Suspension of applicable high-yield discount obligation regime for 2010.

• Author: O'Connell, Frank J., Jr.

With the passage of the American Recovery and Reinvestment Act of 2009, P.L. 111-5 (ARRA), Congress suspended the applicable high-yield discount obligation (AHYDO) rules under Sec. 163(e)(5) for certain debt-for-debt exchanges occurring between September 1, 2008, and December 31, 2009. This temporary suspension was part of an effort to reduce obstacles within the financial system in order to foster increased liquidity in the wake of the financial crisis that erupted in 2008. Under Sec. 163(e)(5)(F)(iii), Treasury was granted authority to extend such suspension in the event it "is appropriate in light of distressed conditions in the debt capital markets." On December 24, 2009, the IRS released Notice 2010-11, which extended the suspension of the AHYDO regime through December 31, 2010, but with additional requirements. Accordingly, practitioners who work in this area, especially those with private equity clients, should be aware of the temporary framework that can deliver favorable tax results while increasing liquidity and reduced cash outflows in the short term.

The AHYDO Rules

Generally speaking, an AHYDO is any debt instrument that is issued by a C corporation (including proportionate corporate ownership of a passthrough entity) for a term of more than five years and has a yield to maturity in excess of five percentage points over the applicable federal rate (AFR) for the month in which it is issued. To the extent a debenture is an AHYDO, accrued interest becomes deductible only when paid, while a portion is subject to permanent disallowance because it is considered to be equivalent to a dividend. On the other hand, interest is fully deductible on debt that remains outside the AHYDO rules as it accrues, consistent with the taxpayer's method of accounting. In any case, the holder of a note that earns interest accrued but unpaid will recognize income under the original issue discount (OID) rules, with the exception of any dividend equivalent that is treated as dividend income. Moreover, it is important to highlight that a corporate note holder of an AHYDO is eligible for a dividends-received deduction under Sees. 243, 245, 246, and 246A for the dividend equivalent earned, concomitant with the holder's equity interest in the borrower.

Under Sec. 163(e)(5)(C), the dividend equivalent is the disqualified portion of the OID of an AHYDO note that would be a dividend if it were a distribution of a corporation with respect to its stock. The...