With an increasing emphasis on identifying value in the marketplace, entrepreneurs have focused their efforts on acquiring debt instruments, senior secured and mezzanine, in particular. Two primary strategies are being employed with respect to the debt: (1) acquire the debt for the purposes of restructuring the terms with the borrower(s) or (2) acquire the debt for the purpose of exercising the creditor’s remedies (i.e., foreclosing on the equity). In either case, it is not only the borrowers on the debt that could have potential tax issues (e.g., cancellation of debt income), the acquirers of the debt may also face potential tax pitfalls (and, in many cases, the tax interests of the borrower(s) and acquirer(s) will be in direct conflict).
In the context of a debt workout, certain adjustments to a debt obligation may result in a deemed “exchange” of such debt obligation if the modification is “significant.” Such deemed exchange may result in the recognition of gain by the holder of the debt obligation. Treasury Regulations Section 1.1001-3 provide rules for determining whether certain modifications of a debt obligation are “significant,” and, thus, trigger a deemed “exchange” of the unmodified debt obligation for the “modified” debt obligation. These regulations were issued following the United States Supreme Court’s decision in Cottage Savings Association v. CIR, 499 U.S. 554 (1991).
In short, an investor that purchases a debt obligation at a discount can have immediate gain if the purchased debt obligation is then “significantly” modified under these regulations. This would be the case if the “issue price” of the “significantly” modified debt obligation were to exceed the discounted price paid by the investor for the debt obligation. Generally, if the debt obligation is not “traded on an established market”/“publicly traded,” the issue price of the modified debt obligation would likely equal its face amount, with the investor’s gain being equal to the excess of the face amount of the modified debt obligation over the price paid by the investor for the debt obligation. However, it may be possible for the investor to defer this gain under one or more non-recognition provisions of the Internal Revenue Code.
Example: Investor purchases a non-publicly traded debt obligation having a face amount of $100 (assume interest on the debt obligation in excess of the “applicable federal rate” or AFR) for $60. After the debt obligation is sold to Investor, Investor agrees to modify the debt obligation (e.g., by lowering the interest rate but not below AFR and allowing for the deferral of payments) and that such modifications constitute “significant modifications” under the “debt modification” regulations (see below). Unless a non-recognition provision were to apply to allow for the deferral of the gain, Investor would have immediate gain recognition of $40—that is, the excess of the post-modified debt obligation’s face amount of $100 over the $60 price paid by Investor to purchase the debt obligation.
In general, the debt modification regulations define the following modifications (among others) to be “significant” modifications:
i. Changes in yield of a debt instrument that exceed 25 basis points or five percent of the original yield of the debt obligation.
ii. Changes in the timing of non-de minimis payments (including any resulting change in the amount of payments) that result in material deferral of scheduled payments, except that a deferral that results in the deferred payments being unconditionally payable by the earlier of five years or 50 percent of the original term of the debt instrument (without regard to any extension option) is not considered “material.”
iii. Substitution of a new obligor with respect to a recourse debt obligation.
iv. Addition or deletion of a co-obligor that results in a “change in payment expectations.”
v. A modification that releases, substitutes, adds or otherwise alters the collateral for, a guarantee on, or other form of credit enhancement in the case of a nonrecourse debt obligation (subject to certain exceptions) and, in the case of a recourse debtobligation, which results in a “change in payment expectations.”
vi. Change in the nature of an debt obligation from recourse to nonrecourse or vice versa.
Not all modifications are “significant” (e.g., a modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification), and some exceptions may apply, however, an investor in debt obligations must consider the potential tax consequences when considering its strategy and structuring its debt purchase.
An unwary investor also may suffer unintended tax consequences when seeking to purchase a debt obligation to foreclose. The foreclosure itself will operate as an exchange for tax purposes and, again, income or gain will be determined in accordance with the investor’s basis in the debt obligation, on the one hand, and amount of its credit bid, on the other.
Example: Assume Investor purchases a debt obligation having a face value of $100 for $60 and the fair market value of the secured property is $80 (and which debt obligation is not thereafter “significantly” modified). Assume further a foreclosure of the applicable lien. At auction, Investor makes a winning credit (i.e., no cash) bid for the secured property in the amount of $80. Investor will have taxable income in the amount of $20 (i.e., the excess of the secured property’s fair market value of $80 over Investor’s tax basis in the debt obligation of $60).
In each case, that is, the foreclosure scenario or the debt modification scenario, whether the income to Investor is taxed as capital gain or ordinary income (e.g., “accrued market discount”) will depend on certain factors.
In sum, looking for opportunity today is a dicey proposition, made all the more challenging if the tax implications of a transaction are not fully investigated and taken into account.