On Feb. 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (the "Act"). The Act modifies existing law to provide significant tax relief to companies that restructure or repurchase their existing debt over the next two years. It allows taxpayers to elect to include cancellation of indebtedness ("COD") income recognized during 2009 and 2010 ratably over a five-year period starting 2014. The Act also temporarily suspends the applicable high yield discount obligation ("AHYDO") rules for certain debt instrument exchanges (including deemed exchanges) that occur between Sept. 1, 2008, and Dec. 31, 2009.
The Act revokes Notice 2008-83, in which the IRS effectively suspended the built-in loss provisions of Section 382 in the case of a bank acquiring another bank.1 The Act also extends the carryback period for net operating losses ("NOLs") of "qualified small businesses" from two years to five years with respect to NOLs arising in a taxable year beginning or ending in 2008. The following is a summary of these tax provisions of the Act. It should be noted that the Act contains other tax provisions (including those relating to renewable energy tax incentives) which this summary does not cover.
A. Tax Relief from Debt Restructurings and Repurchases
Deferral of Income from Discharge of Indebtedness. Generally, a taxpayer with outstanding debt must recognize COD income when all or a portion of such debt is acquired by the taxpayer or a related person at a discount or if such taxpayer's debt is forgiven. The Act allows taxpayers to elect to defer the recognition of COD income arising from the "reacquisition" of a taxpayer's "applicable debt instrument" in 2009 or 2010, by the taxpayer or any person related to the taxpayer.
For this purpose, an "applicable debt instrument" is generally any debt instrument issued by (a) a C corporation or (b) any other person in connection with the conduct of a trade or business (i.e., a partnership, limited liability company or S corporation). The "reacquisition" of an applicable debt instrument includes a broad range of transactions, covering (i) an acquisition of the debt instrument for cash, (ii) the exchange of the debt instrument for another debt instrument (including a deemed exchange resulting from a modification of the debt instrument), (iii) the exchange of the debt instrument for corporate stock or a partnership interest, (iv) the contribution of the debt instrument to capital, and (v) the complete forgiveness of the debt by the holder thereof.
The election is irrevocable and is made on an instrument-by-instrument basis. In the case of a partnership, Scorporation, or other pass-through entity, the election is made at the entity level.2 The electing taxpayer must include the deferred COD income in its income ratably over a five-year taxable period beginning 2014 (i.e., assuming a calendar year taxpayer, 20% of the COD income will be included in the taxpayer's income in each taxable year from 2014 through 2018). Therefore, reacquisitions in 2009 will have a five year deferral, and reacquisitions in 2010 will have a four year deferral ("Deferral Period") before the five year income amortization begins. The election to defer COD income cannot be combined with any other exclusions from COD income available under the Code. The death, the liquidation of the taxpayer or the sale of substantially all the taxpayer's assets (including in a title 11 or other similar case), the cessation of business or similar circumstances in respect of the electing taxpayer will accelerate the deferred COD income. A particularly pernicious rule applies to partnerships; a sale of a partnership interest will require a pro-rata acceleration of the COD deferral.
If an electing taxpayer issues (or is treated as issuing) a debt instrument in exchange for its existing debt, deductions from original issue discount ("OID") accrued by the taxpayer before the first tax year in which the COD income is includable in income on such debt instrument (not exceeding the COD income from such transaction) are similarly deferred, and instead are permitted to be claimed ratably over the five-year period in which the COD income is recognized.
In the case of an electing taxpayer that is a partnership for U.S. tax purposes, deferred income or deductions are allocated to the partners of the partnership in the manner such income or deductions would have been allocated if the income or deductions deferred were recognized immediately before the discharge of indebtedness.
Temporary Relief from AHYDO Rules for Certain Exchanges of Debt. In debt-for-debt exchanges and deemed debt exchanges resulting from debt modifications or related party debt purchases, the new debt will be deemed to be issued with OID if its issue price is less than the adjusted issue price of the old debt. OID is generally deductible by the issuer over the term of the debt instrument on a constant yield basis. However, in respect of certain high-yield debt instruments with significant OID under the so-called "AHYDO" rules issued by corporate taxpayers, a portion of the OID is not deductible until paid in cash and any disqualified portion of such OID is permanently disallowed.
The Act suspends the application of the AHYDO rules for debt instruments that would otherwise be AHYDOs issued in exchange for other debt (including deemed exchanges resulting from a modification of the debt instrument) beginning Sept. 1, 2008, and ending Dec. 31, 2009, if such new debt instruments are issued in exchange for non-AHYDOs issued by the same obligor. The suspension of the AHYDO rules does not apply to any debt instrument that has certain contingent interest, or that is issued to a person related to the taxpayer. The Treasury Secretary is authorized to extend the suspension of the AHYDO rules with respect to debt instruments issued after Dec. 31, 2009, and to permit, on a temporary basis, the use of a higher rate than the applicable Federal rate in the application of the AHYDO rules if the Secretary determines that such suspension or use of a higher rate is appropriate in light of distressed conditions in the debt capital markets.
B. Treatment of Built-in Loss after an Ownership Change
Section 382 generally imposes significant limits on the use of existing NOLs or built-in losses of corporations that undergo certain changes in the ownership of their stock. For example, in the case of a troubled bank that is purchased by a healthier bank, Section 382 would generally limit the healthier bank's ability to deduct losses arising from loans made by the troubled bank that were worthless or distressed (but not yet charged off) at the time of the acquisition. The limitation on the deduction of the loan losses is known as the "built-in loss" limitation. In October of 2008, the IRS issued Notice 2008-83, which suspended the application of the built-in loss limitation in the case of a bank that is acquired by another bank.
The Act revokes Notice 2008-83. However, the Act recognizes that taxpayers may have relied on the notice, and provides that the notice remains effective for ownership changes occurring on or before Jan. 16, 2009. Banks undergoing an ownership change after Jan. 16, 2009, may no longer rely on the notice in the absence of any written binding contract or written agreement described in a public announcement or SEC filing entered into before Jan. 16, 2009.
The Act also carves out an exception to Section 382. Namely, ownership changes (a) pursuant to restructuring plans required under loan agreements or lines of credit entered into with the Department of Treasury under the Emergency Economic Stabilization Act of 2008, and (b) intended to result in a rationalization of the costs, capitalization and capacity with respect to the manufacturing workforce of, and suppliers to, the taxpayer and its subsidiaries, are not subject to the Section 382 loss limitation rules.
C. Net Operating Loss Carryback Election for Eligible Small Businesses
Eligible small businesses may elect an extended NOL carryback period under the Act. Normally these NOLs carryback two years (or three years if they qualify as eligible losses). The Act allows eligible small businesses to elect the application of a three, four or five year NOL carryback period for 2008 NOLs. A 2008 NOL is the taxpayer's NOL for any taxable year ending in 2008 (or at the taxpayer's election, the NOL for any taxable year beginning 2008). Eligible small businesses are those whose average annual gross receipts do not exceed $15,000,000 for a three year period ending in the taxable year in which the NOL is sustained.