Congress’s principal response to the financial crisis of the 1980s was the enactment of rules that limit interest deductions on applicable high-yield discount obligations (AHYDO) — the AHYDO rules. After the wave of LBOs ebbed, these provisions spent much of the following 20 years in hibernation. Then, in 2008, amid the collapse of another investment bubble involving even more exotic securities and more spectacular failures of financial institutions, the AHYDO rules emerged from their slumber. Many corporations were denied interest deductions on market-rate debt they issued or modified because of the anomalous interaction of the LBO-era tax provision with the credit markets in crisis. This decade, Congress has responded by suspending the law it devised to combat the earlier crisis until the current crisis has passed. The broad legislative change came several months after Treasury published guidance to provide more limited relief to taxpayers.
This report discusses the AHYDO rules, including the recent efforts by both Congress and Treasury to relieve taxpayers from their harsh effect. I illustrate the rules by way of an example: a debt instrument issued under a binding financing commitment that is later amended, triggering a deemed exchange.
B. History of AHYDO Rules
The AHYDO rules were enacted in 1989 in response to a great wave of LBOs that occurred during the 1980s. In an LBO, investors wishing to buy a company fund the purchase mostly with nonrecourse debt secured by the target company’s assets, contributing only a small amount of their own funds as equity. The investors intend to pay off the debt with money generated either by the target company’s operations or by selling the target’s assets.
Over the course of the decade, LBOs were financed increasingly by instruments with deferred interest payments that created large amounts of original issue discount. These instruments were treated as debt under the tax law, and issuers were able to deduct the OID as it accrued, while maintaining control over cash that would otherwise have been consumed in making periodic interest payments. Investors in the instruments were entities that did not require current cash flow to make tax payments on the accruing OID such as tax-exempts. Debt used to finance LBOs was often below investment grade because of the high degree of leverage and low quality of loan security. The instruments earned the title of ‘‘junk bonds’’ and their popularization pushed deal volume and takeover premiums to unsustainable heights. The Wall Street Journal reported in 1989 that junk bonds were being used in virtually every LBO by then and typically made up 15 percent to 20 percent of the financing. One expert estimated that at the peak of the mania, ‘‘we [were] flipping the ownership of whole
businesses at a roughly 10 percent annual rate.’
As the decade drew to a close, many high-profile LBOs were collapsing and junk bonds were reportedly defaulting at a rate of 34 percent. A pioneer of the LBO strategy stated publicly that junk bonds had overinflated buyout premiums, were endangering otherwise healthy target companies, and needed to be reined in.
It was widely believed that junks bonds had become popular because they took advantage of a tax arbitrage opportunity. As then-Treasury Secretary Nicholas Brady expressed it: ‘‘The substitution of [deductible] interest
charges for [taxable] income is the mill in which the grist of takeover premiums is ground.’’ Both popular and expert opinions warned that the massive increase in leverage in the economy was dangerous, but there was no agreement on either the cause of or solution to the problem.
Treasury believed that the root of the evil was the unequal tax treatment of debt and equity. Because interest payments were generally deductible, and dividends were not, taxpayers preferred debt over equity financing. In January 1989, Brady repeatedly discussed bringing closer the treatment of debt and equity, both by limiting the deductibility of interest and reducing the taxation of dividends. However, Treasury concluded that it could not devise a regulatory solution, and by May 1989, Treasury informed Congress that it opposed any general limitation on interest deductions
Congress was concerned about the LBO bubble, but was hesitant about taking strong action to halt it. It had attempted to limit interest deductions on debt used for hostile takeovers in a bill approved by the House Ways and Means Committee in October 1987. The following week opened with the infamous Black Monday, when the Dow Jones Industrial Average plunged 22.6 percent. Popular commentators blamed the bill limiting interest deductions for the crash, although more thoughtful studies pointed to other causes. Two years later, so much evidence about the cause of the LBO bubble had accumulated that even another steep stock market decline (termed the ‘‘Friday the 13th mini-crash’’) did not deter legislative action.
In early 1989, Congress waded into the LBO waters, beginning with hearings hosted by both the Senate Finance and Ways and Means Committees. In anticipation of the hearings, the Joint Committee on Taxation prepared a treatise on the tax aspects of corporate financial structures (the JCT report). The JCT report surveys the buildup of leverage in the American economy in the 1980s and searches for its sources. First on the list are federal taxes: an LBO results in ‘‘reduction in future corporate taxes arising from the increased amount of deductible interest’’ in the target corporation. The JCT report quotes studies that provide mathematical evidence that the LBO buyout premiums are mostly the present value of future corporate tax savings. It also expresses grave concern about the fact that increased leverage also leads to increased instability in the corporate sector.
The JCT report offers a sumptuous menu of options to solve the LBO/leverage problem. These are worth reciting, just to be mystified at the narrowness of the approach Congress eventually took: (A) integrating the corporate and individual tax systems; (B) limiting the debt-equity distinction by limiting interest deductions: (1) generally, (2) specifically, where the corporate equity base is threatened, (3) specifically, for corporate acquisitions; (C) a combination of interest disallowance and dividend relief; and (D) other options, including (1) excise tax on acquisition indebtedness, (2) objective standards to distinguish debt and equity.
One sub-sub-policy option offered in the JCT report was to ‘‘disallow interest deductions in excess of a
specified rate of return to investors.’’19 The report suggested the policy could be implemented by disallowing interest deductions on a debt instrument in excess of the rate of return on a risk-free investment, based on the theory that any interest payment above the risk-free rate of return is akin to a dividend distribution and should not be deductible. Presciently, the JCT report identifies two problems with this idea: First, finding the appropriate risk-free rate above which returns would be denied deductibility; second, a blanket rule for the deductibility of interest over a flat rate would penalize riskier business ventures as compared to their more stable brethren.