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Monday, May 21, 2012

PLR 201220004 Illustrates Limited Application of Regs. §1.446-5

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 In PLR 201220004, an accrual method subchapter S corporation filed for Chapter 11 protection and planned to issue a combination of cash, new debt, and stock to its creditors pursuant to its (as yet unconfirmed) plan of reorganization. The S corporation had unamortized debt issuance costs for underwriting services which it sought to treat as a separate item not taken into account in determining the amount of cancellation of debt (COD) income realized on the cancellation or exchange of the existing indebtedness to which the costs relate.

Regs. §1.446-5 provides specific rules to allocate transaction costs incurred by an issuer of debt required to be capitalized (such as amounts paid to facilitate a borrowing) over the term of the debt instrument to which the costs relate, whether or not deductible in the year in which incurred. Regs. §1.446-5 generally requires the use of the constant yield method, which treats the costs as if they decreased the issue price of the debt, thus creating or increasing original issue discount (OID).

An example from the final regulations illustrates the operation of the rules: On January 1, 2004, X borrows $10,000,000. The principal amount of the loan ($10,000,000) is repayable on December 31, 2008, and payments of interest in the amount of $500,000 are due on December 31 of each year the loan is outstanding. X incurs debt issuance costs of $130,000 to facilitate the borrowing. Under [Regs. §1.1273-2], the issue price of the loan is $10,000,000. However, under [Regs. §1.446-5(b)], X reduces the issue price of the loan by the debt issuance costs of $130,000, resulting in an issue price of $9,870,000. As a result, X treats the loan as having original issue discount in the amount of $130,000 […] . Because this amount of original issue discount is more than the de minimis amount of original issue discount for the loan determined under [Regs. §1.1273-1(d)] ($125,000 ($10,000,000 x .0025 x 5)), X must allocate the [OID] to each year based on the constant yield method described in [Regs. §1.1272-1(b)].

In PLR 201220004, the IRS explained that the OID treatment of debt issuance costs is intended only to apply for timing purposes, specifically, for determining the amount of costs which are deductible in each year over the term of the debt instrument. Regs. §1.446-5 does not treat debt issuance costs as OID for all purposes, such as determining deductibility, which the IRS confirmed citing the preamble to the regulations when issued in proposed form. Similarly, Regs. §1.446-5 does not affect the determination of a taxpayer’s COD income, i.e., the issue price adjusted by the debt issuance costs for purposes of Regs. §1.446-5 is not used for purposes of determining the issuer’s adjusted price for purposes of Regs. §1.61-12. Thus, the IRS concluded that unamortized debt issuance costs are not taken into account to determine the amount of COD income realized by a taxpayer upon the cancellation or exchange of the debts to which they relate and are deductible under §162 as an item separate from the determination of the amount of COD income in the taxpayer’s reorganization.

Ryan Prillaman
Business Entities and Tax Accounting
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