Debt restructuring alternatives for the financially troubled corporation: possible risks and benefits.

• Author: Maiorano, Ronald C.

Many companies currently find themselves in serious financial trouble because of the so-called "rolling recession" that has plagued the United States for most of the 1980s and the broader recession that has existed for the last few years. It is not uncommon for companies to be burdened with large amounts of debt that were taken on in better times. With the economy now showing some signs of recovery, the debt service payments on these borrowings can at best make the turnaround of the troubled company slower and more difficult and, at worst, ma threaten to take the company's survival.

Creditors, already faced with numerous delinquent loans, may be willing to reorganize the debt to enable the company to survive in some form and be able to repay at least a part of the debt. Tax executives charged with advising management on the most advantageous manner in which a company can restructure debt are faced with a complex system of laws concerning the recognition of cancellation of debt income (CODI). Several proposed changes to the tax laws have made it more difficult to restructure debt while avoiding either giving up too much control of the company or recognizing CODI.

This article briefly discusses the tax rules concerning debt restructuring and analyzes alternative forms that a debt restructuring might take. This analysis includes a summary of the advantages and disadvantages of each alternative, including the possible risk involved concerning the tax treatment of each alternative. (See Exhibit 1.) Specifically discussed are the rules for recognition of CODI and tax attribute carryover (TAC) reduction under section 108 of the Internal Revenue Code, as well as the rules restricting the use of Net Operating Losses (NOLs) in future years under section 382. Developments in the area of debt restructuring are also outlined and evaluated. The overall focus of this article is on the rules applicable to solvent and insolvent companies that are not in bankruptcy; special rules that apply to companies in bankruptcy are beyond the scope of this article.

APPLICABLE RULES UNDER SECTIONS 108

AND 382

The major tax aspects of a troubled debt restructuring that the financially troubled company should consider include:

* the possibility that section 382 will impose restrictions

on the availability of NOL carryovers in the

event of an "ownership change,"(1)

* the possibility of having to recognize CODI,(2) or, in

lieu of the recognition of CODI,

* the possibility of being forced to reduce certain TACS

(listed in the order in which they generally must be

reduced) such as NOL carryovers,(3)

general business credit

carryovers,(4) capital loss carryover

overs,(5) the bases of assets,(6) or foreign

tax credit carryovers.(7)

Section 382 restricts the availability of NOL carryovers in the event of a "change in ownership" of a corporation. A "change in ownership" occurs when there is a shift in ownership of more than 50 percent among five-percent shareholders within a three-year period.(8) A five-percent shareholder is any person holding five percent or more of the stock at any time during this three-year period.(9) If an ownership change occurs, the amount of NOL carryforward deductible each year is generally limited to the product of the value of the loss corporation multiplied by the longterm tax-exempt rate.(10)

Of course, if the stock of the corporation involved has a relatively large fair market value (FMV), the NOL deduction allowed under section 382 each year in the future can still be quite large. In addition, the annual unused NOL limitation accumulates and carries forward to succeeding years;(11) hence, if the loss corporation expects to endure a few more years of losses before generating income, the limit may never actually come into play. For the corporation with a small FMV and a large NOL carryover, however, the section 382 limitation can significantly reduce the present value of the tax benefits of the NOL carryforward. Exhibit 2 illustrates these provisions.

In general, section 108 requires a solvent corporation that is not in bankruptcy or is not being relieved of qualified farm indebtedness"(12) to include CODI in taxable income. If, on the other hand, the corporation is insolvent, it will reduce the amounts of various TACs in the order stated above.(13) The TACs can only be reduced, however, up to the amount of insolvency, and any excess of debt forgiveness above the amount of insolvency must be recognized as income.(14) For example, if a company's assets have a FMV of $25 million and these assets are encumbered with $35 million of debt, then the company would be insolvent in the amount of $10 million and any debt forgiveness in excess of $10,000,000 would require CODI recognition.

Special rules can apply if stock of the debtor is issued in exchange for the debt. If stock is issued in exchange for debt, a corporation is generally deemed to have satisfied the debt with an amount of money equal to the FMV of the stock exchanged.(15) Where the corporation is solvent, this generally means that the corporation would have CODI equal to the difference between the face value of the debt transferred and the FMV of the stock exchanged. There is an exception to this treatment for insolvent taxpayers.(16) Insolvent taxpayers who exchange stock for debt are not required to recognize CODI or reduce TACS, but this exclusion only applies to the extent the corporation is insolvent. To the extent that CODI exceeds the amount of insolvency, it must be recognized. This stock-for-debt exception only applies if the stock exchanged is not "disqualified stock."(17) Disqualified stock is defined as stock with a stated redemption price if (1) there is a fixed redemption date, (2) the issuer has a right of redemption at one or more times, or (3) the holder has a right of redemption at one or more times.(18)

In order to avoid the recognition of CODI or the reduction of TACS under the stock-for-debt exception, the stock exchanged must also not be "nominal or token."19 Some taxpayers have argued that the determination of whether shares are nominal or not should be based on the ratio of the FMV of the stock transferred to the FMV of the debt exchanged. The IRS, however, has taken a somewhat different view in Prop. Reg. SS 1.108-1, which was published in the Federal Register on December 6, 1990. The regulations provide that the "nominal or token" determination depends on the facts and circumstances as they relate to three tests. The first and most important of these tests turns on the ratio of (1) the FMV of the stock transferred to (2) the principal amount of the debt exchanged - the "Stock to Debt Ratio."(20) If this ratio is low, it is deemed to be evidence that the shares are nominal or token. This test, in and of itself, seems to be the most stringent test of the three since the stock that is swapped by an insolvent corporation may or may not have a FMV high enough to qualify for the stock-for-debt exception. Thus, if the corporation in question remains insolvent after the stock-for-partial-debt swap occurs, the stock exchanged would probably have a very low value. The Stock to Debt Ratio would therefore also be very low, and a strict application of this test might result in the shares being deemed to be "nominal or token."

The reliance of this first test on the Stock to Debt Ratio follows the IRS position taken in Technical Advice Memorandum (TAM) 8837001.(21) This TAM concluded that the taxpayer satisfied the nominal value test where a creditor received stock in return for his debt and the FMV of the stock constituted approximately 10 percent of the stated value of the debt being exchanged for the stock and 15 percent of the total consideration received by the debtor. Although TAM 8837001 involves a Stock to Debt Ratio of 10 percent, neither section 108 nor its legislative history supports any particular "safe harbor" ratio of stock to debt in determining if stock should be considered token or nominal.

The second test in the proposed regulations looks to the ratio of (1) the FMV of the stock received by a creditor to (2) the FMV of the total consideration received by that creditor in a stock-for-debt exchange - the "Stock to Total Consideration Ratio."(22) If this ratio is low, the stock transferred is deemed to be nominal or token. This test was designed to prohibit taxpayers from obtaining exception to CODI recognition simply by adding a few shares of stock to a debt restructure without changing the underlying economics of the transaction. Recall that TAM 8837001 provided that stock would not be nominal or token if it exceeds 10 percent of debt canceled and 15 percent of total consideration received by the debtor. Accordingly, it could reasonably be anticipated that the IRS may not accept a stock-to-total-consideration ratio of less than 15 percent in order for this test regarding nominal or token shares to be satisfied.

The third test in the proposed regulations relies on the ratio of (1) the FMV of the stock issued to the creditors as a group to (2) the total FMV of the outstanding stock after the bankruptcy reorganization or insolvency workout - the "Stock to Total Stock Ratio."(12) This ratio is used because of the likelihood that, if the FMV of the stock issued to the creditors as a group is low compared with the FMV of all of the debtor corporation's outstanding stock, then the creditors really are not receiving an equity interest. Therefore, the stock transferred is deemed to be nominal or token.

The preamble to the proposed regulations contains several "safe harbor" combinations of ratios that the IRS is considering making effective through the issuance of a revenue procedure or other appropriate publication:(24)

* 10-percent Stock to Debt Ratio and 25-percent Stock

to Total Consideration Ratio,

* 25-percent Stock to Total Consideration Ratio and

25-percent Stock to Total Stock Ratio, or

* with respect to unsecured...