The COVID-19 pandemic and the response by governments has led to a substantial drop, and complete cessation in some cases, of revenue and cash inflows. Companies are looking to credit markets to source additional cash to meet their outflows. For existing corporate bond issuers, this additional liquidity may come in the form of additional notes offered pursuant to their existing indenture ("Tap Notes".) Indentures usually permit Tap Notes to be issued that are identical to the company's existing notes ("Original Notes",) whether through a formal offering process or direct private placement. Tap Notes have the benefit of ease of execution, as no additional indenture needs to be negotiated or executed, and allows the company to raise a smaller amount of funds than would be necessary to ensure sufficient liquidity in a new offering.
Tap Notes typically require an identical coupon interest payment to the Original Notes but do not require the same issue price. The COVID-19 pandemic has also led to a significant drop in corporate bond prices. As a result, companies may need to issue Tap Notes at a discount (i.e., at a price below par) in order to incentivize potential investors to purchase the Tap Notes. Although the issuance of Tap Notes at a discount (or with "original issue discount" or "OID") can create potentially adverse tax consequences for U.S. holders, in particular, where the OID exceeds a statutorily defined amount for U.S. tax purposes ("Non-De Minimis OID"), it is possible for issuers to issue Tap Notes with more than De Minimis OID in certain circumstances.
When Can Tap Notes be Issued with More Than De Minimis OID
Contrary to popular belief, Tap Notes often can be issued with Non-De Minimis OID. We have outlined below some key considerations for an issuer and its finance arrangers to consider to help them determine whether they can issue Tap Notes with Non-De Minimis OID. These considerations include contractual restrictions in the existing indenture and disclosure made in connection with the Original Notes, ensuring the tax treatment is sufficiently disclosed to potential purchasers of the Tap Notes, and how many holders of the Original Notes are U.S. taxpayers. In addition to the legal considerations, an issuer and its finance arrangers should consider the potential impact on the existing holders of the Original Notes.
De Minimis OID and Qualified Reopenings
Tap Notes will be treated as having de minimis OID for U.S. tax purposes where the issue price is smaller than the stated redemption price at maturity (generally, the stated principal amount) by an amount that is less than 25 basis points times the number of complete years between the issue date and maturity date of the Tap Notes (26 U.S. Code § 1273). Where the amount of OID represents "Non-De Minimis OID," the U.S. tax rules require U.S. holders to accrue the OID over the term of the Notes under a constant yield method as taxable income. That is, the U.S. tax rules recognize that OID represents additional interest income to U.S. holders that only can be ignored where it is sufficiently de minimis. Non-De Minimis OID can impact both the purchasers of the Tap Notes and the holders of the Original Notes.
In addition, whether Tap Notes will be issued with Non-De Minimis OID impacts whether the tap represents a "qualified reopening" of the Original Notes for U.S. tax purposes. If the Tap Notes are issued within six months of the original issuance, Tap Notes generally will be fungible for U.S. tax purposes with the Original Notes if either (1) the Tap Notes are issued with no more than de minimis OID, or (2) the yield on the Original Notes (based on their fair market value as of the pricing date or, if earlier, the announcement date) is no more than 110% of the yield of the Original Notes as of their issue date (or, if the Original Notes were issued with no OID, their coupon rate). If the Tap Notes are issued more than six months after the original issuance, the Tap Notes generally will be fungible for U.S. tax purposes with the Original Notes if either (1) the Tap Notes are issued with no more than de minimis OID, or (2) the yield on the Tap Notes (based on their fair market value as of the pricing date or, if earlier, the announcement date) is no more than 100% of the yield on the Original Notes as of their issue date (or, if the Original Notes were issued with no OID, their coupon rate). For U.S. tax purposes, Tap Notes issued in a qualified reopening will be deemed to be part of the same issue as the Original Notes (i.e., will be deemed to have the same issue date and the same issue price as the Original Notes) and will be fungible with the Original Notes for U.S. tax purposes.
The Indenture must not Prohibit, and the U.S. tax Disclosure for the Original Notes Offering Must Allow, Issuing Tap Notes with Non-De Minimis OID
As a first step, an issuer and its finance arrangers should review the existing indenture to confirm whether there are any limitations on the issuance of Tap Notes. Although much less common today, contractual provisions in the indenture could specifically prohibit an issuance of Tap Notes where the Tap Notes are not fungible for U.S. tax purposes with the Original Notes. More recent indentures instead may contain a common contractual provision that requires any Tap Notes that are not fungible with the Original Notes to be issued with a separate securities identification number (e.g., ISIN, Common Code, CUSIP etc.). The following is illustrative language of this provision:
"In the event that any [Tap Notes] are not fungible with any [Original Notes] for U.S. federal income tax purposes, such non-fungible [Tap Notes] shall be issued with a separate ISIN, Common Code, CUSIP or other securities identification number, as applicable, so that they are distinguishable from such [Original Notes]."
Language such as this explicitly prohibits the issuance of Tap Notes that are not fungible for U.S. tax purposes unless the Tap Notes are distinct from the Original Notes. A unique identification code will allow a subsequent holder to determine whether it acquires a note that has de minimis OID or not. Absent the unique identifier, a holder would be unable to prove whether they hold a note that was issued with Non-De Minimis OID or de minimis OID.
Failure to comply with such a contractual provision in an indenture could result in an event of default under the indenture, and potentially could trigger cross default provisions of a company's other debt obligations.
The Disclosure for the Original Notes
More recently, some indentures do not contain any U.S. tax restrictions on the ability of the issuer to issue additional notes (that is, the indenture does not contain the illustrative language above). In this situation, an issuer and its finance arrangers also should consider the disclosure in the offering memorandum relating to the Original Notes, because the offering memorandum may contain relevant disclosure. Some offering memorandums contain U.S. tax disclosure notifying holders of the Original Notes that Tap Notes may be issued with Non-De Minimis OID and the value of the Original Notes could be adversely affected. This type of disclosure would support an issuer's decision to issue Tap Notes with Non-De Minimis OID.
Purchasers of the Tap Notes
As described above, where Tap Notes are issued with Non-De Minimis OID, holders of Tap Notes that are U.S. taxpayers will be required to accrue the OID into income on a constant yield basis and will be liable to pay tax on such OID on an annual basis. Practically, this can create issues for a U.S. holder, as they may owe tax without having received the associated cash until the principal amount of the notes is payed at maturity. Any offering documents for such Tap Notes should contain disclosure sufficiently outlining the risks to a potential investor.
Impact on U.S. Holders of the Original Notes
Where Tap Notes are issued with Non-De Minimis OID, they frequently will not be fungible with the Original Notes for U.S. tax purposes. U.S. holders of the Original Notes may be impacted by an offering of Tap Notes where the Tap Notes are not distinguishable from the Original Notes, as the holders of the Original Notes may be liable to pay tax on the OID if they are unable to distinguish their notes from the Tap Notes. The inability to distinguish Original Notes from Tap Notes could adversely affect the prices of the Original Notes, as the holders of the Original Notes now have tax liabilities without the corresponding cash payments and may consider selling their Original Notes.
Non-De Minimis OID Cannot be Solved Through "Reg S" Only Offerings
A common misconception is that the issue of U.S. tax fungibility depends on whether the Original Notes were issued pursuant to Rule 144A of the Securities Act of 1933, as amended (the "Securities Act"), The issue exists where U.S. investors have purchased the Original Notes, which is possible even if the Original Notes were issued only pursuant to Regulation S of the Securities Act after the expiry of a distribution compliance period (if any). Similarly, offering Tap Notes only pursuant to Regulation S of the Securities Act will not necessarily solve the issue, because it can still taint the Original Notes.
However, if allowed under the indenture, an issuer and its finance arrangers may decide to draw a distinction on a practical basis, particularly if the actual number of U.S. holders is small because the Original Notes were, or the Tap Notes will be, offered only pursuant to Regulation S of the Securities Act.
Issuers and finance arrangers need to consider potential U.S. tax implications for noteholders when offering Tap Notes with OID. As described above, the contractual provisions contained in the indenture must be reviewed, as well as the offering documents used in connection with the Original Notes.
Lastly, issuers and finance arrangers should consider the potential financial disadvantage to the holders of the Original Notes and the reputational impact to the issuer and the finance arrangers, even if the issuer can issue Tap Notes with Non-De Minimis OID.
1 This summary description of the qualified reopening rules assumes that the Original Notes are "publicly traded" (generally if a price quote, including an indicative quote, is available from at least one broker, dealer or pricing service during the 31 day period ending 15 days after the relevant date (unless at the time of the determination the outstanding stated principal amount does not exceed $100 million)).
Originally Published 22 April, 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.