Treasury Promulgates Final Regulations on Publicly Traded Debt Instruments

Skadden, Arps, Slate, Meagher & Flom LLP

Stuart M. Finkelstein Steven J. Matays

On September 12, 2012, the Department of the Treasury (Treasury) promulgated important final regulations (the Regulations) that clarify and expand the circumstances in which a debt instrument is to be treated as traded on an established market (the technical term for what is commonly referred to as “publicly traded”). The Regulations apply in determining the issue price of debt instruments in debt-for-debt exchanges, debt modification transactions and other transactions where debt is issued in exchange for property.

The Regulations largely follow the regulations proposed in January 2011 with several key changes and, as compared to the regulations currently in effect (the Existing Regulations), will significantly increase the universe of debt instruments that are classified as publicly traded. As a result, there is a substantially increased risk of significant cancellation of debt income and the deferral or loss of deductions for original issue discount under the applicable high yield debt obligation rules when debt is modified or exchanged. Because the Regulations extend the reach of the public trading definition so broadly, the Regulations also will eliminate some of the uncertainties that taxpayers have encountered working with the Existing Regulations.

Background and the Existing Regulations

If a debt instrument is publicly traded, the instrument’s issue price is its fair market value. Similarly, if a debt instrument is issued for publicly traded property, the instrument’s issue price is that property’s fair market value. The Existing Regulations treat property as publicly traded if at least one of four conditions is satisfied within the 60-day period ending 30 days after the issue date of the debt instrument: (1) the property is listed on a particular securities exchange; (2) the property is of a kind traded on an interbank market or on a board of trade designated as a contract market by the Commodities Futures Trading Commission; (3) the property appears on a general system of circulation that disseminates recent price quotes or recent sales prices that provide a reasonable basis to determine the debt’s fair market value; or (4) price quotes for the debt instrument are readily available from dealers, brokers or traders, subject to certain limitations.

Taxpayers have encountered significant uncertainties applying the 18-year-old Existing Regulations to current debt markets and quotation mediums, particularly in the case of bank loans. Additionally, for the government, the determination of issue price by reference to an instrument’s fair market value is theoretically sounder than looking simply to the instrument’s stated principal amount (which is the result for debt instruments that do not qualify as publicly traded debt). The Regulations reflect Treasury’s judgment that the market for debt instruments has become broader and more transparent and, as a result, can best provide the requisite evidence of a debt instrument’s fair market value. Despite taxpayers’ concerns with the substantive implications of the use of fair market value in determining issue price, Treasury has chosen what it views as the theoretically correct rule without regard to the potentially adverse consequences for taxpayers whose debt carries a significant discount.

The Regulations

Under the Regulations, property is treated as publicly traded if at least one of three conditions is satisfied within the 31-day period ending 15 days after the instrument’s issue date: (1) sales prices for trades of the instrument are available; (2) firm price quotes are available; or (3) indicative price quotes are available. Notwithstanding the foregoing, an instrument will not be treated as publicly traded if the principal amount of the entire issue that includes such instrument does not exceed $100 million on the date on which the instrument is tested under these rules.

Under the first test, a debt instrument is treated as publicly traded if the sales price for that instrument is reasonably available. This test is satisfied if the sales price (or information sufficient to calculate the sales price) appears in a medium that is made available to persons who regularly trade in debt instruments or broker such trades. This broad definition of when sales prices are readily available appears to reduce the uncertainties under the Existing Regulations about the types of quotation media that are to be considered.

The second test is satisfied if a price quote to buy or sell the instrument is available from at least one reasonably identifiable broker, dealer or pricing service and the instrument could be bought or sold for substantially the same price. A quote will be considered a firm quote even if the obligation to buy or sell at that price does not attach to the party providing the quote.

The third test is satisfied if a price quote other than a firm price quote is available from at least one broker, dealer or pricing service. Unlike with firm price quotes, identification of the party providing the quote is not required for indicative price quotes.

Under the Regulations, the fair market value of a debt instrument is presumed to be equal to its sales price or quoted price; however, the Regulations provide taxpayers with some flexibility with respect to the use of trade prices and quotes to determine an instrument’s fair market value and issue price. If a debt instrument has more than one sales price, price quote or combination thereof, a taxpayer may use any reasonable, consistently applied method to determine the instrument’s fair market value. A special rule applies for property for which there is only an indicative price quote. A taxpayer who determines that the indicative price quote materially misrepresents the fair market value of the property may use any reasonable method to determine the fair market value. Ultimately, despite this flexibility, the Regulations will likely result in the classification of most debt instruments as publicly traded.

A Comparison of the Regulations and the Proposed Regulations

As noted above, Treasury had issued proposed regulations in January 2011 on this matter. In the Regulations, Treasury made several major revisions to the proposed regulations:

No de minimis exception. The Regulations dispense with the de minimis trading exception in the proposed regulations. Thus, debt instruments for which indicative or firm quotes are available will be treated as publicly traded even in the absence of any actual trades.

No exchange listing trigger. The Regulations eliminate listing on an exchange as a trigger for property to be classified as publicly traded. Instead, debt instruments or other property listed on an exchange is tested under the other elements of the definition of when an instrument is publicly traded.

Expanded small debt issue exception. Under the Regulations, an instrument is not publicly traded if it is part of an issue that does not exceed $100 million in principal amount (the Existing Regulations provide an exception for small debt issues not exceeding $25 million while the proposed regulations had set the threshold at $50 million). The amount of an issue is determined with reference to the principal amount of an issue that remains outstanding at the time of the determination.

Consistent reporting requirement. The Regulations require both issuers and holders to consistently report the issue price of an instrument. In keeping with Treasury’s belief that the issuer should have better access to pricing and sales information, an issuer’s determination as to whether a debt instrument is publicly traded property and as to the instrument’s fair market value is generally binding on a holder in the absence of disclosure of a contrary position on the holder’s timely filed tax return. Thus, this rule adopts the consistency requirement that has long applied to the characterization of an instrument as debt or equity. The Regulations also require the issuer to make the issue price available to holders within 90 days of the issue date.

Anti-abuse rule. The Regulations add an anti-abuse provision that would disregard a debt instrument’s sale or price quote if a principal purpose of such sale or price quote is to cause the property to be publicly traded or to materially misrepresent the property’s value.

Qualified reopenings. The Regulations expand the definition of qualified reopenings to include non-publicly traded debt instruments. While this is a welcome addition, its utility may be limited in light of the expansive definition of publicly traded debt under the Regulations.

Effective Date

The Regulations apply to debt instruments issued (or deemed issued, in the case of substantial modifications of outstanding debt instruments) on or after November 12, 2012.

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