The recent economic stimulus legislation provided tax relief with respect to borrowers who realize cancellation of indebtedness ("COD") income, but such relief may not be as favorable as existing exemptions to the taxation of COD income rules.
Tax Developments Affecting Debt Repurchases
Many debt issues are trading at depressed prices and, as a result, many borrowers are considering de-leveraging their balance sheets by repurchasing their own debt at substantial discounts to par. The tax rules with respect to COD income generally require that upon the purchase of debt by a borrower of such debt or a party related to such borrower, the borrower recognizes gain in an amount equal to the amount of the indebtedness less the amount paid for such indebtedness, which income is taxable at ordinary income rates. Under the tax rules in affect before the stimulus legislation, there are a number of exemptions to this general rule. For example, bankrupt or insolvent borrowers may qualify for an exemption to the rules requiring the current recognition of income when a borrower realizes COD income. If a borrower takes advantage of the exemption, the rules require the borrower to reduce the amount of its tax "attributes" (e.g., net operating losses or tax basis of assets) by an amount equal to the COD which they are not required to recognize.
The recent economic stimulus legislation provides alternative relief from the rules requiring the current recognition of income when a borrower realizes COD income, by allowing borrowers to defer the COD income. In addition, the stimulus legislation contains provisions that limit the deductibility of original issue discount ("OID") in the case when a borrower elects to defer its COD income under these new rules. However, depending on a debtor's individual circumstances, this new COD income deferral mechanism may not be as favorable as existing exemptions to the COD income rules. As described above, a bankrupt or insolvent borrower (or its members/partners, in the case of an entity taxed as a partnership) may be able to elect to avoid recognizing COD income for tax purposes in exchange for reducing certain tax attributes. Accordingly, you should consult a tax professional before making an election under the new COD income deferral rules.
Deferral of COD Income
Under the new legislation, a qualifying borrower may elect (with the election being irrevocable) to defer the inclusion of COD income resulting from a transaction occurring in either 2009 or 2010 that is (a) a purchase, for cash, of the borrower's debt by the borrower or a related person; (b) a debt-for-debt exchange (including a deemed exchange under the debt modification rules of the U.S. tax code); (c) a debt-for-equity exchange; (d) a contribution of debt to capital; or (e) the total forgiveness of the debt by the debt holder. If the borrower is treated as a pass-through entity for tax purposes, the election is made by the entity and not its owners.
Any COD income resulting from the above described transactions in 2009 or 2010 will be deferred and recognized by the borrower ratably over a five year period beginning in 2014.
Deferral of OID
Any borrower deferring the recognition of the COD income under the above rules will also defer the deduction for any OID attributable to debt issued by the borrower (deemed or otherwise) in the transaction which results in the realization of the COD (e.g., in a debt-for-debt exchange or through the use of proceeds of newly issued debt). These deferred deductions (to the extent that they do not exceed the deferred COD income amount) will be deferred until the recognition of the COD income.
Acceleration of Deferred COD Income and OID Deductions
Should the borrower elect to take advantage of the income deferral rule (described above), and liquidate, sell substantially all of its assets (even in bankruptcy), cease to do business or find itself in other similar circumstances prior to the recognition of all of the COD income, the remaining deferred COD income would be recognized (as well as the OID deductions) in the tax year in which any of the above circumstances occur. If the borrower is treated as a pass-through tax entity, acceleration will also be triggered upon the sale, exchange or redemption of an ownership interest in the borrower. In such case, only the partner/member/S shareholder will recognize its share of the deferred COD income when the sale transaction occurs.
To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that this written advice was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Copyright © 2009 Herrick, Feinstein LLP. Tax Update is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.