The effect of accrual periods on an AHYDO.

• Author: Weck, L. Casey
• Position: Applicable high-yield debt obligations

In response to the widespread use of high-yield original issue discount (OID) and paid-in-kind (PIK) debt in acquisitions, Congress added Sec. 163(e)(5) and (i) in 1989. These rules are designed to scale back the issuer's interest deductions on certain debt instruments (DI); Congress felt that a portion of the return on high-yield OID obligations was more akin to nondeductible distributions of corporate earnings with respect to stock than interest; see H Rep't No. 101-386, 101st Cong., 1st Sess. (1989), p. 553. Thus, if a DI triggers the Sec. 163(e)(5) applicable high-yield debt obligations (AHYDO) provisions, a portion of the debtor's OID expense may be disallowed and a portion of the creditor's OID income may be reclassified as a distribution from a corporation subject to Sec. 301.

Qualifying as an AHYDO

For a DI to trigger the AHYDO provisions, the following conditions must be met: (1) the issuer must be a corporation for Federal tax purposes (but not an S corporation) (Sec. 163(e)(5)(A) and (D)); (2) the instrument must have a maturity date of more than five years from the issue date (Sec. 163(i)(1)(A)); (3) the debt must have a yield to maturity (YTM) that equals or exceeds the sum of the applicable Federal rate in effect for the calendar month in which the DI is issued, plus five percentage points (Sec. 163(i)(1)(B)); and (4) the instrument must have "significant OID" (Sec. 163(i)(1)(C)).

On the surface, the above conditions would appear to be mechanical tests that should not have differing results based on the taxpayer's choices. Indeed, the first three tests are basically mechanical, bright-line tests without much room for choice. However, the determination of significant OID has an elective element of which some taxpayers have not taken advantage. The use of a less-than-optimal accrual period may cause a DI to have significant OID and, thus, inadvertently trigger the AHYDO provisions.

Significant OID: Under Sec. 163 (i)(2), a DI has significant OID if the following is true:

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 Sec. 1272(a)(5)) ending after the date five years after the date of issue, exceeds the sum of--

2. The aggregate amount of interest to be paid under the instrument before the close of such accrual period; and 3. The product of the issue price of such instrument (as defined in Secs. 1273(b) and 1274(a))...