Navigating a tightening economic cycle—characterized by prolonged high interest rates and uncertainty about future rate cuts—requires care and foresight. In the current financial climate, companies tend to accrue substantial net operating losses (NOLs), tax credits, and other tax assets and face deteriorating investments in their subsidiaries. Debt modifications and forbearances are also common as credit becomes scarce and companies face increased liquidity needs as well as challenges in satisfying their debt covenants and obligations.

In this article, we share our perspectives on the often overlooked and potentially drastic tax consequences that can result from various financial actions. These same actions also provide potential opportunities to optimize cash tax savings and beneficial tax attributes. The challenge for companies in the current economic climate lies in avoiding the first while benefiting from the second.

How Can Minor Debt Modifications Trigger Substantial Tax Consequences?

Corporate finance departments often negotiate changes to debt terms or secure forbearance agreements, which can be a lifeline for companies facing liquidity issues or financial strain. However, if the modifications are “significant,” as defined for US federal income tax purposes, the borrower is treated as engaging in a taxable exchange of its original debt for a new, modified instrument.¹ This change could result in the lender recognizing gain or loss on the exchange and the borrower recognizing debt retirement premium or cancellation of indebtedness income (CODI).² As a result, it is imperative that tax departments are aware of any contemplated changes to a company’s debt instruments, since even seemingly minor changes could lead to substantial tax consequences including, but not limited to, reductions to NOLs and other tax assets.

When considering changes to debt instruments (including changes pursuant to the terms of the debt instrument), companies should bear in mind these key points:

• The scope of changes considered “modifications” is broad and encompasses changes made outside a written contract (for example, an oral agreement or conduct of the parties) as well as consent fees and certain prepayment penalties. Additionally, certain changes that occur under the original terms of a debt instrument (for example, a change in obligor or co-obligor) are also within the bounds of modifications subject to these rules;³
• Nuanced rules determine whether a modification is “significant.” There is a general facts-and-circumstances test, along with four specific tests that examine changes in yield, the timing of payments, the obligor or security/collateral, and the nature of the debt instrument (such as a shift from recourse to nonrecourse or from debt to equity);⁴
• A single modification may need to be evaluated under several tests to determine if it is significant. For example, if a fee is paid to extend the maturity date of a debt instrument, the change must be analyzed under both the yield and the timing-of-payments tests; and
• If a modification is not initially considered significant, it must still be factored into the analysis of subsequent modifications. Companies must determine if the cumulative effect of all changes constitutes a significant modification, regardless of the time between modifications or whether a subsequent modification was anticipated at the time of the first change.⁵

Which Analyses Determine the Tax Consequences of a Significant Modification?

When a company’s debt instrument is significantly modified, it triggers two analyses critical for determining the tax consequences: the issue price of the “new” debt instrument and the company’s solvency status for tax purposes.

The-Everything-Is-“Publicly-Traded” Nightmare

Determining the issue price of a modified debt instrument hinges on whether it is classified as “publicly traded.” When either the old or the new debt instrument meets this criterion, the issue price of the new instrument is its fair market value at the time of the exchange, which often falls below the issue price of the old debt, potentially triggering CODI.

To be “publicly traded” for this purpose, a debt instrument must satisfy two conditions. First, it must have a stated principal amount exceeding $100 million. Second, during the thirty-one-day period ending fifteen days after the new debt issuance, it must have one of the following: 1) an accessible actual transaction price, 2) a buy or sell quote from an identified market maker such as a broker, a dealer, or a pricing service, where the quote is expected to be actionable, or 3) a nonbinding price estimate from a market maker not covered in the previous price or quote categories (an “indicative quote”).⁶ Especially because of the last category, which can include Bloomberg BVAL and Markit indicative quotes, most debt is treated as publicly traded for this purpose, which comes as a surprise to many tax (and corporate finance) departments.

However, not all is lost. A careful analysis of the available quotes could yield a higher, yet reasonable, issue price for the new debt, which would reduce the likelihood that the company would recognize any CODI. Although the hierarchy of quotes is as listed above, if multiple quotes exist within a particular category, a company can use any reasonable method, applied consistently under similar circumstances, to determine the fair market value of a debt instrument. Further, if an indicative quote does not accurately reflect the debt’s value, a company can use an alternative method to determine its fair market value.

If neither the old debt nor the new debt is publicly traded, the issue price of the new debt is generally the face amount (irrespective of fair market value). This often leads to minimal or no CODI, assuming no reduction in the principal amount of the debt.

Being Insolvent (for Tax Purposes) May Be a Good Thing

One of the most prevalent exceptions to CODI recognition is the insolvency exception, which allows a company to exclude CODI to the extent of its insolvency.⁷ Although declaring a company insolvent is akin to dragging nails down a chalkboard for corporate finance departments (what with its potential impact on debt covenants, among other risks), for this purpose, insolvency is defined as the excess of the company’s liabilities over the fair market value of its assets, both determined immediately before the discharge.⁸ Therefore, a company can be solvent for financial statement purposes while being insolvent for tax purposes (which generally amounts to a win-win scenario).

To determine if the insolvency exception applies, a detailed analysis of the company’s financial position is required, which involves a comprehensive assessment of all the company’s liabilities and a valuation of its assets. If the modification is known ahead of time, tax planning strategies, including the following, could be facilitated:

• Liability planning. Accelerating liability recognition before the debt discharge—especially for liabilities not tied to asset acquisitions—or increasing the amount of liabilities could cause a company either to become insolvent for tax purposes or to increase its insolvency position before the significant modification, thereby increasing the amount of excluded CODI; and
• Insolvency monitoring. Monitoring the fair market value of a company’s assets, which often yields a range of values rather than a precise figure, can help a company assess its proximity to insolvency and inform decisions on whether it is advantageous to trigger a significant modification.

Special rules apply for testing insolvency when the debtor is a disregarded entity or a partnership, which could affect planning strategies.

Unfortunately, excluding CODI due to the insolvency exception comes at a cost: a company must reduce certain tax assets, including NOLs, tax credit carryforwards, and tax basis in the company’s assets, to the extent of its excluded CODI after calculating its tax liability for the year in which the CODI would have been recognized. Special rules govern the reduction of tax attributes where the excluded CODI is of a disregarded entity or a partnership. Because of the timing of the attribute reduction, companies can engage in proactive tax planning strategies, including:

• Income and deduction management. Deferring deductions or accelerating income to reduce a company’s NOLs, tax credits, and other tax assets can help minimize attribute reduction or affect which attributes must be reduced. This can also be accomplished by engaging in extraordinary transactions that use tax assets that would have otherwise been subject to attribute reduction; and
• Preservation of tax attributes. Modeling the prescribed methods for attribute reduction could help companies determine the best approach to preserve the more valuable tax assets (which are those that will be used sooner).

Additionally, if liabilities were increased using the strategy above, the extent of attribute reduction required as a result of excluded CODI may be decreased because it is generally capped at the excess of the company’s aggregate asset basis over its liabilities, both determined immediately post-discharge.

How Can Companies Benefit From Recognizing CODI?

Although companies may typically avoid triggering taxable income, in certain scenarios it may be advantageous to recognize taxable CODI (CODI that is ineligible for a full exception) through careful planning, including by way of a significant modification. The potential benefits include:

• Unlocking deductions. Counterintuitively, recognizing CODI can benefit a company because the increase in taxable income can unlock deductions that might otherwise be deferred (for example, the deductions for business interest expenses, charitable contributions, and NOLs) or lost (for example, deductions for foreign-derived intangible income [FDII] and global intangible low-taxed income [GILTI]);
• Navigating the corporate alternative minimum tax (CAMT). For a corporation subject to CAMT, recognizing CODI might not result in an immediate increase in taxes if its regular taxable income is less than its adjusted financial statement income. Depending on whether CODI is recognized for financial statement purposes, the recognition of CODI could be “tax-free” in the current year, since the decrease in the corporation’s CAMT liability may fully offset the increase in its regular tax liability; and
• Creating more valuable future deductions. As discussed above, as part of a significant modification, a new debt instrument is deemed to be issued. The difference between the debt’s stated redemption price at maturity and its issue price is known as original issue discount (OID). This OID, which generally equals the CODI amount, can be amortized and deducted as interest expense over the term of the new debt instrument, which can be beneficial if the CODI is recognized in a year in which an NOL is expected. By recognizing CODI, a company can convert a current-year NOL into tax carryforwards in the form of OID tax deductions in future years, which may be subject to the Section 163(j) business interest expense limitation but would not be subject to the eighty-percent-of-taxable-income limitation applicable to NOLs.

How Can Companies Recoup Lost Subsidiary Investments as Tax Benefits?

Shifting gears to opportunities for tax savings, companies with debt or equity investments in failed or financially distressed subsidiaries can often recoup some of their lost investment by claiming a bad debt deduction or a worthless stock loss. The following key steps can maximize value:

• Ascertain the maximum amount of the potential deduction or loss, which is generally the adjusted issue price of the debt or the tax basis in the equity investment (applying special rules for consolidated groups);
• Determine the character of the potential deduction or loss. Losses on debt investments are generally an ordinary deduction for the holder.⁹ Worthless stock losses, however, are generally capital losses, unless both the shareholder and the worthless subsidiary are corporations and members of the same affiliated group, in which case the loss could be ordinary;¹⁰
• Forecast the expected use of the potential deduction or loss. Capital loss carryforwards may offset only future capital gains, whereas NOL carryforwards from a bad debt deduction may offset only eighty percent of a company’s taxable income; and
• Determine how to trigger the loss or deduction. For a debt instrument, a holder may be able to claim a bad debt deduction when it forgives all or some of the debt or modifies the terms such that the change constitutes a significant modification. For equity instruments, liquidations or sales of stock of a subsidiary could trigger a worthless stock loss. Special rules apply for triggering losses within a consolidated group.

Companies should also assess the full extent of losses that can be recognized, considering other rules that could further limit or reduce NOLs, tax credits, and other tax assets, such as change-of-ownership limitations applicable for corporations under Section 382 discussed below and the attribution reduction required when excluding CODI under the insolvency exception discussed above.

Why Are Ownership Changes Such a Big Deal?

Corporations planning to use their tax attributes must keep abreast of their “Section 382 position” (that is, how close they are to an “ownership change”). If a corporation experiences a Section 382 ownership change, the corporation’s ability to use its pre-change NOLs, built-in losses, tax credits, and certain other tax assets to offset post-change taxable income may be limited (generally based on the value of the corporation’s equity). In general, a corporation experiences an ownership change whenever its “five-percent shareholders” (which may include indirect shareholders and certain groups of individuals who own less than five percent of the corporation’s stock by value) increase their direct and indirect ownership in the corporation by over fifty percent in aggregate over a rolling three-year lookback window.

A corporation that relies heavily on the availability of certain tax attributes, and is on the brink of triggering an ownership change, may consider adopting certain share restrictions or a poison pill to reduce the likelihood of an ownership change. Alternatively, if a corporation expects to generate tax assets in the future, it may want to first trigger an ownership change to mitigate the potential effects under Section 382. Importantly, tax assets can be subject to multiple limitations, requiring an ongoing Section 382 exercise, which often involves a historical review of the corporation’s ownership, potentially as far back as 1986. In addition, corporations should consider how a change in ownership could affect other tax strategies, such as those discussed in this article.

Conclusion

Companies facing significant financial challenges should proactively seize opportunities to generate tax savings while avoiding potentially catastrophic tax effects that could arise from certain debt restructuring decisions or changes in ownership. Complexities abound under each of the challenges and opportunities discussed in this article, which are further compounded by the significant overlap. Applying the underlying tax rules (whether in taking a worthless stock loss or modifying “publicly traded” debt) is rife with traps for the unwary. As a result, companies are advised to carefully analyze debt restructuring alternatives and implement tax strategies that maximize savings and minimize adverse tax consequences.

Kevin M. Jacobs is a managing director, co-leader of the restructuring tax service, and the national tax office practice leader in the Washington, D.C., office of Alvarez & Marsal Tax, and Emily L. Foster and Matthew H. Lannan are directors, also in the Washington, D.C., office. The opinions expressed in this article are those of the authors and are not necessarily those of Alvarez & Marsal Tax or its clients.

Endnotes

1. Treasury Regulations Section 1.1001-3.
2. The amount of the gain or loss is determined by comparing the difference between the issue price of the new debt and the lender’s basis in the old debt. See Internal Revenue Code Section 1001. The tax consequences are determined by comparing the difference between the issue price of the new debt and adjusted issue price of the original debt. See IRC Section 108(e)(10) and Treasury Regulations Section 1.61-12(c).
3. Treasury Regulations Section 1.1001-3(c)(2).
4. Treasury Regulations Section 1.1001-3(e). For purposes of determining whether the “modified” debt instrument is properly characterized as debt for federal income tax purposes, the financial condition of the obligor is ignored, unless the modification involves a substitution of obligor or the addition or deletion of a co-obligor. See Treasury Regulations Section 1.1001-3(f)(7).
5. See Treasury Regulations Section 1.001-3(f)(3). The general rule for testing the cumulative effect of a series of debt changes does not apply in all situations. For example, for the change-in-yield test, modifications that occur more than five years before the modification test date are disregarded.
6. Treasury Regulations Section 1.1273-2(f).
7. IRC Section 108(a).
8. IRC Section 108(d)(3). There are special rules governing the determination of insolvency and the corresponding attribution reduction for members of a consolidated group. See Treasury Regulations Section 1.1502-28.
9. IRC Section 166.
10. See IRC Section 165(g)(3) for various requirements for obtaining ordinary treatment.