Application of corporate interest limits to partnership debt.

• Author: Ciszczon, Brian

Certain interest-limit provisions that specifically apply to corporate borrowers must also be examined when debt is issued by a partnership. In particular, Sec. 163(e)(5) (certain high-yield discount obligations) and Sec. 163(1) (debt payable in equity) must be considered carefully by partnerships with corporate partners.

AHYDOs

In response to the widespread use of high-yield original issue discount (OID) and payment-in-kind (PIK) debt in acquisitions, Congress enacted Sec. 163(e)(5) and (i) in 1989. These rules were designed to reduce a corporate borrower's interest deductions on certain debt; Congress concluded that a portion of the return on high-yield OID obligations was similar to a nondeductible distribution of corporate earnings with respect to equity.

Definition: An applicable high-yield discount obligation (AHYDO) is defined under Sec. 163(i)(1) as any debt instrument that:

1. Is issued by a corporation (other than an S corporation).

2. Has a maturity date of more than five years.

3. Has a yield to maturity that equals or exceeds the sum of the applicable Federal rate (AFR) in effect at the time of the debt's issuance plus five percentage points.

4. Has "significant OLD."

Treatment: If an instrument satisfies all four requirements, the interest deduction is bifurcated into deferred and disqualified portions; see Sec. 163(e)(5)(A) and (C). The deferred portion is deductible when paid (in property other than stock or debt of the issuer) under Sec. 163(e)(5)(A) (ii); the disqualified portion is nondeductible, even when paid, under Sec. 163(e)(5)(A)(i). Moreover, to the extent that the disqualified portion of OID would have been treated as a dividend under Sec. 163(e)(5) (B) to corporate holders (under a Sec. 301(c) analysis) had it been distributed with respect to the issuing corporation's stock, it is generally treated as a dividend to debt-holders for purposes of the dividends-received deduction.

Application to partnerships: Although on its face, Sec. 163(e)(5) applies only to debt issued by C corporations, Congress contemplated addressing abuse "through the use of issuers other than C corporations" when it authorized anti-abuse regulations under Sec. 163(i)(5)(B). While no regulations have been issued under that provision, in January 1995 Treasury finalized partnership anti-abuse regulations, which contain an example addressing an AHYDO issued by a partnership; see Regs. Sec. 1.701-2(f), Example 1, which treats each C corporation...