Many businesses are—or soon will be—unable to meet their obligations. Not all businesses in distress are unsuccessful; sometimes, as in the economic circumstances arising from the novel coronavirus (COVID-19) and the governmental directives tailored to address the related public health issues, even successful businesses must confront closures and steep declines in demand that could not have been anticipated, and may find it necessary or desirable to restructure their existing debt obligations.
Already, many companies are facing liquidity pressures and seeing their debt trade at a discount, or at steeper discounts than before the current crisis. Prudent managers are looking ahead, examining ways to relieve these pressures and to stabilize their financial footing. Many will consider making modest adjustments to existing debt obligations, and some will explore more significant amendments or restructurings of their obligations.
Any adjustment of a debt obligation can have tax implications. Even a seemingly innocuous modification is tested under the tax law to determine whether it must be treated as a taxable exchange transaction. For tax purposes, the adjustment—which may take the form of a simple amendment—can be treated as though the issuer of the debt issued a new debt obligation in exchange for the pre-amended debt obligation. If so, the deemed exchange may be a tax event with unanticipated tax consequences. Some minor debt adjustments will, in fact, remain below the tax radar and escape current tax consequences; but other adjustments, deemed under complex tax rules to be significant modifications, can result in tax events, potentially resulting in the debtor (or creditor) incurring a tax liability.
Adverse tax consequences like these are far more likely—if not certain—in more pronounced debt restructurings. A debt restructuring can take many forms – such as an in-form exchange of existing debt for new debt, an exchange of debt for stock, a modification of the terms of a debt instrument or payment deferral thereunder, or borrowing new money and repurchasing existing debt on the market. When a debtor company reacquires its existing debt (or is treated for tax purposes as having reacquired its debt due to a significant modification)—in any of these ways—at a discount, the company generally recognizes taxable “cancellation of debt” income. Often, a corporation in this situation will have been incurring losses for a while and, therefore, would have net operating loss carryforwards that would wholly or significantly offset such otherwise taxable income. However, given the suddenness of the current economic crisis (similar to the financial crisis of 2008), many companies do not have a reservoir of tax losses to draw upon. Fortunately, not all cancellation of debt income is necessarily taxable.
There are various exceptions to cancellation of debt resulting in taxable income that can apply depending on a company’s particular situation. The two most prevalent exceptions in times of distress for corporate taxpayers are the bankruptcy and insolvency exceptions. Notably, the bankruptcy exception is available even in the case of a so-called “pre-packaged” or “pre-negotiated” plan of reorganization. These are plans of reorganization that have already been negotiated, and sometimes even voted on, prior to the actual bankruptcy filing such that their success is essentially assured. These types of plans have become quite common and can be negotiated and brought to completion relatively quickly. Bankruptcy can be a viable alternative even for solvent companies that are unable to pay their debts as they come due. Such a restructuring can result in significant cash-flow and liquidity benefits for the company because otherwise taxable cancellation of indebtedness income may be non-taxable.
Under the bankruptcy exception to cancellation of debt income, any cancellation of debt income that would result from the plan is excluded from current taxable income. Instead, the amount excluded results in the reduction of certain tax benefits, such as various tax losses and tax credits, as well as (subject to certain limitations) the corporation’s tax basis in its assets – with any excess amount generally excluded without any tax cost. Thus, rather than current taxable income, the company generally will pay more tax in the future as business gets better by virtue of some or all of its tax attributes having been reduced or eliminated. Significantly, the bankruptcy exception is available regardless of the corporation’s solvency or insolvency. Outside of bankruptcy, a corporation may still be able to exclude cancellation of debt income under the insolvency exception. Under this exception, any exclusion from taxable income is limited to the amount of the corporation’s insolvency, as determined immediately prior to the transaction under applicable tax principles (in very general terms, the excess of its liabilities over the fair market value of its assets). The determination of a corporation’s insolvency is subject to certain special rules depending on the circumstances, which aren’t always intuitive and can result in a lesser insolvency exclusion amount than expected.
It is clear that the U.S. government is focused on taking steps to reduce the economic pain inflicted by the current crisis. It is therefore possible, as was the case in the 2008 financial crisis, that one form of government assistance could be to relax the cancellation of indebtedness tax rules. In response to the 2008 financial crisis, debtors were granted an election to defer the inclusion of cancellation of indebtedness income over an extended period, as opposed to having current income. As of this writing, we are not aware of any similar legislative proposal in response to the current economic situation.
Our tax team is experienced in these issues and available to discuss them with you and answer any specific questions you may have.
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|Paul Wessel, Co-Chair Tax Department and|
Head of Executive Compensation & Benefits
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