COVID-19: Common U.S. Tax Considerations During an Economic Downturn

Debt Restructurings and Modifications

Debtors may be considering restructuring or modifying their existing debt. As a result, both debtors and creditors should be aware of some of the relevant tax issues this could raise.

Could a modification of existing debt be a taxable event?

Modifying the terms of existing debt does not always result in a taxable event. However, if a modification is considered “significant” under relevant tax rules, the debtor will be considered to have exchanged the outstanding debt for new debt. This exchange may be a taxable event, as discussed in the next section.

Could an actual or deemed exchange of outstanding debt for either new debt or equity result in recognition of income, gain or loss? If so, is there sufficient cash available to cover any resulting tax liability?

When debt is satisfied for less than its full amount, the debtor generally will have taxable cancellation of indebtedness (COD) income (subject to special exceptions for insolvent debtors or debtors in bankruptcy as discussed more below). When outstanding debt is exchanged for new debt or equity, the outstanding debt is considered satisfied by that new debt or equity. If the new debt or equity is considered to be worth less than the outstanding debt, the debtor could have taxable COD income, and the creditor could recognize gain or loss.

In the case of a debt-for-debt exchange, the outstanding debt is considered satisfied for the “issue price” of the new debt. This can lead to unexpected results. For example, even if the face value or principal amount of the new debt is the same as the outstanding debt, if the new debt is trading at below its face amount or an indicative quote below that face amount has been provided, in each case within a certain period of time of the exchange, the issue price will be determined by reference to that trading price or quote rather than its face amount. Debtors contemplating an exchange should consider whether they have sufficient cash on hand to cover potential tax liabilities from COD income, and creditors should consider whether they have sufficient cash on hand to cover potential tax liabilities from recognizing gain on the exchange.

Furthermore, cross-border financings can implicate other tax issues that both debtors and creditors involved in such transactions should carefully consider.

Will the new debt be issued with “original issue discount” (OID)? If so, might the rules for “applicable high-yield discount obligations” (AHYDOs) affect the debtor’s ability to deduct the OID?

When new debt is issued — whether in an exchange or otherwise — at an issue price lower than the stated principal, the debt will generally be considered as issued with OID. Tax rules for OID generally require the creditor to recognize interest income, and the debtor to claim the related deductions, on a current basis over the life of the debt, even if no cash is actually currently paid. If the OID is considered “significant,” the debt may be considered an AHYDO and subject to punitive tax rules that, among other things, could deny interest deductions for the debtor.

Net Operating Losses

In an economic downturn, businesses often expect to generate substantial losses. There may be certain limitations on their ability to use those losses to offset their taxable income. The rules surrounding these limits are complex and nuanced; moreover, some of the limits have shifted significantly as a result of recent changes in law. When planning around the use and value of their net operating losses (NOLs), clients should consider the following:

When did the NOLs arise? What limits are there on their usage as a result?

With some exceptions, the 2017 Tax Cuts and Jobs Act added limitations to taxpayers’ ability to use their NOLs; some of these limits have either been rolled back or modified by the recently enacted Coronavirus Aid, Relief, and Economic Security Act (CARES Act). The specific contours of the recent changes are beyond the scope of this briefing.¹ Broadly, as it stands now, different limits apply to a taxpayer’s ability to carry back, carry forward and apply its NOLs against its taxable income depending on whether the NOLs arose (A) before 2018, (B) in 2018, 2019 or 2020 or (C) after 2020.

Clients who have participated in merger and acquisition transactions should review the tax provisions in the relevant transaction documents to determine whether those provisions allow for carrybacks to years in which the seller owned the target company and whether they adequately and appropriately address which party will be entitled to the benefit resulting from the use of losses in light of the changes enacted in the CARES Act.

Will a change in the debtor’s capital structure trigger an ownership change that limits the use of the debtor’s NOLs? What systems are in place to track whether an ownership change has occurred or will occur?

NOLs may be considerably limited if a taxpayer is treated as undergoing an “ownership change,” generally a cumulative increase by more than 50% in the stock held by one or more “5-percent shareholders” of the taxpayer during the testing period (generally three years). Complex rules around the testing period and the aggregation mechanics governing who constitutes a 5-percent shareholder make it difficult and unintuitive to track when an ownership change is deemed to have taken place. Taxpayers with significant NOLs may have systems in place, or may have third-party service providers, that track whether 5-percent shareholders exist and the extent to which their ownership percentages have changed.

Ownership changes may be triggered by the purchase and sale, redemption or new issuance of stock. Unexpected limitations on a taxpayer’s NOLs as a result of ownership changes may result in greater than anticipated tax liabilities. This could affect, among other things, the taxpayer’s ability to service outstanding debt.

Are there any plans or charter provisions in place to prevent ownership changes and protect NOLs, and, if not, is one appropriate?

Clients have implemented various devices to prevent or at least discourage acquisitions that could lead to ownership changes. Two common corporate actions are (1) “NOL poison pill” plans that serve to dilute an acquiring person’s stock ownership once that person crosses a certain ownership threshold and (2) charter amendments that prevent transfers that might create or increase the ownership of 5-percent shareholders.

Bankruptcy and Insolvency

Both debtors and creditors should be aware of the different tax rules that apply depending on whether a restructuring occurs in or out of bankruptcy court.

How much COD income will result from a restructuring, and what tax attributes will be reduced as a result?

The process of restructuring typically involves the cancellation of debt, which, as discussed above, could generate taxable COD income. However, the Internal Revenue Code provides statutory relief for insolvent debtors or debtors in Chapter 11 proceedings. If a debtor’s debt is discharged while it is insolvent, COD income is excluded from the debtor’s gross income to the extent of the debtor’s insolvency. Bankruptcy, on the other hand, provides a blanket exclusion of any COD income that results from debts discharged in bankruptcy. The cost of this relief in either situation, however, is that the tax attributes — NOLs, tax credits, capital losses, basis in its assets etc. — of the debtor are reduced by the amount of excluded COD income.

For partnerships, the bankruptcy and insolvency exceptions apply at the partner level. Therefore, the bankruptcy or insolvency of an underlying partnership can be irrelevant for purposes of determining whether a partner can exclude COD income. This may lead to unexpected and harsh results.

Can the decision to file for bankruptcy have other effects on a debtor’s ability to use some or all of its NOLs after restructuring?

Restructuring either in bankruptcy or outside of court often results in the debtor’s undergoing an “ownership change” (as described in the previous section) that further limits the future usage of NOLs. Two exceptions under Sections 382(l)(5) and 382(l)(6) of the Internal Revenue Code are available for debtors passing through bankruptcy. Section 382(l)(5) generally removes any limit on a debtor’s usage of its NOLs but has specific requirements regarding who can own the stock of the reorganized company. Furthermore, if a debtor applies Section 382(l)(5) and then undergoes a second ownership change within two years, it will not be able to use any of its NOLs after that second ownership change. Section 382(l)(6), on the other hand, is available to any debtor who passes through bankruptcy and does not impose the punitive rules of Section 382(l)(5) on a second ownership change but only serves to soften rather than remove the limit on the debtor’s ability to use its NOLs. A debtor may elect out of the application of Section 382(l)(5).

These provisions can only be used in a Chapter 11 or similar proceeding and thus may influence the decision whether to restructure in or out of court.

Are there trading restrictions that a debtor might seek as part of its initial bankruptcy filing to preserve its ability to take advantage of the Section 382(l)(5) exception?

A debtor’s NOLs are considered property of the bankruptcy estate. To protect the debtor’s ability to use those NOLs after bankruptcy, debtors can ask the bankruptcy court to issue trading orders. To preserve the debtor’s ability to qualify under Section 382(l)(5), these trading orders will often restrict the ability of creditors to trade either a debtor’s pre-restructuring debt or the debtor’s post-restructuring equity.