Stimulus Legislation Contains Tax Provisions Relevant to Debt Restructuring

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Robinson Bradshaw Publication
April 2009

Background

Any company managing its debt has to consider cancellation of debt income. The tax law generally views any amount a company borrows but does not repay as an addition to wealth that should be taxed. For example, if a company settles a $100 debt for $80, the company generally recognizes COD income of $20. The difficulty with COD income is that it often arises in less obvious circumstances.

When debt is “publicly traded” (a tax concept that is broader than one might think), a mere modification of the terms of the loan can produce COD income, even if the modification does not appear to benefit the borrower. If there is any significant modification of the terms of an outstanding loan – an interest rate increase in exchange for a covenant waiver, for example – the tax law treats the debt as having been reissued. If the debt is then trading publicly at a lower price than its face value, the tax law assigns COD income to the borrower in the amount of the difference, even though it has agreed to a less favorable interest rate. So assume a borrower has a debt with a principal amount of $100 that is currently trading at $80. If the borrower and lender negotiate an increase in the interest rate, the law will treat the debt as having been reissued--not at the face amount of $100, but at the public trading price of $80. The borrower has now received $20 in COD income, despite the fact that the borrower’s interest costs have just gone up.

A company generally does not have to pay tax on COD income in two circumstances: when it is in bankruptcy or to the extent it is insolvent (and has not filed for bankruptcy protection). These two exceptions, however, are no help to companies – even those in decent financial shape – that are pursuing the sound business strategy of retiring debt at low prices. They face the prospect of large amounts of COD income. In extreme cases, the COD income itself might bankrupt a company. Consider the modification example above. The company might need a waiver for a covenant that no longer makes sense in a changed economic environment. If the lender requires an interest rate increase in exchange for the waiver, the consequences could be disastrous for the company if its debt is publicly traded at a deep discount. The resulting COD income could be so large the company does not have enough assets to pay the tax bill.

The New Law – Election to Defer COD Income

Aware that COD income was a potential impediment to economic recovery, Congress included in the recent stimulus legislation an elective deferral regime that allows taxpayers to defer certain COD income and recognize it over a five-year period. The new law allows a company that incurs debt cancellation income in 2009 or 2010 to elect to include the canceled amount in income in five equal installments in the years 2014 through 2018. For example, a company could elect to treat $100 of debt forgiven in 2009 as $20 of income in 2014 through 2018.

Any debt issued by a corporation and the trade or business debt of any other person qualifies for the new deferral election. The election is available when the debtor or a person related to the debtor acquires the outstanding debt. An “acquisition” occurs when the debt is simply forgiven by the lender, acquired for cash, or exchanged for another instrument or when the debt is exchanged for equity in a corporation or partnership or contributed to capital.

If the taxpayer dies or the business is sold or terminated, the deferred COD income must be accelerated and recognized in the year of the acceleration event. A company might make the election and expect to recognize income in 2014 through 2018, but if that company sells all of its assets in 2012, all of the deferred income would be recognized in 2012.

The deferral election is exclusive and irrevocable, meaning that companies that make it cannot rely on the insolvency and bankruptcy exceptions. If a company elects to defer COD income it would otherwise have to recognize in 2010, and the company is insolvent in 2014 when it begins to recognize the deferred income, it still has to recognize the deferred income. Passthrough entities must make the election at the entity level. In a partnership, even though the income will flow through to each partner individually, the partners are bound by the partnership’s deferral election.

The new rules also affect the treatment of original issue discount and high-yield OID. If the issue price of a debt instrument is less than its face amount, the difference is OID. Over the life of the debt instrument the holder of the debt accrues additional interest income in the amount of the OID, and the borrower accrues additional interest expense. For debt instruments with certain features and a large amount of OID, often referred to by the acronym AHYDO, special high-yield OID rules limit the borrower’s OID deductions. In debt-for-debt exchanges covered by the stimulus legislation, the newly issued (or deemed issued) debt could have OID and might also be subject to high yield OID rules. The new legislation requires any borrower that elects to defer COD income to also defer OID deductions until the COD income recognition period. The borrower will deduct any deferred OID deductions ratably from 2014 through 2018. The new rules also turn off the high yield OID rules for certain debt issued (or deemed issued) from Sept. 1, 2008, to Dec. 31, 2009.

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