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Debt Modification Rules Become More Complicated Amid Pandemic

Posted on Dec. 18, 2020

Distressed businesses may be increasingly renegotiating terms with their creditors without understanding the nuances of the debt modification rules or assessing options to avoid potentially alarming tax consequences. 

Accounting and law firms issued alerts early during the coronavirus pandemic, warning clients of the tax effects of restructuring debt, but some practitioners say many businesses have been surprised to learn that specific loan modifications trigger taxable income. 

With an uptick expected in debtors seeking relief on credit terms or covenants, advisers recently discussed how taxpayers’ “significant modifications” of “publicly traded debt” — terms specifically defined for tax purposes — can unexpectedly create cancellation of debt (COD) income for the unwary. They suggested possible actions to mitigate the effects. 

COVID-19 has affected many industries from the onset, particularly those “in the people-to-people business, be it retail, restaurants, energy, hospitality, travel, healthcare, gyms, movie theaters, you name it,” Bill Fasel of Grant Thornton LLP said during a December 7 podcast hosted by his firm.

The initial stimulus funding that provided support for those industries “enabled more of a wait-and-see approach for many of the lenders, stalling many decisive actions that were being taken” regarding borrowers, Fasel said.

Fasel pointed out that as the pandemic evolved, banks and nonbank lenders continued to evaluate how to deal with borrowers and have been “playing sort of . . . nice” but are returning to pre-COVID lending disciplines and terms. 

“With most stimulus programs ending and regular unemployment benefits expiring, infection rates increasing, [and] regional and national lockdowns, there’s increased fear heading into 2021,” Fasel said, adding that the overall restructuring market is “poised to explode.” 

“Companies have become more leveraged as they have used credit facilities and their stimulus money to stem operating losses versus fixing their balance sheet or operations, which will drive the need for debt and debt modifications,” Fasel said. 

Debt modification rules, however, can erode the liquidity — the after-cash tax flow — companies are seeking, said Brian Angstadt, also of Grant Thornton, who joined Fasel on the podcast. 

Don’t Lose Sight of Tax Consequences

Corporate borrowers severely affected by the pandemic have faced issues similar to those of the Great Recession, said Joseph E. Fox of Fried, Frank, Harris, Shriver & Jacobson LLP during a December 10 webinar sponsored by the Tax Executives Institute

Unlike the period 2008 through 2010, which was in large part a debt crisis, credit has continued to flow more fully and freely, with “lenders coming to the table and deals getting done,” Fox said. Those transactions, however, have involved “modifications to the existing debt, so it’s important to understand the tax consequences,” he cautioned. 

Similarly, Matthew Esposito of Grant Thornton, who spoke during his firm’s podcast, said that companies considering debt modifications or restructurings are “focused, and rightly so, on the liquidity concern [and] trying to keep their businesses open,” but they also should be thinking about the unexpected accounting and tax costs as they consider their options. 

According to Angstadt, most companies are aware that large bankruptcies and out-of-court workouts have tax implications but are often surprised “to find out that modifying the terms of their debt could have substantial tax consequences as well.” 

The crucial question is whether the modification of the debt instrument is significant under reg. section 1.1001-3(e), which provides bright-line tests for specific types of changes, such as those regarding yield, timing of payments, and the obligor. Modifications that don’t fall within one of the enumerated rules are tested under the general rule — that is, determining the extent to which the collective changes in legal rights or obligations are economically significant. 

The American Bar Association Section of Taxation recommended in an August 17 letter several clarifications on items that it says the government shouldn’t treat as a significant modification, including “a situation in which a taxpayer seeks an extension but does not otherwise change yield or other terms of the debt.” 

“Although we believe the clarifications are particularly important in the current economic climate caused by the COVID-19 emergency, we believe that Treasury and the Service should consider making them permanent,” the letter says.

When the terms of a debt obligation are significantly modified, section 1001 considers the old debt instrument as having been exchanged for a new debt instrument, and the old debt is treated as having been retired for an amount equal to the issue price of the new debt. 

Under section 108, canceled debt is generally included in gross income unless specific exceptions apply, such as when the debt is discharged in a bankruptcy case or when the taxpayer is insolvent. For those exclusions of COD income, taxpayers must reduce specified tax attributes — including net operating losses, capital loss carryovers, and basis reductions — following prescribed ordering rules. 

Multitude of Modifications

Borrowers typically seek several amendments to their debts, which might include an extension for debt that’s going to mature soon, Fox said. “Or they might have [a material adverse effect] provision that . . . could be triggered because of COVID-19-related conditions affecting the company and they might want either a waiver or a modification of that provision to make it clear that COVID-related consequences won’t be taken into account.” 

Businesses that had to shut down may also be seeking waivers of financial covenants because of noncompliance because of decreased cash flow, according to Fox. 

Fox noted that in exchange for lenders agreeing to various modifications of loan terms or provisions, borrowers have agreed to “pay increased pricing and/or a one-time consent fee.” 

For COVID-related loan modifications, however, “it’s not always clear how to analyze them under these tests,” Fox said. For example, an initial call might be that an amendment to the material adverse effect provision is a change to a customary accounting or financial covenant, which is never considered a significant modification, he said. 

Also, analyzing the effects of changes in yields can be complicated, particularly if there’s a deferral of payments at the same time, according to Fox

Under reg. section 1.1001-3(f)(3), multiple modifications of a debt instrument constitute “a significant modification if, combined as a single change, the change would have resulted in a significant modification.” When testing changes in yield, the regs disregard any modification occurring more than five years before the date of the modification being tested.

The rule “sounds clear enough, but when you have debt that’s been modified multiple times and it wasn’t clear in the past” whether the modifications were significant, that requires evaluating different scenarios to determine if prior modifications — perhaps one that was treated as significant and one that wasn’t — when combined with a current change, together would be a significant modification, Fox said. 

Sizable Effects for Publicly Traded Debt

COD income can arise for debt that is not publicly traded, but there’s substantially more income when it’s publicly traded, Angstadt said. 

If there’s a deemed exchange of debt that is publicly traded, the issue price of the new debt is its fair market value rather than its face amount. That means a debtor can have COD income even though the principal amount of its debt obligation has not been reduced. 

Angstadt described a situation in which a company has debt of $200 million that’s trading at 80 percent of face value and its creditors agree to change the interest rate by an amount that’s considered a significant modification. Because the issue price of the new debt is $160 million, the company would have COD income of $40 million for tax purposes, he said.

Having COD income “can be a bitter hell, particularly for a company that doesn’t have sufficient NOLs to absorb it,” Fox said. He explained that although the income is offset by original issue discount deductions in the remaining years of the new debt, the company has to come up with money for cash taxes for the COD income recognized in the current period.

Further, those deductions might be limited under the applicable high-yield discount obligation rules or the section 163(j) business interest expense provision, Fox said. 

So the gravity of the tax consequences of a significant debt modification turns on whether the debt is publicly traded, Fox said. 

“What’s important to know is that more and more debt is [considered] publicly traded” for tax purposes, Fox said, noting that it generally depends on how the debt is placed and held or whether brokers are quoting the debt. 

Under reg. section 1.1273-2(f), debt is generally considered traded on an established market if during the 31-day period ending 15 days after the issue date there is a sales price for the property, one or more firm quotes for the property, or one or more indicative quotes for the property. Under the small debt issue exception, however, if the outstanding stated principal amount doesn’t exceed $100 million, it won’t be treated as publicly traded. 

Fox pointed out that if there’s a deemed exchange of publicly traded debt, borrowers must make the information available to the public, which he said catches people by surprise. It’s not always clear whether the debt is considered publicly traded, but the debtors “can’t just wait until tax reporting time [because] there’s actually an obligation . . . to make that determination and make the information available within 90 days,” Fox said. 

What’s a Debtor to Do?

During the Great Recession, Congress enacted section 108(i) to provide COD income relief, which “was immensely helpful,” Fox said. Early in the COVID crisis there was a lot of discussion about the possibility of doing that again, but there’s been no movement in that direction, he said. 

Under section 108(i), taxpayers with COD income resulting from the reacquisition of an applicable debt instrument in 2009 or 2010 could elect to defer that income for five or four years, respectively, and then recognize the income ratably over the next five years. 

Section 108(i) “was brilliant in that it . . . kicked the can down the road for companies that were distressed; it didn’t make it worse, it made it better,” Fox said. A legislative response is the best option for companies dealing with COD income amid the pandemic, he said, suggesting that businesses pursue that path. 

Libin Zhang, also of Fried Frank, who joined Fox on the TEI webcast, noted an earlier legislative change — section 108(c) enacted in 1993 — in which Congress gave the real estate industry “an even better COD exclusion” with no income recognition. Under that provision, taxpayers may elect to exclude COD income arising from “qualified real property business indebtedness” and instead reduce their basis in depreciable property immediately before the forgiveness of debt. 

Zhang encouraged businesses to speak with members of Congress or their lobbyists and say, “‘Why do we need to pay tax on COD at all? Why can’t we just reduce our basis in our assets going forward, [which] would make a lot of people happy?’” 

The New York State Bar Association Tax Section urged lawmakers in an October 15 report to consider changes to the COD income provision, including rules for determining the issue price of debt issued in an actual or deemed exchange. As an alternative, the tax section recommended adopting “a permanent provision, akin to former Sections 108(i)(1) and (2), to match the timing of COD income and OID deductions that arise in connection with an actual or deemed exchange of debt instruments.”

Without legislation, borrowers can mitigate the tax consequences if they plan and consider all their options, according to Angstadt. Companies could, for example, work with their creditors to establish a “mix of modifications that may meet the business needs of the debtor and the creditor but not trip into” the significant modification rules, which could limit COD income and potentially avoid it altogether, he said.

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