The Tax Implications of AHYDO Payments
Understand the tax treatment of applicable high-yield discount obligations, where rules for issuers and holders diverge, affecting both corporate deductions and income character.
An Applicable High-Yield Discount Obligation (AHYDO) is a debt instrument subject to special tax rules under the Internal Revenue Code. These regulations were established to address corporations issuing high-yield, long-term debt, often called “junk bonds,” and claiming large interest deductions without making corresponding cash payments. The AHYDO rules limit a corporation’s ability to deduct interest on these instruments, treating a portion of the debt more like equity for tax purposes. This framework ensures the tax treatment of the debt more closely aligns with its economic substance.
Identifying an Applicable High-Yield Discount Obligation
A debt instrument issued by a corporation is classified as an AHYDO only if it satisfies three distinct tests outlined in Internal Revenue Code Section 163. These tests relate to the instrument’s maturity date, its yield, and the significance of its deferred interest component.
The Maturity Test
The first test for an AHYDO is that the debt instrument must have a maturity date of more than five years from its issue date. Any debt with a term of five years or less is automatically exempt from this classification, regardless of its other features.
The Yield to Maturity Test
The second test requires the instrument’s yield to maturity (YTM) to equal or exceed the Applicable Federal Rate (AFR) for the month of issuance plus five percentage points. The YTM is the total annual return an investor expects if the bond is held to maturity. The AFR is an interest rate published monthly by the IRS that reflects the average yield on U.S. Treasury securities.
The Significant Original Issue Discount (OID) Test
The final condition is the significant Original Issue Discount (OID) test. OID is the excess of a debt’s stated redemption price at maturity over its issue price. An instrument has significant OID if the aggregate accrued interest and OID by the end of any accrual period after the fifth year exceeds the total cash interest paid plus the first year’s total yield.
To illustrate, consider a bond issued for $1,000 with a 10% YTM, meaning its first-year yield is $100. If at the end of the sixth year, the total accrued interest and OID is $700 and total cash interest paid has only been $550, the accrued amount ($700) exceeds the sum of cash paid ($550) plus the first year’s yield ($100), which totals $650. Because the accrued interest surpasses this threshold, the instrument has significant OID and would be classified as an AHYDO if it met the other two tests.
Calculating the Disqualified Portion
Once a debt instrument is identified as an AHYDO, the next step is to calculate the portion of the interest that will be subject to unfavorable tax treatment. Not all of the yield is penalized; instead, the rules target the part of the yield deemed most excessive. This calculation isolates the “disqualified portion” of the OID.
The “disqualified yield” is the portion of the YTM that exceeds the AFR plus six percentage points. This threshold is one percentage point higher than the spread used in the initial identification test.
The “disqualified portion” of the OID for a given year is calculated with the formula: (Disqualified Yield / Total Yield to Maturity) Total OID for the year. This formula applies the percentage of the yield considered excessive to the OID accrued during the year.
For example, assume an AHYDO has a YTM of 12%, the relevant AFR is 5%, and the total OID for the year is $20,000. The threshold for disqualified yield is 11% (5% + 6%), so the disqualified yield is 1% (12% – 11%). The ratio of disqualified yield to total yield (1% / 12%) is multiplied by the year’s OID ($20,000), resulting in a disqualified portion of approximately $1,667.
Tax Treatment for the Issuer
For a corporation that issues an AHYDO, the tax consequences impact the deductibility of interest expense. The AHYDO rules separate the OID into components with distinct tax treatments. This separation ensures that the portion of the yield resembling an equity return is not deductible, while the deduction for the remaining portion is deferred.
The “disqualified portion” of the OID, as calculated previously, is permanently non-deductible for the issuer. This amount is treated as a distribution with respect to stock, similar to a dividend.
The remaining portion of the OID is not deductible as it accrues. Instead, the deduction for this part of the OID is deferred until the interest is actually paid in cash or other property. This timing difference can impact a company’s cash flow and tax liability, as the deduction may not be available for many years.
Interest paid in cash at least annually, known as qualified stated interest (QSI), is not subject to the AHYDO deduction rules. The issuer can deduct these cash interest payments as they accrue, subject to other general interest limitation rules.
Tax Treatment for the Holder
The tax implications for the holder of an AHYDO are different from those for the issuer. While the issuer faces limitations on its deductions, the holder must recognize the entire amount of interest income as it accrues. This creates a mismatch in tax treatment between the two parties.
For any debt instrument with OID, including an AHYDO, the holder must include the OID in gross income over the instrument’s life using a constant yield method. This means the holder pays tax on interest as it accrues, regardless of receiving cash payments. The AHYDO rules do not change this principle, even for the portion of OID the issuer cannot deduct.
A special rule exists for corporate holders of an AHYDO. The “disqualified portion” of the OID may be treated as a dividend received by a corporate holder. This recharacterization is beneficial because corporate holders may be eligible to claim the Dividends Received Deduction (DRD) on this amount.
This dividend treatment is not automatic and is only available to the extent the issuing corporation has sufficient earnings and profits (E&P). E&P is a measure of a company’s ability to pay dividends from its economic income. If the issuer has no E&P, the disqualified portion remains fully taxable as interest income to the corporate holder.