cash flows of the hedge and the QDI permit the calculation of a yield to maturity under the OID regulations, the taxpayer may treat the combined cash flows from the different sources as a single cash flow from a synthetic debt instrument for tax purposes..the intent is to permit a more appropriate determination of the character and timing of income (even though this is generally covered by Regs. Secs. 1.1221-1 and 1.446-4), and to treat the cash flow from the hedge as actual interest for other purposes (e.g., income sourcing under Secs. 861(a)(1) and 862(a)(1) or Sec. 263(g) uniform capitalization).

Regs. Sec. 1.1275-6(b)(2)(i) provides that a financial instrument qualifies as a Sec. 1.1275-6 hedge only if the resulting synthetic debt instrument has the same term as the remaining term of the QDI. Also, a currency hedge is not a Regs. Sec. 1.1275-6 hedge.

According to Regs. Sec. 1.1275-6(j), Regs. Sec. 1.1275-6 applies only to QDIs issued or acquired on or after Aug. 13, 1996. If a QDI is acquired on or after that date, (1) the hedge must be acquired substantially contemporaneously with the debt instrument or (2) the QDI can only be a fixed or variable rate debt instrument.

According to Regs. Sec. 1.1275-6(b)(1), the following debt instruments are not QDIs:

1. A tax-exempt obligation (as defined in Sec. 1275(a)(3)).

2. A debt instrument to which Sec. 1272(a)(6) applies (certain interest in or mortgages held by a REMIC, and certain other debt instruments with payments subject to acceleration).

3. Nonpublicly traded CPDIs issued for nonpublicly traded property and subject to either Regs. Sec. 1.483-4 or 1.1275-4(c).

In addition, under Regs. Sec. 1.1275-6(b)(2)(ii)(a), a debt instrument issued by a taxpayer md a debt instrument held by the taxpayer cannot be part of the same integrated transaction.

Regs. Sec. 1.1275-6 is comprehensive and warrants article-length treatment itself. If neither the taxpayer nor a related party enters into a qualifying hedge, Regs. Sec. 1.1275-6 does not apply. However, the existence of a potential Regs. Sec. 1. 1275-6 hedge, even though not entered into, affects the determination of a comparable yield under Regs. Sec. 1.1275-4(b). Most nonmarket-based contingencies (such as contingencies based on the issuer's profits, cash flow or an equity kicker based on nontraded property (e.g., real estate)) securing the loan will not have a hedge available.

Application of the Rules to

Common Lending Transactions

The following example illustrates the operation of the CPDI final regulations when the contingency is nonmarket-based and a Regs. Sec. 1.1275-6 hedge is not available.

Example: On Dec. 31, 1996, limited partnership A borrowed $20,000,000 from lender B to purchase and develop a piece of real estate; A and B are calendar-year taxpayers. Although the note is recourse, none of A's limited partners have guaranteed the debt and A's general partner is a corporation with limited assets. While B is optimistic as to the property's potential, it wants to be compensated for the risk associated with development; thus, the note is structured as a mid-term instrument with 10% interest payable annually, and an "equity kicker" payable at maturity of 50% of the excess of the property's value at maturity over $20,000,000. A expects development to be completed by maturity and the property to be fully occupied. It intends to retire the initial debt by refinancing it on maturity. Both parties expect the investment to have a 20%-25% internal rate of return, based on reasonable projections. If the equity kicker is treated as part of the debt instrument, the Regs. Sec. 1.1275-4(b) NBM applies to this transaction, because the debt instrument was issued for cash.

Because a Regs. Sec. 1.1275-6 hedge is not available and A does not have any outstanding debt with similar terms, there is little guidance as to the determination of the comparable yield or projected payment schedule under Regs. Sec. 1.1275-4(b). Regs. Sec. 1.1275-4(b)(4)(i)(A) requires an accrual at least equal to the AFR, but the 10% stated rate exceeds the current mid-term annual AFR. Probably the best measure of a comparable yield is the parties' expectation of a 20%-25% internal rate of return; this is likely to be the rate that A would have to pay if it issued a fixed rate instrument with similar terms. This issue, if brought up during loan negotiations, might have persuaded B not to enter into the loan; not only is there an income inclusion before the receipt of cash (as is always the case when there is OID from deferred interest), but also, there is an income inclusion in advance of a legal obligation that may never occur. If B insisted on a lower comparable yield, the IRS might find the lower rate unreasonable. Resolution of the comparable yield issue may well depend on the debtor's and creditor's relative bargaining positions; in this example, B will receive sufficient noncontingent cash to cover the taxes on the accrued interest (including interest attributable to the contingency). Thus, B may be willing to accept a comparable yield of 20%.

Assuming that a 20% yield is the comparable yield, a projected payment schedule must then be constructed. Because the contingency is nonmarket-based, its value is the expected value as of the issue date that would result in the comparable yield ($14,883,200 to create a 20% yield to maturity). The chart on page 438 provides the projected payment schedule and the AIP after each payment.

Column E lists the interest income that B must include in income each year and that A can deduct (beginning AIP X 20%). If the value of the property on Dec. 31,2001 is such that the contingent payment, when made, is $14,883,200, no additional interest income or expense will result to B and A, respectively (such amount would have already been included in income or deducted over the term of the loan based on the comparable yield). A positive adjustment will result if the actual contingent payment is greater than the projected and will be treated as additional interest by both A and B in the year the contingency is paid (i.e., at maturity).

If the actual contingent payment is $5,000,000, a net negative adjustment of $9,883,200 ($14,883,200 -- $5,000,000) win result. Interest accrued during the note's final year would first be reduced by the net negative adjustment ($6,147,200 -- $9,883,200), leaving B no interest income for 2001 and a $3,736,000 ordinary loss. The $3,736,000 loss is not limited, because B has previous interest income in excess of that amount that was not reduced by previous net negative adjustments. A win have no interest deduction for 2001 and must include the $3,736,000 in ordinary income in that tax year.

If the actual contingent payment is less than the projected payment, the tax consequences to the debtor are quite favorable, particularly if there is a significant period of time between the debt instrument's issue date and the occurrence of the contingency. In the example, if the contingency is $5,000,000 instead of the projected $14,883,200, A has overaccrued $3,736,000 of interest deductions over four years with no cash outlay and at the cost of including $3,736,000 in income in year 5; thus, A has a large time value of money benefit.

This result could change if the Service determined the comparable yield and the projected payment schedule to be unreasonable; it would seem unlikely in the above example unless the Service could show the requisite intent to overstate deductions based on A's limited partners' circumstances. Even though A did not lose money, presumably its partners were anticipating a much more successful venture.

On the other hand, B had the worst of both worlds: it was forced to overstate income for four years and did not receive the total amount of cash anticipated.

B could have employed any of several strategies to avoid this problem. First, to the extent that the comparable yield is part of a range of reasonable, well-documented and well-supported possible comparable yields, B could have insisted on either the lowest yield in the range or a noncontingent cash flow to meet the tax liability created by the income accrual caused by the contingencies incorporated in the projected payment schedule. Second, it is preferable to have possible contingencies throughout the term of the debt, rather than one contingency at maturity; however, this may create additional costs (e.g., for appraisals, etc.).

Finally, when it is obvious that the contingency has been overvalued, a creditor can avoid the overaccrual either by selling the instrument (if possible) or by modifying its terms such that an exchange is deemed to have occurred under Regs. Sec. 1.1001-3. Any loss on sale is ordinary to the extent that the creditor's total interest inclusions exceed any previous net negative adjustments not deducted as ordinary losses.

For example, changing the instrument from contingent to noncontingent would most likely create a significant modification under Regs. Sec. 1.1001-3(e). A significant modification of the debt instrument creates a loss on the deemed exchange under Sec. 1001(a) if the modified debt instrument's issue price is less than the creditor's adjusted basis in the previous debt instrument, unless the exchange is a nonrecognition transaction (e.g., a recapitalization of a corporate issuer). If the new, modified debt instrument also has a contingency and is subject to Sec. 1274 (nonpublicly traded debt exchanged for nonpublicly traded property), the contingency will be subject to the Regs. Sec. 1.1275-4(c) wait and see rules, not the Regs. Sec. 1.1275-4(b) NBM. However, if the principal purpose of the modification was to substantially reduce the present value of the holder's tax liability by avoiding the NBM through creating an issue price determined by Sec. 1274, the Service could still apply the NBM under the Regs. Sec. 1.1275-2(g) anti-abuse rules.(7) In any event, a debtor would undoubtedly demand additional consideration for any modification, because it will most likely have to realize income in the amount of loss realized by the creditor.

Conclusion

The CPDI final regulations allow a debtor to accrue interest deductions prior to the occurrence of the contingency under the NBM. When information exists to readily determine a comparable yield and the projected payment schedule is based on market-based contingencies, the regulations will be fairly easy to apply. However, when the comparable yield is not as clear and the contingencies are nonmarket-based, the regulations offer scarce guidance other than an admonition to maintain contemporaneous documentation and act in good faith.

Unfortunately, even with contemporaneous documentation, opinions can differ as to whether a particular comparable yield or projected payment schedule is reasonable. Reasonableness, of course, should be determined based on the facts and circumstances when the instrument is issued. But when the projected and actual nonmarket-based contingencies differ greatly, will an IRS examiner use hindsight to infer a prohibited purpose to accelerate or defer interest deductions or income and find the issuer's comparable yield or projected payment schedule unreasonable? What if some (but not all) of the holders benefit from income acceleration or deferral? For example, what if some of the holders have large expiring net operating losses (NOLs) and the projected payment schedule of contingencies is much greater than their actual amount?(8) What if the comparable yield determined by a corporate issuer is slightly less than the threshold for determining an interest limitation (e.g., the Sec. 163(a)(5) applicable high-yield discount obligation rules), but the actual amount of the contingency that occurs years later suggests a much-greater yield was arguably more appropriate?(9)

A problem with Regs. Sec. 1.1275-4(b) is that the determination of a comparable yield in many cases is, realistically, nothing more than a guess. Start-up companies, real estate developers and over-leveraged companies all borrow money with nonmarket-based contingencies. The guidance in the regulations regarding a comparable yield and the existence of a possible Regs. Sec. 1.1275-6 or similar debt traded at a benchmark will not be applicable to many debtors. Often, it is difficult to clearly identify the rate at which a borrower may borrow money, because all lenders will insist on some type of contingent interest for that particular borrower.

The determination of the comparable yield and projected payment schedule may also depend on the debtor's and creditor's relative bargaining positions. A creditor may not be willing to loan funds without the issuer agreeing to a lower comparable yield and projected payment schedule, particularly if the holder is willing to live with the risk of additional income because the possible occurrence of the contingency has a wide range of probabilities. However, if the resulting payment schedule is found unreasonable, the issuer may run the risk of interest deductions attributed to closed tax years, particularly when the contingency occurs at maturity.

The regulations' lack of guidance on determining a comparable yield or projected payment schedule will subject debtors to IRS second-guessing and hindsight; courts may well have to decide reasonableness in a given set of circumstances. Possibly, the Service should consider some type of safe-harbor rate in such circumstances. The Service might also consider a rebuttable presumption when the debtor and creditor agree to a certain comparable yield and projected payment schedule; otherwise, the uncertainties surrounding nonmarket-based contingent payments may result in a reduction of the use of CPDIs for nonmarket-based contingencies.

(1) TD 8674 (6/11/96), IRB 1996-28, 7.

(2) LR-189-84 (4/8/86), 1986-1 CB 820; FI-189-84 (5/7/91),1991-1 CB 834; FI-59-51 (12/16/94), 1995-1 CB 894.

(3) FI-59-51, id.; TD 8674, note 1. In addition to rules on CPDIs, additional regulations were issued (or amended) as part of TD 8674, addressing such issues as the amount realized on receipt of a CPDI (Regs. Sec. 1.1001-1(g)), remote and incidental contingencies (Regs. Sec. 1.1275-2(h)), debt instruments with contingent payment schedules (Regs. Sec. 1.1272-1(c)), debt instruments with indefinite maturities (Regs. Sec. 1.1272-1(d)), the issue price of a nonpublicly traded debt instrument issued for nonpublicly traded property (Regs. Sec. 1.1274-2(g)), variable rate debt instruments (Regs. Sec. 1.1275-5) and tax-exempt debt instruments with contingent payments (Regs. Sec. 1.1275-4(d)). As is discussed later, a new concept was introduced in Regs. Sec. 1.1275-6 to allow taxpayers to integrate debt instruments with any offsetting (i.e., hedge) positions entered into at the same time; integration enables the taxpayer to net the different income and expense cash flows to arrive at a single overall rate that will be treated consistently for most tax purposes.

(4) However, if the nondebt contingent obligation is exchanged for property, Sec. 483 may apply; see Regs. Sec. 1.483-4(b), Example (2).

(5) Regs. Sec. 1.1275-6(b)(4) defines a synthetic debt instrument as the hypothetical debt instrument with the same cash flows as the combined cash flows of the qualified debt instrument (QDI) and the Regs. Sec. 1.1275-6 hedge.

(6) Compare Regs. Secs. 1.1275-4(b)(3)(iii) and 1.1272-1(b)(1)(iv).

(7) See Regs. Sec. 1.1275-2(g)(3), Example (2).

(8) If the instrument was marketed to holders with NOLs, the Regs. Sec. 1.1275-4(b)(4)(i)(B) presumption might apply.

(9) See Sec. 163(e)(5) and (i); presumably, the comparable yield applies to these rules.