ninth annual domestic tax conference - ey€¦ · page 11 applicable tax principles if a...

Ninth AnnualDomestic Tax Conference8 May 2014 | Chicago

Key considerations in debtworkouts and renegotiations

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Disclaimer

Today’s presenters

David C. GarlockRichard G. Larkins

Timothy J. WichmanThomas E. Coony

Debt workouts and renegotiations –agenda

► Realization of gain or loss and unamortized debtissuance costs

► Publicly traded debt► Interest rate hedges► Significant modification and deterioration of

obligor’s financial condition► IRS audit issues

Realization of gain or loss and unamortizeddebt issuance costs

Background

► As the financial crisis has eased and interest rates haveremained low, many borrowers are finding that they areable to refinance borrowings taken out in 2009-12 at lowerrates.

► Refinancings often take one of three forms:► A pure modification of the loan terms, with no change in lenders or

the lenders’ share of the loan► A completely independent borrowing, with the proceeds used to

pay off the old lenders► A new syndicated lending group that largely overlaps the old

lending group, but with some lenders coming and going, and withsome lenders’ shares increasing and some decreasing

Tax issues

► Does the borrower have cancellation of debt (COD)income or deductible repurchase premium fromthe refinancing?

► Are unamortized debt issuance costs and original issuediscount (OID) associated with the original borrowingdeductible at the time of the refinancing?

► Does the lender have a loss (ordinary or capital?) or baddebt deduction?

Potentially relevant facts

► How much of the new debt was issued for cash?► To entirely new lenders?► To old lenders who increased their shares?

► Was the change in terms a “significant modification”?► Is the debt publicly traded?► What is the percentage of overlap (measured by principal

amount) between the old and new lenders?► Were the fees incurred on the refinancings relatively small

compared to the fees on the original financing?

Applicable tax principles

► If a “substantial amount” of the new debt was issued forcash, the issue price of all the debt in the new issue isequal to the cash price.► The regulations do not define “substantial amount,” but 10% or

more of the new issue is clearly enough. A smaller percentage mayalso be substantial.

► If not, then the issue price of the new debt is:► The trading price, if the new or old debt is publicly traded

Or► If not, its stated principal amount (assuming it has interest at least

at the applicable federal rate (AFR), which is always the casein practice)

Applicable tax principles

► The borrower has COD or repurchase premium equal to thedifference, if any, between the aggregate issue price of the new debt(plus any cash paid) and the adjusted issue price of the old debt.

► If the new debt’s issue price is equal to its face amount and the olddebt did not have OID, there is no COD or repurchase premium.

► COD is taxable income, subject to various exceptions. Repurchasepremium is deductible currently unless the new debt was not issued insignificant part for cash and is not publicly traded. Reg. §1.163-7(c).

► In the latter case, the premium could only be attributable to OID onthe old debt. In that case, the OID continues to accrue as discountover the life of the new debt.

Debt issuance costs

► Under case law, if a debt is refinanced, debt issuance costs on the olddebt are immediately deductible if the new loan is “separate andindependent” from the old loan.

► Pro-taxpayer cases include Buddy Schoellkopf Products and Sleiman.Pro-gov’t cases include Williams, Wilkerson and Lay. See Garlock,Federal Income Taxation of Debt Instruments, 6th Ed. ¶1303.08[A].

► The theory of the seminal case (Great Western Power, 297 US 543(1936)) was that “expense in connection with the issuance of the [newdebt] is deductible on the same theory as unamortized discount.”

► At the time that case was decided, unamortized discount carried overto the new debt. As discussed on the next slide, that is no longer thecase.

Treatment of unamortized OID

► Prior to 1990, if a debt instrument with OID was exchanged for a newdebt, the issue price of the new debt was limited to the adjusted issueprice of the old debt. Congress repealed this rule in 1990.

► Also, in a debt-for-debt exchange, if the issue price of the new debtis less than the adjusted issue price of the old debt, the issuer hasCOD income.

► As noted above, repurchase premium is generally currentlydeductible, with a narrow exception for debt that is not issued insignificant part for cash and is not publicly traded.

► So, in general, OID does not carry over from the old debt to thenew debt.

Treatment of debt issuance costs like OID

► Reg. §1.446-5, effective beginning in 2004, provides thatdebt issuance costs are treated “as if they decreased theissue price of the debt.” This rule applies “[s]olely forpurposes of determining the amount of debt issuancecosts that may be deducted in any period.”

► The principal purpose of this regulation was to forceissuers to deduct debt issuance costs on a constant yieldbasis, rather than straight-line, over the life of the debt.

► Unamortized debt issuance costs are deductible asordinary and necessary trade or business expenses,rather than interest expense.

The big unanswered question

► Are unamortized debt issuance costs treated just like unamortizedOID for purposes of applying the rules governing repurchasepremium?

► Arguments for:► Reg. §1.446-5 says that it applies for purposes of determining the amount

of debt issuance costs that may be deducted in any period, and this issuch a question.

► Great Western Power says that debt issuance costs are deductible on thesame theory as OID, and this is consistent with economic reality.

► Arguments against:► There is no evidence that Reg. §1.446-5 was meant to supersede

common law on this point.► Arguably the carryover issue is not within the phrase “amount …

deductible in any period.”

If the regulations control …

► Debt issuance costs on the old debt are fully deductible atthe time of the refinancing as long as either:► A significant amount of the new debt was issued for cash.► The new or old debt is publicly traded.

► Under regulations effective November 2012, debt isconsidered publicly traded if there are one or morepublicly available firm or indicative quotes for the debt.► Most syndicated bank debt would be considered publicly traded

under this definition.

► Issues under $100 million are per se deemed not publiclytraded under the 2012 regulations.► But note that this exception apparently does not apply to the old

debt if issued prior to November 2012.

If common law continues to govern …

► The question is whether the refinancing is separate andindependent from the original financing.

► If there is no change in lenders, this would seem to be avery difficult standard to meet.

► If there are significant new lenders (including increasedshares), the test might be met.► Sufficient new lenders to meet the “issued for cash” test would not

necessarily be sufficient for the “separate and independent” test.

► Case law does not focus on new fees vs. old fees. But ifnew fees are substantially lower than the original lendingfees, that suggests that the refinancing is not separateand independent.

Publicly traded debt

Final publicly traded debt instrumentregulations

► Final regulations (T.D. 9599, Sep. 13, 2012) apply to determine whenproperty is traded on an established market for purposes ofdetermining the issue price of a debt instrument.

► Regulations are effective for debt instruments issued (i.e., debtexchanges) on or after November 13, 2012.

► Final regulations provide that property is publicly traded if, during31-day period around issue date, there exists for the property: (i) asales price, (ii) one or more firm quotes, or (iii) one or more indicativequotes.

► There is an exception to public trading status for any “small debtissuance” of less than $100 million of stated principal.► Exception is not a safe harbor; thus, it will prevent issuers within this

exception from deducting repurchase premium in a debt-for-debtexchange, even if quotes are available for their debt.

Interest rate hedges


► Issuers of debt instruments often hedge risk with interestrate swaps.► Fixed-to-floating (cash flow risk)► Floating-to-fixed (value risk)

► To qualify as a tax hedge, the issuer must identify a swapas a tax hedge on or before the trade date of the swap.

► If a swap is a tax hedge, the timing of income or deductionon the swap is generally matched against the timing ofincome or deduction on the hedged debt.


► If a taxpayer “disposes of or otherwise terminates itsinterest in” a hedged item and retains the hedge, it must“appropriately match the built-in gain or loss” on the hedgeto gain or loss on the disposed hedged item.

► If an issuer redeems a debt and retains its position in ahedging swap, is it required to mark the swap to market?► Actual redemption► Deemed debt-for-debt exchange► Fixed vs. floating rate debt

► Recycled hedges► New identification► Required matching to the new hedged item


► The character of gain or loss on a properly identifiedhedging transaction is ordinary.► Must be a tax identification, made on the day the hedge is

entered into

► Taxpayers who fail to make timely identification couldhave capital loss (but still ordinary gain) if a hedge isdisposed of (or marked) in connection with a debtrestructuring.

► Possible exceptions► Inadvertent error► Application of Section 1234A?

Significant modification and deterioration ofobligor’s financial condition

Restructuring debt of financially troubledborrowers – tax characterization

► In general, if alterations to the term of a debt instrumentconstitute a “significant modification,” there is a deemeddebt-for-debt exchange.► Interest rate change, maturity extension, etc.► Issuer treated as transferring new debt to holder(s) in exchange for

old debt

► New debt is treated as having been issued on the date ofthe significant modification.► Tested to determine whether any disallowance provisions apply

(e.g., applicable high-yield discount obligation (AHYDO) rules,Section 163(l))


► Debt of financially troubled borrowers may not qualify asindebtedness for tax purposes under the general“debt/equity” analysis because of uncertainty as to theability of the borrower to repay the debt.

► Regulations provide that for purposes of determiningwhether an instrument resulting from a significantmodification is indebtedness, any deterioration in thefinancial condition of the debtor between the issue dateand the date of modification will not be considered.► Exception if there is a substitution of a new obligor, or the addition

or deletion of a co-obligor


► If a debt instrument is significantly modified more thanonce, a literal application of the rule could require takinginto account a financially troubled borrower’s financialcondition.► The rule looks back to the previous deemed issuance, not the

original issue date.► If the borrower was not creditworthy at the time of the previous

modification, the instrument could be recharacterized as equity,even if the borrower was creditworthy when the instrument wasinitially issued.

► Intent of the rule

Consequences of significant modificationsof debt of financially troubled borrowers

► The old debt is treated as having been repurchased for the issue priceof the new debt.

► For debt that is publicly traded, the issue price of the new debt is itsfair market value, which is generally well below its face amount.

► So the issuer has COD income equal to the excess of the faceamount of the debt over its fair market value, and the new debt hasOID of the same amount.

► At a minimum, this is a timing problem for solvent issuers, and it canresult in a permanent loss if the OID deductions are denied in partunder the AHYDO rules.

► The 2014 Camp tax reform proposal would fix this problem by makingthe issue price of debt in an exchange equal to the lesser of:► The adjusted issue price of the old debt► The amount that would be the debt’s issue price if it were not publicly

traded (stated principal amount, assuming the interest rate is ≥ AFR)

Consequences of significant modifications ofdebt of financially troubled borrowers

► For debt that is not publicly traded (before or after themodification), the issue price of the new debt is generallythe face amount of the new debt, not its fair market value.

► As a result, debt workouts can produce significantphantom gains to lenders. These usually can be reportedon the installment method (although this generally resultsin an interest charge).

► It may be a tax-free recapitalization if the borrower is acorporation and the debt is long-term.

► The 2014 Camp tax reform proposal would fix thisproblem by making all debt exchanges nonrecognitionevents.

Nonfunctional currency-denominateddebt instruments

► Foreign currency gain or loss realization upon actual ordeemed payment

► Accelerate or defer foreign currency gain or loss underReg. §1.1001-3

► Gain or loss generally treated as ordinary income or lossand sourced to residence of the taxpayer (or qualifiedbusiness unit)

► Consider potential loss deferral or disallowance provisions► Sections 267(f)(2) and (3)(C) and 707(b)► Anti-straddle rules under Section 1092► Prop. Reg. §1.988-2(b)(14)

► Reportable loss transaction disclosure requirement

► Loans held by foreign related party (e.g., controlledforeign corporation) — generally no deduction is permittedfor the interest expense until paid by the borrower

► Deferring interest expense deductions until payment canaffect, among other things, Subpart F (e.g., the applicationof the CFC look-through provision) and foreign taxcredit determinations.

► Consider:► Significant modifications► Accrued interest satisfied with obligor’s own note► Capitalization of debt

Intercompany financingWhen has interest been paid?

IRS audit issues

Increased IRS focus areas

► Scrutiny of hedging: identification and straddles► Scrutiny of intercompany transactions► Increased resources: more financial products and

international specialists involved in examinations earlier► Litigation:

► IRS Large Business and International (LB&I) believed to have 300active debt-equity cases in its inventory (2014 TNT 15-1)► Tyco docketed in the Tax Court

► Recent cases: PepsiCo, NA General Partnership, Chemtech,Hewlett-Packard

Tyco Tax Court petitions

► Per a Form 8-K filed by Tyco on July 1, 2013, the IRSissued notices of deficiency to former subsidiaries of Tycoon June 20, 2013, after concluding that severalintercompany debt transactions in 1997–2000 should betreated as equity.

► The IRS disallowed $2.86 billion in interest deductions onTyco’s income tax returns. As much as $6.6 billion ininterest deductions could be disallowed in later tax years.

► The petitions appear to indicate that Tyco went to greatlengths to ensure that the debt would be respected assuch for tax purposes.

Debt/equity issues

► “Thin capitalization”/Plantation Patterns concerns► Critical to obtain contemporaneous documentation supporting

debt capacity► “Leveraging-up” transactions

► Can a corporation pay a dividend in the form of a note?► Business purpose requirement?

► Repeated refinancings► How to reconcile with obligation to repay debt at maturity

► “Retesting events”► Does a significant modification under Reg. §1.1001-3 require

retesting for debt/equity status?► How much protection is granted under Reg. §1.1001-3(f)(7)(ii)?

Thankyou!

Ninth AnnualDomestic Tax Conference8 May 2014 | Chicago

ninth annual domestic tax conference - ey€¦ · page 11 applicable tax principles if a...

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