The effect of accrual periods on an AHYDO.

In response to the widespread use of high-yield original issue discount (OID) and paid-in-kind (PIK) debt in acquisitions, Congress added Sec. 163(e)(5) and (i) in 1989. These rules are designed to scale back the issuer's interest deductions on certain debt instruments (DI); Congress felt that a portion of the return on high-yield OID obligations was more akin to nondeductible distributions of corporate earnings with respect to stock than interest; see H Rep't No. 101-386, 101st Cong., 1st Sess. (1989), p. 553. Thus, if a DI triggers the Sec. 163(e)(5) applicable high-yield debt obligations (AHYDO) provisions, a portion of the debtor's OID expense may be disallowed and a portion of the creditor's OID income may be reclassified as a distribution from a corporation subject to Sec. 301.

Qualifying as an AHYDO

For a DI to trigger the AHYDO provisions, the following conditions must be met: (1) the issuer must be a corporation for Federal tax purposes (but not an S corporation) (Sec. 163(e)(5)(A) and (D)); (2) the instrument must have a maturity date of more than five years from the issue date (Sec. 163(i)(1)(A)); (3) the debt must have a yield to maturity (YTM) that equals or exceeds the sum of the applicable Federal rate in effect for the calendar month in which the DI is issued, plus five percentage points (Sec. 163(i)(1)(B)); and (4) the instrument must have "significant OID" (Sec. 163(i)(1)(C)).

On the surface, the above conditions would appear to be mechanical tests that should not have differing results based on the taxpayer's choices. Indeed, the first three tests are basically mechanical, bright-line tests without much room for choice. However, the determination of significant OID has an elective element of which some taxpayers have not taken advantage. The use of a less-than-optimal accrual period may cause a DI to have significant OID and, thus, inadvertently trigger the AHYDO provisions.

Significant OID: Under Sec. 163 (i)(2), a DI has significant OID if the following is true:

1. The aggregate amount which would be includible in gross income with respect to such instrument for periods before the close of any accrual period (as defined in Sec. 1272(a)(5)) ending after the date five years after the date of issue, exceeds the sum of--

2. The aggregate amount of interest to be paid under the instrument before the close of such accrual period; and 3. The product of the issue price of such instrument (as defined in Secs. 1273(b) and 1274(a)) and its YTM.

Accrual period: Sec. 163(i)(2) refers to Sec. 1272(a)(5) for the definition of an accrual period; Regs. Sec. 1.163-7(d) provides that the accrual period for AHYDO purposes must be the same one used for OID accruals (the OID rules are generally contained in Secs. 1271-1275). Sec. 1272(a)(5) provides a definition of accrual period, but also contains language allowing regulations to provide a definition that supersedes the Code. P, egs. Sec. 1.12721 (b) (ii) provides as follows:

Accrual periods may be of any length and may vary in length over the term of the debt instrument, provided that each accrual period is no longer than one year and each scheduled payment of principal or interest occurs either on the final day of an accrual period or on the first day of an accrual period.

Examples

Based on the above definition, a taxpayer can choose different accrual periods over the DI's term, as long as the two aforementioned requirements are met. The following illustrates the potential effect of the selection of an accrual period on a DI.

Example 1: Y Corp. issues a $10,000, six-year DI, for which 16% cash interest accrues and is due monthly for the first three years and 16% PIK interest accrues monthly after year three, but is paid at maturity. All principal is paid at maturity. See Exhibit 1 on p. 515 for an OID accrual table.

The DI would meet the first three AHYDO tests, in that the issuer is a corporation, the term exceeds five years and the YTM exceeds the allowable amount. Y selected a monthly accrual period for the DI's entire term for purposes of the OID calculation and, thus, must use the same accrual period for purposes of the significant OID calculation.

It chose the monthly accrual period in the belief it was required, due to the DI's terms requiring monthly cash payments of interest during the first three years. The choice of monthly accrual periods for the DI's final year causes it to have significant OID and trigger the AHYDO provisions. As a result, a sizable portion of the OID interest deduction would be disallowed; see Exhibit 2 on p. 515 for the monthly significant OID calculation.

Unfortunately for Y, the sole reason the DI triggers the AHYDO provisions is its selection of a less-than-optimal accrual period. Y correctly selected a monthly accrual period for the DI's first three years; however, as was discussed, an accrual period may vary over the DI's term. Thus, Y had the option to switch to an annual accrual period for the DI's final three years, because an annual accrual period meets both requirements of an accrual period (i.e., the period would be no more than one year and the only cash payment during such accrual period would occur on the last day of the accrual period).

Example 2: The facts are the same as in Example 1, except that Y varies the accrual period and selects an annual accrual period in the DI's final year. The DI would not have significant OID and would not trigger the AHYDO provisions; see Exhibit 2 for the "annual" significant OID calculation. No portion of the OID interest expense would be disallowed under the AHYDO provisions.

Conclusion

The foregoing illustrations demonstrate that selecting the proper accrual period for OID purposes and, thus, for significant OID purposes, may be beneficial in trying to avoid the negative implications of the AHYDO provisions.

FROM L. CASEY WECK, CPA, OAK BROOK, IL