Final Actively Traded Debt Regulations: Implications for Debt Modifications and Exchanges

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1 Final Actively Traded Debt Regulations: Implications for Debt Modifications and Exchanges By William R. Pomierski and Jeffrey K. Ekeberg Overview If an outstanding debt instrument is modified, or is exchanged for a new debt obligation of the issuer, a taxable exchange will occur if the terms of the outstanding instrument (hereinafter, the old debt ) are significantly modified within the meaning of Treas. Reg In a taxable exchange, the amount deemed paid by the issuer to holders of the old debt will be based on the issue price of the modified or newly issued instrument (hereinafter, the new debt ). 2 The tax consequences, if any, to an issuer and holders resulting from a taxable debt-for-debt exchange can vary significantly depending on whether the issue price of the new debt is based on fair market value, or is determined based on the new debt s stated redemption price at maturity. 3 A fair market value issue price will apply if either of the new debt or the old debt is traded on an established market (hereinafter referred to as publicly traded ) as defined in Treas. Reg (f). Final regulations revising and expanding the definition of publicly traded property for purposes of the issue price determination took effect on November 13, 2012 (the Final Regulations ). As described below, the Final Regulations generally make it easier to classify debt or property as publicly traded for federal income tax purposes, increasing the risk that an issuer in a distressed debt situation may realize phantom cancellation of indebtedness income in a taxable debt-for-debt exchange. On the positive side, classifying debt as publicly traded in a debt-for-debt exchange where a redemption premium is paid allows issuers to immediately deduct the resulting redemption premium, rather than amortizing the deduction over the life of the new debt. This article focuses on the consequences to an issuer resulting from the application of the Final Regulations in the context of a taxable debt-for-debt exchange. Before discussing the Final Regulations and the resulting issue price considerations, a brief summary of the debt-for-debt exchange principles of Treas. Reg is in order. Taxable Debt-for-Debt Exchanges Under Treas. Reg (a), gain or loss is generally realized from the exchange of property for other property differing materially either in kind or in extent. Treas. Reg (b) provides that if an outstanding instrument is modified, or is actually exchanged for a new debt instrument, the modification or exchange is not a taxable exchange for purposes of Treas. Reg (a) unless the terms of the resulting instrument (the new debt) are sufficiently different from the terms of outstanding instrument (the old debt) to result in a significant modification. Treas. Reg establishes a two-step analysis for determining whether a taxable debt-for-debt exchange occurred as a result of a modification or an exchange of debt instruments. The first step is to determine whether there has been a modification to the terms of the old debt. The second step is to determine whether a modification is significant. A. Modifications A modification of a debt instrument is defined broadly as any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder, whether evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. 4 Subject to limited exceptions, alterations that occur automatically by operation of the terms of an instrument are considered modifications. 5 Alterations resulting from the exercise by the issuer or a holder of a right (option) set out in the terms of an instrument are considered modifications under the regulations unless the option is unilateral and in the case of a holder option, exercise does not result in (or, in the case of a variable or contingent payment, is not reasonably expected to result in) a deferral of, or a reduction in, any scheduled payment of interest or principal. 6 An option is unilateral only if the following conditions are met: (1) there does not exist at the time the option is exercised, or as a result of the exercise, a right of the other party to alter, terminate or put the instrument to a person who is related to the issuer (within the meaning of Section 267(b) or Section 707(b)(1)); (2) exercise of the option does not require the consent or approval of the other party, a person related to the other party (within the meaning of Section 267(b) or Section 707(b)(1)), whether or not that person is a party to the instrument, or a court or arbitrator; and (3) exercise of the option does not require consideration (other than incidental costs and expenses) unless, on the issue date, the consideration is de minimis, a specified amount, or an amount based on a formula that uses objective financial information (as defined in Treas. Reg (c)(4)(ii)). 7 B. Significant Modifications If the terms of an instrument are modified pursuant to an alteration or an exchange, step two in the analysis is to determine whether the modification is significant. Except as otherwise provided in a specific rule or a safe harbor, as described below, the general rule is that a modification is significant if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant. 8 In making this determination under the general rule, all modifications (other than modifications described in a specific rule or safe harbor) are considered collectively. 9 Beyond the general rule, Treas. Reg (e)(2) through (6) provide specific rules (and safe harbors) for determining whether certain types of modifications are significant. The specific rules February-March

2 include (1) changes in yield (which are significant only if the change is more than the greater of 25 basis points or 5% of the annual yield on the unmodified instrument); (2) changes (deferral) in the timing of payments (which are not significant if the deferral is the lesser of 5 years or 50% of the original term); 10 (3) changes in the obligor or security; (4) changes in the nature of the instrument (i.e., changes into property that is not debt (e.g., equity) or changes in the recourse nature of the debt); or (5) changes in accounting or financial covenants. If any of these specific rules is violated, the modification will be considered significant for purposes of Treas. Reg regardless of whether or not other specific rules are violated. Also, whether a modification of any term is significant is determined separately under each applicable rule in Treas. Reg (e)(2) through (6). For example, a deferral of payments that changes the yield of a fixed rate debt instrument must be tested under both paragraphs (2) and (3) of Treas. Reg (e). 11 Issue Price Determination In a taxable debt-for-debt exchange resulting from a modification or actual exchange treated as a significant modification under Treas. Reg , the amount realized by the holders of the old debt is based on the issue price of the newly issued debt instrument. 12 Accordingly, after determining that a significant modification occurred, the next step is to determine the issue price of the new debt. For federal income tax purposes, the issue price of a debt instrument is generally determined under Section 1273(b) or Section 1274 and the regulations issued thereunder. Under Section 1273(b), the issue price of an instrument depends on whether it is issued for cash or property, as well as depending on whether the debt instrument itself (the new debt) or the property it is issued in exchange for (i.e., the old debt in a debt-for-debt exchange) is publicly traded. Section 1273(b) and the regulations thereunder reflect a priority approach to determining the issue price of a debt instrument. First, if an instrument is issued for money, the issue price for each debt instrument in the issue is the first price at which a substantial amount of the debt instruments is sold. 13 Next, if debt is not issued for money (that is, the instrument is issued for property) and the newly issued instrument is publicly traded, its issue price is its fair market value as of the issue date. 14 Next, if a debt instrument is issued for property and the newly issued debt instrument is not publicly traded but is issued for publicly traded property, the issue price of the instrument is the fair market value of such property as of the issue date. 15 Finally, if a debt instrument is issued for property and neither the newly issued debt nor the property for which it is issued is publicly traded, then the issue price of the debt instrument is determined under Section 1273(b)(4) or Section In a taxable debt-for-debt exchange, the consequences to the issuer and holders can vary significantly depending on whether the issue price of the newly issued debt is based on fair market value (where either the new debt or the old debt is publicly traded), or is based on the new debt s stated redemption price at maturity or stated principal amount. Accordingly, the determination of whether either debt instrument is publicly traded within the meaning of the Final Regulations is a critical next step. The Final Regulations The Final Regulations apply to determine the issue price of publicly traded debt instruments issued on or after November 13, Based on its view that [T]he increased liquidity and transparency of the debt markets in recent years has largely eliminated concerns about reliable information on sales and pricing being unavailable, 18 Treasury altered and in doing so expanded the prior definition of publicly traded property by providing simply that property (including debt) will be considered publicly traded if, within the 31-day period ending 15 days after the issuance of the debt instrument, any of the following exists: (i) a sales price, (ii) one or more firm quotes or (iii) one or more indicative quotes. 19 A sales price exists, within the meaning of the Final Regulations, if the price for an executed purchase or sale of an instrument within the 31-day testing period is reasonably available within a reasonable period of time after the sale. 20 A price is considered reasonably available if the sales price (or information sufficient to calculate the sales price) appears in a medium that is made available to issuers of debt instruments, persons that regularly purchase or sell debt instruments (including a price provided only to certain customers or to subscribers), or persons that broker purchases or sales of debt instruments. 21 This category loosely follows the quotation medium category under Treas. Reg (f)(4), as it existed prior to issuance of the Final Regulations. 22 Under the second category of publicly traded property, a firm quote exists when a price quote for an instrument is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or to subscribers) and the quoted price is substantially the same as the price for which the instrument could be purchased or sold. 23 A price quote is considered to be available whether the quote is initiated by a person providing the quote or provided at the request of the person receiving the quote (such as a request by the issuer or a holder). The identity of the person providing the quote must be reasonably ascertainable for a quote to be considered a firm quote. A quote is considered a firm quote if it is designated as a firm quote by the person providing the quote or if market participants typically purchase or sell, as the case may be, at the quoted price even if the party providing the quote is not legally obligated to purchase or sell at that price. Under the final category, an indicative quote exists when a price quote for an instrument is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or to subscribers) and the price quote is not a firm quote. 24 This category appears to be the same as the readily quotable category under the prior regulations, minus the safe-harbors that were previously provided. A. Fair Market Value Determination The Final Regulations include a presumption that if an instrument falls within the one of the three enumerated categories, the fair market value of the instrument is presumed to equal to the sale price or the quoted price, as the case may be. 25 However, if there is more than one sales price or quoted price, the issuer may use any reasonable method to determine the fair market value of the property. February-March

3 Note also that if there are only indicative quotes available for the property and the issuer determines that the quote materially misrepresents the fair market value of the property, a taxpayer may use any reasonable basis for determining the fair market value of the property. 26 The taxpayer must, however, establish that the chosen method more accurately reflects the value of the property. B. Small Issue Exception The Final Regulations provide a limited exception from the definition of publicly traded property for debt instruments which are part of an issue, the aggregate principal amount of which does not exceed $100 million. 27 No other exceptions are provided. Accordingly, the Final Regulations raise issues as to whether closely held debt, including debt held by a related party, could be considered publicly traded under the broadly defined indicative quote category if its aggregate principal amount exceeds the small issue threshold. C. Notice and Consistency The Final Regulations require an issuer to exercise reasonable diligence in determining whether property is publicly traded and, if so, the fair market value of the property. If an issuer determines that property is publicly traded, the Final Regulations impose an obligation on the issuer to make its determination, and the fair market value of the property, available to holders within 90 days of the date that the instrument is issued. 28 The issuer s determination is binding on a holder of the debt instrument unless the holder explicitly discloses that its determination is different from the issuer s determination and describes in the disclosure the reasons for its different determination. 29 A holder s disclosure of a different determination as to whether property is publicly traded or a different determination as to fair market value must be reflected on a statement included with a timely filed Federal income tax return for the taxable year that includes the acquisition date of the debt instrument. If an issuer does not make the fair market value or issue price of a debt instrument reasonably available to a holder, the holder must determine the fair market value of the property and issue price of the debt instrument using the rules provided in Treas. Reg (f). Debt Modification Consequences If the fair market value of new debt issued in a debt-for-debt exchange is different than the adjusted issue price of the old debt, 30 the determination of whether either the old debt or the new debt is publicly traded can have significant federal income tax consequences. A. Distressed Debt From an issuer s perspective, if the issue price of the newly issued debt is based on fair market value, and such fair market value issue price is less than the adjusted issue price of the old debt, the issuer may, absent an exception under Section 108, realize phantom cancellation of indebtedness (COD) income. 31 The resulting COD income is considered phantom income to the extent an actual reduction in the principal amount of the debt did not occur as a result of the modifications or exchange. 32 In such cases, the newly issued debt instrument will also be treated as having a reciprocal amount of original issue discount that must be accrued ratably by both the issuer and holders (regardless of their general method of tax accounting) over the term of the instrument. If the newly issued debt instrument has a term-to-maturity of greater than five years, a yield greater than 500 basis points in excess of the applicable Federal rate and has significant original issue discount as such term is defined is Section 163(i)(2), the instrument would constitute an applicable high yield discount obligation. In that event, a portion of the issuer s original issue discount deductions would be deferred and potentially disallowed altogether. 33 As an example, assume an issuer previously issued a publicly traded ten-year debt instrument for cash equal to its stated principal amount of $200,000,000. Assume that the instrument provided, at the time of its original issuance, for a market rate of interest based on the issuer s creditworthiness, the instrument was not issued with original issue discount and its adjusted issue price is currently $200,000,000. Due to changes in the issuer s creditworthiness, the instrument is currently valued at $180,000,000. Assume further that the issuer and holders agree to modify the terms of the instrument and that the modifications are significant for purposes of Treas. Reg , but the principal amount of the debt remains unchanged (i.e., there is no actual debt forgiveness). As a result of the significant modification, the parties must treat the old debt as having been exchanged for a new (the resulting) instrument. Also assume that the new debt is considered publicly traded as defined in the Final Regulations, resulting in a fair market value issue price of $180,000,000. Absent an exclusion under Section 108, the issuer in this example would recognize $20,000,000 of COD income in the year of the exchange, measured by the difference between the issue price of the new debt, which is based on its fair market value, and the adjusted issue price of the outstanding debt instrument (which for purposes of this simple example is assumed to be its stated principal amount of $200,000,000). Note further that the newly issued debt instrument would, in this example, also be treated as having been issued with $20,000,000 of original issue discount. 34 The issuer and holders would be required to accrue such original issue discount over the life of the resulting debt instrument. From the issuer s perspective, the resulting original issue discount deduction will effectively reverse the phantom COD income, but the issuer has a timing mismatch due to the requirement that it recognize all of the resulting COD income in the year of the exchange whereas the offsetting original issue discount deduction will be taken ratably over the life of the resulting instrument. B. Redemption Premiums Under Treas. Reg (c), an issuer is generally entitled to a deduction upon a repurchase of its outstanding debt (including in the case of an actual exchange or a deemed Treas. Reg exchange) where the repurchase price exceeds the instrument s adjusted issue price. The timing of the redemption premium deduction in a debt-fordebt exchange under Treas. Reg depends on whether either of the old debt or the new debt is publicly traded. If an issuer repurchases its own debt in a debt-for-debt exchange and neither the old debt instrument nor the new debt instrument is publicly traded, 44 The Tax Executive

4 as defined in the Final Regulations, then the redemption premium is not deductible in the year of the repurchase (exchange), but instead must be amortized over the term of the newly issued instrument in the same manner as if it were original issue discount. If either the old debt or the new debt is considered publicly traded, however, then Treas. Reg (c) provides that the entire redemption premium is available to the issuer as an interest expense deduction in the year in which the exchange occurs. Thus, the manner in which the issue price of a debt instrument issued in a debt-for-debt exchange is determined will have a critical impact on the timing of the resulting redemption premium deduction for the issuer. 35 Conclusion The expanded definition of publicly traded property set out in the Final Regulations is designed to make it easier to conclude that debt is publicly traded. While the definitions set out in the Final Regulations are simple, it is likely that the regulations may prove difficult to administer in practice, particular in those close call situations involving debt classified as publicly traded under the indicative quote category. The absence of exceptions beyond the small issue exception means issuers and holders will need to be particularly mindful of the publicly traded classification question, and the fair market value implications in a taxable debt-for-debt exchange. As taxpayers consider these transactions, the Final Regulations must be carefully navigated to avoid potentially adverse tax consequences. Copyright February 2013 by William R. Pomierski and Jeffrey K. Ekeberg. All rights reserved. Reprinted with permission. William R. Pomierski, a partner of McDermott Will & Emery LLP, is a member of McDermott s tax practice group. Mr. Pomierski focuses his practice on the federal income tax implications of a variety of domestic, cross-border, and global financial products and capital markets transactions. He received his B.B.A. degree from Michigan State University, and his J.D. degree from the University of Illinois. He may be contacted at wpomierski@mwe.com. Jeffrey K. Ekeberg is an associate of McDermott Will & Emery LLP, and is a member of McDermott s tax practice group. Mr. Ekeberg focuses his practice on international and domestic tax planning for multinational companies. He received his B.A. degree from the University of Michigan, and his J.D. degree from the University of Illinois. He may be contacted at jekeberg@mwe.com. 1. All references to Section are to the Internal Revenue Code of 1986, as amended (the Code ) and all references to Treas. Reg. are to the Treasury Regulations promulgated thereunder. 2. See Treas. Reg (g). 3. A debt instrument s stated redemption price at maturity is the sum of all amounts payable with respect to the instrument other than qualified stated interest (as defined in Treas. Reg (c)). See Section 1273(a)(2) and Treas. Reg (b). 4. Treas. Reg (c)(1)(i). 5. Treas. Reg (c)(1)(ii). Exceptions are provided for alterations that result in (1) substitution of a new obligor, (2) change in the recourse nature of the instrument or (3) a conversion of the instrument to equity. See Treas. Reg (c)(2). 6. Treas. Reg (c)(2)(iii). 7. Treas. Reg (c)(3). 8. Treas. Reg (c)(1). 9. Id. 10. An acceleration of payments is not a significant modification for these purposes. 11. Treas. Reg (f)(1)(i). 12. Treas. Reg (g)(1). Special rules are provided in Treas. Reg (g)(2) for certain debt instruments that provide for contingent payments, a detailed discussion of which is beyond the scope of this article. 13. Section 1273(b)(1); Treas. Reg (a)(1). 14. Section 1273(b)(3)(A); Treas. Reg (b)(1). 15. Section 1273(b)(3)(B); Treas. Reg (c)(1). 16. As a general matter, under Section 1273(b)(4), the issue price would equal the stated redemption price at maturity and under Section 1274, the issue price would equal the stated principal amount as long as the debt instrument provides for adequate stated interest. If the instrument does not provide for adequate stated interest, the issue price would equal the imputed principal amount of the instrument as determined under Section 1274(b)(1) and the regulations thereunder. A detailed discussion of Section 1274 is beyond the scope of this article. 17. Prior to the Final Regulations, Treas. Reg (f) provided that property was considered publicly traded if it fell within any one of the following categories (as each was defined in the prior regulations): (1) exchange listed property; (2) market traded property; (3) property appearing on a quotation medium; or (4) readily quotable debt instruments. Under the final category, price quotations for debt instrument were not considered readily available if any of the following conditions (safe harbors) were satisfied: (i) no other outstanding debt instrument of the issuer (or of any person who guarantees the debt instrument) is described in the first three categories listed above; (ii) the original stated principal amount of the issue that includes the debt instrument does not exceed $25 million; (iii) the conditions and covenants relating to the issuer s performance with respect to the debt instrument are materially less restrictive than the conditions and covenants included in all of the issuer s other traded debt; or (iv) the maturity date of the debt instrument is more than 3 years after the latest maturity date of the issuer s other traded debt. 18. Treasury Decision 9599 (September 13, 2012) (hereinafter, the Preamble ). 19. Note that the Final Regulations include two anti-abuse rules. See Treas. Reg (f)(7). First, if there is any temporary restriction on trading a purpose of which is to avoid the characterization of the property as publicly traded for Federal income tax purposes, then the property is treated as traded on an established market. Second, if a principal purpose for the existence of any sale or price quotation is to cause the property to be publicly traded or to materially misrepresent the value of property, that sale or price quotation is disregarded. 20. Treas. Reg (f)(2)(i). 21. Treas. Reg (f)(2)(ii). 22. For a discussion of various pricing services under the quotation medium category of the prior regulations, see New York State Bar Association Tax Section, Report on Definition of Traded on an February-March

5 Established Market Within the Meaning of Section 1273 and Related Issues, dated March 30, 2010 ( Among various pricing services available, there is a general consensus that TRACE is a quotation medium meeting the requirements under (f)(4), setting aside the requirement for the information to be recent. As discussed in detail in the Appendix, TRACE provides on their website actual trading values and limited trading history of bonds that are registered with the SEC. ). 23. Treas. Reg (f)(3). 24. Treas. Reg (f)(4). 25. Treas. Reg (f)(5)(i). 26. Treas. Reg (f)(5)(ii). 27. Treas. Reg (f)(6). 28. According to the Preamble, there appears to be no prescribed format for making this information available to holders. The Preamble requires that this information must be provided in a commercially reasonable fashion, which can be a posting to a Web site or similar electronic publication, within 90 days of the date that the debt instruments are issued. 29. Treas. Reg (f)(9). 30. Under Treas. Reg (b)(1), a debt instrument s adjusted issue price at the beginning of the first accrual period is its issue price. Thereafter, the adjusted issue price of the debt instrument is the issue price (i) increased by the amount of OID previously includible in the gross income of any holder (determined without regard to Section 1272(a)(7) and Section 1272(c)(1)); and (ii) decreased by the amount of any payment previously made on the instrument other than a payment of qualified stated interest. A special rules is provided in Treas. Reg (b)(2) for instruments issued with bond issuance premium. 31. An issuer would realize COD income in a debt-for-debt exchange equal to the amount by which the adjusted issue price of the old instrument exceeds the adjusted issue price of the new instrument. See Treas. Reg (c)(2)(ii); Section 108(e)(10). In this situation, unless the transaction qualifies as a tax-free recapitalization under Section 368(a)(1)(E), a holder would recognize gain or loss on the exchange equal to the difference between this amount realized (the issue price of the newly issued debt instrument) and the holder s tax basis in the old instrument. See Rev. Rul , C.B. 28, concluding that from an issue s perspective, an exchange of new securities for its old securities does not fall within Section 361(a). 32. On January 24, 2013, Representative Camp, the Chairman of the House Ways and Meetings Committee, released a financial products discussion draft as part of the Committee s efforts on comprehensive tax reform. The discussion draft includes provisions that are specifically intended to eliminate the phantom COD income recognized in a debt-for-debt modification. The proposals would address this issue by providing that in the case of a specified debt modification, the issue price of the modified debt instrument would be the lesser of (1) the adjusted issue price of the existing (old) debt instrument or (2) the issue price of the modified (new) debt instrument which would be determined under Section 1274 as if the debt instrument were a debt instrument to which that section applied (i.e., the principal amount if there is adequate stated interest or, otherwise, the inputed principal amount). If adopted, these provisions would apply to transactions occurring after December 31, See Section 163(e)(5). A catch up clause obligating the issuer to accelerate certain payments of accrued original issue discount could be added to the debt instrument in such situations to avoid the application of Section 163(e). 34. Original issue discount equals the excess of the stated redemption price at maturity of a debt instrument (which in this example is assumed to be $200,000,000, as the principal amount was not reduced) over its issue price (in this example assumed to be $180,000,000). 35. Note that in many cases, a debt-for-debt exchange will qualify, from the perspective of the holders, as a Section 368(a)(1)(E) reorganization, and thus will not result in immediate taxation to the holders. Institute Welcomes Lisa Samuels as its Communications & Marketing Lead TEI welcomed Lisa Samuels as its first Director of Communications & Marketing in early February, adding her broad marketing, communications and editing experience to the Institute s staff. Lisa began her career in publication design and production, with a degree in Journalism and Mass Communications from Drake University (Des Moines, IA). After working in Des Moines for a newspaper publishing house, she came East in the mid-1990s to be closer to friends and family. Since moving here, Lisa has held several positions, including working at two other professional societies. Thanks to some great opportunities along the way, her skillset grew to include marketing and communications. Most recently, she served as the Vice President of Marketing for Seneca One Finance, a privately held factoring company. There, Lisa was responsible for all marketing strategy and implementation for two lines of business, including direct mail, internet marketing, and the company s list development and management. She led a team of 20 and managed an operating budget of $3,000,000. We are extremely fortunate to have Lisa on our team, said Eli Dicker, TEI s Executive Director. In her few short weeks on staff, she has fit in beautifully, begun to learn the rhythms of our organization and most important, has begun to add considerable value, he added. When not working, Lisa enjoys her dog Air Jordan (a/k/a A.J.) as well as cooking and knitting. In addition, she volunteers free time at the National Multiple Sclerosis Society s National Capital Area Chapter. February-March