Debt or equity? New pathways - another dead end or the yellow brick road?

• Author: Salem, Irving

Debt or Equity? New Pathways - Another Dead End or The Yellow Brick Road?

The Omnibus Budget and Reconciliation Act of 1989 intensely examined the debt-equity conundrum and adopted some creative new pathways to deal with it. First, Congress developed irrebuttable presumptions to distinguish debt from equity in connection with the provisions dealing with high-yield discount debentures and earnings stripping. Second, a system of bifurcation, for limited purposes, was devised for certain high-yield discount debentures, with the Department of the Treasury being given the green light to bifurcate other obligations into debt and equity components. This article summarizes the new rules and analyzes the implications.

High-Yield Discounts Bonds

1. Overview

   Tax and economic policy prompted Congress to make a rather prophetic statement on leverage. Concerned about certain high-yield bonds - particularly those calling for interest to be paid with additional debt(1) - the House Committee on Ways and Means concluded that certain high-yield bonds "resemble equity for tax purposes" and, further, that the availability of the interest deduction for such instruments was resulting in "highly leveraged corporate financial structures that impose an undesirable level of risk on investors and the economy."(2)

   As a result, important new debt-equity "safe harbor" rules were adopted. Surprisingly, the rules are not limited to leveraged acquisitions; for example, they may apply to high-yield debt issued by high-tech ventures or real estate enterpreneurs, if they operate through a corporate vehicle.

2. The Basic Bifurcation Rule

   Believing that a "portion of the return on certain high-yield OID obligations is similar to a distribution of corporate earnings,"(3) the House-Senate conferees decided to enact new section 163(e)(5) of the Internal Revenue Code. The new provision bifurcates the yield on an "applicable high yield discount obligation," so that -

   * an interest element of up to 6 points over the applicable federal rate (AFR) will be deductible only when paid (which will not include "payments" in stock or debt), and

   * the excess over 6 points will be treated as a return on equity for which no deduction can ever be had, but for which a dividends-received deduction (DRD) is allowable.

   Congress "split the baby" heavily in favor of debt in that (1) the applicable obligation remains a debt instrument for all purposes of the Code, and (2) the portion of the yield that is deemed to be a dividend is treated as such only for purposes of the DRD. Although the new rule can hardly be characterized as "simplification," this split stands as an ingenuous way of legislating the bifurcation principle while avoiding the severe complexity inherent in the House bill.(4)

   The following two examples from the Conference Report illustrate the basic bifurcation rule:(5)

   Example 1. - Assume a corporation issues an applicable instrument at the beginning of the year with an issue price of $100 and a yield to maturity of 20 percent in a month when the AFR is 9 percent. The AFR plus 6 percentage points is 15 percent. The return on the instrument in the first year is $20 ($100 issue price times the 20-percent yield to maturity) and the adjusted issue price is $120 at the end of the year. The return on the instrument in the second year is $24 ($120 adjusted issue price times the 20-percent yield to maturity). The ratio of the disallowed portion of the yield to the yield is 25 percent (20-percent yield to maturity minus 15 percent) divided by 20-percent yield to maturity). The amount of the disqualified portion in the first year is $5 ($20 return for the year times 25 percent). The ratio of the disallowed portion of the yield to the yield is constant throughout the term of the instrument (in this case, 25 percent). Thus, the disallowed portion in the second year is $6 ($24 return for the year times 25 percent).

   The allocation of payments of OID made under a debt instrument before maturity between the disqualified portion and the remainder is to be made pursuant to Treasury regulations. The Conferees expect such regulations to provide that such payments will be allocated on a pro rata basis between accrued but unpaid OID treated as interest, and the accrued but unpaid disqualified portion of the OID.

   Example 2. - Assume the same facts as in Example 1 above. If the issuer distributes, in cash, $12 with respect to the instrument at the end of the second year, $3 ($12 times 25 percent) will be considered to be a payment of the accrued but unpaid disqualified portion, and the issuer will be allowed a deduction of $9 ($12 minus $3).

3. Defining "Applicable Obligations"

   An "applicable high yield discount obligation" is a debt instrument issued by a corporation that satisfies three tests:

   * Long term: Its maturity date must exceed five years.

   * High yield: The yield to maturity must equal or exceed the AFR (for the month of issue) plus five percentage points. Thus, assuming a 10-year maturity, annual compounding, and issuance in January 1990, the yield to maturity must equal or exceed 13.02 percent (AFR of 8.02% + 5%).

   * Significant OID: Beginning on the 1st accrual period ending after 5 years, and for each accrual period thereafter, the instrument cannot call for the deferral of more than the first year's interest. In general, this rule will catch all debt that is PIK for more than one year.(6)

4. Two Important Tax Policy Achievements

   1. Distillation of the debt-equity rules. The foregoing three tests are, in substance, a distillation of the 13 (more or less) factors that the courts have slavishly played around with - before announcing what they felt in their gut was the right answer all along. The three tests are targeted at the ultimate economic question: whether the funds have been placed at the risk of the venture, or stated slightly differently, is there a reasonable expectation of payment regardless of the success of the business? In the case of an applicable obligation, the statute irrebuttably presumes that the funds are at the risk of the business based on the objective facts that the instrument is both long term and high yield and the interest payments are deferred.(7)

   2. Dual aspect of debt instrument legislated. Another and perhaps more significant achievement is that the Congress codified the principle that a single debt instrument can reflect both a cost of capital (interest) and an equity return (dividend). This may beget other changes.(8)

5. Some Additional Statutory Details

   and Technical and Policy Issues

   1. Regulatory authority. The 1989 Act puts the spotlight on a host of technical issues, and leaves them to forthcoming regulations:

      REGULATIONS. - The Secretary shall prescribe

      such regulations as may be appropriate to carry out

      the purposes of this subsection and subsection (e)(5),

      including -

      (A) regulations providing for modifications to the

      provisions of this subsection and subsection (e)(5) in

      the case of varying rates of interest, put or call

      options, indefinite maturities, contingent payments,

      assumptions of debt instruments, conversion rights,

      or other circumstances where such modifications are

      appropriate to carry out the purposes of this subsection

      and subsection (e)(5), and

      (B) regulations to prevent avoidance of the purposes

      of this subsection and subsection (e)(5) through

      the use of issuers other than C corporations, agreements

      to borrow amounts due under the debt instrument,

      or other arrangements.

   2. Legislative history. The Committee Reports(9) state that the conferees "expect" that the implementing regulations will adopt the following rules:

      i. Variable interest. For debt that calls...