The IRS has made it clear that almost all debt cancellations are taxable. When taxpayers are relieved from the legal obligation to pay back a loan, they must recognize and pay taxes on that cancellation of debt (COD) as if it were income unless the law specifically exempts that transaction. COD income can arise when loans are forgiven or when they are settled for less than fair market value, but simply restructuring debt can also trigger COD income recognition.
Taxable debt restructurings can take many forms. Modifying key terms (like changing interest rates or payback period), making a stock-for-debt exchange, or selling publicly-traded debt to a related party are simple tweaks that can trigger income tax consequences for the borrower. Understanding COD income recognition rules is especially important right now because debt restructurings have become commonplace during the coronavirus pandemic. With much of the economy still operating at a limited capacity, businesses are feeling the crunch and many portfolio companies are having a difficult time servicing their debt. Private equity and venture capital firms (PE/VC) should be mindful that debt modification tax issues may be increasing over the next several months as the economy begins to recover from the disruption caused by the COVID-19 pandemic.
Why Debt Modification Tax Issues Are Increasing
The Coronavirus Aid, Relief, and Economic Security (CARES) Act signed into law on March 27, 2020, has been a life saver for many borrowers because it offers financial aid in the form of stimulus payments and low or no-interest loans. Many portfolio companies were unable to pursue loans under the CARES Act because the law’s affiliation rules aggregated their business with the PE/VC firm backing them. The aggregation rules sometimes even include the business of the other portfolio companies owned by their PE/VC firm. Therefore, most borrower/lender negotiations for portfolio companies must be executed independently of COVID-19-era rules and regulations.
For many portfolio companies experiencing COVID-19-related business disruptions, seeking relief from late payment penalties will not be enough. They will instead need to renegotiate their loan agreements altogether. In some instances, COD income can be difficult to avoid, and borrowers should regard COD income as an additional cost of the new loan.
What is COD Income?
Although most debt forgiveness is considered COD income, the IRS provides few exceptions. And even if debt forgiveness triggers COD income, that COD income is not always taxable. When debt is cancelled in Chapter 11 bankruptcy and when debt that exceeds the fair market value of the company is cancelled, taxpayers have COD income to report, but those amounts can be excluded from gross income — ultimately making them nontaxable.
Debt forgiveness may be common under COVID-19, but portfolio companies are much more likely to recognize COD income from debt modifications.
When portfolio companies modify or restructure their existing debt, they may need to recognize taxable COD income. Because of COVID-19, borrowers may ask for temporary relief from foreclosures or collection efforts if they make late debt payments. This modification should not be considered COD income if the forbearance is granted for a period not longer than two years. But this allowance only goes so far. When creditors implicitly or explicitly defer interest and principal payments, the IRS may classify the change as a “significant” debt modification and treat it instead as a taxable exchange of a debt instrument. The IRS will determine the materiality of the change by looking at all the facts and circumstances, but the only way for taxpayers to guarantee a tax-free modification is if they qualify for the IRS’s safe harbor.
The safe harbor states that the taxpayer must make up all deferred payments within a period that begins on the original due date for the first scheduled payment that is deferred, and ends on the earlier of:
- Five years later, or
- 50% of the loan’s original term.
Payment extensions made beyond that timeline may still qualify for tax-free treatment, but they must be analyzed further to determine if they represent a significant modification of the debt. Generally, the IRS will view a material deferral of payments as a significant modification of the debt instrument. The regulations provide for tests under which a debt modification needs to be analyzed. The testing criteria include changes in:
- Timing of payments,
- Obligor or security,
- Nature of the debt instrument, or
- Accounting of financial covenants.
There is also a general test reviewing facts and circumstances which may indicate that the legal rights or obligations are altered to a degree that is economically significant.
Where a significant modification of debt has occurred, a new (modified) debt instrument is deemed to have been issued in exchange for the old (unmodified) debt instrument. This is called a debt-for-debt exchange. The debtor realizes COD income to the extent the adjusted issue price of the old debt instrument exceeds the issue price of the deemed new debt instrument.
Publicly and Not Publicly-Traded Debt
Determining if a significant debt modification has occurred will differ if the debt instrument is privately held or publicly traded. Unfortunately, it is not always clear when debt is deemed to be publicly traded.
In 2012, the IRS released regulations that stated property (including debt instruments) are publicly traded if, at any time during the 31-day period ending 15 days after the loan’s issue date, the property has:
- A sales price from an actual trade, or
- One or more firm or indicative quotes from a broker.
The one exception to this rule is for small debt issuances. Debts with outstanding principal balances of $100 million or less at the time of the deemed debt-for-debt transaction will not be considered publicly traded and will be taxed as if the exchange was of two private debt instruments.
The tax consequences of modifying publicly traded debt are two-fold. First, taxpayers may need to recognize COD income in more circumstances than those holding private debt. Second, the new debt instrument may carry an original issue discount (OID).
Businesses that modify publicly-traded debt instruments are more likely to recognize COD income than those with private debts because the IRS defines significant modification differently for each. When a business retires publicly-traded debt and purchases new debt, the IRS will deem there to be a significant modification of the debt instrument if the debt is trading below its market value. The market values of privately-held debts are not under the same scrutiny.
Similarly, when businesses purchase publicly-traded debt that is trading at a discount from a related party, the debtor may also need to recognize COD income. This is a common scenario for PE/VC firms. If a PE/VC owner purchases a portfolio company’s publicly-traded debt for a discount, the portfolio company will likely need to recognize COD income.
When publicly-traded debt instruments have been significantly modified, the borrower will recognize COD income at the time of the exchange and will recognize OID over the life of the loan. Unfortunately, OID interest may not be deductible due to the business interest limitation introduced by the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA). Since 2018, business interest expense deductions have been severely limited, and although the CARES Act eased up on this limitation for the time being, many businesses may never be able to deduct those expenses. Let’s look at a significant debt modification example where OID is present:
Company holds $100,000 of publicly-traded debt, but after the market dips, their debt is only valued at $90,000. Because the coronavirus upset their business operations, Company can no longer service this debt. To address their liquidity concerns, their lender agrees to a deferral of interest payments by two years. Although the issue price of the new debt is $100,000, its value reflects that of the old debt ($90,000), which means that the Company recognizes COD of $10,000 and the new debt is issued with OID of $10,000.
Cash Flow Considerations Related to the Tax Impact of COD Tax Treatment
COD income is considered ordinary income for tax purposes, which means the owners of pass-through borrowers will owe taxes at their highest marginal tax rate, not at a more favorable capital gains rate. Not only that, the amount that was forgiven is taxable even if the business replaces that loan with new debt. And because COD income is taxable in the year the debt is discharged, portfolio companies and their owners may have a difficult time paying the tax liability while staying current on new debt payments.
Unused net operating losses (NOLs) can help portfolio companies absorb extra tax liabilities, and thanks to CARES Act changes, NOLs from 2018, 2019, and 2020 can be carried back for up to five years. This may provide short-term tax relief, but losing tax attributes to renegotiate debt can be a difficult pill to swallow.
Cancellation of debt is a particularly tricky subject right now since so many portfolio companies are entering into debt negotiations with their lenders. Borrowers would be wise to consult an expert when negotiations are in process. If they can structure debt modifications with taxes in mind, they can avoid COD income when possible and plan for additional taxes when COD income cannot be avoided.
If one of your portfolio companies needs to modify or renegotiate their debt or you have any other concerns related to private equity or venture capital business issues, please contact us.
George Cobleigh is a Tax Managing Director and is a member of the Private Equity & Venture Capital Practice. He can be reached at 401.626.3201 or firstname.lastname@example.org.
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