Application of Corporate Interest Limits to Partnership Debt

Certain interest-limit provisions that specifically apply to corporate borrowers must also be examined when debt is issued by a partnership. In particular, Sec. 163(e)(5) (certain high-yield discount obligations) and Sec. 163(l) (debt payable in equity) must be considered carefully by partnerships with corporate partners.

AHYDOs

In response to the widespread use of high-yield original issue discount (OID) and payment-in-kind (PIK) debt in acquisitions, Congress enacted Sec. 163(e)(5) and (i) in 1989. These rules were designed to reduce a corporate borrower’s interest deductions on certain debt; Congress concluded that a portion of the return on high-yield OID obligations was similar to a nondeductible distribution of corporate earnings with respect to equity.

Definition: An applicable high-yield discount obligation (AHYDO) is defined under Sec. 163(i)(1) as any debt instrument that:

1. Is issued by a corporation (other than an S corporation).

2. Has a maturity date of more than five years.

3. Has a yield to maturity that equals or exceeds the sum of the applicable Federal rate (AFR) in effect at the time of the debt’s issuance plus five percentage points.

4. Has “significant OID.”

Treatment: If an instrument satisfies all four requirements, the interest deduction is bifurcated into deferred and disqualified portions; see Sec. 163(e)(5)(A) and (C). The deferred portion is deductible when paid (in property other than stock or debt of the issuer) under Sec. 163(e)(5)(A)(ii); the disqualified portion is nondeductible, even when paid, under Sec. 163(e)(5)(A)(i). Moreover, to the extent that the disqualified portion of OID would have been treated as a dividend under Sec. 163(e)(5)(B) to corporate holders (under a Sec. 301(c) analysis) had it been distributed with respect to the issuing corporation’s stock, it is generally treated as a dividend to debtholders for purposes of the dividends-received deduction.

Application to partnerships: Although on its face, Sec. 163(e)(5) applies only to debt issued by C corporations, Congress contemplated addressing abuse “through the use of issuers other than C corporations” when it authorized anti-abuse regulations under Sec. 163(i)(5)(B). While no regulations have been issued under that provision, in January 1995 Treasury finalized partnership anti-abuse regulations, which contain an example addressing an AHYDO issued by a partnership; see Regs. Sec. 1.701-2(f), Example 1, which treats each C corporation partner in a partnership as having issued its share of an AHYDO debt for purposes of determining the deductibility of its distributive share of any interest on such debt. Arguably, the regulation may be subject to criticism, because it purports to apply even to issuances involving partnerships with no evidence of tax avoidance. However, a prudent approach would be to issue debt with terms structured to avoid the AHYDO rules or to ensure that the issuing partnership has no corporate partners—either directly or by looking through to higher-tier owners.

Allocations: If a partnership note cannot be structured to avoid AHYDO characterization, the first task is to determine how much of the debt should be allocated to corporate versus noncorporate partners. If the debt is recourse for Sec. 752 purposes because it is guaranteed by a particular corporate partner (or lent directly by such corporate partner), it should be allocated to that party. If it is nonrecourse because no partner bears an economic risk of loss, it is allocated under Regs. Sec. 1.752-3. Under those rules, partners that have previously contributed appreciated property will receive a preferential allocation of liabilities that could result in a disproportionate share of the AHYDO debt.

Reporting: Another hurdle must be overcome if there are corporate debtholders. Because any disallowed portion of the interest expense may result in dividend treatment, the partnership (as opposed to each corporate partner) must fulfill its Form 1099 reporting obligations by determining the portion of the disallowed interest expense that should be characterized as a dividend, return of capital or capital gain for each corporate holder. Consequently, the partnership must devise a reasonable method of computing (and later adjusting) earnings and profits among its corporate partners. Such an exercise is fraught with uncertainty for the taxpayer; the IRS is burdened with trying to administer an unworkable rule.

Sec. 163(l)

Sec. 163(l) denies an interest deduction for interest on “disqualified debt instruments.” An instrument is a disqualified debt instrument under Sec. 163(l)(2) if it is (1) debt of a corporation and (2) payable in equity of the issuer (or a related party) or equity held by the issuer (or any related party) in any other person. Additional rules under Sec. 163(l)(3)(A)–(C) define the meaning of debt “payable in equity.”

Like the AHYDO rules, Sec. 163(l) would appear, on its face, to apply only to corporate debt. Sec. 163(l)(7) calls for issuance of regulations to prevent “avoidance of this subsection through the use of an issuer other than a corporation,” but such rules have not been issued under either Sec. 163 or the partnership provisions.

Nonetheless, the fact that regulations have not been issued does not automatically render Sec. 163(l) inoperative in its application to partnerships; see, e.g., Occidental Petroleum Corp., 82 TC 819 (1984). The Conference Report to the American Jobs Creation Act of 2004 (AJCA), in describing prior law under Sec. 163(l), addresses the disallowance of deductions on a debt instrument issued “by a corporation (or issued by a partnership to the extent of its corporate partners)…” (H Rep’t No. 108-755, 108th Cong. 2d Sess. (2004), p. 666). Although the significance of this parenthetical statement concerns prior law, and does not discuss the new statutory rule adopted in the AJCA, it should caution any taxpayer that might contemplate circumventing Sec. 163(l) through the use of a partnership.

Similar to the partnership application of AHYDO, Sec. 163(l) should apply only to the portion of the issuance allocable to the corporate partners. Thus, while Sec. 163(l) generally taints all interest on an instrument, only corporate partners should lose their interest deduction.

Observation

While it would appear that many interest-limit provisions apply only to corporate issuers, partnerships (to the extent of their corporate partners) appear to be subject to two—AHYDO and Sec. 163(l). However, corporate partners have not yet been subjected to Sec. 163(j), 249 or 279. It seems unclear whether the general partnership anti-abuse regulation subjects corporate partners to these disallowance provisions as well.

From Brian Ciszczon, CPA, MBA, J.D., Washington, DC