PRIVILEGED & CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
CALDERWOOD & HARKNESS LLP
Tax Structure Memorandum
From: Sylvia Hartwell, Specialist Partner, Tax, Calderwood & Harkness LLP
To: Theodore Langston, Responsible Partner, Capital Markets Vivienne St. Claire, Billing Partner, Capital Markets Claire Dempsey, Lead Associate, Capital Markets Audrey Zhou, Working Associate, Capital Markets
Date: May 1, 2024
Re: U.S. Federal Income Tax Analysis — Verimark Hospitality Group Inc. — Proposed $500,000,000 8.250% Senior Notes due 2031 — Original Issue discount, Interest Deductibility under IRC §163(j), AHYDO Analysis, and Treatment of Optional Redemption Premiums
Client: Verimark Hospitality Group Inc. (EIN: 84-3291057; Nasdaq: VMRK)
Matter No.: 1021-00002
Firm: Calderwood & Harkness LLP, One Liberty Plaza, 45th Floor, New York, NY 10006
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I. Executive Summary and Conclusions
This memorandum sets forth our analysis of the U.S. federal income tax implications of the proposed issuance by Verimark Hospitality Group Inc. ("VHG" or the "Issuer"), a Delaware corporation whose common stock is listed on the Nasdaq Stock Market under the ticker symbol "VMRK," of $500,000,000 aggregate principal amount of 8.250% Senior Notes due 2031 (the "Notes") in a private placement conducted pursuant to Rule 144A under the Securities Act of 1933, as amended (the "Securities Act"), and Regulation S promulgated under the Securities Act. The offering is being underwritten by Kensington Barrow & Co. (as representative of the initial purchasers), Ridgeline Capital Markets LLC, and Stonebridge Marvelo Securities Inc. (collectively, the "Initial Purchasers").
The Notes will be issued at 98.500% of par value, resulting in gross proceeds to VHG of $492,500,000 and an original issue discount ("OID") of 1.500% of par, or $7,500,000 in the aggregate. The Initial Purchasers' discount of 1.750% of par ($8,750,000) will be retained by the Initial Purchasers as compensation for their underwriting services, yielding net proceeds to VHG of approximately $483,750,000.
The proceeds of the offering will be used to refinance approximately $467,342,819.16 in outstanding principal under VHG's Existing Credit Facility (as defined below) with Greystone National Bank, N.A., as administrative agent, together with approximately $4,207,180.84 in accrued and unpaid interest, a prepayment premium of approximately $2,336,714.10 (representing 0.50% of the outstanding principal), estimated transaction fees and expenses of approximately $6,863,285.90, and the balance of approximately $3,000,000.00 for general corporate purposes.
This memorandum addresses four principal federal income tax issues arising from the proposed issuance, and our conclusions are summarized below:
(1) Original Issue discount. The Notes will be treated as debt instruments with de minimis OID for U.S. federal income tax purposes. The total OID of $7,500,000 (1.500% of stated redemption price at maturity) falls below the de minimis threshold of $8,750,000 (1.750% of stated redemption price at maturity), calculated as 0.25% multiplied by seven complete years to maturity multiplied by the $500,000,000 stated redemption price at maturity. Accordingly, the OID may be disregarded for purposes of inclusion by holders and deduction by VHG. In the alternative, should the de minimis test not be met (for example, if the actual issue price is lower than currently anticipated), the OID would be includible in income by holders and deductible by VHG on a constant-yield basis over the life of the Notes pursuant to IRC §1272.
(2) Interest Deductibility. The 8.250% stated interest on the Notes constitutes "qualified stated interest" within the meaning of Treas. Reg. §1.1273-1(c) and is deductible by VHG under IRC §163(a), subject to the limitation on business interest expense under IRC §163(j). Based on VHG's reported Adjusted EBITDA of $412,000,000 for the last twelve months ended March 31, 2024, and VHG's scale of operations, we expect that the §163(j) limitation will not restrict the full deductibility of the annual interest expense of $41,250,000 on the Notes, although this conclusion depends on VHG's adjusted taxable income, which must be confirmed with VHG management and its independent auditors.
(3) AHYDO Status. The Notes do not constitute "applicable high yield discount obligations" ("AHYDOs") within the meaning of IRC §163(e)(5). Although the Notes satisfy the maturity test (maturity exceeds five years), the yield test is not met because the yield to maturity of the Notes (approximately 8.50%) is below the applicable federal rate ("AFR") plus five percentage points (estimated at approximately 9.50% to 10.00%), and the significant OID test is not met because OID is de minimis and vastly exceeded by semi-annual coupon payments. Because all three statutory tests must be satisfied for AHYDO classification, and at least two are not satisfied, no portion of the OID is disallowed as a deduction and no portion is recharacterized as a dividend equivalent.
(4) Optional Redemption Premiums. The optional redemption premiums payable under the Notes (commencing at 104.125% of principal on or after July 1, 2027 and declining to par on or after July 1, 2029), the equity clawback premium (108.250%), and the change of control put premium (101.000%) are not treated as OID under the Treasury Regulations, because the issuer's call options are not presumed to be exercised as of the issue date and the holder's put right is contingent upon a change of control event. These premiums therefore do not affect the OID or AHYDO analysis.
Our analysis is based on the Internal Revenue Code of 1986, as amended (the "Code"), Treasury Regulations promulgated thereunder, published rulings of the Internal Revenue Service (the "IRS"), and relevant judicial decisions, all as in effect as of the date of this memorandum. Each of these authorities is subject to change, possibly with retroactive effect, and differing interpretations.
The conclusions set forth in this memorandum will form the basis of (a) the "Certain U.S. Federal Income Tax Considerations" section of the Offering Memorandum to be prepared by this firm and (b) the formal Tax Opinion of Calderwood & Harkness LLP to be delivered at the closing of the offering on or about June 25, 2024.
II. Transaction Overview and Key Terms
Set forth below is a summary of the material terms and structural features of the proposed offering, based upon our review of the drafts of the Indenture, the Purchase Agreement, and the Offering Memorandum circulated by the Capital Markets group as of April 26, 2024, as well as the term sheet provided by the Initial Purchasers.
Issuer. Verimark Hospitality Group Inc., a corporation organized under the laws of the State of Delaware, publicly traded on the Nasdaq Stock Market under the ticker symbol "VMRK." VHG's principal executive offices are located at 2400 Brickell Bay Drive, Suite 3100, Miami, Florida 33129. VHG operates a portfolio of 47 hotels and 12 resort properties across 23 states and two U.S. territories, comprising approximately 18,400 rooms.
Guarantors. The Notes will be fully and unconditionally guaranteed on a joint and several, senior unsecured basis by the following direct and indirect domestic subsidiaries of VHG (collectively, the "Guarantors"):
• Verimark Resort Holdings LLC, a Delaware limited liability company;
• VHG Properties Inc., a Delaware corporation;
• Bayshore Hotel Management LLC, a Florida limited liability company;
• Verimark Capital Holdings LLC, a Delaware limited liability company; and
• Pinnacle Lodging Enterprises Inc., a Delaware corporation.
Aggregate Principal Amount. $500,000,000.
Coupon. 8.250% per annum, payable semi-annually in arrears on January 1 and July 1 of each year, commencing January 1, 2025. Interest will be computed on the basis of a 360-day year consisting of twelve 30-day months.
Maturity Date. July 1, 2031 (approximately seven years from the anticipated issuance date of June 25, 2024).
Issue Price. 98.500% of par value. Gross proceeds to VHG equal $492,500,000.
Original Issue discount. 1.500% of par value, or $7,500,000 in the aggregate, representing the excess of the stated redemption price at maturity ($500,000,000) over the issue price ($492,500,000).
Initial Purchasers' discount. 1.750% of par value, or $8,750,000 in the aggregate, retained by Kensington Barrow & Co. (as representative of the Initial Purchasers), Ridgeline Capital Markets LLC, and Stonebridge Marvelo Securities Inc. as compensation for their underwriting and distribution services. The Initial Purchasers will acquire the Notes at a price of 96.750% of par ($483,750,000) and resell them to qualified institutional buyers and offshore purchasers at the offering price of 98.500% of par.
Net Proceeds. $483,750,000, representing gross proceeds of $492,500,000 less the Initial Purchasers' discount of $8,750,000.
Optional Redemption Schedule. The Notes are redeemable at VHG's option, in whole or in part, at the following redemption prices (expressed as a percentage of principal amount), plus accrued and unpaid interest to the applicable redemption date:
Equity Clawback. Prior to July 1, 2027, VHG may redeem up to 40% of the original aggregate principal amount of the Notes (i.e., up to $200,000,000) at a redemption price of 108.250% of principal amount, plus accrued and unpaid interest, using the net cash proceeds of one or more qualifying equity offerings; provided that at least 60% of the original aggregate principal amount remains outstanding immediately after such redemption.
Change of Control Put. Upon the occurrence of a change of control triggering event (as defined in the Indenture), each holder will have the right to require VHG to repurchase all or any portion of such holder's Notes at 101.000% of the principal amount thereof, plus accrued and unpaid interest.
Offering Type. The Notes will be offered and sold in a private placement exempt from registration under the Securities Act, pursuant to Rule 144A (to qualified institutional buyers within the United States) and Regulation S (to non-U.S. persons outside the United States). No registration statement will be filed with the Securities and Exchange Commission in connection with the initial issuance. Pursuant to a Registration Rights Agreement to be entered into at closing, VHG will be required to file a registration statement with respect to an exchange offer for the Notes by no later than January 4, 2025 (185 days after closing) and to cause such registration statement to be declared effective by no later than July 8, 2025 (one year and 13 days after closing). Failure to comply with these deadlines will result in the accrual of additional interest at a rate of 0.25% per annum, increasing by an additional 0.25% per annum for each subsequent 90-day period, up to a maximum of 1.00% per annum.
Governing Law. The Indenture, the Notes, the Purchase Agreement, and the Registration Rights Agreement will be governed by the laws of the State of New York.
Trustee. Fidelitas Trust Company, N.A. will serve as trustee, registrar, paying agent, and transfer agent under the Indenture.
Use of Proceeds. The net proceeds of the offering will be applied as follows:
Existing Credit Facility. The "Existing Credit Facility" refers to that certain Amended and Restated Credit Agreement, dated as of March 15, 2021, among VHG, as borrower, Greystone National Bank, N.A., as administrative agent and collateral agent, and the lenders party thereto from time to time. The Existing Credit Facility consists of two term loan tranches: (i) a Term Loan A in the outstanding principal amount of $280,142,819.16, bearing interest at a rate equal to the Secured Overnight Financing Rate ("SOFR") plus 375 basis points, and (ii) a Term Loan B in the outstanding principal amount of $187,200,000.00, bearing interest at a rate equal to SOFR plus 425 basis points. Both tranches mature on March 15, 2026 and are secured by substantially all of the assets of VHG and its domestic subsidiaries. The Existing Credit Facility will be repaid in full and terminated concurrently with the closing of the Notes offering.
Key Financial Metrics. Based on VHG's financial statements for the last twelve months ended March 31, 2024, as reviewed by VHG's independent registered public accounting firm, Palladian & Howe LLP (audit partner: Kenneth W. Sturgis), the following key financial metrics are relevant to the tax analysis:
The pro forma interest coverage ratio of approximately 9.99x reflects the expected annual interest expense of $41,250,000 on the Notes ($500,000,000 × 8.250%) as the sole funded indebtedness following the refinancing.
III. Original Issue discount Analysis
A. Determination of "Issue Price" Under Treasury Regulations
The determination of the "issue price" of the Notes is the threshold inquiry for the OID analysis, as OID is defined under IRC §1273(a)(1) as the excess of the "stated redemption price at maturity" over the "issue price" of a debt instrument.
Under Treas. Reg. §1.1273-2(a)(1), the issue price of a debt instrument that is issued for money is the first price at which a substantial amount of the debt instruments included in the issue is sold to the public. For purposes of this determination, sales to bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters, placement agents, or wholesalers are not treated as sales to the "public." See Treas. Reg. §1.1273-2(a)(1); see also Treas. Reg. §1.1273-2(e) (defining "public" for purposes of determining issue price).
In the present case, the Initial Purchasers — Kensington Barrow & Co., Ridgeline Capital Markets LLC, and Stonebridge Marvelo Securities Inc. — are acting in their capacity as underwriters within the meaning of the Treasury Regulations. They will acquire the Notes from VHG at a price of 96.750% of par (reflecting the 1.750% Initial Purchasers' discount from the 98.500% public offering price) and resell the Notes to qualified institutional buyers under Rule 144A and non-U.S. persons under Regulation S at the public offering price of 98.500% of par.
Accordingly, the issue price of the Notes is 98.500% of $500,000,000, or $492,500,000. This represents the first price at which a substantial amount of the Notes is sold to the investing public, exclusive of the Initial Purchasers.
It is important to note that the Initial Purchasers' discount of 1.750% of par ($8,750,000), representing the spread between the price paid by the Initial Purchasers to VHG (96.750%) and the price at which the Notes are offered to the investing public (98.500%), does not enter into the OID calculation. The Initial Purchasers' discount is the compensation retained by the Initial Purchasers for their underwriting services and is analyzed separately as a cost of issuance (discussed in Section VIII below).
The "stated redemption price at maturity" of the Notes, as defined in IRC §1273(a)(2) and Treas. Reg. §1.1273-1(b), is the sum of all payments provided by the debt instrument other than "qualified stated interest" (discussed in Section IV.A below). Because the Notes have a stated principal amount of $500,000,000 payable at maturity, and all interest payments qualify as "qualified stated interest" (as analyzed below), the stated redemption price at maturity is $500,000,000.
B. Computation of OID
Original issue discount on the Notes is computed as follows:
Stated Redemption Price at Maturity: $500,000,000
Less: Issue Price: ($492,500,000)
Original Issue discount: $7,500,000
Expressed as a percentage of the stated redemption price at maturity, the OID equals:
$7,500,000 ÷ $500,000,000 = 1.500%
C. De Minimis OID Test
Under IRC §1273(a)(3) and Treas. Reg. §1.1273-1(d)(1), OID on a debt instrument is treated as zero — i.e., the instrument is treated as having been issued at par — if the total amount of OID is less than a de minimis amount. The de minimis threshold is defined as 0.25% (one-quarter of one percentage point) of the stated redemption price at maturity, multiplied by the number of "complete years" from the issue date to the maturity date.
The relevant dates and computation are as follows:
Issue Date: June 25, 2024
Maturity Date: July 1, 2031
Complete Years to Maturity: The number of complete years is determined from the issue date to the maturity date. From June 25, 2024 to June 25, 2031 is exactly seven years. The additional six days to the maturity date of July 1, 2031 do not constitute a complete additional year. Accordingly, the number of complete years to maturity is 7.
The de minimis threshold is therefore calculated as:
0.25% × 7 × $500,000,000 = $8,750,000
Alternatively expressed as a percentage of stated redemption price at maturity: 0.25% × 7 = 1.750%
Comparing the actual OID to the de minimis threshold:
Actual OID: $7,500,000 (1.500% of par)
De Minimis Threshold: $8,750,000 (1.750% of par)
$7,500,000 < $8,750,000
Conclusion. The OID on the Notes is de minimis. Accordingly, for U.S. federal income tax purposes, the OID may be disregarded entirely. Holders of the Notes will not be required to include OID in income under the accrual rules of IRC §1272, and VHG will not be entitled to a corresponding deduction for OID accrual. A holder who disposes of a Note at a gain attributable to the de minimis OID will recognize capital gain (rather than ordinary income) on the portion of the gain allocable to the de minimis OID. See Treas. Reg. §1.1273-1(d)(2)–(4).
Sensitivity Note. The foregoing analysis is close to the boundary of the de minimis test. If the number of complete years to maturity were calculated as 6 rather than 7 (which would be the case if the issue date were delayed beyond July 1, 2024, or if "complete years" were measured to the last coupon date rather than the maturity date), the de minimis threshold would be 0.25% × 6 = 1.50% ($7,500,000), which equals the actual OID exactly. Under the strict statutory language, OID must be "less than" (not "less than or equal to") the de minimis amount to qualify for de minimis treatment. See IRC §1273(a)(3) ("the original issue discount ... is less than"). If the OID exactly equals the threshold, it would not be de minimis. However, based on the anticipated issue date of June 25, 2024 and the maturity date of July 1, 2031, we are comfortable that 7 complete years is the correct computation, and the OID falls below the threshold by $1,250,000 (0.25 percentage points).
We nevertheless recommend that the engagement team monitor the actual issue date closely and, if the closing is delayed beyond July 1, 2024, reevaluate the de minimis analysis. Additionally, if the actual first sale price to the public is lower than 98.500% (increasing the OID), the de minimis test should be reconfirmed.
D. Constant-Yield Accrual (Alternative Analysis if OID Not De Minimis)
In the event that the de minimis test is not met — for example, if the actual issue price at closing is lower than currently anticipated, or if the number of complete years to maturity is recalculated as 6 — OID on the Notes would be includible in income by holders and deductible by VHG on a constant-yield basis over the term of the Notes pursuant to IRC §1272.
Under the constant-yield method described in Treas. Reg. §1.1272-1, OID accrues over successive "accrual periods." The amount of OID allocable to each accrual period is determined by (a) multiplying the "adjusted issue price" at the beginning of the accrual period by the yield to maturity of the instrument, and (b) subtracting the amount of qualified stated interest allocable to that period. The adjusted issue price at the beginning of each accrual period equals the original issue price plus the total OID previously accrued, less any payments other than qualified stated interest previously made.
For the Notes, the accrual periods would correspond to the semi-annual interest payment periods (January 1 and July 1 of each year), consistent with the payment schedule under the Indenture. The yield to maturity, calculated on a semi-annual bond-equivalent basis, is approximately 8.50% per annum (4.25% per semi-annual period), reflecting both the 8.250% stated coupon and the accretion of the 1.500% OID over the approximately seven-year term.
In this alternative scenario, VHG would claim a deduction for OID accrual in each taxable year in the same manner and amount as the holder's OID inclusion, subject to the limitation on business interest expense under IRC §163(j) (discussed in Section IV.B below). As a rough approximation, the total OID of $7,500,000 spread over approximately 14 semi-annual accrual periods would result in an average OID accrual of approximately $535,714 per period (approximately $1,071,429 annually), though the actual accrual under the constant-yield method would be slightly lower in earlier periods and slightly higher in later periods.
We emphasize, however, that based on the anticipated terms of the offering, the OID is de minimis and this alternative analysis should not be needed.
IV. Treatment of Stated Interest
A. Qualified Stated Interest
The characterization of the 8.250% coupon on the Notes as "qualified stated interest" is critical to the OID analysis, because only payments that do not constitute qualified stated interest are included in the "stated redemption price at maturity" for purposes of computing OID.
Under Treas. Reg. §1.1273-1(c)(1)(i), "qualified stated interest" ("QSI") is stated interest that is unconditionally payable in cash or in property (other than debt instruments of the issuer) at fixed periodic intervals of one year or less during the entire term of the debt instrument, and that is payable at a single fixed rate or, in certain circumstances, at a qualified floating rate or an objective rate.
The Notes satisfy each element of this definition:
(i) Unconditional Payment Obligation. The Notes provide for the unconditional payment of interest at 8.250% per annum. The obligation to pay interest is not contingent upon VHG's revenues, earnings, or any other financial metric, nor is it subject to any condition precedent other than the passage of time and continued non-default. The interest payments are senior unsecured obligations of VHG, ranking pari passu in right of payment with all of VHG's existing and future senior unsecured indebtedness.
(ii) Fixed Periodic Intervals. Interest is payable semi-annually on January 1 and July 1 of each year, commencing January 1, 2025. Semi-annual payment intervals are well within the one-year maximum interval required by the regulations.
(iii) Single Fixed Rate. The Notes bear interest at a single fixed rate of 8.250% per annum throughout the entire term of the Notes. There is no step-up, step-down, or variable rate feature (other than the additional interest provision under the Registration Rights Agreement, which is contingent and is analyzed separately below).
(iv) Cash Payment. All interest payments will be made in cash (U.S. dollars). The Notes do not provide for payment-in-kind ("PIK") interest or for payment in any form other than cash.
Accordingly, the 8.250% semi-annual interest payments on the Notes constitute qualified stated interest within the meaning of Treas. Reg. §1.1273-1(c). As QSI, these payments are excluded from the stated redemption price at maturity and are not treated as OID. See Treas. Reg. §1.1273-1(b)(1)(ii).
Registration Rights Additional Interest. The Registration Rights Agreement provides that additional interest of up to 1.00% per annum may accrue if VHG fails to meet specified registration deadlines. Under Treas. Reg. §1.1275-4 (contingent payment debt instruments), the potential additional interest could raise CPDI issues if the likelihood of the contingency is "remote" or "incidental." We believe the additional interest provision is properly treated as a "remote" contingency that does not affect the characterization of the Notes as fixed-rate debt instruments bearing QSI, because VHG fully intends to comply with the registration deadlines and has historically demonstrated an ability to complete exchange offers on similar timetables. If the additional interest becomes payable, it would be treated as ordinary interest income to holders and deductible by VHG in the year incurred.
Conclusion. The 8.250% coupon on the Notes constitutes qualified stated interest. It is includible in income by holders as ordinary interest income in the taxable year to which it is properly allocable under the holder's regular method of accounting (cash or accrual), and it is deductible by VHG under IRC §163(a) in the taxable year to which it is allocable, subject to the limitation under IRC §163(j) discussed immediately below.
B. Deductibility of Interest under IRC §163(j)
1. Statutory Framework. IRC §163(j), as substantially amended by the Tax Cuts and Jobs Act of 2017 (P.L. 115-97) (the "TCJA") and further modified by the Coronavirus Aid, Relief, and Economic Security Act of 2020 (P.L. 116-136) (the "CARES Act"), imposes a limitation on the deduction of "business interest expense" by taxpayers. Under §163(j)(1), the deduction allowed for business interest expense for any taxable year shall not exceed the sum of:
(i) the taxpayer's "business interest income" for the taxable year;
(ii) 30% of the taxpayer's "adjusted taxable income" ("ATI") for the taxable year; and
(iii) the taxpayer's "floor plan financing interest" for the taxable year (not applicable to VHG).
"Business interest expense" is defined in §163(j)(5) as any interest paid or accrued on indebtedness properly allocable to a trade or business. The 8.250% interest on the Notes, as well as any OID accrual (if applicable), would constitute business interest expense.
"Adjusted taxable income" is defined in §163(j)(8) as the taxable income of the taxpayer, computed without regard to (A) any item of income, gain, deduction, or loss that is not properly allocable to a trade or business, (B) any business interest expense or business interest income, and (C) the amount of any net operating loss deduction. Critically, for taxable years beginning after December 31, 2021, ATI is computed without adding back deductions for depreciation, amortization, or depletion. This is a significant change from the CARES Act's temporary rule (applicable for taxable years beginning in 2019 and 2020), under which ATI was computed by adding back depreciation, amortization, and depletion (effectively making ATI an EBITDA-like measure). For taxable years beginning after December 31, 2021, ATI more closely approximates taxable income before interest, which is generally lower than EBITDA.
Any business interest expense that is disallowed in a taxable year under §163(j) may be carried forward indefinitely to succeeding taxable years and treated as business interest expense paid or accrued in the succeeding year. See §163(j)(2).
2. Application to VHG. VHG's annual interest expense on the Notes will be $41,250,000 ($500,000,000 × 8.250%). Assuming the Existing Credit Facility is fully repaid at closing, the Notes will be VHG's sole material funded indebtedness, and total annual business interest expense should approximate $41,250,000 (subject to any revolving credit facility or other indebtedness incurred after closing).
VHG reported Adjusted EBITDA of $412,000,000 for the last twelve months ended March 31, 2024. However, as noted above, ATI for purposes of §163(j) is not equivalent to EBITDA for taxable years beginning after December 31, 2021, because depreciation and amortization are not added back. VHG is a hospitality and real estate company operating a portfolio of 47 hotels and 12 resort properties comprising approximately 18,400 rooms, with significant depreciable real and personal property assets. Depreciation and amortization expense for a company of VHG's size and asset intensity is likely to be substantial — potentially in the range of $80,000,000 to $150,000,000 or more per year, depending on the mix of owned versus managed properties, capital expenditure patterns, and accounting methods used for tax purposes.
Assuming, for illustrative purposes, that VHG's depreciation and amortization expense for tax purposes is approximately $120,000,000 per year, ATI would approximate:
Adjusted EBITDA: $412,000,000
Less: Depreciation & Amortization: ($120,000,000)
Less: Other adjustments (NOL deductions, non-business items, etc.): (TBD)
Approximate ATI: ~$292,000,000 (subject to confirmation)
30% of ATI: ~$87,600,000
Under this illustrative calculation, VHG's §163(j) limitation of approximately $87,600,000 (plus business interest income, if any) would comfortably exceed the annual interest expense on the Notes of $41,250,000. Even if depreciation and amortization were significantly higher than assumed (e.g., $200,000,000), the resulting ATI of approximately $212,000,000 would yield a §163(j) limitation of approximately $63,600,000, which still exceeds the annual interest expense.
We caution, however, that the foregoing analysis is illustrative only and is based on publicly reported Adjusted EBITDA, which may differ from taxable income. The engagement team should confirm with VHG management and Palladian & Howe LLP (independent auditors; audit partner: Kenneth W. Sturgis) the estimated adjusted taxable income before interest for the current and projected taxable years.
3. Real Property Trade or Business Election. VHG may be eligible for, and may have already made, an irrevocable election under IRC §163(j)(7)(B) to be treated as an "electing real property trade or business." A taxpayer that makes this election is exempt from the §163(j) limitation entirely, meaning that all business interest expense would be fully deductible without regard to the 30% ATI cap.
The trade-off for making this election is that the electing taxpayer is required to use the alternative depreciation system ("ADS") under IRC §168(g) for all nonresidential real property, residential rental property, and qualified improvement property placed in service after December 31, 2017. ADS generally requires longer recovery periods (e.g., 40 years for nonresidential real property, 30 years for residential rental property) and the straight-line method, which results in lower annual depreciation deductions compared to the Modified Accelerated Cost Recovery System ("MACRS").
Given VHG's significant real property holdings, the election under §163(j)(7)(B) could have meaningful implications. If VHG has made or intends to make this election, the interest deductibility analysis becomes straightforward — all interest would be fully deductible without limitation. If VHG has not made the election and does not intend to do so, the §163(j) limitation analysis described above governs.
We recommend that the engagement team discuss with VHG management and Palladian & Howe LLP whether the §163(j)(7)(B) election has been made or is contemplated. The election is irrevocable, and its consequences extend well beyond the Notes offering, so VHG should have independent tax counsel and its auditors fully advise on the matter.
4. Conclusion on Interest Deductibility. Interest on the Notes at a rate of 8.250% per annum ($41,250,000 annually) should be deductible by VHG under IRC §163(a), subject to the limitation on business interest expense under IRC §163(j). Based on VHG's scale of operations, as reflected in its Adjusted EBITDA of $412,000,000, the §163(j) limitation is not expected to restrict the full deductibility of the interest expense on the Notes, although this conclusion must be confirmed based on VHG's actual adjusted taxable income. Any disallowed business interest expense may be carried forward indefinitely under §163(j)(2). If VHG has made or makes the real property trade or business election under §163(j)(7)(B), the limitation would not apply at all.
V. Applicable High Yield discount Obligation (AHYDO) Analysis
A. Statutory Framework — IRC §163(e)(5)
Congress enacted the AHYDO provisions of IRC §163(e)(5) in 1989 as part of the Revenue Reconciliation Act of 1989 to address perceived abuses associated with high-yield, deeply-discounted debt instruments used in leveraged buyout and recapitalization transactions during the 1980s. The AHYDO provisions are designed to deny or defer the deduction for a portion of the OID on certain high-yield debt instruments where the OID effectively functions as equity-like deferred compensation.
Under IRC §163(e)(5)(C), a debt instrument is classified as an "applicable high yield discount obligation" if, and only if, it satisfies all three of the following tests:
(1) Maturity Test. The instrument has a maturity of more than five years from the date of issue. See IRC §163(e)(5)(C)(i).
(2) Yield Test. The yield to maturity of the instrument equals or exceeds the sum of (a) the "applicable federal rate" in effect under IRC §1274(d) for the calendar month in which the obligation is issued, determined by reference to the term of the obligation, plus (b) five percentage points. See IRC §163(e)(5)(C)(ii).
(3) Significant OID Test. The instrument has "significant original issue discount." An instrument has significant OID if the aggregate amount of OID that would accrue during any "accrual period" beginning after the date that is five years after the date of issue exceeds the sum of (a) the aggregate amount of interest to be paid during such accrual period and (b) the product of the issue price of the instrument and the yield to maturity of the instrument, expressed as a fraction for the accrual period. See IRC §163(e)(5)(C)(iii) and §163(e)(5)(D).
If a debt instrument is classified as an AHYDO, two adverse consequences follow:
First, the deduction for the "disqualified portion" of the OID is permanently disallowed. See IRC §163(e)(5)(A)(i). The "disqualified portion" is the lesser of (a) the total amount of OID less the portion of the total return that the issuer would have been entitled to deduct if the yield were AFR plus 6 percentage points, or (b) the total amount of OID that represents a "disqualified yield." See IRC §163(e)(5)(B).
Second, the disqualified portion is treated as a dividend paid by the issuer for purposes of determining whether a corporate holder may claim a dividends-received deduction under IRC §243. See IRC §163(e)(5)(A)(ii)(II). This recharacterization can have significant consequences for corporate holders.
Because AHYDO classification requires the satisfaction of all three tests, failure of any single test is sufficient to prevent classification. We analyze each test below.
B. Application to the Notes
Test 1: Maturity Test. The maturity test is satisfied if the Notes have a maturity of more than five years from the date of issue.
Issue Date: June 25, 2024
Maturity Date: July 1, 2031
Term: Approximately 7 years and 6 days
Does the term exceed 5 years? Yes.
Result: The maturity test is met. This alone does not cause AHYDO treatment; all three tests must be satisfied for the Notes to be classified as AHYDOs.
Test 2: Yield Test. The yield test is satisfied if the yield to maturity of the Notes equals or exceeds the applicable federal rate plus five percentage points.
Yield to Maturity of the Notes. The yield to maturity must be calculated based on the issue price of 98.500% ($492,500,000), the stated redemption price at maturity of 100% ($500,000,000), the 8.250% coupon payable semi-annually, and the approximately seven-year term to maturity. Using standard bond pricing conventions, the yield to maturity of the Notes on a bond-equivalent basis is approximately 8.50% per annum (reflecting the 8.250% stated coupon enhanced by the accretion of the 1.500% OID over the term). On a semi-annual compounding basis, the semi-annual yield is approximately 4.25%.
Applicable Federal Rate. The yield test compares the yield to maturity of the Notes against the sum of (a) the "applicable federal rate" for the calendar month in which the Notes are issued, determined by reference to the appropriate compounding period and term, plus (b) 5 percentage points. For a debt instrument with a term exceeding nine years, the long-term AFR applies; for a term of more than three years but not exceeding nine years, the mid-term AFR applies. See IRC §1274(d)(1)(B). The Notes have a term of approximately seven years, which places them in the mid-term AFR category.
Based on published IRS Revenue Rulings for recent months, the mid-term AFR for instruments issued in early-to-mid 2024 has been in the range of approximately 4.50% to 5.00% (semi-annual compounding). The engagement team should confirm the exact mid-term AFR published by the IRS for June 2024 in the applicable Revenue Ruling (typically published during the third or fourth week of the preceding month). For purposes of this analysis, we assume a mid-term AFR of 4.75% (semi-annual compounding).
Comparison:
AFR + 5 percentage points: 4.75% + 5.00% = 9.75%
Yield to maturity of the Notes: ~8.50%
8.50% < 9.75%
Result: The yield test is not met. The yield to maturity of the Notes (approximately 8.50%) is well below the AFR-plus-5% threshold (approximately 9.75%). There is a margin of approximately 125 basis points between the Notes' yield and the threshold, providing a comfortable cushion against variations in the AFR.
We note that even if the AFR for June 2024 were lower than assumed (e.g., 4.00%), the threshold would be 9.00%, and the Notes' yield of approximately 8.50% would still fall below it. Conversely, even if the issue price were somewhat lower than 98.500% (increasing the yield), the yield would have to increase to 9.75% or more to trigger the yield test — this would require an issue price of approximately 92.50% or lower, which is far below the contemplated issue price.
Test 3: Significant OID Test. Because the yield test is not met, it is technically unnecessary to analyze the significant OID test for purposes of the AHYDO determination. However, for completeness and to provide a fully documented record, we address this test as well.
The significant OID test is satisfied if the aggregate amount of OID that would accrue during any accrual period beginning after the fifth anniversary of the issue date exceeds the sum of (a) the aggregate interest to be paid during that accrual period and (b) the product of the issue price and the yield to maturity (expressed as a fraction of the accrual period).
As determined in Section III above, the OID on the Notes is de minimis ($7,500,000, or 1.500% of par). Even if the OID were treated as non-de minimis and were accrued on a constant-yield basis, the per-period OID accrual would be modest. As a rough approximation, distributing $7,500,000 of OID over 14 semi-annual periods yields an average of approximately $535,714 per semi-annual period (the actual constant-yield accrual in later periods would be somewhat higher due to compounding effects, but even doubling this figure would not change the conclusion).
The semi-annual interest payment on the Notes is $20,625,000 ($500,000,000 × 8.250% ÷ 2). This amount vastly exceeds the OID accrual for any period. Specifically, even in the most generous calculation, the OID accrual in any post-fifth-anniversary period would not exceed approximately $600,000 to $700,000 per semi-annual period, which is a fraction of the $20,625,000 in interest payments.
Accordingly, in no accrual period beginning after the fifth anniversary of the issue date would the OID accrual exceed the sum of the interest payments and the issue price times the yield. The instrument is current-pay, with a high cash coupon relative to the modest OID.
Result: The significant OID test is not met.
C. AHYDO Conclusion
The Notes fail the yield test (Test 2) and the significant OID test (Test 3). Because all three tests must be satisfied for AHYDO classification, and at least two of the three tests are not met, the Notes are not applicable high yield discount obligations under IRC §163(e)(5).
Accordingly:
(a) No portion of the OID on the Notes is disallowed as a deduction under IRC §163(e)(5)(A)(i);
(b) No portion of the OID is recharacterized as a dividend equivalent under IRC §163(e)(5)(A)(ii)(II); and
(c) The full amount of OID (if not de minimis) and qualified stated interest is deductible by VHG in accordance with the general rules of IRC §163, subject to the §163(j) limitation discussed in Section IV.B above.
This conclusion should be confirmed as of the actual issue date using the applicable mid-term AFR published by the IRS for June 2024. As noted, however, the margin between the Notes' yield and the AFR-plus-5% threshold provides substantial comfort against changes in the published AFR.
VI. Treatment of Optional Redemption Premiums
A. Call Premiums Under the Notes
The Indenture provides VHG with a series of optional redemption rights, as well as an equity clawback right, and grants holders a put right upon a change of control. The following table summarizes the applicable premiums:
B. OID Treatment of Redemption Premiums
Under Treas. Reg. §1.1272-1(c)(5), a redemption premium — i.e., the excess of the amount payable upon redemption over the stated redemption price at maturity — is included in the stated redemption price at maturity (and therefore treated as OID) only if, based on all the facts and circumstances as of the issue date, it is "more likely than not" that the issuer's option to redeem will be exercised. If the issuer's option to call the debt instrument is not more likely than not to be exercised, the call premium is disregarded in computing OID.
The Treasury Regulations provide a safe harbor under Treas. Reg. §1.1272-1(c)(5)(ii): if the stated redemption price at the first available call date exceeds the adjusted issue price of the instrument at that date, it is presumed that the issuer will not exercise the call option, unless the facts and circumstances strongly suggest otherwise. This presumption reflects the economic reality that a rational issuer would not redeem a debt instrument at a premium to its carrying value unless compelled by other economic considerations.
We analyze each redemption feature below:
Optional Redemption. The optional redemption schedule begins on July 1, 2027 at 104.125%, declining to 102.063% on July 1, 2028 and par on July 1, 2029. At each of these dates, the redemption price exceeds the stated redemption price at maturity (100% of par). As of the issue date, there is no factual basis for concluding that VHG is "more likely than not" to exercise the call option at a premium. The declining call schedule is a standard structural feature of high-yield note offerings and is typically not presumed to be exercised as of the issue date. VHG would exercise the call only if interest rates decline sufficiently to make refinancing economically advantageous, which is inherently uncertain as of the issue date. Accordingly, the optional redemption premiums are not included in the stated redemption price at maturity and are not treated as OID.
Equity Clawback. The equity clawback provision permits VHG to redeem up to 40% of the original aggregate principal amount at 108.250% using the proceeds of qualifying equity offerings. This is also an issuer option, and the same analysis applies: the clawback premium exceeds par and is not more likely than not to be exercised as of the issue date. The exercise of the equity clawback is doubly contingent — it requires not only VHG's election to redeem but also the completion of a qualifying equity offering. Accordingly, the equity clawback premium is not treated as OID.
Change of Control Put. The change of control put at 101.000% is a holder option (i.e., a right of the noteholders, not the issuer), triggered only upon the occurrence of a change of control event as defined in the Indenture. Under Treas. Reg. §1.1272-1(c)(3), a holder's option to put a debt instrument is generally not taken into account in computing OID unless the holder is deemed most likely to exercise the put (which would apply only if the put price exceeds the instrument's value, e.g., if the instrument is deeply discounted). Here, the change of control put is at 101.000% — modestly above par — and is contingent upon an external event (a change of control) that is not assumed to occur. The change of control put premium therefore does not affect the OID calculation.
Conclusion. The optional redemption premiums, equity clawback premium, and change of control put premium are not treated as additional OID and do not affect the OID calculation or the AHYDO analysis set forth in Sections III and V above. The stated redemption price at maturity remains $500,000,000 (100% of par), and the OID remains $7,500,000 (1.500% of par), which is de minimis.
If VHG actually redeems the Notes at a premium in a future taxable year, the premium paid above par would be deductible by VHG as additional interest expense in the year of redemption, subject to the §163(j) limitation. Holders who receive a redemption premium would generally treat the excess of the redemption price over their adjusted tax basis in the Notes as capital gain (or ordinary income, to the extent of any previously accrued market discount).
VII. Taxation of Holders — Summary for Offering Memorandum
This section summarizes the key U.S. federal income tax consequences for holders of the Notes, for purposes of drafting the "Certain U.S. Federal Income Tax Considerations" section of the Offering Memorandum to be prepared by Calderwood & Harkness LLP. This summary is intended for internal use by the Capital Markets team and should be adapted and expanded as appropriate for inclusion in the disclosure document, subject to review by the Tax group prior to distribution. As is customary, the disclosure will be subject to a disclaimer regarding the limited scope of the discussion and the recommendation that each investor consult its own tax advisor.
U.S. Holders. Stated Interest. The 8.250% stated interest on the Notes will be includible in the gross income of a U.S. holder as ordinary interest income in accordance with the holder's regular method of accounting for U.S. federal income tax purposes (cash or accrual method), as and when interest payments are received or accrued.
De Minimis OID. Because the OID on the Notes is de minimis (as discussed in Section III.C above), holders will not be required to include OID in income under the accrual rules of IRC §1272. A holder who disposes of a Note (including by sale, exchange, retirement, or redemption) will recognize gain or loss equal to the difference between the amount realized on the disposition and the holder's adjusted tax basis in the Note. To the extent gain is attributable to de minimis OID, such gain will be treated as capital gain (long-term or short-term, depending on the holder's holding period). See Treas. Reg. §1.1273-1(d)(2)–(4). A holder who acquired the Note at the original issue price will include a ratable share of the de minimis OID (based on the ratio of the number of complete months the holder held the Note to the number of complete months from the original issue date to the maturity date) in determining the portion of gain treated as capital gain.
Market discount. A holder who acquires a Note in the secondary market at a price below the Note's "revised issue price" (generally, the issue price plus any accrued OID, less any prior payments other than QSI) may be subject to the market discount rules under IRC §§1276–1278. Under these rules, gain realized on the disposition of a market discount bond is treated as ordinary income to the extent of accrued market discount, unless the holder has made an election to include market discount in income currently. Holders should be advised to consult their own tax advisors regarding the application of the market discount rules to their particular circumstances.
Bond Premium. A holder who acquires a Note at a price in excess of the Note's stated redemption price at maturity ($500,000,000 in the aggregate, or $1,000 per $1,000 principal amount) may elect to amortize the bond premium under IRC §171. Given that the Notes are being offered at 98.500% of par (i.e., at a discount), this scenario is unlikely to arise at issuance but may be relevant for secondary market purchasers if the Notes trade above par after issuance. Bond premium is amortized on a constant-yield basis over the remaining term of the Notes, and the amortization offsets the interest income otherwise includible by the holder.
Non-U.S. Holders. Portfolio Interest Exemption. Interest (including OID, if any) paid on the Notes to a non-U.S. holder generally will be exempt from U.S. federal withholding tax under the portfolio interest exemption set forth in IRC §871(h) (for nonresident alien individuals) and IRC §881(c) (for foreign corporations), provided that:
(i) the interest is not "effectively connected" with a U.S. trade or business conducted by the non-U.S. holder;
(ii) the non-U.S. holder does not actually or constructively own 10% or more of the total combined voting power of all classes of VHG stock entitled to vote;
(iii) the non-U.S. holder is not a "controlled foreign corporation" that is related to VHG within the meaning of IRC §864(d)(4); and
(iv) the non-U.S. holder satisfies applicable certification requirements by providing a properly completed IRS Form W-8BEN (for individuals) or IRS Form W-8BEN-E (for entities), or applicable successor form, certifying under penalties of perjury that the holder is not a U.S. person.
FATCA. Withholding at a rate of 30% may apply to payments of interest (including OID, if any) on the Notes under the Foreign Account Tax Compliance Act provisions of IRC §§1471–1474 ("FATCA") if the payee is a foreign financial institution or other non-financial foreign entity that does not comply with applicable reporting requirements. Under current IRS guidance and proposed Treasury Regulations, FATCA withholding on gross proceeds from the sale or other disposition of the Notes has been deferred indefinitely and, based on proposed regulations, would not apply.
The foregoing summary is provided for the Capital Markets team's reference and should be reviewed and finalized as part of the Offering Memorandum drafting process. Claire Dempsey and Audrey Zhou should coordinate with the Tax group to ensure that the disclosure accurately reflects the analysis herein and includes all customary disclaimers, including as to the limited nature of the discussion, the recommendation to consult individual tax advisors, and the fact that the discussion does not address state, local, or non-U.S. tax consequences.
VIII. Tax Treatment of Transaction Costs
VHG will incur substantial transaction costs in connection with the issuance of the Notes and the refinancing of the Existing Credit Facility. The characterization and timing of the deduction for these costs depend on the nature of the expenditure and the applicable provisions of the Code and Treasury Regulations.
Debt Issuance Costs. Under IRC §263 and Treas. Reg. §1.263(a)-5(a)(2), amounts paid to facilitate the issuance of debt instruments must be capitalized. Facilitative costs include legal fees, accounting and advisory fees, trustee fees, rating agency fees, printing costs, SEC registration fees (if applicable), and other costs directly related to the issuance of the Notes. VHG's estimated transaction costs of $6,863,285.90 for legal, trustee, rating agencies, printing, and miscellaneous expenses fall within this category and must be capitalized.
Capitalized debt issuance costs are amortized over the term of the debt instrument to which they relate. Under Treas. Reg. §1.446-5 (applicable for debt issuance costs incurred after December 31, 2003), the amortization is computed using the constant-yield method, consistent with the OID rules. As a practical matter, because the OID on the Notes is de minimis, VHG may elect to amortize the debt issuance costs on a straight-line basis over the approximately seven-year term of the Notes (June 25, 2024 to July 1, 2031), resulting in an annual amortization deduction of approximately $980,469 ($6,863,285.90 ÷ 7), subject to the §163(j) limitation. The amortized debt issuance costs are treated as interest expense for purposes of §163(j). See Treas. Reg. §1.163(j)-1(b)(22)(ii).
Initial Purchasers' discount. The Initial Purchasers' discount of $8,750,000 (1.750% of par) is similarly treated as a cost of issuing debt. It represents the difference between the issue price (98.500%) and the price paid by the Initial Purchasers (96.750%) and is economically the underwriting spread. Like other debt issuance costs, the Initial Purchasers' discount must be capitalized and amortized over the life of the Notes. The annual amortization of the Initial Purchasers' discount is approximately $1,250,000 ($8,750,000 ÷ 7), also subject to the §163(j) limitation.
Prepayment Premium on Existing Credit Facility. The prepayment premium of $2,336,714.10 (0.50% of $467,342,819.16 outstanding principal) payable to the lenders under the Existing Credit Facility upon its early termination is deductible as additional interest expense in the year of repayment (i.e., VHG's taxable year in which the closing occurs). See Rev. Rul. 57-198, 1957-1 C.B. 94 (premiums paid for the early retirement of debt are deductible as interest expense); Treas. Reg. §1.163-7(c) (repurchase premium on debt instrument). The prepayment premium deduction is subject to the §163(j) limitation.
Unamortized Debt Issuance Costs on Existing Credit Facility. VHG capitalized debt issuance costs when the Existing Credit Facility was entered into on March 15, 2021. The Existing Credit Facility has an original maturity date of March 15, 2026 (a five-year term). As of the anticipated closing date of June 25, 2024, approximately 1 year and 9 months (approximately 21 months) of the five-year term will remain unamortized. Upon the complete extinguishment of the Existing Credit Facility, VHG is entitled to deduct the remaining unamortized debt issuance costs in full in the taxable year of extinguishment. See Treas. Reg. §1.446-5(c) (allowing acceleration of deduction upon retirement of the related debt instrument); see also Rev. Rul. 67-409, 1967-2 C.B. 128.
The exact amount of unamortized debt issuance costs remaining on the Existing Credit Facility is not known to us. We recommend that VHG confirm with Palladian & Howe LLP the remaining unamortized balance as of the anticipated closing date for proper write-off treatment. Any such write-off would constitute additional interest expense subject to the §163(j) limitation.
The following table summarizes the tax treatment of the principal transaction costs:
All of the foregoing deductions are treated as business interest expense for purposes of the §163(j) limitation.
IX. Assumptions and Limitations
This memorandum is based on the Internal Revenue Code of 1986, as amended, Treasury Regulations promulgated thereunder, published rulings and administrative pronouncements of the Internal Revenue Service, and relevant judicial decisions, all as in effect as of the date hereof. Each of these authorities is subject to change, possibly with retroactive effect, and any such change could affect the conclusions expressed herein. No assurance can be given that the IRS will not take a position contrary to the conclusions expressed in this memorandum or that a court would not sustain such a position.
Our analysis is based on the following specific assumptions and is subject to the following limitations:
1. Debt vs. Equity Classification. We assume that the Notes will be treated as debt instruments (and not as equity) for U.S. federal income tax purposes. This assumption is well-supported by the following characteristics of the Notes: (a) a fixed, stated maturity date of July 1, 2031 (approximately seven years from issuance); (b) unconditional payment obligations for principal at maturity and interest at a fixed rate of 8.250% per annum; (c) senior unsecured ranking in the capital structure, with no subordination to equity interests; (d) the absence of any equity conversion feature, participation right, or equity kicker; (e) a reasonable debt-to-equity ratio (pro forma net leverage of approximately 1.21x); and (f) the arms'-length nature of the offering to unrelated investors through institutional placement. We do not believe there is any material risk that the Notes would be recharacterized as equity.