Tax News
Defining “Publicly Traded” for Sec. 1273 Purposes – Proposed Regulations Shed New Light
January 07, 2011
Administrative Actions
In Federal Register Volume 76, Number 5 (Friday, January 7, 2011) Treasury issued Proposed Regulation 1.1273-2(f) (REG-131947-10).  The regulation changes the definition of “publicly traded” for purposes of determining “Issue Price” under Sec. 1273 of the Code. The determination of “Issue Price” has various tax implications on both private equity and hedge funds. It is common practice for funds to invest in various types of debt, both publicly and privately held.  Moreover, once the debt is purchased by the fund, it is often modified. Typically, if the modification is material, it is treated as a sale or exchange under Treas. Reg. §1.1001-3.  The three most prominent issues in these transactions are CODI (to the issuer of the debt), OID (to the fund), and phantom gain (again to the fund, at the time of modification of the debt). If you ask funds, they would prefer that all of these tax exposures are minimized, if at all possible. While CODI is a tax issue for the issuer, it indirectly affects the fund because it wipes out tax attributes. OID is an issue obviously because it creates phantom income exposure.  The phantom gain issue again is a significant issue because the fund has no cash from the transaction to pay the tax. Well, the amount of CODI, OID or phantom gain that the parties would have to recognize (if any) depends on the definition of “Issue Price.”  The “Issue Price” is usually determined either under Treas. Reg. §1.1273-2 or §1.1274-2. If debt is issued for money or publicly traded property, the price is determined under the former regulation.  If the debt is issued for non-publicly traded property, the determination is made under the latter regulation.  

The “Issue Price” under these 3 categories is determined differently.  For debt issued for money it is the first price at which a substantial amount of the debt instruments is sold for money. For publicly traded property transactions, it is usually the fair market value. For non-publicly traded property transactions under Sec. 1274 it is either the stated principal amount of the debt or the imputed principal amount. Obviously, the big difference here would come up for distressed debt.  In that instance the fair market value could significantly differ from the stated principal amount or the first cash price paid for the debt.  This proposed regulation broadens the definition of “publicly traded,” thus, expanding the instances when funds could fall under the Sec. 1273 fair market value rules instead of the Sec. 1274 stated principal amount rules. Again, one instance where these proposed regulations can have a material impact on funds is when the fund modifies distressed debt. In light of the present state of the economy, this occurs quite often.  The fund purchases debt at discount and then in order to improve its chances for repayment or selling the debt, it modifies its terms.  If the modification is material and involves an exchange of “publicly traded” debt, the FMV rule applies. If it is not, the principal amount rule applies.  Considering that the FMV of distressed debt would likely be low, any phantom gain exposure to the fund resulting from the modification (absent a non-recognition provision) also should be low compared to the non-publicly traded scenario. On the flip side, the OID exposure becomes larger because the difference between stated redemption price and issue price is larger.  Practitioners have been complaining about the phantom gain issue (see e.g. TNT Doc 2009-12946) and it seems that these proposed regulations offer some relief, inasmuch as they expand the instruments that fall within the definition of “publicly traded.”  Funds should keep an eye on this modified definition of “publicly traded” because it could have material tax consequences to the fund and its investors.

The proposed regulations could be found here http://origin.www.gpo.gov/fdsys/pkg/FR-2011-01-07/html/2011-83.htm. For expanded coverage on this issue readers could also review Amy S. Elliott’s coverage on TNT (2011 TNT 5-1).
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Tags: private equity OID, private equity phantom income, publicly traded, publicly traded debt, section 1273