Introduction
As a result of the current difficult economic environment, many debtors and lenders find themselves in the position of having to renegotiate and restructure their debt obligations and entitlements. Without careful upfront tax planning, these restructurings may result in adverse tax consequences that can exacerbate the economic pain that the parties are already suffering. For the distressed debtor, the principal consideration is to avoid cancellation of indebtedness (COD) income or the loss of valuable tax attributes such as net operating loss carryforwards (NOLs). For the lender, the principal consideration is to avoid restructuring the debt in a manner that results in the deemed issuance of a new debt that includes original issue discount (OID) and, consequently, taxable income in advance of receiving cash. It should be noted that recent changes in tax law have made these rules more relevant to debt restructurings of “controlled foreign corporations” (CFCs). The following discussion summarizes the key federal income tax issues at play which should be kept in mind by the parties in implementing any such restructuring.
COD and OID
As a general matter, COD income arises for a debtor if its debt is reduced to or satisfied or repurchased at less than its outstanding balance. (For debt originally issued with OID, COD income is measured by reference to the original issue price plus accrued and unpaid OID, instead of the principal due at maturity.) This may occur through a straightforward cash payment at a discount by the debtor or through a swap by the debtor of its stock or other equity (such as the issuance by a partnership of a partnership interest for debt) or other property for the debt or in payment of the debt. In such case, the debt would be viewed as having been paid off in an amount equal to the fair market value of the property conveyed to the lender (although the rules can be different if the debt in question is nonrecourse).
COD of a partnership or a limited liability company taxed as a partnership is generally allocated among its partners or members, and 10 percent “United States shareholders” of a CFC may be required to take into account their proportionate share of any COD of the CFC.
If the debtor is not bankrupt or insolvent when the debt is cancelled in whole or part, then the COD income is taxable as ordinary income to the debtor. If, however, the debtor is insolvent or in bankruptcy at the time the COD income is recognized, then some or all of the COD can be excluded from income. In the case of partnerships or LLCs, the bankruptcy and insolvency exceptions are applied at the partner or member level rather than the partnership or company level. Thus, COD income arising from an entity taxed as a partnership that is insolvent or in bankruptcy will only be excluded if the partner also is in bankruptcy or is deemed to be insolvent for this purpose.
If the debtor is in bankruptcy, then all of the COD income is excluded. If the debtor is insolvent (based on the amount of its debt in excess of the fair market value of its assets) but not in bankruptcy, then the COD is excluded from income to the extent of such insolvency. Any amount of COD that is excluded from income under the bankruptcy or insolvency exceptions will reduce the debtor’s tax attributes, such as any net operating losses remaining after those losses are used in the current year, and its tax basis in its assets (subject to certain rules).
These rules are fairly easy to apply in the case of a simple reduction, forgiveness, repurchase, or satisfaction of the debt for less than the outstanding balance. However, the analysis is far more complicated where the parties agree to restructure the debt. The tax law provides that certain adjustments or revisions to the terms of a debt instrument, referred to as “significant modifications,” result in a deemed exchange of the old debt instrument for a new debt instrument, even though in form no “new” debt is issued. In the deemed exchange, the borrower is treated as satisfying the old debt with an amount of money equal to the “issue price” (not face amount) of the new debt. If the issue price of the new debt, computed in accordance with these rules, is more or less than the outstanding balance of the old debt, adverse tax consequences could result to the debtor or lender, as described further below.
When neither the existing debt nor new debt is publicly traded, the issue price of the new debt will equal the outstanding balance of the existing debt so long as the old debt instrument and new debt instrument have an interest rate at least equal to the applicable federal rate (AFR) and the principal amount does not change. Under this rule, due to the currently low AFR, the parties could significantly reduce the interest rate of a debt instrument and any deemed new debt instrument could still have an issue price equal to the outstanding balance of the existing debt, so long as the principal amount remains unchanged. However, where either the existing debt or new debt is publicly traded, the existing debt is deemed to be satisfied in an amount equal to the fair market value of the new debt.
A debt instrument is treated as publicly traded if within 15 days before or after the issue date (or in the case of a workout that is treated as a significant modification, the deemed reissue date) there is available for the debt instrument 1) a sales price, 2) a firm quote, or 3) an indicative quote. These rules are generally viewed as casting a wide net in terms of what can cause an instrument to be treated as publicly traded. Note however, that no instrument is treated as publicly traded if the outstanding principal amount of the issue that includes the debt instrument does not exceed $100 million.
In general, a “sales price” exists if the price for an executed purchase or sale of the debt instrument is reasonably available within a reasonable period of time after the sale. For this purpose, the price of a debt instrument is considered reasonably available if the sales price appears in a medium that is made available to issuers of debt instruments, persons regularly purchasing or selling debt instruments, or persons brokering purchases or sales of debt instruments. A “firm quote” exists if a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or subscribers) for the debt instrument and the quoted price is substantially the same as the price for which the person receiving the quoted price could purchase or sell the instrument (i.e., where the quote functions as a firm quote as a matter of law or industry practice). And finally, an “indicative quote” exists if a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or subscribers) that is not necessarily substantially the same as the price at which the person receiving the quoted price could purchase or sell the instrument.
If the issue price of the new debt is deemed to be less than the outstanding principal of the existing debt, the debtor will recognize COD income. This could be the case even if the face amount of the new debt is equal to the outstanding balance of the existing debt, under the foregoing rules. For example, if existing publicly traded debt with an outstanding balance of $100 is deemed to have been exchanged for new debt that has a face amount also of $100 but a fair market value of $90 (because of the erosion of the credit of the debtor), the debtor will recognize $10 of COD income. In addition, the lender will be viewed as exchanging the existing debt of $100 for new debt of $90 resulting in a) a $10 loss if the lender’s tax basis in the existing debt is the same as the outstanding balance, i.e., $100, and b) $10 of OID reflecting the excess of the face amount of the new debt ($100) over the deemed issue price of the new debt ($90). Unless OID can be treated as de minimis, a U.S. lender of a deemed reissued instrument issued with OID would be required to accrue the $10 OID as additional interest income over the term of the debt. While a deductible loss can be beneficial, many lenders would rather avoid both the deductible loss and the taxable OID. Additionally, OID is always ordinary income, even if the lender’s loss on the deemed exchange was a capital loss, and OID when paid may be subject to withholding tax in the case of foreign lenders.
Conversely, if the issue price of the new debt is deemed to be more than the outstanding balance of the existing debt, the debtor may recognize a loss and the lender may recognize gain on the exchange as the tax law views the existing debt as having been satisfied in an amount that is more than its outstanding balance. Using the same example, if the new debt had a fair market value of $110, the debtor may recognize a debt premium payment loss of $10 (which would generally result in a reduction to the debtor’s interest deductions on the new debt), while the lender may recognize a gain of $10 (which would generally reduce the lender’s interest income on the new debt).
Finally, even where the issue price of the new debt is the same as the outstanding balance of the existing debt, adverse tax consequences could result from a restructuring of the debt that results in a deemed exchange. For example, if the current lender purchased the debt from the original lender at a discount, the current lender could recognize gain on the constructive exchange because its tax basis in the debt is less than the face amount. For example, if the debt is restructured and the existing debt of $100 is deemed to be exchanged for new debt with an issue price of $100, the current lender may recognize $10 of gain if it purchased the debt for $90 (adjusted for any prior inclusions of market discount).
Significant Modification
A “modification” is any change, e.g., a deletion or addition, of a legal right or obligation of the borrower or a holder of a debt instrument, other than a change made in accordance with the terms of the debt instrument (for example, extending the maturity of a debt obligation pursuant to an option to do so included in the instrument). For example, and as discussed further below, the substitution of a new borrower, the addition or deletion of a co-borrower, or a change (in whole or in part) in the recourse nature of the instrument (from recourse to nonrecourse or from nonrecourse to recourse) is generally a modification for these purposes. A “significant modification” is a modification that is significant economically, which is generally determined based on the overall facts and circumstances (subject to bright line rules and safe harbors for certain types of modifications). Note that the mere deterioration of the financial condition of the borrower, or even a default or other lesser divergence from the terms of the debt instrument, is not a modification unless the parties agree to an actual change of the terms of the agreement.
An agreement by the debt holder of forbearance, i.e., to stay collection or temporarily waive an acceleration clause or similar default right (including such a waiver following the exercise of a right to demand payment in full) is not a modification unless the period of deferral or delay exceeds certain specified time periods. The safe harbor period for a deferral that does not lead to a modification is two years following the borrower’s initial default, plus any additional period during which the parties conduct good faith negotiations or during which the borrower is in a Title 11 or similar case.
A reduction in the interest rate of debt results in a significant modification if the yield on the modified debt instrument varies from the yield of the old debt instrument by more than the greater of: i) 25 basis points or ii) 5 percent of the yield on the old debt. A change in the timing of the payments under the debt instrument, e.g., a deferral of the payments or the extension of the maturity date, is significant if it results in a material change in the payment terms. Under a safe harbor, if the deferred payments are unconditionally payable no later than the due date of the first deferred payment plus a period equal to the lesser of five years or 50 percent of the original term of the instrument, the deferral is not significant.
In the case of a substitution of the borrower, there is a distinction between a new borrower on recourse debt and one on nonrecourse debt. The substitution of a borrower on recourse debt is generally a significant modification (outside of the context of certain acquisitions of the original borrower) because the lender under recourse debt looks to the credit of the borrower and a change in the borrower is generally deemed to fundamentally change such credit. In contrast, the substitution of a new obligor on nonrecourse debt generally has little or no effect on the credit as the lender is principally looking at the value of the assets securing the debt and is not treated as a significant modification. A change in collateral of a recourse obligation, a change in guarantors or other credit support, or a substitution of borrowers in the context of an acquisition of the original borrower will generally be a significant modification if it results in a change in the parties’ “payment expectations.” Generally, there is only a change in payment expectations if the borrower’s capacity to meet its obligations under the debt was speculative and becomes adequate (or was adequate and becomes speculative).
Conclusion
It should be noted that the discussion above only provides a general summary of the issues that arise in a debt restructuring, and there are several other tax issues not discussed that may so arise (including with respect to the taxability of a foreign lender in the U.S. and limitations on the deductibility by the debtor of the interest on the new restructured debt). Partnership debtors, in particular, face a phalanx of highly complex basis and allocation issues, and recent changes in law have raised new issues regarding the treatment of CFC debtors. For all these reasons, it is imperative that prior to implementing a debt workout, all of the tax consequences should be considered by the parties and reflected in the form and shape of the restructuring.
