Recovery Act Permits Deferral of COD Income, Facilitates Issuer Repurchases and Restructuring of Debt

Recovery Act Permits Deferral of COD Income, Facilitates Issuer Repurchases and Restructuring of Debt

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In the current economic environment, many companies are considering restructuring their debt or repurchasing their debt at a discount with cash or common stock. One of the main considerations of such a restructuring or repurchase is the tax consequences to the company. The repurchase of debt at a discount generally will result in cancellation of debt, or COD income, to the company. Similarly, restructuring debt, such as exchanging outstanding debt for new debt or significantly modifying the terms of existing debt, may result in COD income to the company. The tax consequences of COD income can significantly reduce the economic benefits of repurchasing debt at a discount. The American Recovery and Reinvestment Act of 2009 (the Recovery Act), signed by President Obama on February 17, 2009, provides some relief to companies considering such a restructuring or repurchase by allowing companies to make an election to defer the inclusion of certain COD income recognized in 2009 and 2010 to future taxable years.

Elective Deferral of COD Income

Section 108 of the Internal Revenue Code provides certain exceptions, such as in the case of bankruptcy or insolvency, to the general rule that COD income is included in gross income. The Recovery Act amends Section 108 to add a new exception. Under this exception, a company may elect to defer COD income resulting from the reacquisition of its debt during the period January 1, 2009, through December 31, 2010. To qualify for the election, the acquisition must be made by the issuer of the debt or a related person. Acquisitions include (i) acquisitions of debt for cash, (ii) the exchange of debt for another debt (including a deemed exchange resulting from the modification of the terms of existing debt), (iii) the exchange of debt for corporate stock or partnership interests, (iv) the contribution of debt to capital, and (v) the complete forgiveness of debt by the holder.

Pursuant to the election, the COD income is generally deferred for five taxable years, in the case of a reacquisition occurring in 2009, and for four taxable years, in the case of a reacquisition occurring in 2010. The COD income is then included in gross income ratably over the five-taxable-year period following the deferral period. Accordingly, a calendar year taxpayer would be required to include the deferred COD income in gross income ratably in taxable years 2014 through 2018. The election to defer is made by filing a statement with the tax return for the year in which the reacquisition occurs, and the election, once made, is irrevocable. Special rules apply for partnerships and other pass-through entities, such as S corporations.

If a company makes such an election, the other exceptions to Section 108, such as the bankruptcy and insolvency exception, generally will not apply. In the case of the liquidation or sale of substantially all the assets of the company, the cessation of business by the company, or similar circumstances, any deferred COD income which has not previously been taken into account must be taken into account in the taxable year in which such event occurs.

The Treasury Secretary may adopt such regulations, rules or other guidance as may be necessary or appropriate for purposes of applying this new exception.

Corresponding Deferral of OID Deduction

In addition to resulting in COD income, the restructuring of debt may result in original issue discount, or OID, with respect to the new (or modified) debt issued in exchange for the existing debt. The holders of the debt are required to accrue and include the OID in income over the remaining term of the debt, and the company is entitled to a corresponding interest deduction for the OID. If a company elects to defer the inclusion of COD income with respect to an exchange of its debt and such restructuring results in OID on the new (or modified) debt, the company is also required to defer the deductions for such OID. The deferred deductions generally cannot exceed the amount of the corresponding deferred COD income, and the deferred deductions are taken into account ratably over the same five-taxable-year period in which the deferred COD income is included in gross income. If the company does not restructure its debt, but issues new debt and the proceeds of the new debt are used to reacquire existing debt, the new debt is treated as issued for the debt reacquired and any OID on the new debt will be subject to this rule.

AHYDO Rules Modified

The Recovery Act also suspends, in certain limited circumstances, the rules which disallow or defer deductions for OID on applicable high yield discount obligations (the AHYDO rules). An applicable high yield discount obligation generally is a debt instrument with OID that has a term of more than five years and a yield to maturity equal to or in excess of the applicable federal rate plus 5% and meets certain other requirements. The AHYDO rules generally will not apply to any obligation issued during the period September 1, 2008, through December 31, 2009, in exchange (including a deemed exchange resulting from a modification of the obligation) for an obligation which is not subject to the AHYDO rules. The AHYDO rules will continue to apply to any obligation issued for cash or any other property, including an obligation which is subject to the AHYDO rules.

Conclusion

These new provisions will facilitate the repurchase and restructuring of debt by companies in 2009 and 2010. Although they do not eliminate the tax on COD income, the deferral significantly reduces the effective tax cost on a present value basis. For example, if a company with a 5% cost of capital repurchases debt at a discount in 2009 and defers the COD income, the present value of the tax expenditure for the repurchase would be reduced by approximately 32%, assuming tax rates do not increase. In effect, the government is providing the company with an interest-free loan for the period of the deferral.

While refinancing options in the current economic environment remain limited, these Recovery Act provisions, combined with the discounted secondary market prices for debt, present a unique opportunity for companies to deleverage their balance sheets in a tax-efficient manner. Of course, debt restructurings and repurchases implicate a variety of securities law issues and other legal and accounting issues to be considered. You should consult with counsel about your company's circumstances before engaging in such a transaction.

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