Debt discharge in corporate recapitalizations: avoiding surprises.

• Author: Kerekes, Michael S.

Recapitalizations in which corporate debt is restructured or discharged are assuming a new prominence in the current economy. This item addresses some points that may be of particular practical importance in such transactions. Many recapitalizations are tax deferred under Sec. 368(a)(1)(E) (E reorganizations). However, other Code provisions create many exceptions to that nonrecognition treatment, and those exceptions can lead to unpleasant surprises.

A recapitalization generally is a transaction whereby a corporation changes its debt or equity capital structure (or both). Recapitalizations can include stock-for-stock, stock-for-debt, and debt-for-debt transactions. This item discusses transactions in which the debtor corporation is released from debt.

Preliminary Considerations

Some transactions that appear at first glance to be debt-for-debt exchanges may not be recognition events at all. If a change in debt terms is not a "significant modification" as defined by Regs. Sec. 1.1001-3, there may be no exchange.

Another point to consider before beginning to analyze a transaction is whether the debt in question has previously been discharged--for example, by becoming owned by a person related to the debtor and therefore discharged under Sec. 108(e)(4). The consequences of any prior discharge may have a significant effect on the consequences of the recapitalization.

An obligation' labeled debt may not actually be debt, and when there is no debt there can be no discharge. If there was serious doubt about an issuer's capacity to repay at the time of issuance, the obligation may have been equity from the beginning (although if it has been consistently treated as debt this argument may be difficult to sustain). While relatively rare, there may even be instances in which obligations that began as true debt have been converted to equity.

Tax-Free Recapitalizations

Secs. 368(a)(1)(E), 354, and 1032 provide for nonrecognition treatment for the debt holders and the debtor corporation. This provision is broad; a recapitalization that has a business purpose and is carried out under a reorganization plan generally qualifies (Kegs. Secs. 1.368-1(c) and 1.368-2(g)). Unlike most reorganizations, there is neither a continuity of interest nor a continuity of business enterprise requirement in a recapitalization. (See Rev. Ruls. 77-415 and 82-34; TD 9182.)

Only debts constituting "securities" are covered by Sec. 354(a)(1).What is a security depends on the facts...