IRS limits "qualified stated interest" on debt instruments.

The IRS has recently issued a revenue ruling that could significantly expand the universe of original issue discount (OID) instruments. Under the terms of this ruling, many debt instruments that were previously thought to have current pay interest and, thus, no OID, may now have OID.

In determining whether a debt instrument has OID, one looks at the excess of the stated redemption price at maturity over the instrument's issue price. The stated redemption price at maturity is defined as all payments due under the debt instrument that are not qualified stated interest. Qualified stated interest is defined as stated interest unconditionally payable at least annually at a single fixed rate. Interest is considered unconditionally payable (according to Regs. Sec. 1.1273-1 (c) (1) (ii)) only if late payment or nonpayment of the interest is expected to be penalized or if reasonable remedies exist to compel payment. Interest is not considered to be unconditionally payable if the lending transaction is not at arm's length or if the holder does not intend to enforce any remedies. The possibility of nonpayment due to default, insolvency or any other circumstances is ignored for purposes of determining whether interest is unconditionally payable.

In Rev. Rul. 95-70, the Service further defined when interest was or was not unconditionally payable. The facts of the ruling cover two situations, one in which the penalty for nonpayment of interest was the inability to pay dividends, and the other, when an additional 2% interest was charged on past due interest payments. In both instances the holder had the ability to sue for payment after the issuer's failure to make interest payments for 12 consecutive quarters. In neither circumstance did the IRS find the penalty sufficient for the interest payments to rise to the level of unconditionally payable.

In the first case, the Service reasoned that the dividend restriction on the issuer's stock was not a real penalty within the meaning of the regulations because it did not inure directly to the holder's benefit.

In the second case, debt was issued with a stated interest rate of 8% and a 10% penalty rate of interest accrued on past due interest. Although the benefit of the penalty accrued to the holder, the IRS ruled that a 2% differential was an insufficient penalty to ensure with reasonable certainty that the issuer would make interest payments when due. According to the ruling, there may be circumstances in which the benefit of deferring payments of the interest exceeds the additional interest penalty. The ruling went on to suggest that if the penalty interest rate was high enough, it might, in certain circumstances, constitute sufficient penalty to make the interest unconditionally payable. A penalty interest rate 12 percentage points higher than the effective yield was suggested as possibly being sufficient penalty; thus, on a note with an effective yield of 8%, the penalty rate would have to be 20%.

If the principles of Rev. Rul. 95-70 are applied, many debt instruments may have OID rather than qualified stated interest. While this may not change the amounts that accrue over the life of a loan if the loan remains on current status, it could significantly change the traditional treatment of interest on loans of doubtful collectibility. The Service recently issued Letter Ruling (TAM) 9538007, disclosing its view on the accrual of OID on loans of doubtful collectibility. The TAM requires the holders of OID instruments to include the OID in income as it accrues, despite the fact that the issuer is in dire financial straits and the doubt regarding collectibility of the debt is high.

The ruling and the TAM could cause lenders to rethink the terms they offer to borrowers, specifically in the area of restructured loans when collectibility may be more uncertain from the outset. They may want to review the terms under which the loan is considered in default and the point at which they can take legal action against the borrower in conjunction with any amounts of penalty interest that may be charged.

From Henry C. Ruempler, Esq., Washington, D.C.