NYSBA Members Suggest Further Guidance on Debt Instruments

Dear Sirs:

We write to suggest some supplemental guidance to Revenue Procedure 2008-51.

In Revenue Procedure 2008-51, the Internal Revenue Service provided that, under certain circumstances, it will not treat a debt instrument that has an issue price that is less than the amount loaned to the borrower as an "applicable high yield discount obligation" ("AHYDO").

The Revenue Procedure contemplates the situation where a lender makes a term loan to a borrower. Subsequently, market conditions deteriorate and, while acting in the capacity of an underwriter for purposes of Treasury regulations section 1.1273-2, the lender sells a substantial amount of the term loan to third parties for an amount that is significantly less than the amount loaned to the borrower under the term loan. Under Section 4.01 of the Revenue Procedure 2008-51, if certain conditions are satisfied, the IRS will not treat the loan as an AHYDO.

The Revenue Procedure also contemplates the situation where lender makes a temporary ("bridge") loan to a borrower, and by reason of deteriorations in market conditions, the borrower is not able to refinance the bridge loan. Subsequently, the bridge loan is modified or exchanged for another debt instrument issued by the borrower in order to facilitate the syndication by the lender. If the modifications to the loan or the exchange of the loan constitute a "significant modification" of the loan within the meaning of Treasury regulations section 1.1001-3, and the "new" debt instrument is treated as traded on an established securities market under Treasury regulations 1.1273-2, the issue price of the "new" debt instrument may be significantly less than the amount initially loaned to the borrower. Under Sections 4.02 and 4.03 of the Revenue Procedure 2008-51, if certain conditions are satisfied, the IRS will not treat the "new" debt instrument as an AHYDO.

Although Revenue Procedure 2008-51 was designed to provide relief to borrowers, it fails to address the potential recognition of cancellation of indebtedness income ("CODI") by borrowers described in Sections 4.02 and 4.03 of the Revenue Procedure and, therefore, is not as helpful as it might be. We offer several suggestions to address the potential CODI recognition in these situations. First, the IRS could permit the CODI recognized by a borrower described in Section 4.02 or 4.03 of the Revenue Procedure to be amortized into income over the term of the debt instrument as an offset to the corresponding amount of original issue discount ("OID") deductions that arise as a result of the issue price of the debt instrument being less than the amount initially loaned to the borrower. We believe that the IRS has regulatory authority under section 446(b) to provide for this treatment. However, if this treatment is adopted, we note that taxpayers that are not described in the Revenue Procedure may take the position that they can amortize the CODI that arises from consensual modifications of their debt.

Alternatively, the lender could be treated as a "principal" and not as an "underwriter" for purposes of Treasury regulations section 1.1273-2. If the lender is treated as a principal, and the modifications to the loan or the exchange of the loan do not constitute a "significant modification" of the loan within the meaning of Treasury regulations section 1.1001-3, then the issue price of the loan would be the amount loaned to the borrower, and neither CODI nor OID would arise. However, this solution would result in the debt purchased by a third party as having been acquired with market discount, rather than OID. Market discount is not generally required to be accrued and included in income currently. Nevertheless, treatment of the discount as market discount does not appear inconsistent with the lender's recognition of an economic (and tax) loss from the transaction.

Another alternative would be to suspend application of Treasury regulations section 1.1273-2(f)(4), (f)(5) and (f)(6) to the situations described in the Revenue Procedure. However, this alternative may be difficult to justify where the debt clearly is traded on an established market. A third alternative would be to modify application of Treasury regulations section 1.1001-3 in the situations described in the Revenue Procedure. However, this alternative may be difficult to justify from a policy perspective, particularly where material changes are made to the debt instrument.

We note that, because the Revenue Procedure does not affect the OID issue price rules, a borrower that applies Section 4.01 of the Revenue Procedure appears to obtain a tax windfall in the form of OID deductions that do not economically reflect an increased cost of the borrowing to the borrower. We believe this windfall is inappropriate. A possible solution to avoid the windfall would be to require a borrower that applies Section 4.01 of the Revenue Procedure to amortize into income the difference between the amount loaned and the OID issue price as an offset to the corresponding OID deductions. We believe that the IRS has regulatory authority under section 446(b) to provide for this treatment.

We also address some issues that arise when an initial bridge loan is replaced with permanent financing pursuant to a securities demand (which generally requires the borrower to issue replacement "demand securities" to the initial lender or one of its affiliates). We suggest that the Revenue Procedure could be clarified to indicate that it applies to demand securities.

Finally, we offer certain other technical comments on the Revenue Procedure.

We appreciate your consideration of our comments. Please let us know if you would like to discuss these matters further or if we can assist you in any other way.

Section 163(i)(5) provides that "[t]he Secretary shall prescribe such regulations as may be appropriate to carry out the purposes of [Section 163(i) and (e)(5)], including . . . regulations providing for modifications to the provisions of [Section 163(i) and (e)(5)] in the case of . . . other circumstances where such modifications are appropriate to carry out the purposes of [Section 163(i) and (e)(5)]."

Section 163(e)(5) provides that the issuer's deductions for OID on an AHYDO in excess of AFR plus 6% are permanently disallowed, and the remaining deductions for OID are deferred until the OID is actually paid in cash or property (other than debt of the issuer). For this purpose, a partnership is treated as an aggregate of its partners, and each partner that is a corporation is treated as issuing its share of the AHYDO for purposes of determining the deductibility of its allocable share of OID on the AHYDO.⁵

The AHYDO rules were aimed at long-term high-yield instruments that postpone payments of interest (i.e., interest accrues in the form of OID or is "paid in kind") because those instruments have characteristics of equity, and they were also intended to minimize tax incentives for the use of these types of instruments in highly levered corporate acquisitions and restructurings.⁶

The commitment papers will contain the parties' agreement on the significant terms and conditions of the loans (e.g., principal amount, maturity date, principal amortization schedule, provisions concerning mandatory and optional principal prepayments, use of proceeds of the loans, interest rate, fees, covenants, events of default, collateral and guarantees by the borrower's affiliates). Under the commitment papers, subject to certain conditions, the initial lenders typically will have the right to sell or syndicate their financing commitment (prior to the closing) and/or the loans (or participations in the loans) to a group of banks, financial institutions and other institutional lenders.⁸ In some cases, the initial lenders will have the right to change certain terms of the loans (e.g., the interest rate and covenants), within agreed-upon parameters or subject to agreed-upon limitations, prior to the closing and funding of the loans in order to facilitate a successful syndication of their financing commitment (a so-called "market flex"). This right to change the terms of the loans under a market flex is typically exercisable in consultation with, but without the consent of, the borrower.

Under some commitment papers, the initial lenders' right to change the terms of the loans extends for a period of time after the loans are closed and funded by the initial lenders until the loans have been successfully syndicated. In addition, after the closing and funding of the loans, the borrower and the initial lenders may agree upon additional changes to the loans' terms to facilitate the initial lenders' syndication of the loans to third parties.

The bridge loans will have an initial term (typically one year) and will be prepayable by the borrower (usually without premium or penalty) at any time during the initial term at the borrower's option. During the initial term, the interest rate on the bridge loans will periodically increase up to an agreed-upon maximum rate (which may be a spread to an index or a specific benchmark). At the end of the initial term, the bridge loans, if not fully repaid by the borrower, will often automatically convert or be exchanged into the same principal amount of term loans of the borrower ("replacement loans"), unless a bridge lender elects to convert its bridge loans (in whole or in part) into an equivalent principal amount of notes issued by the borrower ("replacement notes"). Thereafter, a bridge lender usually can elect to exchange its replacement loans for an equal principal amount of replacement notes (generally so long as some minimum amount of replacements loans are being exchanged).

The significant terms and conditions of the replacement loans and replacement notes generally are contained in the commitment papers. Typically, the replacement loans have many of the same terms as the bridge loans (including that they are prepayable by the borrower, usually without premium or penalty, at any time), although the interest rate usually is higher than the interest rate on the bridge loans and may increase periodically up to an agreed-upon maximum rate. The interest rate on the replacement notes typically becomes fixed at the rate then applicable to the replacement loans (or bridge loans) at the time the replacement loans (or bridge loans) are exchanged for the replacement notes. The term to maturity of the replacement notes is usually the same as the term to maturity of the replacement loans (typically 8-10 years from the initial closing and funding of the bridge loan). The replacement notes are generally structured to follow the form of high-yield debt securities and will have features, including covenants and prepayment protections, comparable to market conventions for high-yield debt securities.

As the bridge loans are intended to be temporary financing and the initial lenders (or other holders of the bridge loans) typically do not want to hold the bridge loans or replacement loans on a long-term basis, the overall terms of the bridge loans and the replacement loans are designed to give the borrower an economic incentive to repay them with the proceeds of a bond offering, other debt financing or an offering of equity. Similarly, the purpose of allowing for replacement notes is to enable the initial lenders to approach, and sell the replacement notes to, institutional bond buyers, whereas the replacement loans allow the initial lenders to try to sell the replacement loans to buyers that are traditionally more interested in institutional loans.

In addition, the commitment papers will provide that, if any bridge loans are made during a specified period of time after their issuance (and frequently, particularly in the current market environment, before any bridge loans are required to be made), the initial lenders (or affiliates of the initial lenders that are securities underwriters) may from time to time (and, in better market conditions, for a limited number of times) require that the borrower issue and sell to underwriters debt securities (and, in rare instances, equity or equity-linked securities) at par, the proceeds of which will be applied to repay the bridge loans and also any outstanding replacement loans received in exchange for the bridge loans after their initial term. (This right of the initial lenders or their affiliates to require the borrower to issue debt, equity or equity-linked securities is referred to as a "securities demand" and the securities that are issued are referred to as "demand securities.")

The terms and conditions of the demand securities are not fully contained in the commitment papers. Rather, the commitment papers usually provide that the demand securities will contain terms that take into account prevailing market conditions as determined by the underwriters. In certain circumstances, when market conditions are more favorable, the commitment papers may provide that the demand securities will contain customary and typical provisions for similarly situated companies or as received by affiliates of an equity sponsor. Also, in better market conditions, the commitment papers may provide for periods when demand securities are not required to be issued by the borrower. The interest rate on the demand securities generally is subject to a maximum interest rate contained in the commitment papers, and the commitment papers generally provide that the term to maturity of the demand securities is not longer than that of the replacement notes. The terms and conditions of the demand securities, when they are required to be issued, frequently wind up being the subject of extensive negotiations between the borrower and the underwriters.

II. Cancellation of Indebtedness Income.

The Revenue Procedure was designed to provide relief to borrowers. However, it fails to address the potential recognition of cancellation of indebtedness income ("CODI") by borrowers in Situations 2 and 3⁹ and, therefore, is not as helpful as it might be. In some cases, these borrowers may not have sufficient net operating losses to completely shelter the CODI. In this regard, we note that the recognition of CODI by distressed borrowers in this economic environment is not limited to borrowers within the scope of the Revenue Procedure. Solvent borrowers that are distressed but not in bankruptcy and whose publicly-traded debt trades below par also recognize CODI as a result of consensual debt modifications.¹⁰

A. Section 108(e)(10). Section 108(e)(10) provides that, for purpose of determining whether a borrower recognizes CODI upon issuance of a debt instrument (the "New Debt") in satisfaction of another debt instrument (the "Old Debt"), the borrower is treated as having satisfied the Old Debt with an amount of money equal to the issue price of the New Debt. Section 108(e)(10) indicates that the issue price of the New Debt is determined under Sections 1273 and 1274, applying Section 1273(b)(4) by reducing the stated redemption price of the New Debt by the portion of the stated redemption price that is treated as interest under the Code.¹¹ The legislative history indicates that CODI is recognized only if the exchange constitutes a realization event under Section 1001.¹²

Neither the statute nor the legislative history grants any express regulatory authority to the Secretary to modify the provisions of Section 108(e)(10). The legislative history to Section 108(e)(10) provides that: "The amount of COD created on a debt-for-debt exchange is properly determined by comparing the adjusted issue price of the old obligations being discharged to the issue price of the new obligations, and that [sic] the OID rules, as modified by the bill, provide the appropriate framework for determining the issue price of a new obligation."¹³ In addition, in repealing Section 1275(a)(4),¹⁴ Congress indicated that the OID issue price rules apply to holders that receive a new obligation in a debt-for-debt exchange such that OID may be created for the holder, as well as gain or loss recognition where the exchange is a Section 1001 realization event that does not qualify as a tax-free reorganization.¹⁵

B. Application to Revenue Procedure. CODI would arise where the exchange of Debt Instrument A for Debt Instrument B in Situation 2 and/or the exchange of Debt Instrument B for Debt Instrument C in Situation 3 constitutes an actual or deemed exchange under Treas. Reg. Section 1.1001-3, and the issue price of Debt Instrument B is less than the adjusted issue price of Debt Instrument A in Situation 2 and/or the issue price of Debt Instrument C is less than the adjusted issue price of Debt Instrument B in Situation 3. In some cases, it may be not be certain whether these exchanges constitute an actual or deemed exchange.¹⁶ Consider the following example:

However, the borrower in this example has not recognized any economic "accretion of wealth"²⁰ because the borrower is contractually obligated to repay the exact same amount that it originally borrowed under the bridge loan. Similarly, the $30 million total discount at which the replacement loan and replacement notes were sold by the initial lender does not economically increase the yield of the borrower's indebtedness now represented by the replacement loans and the replacement notes. Rather, the $30 million discount represents the initial lender's total economic loss on the transaction.

A possible solution to avoid this result is to permit the amount of any CODI recognized by the borrower in Situation 2 and/or Situation 3 to be amortized into income over the term of the debt instrument as an offset to the corresponding amount of OID deductions created by such debt instrument's issue price being treated as less than the amount of the gross cash proceeds received by the borrower in Situation 1.²¹

We believe that the Treasury Department has regulatory authority under Section 446(b) to provide for this treatment. Section 446(b) provides that if the method of tax accounting used by a taxpayer does not clearly reflect income, taxable income is computed under such method as, in the opinion of the Treasury Department, clearly reflects income. Thus, Section 446(b) grants authority to the Treasury Department to exercise its discretion in prescribing methods of accounting. The IRS has interpreted this authority broadly: Treas. Reg. Section 1.446-1(a)(2) provides that "no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income." The Supreme Court has confirmed that the IRS has wide discretion to establish methods of tax accounting that clearly reflect income.²² Moreover, this exercise of discretion should be available even in a situation where a method of accounting is not authorized by the Code but results in clear reflection of income.²³

Although Section 446(b) itself does not explicitly provide the Treasury Department with authority to issue rules and regulations, authority is found in Section 7805(a), which provides that the Treasury Department "shall proscribe all needful rules and regulations for the enforcement of this title, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue."²⁴

The Treasury Department has previously issued regulations under Section 446(b) that require specific methods of accounting with respect to certain types of transactions. For example, in Treas. Reg. Section 1.446-3, the Treasury Department prescribed specific accounting rules governing the timing of reporting of income, deductions, gains and losses related to notional principal contracts, requiring that income associated with nonperiodic payments be taken into account over the duration of the contract, rather than at the time of the payment or receipt.²⁵ Similarly, in Treas. Reg. Section 1.446-4, the Treasury Department prescribed the accounting method that must be used to account for hedging transactions, requiring that income, deduction, gain and loss be reported on a basis that matches the timing of the income, deductions, gains or loss from the item being hedged, rather than simply when realized.²⁶

The preamble to Treas. Reg. Section 1.446-4 in its proposed form indicated that "the proposed regulations invoke the Commissioner's authority under sections 446(b), 451, and 461 to require that a taxpayer's method of accounting for hedging transactions clearly reflect income" and that "[i]n general, the proposed regulations require a taxpayer that enters into a hedging transaction as defined in 1.1221-2(b) to reasonably match the timing of income, deduction, gain, or loss from the hedging transaction with the timing of income, deduction, gain, or loss from the item being hedged."²⁷

One issue with this solution is the possibility that taxpayers that are not described in the Revenue Procedure will take the position that they may amortize CODI that arises from consensual modifications of their debt. Although a revised Revenue Procedure could expressly preclude that ability, we have trouble identifying a principled basis to permit the borrowers described in the Revenue Procedure to amortize their CODI but not borrowers that consensually modify their outstanding debt.

An alternative solution for cases that do not involve debt that is traded on an established market for OID purposes would be to treat the underwriter in the example as a "principal," and not as an "underwriter," for purposes of Treas. Reg. Section 1.1273-2.²⁸ Treas. Reg. Section 1.1273-2(e) provides that sales to "bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters, placement agents, or wholesalers" are not taken into account for purposes of determining the issue price and issue date of a debt instrument under Treas. Reg. Section 1.1273-2. It appears that Treas. Reg. Section 1.1273-2(e) is intended to apply to situations where debt instruments are sold to third parties relatively close in time to their issuance and to exclude from determination of the issue price an underwriter's customary discount at which it purchases the debt instruments from the borrower.²⁹ The regulation does not contemplate a situation where an initial lender makes a firm commitment to make a loan, thereby bearing market risk, is separately compensated for its services, and suffers an economic loss from selling the debt instruments for less than the amount it loaned to the borrower (net of fees). In these cases, it may be possible to view the initial lender as acting in the capacity of a principal in the transaction. If the initial lender is treated as a principal, then the issue price under Treas. Reg. Section 1.1273-2 is the amount loaned to the borrower.³⁰ We note, however, that this alternative would result in the discount at which the debt instruments are ultimately sold to third parties being treated as market discount, rather than OID.³¹ Nevertheless, treatment of the discount as market discount does not appear inconsistent with the initial lender's recognition of an economic (and tax) loss on the transaction.

With respect to Situations 2 and 3, another alternative would be to suspend application of Treas. Reg. Section 1.1273-2(f)(4),³²(f)(5)³³ and/or (f)(6).³⁴ However, this alternative may be difficult to justify where a debt instrument clearly is traded on an established market.

As mentioned above, CODI is triggered only if the transaction involves a realization event under Section 1001. Accordingly, a final possibility would be to modify application of Treas. Reg. 1.1001-3 in situations covered by the Revenue Procedure. However, this alternative may be difficult to justify from a policy perspective, particularly where material changes are made to the terms of the debt instruments in Situations 2 and/or 3 pursuant to negotiations between the initial lender and the borrower occurring after they entered into the financing commitment.

Second, we understand that some borrowers have taken the position that they do not recognize CODI in the fact pattern in this example under the theory that the borrower repaid the bridge loan to the initial lender at par, and the underwriter, an affiliate of the initial lender, purchased and sold the high-yield debt securities at a $30 million loss.³⁶ Alternatively, these borrowers argue that the form of the transaction should be disregarded, and that there is no deemed exchange under Treas. Reg. Section 1.1001-3 when the bridge loan is refinanced with the high-yield debt securities, and therefore no CODI. Regardless of whether or not the form of the transaction is respected, the issue price of the high yield debt securities appears to be $70 million (in the latter case, assuming the initial lender is acting in the capacity of an underwriter in the transaction, as opposed to a principal,³⁷ in making the bridge loan). If the issue price of the high-yield debt securities is $70 million, then the borrower has $30 million of OID deductions. Absent recognition of CODI by the borrower, the borrower appears to obtain a tax windfall by reason of the $30 million of OID deductions. We do not believe that a windfall to the borrower is the appropriate result.

A possible solution is that, in cases where borrower reports CODI as a result of such a transaction, as discussed above, the CODI would be amortized into income as an offset to the corresponding OID deductions (not limited by the AHYDO rules pursuant to the Revenue Procedure) under the authority of Section 446(b). In situations where the borrower does not report CODI but reports OID deductions (not limited by the AHYDO rules pursuant to the Revenue Procedure), as discussed below, the borrower would be required to amortize into income the excess of (x) the gross cash proceeds received by the borrower from the bridge loan over (y) the issue price of the demand securities used for purposes of computing those OID deductions, as an offset to the corresponding OID deductions.

III. Additional Comments on the Revenue Procedure.

2. Tax Windfall to Borrower. Although the Revenue Procedure makes the AHYDO rules inapplicable to a debt instrument described in Section 4.01 of the Revenue Procedure, the Revenue Procedure does not affect the OID issue price rules. The issue price of Debt Instrument A in Situation 1 will thus be the first price at which a substantial amount of the debt instrument is sold for money to persons other than bond houses, brokers or similar persons or organizations acting in the capacity of underwriters, placement agents or wholesalers.³⁹ In this situation, the borrower appears to obtain a tax windfall in the form of OID deductions that do not economically reflect an increased cost of the borrowing to Borrower, as indicated in the following example:

It is not clear that the borrower is required to treat as income the difference between the gross cash proceeds it receives for the debt instrument and the OID issue price of the debt instruments.⁴⁰ A solution is that a borrower that applies Section 4.01 of the Revenue Procedure, or that otherwise issues a debt instrument that has an OID issue price that is less than the gross cash proceeds received in exchange for the debt instrument, be required to amortize into income, using a constant yield method, the excess of the gross cash proceeds received by the borrower for a debt instrument over the OID issue price of the debt instrument, as an offset to the corresponding OID deductions.⁴¹ We believe that the IRS and Treasury Department have authority to require this method of accounting pursuant to Section 446(b) and the other authorities discussed above in Part II.B. Indeed, the Treasury Department has promulgated analogous rules applicable to (i) issuers of debt instruments issued in debt reopenings, (ii) issuers and holders of debt instruments issued with bond premium and (iii) holders of debt instruments issued with OID and acquired by the holders with acquisition premium, in each case, so that the tax consequences follow the economic consequences to the issuers and holders of the applicable debt instruments.⁴²

3. Date of Financing Commitment. Section 4.01 of the Revenue Procedure requires that the first debt instrument issued by the borrower in Situation 1 be issued pursuant to a financing commitment entered into prior to January 1, 2009. As recent events have demonstrated, the U.S. economy and credit markets are unlikely to recover by January 1, 2009. If they have not recovered sufficiently by January 1, 2009, taxpayers seeking access to the credit markets after that date may still need the relief provided by the Revenue Procedure. Accordingly, a solution would be to extend application of the Revenue Procedure to financing commitments entered into after January 1, 2009. Such an extension could be done in six month increments as economic conditions warrant.

The application of Sections 4.02(4) and 4.03(4) of the Revenue Procedure is unclear in the context of a bridge loan. As mentioned above, at the end of the initial term of a bridge loan (typically one year from its issuance), if the bridge loan is not fully repaid by the borrower, the bridge loan will often automatically convert or be exchanged into the same principal amount of replacement loans or replacement notes. Replacement loans and replacement notes typically have a maturity of 8-10 years from the initial funding of the bridge loan (demand securities typically have a maturity date that does not extend beyond the maturity date of the replacement loans), and the maturity dates of the replacement loans and replacement notes will be agreed upon by borrower and the initial lenders in the commitment papers. In this case, the bridge loan appears to be Debt Instrument A described in Section 4.01 of the Revenue Procedure. Therefore, it is not clear that the replacement loans or replacement notes (or any demand securities) can satisfy Sections 4.02(4) and 4.03(4) of the Revenue Procedure.

A solution is to clarify that Debt Instrument B and Debt Instrument C will satisfy Sections 4.02(4) and 4.03(4) in cases where (1) their maturity dates are agreed upon in the commitment papers evidencing the financing commitment for Debt Instrument A and (2) their actual maturity dates, when issued, are not more than one year later than the maturity dates agreed upon in those commitment papers.

2. Timing of Issuance of Debt Instrument C. Section 4.03(2) of the Revenue Procedure requires that Debt Instrument C be issued within 15 months following the issuance of Debt Instrument A. Section 4.03(2) of the Revenue Procedure applies to debt instruments issued prior to August 8, 2008 even if they were issued under a financing commitment entered into prior to August 8, 2008.

As described above, lenders under a bridge loan usually can elect to exchange replacement loans received at the expiration of the initial term of the bridge loan (typically one year) for an equal principal amount of replacement notes (generally so long as some minimum amount of replacement loans are being exchanged). Accordingly, replacement notes can be issued more than 15 months after the bridge loan (Debt Instrument A) is initially funded.

Prior to the issuance of the Revenue Procedure, taxpayers seeking financing commitments in difficult market conditions would not have sought to limit the time period for issuance of replacement notes to 15 months after the funding of the related bridge loan. Moreover, given recent and current market conditions, taxpayers negotiating financing commitments after the issuance of the revenue procedure may not have the bargaining power to obtain financing commitments that limit the issuance of replacement notes to this 15-month period. In addition, in light of current market conditions, lenders may delay exchanging replacement loans for replacement notes until conditions improve. A solution is to apply Section 4.03 to debt instruments issued prior to January 1, 2010.

3. Stated Redemption Price at Maturity. Sections 4.02(5) and 4.03(5) of the Revenue Procedure require that the stated redemption price at maturity ("SRPM")⁴³ of Debt Instrument B or Debt Instrument C, respectively, not exceed the SRPM of the Debt Instrument A. This requirement does not apply to debt instruments issued before August 8, 2008.

Therefore, the Revenue Procedure may not apply to a debt obligation issued after August 8, 2008 in exchange for Debt Instrument A or Debt Instrument B if the debt obligation provides the borrower with an option to defer payment of interest (which would be added to the principal amount) or provides for "pay-in-kind" interest (i.e., interest that is paid by issuance of additional debt instruments by the borrower). These features were included in terms of bridge loans, as well as replacement loans and replacement notes, contained in commitment papers entered into at the apex of the credit "bubble" (i.e., before August 8, 2008). In addition, the Revenue Procedure does not apply to a debt obligation with these features issued in exchange for Debt Instrument A or Debt Instrument B where the SRPM of the debt obligation exceeds the SRPM at maturity of Debt Instrument A or Debt Instrument B by reason of the debt obligation's term exceeding the term of Debt Instrument A or Debt Instrument B by up to one year as permitted by Sections 4.02(4) and 4.03(4) of the Revenue Procedure. A solution is to apply the Revenue Procedure to situations where the SRPM of Debt Instrument B or Debt Instrument C exceeds the SRPM at maturity of Debt Instrument A as a result of the terms of Debt Instrument B or Debt Instrument C contained in a financing commitment entered into by a borrower prior to August 8, 2008 even if Debt Instrument B or Debt Instrument C is issued after August 8, 2008. In addition the Revenue Procedure could be applied to situations where the SRPM of Debt Instrument B or Debt Instrument C exceeds the SRPM at maturity of Debt Instrument A as a result of the term of Debt Instrument B or Debt Instrument C being longer than that of Debt Instrument A by up to one year.

4. Application to Corporate Partners. As discussed above, the AHYDO rules apply to corporate partners of partnerships. Accordingly, we recommend that it be clarified that the relief afforded by the Revenue Procedure also applies to corporate partners of partnerships.

5. Effective Date. Section 6 of the Revenue Procedure specifies that Sections 4.02(4), 4.02(5), 4.03(4), and 4.03(5) of the Revenue Procedure do not apply to debt instruments issued before August 8, 2008. We suggest that it be clarified that the other sections of the Revenue Procedure do apply to debt instruments issued before August 8, 2008. In addition, we recommend that it be clarified that taxpayers may file amended returns to claim the benefits of the Revenue Procedure.

² Rev. Proc. 2008-51, 2008-35 IRB 562.

³ All section references herein are to the Internal Revenue Code of 1986, as amended (the "Code"), and the Treasury Regulations promulgated thereunder.

⁴ More specifically, under Section 163(i)(2), a debt instrument will have significant OID if (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 Section 1272(a)(5)) ending after the date 5 years after the date of issue, exceeds (2) the sum of (a) the aggregate amount of interest to be paid under the instrument before the close of such accrual period, and (b) the product of the issue price of such instrument (as defined in Sections 1273(b) and 1274(a)) and its yield to maturity.

⁵ Treas. Reg. Section 1.701-2(e) and (f). Example 1. Treatment of a partnership as an aggregate of its partners for this purposes applies regardless of whether any party had a tax avoidance motive in having the partnership issue the relevant debt obligation.

⁶H.R. Rep. No. 101-247, at 1220 (1989).

⁷ We refer to the commitment letter, along with the term sheets attached to it and the other related letter agreements between the borrower and the initial lenders, as the "commitment papers."

⁸ It should be noted that, in normal market conditions (i.e., prior to the current credit "crunch" and even prior to the preceding credit "bubble"), the initial lenders typically fully syndicated their financing commitment prior to the closing and funding of the loans, and it was extremely rare for the initial lenders to fund all of the loans themselves or to fund bridge loans at all. This was also the case in capital markets transactions. Underwriters that entered into firm commitment underwritings (i.e., the underwriters purchased the debt securities from the issuer and then resold them to investors) typically obtained orders from investors to purchase the entire issue of debt securities in connection with the process of pricing the debt securities prior to the closing of the underwriters' purchase of the debt securities from the issuer, and the underwriters rarely were left holding unsold allotments.

⁹ Section 61(a)(12); Treas. Reg. Section 1.61-12(a). A taxpayer does not realize gain or loss from receipt of proceeds upon the issuance of a debt instrument. Treas. Reg. Section 1.61-12(c)(1). Accordingly, satisfaction of the debt instrument for an amount less than its adjusted issue price (i.e., issue price plus or minus previously amortized OID or bond premium) generally gives rise to CODI. Treas. Reg. Section 1.61-12(c)(2)(ii); see Section 108(e)(3).

¹⁰ This issue does not arise for insolvent borrowers and borrowers in bankruptcy. See Section 108(a) (CODI is excluded from a taxpayer's gross income if the related discharge of the taxpayer's indebtedness occurs in a title 11 case or when the taxpayer is insolvent).

¹¹ If a substantial amount of the New Debt is traded on an established market, the issue price of the New Debt is its fair market value on its issue date. If a substantial amount of the New Debt is not traded on an established market but a substantial amount of the Old Debt is so traded, the issue price of the New Debt is the fair market value of the Old Debt on the issue date of the New Debt. If the New Debt provides for adequate stated interest and neither a substantial amount of the New Debt nor a substantial amount of the Old Debt are traded on an established market, the issue price of the New Debt is its stated principal amount. Section 1273 and 1274; Treas. Reg. Sections 1.1273-2 and 1.1274-2. Treas. Reg. Section 1.1273-2(f) describes the conditions under which a debt instrument is treated as traded on an established market, and the New Debt or the Old Debt is so treated if, at any time during the 60-day period ending 30 days after the issue date for the New Debt, either the New Debt or the Old Debt satisfy any of those conditions.

¹² H.R. Rep. No. 101-37, at 84 and Fn. 44 (1990) (indicating in a footnote that "[i]n any case in which an old instrument is exchanged by the holder for a new debt instrument, or in which the terms of an old debt instrument are modified so as to constitute an exchange by the holder, the debtor is treated as having issued a new debt instrument in satisfaction of an old debt instrument," and continuing to explain in the text that, "[t]hus, either or both COD or OID may be created in a debt-for-debt exchange that qualifies as a reorganization, so long as the exchange qualifies as a realization event under Section 1001 for the holder."); see Treas. Reg. Section 1.61-12(c)(2) (repurchase of a debt instrument by an issuer includes the exchange of the debt instrument for a newly issued debt instrument, including an exchange under Section 1001).

¹³ H.R. Rep. No. 101-37, at 83 (1990).

¹⁴ Prior to its repeal, Section 1275(a)(4) provided that the issue price of a debt instrument issued in a Section 368 reorganization in exchange for another debt instrument (the "old debt instrument") would not be less than the adjusted issue price of the old debt instrument.

¹⁵ H.R. Rep. No. 101-37, at 84 (1990).

¹⁶ Under Treas. Reg. Section 1.1001-3, an alteration of a debt instrument that occurs pursuant to the exercise of a unilateral option of a holder to change a term of the debt instrument is not treated as a modification if the exercise of the option does not result in a deferral of, or reduction in, any scheduled payment of interest or principal. An option is treated as a unilateral option only if, under the terms of the debt instrument or applicable law. among other requirements, there does not exist at the time the option is exercised the right of the other party to terminate the instrument. The preamble to the final regulations explains that, because alterations resulting from the exercise of an option that is not unilateral typically involve negotiations between an issuer and holder, the IRS and Treasury Department believed it is appropriate to treat them as modifications and test for significance. T.D. 8675 (June 25, 1996).

As mentioned above, the typical bridge loan is prepayable by the borrower at any lime without premium or penalty. Thus, it appears to be uncertain whether, at the time the bridge loan converts into or is exchanged for a replacement loan, any change in the interest rate or other terms which would otherwise constitute a significant modification under Treas. Reg. Section 1.1001-3 should be disregarded because those changes occur automatically pursuant to the terms of the bridge loan or pursuant to the exercise of a unilateral option by the initial lender. In addition, to facilitate the syndication of the replacement loans or the replacement notes, the Borrower may agree to modifications to the interest rate and other material terms of the replacement loans or the replacement notes not contemplated by the commitment papers that collectively constitute a significant modification under Treas. Reg. Section 1.1001-3. Finally, as mentioned above, the terms and conditions of the demand securities are not fully contained in the commitment papers and, when demand securities are required to be issued pursuant to a securities demand (which is typically made by an underwriter that may be an affiliate of the initial lender), the terms and conditions of the demand securities frequently wind up being the subject of extensive negotiations between the borrower and the underwriter. Accordingly, it appears to be uncertain whether demand securities are issued pursuant to the exercise of a unilateral option by the initial lender.

¹⁷ As discussed below, we request that the meaning of "net cash proceeds" be clarified.

¹⁸ See Treas. Reg. Section 1.1273-2(f)(4) and (f)(5).

¹⁹ This assumes that the issue price of the bridge loan is the amount loaned to the borrower. If the initial lender is not acting in the capacity as an underwriter with respect to the replacement loan, the issue price of the replacement loan would be the amount loaned to the borrower under the bridge loan, and the borrower would not recognize CODI upon the exchange of the bridge loan for the replacement loan.

²⁰Sanford & Brooks Co. v. Comm'r, 35 F.2d 312 (4th Cir. 1929); U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931).

²¹ The CODI recognized by the borrower would be the difference between (i) the gross cash proceeds received by the borrower in Situation 1 ($100 million in Example 1) and (ii) the issue price of the debt instrument (as determined under Section 1273 or 1274) described in Situation 2 or Situation 3 ($70 million in Example 1).

²²U.S. v. Hughes Properties, Inc., 476 U.S. 593 (1986); Thor Power Tool Co., v. Comm'r, 439 U.S. 522 (1979); Hansen v. Comm'r, 360 U.S. 446 (1959); Lucas v. American Code Co., 280 U.S. 445 (1930).

²³ See, e.g., Gertzman, Federal Tax Accounting, ¶ 2.04[1] (Proper Exercise of Discretion), available at RIA Checkpoint (indicating that courts in recent years apparently have found that the Commissioner's discretion is available to permit the use of a method that is expressly prohibited by otherwise applicable Code sections and Treasury regulations if the use of such method is found to reflect income clearly); Johnson v. Comm'r, 184 F.3d 786 (8th Cir. 1999) (where accrual basis taxpayer deferred recognition of income attributable to amount received for a vehicle service contract that was put into an escrow account until repairs were performed or the contract was terminated. Commissioner did not exceed his broad powers when he determined that the method of accounting used by the taxpayer did not clearly reflect income); In re EWC, Inc., 114 F.3d 1071 (10th Cir. 1997) (holding that, although Section 448 precluded the taxpayer from using the cash method, the IRS was permitted to use the cash method because it clearly reflected income). See also Rev. Proc. 2001-10, modifying Rev. Proc. 2000-22 (stating that the IRS exercised discretion under Section 446(b) and Section 471 to except certain taxpayers from the requirement to account for inventories and to allow them to use the cash method of accounting to account for sales of merchandise, which normally must be accounted for on an accrual basis).

²⁴ Section 7805(a). A potential challenge to the authority of the Treasury Department to issue a rule under Section 446(b) that requires taxpayers to use a specific accounting method for a particular transaction might exist on the grounds that Section 7805(a) only grants the Treasury Department the authority to issue "interpretive" rather than "legislative" rules and regulations. However this distinction has largely been ignored by the Supreme Court, which has held that regulations "must be sustained unless unreasonable and plainly inconsistent with the revenue statutes" and that "the role of the judiciary in cases [challenging the validity of an interpretive regulation] begins and ends with assuring that the Commissioner's regulations fall within his authority to implement the congressional mandate in some reasonable fashion." Comm'r v. South Tex. Lumber Co., 333 U.S. 496, 501 (1948) ("must be sustained"); U.S. v. Correll, 389 U.S. 299, 307 (1967) ("role of the judiciary").

²⁵ Treas. Reg. Section 1.446-3(f)(2) (nonperiodic payments generally must be recognized over the term of a notional principal contract in a manner that reflects the economic substance of the contract); see Preamble to Prop. Treas. Reg. Section 1.446-3, 2004-1 C.B. 655 (addressing method of accounting for contingent nonperiodic payments).

²⁶ Treas. Reg. Section 1.446-4(b). Indeed, Treas. Reg. Section 1.446-4(e)(4) could also be the basis for a method of accounting that results in a clear reflection of the borrower's income in this case. To explain, that regulation provides that any gain or loss from a transaction that hedges a debt instrument "to be issued by the taxpayer" is required to be accounted for by reference to the terms of the debt instrument and the period or periods to which the hedge relates. Hedging gain or loss is taken into account in the same periods it would be taken into account if it adjusted the yield of the instrument over the term to which the hedge relates. In Example 1, the initial lender's financing commitment could be viewed as an anticipatory hedge of the borrower's borrowing costs and the $30 million of CODI could instead be viewed as hedging gain to be accounted for under that regulation. See Jeffrey Maddrey and Rebecca Lee, "COD and AHYDO Considerations for Issuers in 'Underwriter Loss' Transactions" (unpublished draft dated June 21, 2008).

²⁷ Preamble to Proposed Treas. Reg. Section 1.446-4, 1993-2 C.B. 615.

²⁸ See Charles Morgan, "Bridge Loans -- Confronting Tax Issues Triggered by the Recent Economic Downturn" at 46-56 (hereinafter referred to as "Morgan").

²⁹ See Morgan at 11-13.

³⁰ See also Treas. Reg. Section 1.1273-2(g) (applicable to cash payments made incident to private lending transactions). This alternative also addresses a practical problem that has arisen under recent market conditions when initial lenders have been unable to sell loans to third parties for weeks or months after their issuance thus leaving the issue price uncertain.

³¹ Under Section 1272, OID is required to be accrued and included in income currently by taxpayers, whereas under Section 1278 a taxpayer is not required to accrue and include market discount in income currently unless the taxpayer elects to do so.

³² Under Treas. Reg. Section 1.1273-2(f)(4), a debt instrument will be treated as publicly traded for OID purposes if it appears on a system of general circulation (including a computer listing disseminated to subscribing brokers, dealers, or traders) that provides a reasonable basis to determine fair market value by disseminating either recent price quotations (including rates, yields, or other pricing information) of one or more identified brokers, dealers, or traders or actual prices (including rates, yields, or other pricing information) of recent sales transactions.

³³ Under Treas. Reg. Section 1.1273-2(f)(5), a debt instrument will be treated as publicly traded for OID purposes if price quotations are readily available from dealers, brokers or traders and the safe harbor from application of this rule is not applicable to the debt instrument. Under that safe harbor, a debt instrument will not be treated as publicly traded for OID purposes if (1) no other debt instrument of the issuer (or any person that guarantees such debt instrument) is publicly traded for OID purposes under Treas. Reg. Section 1.1273-2(f)(2), (3) or (4), or (2) the original principal amount of the issue that includes the debt instrument does not exceed $25 million, or (3) the conditions and covenants relating to the issuer's performance with respect to the debt instrument are materially less restrictive than the conditions and covenants included in the all of the issuer's other traded debt (i.e., the debt instrument is subject to an economically significant subordination provision whereas the issuer's other traded debt is senior), or (4) the maturity date of the debt instrument is more than 3 years after the latest maturity date of the issuer's other traded debt. In practice, it may be difficult for Replacement Loans or Replacement Notes to satisfy any of the prongs of this safe harbor.

³⁴ Treas. Reg. Section 1.1273-2(f)(6) provides that, if there are any temporary restrictions on trading (regardless of whether imposed by the issuer of the debt instrument or another party), a purpose of which is to avoid characterization of the debt instrument as publicly traded for OID purposes, then the debt instrument is treated as publicly traded for OID purposes.

³⁵ Indeed, we are aware of a recent financing commitment that expressly required the borrower to comply with the securities demand even if it experienced material tax consequences (which were understood to be recognition of CODI with the related OID deductions possibly being limited by the AHYDO rules because the Revenue Procedure might not apply). This financing commitment also excluded these tax consequences from the costs required to be taken into account in determining whether the yield to the borrower arising from the issuance of the demand securities exceeded an agreed-upon cap.

³⁶ Undoubtedly, as discussed above, the underwriter would do this only to provide liquidity to the initial lender.

³⁷ If the initial lender is acting as a principal in making the bridge loan, the issue price is the amount loaned, i.e., $100 million. If there is not a deemed exchange under Treas. Reg. Section 1.1001-3 when the demand securities are issued to refinance the bridge loan, the issue price of the demand securities also is $100 million, and the borrower does not recognize CODI and does not have any OID deductions. Regardless of whether the initial lender is acting as an underwriter or principal in making the bridge loan, if there is a deemed exchange under Treas. Reg. Section 1.1001-3 when the demand securities are issued to refinance the bridge loan, the borrower recognizes $30 million of CODI and has $30 million of OID deductions that would not be limited by the AHYDO rules if the Revenue Procedure applies.

³⁸ In this regard, we note that Treas. Reg. Section 1.1273-2(g)(2) provides that, in a private lending transaction, a payment for services made by the borrower to a lender does not reduce the issue price of the debt instrument evidencing the loan. In addition, fees for services and expense reimbursements paid by a borrower to a lender would be amortized on a pro rata basis by the borrower over the life of the debt instrument. Treas. Reg. Section 1.446-5.

³⁹ Treas. Reg. Section 1.1273-2(a) and (e).

⁴⁰ The debt instrument in this example is not issued with "bond premium" because its $70 million issue price does not exceed its $100 million principal amount. Treas. Reg. Section 1.163-13(c) (bond issuance premium is the excess, if any, of the issue price of a debt instrument over its stated redemption price at maturity). It is possible that the hedging rules of Treas. Reg. Section 1.446-4(e)(4) apply, but this is unclear. See note 26 above.

⁴¹ As discussed above in Part II.B., another alternative is that the initial lender would not be treated as an underwriter for purposes of Treas. Reg. Section 1.1273-2, so that the issue price would be the amount loaned to the borrower.

⁴² See Treas. Reg. Section 1.163-7(e) (in a qualified reopening of an issue of debt instruments, the issuer treats the difference between the holder's purchase price for the additional debt instruments and the adjusted issue price of the original debt instruments as an adjustment to the issuer's interest expense for all of the debt instruments, which adjustment is taken into account over the term of all of the debt instruments using a constant yield method); Treas. Reg. Section 1.163-13 (issuer of a debt instrument issued with bond premium amortizes the premium under a constant yield method (in a manner that generally conforms to the method applied to debt instruments issued with OID) as an offset to the amount of interest on the debt instrument that the issuer otherwise would deduct); Treas. Reg. Section 1.1272-2(a) (holder that purchases a debt instrument at a premium does not include any OID in gross income); Treas. Reg. Section 1.1272-2(b)(3) and (4) (holder that purchases a debt instrument at an acquisition premium reduces the amount of OID includible in income by a ratable portion of the acquisition premium).

⁴³ The stated redemption price at maturity of a debt instrument is the sum of all payments provided by the debt instrument other than qualified stated interest payments. Treas. Reg. Section 1.1273-1(b). Qualified stated interest is stated interest that is unconditionally payable in cash or property (other than debt instruments of the issuer), or that will be constructively received under Section 451, at least annually at a single fixed rate or certain qualified floating rates. Treas. Reg. Section 1.1273-1(c); Treas. Reg. Section 1.1275-5(e).