Earlier this month the IRS proposed Treasury Regulations (the "Proposed Regulations") to address when property is traded on an established market, or "publicly traded," for purposes of determining the issue price of a debt instrument. The Proposed Regulations would amend the existing Treasury Regulations that have been frequently criticized for their lack of clarity and inapplicability to current debt markets. The Proposed Regulations expand the scope of property treated as "publicly traded" and are likely to have a significant impact on the tax consequences of certain debt-for-debt exchanges to both the debtor and creditors.
The Importance of Expanding the Scope of "Publicly Traded"
The issue price of a debt instrument issued for cash generally is the first price at which a substantial amount of the debt instrument is sold for cash. The issue price of a "publicly traded" debt instrument issued for property is the fair market value of the debt. Similarly, if a debt instrument is issued in exchange for "publicly traded" property (including another debt instrument), the issue price of the debt is the fair market value of the property exchanged. If neither the newly issued debt instrument nor the property exchanged for such debt instrument is "publicly traded," the newly issued debt instrument's issue price generally equals its stated principal amount.
The issue price of a debt instrument is particularly important in actual or deemed debt-for-debt exchanges. When the parties exchange existing debt for new debt of the same issuer, or significantly modify the terms of the existing debt so that the modification is treated as an exchange for new debt, the issuer will realize cancellation of debt income ("CODI") in an amount equal to the excess, if any, of the amount due on the existing debt over the issue price of the new debt. If the debt were "publicly traded," the CODI realized would equal the excess of the old debt's adjusted issue price over the fair market value of the new debt, which commonly is less than its face amount when the issuer is in financial distress. In contrast, if the debt were not "publicly traded," the issuer would realize CODI equal to the difference between the adjusted issue price of the old debt and the stated principal amount of the new debt, which generally is zero unless the principal amount of the debt is modified in the exchange. Thus, the expansion of the scope of debt treated as "publicly traded" could cause issuers to realize greater amounts of CODI than under the old regulations.
Expansion of the scope of debt treated as "publicly traded" may also impact a holder of the debt. In debt-for-debt exchanges, creditors recognize gain or loss equal to the difference between their tax basis in the existing debt and the issue price of the new debt. Holders of distressed debt often acquire such debt in the secondary market at a price that is significantly less than its stated principal amount. Accordingly, upon an exchange of debt for new debt that is "publicly traded," a holder's gain or loss is computed based upon the fair market value of the new debt. Thus, gain on such exchange may be less (or any loss may be greater) than if the debt were not "publicly traded" and the issue price of the new debt was equal to its stated principal amount.
For example, assume an investor purchases distressed debt with an adjusted issue price of $100 for $50. The debt is significantly modified and is treated as exchanged for new debt with a stated principal amount of $100 that is treated as "publicly traded" and has a market value of $60. The issue price of the new debt instrument will equal $60, the issuer will realize $40 of CODI and the holder will realize a gain of $10. If neither the new debt instrument nor the exchanged debt instrument had qualified as "publicly traded," the issue price of the new debt would be $100, its stated principal amount. As a result, the issuer would not have realized CODI and the investor would have realized a gain of $50. This illustrates the potential significance of expanding the debt treated as "publicly traded" and demonstrates that, under the Proposed Regulations, investors may be encouraged to modify their debt. Issuers may not be deterred by the chance of realizing more CODI if they are able to avoid recognizing the CODI because they are in bankruptcy or insolvent.
"Publicly Traded" Under the Proposed Regulations
In the current debt markets, there are several methods for trading debt, but most debt is purchased and sold over-the-counter in privately negotiated transactions between a financial institution (such as a securities dealer or broker) and a customer. Some of the over-the-counter trades are done on the basis of a "firm" quote, generally an offer to buy or sell at the designated price that can be accepted by the other party. Others trades are initiated with a "soft" or "indicative" quote, a price at which the buyer or seller may be willing to buy or sell debt subject to the terms of the specific transaction. Lastly, trades are also completed on the basis of information provided by data services, including recent sales prices or price quotes.
The preamble to the Proposed Regulations explains that because there has been an increase in the depth and transparency of the debt markets, there is greater confidence that trading prices reflect fair market value. The Treasury and the IRS believe that, when reliable market information is available, such information should be used to determine the issue price of debt. Thus, the Proposed Regulations are intended to expand the definition of "publicly traded" so that, when credible pricing information is available, such information should be the basis for determining issue price.
Under the Proposed Regulations, property will be treated as "publicly traded" if, within the 31-day period ending 15 days after the issue date (the "Measurement Period") of the debt instrument: (1) the property is listed on an exchange, (2) a sales price for the property is reasonably available, (3) a "firm" price quote is available, or (4) an "indicative" price quote is available from a dealer, broker or pricing service.
Property is listed on an exchange for purposes of these rules if the property is listed on a national securities exchange registered under the Securities Exchange Act of 1934, a foreign securities exchange recognized by a governmental authority in such jurisdiction, or a board of trade designated as a contract market by the Commodities Future Trading Commission. A sales price for the property will be determined to be reasonably available if the sales price (or information sufficient to calculate the sales price) appears in a medium that is available to persons that regularly purchase or sell debt instruments or persons that broker the purchase and sale of debt instruments.
"Firm" quotes are considered to be available when a price quote is available from a broker, dealer, or pricing service and such quoted price is substantially the same as the price for which the debt instrument could be purchased or sold. The identity of the person providing the quote must be reasonably ascertainable. However, it is not necessary that the person providing the quote be legally obligated to buy or sell at the quoted price if the market participants typically buy or sell at the quoted price. Finally, an "indicative" quote is available when a price quote is available from at least one broker, dealer or pricing service, even though the price quote is not a "firm" quote as defined in the Proposed Regulations.
When property meets the standard for "publicly traded," the trading price, sales price or quote obtained is presumed to be equal to the fair market value of such property. If more than one price or quote is available, a taxpayer may use any reasonable method, consistently applied, to determine the price. If only "indicative" quotes are available with respect to property and the taxpayer believes that such quote (or the average of the quotes) materially misrepresents the fair market value of the property, the taxpayer can use a method that provides a reasonable basis to determine the fair market value of the property. However, the taxpayer must establish that the method chosen more accurately reflects the value of the property than the quote or quotes for the property.
To prevent abuse, the Proposed Regulations provide that if there is any temporary restriction on trading, whether or not imposed by the issuer, intended to prevent any property from being "publicly traded," then the property will be treated as "publicly traded." Similarly if a sale or price quote is made for the principal purpose of misrepresenting the value of a property, such sale or quote may be disregarded.
The Proposed Regulations also include two circumstances under which property will not be treated as "publicly traded." First, property will not be "publicly traded" if there is no more than de minimis trading in the property. De minimis trading exists only if (i) each trade of the debt instrument during the Measurement Period is for quantities of $1 million or less, and (ii) the aggregate amount of all trades during the Measurement Period does not exceed $5 million. Debt also will not be treated as "publicly traded" if the original stated principal amount of the issue that includes such debt instrument does not exceed $50 million.
The Proposed Regulations apply to debt instruments that have an issue date on or after the date such regulations are adopted as final regulations in the Federal Register.