United States: Proposed Regulations Revise Rules For Determining The Issue Price Of Debt Instruments Issued For Property

On January 6, 2011, the Treasury Department and the Internal Revenue Service ("IRS") issued proposed regulations substantially revising the manner in which issue price is determined for debt instruments that are not issued for cash.

The determination of the issue price of a debt instrument issued for property, including in an actual or deemed debt-for-debt exchange (i.e., where there has been a "significant modification" of the terms of an outstanding debt instrument), has important tax consequences for both issuers and holders. From the issuer's standpoint, the issue price of a debt instrument issued in a debt-for-debt exchange is used to calculate the amount of cancellation of indebtedness income or potentially deductible repurchase premium recognized by the issuer in connection with the exchange. From the holder's standpoint, when the holder exchanges property (including a debt instrument) for a debt instrument in a taxable transaction, the amount realized by the holder in the exchange is equal to the issue price of the new debt instrument. The issue price of a debt instrument also affects whether such instrument is treated as issued with original issue discount ("OID"), which is relevant to both issuers and holders.

The issue price for a debt instrument issued for property generally depends on whether the debt instrument is "traded on an established securities market" (generally referred to as "publicly traded") or is issued for property that is publicly traded. Specifically, the issue price of a publicly traded debt instrument issued for property is the new debt instrument's fair market value or, where the property exchanged for the debt instrument is publicly traded but the newly-issued debt instrument is not, the fair market value of the property exchanged for the debt instrument.¹

While maintaining the "publicly traded" concept for purposes of determining the issue price of debt instruments issued for property, the proposed regulations are intended to clarify the circumstances in which property will be considered publicly traded. The proposed regulations also revise the rules relating to "qualified reopenings" of debt instruments (as described below). Importantly, the proposed regulations are proposed to be effective only with respect to debt instruments issued after the date on which the regulations are finalized.

Current Regulations

As stated above, if a debt instrument is not issued for cash, the issue price of such debt instrument will be:

• its fair market value if the debt instrument is publicly traded, or

• the fair market value of the property exchanged for the debt instrument if the debt instrument is not publicly traded but the property exchanged for the debt instrument is publicly traded.

Thus, in the case of a debt-for-debt exchange, the issue price of the new debt instrument depends upon whether either the old instrument or the new instrument is considered publicly traded.

Under the current regulations, property is considered to be publicly traded for purposes of determining issue price if, at any time during the 60-day period ending 30 days after the issue date, the property is described in any one of the following four categories:

1. Exchange listed property. Property is exchange listed if the property is listed on a national securities exchange, an interdealer quotation system or a specified exchange or board of trade.
2. Market traded property. Property is market traded property if it is of a kind that is traded either on a board of trade designated as a contract market by the Commodities Futures Trading Commission or on an interbank market.
3. Property appearing on a quotation medium. Property appears on a quotation medium if it appears on "a system of general circulation . . . that provides a reasonable basis to determine fair market value by disseminating either recent price quotations . . . of one or more identified brokers, dealers, or traders or actual prices . . . of recent sales transactions . . . ."
4. Readily quotable debt instruments. A debt instrument is a readily quotable debt instrument if, subject to certain meaningful exceptions, price quotations for the instrument are readily available from dealers, brokers or traders.

5. The current regulations have been criticized for years both for their lack of clarity (particularly with respect to what it means to appear on a quotation medium or to trade on an interbank market), as well as for being out-of-date given the dramatic changes in the availability of market information concerning quotes and sales prices for debt instruments. The focus on these regulations intensified during the recent financial crisis, as the increased number of debt restructurings and the depressed values of many instruments highlighted the current regulations' shortcomings.

   Proposed Regulations

   Overview. The proposed regulations, set forth in Prop. Treas. Reg. § 1.1273-2, largely maintain the general framework of the current regulations, but (as described below) make several important changes. These changes include altering the four categories of publicly traded property, shortening the period during which the publicly traded determination is made and providing exceptions where there is no more than de minimis trading of the property or where a debt instrument is part of a "small debt issue." The philosophy underlying the new rules is stated in the preamble to the proposed regulations, providing that "the Treasury Department and the IRS believe that the 'traded on an established market' standard established by section 1273(b)(3) is intended to be interpreted broadly" and that "to the extent accurate pricing information exists, whether it derives from executed sales, reliable price quotations, or valuation estimates that are based on some combination of sales and quotes, the Treasury Department and the IRS believe that that information should be the basis for the issue price determined under section 1273(b)(3)."

   Categories of publicly traded property. Under the proposed regulations, property (including a debt instrument) will be considered publicly traded if, at any time during the 31-day period ending 15 days after the issue date, the property is described in any of the following four categories:

1. Exchange listed property. Property is described in this category if it is listed on a national securities exchange, a board of trade designated as a contract market by the Commodities Futures Trading Commission, certain foreign securities exchanges or any other exchange, board of trade or other market identified by the IRS. This category now includes certain types of property that would have been considered market traded property under the current regulations, but otherwise simply updates the current regulations.
2. Sales price. Property is described in this category if the price for an executed purchase or sale of the property is reasonably available. For this purpose, the price of a debt instrument is considered to be reasonably available if the sales price appears in a medium that is made available to persons that regularly purchase or sell debt instruments or persons that broker purchases or sales of debt instruments.
3. Firm quote. Property is described in this category if a price quote is available from at least one broker, dealer or pricing service and the quoted price is substantially the same as the price for which the property could be purchased or sold. A quote may be considered a firm quote even if the party providing the quote is not legally obligated to purchase or sell at that price so long as market participants typically purchase or sell at the quoted price. A quote will be considered a firm quote, however, only if the identity of the person providing the quote is reasonably ascertainable.
4. Indicative quote. Property is described in this category if a price quote is available from at least one broker, dealer or pricing service, but the price quote is not a firm quote described in the third category.

For purposes of the second, third and fourth categories, a medium or pricing service used to determine a sales price, firm quote or indicative quote (as the case may be) may include a medium or pricing service that provides prices only to certain customers or to subscribers.

De minimis trading and small debt issues exceptions. Notwithstanding that property may be described in one of the four categories set forth above, the proposed regulations provide that such property will not be treated as publicly traded if there is no more than de minimis trading of the property. For this purpose, a debt instrument will be treated as traded in de minimis quantities only if:

In addition, a debt instrument will not be treated as publicly traded if the original stated principal amount of the issue that includes the debt instrument does not exceed $50 million.

Determination of fair market value. Once it is determined that property is publicly traded for this purpose and that no exception applies, the proposed regulations provide that the fair market value of the property is presumed to be equal to its trading price (if the property is exchange listed) or the sales price or quoted price (if the property is described in one of the other three categories). If one or more of the categories yield more than one price or quote, the taxpayer may use any reasonable method, consistently applied, to determine the fair market value of the property. A special rule also applies where property is described only in the fourth category (i.e., only indicative quotes exist) and the taxpayer determines that the indicative quote or an average of such quotes materially misrepresents the fair market value of the property. In such a case, the taxpayer may use any method that provides a reasonable basis to determine the fair market value of the property, but the taxpayer must establish that the method chosen more accurately reflects the fair market value of the property than the indicative quote or quotes.

Other provisions. The proposed regulations contain a provision identical to a provision contained in the current regulations that provides that where a purpose of a temporary restriction on trading of property is to avoid the characterization of the property as publicly traded, the property is treated as publicly traded even if the restriction is not imposed by the issuer. The proposed regulations, however, also add an additional anti-abuse rule pursuant to which a sale or price quotation may be disregarded if a principal purpose for the existence of such sale or price quotation is to materially misrepresent the value of the property. The proposed regulations also would continue to provide that a debt instrument is not treated as publicly traded solely because the debt instrument is convertible into property that is publicly traded.

Effective date. The proposed regulations are proposed to be effective for debt instruments issued on or after the date of publication of the final regulations. Neither the proposed regulations nor the preamble permits taxpayers to rely on the proposed regulations prior to their issuance in final form. Thus, the proposed regulations have no current effect, and will be effective only on a prospective basis once finalized.

Changes to the Qualified Reopening Rules

The proposed regulations also modify the rules relevant to the issuance of additional debt instruments pursuant to the "qualified reopening" rules. By way of background, reopenings are sales of additional debt instruments by an issuer subsequent to an original issuance, but with terms identical to the original issuance. Two offerings of debt instruments are treated as part of the same issue for federal income tax purposes (and thus have the same issue price and are generally fungible) if they occur within 13 days of one another (and the instruments are issued with the same credit and payment terms either pursuant to a common plan or as part of a single transaction or series of related transactions).

In the case of a "qualified reopening," the current regulations treat additional debt instruments with identical terms as part of the same issue as the original debt instruments, even where the additional instruments are issued more than 13 days after the original issue date. A "qualified reopening" is a reopening of original debt instruments where the original debt instruments are publicly traded and either:

The proposed regulations would eliminate the requirement that the original debt instruments be publicly traded so long as the additional debt instruments are issued for cash to unrelated persons for an arm's length price and the other requirements for qualified reopening treatment are satisfied. In such case, where the additional debt instruments are issued not more than six months after the original issuance, the requirement that the yield is not more than 110% of the yield of the original instruments would be based on the yield of the newly-issued debt instruments based on the cash purchase price of the new instruments rather than looking to the fair market value of the original instruments at the time of the additional issuance. These proposed regulations are proposed to be effective for reopenings on or after the date of publication of the final regulations.

Observations

While the proposed regulations leave unanswered a number of important questions regarding the publicly traded determination, they represent a major step forward in modernizing the rules to reflect more closely the information available to market participants regarding the value of outstanding debt instruments. In drafting the proposed regulations, the Treasury Department and the IRS have closely followed the recommendations contained in a recent report of the New York State Bar Association Tax Section concerning when a debt instrument should be considered publicly traded, but largely ignored the other recommendations contained in such report.²

The proposed regulations helpfully move away from the concept of trading on a quotation medium and an interbank market (as categories of publicly traded property) and instead look to whether there is reliable information regarding sale prices or quotes for the property in question.

Perhaps the biggest change in the proposed regulations (as compared with the current regulations) is the exceptions provided where there is no more than de minimis trading of a debt instrument and where the debt instrument is part of an issue with an original stated principal amount of no more than $50 million.

At first blush, one might wonder whether the de minimis trading exception might make irrelevant a large part of the general rule (and, in particular, the firm quote and indicative quote categories of publicly traded property). In other words, if there must be actual sales of a debt instrument in order for it to be treated as publicly traded, one might think that the sales price category will necessarily be satisfied and thus the firm quote and indicative quote categories would serve no purpose.

The answer is that a taxpayer may have reason to believe that more than de minimis trading of the debt instrument has occurred (e.g., through information provided by the administrative agent for the debt), but the prices at which such sales occurred are not reported. This is often the case because, while sales prices are widely available for debt registered with the Securities and Exchange Commission, sales prices for other types of debt (such as syndicated bank debt and debt issued in a private placement) are often not available even where the issuer has access to information regarding the existence of trading activity. In such a case, the existence of firm quotes or indicative quotes would cause the debt instrument to be treated as publicly traded. Further, even where sales prices are reported, such prices might not represent the most accurate manner of determining fair market value. For instance, if more than de minimis sales of property occurred 15 days prior to the issue date, but one or more firm quotes or indicative quotes are available on or around the issue date, the taxpayer may reasonably determine that such quotes represent the best estimation of the property's fair market value.

Finally, while the proposed regulations provide that the fair market value of property that is publicly traded is "presumed" to be equal to the trading, sales or quote price of the property (depending on which category is applicable), it is unclear how this presumption would operate. The existence of a presumption ordinarily suggests that the presumption can be rebutted, and thus in appropriate cases a taxpayer might not use any trading, sale or quoted price for an instrument even where one or more of such prices is available and no exception applies in determining the issue price. While not entirely consistent with the ordinary concept of a presumption, it also is possible that the Treasury Department and the IRS intended that the sole means of rebutting the presumption are through the special rule for disregarding an indicative quote.

Footnote

1. When a debt instrument is not issued for cash or publicly traded property and is not itself publicly traded, the issue price of the instrument is determined under section 1274, generally resulting in the instrument having an issue price equal to its stated principal amount so long as the instrument provides for adequate stated interest.

2. New York State Bar Association Tax Section, Report on Definition of "Traded on an Established Market" Within the Meaning of Section 1273 and Related Issues, 2010 TNT 61-24 (2010); see also New York State Bar Association Tax Section, Report on Definition of "Traded on an Established Market" Within the Meaning of Section 1273, 2004 TNT 159-7 (2004).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.