The global COVID-19 pandemic has created financial distress for businesses across the United States, many of which may have been forced to close or otherwise limit their revenue-generating activities. As result, many businesses are suffering from cash flow shortages and are taking steps to prioritize how they expend their limited cash resources. Many businesses may consider working with their lenders to seek temporary forbearance of payments, changes in collateral or guaranty terms, or other modifications of their debt instruments. In so doing, it is important to remember that these actions can have unforeseen income tax consequences that can give rise to cancellation of indebtedness (COD) income for debtors.
| Eversheds Sutherland Observation: COD income may be particularly detrimental for a cash-strapped debtor because it is “phantom income” – i.e., income that is not associated with any new cash received by the debtor to satisfy any resulting tax liability. Current inclusion may be less disadvantageous or even beneficial to the extent a debtor has available or expiring net operating losses. |
COD income is income realized when a debtor is relieved (or deemed relieved) of some or all of its liability to repay an outstanding debt obligation. While COD income can arise where a creditor simply forgives an indebtedness, it can also arise where a creditor accepts property (including a new debt instrument) in full satisfaction of an existing debt instrument. Surprisingly, an agreement between the creditor and the debtor to modify the terms of existing debt instrument can also give rise to COD income. If such a modification is considered to be a “significant modification” for tax purposes, the modification results in a deemed exchange of the original debt instrument for a modified debt instrument. As discussed below, if the original debt instrument is exchanged (or is deemed to be exchanged) for a new (or modified) debt instrument, the debtor will have COD income if the “issue price” of the new (or modified) debt instrument is less than the “adjusted issue price” of the original debt instrument.
| Eversheds Sutherland Observation: In the case of a debt instrument issued for cash, the “issue price” typically is the principal amount of the debt (unless the debt instrument has “original issue discount”), but in certain cases, the issue price may be the fair market value of the debt instrument, or of property received (or deemed received) in exchange for the debt instrument. The “adjusted issue price” generally is the original issue price, adjusted to take into account any accruals of discount or premium. |
A “modification” of a debt instrument is any alteration of a legal right or obligation of the issuer or a holder of a debt instrument. Under this definition, almost any agreed-upon change to the terms of the debt instrument will be viewed as a modification of the instrument. However, the modification will result in a deemed exchange that could give rise to COD income if it is considered a “significant modification.”
A modification is considered “significant” for this purpose “only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant.” In making this determination, a series of modifications generally must be taken into account even if any single modification would not be significant by itself. Certain modifications, subject to various limitations, exceptions, and safe harbors, are deemed to be “significant modifications.” These include:
- A change in yield of more than the greater of 25 basis points (0.25%) or 5 percent (5%) of the annual yield of the unmodified debt instrument.
- A change in the payment schedule that results in a material deferral of scheduled payments (e.g., through an extension of the final maturity date or a deferral of payments due prior to maturity).
- A modification that releases, substitutes, adds or otherwise alters the collateral for, a guarantee on, or other form of credit enhancement for a debt instrument.
As noted above, not all modifications are “significant” such that they trigger taxable exchange treatment. Examples of modifications that are typically not considered significant include:
- The substitution of a new obligor on a nonrecourse debt instrument.
- An improvement to the property securing a nonrecourse debt.
- An addition, deletion, or alteration of customary accounting or financial covenants.
If a modification of a debt instrument is considered a “significant modification,” thereby resulting in a deemed exchange of the original debt instrument for a new debt instrument, the borrower will realize COD income if the issue price of the new debt instrument deemed to be issued in the exchange is less than the adjusted issue price of the original debt instrument. Determining the issue price of a debt instrument generally depends on whether the debt instrument is “traded on an established market” (“publicly traded”) or is issued for property (including another debt instrument) that is publicly traded. For this purpose, a debt instrument or other property generally is considered publicly traded if the debt instrument or other property is listed on an exchange, traded in markets or “readily quotable” – i.e., a debt or property for which price quotations are readily available from dealers and brokers.
| Eversheds Sutherland Observation: The concept of publicly traded for this purpose is intentionally expansive. It encompasses a broad range of debt instruments that traditionally one would not think of as “publicly traded” because they are not regularly traded in the market, including debt instruments that generally are not subject to regular trading, but for which it is possible to obtain a price quote from a broker. Under this definition, privately placed debt held by third parties may be considered “publicly traded,” although intercompany obligations generally would not be so considered. |
In the case of an actual or deemed exchange where the original debt instrument or the new debt instrument is considered publicly traded, the issue price of the new debt instrument is the fair market value of the new debt instrument on the date of the exchange. Fair market value may be different from the principal amount of the loan, and more importantly may differ from the adjusted issue price of the existing debt. In the case of publicly traded debt, the borrower realizes COD income where the fair market value of the new debt is less than the adjusted issue price of the original debt instrument.
Another situation in which COD income may arise is if the interest rate on non-publicly traded debt falls below the applicable federal rate (“AFR”). In the case of non-publicly traded debt that is deemed exchanged, the issue price of the new debt ordinarily is its stated principal amount, provided that it pays interest at least annually and the interest rate of the new debt equals or exceeds the AFR. If the interest rate on the new non-publicly traded debt does not at least equal the AFR, then the issue price of the new debt instrument is its imputed principal amount (generally, the present value of all payments under the debt other than qualified stated interest). If this is lower than the adjusted issue price on the pre-modification debt, the borrower will have COD.
Even if a taxpayer realizes COD income as a result of a debt exchange or significant modification, the COD income may be excluded from gross income under several scenarios, including when the discharge is a result of a bankruptcy proceeding or the taxpayer is insolvent (generally, where the taxpayer’s liabilities exceed the fair market value of its assets) at the time of the exchange or modification. Special rules apply if the debtor is a partnership that may complicate the ability of taxpayers to exclude COD income.
| Eversheds Sutherland Observation: It is in the interest of both creditors and debtors to minimize the potential tax costs of a debt modification. Taxpayers considering an exchange or modification of a debt instrument should consider the potential COD consequences resulting from the exchange or modification, and evaluate steps to minimize or eliminate the tax cost of the modification to the benefit of both the creditor and debtor. |
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