Tax Considerations in Debt-for-Equity Partnership Debt Restructuring. Part I: Creditor s Perspective

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1 Tax Considerations in Debt-for-Equity Partnership Debt Restructuring Part I: Creditor s Perspective Capital Markets Subcommittee August 2013

2 Introduction This paper provides an overview of the various U.S. federal income tax rules that must be taken into consideration by a creditor in connection with a debt-for-equity partnership debt restructuring. These rules include the various statutory and regulatory provisions, as well as certain judicial doctrines and relevant case law. Summary I. Statutory and Regulatory Framework General Cancellation of Debt Rules In general, a debtor may recognize cancellation of debt ( COD ) income when the amount of debt is reduced or reacquired at a discount. 1 Because COD income is phantom income to the debtors (i.e., income the recipient is deemed to have received despite the lack of a corresponding liquid cash flow), creditors must be prepared to consider and address this issue when negotiating the terms of a debt restructuring arrangement. There are a number of exceptions that may allow the debtor to avoid recognition of COD income. 2 For example, exceptions exist if debt is discharged as part of a Chapter 11 bankruptcy proceeding or while the debtor is insolvent. 3 In addition, the cancellation of qualified real property business indebtedness does not give rise to COD income if certain conditions are met. 4 It should be noted that the application of the COD rules involves additional complexity when the debtor is a partnership for federal tax purposes. General Debt-for-Equity Cancellation of Debt Rule Subject to certain qualifications, if a debtor partnership transfers a capital or profits interest in such partnership to a creditor in satisfaction of its recourse or non-recourse indebtedness, such partnership shall be treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the equity interest. 5 The fair market value of the partnership interest transferred by the debtor partnership in satisfaction of its debt is determined by taking into account all of the facts and circumstances. 6 However, the regulations provide for a safe harbor rule under which such fair market value is deemed to be the liquidation value of the partnership interest if certain conditions are met. 7 The liquidation value of the partnership interest is the amount the creditor would receive for the interest if the partnership sold all of its assets for cash immediately after the transfer. 8 In the case of a tiered partnership where an upper-tier partnership owns an interest in a lower-tier partnership, the liquidation value of an interest in an upper-tier partnership held by a lower-tier partnership is determined by taking into account the liquidation value of the lower-tier partnership interest. 9

3 Creditor Nonrecognition and Basis Rules In debt-for-equity exchanges, generally the creditor does not recognize a gain or loss or bad debt deduction, and the creditor s basis in the partnership interest is increased under Code 722 by the adjusted basis of the indebtedness. 10 Thus, the basis of a partnership interest acquired in connection with a contribution of debt is equal to the contributing creditor s adjusted basis in the debt, increased by any gain recognized under Code 721(b) by the contributing creditor. 11 In other words, so long as a profits or capital interest in the partnership is received the rules of Code 722 should apply. Given the rejection of the bifurcation approach (discussed below), the contributing creditor likely should have a basis in its partnership interest under the rules of Code 722 (which rules do not provide for a proration or reduction in basis). It is unclear, however, how the basis rules should apply in the event the capital interest in the partnership received by the creditor has no current liquidation value. Rejection of the Bifurcation Approach Although certain commentators contended that, in the partnership context, a debt-for-equity exchange should be bifurcated into the cancellation of part of the debt and the contribution of the remainder in exchange for a partnership interest (i.e., the so-called bifurcation approach ), the Treasury and the IRS rejected this approach, instead following the position of another commentator who argued that the bifurcation approach is inconsistent with Code 721 and case law. 12 In addition, the Treasury and the IRS noted that the bifurcation approach would be inconsistent with the treatment of analogous corporate debt-for-equity transactions, such as those to which Code 351 would apply. 13 Because the final regulations reject the use of the bifurcation approach, it follows that the Treasury and the IRS likely would not assert an allocation of basis between the debt contributed and the debt retained in a manner other than a straight prorated allocation based on relative amounts. II. Case Law and Judicial Doctrine In applying the Code to particular transactions, the courts frequently assert that transactions are to be taken at face value for tax purposes only if they are imbued with a business purpose or reflect economic reality, and integrate all steps in a prearranged plan rather than give effect to each step as though it were an isolated transaction. These concepts are more commonly known as the Business Purpose Doctrine and Step Transaction Doctrine. 14 In addition to the statutory and regulatory framework set forth above, creditors must also be aware of the potential impact of these common law doctrines when engaging in negotiations with a debtor in connection with a debt restructuring. Each is discussed in turn below. Business Purpose Doctrine The Business Purpose Doctrine requires that tax statutes be construed so as to refer to transactions entered into for commercial or industrial purposes but not transactions entered into for no other motive but to escape taxation. 15 In other words, courts have required that a transaction have a real business purpose or reflect economic reality in order to apply the Code to such transaction and take full advantage of the Code s provisions. Indeed, courts may invoke this doctrine to disallow a taxpayer s desired tax treatment where a transaction does not have purpose, substance, or utility apart from [its] anticipated tax consequences even where the transaction cannot be characterized as a sham. 16 However, the Business Purpose Doctrine does not prohibit legitimate tax planning and does not require a

4 motivation that is free of tax considerations. Rather, a transaction has a business purpose as long as it figures in a bona fide, profit-seeking business. 17 Further, in the context of debt cancellation by a parent-creditor, the IRS has followed the lead of the courts by giving substance to a cancellation of debt that had independent economic significance because it resulted in a genuine alteration of a previous bona fide business relationship. 18 Step Transaction Doctrine The Step Transaction Doctrine requires the interrelated steps of an integrated transaction to be taken as a whole rather than treated separately. The step transaction doctrine does not require a prior agreement committing the parties to the entire series of steps once the first is taken; there is ample authority for linking several prearranged or contemplated steps, even in the absence of a contractual obligation or financial compulsion to follow through. 19 Moreover, while simultaneity is often the best evidence of interdependence, the step transaction doctrine has been applied to events separated by as much as five years and, on other facts, held inapplicable to events occurring within a period of thirty minutes. 20 Generally speaking, the courts apply three different variations of this doctrine.the three principal tests are based on: (i) binding commitment, (ii) interdependence, and (iii) end result. 21 Under the binding commitment test, transactions are treated as steps of a single transaction if the parties were legally obligated to complete all of the transactions. The interdependence test is met if the steps were so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series. The end result test combines into a single transaction separate events that were intended from the outset to be component parts of reaching a particular result. Courts often decline to apply the Step Transaction Doctrine if the taxpayer structures a series of transactions to take advantage of a favorable tax provision, as long as each step has colorable independent economic substance and business purpose. 22 Further, courts are also reluctant to apply the step transaction doctrine where there is no indication that the taxpayer sought to obtain a tax advantage by adding meaningless steps to a transaction with a bona fide business purpose. 23 Finally, it should be noted that the application of the various elements of this doctrine are not applied uniformly throughout the various courts. Generally speaking, because the courts may apply different standards and variations of the tests in applying the doctrine, a taxpayer may not necessarily need to meet all three of the elements outlined above depending upon a particular court s venue or jurisdiction. Briarpark In 2925 Briarpark Ltd. v. Comm r, 24 the Fifth Circuit upheld a Tax Court decision that treated the amount realized on the discharge of non-recourse indebtedness as gain from dealings in property because the discharge was part of a single sale or exchange of the underlying encumbered property. The taxpayer took out non-recourse obligations in connection with the acquisition of land, construction of a building, and tenant improvements. At a time when the loan balances exceeded the fair market value of the property, the taxpayer requested that the lender modify the loans to allow for a cash sale of the building. At the lender s suggestion, the taxpayer put the building on the market and brought in several proposals for purchase. The lender was concurrently contemplating several options, including liquidation on default, refinancing, and a sale/settlement. Six months later, the taxpayer signed a sale agreement to

5 sell the property. The buyer conditioned the purchase upon the lender s removal of the encumbrances. Before the end of the year, the taxpayer sold the property and the lender released the liens against the taxpayer. While the taxpayer characterized the release of the encumbrances as cancellation of debt income, the IRS determined that the cancellation of debt income should have been reported as a gain from dealing in property because the amount of the discharged debt was includable in the amount realized. The Tax Court agreed with the IRS noting that the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. Rejecting the taxpayer s argument that the lender should be regarded as having forgiven, independently of the sale, the excess of the debt over the cash it received, the court found that the sale and loan discharge were the result of a single transaction involving the sale of encumbered property and not two independent events. 25 Discharge of debt will be characterized as realization of a gain on a sale or exchange where the transaction: (1) relieved the taxpayer-owner of his obligation to repay the debt; and (2) the taxpayer is relieved of title to the property. III. Examples The following examples are intended to illustrate the potential U.S. federal income tax consequences of various debt restructuring approaches, similar to those contemplated in Briarpark. For ease of illustration, assume for each scenario discussed in turn below that (i) the loan balance is $1,000,000 ($800,000 principal and $200,000 unpaid interest), (ii) the liquidation value of the partnership interest is $500,000, and (iii) there are two 50/50 partners each having a $150,000 tax basis and a $500,000 share of the debt ($400,000 principal and $100,000 unpaid interest). Foreclosure In the event the debt is not restructured, the encumbered property is generally foreclosed upon. For U.S. federal income tax purposes a foreclosure of the lien on encumbered real property that secures a non-recourse indebtedness (such as that in Briarpark) is treated as a sale of the encumbered property for the principal amount of the debt. In our example, each partner would be treated as having sold its interest in the encumbered property for $400,000, resulting in $250,000 of capital gain ($400,000 less $150,000 tax basis). The partners could have avoided the recognition of capital gain in this scenario only if their tax basis exceeded their share of the debt. As noted above, creditors generally can expect debtors to approach them seeking some sort of debt restructuring arrangement whereby the parties can mitigate the amount of phantom COD income the debtors must recognize. Restructuring Assume that, instead of foreclosing on the encumbered property, the creditor in connection with the hypothetical loan agrees to restructure the indebtedness, forgiving the outstanding balance of the debt in exchange for an interest in the partnership. Assuming that the requirements of the safe harbor noted above have been met, the debt is treated as having been satisfied for $500,000 (i.e., the liquidation value of the partnership interest to be exchanged). The amount by which the outstanding principal balance of the debt exceeds the fair market value of the transferred interest is the amount of COD income that must be included in the distributive shares of the remaining partners. Thus, assuming there was no unpaid interest, each partner will realize $150,000 of COD income (their 50% share

6 of the $300,000 difference between $800,000 forgiven principal and the $500,000 fair market value of the partnership interest). However, where there is unpaid interest, the Treasury Regulations require that any payment received in a debt restructuring first be applied against such outstanding balance. In our example, the first $200,000 of the deemed payment is treated as repaying interest, and then the remaining $300,000 is treated as repaying a portion of the principal. Thus, the partners would each realize $250,000 of COD income (their 50% share of the $500,000 difference between $800,000 forgiven principal and the $300,000 portion of fair market value of the partnership interest applied to principal). When writing off debt, a creditor must consider whether the worthless securities or bad debt deduction rules apply. In the case of a straightforward debt-for-equity partnership debt restructuring the creditor generally will be precluded from taking a deduction under the more restrictive worthless securities rules in Code 165 which define a security as 1) a share of stock in a corporation, 2) a right to subscribe for, or to receive, a share of stock in a corporation, or 3) a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form. Where a debt does not constitute a security (and, hence, the worthless securities rules do not apply) a creditor must then look to the bad debt deduction rules in order to claim a deduction for the portion of debt forgiven in connection with a restructuring. With the denial of the previously discussed bifurcation approach, in the case of a debtfor-equity partnership debt restructuring the creditor is not allowed to treat the spread between the forgiven principal and the value of the exchanged interest (i.e., $300,000 in our example above) as a Code 166 bad debt deduction unless it can establish partial worthlessness (complete worthlessness if the creditor is not in a trade or business of lending money) prior to the exchange and satisfy all the requirements of Code 166. REISA White Paper: Tax Considerations in Debt-for-Equity Partnership Debt Restructuring (Part I: Creditor s Perspective) Authors of this White Paper: Prepared by Peter R. Matejcak and Daniel F. Cullen of Bryan Cave LLP, with assistance from Darryl Steinhause of DLA Piper LLP. Date Approved by the REISA Board: August, 2013 This REISA White Paper is provided by REISA for educational and informational purposes only and is not intended, and should not be construed, as legal or investment advice. This REISA White Paper is not a statement of substantive law. Persons or entities are urged to consult their own legal counsel should they seek advice regarding the matters discussed herein. Copyright 2013 by REISA. All rights reserved Readers may copy section of this publication for personal use. However, it is a violation of U.S. copyright laws to copy substantial portions of the publication for any other reason without permission. The Copyright Act of 1976 provides for damages for illegal copying. If you wish to copy and distribute sections of this publication, please contact REISA headquarters at reisa@reisa.org or Pursuant to requirements relating to practice before the Internal Revenue Service, nothing in this publication is intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United State Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax-related matter. REISA and the triangle logo are proprietary trademarks of REISA. All rights are reserved regarding these rights. You may not use any of REISA s trademarks or trade names without permission.

7 References 1 I.R.C. 61(12). 2 See I.R.C. 108(a)(1). 3 I.R.C. 108(a)(1)(A) and (B). 4 See I.R.C. 108(c). Note that this exception does not apply to debtors that are C corporations for federal income tax purposes. 5 I.R.C. 108(e)(8); Treas. Reg (a). 6 Treas. Reg (b)(1). 7 Treas. Reg (b)(2)(i). The requirements of the safe harbor rule include: the creditor, partnership, and partners must treat the fair market value of the debt as being equal to the liquidation value for tax purposes; if the partnership transfers more than one equity interest to a creditor, then the creditor, partnership, and partners must treat the fair market value of each interest as equal to its liquidation value; the debt-for equity exchange is an arm s-length transaction; and after the exchange, neither the partnership redeems nor any related person purchases the interest as part of an existing plan a principal purpose of which is the avoidance of cancellation of debt income by the partnership. 8 Treas. Reg (b)(2)(iii). 9 Treas. Reg (b)(2)(ii). 10 Treas. Reg (d); T.D (Nov. 17, 2011); Prop. Regs. 10/31/2008, Fed. Reg. Vol. 73, No. 212 p I.R.C Note that Code 721(b) only applies to a partnership that would constitute an investment company (under I.R.C. 351) if incorporated. 12 T.D (Nov. 17, 2011). 13 Id. 14 In addition to the doctrines considered in this memorandum, Code 7701(o) codifies the Economic Substance Doctrine, which itself requires that, in order to have economic substance, (i) a transaction must change the taxpayer s economic position in a meaningful way (other than with respect to federal income taxes) and (ii) a taxpayer must have a substantial purpose (other than federal income tax effects) for entering into such transaction. 15 Comm r v. Transport Trading & Terminal Corp., 176 F.2d 570, 572 (2d Cir. 1949), cert. denied, 338 U.S. 955 (1950). 16 Goldstein v. Comm r, 364 F.2d 734, 740 (2d Cir. 1966), cert. denied, 385 U.S (1967). 17 See United Parcel Service v. Comm r, 254 F.3d 1014 (11th Cir. 2001) (There may be no tax-independent reason for a taxpayer to choose between these different ways of financing the business, but it does not mean that the taxpayer lacks a business purpose. To conclude otherwise would prohibit tax planning.). 18 See Rev. Rul (in arriving at this decision, the IRS pointed to Simpson v. Comm r, 43 T.C. 900 (1965) regarding the importance of independent economic significance). 19 See McDonald s Restaurants of Ill. v. Comm r, 688 F.2d 520 (7th Cir. 1982); King Enters., Inc. v. U.S., 418 F.2d 511 (Ct. Cl. 1969). 20 Douglas v. Comm r, 37 B.T.A (1938) (acq.) (five-year delay in consummating a corporate reorganization resulting from non-assignability of contracts and disputed claims); Henricksen v. Braicks, 137 F.2d 632 (9th Cir. 1943) (liquidation treated as independent of transfer of assets to new corporation thirty minutes later). 21 See, e.g., Kornfeld v. Comm r, 137 F.3d 1231 (10th Cir.), cert. denied, 525 U.S. 872 (1998); American Bantam Car Co. v. Comm r, 11 TC 397 (1948), aff d per curiam, 177 F.2d 513 (3d Cir. 1949); Comm r v. Gordon, 391 U.S. 83 (1968). 22 See, e.g., Esmark, Inc. v. Comm r, 90 T.C. 171 (1988), aff d by order, 886 F.2d 1318 (7th Cir. 1989); Tandy Corp. v. Comm r, 92 T.C (1989). 23 See Turner Broad. Sys. v. Comm r, 111 T.C. 315 (1998) Briarpark Ltd. v. Comm r, 163 F.3d 313 (5th Cir. 1999). 25 The court specifically noted that there was no indication that the lender was willing to forgive any part of the taxpayer s debt except as a condition of sale to the buyer.

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