tax implications of refinancing or restructuring debt
TRANSCRIPT
Tax Implications of Refinancing or Restructuring Debt
Learning Objectives
• What is Debt Restructuring and Why Are We Seeing It?
• What is a Significant Modification?
• Cancellation of Debt (COD) Income – Special Issues
• Exclusion of COD Income and Impact to Tax Attributes• Why is Debt Restructuring More Difficult Now?
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WHAT IS DEBT RESTRUCTING AND WHY ARE WE SEEING IT?
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Debt Restructuring During the COVID-19 Pandemic
• COVID-19 pandemic has created unprecedented stress on businesses’ ability to service their debt – both external and internal debt
• Many businesses need some form of debt relief to avoid triggering defaults, foreclosures and collection activity
• Debt workouts consist of many different forms:• Lender’s agreement to forbear foreclosure/collection activity for period of time• Deferral of interest or principal payments• Reduction of interest rate• Forgiveness of interest for period of time• Reduction of principal amount• Extension of maturity date• Debtor’s issuance of warrants or other equity interest to lender.
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Debt Restructuring Beyond the COVID-19 Pandemic
• Taking advantage of reduced interest rates• Addressing the implications of international tax reform
• thin capitalization• anti-hybrid rules• GILTI and global minimum tax
• Entity rationalization• M&A
• pre-transaction structuring• post-acquisition integration
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WHAT IS A SIGNIFICANT MODIFICATION?
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When Does a Significant Modification (SM) Occur?
1) Lender’s forbearance of foreclosure/collection activity for period of time• Not a modification (and therefore not a SM) unless and until forbearance period
exceeds two years plus period in which parties are conducting good faith negotiations
2) Deferral of interest• Not a SM if deferral is not “material” based on facts/circumstances• Under safe harbor, no SM if deferral is within period that begins on due date of
first payment deferred and ends five years later (or, if a lesser period, 50% of debt’s original term)
• Unused portion of deferral period may be used in respect of subsequent deferral3) Deferral of principal
• Same facts/circumstances test and safe harbor as for interest
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When Does a Significant Modification (SM) Occur? (cont’d)
4) Reduction of interest rate• SM occurs if change in yield of modified debt exceeds greater of 25 basis points and 5% of
yield on unmodified debt instrument
• Yield of unmodified debt is determined by comparing adj. issue price of unmodified debt to payments scheduled to be made on modified date from date of modification
5) Forgiveness of interest for period of time• Forgiven interest (as distinct from “deferred” interest) causes SM under rule applicable to
reduction of interest rate
• Cash basis debtor does not have COD income from forgiven interest on theory that debtor’s payment would have been deductible
• Accrual basis debtor likely will have offsetting accrued interest expense and COD income
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When Does a Significant Modification (SM) Occur? (cont’d)
6) Reduction of principal obligation
• Any reduction of principal will trigger COD income to extent of reduction under general tax principles, apart from the SM rules
• Nevertheless, a SM will occur if change in yield of modified debt exceeds greater of 25 basis points and 5% of yield on unmodified debt instrument
7) Extension of maturity date
• Whether SM occurs is determined by same facts/circumstances test and safe harbor that apply to deferred interest and principal payments
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When Does a Significant Modification (SM) Occur? (cont’d)
8) Change in Obligor or Security
• Substitution of new obligor on recourse debt generally gives rise to SM, unless an exception applies such as in the case of a section 381 transaction where no change in payment expectations
• Change in obligor on a nonrecourse obligation is not an SM
• Changes in security, or in the nature of an instrument as recourse or nonrecourse, can give rise to an SM, generally if there is a change in payment expectations
9) Accounting and Financial Covenants
• A change to accounting or financial covenants is NOT an SM
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Determining Whether Debt Restructuring Triggers COD Income to Debtor
Is there a significant modification?
No COD income
Is debt publicly traded? Is FMV of debt
less than its adj. issue
price?
Is “new” debt’s yield at least
equal to AFR?Excess of adj.
issue price over FMV is COD income
Is stated principal amount reduced?
COD income equal to reduction in principal
Excess of adj. issue price over imputed prin. amount is COD
income
No COD income
yes
yes
yes
yes
yes
no
no
no
no
no
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When is Debt Publicly Traded? • Debt is publicly traded if at any time ending 15 days after the issue date (or deemed reissue date
in case of a SM), there is available for the debt:
• A reasonably available sales price appearing in a medium (e.g., Bloomberg terminal) that is accessible by issuers, purchasers or sellers of debt, or brokers of sales or purchases.;
• A firm quote from a broker, dealer or pricing service for the debt, and the quote is substantially the same as the price for which the person receiving the quote could purchase or sell the debt; or
• An indicative quote from a broker, dealer or pricing service for the debt, and the quote is not necessarily substantially the same as the price for which the person receiving the quote could purchase or sell the debt
• No debt is publicly traded (even if it is in one of the above categories) if the outstanding principal amount of the debt’s issue is $100M or less
• Issuer’s determination of publicly traded status is binding on a holder unless holder discloses contrary position on its tax return
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CANCELLATION OF DEBT INCOME-SPECIAL ISSUES
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Partnership COD Allocations and Related Issues
• If a partnership liability is canceled, the partnership generally recognizes COD income equal to the amount of the canceled debt and allocates that income to its partners
• How is COD income allocated?
• Generally follow terms of partnership agreement
• Partners’ shares of partnership income
• Partners’ shares of canceled debt (determined under section 752)
• Recourse versus non-recourse liabilities
• Other?
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Partnership COD Allocations and Related Issues, cont.
• Allocation of COD income increases a partner’s “outside” tax basis
• Deemed distribution reduces partner’s outside tax basis and can be taxable
• If a partner’s share of partnership liabilities is canceled, the partnership is treated as distributing cash to the partner
• Distributee partner recognizes gain to extent that the cash deemed distributed exceeds its outside tax basis
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Partnership COD Allocations and Related Issues, cont.
• Timing considerations
• Deemed cash distribution treated as an advance or draw and taken into account at partnership’s year-end
• Outside tax basis increase precedes deemed distribution
• Mismatch can arise (and partners can recognize gain) if COD income allocations are not consistent with the partners’ shares of the canceled debt
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COD Income International Tax Considerations• Subpart F
• COD Income generally is not subpart F income – PLR 9729011• Under tax benefit rule, to the extent accrued interest offset subpart F income, cancelation of interest can give
rise to subpart F income
• Section 951A GILTI• Generally should be included in tested income for purposes of section 951A GILTI
• Section 385• Deemed reissuance of obligations can have implications under section 385 and particularly the safe harbor rules
• Section 988• Also important to consider potential FX gain or loss on deemed exchange of debt, if not in functional currency• Important to consider impact on any hedging transactions, or integrated debt treatment
• Section 482• Restructuring transactions also need to be at arm’s length
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COD Income State Issues• Internal Debt
• May trigger COD income among related non-consolidated entities• Significant Modification should be separately analyzed• Consider addback provisions
• External Debt• Change to the obligors and guarantors on the debt• CARES Act PPP Loan forgiveness• Attribute reduction differences
• Apportionment • Sales factor• Election to reduce basis in assets
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Intercompany debt – looks simple right?
• Subsidiary paying the tab• Is the subsidiary an obligor?• Ordinary and necessary?• Unitary/combined?
• Subsidiary deduction• State addback provisions• State Section 482 power
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U.S. Sub Foreign Sub
Parent
Interest
Interest
Obligor vs. Guarantor State Issues
• Deductibility of debt generally follows requirements of federal tax law
• States may care more• Unitary group may not be the same as consolidated• Separate filing state deductions
• In re St. Johnsbury Trucking Co, Inc., Debtor U.S. Bankruptcy Court, S.D. New York, No. 93-B-43136, 206 B.R. 318, March 7, 1997 interest expense could not be allocated to the subsidiary because it was not the primary obligor but merely guarantor on the loan
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EXCLUSION OF COD INCOME AND IMPACT TO TAX ATTRIBUTES
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Exclusion of COD Income by Reason of Debtor’s Bankruptcy • Section 108(a)(1)(A) excludes COD income from gross income if the discharge occurs
in a title 11 case
• “Title 11 case” means a case under chapter 11 of Bankruptcy Code if (1) taxpayer is under jurisdiction of bankruptcy court and (2) discharge of debt is granted by court or pursuant to court-approved plan.
• This exclusion applies only to a corporate or noncorporate debtor whose debts are discharged upon confirmation of the plan. It does not apply to chapter 11 case where the debtor liquidates and does not engage in business after confirmation of plan
• COD income is not realized until year in which plan is confirmed by court
• Amounts excluded from gross income must be applied to reduce certain specified attributes; any excess (“black hole”) COD income disappears
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Exclusion of COD Income by Reason of Debtor’s Insolvency • Sections 108(a)(1)(B) and 108(d)(3) exclude COD income from gross income to the
extent the debtor is insolvent immediately before the discharge
• “Insolvent” means the excess of liabilities over the fair market value of assets.
• This exclusion applies to any non-bankruptcy situation in which debtor is insolvent at the time of discharge, but also applies to chapter 7 case, or a chapter 11 case in which the debtor is liquidated and ceases to engage in business after confirmation of plan
• COD income is not realized in bankruptcy case until the debtor makes all distributions to claimants pursuant to the plan
• Amounts excluded from gross income must be applied to reduce certain specified attributes; any excess (“black hole”) COD income disappears
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Reduction of Attributes by Reason of Excluded COD Income • If taxpayer does not elect to reduce depreciable basis first, attributes are reduced at
end of year of discharge, in the following order:• NOL for year of discharge and NOL carryovers from prior years
• Sec. 38 tax credit carryovers ($0.33 of credit per $1 of COD income)
• Sec. 53 minimum tax credit at beg. of year following year of discharge (also $0.33 of credit per $1 of COD income)
• Net capital loss for year of discharge and cap. loss carryovers from prior yrs.
• Basis of debtor’s assets, but not below amt. of debt immed. after discharge
• Sec. 469 passive activity loss or credit carryover from year of discharge ($1 of loss and $0.33 of credit per $1 of COD income)
• FTC carryover to/from yr. of discharge ($0.33 of credit per $1 of COD income)
• Taxpayer may elect to reduce depreciable basis before other attributes
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Application of COD Income Exclusion and Attribute Reduction to Consolidated Group
• COD income/attribute reduction rules apply only to non-intercompany debt. Treatment of intercompany debt is governed by matching, acceleration, and deemed satisfaction and reissuance rules in Reg. § 1.1502-13.
• The bankruptcy and insolvency exclusions are applied at the member level• Attribute reduction involves a three-step process
• First, the member with excluded COD income reduces its attributes, including basis in subsidiary stock
• Second, under a “look through rule,” each subsidiary of the member must reduce its attributes to the extent its stock basis was reduced under the first step
• Third, attributes of other consolidated group members (other than basis in their assets) are reduced to the extent that excluded COD income exceeds the reduction of tax attributes under the first step
• Any black hole COD income effectively disappears
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Relevant Tax Considerations When Only Part of a Consolidated Group Files for Bankruptcy
• The bankrupt member remains a member of the consolidated group until it is either acquired by new shareholders pursuant to a reorganization or is liquidated.
• COD income (and therefore attribute reduction) does not arise until year in which plan is confirmed (if non-liquidating chapter 11) or assets are fully distributed pursuant to plan (if chapter 7 or liquidating chapter 11)
• Acquisition of equity interests in member by claimants could cause Sec. 382 limitation on use of member’s NOLs, subject to special rules in Sections 382(l)(5) and (l)(6)
• Consolidated group’s ability to use debtor member’s NOLs may be hindered by tax sharing agreement and potential bankruptcy trustee’s claim that debtor owns its NOLs
• Consolidated group’s sale of debtor member stock or worthless stock deduction may implicate attribution reduction rules under Reg. § 1.1502-36, which may need to be coordinated with contemporaneous application of attribution reduction rules under Reg. § 1.1502-28
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Attribute Reduction at State Level
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• Basis differences
• Fan out rule
• State specific rule
• Different unitary group
• Separate filing states
• Apportioned vs. Pre-apportionment
Reg. § 1.1502-28
Bankruptcy and Insolvency Exclusions and Partnerships
• Generally apply at partner level• Partnership’s bankruptcy or insolvency not determinative
• Bankruptcy exclusion• Case law provides that a partner can apply bankruptcy exclusion if it is
relieved of partnership liabilities as part of the partnership’s Title 11 proceeding
• IRS has taken a different view• Insolvency exclusion
• Certain partnership liabilities can be treated as liabilities of partners for purposes of insolvency exclusion
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Attribute Reduction in Partnerships
• Generally applies at partner level
• For purposes of election to reduce depreciable basis before other attributes, partnership interest can be treated as depreciable property to extent of the partner’s share of the partnership’s depreciable property
• Partnership consent generally required
• Partnership must reduce partner’s share of partnership’s depreciable tax basis (“inside basis”)
• Tax basis adjustment is unique to electing partner (similar to section 743(b) adjustment)
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Exclusion for Qualified Real Property Business Indebtedness• Limited exclusion available for non-corporate taxpayers• Does not apply if taxpayer is bankrupt or insolvent• Qualified real property business indebtedness (“QRPBI”) generally includes
indebtedness that (i) was incurred in connection with real property used in a trade or business; (ii) is secured by the real property; and (iii) was incurred to acquire, construct, reconstruct, or substantially improve the real property
• Partner level election required• Determination whether indebtedness is QRPBI is made at partnership
level• If exclusion applies, taxpayer must reduce tax basis of depreciable real
property
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Section 163(j) and Section 108
• Section 163(j) interest carryforwards are not included in the list of attributes subject to reduction
• Intersection of section 108 and section 163(j) is uncertain• Section 108(e)(2) generally provides that COD income is not realized to
the extent that payment of the canceled debt would have given rise to a deduction; see also tax benefit rule
• Would a taxpayer realize COD income if accrued but unpaid interest on canceled debt is disallowed under section 163(j)?
• No guidance in final or recently proposed regulations; preamble to final regulations states that these issues require further consideration and may be the subject of future guidance
The potential consequence of CODI with respect to a liability for accrued interest can be unexpected, given that disallowed business interest expense carryovers are not among the tax attributes that can
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Section 163(j) and Partnerships: Issues and Uncertainty
• Section 163(j) applies at partnership level, but excess business interest expense and other items pass through to partners
• Partner’s ability to deduct excess business interest expense depends on allocation of excess taxable income
• Rules provide for certain outside basis adjustments• CARES Act amendments
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Section 163(j) and Partnerships: Issues and Uncertainty, cont.• Intersection of sections 163(j) and 108 in partnership context• Tiered partnership structures• Guaranteed payments for use of capital• Self-charged interest rules• Debt-financed distributions• Others
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Partnership Debt for Equity Exchange
• Exchange generally is tax-free except to the extent that a partnership interest is transferred in exchange for the partnership’s obligation to pay interest or certain other amounts
• If a partnership transfers a capital or profits interest to a creditor in satisfaction of partnership debt, the partnership recognizes COD income as if the debt had been satisfied with cash equal to the value of the partnership interest
• Generally liquidation value• Partnership COD income is allocated to the partners existing immediately
before debt for equity exchange
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RESTRUCTURING CHALLENGES
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Debt Restructuring in Cross-Border Context is Complicated by Tax Reform• New considerations for deciding how to structure external debt
• USP borrows externally, lends/contributes to CFC: • USP’s int. exp. subject to Sec. 163(j) limits• CFC’s int. exp. first reduces Sec. 951A’s DTIR; Sec. 163(j) limits apply to rest
• CFC borrows with USP guarantee: • CFC’s int. exp. subject to Sec. 163(j) limits after DTIR reduction• Imputed guarantee fee under Sec. 482
• FP borrows externally, lends/contributes to US Sub: • US Sub’s int. exp. potentially subject to Sec. 163(j) limits, BEAT, and Reg. § 1.385-3
• US Sub borrows externally with FP guarantee: • US Sub’s int. exp. subject to Sec. 163(j) limits, but avoids BEAT and Reg. § 1.385-3• Imputed guarantee fee potentially subject to BEAT
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Debt Restructuring in Cross-Border Context is Complicated by Tax Reform (cont’d)• New considerations for deciding whether to restructure or even eliminate internal debt
• USP borrows from CFC: • USP’s int. exp. subject to Sec. 163(j) and BEAT, notwithstanding Subpart F inclusion• Final Sec. 956 regs may prevent deemed dividend if sec. 245A would apply to dividend
• CFC borrows from USP: • CFC’s int. exp. first reduces Sec. 951A’s DTIR; Sec. 163(j) limits apply to rest
• CFC borrows from another CFC: • Borrower’s int. expense is not netted against lender’s int. income for purposes of
determining borrower’s and lender’s tested income or loss.• However, int. expense and int. income may effectively be netted for Sec. 163(j) interest
limitation purposes if CFC group election is made under 2020 Sec. 163(j) prop. regs.
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INTERNATIONAL AND TRANSFER PRICING CONSIDERATIONS
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Restructuring Intercompany Debt: Permanent Reduction of Interest Rate
USP
ForeignHoldco
FSub2FSub1
$1M 10 year loan @ 5% ann.(6 yrs. remaining)
Facts:• FSub1 unable to service 5% rate. FSub1’s current mkt. interest
rate is 6%. Parties desire to achieve maximum rate reduction.• Medium term AFR in Aug. 2020 is 0.41%. LT AFR is 1.12%.• Forecasted cash supports payment of MT AFR and principal.
Issue: May parties reduce interest rate to 0.41% for remaining 6 year term without adverse tax consequences?
Tax Considerations:1) Does signif. modif. trigger COD income? OID? § 988 gain?2) Does interest rate meet arm’s length standard? See Reg. §
1.482-2(a)(2)(iii)(B).3) Could debt be recharacterized as equity?
• Scottish Power (TCM 2012); Nestle (TCM 1995)• Reg. § 1.1001-3(f)(7)
Restructuring Intercompany Debt: Temporary Reduction of Interest Rate
USP
ForeignHoldco
FSub2FSub1
$1M 10 year loan @ 5% ann.(6 yrs. remaining)
Facts:• Same except parties desire to reduce rate to MT AFR for 2
years, then return to 5% for 4 years.• Forecasted cash supports payment of MT AFR for 2 years, 5%
for 4 years, and principal at maturity.
Issues: How are the tax consequences different?1) Still no COD but there is OID due to changing int. rate.2) Same ability to rely on § 482 safe harbor for entire 6 years, as
5% is between AFR and market rate.3) Stronger case for supporting debt characterization
• Forecasted cash supports market rate after interim period.• 5% rate is only 100 basis points less than market rate.• Arguably resembles what third party would do.
4) Switch to 5% rate not cause signif. modif. in yr. 3.
State Transfer Pricing and Debt
• United Parcel Service General Services Co. v. Dir., Div. of Taxation, 25 N.J. Tax 1 (N.J. Tax Ct. 2009) Cash sweeps should be treated as loans and interest should be imputed
• Metro Touch, Inc. v. Dir., Div. of Taxation, 21 N.J. Tax 312 (N.J. Tax Ct. 2004) • Court upheld imputation of interest on interest-free loans • N.J.S.A. 54:10A-10a and -10b allows the Division to include “fair profits” in a
taxpayer’s income where a transaction is at less than a “fair price”
• Comm’r v. AMIWoodbroke, Inc., 634 N.E.2d 114 (Mass. 1994) Court upheld imputation of interest on a subsidiary’s interest-free loans to its parent “to correct the effect of less than arm’s length transactions.”
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States sometimes misfire their arrows…• In re Sears, Roebuck and Co., TSB-D-94(7)C (N.Y.S. Tax App. Trib. Apr. 28,
1994) Rejected forced combination as attempt to disallow interest deduction where taxpayer showed debt was at arm’s length rates
• Carpenter Technology Corp. v. Dep’t of Revenue Services, 779 A.2d 239, Taxpayer capitalized the subsidiary with a $300,005,000 contribution and the subsidiary loaned $300,000,000 back to the taxpayer.
• Held that Commissioner did not have discretion under Section 12-226a to disallow interest deduction because the loans had economic substance and business purpose, and the arrangement did not inaccurately reflect income.
• Connecticut amended Section 12-226a in 2002 and declared that the facts in Carpenter “amply satisfy the improper or inaccurate reflection of net income standard”
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The Panel – Contact Information
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ERIC M. [email protected]
ROBB [email protected]
MORGAN W. [email protected]
GARY B. [email protected]
MARJI [email protected]