As market conditions continue to depress the value of outstanding debt, private equity funds and other debt issuers have the opportunity to acquire their indebtedness at significant discounts. The American Recovery and Reinvestment Act of 2009 (the Act), signed in to law by President Obama on February 17, will further encourage such acquisitions and debt modifications by deferring the tax costs associated with such transactions.
The Act modifies the rules applicable to cancellation of indebtedness (COD) income. For U.S. tax purposes, gross income includes income from the discharge of indebtedness. Thus, unless an exception applies,1 a debtor recognizes taxable COD income upon the satisfaction of its indebtedness for less than the amount due under the obligation. COD income also may be recognized where modifications to an existing debt obligation rise to the level of an exchange for tax purposes,2 as well as upon the purchase of debt by a party related to the debtor from an unrelated creditor. The amount of the COD income generally is the difference between the amount due under the obligation and the amount paid (or deemed paid) by the debtor or its affiliate.
The Act does not change the circumstances giving rise to COD income, but rather changes when the debtor pays tax on the income. If a debtor “reacquires” an “applicable debt instrument” (ADI) after December 31, 2008 and before January 1, 2011, the debtor can irrevocably elect to defer recognition of any COD income (by filing a statement with its tax return for the year of the reacquisition) and include it ratably over a five-year period that begins in 2014.
This alert highlights the Act’s tax benefits as well as planning opportunities that private equity funds and issuers of debt should consider when buying back debt. Unless otherwise noted, in each example it is assumed that a fund (Fund) established an acquisition vehicle (Debtor) that incurred indebtedness from a lender (Creditor) to acquire 100 percent of the stock of a target corporation. It is further assumed that, unless otherwise noted, no other exceptions to the recognition of COD income apply.
I. Qualification, Income Timing, and Election Considerations: In General
Example 1 – Repurchase by Corporation for Cash: Debtor, a C corporation, borrowed $10 million from Creditor pursuant to a note providing for a fixed rate of interest, payable annually. All interest has been paid under the note. In 2009, Debtor transfers $8 million from its cash reserves to Creditor in complete satisfaction of Debtor’s obligations pursuant to the note. Debtor realizes $2 million of COD income in 2009.
Qualification Under the Act. An ADI includes any debt instrument issued by a C corporation. A qualifying reacquisition is an acquisition of an ADI by the Debtor that issued the ADI or by a related person to such Debtor. The term acquisition includes (1) acquisitions for cash, (2) the exchange of the ADI for another debt instrument, (3) the exchange of the ADI for corporate stock or a partnership interest, (4) the contribution of the ADI to capital, and (5) the complete forgiveness of the ADI. Thus, Debtor’s transfer of cash in exchange for the note is a qualifying reacquisition under the Act. Therefore, Debtor is eligible to defer the $2 million of COD income.
Deferral. If Debtor is eligible and elects to defer the COD income under the Act, the $2 million of COD income will be deferred until 2014, at which point Debtor will include the $2 million of COD income in gross income ratably over the following five-year period ($400,000 each year).
Tax Attributes. If the Debtor does not have net operating loss carryfowards (NOLs) or other tax attributes that can shelter the COD income, Debtor should make the election to avoid using cash to satisfy a tax liability in 2009. If the Debtor has NOLs, Debtor will need to determine whether using the NOLs currently is more beneficial than the deferral of tax. This may arise in cases in which the NOLs are set to expire in the year of the reacquisition of the ADI.
Loss of Interest Deduction. Because the debt is extinguished, Debtor will no longer incur an interest expense that would otherwise be available as a tax deduction to shelter its income. The loss of this deduction going forward must be taken into account when evaluating whether the debt repurchase makes sense.
Earnings & Profits. Unlike a predecessor proposal, the Act does not indicate whether a C corporation’s earnings and profits are increased when the COD income is realized (i.e., in the year of reacquisition) or whether they are increased as the deferred COD income is recognized. We hope that the Internal Revenue Service (IRS) will address this issue in regulations, because the amount of earnings and profits a corporation has determines the extent to which a distribution is taxable as a dividend.
Application of other COD Income Exceptions. If Debtor is insolvent, Debtor could exclude the COD income to the extent it was insolvent. In such case, Debtor would reduce its tax attributes to the extent it excluded COD income. If Debtor elected to defer the COD income, the election would trump the insolvency exception (and other COD income exceptions). Accordingly, before making the election, a Debtor should consider whether it would be more beneficial to apply a COD exclusion (with the corresponding tax attribute reduction) rather than to defer the tax cost of the COD income (with no tax attribute reduction).
Example 2 – Repurchase by Partnership for Cash: Same facts as in Example 1, except that Debtor is a partnership.
Qualification. Although an acquisition of debt for cash is a qualifying reacquisition, whether Debtor’s note is an ADI will depend upon whether Debtor’s activities rise to the level of a trade or business. A debt of a taxpayer that is not a C corporation is an ADI only if it was issued in connection with their trade or business. Because Debtor is a holding company, it may not be viewed as engaged in a trade or business, and therefore may not be eligible to make the deferral election.
Phantom Income. COD income will be allocated to Debtor’s partners, and, if Debtor’s partners cannot shelter the COD income, the partners will be recognizing income without a corresponding receipt of cash (Phantom Income). Other COD income exceptions (such as insolvency or bankruptcy) apply at the partner level. However, the deferral election is made at the partnership level. Thus, the partners may have different views regarding whether the election should be made.
Special Rules Applicable to Partnerships. To prevent changes in the membership of the partnership after a debt buy-back from changing the partners to whom the deferred COD income is allocated, the Act requires that partners of Debtor at the time of the reacquisition be allocated the COD income as it is recognized. In addition, the Act contains a helpful technical rule that prevents the reacquisition of an ADI from resulting in gain to partners by reason of the deemed cash distribution that occurs when partnership liabilities are reduced. For example, the Fund would be deemed to receive a distribution equal to the reduction in its share of Debtor’s liability. However, this deemed distribution is deferred to the extent it would cause the Fund (and therefore its taxable U.S. partners) to recognize gain.
II. Original Issue Discount/Related Party Acquisitions
If the stated redemption price at maturity of a debt instrument exceeds its issue price, the debt instrument carries original issue discount (OID). OID accrues over the instrument’s term as taxable interest income to the holder and as deductible interest expense to the Debtor. In the context of an acquisition of debt by a party related to the Debtor, the Debtor is deemed to issue a note to the related party purchaser for an issue price equal to the related party’s acquisition cost. Where the debt was acquired at a discount, the debt will invariably contain OID.
To avoid a windfall (i.e., deferring income and creating a deduction), the Act defers the Debtor’s deduction for OID accruals arising from the reacquisition of an ADI until the COD income is included in income.3 Notably, the holder of the OID instrument will continue to recognize OID as it accrues.
Example 3 – Repurchase by Related Party Purchase for Cash: Same facts as in Example 1, except that the Fund acquires the note from Creditor for $8 million. Assuming the Fund is a related party to Debtor, Debtor realizes $2 million of COD income in 2009.
Deferral. An acquisition of debt by a related party for cash is a qualifying acquisition, and, therefore, Debtor can elect to defer the COD income and include it ratably in 2014-2018.
OID. Debtor is deemed to issue a note to the Fund with an issue price of $8 million and a stated redemption price at maturity of $10 million, and therefore the “new” note contains $2 million of OID. If the Debtor elects to defer its $2 million of COD income, it must also defer the deduction for its OID accruals. The Fund, however, will continue to recognize the corresponding OID income, and its U.S. taxable investors will therefore recognize Phantom Income.
Use of SPV. If the Fund instead established a special purpose vehicle (SPV) that is a foreign entity classified as a corporation for U.S. tax purposes to acquire the note for $8 million, then assuming the SPV is related to Debtor, Debtor still would realize $2 million of COD income that it can elect to defer. Debtor also would be deemed to issue a note to SPV that has $2 million of OID, and the deductions for which will be deferred until COD income inclusion begins in 2014. However, U.S. taxable investors would only recognize Phantom Income on the SPV’s OID accrual if the SPV were a controlled foreign corporation (CFC) or a passive foreign investment company (PFIC).4
Example 4 – Debt Modification: Same facts as in Example 1, except that, in 2009, Debtor and Creditor agree to extend the maturity date of the note, but do not otherwise change the terms of the note.
Qualification. A significant modification of a debt instrument (including the extension of the maturity date in certain situations) is treated as an exchange of a new debt instrument (the modified instrument) for an old debt instrument (the unmodified instrument). If the issue price of the new instrument is less than the amount the Debtor is considered to owe under the old instrument, COD income will arise. For example, the issue price of the new instrument will equal its fair market value if the instrument is publicly traded, and, if the fair market value is less than the amount the Debtor is considered to owe, the Debtor will realize COD income. Under the Act, significant modifications treated as exchanges are treated as qualifying acquisitions of debt instruments, and, therefore, any COD income realized from the significant modification of an ADI can be deferred at the Debtor’s election.
OID. If the issue price of the “new” instrument is less than its stated redemption price at maturity, the new instrument will contain OID. Debtor’s deductions for such OID will be deferred until 2014.
Suspension of AHYDO Deduction Limitation. As noted above, an issuer of an OID obligation can generally deduct accruals of OID. However, if a corporation issues an applicable high-yield debt obligation (an AHYDO),5 the corporation is prohibited from deducting a portion of the OID accrual, and the remainder cannot be deducted until paid. The Act suspends these rules for certain AHYDOs issued after August 31, 2008 and before January 1, 2010 (unless the period is extended by the IRS), including those issued in a debt-for-debt exchange (or deemed issued in connection with a modification). For the Act’s suspension rule to apply, the AHYDO cannot be issued to a related party (and therefore would not apply to Example 3). Therefore, the Act may permit a Debtor to deduct OID that would otherwise not be deductible.
III. Acceleration of Deferred Items
Example 5 – Sale of Debtor Stock: Same facts as in Example 1, except that in 2013, Fund sells its stock in Debtor.
General Acceleration Rule. If COD income (or OID) was deferred under the Act, such items are accelerated to any taxable year in which the Debtor dies, liquidates, sells substantially all of its assets (including a bankruptcy case, unless the taxpayer reorganizes and emerges from a Title 11 case), or ceases business. Accordingly, the Debtor’s deferred COD income will not be accelerated by reason of the Fund’s sale.
Example 6 – Sale of Debtor Partnership Interest: Same facts as in Example 2, except that in 2013, Fund sells its partnership interest in Debtor.
Special Acceleration Rule for Pass-Through Entities. In the case of a Debtor that is a partnership or S corporation, acceleration also occurs in the case of the sale, exchange, or redemption of an interest in such partnership/S corporation. Presumably, this acceleration is limited to the transferring partner/shareholder, but, as this is not clear in the Act, we hope that the IRS will clarify this rule in regulations. Accordingly, the Fund (and potentially the other partners of Debtor) will recognize the deferred COD income upon its sale of its partnership interest.
IV. Pepper Perspective
Debt buy-backs and restructurings in the current market can prove economically lucrative, and may even be necessary to keep a Debtor afloat. The Act’s COD income provisions should further enhance the appeal of these transactions by permitting Debtors to defer the associated tax costs in cases in which no other exception would be applicable. Nevertheless, private equity funds and other debt issuers must carefully plan their debt purchases to not only achieve the deferral, but to ensure that the Act’s tax benefits are not diminished or eliminated by other tax considerations. Anyone with questions should contact the authors of this Alert: Steven D. Bortnick at firstname.lastname@example.org or 212.808.2715 / 609.951.4117, or Timothy J. Leska at email@example.com or 215.981.4008.
1 Certain exceptions apply to COD income recognized in bankruptcy or to the extent the Debtor is insolvent. The cost of such exceptions is that the Debtor must reduce tax attributes, such as net operating loss carryforwards, capital loss carryforwards, and basis in assets.
2 Regulations set forth the modifications that are considered to be significant, which can include modifications that change the yield of the debt, the timing of payments, the source of repayment (e.g., change in obligor or debt collateral), and the nature of the instrument (e.g., recourse to nonrecourse or vice versa).
3 This deferral will also apply to OID accruals from a debt instrument, the proceeds of which are used to reacquire an ADI.
4 The use of SPVs require special consideration of foreign tax issues, U.S. withholding tax issues, as well as consideration of the CFC and PFIC rules.
5 A debt instrument is an AHDYO if (1) its maturity date is more than five years from the issue date, (2) the yield to maturity equals or exceeds the sum of the applicable federal rate (AFR) in effect for the calendar month the obligation is issued plus five percentage points (high yield to maturity), and (3) it has “significant original issue discount.”