In February, the IRS released a private letter ruling (PLR 201105016) addressing the federal income tax treatment of repurchase premium and consent fees in connection with the repurchase and modification of certain debt instruments issued by a corporate taxpayer. Simplified, the facts were as follows: the taxpayer had senior unsecured notes (treated as debt for federal income tax purposes) outstanding. The taxpayer announced a tender offer and a consent solicitation to obtain the consent of the note holders to certain amendments to the note indenture. Pursuant to the tender offer, the taxpayer offered to purchase a certain percentage of the outstanding notes for a specified price in excess of the notes’ adjusted issue price. With respect to the notes that were not repurchased pursuant to the tender offer, the taxpayer represented that the consent fee payment and amendment to the indenture did not result in a “significant modification” of the notes under Section 1.1001-3 and, therefore, did not result in a deemed exchange for federal income tax purposes. With respect to the repurchase premium (i.e., the amount paid by the taxpayer for the notes in excess of their adjusted issue price), the IRS ruled that such amount was deductible as interest. This result isn’t too surprising since Section 1.163-7(c) specifically so provides.6
With respect to the consent fee, the IRS ruled that such payments are treated as payments on the notes and must, therefore, be taken into account in determining the yield on the “modified notes.” This is relevant because if the yield of the modified notes varies from the yield on the unmodified notes (determined as of the date of the modification) by more than the greater of (1) 0.25%, or (2) 5% of the annual yield of the unmodified instrument, this would result in a significant modification of the debt instrument and, therefore, a deemed exchange for federal income tax purposes. Notwithstanding this ruling, the taxpayer represented that the payment of the fee and the amendments to the indenture did not result in a significant modification of the notes. Further, the IRS ruled that the consent fees are treated first as payments of accrued interest (to the extent of any accrued interest on the notes at the time of payment of the consent fees), and second as payments of principal on the notes.7 The IRS further clarified that to the extent any consent fee was treated as payment of principal on the notes, such amount would decrease the adjusted issue price of the notes with the result that a subsequent repurchase of the notes for an amount in excess of the reduced adjusted issue price would result in repurchase premium deductible as interest (consistent with the IRS’s first ruling).
The private letter ruling leaves unanswered the question of the federal income tax treatment applicable to the interest accrued as of the date the consent fee was paid. An example: a taxpayer has a note outstanding with a principal amount and adjusted issue price equal to $100 and which pays an annual coupon of $7. Interest in an amount equal to $3 has accrued at a particular point in time. At that time, the taxpayer, in connection with an amendment of the note indenture, pays a consent fee of $5 to the consenting note holder. According to the ruling, $3 of the $5 consent fee is treated as interest and the remaining $2 reduces the adjusted issue price of the note to $98. But what happens when the annual $7 coupon is paid? One option would be that of the $7 coupon, $4 is treated as interest when paid (i.e., the portion of the coupon accrued after the consent fee was paid) and the remaining $3 is treated as further reducing the note’s adjusted issue price to $95. Economically, this would mean that the entire amount of the consent fee would be treated as a return of capital resulting in gain or loss to the holder upon maturity or upon earlier disposition. Alternative treatments may also be possible. For example, the entire $7 coupon may be treated as interest income when paid. This alternative, however, would cause different tax results depending on the amount of accrued interest at the time the consent fee is paid.