Whether it’s due to the current economic environment or other challenges, businesses are increasingly struggling to service their debt and many will need to restructure their capital. There are many options for restricting debt and many can create cancellation of debt income (CODI) for tax purposes, which could significantly impact the debtor’s current and future after-tax cash flow. In order to properly manage the liquidity and value of the debtor, it is important to consider the tax ramifications before any restructuring.
This article will explore the federal income tax consequences of common transactions that can create CODI, including:
- Debt modifications
- Debt-for-debt exchanges
- Cash settlements
- Debt-for-equity exchanges
- Debt for asset exchanges
- Related party acquisitions
Cancellation of debt income
As discussed in a prior story on the tax implications of bankruptcy versus settlement, a debtor may realize CODI when it restructures its debt. If an exclusion from taxable income does not apply, a corporation can use its tax attributes (e.g., net operating losses (NOLs), deferred interest deductions, credit carryforwards, etc.) to offset the CODI. To the extent the debtor lacks enough attributes to offset the CODI, the corporation may owe taxes as a result of the restructuring.
To alleviate the immediate tax burden created by CODI, the tax code allows corporations to exclude some or all CODI from taxable income depending on how their debt is restructured. In a bankruptcy, a corporation can generally exclude all the CODI from taxable income, even when the taxpayer is made solvent. In an out-of-court debt restructuring, however, a corporation can only exclude CODI to the extent the corporate debtor was insolvent immediately prior to the debt restructuring. To extent that a corporate debtor excludes CODI because of bankruptcy and/or insolvency, such debtor will generally have to reduce its tax attributes (e.g., NOLs, credits, basis in property) thereby increasing its future taxes.
Grant Thornton Insight:
The rules regarding attribute reduction are complex and generally require a significant amount of data. Often, how a debtor structures a restructuring may significantly affect the types and amounts of attributes that are reduced. Thus, debtors should consider and model its various alternatives prior to effectuating a debt restructuring.
A partner in a partnership may only exclude partnership CODI from taxable income to the extent the partner (not the partnership) is in bankruptcy and/or insolvent. This creates substantial pressure on the partnership to determine not only the amount of CODI but also how it is allocated among the partners.
Because of the potential tax consequences, it is often important to manage the timing and amount of CODI. The following are some common transactions that may cause a company to incur CODI.
Debt-for-debt exchanges or debt modifications
A debtor may negotiate with its lenders to modify the terms of an existing debt instrument by 1) exchanging the existing debt instrument for a new debt instrument, or 2) amending the terms of the existing debt instrument. Regardless of the legal form, the debtor may incur CODI to the extent that the terms of the existing debt instrument have a “significant modification.”
As discussed in our prior story on understanding the tax effects of debt modifications, a “significant modification” occurs if the legal rights or obligations are altered and the degree to which they are altered is economically significant. The regulations provide bright-line tests for change in the yield, timing of payments, obligor or security and recourse nature of a debt instrument. To the extent the terms have a “significant modification,” the debtor is treated as retiring the old debt with a new debt instrument. The debtor realizes CODI to the extent that the amount of the old debt (its adjusted issue price) exceeds the “issue price” of the new debt instrument.
The “issue price” of the new debt can depend on whether the debt is traded or quoted on an established market (i.e. publicly traded). In an exchange of non-publicly 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). Thus, if a non-publicly traded debt instrument is significantly modified, there is generally minimal CODI realized in the debt-for-debt exchange if there is no reduction in the principal amount and the stated interest is at least at the AFR.
If, however, the debt is publicly traded or quoted in the 15 days before or after the modification, the issue price may be based on the trading price or quoted 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 CODI.
Grant Thornton Insight:
The significant modification rules generally act as a cliff, but it may be possible to modify a debt’s terms to meet the debtor’s and creditor’s needs in a manner that does not create a significant modification. This typically requires the relevant parties to perform certain calculations related to the modified the terms, or proposed terms. 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. Thus, when calculating whether proposed modifications are significant, the parties will need to consider historic modifications as well.
The debtor may settle its debt with a cash payment. If the debtor is insolvent and/or illiquid, the creditor may agree to a payment that is less than the outstanding balance. Alternatively, because publicly traded debts may be trading at low prices, it may advantageous for the debtor to acquire its publicly traded debt on the open market. The debtor realizes CODI to the extent that the issue price of the settled debt exceeds the cash payment.
A debtor may settle its existing debt with its equity. This may be legally effectuated in a variety of ways. For instance, the debtor may issue treasury stock and/or newly issued stock. The exchange may be consummated in bankruptcy or out-of-court. Regardless of the legal steps, the end result is that the creditor obtains an equity position (whether minority or majority) in the debtor in exchange for reducing the existing debt (whether partially or wholly).
In a debt-for-equity exchange, the debtor generally realizes CODI to the extent that the adjusted issue price of the settled debt exceeds the fair market value of the equity received by the creditors. For debtors that are materially insolvent, a debt-for-equity exchange often creates significant CODI because a substantial amount of debt will need to be settled when the equity has insufficient value. If, however, the debtor is solvent, it may be viable for a debt-for-equity exchange to create less CODI, but the specific facts and circumstances still need to be comprehensively analyzed.
Grant Thornton Insight:
If the creditor is also a shareholder of a corporate debtor, the creditor may contribute the debt to the capital of the debtor (rather than have the debtor issue equity). If the creditor is the sole shareholder, a contribution to capital may leave the creditor economically in the same position as if equity was issued. For income tax purposes, if a debtor corporation receives its debt as a contribution to capital, the debtor is treated as satisfying the indebtedness with an amount equal to the creditor’s adjusted basis in the indebtedness. Thus, if the creditor has sufficient basis in the indebtedness, structuring the exchange as a contribution to capital may allow the debtor to avoid CODI.
A debtor may settle its debt by transferring assets to its creditors. The federal income tax consequences of a debt-for-asset exchange will generally depend on whether the debt is nonrecourse or recourse for income tax purposes. A nonrecourse liability is one in which the lender’s rights to collect on a debt is secured by specified assets of the borrower and are limited solely to foreclosing on the collateral that secure the obligation. In contrast, with a recourse liability, a lender is not limited to specified assets of the borrower.
If the debtor settles a recourse debt with property, the debtor generally realizes: 1) gain or loss on the difference between the fair market value of the transferred assets and their tax basis, and 2) CODI to the extent that the adjusted issue price of the settled debt exceeds the fair market value of such assets. Although the CODI may be excluded from taxable income (as discussed above), any gain on the assets is generally not excludable and may cause the debtor to incur federal income tax.
If the debtor settles a nonrecourse debt with the collateral that secure the debt, for income tax purposes, the amount realized in determining gain or loss in disposition of the asset includes the issue price of the debt settled. As a result, the debtor will generally realize: 1) gain or loss on the difference between the adjusted price and the tax basis of the associated assets, and 2) no CODI. Thus, settling a nonrecourse debt with low basis assets will likely result in material taxable gain regardless of the fair market value of such assets.
Grant Thornton Insight:
If a debtor is contemplating settling a nonrecourse debt that materially exceeds the fair market value of its collateral, it may be beneficial to explore whether the creditor would allow the debtor to sell such assets to a third party and use the proceeds to settle the debt. In this case, the debtor may be able to reduce the gain on the sale of assets to the sales price and incur CODI (that may be excludable) on the amount that the adjusted issue price of the debt exceeds the cash settlement.
Rather than the debtor settling its debt directly, a related party of the debtor (e.g., a shareholder or partner owning more than 50% of the equity) may acquire the debt from a third-party creditor for less than the face amount. For income tax purposes, this acquisition of debt by a related party is treated as if the debtor acquired such debt. Thus, the debtor realizes CODI to the extent that the adjusted issue price of the debt exceeds the price that related party paid for such debt.
A debtor may also realize CODI if a current holder acquires a controlling interest in the debtor. For instance, a third party may acquire the debt of a distressed company on the open market for less than face. The third-party holder may then use this debt to leverage acquiring the equity of the company within a short period. In this case, the distressed company may realize CODI to the extent that the adjusted issue price exceeds the third party’s basis in such debt upon the lender becoming related to the borrower.
Companies may realize cancellation of debt income in a variety of transactions. In some cases, this cancellation of debt income may create a material current or future income tax liability. Thus, before finalizing a transaction, it is important to understand the amount of cancellation of debt income that may arise and to plan accordingly.
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
- Corporate tax
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