Stimulus Legislation Contains Tax Provisions Relevant to Debt RestructuringPDF
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.
- Any action that affects outstanding debt raises the possibility of COD income. COD income can result from something as simple as an interest rate change.
- The new deferral election will be useful to many borrowers, but is not always the best option. The election provides for deferral, not exclusion – the tax will have to be paid at some point. Each borrower must analyze its current economic situation and anticipate where it will be in 2014-18 before it decides to elect COD income deferral. It is possible a company’s net operating losses will offset any COD income and make deferral unnecessary. If a company expects large amounts of taxable income in 2014-18 (e.g., because net operating losses expire or installment payments are due to the company, for example), moving additional income to that period by making the deferral election may not be a good choice. In other cases, relying on the bankruptcy or insolvency exception to exclude COD income from taxation altogether may be a better alternative. The deferral election must be weighed carefully against other available options.
- Partnerships (and limited liability companies taxed as partnerships) should consider the impact of an election on individual partners. The deferral election is made at the entity level, and the partners are bound by the election. Spreading the COD income over the period from 2014-18 may not be the best choice for all partners. Some partners may prefer current recognition because they can offset the COD income with other losses or because they qualify for the bankruptcy or insolvency exception.