When Is a Debt Instrument `Traded on an Established Market’?

The “issue price” of a debt instrument is determined under §1273(b) or 1274 of the Code, and has important tax consequences.

For example, the difference between the issue price and the stated redemption price at maturity of a debt instrument measures whether there is, and the amount of any, original issue discount (OID) with respect to the debt instrument. ¹See §1273(a).

Moreover, a debt-for-debt exchange, in the context of a “workout,” may result in a reduced issue price for the new debt, which would produce cancellation of indebtedness (COD) income for the issuer (in an amount equal to the excess of the adjusted issue price of the old instrument over the issue price of the new instrument). ²See §108(e)(10). Moreover, in these cases, the holder of the debt instrument will record a loss measured by the amount by which his or her basis in the surrendered instrument exceeds the issue price of the new instrument, unless the instruments constitute, within the meaning of §354(a)(1), “securities.” Where the instruments constitute securities, since the exchange is a recapitalization and therefore a reorganization under §368(a)(1)(E), no gain or loss shall be recognized on the exchange and the holder’s basis in the new security is equal to his or her basis in the security surrendered in the exchange. Thus, the loss is preserved for future realization through these “substituted” basis rules. See §358(a). Further, in these cases, the holding period of the new security includes the period for which the relinquished security was held. See §1223(1).

Section 1273(b)(3) generally provides that, in the case of a debt instrument that is issued for “property” and that is part of an issue some or all of which is traded on an established securities market (publicly traded), the issue price of the debt instrument shall be the fair market value of the debt instrument. Similarly, if the debt instrument is issued for stock or securities (or other property) that are publicly traded, the issue price of the debt instrument shall be the fair market value of the property (for which the debt instrument was exchanged).

Under Regs. §1.1273-2(c)(1), the term “property” encompasses a debt instrument, stock, security, contract, commodity, or nonfunctional currency.

Regs. §1.1273-2(f) defines when property is traded on an established market for purposes of §1273(b)(3). In general, a debt instrument is considered traded on an established market if either the debt instrument or the property for which the debt instrument is exchanged is described in Regs. §1.1273-2(f)(2)-(f)(5):

• Property is described in Regs. §1.1273-2(f)(2) if it is listed on a specified exchange.
• Property is described in Regs. §1.1273-2(f)(3) if it is “of a kind” that is traded on a contract market designated by the Commodities Futures Trading Commission (CFTC) or an interbank market.
• Property is described in Regs. §1.1273-2(f)(4) if it appears on a system of “general circulation” that disseminates price quotations or recent trading prices.
• Property is described in Regs. §1.1273-2(f)(5) if price quotations are “readily available” from dealers, brokers, or traders.

The IRS has decided to extensively overhaul these rules. It has issued proposed regulations (REG-131947-10) with a view toward “simplifying and clarifying” the determination of when property is traded on an established market.

Price Quotes

Prop. Regs. §1.1273-2(f)(1) provides that property (including a debt instrument) is traded on an established market if, at any time during the 31-day period ending 15 days after the issue date:

• the property is listed on an exchange described in Prop. Regs. §1.1273-2(f)(2);
• there is a “sales price” for the property;
• there are one or more “firm quotes” for the property; or
• there are one or more “indicative quotes” for the property.

Property is considered listed on an exchange if it is listed on:

• a national securities exchange registered under §6 of the Securities Exchange Act of 1934;
• a board of trade designated as a contract market by the CFTC;
• a foreign securities exchange that is officially recognized, sanctioned, regulated, or supervised by a governmental authority of the foreign country in which the market is located; or
• any other exchange, board of trade, or other market the IRS commissioner identifies as an exchange in guidance published in the Internal Revenue Bulletin. ³See Prop. Regs. §1.1273-2(f)(2).

A sales price exists if the price for an executed purchase or sale of the property is “reasonably available.” The price of a debt instrument is considered reasonably available if the sales price (or information sufficient to calculate the sales price) appears in a medium that is made available to persons that regularly purchase or sell debt instruments (including a price provided only to certain customers or subscribers) or persons that broker purchases or sales of debt instruments. ⁴See Prop. Regs. §1.1273-2(f)(3).

Under Prop. Regs. §1.1273-2(f)(4), a firm quote is considered to exist when a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or subscribers) for property, and the quoted price is substantially the same as the price for which the property could be purchased or sold. A quote will be considered a firm quote if market participants typically purchase or sell, as the case may be, at the quoted price, even if the party providing the quote is not legally obligated to do so.

An indicative quote is considered to exist when a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or subscribers) for property and the price quote does not rise to the level of a firm quote. ⁵See Prop. Regs. §1.1273-2(f)(5).

Prop. Regs. §1.1273-2(f)(6), in order to dispel any doubt, provides that the fair market value of property described in this section will be presumed to be its trading price on an exchange or its sales price or quoted price. If there is more than one such trading price, sales price, or quoted price, a taxpayer may use any reasonable method, consistently applied, to determine the price.

However, if property is described only in Prop. Regs. §1.1273-2(f)(5), and the taxpayer determines that the quote (or an average of the quotes) “materially misrepresents” the fair market value of the property, the taxpayer is permitted to use any method that provides a reasonable basis to determine the fair market value of the property.

Avoiding Treatment as Traded

Notwithstanding any other provision in this section, according to Prop. Regs. §1.1273-2(f)(7), property will not be treated as traded on an established market if there is no more than de minimis trading of the property. A debt instrument will be treated as traded in de minimis quantities only if:

• each trade of such debt instrument during the 31-day period ending 15 days after the issue date is for quantities of $1 million or less; and
• the aggregate amount of all such trades does not exceed $5 million.

Moreover, under Prop. Regs. §1.1273-2(f)(8), notwithstanding any other provision in this section, a debt instrument will not be treated as traded on an established market if the original stated principal amount of the issue that includes the debt instrument does not exceed $50 million.

If there is any temporary restriction on trading, a purpose of which is to avoid the characterization of the property as one that is traded on an established market, then the property is treated as traded on an established market. ⁶See Prop. Regs. §1.1273-2(f)(9).

Finally, under Prop. Regs. §1.1273-2(f)(10), a debt instrument will not be treated as traded on an established market solely because the debt instrument is convertible into property that is so traded.

More Exchanges
Likely to Produce COD Income

It would appear that these proposed regulations expand the circumstances under which a debt instrument will be treated as publicly traded. Accordingly, in debt-for-debt exchanges, there will be fewer opportunities to take advantage of the rule that provides that where neither the old nor new debt instrument is publicly traded, the issue price of the new instrument (assuming the instrument bears “adequate stated interest”) is its stated redemption price at maturity. ⁷See §1273(b)(4).

Accordingly, a larger number of such exchanges should produce COD income for the issuer since it is likely that, in the context of a workout, the issue price of the new debt instrument (its trading price on an exchange or its sales price or quoted price) will be smaller than the adjusted issue price of the retired instrument.

The realization of COD income is easier to avoid in cases where the issue price of the new instrument is, under §1273(b)(4), treated, however artificially, as its stated redemption price at maturity.

These regulations will apply to those debt instruments which are issued on or after the date on which the Treasury decision anointing them as final regulations is published in the Federal Register.