By Eli Katz and Jenny Kim

Special-purpose companies created to develop, finance and operate large power and infrastructure projects have not been immune to the growing credit crisis. Owners of these project companies are often surprised to learn that they face significant tax consequences as they attempt to renegotiate the terms of the project debt.

These tax consequences result from broad application of a rule that requires a borrower to pay taxes when its debt is cancelled. A borrower may also trigger a tax when the debt is merely restructured.

This rule applies so broadly that it has consequences for nearly all project debt workouts, even those where only relatively minor changes are made to the project debt. It also affects debt-for-equity swaps and comes into play when project owners buy out the project debt.

In many cases, the project owners will find themselves saddled with a large tax liability at a time when they are least able to pay it. The size of this tax liability will often depend on the type of restructuring undertaken as well as the extent of the planning done to avoid or minimize these taxes. Project owners working in close cooperation with their lenders can minimize and even eliminate tax liabilities entirely when they restructure project debt. The key to accomplishing this is to identify the issues early in the restructuring phase and work closely with all project stakeholders.

Background

A typical project is owned by one or a small number of project owners who actively manage the the project’s assets. The project is financed through equity contributions by the sponsor and large amounts of project debt held by banks and other financial investors. The project debt is usually concentrated with a small group of lenders, but can be held more widely and managed by an agent chosen by the lenders.

Some projects were still in the development or construction phases when credit conditions rapidly tightened. The lenders to these projects have begun to advance funds more slowly and demand more security from the project sponsors. Other projects are well into the operating stage and are finding their operating margins squeezed due to a non-performing offtaker or increased costs to operate the project. In either case, the lenders and the project owners have begun the search for ways to reduce or restructure the debt to keep the project afloat.

The tax structure common to project finance debt is what creates some of the pitfalls as well as the opportunities.

In most cases, the project owners are responsible for the project company’s tax liability. This is because projects are usually held in a special-purpose entity that is either “disregarded” for tax purposes — it is considered for tax purposes to be held directly by the project owners — or is a tax partnership among a small number of project owners. The project debt is usually nonrecourse to the owners of the project; it is secured only by the assets and the contracts of the project. Also, the assets of an operating project are frequently written off, or depreciated for tax purposes more quickly than they are for book purposes, resulting in the undepreciated tax basis of the project assets being lower than its outstanding debt balance.

When Project Debt is Cancelled

Anyone whose debts are cancelled by a lender must pay taxes on the cancelled debt. This rule applies to a wide range of possible transactions. In its simplest application, the project owners are taxed if the project debt is cancelled or paid off by the borrower at less than face value. The borrower owes tax on the difference between the face value of the note and the value given to pay off the note.

Even when the project debt is not formally cancelled or reduced, project owners can be penalized if they renegotiate the terms of their project debt or convert the project debt into an equity stake in the project company.

When project debt is changed in a “significant” way, the tax rules create the fiction that the “old” project debt has been cancelled in exchange for new and restructured project debt. This fiction is maintained whether or not the old debt instrument is formally cancelled or whether a new debt instrument is actually delivered. The act of changing the terms of the loan is what triggers this result. If the new restructured debt is valued at less than the face amount of the old debt, the project owners can get stuck with a tax bill for the shortfall.

Project owners who convert project debt into an equity stake in the project are just as likely to trigger a tax. In a fairly common workout technique, the project lender exchanges its loan for an equity stake (usually a preferred equity stake) in the project company. In this case, the project company is considered to have paid off the debt for the fair value of the equity stake that it gave to the lender. If this equity stake is worth less than the outstanding balance on the loan, then the project will owe tax on the difference.

Thankfully, there are a few exceptions that can protect project owners from owing tax when the project debt is renegotiated. The three most likely to apply are the bankruptcy exception, the insolvency exception and a special exception for loans that are used to buy real estate. The bankruptcy exception allows the project owners to avoid tax if the restructuring happens during a title 11 bankruptcy proceeding and the project debt is discharged by the bankruptcy court. The insolvency exception lets the project owners escape tax if the restructuring occurs when the project owners are insolvent. The real estate exception can be helpful to a project that is comprised of a significant amount of real estate.

Using any of these exceptions does not come free to the project owners. Project owners who avoid tax under these exceptions must reduce their tax attributes (or tax assets) up to the amount of debt that was cancelled. These tax assets include net operating loss carryforwards, existing tax basis in project assets and unused tax credits. Trading tax assets to avoid a current tax liability is usually advantageous. It allows current tax to be deferred at no cost to the project owners because the tax assets are used to reduce current tax instead of tax liability in the future.

Project Workouts

Virtually all project debt restructurings raise a potential tax issue for project owners. In each case, it must be determined whether some of the debt has been “cancelled” under the tax rules and, if so, how much tax is still owed.

Typically, a restructuring of project debt involves some combination of the following techniques: the lender can forbear on its rights to demand payment on the debt for some period of time or renegotiate the financial covenants or debt service coverage ratios in the loan agreement. The parties may negotiate to defer a portion of the scheduled loan payments or agree to reduce the principal balance of the outstanding debt. Other commonly-used approaches include changing the rate of interest or life to maturity of the debt, or charging the project a restructuring or other accommodation fee to allow changes to the loan agreement. Some project lenders will require a project owner or other creditworthy entity to guarantee the debt or attempt to exchange the project debt for an equity interest in the project company.

Debt-for-Debt Exchanges

The Internal Revenue Service has regulations that describe when a modification to project debt will be considered significant enough to be considered an exchange of one debt instrument for another. These regulations give no weight to whether or not the parties physically “exchange” one note for another, or whether or not the lender formally cancels the first note and creates a second one. Regardless of the form the parties use to document the change to the terms of the project debt, the change will be considered an exchange of one note for another if the cumulative changes are a “significant modification” under these rules.

The regulations spell out specific changes that are considered significant, and also provide a general rule for types of changes that are not covered in the specific categories. The IRS has set a fairly low threshold for changes to project debt that will result in a significant change. The result is that many project loan workouts will be considered a debt-for-debt exchange.

If the yield on the debt is changed by an amount greater than 25 basis points per year, or 5% of the annual yield of the original project debt, the change will be considered significant. There is an important exception to this rule for yield changes that are triggered by operation of the original loan agreement. For example, it is not a significant modification if the original loan agreement allows the lender to increase the interest rate on the project debt in the event of a project downgrade or other agreed-upon circumstance. Deferral of a scheduled loan payment is significant if the deferral period is longer than the lesser of five years or 50% of the original term of the loan. Scheduled payments may be deferred by extending the maturity date of the loan or by simply deferring one or more payments due before the loan matures. A deferral of even a small payment all the way to the maturity date of the loan may well be considered significant if the maturity date is more than five years away.

Unsurprisingly, a change in the obligor under a nonrecourse project debt is not considered significant. The identity of the obligor under a nonrecourse loan is of little importance where the project lender must look solely to the project assets to recover its loan. Conversely, a change in the collateral or other forms of credit enhancement that secure the project debt will be considered significant, subject to a few limited exceptions. Requiring a project sponsor (or other creditworthy entity) to guarantee the project debt will almost always be significant, unless the guarantee does not change the project lender’s expectation of receiving payment under the loan. It is often difficult to argue that a sponsor guarantee does not change payment expectations when the lender specifically negotiates for this feature in a project debt restructuring.

Additionally, it is a significant change if the project debt is exchanged for an equity interest in the project. There are at least two ways for a change of this type to occur. First, the lender can cancel its debt in exchange for membership interests in the project company that are clearly defined as equity interests. Alternatively, the lender can continue to hold an interest that is defined as debt but, for tax purposes, might be reclassified as an equity interest after it is modified. Drawing the line between debt and equity interests in a troubled project company can be a challenging endeavor. Some of the factors that might indicate that the project debt is in fact an equity interest include no fixed maturity date, relaxed default rights, the project company’s debt-to-equity ratio and conversion or participation rights in the project.

As a general matter, changes to customary financial or accounting covenants from the project company are not significant. There is very little guidance on what is a “customary” covenant in the project financing arena, making this rule difficult to apply with any degree of certainty.

Aside from these specific categories, a change to project debt can be significant if the nature and degree of the change is economically significant based on all the facts and circumstances. When testing whether or not a change is significant, successive changes are tested on a cumulative basis. For example, if the yield on project debt is changed first by 15 basis points a year, and then is later changed again by another 15 basis points, then the cumulative change of 30 basis points may be significant under these rules.

In some project finance workouts, the lender will require a change to the interest rate or allow for a deferral of certain payments only if certain contingencies happen. One possibility might be that if the project EBIDTA falls below a certain benchmark, the interest rate will ratchet up to a higher level. Changes to the loan agreement might be dependent on future contingencies, for example, if the loan is changed so that if project EBIDTA falls below 1.2x debt service, the interest rate is increased by 50 basis points per year. There is no clear answer as to how much weight to give the likelihood of the contingency happening when measuring whether a change is significant.

When a debt workout is a debt-for-debt exchange under these rules, the project owners will owe tax on the difference between the principal balance of the old debt (before it is restructured) and the amount paid to cancel the old debt. The payment to cancel the old debt is the new restructured debt delivered to the lender. If the old debt was cancelled for a payment (issuance of the restructured debt) that is less than the principal balance outstanding on the old debt, then the project company will owe tax on the difference between these two amounts. The value of the new debt is its “issue price.”

While the issue price of the new debt is generally equal to its principal balance, there are at least three situations where this is not the case. First, if the old debt is considered by the tax rules to be “publicly traded,” then the issue price of the new debt is the fair value of the old debt and not the principal balance of the new debt. Second, if the new debt is considered “publicly traded,” then the issue price of the new debt is the fair value of the new debt and not its principal balance. Third, even if both the old debt and the new debt are not publicly traded, the issue price of the new debt might be less than its principal balance if the new debt has an interest rate that is below the lowest “applicable federal rate” (currently around 4%) in effect in the three months preceding the restructuring.

The tax definition of “publicly traded” sets a far lower threshold than the commonly understood meaning of this term. Debt is publicly traded under this rule if it is either “exchange listed property,” which is property listed on a national securities exchange or certain interdealer quotation systems registered by the US Securities and Exchange Commission, or “market traded property” which is property traded on certain boards of trade or on an “interbank market.” An interbank market means an informal market consisting of a group of banks or other financial services companies holding themselves out to the general public as being willing to purchase, sell or otherwise enter into certain transactions. Some project finance loans might fall within this category as one can find a bank or other finance company willing to purchase or sell many types of debt paper. Debt is also publicly traded if it appears on a “quotation medium.” A quotation medium means a system of general circulation that provides a reasonable basis to determine fair market value by disseminating either recent price quotations of one or more identified brokers, dealers or traders or actual prices. Lastly, debt is publicly traded if price quotes are readily available from brokers, traders or dealers. Like a number of the former categories, it is possible to obtain a quote on virtually any debt paper in the market increasing the risk that project finance debt call fall within this category.

A simple example illustrates how the project company should compute the amount of tax it owes when it restructures its debt in a significant way and causes a debt for debt exchange: Project company has $1 million of debt outstanding that pays interest at 10% annually. As part of a workout with its lender, the interest rate is increased to 12% annually in exchange for the lender agreeing to lower the required debt service coverage ratios. The outstanding principal balance remains at $1 million. The change to the interest rate is a significant modification because it exceeds 25 basis points. Therefore, the project company is considered to have paid off the old debt by issuing new debt. Assume the project lender then sells 50% of the debt for 80¢ on the dollar. If the new debt is “publicly traded,” then the project company will owe tax on $200,000 of cancelled debt. The new debt is valued at $800,000, even though the principal balance is $1 million. The project company has paid off a $1 million debt by paying $800,000. If the new debt is not “publicly traded,” then the project company owes no tax and a far more sensible result is reached. It paid off debt of $1 million with a new note with a face value of $1 million.

As is obvious from this example, borrowers with publicly-traded debt are significantly disadvantaged by this rule. Indeed, the project company is economically worse off after the restructuring — it owes the same $1 million except now it must repay the debt at a higher rate of interest. The tax result adds insult to injury as the project company now owes tax on $200,000 of cancelled debt. The project owners will get this $200,000 back from the government sometime in the future as they pay down the principal balance of the loan. The tax rules allow the project owners to amortize the $200,000 as a tax deduction over the life of the note. The project owner, however, loses the time value of money as it pays current tax in exchange for a deferred tax deduction.

Debt-for-Equity Swaps

Prior to 2004, a project lender was able to convert its project debt into an equity stake in the project company without causing any tax consequences to the project company and its owners. This technique was often used to avoid the unfavorable tax results that could result from modifying project debt. Lenders could structure the equity interest as a preferred interest that had many of the protections and advantages of project debt while at the same time avoiding tax penalties to the project company.

Congress changed this rule in 2004. Since then, if a project company converts its debt into an equity stake, the project company will owe tax if the value of the equity stake is less than the principal balance of the loan. When it enacted this rule, Congress left open the critical question as to how to value the equity stake in a project.

The IRS recently issued proposed regulations that addressed this question. The IRS said that if certain rules are followed, the equity stake could be valued using a “liquidation value” approach. This approach values the equity stake as the amount of cash the lender would receive if the project company immediately sold all its assets in the open market and distributed the cash to the lender. The liquidation value, then, is the starting capital account that the lender is given when it receives its equity interest in the project company. Allowing the project to value the lender’s equity stake at liquidation value is usually advantageous. Without this approach, the project company might be forced to reduce the value assigned to the lender’s equity stake by a minority or illiquidity discount. The liquidation approach should enable the project company to increase the value given to the lender’s equity stake and reduce the amount of its tax bill.

A project company can take advantage of the liquidation value approach only if it follows a number of rules. First, the project company must maintain capital accounts in accordance with the tax regulations. Second, all parties to the exchange must use the same valuation number for all tax purposes. Third, the exchange must be done at arm’s length. Lastly, there can be no plan for the project to redeem or buy the lender’s interest and avoid tax on cancelled debt.

While these proposed regulations are generally favorable to the project company, they create some tax difficulties to the lender. In a debt workout, the lender is most concerned with getting an immediate tax loss for the decline in value of its investment. If an economic decline cannot be matched with an immediate tax benefit (tax writeoff), the economic pain to the lender is increased. The lender must then defer the tax benefit associated with the current economic decline. The proposed regulations do not allow the lender to take the tax writeoff when it exchanges its debt interest for an equity stake in the project; it must defer the tax loss until it sells the equity stake in the project company. This result may make it more difficult to get lenders to agree to debt-for-equity swaps in project debt workouts.

Possible Approaches for Troubled Projects

The primary tax concern for project owners during a workout will be avoiding or minimizing a tax penalty associated with a restructuring. While each workout negotiation will be different, the project owners have a variety of approaches for dealing with this tax problem.

In the case where the principal balance of the note remains unchanged during the workout, but there are changes to the terms of the debt, the project owners might attempt to keep the changes below the “significant” threshold described in the IRS regulations.

In situations where the changes necessitated by the workout are too pervasive to remain below the “significant” threshold, the project owners will need to determine the likelihood that the debt will be considered “publicly traded.” If the debt is widely held among a syndicate of lenders, the risk of it being publicly traded is increased. Whether or not the debt is publicly traded, once the debt is changed in a significant way, the project owners should determine how much tax is owed on account of this change. The tax is calculated by reference to the “issue price” of the restructured debt. The difference between the issue price of the new debt and the outstanding balance on the old debt will generally equal the amount of income upon which tax will be owed.

If the new project debt is publicly traded, then the issue price will be its fair value. The fair value of the debt of a troubled project company is likely to be below the face value of the old debt resulting in a potential tax liability to the project owners. If the project debt is not publicly traded, then the project company should be able to avoid tax if the principal balance of the debt is not reduced and the interest rate is at least as high as the three month applicable federal rate.

In the situation where a project company has restructured its debt, it can try to eliminate or reduce its tax liability by making use of the insolvency or real estate exceptions. To claim the insolvency exception, each project owner (and not the project company) must demonstrate its insolvency. A project owner is insolvent if its pre-workout liabilities exceed the fair value of all its assets. Ordinarily, there will be no objective measure of the fair value of the project owner’s assets and therefore no way to measure if it is insolvent. Project owners that intend to rely on the insolvency exception should consider hiring an expert to value its assets before the restructuring. The real estate exception requires a detailed review of the assets of the project to see if any of them qualify as “real estate” under a set of detailed tax rules.

When project owners cannot otherwise use any of the exceptions to avoid tax, they should consider swapping the lender’s debt for an equity stake in the project. In order to avoid tax on this exchange, the lender’s starting capital account must equal the principal balance of the project debt immediately before the swap. The equity stake can then be structured to offer the lender a preferred return or other form of guaranteed payments to enable it to achieve an economic return similar to had it restructured the project debt. This last technique is obviously only possible in close cooperation with the lender and requires identifying and working toward this solution at an early stage.

A final approach worth considering in appropriate circumstances is for the lender to contribute its note to a joint venture between the lender and the project company. As long as the project company holds less than 50% of the economics of this joint venture, no tax should result from the transfer. The borrower and the lender can then attempt to structure the lender’s return in a way that resembles the economic position it would have achieved had it simply restructured the note.