Chapter 15 Bankruptcy-Related Tax and Accounting Issues

• Jurisdiction: United States

Chapter 15: Bankruptcy-Related Tax and Accounting Issues

A. Income Tax Consequences of Debt Modifications

Debt restructuring is a common aspect of business bankruptcy proceedings. It is also common to many financially troubled debtor companies, even if they do not pursue a bankruptcy filing. Debt restructurings may also relate to real estate-related debt, leveraged buyout debt, and secured or unsecured general corporate debt. This section summarizes the potential income tax consequences to debtors, creditors and purchasers of debt in connection with a debt modification.

A debt modification may result in the deemed taxable exchange of the old debt instrument for a new debt instrument. The deemed exchange could trigger the recognition of cancellation of debt (COD) income. The deemed exchange could also trigger (1) the accrual of original issue discount (OID) deductions over the remaining debt term to the debtor, and (2) immediate gain/loss recognition and OID income to the creditor. Interest limitations may also affect the tax deductibility of the OID.

A two-step analysis is required to determine whether a deemed exchange has occurred. The first step of the analysis considers whether the terms of the debt were modified. The second step of the analysis considers whether the modification was significant. If the modification was significant, then both the debtor and the creditor should consider the associated income tax consequences.

This section summarizes the provisions of Treasury Regulation 1.1001-3, titled, "Modifications of Debt Instruments" (issued with a July 6, 2011, effective date). To cite the actual language of the regulation or read the entire (unabridged) version of the regulation, readers should review the entire document at 26 C.F.R. Section 1.1001-3.

Step 1 Analysis: Has a Debt Modification Occurred?

The term "modification" is broadly defined in the Treasury regulations. A "modification" typically means any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or debt instrument holder.

The alteration can be evidenced by an express agreement (oral or written), conduct of the parties or otherwise. A modification can occur by either amending the debt terms or exchanging one debt instrument for another. There are three principal exceptions to the definition of a modification.

Exception 1: Debt Instrument Terms

An alteration of a legal right or obligation that occurs by operation of the debt terms is not a modification. For example, an annual interest rate resetting based on an interest rate index is not a modification. However, certain alterations do constitute a modification, even if the alterations occur by the operation of the debt terms. An example of such a modification is a change in the nature of the debt from recourse to non-recourse or vice versa.

Exception 2: Failure to Perform

An issuer's failure to perform its debt obligations is not a modification. However, while the issuer's nonperformance is not a modification, the agreement of the holder not to exercise its contractual remedies under the debt instrument may be a modification.

Exception 3: Failure to Exercise an Option

If a party to the debt has an option to change the terms of the instrument, the failure of the party to exercise that option is not a modification.

Step 2 Analysis: Was the Debt Modification Significant?

Assuming a modification has occurred, Treasury Regulation 1.1001-3 provides six tests for analyzing whether the modification is considered significant:

1. facts and circumstances;
2. changes in yield;
3. changes in payment timing;
4. change in obligor or security;
5. changes in debt instrument nature; and
6. change in accounting or financial covenants.

The determination of whether the modification of any term is a significant modification is analyzed under each applicable test.

Facts and Circumstances

Under this general test, the modification is significant only if, based on all facts and circumstances, the legal rights or obligations are altered to a degree that is economically significant. In making a determination under the facts and circumstances test, all debt modifications should be considered collectively. Therefore, a series of modifications may be significant when considered together even though each individual modification, if considered alone, would not be significant. This general test does not apply if there is a specific test that applies to the particular modification.

Change in Yield

This test specifically applies to debt that (1) provides for fixed payments only, (2) has alternative payment schedules (e.g., debt subject to contingencies), (3) provides for a fixed yield (such as certain demand loans) and (4) has a variable interest rate. If the debt does not fall within one of these categories, then whether a change in yield is a significant modification is determined under the facts and circumstances test.

A change in yield is a significant modification if the yield varies from the annual yield on the unmodified debt (determined as of the modification date) by more than the greater of (1) one-quarter of 1 percent (25 basis points) or (2) 5 percent of the annual yield of the unmodified debt (that is, 0.05 x annual yield). A reduction in debt principal reduces the total payments on the modified debt and would result in a reduced yield on the instrument, often resulting in a significant modification. Therefore, the regulations treat a change in debt principal the same as a change in interest rates.

Change in Payment Timing

In general, a modification that changes the timing of the debt payments is a significant modification if it results in the material deferral of scheduled payments. Examples of such a modification include an extension of the final maturity date or a deferral of payments due prior to maturity (such as a deferral of interest payments). For this exception, considerations include (1) the length of the deferral, (2) the original debt term, (3) the amounts of the payments deferred and (4) the time period between the modification and the actual deferral of payments.

The regulations provide for a safe-harbor provision. The safe-harbor provision indicates that the modification will not be significant if the deferred payments are required to be paid within the lesser of five years or one-half the original term of the instrument. For purposes of this safe-harbor provision, the debt term is determined without regard to any option to extend the original maturity. Deferrals of de minimis payments are ignored. Deferrals are tested on a cumulative basis so that, when payments are deferred for less than the full safe-harbor period, the unused portion of the period remains for any subsequent deferrals.

Change in Obligor or Security

The substitution of a new obligor on nonrecourse debt is not a significant modification. In contrast, the substitution of a new obligor on recourse debt generally is a significant modification.

There are a few exceptions to this rule for substitutions of obligors on recourse debt, including the following:

1. The new obligor is an acquiring corporation to which Internal Revenue Code § 381(a) applies.
2. The new obligor acquires substantially all of the obligor's assets.
3. The change in obligor is a result of either an Internal Revenue Code § 338 election or the filing of a bankruptcy petition.

For an exception to apply, the change in obligor should not result in (1) a change in payment expectations or (2) a significant alteration. The alteration would be a significant modification but for the fact that the alteration occurs by operation of the debt terms.

A change in payment expectations occurs if, as a result of a transaction, there is a substantial enhancement or impairment of the obligor's capacity to meet the payment obligations after the modification as compared to before the modification. The addition or deletion of a co-obligor on the debt is a significant modification if the addition or deletion of the co-obligor results in a change in payment expectations.

For recourse debt, a modification that releases, substitutes, adds or otherwise alters the collateral for, a guarantee on, or other form of credit enhancement for recourse debt is a significant modification if it results in a change in payment expectations. For nonrecourse debt, a modification is a significant modification if it releases, substitutes, adds or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for nonrecourse debt.

Change in Debt Instrument Nature

A change in the debt nature from recourse to nonrecourse, or vice versa, is a significant modification. There are two exceptions to this significant modification test.

First, the defeasance of a tax exempt bond is not a significant modification if (1) the defeasance occurs by...