Amendments to Debt Not Always Relief for the Borrower

Journal Issue

Feb 2005

Column Name

Topic Tags

Journal HTML Content

Out-of-court restructurings and workouts
have become more common in recent years due to the sophistication of the
debt markets, the availability of capital—even for high-risk
borrowers—and the inherent reluctance of companies to utilize the
chapter 11 process to restructure debt except as a last resort. This
trend accounts for some of the decline in the number of chapter 11
filings since 2001 and the increase in high-yield debt outstanding for a
wide range of companies, including those still far from chapter 11's
doorstep. Such restructurings may involve an actual exchange of old debt
instruments for new ones, or only modifications to the terms of an
existing debt instrument. When a debt instrument is amended
(e.g., to increase the interest rate) as part of a restructuring
without changing the face amount of the obligation, it is possible that
the amendment may create cancellation of indebtedness (COD) income. The
key is whether the changes to the terms of the debt constitute a
"significant modification" in accordance with the Internal Revenue
Service (IRS) regulations. If a cash-strapped company facing imminent
default needs more flexibility in its financing arrangements, it may
suddenly find that amendments to the terms of its debt that address
these problems may come with a cash cost in the form of taxes due for a
transaction that, on its surface, does not appear to generate taxable
income. The cash impact of such a restructuring may be immediate if it
is achieved out of court by borrowers who do not have sufficient net
operating losses (NOL) to offset the COD income. Even for borrowers with
sufficient NOL, the Alternative Minimum Tax (AMT) may apply with an
effective 2 percent cost. If the amendments occur in a chapter 11
proceeding, however, the tax impact may be deferred until well after
emergence.

The following example, suggested by a real transaction, illustrates
one of the bright-line rules or tests under these IRS regulations. This
test requires a calculation of the change in total yield of the
restructured debt, and in this instance, results in the creation of
taxable COD income. Company X issued publicly traded debt in 2002 with
the following terms:

Original Notes 
Issue Amount: $200,000,000 
Issue Date: June 28, 2002 
Maturity Date: July 1, 2010

Coupon: 11.00% 
Yield to Maturity at Issuance: 11.00%

In June 2004, when the notes were trading at 92 cents on the dollar,
the company triggered an event of default under terms of the debt. The
company negotiated a waiver from its creditors and, in consideration
thereof, agreed to increase the interest rate on the debt and pay a
consent fee as follows:

June 2004 Amendments 
Consent Fee: 1.00% 
Amended Coupon: 11.40% 
Yield After Modification: 11.61% 
(calculated after reducing the original issue price by the consent fee)

The combination of the change in interest rate and the consent fee
effected a change in yield of more than 5 percent of the original annual
yield. Under the change-of-yield rule or test of the IRS regulation,
this change in yield constituted a "significant modification".

Change-in-yield Rule 
Yield-Restructured: 11.61%

Yield-Original: 11.00% 
Threshold for Significant Modification: 11.55%

As will be discussed in more detail in the following text, this
change in yield, and resultant "significant modification," will have the
following tax effect:

Cancellation of Indebtedness Income 
Face Value (per note): $1,000 
Market Price at date of restructuring (per note): $920 
COD Income (%): 8.0% 
COD Income ($): $16,000,000 
Tax Cost (regular tax rate or AMT) 
Regular tax (35%): $5,600,000

AMT (2%): $320,000

This change in yield rule or test is only one of the rules or tests
used to determine whether there has been a "significant modification" of
a debt instrument. Before completing an assessment of whether to proceed
with amending its debt, a company and its advisors must analyze the
proposed amendments under each of the rules or tests discussed below.

This article will discuss this trap for the unwary where one or more
simultaneous or serial amendments to a debt instrument issued by a
company may result in taxable COD income.

<h4>Background</h4>

Historically, there has been a well-developed body of law concerning
the tax treatment of debt modifications. Although there were areas of
uncertainty, under the case law and rulings, a debt modification usually
did not result in a taxable exchange unless the obligor with respect to
the debt was changed or the yield on the debt instrument was materially
changed. See Rev. Rul. 89-122, 1989-2 C.B. 200; Rev. Rul. 87-19,
1987-1 C.B. 249; Rev. Rul. 73-160, 1973-1 C.B. 365. Thus, for example,
there generally were no tax consequences with respect to debt
modifications that effected an alteration of collateral, the addition or
subtraction of guarantees, an extension of maturity date, a deferral of
payments or a waiver of an event of default. See Rev. Rul. 87-19,
1987-1 C.B. 249 (change in yield); Rev. Rul. 77-416, 1977-2 C.B. 34
(change in collateral); Rev. Rul. 73-160, supra (extension of
maturity). In its 1991 decision in Cottage Savings Association v.
Commissioner, 499 U.S. 554 (1991), however, the Supreme Court held
that the exchange of mortgage portfolios by two savings and loans was a
taxable event, even though the portfolios were substantially identical
in an economic sense. Many commentators interpreted the Supreme Court's
decision in Cottage Savings as establishing a "hair trigger" for
determining whether a debt modification would result in a taxable
exchange. In response to the uncertainty caused by the Supreme Court's
decision, the IRS issued regulations in June 1996 on the issue of when
the modification of a debt instrument would result in a deemed taxable
exchange of the original debt instrument for a "new" debt instrument.
Treas. Reg. §1.1001-3, T.D. 8675, 61 Fed. Reg. 32926 (June 26,
1996).

<h4>The IRS Regulations</h4>

The so-called Cottage Savings regulations establish a two-part
test to determine if alterations of the legal rights or obligations
under a debt instrument will be treated as an exchange of the original
debt instrument for a "new" debt instrument. Treas. Reg.
§1.1001-3(b). First, the regulations require a determination as to
whether the alterations constitute a "modification." Treas. Reg.
§1.1001-3(c) and (d). Second, if the alterations constitute a
"modification," the regulations require that the modification must be
tested under a series of specific rules or a general "catch-all" rule to
determine if the modification is "significant." Treas. Reg.
§1.1001-3(e) and (f). If a significant modification has occurred,
the borrower and holders of the debt will be deemed to have exchanged
the original debt instrument for a new debt instrument in a taxable
exchange. Treas. Reg. §1.1001-3(b).

<h4>What Is a Debt Modification?</h4>

The regulations define a modification as any change (whether oral or
written) of a legal right or obligation of the issuer or holder of a
debt instrument. Treas. Reg. §1.1001-3(c)(1)(i). The regulations,
however, contain three exceptions to this seemingly all-encompassing
definition.

First, an alteration of rights or obligations will not be treated as
a modification if the alteration of rights occurs pursuant to the
original terms of the debt instrument, provided that the change does not
result in the substitution of a new obligor, the addition or deletion of
a co-obligor, or a change from a recourse to a non-recourse debt or vice
versa. Treas. Reg. §1.1001-3(c)(1)(ii).

Similarly, the exercise of an option afforded to the issuer or holder
under a debt instrument is not a modification unless the option is
"unilateral" and, in the case of an option exercised by a holder of a
debt instrument, does not result in a deferral of, or reduction in, a
scheduled payment. Treas. Reg. §1.1001-3(c)(2)(iii). For this
purpose, an option is unilateral if it does not require the consent of
the other party to the debt instrument (or a party related ) or a court,
and the exercise does not require consideration other than a de
minimus amount, specified amount or amount based on a formula
established on the issue date. Treas. Reg. §1.1001-3(c)(3).

Finally, an alteration of rights or obligations will not be treated
as a modification if the alteration results from a failure by the issuer
of the debt instrument to perform its obligations under the instrument
or a waiver by a holder of such instrument of a default right, unless
such holder's forbearance continues for more than two years. Treas. Reg.
§1.1001-3(c)(4). Thus, a temporary stay of collection or a waiver
of an event of default under a debt instrument will not, in and of
itself, constitute a modification so long as the issuer and holder do
not agree to alter any other terms of the debt instrument during the
two-year period following the forbearance. Accordingly, a mere waiver of
an event of default will not, in and of itself, be treated as a
modification.

<h4>When Is a Debt Modification Significant?</h4>

In defining a "significant modification," the regulations adopt a
number of specific bright-line rules and a general rule. Treas. Reg.
§1.1001-3(e)(1) and 3(c)(2) through (6). Under the general rule,
which generally only applies if a specific bright-line rule does not, a
modification is significant if the legal rights or obligations are
changed in an "economically significant" manner. Treas. Reg.
§1.1001-3(f)(1)(i). In making this determination, all modifications
to a debt instrument other than those subject to a bright-line rule are
considered so that a series of modifications taken together may
constitute a significant modification even though each modification
alone would not be "economically significant." Treas. Reg.
§1.1001-3(e)(1).

Under the specific bright-line rules, any of the following changes
will be considered a "significant modification".

<ol>
<li>Changes in Yield: The first rule characterizes any change in
legal rights or obligations that effects a change of yield exceeding the
greater of 25 basis points or 5 percent of the annual yield of the
original unmodified debt instrument as a "significant" modification.
Treas. Reg. §1.1001-3(e)(2)(i) and (ii). In calculating yield for
this purpose, yield is determined by reference to the issue price of the
unmodified debt instrument as increased for any payments by the holders
to the issuer and decreased by any payments by the issuer to the holders
of the debt. Treas. Reg. §1.1001-3(e)(2)(iii)(A). Thus, a consent
or inducement fee, such as the inducement fee discussed in the example
which introduced this article, paid by an issuer to holders of its debt
would, by dint of this deduction, result in an increase in yield.

</li><li>Changes in Timing and Amount of Payment: The second specific
bright-line rule provides that a "material" deferral (based on all of
the facts and circumstances) in the timing of scheduled payments under a
debt instrument, either by reason of the extension of the maturity date
of such instrument or a deferral of payments due, is a "significant"
modification. Treas. Reg. §1.1001-3(e)(3)(i). The regulations do,
however, provide a safe-harbor for this purpose. Under the safe harbor,
an extension of the maturity date of a debt instrument that is shorter
than five years or 50 percent of the instrument's original term is not a
"significant" modification. Treas. Reg. §1.1001-3(e)(3)(ii).

</li><li>Changes in Obligor: The third specific bright-line rule
provides that the replacement of the obligor on a recourse debt
instrument is a "significant" modification, unless the change results
from a tax-free reorganization or liquidation or an acquisition of
substantially all the original obligor's assets, the debt is not
otherwise modified and the transaction does not result in a "change in
payment expectations." Treas. Reg. §1.1001-3(e)(4)(i).
Interestingly, a change in obligor on a non-recourse debt instrument is
not a "significant" modification. Treas. Reg. §1.1001-3(e)(4)(ii).

</li><li>Changes in Payment Expectations: The next several specific
bright-line rules require that the change or alteration of the debt
instrument will not be treated as a "significant" modification unless it
results in a "change in payment expectations." For this purpose, a
change in payment expectations occurs if the obligor's capacity to
satisfy the debt is (1) enhanced, and the change in the debt instrument
reduces the credit risk with respect to the debt from speculative to
adequate, or (2) impaired, and the change in the debt instrument
increases the credit risk from adequate to speculative. Treas. Reg.
§1.1001-3(e)(4)(v). Where payment expectations change, the
regulations provide that the following changes in a debt instrument will
be treated as a "significant" modification: (1) an addition or deletion
of a co-obligor; (2) the release, substitution, addition or alteration
of collateral (including any guarantee or other credit enhancement)
securing a recourse debt; (3) the release, substitution, addition or
other alteration of a substantial amount of the collateral (including
any guarantee or other credit enhancement, but excluding a substitution
involving commercially fungible collateral or commercially available
credit enhancements) for a non-recourse debt; and (4) a change in the
"priority" (seniority or subordination) of a debt instrument. Treas.
Reg. §1.1001-3(e)(4)(iii) (addition/deletion of obligor); Treas.
Reg. §1.1001-3(e)(4)(iv)(A) (collateral on recourse debt); Treas.
Reg. §1.1001-3(e)(4)(iv)(B) (col-lateral on non-recourse debt);
Treas. Reg. §1.1001-3(e)(4)(v) (change in priority).

</li><li>Changes in the Nature of a Debt Instrument: The final
bright-line rule provides that a change in a debt instrument that
converts that instrument to equity for tax purposes, or that converts
that debt from recourse to non-recourse or vice versa, is a
"significant" modification. Treas. Reg. §1.1001-3(e)(5)(i) and
(ii). Thus, for example, a legal defeasance of a debt instrument that
releases the obligor from all liability to make payments on such debt is
a "significant" modification. Treas. Reg. §1.1001-3(e)(5) (ii)(A).
Importantly, however, a modification that adds, deletes or alters
customary accounting or financial covenants is not a "significant"
modification. Treas. Reg. §1.1001-3(e)(6). Accordingly, a mere
change in financial covenants will not, in and of itself, result in a
"significant" modification.
</li></ol>

In aid of determining whether a change or alteration of a debt
instrument is a "significant" modification, the regulations provide that
changes in the terms of the instrument of a lesser degree than the
degree of change that is considered a "significant" modification under
the regulations is not a "significant" modification. Treas. Reg.
§1.1001-3(f)(2). Similarly, modifications of different terms under
an instrument, none of which separately would constitute a "significant"
modification, do not collectively constitute a "significant"
modification. Treas. Reg. §1.1001-3(f)(4). The regulation does,
however, provide that a series of modifications to a particular term of
a debt instrument over a period of time (up to five years) must be
combined to determine if the changes would have resulted in a
"significant" modification had the changes been made as a single change.
Treas. Reg. §1.1001-3(f)(3). Thus, for example, a change in
financial covenants accompanied by an inducement fee, followed at some
later point during the following five years by a change in interest
rate, will be treated as a single change in determining whether there
has been a change in yield that exceeds the 25 basis points/5 percent
rule discussed above.

<h4>Consequences of Significant Modifications</h4>

If a debt instrument has been significantly modified under these
regulations, the original debt instrument is deemed to have been
exchanged by the obligor and holders for a new debt instrument. From the
perspective of the obligor, cancellation of indebtedness income will
result from the deemed exchange if the "issue price" of the new debt
instrument is less than the "adjusted issue price" for federal income
tax purposes (i.e., the original issue price as increased by any
original issue discount previously included in the income of any holder)
of the original debt instrument. Internal Revenue Code §108(e)(10);
Treas. Reg. §1.1275-1(b). Where the original debt instrument is
publicly traded, the issue price of the new debt instrument will equal
the trading price of the original debt instrument. Treas. Reg.
§1.1273-2(c)(1). Thus, as discussed in the example that introduced
this article, the obligor on a publicly traded debt instrument will
recognize COD income if the original debt instrument is traded at less
than its "adjusted issue price" for federal income tax purposes. From
the perspective of the holder, gain or loss will be recognized on the
deemed exchange of the original and "new" debt instruments, unless the
original and "new" debt instruments each qualify as a "security"
(generally an instrument due more than 10 years from the date of
issuance) for federal income tax purposes.

<h4>Conclusion</h4>

Where a company is negotiating an amendment or a series of amendments
to the terms of its debt in order to avoid or cure a default or gain
more flexibility in its financing arrangements, it is critical to be
aware of this possible tax issue and consult tax advisors to determine
how the amendment(s) will be treated under IRS regulations. Failing to
evaluate the amendment(s) under these IRS regulations may result in the
company inadvertently generating taxable COD income and incurring a
current tax cost as a consequence. Although the tax effect of a debt
amendment(s) may be the same in and out of court, a chapter 11 filing
may allow the company to defer the cash tax impact until well after
emergence.

Journal Authors

Gina Gutzeit

Steven Joffe

Journal Date

Tuesday, February 1, 2005 - 12:00

Bankruptcy Rule

2005

none