The House of Representatives and the Senate passed the American Recovery and Reinvestment Tax Act of 2009 (the “Act”). The Act is expected to be signed into law by President Obama on February 16, 2009.
The Act contains a number of provisions intended to stimulate the US economy that will be of interest to, among others, troubled companies and their creditors. In particular, the Act provides for the delayed recognition of income resulting from the cancellation of indebtedness attributable to certain debt repurchases and suspends the application of the applicable high yield discount obligation (“AHYDO”) rules for certain instruments issued during the period beginning on September 1, 2008 and ending on December 31, 2009.
The Act also contains provisions that remove the limitation on the use of net operating losses (“NOLs”) and built-in losses following an ownership change of certain loss corporations, extend the bonus depreciation rules, provide more favorable treatment for tax-exempt bonds and reduce the tax on the gain from the sale of qualified small business stock.
Delayed Recognition of Cancellation of Indebtedness Income
The Act alters the tax treatment of cancellation of indebtedness (“COD”) income resulting from the repurchase at a discount of a debt instrument by the debtor or any party. Currently, income realized from the repurchase of a debt instrument at a discount by the debtor (or related party) must be included in the debtor’s gross income for the taxable year in which the repurchase occurred. Under the Act, any COD income resulting from a debtor’s (or related party’s) repurchase of a debt instrument during calendar years 2009 and 2010 will not be included in the debtor’s gross income in the year it is repurchased. Instead, if the debtor so elects (an “Electing Debtor”), the income will be included in the debtor’s gross income ratably over a five-taxable-year period beginning in 2014 for calendar-year taxpayers. This favorable tax treatment applies to cash purchases, debt-for-debt exchanges (including deemed debt exchanges) and other non-cash repurchases of a debt instrument by either the debtor who issued the debt or its related party.
In order to prevent a mismatch of income and deductions, the Act imposes a limit on the original issue discount (“OID“) deductions that may be claimed by an Electing Debtor on debt issued in an actual or deemed debt-for-debt exchange. Under the Act, OID of an Electing Debtor that is attributable to a debt instrument issued in connection with an actual or deemed debt-for-debt is not deductible by the issuer of the new debt until the year 2014. OID deductions that are deferred pursuant to this provision would be deducted ratably over five years, beginning in 2014. Under a special rule, if the aggregate amount of OID exceeds the COD income from the canceled debt instrument, the taxpayer may deduct such excess OID prior to 2014.
Private equity funds and their portfolio companies, in particular, will benefit from such a change. Specifically, the Act will enable private equity funds and their portfolio companies to repurchase debt of their portfolio companies without the debtor portfolio company having to include any COD income resulting from repurchase as gross income for four or five taxable years after the repurchase, and then only ratably include such income in the five years thereafter.
Suspension of Restrictions of Deductions on Applicable High Yield Discount Obligations
The Act suspends the restriction on interest deductions for OID on certain AHYDO instruments. Under current law, deductions for OID on an AHYDO instrument are deferred in part and disallowed in part. Under the Act, the AHYDO rules are suspended temporarily for debt instruments issued between September 1, 2008 and December 31, 2009 in exchange (including a deemed exchange) for an obligation that is not an AHYDO. The OID income on the newly issued AHYDO can be deducted as it accrues without deferral or disallowance. AHYDO instruments, however, that are issued to related persons or provide for contingent interest are not eligible for this benefit.
Miscellaneous Tax Provisions
Ownership Changes Pursuant to the Emergency Economic Stabilization Act of 2008
The Act creates a narrow exception to the current law restrictions on the use of NOLs and built-in losses following an ownership change of a loss corporation. Generally under the Act, if an ownership change of a loss corporation occurs pursuant to a restructuring plan required by an agreement with the Department of the Treasury under the Emergency Economic Stabilization Act of 2008, the loss corporation will not be subject to the restrictions that otherwise would apply to the carryforward of its NOLs or its use of built-in losses following the ownership change provided that no person (other than certain VEBA plans) owns 50 percent or more of the new loss corporation following the ownership change.
Extension of Bonus Depreciation for Newly Acquired Property
The Act extends the additional first-year depreciation deduction introduced in the Foreclosure Prevention Act of 2008 (which allows taxpayers to take an additional first-year depreciation deduction of 50 percent of the adjusted basis of certain qualified property (“bonus depreciation”)) to certain property placed in service during 2009 or 2010. Subject to certain exceptions, qualified property means property to which the modified accelerated cost recovery system applies with a recovery period of 20 years or less, certain computer software, water utility property or qualified leasehold improvement property, which is purchased and placed into service within the applicable time period. The Act allows taxpayers to also take the bonus depreciation for qualified property acquired and placed in service in calendar year 2009 (or 2010 for certain property with longer production periods and transportation property). Extension of Election to Accelerate Accumulated AMT and R&D Credits In Lieu of Bonus Depreciation The Act extends the current law provision that allows a taxpayer to elect to increase the cap on its use of research and development (“R&D”) and/or alternative minimum tax (“AMT”) credits, in lieu of taking the bonus depreciation (as described above). The cap on R&D and AMT credits can be increased by up to 20 percent of the bonus depreciation the taxpayer could have claimed on property that would qualify for bonus depreciation. Prior to the Act, taxpayers could make this election only with respect to property acquired and placed in service between March 31, 2008 and January 1, 2009. The Act extends the benefit by one-year to also apply to property acquired and placed in service before January 1, 2010 (or January 1, 2011 for certain property with longer production periods and transportation property).
Further, the Act also provides taxpayers with increased flexibility when deciding whether to elect-out of the bonus depreciation available for qualified property in exchange for the increased cap on historic R&D and AMT credits. Specifically, taxpayers that elected out of the bonus depreciation in the first taxable year ending after March 31, 2008 may elect to take the bonus depreciation for assets acquired in calendar year 2009. Conversely, taxpayers that did not elect out of bonus depreciation in the first taxable year ending after March 31, 2008 may elect out of the bonus depreciation for assets acquired in calendar year 2009 for its first taxable year ending after December 31, 2008.
Favorable Treatment of Tax-Exempt Debt Instruments
Pursuant to the Act, a financial institution can deduct a portion of its interest expense allocable to its tax-exempt obligations issued in 2009 and 2010 to the extent such obligations comprise less than two percent of the financial institution’s total assets. Currently, financial institutions are not permitted to deduct such interest expense. Tax-exempt obligations refer to debt incurred by the financial institution to purchase tax-exempt debt instruments.
In addition, the Act provides that interest on tax-exempt private activity bonds issued in 2009 and 2010 is not an item of tax preference for purposes of the alternative minimum taxable income (“AMTI”). This change effectively exempts interest on tax-exempt activity bonds issued in 2009 and 2010 from the AMT.
Increase in Exclusion of Gain from Sale of Qualified Small Business Stock
The Act increases the 50 percent exclusion for gain realized by an individual on the sale or exchange of qualified small business stock to 75 percent for stock issued in the years 2009 and 2010. Therefore, 75 percent of gain from the sale of stock of a qualified small business is not taxed as long as the stock was acquired by the individual at its original issue and was held for at least five years. Generally, a qualified small business is any domestic C corporation, the assets of which do not exceed US$50 million from August 10, 1993 until immediately after the stock is issued. A qualified small business must also meet certain active trade or business requirements.
The American Recovery and Reinvestment Tax Act of 2009 provides several tax benefits available for taxpayers during the calendar years 2008, 2009 and 2010. This Client Alert only provides a general discussion of certain key provisions; therefore taxpayers are advised to evaluate the general impact of the Act on their specific circumstances. As always, White & Case looks forward to assisting you in taking full advantage of these benefits and new opportunities.