Whether due to an economic downturn or other challenges, many businesses have to face restructuring their debt. There are often alternatives for restructuring debt. One typical consideration for an alternative is whether it creates cancellation of debt income (CODI) or other tax consequences ꟷ which could significantly impact the debtor’s current and future after-tax cash flows. Thus, in order to properly manage the liquidity and value of the debtor, it is important to consider tax ramifications before finalizing any debt 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
A debtor may realize CODI when it restructures its debt. Unless a taxpayer is properly advised, CODI may result in unforeseen circumstances. If CODI is not excludable from taxable income, a corporation may be faced with a cash tax liability or else may be forced to use its tax attributes (e.g., net operating losses (NOLs), deferred interest deductions, credit carryforwards, etc.) to offset the CODI.
To alleviate the immediate tax burden created by CODI, the tax code allows some taxpayers to exclude a portion or all CODI from taxable income depending on their circumstances. For example, a corporation can generally exclude all the CODI from taxable income in a bankruptcy, even when the taxpayer is solvent upon its emergence (the “Bankruptcy Exclusion”). For an out-of-court debt restructuring, a corporation may only exclude CODI to the extent the debtor was insolvent immediately prior to the CODI event (the “Insolvency Exclusion”).
The exclusion rules are different for partnerships. When a partnership realizes CODI, each partner may exclude such 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.
Grant Thornton Insight:
The rules regarding partnership CODI transactions can cause significant headaches for the partners in any partnership business, including private equity limited partners invested in flowthrough portfolio companies. These investors may not meet the requirements to exclude CODI from taxable income, and they could not have tax attributes to offset taxable CODI. Careful planning and messaging are critical in these circumstances.
Attribute reduction
The exclusion of CODI from taxable income may come at a cost. For example, a corporate debtor must reduce its tax attributes to the extent it excludes CODI from taxable income. The effect of the tax attribute reduction is to increase the future taxes of the debtor due to the benefit of excluding CODI from current taxable income.
- Attributes are generally reduced in the following order ꟷ (i) net operating losses, (ii) general business credit, (iii) minimum tax credits, (iv) capital loss carryovers, (v) basis in property (including basis in stock of subsidiaries and intercompany accounts but not cash) held at the beginning of the taxable year following the taxable year in which discharge occurs, (vi) passive activity loss and credit carryovers, and (vii) foreign tax credit carryovers.
- A reduction in the basis of property may be limited to the extent that the bases of such property exceed the liabilities of the debtor immediately after the discharge (the “1017 Liability Floor”). The 1017 Liability Floor may be extremely beneficial when a debtor has substantial liabilities following a debt restructuring.
- Taxpayers may make an election under Section 108(b)(5) to apply any portion of the attribute reduction to first reduce the basis of depreciable property prior to reducing net operating losses (the “108(b)(5) Election”). The 108(b)(5) Election may be beneficial in cases when the debtor’s net operating losses may be used sooner than depreciation deduction. The 1017 Liability Floor does not apply to the basis of depreciable property to the extent a 108(b)(5) Election has been made (i.e. basis may be reduced beyond the 1017 Liability Floor resulting in greater reduction of depreciable asset basis).
The amount and type of tax attribute reduction depends on numerous factors, including the type of property that the debtor owns at year-end. In some cases, a debtor may be able to dispose of assets prior to year-end to avoid reducing basis in such property. Thus, with careful planning and modeling, a debtor may be able to limit the impact of attribute reduction and increase future after-tax cash flows.
Grant Thornton Insight:
The rules regarding attribute reduction are complex and generally require a significant amount of data and modeling. The circumstances surrounding how a debt 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.
Common transactions
Because of the potential tax consequences, it is important to understand the timing and potential 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.”
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 modified terms provide for 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 often minimal CODI so long as there is no reduction in the principal amount and the stated interest in the modified terms is at least 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 quoted at a discount (e.g., during a business decline, an economic downturn, etc.), the debtor may realize CODI reflecting such discount, which can be a material amount of CODI notwithstanding that the stated principal amount of the debt has not changed.
Grant Thornton Insight:
The significant modification rules can have a cliff effect, but it may be possible to mitigate their impact through planning and modeling the potential impact of alternatives. For example, it may be possible to modify a debt’s terms in a manner that does not create a significant modification. It should be noted that 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 a currently proposed modification is significant, the parties will need to consider historic modifications as well.
Cash settlements
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 be advantageous for the debtor to acquire its own publicly traded debt on the open market. When debt is retired at a discount for cash, the debtor realizes CODI to the extent that the adjusted issue price of the settled debt exceeds the cash payment.
Debt-for-equity exchanges
A debtor may settle its existing debt with its own 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 (either minority or majority) in the debtor in exchange for reducing the existing debt (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 reduced in order for the equity to have 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.
Debt-for-asset exchanges
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 transferred 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:
There are circumstances when a taxable sale of the debtor’s assets to the creditor may be more beneficial than other transactions (e.g., debt-for-equity transactions). For instance, a taxable sale of the debtor’s assets to the creditors may offer the purchaser of the assets a valuable step in basis while the income to the debtor can be offset with tax attributes like net operating losses or suspended deductions ꟷ attributes that may be lost in a debt-for-equity transaction. There are a number of variables that must be considered to determine whether a taxable sale to the creditors is viable and beneficial.
Related party acquisitions
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.
Next steps
Companies may realize unforeseen cancellation of debt income for tax purposes 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 CODI that may arise and consider any planning alternatives.
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