Interest Disallowance, Section 279, and AHYDO Rules

Sections Dealing with Interest Disallowance

Because interest paid on debt is deductible while dividends paid on equity are not, a lot of taxpayers attempt to structure their capital with large amounts of debt and small amounts of equity. Though they classify these instruments as debt, in a lot of cases the instruments “smell” like equity, or will even be converted to equity in the future. Congress has taken steps to eliminate these types of instruments, or at least minimize the deductions allowed to these instruments.

Here are some of the sections that deal with such instruments:

  1. Section 279 deals with junk bond interest
    1. This disallows annual interest in excess of $5 million on “corporate acquisition indebtedness” if:

i.     Proceeds are used to acquire another corporation or two-thirds of the assets of another trade or business,

ii.     Debt is subordinated to trade creditors and unsecured debt,

iii.     Debt is convertible into equity of the corporation, and

iv.     The corporation’s debt to equity ratio is greater than 2:1 on a tax basis or the projected earnings to not exceed 3X the total annual interest to be paid or incurred

  1. Section 163(e) and Section 163(i) deal with the AHYDO rules: Applicable High Yield Discount Obligation
    1. This disallows interest in excess of the applicable federal rate + 6% if the debt obligation:

i.     Maturity date is more than 5 years in the future

ii.     Yield to maturity is more than the AFR rate +5% which is based on the date of issuance, and

iii.     It has significant original issue discount

  1. Section 163(j) deals with earnings stripping
    1. This says that interest that’s in excess of 50% of adjusted taxable income is deferred if:

i.     The corporation’s debt to equity ratio is greater than 1:5:1

ii.     The creditor is a related party, and

iii.     The creditor does not pay U.S. tax on the interest income (generally a foreign entity)

  1. Section 163(l) deals with paid in kind interest(PIK interest)
    1. This disallows interest on a ‘disqualified debt instrument’ if:

i.     The debt will be paid off in equity- meaning the debt will be converted to equity or

ii.    The debt instrument payoff will be calculated based on the corporation’s equity value

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