This article first appeared in PEI Manager, February 2009. Copying without permission from PEI Manager is unlawful. It is reprinted here with permission.
In the second in a two-part series on debt buybacks, Steven Bortnick, Bradley Boericke and Timothy Leska explore the tax implications of structuring a debt purchase. In the January issue, they examined the legal implications.
Debt instruments used to fund private equity transactions currently are trading at significant discounts. These market conditions have caused private equity firms to consider purchasing the debt of their acquisition companies (ACs). The purchase by a fund of a debt instrument issued by one of its ACs can be economically lucrative, but the tax consequences of these acquisitions must be understood to fully evaluate their merit. This article describes the tax consequences of three alternative structures that a private equity fund can implement to acquire the debt of its ACs, and then highlights some of the legal considerations involved in the purchase of debt.
Acquisition Company Acquires the Debt
For US tax purposes, gross income includes income from the discharge of indebtedness. Thus, subject to several exceptions (the two most important exceptions to the rule that discharge of indebtedness produces gross income relate to a discharge pursuant to a case under the US bankruptcy code and a discharge to the extent that the taxpayer is insolvent) a debtor must recognize cancellation of indebtedness (COD) income upon the satisfaction of its indebtedness for less than the amount due under the obligation. The amount of the COD income is generally the difference between the amount due under the obligation and the amount paid by the debtor. Accordingly, unless an exception applies, an AC will recognize COD income upon its purchase of its debt obligation at a discount.
Where the AC is a US corporation, the recognition of COD income requires the AC to either pay tax (which could be substantial in the case of a large buy back at a significant discount) or use up valuable net operating loss carryforwards. Additionally, if the AC is a corporation (US or foreign), the earnings and profits of the corporation will generally be increased by the COD income. This increase in earnings will make it more likely that the corporation’s distributions will be taxable dividends to its shareholders.
Alternatively, if the AC is classified as a partnership for US tax purposes, the COD income will be allocated among the partners. The US partners of the AC (and of the fund) generally will be subject to tax on the COD income recognized by the partnership. Although AC’s that incur debt typically are formed as corporations to avoid the recognition of UBTI by US tax exempt investors, COD income (whether recognized by a US corporation or US partners of an
AC formed as a partnership) may require the payment of US tax on income without a corresponding receipt of cash (dry income).
Finally, because the debt is extinguished, the AC no longer will incur interest expense that otherwise would be available as a tax deduction to shelter its income.
Fund Acquires the Debt
If a party related to the debtor acquires an outstanding debt from a creditor who is not related to the debtor, the debtor is treated as acquiring the debt. Thus, if the related party acquires the debt at a discount, the debtor must recognize COD income consistent with the principles discussed above. The term “related party” is defined broadly for purposes of this rule and whether the fund is related to the AC will depend upon the particular facts of the investment. However, depending on the structure of the fund and its proportionate interest in the debtor, it may be possible to avoid the COD related party rules.
If the debt instrument acquired by the fund was originally issued with original issue discount (OID), taxable investors in the fund will recognize dry income. OID is the excess of a debt’s stated redemption price at maturity over its issue price, and accrues over the instrument’s term as taxable interest income to the holder and as deductible interest expense to the debtor. In addition to any OID with which the debt instrument originally was issued, where an AC realizes COD income by reason of the related party rules, it is deemed to issue a new debt to the fund with an issue price equal to the amount the fund paid for the instrument. This will create or increase OID on the “new” debt instrument.
In addition to OID, the market discount rules may come into play when a fund acquires an AC’s debt at a discount. Market discount is equal to the difference between a debt’s stated redemption price at maturity and the holder’s purchase price for the debt (or, in the case of a debt instrument issued with OID, the excess of (1) issue price plus prior OID accruals over (2) the holder’s purchase price). Under the market discount rules, gain generally must be recognized as ordinary income on the disposition or redemption of the bond to the extent of the market discount, even if the transaction is one in which gain is generally not recognized. Although market discount accrues ratably on a daily basis, (taxpayers can elect to accrue market discount on a constant interest basis rather than on a ratable basis; market discount accrues slower using the constant interest basis, and, therefore, funds should consider making this election if the amount of market discount is significant enough to warrant the additional computational complexities, particularly where the debt also contains OID, under this method) a taxpayer does not recognize income from market discount until a disposition or redemption of the bond (unless the taxpayer otherwise elects). Thus, if the value of the bond appreciates faster than the market discount accrues, the fund can recognize capital gain on its disposition or redemption of the bond. Where an AC realizes COD income upon the fund’s purchase of its indebtedness, the market discount rules will not apply because the debt will be deemed reissued and market discount essentially will be converted into OID.
The fund’s purchase of its AC’s debt can preserve the interest deduction of the AC for US tax purposes because the debt is not extinguished. However, the use of the interest expense comes at the potential cost of US tax on the fund’s investors at ordinary rates, both during the period the debt is outstanding (as dry income) due to the OID rules, and on a disposition of the debt due to the market discount rules. Moreover, the deductibility of interest incurred to acquire a market discount bond is limited in certain instances.
Special Purpose Vehicle (SPV) Acquires Debt
This structure also preserves the interest deduction at the AC level. As in the case of the acquisition by the fund, it is necessary to determine whether the SPV is related to the AC, and, whether the purchase of the debt therefore gives rise to COD income to the AC. Although the fund would not hold the debt directly, the fund’s investors still may recognize dry income if the special rules applicable to controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs) apply.
A CFC is a foreign corporation more than 50 percent of its stock (by vote or value) of which is owned by US taxpayers (including domestic partnerships) who own 10 percent or more of the voting stock of the foreign corporation. If a foreign corporation is a CFC, US taxpayers who own, directly or by reason of special attribution rules, 10 percent or more of the voting stock of the CFC must include certain types of the CFC’s income currently. The most common type of income that must be currently included under the CFC rules is passive income, such as interest income and capital gains. Thus, if an SPV is a CFC, certain US taxpayers of the fund may recognize dry income on any OID that accrues (and any market discount or capital gain recognized by the SPV).
If a foreign corporation is a PFIC, US taxpayers owning stock, directly and indirectly, in the corporation must either (1) include in income the earnings of the corporation currently as dry income, (2) include the earnings in income but defer payment of tax (subject to an interest charge), or (3) defer recognition of income until a distribution or disposition of the corporation’s stock but recognize ordinary income (and pay interest on their deferral) rather than capital gain. Generally, a PFIC is a foreign corporation at least 50 percent of the assets of which give rise to passive income, or 75 percent of the gross income of which is passive income. However, investment in a debt instrument may not be viewed as giving rise to passive income if it is issued by a party related to the PFIC (except to the extent the related payor earns passive income). Because the definition of a related party under this PFIC rule is similar to the definition of related party under the COD income rules, COD income and dry income in the SPV structure will likely bear an inverse relationship. That is, if COD income is avoided, dry income (or the other harsh PFIC alternatives) can arise, and if COD income is recognized, dry income (or the other harsh PFIC alternatives) can be avoided. However, depending on the structure of the fund and its proportionate interest in the debtor, it may be possible to avoid both COD income and dry income.
Other considerations include whether interest paid to the SPV will be subject to withholding tax, whether the SPV will be subject to tax in its home country and whether distributions from the SPV will be subject to withholding tax. If the debt issuer is a US entity and the SPV owns (constructively) at least 10 percent of the issuer, interest will not be exempt from withholding under the portfolio interest rules. However, if the SPV is formed in a country that has a treaty with the US and the limitation on benefits provisions are satisfied, the treaty may reduce or eliminate withholding on the interest.
Possible Relief from COD Income
On January 6, 2009, Senator Ensign (R-NV) introduced a proposal in the Senate to exclude from taxable income COD income arising from the discharge of “applicable financial indebtedness” recognized in 2009 and 2010. If applicable, this proposal would apply to COD income otherwise arising on the repurchase of debt by the issuer or a related party, or the modification of a debt instrument. It also would exclude such COD income from the issuer’s earnings and profits and prevent the conversion of market discount into OID. It is not yet possible to know whether this proposal will ultimately be enacted. Moreover, in its current form it is unclear how helpful this provision would be to ACs, as, on its face, it does not appear to apply to holding companies and only applies to debt issued to certain financial institutions (not including mezzanine funds and hedge funds). However, funds should monitor the proposal given the potential tax savings it potentially offers.
Steven D. Bortnick , J. Bradley Boericke and Timothy J. Leska
The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.