Fixed-to-floating rate notes appear to becoming more popular for fixed-income investors lately. We suspect this is due to a combination of factors, including investors’ appetite for higher yielding securities in the current economic environment, where the yield for securities appears to be historically quite low. The current array of fixed-to-floaters provide a relatively high fixed interest during the earlier years, and subsequently a variable rate of interest in later years (potentially subject to a cap or floor), which allows an investor to have a (at least partial) hedge against inflation, should the inflation risk ever rear its head.  

So how are these instruments taxed? Fixed-to-floating rate notes are generally treated as either “variable rate debt instruments” (“VRDI”) or “contingent payment debt instruments” (“CPDI”) for U.S. federal income tax purposes. In a prior issue of MoFo Tax Talk,1 we explored some of the boundaries of variable rate debt instruments—specifically, the taxation of floating rate notes that provide interest at a floating rate that qualify under applicable Treasury regulations as an “objective rate” (rather than a “qualified floating rate” (“QFR”)). QFRs can generally be defined as floating rates that measure the cost of newly borrowed funds under applicable Treasury regulations and can generally be described as “typical” floating rates, such as LIBOR. Objective rates, on the other hand, are more exotic, “atypical” floating rates (such as an inflation rate), which do not necessarily measure the cost of newly borrowed funds, but are nonetheless based on objective financial information.  

As discussed in our prior issue of MoFo Tax Talk, in order to qualify for VRDI tax treatment, the tax restrictions imposed on floating rate notes that provide for objective rates are stricter than those restrictions imposed on floating rate notes that provide for QFRs. For example, to qualify for VRDI tax treatment, the note must provide interest at a single objective rate. Accordingly, fixedto- floating rate notes, for which the floating rate leg of the note provides for interest based on an “objective rate,” are generally disqualified from VRDI tax treatment unless a narrow safe harbor (the “Approximation Test”) is met, which, in such case, would generally be treated, for purposes of VRDI qualification, as if the note provided interest at a single objective rate.2

Example 1. X issues at par a 10-year 100% principal protected note that pays interest annually, equal to, for the first 2 years, fixed interest at 6% and thereafter a variable rate based on the consumer price index. The note would not qualify for VRDI tax treatment, and instead would be classified as a CPDI for U.S. federal income tax purposes. This is because the note does not provide interest at a single objective rate nor can the Approximation Test be satisfied because the fixed interest is not paid for an initial period of one year or less.

A VRDI, may, on the other hand, provide for interest at a single fixed rate followed by one or more QFRs, even if the Approximation Test is not met, if the general requirements of VRDI tax treatment are met (including the requirement that interest is paid or compounded at least annually, the instrument does not, in general, have any contingent principal, and the rate in effect is based on a “current” value, as defined in applicable Treasury regulations).

Example 2. X issues at par a 10-year 100% principal protected note that pays interest annually, equal to, for the first 2 years, fixed interest at 6% and thereafter a variable rate based on 3-month USD LIBOR plus a spread of 2%. The note would generally qualify for VRDI tax treatment because the note provides for fixed interest for an initial period followed by a QFR.

Once the classification of the instrument is determined for U.S. federal income tax purposes, the next question is how that instrument is actually taxed under applicable Treasury regulations. The simplest VRDI is one that provides for a single variable rate. The tax consequences of such an instrument are generally determined by (i) converting the debt instrument into an “equivalent fixed rate debt instrument,” (ii) applying the rules applicable to such instruments (i.e., the original issue discount (“OID”) rules, which generally assume the taxpayer should accrue interest income under a constant interest basis), and (iii) making appropriate adjustments for actual interest payments on the notes. The debt instrument is converted into an equivalent fixed rate debt instrument by assuming that the QFR is equal to the value, as of the issue date, of the QFR, or in the case of an objective rate, a fixed rate that reflects the yield that is reasonably expected for the debt instrument (the “fixed rate substitute”). If the note that provides interest solely at a single variable rate is issued at par (i.e., not issued at a discount), then the taxpayer generally includes interest income at the time it is received or accrued under the taxpayer’s regular method of accounting.

Example 3. X issues at par a 10-year 100% principal protected note that pays interest annually at a variable rate based on the 3-month USD LIBOR plus a spread of 2%. Assume the value of 3-month USD LIBOR on the issue date is .5%. The note would generally qualify for VRDI tax treatment because the note provides interest at least annually at a QFR.

The tax consequences of the note would be determined by converting the floating rate note into an equivalent fixed rate debt instrument. The floating rate note is converted into the equivalent fixed rate debt instrument by assuming the note paid interest at the value of 3-month USD LIBOR on the issue date, or 2.5% per annum. Because the note is issued at par and provides interest at a constant interest rate for each interest period (i.e., 2.5% per annum), the instrument would not have OID.

The taxation of VRDIs that provide for interest at a single fixed rate followed by a QFR is more complex. As described above, the rules require one to convert the debt instrument into an “equivalent fixed rate debt instrument.” However, in doing so, applicable Treasury regulations add one additional step in the process. The applicable Treasury regulations first require replacing the initial fixed rate by a QFR that would preserve the fair market value of the notes, assuming the terms of the note otherwise remain identical. Once this initial first step is completed, the rules then require replacing the QFRs with their fixed rate substitutes (i.e., their values as of the issue date), similar to the rules described above. Once the debt instrument is converted into the equivalent fixed rate debt instrument, one applies the tax rules applicable to fixed rate debt instruments, and then makes appropriate adjustments for actual interest payments on the notes. Since the interest rates on the equivalent fixed rate debt instrument are unlikely to be constant throughout, the instrument may have OID (unless the OID is “de minimis”).3  

Example 4. X issues at par a 10-year 100% principal protected note that pays interest annually, equal to, for the first 2 years, fixed interest at 6% and thereafter a variable rate based on the 3-month USD LIBOR plus a spread of 2%. Assume 3-month USD LIBOR on the issue date equals .5%. Further assume that the note’s value would be preserved assuming the note paid interest at 3-month USD LIBOR plus a spread of 5% in lieu of fixed interest for the initial fixed interest rate period. As discussed above, the note would generally qualify for VRDI tax treatment because the note provides for fixed interest for an initial period followed by a QFR.

The taxation of the note would be determined by converting the floating rate note into an equivalent fixed rate debt instrument. The first step would be to substitute for the initial fixed rate 3-month USD LIBOR plus a spread of 5%, which would preserve the fair market value of the notes, assuming all other terms remain identical. The floating rate note would be converted into an equivalent fixed rate debt instrument by assuming the note paid interest at the value of 3-month USD LIBOR on the issue date, or a fixed rate of 5.5% per annum for the first 2 years, and thereafter a fixed rate of 2.5% per annum for the remaining term. Although the note is issued at par, the equivalent fixed rate debt instrument does not provide for interest at a constant rate throughout its term. Accordingly, only 2.5% per annum is considered to be qualified stated interest. The excess of 5.5% over 2.5% for the first two interest rate periods is deemed to be OID, and must be accounted for under a constantinterest basis over the term of the note.