Published: June 25, 2018 at 09:35 AM PST | Updated: June 18th, 2020 at 9:30 AM PST
Payment-in-kind loans allow businesses to borrow money without having to come up with the cash to service the debt. The interest accrued on these loans is Paid-In-Kind (“PIK”) and added to the principal balance at the end of the accrual period.
There are specific rules relating to the tax treatment of the PIK interest that may have unexpected results for both the debtor and creditor.
What is payment-in-kind?
Payment-in-kind refers to a financial instrument that allows the borrower to pay interest or dividends in form other than cash, such as bonds, notes, or preferred stock with additional securities or equity.
Payment-in-kind securities are at type of mezzanine financing, where they have characteristics indicative of debt and equities. They tend to pay a relatively high rate of interest but are considered risky. Investors who can afford to take above-average risks, such as private equity investors and hedge fund managers, are most likely to invest in payment-in-kind securities.
Payment-in-kind notes give the issuer a chance to delay making dividend payments in cash and in return for the delay, the issuing company typically agrees to offer a higher rate of return on the note. It is an attractive way for companies to avoid cash outflows for debt interest, especially when participating in a leveraged buyout (LBO) or when seeking to expand the business.
What are the specific rules related to tax treatment of payment-in-kind interest?
It is important to distinguish PIK interest from accrued but unpaid Qualified Stated Interest (“QSI”) to determine the treatment of the interest for tax purposes. In addition, understanding when related-party rules may change the tax treatment of a debtor or creditor helps to ensure appropriate planning takes place to avoid unknown tax liabilities.
QSI is interest at a stated fixed rate unconditionally payable in cash or property other than additional debt instruments of the debtor, and must be payable at least annually. If interest meets the definition of QSI, then the interest accrues over the period, and the income tax treatment is determined under the method of accounting (cash or accrual) of each party.
Therefore, a cash basis creditor would not have to include in income QSI that is unpaid at the end of a tax year. Accrual basis taxpayers would accrue for the deduction or income as it accrues through the period. Related party rules would serve to defer a deduction to the debtor in the case of a related cash basis creditor in order to match the income with the deduction.
However, the treatment for a cash-basis taxpayer changes significantly where the note calls for PIK interest. PIK interest accrues during the applicable accrual period and is then “paid in kind” through either the issuance of additional debt instruments or an increase in the principal of the existing debt. Therefore, PIK interest is accounted for under the Original Issue Discount (“OID”) provisions for inclusion in income. Under these rules, interest accrues at a constant yield over the life of the loan, which will typically yield a different result than the accrual of QSI. The creditor is required to report the current year OID inclusion as income regardless of the method of accounting used.
Therefore, a cash-basis creditor can have an unwelcome surprise of OID income inclusion with no corresponding cash payment. Likewise, the debtor is entitled to a deduction for the OID amount included as income by the creditor. The related party rules do not provide for the deferral of inclusion or deduction of PIK interest, regardless of the creditor’s method of accounting.
PIK interest loans should be evaluated to determine if the applicable high-yield debt obligation (“AHYDO”) rules apply, as this can result in a re-characterization of a portion of the interest to dividend income, which is non-deductible to the debtor. The AHYDO rules apply to any debt 1) issued by a corporation, 2) with a term of more than 5 years, 3) that has “significant OID”, and 4) has a yield to maturity the equals or exceeds the applicable federal rate (“AFR”) plus 5 percent.
In simple terms, “significant OID” exists whenever the debt instrument permits the borrower to pay more than one year’s worth of interest expense in kind over the first five years of the debt instrument.
How can Squar Milner help?
Proper identification of whether a debt instrument has QSI or PIK interest is essential in the determination of which set of rules to apply to determine the inclusion and deduction of accrued and unpaid interest.
Therefore, it is critical to consult your tax advisor when entering into any debt agreement where there is a potential for the interest to be classified as PIK in order to avoid any unintended consequences in the future.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.