Altering the Terms of a Debt Instument
Altering the terms of a debt instrument can sometimes have tax consequences.
However, the IRS ruled privately that there were no such consequences in a case where the borrower — a corporation — essentially disappeared by converting into a limited liability company that was “disregarded” for tax purposes.
Companies should exercise caution before changing the terms of an outstanding loan. Under IRS rules, after any “significant modification” of a debt instrument, the parties to the loan are treated as if they exchanged a new debt for the old one. If the “issue price” as determined for tax purposes of the “new” loan differs from the issue price of the old loan, then one of the parties to the loan will have a taxable gain and the other a loss. The hypothetical exchange of the old debt for the new one will trigger a tax on the gain.
This is unlikely to be a problem in practice unless the debt instrument is publicly traded.
Examples of a change in terms that the IRS considers significant are a change in the borrower of a recourse debt, a change in yield of more than 5%, or if greater, 25 basis points on a debt with a fixed amortization schedule, or a change in a substantial amount of the collateral and guarantees that secure a nonrecourse debt.
In the case addressed in the IRS ruling, a parent corporation issued five series of publicly- traded debentures that were essentially recourse loans to the parent. However, the holders of the debentures could exchange them for a number of shares of subsidiary or parent corporation stock.
The parent corporation merged with another company and became a subsidiary of a new parent corporation. It then converted into a limited liability company that was “disregarded” for tax purposes, meaning that it essentially disappeared. This had the effect of making the new parent corporation the obligor under the debentures for tax purposes. At the time, the debentures were trading substantially below their issue price, so there would have been tax if there was a change in obligor.
The IRS ruled privately that there was not. It said even though the original obligor disappeared for tax purposes, it was still there as a corporate legal matter and nothing had changed for anyone but tax lawyers. It said it would look to state corporate law in such cases to see to see whether anything has changed.
The ruling is Private Letter Ruling 200630002. The IRS made the text public in late July.
Although the ruling was helpful to the taxpayer, it is a warning not to assume that “disregarded entities” are always ignored. Even though IRS regulations say that such entities are ignored for almost all tax purposes, the IRS continues to chip away at this principle in rulings.