On January 6, 2011, the Internal Revenue Service (IRS) and U.S. Department of the Treasury issued proposed regulations expanding and clarifying the meaning of “traded on an established market,” or “publicly traded,” for purposes of determining the issue price of a debt instrument. Whether or not debt is publicly traded can have a significant impact on the tax treatment of debt exchanges and modifications, in particular whether the issuer is required to recognize discharge of indebtedness income. While the proposed regulations are not effective until final, clients contemplating debt restructurings should consider whether the debt would be treated as publicly traded under the current or proposed regulations.

Significance of Public Trading

When a debt instrument is issued in exchange for property, such as a debt-for-debt exchange in a workout, the issue price of the debt instrument under Section 1273(b)(3) is its fair market value if either the existing debt or the new debt is publicly traded. A debt-for debt exchange also may be deemed to occur for U.S. federal income tax purposes as a result of a significant modification of existing debt. Given the declining fortunes of the issuer in the workout context, it often will be the case that the issue price of the new or modified debt instrument, if required to be determined based on public trading, will be less than the adjusted issue price of the existing debt. As a consequence, the issuer generally will recognize cancellation of debt income, and the new/modified debt will have original issue discount, which must be accounted for by both the issuer and the holder. These income tax consequences havebeen exacerbated by the recent turmoil in the capital markets, and temporary relief provided by the Internal Revenue Code expired on December 31, 2010.