The Great Recession of 2007-2009 spawned a multitude of commentary regarding cancellation-of-debt (COD) income and its consequences for taxpayers. Sec. 108 and its many complications suddenly took on importance for private individuals, businesses, and tax advisers. Sec. 108 can turn the renegotiation of debt, quite common both in personal life and in business, into a fiendishly difficult exercise.
One situation in which a debt may be renegotiated is in the context of a purchase or acquisition—previously agreed-upon debts often are renegotiated based on post-purchase events. When the renegotiated debt is contingent upon the fulfillment or occurrence of other post-purchase events (as is commonly seen in the merger and acquisition context), there can be interesting and complex interactions between the COD income rules and other provisions of the Code. It should be noted that the final results often provide for inconsistent tax treatment between the debt issuer and the debt holder, although the tax treatment of the debt holder is not discussed in this item.
This item addresses the tax consequences when a nonpublic, financially healthy company renegotiates a debt that was incurred to purchase the company's assets, and the resulting new debt is contingent on the occurrence of future events. This item presents an example of such a transaction from the company's perspective and explains the relevant tax considerations at each step of the transaction. Note that this item does not address the debt holder's tax treatment, which is governed by the debt modification and installment sale rules.
Example: On Jan. 1 of year 1, NewCo purchases all the assets and assumes all liabilities of OldCo for $50 million in cash and a note for $10 million plus 7% interest to be repaid in five years. The note is due and payable to Seller regardless of NewCo's performance. The transaction is not a reorganization and is fully taxable to Seller. NewCo receives basis in the purchased assets equal to $60 million.
In year 2, NewCo's major contract with a government agency is canceled due to poor product performance. NewCo's shareholders determine that Seller was aware of problems with NewCo's major contract prior to the sale and did not disclose those problems during the due-diligence process.
To avoid litigation, NewCo and Seller agree to revise the terms of Seller's $10 million note. The interest rate and payment date of the debt are unchanged. However, repayment of the note is now based on NewCo's performance over years 3-5. Seller can receive anywhere from nothing to $10 million on the note. The most likely outcome is that Seller will receive nothing. The note's fair market value is estimated to be $2.5 million.
On Dec. 31 of year 5, NewCo pays Seller $4 million plus interest in full satisfaction of the debt.
General Rule for COD Income on Debt Restructuring
If a debt issuer restructures or renegotiates a debt, the issuer is treated as issuing a new debt instrument to satisfy the original debt instrument, which is a taxable event under Regs. Sec. 1.61-12(c)(2)(ii). COD income is realized equal to (1) the adjusted issue price of the original debt, less (2) the issue price of the new debt under Sec. 108(e)(10), as shown in Exhibit 1 (below).
The first step is to figure out the adjusted issue price of the original debt. The issue price of debt given to the seller of nonpublicly traded property is usually defined as the face value or stated redemption price at maturity of the debt under Sec. 1273(b)(4). (However, the issue price of debt can be unequal to the face value of the debt in different situations. See Sec. 1274, Sec. 1273(b)(1), Sec. 1273(b)(2), and Sec. 1273(b)(3) for examples of situations in which the issue price of a debt is not equal to the face value of the debt.) Then, any previous payments of principal are subtracted from the issue price to arrive at the adjusted issue price of the original debt used in the earlier calculation.
The second step in the analysis is to figure the issue price of the renegotiated debt (here called the "new debt"). Often, the new debt is issued for the same principal amount as the original debt, and only the terms have changed. In that case, there is usually no COD income as long as there is an adequate interest rate, as the issue price of the new debt is equal to the adjusted issue price of the original debt.
However, this is not the case if the new debt is contingent upon future events. Regs. Sec. 1.1274-2(g) sets forth the issue price of a debt when all or part of the debt is contingent. The regulation provides that the issue price of a contingent debt is equal to the sum of the noncontingent payments (i.e., the total of all payments that are unconditionally due and payable). The fact that it is probable that a contingent portion of the debt actually will be paid is disregarded in determining the debt's issue price.
This rule can lead to uncomfortable results for NewCo, the debt issuer. NewCo issued a debt to Seller with an issue price of $10 million in year 1 to purchase the business assets. The new debt, however, is wholly contingent on the future financial performance of NewCo. Therefore, under Regs. Sec. 1.1274-2(g), the issue price of the new debt instrument is zero. This results in COD income of $10 million to NewCo (absent any exclusions, which will be discussed later) as shown in Exhibit 2 (below).
Statutory Exception: Purchase Price Reduction
In NewCo's case, there is a statutory exclusion from the general rule under Sec. 108(e)(5). The exclusion applies when the purchaser of property owes a debt to the seller of the property, and the debt is reduced and would otherwise result in COD income. The exclusion is available only if the debt reduction does not occur in a Title 11 bankruptcy case or when the purchaser is insolvent.
Because NewCo bought the assets of the business from Seller for the original $10 million debt, and the debt is reduced to an issue price of zero, this is a purchase price adjustment. The purchase price adjustment is equal to $10 million, the amount of COD income that otherwise would apply based on the general rule discussed earlier. Therefore, the transaction does not give rise to COD income, but it does give rise to a $10 million reduction to the purchase price.
Note that under Sec. 108(e)(5), the purchase price reduction applies only if the debt is owed to the seller of the property. If Seller had sold the $10 million note to a third party, the purchase price exception would not be available to NewCo. In that case, NewCo would be stuck with the $10 million of COD income.
When COD income is excluded from taxable income under Sec. 108, there is a corresponding reduction of tax attributes for the amount of the COD income.
No guidance specifically orders a reduction in tax basis for excluded COD income under the purchase-price-reduction exclusion of Sec. 108(e)(5). However, it would appear that basis reduction arguably is required because the basis in property reflects the original purchase price, and this is a purchase price reduction.
There also is no guidance from Sec. 108(e)(5) on how to reduce basis in the acquired assets specifically for purchase price reductions. Sec. 108(b) provides basis reduction ordering rules for various other exclusions in Sec. 108 from COD income, but it does not provide rules on basis reduction for a purchase price reduction. It seems logical, however, to reduce basis according to the rules by which basis originally was assigned to the assets under Sec. 1060 when the assets were purchased.
Payment of Debt
At the end of year 5, NewCo settles the debt for $4 million plus accrued interest. This payment to Seller is treated as two separate payments: (1) a payment of the debt as additional purchase price, which is added to Seller's basis in its purchased assets under Sec. 1012, and (2) a payment of interest expense on the debt, which is deductible as interest expense.
The debt provides for 7% interest to be paid to Seller at maturity on any amount of the debt that actually comes due. Regs. Sec. 1.1275-4(c) provides the rules for determining interest expense deductions on a contingent debt. The contingent debt is separated into two pieces: (1) principal that is noncontingent, and (2) principal that is contingent. Interest expense then is computed separately on each portion of the debt.
In NewCo's case, all payments on the debt are contingent. Under Regs. Sec. 1.1275-4(c)(4)(ii)(A), a present value calculation is required. NewCo must calculate the present value of the total payment to Seller as of year 1. The present value of the debt at year 1 is treated as a payment of principal, while the remainder of the payment is treated as a payment of interest.
The test rate for these purposes is the rate that would be the test rate for the overall debt instrument under Regs. Sec. 1.1274-4 if the term of the overall debt instrument began on the issue date of the overall debt instrument and ended on the date the contingent payment is made. However, in the case of a contingent payment that consists of a payment of stated principal accompanied by a payment of stated interest thus calculated, the test rate is the stated interest rate. The test rate under Regs. Sec. 1.1274-4 generally is the lowest applicable federal rate during the three-month period before the debt was issued. Assuming the 7% stated interest rate in the NewCo debt is higher than the test rate, the 7% rate is used in the present value calculation as shown in Exhibit 3 (below).
NewCo will receive a deduction on Dec. 31 of year 5 for the $1,549,875 of deemed interest expense. The other $3,850,125 of the payment will be capitalized into the basis of NewCo's assets and amortized, depreciated, or deducted as appropriate.
As the economy continues to slowly recover from the Great Recession, there may be less discourse on the tax rules for COD income. However, the complexities of Sec. 108 should not be overlooked and must be evaluated whenever a company renegotiates a debt. This has specific significance when there are contingent debt issues. When both issues are present, the evaluation of Sec. 108 and its effects becomes complex indeed.
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.