IRS rules consent fee paid on contingent payment debt instrument may result in a taxable exchange

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1 13 August 2014 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date IRS rules consent fee paid on contingent payment debt instrument may result in a taxable exchange In PLR , the IRS ruled that a consent fee paid to holders of certain contingent payment debt instruments will not result in a deemed exchange of those instruments because the payment did not change the debts yield by more than 5%. Facts The Taxpayer is the parent of an affiliated group of corporations for US federal income tax purposes. A member of the group has a series of publicly traded exchangeable debentures (the Notes) outstanding. Each of the Notes is a contingent payment debt instrument under Reg. Section and is subject to the noncontingent bond method of Reg. Section (b) (an instrument subject to these rules will be referred to herein as a CPDI ). Pursuant to a proposed corporate transaction that would necessitate amending the Notes to alter certain covenants, Taxpayer intended to make a one-time payment to holders of the Notes in exchange for their consent to that amendment (the Consent Fee). The ruling effectively assumes that the amendment of the covenants would not alone constitute a significant modification of the Notes under Reg. Section Analysis and rulings Section 1001 provides rules for calculating gain or loss on the sale or other disposition of property. Under Reg. Section (a), gain or loss is generally realized when property is exchanged for other property differing materially in kind or extent. Reg. Section (a) provides rules for determining whether a modification of the terms of a debt instrument results in such an exchange. Reg. Section (c)(1)(i) defines

2 modification for such purposes, and Reg. Section (b) specifies that a modification that is not significant is not an exchange for purposes of Reg. Section (a). The IRS reasoned that because the Consent Fee will result in the Note holders receiving money that they had not previously been entitled to under the terms of the Notes, such a payment would alter their legal rights and thus be a modification of the Notes under Reg. Section (c)(1)(i). Specifically, by increasing the amount the holders would receive under the Notes, the Consent Fee will change the yield on the Notes. Whether a change in yield results in a significant modification of a debt instrument is usually tested under Reg. Section (e)(2) (the Change in Yield Test). Under the Change in Yield Test, the threshold for significant modification is whether the yield changes by more than the greater of 25 basis points or 5% of the yield of the unmodified instrument. By its terms, however, the Change in Yield Test does not apply to CPDIs and instead states that whether changes in the yield of CPDIs constitute significant modifications is determined under the general economic significance rule of Reg. Section (e)(1). Nevertheless, the IRS decided that because (a) the Notes are CPDIs with interest that accrues by reference to a comparable yield and a projected payment schedule under Reg. Section (b), and (b) the Consent Fee will not alter the amounts the Note holders will receive other than through the one-time payment, it is appropriate to apply a test similar to the Change in Yield Test. Thus, to determine whether the Consent Fee results in a significant modification of the Notes, the IRS instructed the Taxpayer to compare the go-forward yield to the original yield on the Notes. Applying similar methodology to the one required by the Change in Yield Test, the IRS specified that, for these purposes, the go-forward yield is the yield of a hypothetical debt instrument having (i) an issue date on the date the Notes are modified; (ii) an issue price equal to the adjusted issue price of the applicable Note as of that date, reduced by the amount of the Consent Fee; and (iii) a projected payment schedule consisting of the remaining payments on the applicable Notes original projected payment schedule. Consistently, the original yield is the comparable yield of each Note determined under Reg. Section (b)(4) as of the issue date of each Note. The IRS then ruled that if the excess of the go-forward yield over the original yield is not more than 5% of the original yield, the modification will not result in a significant modification within the meaning of Reg. Section (e)(1) (the CPDI Change in Yield Test). The IRS did not consider the alternative threshold of 25 basis points, likely because the comparable yield on the Notes was greater than 5%, so any change in yield less than 5% of the original yield would necessarily be less than 25 basis points. The IRS added that, because the Consent Fee was not originally reflected in the Notes projected payment schedule, it is akin to an amount received in respect of a projected payment of zero. Thus, it is a payment in excess of the projected payment and it is appropriate to treat the full amount of the payment as a positive adjustment under Reg. Section (b)(6)(i). Finally, the IRS ruled that to the extent the Consent Fee does not result in a significant modification under the test described above, and to the extent any other modifications to the terms of the Notes do not individually result in a significant modification under Reg. Section (e)(6) regarding changes to covenants, such modifications will not collectively result in a significant modification under Reg. Section (e)(1). Implications Taxpayers and their advisors have often wondered how payments on CPDIs that result in yield changes should be tested under Reg. Section This ruling is a welcome development in that it suggests that the CPDI Change in Yield Test can be used when applying the general economic significance test under Reg. Section (e)(1), which will provide greater certainty than the general economic significance test in determining whether certain modifications are significant. 2 International Tax Alert

3 It is not clear, however, whether the IRS intended the CPDI Change in Yield Test to be a bright-line test or just a safe harbor. In other words, it is not clear whether a yield change of more than 5% under the CPDI Change in Yield Test is, per se, a significant modification. Given that the normal Change in Yield test acts as a bright-line test, it would seem likely that the CPDI Change in Yield Test would be applied the same way. It is also unclear whether, if the comparable yield is less than 5% (admittedly unlikely), a payment of more than 5% of the original yield but less than 25 basis points would be considered economically significant. The conclusion that the Consent Payment creates a positive adjustment means that the payment generates, in effect, a current deduction for the debtor under the CPDI regulations. This is unique to CPDIs. Generally, if the modification of a non-contingent debt instrument is not significant, the consent fee paid thereon is not currently deductible. Moreover, it is unclear whether the consent fee is capitalized and then amortized over the remaining term of the debt or, alternatively, reduces the adjusted issue price of the debt instrument and is deductible only when the debt is retired. See PLR International Tax Alert 3

4 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services Capital Markets, Washington, DC David Garlock Richard Larkins Matthew Stevens Amy Sargent Hubert Raglan Leila Vaughan International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Jonny Lindroos, McLean, VA Financial Services Phil Green, New York Central Mark Muktar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City South America Luiz Sergio Vieira, São Paulo 4 International Tax Alert

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