Taxes & Entities

Original Issue Discount and the AHYDO Rules

Learn how interest that has not been paid in cash still accrues into income and deduction — and how a high-yield instrument can permanently lose part of its interest deduction unless a specific covenant is drafted into it.

  • Expert
  • 13 min total
  • 12 chapters

What decision this helps you make: How to structure a PIK, discount or deferred-pay instrument so the issuer keeps its deduction, and how to price the holder's phantom income.

What this topic is

Original issue discount is the excess of what a debt instrument pays at maturity over what was paid for it at issuance. The code requires that discount to be taken into income and deduction over the life of the instrument on a constant-yield basis, whether or not cash moves. The rules on applicable high yield discount obligations then take away part of the issuer's deduction entirely, and defer the rest, where an instrument is long-dated, high-yield, and lets too much interest go unpaid.

Why it matters

Any instrument where the return is not paid currently in cash carries OID: zero-coupon notes, PIK notes, PIK toggles, discount notes, warrants issued with debt, and most seller paper. The holder pays tax on income it has not received. The issuer deducts interest it has not paid — until the high-yield rules intervene, at which point a permanent slice of the deduction disappears and the rest waits for cash. On a mezzanine or holdco financing that permanent loss can be worth many millions, and it is entirely avoidable with one clause.

Who should learn it

Structured finance and leveraged finance practitioners, tax directors, private credit and mezzanine investors, and anyone drafting or buying seller notes and PIK paper.

What you will understand

  • How OID is computed and accrued on a constant-yield basis, and when the de minimis rule saves you
  • Why PIK interest is OID by definition and what that means on both sides of the instrument
  • The three tests that make an instrument an applicable high yield discount obligation, and the two consequences that follow
  • How the standard catch-up covenant works, and where it does not help

Prerequisites

Common misconception

"No cash has been paid, so there is nothing to report." Exactly backwards. OID accrues on economics, not on cash. A holder of a zero-coupon or PIK note reports income every year and receives nothing — the classic phantom income problem, and the reason tax-exempt and foreign investors often refuse this paper or hold it through a blocker. The issuer's mirror deduction, meanwhile, is the thing the high-yield rules were written to attack.