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-taxyear 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 excess of tax attribute reduction). However, Sec. 108(a)(2)(B) limits an insolvent company’s COD exclusion to the extent of the company’s insolvency.
Sec. 1017(b)(2) limits the reduction in the tax basis of property in an insolvency or bankruptcy case to the post-discharge excess of the aggregate tax basis of property less liabilities of the taxpayer. Only property held by the taxpayer at the beginning of the tax year following discharge suffers basis reduction. Various planning opportunities, such as disposing of certain debtor property in the year of COD realization (via sales to creditors or third parties), may be available to debtors to utilize NOLs or avoid basis reduction.
Example 1: In 2009, Company Z, a calendar-year C corporation, is in bankruptcy and realizes $100 million of COD upon repurchase of its debts for cash. Also in 2009, Z generates $50 million of income (excluding COD) and has an NOL carryforward of $60 million (limited only by Sec. 172). Z’s tax basis in its assets immediately after discharge is $60 million, and it has $55 million of post-discharge liabilities. COD deferral is not elected. At the beginning of 2010, Z holds property with a tax basis of $50 million.
Applying the tax attribute reduction provisions of Sec. 108(b), Z first reduces its remaining NOL ($60 million – $50 million) by $10 million to $0, and in the beginning of 2010 it reduces the tax basis of its property by $5 million (see Secs. 1017(b)(2) and (a)(2)). The entire $100 million of COD escapes recognition at the cost of $15 million in tax attribute reduction.
COD Deferral Election
A company makes the new irrevocable COD deferral election on an instrumentby- instrument basis and recognizes deferred COD ratably over the five-tax-year period beginning in 2014. The election can be applied to any COD realized on the reacquisition (as defined in Sec. 108(i) (4)) of an applicable debt instrument after December 31, 2008, and before January 1, 2011.
For example, if a solvent calendar-year C corporation that is not in bankruptcy purchases its debt for $75 million in 2009 when the debt has an AIP of $100 million, the corporation realizes $25 million of COD. The corporation may elect to defer recognition of the $25 million of COD and to recognize COD ratably ($5 million per year) over the tax years 2014–2018 inclusive.
Certain events, such as the liquidation or sale of all the taxpayer’s assets (including a sale in bankruptcy), terminate deferral. Additional rules apply to partnerships (see Sec. 108(i)(5)(D)).
Debt for Debt
Under Sec. 108(e)(10), if a company retires a debt obligation with a new debt obligation or a company significantly modifies a debt instrument (see Regs. Sec. 1.1001-3), the company recognizes COD income equal to the difference between the AIP of the old debt and the issue price of the new debt. If either old or new debt qualifies as publicly traded, as defined in Regs. Sec. 1.1273-2(f), the issue price of the new debt is its fair market value. Otherwise, the issue price of the new debt generally is its face—i.e., the principal amount of the note provided that the note includes adequate stated interest (see Sec. 1274).
Example 2: Y, a calendar-year C corporation, realizes $70 million of COD upon exchange of its publicly traded debt with an AIP of $100 million and a value of $30 million for its new debt with a face of $100 million.If Y elects to defer COD, it will recognize deferred COD into income ratably over the tax years 2014–2018 inclusive but must also defer the portion of the $70 million of OID deductions accrued while the corresponding COD is deferred. Unfortunately, no OID income deferral is available for the creditor. A related relief provision suspends the applicable highyield discount obligation interest deferral and disallowance rules (see Sec. 163(e) (5)) for certain debt exchanges between September 1, 2008, and December 31, 2009.
Should a Company Elect COD Deferral?
A company in insolvency or bankruptcy or with NOL carryforwards (expiring or potentially limited) should weigh the costs and benefits of COD deferral versus current recognition or exclusion. For instance, it would not be beneficial for Z, in Example 1, to make the COD deferral election because the bankruptcy exception provides Z with $100 million of COD exclusion while the COD deferral election would only defer such income. Further, an insolvent or bankrupt corporation, with NOLs severely limited by Sec. 382, may forgo COD deferral to apply tax attribute reduction to otherwise unusable NOLs.
In addition, a partnership makes the COD deferral election at the partnership level, while the bankruptcy and insolvency exceptions are tested at the partner level. Partners with differing tax attributes or solvency status may disagree as to whether a partnership should make the election.
Various planning opportunities exist for debtor businesses realizing COD. A company should analyze the benefits and costs of COD deferral as part of its overall COD planning.
Annette Smith is with Price-waterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Pricewater-houseCoopers LLP.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or firstname.lastname@example.org.