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Today’s Distressed Debt: Emerging Tax Issues and Concerns

Today’s Distressed Debt: Emerging Tax Issues and Concerns.

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Today’s Distressed Debt: Emerging Tax Issues and Concerns

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  1. Today’s Distressed Debt:Emerging Tax Issues and Concerns IRS Circular 230 DisclosureTo ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any matters addressed herein.

  2. Dechert Panelists • Daniel M. Dunn – Partner, International and Domestic Tax • Represents 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 Reorganization • Represents 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 Equity • Represents 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 Finance • Represents 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

  3. Outline • Pre-American Recovery and Reinvestment Act • Purchases of Discounted Debt • Related Purchasers • Unrelated Purchasers • Restructuring Debt • Debt-for-Debt • Stock-for-Debt • American Recovery and Reinvestment Act Today's Distressed Debt: Emerging Tax Issues and Concerns

  4. Historic Discounts • Debt of all stripes is trading with discounts sometimes exceeding 50% • Compelling investment opportunity for funds • Private equity-like yields for performing companies • A seat at the table for troubled companies approaching workout or bankruptcy Today's Distressed Debt: Emerging Tax Issues and Concerns

  5. Substantial Tax Implications • Upon purchase of debt at discount • Potential tax consequences • for the purchaser • for the debtor • Upon restructuring, or a simple modification of the debt • Again, potentially significant tax consequences for note holder and the debtor Today's Distressed Debt: Emerging Tax Issues and Concerns

  6. Tax Consequences of Purchase • First question: is purchaser related to the debtor? • Consequences if the purchaser is related • “Cancellation of Debt” or (“COD”) for debtor • Deemed newly issued debt • Substantial “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

  7. Related Purchaser • COD is ordinary income that is created when the amount due under an old note exceeds the “amount paid” upon repayment—in effect, it is phantom income because typically there is no actual receipt of cash • If 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 party • If 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

  8. Related Purchaser • In addition, when a related purchaser triggers COD, the debt is deemed to be reissued for the purchase price, creating OID • Accordingly, 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

  9. Unrelated Purchaser • No COD; no creation of OID • But beware market discount for purchaser • Principal repayments are ordinary income up to the amount of the discount • Gain from sale of the note is taxed as ordinary income to the extent of accrued market discount at the time of the sale • Also, potentially serious problems for purchaser in a restructuring of the debt (discussed further below) • Possible phantom gain • Potential OID • Possible U.S. trade or business income => anathema for funds with foreign investors Today's Distressed Debt: Emerging Tax Issues and Concerns

  10. Restructuring Debt Issues for the Debtor • COD will be a major issue for a debtor in any restructuring, including, possibly, simple amendments to a credit facility • If 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 property • If 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

  11. Publicly Traded Debt for Tax Purposes • Per 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);” or • It 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

  12. Publicly Traded • Trace • Debt constituting “securities” for ‘33 Act purposes • LSTA • Bloomberg • Markit • Others? Today's Distressed Debt: Emerging Tax Issues and Concerns

  13. Significant Modifications • In 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 terms • A significant modification occurs if legal rights and obligations are altered to a degree that is “economically significant” Note: Adding, deleting, or altering customary accounting or financial covenants => generally, not a significant modification Today's Distressed Debt: Emerging Tax Issues and Concerns

  14. Significant Modifications • Modifications that are considered significant • Changes to the yield (other than de minimis changes) • Material deferral of scheduled payments • A “change in payment expectations”—i.e., a substantial enhancement or impairment of obligor’s 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 equity • Changing 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

  15. Deemed Exchange Example • Interest 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 debtor • If 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

  16. Restructuring Concerns for the Note Holder • Potential phantom gain • Potential OID • Potential U.S. trade or business Today's Distressed Debt: Emerging Tax Issues and Concerns

  17. Phantom Gain • If 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

  18. Comments • Alternatively, 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 gain • Losses • In some cases, note holders may welcome a taxable exchange if it will generate a loss—although different note holders may have different objectives due to the tax basis they have in the notes • Also, a creditor’s 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 ownership—but 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

  19. Potential OID • If debt is publicly traded, a restructuring may not trigger gain for a note holder that bought the debt at a discount • However, a deemed newly issued note would have an issue price equal to trading value => thus creating substantial OID • Note that this result also produces COD for debtor (as discussed above), and OID deductions (subject to AHYDO) Today's Distressed Debt: Emerging Tax Issues and Concerns

  20. Deemed Exchange Example • Interest 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 debtor • If 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

  21. U.S. Trade or Business • Acquiring debt with the intent and expectation that the purchasing fund will restructure the debt raises an issue of whether the fund will be deemed to have a U.S. trade or business Today's Distressed Debt: Emerging Tax Issues and Concerns

  22. Loan-to-Own Issues • Debt-for-stock exchanges • Gain or loss issues for the note holders • COD issues for the debtor • Preserving value of net operating losses (or “NOLs”) Today's Distressed Debt: Emerging Tax Issues and Concerns

  23. Debt-for-Stock Exchanges • Gain or loss for note holders • Taxable or tax-free exchange • Differing circumstances of note holders • COD issues • COD will result to the extent the debt surrendered exceeds the value of the stock issued in the exchange • Insolvency/bankruptcy exception • Establishing insolvency • Attribute reduction Today's Distressed Debt: Emerging Tax Issues and Concerns

  24. Change of Control • “Section 382”: in a change of control, NOLs may become subject to substantial limitations • For these purposes, a change of control occurs if there is a 50% shift in equity ownership over a 3-year period (applying a host of complex rules of constructive stock ownership) • Under the limitation, pre-change NOLs can only be used, per year, against an amount of income equal to the product of (i) the net equity value of the company, and (ii) a rate published by the IRS (currently 5.49%) Today's Distressed Debt: Emerging Tax Issues and Concerns

  25. Considering Bankruptcy • COD shelter: Greater certainty than in the case of insolvency • NOL preservation • “(l)(5)”: No Section 382 limitation • Old and Cold” creditor must get 50% of the company’s equity in the plan” • There can be no additional change of control for 2 years post-emergence • “(l)(6)”: Section 382 limitation applies, but the value of the post-emergence company is used Today's Distressed Debt: Emerging Tax Issues and Concerns

  26. Non-Bankruptcy Example • Assume a debtor with $70 million of NOLs owes $100 million. The debtor satisfies the debt by issuing stock worth $60 million (after the restructuring), and the stock represents 100% of stock post-issuance • $40M COD • Attribute reduction: Due to debtor’s insolvency prior to restructuring, the COD would be excluded from income and would reduce the debtor’s NOL from $70 million to $30 million • Tax free or taxable for note holders? • Change of control => Section 382 => value before change is arguably zero, meaning NOLs could not be used after the restructuring Today's Distressed Debt: Emerging Tax Issues and Concerns

  27. A Bankruptcy Comparison • Assume the same facts • $70 million of NOLs • $100 million debt • $60 million of stock satisfies the debt pursuant to the bankruptcy plan • Consequences • $40 million of COD excluded from income ($100 million debt minus $60 million stock) • NOLs reduced from $70 million to $30 million (reflecting the sheltered $40 million of COD) • Section 382: • (l)(5): remaining $30 million of NOLs fully available • (l)(6): remaining $30 million of NOLs available for up to $3.294 million per year ($60 million times 5.49% published rate) Today's Distressed Debt: Emerging Tax Issues and Concerns

  28. New Legislation • The American Recovery and Reinvestment Act allows debtors to elect to defer COD arising from a "reacquisition" of an "applicable debt instrument" occurring in 2009 and 2010 • An "applicable debt instrument" is a debt instrument issued by (i) a C corporation or (ii) any other person in connection with the conduct of a trade or business by such person • A "reacquisition" is any acquisition of the debt by the debtor or a related person, including acquisitions for cash (or other property), a debt-for-debt exchange (including a deemed exchange by a significant modification to a debt), a contribution of the debt to the capital of the debtor, or simple forgiveness of the debt Today's Distressed Debt: Emerging Tax Issues and Concerns

  29. New Legislation • The Deferral Regime • The COD is deferred until 2014, at which point the debtor includes the COD into income ratably over a five-year period (i.e., 2014-2018) • OID: The provision also requires the deferral of any OID created as a result of the COD event in order to match more closely the OID deduction and COD deductions • No OID Relief for Holder of Debt: Although the new Act provides relief from COD income for the debtor, it does not provide relief for a note holder • Accordingly: • If a related party buys debt at a discount, the related party will hold debt that generates OID (phantom income for the note holder) • If publicly traded debt is restructured or undergoes a significant modification, the holders of the debt will similarly have OID income Today's Distressed Debt: Emerging Tax Issues and Concerns

  30. New Legislation • Special Rules • Acceleration of deferred items will occur if the debtor liquidates or sells substantially all of its assets (including in a chapter 11 or similar case), ceases to do business or is in similar circumstances (for partnership debtors, acceleration also occurs upon sale of an interest in the partnership) • The election is made by the debtor on a debt by debt basis, and is irrevocable • If the election to defer is made, the COD from that debt cannot later be excluded from income under the insolvency or bankruptcy exception (or any of the other exceptions) that would otherwise permit exclusion from income and result in a reduction of tax attributes • An additional provision in the Act also seeks to alleviate the adverse effect of the AHYDO rules on debt restructured in 2009; this relief could be helpful in reducing the likelihood that a debtor will lose deductions in respect of restructured debt with substantial OID Today's Distressed Debt: Emerging Tax Issues and Concerns

  31. Example under the New Act • Assume a debtor owes $100 million and a related party buys its debt for $60 million (assume four years remaining on the debt) • Without the election • $40 million COD for the debtor immediately • $40 million OID income (approx. $10M/year) for the related party, and $40 million of OID deductions (approx. $10M/year) for the debtor over remaining term of the debt • With the election • $40 million of COD income for the debtor includible $8M/year in years 2014-2018 • $40 million of OID deductions for the debtor, $8M/year in years 2014-2018 • $40 million of OID income for the related party, approx. $10M/year starting right away Today's Distressed Debt: Emerging Tax Issues and Concerns

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