Debt-for-debt exchanges are not new, but are worth revisiting given the current economic climate. Furthermore, the recently enacted "Stimulus Act"1 provides some temporary relief to debtors from potentially harsh tax consequences of restructuring. The following discussion is relevant to issuers (also referred to as debtors) or holders (also referred to as creditors) of debt who are "US persons" (as defined in the US Internal Revenue Code).2

In order to illustrate some of the key US federal income tax consequences of a debt-for-debt exchange, consider the following example:

A US person ("Creditor") holds debt (bank debt or high yield debt) of Corporation A, organized in the United States ("Debtor"), with a stated principal amount (and stated redemption price at maturity) of US$100x that is currently trading at 60 cents on the dollar ("Old Debt"). Creditor acquired the Old Debt for US$100x upon its original issuance in 2002 and its adjusted tax basis is US$100x. Debtor wants to issue new debt with a stated principal amount (and stated redemption price at maturity) of US$70x ("New Debt") in exchange for the Old Debt. The fair market value of the New Debt is US$65x as of the issue date.

US Tax Consequences to a Debtor Exchanging Debt Instruments

Cancellation of debt income

A debtor is generally required to include income from the discharge of indebtedness (also known as cancellation of debt income or "COD" income) in gross income.3 There are some exceptions to this rule, including where debt is discharged in the debtor's bankruptcy proceeding, where the debtor is insolvent (to the extent of the insolvency) or where payment of the debt liability would have given rise to a deduction.4 The Stimulus Act also provides some relief from this rule (discussed below). For purposes of determining COD income of a debtor that issues a replacement debt instrument in satisfaction of its outstanding indebtedness, such debtor is treated as having satisfied the indebtedness with an amount of money equal to the "issue price" of such replacement debt instrument.5

If either the outstanding debt instrument or the replacement debt instrument is "publicly traded" (traded on an "established securities market"), the issue price of the replacement debt instrument is the fair market value.6 If neither the outstanding debt instrument nor the replacement debt instrument is publicly traded, the issue price of the replacement debt instrument is the stated principal amount if its terms provide for adequate stated interest.7

As applied to the example:

If neither the Old Debt nor the New Debt is publicly traded, Debtor is deemed to satisfy the Old Debt (which has a stated principal amount of US$100x) with US$70x (the stated principal amount of the New Debt). Thus, in the absence of any exception to the COD rules, Debtor will have US$30x of COD income.

If either the Old Debt or the New Debt is publicly traded, Debtor is deemed to satisfy the Old Debt (which has a stated principal amount of US$100x) with US$65x (the fair market value of the New Debt). Thus, in the absence of any exception to the COD rules, Debtor will have US$35x of COD income.

Under the Stimulus Act, for a reacquisition (by issuer or a related party) of an "applicable debt instrument" (indebtedness of a C corporation or any other person in connection with the conduct of a trade or business) after December 31, 2008 and before January 1, 2011, the issuer may elect to include COD in income ratably during the period 2014-2018 rather than in the current year. This election is made on an instrument-by-instrument basis. The election is not available where the debt is purchased by a party unrelated to the issuer.8

Original issue discount

If the stated redemption price at maturity of the replacement debt instrument issued in the exchange exceeds the issue price, the debt will have original issue discount ("OID"). The debtor will amortize the OID over the term of the debt instrument.9

As applied to the example:

If either the Old Debt or the New Debt is publicly traded, the stated redemption price at maturity of the New Debt (US$70x) will exceed the issue price (US$65x) by US$5x. Debtor will amortize the US$5x of OID over the term of the New Debt.

If the issuer has elected to take COD into income from 2014 2018, there will be a corresponding deferral of deductions for OID.10

AHYDO Rules

If the new debt that is deemed to be issued constitutes an applicable high yield debt obligation ("AHYDO"), which is highly likely in the current economic climate, the issuer will not be allowed to deduct the non-cash interest, including any OID, until it is paid in cash, and a portion of the interest deduction may be permanently disallowed.11

The Stimulus Act provides that if an AHYDO is issued during the period beginning September 1, 2008 and ending on December 31, 2009, in exchange for an obligation which is not an AHYDO, the AHYDO rules may be suspended (and therefore interest deductions are not limited by such rules). This AHYDO suspension rule does not apply to obligations issued to related parties or to obligations with contingent interest.12

US Tax Consequences to a Creditor Exchanging Debt Instruments

Exchange of debt

If both the outstanding debt instrument and the replacement debt instrument are "securities" for US federal income tax purposes, the exchange will be a tax-free recapitalization.13 If either the outstanding debt instrument or the replacement debt instrument are not securities, the exchange will be taxable.14

There is no definition in the US Internal Revenue Code or Treasury Regulations of a security, and accordingly there is some uncertainty surrounding this determination. Important factors to be considered include, among other things, the length of time to maturity, the degree of continuing interest in the issuer, and the purpose of the borrowing. Generally, debt instruments that mature within five years of issuance are not considered securities and debt instruments that mature ten years or more from the time of issuance are considered securities.

If the outstanding debt instrument and the replacement debt instrument are securities and therefore the exchange is a tax-free recapitalization, a creditor will not recognize a loss and will only recognize a gain to the extent that the stated principal amount of the replacement debt instrument exceeds the stated principal amount of the outstanding debt instrument. However, if the outstanding debt instrument has accrued but unpaid interest (that accrued during the relevant creditor's holding period), a portion of the replacement debt instrument may be attributable to such interest and taxable as such.15 The creditor will have an initial tax basis in the replacement debt instrument equal to its tax basis in the outstanding debt instrument exchanged therefor, and the creditor's holding period for the replacement debt instrument will include the period during which it held the outstanding debt instrument.16

If either of the debt instruments are not securities, the creditor will recognize gain or loss in an amount equal to the difference between the issue price of the replacement debt instrument and its adjusted tax basis in the outstanding debt instrument.17 If the outstanding debt instrument was held as a capital asset, any gain or loss will be capital gain or loss.18 However, if the outstanding debt instrument has accrued but unpaid interest (that accrued during the relevant creditor's holding period), a portion of the replacement debt instrument may be attributable to such interest and taxable as such.

As applied to the example:

Assume the Old Debt was issued in 2002 with a maturity date of 2017, that the New Debt will be issued in 2009 with a maturity date of 2024, and that they are securities for US federal income tax purposes. Creditor will not recognize gain or loss on the exchange. Creditor will have an initial tax basis in the New Debt of US$100x and will be deemed to have held the New Debt since 2002.

If instead we assume that either the Old Debt or the New Debt are not securities, Creditor will recognize a loss of US$30x if the debt instruments are not publicly traded (the difference between the stated principal amount of the New Debt and Creditor's basis in the Old Debt) and will recognize a loss of US$35x if the debt instruments are publicly traded (the difference between the fair market value of the New Debt and Creditor's basis in the Old Debt). Creditor's basis in the New Debt will be the issue price (either US$65x or US$70x) and its holding period will begin on the day following the exchange.

OID

If a debt instrument has more than a de minimis amount of OID, a creditor, regardless of its method of accounting, will be required to include such OID in income as it accrues, in accordance with a constant yield method based on a compounding of interest before the receipt of cash payments attributable to this income.19

As applied to the example:

If the Old Debt or the New Debt is publicly traded, the stated redemption price at maturity of the New Debt exceeds the issue price by US$5x. Creditors will be required to include US$5x in income as it accrues, in accordance with a constant yield method.