Taxation Issues Related to Debt Restructuring, Modifications, and Bankruptcies

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1 Taxation Issues Related to Debt Restructuring, Modifications, and Bankruptcies Steven D. Bortnick, Esq. Michelle M. Moersfelder, Esq. November 21, # v.3

2 Agenda Debt Restructurings Cancellation of Indebtedness Income Investing in Distressed Debt Section 382 and Bankruptcy 2

3 Debt Restructurings Repurchase or settlement of debt by issuer for cash or other property (including stock) Actual exchange of old debt for new debt with significantly modified terms Significant modification of old debt (deemed exchange) Purchase of old debt by related party of issuer (deemed exchange) Related party described in 267(b) or 707(b)(1); attribution rules apply 3

4 Tax Consequences of Debt Restructuring Borrower COD income if and to extent face value of old debt > cash, FMV of property, or issue price of new/modified debt given in settlement Possible OID deductions over term of new/modified debt Holder Taxable vs tax-free Generally capital gain or loss (loss may not be recognizable) Possible OID (ordinary) income inclusions over term of new/modified debt No OID if/to extent basis is amounts payable (other than qualified stated interest) and > issue price 4

5 Repurchase of Debt at Discount for Cash CODI How to measure Debt issued with OID Debt issued without OID Character of income Traditional exceptions to recognition of CODI Bankruptcy Insolvency Contribution to capital No more debt for equity exclusion (including equity of partnerships) Deferral Election (discussed below) 5

6 Cancellation of Debt Income Tax Treatment to Debtor Immediately taxable to debtor if no exclusion applies; Debtor may (mostly) offset with available NOLs Exclusion for bankruptcy, insolvency, or non-corporate qualified real property indebtedness: reduce tax attributes (NOLs, asset basis - subject to liability stop ) by amount of COD ( 108(a), (b)) Elect to defer COD income under American Recovery and Reinvestment Tax Act of 2009 (Pub. L. No ) ( ARRTA ) (Principal IRC provisions: 108(i); 163(e)(5)(F)) 6

7 Purchase of Debt at Discount by Related Party CODI recognized as though issuer repurchased Traditional exceptions to CODI available Election to defer CODI Deemed reissuance of note from issuer to related party Effectively converts market discount to OID 7

8 OID vs Market Discount Original Issue Discount Accrues daily Constant yield basis Taken into income currently Generally deductible by issuer (subject to AHYDO and certain related party timing rules) Market Discount Accrued market discount generally treated as interest income Accrues daily Ratable basis unless elect constant yield Only taken into income on payment or sale Not deductible by issuer 8

9 New COD Deferral Election Debtor can elect to defer COD income on 2009 or 2010 re-acquisitions of an applicable debt instrument ( 108(i)(4)(B)): Buy-back of debt for cash by issuer/related party Actual (or deemed) exchange of debt for debt of issuer or related party Defer OID deduction to extent defer CODI inclusion Exchange of debt for stock or partnership interest Contribution of debt to capital Complete forgiveness of debt 9

10 Debt for Debt Exchange Debts securities Tax-free recap No gain or loss Boot includes excess principal amount on new debt CODI not gain, so can have CODI Depending on issue price (discussed below), new debt can have OID One debt not security Fully taxable 10

11 Taxable Debt for Debt Exchange CODI Issue price of new debt < adjusted issue price of old debt Holder may recognize gain or loss Amount realized deemed equal to issue price of new debt 11

12 Issue Price Meaning of Publicly Traded Issue price Publicly traded debt - Fair market value Nonpublicly traded - Face value if adequate stated interest Current depressed market prices for publicly traded debt likely cause COD on debt exchanges even if new debt face equals old debt face Publicly traded is broadly construed: Listed on exchange or interdealer quotation system, Traded on board of trade or interbank market, Appears in system of general circulation (including by subscription) providing reasonable basis for determining FMV, or Readibly quotable price from dealers, brokers, or traders Syndicated bank debt can be considered publicly traded 12

13 Significant Modification Deemed Exchange Economically significant alteration(s) of legal rights/obligations Safe harbor: customary accounting/financial covenant changes What is covered? Lack of authority; covenant waivers risky Deemed exchange likely if: Change in yield of >25 bps or 5% of existing yield count fees/interest paid to lenders for amendment/forbearance Deferral of payments (e.g. beyond lesser of 5 yrs or 50% of original term) Change in obligor, credit support, or priority possibly requiring change in payment expectations From primarily speculative to adequate or vice versa Change from recourse to nonrecourse Change from debt to equity 13

14 Equity Treatment Modification resulting in non-debt is significant Mere deterioration in ability to pay not taken into account in determining if modification results in nondebt, unless change in obligors in connection with modification. Section 382 effect 14

15 Transaction Focused Issues Bad Debts Under 166 Many companies are experiencing a higher trend in bad debts, both wholly worthless and partially worthless Section 166 allows a deduction for any debt which becomes worthless with the taxable year Section 166 applies to all business deductions, and thus, permits a deduction for amounts that taxpayer determines are uncollectible Section 166(a)(2) allows a deduction for partially worthless debts 15

16 Transaction Focused Issues Bad Debts Under 166 Taxpayer is responsible for demonstrating worthlessness TP must show that debt had value at the beginning of the tax year and no value at the end of the year Deduction is warranted if surrounding circumstances indicate legal action would not result in satisfaction Determination of partial or total worthlessness is a factual inquiry Factors indicating worthlessness may include: Value of the collateral as compared to outstanding obligation Financial condition of the Debtor Debtor bankruptcy generally indicates worthlessness Insolvency of Debtor, without more, is insufficient to determine worthlessness Determining tax year when debt becomes worthless may also be challenging 16

17 Transaction Focused Issues Bad Debts Under 166 Section 166 bad debt rules don t apply to securities REMIC investments are treated as debt under Section 860B Impairment may lead to bad debt deduction 17

18 Transaction Focused Issues Bad Debts Under 166 Section 166(a)(2) allows a deduction for partially worthless debts TP must satisfy the charge-off requirement for a partial worthlessness deduction; and TP must demonstrate that the loan or receivable is actually worthless to the extent of the deduction Taxpayer may wait for debt to become wholly worthless and not required to treat debt as partially worthlessness If business debt is recoverable only in part, a deduction is available to the extent it is written off on the taxpayer's books within the year But, a creditor is not required to take a partial bad debt deduction even though it becomes certain within the year that the debt is partially worthless He may instead wait until the debt becomes wholly worthless and deduct the full amount of the debt at that time 18

19 Transaction Focused Issues Bad Debts Under 166 IRS guidance does not define charge off Taxpayer must take action to remove the worthless portion of an asset from its books as an indication of worthlessness Courts have held that a reserve or a contra-account that is credited with regard to a specific debt constitutes a chargeoff under Section 166(a)(2), even if the debt is not removed from the taxpayer s books Automatic change in method of accounting under Rev. Proc Change from a reserve method (or other improper method) to a specific charge-off method that complies with section 166 Applies to a taxpayer other than a bank 19

20 Transaction Focused Issues Losses Under 165 Section 165(a) allows a deduction for any loss sustained during the taxable year which is not compensated for by insurance or otherwise Additionally, Section 165(g) allows a deduction in the year that a security becomes worthless Losses are treated as losses from a sale or exchange of the underlying security Capital loss treatment provided Section 165(g)(3) provides ordinary loss treatment if worthless securities were issued by an affiliated corporation With the increase in loss transactions under section 165, additional consideration of the reportable transactions under section 6011 and the regulations is required 20

21 Transaction Focused Issues Losses Under 165 Section 165(g)(3) provides ordinary loss treatment for certain worthless securities issued by an affiliated corporation Affiliation test: TP owns directly stock in such corporation meeting the requirements of section 1504(a)(2) and More than 90% of the aggregate of its gross receipts for all taxable years has been from sources other than investments (e.g., royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of stocks and securities) Allows ordinary treatment for companies that are not consolidated and have losses attributable to operations and not investment activity 21

22 Transaction Focused Issues Losses Under 165 Potential relief from recent guidance PLR Dividends paid by an operating company to a holding company constitute passive dividend income to the holding company under Section 165(g)(3)(B) TAM Exception applies to subsidiary that never had gross receipts 22

23 Transaction Focused Issues Losses Under 165 Section 165(g)(3) allows ordinary treatment for companies that cannot access operating losses of affiliate due to lack of consolidation, e.g., foreign/us relationship, C Corp/partnership, insurance life and non-life entities Section 165(g)(3) treatment should be carefully considered for ancillary tax issues Detailed basis determination is required to support loss Possible Section 382 limitation may prevent access to operating losses Commentators have requested guidance similar to Rev. Rul , which allows ordinary treatment for a business with significant investment activity Argument is that losses should be ordinary because insurance business is an active trade or business Similar issues will be present in other industries with investment component in operations (e.g., financial institutions) 23

24 Transaction Focused Issues Losses Under 165 A loss transaction is a reportable transaction A transaction is a loss transaction if a taxpayer claims a loss under Section 165 Corporation: $10M/one year $20M/two+ years S Corps/Trusts: $2M/one year $4M/two+ years 24

25 Transaction Focused Issues Losses Under 165 Exceptions to the Section 165 reportable transaction filter are in Rev. Proc Exclusions: Arises from casualty/theft, etc. Recognized under move-to market rules (475(a)/1256(a)) Recognized in a hedging transaction Arises from abandonment of tangible T/B property Cash payment by TP (e.g., cash payment by guarantor) Loss from bulk sale of inventory Loss from sale to someone other than a related party Treas. Reg. Section (e)(1) states, If a reportable transaction results in a loss which is carried back to a prior year, the disclosure statement for the reportable transaction must be attached to the taxpayer s application for tentative refund or amended tax return for that prior year. 25

26 Section 382 Basics Limits a loss corporation That undergoes an ownership change An ownership change occurs if immediately after an owner shift or an equity structure shift - The percentage by value of stock of the loss corporation owned by one or more 5-percent shareholders has increased by more than 50 percentage points over the lowest percentage ownership of such shareholders During a 3-year testing period From utilizing pre-change losses or other tax attributes Against post-change income 26

27 Section 382 Loss Corporation NOL, tax credit, capital loss, or other attribute carryforward Net Unrealized Built-In Loss ( NUBIL ) Testing period Begins on the first day of the tax year when carryforward begins 3-year rolling period unless change occurs 27

28 Equity Under 382 What generally counts as equity when determining a Section 382 ownership change? Common voting stock Convertible preferred stock Voting preferred stock 28

29 NOL Poison Pills Protect your NOLs with a NOL poison pill plan Shareholder rights plans deter new 5% shareholders Can prohibit existing shareholders from buying more without board approval Board can waive Watch out Selectica, Inc. v. Versata Enterprises, Inc., No VCN (Del. Ch. January 3, 2009) 29

30 Section 382 Limitation Value Does not include any new investment being made on the change date Value of pure preferred (1504(a)(4) stock) is included in the limitation calculation Even though not tracked for equity shifts Market capitalization of a public company may be the starting point Does a control premium matter? See TAM

31 Adjustments to Value Holding substantial nonbusiness assets (1/3 of total asset value) immediately after the ownership change May be required to back out value of capital contributions made within 2 years of ownership change if they are pursuant to a plan Annual limitation may become zero if continuity of business enterprise is violated within 2 years of change A loss group is treated as a single entity for this test Need at least one member loss group member to continue business Corporate contractions PLR no corporate contraction where target guaranteed debt 31

32 Calculation of the Section 382 Limitation Section 382 Limitation Example: Value immediately before change $1,820 Capital Contributions pursuant to a plan ($200) Adjusted value $1,620 Published rate (L.T. tax exempt) 5.00% Annual NOL Limitation $81 Annual limitation accrues, even if unused 32

33 Successive Ownership Changes If two or more successive ownership changes, then each Section 382 limitation is applied independently (Reg. Section (d)) Later ownership changes may result in a lower, but not a higher, Section 382 limitation Application of rule may result in layers of NOLs where each layer is subject to different limitations A single low limitation can trap prior NOLs, and subsequent limitations can not create a higher limitation for previously limited NOLs 33

34 Section 382 in Bankruptcy Special Rules Assuming that loss corporation has NOLs and other attributes that survive attribute reduction under Section 108(b), Section 382 will likely apply to the utilization of losses post bankruptcy Consider the impact of an election under Section 108(b)(5) 382(l)(5) - generally provides for no limitation on use of NOLs if certain requirements are met 382(l)(6) generally provides for increased limitation if certain requirements are met (l)(6) is applicable if requirements for (1)(5) are not met or if debtor elects out of (l)(5) 34

35 Section 382 in Bankruptcy 382(l)(5) In title 11 immediately before the change Continuity of interest (tests pre-change shareholders and qualified creditors ) Post bankruptcy former creditors or historic shareholders must hold greater than 50% of the vote and value Special option rules for determining ownership that may have retroactive effect Example: options or warrants exercised by creditors and historic shareholders within three years of emergence from bankruptcy could allow a loss corporation to qualify for Section 382(l)(5) benefits back to the emergence from bankruptcy 35

36 Section 382 in Bankruptcy 382(l)(5) Effects and Consequences The use of pre-change losses is not subject to limitation under Section 382 If another ownership change occurs within 2 years, the Section 382 limitation with respect to the second ownership change will be zero Interest haircut: NOLs & excess credits are reduced by: Interest on the debt converted into equity in the bankruptcy proceeding (interest haircut) that was paid or accrued in: Any taxable year ending during the three-year period preceding the taxable year in which the ownership change occurs, and The period of the taxable year in which the ownership change occurs on or before the change date CCA (l)(5) not available for pre-packaged bankruptcy 36

37 Section 382 in Bankruptcy Example: A loss corporation enters bankruptcy with $500M in NOL $300M of debt is cancelled and the creditors receive $100M worth of equity $50M of interest was incurred on the converted debt during the look back period $200M of COD is excluded, none of which relates to accrued interest on the converted debt The NOLs are reduced to $250M ($500-$200-$50) 37

38 Section 382 in Bankruptcy 382(l)(6) Certain tax-free reorganizations; or Title 11 case; and 382(l)(5) doesn t apply Must continue the business for 2 years following the change date or the 382 limitation is 0 38

39 Section 382 in Bankruptcy 382(l)(6) Effects 382 limit applies Limitation is based on enhanced value following surrender or cancellation of creditor s claims Interest haircut does not apply 39

40 Section 382 in Bankruptcy Choosing between (l)(5) and (l)(6) Compare amount of NOLs Compare amount of COD income Interest haircut Comfort the transaction will qualify under (l)(5) Application of Notice Future plans Ownership change Continuing the business May want to modify bylaws/charter to prevent sales for 2 years 40

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