Stimulus Act Enhances Flexibility in Debt Restructuring by Temporarily Suspending the AHYDO Rules

March 3, 2009

The recently enacted American Recovery and Reinvestment Act of 2009 (the “Stimulus Act”) provides businesses that modify, repurchase or restructure indebtedness in ways that result in cancellation of debt income (“CODI”) the ability to defer federal income taxation on such CODI as previously discussed in our  2/13/09 update. In addition to the CODI deferral provisions, the Stimulus Act temporarily suspends the application of the applicable high yield discount obligation (“AHYDO”) rules and, in doing so, provides additional flexibility to corporate issuers that restructure outstanding indebtedness.

Issuers are generally entitled to deduct (and, similarly, holders are required to include as income) “original issue discount” (“OID”) on an obligation as it accrues over the term of the instrument notwithstanding that under the terms of the obligation interest is not payable until a later time. OID is the excess of total interest (as computed for tax purposes) in excess of the interest that is unconditionally payable not less frequently than annually. Under the law prior to the Stimulus Act, however, where a debt instrument fell within the Internal Revenue Code’s definition of an AHYDO, no deduction was permitted to a corporate issuer for the “disqualified portion” of the OID on the instrument, and the remainder of the OID was deductible only when actually paid by the issuer. The AHYDO rules thus operate as a disincentive to structure or restructure debt with high yield discount obligations.

An instrument falls under the AHYDO rules if it (i) has a term in excess of five years, (ii) has “significant OID” and (iii) has a yield to maturity equal to or in excess of the applicable federal rate (the “AFR”) for the month of issuance plus five percent. The “disqualified portion” of the interest on an AHYDO is defined with reference to a yield to maturity in excess of the AFR plus six percent. Note, however, that S corporation issuers are not subject to the AHYDO rules.

The Stimulus Act suspends the application of the AHYDO rules for obligations issued after August 31, 2008 and before January 1, 2010 in an exchange (including a deemed exchange resulting from a “significant” modification of a debt instrument) for another debt instrument issued by the same issuer that is not an AHYDO. The suspension of the AHYDO rules does not apply to instruments having a contingent interest coupon or those issued to persons related to the issuer.

To illustrate, consider a corporate issuer having outstanding, non-contingent, non-AHYDO indebtedness held (publicly or privately) by non-related holders. The issuer issues new zero-coupon indebtedness during the AHYDO suspension period in exchange for the outstanding indebtedness. The new debt instrument matures in ten years and has a yield to maturity equal to the AFR plus 6.5% and significant OID. Under the law before the Stimulus Act, the issuer would have been subject to the interest deferral and disallowance rule under the AHYDO regime. Because the Stimulus Act, effectively turns off the AHYDO rules with respect to such an instrument issued after August 31, 2008 and before January 1, 2010, the issuer of such an obligation during that period would be entitled to deduct the full amount of the OID over the life of the instrument.

In effect, the Stimulus Act’s suspension of the AHYDO rules gives additional flexibility to issuers who must or wish to restructure their existing debt. For debt instruments otherwise meeting the AHYDO definition issued during the limited window (which may be extended beyond 2009 by the Secretary of the Treasury), the Stimulus Act’s suspension of the AHYDO rules ensures that issuers are able to deduct OID without the deferral or disallowance that would have resulted under prior law.

For more information on this and related regulatory and business matters, please visit the McGuireWoods Stimulus Package section, or contact the members of our Business Tax practice.