Attorneys Urge Further Relief in Guidance on Debt Instruments

We respectfully submit the following comments related to Revenue Procedure 2008-51 (the "Revenue Procedure").

The Revenue Procedure provides material benefits to companies that find themselves in the situations described in Sections 4.01, 4.02 and 4.03 by avoiding the potential disallowance of OID deductions in circumstances where there is little likelihood that the purposes of the applicable high yield debt obligations ("AHYDO") rules are violated. We recommend that the IRS make the approach set forth in the Revenue Procedure permanent. While companies and lenders may be able to protect themselves to some extent from the underlying issues by having wider "flex'" terms and other contractual provisions, given the enormous volatility we are facing in the financial markets, the approach set forth in the Revenue Procedure will continue to have value. We have several technical comments on the Revenue Procedure set out in Sections B and C below.

The Revenue Procedure does not, however, address the much bigger tax problem that companies face in situations covered by Sections 4.02 and 4.03 of the Revenue Procedure -- whether they must recognize cancellation of debt income ("CODI") on the exchange or deemed exchange of old debt for new debt, where their debt is selling at large discounts to face. Borrowers are more concerned with the potential recognition of upfront taxable income and the corresponding obligation to write an immediate check for the associated tax liability than they are with losing or deferring deductions under the AHYDO rules (which can be mitigated in most cases -- albeit with a cash flow cost -- by being bound to make AHYDO "catch-up" payments after the fifth anniversary of the new debt's issuance). While it is true that the relief of the Revenue Procedure generally means that any CODI is eventually offset by OID deductions over the life of the instrument, the timing mismatch creates a substantial economic cost to the borrower.

Moreover, the problem of recognizing CODI in connection with an exchange or deemed exchange of debt instruments has become significantly more widespread than it was when the Revenue Procedure was issued Financial markets are more turbulent and all forms of private debt sell at unprecedented and increasing discounts. We initially saw the CODI and AHYDO issues considered in the Revenue Procedure in leveraged transactions that were agreed to in the first half of 2007 (which was prior to the beginning of the credit crisis) but that closed using bridge debt in the second half of 2007 and in 2008 (which was after the beginning of the credit crisis). Now we are seeing companies with existing permanent debt obtained prior to the credit crisis facing enormous CODI and AHYDO issues on the exchange or deemed exchange of debt instruments. Even with respect to AHYDO issues, the Revenue Procedure does not provide relief in these cases as the existing debt has generally been in place more than 15 months.

A common fact pattern involves a relatively healthy company that defaults on financial covenants in its debt or is concerned that it might default if such covenants are not changed. Given the current turbulence in the financial markets, its debt would sell at a large discount to par. The company seeks to have lenders waive the covenant default and/or modify its debt covenants to avoid a covenant default in the future. While changes to customary financial covenants generally would not result in a deemed exchange on their own,¹ lenders are demanding significant increases to the interest rates on the debt and/or fees as a condition to agreeing to a waiver or change. To the extent such changes produce a deemed exchange of debt under Treas. Reg. § 1.1001-3, the borrower potentially will have significant CODI and AHYDO issues if there is a risk that its debt may be considered publicly traded for purposes of the issue price regulations.

Eliminating the CODI and AHYDO obstacles that stand in the way of borrowers and lenders attempting to adjust to the terms of the current turbulent financial markets is good economic and tax policy, helping both borrowers in the non-financial economy and lenders in the financial system. Thus, we urge the IRS to provide relief for both the CODI and AHYDO issues in the situations addressed in the Revenue Procedure and in the more general cases of debt modification that we are seeing on a regular and continual basis as a result of today's markets.

For example, assume a borrower has outstanding existing debt of $500 million issued without OID, bearing current-pay interest at 10%. The borrower and lenders agree to amend the terms of the debt, increasing the interest rate to 11%, thereby causing a deemed exchange of such debt under Treas. Reg. § 1.1001-3. This may arise in a situation where the borrower and lenders are amending bridge debt to make it into permanent debt in a transaction covered by Section 4.02 or Section 4.03 of the Revenue Procedure. In today's market, it more commonly arises in the situation where the borrower seeks to modify financial covenants in its debt to avoid default and is forced to agree to an increase in interest rates to obtain the lenders' agreement to the change. Such a situation is not covered by the Revenue Procedure if the existing debt has been in place for more than 15 months. Assume further that the lenders would like to sell their stake in the debt to raise cash and limit their exposure to further losses on the debt. Within 30 days of the amendment, certain lenders sell 10% of the debt issue for 65% of its face amount.

If neither the old debt nor the new debt is publicly traded, the issue price of the new debt will generally equal $500 million under Code § 1274 because it bears interest at a rate greater than the applicable federal rate. As a result, the borrower would not recognize CODI and the new debt would not be an AHYDO.

However, if either the old debt or the new debt is considered publicly traded within the 30 days before or the 30 days after the amendment, the issue price of the new debt will generally be the fair market value of the traded debt. As discussed below, in the age of internet markets, there is substantial concern that any debt instrument is or could become publicly traded within the meaning of Treas. Reg. § 1.1273-2. If the new debt is publicly traded, its issue price -- absent guidance from the IRS -- will likely be $325 million in which case the borrower will realize $175 million of CODI as a result of the amendment. Borrowers uniformly express disbelief when informed of this tax result, asking how it is that they could recognize a huge amount of taxable income when they view themselves as worse off economically -- they still owe the same $500 million in principal and are now paying interest at a higher rate. Given the meaningful timing differences, the potential availability of $175 million of OID deductions over the remaining life of the debt (assuming the Revenue Procedure's AHYDO relief applies, which it will not except in the limited circumstances described therein) is of little solace when the borrower is required to write a $61.25 million check to the IRS ($175 million CODI x 35%) for the year of the modification.⁴

In the current crisis where debt of even the most healthy companies is selling for unprecedented discounts to par, a company that modifies the terms of its debt -- e.g., by paying a higher interest rate to obtain covenant changes that will avoid an impending default -- creating a deemed exchange under Treas. Reg. § 1.1001-3, faces a tax disaster if either the new debt or the old debt is publicly traded.

Treasury regulations provide that old or new debt is publicly traded if 30 days before or after the issue date of the new debt, either the old debt or new debt falls in any one of the following categories:⁵

• The debt is "exchange listed property," which is property appearing on a national securities exchange, certain interdealer quotation systems registered under the Securities Exchange Act, or certain foreign exchanges. Treas. Reg. § 1.1273-2(f)(2).

• The debt is "market traded property," which is property of a kind traded on certain boards of trade or on an "interbank market." Treas. Reg. § 1.1273-2(f)(3). It is unclear what might constitute an "interbank market," and many have worried that this has the potential to pick up any debt instrument.⁶

• The debt is property appearing on "a quotation medium." Like the "interbank market" category, this category causes taxpayers to worry that most instruments are (or could easily be) "publicly traded" for purposes of the issue price regulations. It applies to property that:

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  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 (a quotation medium). A quotation medium does not include a directory or listing of brokers, dealers, or traders for specific securities, such as yellow sheets, that provides neither price quotations nor actual prices of recent sales transactions.

   

  Treas. Reg. § 1.1273-2(f)(4).

• Finally, debt is publicly traded if "price quotations are readily available from dealers, brokers or traders." Treas. Reg. § 1.1273-2(f)(5).⁷

Given the limitations imposed by Code § 108(e)(10) (and the repeal of Code § 1275(a)(4)), we believe there are three ways the IRS could provide quick relief to companies facing the potential realization of large amounts of CODI where old debt is exchanged (or deemed exchanged) for new debt. It is critical that this relief be available broadly to all companies that are forced to modify their outstanding debt in today's turbulent markets, not just to those falling in the more narrow fact pattern described in the Revenue Procedure.

The SEC and FASB have taken similar steps regarding the application of FAS Statement 157, Fair Value Measurements, noting that the prices of transactions or quotations in inactive or disorderly markets are not necessarily determinative of fair market value and may require adjustments and the use of other valuation models.¹²

We believe that public trading should be used to determine issue price only where the publicly available pricing information provides a reasonable basis for determining fair market value without the need for adjustments. This conclusion is consistent with the regulations as written. Where adjustments would be needed to make publicly available pricing information reflect fair market value, issue price should be determined under Code § 1274.

Given the current market turmoil, we believe it would be appropriate for the IRS to take the position that debt instruments will not be regarded as publicly traded on the interbank market, a quotation medium, or as quoted property for a period of time, say six to twelve months (leaving open the possibility of extending the period if markets remain turbulent). Doing so will allow borrowers to modify outstanding debt instruments in ways beneficial to borrowers and lenders without the potential for triggering enormous tax liabilities for borrowers. Again, we believe that such an approach is consistent with the Code § 1273 regulations as written.

If a new debt instrument is not regarded as publicly traded, in most cases it will have an issue price equal to its face amount and there will be no discount created to cause CODI or AHYDO issues.

Although we believe that the CODI issue is significantly more important as an economic matter to borrowers than the AHYDO issue, if the IRS chooses to provide relief by deferring recognition of CODI, it would be highly desirable to extend the Revenue Procedure's AHYDO relief to the same transactions so that CODI income and OID deductions will match. In general, this would require the IRS to eliminate the 15-month limitation set forth in Sections 4.02 and 4.03 of the Revenue Procedure and note in the facts discussed that the AHYDO relief applies in general to debt modifications. If the IRS does not do this, borrowers would generally be required to agree to be bound to make AHYDO catch-up payments, potentially creating significant cash flow issues for some companies.

We believe the better answer is that the borrower should not recognize income in this situation. If the lenders deliver cash proceeds to the borrower in excess of the amount paid by the persons purchasing the debt from the lenders in an underwriting transaction, the excess proceeds should be treated as part of the issue price of the debt. The payment of the excess proceeds is an integral part of the lending transaction agreed to in the financing commitment -- without such a commitment, no lender would be willing to pay excess proceeds to the borrower.¹⁵ Under this approach, the borrower would receive proceeds equal to the issue price of the debt and no income would result. In addition, there would be no OID from the borrower's perspective to cause the debt to be an AHYDO.¹⁶

The result that a borrower does not realize income in this case is consistent with the general tax principle that a borrower is not taxed on issuing a debt instrument, even if the debt instrument is issued with bond issuance premium.¹⁷ It is also consistent with the general tax principle that a taxpayer is not taxed merely because it has entered into a favorable contract or made a favorable purchase.

Alternatively, if the IRS believes that the excess proceeds are not part of the debt instrument's issue price and that a borrower realizes income in the event that proceeds received exceed the issue price of the debt, the IRS should provide that the borrower is entitled to defer the recognition of that income, taking it into account over the life of the debt instrument. The IRS could reach this result by applying the hedge accounting rules of Treas. Reg. § 1.446-4(e)(4).¹⁸ As an economic matter, the financing commitment described in the Revenue Procedure is a hedge that protects the borrower against the risk of being unable to obtain financing at a specified time and increases in the cost of that financing. Under the hedge accounting approach, payment of any excess proceeds by the lenders would be treated as a cash settlement of the hedge contained in the financing commitment and the excess would be taken into income over the life of the debt. Alternatively, the IRS could allow the borrower to recognize any income over the life of the debt instrument using its general authority under Code § 446. Note that a deferred income approach would not be desirable unless AHYDO relief is available under the Revenue Procedure to allow the income deferred to be offset by OID deductions.

2. Application where Borrower is a Partnership with Corporate Partners. The AHYDO rules apply to debt issued by a partnership where the interest expense is allocated to a corporate partner.²⁰ The Revenue Procedure literally appears only to apply to debt issued directly by a corporation. We see no policy reason why the benefits of the Revenue Procedure should not apply to a corporate partner with respect to borrowings at the partnership level and recommend that the Revenue Procedure be extended to cover such situations.

3. Multiple Amendments. Section 4.02 of the Revenue Procedure covers debt exchanged (including in a deemed exchange) for debt covered by Section 4.01. Section 4.03 covers debt exchanged (including in a deemed exchange) for debt covered by Section 4.02. Thus, the Revenue Procedure literally allows only two exchanges or amendments with respect to the original debt covered by Section 4.01. We have seen situations involving negotiations between borrowers and lenders where more than two amendments to the terms of the debt were made as the parties reacted to the continuing stresses of the current financial crisis. Importantly, each such amendment potentially could have caused a deemed exchange under Treas. Reg. § 1.1001-3. While it may be possible to interpret the Revenue Procedure to cover this situation, there is a risk that the protection of the Revenue Procedure could be lost. We recommend that Section 4.03 of the Revenue Procedure be revised to cover debt instruments issued in exchange for debt instruments described in either Section 4.02 or Section 4.03.

4. Authority. Treasury and the IRS have the authority under Code § 163(i)(5) to issue "regulations as may be appropriate to carry out the purposes of" the AHYDO rules. Use of a Revenue Procedure to provide quick relief to borrowers in the current crisis is appropriate and welcome. The IRS should consider whether more permanent relief ought to be grounded in its regulatory authority under Code § 163(i)(5). Quick relief could still be provided (and is desirable and appropriate) through a notice indicating how regulations will be amended that borrowers could rely on pending issuance of such regulations.

²See Treas. Reg. § 1.61-12(c)(2)(ii) (providing that an "issuer realizes income from the discharge of indebtedness upon the repurchase of a debt instrument for an amount less than its adjusted issue price").

³ We use the phase "publicly traded" as a short hand for "traded on an established market."

⁴ The example assumes that the borrower is neither in bankruptcy or insolvent and does not have available net operating losses to offset the CODI.

⁵ Importantly, taxpayers cannot engage in self help to try to avoid application of these rules by placing restrictions on a holder's ability to trade the new or old debt for the 60 days beginning 30 days before the issuance of the new debt and ending 30 days after such issuance. Treas. Reg. § 1.1273-2(f)(6) provides that "any temporary restriction on trading a purpose of which is to avoid the characterization of the property as one that is traded on an established market" will result in the property being treated as traded on an established market.

⁶See New York State Bar Association, Tax Section, Report No. 1066. Definition of "Traded on an Established Market" Within the Meaning of Section 1273 (August 12, 2004), reprinted at 2004 TNT 159-7 (the "NYSBA Report") (citing FSA 2000025020 (June 23, 2000), which interprets the term "interbank market" in the context of section 1256(g)(2) to mean "not a formal market, but rather a group of banks holding themselves out to the general public as being willing to purchase, sell or otherwise enter into certain transactions" and concluding that if this definition is "literally applied . . . almost all debt instruments might be treated as publicly traded, as one could find a bank or an investment bank that would be willing to purchase or sell practically any debt instrument susceptible of being transferred").

⁷ The regulations contain important safe harbors that limit the scope of this element of the definition of publicly traded in certain cases. See Treas. Reg. § 1.1273-2(f)(5)(ii).

⁸See, e.g., NYSBA Report.

⁹ The regulations were finalized in 1994, which was prior to the internet era as we currently know it.

¹⁰ It may also be appropriate to extend this relief to property appearing on an exchange or over-the-counter market, even though borrowers in that situation chose to issue debt they expected to be publicly traded.

¹¹ Under the current conditions, discounts in debt prices reflect the general crisis in the debt markets more than the particular risk associated with a borrower's debt (and thus the true value of such debt).

¹² See SEC Office of the Chief Accountant and FASB Staff Clarifications on Fair Value Accounting (September 30, 21008); FASB Staff Position, FAS No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (October 10, 2008).

¹³See Treas. Reg. § 1.61-12(c)(2)(ii) (providing that an "issuer realizes income from the discharge of indebtedness upon the repurchase of a debt instrument for an amount less than its adjusted issue price").

¹⁴ Deferral would probably not be appropriate to the extent that the principal of the new debt was less than the principal of the old debt.

¹⁵Compare PLR 9627027 (April 11, 1996) (ruling that put option fee advanced by lender to borrower at inception of transaction was an "integral part" of the lending transaction and thus must be included in the issue price of the loan at issue; under the PLR's facts, this inclusion in issue price resulted in the loans being issued with bond premium within the meaning of Treas. Reg. § 1.61-12(c)); FSA 200142005 (Oct. 19, 2001) (ruling that amount paid by a remarketing agent -- i.e.. not the lender -- for the privilege of remarketing debt in the future was treated as an adjustment to issue price of the debt resulting in bond issuance premium); Treas. Reg. § 1.1273-2(g) (treating certain payments made incident to a lending transaction as adjustments to issue price) and Treas. Reg. § 1.163-7(e) (providing that where a holder purchases new debt in a qualified reopening for an amount that is more or less than the adjusted issue price of the issue prior to the reopening, the difference is treated as an adjustment to issue price rather than income or deduction).

¹⁶ Holders of the debt generally would have market discount on the debt rather than OID. Similar treatment would occur if the lenders were deemed to pay the excess proceeds to the purchasers of the debt to induce them to buy the debt at face on the terms set forth in the financing commitment. In such case, the inducement payment would not be income to the purchasers; rather it would reduce their basis in the debt instrument producing market discount. Compare Treas. Reg. § 1.1273-2(g). For cases and rulings holding that an inducement payment is not income, see Rev. Rul. 73-559 1973-2 CB 299; General Motors Corp. v. Comm'r, 112 TC 270 (1999); Rev. Rul. 76-96, 1976-1 CB 23; Freedom Newspapers, Inc. v. Comm'r, T.C. Memo 1977-429.

¹⁷ See Treas. Reg. § 1.61-12(c)(1); Treas. Reg. § 1.163-13.

¹⁸ A financing commitment is not a debt instrument. Accordingly, Treas. Reg. § 1.1221-2(d)(5)(i) (providing that the purchase or sale of a debt instrument is generally not a hedge) should not prevent the use of hedge accounting.

¹⁹See Rev. Proc. 2008-51 § 4.01(I) ("The debt instrument is issued for money and the terms of the debt instrument are consistent with the general terms of a binding Financing Commitment obtained by the corporation from an unrelated party before January 1, 2009.") (emphasis added).

²⁰See Treas. Reg. § 1.701-2(f) Ex. 1.