Tax Issues In Debt Restructurings
By Heléna Klumpp
Many banks and US power companies are currently engaged in debt restructuring talks, but the parties to these talks are not always aware of the minefield through which they walk. There is the potential in a debt restructuring inadvertently to trigger taxable income for the borrower, the lenders, or both.
The debt restructuring negotiations this year may be little more than a warmup for next year and the year after, when estimates are that as much as $30 billion in short-term loans — called “mini-perms”— will come due that banks made to finance merchant plants.
This article explains where the tripwires are located. It focuses on exchanges of new debt for old as a way to present the basic issues, but it also discusses the ramifications of having lenders convert loans into stock in the borrower and potential traps for which both parties should be on the lookout.
Many debt restructurings involve something as simple as an extension in the repayment schedule. The interest rate could change. Other terms could be relaxed to enable the borrower to repay rather than force the borrower into default. The borrower might have to post additional security. Affiliates of the borrower could be required to guarantee repayment.
There can be tax consequences for both parties.
An outright exchange of an existing debt for a new one could trigger gain or loss. There is also a concept known as a “deemed” exchange; the parties do not have to write a new loan, but they might be considered to have done so if the terms of the existing loan change enough that the loan is considered to have undergone a “significant modification.” The lender will then have to determine whether it has taxable gain or loss by comparing the value of the new loan to its “tax basis” — generally the outstanding loan principal — in the old loan. For example, the lender would have a loss if the market value of the restructured debt is less than the principal amount the lender was owed earlier. Meanwhile, the borrower must determine whether part of its debt has been effectively cancelled, in which case the borrower may have to report “cancellation of indebtedness,” or “COD,” income. Section 108 of the US tax code may excuse the borrower from having to report the income if the renegotiation of loan terms occurred while the borrower was insolvent or going through a chapter 11 bankruptcy proceeding. However, none of these issues arises unless the changes in loan terms rise to the level of a “significant modification.”
Whether a modification or group of modifications is significant enough to be treated as an exchange must be tested against guidelines found in Internal Revenue Service regulations. Under the guidelines, a restructured debt is significantly different than the original debt if the yield on the loan increases by 25 basis points or 5% of the annual yield on the original loan, whichever is greater.
Any “material deferral of scheduled payments” is a significant change. The IRS does not treat a delay as significant as long as the payment is “unconditionally payable” within five years or 50% of the original loan term, whichever is less. The delay is measured from the “original due date of the first scheduled payment.” For example, if the lender of a 20-year loan agrees in year 11 to let interest for the next four years accrue and be paid in a lump sum in year 15, that is not a modification since it is within the limit allowed.
With a few exceptions, changing the borrower on a recourse debt instrument is automatically significant. One exception is where the borrower is acquired by another company in certain kinds of tax-free reorganizations. Even then, the change will be considered significant if there is a “change in payment expectations” on the loan.
Changing the borrower on a nonrecourse loan is never considered significant.
A change in the collateral or other security for a recourse loan is only significant if it causes a change in “payment expectations.” A change in security for a nonrecourse loan is significant if it replaces a “substantial amount” of the collateral. An exception is where the collateral is fungible. A change from recourse to nonrecourse or vice versa is always significant.
Debtors — especially those whose debt is publicly trading below face value — need to approach a potential restructuring by first considering whether it will create taxable COD income.
Unfortunately, this inquiry is more complicated than simply comparing the principal amount of the old debt to that of the new. The amount of COD income is measured by comparing the “issue prices” of the old and new debt. The issue price of a debt instrument is a number that most accurately reflects the instrument’s true value. In determining the consequences of an exchange, the idea is to compare the true values of both instruments to each other, and the issue price of a debt instrument provides a better reflection its value than its “face” or principal amount does. To make a borrower’s analysis even more difficult, different rules apply to determine the issue prices of the old and new instruments.
Starting with the old debt, its issue price in many cases should equal its face amount. However, if the debt was issued at a discount, then its issue price is equal to the price at which the debt was issued, increased by the amount of the discount that has accrued to date on the debt. For example, a company may borrow $700 but promise to repay the lender $1,000 in 10 years when the loan matures. The debt has $300 of “original issue discount, “or “OID.” The issue price of that debt is $700. The $300 discount accrues over the life of the loan. The issue price is adjusted over time to include such accruals. Thus, on any given date, the “issue price” of the old debt is $700 plus the discount that has accrued up to that date.
The issue price of the old debt must be compared to the issue price of the restructured debt to determine whether the borrower has COD income. It does if the issue price of the restructured debt is less.
The issue price of the restructured debt depends on whether either it or the old debt is traded publicly on an established securities market. If either debt is publicly traded, then the issue price of the restructured debt will be its fair market value. This is because that value should be easy to determine by checking the market listings on the date the debt restructuring is concluded. However, if neither debt instrument is publicly traded, then the issue price of the restructured debt is its “face,” or principal, amount. (The face amount is used only if the interest rate charged on the restructured debt is at least equal to the applicable federal rate.)
In practice, COD income is not a problem in debt restructurings where neither of the debt instruments is publicly traded, unless the lender agrees to write off some of the loan principal.
Parties to publicly-traded debt should be very careful about restructuring a debt instrument when it is trading below face value. If the debt is significantly modified in the restructuring, then the borrower will have COD income equal to the amount by which the value of the instrument has dropped below the price at which it was originally issued (adjusted upwards for any accruals of OID). For example, if a borrower restructures a debt with a $1,000 face amount that has dropped in value to $700 and the face amount of debt remains at $1,000 after the restructuring, then the debtor will have $300 of COD income. The amount of COD income is the difference between the face amount of the original debt, which is $1,000 (assuming it wasn’t issued at a discount), and the value of the new bond, $700 (set by reference to the market value of the original debt for which it is being issued).
The borrower can avoid some or all of the COD income in such situations if it can show it is insolvent or by waiting to restructure the debt until it has filed for chapter 11 bankruptcy.
An “insolvent” debtor for this purpose is a debtor whose liabilities exceed the fair market value of its assets. An insolvent debtor does not have to report COD income, up to the amount of its insolvency. However, there is a tax cost: the debtor is required to reduce certain “tax attributes” for every dollar of COD income that escapes taxation. Tax attributes are particular types of tax benefits that the debtor may have, such as net operating losses, tax credits, and capital losses carried forward from prior years. The debtor must reduce any of these items it has in a certain order until the forgiven COD income has been fully absorbed. A debtor may elect to apply the reduction first against its tax basis in any depreciable property it owns. Although this may seem like an obvious choice to make, a lower tax basis will mean lower depreciation deductions going forward, as well as greater taxable gain if the assets are sold.
A borrower might unwittingly also trigger COD income by having an affiliate buy back its debt at a discount in the market.
If a company acquires debt of a related party from an unrelated party, the debtor will be forced to recognize COD income, if any. Such an acquisition could occur in one of two ways. The first way is a direct acquisition of the instrument itself — in other words, the related party buys the debt instrument from the unrelated holder. The second way is an indirect acquisition. This is a transaction in which an unrelated party acquires the debt instrument and then becomes related to the debtor through a corporate acquisition. “Related” generally means that there is more than 50% overlapping ownership between two parties.
Lenders need to be careful that a restructuring does not create taxable gain. This could occur if the restructuring increases the value of the debt. The analysis is the same as for the borrower. A mismatch between issue prices of the old debt and restructured debt is unlikely in practice unless at least one of the debt instruments is publicly traded. A debt restructuring might be structured in form as a tax-free “recapitalization” of the borrower. A lender facing a potential loss might prefer a taxable transaction so that it can claim the loss.
Even if a lender gives up more than it gets in return and thus has an economic loss, it may have to report taxable income from the restructuring. If a debt is restructured between interest dates or in any other situation where accrued interest has not yet been included by the lender in income, a portion of the consideration paid to the lender as part of the restructuring will be treated as the interest on the original debt that has accrued but has not yet been paid. Any such amount is taxable as ordinary income. It will increase the lender’s “tax basis” in the original debt for purposes of determining its overall gain or loss on the restructuring. (Since the loss may be a capital loss, the lender could be whipsawed because that capital loss cannot be used to offset the ordinary income.) A lender may have an argument that no portion of the consideration should be allocable to interest if the debtor is in a questionable financial position and the collectibility of the interest is doubtful. This is an especially important point to keep in mind in cases where the restructuring is prompted by the debtor’s current inability to make payments on the old debt.
Another issue should remain on the radar screen for any holder of a debt instrument who was not the original lender. An example is a “bottom fisher” who buys corporate or project debt in the market hoping to make a profit when the borrower recovers. A bottom fisher is more likely to show a gain after a debt restructuring. If the restructuring leads to a “significant modification” of the original loan, it will trigger a tax on any gain, and — worse still — the tax rules may recharacterize what would otherwise have been capital gain as ordinary income. This means that a corporate holder can only use ordinary losses — as opposed to capital losses — to offset that portion of the taxable gain.
This result stems from the fact that the bargain price paid by the holder when it acquired the debt reflects an economic benefit known as “market discount.” Simply put, assuming the debt is ultimately paid in full, the holder will get back more income than it paid for. A holder of a debt instrument with market discount can either wait to report the market discount as income when the underlying debt instrument is paid off or resold, or the holder can elect to report the market discount as it accrues. Any holder of a debt with unaccrued, unreported market discount will have to recharacterize any gain it has on the restructuring as ordinary income.
Even if a holder has no gain from a restructuring, any market discount on the old debt could affect the holder going forward. This is because the market discount on the old debt will be converted into OID on the new debt if either instrument is publicly traded. This occurs due to the way one computes the issue price of a bond that is publicly traded. The resulting OID will have to be taken into income by the holder over the remaining term of the debt; the holder cannot wait to report it all at once at maturity as it could with market discount. This conversion will occur if two things are true of a debt with market discount: first, either the new or old debt is traded on an established securities exchange and, second, the market value of the old debt has dropped below its face amount.
Conversion into Equity
One option for a struggling debtor with little cash today but decent growth prospects is to offer its creditors stock in exchange for their debt instruments. Some debtors might prefer this route because it can improve a company’s balance sheet at the same time as it reduces interest expense, without any up-front cash outlay. The tax consequences are similar to those of a debt-for-debt exchange (or debt modification): the debtor might have COD income and the lender might have a gain or loss.
The key question is how to value the stock received in the exchange for purposes of calculating the debtor’s COD income and the lender’s gain or loss. The debtor is treated as having satisfied the debt with an amount of money equal to the fair market value of the stock. Therefore, if the stock is worth less than the principal amount of the debt, then the debtor will have COD income.
The lender does the same calculation to figure out whether it has a gain or loss on the exchange. It compares the market value of the shares it received to its tax basis in the debt instrument. If it acquired the debt at a discount from the face amount, it could have a gain. The lender will have to report part of the stock value as ordinary income to the extent there was accrued, unpaid interest on the debt instrument that the lender has not yet included in income at the time of the exchange.
The parties to a debt restructuring might try to structure it as a tax-free “recapitalization.” This only works if the borrower is a corporation. It will not spare the debtor from having to report any COD income, and it may only limit the amount of gain the lender must recognize as taxable income.
A recapitalization can take many forms, but it is generally described as a reshuffling of a corporation’s capital structure. Examples include an exchange of new debt instruments for old ones, or the issuance of corporate stock in exchange for the cancellation of an old debt instrument. As long as a transaction is motivated by business — as opposed to tax avoidance — concerns, many structures are acceptable. One exception is that a stockholder cannot convert its shares into debt and call it a recapitalization. (It will be viewed as an outright sale of the shares.) Another requirement is that the instruments being exchanged must either be corporate stock or “securities.” Although the definition is not precise, securities are generally understood to be obligations of a corporation to pay a certain sum of money. Generally a debt must have a term of at least five years to be considered a security, but other terms of the instrument are important as well.
A debtor reaps no benefit from structuring an exchange as a tax-free recapitalization; it can only benefit the lenders. Lenders who would otherwise have to report a gain from the restructuring might find such a structure appealing.
A lender has taxable gain in a tax-free recapitalization only to the extent it receives “boot” in the transaction. “Boot” is consideration other than common stock, some forms of preferred stock, and securities. An example of boot is cash.