The American Recovery and Reinvestment Act of 2009, P.L. 111-5, provides certain business debtors with a cancellation of debt (COD) income deferral election under new Sec. 108(i) for reacquisitions by the debtor or by certain related parties of applicable debt instruments after December 31, 2008, and before January 1, 2011. Electing debtors recognize deferred COD ratably over the five-tax-year period beginning in 2014. The debtor must also defer original issue discount (OID) deductions related to the COD deferral in certain actual and deemed debt modifications and exchanges, including using the proceeds of a new issuance to pay off an existing debt.
An electing debtor forgoes the potential benefits of the insolvency and bankruptcy exceptions under Sec. 108(a)(1) for the deferred COD but also avoids the detriment of tax attribute reduction under Sec. 108(b). Companies realizing COD should analyze the costs and benefits of COD deferral.
Overview of COD and Attribute Reduction
Generally, when a company purchases its own debt for less than the adjusted issue price (AIP) of the debt, it realizes COD under Sec. 61(a)(12) equal to the difference between the acquisition price and the AIP of the debt. For example, if a company purchases its own debt for $30 million when the debt has an AIP of $100 million, the company realizes $70 million of COD. In addition, if a party related to the debtor (as defined in Sec. 108(e)(4)) acquires the debt, the debtor is deemed to have acquired the instrument (with potential COD) and reissued the instrument with an issue price equal to the amount the related party paid for the instrument.
Solvent debtors and debtors outside bankruptcy generally must recognize realized COD unless the debtor makes a deferral election or another relief provision applies. However, under Sec. 108(a), a bankrupt or insolvent debtor generally does not recognize COD income but is subject to a required reduction of tax attributes. Unless a debtor elects to first reduce the tax basis of depreciable property, the debtor first reduces net operating losses (NOLs) (after absorption against current-year income) and then reduces various other tax attributes. Of note, Sec. 382-limited NOLs are available in full for attribute reduction. Complex additional rules apply for partnerships and consolidated groups (see, e.g., Sec. 108(d)(6) and Regs. Sec. 1.1502-28, respectively).
In bankruptcy, Sec. 108 permanently excludes recognition of COD (even COD in...