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Lawyers Urge Congress and Treasury to Fix Tax Issues With Debt

Posted on Oct. 16, 2020

The government needs to act quickly to address the adverse tax consequences debt issuers will likely face as more businesses struggle because of the pandemic, according to a group of New York lawyers.

Issues regarding cancellation of debt (COD) income and the tax consequences for debt issuers that exchange new debt for their outstanding debt — or even modify the terms of outstanding debt — will only become more prevalent as the economy continues to struggle, according to a New York State Bar Association report issued October 15.

“This problem is not new, but when markets are distressed, as is currently the case, the number of distressed issuers increases, the magnitude of the problem becomes greater and the need for a solution becomes more urgent,” the report said.

When the nation was reeling from the economic collapse in 2008, Congress responded by enacting sections 108(i) and 163(e)(5)(F) to help some businesses deal with the fallout as it related to debt. But since then, more transactions can result in COD income and the adverse consequences around it have also expanded, NYSBA noted.

“In some instances, distressed issuers have even filed for bankruptcy to ensure that their COD income qualifies for more favorable treatment available to debt discharged in a title 11 case, resulting in far greater expense than would have been incurred in an out-of-court restructuring,” the report said.

In response to the economic slowdown that followed the onset of the COVID-19 pandemic, Congress passed the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136), which included the Paycheck Protection Program. That program provided loans to businesses that can be forgiven on a tax-free basis if a specific portion of the proceeds is spent on payroll. Employee retention credits were also enacted, along with an expansion and carryback of net operating losses.

Treasury, for its part, extended filing deadlines and made it easier for taxpayers to send in claims for NOLs and credits.

Lawmakers are negotiating another round of relief, but whether that becomes law before the November 3 election remains to be seen.

NYSBA’s report urges both lawmakers and Treasury to move quickly to take steps to address the obstacles debt issuers face regarding modifications and exchanges. The group recommended that Congress reinstate and expand an old provision that addressed debt exchange issues.

“We recommend that Congress adopt a new, expanded version of former Section 1275(a)(4) providing for the issue price of debt issued in an actual or deemed exchange to be equal to the least of (1) the adjusted issue price of the exchanged debt instrument, (2) the stated principal amount of the new debt instrument and (3) the imputed principal amount of the new debt instrument, with such rule applying to both taxable exchanges as well as exchanges that qualify as reorganizations under Section 368(a),” the report said.

Alternatively, Congress should adopt a permanent provision to make the timing of COD income and original issue discount deductions that arise in connection with an actual or deemed exchange of debt instruments similar to that under former sections 108(i)(1) and (2), NYSBA said.

And if lawmakers can’t get it done, Treasury should issue regulations changing the timing inclusion of COD income incurred in an actual or deemed debt-for-debt exchange to match the corresponding OID deductions, the group said.

“In addition, we recommend that Treasury suspend the AHYDO [applicable high-yield discount obligation] rules that could otherwise be applicable to the modification of a non-AHYDO debt instrument and exercise regulatory authority to harmonize the consequences of COD income and related OID deductions in the context of the Section 163(j) rules and the foreign tax credit limitation rules,” the group said.

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