The regulations require taxpayers to find the FMV of a debt instrument to determine its issue price in at least two circumstances, but no definition of FMV is provided. The two circumstances (discussed above) are when either the debt is traded on an established market, or it is issued in exchange for property that is traded on an established market. Instinctively, a tax adviser would assume that the information that helps conclude that debt is traded on an established market should also be used to determine the FMV of the debt. But nowhere in the regulations is this connection drawn. For example, if a price quotation for recently issued debt is found on a computer listing
widely disseminated to subscribers, the debt could be considered traded on an established market. Then, one might assume, the price quotation found on the computer listing could (or should) be used to determine the issue price of the debt. Although the regulatory definition of ‘‘quotation medium’’ does hint to the connection, nothing more is suggested by the rules as to how taxpayers are to determine the fair market values of their debt issuances.
I would argue that the absence of a definition of FMV in the OID regulations is not a mere oversight. In the original rules that governed this area, reg. section 1.1232-3, FMV was indeed defined, by reference to the estate and gift valuation rules. When the regulations under section 1273 were finalized (replacing the section 1232 regulations), the cross reference was eliminated. Had Treasury or the IRS felt it necessary to define FMV, they would have either used the original cross reference or devised something new. Perhaps the government wished to leave the concept undefined, so as to allow it to adapt to changing marketplace practices and technologies for valuing securities. Alternatively, the government may have been looking for assistance from practitioners before issuing guidance in this fast-developing area.
In the absence of guidance, taxpayers searching for the issue price of their debt generally use the values found on ‘‘established markets’’ defined in the regulations. However, when trading in an asset is thin, the kinds of market data the regulations refer to are an unreliable gauge of value. During 2008, trading in corporate debt securities collapsed, as did market prices. Nevertheless, various electronic services listed bid prices for debt securities, even though few (if any) actual trades were being consummated. Taxpayers using this unreliable market data to value debt instruments was a second reason (along with the divergence between corporate and federal borrowing rates) why a large proportion of debt instruments began triggering the AHYDO rules last year.
However, even under non-crisis conditions, the breadth of the definition of ‘‘traded on an established market’’ causes issuers practical problems. For example, because a debt instrument can meet the ‘‘traded on an established market’’ test any time within 30 days of its issue date, its issue price could remain uncertain for up to a month after it is issued. Further, issuers do not necessarily have any control over whether their debt instruments become publicly traded if initial holders seek to resell them, or third parties seek to buy them, after the instruments are out of the issuer’s control. If the potential for resale or purchase activity leads a broker to post a price quote on a ‘‘quotation medium’’ too soon after the issue date, the securities are treated as traded on an established market. Moreover, issuers will not always know whether or when those quotes appear on a quotation medium or become available from brokers, which could make the rules virtually impossible to comply with.
Given the many difficulties in finding a market-based issue price for many debt instruments, one wonders why the government did not encourage greater use of an alternative system, for example, that found in section. Section 1274 generally applies to debt instruments with a duration greater than six months that are issued in consideration for the sale or exchange of property unless the instrument provides for adequate stated interest and no OID, or if certain exceptions apply. If section 1274 governs an instrument, the issue price generally equals either the stated principal amount or an imputed principal amount depending on whether the instrument calls for adequate stated interest. If neither section 1274 nor any of the other rules fit the facts of the debt issuance, the issue price equals the instrument’s SRPM. Anecdotally, the government has expressed nervousness that these catchall rules governing issue price are susceptible to manipulation by issuers, and because values found on established markets are less open to abuse, the law forces taxpayers to use market values in most circumstances.
Recognizing that the government may not be comfortable with the definitions of issue price found in section 1274 or reg. section 1.1273-2(d)(1), we are still left with the problem of defining issue price in cases involving
publicly traded property. Inspiration can be found elsewhere in the tax law. For example, reg. section 1.1275-1(h) defines a debt instrument as ‘‘publicly offered’’ if it is part of an issue of debt instruments the initial offering of which was either registered with the SEC, or would have been required to be registered but for certain exemptions from registration. Issuers know whether they registered a debt offering with the SEC, or whether they qualified for a specific exemption from registration. Further, because the definition of ‘‘publicly offered’’ debt instruments looks to the initial issuance, whether an instrument meets that definition is fixed on its issue date. Unlike the definition of ‘‘publicly traded’’ property, this definition looks only to an instrument’s issue date and relies on criteria that the issuer controls and has full knowledge of.