REVENUE RULE 95-70

1995-2 C.B. 124, 1995-43 I.R.B. 4

DEFINITION OF QUALIFIED STATED INTEREST

Released: October 5, 1995
Published: October 23, 1995

Section 1273. Determination of Amount of Original Issue Discount, 26 CFR 1.1273-1: Definition of OID.

Definition of qualified stated interest. For purposes of the definition of "qualified stated interest" in section 1.1273-1(c), scheduled interest payments on a debt instrument are not "unconditionally payable" merely because, under the terms of the debt instrument, the failure to make interest payments when due requires (1) that the issuer forgo paying dividends, or (2) that interest accrue on the past-due payments at a rate that is 2 percentage points greater than the stated yield.

ISSUE

For purposes of the definition of "qualified stated interest" in s 1.1273- 1(c) of the Income Tax Regulations, are scheduled interest payments on a debt instrument "unconditionally payable" if, under the terms of the debt instrument, the failure to make interest payments when due requires (1) that the issuer forgo paying dividends or (2) that interest accrue on the past-due payments at a rate that is 2 percentage points greater than the stated yield?

FACTS

Situation 1. On January 1, 1995, Y corporation issued a 15-year debt instrument to A for $100x. The debt instrument provides for a principal payment of $100x at maturity and for quarterly interest payments of $2x, beginning on March 31, 1995, and ending on the maturity date. Thus, the yield on the debt instrument is 8 percent, compounded quarterly. Under the terms of the debt instrument, if Y corporation fails to make one or more interest payments when due, interest will accrue on the past-due interest at the 8 percent yield. The failure of Y corporation to make interest payments when due for 12 consecutive quarters will entitle A to sue for payment.

If past-due interest is outstanding, the terms of the debt instrument provide that Y corporation may not declare or pay any dividend on, redeem, purchase, acquire, or make a liquidation payment with respect to, its stock. Y corporation has a policy and a long-established history of regularly paying dividends on its stock. Any failure of Y corporation to pay regular dividends on its stock is reasonably expected to result in a significant decline in the value of its stock.

Situation 2. The facts are the same as in Situation 1, except that, under the terms of the debt instrument, if Y corporation fails to make one or more interest payments when due, interest will accrue on the past-due interest at the rate of 10 percent, compounded quarterly, rather than 8 percent. This higher interest rate, which the documents describe as a "penalty" rate, is in addition to the restriction on dividend payments.

LAW AND ANALYSIS

Sections 163(e) and 1271 through 1275 of the Internal Revenue Code provide rules for the treatment of debt instruments that have original issue discount. If a debt instrument is issued with original issue discount, the discount is includible in income by the holder of the instrument, and deductible by the issuer of the instrument, as it accrues. See ss 163(e) and 1272.

Section 1273(a)(1) defines original issue discount as the excess (if any) of a debt instrument's stated redemption price at maturity over the debt instrument's issue price. Under 1273(a)(2), a debt instrument's stated redemption price at maturity includes all amounts payable on the instrument (other than any interest based on a fixed rate, and payable unconditionally at fixed periodic intervals of 1 year or less during the entire term of the debt instrument).

The regulations under s 1273-(a)(2) refer to interest that is excluded from the definition of stated redemption price at maturity as "qualified stated interest." See s 1.1273-1(b). In general, s 1.1273-1(c)(1)(i) defines qualified stated interest as stated interest that is unconditionally payable at least annually at a single fixed rate. Under s 1.1273-1(c)(1)(ii), interest is unconditionally payable only if late payment or nonpayment is expected to be penalized or reasonable remedies exist to compel payment. Interest is not unconditionally payable, however, if the lending transaction does not reflect arm's length dealing and the holder does not intend to enforce such remedies. For purposes of determining whether interest is unconditionally payable, the possibility of nonpayment due to default, insolvency, or similar circumstances is ignored.

The definition of unconditionally payable in s 1.1273-1(c)(1)(ii) is designed to limit qualified stated interest to interest that must be paid on a current basis. Stated interest is unconditionally payable only if the holder has the right to compel payment or to extract a penalty from the issuer for nonpayment. See S.Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 255 (1984) ("[I]n general, interest will be considered payable unconditionally only if the failure to timely pay interest results in an acceleration of all amounts under the debt obligation or similar consequences.") If the terms of the debt instrument do not provide the holder with the right to compel payment, they must provide for a penalty that inures directly to the benefit of the holder and that is large enough to ensure that, at the time the debt instrument is issued, it is reasonably certain that, absent insolvency, the issuer will make interest payments when due.

In Situation 1, the failure of Y corporation to make interest payments when due limits Y corporation's ability to pay dividends on its stock. This dividend restriction is not a penalty within the meaning of s 1.1273-1(c)(1)(ii) because it does not inure directly to the benefit of the holder, A.

In Situation 2, if Y corporation fails to make interest payments when due, interest will accrue on the past-due interest at the "penalty" rate of 10 percent, compounded quarterly. This 10 percent rate increases the yield on the entire debt instrument above its stated 8 percent rate, and, therefore, inures directly to the benefit of the holder. Nevertheless, the increase in yield is not large enough to ensure that it is reasonably certain that, absent insolvency, Y corporation will make interest payments when due. It is possible that there may be circumstances in which the benefit of deferring is worth the additional cost. This increase in yield is thus not a penalty within the meaning of s 1.1273-1(c)(1)(ii). Depending on the facts and circumstances, however, an increase in yield that is 12 percentage points greater than the stated yield might be sufficient to ensure that, absent insolvency, interest payments are reasonably certain to be paid when due.

HOLDING

For purposes of the definition of "qualified stated interest" in s 1.1273- 1(c), scheduled interest payments on a debt instrument are not "unconditionally payable" merely because, under the terms of the debt instrument, the failure to make interest payments when due requires (1) that the issuer forgo paying dividends or (2) that interest accrue on the past-due payments at a rate that is 2 percentage points greater than the stated yield.

DRAFTING INFORMATION

The principal author of this revenue ruling is Jeff Maddrey of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Mr. Maddrey on (202) 622-3940 (not a toll-free call).

Rev. Rul. 95-70, 1995-2 C.B. 124, 1995-43 I.R.B. 4