3. Unanswered questions in revenue procedure. The revenue procedure is as interesting for the questions it does not address as for those it does. In each case of debt modification described by the revenue procedure, there
would likely be COD income generated. No doubt Treasury felt it did not have authority to relieve taxpayers of that burden, and so the guidance is silent on COD. By abrogating the operation of the AHYDO rules, the revenue procedure does eliminate, for most taxpayers, the permanent ill effects of the interaction between the COD and AHYDO rules. As long as a taxpayer can deduct OID throughout the life of its debt, COD income recognition can be reversed over time
A second question raised by the facts in the revenue procedure is the treatment of the difference in cash received by the borrower and the amount the lender is able to sell the debt for in the secondary markets. For
example, if a borrower received $100 cash under a commitment made earlier by a lender, but because of economic conditions, the lender can only sell the loan to third parties for $60, the question is how the borrower
should treat the $40.
If, in the above example, the borrower concludes that the FMV of its debt is $60, then it has OID deductions of $40. If, in addition, the conditions of the borrowing are such that the revenue procedure ensures the AHYDO
rules do not limit the OID deductions, it appears that a large tax benefit has been conferred on the borrower with no corresponding cost.
The New York State Bar Association report on Rev. Proc. 2008-51 claims that it is not clear that a borrower should treat the difference between the cash it received and the issue price of the debt as income,73 but Treasury officials have rejected this conclusion orally in public forums. Under one theory, the difference between cash received by the borrower and the ultimate issue price on the debt instrument (determined by the market) is current, unencumbered accretion to wealth and must be recognized immediately. Under another theory, the difference is attributable to an anticipatory hedging transaction — the financing commitment — and the benefit of the hedge must be taken into account over the life of the loan.
The hedge timing theory is novel. One of the types of transactions defined as a hedging transaction in section 1221(b)(2)(A) and reg. section 1.1221-2(b) is a transaction that a taxpayer enters into in the normal course of its trade or business primarily to manage the risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer. Under reg. section 1.446-4, hedges of debt instruments that meet the above definition must be accounted for by reference to the terms of the debt instrument and the period or periods to which the hedge relates. The example provided in the regulation is of a transaction that hedges the whole term of an anticipated fixed rate borrowing; gain or loss generated by the hedge is treated as if it decreased or increased the issue price of the debt instrument.
Although hedging transactions are required to be identified by taxpayers for both character and timing purposes, a recent revenue ruling interprets the statute and regulations to mean that a transaction that meets the statutory definition must be accounted for as a hedging transaction even without proper identification
Treating the difference between what the borrower received from the lender under the financing commitment and what the lender sold the debt for as a hedging gain, as Treasury officials have suggested, is interesting,
but not entirely persuasive. Even if no hedge identification of the initial commitment is necessary, it is not clear that such commitments are entered into primarily to manage risk of interest rate or price changes or currency
fluctuations of the anticipated loan. The primary purpose of a financing commitment is to ensure access to cash when the borrower needs it. In 2008, the promise embodied in a financing commitment was not equivalent to an interest rate hedge.
Irrespective of the persuasiveness of the oral opinions expressed by Treasury officials on this matter, if the government has a view on the appropriate treatment of the difference between issue price and cash received in a debt entered into under a financing commitment, it should publish guidance and give taxpayers an opportunity to comment.
4. Application of revenue procedure to example. Amended DI is issued in direct exchange for Original DI. Therefore, Amended DI must be issued in exchange for an Original Instrument under Rev. Proc. 2008-51.
Amended DI was deemed to be issued in exchange for Original DI by operation of reg. section 1.1001-3:
a. Original DI was issued by the same issuer as Amended DI;
b. Original DI is described as an Original Instrument in Rev. Proc. 2008 -51:
i. Original DI was issued by Borrower, a
ii. Original DI was issued for money;
iii. the terms of Original DI were generally consistent with the terms of a financing commitment that was:
1) binding on the parties;
2) obtained from Lender, who is not related to Borrower; and
3) obtained in 2007, before the cutoff
date of January 1, 2009;
iv. Original DI would not be an AHYDO if its issue price were the net cash proceeds actually received by Borrower for Original DI since:
1) Borrower received net cash proceeds for Original DI of $1 billion;
2) at an issue price of $1 billion, Original DI would yield 6.87 percent;
3) 6.87 percent does not exceed the AFR applicable to Original DI of 3.55 percent plus 5 percent (6.87 percent < 3.55 percent + 5 percent, or 8.55 percent).
- Amended DI was issued within 15 months of Original DI since Original DI was issued in January 2008 and Amended DI was issued in December 2008.
- Amended DI would not be an AHYDO if its issue
price were equal to the net cash proceeds Borrower
received for Original:
a. Net Cash Proceeds: Borrower received net cash proceeds of $1 billion for Original DI in January 2008. However, Borrower also made two payments to Lender in connection with the debt modification transaction in December 2008, as well as an interest payment between those two dates. Rev. Proc. 2008-51 does not specify whether any of these later payments should be taken into account in determining the net cash proceed that Borrower received for Original DI.