The compromise economic stimulus legislation approved by the House earlier today contains numerous tax changes, several of which are likely to be important to corporate borrowers and to banks:
- Optional deferral of cancellation of indebtedness (COD) income for up to five years, with inclusion in income over an additional five years;
- Modification of the AHYDO rules for certain debt exchanges;
- Revocation of I.R.S. Notice 2008-83 (relating to certain built-in losses of banks) on a prospective basis; and
- For certain small businesses, extension of the operating loss carryback period from two years to five.
COD Deferral: The stimulus package permits taxpayers to defer the inclusion of certain income that would otherwise be recognized on the repurchase of a debt instrument. Generally, a taxpayer that repurchases its debt for less than the adjusted issue price of that debt must recognize cancellation of indebtedness (COD) income equal to the difference between the amount of cash or property paid to the debtholder and that adjusted issue price. Under the stimulus package, 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. If the COD income resulted from the issuance of a new debt instrument, the taxpayer must defer deducting original issue discount on the new debt instrument to match the inclusion of the deferred COD income. 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.
AHYDO Modifications: The stimulus package eliminates concerns about the AHYDO rules for debt issued in certain exchanges. The AHYDO rules generally provide that 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 5 percentage points, and a substantial amount of the payment is in the form of original issue discount that is not paid after five and a half years, then the taxpayer may not deduct any of such discount until it is paid. And, to the extent that the yield on the debt exceeds the AFR plus 6 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. The AHYDO provisions generally pose a substantial financial accounting detriment to restructuring debt, in part because of the permanent book-tax difference. To alleviate this, the stimulus package provides that the AHYDO rules do not apply to debt issued in a debt-for-debt exchange occurring after August 31, 2008 and before January 1, 2010. The stimulus package thereby removes a substantial impediment to restructuring publicly traded corporate debt.
Built-In Losses of Banks: The bill revokes I.R.S. Notice 2008-83. Generally, if a company is acquired at a time when it has depreciated assets (often referred to as “built-in losses”), the company’s use of those built in losses to reduce its income tax liability in subsequent years is subject to strict limits. Notice 2008-83, which was issued last fall as the financial crisis worsened, removed those limits if the acquired company was a bank and the depreciated assets were loans. The stimulus package revoked that Notice for acquisitions occurring after January 16, 2009, unless the acquisition was described in a binding written contract entered into before that date, and the agreement was either publicly announced or described in a filing with the SEC on or before that date. Thus, taxpayers who were considering relying on this Notice to assist with a bank acquisition will not be able to do so unless they meet the conditions of the transition grandfather provision.
NOL Carrybacks: The stimulus package also contains a provision that allows a small business (generally one that has gross receipts of less than $15 million a year, but excluding any recipient of TARP funds) to carry back a net operating loss incurred in its taxable year that ends in (or, at the taxpayer’s election, that begins in) 2008 as many as five taxable years, rather than the two years generally permitted.