On September 12, 2012, the Internal Revenue Service (IRS) issued final regulations (the Final Regulations) for determining when property is treated as “publicly traded” for purposes of determining the issue price of a debt instrument. The Final Regulations adopt the broad and simplified definition of the term suggested in the 2011 proposed regulations (the Proposed Regulations) with certain modifications. In general, the revised definition of the term “publicly traded” will make it more likely that issuers will recognize cancellation of indebtedness income (CODI) and holders will receive debt instruments deemed to be issued with original issue discount (OID) in debt-for-debt exchanges and other debt restructurings.
The Final Regulations also expand the definition of “qualified reopening,” making it easier for a new debt instrument to be treated as fungible with an existing debt instrument for tax purposes. This portion of the Final Regulations will be discussed in a forthcoming Alert.
Relevance of Issue Price and Being “Publicly Traded”
The issue price of a new debt instrument affects the tax consequences of the exchange of an existing debt instrument for a new debt instrument, as well the tax treatment of the new debt instrument, to both the issuer and the holder. For example, if an issuer exchanges an existing debt instrument for a new debt instrument, or if an existing debt instrument is significantly modified within the meaning of applicable tax rules, the issuer would generally recognize CODI to the extent that the issue price of the new (or modified) debt instrument is less than the adjusted issue price of the existing debt instrument. In addition, the issue price of a new debt instrument will affect the amount of gain realized by a holder upon the exchange of an existing debt instrument for such new debt instrument. Moreover, to the extent the issue price of a debt instrument is less than its stated redemption price at maturity (generally, its stated principal amount), the debt instrument will be treated as having been issued with OID, which would be includible by a holder, and generally deductible by the issuer, on a constant yield basis over the term of the instrument.
When a new debt instrument is issued in exchange for an existing debt instrument or other property, the determination of its issue price varies depending on whether the new debt instrument or the existing debt instrument or other property is publicly traded within the meaning of the applicable tax rules. If the new debt instrument, or the existing debt instrument or other property, is publicly traded, the issue price of the new debt instrument will be determined based on the fair market value of the new debt instrument (if it is publicly traded) or the fair market value of the existing debt instrument or other property (if the new debt instrument is not publicly traded but the existing debt instrument or other property is). If none of the existing debt instrument, other property or the new debt instrument is treated as publicly traded, then the issue price of the new debt instrument will generally be equal to its stated principal amount, if the debt instrument provides for adequate stated interest (generally, interest at least equal to the applicable federal rate).
By broadening the definition of “publicly traded,” the Final Regulations make it more likely that the issue price of the new debt instrument issued in a debt-fordebt exchange or other debt restructuring will be determined based on its fair market value. As a result, an issuer that effects a debt-for-debt exchange when its debt is trading at a discount is more likely to recognize CODI, and the new debt instrument is more likely to be deemed to have been issued with OID or additional OID (generally, in an amount equal to the CODI). OID generally would be deductible by the issuer over the term of the new debt, but such deductions may be deferred or disallowed under applicable tax rules, creating the possibility of a mismatch between CODI and OID. Due to this potential CODI issue, the expanded scope of the definition of the term “publicly traded” originally put forth in the Proposed Regulations raised significant concerns. While comments and suggestions were made to alleviate this problem, the IRS declined to accept them in the Final Regulations, noting in the preamble to the Final Regulations that the suggested remedies were outside the scope of the regulations.
The Prior Rules
Under regulations issued in 1994, property (including a debt instrument) was generally treated as publicly traded if, at any time during the 60-day period ending 30 days after the issue date:
- It was listed on a US national securities exchange, an interdealer quotation system or a number of specified foreign exchanges
- It was of a kind traded on a contract market designated by the Commodities Futures Trading Commission or on the interbank market
- It appeared on a system of general circulation (“quotation medium”) that provided a reasonable basis to determine fair market value by disseminating either recent price quotations of identified brokers, dealers or traders, or actual sales prices or
- Price quotations were readily available from brokers, dealers, or traders, subject to certain limitations
The definition of the term “publicly traded” under the 1994 regulations was criticized as being outdated and ambiguous in several respects. For instance, the meaning and the scope of terms such as “quotation medium,” “interbank market” and “readily available” were unclear and often confusing.
In 2011, the IRS issued the Proposed Regulations revising the definition of the term “publicly traded” under the existing regulations. Under the Proposed Regulations, property would generally have been treated as publicly traded if, at any time during the 31-day period ending 15 days after the issue date:
- It was listed on an exchange
- There was a sales price reasonably available
- There were one or more firm quotes or
- There were one or more indicative quotes
If one or more of the four tests described above were met, the Proposed Regulations provided that a debt instrument would be treated as publicly traded, and the issue price of the debt instrument would be determined based on the relevant fair market value. However, even if one or more of the tests were met, the debt instrument would not have been treated as publicly traded if it met:
- The de minimis trading safe harbor (which would have applied when each trade was $1.0 million or less and the aggregate amount of trades was $5.0 million or less); or
- the small debt issue safe harbor (which would have applied when the principal amount of the debt issue was $50.0 million or less).
Definition of “Publicly Traded”
Under the Final Regulations, property (including a debt instrument) will be treated as publicly traded if, at any time during the 31-day period ending 15 days after the issue date, there exists pricing information of one or more of the kinds described below with respect to the property:
- A sales price. A sales price exists if the sales price for an executed purchase or sale of the property within the 31-day period is reasonably available within a reasonable period of time after the sale. A price will be considered reasonably available if the sales price, or information sufficient to calculate the sales price, appears in a medium available to issuers of debt instruments or other persons who regularly purchase or sell debt instruments, including where the price is provided only to certain customers or subscribers.
- One or more firm quotes. A firm quote exists if a firm price quote is available from at least one broker, dealer or pricing service (including a price quote available only to certain customers or to subscribers). A price quote is treated as a firm quote if it is substantially the same as the price for which the property could be purchased or sold and the identity of the person making the quote is reasonably ascertainable. A price quote can be a firm quote even if it does not legally obligate the broker, dealer or pricing service to complete a purchase or sale at that price.
- One or more indicative quotes. An indicative quote exists if a price quote (that is not a firm quote) is available from a broker, dealer or pricing service, including a price provided only to certain customers or subscribers. An indicative quote is any price quote that is not a firm quote.
Under the Final Regulations, exchange listed property will not automatically be treated as publicly traded. Property traded on an exchange will be treated as publicly traded only if it meets one or more of the tests described above. The Final Regulations also eliminated the de minimis trading safe harbor. However, the Final Regulations retained a modified version of the “small debt issue” safe harbor. Under the “small debt issue” safe harbor as adopted in the Final Regulations, a debt instrument will not be considered to be publicly traded if, at the time the determination is made, the outstanding principal amount of the debt instrument does not exceed $100.0 million, regardless of the availability of the pricing information described above. For debt instruments denominated in a currency other than US dollars, the threshold amount is the equivalent amount in such non-US currency.
If any of the pricing information described above is available for the new debt instrument or the property (other than cash) in exchange for which the debt instrument is issued during the relevant testing period, the issue price of such debt instrument will generally be equal to its fair market value (or, if such pricing information is not available for the new debt instrument, the fair market value of such property) on its issue date. The fair market value is presumed to be the relevant sales price or quote.
If there is more than one such sales price and/or quote, a taxpayer may use any reasonable method to determine the relevant price or the fair market value. The Final Regulations provide a special rule for an indicative quote. If the available pricing is an indicative quote, and if the indicative quote materially misrepresents the fair market value of the relevant property, the taxpayer may use any reasonable method in establishing the issue price so long as such method more accurately reflects the value of the property. Volume discounts or control premiums are deemed not to create a material misrepresentation of fair market value.
In response to the comments on the Proposed Regulations, the Final Regulations now require issuers and holders to report issue prices consistently. The issuer is required to determine the issue price and make it available in a commercially reasonable fashion, which can include posting it on a website or similar electronic publication, within 90 days of the date of issue. The holder can take a position inconsistent with the issuer only upon adequate disclosure to the IRS in its income tax return.
The Final Regulations relating to the definition of the term “publicly traded” apply to debt instruments issued on or after 60 days after September 13, 2012.