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The Tax Treatment of Securities Reopenings

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The Tax Treatment of Securities Reopenings WHAT LOOKS THE SAME MAY NOT BE THE SAME 143 What Looks the Same May Not Be the Same: The Tax Treatment of Securities Reopenings JEFFREY D. HOCHBERG* & MICHAEL ORCHOWSKI** ABSTRACT This Article examines the U.S. federal income tax treatment of securi- ties “reopenings”—that is, issuances of new securities that are intended to be identical to (and fungible with) an existing class of securities. Reopen- ing transactions have become increasingly common in recent years and are primarily motivated by nontax considerations. However, as discussed in this Article, reopened securities that are otherwise identical to original securities sometimes have different tax attributes, in which case the original securi- ties and the reopened securities will not be fungible with each other, thereby defeating the purpose of the reopening. The first Part of this Article provides an overview of reopening transactions and the nontax considerations that motivate such transactions. The second Part examines reopenings of debt obligations, including a discussion of when reopened notes are treated as part of the same “issue” as original notes. This Part also includes a comprehensive discussion of the “qualified reopening reg- ulations” and some of the uncertainties and ambiguities in such regulations. The third Part addresses reopenings of preferred stock, including some of the unique issues applicable to reopenings of preferred stock at a premium. The fourth Part addresses reopenings of certain types of structured notes—spe- cifically reopenings of notes that are classified for tax purposes as forward or derivative contracts or as “reverse convertible” notes. Finally, the last Part of this Article addresses reopenings of interests in entities that are classified as grantor trusts for tax purposes. * Jeffrey D. Hochberg, Partner, Sullivan & Cromwell LLP; Yeshiva University, B.A., 1992; Columbia Law School, J.D., 1995. ** Michael Orchowski, Associate, Sullivan & Cromwell LLP; Dartmouth College, A.B., 2000; University of Pennsylvania Law School, J.D., 2007. A prior version of this Article was presented to the New York City Tax Club. The authors thank the members of the New York City Tax Club for their comments, some of which are incorporated herein. Tax Lawyer, Vol. 67, No. 1 143 144 SECTION OF TAXATION Table of Contents I. Introduction .................................................................................144 II. Debt Securities ..............................................................................145 A. Background: Fungibility, OID and Market Discount .............. 145 B. Instruments in the Same Issue ..................................................149 1. In General .........................................................................149 2. Sales to Affiliates ................................................................150 C. Qualified Reopenings ...............................................................152 1. Definition of a Qualified Reopening ..................................154 2. Tax Treatment of Holders ..................................................156 3. Tax Treatment of Issuer ......................................................157 4. Qualified Reopenings and Grandfather Rules ....................158 5. Debt Instruments Issued for Property ................................160 6. “Identical” Terms ...............................................................163 7. Short-Term Debt Instruments ...........................................164 8. Variable Rate Debt Instruments .........................................167 9. Contingent Payment Debt Instruments .............................169 10. Tax-Exempt Obligations ....................................................171 11. Treasury Securities .............................................................172 D. Legislative Proposals .................................................................172 III. Preferred Stock .............................................................................172 A. Preferred Stock Issued at a Premium .........................................173 B. Preferred Stock Issued at a Discount .........................................175 C. Classification of Preferred Stock................................................177 IV. Structured Notes ...........................................................................178 A. Notes Treated as a Forward or Derivative Contract ...................179 B. Reverse Convertible Notes ........................................................181 V. Grantor Trusts ...............................................................................183 VI. Conclusion ....................................................................................186 I. Introduction It has become increasingly common in recent years for issuers to issue new securities with terms identical to the terms of an outstanding class of securi- ties, with the intent that the “new” and “old” instruments trade as a single, fungible class of securities with the same CUSIP number. Reopening an existing securities issuance, as opposed to issuing a new class of securities, has a number of nontax advantages. First, a reopening of securities can increase the notional amount of the outstanding securities and may thereby increase the liquidity of the securities. This increase in turn may improve investor demand for the securities and may enable the issuer to obtain better pricing terms for the securities. Second, a reopening of securi- ties may enable an issuer to issue new securities more efficiently, cheaply, and quickly than if it had to issue a new class of securities with new documenta- tion. Third, a reopening of securities may cause the issuer’s ongoing debt Tax Lawyer, Vol. 67, No. 1 WHAT LOOKS THE SAME MAY NOT BE THE SAME 145 servicing costs to be less than they would have been if the issuer had instead issued a separate class of securities. Finally, the increase in notional size of a security may enable that security to be included in certain indices that require a minimum notional amount for inclusion in the index. There are also instances in which an issuer will be treated as reopening a securities issuance for tax purposes, even though no nontax reopening occurs. For example, suppose an issuer acquires an outstanding security and subse- quently sells the security to the market. The acquisition and sale of the secu- rity will generally be treated for tax purposes as redemption of the security followed by a reopening of the securities, notwithstanding that it may not be viewed as a reopening for nontax purposes.1 Issuers and bankers are often surprised to learn that otherwise identical securities are not identical, and are therefore not fungible, for tax purposes. As discussed below, reopening tax issues have recently received additional atten- tion in light of new regulations regarding reopenings of debt instruments, and various provisions that “grandfather” existing debt obligations from new rules. These include the Foreign Account Tax Compliance Act (FATCA), which includes a grandfather rule for debt securities issued prior to July 1, 2014, and the new limitations on issuers’ ability to issue “bearer” bonds. While there is substantial tax guidance regarding reopenings of debt instruments, there is little, if any, tax guidance regarding reopenings of other financial instruments. This Article addresses the primary tax issues related to reopenings of the most common types of reopened securities—specifically, reopenings of debt instruments, preferred stock, structured notes, and equity interests in grantor trusts.2 II. Debt Securities A. Background: Fungibility, OID and Market Discount As discussed below, most of the tax issues relating to reopenings of debt securities stem from the different tax treatment of original issue discount (OID) and market discount, and the possibility that an investor that pur- chases notes in a reopening could convert what otherwise would be OID into market discount. 1 In addition, an acquisition of debt by an affiliate of the issuer followed by a sale of the debt could, under certain circumstances, be treated as a redemption of the debt followed by a reopening. See I.R.C. § 108(e)(4); Reg. § 1.108-2. 2 This Article does not discuss reopenings of common stock of a corporation as such reopen- ings generally do not raise any fungibility or other tax issues. In addition, this Article does not address reopenings of equity interests in a partnership because such reopenings raise multiple unique subchapter K issues (e.g., I.R.C. § 704(c) issues and capital account “book-up” issues) that are beyond the scope of this Article. For a discussion of some of the issues related to reopenings of publicly traded partnerships, see N.Y. State Bar Ass’n, Tax Section, Report on the Request for Comments on Section 704(c) Layers Relating to Partnership Mergers, Divisions and Tiered Partnerships 47-52 (2010). Tax Lawyer, Vol. 67, No. 1 146 SECTION OF TAXATION A typical fixed or floating rate note that bears interest at least annually will generally be treated as issued with OID if the principal amount of the note exceeds the offering price for the note by at least a de minimis amount.3 An investor must accrue OID on a note, and an issuer must likewise accrue OID deductions on a note, on a constant yield basis, over the term of the note.4 A note’s OID accrual schedule carries over to subsequent purchasers of notes, irrespective of the amount such purchaser paid for the note.5 Market discount is generally attributable
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