Congress seized on this idea and applied it narrowly to the securities considered to be at the eye of the LBO storm — OID debt. But the House and Senate envisaged different solutions to the problem. The House bill treated
high-yield OID securities as preferred stock, permanently disallowing all deductions on the instruments whether for OID or cash payments. The Senate bill preserved all interest deductions, but deferred them until paid out in cash.
The conference report describes an awkward detente.
The AHYDO provision that came out of conference ‘‘bifurcates the yield on applicable instruments, creating an interest element that is deductible when paid and a return on equity element for which no deduction is granted and for which the dividends received deduction may be allowed.’’ The yield is bifurcated by reference to the applicable federal rate (AFR), a set of interest rates published by the IRS and reflecting the federal government’s borrowing costs.
In the conference report, the conferees contrast the treatment of OID debt and equity in the tax law at that time. Discount on debt was deductible as interest even if no actual interest was paid until maturity. Distributions on stock, even if paid in cash on a regular basis, were not deductible (although a dividends received deduction was available in some circumstances). The conferees recognize that the determination of whether an instrument fits within the deductible debt or nondeductible equity camps is a ‘‘facts and circumstances’’ determination and that ‘‘characteristics of debt include the following: a preference over, or lack of subordination to, other interests in the corporation, insulation from risk of the corporation’s business; and an expectation of repayment.’’ The conferees then announce, without further analysis, ‘‘that a portion of the return on certain high-yield OID obligations is similar to a distribution of corporate earnings with respect to equity.
The AHYDO rules that resulted from the compromise between the House and Senate bills generally apply to debt instruments issued by corporations with durations greater than five years, that bear interest at a rate greater
than or equal to the AFR plus 5 percent, and that have significant amounts of OID. If a taxpayer has issued an AHYDO, the total return on the instrument exceeding the AFR plus 6 percent is treated as a nondeductible dividend, and any remaining return is deferred until paid in cash.
How did Congress arrive at the 5 percent and 6 percent rates enshrined in the AHYDO rules? In 1989, borrowing rates for credit-worthy corporations had never diverged from Treasury rates by even as much as 4 percent, 25 so a rate greater than 5 percent over federal borrowing costs apparently looked to Congress to be an equity-type return.26 From 1989 until late 2008, Congress’ choice of AHYDO-triggering rates was appropriate, as the difference between borrowing rates for highly rated corporations and the federal government only exceeded 4 percent during the 2002-2003 period and in 2008, and, until September 2008, the difference always remained
safely below 5 percent. However, in late 2008, the difference between the rates diverged dramatically. While Treasury rates continued a decline that had begun in mid-2007, corporate borrowing rates surged in September 2008, peaking two months later at a spread over Treasury yields just below 7 percent. This spread remained above 6 percent into the second quarter of 2009 as Treasury rates remained unusually low.
When the spread between corporate and federal government borrowing costs widened dramatically at the end of 2008, large numbers of debt securities came within the ambit of the AHYDO rules, even though they lacked the significant equity flavor that Congress intended to target. Because the rules are triggered by a crude and inflexible measure of equity-return — a yield that is a fixed percentage above the AFR — they were punishing a wide swath of all public debt issued during the financial crisis, rather than being limited to deterring the kinds of abuses that plagued the country in 1989.
C. Future of AHYDO Rules
The AHYDO rules were enacted to respond to an economic crisis that had resulted partly from two tax arbitrages: between debt and equity, and between taxable and nontaxable entities. Instead of addressing the sources
of the arbitrages, Congress developed a targeted rule to solve what it believed was the immediate cause of the problem, namely, the favorable treatment of certain highyield debt. In the 20 years since the rules were enacted, changes in tax regulations and in the market for debt instruments have made it more likely for the AHYDO rules to apply to debt that Congress never intended to target. Congress moved commendably fast to temporarily abrogate the AHYDO rules during the 2008-2009 crisis. But the moratorium did nothing to solve the anomalies in the rule itself, and these anomalies will rear their heads when the rules come into operation again at the end of 2009.
Congress has given Treasury wide powers to prevent the AHYDO rules from applying in inappropriate circumstances. Before the legislative moratorium ends, Treasury should use those powers to do one or more of
the following: (1) continue abrogation of the rules until the credit markets have normalized; (2) change the formula for determining when the AHYDO rules begin to be applicable, from a simple interest rate trigger to something more nuanced; and (3) reconsider when and how the AHYDO rules should be applied if an issuer amends its debt. If Treasury fails to exercise its regulatory powers to relieve taxpayers from inappropriate application of the AHYDO rules, Congress should provide relief at least for the problem that causes the greatest trouble, namely debt that is amended but is treated by the law as if it were issued anew in exchange for the originally issued debt.