United States: Tax Tips - Debt Workout From Holder's Perspective

A debtor entering into a workout scenario may find himself negotiating with a party different from the original lender. Investors such as private equity funds purchase distressed debt at a discount to its face value in anticipation of receiving a return on their investment. But unlike traditional investments such as stock in a corporation, the purchase of debt instruments can create unique income tax consequences for the purchaser. As a result, whether you are looking to invest in distressed debt instruments, or you or a client are negotiating a workout with a purchaser of a distressed debt instrument, it is useful to have some basic understanding of the tax issues involved with holding this type of debt.

As a general rule, an issuer of a debt instrument does not recognize taxable income upon receipt of payments of principal but is taxed on the receipt of stated interest at ordinary income rates.¹ One could argue that if an investor purchases a note at a discount, then the investor (the "Holder") should step into the shoes of the issuer and receive payments of principal tax-free until the Holder recovers its basis in the note. Along these same lines, any payments of principal received in excess of the Holder's basis would be taxed at capital gain rates assuming that the note is a capital asset in the Holder's hands.² Unfortunately there is very little case law that is directly on point with respect to these issues. As a result, the IRS would likely argue that a literal interpretation of federal tax law provides a couple of roadblocks to achieving the tax-favored result the Holder is seeking (in addition to other complicating factors such as original issue discount, which are beyond the scope of this article).

Market Discount.

If the Holder merely holds onto the distressed debt and collects payments, then the literal application of the market discount rules will require the Holder to recharacterize some portion of the payments received as ordinary income. "Market discount" is the amount by which the outstanding principal balance of the purchased note exceeds the purchase price of such debt obligation (i.e., the amount of the discount that the market provides for the instrument).³ Market discount accrues ratably over the life of the debt instrument and to the extent such market discount is not recognized in any year it carries over to subsequent years.⁴ If a debt instrument accrues market discount, then, contrary to some Holders' expectations, the Holder will have to include the principal payments as income taxable at ordinary income rates to the extent of accrued market discount before recovering any basis in the note.

Example 1: Holder purchases a note that has 10 years remaining until maturity with an adjusted issue price of $10 million and requires annual payments of $1 million (ignore interest for purposes of this example). The purchase price of the note is $2 million. The Holder will have $8 million of market discount that may accrue over the remaining term of the note (i.e., 10 years). Assuming the market discount is allocated using the straight line method, the Holder will accrue market discount of $800,000 per year. The Holder will recognize income taxable at ordinary income rates each year to the extent of the accrued market discount. So, if in year 1 the debtor makes the full $1 million payment, $800,000 of this will be taxed at ordinary income rates and the remaining $200,000 will be a tax-free return of capital, reducing the Holder's basis in the note. In the alternative, if in year 1 the debtor only makes a $500,000 payment, then the entire amount of the payment is taxable at ordinary income rates and the remaining $300,000 of market discount will carryover to next year, resulting in a year 2 balance of accrued market discount of $1,100,000. As a result, it is possible that the Holder of a distressed debt instrument will never reduce the market discount enough to receive a tax-free return of capital.

Significant Modification.

The Holder may experience additional adverse tax consequences if, after the purchase of the note, it works out the debt with the debtor. If the workout results in a significant modification of the debt instrument, then the Holder will be deemed to have exchanged the original debt for the modified debt.⁵ This deemed exchange will create tax consequences to the Holder of a note because the Holder's basis in the purchased debt obligation will often be substantially less than the issue price of the "modified" debt instrument that the Holder is deemed to receive.

Example 2: Holder purchases a note with an outstanding principal balance of $10 million for $2 million and thereafter agrees to reduce the outstanding principal of the debt to $4 million, The Holder would recognize a taxable gain equal to the difference between its basis in the original obligation (i.e., $2 million) and the issue price of the modified obligation (i.e., $4 million), being $2 million of gain. If the note qualifies as a capital asset, then this gain could be capital, but it could be short-term capital gain if the workout is accomplished in less than a year after the purchase of the note. The Holder also has to be concerned about the market discount rules applying to the exchange, recharacterizing the $2 million of gain as ordinary income. Any of these results is particularly troublesome since the Holder will be triggering taxable income without receiving any payments to assist in the payment of the accelerated taxes.

It is important to note that recently proposed Treasury Regulations could change this analysis. On January 6, 2011, the IRS issued proposed regulations (REG-131947-10) that amend the current rules for determining whether a debt instrument is publicly traded. The proposed regulations modify the current rules to greatly expand the definition of publicly traded debt. The expansion of the definition of publicly traded debt instruments could impact the outcome in Example 2 above to the advantage of the Holder, but not the debtor, because the Holder will be deemed to have exchanged a debt instrument worth $2 million (its cost basis) for a new debt instrument worth $2 million (based on the current market value of the debt, not its issue price of $10 million or its modified redemption price of $4 million) resulting in no phantom gain to the Holder but cancelation of indebtedness income to the debtor.⁶

A purchaser of a distressed debt obligation can experience unexpected adverse tax consequences which may impact the purchaser's return on investment. Market discount could accelerate and recharacterize gain arising out of the note. The shorter the period of maturity remaining under the debt, the more rapidly market discount will accrue. Additionally, if the purchaser of the note enters into a workout with the debtor, the purchaser runs the risk of triggering taxable gain equal to the difference between the basis in the debt and the issue price of the "new debt;" however, the proposed Treasury Regulations could lessen or eliminate the impact of the significant modification issue for the purchaser (but not the debtor).

Footnotes

1 IRC §1271.

2 IRC §1221 and §1001.

3 IRC §1278(a)(2)(A).

4 IRC §1276(a)(3).

5 Reg. §1.1001-1(g).

6 For further discussion, see Treasury Expands Definition of Publicly Traded Debt Instruments, 2011 TNT 5-1.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.