A Periodic Discussion of Tax Topics for Bankruptcy Attorneys
Generally [1], an exchange of one property for another is a taxable event for the parties to the exchange [2]. This general principle can apply when the terms of a debt instrument are modified by an agreement of the creditor and debtor or by court order in a bankruptcy. In certain cases, changes to the terms of a loan are considered to be significant enough (referred to as a significant modification) for the modified loan to be treated as a new loan that is exchanged for the original loan. This is commonly referred to as a “deemed exchange” because an actual exchange did not occur.
A modification of a debt instrument raises two key tax considerations:
- Is the modification of terms significant enough for the tax law to regard the modified debt as new debt that has been exchanged for the original debt (i.e., a deemed exchange)?
- If so, what are the income tax consequences of the deemed exchange of debt?
This article provides a general overview of the answers to both questions.
Significant Modifications of Debt Instruments
Tax law requires that a “modification” of the terms of a debt instrument be “significant” for a deemed exchange to occur [3]. This is important, because generally tax consequences only arise if the tax law creates a deemed exchange of a modified debt instrument for the original debt instrument.
A modification is any alteration of a legal right or obligation of the issuer or a creditor of an instrument, however affected. Some actions are excluded from the definition of modification, including certain forbearance actions and the exercise of certain options.
Generally, a significant modification occurs if the alteration is economically significant individually or, in some instances, collectively if there is more than one modification over a certain period of time. The regulations provide special rules that apply to certain types of modifications [4]. Most relevant in a bankruptcy or debt-workout context are two special rules applicable to changes in yield (i.e., interest rate) and deferrals of payments:
- A change in yield is a significant modification if the modified yield varies from the annual unmodified yield by more than the greater of one-quarter of 1% (25 basis points) or 5% of the annual yield of the unmodified instrument.
- A deferral of scheduled payments generally is a significant modification if the deferral is greater than the lesser of five years or 50% of the original term of the instrument.
Practitioners commonly attempt to work within the parameters of these special rules when helping debtors negotiate changes to their debt terms to conserve cash without triggering a significant modification. For example, the parties may seek to convert future cash interest payments to payments-in-kind or payments contingent on the occurrence of a specified future event. These changes may involve changes to the yield and deferrals of payments that must be analyzed under the rules discussed above. Application of the special rules can result in a deemed exchange as a result of (in some cases) relatively minor changes to the yield [5] or payment schedule, so practitioners should carefully consider the application of these rules and the tax implications of any resulting deemed exchange.
Tax Consequences of a Significant Modification
If a debt instrument is significantly modified, the original debt instrument is deemed to be retired for an amount equal to the issue price of the new debt instrument. As a result, the issue price of the modified debt must be determined and compared to the adjusted issue price of the old unmodified debt.
The issue price of a debt instrument may be thought of as the amount that the tax law considers the liability to be. As time passes and interest accrues and payments are made, the issue price is adjusted (increased or decreased) as appropriate (resulting in the adjusted issue price (or AIP) of the debt).
In many cases, the issue price of the modified debt instrument will be its stated principal (face) amount. However, there are a number of complex rules for determining the issue price in different situations. One such rule operates when debt with an outstanding stated principal amount in excess of $100 million is traded on an established market (i.e., the debt is considered to be publicly traded) [6].
The tax rules define public trading broadly to include a debt instrument that is quoted by certain pricing services. Common examples include Bloomberg, Capital IQ and HIS Markit. If the debt instrument is publicly traded (for example, because price quotes are available on Bloomberg), the instrument will have an issue price determined by reference to the trading price (fair market value or FMV) within a specified period before and after the deemed exchange [7].
Similarly, if the modified debt instrument is not publicly traded but the original debt is so traded, the original debt’s trading price will set the modified debt’s issue price. Because of the broad definition of public trading, many debt issuances with total principal in excess of $100 million are publicly traded. Therefore, it is very important that diligence be performed to confirm whether sales prices or quotes are available whenever the principal amount of a debt instrument exceeds $100 million.
In an exchange of nontraded debt, the issue price of a new debt is generally equal to the stated principal amount if the stated interest rate is above the applicable federal rate [8]. In this case, the deemed exchange might not have material tax implications to the parties.
It is important to note that the issue price and AIP need not be the same as the stated principal amount due on a loan. For example, the issue price of a debt instrument that is publicly traded will generally be its FMV, which may be less than (or in some cases greater than) the debt instrument’s principal amount. If the issue price of a modified debt instrument is less than the stated principal amount [9] of the unmodified debt, the exchange could result in the immediate realization of cancellation of debt income (CODI) by the issuer, offset by future deductions of interest expense by the issuer over time.
Specifically, when the issue price of a loan is less than the stated principal amount, the excess of the stated principal amount over the issue price is a discount, referred to as original issue discount (OID), which is generally accounted for as interest by both debtor and lender over the term of the instrument [10]. The amount of total OID recognized in any one tax year by the debtor and lender is generally computed using a constant yield-to-maturity method.
In some instances, an issuer’s OID deductions may be deferred or disallowed by other tax rules governing deductions of interest. Because CODI and OID are most common in deemed exchanges in which public trading sets the issue price of the modified debt instrument at an amount less than the stated principal amount of the unmodified debt, practitioners analyzing modifications of the terms of a debt instrument issued by a business that has fallen into financial distress should carefully consider whether the instrument is publicly traded for tax purposes.
The creditor, on the other hand, may have no income tax consequences or, depending on how the creditor came to hold the debt (and its adjusted basis), may have a loss. Moreover, if the modified debt instrument has an issue price that is less than the stated principal amount, the creditor may also realize future interest (OID) income over the term of the modified debt instrument. The creditor’s inclusion of OID income is independent of any deduction the debtor may or may not receive.
Conclusion
Changes to the terms of a debt instrument are often important to help debtors conserve cash. Modifications that stray outside of the safe harbors provided in Treasury regulations can result in both immediate and future tax consequences for debtors and creditors. For this reason, it is important to assess the potential tax consequences before finalizing any modifications of the terms of a debt instrument.
[1] All § references are to the Internal Revenue Code of 1986 as amended and the Treasury Regulations thereunder.
[2] § 1001.
[3] Reg. § 1.1001-3.
[4] For example, specific rules apply to changes in the obligor or security on a debt instrument, changes in the nature of a debt instrument (e.g., a modification that results in the instrument no longer being debt) and changes in financial covenants. With some exceptions, substitution of a new obligor on a recourse debt instrument is a significant modification. The substitution of a new obligor on a nonrecourse debt instrument is not a significant modification. Changes in priority of a debt, co-obligors, security or credit enhancements can result in significant modifications depending on the facts. Changes in common financial covenants generally do not result in a significant modification.
[5] For example, in some cases, fees paid in connection with a modification can change the yield.
[6] Reg. § 1.1273-2(f). A debt instrument is traded on an established market if sales prices are reasonably available in a public medium, or if firm or indicative price quotes are available from a broker, dealer or pricing service. It is the author’s experience that many debt issues of more than $100 million are included in one or more of these services. Several debt instruments may be aggregated together if they are part of the same “issue” as defined in the regulations.
[7] Special rules may apply if a portion of the debt is issued for cash that may result in the cash purchase price setting the issue price.
[8] The applicable federal rate is an interest rate specified by the Internal Revenue Service based on the duration of the instrument. This rate is revised monthly. The lowest rate in effect for the month of the transaction or the prior two months is the relevant rate.
[9] If the debt was originally issued for cash, the stated principal amount is often the same as the face amount.
[10] The technical definition of OID is the excess of a debt instrument’s stated redemption price at maturity as defined in the regulations over its issue price. Depending on its terms, the stated principal amount of a debt instrument may differ from its stated redemption price at maturity.