IRS limits "qualified stated interest" on debt instruments.

• Author: Ruempler, Henry C.

The IRS has recently issued a revenue ruling that could significantly expand the universe of original issue discount (OID) instruments. Under the terms of this ruling, many debt instruments that were previously thought to have current pay interest and, thus, no OID, may now have OID.

In determining whether a debt instrument has OID, one looks at the excess of the stated redemption price at maturity over the instrument's issue price. The stated redemption price at maturity is defined as all payments due under the debt instrument that are not qualified stated interest. Qualified stated interest is defined as stated interest unconditionally payable at least annually at a single fixed rate. Interest is considered unconditionally payable (according to Regs. Sec. 1.1273-1 (c) (1) (ii)) only if late payment or nonpayment of the interest is expected to be penalized or if reasonable remedies exist to compel payment. Interest is not considered to be unconditionally payable if the lending transaction is not at arm's length or if the holder does not intend to enforce any remedies. The possibility of nonpayment due to default, insolvency or any other circumstances is ignored for purposes of determining whether interest is unconditionally payable.

In Rev. Rul. 95-70, the Service further defined when interest was or was not unconditionally payable. The facts of the ruling cover two situations, one in which the penalty for nonpayment of interest was the inability to pay dividends, and the other, when an additional 2% interest was charged on past due interest payments. In both instances the holder had the ability to sue for payment after the issuer's failure to make interest payments for 12 consecutive quarters. In neither circumstance did the IRS find the penalty sufficient for the interest payments to rise to the level of unconditionally payable.

In the first case, the Service reasoned that the dividend restriction on the issuer's stock was not a real penalty within the meaning of the regulations because it did not inure directly to the holder's benefit.

In the second case, debt was issued with a stated interest rate of 8% and a 10% penalty rate of interest accrued on past due interest. Although the...