Today’s Distressed Debt: Emerging Tax Issues and Concerns

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  • Dechert PanelistsDaniel M. Dunn Partner, International and Domestic TaxRepresents financial institutions, private equity funds, and public and private companies on the tax aspects of a broad range of transactions, including workouts and restructurings, private equity transactions, mergers and acquisitions, joint ventures, and securities offerings, including hybrid financings. Michael J. Sage Partner, Business Restructuring and ReorganizationRepresents financial institutions that have acquired substantial strategic positions in debt issued by troubled companies as well as the bankruptcies, out-of-court restructurings, and divestitures relating to such acquisitions.Mark E. Thierfelder Partner, Private EquityRepresents leading private equity funds and their portfolio companies in a full range of corporate transactions, including mergers and acquisitions, recapitalizations, leveraged financings, and restructurings. Scott M. Zimmerman Partner, Leveraged FinanceRepresents public and private companies, private equity firms and their portfolio companies, and commercial and institutional providers of senior debt and mezzanine capital in connection with leveraged financings, workouts and restructurings, and recapitalizations.

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • OutlinePre-American Recovery and Reinvestment ActPurchases of Discounted DebtRelated PurchasersUnrelated PurchasersRestructuring DebtDebt-for-DebtStock-for-DebtAmerican Recovery and Reinvestment Act

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Historic DiscountsDebt of all stripes is trading with discounts sometimes exceeding 50%Compelling investment opportunity for fundsPrivate equity-like yields for performing companiesA seat at the table for troubled companies approaching workout or bankruptcy

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Substantial Tax Implications Upon purchase of debt at discountPotential tax consequencesfor the purchaserfor the debtorUpon restructuring, or a simple modification of the debtAgain, potentially significant tax consequences for note holder and the debtor

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Tax Consequences of PurchaseFirst question: is purchaser related to the debtor?Consequences if the purchaser is relatedCancellation of Debt or (COD) for debtorDeemed newly issued debtSubstantial Original Issue Discount or (OID)Applicable High Yield Debt Obligation or (AHYDO) rules could limit interest deductions

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Related PurchaserCOD is ordinary income that is created when the amount due under an old note exceeds the amount paid upon repaymentin effect, it is phantom income because typically there is no actual receipt of cashIf a person related to the debtor purchases the debt, it is treated as if the debtor had repurchased the debt for the amount paid by the related partyIf a person related to the debtor purchases for $600,000 a $1M note of the debtor from an unrelated person, the debtor will have $400,000 of COD => just as though the debtor had repurchased its own debt for $600,000

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Related Purchaser In addition, when a related purchaser triggers COD, the debt is deemed to be reissued for the purchase price, creating OIDAccordingly, in the prior example where a related purchaser acquired the $1 million debt for $600,000, a new note is deemed to be issued with $400,000 OID Due to the large amount of OID, interest deductibility may be deferred and, to some extent, eliminated under the AHYDO rules (although AHYDO rules will only apply if the debt matures more than 5 years after the deemed reissuance)Also, there are potential fungibility issues if not all of the debt is acquired

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Unrelated PurchaserNo COD; no creation of OIDBut beware market discount for purchaser Principal repayments are ordinary income up to the amount of the discountGain from sale of the note is taxed as ordinary income to the extent of accrued market discount at the time of the saleAlso, potentially serious problems for purchaser in a restructuring of the debt (discussed further below)Possible phantom gainPotential OIDPossible U.S. trade or business income => anathema for funds with foreign investors

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Restructuring Debt Issues for the DebtorCOD will be a major issue for a debtor in any restructuring, including, possibly, simple amendments to a credit facilityIf cash or other property (including equity) is exchanged for the old debt, the amount paid is the amount of cash or the fair market value of the propertyIf debt is issued (or deemed issued) for the old debt, the amount paid is the issue price, i.e.In the case of publicly traded debt => its fair market value (i.e., its trading price)Otherwise => the face amount (assuming adequate stated interest)

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Publicly Traded Debt for Tax PurposesPer Treas. Reg. 1.1273-2(f), property is traded on an established market if at any time 30 days before or after the issue date:It is traded on a registered national securities exchange, interdealer quotation system, or certain foreign exchanges;It is traded on a designated contract market or interbank market;It appears on a system of general circulation that provides a reasonable basis to determine fair market value by disseminating either recent price quotations (including rates, yields, or other pricing information) of one or more identified brokers, dealers, or traders or actual prices (including rates, yields, or other pricing information) of recent sales transactions (a quotation medium); orIt is a debt instrument for which price quotations are readily available from dealers, brokers, or traders (subject to many exceptions).

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Publicly TradedTraceDebt constituting securities for 33 Act purposes LSTABloombergMarkit Others?

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Significant ModificationsIn addition to an actual exchange of old debt for new debt, cash or property, there can be a deemed taxable exchange of debt resulting from a significant modification to the debt termsA significant modification occurs if legal rights and obligations are altered to a degree that is economically significantNote: Adding, deleting, or altering customary accounting or financial covenants => generally, not a significant modification

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Significant Modifications Modifications that are considered significant Changes to the yield (other than de minimis changes)Material deferral of scheduled paymentsA change in payment expectationsi.e., a substantial enhancement or impairment of obligors capacity to meet payment obligations (e.g., changing priority, changing collateral, adding a guarantor or co-obligor)Substituting a new obligor on a recourse debt (with several exceptions)Causing the note to be treated as equityChanging the debt from recourse to non-recourse (or the reverse)Often, such modifications are not of any particular consequence for the debtor unless the debt is publicly traded debt and it trades at a discount (although special rules may apply in certain circumstances, such as in the case of securitized debt)

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Deemed Exchange ExampleInterest rate on non-publicly traded $100 debt is increased from 6% to 8% => deemed exchange of a new $100 note for the old $100 note. No COD for the debtorIf note is publicly traded, and trading price is 60% of face, the same modification will be treated as a retirement of the old debt for $60, creating COD of $40. (The deemed new note would also then have OID of $40)

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Restructuring Concerns for the Note HolderPotential phantom gainPotential OIDPotential U.S. trade or business

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Phantom GainIf a creditor acquires debt at a substantial discount, or the creditor has written the note down for tax purposes, there will be a depressed tax basis, and the creditor could actually incur taxable gain on the restructuring (e.g., if a $1,000 non-publicly traded debt was acquired for $600, and the debt terms were significantly modified the creditor would have a $400 gain!)

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • CommentsAlternatively, one could argue, if the facts permit: (i) the debt exchange is a tax-free exchange of securities (ii) the debt is publicly traded, and therefore the amount realized is the value of the debt (in this case, $600-resulting in no immediate gain), or (iii) installment sale treatment applies, allowing deferral of the gainLosses In some cases, note holders may welcome a taxable exchange if it will generate a lossalthough different note holders may have different objectives due to the tax basis they have in the notesAlso, a creditors loss realized on a taxable exchange of debt will be disallowed if the debtor and creditor are related, meaning, generally, there is a greater than 50% equity ownershipbut constructive ownership rules apply. This rule applies even if the related party status is created in connection with the debt restructuring

    Today's Distressed Debt: Emerging Tax Issues and Concerns

  • Potential OIDIf debt is publicly traded, a restructuring may not trigger gain for a note holder that bought the debt at

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