B. Cancellation of Indebtedness Income
Discussion. An issuer recognizes cancellation of indebtedness (COD) income on the repurchase of a debt instrument for an amount less than its adjusted issue price. A significant modification of a debt instrument is treated as an exchange of the original debt instrument for a new debt instrument. If a debtor satisfies a debt obligation by issuing a new debt instrument, then the
debtor is treated as satisfying the old debt with a payment equal to the issue price of the new debt.
If an issuer and holder modify a debt instrument in a manner considered ‘‘significant,’’ then the issuer is treated as repurchasing the original debt instrument for consideration in the amount of the issue price of the amended debt instrument (plus any other consideration exchanged in the transaction). As discussed above, the issue price of the original debt may vary widely from the issue price of the amended debt based on market conditions, and both may differ significantly from the face amount of the instrument. Also, reg. section 1.1001-3 has a low threshold for determining significance and does not distinguish between an increase or decrease in the borrower’s burden.
2. Applying COD rules to example. Borrower and Lender agreed to amend Original DI. This amendment was a significant modification within the meaning of reg. section 1.1001-3(e) and therefore is treated as an exchange
of Original DI for a new instrument, Amended DI, under reg. section 1.1001-3(b). Under section 108(e)(10), Borrower is deemed to have satisfied Original DI for an amount of money equal to the issue price of Amended DI
plus additional consideration of $10 million in cash. Under reg. section 1.61-12(c)(2)(ii), Borrower must recognize COD income equal to the difference between the adjusted issue price of Original DI and the sum of the issue price of Amended DI and $10 million.
The issue price of Original DI is adjusted for OID accruals and Borrower’s $100 million principal payment to calculate Original DI’s adjusted issue price of $923.5 million. Because Amended DI’s issue price is $760 million, Borrower recognizes COD income on the Amendment Date in an amount equal to: $923.5 million – ($760 million + $10 million) =$153.5 million.
Borrower recognizes $153.5 million in income from its amendment of Original DI even though, by most measures, its debt burden increased: the interest rate increased, while none of the principal was forgiven, the term of the debt was not extended, and Borrower remains obligated to pay interest semiannually. This counterintuitive result is due to (1) the difference in how the tax law determines the issue prices of Original DI and Amended DI, and (2) the change in market conditions between the issue dates of the two instruments.
In the absence of the AHYDO rules, Borrower’s $153.5 million in COD income would be offset by an increase in OID deductions in the same amount. In that scenario, although Borrower might be faced with an unfavorable timing difference, it ultimately would recapture the entire amount of COD. However, to the extent that the AHYDO rules prevent Borrower from deducting OID (as will be discussed below), Borrower can never recapture the COD income it must recognize from amending its debt.
C. AHYDO Defined
1. Discussion. A debt obligation is subject to the AHYDO rules if it (1) was issued by a corporation, and has (2) a term greater than five years, (3) a yield equal to or greater than the AFR plus 5 percent, and (4) ‘‘significant original issue discount.’’56 An obligation has significant original
A. the aggregate amount which would be includable in gross income with respect to such instrument for periods before the close of any accrual
period… ending after the date five years after the
date of issue, exceeds —
B. the sum of — i. the aggregate amount of interest to be paid
under the instrument before the close of such accrual period; and ii. the product of the issue price of such instrument . . . and its yield to maturity
Part (A): Part (A) of the definition of significant OID requires that a test be performed with regard to any accrual period ending after the fifth anniversary of the issue date of the obligation (the test period). A debt
obligation has significant OID if the ‘‘aggregate amount’’ includable in the gross income of the holder of the obligation from the time that the obligation was issued through the end of the test period is greater than the
amount calculated in Part (B). The aggregate amount includable in the gross income of a holder of a debt generally consists of (x) payments of QSI, and (y) OID. The aggregate amount can thus be expressed as the sum of all payments of QSI made, and all amounts of OID accrued, through the end of the test period.
Part (B): Part (B) of the test for significant OID calls for adding (i) the amounts of all of the interest payments due under the terms of the obligation from the issue date through the end of the test period, to (ii) the product of the obligation’s issue price and yield to maturity. If the Part (A) amount exceeds the Part (B) amount, then the debt instrument has significant OID. If the other three tests are also satisfied, then the instrument is an AHYDO.
2. Applying AHYDO definition to example. A debt instrument is an AHYDO if it:
• is issued by a corporation;
• has a term greater than five years;
• has a yield at least 5 percent greater than the AFR;
• has significant OID
Both Original DI and Amended DI meet the first two criteria because Borrower is a corporation and both debt instruments have terms exceeding five years. The yield of each instrument is a calculated value based on its issue price and scheduled payments, and equals 6.51 percent for Original DI and 11.74 percent for Amended DI. The AFR applicable to Original DI is 3.55 percent, and for Amended DI is 2.83 percent. Because the yield on Original DI does not exceed its threshold amount (AFR of 3.55 percent + 5 percent spread = 8.55 percent), Original DI is not an AHYDO. However, because of its depressed issue price, Amended DI carries a yield far above its threshold amount of 7.83 percent (AFR of 2.83 percent + 5 percent spread = 7.83 percent).