The economic impact of COVID-19 may result in a prolonged period of financial hardship for businesses. In the face of such difficulty, many debtors may seek to negotiate with lenders to modify the terms of an existing debt instrument. For example, a debtor that experienced a decline in business as a result of lockdowns may seek to extend the maturity of a term loan until normal operations resume. However, while debt modifications may be beneficial for liquidity reasons, they may yield surprising and costly tax results. As businesses weigh their options, it is important that they consider the tax impact of debt modification prior to finalizing a workout.
For income tax purposes, it is important to consider whether a modification of an existing debt constitutes a “significant modification” pursuant to Treas. Reg. Sec. 1.1001-3. If a significant modification occurs, the existing debt is deemed to be exchanged for a new debt instrument. If, however, a significant modification does not occur, the existing debt is not deemed to be exchanged, thereby limiting any income tax consequences.
A modification is a “significant modification” if the legal rights or obligations are altered and the degree to which they are altered are economically significant. The regulations provide bright-line tests for changes in the:
- Yield (e.g., interest rate)
- Timing of payments
- Obligor or security
- Recourse nature of a debt instrument
A modification that adds, deletes or alters customary accounting or financial covenants is generally not a significant modification, but any fees paid to a lender related to a modification must be assessed as a change in the yield. Two or more modifications over the life of a debt instrument constitute a significant modification if they would have resulted in a significant modification had they been made as a single change.
Income tax effect of debt-for-debt exchange
In a debt-for-debt exchange, the debtor is treated as repaying the old debt with an amount equal to the issue price of the new debt. The debtor realizes cancellation of debt (COD) income to the extent that the amount of the old debt (its adjusted issue price) exceeds the “issue price” of the new debt instrument. In an exchange of non-traded debt, the issue price of a new debt is generally equal to the stated principal amount if the stated interest is above the applicable federal rate (AFR). The long-term May 2020 AFRs is 1.15%. Thus, if a non-traded debt instrument is significantly modified, there is, generally, minimal COD income realized in the debt-for-debt exchange if there is no reduction in the principal amount and the stated interest is at least the AFR.
If the debt is publicly traded in the 15 days before or after the modification, the issue price is based on the fair market value of the debt. Thus, if a debtor significantly modifies a publicly traded debt when the trading price is low (e.g., during a business decline, an economic downturn, etc.), the debtor may realize a material amount of COD income.
Debt is publicly traded, if there is a reported sales price or an available quote from at least one broker, dealer or pricing service. Most SEC registered notes and private placement notes are considered publicly traded because sale prices are reported on FINRA’s Trade Reporting and Compliance Engine (TRACE). Many syndicated bank loans are considered publicly traded as dealer quotes are disseminated on platforms as Bloomberg or Markit. Under a safe harbor rule, the debt is not publicly traded for tax purposes if the outstanding balance of the issue does not exceed the $100 million.
Unless the debtor is in bankruptcy or insolvent, the realized COD income is generally taxable, and the debtor may owe income tax to the extent it lacks tax attributes to offset such taxable income. If the debtor is in bankruptcy or insolvent, it typically can exclude the COD income from taxable income. This exclusion comes at a cost in that the debtor must reduce its tax attributes (e.g., net operating losses, business credits, tax basis in property) to the extent of the excludable COD income. Thus, although the tax law allows a debtor to exclude COD income from taxable income when it is distressed, the effect is generally temporary, and the debtor will have higher cash taxes in the future.
During a period of financial hardships, a debtor may seek to restructure existing debt with more favorable terms. It is important to understand both the short-term and the long-term cash tax impact before finalizing the modification. Although not an exhaustive list, modifications that a debtor may pursue are provided below.
Extending maturity date
Extending the maturity date may be treated as a significant modification to the timing of payments under Treas. Reg. Sec. 1.1001-3. Generally, an extension of the maturity is not significant” if the extension is equal to the lesser of five years or 50%of the original term of the instrument. Thus, it may be advantageous for a debtor to negotiate an extension within the safe harbor period.
Obtaining payment holidays
Similar to extending the maturity date, obtaining a holiday on principal or interest payments is a modification. Often a short-term holiday may not be a significant modification on its own. However, factoring in other modifications on a debt instrument over its life, the holiday may cause the instrument to become significantly modified under Treas. Reg. Sec. 1.1001-3.
Changing the interest rate
Under Treas. Reg. Sec. 1.1001-3, a change in yield of the existing debt is significant if it is more than the greater of 25 basis points or 5% of the unmodified yield. The calculation of yield for tax purposes may differ from the calculation of yield that a company uses for book purposes.
Converting cash interest to pay-in-kind (PIK) interest
To provide more short-term liquidity, a debtor may seek to change some or all of cash interest payments to payment-in-kind, which results in an increase to the principal. A debtor must analyze whether this modification is significant to the timing of payments under Treas. Reg. Sec. 1.1001-3.
Changing fixed payments of principal to contingent amounts
For non-traded debts, a change that makes a portion of the principal contingent is likely to be considered a significant modification under the general rule in Treas. Reg. Sec. 1.1001-3(e)(1). For non-traded debts, contingent amounts are not part of the issue price and thus cancellation of debt income results (even if some contingent payments are expected).
Entering into standstill agreements
¬If a debtor has missed or will miss payments on its debt, the debtor may seek to enter into a standstill agreement with lenders. Typically, these agreements will create modifications to the existing debt instruments which may be significant. Because an associated publicly traded debt may be significantly impaired, a standstill agreement could yield significant COD income. An exception in the regulations to forbear on past defaults does not encompass “forbearance” of future defaults.
Changing covenant terms
Typically, a change to covenants on an existing debt instrument is not a significant modification under Treas. Reg. Sec. 1.1001-3. However, a change in the covenants may often require the debtor to pay a fee to its lenders. The debtor should test whether this fee creates a significant modification (e.g., a change in the yield of the existing debt).
Exercising conversion features
A debt instrument may allow the issuer to convert the instrument into equity of the issuer. If the option is exercised, the issuer will realize COD income to the extent the adjusted issue price of the debt instrument exceeds the fair market value of the associated equity.
Because debts traded on the public market may be trading at historically low prices, a related party to the debtor (e.g., a shareholder that owns more than 50% of the stock of the debtor) may acquire the debtor’s debt instruments for less than the face amount. Likewise, a related party may also seek to acquire non-traded debt from the lenders. A debtor realizes COD income when a related party acquires its liabilities for less than the adjusted issue price. Similarly, a debtor may also realize COD income when it repays its own debt for less than the adjusted issue price.
Before modifying a debt, it is important that a debtor considers its business needs and income tax ramifications. With careful planning, the debtor may be able to maximize its after-tax cash flow.
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Russell A. Daniel
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
- Tax reporting and advisory
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
- Mergers and acquisitions
- Restructuring and turnaround
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