In light of the economic uncertainty resulting from the coronavirus pandemic, many companies, either by choice or through lender action, are modifying their outstanding debt by restructuring terms or exchanging one debt instrument for another.

In addition to considering the accounting implications of debt restructuring, it is important for companies to understand the potential income tax consequences of modifying, forgiving, or restructuring a debt instrument.

Debt modifications

Modifications of debt instruments may result in a deemed taxable exchange, which could lead to a cancellation of debt (COD) income to the borrower and the accrual of original issue discount (OID) deductions. The determination of whether a deemed taxable exchange has occurred is a two-step analysis:

Step 1: Determine whether the terms of the debt instrument were modified

The term “modification” is broadly defined in tax regulations. Generally speaking, a modification refers to any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument. A modification can occur from amending the terms of a debt instrument or through exchanging one debt instrument for another. The regulations contain a number of items that do not constitute modifications, most of which stem from the contractual obligations contained in the terms of the debt instruments.

Step 2: Determine the significance of the modifications.

Assuming that a modification has occurred, the next step is to determine the significance of the modification. The tax regulations set forth six tests for analyzing whether the debt modification is significant:

• Change in yield: This test provides that a change in yield is significant if the yield varies from the annual yield on the unmodified instrument by more than the greater of 25 basis points or 5 percent of the annual yield of the unmodified instrument.
• Change in timing of payments: A modification that changes the timing of payments (including any resulting change in the amount of payments) due under a debt instrument is a significant modification if it results in the material deferral of scheduled payments.
• Change in obligor or security: The substitution of a new obligor on a nonrecourse debt instrument is not a significant modification. Conversely, a substitution of a new obligor on a recourse debt instrument is generally a significant modification.
• Changes in the nature of a debt instrument: Generally, a change in the nature of a debt instrument from recourse to nonrecourse, or vice versa, is a significant modification.
• Changes to accounting or financial covenants: A modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification. However, the issuer may make a payment to the lender in consideration for agreeing to the modification. The payment would be taken into account in applying the change-in-yield test. Therefore, a modification to a debt instrument’s covenants can result in a significant modification if the lender receives a payment for agreeing to the modification
• General test: Under the general test, a modification is significant only if the legal rights or obligations are altered in a manner that is economically significant. In making the determination under the general test, all modifications should be considered collectively. A number of small modifications that are insignificant on their own may constitute a significant change when considered together. The general test does not apply if there is another specific rule that applies to a specific modification.

Once it has been determined that a debt modification is significant, both the debtor and creditor should analyze the income tax consequences. The debtor’s income tax consequences are determined by comparing the new debt issue price to the old debt adjusted issue price.

The adjusted issue price is generally the outstanding principal amount if the debt was not issued at discount and the debt provided for current interest payments. To determine the issue price of the new debt, one must analyze if the debt is publicly traded. If the debt is publicly traded, the issue price is the fair market value (FMV) of the debt. If the debt is not publicly traded, the issue price is the stated principal amount if there is adequate stated interest or an imputed principal amount if there is not adequate stated interest.

The following example explains the tax consequences of a modification.

Debt forgiveness and cancellation

For tax purposes, a borrower generally realizes income from debt forgiveness or cancellation when the indebtedness is satisfied for less than the tax basis of the debt. Exceptions to this rule apply to bankrupt taxpayers under the jurisdiction of a Title 11 case and insolvent taxpayers. Insolvent taxpayers are those who have liabilities in excess of the fair market value of their assets. Insolvent taxpayers may exclude from taxable income debt discharge income to the extent that the debtor’s liabilities exceed the fair market value of the debtor’s assets.

While bankrupt and insolvent taxpayers can exclude COD income from taxable gross income, those taxpayers must reduce certain tax attributes to offset the COD income exclusion. Tax attributes must be reduced in the following order:

1. Net operating losses
2. General business credits
3. Minimum tax credits
4. Capital loss carryovers
5. Tax basis of the property
6. Passive activity loss and credit carryovers
7. Foreign tax credit carryovers.

A taxpayer can elect to change the order to instead first reduce the basis of property, however, the basis of property is reduced only to the extent aggregate tax bases exceeds total liabilities.

If there is excess COD income, after reducing tax attributes, the excess may be permanently excluded from the reporting entity’s taxable income without generating a corresponding attribute reduction. This amount is commonly referred to as “black hole” income.

Conversion to equity

Another option for a struggling debtor is to offer its creditors equity in the company in exchange for the debt instruments. The tax consequences of this type of transaction can be similar to those of a debt modification in that the debtor might incur COD income.

The key determination for purposes of calculation the debtor’s COD income is the valuation of the stock exchanged. The debtor is treated as having satisfied the debt with an amount of money equal to the fair market value of the stock. Therefore, if the stock is worth less than the principal amount of the debt, then the debtor will have COD income.

Familiarity with the potential tax consequences of debt restructuring is necessary in order to mitigate the risk of unintentionally creating taxable income. Since the regulations include a very broad definitions, careful planning and analysis is needed when faced with the possibility of a debt restructuring or modification.