OID Demystified (Somewhat)

NEW MARKETS TAX CREDIT CONNECTION

Prepared by:

Ed Creskoff, Reznick Group

Fall 2011

OID Demystified (Somewhat)

Over the past year, every New Markets Tax Credit (NMTC) transaction on which Ive worked has involved efforts to avoid so-called OID issues. Why? Failure to identify and manage loans with original issue discountOID for shortcould have ramifications in a NMTC transaction, up to and including credit recapture. Do I have your attention? For some, OID is a mysterious technical issue with mysterious consequences. This article aims to demystify OID and explain how to prevent issues. What Is OID? Industry practitioners often say OID with different meanings in mind. Here are two common definitions. 1. Technical definition of OIDOID is defined in Internal Revenue Code (IRC) Section 1273(a)(1) as: the excess of (A) the stated redemption price at maturity, over (B) the issue price. Based only on the above, if a note was issued for $1million in cash but had a face amount and stated principal payments of $1.1 million over its term, it would have OID of $100,000. In other words, it was originally issued for a discount on the principal amount. This is a simple enough concept. As well see later, the devil is in the details. Often, though, industry participants will use the term OID to refer to a broader set of related issues that are important to track for NMTC program compliance. 2. Loose (but common) definition of OIDany loan structure that causes interest and principal payments to be accrued differently, for federal income tax purposes, from the way those payments would be accrued from a simple reading of the loan terms. So dont be confused. The simple concept in the first definition has some unexpected implications. The Internal Revenue Code sections governing OIDgenerally within IRC 1271 through 1275 and associated regulationsstretch the concept so that it applies in situations that are not obvious at first glance. Importantly, the Code and regulations apply time-value of money concepts to ensure that fundamental financial principles are applied to the determination of the accrual of interest expense and income. For example, the applicable federal rate (AFR), the Treasury-determined interest rate for various loans, may be applied as a minimum rate for certain loans, with OID created for those loans that do not carry that minimum rate. How Do the OID Rules Work in Practice? To understand how to avoid problems related to OID, it is helpful to understand how the rules work. Lets take an example of a notional pair of qualified low-income community investment (QLICI) loans, as illustrated below. Assume that the following two loans are made in satisfaction of a single loan as part of a restructuring.

Figure 1

Illustration of Loans with OID

Loan A CDE
$3mprincipal 4.5%fixedrate 20yearterm 7yearsinterestonly,followedbyself amortizingpaymentsoverremaining term

$3m Loan A $1m Loan B

QALICB

Loan B
$1mprincipal 1.5%fixedrate 20yearterm Interestonlyduringtermwithballoon

A simple reading of the first definition above would not on its face seem to show that any OID is indicated. After all, in both cases the same amount of money is being transferred to the qualified active low-income community business (QALICB) as is written into the stated principal amounts of the notes. Doesnt that mean that there is no OID? As you can tell from the title of Figure 1, these loans do have OID. Treasury regulation 1.1275-2(c) requires that loans A and B be aggregated as if they were a single loan for the OID analysis: debt instruments issued in connection with the same transactionare treated as a single debt instrument for the purposes of sections 1271 through 1275 and the regulations thereunder. [1.1275-2(c)] Therefore, assuming that the regulations apply, the regulations require that we look at loans A and B as if they were a single loan. The full analysis is too involved to discuss in this article. When we do that analysis, it results in OID of over $1.2 million, which must be accrued as the borrowers deduction from income at a constant yield. The result separates payments into 1) qualified stated interest, 2) OID accrued as expense and 3) other payments. Those other payments are payments that arent related to qualified interest or OID accrualsIm going to call that principal. Below are two figures illustrating the transition from how the payments are viewed from a simple reading of the note terms to how they are viewed for federal income tax purposes after the OID analysis.

Figure 2

Figure 3

The charts above show the allocation of loan payments to interest and principal. Figure 2 is an interpretation of the loan terms without an OID analysis. Figure 3 shows how the payments would be allocated to interest expense (qualified stated interest and OID accruals) and principal (effectively, the portion of payments other than qualified stated interest that are not OID accruals). The first thing to note is that the aggregate shape of the charts is the samethe payments arent changing, just how they are allocated. In the first chart, notice that there appear to be no principal payments during the first 7 years, only interest on the A and B loans. However, the OID analysis reveals that, for federal income tax purposes, there are principal payments during the first 7 years! See Figure 4 below for detail on the first 7 years of the loan payment allocations. Figure 4

Not only has the OID analysis changed the shape of the interest expense accruals, but it has moved principal payments forward into the first 7 years of this loan. If these loans were restructured during the NMTC compliance period, many in the industry would recognize this as a potential compliance issue in an NMTC transaction. The payments on this loan may present a compliance challenge for the community development entity to manage. Simple Rules to Avoid OID To do a complete OID analysis is complex, and accuracy is criticalif it is done incorrectly there could be NMTC compliance concerns. Therefore, follow one or both of two simple rules to help avoid OID in QLICI loans. 1. Use Blended Interest RatesGive all the QLICI loans in the transaction the same rate. You will likely want to determine a rate that will result in neither too much cash flow, nor too little. This is usually a weighted average rate, blending the different interest rates that first were determined by the economic needs of the parties.

2. Prorate Draws and Principal PaymentsEnsure that all QLICI loans in the transaction use the same draw and principal repayment schedule. That schedule must be proportional to each loans principal amount. In the example used in Figure 1 above, if terms were modified so that QLICI Loan B repaid principal each period in the same proportion that QLICI Loan A pays principal, there may be no OID. Make note of two pitfalls with rule #2. First, if there is the need for a special principal paydown after the compliance period, it must be made from all the QLICI loans in proportion to their size. The second relates to self-amortizing loans. Self-amortizing loans are loans that have a fixed payment over time that covers principal and interest, like a typical fixed-rate, single-family mortgage payment. Be aware that selfamortizing loans with the same terms but different rates do not have pro rata repayment schedules. Instead, each loan is paying different proportions of the principal balance with each payment; the proportions depend on both the term and the rate. Special Cases and Exceptions There are several special cases to be aware of, where OIDs impacts may be minimized, or where OID may be lurking for the unaware. Loans below AFRWhile there are exceptions, any loan bearing interest below AFR should be examined to determine if further OID analysis is required. De minimis OIDWhen is OID not OID? When its de minimis! The regulations provide the de minimis test, which functions as a materiality threshold. Even if a small amount of OID results, if it is considered de minimis, the OID does not need to be accrued but may be taken at the end of the loan. Multiple fixed-rate loansa loan that contains multiple fixed rates, say 5 percent for the first 7 years and 7 percent thereafter, requires an OID analysis. This also applies to simple interest rates. Variable-rate or contingent payment loansloans that have variable rates must meet the definition of variable-rate loans under Treasury Regulation 1.1275-5. If not, they may be considered contingent-rate loans under Treasury Regulation 1.1275-4. Likewise, loans with contingent payments require OID analysis.

There are other salient terms, facts and circumstances that can give rise to the need for an OID analysis and materially affect the results. Industry participants should rely on qualified tax advisors with respect to these issues. Conclusion Original issue discount rules can influence NMTC compliance. Knowing what OID is, how it arises and the possible implications can help you spot issues and structure transactions wisely. Keep in mind that two simple rules for structuring QLICIs will help avoid many OID-related NMTC compliance problems.