The House and Senate conference reached agreement on a final version of the American Recovery and Reinvestment Act of 2009 (the “Stimulus Bill”). One of the important provisions of the Stimulus Bill allows certain businesses to defer the payment of tax attributable to the repurchase, modification, or cancellation (collectively, the “reacquisition”) of their outstanding debt. This pro-taxpayer provision applies to reacquisitions after December 31, 2008, and before January 1, 2011. It applies to solvent as well as insolvent borrowers; for that reason and others, it is expected to enhance significantly the ability of taxpayers to restructure their debt.
Under current law, corporations and other taxpayers that reacquire debt at a discount must generally include in taxable income the difference between the “adjusted issue price” (usually, the face amount) of the debt and the reacquisition price. This difference is referred to as cancellation of debt income (“CODI”). Unless certain exceptions apply, CODI is currently taxable to the borrower or, in circumstances where the borrower is a partnership or limited liability company, its equity owners. This up-front tax cost restricts the ability of many borrowers to restructure their debt.
Under the Stimulus Bill, taxpayers may elect to recognize CODI income on a deferred basis. This is accomplished in two steps. First, an electing taxpayer is granted an initial deferral period of four or five years (depending on the year in which the debt restructuring occurs), during which none of the CODI is taxable. Then, the taxpayer is permitted to include the CODI in taxable income ratably over a five-year period beginning with the fifth year following the year of the reacquisition. The election is to be made on an instrument-by-instrument basis and is irrevocable once made.
In certain cases, borrowers would be disadvantaged by making the new election, because it requires them to forego certain exclusions provided under current law. For example, current law excludes from taxable income the CODI that occurs in a Title 11 case and when (and to the extent that) the taxpayer is insolvent. In exchange for this present law exclusion, the taxpayer must reduce certain tax attributes, such as net operating losses. If the taxpayer instead elected to exclude CODI under the new law, it would not be eligible for the 100% exclusion. Rather, it would be required to include CODI in taxable income over the deferral period discussed above. Although the electing taxpayer would be permitted to retain its tax attributes, the benefit of doing so may not offset the tax it must pay in the future on the deferred CODI amount. In cases such as this, the Stimulus Bill effectively provides borrowers with a choice of tax-ameliorating provisions.
There are a number of special rules that accompany this provision. For example, the election to defer is made at the issuer level, regardless of whether the borrower is a corporation, a partnership, or a limited liability company. In addition, electing taxpayers are restricted in their ability to deduct original issue discount (“OID”) that may arise in connection with the debt reacquisition. Further, the new rules apply to direct and indirect debt reacquisitions (including the acquisition of debt by related persons), as well as the cancellation or acquisition of debt in exchange for cash, stock, or partnership interests.
Importantly, the CODI recognition is accelerated if the electing taxpayer liquidates, dies, or sells substantially all of its assets (including in Title 11 or similar cases). Recognition also is accelerated upon the sale of an equity interest in an electing partnership, limited liability company or S corporation. This acceleration could be important in analyzing the tax effects of future sales and equity restructurings.
Broad discretion is granted to the Secretary of the Treasury to prescribe regulations and other rules. Special attention likely will be afforded to partnerships and other pass-through entities in circumstances where the rules could adversely impact the economic parity arrangement among the partners or other equity owners.
The rules are a welcome change, as they likely will enhance significantly the ability of troubled companies and their creditors to restructure debt without incurring an immediate tax cost. They do not, however, change the fact that debt reacquisitions, including debt modifications such as extensions of the period for repayment, have important and often unexpected tax consequences to both borrowers and lenders. They underscore the importance of careful consideration of such consequences in planning for debt restructurings.