A complication that arises for floating rate-linked notes within the Type 1 category (i.e., principal protected notes treated as debt for U.S. federal income tax purposes) where the rate is expressed by reference to an index that does not measure borrowing rates (e.g., LIBOR or EURIBOR) is whether the expressed rate is treated as an objective rate within the meaning of the applicable regulations. This question is important because if a rate qualifies as an objective rate, the note generally is treated as a variable rate debt instrument (“VRDI”) for tax purposes. If the rate fails to qualify as an objective rate, the note generally is treated as a contingent payment debt instrument (“CPDI”) for tax purposes. In most cases, VRDIs are preferable to CPDIs for investors. In the case of a VRDI, an investor’s taxable income inclusions generally match up squarely with the cash that is paid out, so there is no “phantom income,” unlike a CPDI. In addition, if an investor recognizes any gain on sale, it generally is capital gain in the case of a VRDI, versus ordinary income for CPDIs.
For most rate linked structured notes in the market, to qualify for VRDI status, the expressed interest rate must either be a qualified floating rate (“QFR”) or an objective rate. QFRs include “plain vanilla” rates that measure contemporaneous variations in the cost of borrowing money (e.g., rates expressed by reference to LIBOR or EURIBOR). When an objective rate is involved, under regulations, the instrument must provide for a single objective rate (generally, a rate that is determined using a single fixed formula that is based on objective financial information). Examples are rates determined by reference to inflation, or rates that are linked to the difference between two rates (e.g., the “curve steepener,” a popular structured note product discussed below).
Two special rules apply in limiting the scope of the objective rate universe. First, a rate is not an objective rate if “it is reasonably expected that the average value of the rate during the first half of the instrument’s term will either be significantly less than or significantly greater than the average value of the rate during the final half of the instrument’s term.” The other special rule is the following: If interest on a debt instrument is stated at a fixed rate for an initial period of one year or less followed by a variable rate that is an objective rate for a subsequent period, and the value of the variable rate on the issue date is intended to approximate the fixed rate, the fixed rate and the variable rate together constitute a single qualified floating rate or objective rate. A fixed rate and a variable rate is conclusively presumed to meet the requirements of the preceding sentence if the value of the variable rate on the issue date does not differ from the value of the fixed rate by more than .25 percentage points (25 basis points).
Here’s a real life example of a structured note where these rules are applied, the so-called curve steepener. Consider a note that has a 10 year term and an issue price of $10 per note. During the first four quarterly interest periods, interest on the notes accrues at a rate of 10.00% per annum. During each subsequent quarterly interest period, interest on the notes accrues at a rate per annum equal to the product of
(a) 10, and
(b) the amount by which the 30-year U.S. Dollar Constant Maturity Swap Rate (“CMS30”) exceeds the 2-year U.S. Dollar Constant Maturity Swap Rate (“CMS2”) on the applicable interest determination date. The rate is subject to a 10% cap. CMS30 and CMS2 are “constant maturity swap rates” that measure the fixed rate of interest payable on a hypothetical fixed-for-floating U.S. dollar interest rate swap transaction with a maturity of 30 years and two years, respectively.
Applying the rules described above, the expressed rate is not a QFR. Since the fixed rate is in effect for one year or less, the analysis must measure the difference between the initial fixed rate and the value of the expressed variable rate. For example, suppose that on the issue date, the spread between the CMS30 and the CMS2 is 2%. Plugging that into the formula (and taking into account the cap) results in a value that is exactly equal to the fixed rate. Thus, applying the 25 bps rule, you would say that there is a conclusive presumption that the expressed rate results in a single objective rate. But that is not the end of the analysis. There is one last hurdle: the note would not qualify as a VRDI unless it is reasonably expected that the average value of the rate during the first half of the instrument’s term will not either be significantly less than or significantly greater than the average value of the rate during the final half of the instrument’s term. This is a factual question the resolution to which typically requires a market-based analysis, one that generally requires input from the business desk that prices the note.