Final regs. on contingent payment debt instruments leave questions on nonmarket-based contingencies.

• Author: Sair, Edward A.

In June 1996, contingent payment debt instrument (CPDI) final regulations were issued under Regs. Sec. 1.1275-4.(1) Effective for CPDIs issued on or after Aug. 13, 1996, the regulations are the culmination of Treasury's repeated attempts to address original issue discount (OID) uncertainties created by debt instruments with contingent payments. The first set of proposed regulations, issued in 1986 and amended in 1991, were never finalized and were withdrawn in 1994.(2) A different set of proposed regulations (which would have significantly changed the 1986 proposed regulations) were scheduled to be issued in January 1993, but were delayed by the change in presidential administration and never issued. A third set of proposed regulations was issued in 1994 and finalized in 1996.(3)

Essentially, Regs. Sec. 1. 1275-4(a) divides debt instruments with one or more contingent payments into two major classes. The first applies to any debt instrument with one or more contingent payments whose issue price is determined under Sec. 1273 (other than Sec. 1273(b)(4)); this covers debt instruments issued for cash or publicly traded property, and publicly traded debt instruments. Such instruments are subject to the "noncontingent bond" method (NBM) of Regs. Sec. 1.1275-4(b). Debt instruments whose issue price is determined under Sec. 1274 are subject to the "wait and see" method of Regs. Sec. 1.1275-4(c); such instruments have OID, are not publicly traded and are issued for nonpublicly traded property. (The 1986 proposed regulations used this method for all CPDIs.)

The NBM represents a major change from prior law on the income inclusion and deduction of contingent interest. Under prior law, holders of debt instruments generally were not required to include in income or deduct any contingent amount until the contingency became either fixed or paid, depending on the taxpayer's method of accounting. The NBM can require an income inclusion and a corresponding deduction for a contingent amount prior to the occurrence of the contingency. The Preamble to the 1994 proposed regulations states that, in Treasury's view, this approach is consistent with congressional intent under the, OID provisions to require a current accrual of interest on a debt instrument. Debt instruments subject to the wait and see approach retain the prior-law approach to contingencies -- generally, there are no tax consequences until the contingency is paid.

The CPDI final regulations change the calculation of income or deduction (and gain or loss) for a CPDI subject to the NBM. Instead of waiting for the contingency to occur, both holders and issuers must now accrue income and deductions based on the debt instrument's yield as if all payments were noncontingent. Although not explicitly stated, the theory of the NBM could be that the parties to the transaction expect a certain approximate yield on the instrument, based on both the noncontingent payments and a reasonable expectation of the occurrence of the contingencies. Generally, this expected yield will approximate the yield on comparable debt instruments of the issuer that call for only noncontingent payments; thus, a "comparable yield" will now be reflected in the accrual of income and expense. When the contingency is based on the future price of traded property or on some market index, the facts and circumstances regarding the expected value of the contingency will be somewhat clearer; however, when the contingency is based on nonmarket information (e.g., cash flow, the issuer's sales or profits or an increase in the value of nonpublicly traded property securing the debt instrument), any valuation of the future contingency is much more problematic.

This article discusses the NBM, focusing on contingencies not based on the future value of traded property, an index or other objective financial information. A future article will examine the wait and see method for CPDIs not subject to the NBM and the regulations' unexpected effects when restructuring troubled debt.

General Rules

What Is a CPDI?

Regs. Sec. 1.1275-4 governs the character and timing of income, deductions, gains or losses from CPDIs. Regs. Sec. 1.1275-1(d) provides that Regs. Sec. 1.1275-4 does not apply if a contingent payment obligation is not actually a debt instrument under general Federal tax principles.(4) While Regs. Sec. 1.1275-4 does not define "contingent payments," it specifies several types of instruments treated elsewhere in the Code or regulations to which it does not apply: * A debt instrument with an issue price determined under Sec. 1273(b)(4) (e.g., a debt instrument subject to Sec. 483) (Regs. Sec. 1.1275-4(a)(2)(i)). * A variable rate debt instrument (as defined in Regs. Sec. 1.1275-5) (Regs. Sec. 1.1275-4(a)(2)(ii)). * A debt instrument with an alternative payment schedule(s) applicable on the occurrence of a contingency(ies) subject to Regs. Sec. 1.1272-1(c) (Regs. Sec. 1.1275-4(a)(2)(iii)). * A debt instrument with an indefinite maturity and a fixed yield (as defined in Regs. Sec. 1.1272-1(d)) (Regs. Sec. 1.1275-4(a)(2)(iii)). * A debt instrument subject to Sec. 988 (foreign currency loans) (Regs. Sec. 1.1275-4(a)(2)(iv)). * A debt instrument to which Sec. 1272(a)(6) applies (certain interests in or mortgages held by a real estate mortgage investment conduit (RF-MIC), and certain other debt instruments with payments subject to acceleration) (Regs. Sec. 1.1275-4(a)(2)(v)). * A debt instrument (other than a tax-exempt obligation) described in Sec. 1272(a)(2) (e.g., U.S. savings bonds, certain loans between natural persons and short-term taxable obligations) Regs. Sec. 1.1275-4(a)(2)(vi)). * An inflation-indexed debt instrument (as defined in Temp. Regs. Sec. 1.1275-7T) (Regs. Sec. 1.1275-4(a)(2)(vii)). * Certain state-sponsored prepaid tuition plans (Regs. Sec. 1.1275-4(a)(2)(viii)).

Further, according to Regs. Sec. 1. 1275-4(a) (3), payments are not contingent merely because of the possibility of impairment by insolvency, default or similar circumstances. In addition, under Regs. Sec. 1.1275-4(a) (4), a debt instrument does not provide for contingent payments merely because it is convertible into stock of the issuer or stock or debt of a related party (or its cash or property equivalent).

The exception to NBM treatment for debt instruments with alternative contingent payment schedules subject to Regs. Sec. 1.1272-1(c) reflects the regulations' attempt to give a taxpayer greater flexibility in structuring a debt instrument without becoming subject to the CPDI rules. When the timing and amount of each payment of each alternative schedule are known as of the issue date and, based on the facts and circumstances as of that date, a single payment schedule for a debt instrument (including the stated payment schedule) is significantly more likely than not to occur, Pegs. Sec. 1.1272-1(c)(2) requires the yield and maturity of such instrument to be computed based on that payment schedule. Regs. Sec. 1.1272-1(c)(1) provides that if no single payment schedule is significantly more likely than not to occur, the debt instrument is subject to the CPDI regulations.

A debt instrument does not provide for an alternative payment schedule merely because there is a possibility of impairment of payment by insolvency, default or similar circumstances; under Regs. Sec. 1.1272-1 (c) (5), if the alternative payment schedule is triggered by an unconditional option held by the issuer or holder, the option will be presumed exercised if it lowers (if held by the issuer) or raises (if held by the holder) the debt instrument's overall yield. An option includes a right to can, put or extend. Regs. Sec. 1.1272-1(c)(6) provides that if the presumed payment schedule does not occur because of a change in circumstances, the debt instrument is treated as if retired and reissued at its adjusted issue price (AIP) on the date of such change; the instrument is reexamined at that time under Regs. Sec. 1.1272-1(c).

Remote or Incidental Contingencies

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