Debt restructurings and contingencies.

• Author: Skrip, Martin J.

The Great Recession of 2007-2009 spawned a multitude of commentary regarding cancellation-of-debt (COD) income and its consequences for taxpayers. Sec. 108 and its many complications suddenly took on importance for private individuals, businesses, and tax advisers. Sec. 108 can turn the renegotiation of debt, quite common both in personal life and in business, into a fiendishly difficult exercise.

One situation in which a debt may be renegotiated is in the context of a purchase or acquisition--previously agreed-upon debts often are renegotiated based on post-purchase events. When the renegotiated debt is contingent upon the fulfillment or occurrence of other post-purchase events (as is commonly seen in the merger and acquisition context), there can be interesting and complex interactions between the COD income rules and other provisions of the Code. It should be noted that the final results often provide for inconsistent tax treatment between the debt issuer and the debt holder, although the tax treatment of the debt holder is not discussed in this item.

This item addresses the tax consequences when a nonpublic, financially healthy company renegotiates a debt that was incurred to purchase the company's assets, and the resulting new debt is contingent on the occurrence of future events. This item presents an example of such a transaction from the company's perspective and explains the relevant tax considerations at each step of the transaction. Note that this item does not address the debt holder's tax treatment, which is governed by the debt modification and installment sale rules.

Example: On Jan. 1 of year 1, NewCo purchases all the assets and assumes all liabilities of OldCo for $50 million in cash and a note for $10 million plus 7% interest to be repaid in five years. The note is due and payable to Seller regardless of NewCo's performance. The transaction is not a reorganization and is fully taxable to Seller. NewCo receives basis in the purchased assets equal to $60 million.

In year 2, NewCo's major contract with a government agency is canceled due to poor product performance. NewCo's shareholders determine that Seller was aware of problems with NewCo's major contract prior to the sale and did not disclose those problems during the due-diligence process.

To avoid litigation, NewCo and Seller agree to revise the terms of Seller's $10 million note. The interest rate and payment date of the debt are unchanged. However, repayment of the...