As discussed in our prior issue of MoFo Tax Talk (see MoFo Tax Talk, Volume 2, Issue 1), debt issues are often “reopened,” meaning that an issuer issues an additional tranche of notes (“additional notes”) at some point after the original issuance (“original notes”). The additional notes bear the same terms and security identification code (e.g., CUSIP number) as the original notes. Generally speaking, the economic motive behind a reopening is to give existing holders a more liquid instrument and to give the issuer a lower cost of financing. To achieve these goals, the issuer’s intent is that the original notes and the additional notes be indistinguishable and, therefore, completely fungible. Reopening a debt issue can have significant tax consequences, particularly where the additional notes, treated as debt instruments for U.S. federal income tax purposes, are issued with original issue discount (“OID”).
Taxpayers are required to currently accrue OID on a constant yield basis for any debt instrument that is issued with more than a de minimis amount of OID. OID generally arises where a note is originally issued at a discount and is an attribute of the note itself (i.e., OID “travels” with the note and does not vary depending on whether an original investor or a secondary market investor holds the note). In contrast, “market discount” generally arises when a secondary-market investor purchases a debt instrument at a discount after original issue. Market discount generally is not taxable currently as it accrues, unless the holder so elects.
Thus, where the original notes are not issued with OID, but where the additional notes are priced at a discount in excess of the statutory de minimis amount (e.g., because interest rates have risen after original issue), a holder generally would prefer the original notes and the additional notes to be fungible from a tax standpoint, so that the additional notes (like the original notes) are not treated as having been issued with OID, but rather are treated as being acquired by holders at a market discount. The reopening rules discussed below police the boundaries within which the additional notes may be treated as fungible with the original notes in this manner.
If the original notes and the additional notes do not meet the requirements described below, the tax law treats the additional notes as a fresh issuance issued with OID and, accordingly, the original notes and the additional notes would not be fungible from a tax standpoint. If the original notes and the additional notes are nonetheless issued so that they are indistinguishable (i.e., issued with the same terms and CUSIP number) it would be impossible for secondary market purchasers or, for that matter, the IRS, to trace securities through the chain of intermediate ownership and determine whether their notes were issued as part of the original issuance (issued without OID) or the additional issuance (issued with OID). There is a risk, then, that the additional notes may taint the original notes, with the IRS treating both the original notes and the additional notes as having been issued with OID in the hands of a purchaser who buys notes after the reopening.
To be fungible from a tax standpoint, the reopening must satisfy one of three tests: the original notes and the additional notes must be part of the same “issue” (under the 13-day rule discussed below), or the additional notes must be part of a “qualified reopening” of the original notes (under either one of the two alternative tests discussed below). Under each of the three tests, a precondition is that the additional notes must have terms that are in all respects identical to the terms of the original notes.
Under applicable regulations, an “issue” of debt instruments includes all debt instruments that:
- are issued either pursuant to a common a. plan or as part of a single transaction or a series of related transactions, and
- are issued within a period of 13 days b. beginning with the date on which the first debt instrument that would be part of the issue is sold to a person other than a bond house, broker, or similar person or organization acting in the capacity of an underwriter, placement agent, or wholesaler.
The regulations provide rules for two types of qualified reopenings. Under the first rule, a reopening of debt instruments is treated as a qualified reopening if:
- the original notes are “publicly traded” a. (see discussion below),
- the issue date of the new notes (treated b. as a separate issue) is not more than six months after the issue date of the original notes, and
- on the pricing date of the reopening c. (or, if earlier, the announcement date), the yield of the original notes (based on their fair market value) is not more than 110% of the yield of the original notes on their issue date (or, as is often the case, if the original securities were issued with no more than a de minimis amount of OID, their coupon rate).
Alternatively, a reopening of debt instruments (regardless of whether the reopening occurs within six months or not) is treated as a qualified reopening if:
- the original notes are publicly traded, a. and
- the additional notes (treated as a b. separate issue) are issued with no more than a de minimis amount of OID.
Publicly Traded Test
Applicable regulations provide detailed rules that define when notes are treated as “publicly traded.” The most common scenarios are (a) the notes are listed on a national securities exchange, or (b) the notes appear on a system of general circulation (including a computer listing disseminated to subscribing brokers, dealers, or traders) that provides a reasonable basis to determine fair market value by disseminating either recent price quotations (including rates, yields, or other pricing information) of one or more identified brokers, dealers or traders, or actual prices (including rates, yields, or other pricing information) of recent sales transactions (a “quotation medium”). A quotation medium does not include a directory or listing of brokers, dealers or traders for specific securities that provides neither price quotations nor actual prices of recent sales transactions. Bloomberg and/or TRACE may qualify as a quotation medium for a particular issuance if there is sufficient trading frequency and volume within the testing period. Even if any particular tranche of notes does not satisfy the requirements of (a) and (b) above, they may nonetheless be treated as publicly traded under additional tests that are more fact specific.
Reopening Structured Notes
Whether an issue of structured notes (for a taxonomy on structured notes, see our prior issue of MoFo Tax Talk, Volume 1, Issue 1) may be reopened without the above described adverse U.S. federal income tax consequences generally depends on the characterization of the note and the technical rules that apply to the structured note.
Type 1 notes are generally treated either as fixed rate debt instruments, variable rate debt instruments (“VRDIs”), or contingent payment debt instruments (“CPDIs”). The discussion above regarding the 13-day rule generally applies to all structured notes that are treated as Type 1 notes. In addition, the qualified reopening rules described above generally apply to all Type 1 notes that are treated as either fixed rate debt instruments or as VRDIs. However, the qualified reopening rules do not apply to Type 1 notes that are considered CPDIs for U.S. federal income tax purposes. Therefore, an issue of Type 1 notes treated as CPDIs can only be reopened for tax purposes if the reopening meets the requirements of the 13-day rule. If additional notes in an issue of CPDIs are issued outside of the 13-day rule, such additional notes will have a different issue date, a different issue price and a different adjusted issue price from the original notes. In addition, the issuer would be required to provide a new “comparable yield” and “projected payment schedule” with respect to the additional notes. Further, the additional notes would have to be distinguished from the original notes (e.g., through a different CUSIP number).
Type 2 notes are not treated as debt instruments for U.S. federal income tax purposes and, under current law, a holder of a Type 2 note is not required to accrue any income (including OID or market discount). As a result, the above described concern regarding the conversion of OID into market discount does not exist, and U.S. federal income tax law does generally not impose any restrictions on reopening Type 2 notes.
To the extent a Type 3 note is treated as an income-bearing single financial contract, the same considerations as to the reopening of Type 2 notes apply and U.S. federal income tax law generally does not impose restrictions on reopening. However, to the extent a Type 3 note is treated as a unit consisting of a debt component and a derivative, an analysis of a reopening of a Type 3 note will depend on the facts and circumstances, on the agreed upon treatment between the issuer and the holder of the particular note and the prevailing market conditions at that time. As such, the reopening of Type 3 notes may be subject to the same considerations as the reopening of Type 1 notes or of Type 2 notes.