Debt issuers could face unintended tax consequences if they don’t consider the potential income exposure from significant debt modifications.
Organizations could prevent cancellation of debt (COD) income that might be triggered amid the current debt market environment by tracking specific indicators and through effective tax planning, according to Ken Gerstel of Deloitte Tax LLP.
“Because there’s a broad market decline in the trading or indicative pricing of debt,” the tax function needs to focus on the rules that could affect a company’s plans to issue new debt or, for example, make covenant concessions and negotiate with lenders on existing debt, Gerstel said during his firm’s May 15 webinar.
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.
For 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.
As a result of the coronavirus pandemic, “higher-risk debt — whether it be below-investment-grade bonds or leveraged loans — has repriced substantially lower and there’s significant volatility across industries,” Gerstel said.
In the current market environment, credit downgrades have accelerated, and the percentage of borrowers with an indicative price that’s below 80 percent of the face amount has more than doubled in the last eight weeks, Gerstel said.
Gerstel also pointed out that borrowers entering the credit markets are frequently paying double the interest rate they would have before the COVID-19 crisis started.
Gerstel described a situation in which a company that has a $500 million debt instrument, which is quoted at 80 percent of the face amount, intends to modify that debt, such as by extending the term or relaxing a loan covenant with a fee.
If the modification is considered significant, “the tax rules that [have been] in place since 2012 make it highly likely that any obligation that has more than $100 million of issue price will be treated as publicly traded,” Gerstel said. That’s true even if it’s a public bond because “there still would be an indicative quote,” he added.
For a significant modification, “the difference between the fair market value and the face [amount] of the debt, or 20 percent in this example . . . would result in $100 million of COD income, even if the amount owing under the debt did not change,” Gerstel explained.
“Because the company still owes the full amount of the debt — the $500 million that was modified — the difference would be recovered as future interest deductions,” which may temporarily not be useful under section 163(j) or permanently limited under the applicable high-yield discount obligation (AHYDO) rules for some debt-for-debt exchanges, Gerstel said.
Connected Tax Function
Gerstel emphasized the role the tax function should play in preventing adverse consequences that could stem from significant debt modifications.
Gerstel noted that tax staff generally have “high visibility” if the company is planning a wholesale restructuring of its balance sheet but may be less involved when an instrument is modified.
Thus, Gerstel said it’s critical that a company’s tax department is connected to other functions, such as treasury, finance, and legal, as the organization determines how to address liquidity and other concerns in the current debt market environment.
That would help ensure that tax staff members aren't in hindsight reacting to a modification but can plan ahead to keep it from being significant,” Gerstel said.
Gerstel also pointed to several indicators that the tax department could track to help identify potential COD income exposure from significant debt modifications, such as existing leverage, new loan draws, rating downgrades, and 2020 covenant issues.
Debt Relief Requested
In an April 29 letter to the IRS, the American Bar Association Section of Taxation recommended the government provide taxpayer relief from the consequences of debt modifications. It suggested that the IRS allow borrowers “to treat a debt issue, regardless of size, as being a ‘small debt issue’ that is treated as not being traded on an established market” under reg. section 1.1273-2(f)(6).
“This change would allow financial institutions to aid debtors during the COVID-19 emergency while mitigating adverse tax consequences to debtors,” the letter said.
Concerning the AHYDO rules applied to debt-for-debt exchanges, the ABA tax section suggested that Treasury exercise its authority to suspend those rules, “or permit taxpayers to use a benchmark greater than the [applicable federal rate], ‘in light of distressed conditions in the debt capital markets.’”
“If the trading price of the new instrument is artificially depressed because of market conditions, the instrument could be considered an AHYDO and the issuer could be denied [original issue discount] deductions notwithstanding the cancellation-of-debt income resulting from the exchange,” the letter said.
Section 163(e)(5) prevents a corporation from deducting the disqualified portion of the OID on an AHYDO, and the corporation’s deduction for the remaining portion of the OID is deferred until the OID is paid in cash or in property other than debt of the issuer or a related person.
During the Great Recession, Congress provided taxpayers relief from the AHYDO rules through 2009 and granted Treasury the authority to extend that relief, which it did through 2010 (Notice 2010-11, 2010-4 IRB 326).