Companies planning to reorganize their capital structure, whether it’s due to the current economic challenges or because of their debt, should consider the demands that it will put on their tax department.
Future tax cash flows are critical to the success of a restructuring plan, but a lot of data must be gathered and analyzed to properly evaluate restructuring options from a tax perspective. The tax department should be prepared to provide tax information promptly, because the process will move quickly. Complete and accurate tax information will help stakeholders make informed decisions to minimize cash tax exposure following the debt restructuring.
The entire process may require addressing several tax issues including:
- Determining whether a debt has been significantly modified for tax purposes
- Understanding the consequences of exchanging existing debt for new debt
- Quantifying any cancellation of indebtedness income
- Determining tax attribute reduction
- Modeling the various debt restructuring alternatives
- Preparing the associated tax filings
Discussed below are some of the significant tax considerations that may arise before, during and after a debt restructuring. Our prior stories on the impacts of debt modifications provide additional insights for companies considering reorganizing their capital structure.
Prior to debt restructuring
Prior to the restructuring, there are several tax data points that the company should evaluate and maintain.
Current and historic debt instruments
The starting point is to understand the complete landscape of the company’s outstanding debt load. The tax department should have copies of any debt instruments issued by the company. If the debt instruments have been modified previously, the company should maintain copies of both original and amended instruments, and the past tax impact of those modifications. This could impact the amount of cancellation of indebtedness income (or repurchase premium) as a result of the current restructuring.
Tax classification of debt instruments
The tax department may need to assess whether the company’s debt instruments are considered publicly traded for U.S. federal income tax purposes. The term “publicly traded” is a trap that catches many off guard. For tax purposes, a debt is generally considered to be publicly traded if the face amount of the debt instrument is over $100 million, and at any time during the 31-day period ending 15 days after the issue date of the new debt instrument there is a sales price for the instrument, one or more “firm quotes” for the instrument, or there is one or more “indicative quotes” for this instrument. These quotes are not necessarily readily available on the internet and may require subscriptions to online pricing services, so it will be important to consult with advisors who can quickly search for these instruments.
Legal identity of debtors (and intercompany balances)
The tax department may need to confirm which legal entity is the debtor for tax purposes (often an issue raised within a consolidated return context). In many consolidated groups, the intercompany balances may not be tracked correctly, and this can distort allocations of attributes and tax basis. If it is determined that debt has been historically accounted for at the wrong legal entity, the process could be held up in order to address the previously incorrect reporting. In our experience, some tax preparers do not focus heavily on balance sheet presentation, and balances may be classified in a way that distorts the overall economic picture for the group.
Tax basis balance sheet and tax attributes
One of the most crucial needs is a complete and accurate tax basis balance sheet. If the company files as a consolidated group, it is important to have tax basis balance sheets prepared for each separate company, (including the amount and source of any intercompany balances), as well as subsidiary stock basis. If a debt restructuring results in attribute reduction, the tax basis balance sheet will provide many key items to help determine which attributes exist for potential reduction under Sections 108 and 1017.
Other attributes may also be impacted, so it is important to have an accurate report of all the company’s tax attributes by legal entity, such as net operating losses (NOLs), capital losses, Section 163(j) interest expense carryforwards, general business credit carryforwards, etc. This may include reassessing previously posted intercompany transactions to understand their impact to each entity’s tax attributes. In our experience, some tax software may not sufficiently track the assignment of attributes to specific entities under the consolidated return rules, so we recommend a thorough review.
Stock basis study (consolidated groups only)
As noted above, the company may also need to have an up-to-date stock basis study. The stock basis the group has in its subsidiaries will greatly impact the results of attribute reduction. A stock basis study will also help determine whether any excess loss accounts (i.e., negative stock basis) exist; this can have adverse consequences in a debt restructuring. In addition, the stock basis study may also identify potential worthless stock deductions available in the group; they can help to manage cash flow through the process and after exit.
Having these items prepared and ready will allow the company to quickly determine which debt restructuring alternatives may be practical and whether the company is likely to trigger any cancellation of indebtedness income.
During debt restructuring
Once the restructuring or bankruptcy proceeding is imminent, there are several other items that the tax department should provide.
Preliminary valuation estimate
The company may need a reasonable valuation of the company for multiple reasons. First, the value of the company’s equity will impact the amount of cancellation of indebtedness income that is triggered. Second, a valuation will enable the company to determine each separate entity’s solvency or insolvency, which is critical in assessing the cash tax impact of a restructuring. Note that the company will likely need a full valuation upon exiting bankruptcy for financial reporting and other purposes; the preliminary valuation suggested here is for planning and modeling purposes.
Section 382 analysis
The company may also need an up-to-date Section 382 analysis. Specifically, the company needs to document whether it has experienced any prior ownership changes under Section 382. If the company has gone through multiple transactions, it will be important to understand the availability of tax attributes for managing cash flow in various scenarios.
State and local income tax analysis
In addition to the federal income tax consequences of a debt restructuring, state and local taxes can play a large role in the ultimate form of a debt restructuring. All of the items noted above will likely apply for state tax purposes, although the specifics may vary by legal entity and by state. For example, stock basis may be computed differently in separate filing states than in consolidated state filings, and Section 382 may apply differently to various subsidiaries.
The above items will all be instrumental in preparation of a transaction model. Current ownership and creditors will want to understand the different outcomes of a debt-for-equity exchange versus an asset sale transaction. A transaction model can be prepared to show the tax attributes remaining after a debt-for-equity exchange and demonstrate the amount of taxes that may be owed in either transaction scenario. Note that this is a significant undertaking and most companies will engage outside advisors for this analysis.
Due diligence documentation
During the restructuring process, creditors or other potential buyers may also be performing due diligence on the company. The tax department should be prepared to provide standard due diligence items such as historic direct and indirect tax returns for the last three to four years, purchase agreements for any historic transactions, documentation for any previous federal or state audits, and any other documents typically requested during due diligence.
Following debt restructuring
Following the closing, the tax department will still have a variety of tasks to accomplish.
Tax basis balance sheet updates
The tax basis balance sheets will need to be refreshed from those that were prepared for the initial restructuring discussion. The company may need tax basis balance sheets as of the effective date of the restructuring, as well as at the end of the tax year. Both could play a role in accurately reporting the debt restructuring and attribute reduction.
Updated report of other tax attributes
The company’s tax attributes will need to be updated as of the end of the taxable year. If the debt restructuring leads to tax attribute reduction, the attribute reduction does not occur until the first day after the tax year that includes the cancellation of indebtedness event. Therefore, it will be important to make sure that all tax attributes are accurately updated to reflect usage in the year of the restructuring.
Transaction cost analysis
Debt restructuring can be very expensive in terms of professional fees. The default treatment of such expenditures is for the amounts to be permanently capitalized; a transaction cost analysis will identify and document any deductible or amortizable costs. This provides another opportunity for the company to minimize any cash tax exposure following the debt restructuring.
Financial statement filings Following a debt restructuring, it is also important to understand how the results may need to be reported on the company’s financial statements. If the company is public, there is likely significant more effort necessary to prepare the company’s tax provision to accurately reflect the debt restructuring.
As part of a company’s tax return, to report any attribute reduction Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness will need to be prepared. Form 982 requires several pieces of information to be reported, including the amount of excluded cancellation of indebtedness income, the reduction of tax attributes by category prescribed in Treas. Reg. Sec. 1,1017-1, and whether any elections are being made with respect to the attribute reduction (i.e., Section 108(b)(5)).
Before a debt restructuring or bankruptcy proceeding, the tax department should prepare for the potential of a high volume of requests and a significant modeling exercise. A tax department that has appropriately prepared for the process will put the company in a much better position to work out its debt quickly and efficiently while maintaining the ability to manage cash tax outlays throughout the process.
To learn more, gt.com/tax
Russell A. Daniel
Partner, Mergers and acquisitions
Russell A. Daniel is a partner in the Tax Services practice in Charlotte, and leads the Mid-South market territory’s Tax Services practice. He assists clients in identifying and evaluating tax risks and opportunities in connection with transactions, including M&A, and implementing federal tax planning strategies.
Charlotte, North Carolina
- Strategic federal tax
- Corporate tax
Managing Director, Corporate Tax Services
Barry Grandon is a managing director in the M&A Tax Services group in New York. Grandon has more than 20 years of comprehensive experience in identifying and addressing tax issues and opportunities in a transaction-based environment.
- Technology and telecommunications
- Transportation, logistics, warehousing and distribution
- Retail and consumer products
- Strategic federal tax
- International tax
- Restructuring and turnaround
- Mergers and acquisitions
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