It’s a fact of life in everyday business that companies take on debt to finance their operations and growth, and bonds are one type of debt instrument corporations use. Market influences and other forces can impact bond interest rates, but when a change in the federal corporate tax rate automatically changes a bond’s interest rate, is that a taxable event?
This precise question recently arose with a client when the 2017 Tax Cuts & Jobs Act (TCJA) lowered the corporate tax rate.
Some bonds and other debt instruments are structured so that their interest rates can be adjusted when the federal corporate tax rate changes. In some instances, the rate goes up or down automatically and doesn’t depend on the action of the bond issuer, bondholder or any other party.
Internal Revenue Service regulations specifically address these types of changes, with rules governing “modification,” “significant modification,” and “unilateral change” causing a possible taxable event with regard to a debt instrument.
For tax purposes, IRS rules are concerned with whether there is a taxable “exchange” – a possible taxable gain due to one particular asset, with a given value, being exchanged for another asset of a different value. The rules can apply to any modification of a debt instrument, regardless of the form of the modification, which can happen with an exchange of a new instrument for an existing debt instrument, or an amendment of an existing debt instrument.
There is the possibility that a “significant modification” with possible taxable exposure can occur in a transaction where the value of what is received is greater than the value of what is given up. The significant modification rule does not have to be addressed, however, if there is no modification of the debt instrument.
Normally, an alteration of a legal right that occurs simply because of the operation of the terms of the debt instrument, such as the annual resetting of the interest rate based on the value of an index, is not a modification (sometimes referred to in the bond finance world as a “reissuance”).
The IRS lists a number of exceptions to the significant modification rule, one of which is a “unilateral option.” An option to alter a debt instrument is “unilateral” if:
“Objective financial information” is defined as any current, objectively determinable financial or economic information that is not within the control of any of the parties to the contract and is not unique to one of the parties’ circumstances (such as dividends or profits).”
While there is no ruling that applies directly to an automatic change in the bond’s interest rate caused by change in the federal corporate tax rate, this example from the IRS regulations seems to provide that a change in interest rate, due to the existing terms of a bond, is not a unilateral action and, therefore, not a modification.
Example 1: Reset Bond. A bond provides for the interest rate to be reset every 49 days through an auction by a remarketing agent. The reset of the interest rate occurs by operation of the terms of the bond and is not an alteration (as described in the Regulations). Thus, the reset of the interest rate is not a significant, taxable, modification of the debt instrument.
The conclusion is different where one party has an option to make a change. Consider another example from the IRS regulations, where a corporation issues an eight-year note to a bank in exchange for cash. Under the terms of the note, the bank has the option to increase the rate of interest by a specified amount if certain covenants in the note are breached. The bank’s right to increase the interest rate is a unilateral option and is, therefore, a modification.
As mentioned above, a client encountered the situation where, because the TCJA prompted a downward change in the federal corporate tax rate, the interest rate in a 2012 bank purchase bond changed. Applying this legal analysis, the tax rate change was an automatic occurrence, and not a unilateral option that could be exercised or not exercised by any party. Consequently, there was no modification of the debt instrument that would call into question its taxability or result in a taxable event.