The American Recovery and Reinvestment Act of 2009 (the “Act”) contains two provisions that any business taxpayer that is considering modifying or retiring its outstanding debt should be sure it understands. The first provision provides for the deferral of income from the cancellation of indebtedness (“COD income”), and the second temporarily suspends certain rules (the “AHYDO rules”) that defer or disallow the deduction of original issue discount on certain debt instruments.
Deferral of COD Income
Business taxpayers who fall on hard times may seek to strike a deal with their creditors to forgive some of their indebtedness, usually in exchange for the modification of that indebtedness or the issuance of stock. Generally, a taxpayer that repurchases (or is deemed to repurchase) its debt for less than the adjusted issue price of that debt must recognize COD income equal to the difference between the amount of cash or property paid to the debtholder and that adjusted issue price. Under the Act, however, if a business taxpayer would otherwise be required to recognize COD income in 2009 or 2010, the taxpayer is permitted (but not required) to defer including this COD income for either four or five taxable years (depending on whether the exchange occurs in 2009 or 2010), and then include it in income over the subsequent five taxable years. For calendar method taxpayers, then, COD income realized in 2009 may be taken into account ratably over the five taxable years starting with 2014. If the COD income resulted, directly or indirectly, from the issuance of a new debt instrument, the taxpayer must defer the deduction of original issue discount on the new debt instrument until the deferred COD income is included. If the taxpayer ceases business operations, the deferred COD income and any deferred original issue discount (OID) must be included in income at that time. While this provision does not change the taxpayer’s total lifetime income, and therefore will not produce a financial accounting benefit, we would expect it to provide a substantial time value of money benefit to qualifying taxpayers.
The COD deferral provisions in the Act contain special rules for partnerships and other pass-through entities. For partnerships, the election to defer is made at the partner level, and the deferred COD income is allocated among the then-current partners. The discharge of indebtedness is not treated as a reduction of a partner’s share of the liabilities of the partnership to the extent that such treatment would cause the partner to recognize gain under Section 731. (Note, however, that the discharge of indebtedness generally will reduce the partner’s share of liabilities to the extent that the resultant deemed distribution does not cause the partner to recognize gain under Section 731—i.e., to the extent that the partner’s basis in his partnership interest is not reduced below zero. Thus, if the partnership plans any distributions of cash or other property around the time the indebtedness is forgiven, it will be important to make the distributions prior to the forgiveness of income, if possible.) Instead, the reduction of a partner’s share of the liabilities occurs as the deferred COD income is included. A sale or other disposition of the partnership interest will trigger the end of the deferral.
The Act also eliminates concerns about the AHYDO1 rules for debt issued in certain debt-for-debt exchanges. The AHYDO rules are premised on the idea that, if a debt instrument issued by a corporation bears interest at a high rate and if a substantial amount of that interest comes in the form of original issue discount that is not paid for many years after it accrues, the allowance of a tax deduction of that interest should be restricted. Specifically, if a corporate taxpayer issues a debt instrument that has a yield greater than the applicable federal rate (basically, the rate at which a Treasury bond would pay interest) plus five percentage points, then the instrument must provide in essence that no more than one year’s worth of discount will remain unpaid at all times after five and a half years. If the instrument allows more than this amount of discount to remain unpaid after such time, then, under the AHYDO rules, (i) the taxpayer may not deduct any of such discount until it is paid and (ii) to the extent that the yield on the debt exceeds the AFR plus six percentage points, a pro rata share of the discount cannot ever be deducted.
The AHYDO rules can apply, not only when a taxpayer issues a debt instrument for cash, but also when a taxpayer issues a debt instrument in exchange for another debt instrument (including a deemed reissuance that results from a modification of the debt instrument). In the case of such modification, if the new debt instrument has an issue price that is less than its stated principal amount, and either the old debt instrument or the new debt instrument is publicly traded, original issue discount can result. If this original issue discount exceeds the AHYDO thresholds in size and timing of payment, the deferral and disallowance provisions will apply. Holders can usually avoid the impact of the AHYDO provisions by putting in so-called “catch up” provisions that require the accrued discount to be paid to holders as necessary to preserve the deductibility of such discount. However, these catch up provisions can substantially increase the debtor’s cost of funds and decrease its available cash. Moreover, in the current market environment, the AHYDO provisions can pose a substantial financial accounting detriment to restructuring debt, in part because the disallowance of any deduction for the discount creates a permanent book-tax difference.
To remove these obstacles to restructuring debt, the Act provides that the AHYDO rules generally do not apply to debt issued in a debt-for-debt exchange occurring after August 31, 2008, and before January 1, 2010, as long as the old debt was not itself subject to the AHDYO rules. However, the AHYDO rules continue to apply to debt issued for cash or other property. Additionally, the AHYDO rules also continue to apply to debt-for-debt exchanges if the new debt is either held by a related party or pays interest based on certain types of contingencies. The stimulus package thereby removes a substantial impediment to restructuring publicly traded corporate debt.