In the current economic environment, it is not surprising that debt obligations are being renegotiated. There is a general understanding that cancellation of debt and other debt modifications may have adverse tax consequences for a debtor.
But tax consequences of debt modification are not only a debtor’s concern. Creditors are often surprised that debt modification can result in unanticipated adverse tax consequences. This article considers debt modification from the creditor’s perspective; however, it does not analyze the special tax rules that may apply to modifications that occur as part of bankruptcy proceedings, modifications of publicly traded debt instruments,modifications of a particular debt within a pool of collateralized mortgage obligations, modifications of debt that arise in connection with an installment sale of property by the holder of such debt, or modifications affecting creditors who have special status under the Internal Revenue Code, such as real estate investment trusts or real estate mortgage investment conduits.
When a creditor reduces a debtor’s principal obligation to facilitate the debtor’s financial rehabilitation, there may be an immediate recognized tax loss. However, many debt renegotiations do not result in explicit reductions of principal amounts owed, but rather in changed interest payments, guarantees, provisions for additional or different collateral, and issuance of equity interests in exchange for principal or interest modifications. Debtors and their creditors have devised a variety of other modifications that do not expressly change the principal balance owed.
For federal income tax purposes, most modifications to debt other than de minimus changes constitute a sale or exchange of the obligation. Unfortunately, when “old” debt is treated as having been sold or exchanged for “new” modified debt, the economic or fair market value of the “new” debt may have little to do with measuring the creditor’s gain or loss for tax purposes. Rather, gain or loss may be determined with reference to the deemed “issue price” of the “new” debt, which may be well in excess of its fair market value. This can result in significant taxable gain for a creditor, even when an economic loss has been sustained. For example, a creditor who may have purchased distressed debt at a discount may be particularly concerned with debt modification, because such debt has a tax basis that could be significantly lower than the remaining stated principal amount of the debt. If amodification results in a deemed sale or exchange, the creditor may have taxable gain on the constructive issuance of the new debt, even if the fair market value of the modified debt is no greater than the value of the distressed debt when originally purchased or immediately preceding the modification. In this regard, a purchaser of distressed debt would be well advised to insist that the current holder restructure the debt with the debtor before it is purchased, or to take tax consequences into account when negotiating the purchase price.
Creating Original Issue Discount
Even where there is no gain or loss, the modified debt could create “original issue discount” (“OID”), which could alter the amount and timing of interest income for tax purposes. OID could arise because “interest” for federal income tax purposes generally includes only amounts designated as interest that are payable on an unconditional basis, not less frequently than annually. If interest payments are subject to cash flow contingencies, designated interest payments may be considered principal payments for tax purposes, with the result that a modified debt instrument may be transformed into an obligation that has OID or an obligation that is not treated as having adequate “stated interest,” so that additional interest must be imputed.
OID rules may be a particular problem for a creditor using the cash method of accounting, because these rules generally require even a cash-method creditor to report OID on the accrual basis. Cashmethod creditors are sometimes dismayed to receive from a debtor a Form 1099-OID reporting OID on a modified debt, even where in a particular year no interest is required to be paid, and thus none is received, under the modified obligation.
Creditor Acquisition of an Equity Interest
Debt modification can take the form of giving the creditor an equity interest in the debtor in addition to a creditor position. Such an equity interest may be in the form of an option or warrant to acquire an equity interest. Some of the creditor’s cost or “basis” in the “old” debt generally will be allocated to such equity interest. Such allocation may create or increase the amount of OID that the creditor recognizes on the “new” debt, and reduce or postpone recognition of the amount of any loss.
If there is a significant change in the ownership of the debtor as a consequence of a creditor’s acquisition of an equity interest in the debtor, certain favorable tax attributes of the debtor, such as net operating loss or credit carryovers may be reduced or eliminated as a consequence of the ownership change. If the debtor is a partnership (or limited liability company taxed as a partnership), future allocations of partnership taxable income and loss may be affected, with the result that income and loss may be allocated not as specified in the partnership or operating agreement, but in a manner not anticipated by the creditor and other partners.
For a variety of reasons, a creditor and a debtor must carefully consider the array of tax consequences following the creditor’s acquisition of an equity interest in the debtor or options to acquire such interests, and these consequences should enter into their negotiations.
Even when a creditor sustains an economic loss associated with renegotiated debt, tax laws may impede the creditor’s ability to recognize a tax benefit. For example, for some creditors, a recognized loss associated with modified debt may constitute a capital loss rather than an ordinary loss for federal income tax purposes. Capital losses may have limited or no current tax benefits for many creditors, and given the posture of many taxpayers in today’s economy, it could be years before a creditor reaps tax advantages from an additional recognized capital loss.
A debt modification may also lead to a negative arbitrage for a creditor—a current capital loss to be offset by increased future ordinary income. This can occur when a capital loss is recognized in connection with a debt modification where the “new” modified debt bears OID. Consequently, the creditor may have traded an immediate capital loss of questionable tax benefit for additional ordinary income that will be recognized yearly over the term of the obligation.
As with many income tax provisions, there are a myriad of exceptions to the general rules. Many of the rules applicable to cancellation of indebtedness, debt modification and OID were developed when credit markets and economic conditions were considerably different than they are at the time of this is writing in April, 2009. The current environment has lead to some new laws and regulations to address these matters, and further changes are anticipated. A creditor thinking about debt modification should carefully consider the tax ramifications of such actions in order to avoid unanticipated consequences.