How an AHYDO Catch-Up Payment Prevents AHYDO Status

The Applicable High-Yield Discount Obligation (AHYDO) rules are a facet of U.S. tax law impacting corporate debt with significant deferred interest payments. These regulations, within the Internal Revenue Code, limit a corporation’s ability to claim interest deductions on debt that functions more like equity. This article explains the definition of an AHYDO, its tax consequences, and the function of the catch-up payment used to avoid them.

Defining an Applicable High-Yield Discount Obligation (AHYDO)

For a debt instrument to be classified as an Applicable High-Yield Discount Obligation (AHYDO), it must satisfy four distinct tests.

• It must be issued by a corporation. This rule can also apply to debt issued by a partnership with corporate partners, in which case the tests are applied by looking through the partnership to its corporate partners.
• The debt must have a maturity date more than five years from its issue date. This five-year threshold distinguishes between shorter-term debt and longer-term obligations. Any instrument maturing on or before the fifth anniversary of its issuance is automatically excluded from AHYDO classification.
• Its yield to maturity must equal or exceed the Applicable Federal Rate (AFR) for the month of issuance plus five percentage points. The AFR is a set of interest rates published monthly by the IRS that reflects the average yield on U.S. Treasury securities.
• The instrument must have “significant original issue discount” (OID). OID occurs when a debt instrument is issued for a price less than its redemption price at maturity. An instrument has significant OID if, on any date after its fifth anniversary, the total accrued and unpaid interest and OID exceeds the first year’s total yield.

To illustrate, consider a zero-coupon bond issued by a corporation for $500 that pays $1,000 at maturity in ten years, with a 7.18% yield to maturity. The first year’s yield is $35.90 ($500 issue price x 7.18% yield). The test requires checking if the accumulated, unpaid OID after the fifth year exceeds this $35.90. Since a zero-coupon bond pays nothing until maturity, the accrued OID will grow each year and will inevitably surpass this amount, causing it to have significant OID.

Tax Consequences of AHYDO Status

When a debt instrument is classified as an AHYDO, the issuing corporation faces tax consequences designed to curb the benefits of issuing such debt. The primary impact is on the timing and deductibility of the interest expense.

The first consequence is the deferral of the interest deduction for the original issue discount. For an AHYDO, the corporation’s deduction for the OID portion of the yield is deferred until the amount is paid in cash. This aligns the issuer’s deduction with its cash outflow, removing the tax advantage of accruing non-cash interest deductions.

A more significant consequence is the permanent disallowance of a portion of the interest deduction. This “disqualified portion” is the part of the yield that exceeds the Applicable Federal Rate (AFR) plus six percentage points. This part of the interest is never deductible by the issuing corporation, representing a permanent tax cost.

This disqualified portion receives different treatment for the debt holder. If the issuing corporation has sufficient earnings and profits, the holder may treat the disqualified portion of the OID as a dividend. This can be advantageous for corporate holders, who may be eligible for the dividends-received deduction (DRD), which would reduce the tax on that income.

The Role of the Catch-Up Payment

The AHYDO catch-up payment is a mechanism designed to prevent a debt instrument from meeting the “significant OID” definition, thereby avoiding AHYDO status. It is a cash payment made to the debt holder that reduces the amount of accrued, unpaid yield below the test’s threshold.

The payment is timed to occur on or before the end of the first accrual period that concludes after the five-year anniversary of the instrument’s issuance. This timing is directly linked to the significant OID test, which becomes operative only after the five-year mark. The payment must be large enough to cover all accrued interest and OID up to that point, less an amount equal to the first year’s yield.

This is a preventative measure, not a remedy after an instrument has become an AHYDO. The terms of the catch-up payment are typically embedded in the original debt agreement, obligating the issuer to make the payment if necessary to avoid the interest deferral and disallowance that comes with AHYDO status.

Calculating and Reporting the Catch-Up Payment

The calculation of an AHYDO catch-up payment is a precise process performed for the first accrual period ending after the fifth anniversary of the issue date. The goal is to reduce the accrued but unpaid yield to a level at or below the maximum permitted threshold.

The first step is to determine the total amount of interest and OID that has economically accrued on the debt instrument from its issue date to the test date. This requires applying the instrument’s yield to maturity to its adjusted issue price over each accrual period.

Next, the issuer calculates the maximum amount of unpaid accrual permitted under the significant OID test, which is the instrument’s first-year yield. The catch-up payment must be at least the amount by which the aggregate accrued OID exceeds this threshold.

For example, assume a bond was issued for $10,000 with a 10% yield to maturity. The maximum permitted unpaid accrual is $1,000 ($10,000 x 10%). If on the first test date after year five the total accrued OID is $5,500 and no cash interest has been paid, the required catch-up payment would be $4,500 ($5,500 – $1,000). This reduces the remaining unpaid OID to the $1,000 limit.

For the issuing corporation, the payment is treated as a payment of interest and is deductible as an interest expense in the tax year in which it is paid. For the holder of the debt instrument, the catch-up payment is recognized as taxable interest income in the year it is received.