what looks the same may not be the same what looks the same may not … · 2014-02-25 · what...

Tax Lawyer, Vol. 67, No. 1

WHAT LOOKS THE SAME MAY NOT BE THE SAME 143

143

What Looks the Same May Not Be the Same: The Tax Treatment of Securities Reopenings

JEFFREY D. HOCHBERG* & MICHAEL ORCHOWSKI**

ABSTRACTThis 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.

144 SECTION OF TAXATION


Table of ContentsI. Introduction ................................................................................. 144II. 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 ............................................................................... 183VI. Conclusion .................................................................................... 186

I. IntroductionIt 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



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 DiscountAs 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).



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 to a decline in the value of a note between the issuance of the note and an investor’s purchase of the note. More specifically, an investor will generally be treated as purchasing a note with market discount if the principal amount of the note6 (or, in the case of a note that is issued with OID, the adjusted issue price of the note) exceeds the investor’s basis in the note by at least a de minimis amount.7 Unlike OID, investors (including accrual basis taxpayers) are not required to accrue mar-ket discount over the term of the note, although they may elect to do so.8 Investors that do not elect to accrue market discount currently are generally required to include the accrued market discount in ordinary income upon the sale or maturity of the note,9 and are limited in their ability to claim interest deductions in respect of debt that is attributable to a market discount note.10

3 More technically, a note is treated as issued with OID if its “stated redemption price at maturity” exceeds its issue price, unless that excess is less than a de minimis amount. See Reg. § 1.1273-1. The specified de minimis amount is equal to 25 basis points per complete year between the note’s issue date and its maturity date. Id. The stated redemption price at maturity of a note is equal to all payments under the note other than payments that are “qualified stated interest.” Id. Qualified stated interest includes stated interest that is unconditionally payable at least annually at a single fixed rate and certain interest on “variable rate debt instruments.” Id. Most notes only provide for interest payments that are qualified stated interest, in which case its stated redemption price at maturity would be equal to the principal of the note. The issue price of a note is equal to “the first price at which a substantial amount of” notes are sold to purchasers other than underwriters, brokerage houses, bond brokers, or similar persons. Reg. § 1.1273-2. Most note issuances provide for a single offering price, in which case the issue price for the notes would equal the offering price for the notes. See id.

4 I.R.C. §§ 1272(a)(1), 163(e). 5 The purchaser, however, would reduce the amount of OID that it includes in income over

the term of the note by the excess of its purchase price for the note over the adjusted issue price of the note at the time of acquisition. I.R.C. § 1272(a)(7); Reg. § 1.1272-2(b).

6 As a technical matter, the market discount rules provide that the relevant amount for a note that is issued without OID or with a de minimis amount of OID is its stated redemption price at maturity rather than its principal amount. I.R.C. § 1278(a)(2). However, for purposes of simplicity, the discussion above refers to the principal amount of the note because the stated redemption price at maturity of such a note will always equal its principal amount unless it is issued with a de minimis amount of OID.

7 § 1278(a)(2). The de minimis amount is computed in the same manner as described above with respect to OID.

8 § 1278(b).9 I.R.C. § 1276.10 I.R.C. § 1277.



The primary tax issue in respect of a reopening of notes issued at a discount is whether the reopened notes should be treated as part of the same issue as the original notes. If they are treated as part of the same issue, then the reopened notes would have the same issue price and OID (if any) as the origi-nal notes, and any further discount in the price of the reopened notes would be treated as market discount.11 By contrast, if the reopened notes were not treated as part of the same issue as the original notes, then all of the discount in respect of the reopened notes would be treated as OID. The effect of this distinction in respect of an initial investor can be illustrated by an example in which an issuer issues a $100 ten-year note that pays semi-annual fixed rate interest for a price of $95. Assume that the issuer later sells the same note in a reopening for a price of $90 at a time at which the adjusted issue price for the original note is $96. If the notes purchased in the reopening are treated as part of the same issue as the original notes, then a holder that purchases the notes in the reopening would have $4 of OID that it would be required to accrue over the term of the notes, and $6 of market discount that it would not be required to include in income prior to the sale or maturity of the notes. In that case, an investor would effectively convert what otherwise would have been OID if the notes had been a separate issue into market discount. By contrast, if the notes issued in the reopening are treated as a new issuance of notes, a purchaser of the reopened notes would have $10 of OID that it would be required to accrue over the term of the notes.

Moreover, if the reopened notes issued in the example above are not treated as part of the same issue as the original notes, then the original notes and the reopened notes would not be fungible for tax purposes. That is because a secondary purchaser would be in a different tax position depending upon whether it purchases notes from an investor that purchased the original notes (in which case it would be subject to the $5 OID accrual schedule attribut-able to such notes) or whether it purchases notes from a holder that purchased the notes in the reopening (in which case it would be subject to the $10 OID accrual schedule attributable to such notes). To compound matters, a pur-chaser of publicly traded notes would have no way of knowing which notes it purchased, thereby creating uncertainty for the investor, the issuer, and the Service regarding the investor’s proper tax liability in respect of the notes.

To be sure, there is no tax law that prohibits an issuer from issuing reopened notes with the same CUSIP number as the original notes, notwithstanding that such notes are not fungible with each other for tax purposes. However, there are a number of reasons as to why an issuer would be well advised not to reopen notes in such a manner. First, in such a case, the issuer would not be able to report the amount of OID on the notes to secondary purchasers accurately because it would not know whether the secondary purchasers own

11 See Reg. § 1.1273-2(a)(1) (stating that where a “substantial amount of the debt instru-ments in an issue is issued for money, the issue price of each debt instrument in the issue is the first price at which a substantial amount of the debt instruments is sold for money”).



the original notes or the reopened notes. This inability could cause the issuer to be subject to penalties for inaccurate Form 1099 reporting.12 In addition, financial institutions that hold the notes on behalf of clients may also be unable to report the OID on the notes properly, in which case they may refuse to hold the notes or they may discourage their clients from purchasing the notes.

Second, the Service, and perhaps securities regulators, would presumably not look kindly on issuers and underwriters that present reopened notes to the market as being fungible with the original notes by assigning the same CUSIP number to them, when they are in fact not fungible. Such actions create unnecessary confusion and disruption in the market, and undermine the objective of ensuring that identical securities with the same CUSIP num-ber trade interchangeably in the market. Furthermore, the use of the same CUSIP number in such a case could result in a loss of revenue to the govern-ment to the extent that secondary purchasers assume that they purchased notes with the lesser amount of OID.

Third, if the notes are reopened with more OID than the original notes but with the same CUSIP number as the original notes, the secondary market may treat all of the outstanding notes as having an amount of OID equal to the OID on the reopened notes because the market will have no way to sepa-rately identify the original notes. This treatment may cause the original notes to decline in value because the additional OID would create an incremental tax cost for purchasers of the notes. In such a case, a holder of the original notes would be adversely affected by the reopening, and may be able to bring a claim against the issuer for damages that the issuer caused to holders of the original notes by engaging in the reopening transaction.13

Fourth, an issuer that issues non-fungible notes with the same CUSIP number would be unable to determine its taxable income or deductible loss

12 Section 6721 imposes a penalty of $100 per information return (up to a maximum of $1.5 million per year) for failure to file a correct information return. I.R.C. § 6721. In addi-tion, issuers of publicly offered (including all SEC-registered) notes with OID are required to file a Form 8281, signed under penalties of perjury, and are subject to a penalty of one percent of the bond’s principal amount (subject to a maximum of $50,000) for failing to do so. I.R.C. § 6706.

13 An issuer may be able to avoid this risk by disclosing to investors that it might issue additional notes with the same CUSIP number as the original notes even though they are not fungible with the original notes for U.S. tax purposes. U.S. issuers usually do not include such disclosure because they generally only intend to issue additional notes if they are fungible with the original notes for U.S. tax purposes. In fact, many issuers of notes specifically state in the offering document for the notes that they will only issue additional notes in a reopening if the notes will be fungible with the original notes for U.S. tax purposes. See, e.g., Lloyds Bank-ing Group PLC, Registration Statement (Form 8-A) Exhibit 4.3 (Nov. 25, 2013) (stating “such Additional Notes must be fungible with the Senior Notes for U.S. federal income tax purposes”). Foreign issuers may not want to be so constrained in light of the fact that some, and perhaps most, of the factors set forth above will not be relevant to foreign issuers. This may be particularly the case if payments on the notes are made outside of the U.S. and there are relatively few U.S. investors.



properly if it were to redeem some, but not all, of the outstanding notes. More specifically, an issuer will recognize cancellation of indebtedness income or a repurchase premium deduction upon the redemption of its notes in an amount equal to the difference between the redemption price and the adjusted issue price of the redeemed notes.14 If an issuer cannot determine the “adjusted issue price” of the redeemed notes because it is unsure whether it redeemed the original notes or the reopened notes, the Service may treat the issuer as having redeemed the notes with the lowest adjusted issue price, thereby increasing the income or decreasing the deductions that the issuer would have otherwise recognized upon the redemption if it had been able to determine which notes it redeemed.

As discussed below, Treasury regulations provide that reopened notes will have the same amount of OID as original notes, and will therefore be fun-gible with the original notes, if (1) the reopened notes are part of the same issue as the original notes under the definition of such term set forth in the regulations15 or (2) the reopened notes are issued in a “qualified reopen-ing” of the original notes.16 In addition, subject to the FATCA discussion below, original notes and reopened notes will be effectively fungible with one another, without regard to whether they satisfy either of the two tests in the preceding sentence, if they are both issued with no more than a de minimis amount of OID. That is because in such a case the fact that the original notes and the reopened notes have a different issue price would not affect second-ary purchasers because neither group of notes would be subject to the OID accrual rules.

B. Instruments in the Same Issue

1. In GeneralAs noted above, debt instruments that form a single issue are fungible for

tax purposes. Prior to 2001, debt instruments were considered part of the same issue if the debt instruments: (1) had the same credit and payment terms, (2) were sold “reasonably close in time” to one another, and (3) were sold either pursuant to a common plan or as part of a single transaction or a series of related transactions.17 There was no guidance that interpreted the “reasonably close in time” standard.

In 2001, this rule was replaced with the “qualified reopening” rules discussed below and a more specific test for determining whether debt instruments are part of a single issue. More specifically, under the current regulations, two or more debt instruments will be part of the same issue if they:

14 See United States v. Kirby Lumber Co., 284 U.S. 1, 3 (1931); Reg. § 1.61-12(c)(2)(ii); Reg. § 1.163-7(c).

15 Reg. § 1.1275-1(f ).16 Reg. § 1.1275-2(k).17 See Reg. § 1.1275-1(f ), amended by T.D. 8934, 2001-1 C.B. 904.



• have the same credit and payment terms;• are issued within a period of 13 days beginning on the date on which the

first debt instrument that would be part of the issue is issued to a person other than an underwriter, placement agent or similar party;18 and

• are sold either (1) pursuant to a common plan or (2) as part of a single transaction or a series of related transactions.19

While the regulations refer to a “13-day” period, this is a bit of a misnomer because the issue date is treated as the “first” day of the period. For example, if a note is issued on April 1, a note that is issued on April 13 could be treated as part of the same issue as the note issued on April 1 (assuming the reopen-ing satisfies the other requirements set forth above) but a note issued on April 14 could not be so treated. Accordingly, some refer to the relevant period as a “12-day” period. In addition, the 13-day provision does not exclude non-business days, and, unlike the rules governing qualified stated interest, does not provide for any extension if the final day of the period is on a weekend or public holiday.20

There is also no guidance regarding the requirements necessary for a reopen-ing to be treated as part of a “common plan” or a “series of related transac-tions.” A reopening pursuant to a “green shoe,” under which the issuer agrees to sell more notes to the underwriter if there is excess demand for the notes, should satisfy this requirement. However, it is not entirely clear whether an unexpected reopening during the 13-day period would satisfy this require-ment, particularly if the issuer uses a different underwriter for the reopening or if the notes are sold in a different market than the original notes.

2. Sales to Affiliates Although sales to underwriters are ignored for purposes of determining the

issue price of a note,21 notes that are issued to underwriters are nevertheless treated as issued and in existence for tax purposes, notwithstanding that the underwriter may hold the notes in inventory.22 Thus, notes that are sold by an underwriter (other than an underwriter that is part of the same tax con-solidated group as the issuer) after the expiration of the 13-day period would

18 The notes should be treated as issued for this purpose on their settlement date and not on their pricing date because the OID regulations provide that the issue date of a note is its settle-ment date. See Reg. § 1.1273-2(a)(2).

19 Reg. § 1.1275-1(f ).20 Reg. § 1.1273-1(c)(6) (providing that interest that is deferred until the business day fol-

lowing a scheduled payment date that is a weekend or federal holiday is treated as paid on the scheduled payment date, notwithstanding the deferral).

21 Reg. § 1.1273-2(e).22 This assumes that there is no side agreement between the issuer and the underwriter under

which the issuer would reimburse the underwriter for any losses that it realizes in respect of the notes or under which the underwriter would remit any profits that it realizes in respect of the notes to the issuer.



not be treated as issued in a reopening, and such sales would be treated no differently than any other sale of notes in the secondary market.23

A sale of notes to a nonconsolidated affiliate could possibly be used to enable an affiliated group of corporations to reopen notes after the 13-day period without being subject to the qualified reopening rules described below.24 More specifically, an issuer of notes that believes that it may seek to issue additional notes beyond the 13-day period may issue such notes to a nonconsolidated affiliate on the original issue date for the notes, with the intent that the affiliate would sell the notes to the market when the issuer’s affiliated group decides that it would like to obtain additional funding. The issuer would then take the position that the affiliate’s sale of the additional notes does not constitute a reopening of the notes, but is rather a sale of the notes in the secondary market. Under this approach, any decline in the value of the notes subsequent to its original issuance would be market discount and not OID, and the additional notes would therefore be fungible with the original notes for tax purposes.

The Service could seek to challenge this result by asserting that the issu-ance of the notes to the affiliate should be disregarded, and that therefore the affiliate’s sale of the notes to the public should be treated as a reopening of the notes for tax purposes.25 This assertion is unlikely to succeed if the notes are issued on an arm’s length basis and are otherwise treated as issued and in existence for financial accounting and regulatory purposes. In order to sus-tain the arm’s length nature of the issuance: (1) there should be no explicit or implicit agreement or understanding between the issuer and the affiliate under which the affiliate would be reimbursed for any losses in respect of the notes, or under which the affiliate would transfer any profits in respect of the notes to the issuer; (2) there should be no explicit or implicit agreement or understanding between the issuer and the affiliate that would grant either party a right or obligation (e.g., a put right or call right) that differs from the rights and obligations of any unrelated holder of the notes; and (3) the issuer should not, directly or indirectly, provide funding to the affiliate to enable it to purchase the notes.26

The Service may also seek to challenge such a transaction under the OID anti-abuse rule. More specifically, the OID anti-abuse rule provides that if

23 If the underwriter is part of the same tax consolidated group as the issuer, the underwriter’s sale of the notes would generally be treated for tax purposes as a redemption of the notes for their fair market value followed by a new issuance of the notes. See Reg. §§ 1.1502-13(g)(3)(i)(A)(2), -13(g)(7)(ii), Ex. (2).

24 This may be particularly important for an issuer of a contingent payment debt instrument, which, as discussed below, cannot be issued in a qualified reopening.

25 The Service would have no reason to challenge the transaction unless the value of the notes at the time the affiliate sells the notes is less than the adjusted issue price of the notes at such time.

26 See Reg. § 1.482-1(b) (providing that the arm’s length standard requires that results of a transaction between related entities be consistent with the results that would have been realized between unrelated entities).



a principal purpose in structuring a debt instrument or engaging in a trans-action is to achieve a result that is unreasonable in light of the purposes of the OID rules, the “Commissioner can apply or depart from the regulations under the applicable sections as necessary or appropriate to achieve a reason-able result.”27 The Service may assert that a secondary purchaser’s ability to convert market discount into OID in this case should be treated as unreason-able in light of the general purpose of the OID regulations. This argument is unlikely to succeed because the OID anti-abuse rule provides that a result will not be considered unreasonable “in the absence of an expected substantial effect on the present value of a taxpayer’s tax liability.”28 In this case, a holder would only be able to convert what otherwise would be OID into market discount if the note declines in value, or if the note appreciates less than the amount of accrued OID on the note. As a general matter, issuers do not expect that their notes will depreciate in value or will appreciate less than the accrued OID on the notes. An issuer would thus not normally expect that its issuance of notes to an affiliate would have a “substantial effect on the pres-ent value of a taxpayer’s tax liability.” In addition, as discussed above, the tax law treats discount that accrues after the issuance of a note differently than OID. It therefore seems that there is nothing unreasonable about the fact that an investor can purchase notes from an affiliate of the issuer and treat the discount that accrued post-issuance as market discount, when the notes will in fact have been outstanding since the original issuance of the notes, and the purchaser could, in any case, have achieved the same result if it had purchased the notes from any other holder of the notes. Furthermore, in the case of a publicly traded note, the Service would have no way of identifying which purchaser acquired notes from the affiliate, and, even if it could iden-tify the purchaser, it would seem inappropriate to penalize an investor simply because it happened to purchase the notes from the affiliate rather than any other holder of the notes.

C. Qualified ReopeningsThe qualified reopening rules were originally issued in 2001, but were sub-

stantially updated and liberalized in 2012.29 These rules, when they apply,

27 Reg. § 1.1275-2(g).28 Reg. § 1.1275-2(g)(2).29 See T.D. 9599, 2012-40 C.B. 417; T.D. 8934, 2001-12 C.B. 904.



allow issuers to treat “additional debt instruments”30 that are part of a single issue and have terms that are “in all respects identical to the terms of the origi-nal debt instruments” as fungible for U.S. federal income tax purposes with the original debt instruments, notwithstanding that they are not part of the same issue as the original debt instruments under the rules discussed above.31

The qualified reopening rules attempt to strike a balance between the policy objective of allowing issuers to issue additional notes in a reopening that are fungible with the original notes for tax purposes, and the policy objective of preventing investors from using reopenings to convert what otherwise would have been OID into market discount.32 As described below, the qualified reopening regulations balance these two objectives by (1) allowing qualified reopenings within six months of the issuance of the original notes only if the amount of OID that is converted into market discount does not exceed a minimum threshold, and (2) allowing qualified reopenings after six months of the issuance of the original notes only if the reopening does not convert any OID into market discount.

The discussion in this Part is divided into 11 parts. The first Part sets forth the requirements that a reopening must satisfy to constitute a qualified reopening, the next two Parts discuss the tax treatment of issuers and holders

30 The qualified reopening regulations define the term “additional debt instruments” as “debt instruments,” thereby implying that a reopening will be not treated as a qualified reopening if the reopened debt instruments would not be classified as debt instruments for tax purposes on a stand-alone basis. Whether an obligation represents debt or equity for tax purposes is determined by judicially developed facts-and-circumstances tests that consider, among other factors, whether the issuer is thinly capitalized and the issuer’s ability to repay the instrument. See, e.g., Notice 94-47, 1994-1 C.B. 357; Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973). The status of both of these factors could change between the issuance of the “original debt instruments” and additional debt instruments if, for example, the issuer’s financial condition were to significantly deteriorate. It is therefore possible that original debt instruments and additional debt instruments that have the same terms could be treated differ-ently for tax purposes with the original debt instruments classified as debt for tax purposes and the additional debt instruments classified as equity for tax purposes. In such a case, a reopen-ing of the debt instruments would likely not constitute a qualified reopening. However, this issue is unlikely to be of much practical consequence because any significant deterioration of an issuer’s credit quality is virtually certain to cause the additional debt instruments to be sold with more than a de minimis amount of OID and with a yield in excess of the 110% yield test described below. Thus, based on the discussion below, such a reopening would in any case generally not constitute a qualified reopening.

31 See Reg. § 1.1275-2(k)(2)(ii).32 The preamble to Proposed Regulation section 1.1275-2(k) states:

The qualified reopening rules attempt to strike a balance between tax policy concerns about the conversion of OID into market discount and the need to have the tax rules reflect current capital market practices. The [Service] and the Treasury Department believe the appropriate balance is to provide reopening rules for situations where the issuer can prove by objective, market-based information that the reopening will con-vert, at most, only a small amount of OID into market discount.

Prop. Reg. § 1.1275-2(k), 64 Fed. Reg. 60,395, 60,396 (1999).



that engage in a qualified reopening transaction, and the final eight Parts dis-cuss specific types of qualified reopening transactions that raise special issues.

1. Definition of a Qualified ReopeningAdditional notes can only be issued in a qualified reopening transaction if

the original notes are publicly traded33 or if the additional notes are issued for cash to persons unrelated to the issuer for an arm’s length price.34 In the case of additional notes that are issued within six months of the original notes, the additional notes will generally be treated as issued in a qualified reopening of the original notes if:

• the additional notes would—absent the application of the qualified reopening rules—be issued with no more than a de minimis amount of OID;35 or

33 See Reg. § 1.1273-2(f ). Whether a debt instrument is “publicly traded” is determined by rules that themselves depend on when the debt instrument was issued. A debt instrument issued on or after November 13, 2012 will generally be publicly traded if (1) it has a stated principal amount of more than $100 million and (2) at any time during the 31-day period ending 15 days after the issue date, there is a “sales price,” “firm quote,” or “indicative quote” that is available for the debt instrument. For securities issued before November 13, 2012, an original debt instrument is publicly traded if at any time during the 60-day period ending 30 days after the issue date, it is: (1) listed on a national securities exchange, an interdealer quota-tion system or certain international exchanges; (2) property of a kind that is traded either on a board of trade designated as a contract market by the Commodity Futures Trading Commis-sion or an interbank market; (3) property appearing on certain quotation systems; or (4) a debt instrument for which price quotations are “readily available” from dealers, brokers or traders. See Reg. § 1.1273-2(f ) (1994).

34 See Reg. § 1.1275-2(k)(3). 35 Reg. § 1.1275-2(k)(3)(iii). This rule differs slightly from the OID de minimis rule because

this rule applies to notes issued with “no more than a de minimis amount” of OID, whereas the OID rules only treat OID as de minimis if it is “less than” the de minimis amount. See Reg. § 1.163-7(e). It is therefore seemingly possible that a note could be issued in a qualified reopening with exactly the de minimis amount of OID (e.g., 50 bps for a note with 2.5 years to maturity), notwithstanding that the same note would be issued with OID if it were issued in a standalone offering. While it is questionable whether Treasury intended for there to be this distinction between the qualified reopening de minimis test and the general OID de minimis test, taxpayers could presumably rely on the explicit language of the regulations in this unlikely circumstance.



• the original notes are publicly traded, and on the date on which the price of the additional notes is established36 (or if earlier, the announce-ment date),37 the yield of the original notes (based on their fair market value) is no more than 110% of the yield of the original notes on their issue date (or if the original notes were issued with no more than a de minimis amount of OID, the coupon rate);38 or

• the additional notes are issued for cash to persons unrelated to the issuer for an arm’s length price, and on the date on which the price of the additional notes is established (or if earlier, the announcement date), the yield of the additional notes (based on their cash purchase price) is no more than 110% of the yield of the original notes on their issue date (or if the original notes were issued with no more than a de minimis amount of OID, the coupon rate).39

In the case of additional notes that are issued more than six months after the issuance of the original notes, the additional notes will generally be treated as issued in a qualified reopening of the original notes if:

36 The date on which the price of the additional debt instruments is established may be uncertain in the case of a note that is issued in exchange for property (such as an outstanding note of the issuer) because it is unclear whether the “price” of the additional debt instruments in such a case should be determined in-kind or in U.S. dollars. This can be illustrated by an example in which the issuer commits to exchange one reopened note for one outstanding note of a different class. If the price of the reopened note can be determined in-kind for this purpose (i.e., if the price for each additional note could be said to be one outstanding note), then the price of the reopened notes would be established on the date that that issuer establishes the terms of the exchange. If, on the other hand, the price of the additional notes cannot be deter-mined in-kind, then the price for the additional notes would presumably be determined based on the U.S. dollar value of one outstanding note on the date of the settlement of the exchange. Under this approach, the price of the reopened notes would be established on the settlement date for the exchange. The latter approach is supported by the fact that the issue price of a note for OID purposes is determined in U.S. dollars, even if the holder delivers property as consideration for the note.

37 The “announcement date” is the later of (1) seven days before the date on which the price of the additional debt instruments is established or (2) the date on which the issuer’s intent to reopen a security is publicly announced through one or more media, including an announce-ment reported on the standard electronic news services used by security broker-dealers (e.g., Reuters, Telerate, or Bloomberg). See Reg. § 1.1275-2(k)(2)(iv).

38 Reg. § 1.1275-2(k)(iii)(2). Prior to September 2012, similar requirements applied, except that a reopening generally needed to be publicly traded in order to be reopened in a “qualified reopening.” In addition, the transaction needed to either (1) occur within six months of the issue date of the original debt instrument and meet the 110% yield test described above or (2) be an issuance of additional debt instruments with de minimis OID. See Reg. § 1.1275-2(k)(3) (2004). Nevertheless, some issuers took the position that a reopening after six months was acceptable so long as—as the current rules provide—the yield of the notes issued in the reopening did not exceed their yield on the original issue date (i.e., the transaction did not convert OID into market discount).

39 Reg. § 1.1275-2(k)(3)(iv).



• the additional notes would—absent the application of the qualified reopening rules—be issued with no more than a de minimis amount of OID;40 or

• on the date on which the price of the additional notes is established (or if earlier, the announcement date), the yield of the additional notes (based on their fair market value or cash purchase price, whichever is applicable)41 is no more than 100% of the yield of the original notes on their issue date (or if the original notes were issued with no more than a de minimis amount of OID, the coupon rate).42

2. Tax Treatment of HoldersNotes that are issued in a qualified reopening will be treated as part of

the same issue as the original notes, and a holder will therefore treat the reopened notes as having the same issue date and adjusted issue price as the original notes.43 The reopened notes will consequently have the same OID accrual schedule as the original notes, and therefore the original notes and the reopened notes will be fungible with each other for tax purposes.

As discussed earlier,44 this is often a taxpayer-favorable result because a tax-payer that purchases reopened notes in a qualified reopening for a price that is less than the adjusted issue price of the original notes would treat the dif-ference as a market discount rather than as OID. In contrast, if the taxpayer had not purchased the notes in a qualified reopening, the difference would have been treated as OID.

However, if the price of the reopened notes is greater than the adjusted issue price of the original notes, a reopening actually does the opposite: it increases the amount of OID that holders of the reopened notes must accrue. Consider the example above,45 in which an issuer issues a $100 ten-year note that pays semiannual fixed rate interest for a price of $95. Assume that the issuer later sells the same note in a qualified reopening for a price of $97 at a time at which the adjusted issue price for the original note is $96. In this case, a purchaser of the reopened note would be required to accrue $4 of OID

40 Reg. § 1.1275-2(k)(3)(iii).41 The yield tests for reopenings of publicly traded notes within six months of issuance and

after six months of issuance differ slightly in that the test within six months is based on the yield of the original notes, while the test after six months is based on the yield of the additional notes. See Reg. § 1-1275.2(k)(3). The regulations do not provide any explanation for this dif-ference, and it is questionable whether the drafter of the regulations intended to provide for this result in the case of notes issued after the six-month period. While the value of the original notes and additional notes will generally be the same, as discussed infra Part II(C)(8) “Variable Rate Debt Instruments,” the different definition creates some uncertainty regarding the appli-cation of the yield test to variable rate debt instruments that are reopened after six months.

42 Reg. § 1.1275-2(k)(3)(v). 43 See Reg. § 1.1275-2(k)(1).44 See supra discussion following note 11.45 Id.



over the term of the note based on the OID accrual schedule for the original note, notwithstanding that it would have only had to accrue $3 of OID over the term of the note if it had not purchased the note in a qualified reopening. The taxpayer in this example should not be adversely affected by this result because it would offset the extra $1 OID inclusion with the $1 of acquisition premium that it would have in respect of the excess of its basis in the note over the adjusted issue price of the note.46

Therefore, the only possible negative consequence to a purchaser of the reopened notes in the example above is that the secondary market might dis-count the price of the reopened notes if the value of the notes subsequently declines. In such a case, the fact that reopened notes have the lower adjusted issue price of the original notes would cause the secondary purchaser to accrue more OID than it would have had to accrue if the reopened notes had not been issued in a qualified reopening. The secondary purchaser may therefore pay less for such a note than the amount that it would have paid for the note if it had not been issued in a qualified reopening.

Furthermore, the initial purchaser of notes in the example above could be adversely affected if it purchases the notes for a purchase price that is within the OID de minimis threshold. For example, assume that the purchaser in the example acquires the reopened notes for $98.25 at a time when the notes have been outstanding for less than two years and have an adjusted issue price of $96. In such a case, the purchaser would not have been required to accrue any OID over the term of the notes if the notes had not been issued in a qualified reopening because the OID would have been de minimis. However, because the notes are issued in a qualified reopening, the purchaser would be required to accrue $4 of OID based on the OID accrual schedule for the original notes. Although the purchaser would offset that amount with $2.25 of acquisition premium, it would still be required to include a net $1.75 of OID over the remaining term of the notes as opposed to it not having to accrue any OID if the notes had not been issued in a qualified reopening.

3. Tax Treatment of IssuerAs with holders, issuers are required to treat debt instruments issued in

qualified reopening transactions as fungible with one another.47 However, by contrast to holders, issuers do not relate the issue price and other terms of a debt instrument back to the issue price of the original debt instrument. Instead, as discussed more fully below, to the extent a holder pays more or less than the adjusted issue price of the original debt instruments, issuers are generally required to make adjustments to their interest accruals to account for the price differential.48

46 See I.R.C. § 1272(a)(7); Reg. § 1.1272-2(b)(3).47 Reg. § 1.163-7(e).48 Id.



More specifically, issuers of debt obligations in qualified reopenings are required to make “positive adjustments” to the extent that a purchaser in a qualified reopening pays more than the adjusted issue price of the original debt instrument.49 The effect of a positive adjustment is to increase the aggregate adjusted issue prices of all debt instruments (both original and additional) in the issue.50 Likewise, to the extent a holder pays less than the adjusted issue price of the original debt instrument, an issuer is required to make “negative adjustments,” which reduce the aggregate adjusted issue prices of all obliga-tions in the issue.51

Thereafter, an issuer is required to redetermine the yield of the debt instru-ments in the issue for the purpose of calculating its interest accruals.52 As with an original offering, the issuer is also permitted to calculate its deductions on a straight-line basis, rather than on a constant-yield basis, if the redetermined amount of OID is less than a de minimis amount.53

4. Qualified Reopenings and Grandfather RulesIf there is a change in law that does not apply to notes that are issued

before a “grandfather date,” the question then arises as to whether the change in law applies to notes that are issued after the grandfather date in a quali-fied reopening of notes that were issued before the grandfather date. The qualified reopening regulations do not explicitly address this issue because the regulations only state that the reopened notes have the same issue date as the original notes under the OID regulations.54 They do not address, however, whether the reopened notes are otherwise treated as issued on the same date as the original notes for all other tax purposes.

This issue presents two competing policy concerns. On the one hand, the qualified reopening rules are designed to enable issuers to reopen notes in a manner in which the reopened notes and the original notes will be fungible with each other for tax purposes. If notes issued in a qualified reopening are not treated as issued on the same date as the original notes for purposes of a change in law grandfather date, the reopened notes would not be fun-gible with the original notes because the reopened notes, and not the original notes, would be subject to the change in law.

On the other hand, the usual policy reason for including a grandfather date in “change in law” provisions is that it is considered unfair to subject a tax-payer to a change in law if (1) it did not know about the change in law when it entered into a transaction or (2) it did not have a sufficient amount of time

49 Reg. § 1.163-7(e)(2).50 Id.51 Reg. § 1.163-7(e)(3).52 Reg. § 1.163-7(e)(4).53 Reg. §§ 1.163-7(e)(4), -7(b)(2).54 Reg. § 1.1275-2(k)(1).



to plan for the change in law.55 That policy objective would be undermined if taxpayers could avoid a change of law relating to debt securities simply by engaging in a qualified reopening of notes, which could possibly occur many years after the change in law and the relevant grandfather date. In such a case, the issuer and the investors would know about the change in law and would have had sufficient time to plan for the change in law at the time of the quali-fied reopening. There would therefore be no policy reason—aside from the fungibility point mentioned above—why they should not be subject to the change in law. Furthermore, such an approach would undermine the policy objective that two similarly situated taxpayers should be treated the same for tax purposes. More specifically, if notes issued in a qualified reopening are not subject to changes in law that have a grandfather date after the issuance of the original notes, there would effectively be two classes of issuers in the market: (1) issuers that have outstanding notes that could be issued in a qualified reopening and that would not be subject to the change in law, and (2) issu-ers that do not have such notes outstanding that could only issue notes that would be subject to the change in law.

The Treasury and the Service encountered this issue in connection with the new FATCA reporting and withholding regime56 under which notes issued before July 1, 2014 are not subject to the FATCA rules.57 More specifically, the government had to consider whether notes issued after July 1, 2014 in a qualified reopening of notes that were issued before July 1, 2014 would be subject to FATCA. The proposed FATCA regulations did not specifically address this issue, which raised the uncertainty described above.58 The pream-

55 See generally Michael J. Graetz, Legal Transitions: The Case of Retroactivity in Income Tax Revision, 126 U. Pa. L. Rev. 47, 73-79 (1977) (noting that proponents of “prospectivity” in the tax law often base arguments of fairness upon individual reliance).

56 See generally Hiring Incentives to Restore Employment Act, Pub. L. No. 111-147, §§ 501-562, 124 Stat. 71, 97-118 (2010). FATCA imposes a 30% withholding tax on payments (including, among other things, principal and interest on debt issued by U.S. obligors) made to “foreign financial institutions” that have not signed an information reporting agreement with the Service.

57 The original grandfather date was March 18, 2012, but this date was first extended to January 1, 2013 in the proposed FATCA regulations, was then further extended to January 1, 2014 in the final FATCA regulations, and was extended yet again (to July 1, 2014) in Notice 2013-43. Compare Notice 2013-43, 2013-31 I.R.B. 113, with Reg. § 1.1471-2(b), and Prop. Reg. § 1471-2(b), 77 Fed. Reg. 9,028 (2012). In the case of notes that are subject to FATCA solely because they generate “foreign passthru payments,” the applicable grandfather date is six months after the date on which the term “foreign passthru payment” is defined in final regula-tions. Reg. § 1.1471-2(b). The discussion below is equally applicable to notes that are subject to the extended grandfather date.

58 The proposed regulations simply included a rule—which is textually identical to the rule in the final FATCA regulations—providing that any debt obligation with an “issue date” prior to the grandfather date would be treated as “outstanding” on that date (and therefore generally grandfathered). Technically, this language would also grandfather any note that is issued in a qualified reopening of a grandfathered note. However, prior to the release of the final FATCA regulations, it was not clear whether this result was intended. Compare Prop. Reg. § 1471-2(b)(2)(iii), 77 Fed. Reg. 9,029 (2012), with Reg. § 1.1471-2(b)(2)(iii).



ble to the final FATCA regulations, however, provides that debt obligations issued after July 1, 2014 in a qualified reopening of obligations that were issued before that date will be treated as issued on the same date as the origi-nal obligations for FATCA purposes, and therefore will be grandfathered from the FATCA rules.59 In this case, the government apparently decided that the policy objective of enabling taxpayers to reopen notes that were issued before the grandfather date outweighed the policy objective of limiting grandfather date eligibility to taxpayers that did not know of the change in law or did not have sufficient time to prepare for the change in law when they entered into a transaction. This decision creates a significant planning opportunity for issuers that have outstanding notes that are grandfathered from FATCA and that can be issued in the qualified reopening as such issuers can issue notes in a qualified reopening many years after July 1, 2014 that will not be subject to FATCA. This planning opportunity may be particularly advantageous for issuers that would like to issue notes in markets in which the FATCA rules might otherwise preclude the marketability of notes issued by U.S. issuers.60

The government also encountered the same issue in connection with the repeal of the “foreign targeted” bearer debt rules, under which interest that is paid on any such notes that are issued after March 18, 201261 will not be deductible and will not be eligible for the portfolio interest exception. This raises the question as to whether bearer debt that is issued after March 18, 2012 in a qualified reopening of notes that were issued before such date is subject to this change of law. Unlike the FATCA rules described above, there is no authority that addresses this issue. In light of this uncertainty and the very harsh consequences to issuers that issue bearer debt after March 18, 2012, issuers would be well advised not to issue notes after such date, even if the notes are issued in a qualified reopening of notes that were issued before the grandfather date.

5. Debt Instruments Issued for PropertyAlthough notes issued in a qualified reopening are generally issued for

cash, the qualified reopening rules also apply in cases in which notes are

59 See T.D. 9610, 2013-15 I.R.B. 765, 770.60 As discussed above, original notes and reopened notes will generally be effectively fungible

with one another, without regard to whether they are part of the same “issue” or part of a qualified reopening, if they are both issued with no more than a de minimis amount of OID. However, if the reopening is not a qualified reopening, the issue date of the reopened notes will be the date on which they are issued and not the issue date for the original notes. In such a case, the reopened notes will be subject to FATCA if they are issued after July 1, 2014, and thus will not be fungible with the original notes for tax purposes if they were issued before July 1, 2014. However, this will rarely be a problem because a long-term note that is issued with no more than a de minimis amount of OID will generally be treated as issued in a qualified reopening under the revised regulations described above unless they are not publicly traded and not issued for cash to unrelated persons.

61 Hiring Incentives to Restore Employment Act, Pub. L. No. 111-147, § 502(f ), 124 Stat. 71, 108 (2010).



issued for property. Most commonly, this will involve an exchange offer, in which the issuer offers new notes in exchange for other notes, but it can also occur in a case in which an issuer purchases other property in exchange for reopened notes.

In the case of a taxpayer that sells property in exchange for a note of the purchaser, the seller’s “amount realized” is generally equal to the issue price of the note that it receives (as determined under the OID regulations).62 Simi-larly, an issuer that repurchases its outstanding debt in exchange for its newly issued debt will generally recognize cancellation of indebtedness income or a redemption premium deduction based on the difference between the issue price of the newly issued debt and the adjusted issue price of the old debt that is extinguished in the exchange.63 This approach generally makes economic sense: in most cases, the issue price of a debt instrument approximates its fair market value.64 The issue price of an obligation issued in a qualified reopen-ing, however, relates back to the issue price of the “original debt instruments,” and thus may differ significantly from the current fair market value of the obligation. This approach can—in certain cases—lead to seemingly inappro-priate tax results.

For example, consider a publicly traded note that was originally issued for $1,000, but which has a fair market value of $1,300. Assume that the issuer of the note seeks to purchase an asset that has a value of $1,300—which may be an outstanding debt instrument of the issuer—in which the seller has a tax basis of $1,000. If the issuer were to purchase the asset for cash or for a new publicly traded note (i.e., a note that is not issued in a qualified reopen-ing), the seller would generally recognize $300 of gain upon the sale.65 The purchaser would then have a $1,300 basis in the asset, or it would recognize a $300 premium deduction if the asset that it acquires is its outstanding debt (assuming the adjusted issue price of the outstanding debt is $1,000).

If, alternatively, the purchaser were to purchase the asset in exchange for a reopening of the note described above, the reopening would be a quali-

62 See Reg. § 1.1001-1(g). This rule provides exceptions for CPDIs and instruments whose issue price is determined under section 1273(b)(4).

63 See I.R.C. § 108(e)(10); Reg. § 1.61-12(c)(2); Reg. § 1.163-7(c).64 The issue price of a note is generally determined under one of four rules. The issue price of

a note, a substantial amount of which is sold for money, is the first price at which a substantial amount of the debt instrument is sold for money. If the note is not sold for money, and the newly issued notes are publicly traded, then the issue price of the newly issued note is equal to the fair market value of the note. If the newly issued note is not sold for money and is not publicly traded but is issued in exchange for stock or securities that are publicly traded, then the issue price of the newly issued note would equal the fair market value of the notes that are surrendered in exchange for the new notes. If none of the three rules apply to the newly issued notes, the issue price of the new notes would equal the principal amount of the notes if the notes provide for “adequate stated interest.” Thus, under the first three rules, the issue price of a newly issued note would generally equal its fair market value. See Reg. § 1.1273-2.

65 In the case of a debt for debt exchange, this discussion assumes that the exchange does not constitute a tax-free recapitalization.



fied reopening, and therefore the issue price of the reopened note would be $1,000, notwithstanding that it has a current value of $1,300. The seller would accordingly be treated as receiving $1,000 of consideration and it would thus not recognize any gain upon the sale. The purchaser would have a $1,000 tax basis in the purchased asset, or if the purchased asset is its outstanding debt, it would not recognize any premium deduction upon the transaction.

The difference between these two transactions would reverse over time because the reopened note would have an above-market coupon. More spe-cifically, the seller in the latter transaction would be required to include the entire above-market coupon on the reopened note in income, while it would have included a smaller coupon in income if it had instead received a newly issued note in the former transaction.66 Conversely, the purchaser in the latter transaction would be entitled to deduct the full above-market coupon on the reopened note, while it would have been entitled to deduct a smaller amount if it had instead purchased the asset in exchange for a newly issued note in the former transaction.

There would also be a seemingly inappropriate tax result if one assumes the facts in the example above, except that one assumes that the asset and the note issued in the reopening instead each had a value that was less than $1,000 on the date of the sale. In such a case, the seller would have economically recognized a loss in connection with the sale because the issuer would deliver an asset (i.e., the reopened note) with a value of less than $1,000. However, because the issue price of the reopened notes under the qualified reopen-ing rules would be $1,000, the seller would not be permitted to recognize a loss on the sale (and the issuer would likewise not recognize cancellation of indebtedness income if the asset is its outstanding debt).67

There is no policy reason why a taxpayer that sells an asset in exchange for a note that is issued in a qualified reopening should be subject to such dramatically different tax consequences than if it had instead sold the asset in exchange for cash or a newly issued note. The drafters of the section 108 and section 1001 regulations could not have contemplated that the fair market value of a publicly traded note could significantly differ from its issue price because both provisions were enacted before the qualified reopening regula-tions were first proposed in 1999.68 The Tax Section of the New York State

66 This may have negative character consequences to the extent that the seller would have recognized capital gain under the former transaction and it instead recognizes an increased amount of ordinary income under the latter transaction.

67 The distortive effect in this scenario would be relatively limited because the 100% and 110% yield tests described supra Part II(C)(1) would limit the extent of the discount on a note that is issued in a qualified reopening.

68 Regulation section 1.1001-1(g), in its current form, was promulgated in 1996. T.D. 8674, 1996-28 I.R.B. 7. Section 108(e)(10) was added to the Code in 1990 (as old section 108(e)(11)). Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-508, § 11325, 104 Stat. 1388 (1990). The final version of Regulation section 1.1275-2(k) was promulgated in 2001. T.D. 8934, 2001-1 C.B. 904.



Bar Association issued a report in 2010 that identified this issue. The Report recommended that guidance be issued that would provide that the amount realized by a taxpayer that sells property in exchange for a note that is issued in a qualified reopening should equal the fair market value of the note on the date of the sale, notwithstanding that such amount differs from the issue price of the note.69 However, in the absence of such guidance, taxpayers can presumably rely on the Code and regulations in deciding whether to acquire assets in exchange for a note issued in a qualified reopening. This absence of guidance creates a planning opportunity for issuers that have publicly traded notes outstanding that are trading at a premium because such issuers have the ability to deliver a form of consideration (i.e., reopened notes issued in a qualified reopening) that would enable sellers to recognize a tax benefit in respect of a sale of an asset in exchange for the reopened notes.

6. “Identical” TermsAs noted above, the qualified reopening rules require that the “additional

debt instruments” must “have terms that are in all respects identical to the terms of the original debt instruments as of the reopening date.”70 While this requirement will generally be easily satisfied, there is some uncertainty as to whether reopened notes that are not registered with the SEC should be treated for this purpose as having identical “terms” as original notes that are registered with the SEC.

This issue will be relevant in the case of an issuer that has existing SEC-registered notes that it would like to reopen (and which, if reopened today, would satisfy the qualified reopening yield test), but that, because of timing or other constraints, cannot be reopened on an SEC-registered basis. The issuer might then issue nonregistered notes with otherwise identical terms as the original notes (apart from the CUSIP number) and commit to subse-quently either exchange those notes for SEC-registered notes or file a registra-tion statement covering the notes.71 Once the reopened notes are registered with the SEC, the intent would be that the reopened notes would have the

69 See N.Y. State Bar Ass’n Tax Section, Report on Uncertainties and Ambiguities in the Original Issue Discount Regulations 18-24 (2010). As noted in the report, the mar-ket discount and amortizable bond premium rules would then govern inconsistencies between a holder’s basis in the note and the note’s adjusted issue price.

70 Reg. § 1.1275-2(k)(2)(ii).71 The terms of such notes sometimes provide that the issuer will pay additional interest on

the notes if it does not file a registration statement for the notes or offer to exchange the notes for registered notes by a specified date. If the nonregistered notes have such a provision, the notes may be treated as having different “terms” than the original registered notes for qualified reopening purposes because the original notes would not include the same provision. If that were the case, the nonregistered notes could not be treated as issued in a qualified reopening of the original notes. It is possible, however, that such a provision should be disregarded for qualified reopening purposes because the possibility of receiving the additional interest will generally be a “remote” contingency that is otherwise ignored for OID accrual purposes. See Reg. § 1.1275-2(h)(2).



same CUSIP number as, and would trade interchangeably with, the original notes. In this case, it is critical that the nonregistered notes are treated as issued in a qualified reopening of the original notes, notwithstanding that they will not trade interchangeably as long as the reopened notes are not registered, because the notes will not be treated as newly issued for tax pur-poses when a registration statement is filed with respect to the notes or when the nonregistered notes are exchanged for registered notes.72 There would, therefore, be no new issuance of notes at such time that could be treated as a qualified reopening. Accordingly, if the nonregistered notes are not treated as issued in a qualified reopening of the original notes, the reopened notes will never be fungible with the original notes (unless both the original notes and reopened notes are issued with no OID or a de minimis amount of OID), even if they are registered with the SEC or exchanged for registered notes.

Although there is no authority on point, it is likely that SEC registration would not be treated as a term of the notes for this purpose because it does not relate to the rights and obligations between the issuer and the holder of the notes. It rather represents an external restriction on transferability that is imposed by the United States securities laws. Moreover, allowing the nonreg-istered notes to be issued in a qualified reopening would be consistent with the policy objective of the qualified reopening rules described above of allow-ing capital markets reopenings to the extent that no more than a minimum amount of OID is converted into market discount. The fact that reopened notes are not yet registered with the SEC would not result in any conver-sion of OID into market discount beyond the amount allowed by the quali-fied reopening regulations, and allowing for qualified reopening treatment in this case would further the policy objective of accommodating capital market reopenings.

7. Short-Term Debt InstrumentsReopenings of short-term notes raise unique tax issues because all interest

on a short-term note is generally treated as OID73 and holders of short-term notes are otherwise subject to special rules. More specifically, a note is treated as a short-term note if it has a maturity date that is one year or less after the date of issue for the note.74 Although not entirely clear, the term “date of

72 The filing of a registration statement with respect to the notes would not be treated as a disposition of the nonregistered notes in exchange for newly issued notes because such fil-ing would not be treated as a “modification” of the nonregistered notes for tax purposes. See Reg. § 1.1001-3(d), Ex. (3). While an exchange of nonregistered for registered notes would be treated as a modification of the nonregistered notes for tax purposes, the exchange should also not be treated for tax purposes as a disposition of the nonregistered notes in exchange for newly issued registered notes, because such modification should not be treated as “significant” as it will not affect the legal rights and obligations under the notes. See Reg. § 1.1001-3(e)(1).

73 This is because none of the interest on a short-term note is treated as qualified stated inter-est. See Reg. § 1.1273-1(c)(5).

74 I.R.C. § 1283(a)(1)(A); Reg. § 1.1272-1(f ).



issue” presumably has the same meaning as the term “issue date” under the OID regulations, as the short-term note definition is itself included in the OID regulations. Although a cash basis taxpayer is generally not required to currently accrue OID on a short-term note, it must treat any gain that it recognizes upon a sale of the note as ordinary income to the extent of the accrued OID on the note,75 and it must defer interest deductions that are allocable to its ownership of the note to the extent of the accrued OID on the note.76

Alternatively, a holder of a short-term note may elect to accrue the discount on the note based on the “acquisition discount” for the note, rather than the OID for the note.77 A note’s acquisition discount will equal the excess of all principal and interest on the note over the holder’s basis for the note.78 However, such an election, if made, will apply to all short-term notes held by the taxpayer and cannot be revoked in the future—including with respect to future notes held by the taxpayer—without the consent of the Secretary of the Treasury.79

If notes that originally had a term of more than one year are reopened when they have a remaining term of less than one year, the original notes and the reopened notes would, subject to the following sentence, not be fungible with each other for tax purposes, because the reopened notes, and not the original notes, would be subject to the special short-term debt rules described above. The notes would be fungible with each other, however, if they are treated as part of the same issue for tax purposes, because in such a case the reopened notes would have the same issue date as the original notes and thus would not be treated as short-term notes.

Similarly, if an issuer reopens notes that originally had a term of less than one year, the reopened notes and the original notes would, subject to the discussion below, generally not be fungible with each other for tax purposes because they would generally have a different OID accrual schedule.80 The notes would be fungible with each other, however, if all holders of the notes make the acquisition discount election described above, because in such a case each holder would accrue discount on its note based on its individual purchase price for the note rather than the amount of OID on the note.81 In

75 I.R.C. § 1271(a)(4).76 I.R.C. § 1282.77 I.R.C. § 1283(c)(2).78 § 1283(a)(2).79 § 1283(c)(2)(B).80 The notes would be fungible with each other if the reopened notes are issued with the exact

same yield to maturity as the original notes. However, this will presumably rarely be the case.81 This will generally not be a practical way to achieve fungibility as there is no way to

ensure that all holders will make the election unless they are bound to do so under the terms of the note. Holders may be reluctant to agree to make the election in light of the fact that, as discussed above, the election will also apply to all other short-term notes that are held by the taxpayer and the election cannot be revoked in future years without the consent of the Secretary of the Treasury.



addition, the notes would be fungible with each other if they were treated as part of the same issue for tax purposes, because in such a case, the reopened notes would have the same issue date as the original notes and thus would have the same OID accrual schedule as the original notes.

The primary issue in this regard is whether the 13-day rule and qualified reopening rule described above should equally apply to short-term notes, in which case a reopening of short-term notes could be treated as part of the same issue as the original notes if it satisfies either of these two rules. Although many of the OID regulations are inapplicable to short-term debt, there is nothing in either such rule that would exclude short-term notes; therefore, absent an exception, one should infer that they do apply to short-term notes. Furthermore, the qualified reopening rules are issued as part of Treasury Reg-ulations section 1.1275-1, which states that it applies for purposes of sec-tions 163(e) and sections 1271 through 1275. Sections 1271 through 1275, which are typically thought of as “the OID rules,” are primarily relevant to long-term debt, but can affect short-term obligations. For example, section 1271(a)(4) provides rules that gain on the sale or exchange of a short-term nongovernment obligation is treated as ordinary income to the extent of accrued “original issue discount.”

Another issue that one must consider upon a reopening of short-term notes relates to the rule under which interest that is paid to a non-U.S. person on a note with a term of 183 days or less from the “date of original issue” is not subject to FATCA or withholding tax, irrespective of whether the interest otherwise satisfies the portfolio interest exemption.82 As discussed above, the qualified reopening rules provide that notes issued in a qualified reopening have the same issue date as the original notes for OID purposes, but they do not otherwise specify whether the reopened notes should be treated as issued on the same date as the original notes for other tax purposes. It is therefore uncertain how the 183-day rule should apply in the case of notes that origi-nally had a term of more than 183 days but which are reopened in a qualified reopening when the notes have a remaining term of less than 184 days. If the date of original issue for the notes is the reopening date, the interest on the reopened notes would be exempt from FATCA and withholding tax under the 183-day rule, but they would not be fungible with the original notes because interest payments on the original notes would not be exempt from FATCA and withholding tax under such rule. Conversely, if the date of origi-nal issue for the reopened notes is the issue date for the original notes, then the reopened notes would not be exempt from FATCA and withholding tax under the 183-day rule, but they would be fungible with the original notes. In order to ensure fungibility in such a case, an issuer may want to require that holders of the reopened notes agree to treat the reopened notes as having a term of more than 183 days for purposes of the 183-day rule so that the original notes and the reopened notes are definitely fungible with each for tax

82 I.R.C. § 871(g)(1)(B); Reg. § 1.1473-1(a)(4)(i).



purposes. Foreign investors would generally not object to the withholding tax consequence of such treatment as in most cases the interest on the notes would in any case be eligible for the portfolio interest exemption as long as the investors provide a Form W-8-BEN.83 In addition, foreign investors would have no reason to object to the application of FATCA to the notes unless they are nonparticipating foreign financial institutions or they hold the notes through such institutions. The Service would have no reason to object as it results in the reopened notes being subject to the more restrictive with-holding tax and FATCA regime applicable to the original notes.

8. Variable Rate Debt InstrumentsThe qualified reopening rules also apply to variable rate debt instruments

(VRDIs), as the regulations provide a special exception for contingent pay-ment debt instruments84 but do not likewise exclude VRDIs that provide for contingent payments. The regulations, however, do not address how the 100% and 110% yield tests described above should be applied to a reopen-ing of a VRDI. More specifically, in the case of a VRDI, the floating rate payments on the instrument are contingent, and thus one cannot compute a yield for the instrument. The VRDI regulations provide that for purposes of determining the amount of OID on a VRDI, taxpayers should gener-ally replace the floating rate on the VRDI with a fixed rate that is equal to the value of the floating rate as of the issue date of the VRDI (the fixed rate substitute).85 While the qualified reopening rules do not explicitly so state, it would make sense to likewise use a VRDI’s fixed rate substitute when deter-mining the yield of a VRDI for purposes of applying the qualified reopening yield tests.

However, a further complication arises from the fact that in the case of a reopening under the cash issuance rule, as well as a reopening after six months under the publicly traded rule, the qualified reopening regulations provide that the yield test is based on a comparison of the yield of the reopened notes and the yield of the original notes, and not on the yield change of the original notes.86 The question that then arises is whether the fixed rate substitute that should be used for the reopened notes in making the yield comparison should be the value of such rate on the date of the issuance of the reopened notes or should be the fixed rate substitute that was used to determine the OID accru-als, if any, for the original notes.

This uncertainty can best be illustrated by an example in which one assumes that an issuer issues non-publicly traded notes for 95% of par that bear inter-est at a floating rate equal to 3-month U.S. dollar LIBOR (“LIBOR”) at a time at which LIBOR equals one percent. Assume that the issuer reopens the

83 Reg. § 1.871-14(e)(1). 84 Reg. § 1.1275-2(k)(3)(vi). 85 Reg. § 1.1275-5(e)(2)(ii).86 Reg. §§ 1.1275-2(k)(3)(iv) to -2(k)(3)(v).



notes at a time at which (1) LIBOR equals two percent, (2) the adjusted issue price of the original notes is 96% of par, and (3) the issuer’s credit quality has improved so that the notes are sold for 97% of par. For purposes of applying the relevant yield test under the qualified reopening regulations, should the yield of the reopened notes be based on the two percent rate or should it be based on the one percent rate that was originally used as the fixed rate substi-tute for the original notes? While there is no authority in the regulations that addresses this issue, it seems clear that one has to use the same fixed rate sub-stitute for the original notes and the reopened notes (i.e., either one percent or two percent in the example above), because otherwise the yield change between the two notes would be artificially increased or decreased due to the change in LIBOR between the issuance of the original notes and the issuance of the reopened notes. The illogical result that could arise if one were to use the original fixed rate substitute for the original notes and a different fixed rate substitute for the reopened notes can be illustrated using the example above. In that case, if one were to apply the yield test based on a two percent fixed rate substitute for the reopened notes and a one percent fixed rate sub-stitute for the original notes, the reopened notes would have a much higher yield than the original notes because of their higher fixed rate substitute. The reopening would therefore fail both the 100% and 110% yield tests even though the reopened notes were issued at a higher price than the adjusted issue price of the original notes. That result would be wholly inconsistent with the policy of allowing reopenings that do not result in the conversion of OID into market discount. Therefore, in the example above, one should presumably employ the yield test either by using the two percent fixed rate substitute, or the one percent fixed rate substitute, for both the original notes and the reopened notes. While there generally will not be a significant dif-ference in the yield change under the two approaches, it is possible that in some cases the yield test would be satisfied under one approach and would not be satisfied under the other approach. In the absence of any guidance in the regulations as to which is the correct approach, it may be advisable for taxpayers to ensure that a reopening of a VRDI satisfies both yield tests before proceeding with the reopening.

If a reopening of a VRDI is a qualified reopening, then it follows that the reopened notes should use the same OID accrual schedule as the original notes because otherwise the original notes and the reopened notes would not be fungible with each other. However, the regulations do not explicitly provide for that result. Rather, the regulations only provide that the reopened notes have the same issue date, issue price, and adjusted issue price as the original notes.87 In the case of a fixed rate note, it then automatically follows that the reopened notes would have the same OID accrual schedule as the original notes. In the case of a VRDI, by contrast, it does not necessarily follow that the reopened notes would have the same OID accrual schedule

87 Reg. § 1.1275-2(k)(1).



as the original notes unless the reopened notes have the same fixed rate sub-stitute as the original notes. However, the most sensible way to interpret the regulations in the case of a qualified reopening of a VRDI is as requiring that the reopened notes use the same OID accrual schedule as the original notes based on the fixed rate substitute that was used to determine the OID accrual schedule for the original notes, and not based on the fixed rate substitute that would have been used to determine the OID accrual schedule for the reopened notes if they had not been issued in a qualified reopening. That is because the issue date for notes issued in a qualified reopening is the same as the issue date for the original notes, and the fixed rate substitute for a VRDI is determined upon the issuance of the VRDI.88 Thus, as a technical matter, the regulations arguably require that a VRDI issued in a qualified reopening should have the fixed rate substitute that was in effect upon the issuance of the original notes. Moreover, any other result would be illogical as the regula-tions clearly intended to allow for the reopening of VRDIs by virtue of the fact that they specifically exclude contingent payment debt instruments and do not likewise exclude VRDIs. In addition, the provision that states that notes issued in a qualified reopening have the same issue price, issue date, and adjusted issue price as the original notes is obviously intended to enable the reopened notes to be treated as fungible with the original notes for tax purposes. Therefore, the position that a VRDI issued in a qualified reopening should not have the same OID accrual schedule as the original notes would be inconsistent with the intent of the qualified reopening regulations.

9. Contingent Payment Debt InstrumentsContingent payment debt instruments (CPDIs)89 are specifically excluded

from the qualified reopening rules.90 CPDIs can, in theory, be reopened if the “new” notes have the same “comparable yield” and “projected payment schedule” as the “old” notes because in such a case a holder’s accrual schedule would be the same for both offerings. However, absent this limited circum-stance, CPDIs generally cannot be reopened unless the CPDIs are treated as part of the same issue under the 13-day rule described above.

It is unclear whether a note that is not a CPDI can be reopened in a quali-fied reopening if the reopened note would be treated as a CPDI on a stand-alone basis (i.e., if it were not issued in a qualified reopening of the original note). For example, consider a note that includes a clause requiring the issuer to repurchase the note for 101% of its principal amount if the issuer under-goes a “change-in-control.” Such notes are typically not treated as CPDIs because the OID regulations provide that “remote or incidental” contingen-

88 Reg. § 1.1275-5(e)(2)(ii)(A). 89 CPDIs are debt securities that provide for one or more payments that are subject to con-

tingencies (other than “remote or incidental” contingencies and certain other excluded contin-gencies). See Reg. § 1.1275-4.

90 Reg. § 1.1275-2(k)(3)(vi).



cies are disregarded for CPDI purposes, and taxpayers usually take the posi-tion that a change-in-control is “remote or incidental.”91 Alternatively, such notes may not be treated as a CPDI under the “alternative payment schedule rules,” which provide that alternative payment schedules under a note can generally be ignored if there is a single payment schedule under the note that is “significantly more likely than not to occur.”92 It is possible, however, that a change in control could be remote or incidental or could be ignored under the alternative payment schedule rules when an original note is issued, but no longer be remote or incidental or significantly more likely than not to not occur when the issuer seeks to reopen the note. In such a case, the reopened note would be treated as a CPDI if it were not issued in a qualified reopening of the original note.

In addition, this issue can arise if a note provides for an issuer call option under which the issuer can redeem the note for an amount equal to the greater of the principal amount of the note and a “make whole” amount that is determined based on interest rates in effect at the time of the redemption. The existence of such an optional redemption feature is ignored for CPDI purposes if the note is issued without any premium because the OID “option rule” provides that in such a case the issuer is presumed not to exercise its option because doing so would either increase the yield of the note or would not change the yield of the note.93 However, if such a note is issued at a pre-mium, the option rule would not apply to the note, and therefore the contin-gent price redemption right would generally cause the note to be classified as a CPDI. If such a note is originally issued without premium and is reopened with premium, the question then arises as to whether the reopening is a quali-fied reopening because the reopened notes would, if issued on a stand-alone basis, be treated as a CPDI.94

Under one approach, the regulations would not prohibit a qualified reopening in the cases described above because, although it is not entirely clear, the reference in the regulations to a “reopening of . . . a contingent pay-ment debt instrument” seems to only be referring to a reopening of original notes that were CPDIs. Therefore, one could argue that as long as the original debt instruments are not CPDIs, no “reopening of . . . a contingent payment debt instrument” will occur, even if the additional debt instruments—in the

91 See Reg. § 1.1275-4(a)(5). 92 Reg. §§ 1.1272-1(c)(1) to -1(c)(2).93 See Reg. §§ 1.1272-1(c)(5), -1(d).94 A similar issue could arise upon a reopening of a VRDI that pays interest at a single

“objective rate” (i.e., a rate based on objective financial information). Among other require-ments, such a note can only qualify as a VRDI if it is not “reasonably expected that the average value of the rate during the first half of the instrument’s term will be either significantly less than or significantly greater than” the average value of that rate during the second half of the instrument’s term. See Reg. § 1.1275-5(c)(4). If the note does not satisfy this requirement, it would be treated as a CPDI rather than as a VRDI. It is possible that a note that originally satisfies such test will not satisfy the test upon a reopening, in which case the reopened note would be treated as a CPDI if it were issued on a stand-alone basis.



absence of the qualified reopening rules—would be CPDIs. Once the reopen-ing is a qualified reopening, the fact that the contingencies are not remote or incidental upon the reopening would be irrelevant because (1) the contingen-cies were remote or incidental on the issue date for the original notes, (2) the determination as to whether a contingency is remote or incidental is made on the notes’ issue date,95 and (3) under the qualified reopening rules, the new notes would have the same issue date as the original notes.96

On the other hand, it is possible that the issuance of additional debt instru-ments that would be CPDIs if they were sold in a de novo offering amounts to “a reopening of . . . a contingent payment debt instrument.” Under this approach, the CPDI that is referenced by the regulation is not only an origi-nal note that is a CPDI but also an additional note that would be a CPDI if it were not issued in a qualified reopening. Further, under this approach, although the qualified reopening rules treat the reopened notes as having the same issue date as the original notes, that rule would not apply if the reopened notes would be CPDIs on a stand-alone basis, because in such a case the reopening would not be a qualified reopening in the first place. Although potentially weaker on a technical basis, this argument may be bet-ter supported by the policy underlying the qualified reopening rules, which as discussed above, are designed to limit the amount of OID that can be converted into market discount in a reopening transaction. If a note that would otherwise be treated as a CPDI is not so treated if it is issued in a quali-fied reopening, taxpayers could potentially avoid the special CPDI rules that would otherwise require it to accrue OID on the note97 and to treat any gain that it recognizes upon the sale or maturity of the note as ordinary income.98

10. Tax-Exempt ObligationsTax-exempt obligations, such as municipal bonds, are specifically excluded

from the qualified reopening rules.99 This is relevant because although OID on a tax-exempt obligation is treated as tax-exempt interest, gain realized upon the sale of a tax-exempt obligation—including gain that is attributable to market discount—is not treated as tax-exempt interest.100 Thus, holders of tax-exempt obligations that have a different issue price will be treated differ-ently for tax purposes. Accordingly, tax-exempt obligations that are otherwise not treated as part of the same issue under the 13-day rule described above will not be fungible with each other unless the reopened notes are issued for an amount that is exactly equal to the adjusted issue price of the original notes.

95 See Reg. § 1.1275-2(h)(1).96 See Reg. § 1.1275-2(k)(1).97 See Reg. § 1.1275-4(b)(2).98 See Reg. § 1.1275-4(b)(8).99 Reg. § 1.1275-2(k)(3)(vi).100 Rev. Rul. 73-112, 1973-1 C.B. 47.



11. Treasury SecuritiesThe OID regulations provide for special qualified reopening rules for U.S.

Treasury securities under which a reopening of Treasury securities will be treated as a qualified reopening if (1) the reopening satisfies the general quali-fied reopening rules described above or (2) the reopening occurs no more than one year after the issuance of the original Treasury securities to the public.101

D. Legislative ProposalsRepresentative David Camp’s much publicized proposals to reform the

taxation of financial instruments, as well as President Obama’s Fiscal Year 2014 Revenue Proposals, include a provision that would generally align the tax treatment of OID and market discount and would therefore generally require investors to currently accrue market discount in income over the term of a note.102 As discussed above, most of the tax issues relating to reopenings of debt securities, and much of the complexity described in the preceding sec-tions, stem from the different tax treatment of OID and market discount. The two proposals, however, would not entirely eliminate the differences between market discount and OID, as they would not require investors to currently accrue market discount if the amount of such discount exceeds certain thresh-olds.103 These proposals would therefore not eliminate the reopening fungibil-ity issues and the associated complexity described above. It remains to be seen whether future proposals might further equate the tax treatment of OID and market discount in a manner that would eliminate, or perhaps simplify, the tax issues associated with reopening of debt securities.

III. Preferred StockAs discussed above, reopenings of debt securities generally only raise tax

fungibility issues when the debt is issued at a discount. By contrast, in the case of preferred stock, as discussed in more detail below, a reopening at a

101 Reg. § 1.1275-2(d).102 See House Ways and Means Comm., 113th Cong., To Amend the Internal Rev-

enue Code of 1986 to Provide for Comprehensive Income Tax Reform 27 (Discussion Draft, Jan. 23, 2013), http://waysandmeans.house.gov/uploadedfiles/leg_text_fin.pdf; Dep’t of the Treasury, General Explanations of the Administration’s Fiscal Year 2014 Rev-enue Proposals 151 (Apr. 2013), http://www.treasury.gov/resource-center/tax-policy/Docu-ments/General-Explanations-FY2014.pdf.

103 In particular, no inclusions would be required to the extent they would exceed the OID that would accrue on a bond with an imputed principal amount determined using a discount rate equal to the greater of: (1) the bond’s yield to maturity (at original issue) plus five percent and (2) the applicable federal rate (determined as of the date of acquisition) plus ten percent. House Ways and Means Comm., 113th Cong., To Amend the Internal Revenue Code of 1986 to Provide for Comprehensive Income Tax Reform 28 (Discussion Draft, Jan. 23, 2013), http://waysandmeans.house.gov/uploadedfiles/leg_text_fin.pdf.



premium or discount may raise tax fungibility issues as well as other tax issues that could adversely affect investors.104

A. Preferred Stock Issued at a PremiumMany, if not most, purchasers of corporate preferred stock are corporations

who choose to invest in preferred stock rather than debt primarily to claim a dividends received reduction with respect to at least 70% of the dividends that they receive on the stock.105 As discussed below, the primary tax issue that arises upon a reopening of preferred stock at a premium is that the special tax rules applicable to preferred stock issued at a premium may effectively eliminate most of the benefit of the dividends received deduction in respect of the stock.

More specifically, section 1059 provides that a taxpayer that receives an “extraordinary dividend” with respect to stock must reduce its tax basis in the stock by the portion of the dividend for which it received the dividends received deduction.106 This rule has the effect of eliminating the benefit of the dividends received deduction for a corporate investor (other than a timing benefit) because the reduction in basis will eventually result in the taxpayer recognizing gain, or a reduced amount of loss, upon the sale or maturity of the stock that is equal to the amount of its dividends received deduction.107 This rule is designed to prevent corporate investors from claiming a dividend received deduction in respect of a large dividend and then recognizing a loss upon a sale of the stock that is attributable to the reduction in its value as a result of the payment of the dividend.

Section 1059(f ) has a rather draconian rule under which any dividend paid on preferred stock will be treated as an extraordinary dividend subject to these rules if the issue price for the stock exceeds the liquidation or redemp-

104 The FATCA fungibility issues discussed above regarding reopenings of debt securities would not be relevant to a reopening of preferred stock because the FATCA rules do not include a grandfather date for stock—rather, FATCA will apply to all U.S. source dividends paid after June 30, 2014 irrespective of when the stock was issued. See Reg. § 1.1471-2(b)(2)(ii)(B)(1) (instru-ments treated as equity for U.S. tax purposes not considered “obligations” that are eligible to benefit under the FATCA grandfather rules).

105 I.R.C. § 243(a).106 I.R.C. § 1059(a).107 Extraordinary dividend treatment could also be relevant to non-corporate taxpayers

because a taxpayer that receives a “qualified dividend” that is an extraordinary dividend must treat any loss on the applicable stock as long-term capital loss to the extent of such dividends (even if it has a short-term holding period in the stock). I.R.C. § 1(h)(11)(D)(ii). The fungibil-ity issues described below would therefore also be relevant even if the issuer prohibits corporate ownership of the preferred stock.



tion price of the stock by any amount.108 This is typically not a problem in connection with an initial issuance of preferred stock because preferred stock is almost always issued at par. However, this provision will apply upon a reopening of preferred stock if the reopening is at a premium and the reopen-ing is not treated as part of the same issue as the original issuance of the preferred stock. Preferred stock could be issued at a premium upon a reopen-ing even if the value of the stock has not increased since its initial issuance because the offering price for the stock generally includes accrued dividends on the stock. In the case of equity, there is no rule that is analogous to the rule in the OID regulations that permits taxpayers to exclude pre-issuance accrued interest from the issue price of the note.109 Therefore, preferred stock issued in a typical 30-day green shoe will be treated as issued at a premium, if it is not otherwise treated as part of the same issue as the original issuance of the preferred stock, if the purchase price under the green shoe is equal to the original offering price for the stock plus accrued dividends on the stock.

Aside from the negative tax consequences to a corporate holder of preferred stock that is issued at a premium, any reopened preferred stock that is issued at a premium that is not treated as part of the same issue as an original offer-ing of preferred stock that was issued for par would also not be fungible with the original preferred stock. That is because a secondary purchaser of such stock would be in a different position depending upon whether it purchases the original preferred stock (the dividends on which would not be extraor-dinary dividends) or the reopened preferred stock (the dividends on which would be treated as extraordinary dividends).

Accordingly, based on the discussion above, it is critical that any preferred stock that is issued upon a reopening is not issued at a premium or is treated as part of the same issue as the original issuance of preferred stock. Unfor-tunately, there is no authority that defines the term “issue” for this purpose, and there is therefore often a great deal of uncertainty as to whether an issu-ance of preferred stock is treated as part of the same issue as the original

108 The legislative history of section 1059(f ), in describing “Reasons for Change” leading to the adoption of that section, states as follows:

Corporate stockholders may receive dividends eligible for the dividends received deduction in circumstances where the dividends more appropriately should be char-acterized as a return of capital. In many of these cases, the dividends are not subject to the ‘extraordinary dividend’ rules of present law, so the holder’s basis in the stock is not reduced as it should be economically. Thus, the holder can sell the stock and cre-ate an artificial capital loss in an amount approximately equal to the return-of-capital dividends. The committee believes that basis reduction in such cases is appropriate to accurately reflect the true economic effect of these types of transactions.

H.R. Rep. No. 101-247, at 1233 (1989), reprinted in 1989 U.S.C.C.A.N. 1906, 2703. The legislative history does not address, however, why section 1059(f ) did not limit its applica-tion to the extent of the excess of the issue price of the preferred stock over the liquidation or redemption price of the stock.

109 Reg. § 1.1273-2(m).



offering of preferred stock. The only analogous authority is the definition of issue in the OID regulations under which, as discussed above, notes issued within a 13-day period of the initial offering pursuant to a common plan or arrangement will be treated as part of the same issue as the original notes. It is unlikely that the Service would challenge a taxpayer that uses the OID defini-tion for section 1059 purposes in light of the lack of any other tax definition of the term “issue.” However, the 13-day rule will not give sufficient comfort to many issuers, underwriters, and investors in light of the fact that many equity offerings contain a 30-day green shoe that would extend beyond the expiration of the 13-day period.

Alternatively, it may be possible to assert that the pre-2001 more liberal definition of “issue” in the OID regulations that is described above should apply for section 1059 purposes. The theory would be that the subsequent OID regulations only applied the more restrictive 13-day rule because it also allowed for the possibility that reopened debt could effectively be part of the original issue if it satisfied the more liberal qualified reopening rules. It may also be possible to argue in this regard that an analogy to the OID rules should also allow taxpayers to apply rules that are analogous to the OID qualified reopening rules for purposes of determining whether a reopening of preferred stock is treated as part of the same issue as the original issuance of preferred stock.110 The Service may be particularly sympathetic to such arguments if the preferred stock is reopened with a de minimis amount of premium or if the premium is solely attributable to accrued dividends on the preferred stock.

In sum, based on the adverse tax consequences if reopened preferred stock is issued at a premium and the lack of any specific authority governing when a reopening of preferred stock is treated as part of the same issue as an original offering of preferred stock, taxpayers should only reopen preferred stock at a premium if they are very comfortable that the reopening is part of the same issue as the original issuance of the preferred stock.

B. Preferred Stock Issued at a DiscountPreferred stock with a mandatory redemption date that is issued with more

than a de minimis amount of discount will generally raise the same fungibility issues as described above with respect to debt because investors are generally required to treat the excess of the redemption price of preferred stock over its issue price as a stock dividend that it must accrue on a constant yield basis over the term of the stock.111 As in the case of debt, the preferred stock dis-count accrual schedule carries over to secondary purchasers of the preferred

110 As noted above, section 1059(f ) is concerned with premium on securities rather than discount. Accordingly, if the qualified reopening rules were applied to a reopening of preferred stock, the yield tests would presumably be based on whether the yield of the original shares is greater than 100% or 110% of the yield of the reopened shares.

111 See Reg. § 1.305-5(b).



stock based on the adjusted issue price of the stock. Accordingly, mandatorily redeemable preferred stock that is reopened with a different amount of unac-crued discount than the original preferred stock (assuming the discount is not de minimis) will generally not be fungible with the original stock if the reopened stock is not treated as part of the same issue as the original stock. That is because in such a case a secondary purchaser would have to accrue a different amount of stock dividends depending upon whether it purchases the preferred stock from an original holder of the preferred stock or from a holder that purchased preferred stock in the reopening.

Perpetual preferred stock that is issued at a discount will also be subject to the discount accrual rules described above (and thus reopenings of such stock will be subject to the fungibility issues described above) if (1) the holder of the stock has the option to require the issuer to redeem the stock, or (2) the issuer has a right to redeem the stock and, as of the issue date, redemption pursuant to that right is more likely than not to occur.112 An issuer call will be disregarded for this purpose if, based on all the facts and circumstances as of the issue date, redemption pursuant to that right is not more likely than not to occur.113 Furthermore, even if redemption is more likely than not to occur, the discount accrual rules will not apply if the redemption premium is solely in the nature of a penalty for premature redemption.114 Finally, under a safe harbor set forth in the regulations, an issuer call right will generally not be treated as more likely than not to occur if the issuer and holder are not related to each other and there are no plans, arrangements, or agreements that effectively require or are intended to compel the issuer to redeem the stock.115 Thus, the fungibility issues described above with respect to a reopen-ing of preferred stock at a discount will generally be irrelevant to perpetual preferred stock that is subject to an issuer call and that does not include a holder put option.

As in the case of debt, a reopening of preferred stock will not raise the fun-gibility issues described above if the reopened stock is part of the same issue as the original preferred stock because in such a case the reopened stock and the original stock would have the same issue price and thus the same discount accrual schedule (if any). The section 305 regulations do not define the terms “issue” and “issue price,” but they state that the discount should be “taken into account under principles similar to the principles of section 1272(a).”116 While not entirely clear, it is possible that this language should be interpreted as incorporating the definitions of “issue” and “issue price” that are set forth in the OID regulations. It might also be possible to assert that the cross refer-

112 Reg. §§ 1.305-5(b)(2) to -5(b)(3). 113 Reg. § 1.305-5(b)(3).114 Id. 115 This presumption only applies if the issuer’s call right would not reduce the yield of the

stock. Reg. § 1.305-5(b)(3)(ii)(c). However, this test should generally be satisfied if the stock is issued at a discount.

116 Reg. § 1.305-5(b)(1).



ence to the OID rules should also incorporate rules analogous to the OID qualified reopening rules in determining the issue price of preferred stock. As discussed above in the case of section 1059, the Service is unlikely to chal-lenge taxpayers that use the definition of “issue” in the OID regulations for section 305 purposes—even if the cross reference language described above should not be interpreted as explicitly incorporating the definition of “issue” in the OID regulations—in light of the lack of any other definition of such term and the fact that the preferred stock redemption premium rules are intended to closely mirror the OID accrual rules.

C. Classification of Preferred StockIn addition to the considerations described above, a reopening of preferred

stock will not be fungible with the originally issued preferred stock if the original stock is classified as preferred stock for tax purposes and the reopened stock is more properly classified as debt or common equity for tax purposes. More specifically, the Service and the courts have considered whether certain types of redeemable preferred stock should be treated as debt or equity for tax purposes.117 While a full discussion of this issue is beyond the scope of this Article,118 it is possible that preferred stock issued in a reopening could be characterized differently for tax purposes than the originally issued preferred stock. For example, one of the factors that is taken into account in determin-ing whether preferred stock should be treated as debt or equity is the term of the instrument.119 It is therefore possible that preferred stock will initially be issued with a term that is sufficient for it to be classified as equity for tax purposes, while it may be reopened when the remaining term of the stock is such that it is more properly classified as debt for tax purposes. In such a case, the originally issued stock and the reopened stock would not be fungible with each other because they would have a different tax classification.

Furthermore, even if preferred stock is still classified as equity for tax pur-poses upon its reopening, it is possible that it will no longer be treated as pre-ferred stock for tax purposes. More specifically, the classification of stock as preferred, as opposed to common, has consequences for purposes of a number

117 See, e.g., Rev. Rul. 78-142, 1978-1 C.B. 112; G.C.M. 39,187 (Mar. 13, 1984); Miele v. Commissioner, 56 T.C. 556, 563 (1971), aff’d, 474 F.2d 1338 (3d Cir. 1973); Milwaukee & Suburban Transp. Corp. v. Commissioner, 283 F.2d 279, 282 (7th Cir. 1960), vacated in part and remanded, 367 U.S. 906 (1961).

118 For a discussion of the classification of preferred stock as debt or equity for tax purposes, see Kenneth H. Heitner, Some (Random) Thoughts About Preferred Stock and the Dividends-Received Deduction, The Tax Club (Feb. 21, 2001); James L. Dahlberg & Robert J. Mason, Preferred Stock: Debt or Equity?, 480 Practicing Law Institute, Tax Strategies for Corpo-rate Acquisitions, Dispositions, Spin-offs, Joint Ventures, Financings, Reorganiza-tions & Restructurings 869 (2000).

119 See generally David Garlock, Federal Income Taxation of Debt Instruments ¶ 102.01[B] (6th ed. 2010) (stating that “[t]he shorter the time between issuance and the maturity/redemption date, the more the instrument appears to be debt”).



of provisions in the Code.120 The term preferred stock is defined differently for purposes of many of these provisions.121 While a full discussion of the dif-ferent definitions and their consequences is beyond the scope of this Article, in most cases, whatever the relevant definition is, stock that is preferred upon its initial issuance will still be preferred upon a reopening because its terms will be the same. However, one factor that is usually required in order for stock to be classified as preferred is that the stock does not “participate in cor-porate growth to any significant extent.”122 Plain vanilla fixed-rate preferred stock that is issued for par will easily satisfy this requirement. It is possible, however, that such stock will not satisfy this requirement upon a reopening if, for example, the issuer’s fortunes have declined so that the total value of the issuer at the time of the reopening is less than the total value of its outstand-ing preferred stock at such time—in which case, the preferred stock issued in the reopening would presumably be issued at steep discount to par. In such a case, the reopened stock would likely be treated as “participating in corporate growth to a significant extent” because any growth in the value of the issuer would accrue to the holders of the preferred stock until the total value of the issuer exceeds the aggregate principal amount of its outstanding preferred stock. The originally issued preferred stock and the reopened stock would then not be fungible with each other because some holders might be affected by whether the stock is classified as preferred for tax purposes, and therefore a secondary purchaser might be in a different tax position depending upon whether it purchases the original stock or the reopened stock.

IV. Structured NotesStructured notes are increasingly used by issuers (particularly financial insti-

tutions) to raise capital and to enable investors to take positions in respect of underlying equities, currencies, interest rates, and commodities. While a full discussion of the tax treatment of structured notes is beyond the scope of this Article,123 the following describes some of the unique issues that arise in connection with reopenings of the most common types of structured notes. Specifically, the discussion below addresses the tax treatment of reopenings of (A) non-principal protected notes that are treated as forward or derivative contracts for tax purposes and (B) reverse convertible notes that are treated

120 See I.R.C. §§ 305(a)(3), 306, 1504(a)(4)(B).121 See, e.g., Reg. § 1.305-5(a); Rev. Rul. 79-163, 1979-1 C.B. 131; Rev. Rul. 79-21, 1979-1

C.B. 290.122 See, e.g., I.R.C. § 1504(a)(4)(B) (refers to stock that “does not participate in corporate

growth to any significant extent”); Reg. § 1.305-5(a) (preferred stock “does not participate in corporate growth to any significant extent”).

123 See Michael S. Farber, Equity, Debt, Not--The Tax Treatment of Non-Debt Open Trans-actions, 60 Tax Law. 635 (2007), for a comprehensive discussion of the tax treatment of structured notes. See also Omri Marian & Andrew D. Moin, Taxation of Structured Debt in a Low-Rate Environment, 135 Tax Notes (TA) 323 (Apr. 16, 2012).



as an investment unit consisting of a debt component and an option compo-nent for tax purposes.124

A. Notes Treated As a Forward or Derivative ContractThese are notes in which an investor takes a long position with respect to an

underlying asset, and in which the investor is wholly or partially exposed to the downside performance of the underlying asset. For example, an investor might purchase a $100 note that is linked to the performance of an equity index, under which the investor would be subject to all of the appreciation and depreciation in respect of the index, except that its principal investment would be protected to the extent that the underlying index does not decline by more than 40% over the term of the note.

The tax disclosure in the offering document for such a note typically states that in the opinion of counsel it would be “reasonable” for an investor to treat the note as a derivative or forward contract for U.S. federal income tax pur-poses.125 Under this approach, an investor would not recognize any income over the term of the note, and it would recognize gain or loss upon the sale or maturity of the note in an amount equal to the difference between the amount that it paid for the note and the amount that it receives at such time.

Counsel’s conclusion that it would be “reasonable” for an investor to treat such a note as a derivative or forward contract for U.S. federal income tax purposes is typically premised on a representation from the issuer regarding the risk that an investor would lose a material portion of its principal invest-ment by virtue of a decline in the underlying index beyond the 40% thresh-old. For example, some outside counsel would require an issuer in this case to

124 Another common type of structured notes is contingent principal protected notes, which are generally either treated as contingent payment debt instruments or as VRDIs for tax pur-poses. The discussion in this section does not address the tax consequences of reopening such notes as they are addressed in the general discussion above regarding reopenings of VRDIs and contingent payment debt instruments.

125 See, e.g., Barclays Bank PLC, SuperTrack Notes due September 22, 2014 (Pric-ing Supplement to the Prospectus dated Aug. 31, 2010) PS-4 (Sept. 18, 2012), http://www.sec.gov/Archives/edgar/data/312070/000119312512395587/d413289d424b2.htm; JP Morgan Chase & Co, Capped Buffered Return Enhanced Notes Linked to the Rus-sell 2000® Index due April 1, 2015 (Pricing Supplement No. 1224) PS-1 (Mar. 26, 2013), http://www.sec.gov/Archives/edgar/data/19617/000095010313002070/dp37281_424b8-ps1224.htm.

Some issuers and counsel classify such notes as “financial contracts” or “open transactions” for tax purposes. However, all of these characterizations have the same tax result; specifically, that the investor does not recognize any income prior to the sale or maturity of the notes and that any gain or loss recognized by the investor upon the sale or maturity of the notes is generally capital gain or loss. In addition, some counsel do not use the term “reasonable” in expressing their opinions, but rather use the terms “more likely than not” or “should” (in cases in which the investor is subject to all of the downside in respect of the underlying asset). Alter-natively, some counsel do not express any opinion regarding the tax treatment of the note, but rather state that the issuer intends to treat the note as a forward contract or derivative contract for tax purposes.



represent that there is at least a ten percent chance that the underlying index would decline beyond the 40% threshold described above in a manner such that there would be at least a ten percent chance that an investor would lose at least ten percent of its principal investment in the note.

If the notes are properly treated as a forward or derivative contract for tax purposes, the primary tax issue that arises upon a reopening is whether the reopened notes satisfy the relevant risk of loss threshold criteria. For example, assume that the index in the example above has increased by 20% during the term of the notes and that the notes are reopened at a price of $120. In that case, an investor that purchases the notes in the reopening would only lose a portion of its investment if the underlying index were to decline by more than 50% during the term of the notes (i.e., it would have to decline from $120 to less than $60). The issuer may therefore be unable to represent that the relevant risk of loss threshold described above would be satisfied, in which case counsel may be unable to opine that it is reasonable to treat the instru-ment as a forward or derivative contract, rather than as a debt instrument, for tax purposes. If the reopened notes were treated as debt for tax purposes, the notes issued in the reopening would not be fungible with the original notes because the original notes and the reopened notes would have a different tax treatment. However, if counsel concludes that it would be reasonable for an investor to treat the reopened notes as a derivative or forward contract for tax purposes, then, subject to the FATCA discussion below, there is no tax issue that would preclude such a reopening.126

In addition, under the FATCA grandfathering rules described above, reopened structured notes that are not treated as debt for tax purposes and that provide for payments that are subject to FATCA127 will not be fun-gible with original notes if the reopened notes are issued after the applica-ble FATCA grandfather date and the original notes were issued before the

126 It is arguable that notes of this type that have the same opinion level might not be fun-gible if the reopened notes and the original notes have different levels of tax risk. For example, consider a case in which the underlying index in the example above has increased between the original issue date and the reopening date, but in which counsel still concludes that the holder’s risk of lost is sufficient for it to opine that it would be reasonable to treat the notes as a derivative or forward contract for tax purposes. In such a case, counsel might also conclude that there is a greater risk that the reopened notes will be treated as debt for tax purposes, notwithstanding that its opinion level is the same for both notes. One may argue that in such a case the difference in tax risk between the original notes and the reopened notes should cause the notes to not be fungible with each other, because a secondary purchaser of the notes would have a different level of tax risk depending on whether it purchases the original notes or the reopened notes.

127 Most structured notes that are treated as forward or derivative contracts will not be sub-ject to FATCA because any gain realized by a foreign investor upon the sale or maturity of the notes would be treated as foreign source income. However, FATCA could apply to such notes if they provide for periodic payments that are U.S. source income or if they provide for “dividend equivalents” that are subject to section 871(m). See I.R.C. §§ 1473(1)(a), 871(m).



grandfather date.128 That is because in such a case the originally issued notes would not be subject to FATCA, while the reopened notes would be subject to FATCA. The original notes and the reopened notes would therefore not be fungible with each other because a secondary purchaser would be subject to different FATCA consequences depending upon whether it purchases the originally issued notes or the reopened notes. In addition, once the notes start trading in the secondary market, the issuer and investors would not be able to identify which notes are subject to FATCA and which are not. There is no rule in this context that is similar to the qualified reopening rules described above in respect of debt that would allow the issuer and investors to treat the reopened notes as having the same issue date as the originally issued notes for purposes of the FATCA grandfathering date.

B. Reverse Convertible NotesIn the case of a reverse convertible note, an investor receives an above-

market rate of interest in respect of its investment in exchange for its being subject to all or a portion of the downside exposure in respect of the underly-ing asset. For example, an investor might purchase a $100 note linked to the performance of an equity index that bears an above-market interest rate of ten percent per annum. The investor would receive a return of its $100 principal amount upon the maturity of the note unless the underlying index declines by more than 40% over the term of the note, in which case the investor’s return would be reduced by the percentage decrease in the underlying index over the term of the note.

The tax disclosure in the offering document for such a note typically states that in the opinion of counsel it would be reasonable to treat the note as an investment unit consisting of: (1) a fixed-rate debt obligation that the issuer issued to the investor for an amount equal to the principal amount of the notes (the Deposit) and (2) a put option in respect of the underlying asset (the Put Option) that the investor sold to the issuer in exchange for a por-tion of the stated interest on the notes.129 Like the case of the notes described above, counsel’s conclusion in this regard is typically premised on a represen-tation from the issuer regarding the risk that an investor would lose a material portion of its principal investment by virtue of a decline in the underlying index beyond the 40% threshold.

128 As noted above, the grandfather date is July 1, 2014 but such date is further extended in the case of structured notes that are subject to FATCA solely because they generate foreign pass-through payments or because they provide for dividend equivalents that are subject to section 871(m). See supra note 57 and accompanying text.

129 See, e.g., Barclays Bank PLC, Barclays Reverse Convertible Notes (Preliminary Pricing Supplement to the Prospectus dated Aug. 31, 2010) PPS-4 (Apr. 11, 2013), http://www.sec.gov/Archives/edgar/data/312070/000119312513151328/d520707d424b2.htm; Morgan Stanley, RevCons Based on the Common Stock of Caterpillar Inc. Due April 9, 2014 (Pricing Supplement No. 731) 11 (Apr. 4, 2013), http://www.sec.gov/Archives/edgar/data/895421/000095010313002240/dp37453_424b2-ps731.htm.



The tax disclosure generally sets forth the portion of the stated interest on the notes that is treated as interest on the Deposit, with the remainder treated as premium with respect to the Put Option (this amount is denoted as “Put Premium”). Under this approach, the Deposit is not issued with any discount and thus does not have any OID. The Put Option has no value at the time that the notes are issued because the value of the Put Premium that will be paid in the future represents the arm’s-length consideration for the investor’s downside exposure in respect of the underlying index. The investor would then include the interest on the Deposit at the time it accrues or is received based on its normal method of tax accounting, and it would account for the Put Premium upon the sale, expiration or settlement of the Put Option.

In the case of a reopening of a reverse convertible note, the reopened note must provide for the same allocation of the interest payment between the interest on the Deposit and the Put Premium on the Put Option. Otherwise, a secondary purchaser of the note would realize different amounts of interest income and Put Premium depending upon whether it purchased the origi-nally issued note or the note issued in the reopening. Of course, the value of the Deposit and the value of the Put Option at the time of the reopening may differ from their respective values at the time of the initial issuance of the notes. Thus, upon a reopening of a reverse convertible note, the purchaser and issuer must allocate the purchase price between the Deposit and Put Option components of the note based on their respective fair market values.

While, as described above, the Put Option component of a reverse convert-ible note has no value upon the original issuance of the notes, it may have positive or negative value upon the reopening. If the Put Option has positive value, the holder of the reopened note would be treated as having paid a por-tion of its purchase price in exchange for the Put Option, with the remainder of its purchase price treated as paid for the Deposit. If the Put Option has negative value at the reopening, the issuer of the reopened note would be deemed to pay the holder an amount equal to its negative value in order to induce the holder to enter into the Put Option. The holder’s purchase price for the Deposit would then be equal to the sum of its purchase price for the note plus the amount deemed paid by the issuer under the preceding sen-tence. The change in the value of the Put Option between the original issue date of the notes and the reopening date would not create any fungibility problems because the stated Put Premium would be the same for both notes, and each investor would separately realize gain or loss upon the sale, expira-tion, or settlement of the Put Option based on the amount that it receives and pays with respect to the Put Option.

If, however, the value of the Deposit component of the note has declined between the original issuance and the reopening, it is possible that the Deposit component of the reopened notes may be issued at a discount and may have greater than de minimis OID. If that were the case, the reopened notes would only be fungible with the original notes if the Deposit component by itself satisfies the qualified reopening rules described above. By contrast, if the



value of the Deposit at the reopening was higher than its value upon initial issuance, then the Deposit component of the original notes and the Deposit component of the reopened notes would be fungible with each other because neither would be issued with OID. 130

Furthermore, as discussed above regarding notes that are treated as forward or derivative contracts for tax purposes, it is possible that an increase in the value of the underlying index may cause the issuer to be unable to make the risk of loss representation described above upon the issuance of the reopened notes. In such a case, the issuer may treat the reopened reverse convertible notes as debt for tax purposes, with the result that the notes issued in the reopening would not be fungible with the originally issued notes because they would have a different tax treatment.

V. Grantor TrustsThe following Part addresses reopenings of interests in entities that are clas-

sified as grantor trusts for U.S. tax purposes. In addition to being used as an estate planning vehicle, grantor trusts are also often used as a public invest-ment vehicle for certain commodity exchange-traded funds (ETFs) and secu-ritization transactions.131 The holders of the equity in the trust are treated for tax purposes as holding a pro rata share of the assets of the trust.132

130 As discussed above, a reopening of notes will only constitute a qualified reopening if the new notes are issued for cash to unrelated purchasers or if the original notes are treated as publicly traded for tax purposes. As most reverse convertible notes are not publicly traded, such notes will generally only be eligible for qualified reopening treatment under the cash issuance rule. However, it is arguable that as a policy matter, the cash issuance rule should not apply to an offering of an investment unit, such as the reverse convertible notes, for cash. That is because the reason why the regulations only permit qualified reopening treatment for non-publicly traded notes if they are issued for cash to unrelated purchasers is presumably because only in such a case can one be reasonably certain that the issue price of the reopened notes reflects their fair market value, and that therefore the applicable yield test is being applied appropriately. In the case of an investor in a reverse convertible note that is not publicly traded, however, the parties may have some flexibility in allocating the purchase price between the option component and the debt component, particularly if the issuer does not have any traded outstanding debt with similar terms as the debt component of the reverse convertible note. See supra notes 33-35 and accompanying text.

131 This Article does not discuss reopenings of securitization vehicles other than grantor trusts because interests in a securitization vehicle are generally treated for tax purposes either as debt (including regular interests in a “real estate mortgage investment conduit,” or “REMIC” that are treated as debt) or equity in a corporation, partnership, or grantor trust. A REMIC cannot engage in a reopening transaction because it is subject to a 100% tax on contribu-tions after the “startup day.” See Reg. § 1.860G-1(d). In addition, the tax issues in respect of a reopening of corporate debt or preferred stock issued by a securitization vehicle are generally no different than those described above in the general discussion of reopenings of debt and preferred stock. Finally, as noted above, (1) reopenings of common stock of a corporation gen-erally do not raise any fungibility or other tax issues and (2) reopenings of a partnership inter-est raise multiple unique subchapter K issues (e.g., section 704(c) issues and capital account book-up issues) that are beyond the scope of this Article.

132 See I.R.C. §§ 671-679.



Notwithstanding that grantor trusts are passive investment vehicles, they sometimes engage in reopening transactions. For example, many ETFs that hold precious metals are formed as grantor trusts, and they often engage in reopenings in which new investors either contribute the relevant com-modity to the ETF or the investor contributes cash to the ETF that is then invested in the relevant commodity.133 The primary issue that arises upon such a reopening relates to the fact that an entity will not qualify as a grantor trust if the trustee has the power to “vary the investment” of the trust.134 The “power to vary the investment” rule is generally understood to require that the trust holds a static pool of assets and that it generally may not make any new investments subsequent to its formation. The question that then arises is whether the trust has impermissibly varied its investment when it acquires new assets upon a reopening either through a direct contribution of the rel-evant commodity or upon a contribution of cash that the trust then invests in the relevant commodity. At least one court has held,135 and the Service has stated in a number of rulings,136 that such a reopening will not cause a grantor trust to be treated as varying its investment because the trust will ultimately hold assets that are identical to its existing assets. More specifi-cally, the Service stated in one ruling that a trust’s power to acquire identi-cal additional assets in a reopening does not violate the grantor trust rules because “[s]uch power does not enable a trust to take advantage of market variations to improve the investment of the investors.”137 A commodity ETF that is classified as a grantor trust for tax purposes can therefore reopen on a daily basis—making it effectively an open-end fund—as long as it invests any assets that it receives in the reopening in commodities that are identical to its existing commodities.138 The ETF should also ensure that any cash that it holds pending investment in additional commodities is not invested in an

133 Examples of such ETFs include the SPDR, Gold Trust, the ETFS Palladium Trust and the iShares Silver Trust. See, e.g., ETF Securities, ETF Securities Palladium Trust 2010 Grantor Trust Tax Reporting Statement (2010), http://www.etfsecurities.com/Documents/ETFS_Pal-ladium_Trust_2010_us.pdf.

134 See Reg. § 301.7701-4(c).135 Commissioner v. Chase Nat’l Bank of N.Y.C., 122 F.2d 540, 543-44 (2d Cir. 1941).136 P.L.R. 1993-29-014 (Apr. 23, 1993); P.L.R. 1989-40-067 (July 12, 1989).137 P.L.R. 1989-40-067 (July 12, 1989).138 It may be uncertain whether this requirement is satisfied if the new commodities that are

acquired pursuant to the reopening are stored in a different location than the existing com-modities that are held by the trust. In such a case, the original commodities and the newly purchased commodities, which are otherwise identical, could have a different value if there are different storage and transportation costs in the two locations. The acquisition of the new com-modities could then cause the trust be treated as having “varied its investment” in a manner that would cause it to lose its grantor trust status.



interest-bearing account so that such account is not treated as an impermis-sible discretionary additional investment.139

A second issue that arises upon a reopening of a grantor trust is whether an initial investor’s holding period is affected by the reopening. For example, consider a commodity ETF grantor trust that invests in physical gold bullion and that allows for reopenings in which an investor can contribute cash to the trust that the trust would immediately invest in gold bullion that is identical to its existing gold bullion. Assume that the ETF issues additional interests in the trust more than one year after its initial formation. As discussed above, a holder of an interest in a grantor trust is treated as holding a pro rata interest in each asset that is held by the trust. Thus, an original holder of equity in the trust would hold a ratable interest in the original gold bullion that was acquired by the trust as well as the additional gold that was acquired by the trust in the reopening. The question that then arises is whether the initial investor should be treated as having a short-term holding period in its share of the additional gold that was acquired by the trust if the trust were to sell such gold, or if the initial investor were to sell its equity in the trust, within one year after the reopening, notwithstanding that the investor has a hold-ing period of more than one year in its trust interest. If that were the case, the original investor in the ETF would be adversely affected by the reopen-ing because it would have had a long-term holding period in its share of the underlying gold bullion before the reopening, but it would now have a short-term holding period in a portion of its share of the gold bullion after the reopening.

It seems clear, both as a policy matter and as a technical matter, that such a conversion of a long-term holding period to a short-term holding period should not occur. That is because while a grantor trust is treated as an entity for some purposes (primarily for various reporting purposes),140 it does not have an independent holding period in its assets. Rather each investor is treated for tax purposes as if it directly holds a pro rata share of the underly-ing assets held by the trust141 and it therefore has its own holding period in such assets.142 Accordingly, in the case of the ETF reopening described above, an initial investor should be treated for tax purposes as having transferred a portion of its interest in the existing commodities that are held by the ETF

139 Although the Service has in some cases permitted grantor trusts to make temporary investments upon formation or pending distributions, see, e.g., P.L.R. 2004-07-002 (Feb. 13, 2004), it is possible that it would not permit a grantor trust to make such a temporary invest-ment after a reopening.

140 See, e.g., Reg. § 1.671-4; Reg. § 1.671-5.141 See I.R.C. § 674.142 It may also be possible to conceptualize a reopening of a commodity ETF as a like-kind

exchange under section 1031. Cf. Rev. Rul. 2004-86, 2004-2 C.B. 191 (section 1031 exchange possible through a grantor trust); Rev. Rul. 82-96, 1982-1 C.B. 113 (exchange of gold bullion for Canadian Maple Leaf coins is a section 1031 exchange where all items are held for invest-ment and coins are worth more than their face value due to gold content).



to the new investor in exchange for a portion of the additional identical com-modities that are purchased by the ETF subsequent to the reopening. That deemed exchange is not a taxable exchange under the section 1001 regula-tions because the original gold bullion and the new gold bullion do not dif-fer “materially either in kind or extent,”143 and therefore an initial investor’s holding period in its share of the additional gold bullion should include its holding period in the gold bullion that it exchanged. An initial investor in the trust should accordingly have a long-term holding period in all of its inter-est in the commodities held by the trust. Similarly, an investor that acquires trust interests in the reopening should be treated as having newly acquired an interest in the original commodities held by the trust pursuant to the deemed exchange described above, and it should therefore have a short term holding period in its share of the commodities held by the trust—including in respect of the commodities that have been held by the ETF for more than one year.

VI. ConclusionThe discussion in this Article illustrates that securities reopenings raise

unique tax issues that are often unanticipated by taxpayers and tax advisors. The regulations governing reopenings of debt instruments strike a reasonable balance between the policy objective of allowing issuers to issue additional notes in a reopening that are fungible with the original notes for tax purposes and the policy objective of preventing investors from using reopenings to convert what otherwise would have been OID into market discount. How-ever, as discussed above, there are a number of ambiguities and uncertainties under the regulations, and some questions regarding debt reopenings remain unanswered.

While there is little specific guidance regarding reopenings of other types of securities—such as preferred stock, structured notes and grantor trusts—the discussion above sets forth the numerous tax issues that need to be considered in connection with such reopening transactions. While it may not be imme-diately apparent, reopenings of these instruments raise fungibility and other tax issues that need to be considered by taxpayers and tax advisors before engaging in any reopening transaction.

143 See Reg. § 1.1001-1(a).