2.2. Tax deductibility of interest paid on the bonds
In general, Sec. 163(a) provides that all interest paid or accrued on indebtedness within a taxable year is allowed as a deduction. If an obligation is issued by a corporation with original issue discount (OID), the amount of such discount is deductible as interest and is prorated or amortized over the life of the obligation. Sec. 163(e) further adds that, in the case of debt instruments issued after 1 July 1982, the portion of the OID with respect to such debt instrument which is allowable as a deduction will be equal to the aggregate daily portions of the OID for days during such taxable year.
For US tax purposes, an instrument has OID if the issue price of the instrument is less than the amount payable at maturity, including in amounts payable at maturity for the purpose of this calculation all amounts paid on the instrument other than amounts unconditionally payable at fixed periodic intervals of one year or less during the entire term of the debt instrument.
If the yield on a note is in excess of 6% above the US applicable federal rate (AFR) for the month the instrument is issued, a portion of the OID on the instrument may be disallowed as a deduction to the borrower. Under Sec.
163(e)(5), in the case of an applicable high-yield debt obligation, as defined in Sec. 163(i), a corporation is not allowed a deduction for the disqualified portion of the OID on the obligation, and the corporation’s deduction for the remaining portion of the OID is deferred until the OID is paid in cash or in property (other than debt of the issuer or a related person within the meaning of Sec. 453(f)(1)).
Thus, if the instrument is characterized as debt, some portion of the accretion in value may be allowable as a deduction, subject to the limitations described above and general limitations such as the US earnings stripping rules.
2.3. Deductibility on an accrual basis for any deferred interest
Treas. Reg. Sec. 1.1275-4 provides rules for the treatment of contingent payment debt instruments. In general, if a contingent payment debt instrument is issued for cash or publicly traded property, the non-contingent bond method applies to the instrument. Under the non-contingent bond method, interest accrues on the debt instrument as if it were a fixed-payment debt instrument. This fixed-payment debt instrument is constructed by using the instrument’s comparable yield and a projected payment schedule.
In general, under Treas. Reg. Sec. 1.1275-4(b)(4)(i), the comparable yield for a contingent payment debt instrument is the yield at which the issuer would issue a fixed-rate debt instrument with terms and conditions similar to those of the contingent payment debt instrument. Relevant terms and conditions include the level of subordination, term, timing of payments, and general market conditions. In determining the comparable yield, no adjustments are made for the riskiness of the contingencies or the liquidity of the debt instrument. In all cases, the yield must be a reasonable yield for the issuer and may not be less than the applicable federal rate. In certain situations, the comparable yield is presumed to be the applicable federal rate (based on the overall maturity of the debt instrument).
The projected payment schedule for a debt instrument. includes each non-contingent payment and a projected amount for each contingent payment. In general, if a contingent payment is based on market information, the amount of the projected payment is the forward price of the contingent payment. If a contingent payment is not based on market information, the amount of the projected payment is the expected value of the contingent payment as of the issue date. If the projected payment schedule and the instrument’s issue price do not produce the comparable yield, the schedule must be adjusted to produce the comparable yield. In most cases, the issuer’s determination of the projected payment schedule will be respected unless it was set with a principal purpose to overstate, understate, accelerate or defer interest accruals on the debt instrument.
If the actual amount of a contingent payment is different from the projected payment, the difference is taken into account as either a positive or negative adjustment. A positive adjustment results when the actual amount is greater than the projected amount. In general, a net positive adjustment is treated as interest and is includible in income by the holder and deductible by the issuer in the taxable year in which the adjustment occurs. A negative adjustment results when the actual amount is less than the projected amount. In general, a net negative adjustment (1) reduces interest accruals on the debt instrument for the taxable year, (2) to the extent of any excess, is treated as an ordinary loss by a holder and ordinary income by
the issuer, but only to the extent of prior accruals on the debt instrument by the holder or issuer and (3) to the extent of any further excess, is a carry-forward to the next taxable year.
Except as provided in Treas. Reg. Sec. 1.1275-4(a)(2), Treas. Reg. Sec. 1.1275-4 applies to any debt instrument that provides for one or more contingent payments. A payment is not a contingent payment merely because of a contingency that, as of the issue date, is either remote or incidental.