The COVID-19 pandemic has resulted in tremendous challenges for both individuals and businesses. One priority for companies will be working with their lenders to restructure current financing arrangements to help to ease the burden of these obligations during this crisis. Absent such relief, many businesses will not be able to avoid default, foreclosure and/or collection activity on their debt.
Many business debtors will find their lenders willing to work with them on restructuring. Lenders often prefer negotiating a solution in the short-term (on the assumption the borrower will be able to service its obligation post-crisis) versus commencing with foreclosure or collection proceedings.
Debt workouts typically include some of the following attributes: forbearance of collection efforts for some length of time; deferral of interest or principal payments; reduction of interest rate; reduction of principal; extension of maturity; or conversion of existing debt to equity.
Both borrower and lender need to consider the tax consequences of modifying an existing debt instrument. The borrower must be mindful of any potential cancellation of indebtedness income (“COD”) and the lender is primarily concerned about noncash taxable income such as original issue discount (“OID”).
A modification of a debt instrument deemed “significant” under federal tax law may result in its being treated as if the existing debt instrument was exchanged for the modified debt potentially triggering the recognition of COD/accrual of OID.
There is a two-step analysis to determine if a debt instrument has been exchanged: (1) was the instrument modified and (2) was the modification significant?
Existing rules provide three exceptions to what is a very expansive view of modification:
- Alteration of rights/obligations that occur by operation of the debt instrument itself are not modifications;
- The failure of a borrower to perform its obligations under a debt instrument is not a modification (although the lender’s failure to assert its legal rights may be); and
- Failure of a party to exercise an option to change the terms of a debt instrument is not a modification.
Regulations provide six criteria for determining whether a modification is significant:
- General facts and circumstances test — All modifications to the debt instrument are considered collectively, so that a series of such modifications may be significant when considered together, although each modification, if considered alone, would not be significant;
- Change in yield — Considered significant if the yield varies from the annual yield on the unmodified instrument (determined as of the date of the modification) by more than the greater of: (1) one-quarter of 1% (25 basis points) or (2) 5% of the annual yield of the unmodified debt instrument (0.05 X annual yield);
- Change in timing of required payments — There is a safe harbor whereby if the deferral of one or more scheduled payments occur within the safe harbor period, the modification is not significant. The safe harbor period begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of 5 years or 50% of the original term (excluding options) of the instrument;
- Change in obligor or security – Generally, a substitution of a new obligor on a nonrecourse debt instrument is not a significant modification and substitution of a new obligor on recourse debt is a significant modification;
- Change in nature – Typically recourse to nonrecourse, or vice versa, of the underlying instrument is a significant modification;
- Changes to accounting/financial covenants – Adding, deleting or altering customary accounting or financial covenants is not a significant modification (consideration is typically required to trigger).
Once it has been determined that a modification is significant pursuant to the foregoing, tax consequences to both borrower and lender must be assessed. The borrower will need to compare the issue price of the new debt to the adjusted issue price (typically outstanding principal amount) of the old debt. The lender will measure gain/loss as the difference between the issue price of the new debt and the tax basis of the old debt. Issue price of new debt requires an assessment of whether the debt is publicly traded or not. The issue price of publicly traded debt (debt instruments under $100 million are not treated as publicly traded) is its fair market value, while non-publicly traded debt will normally have an issue price equal to its principal amount.
Example 1: Lender agrees to reduce outstanding principal due on non-publicly traded debt from $100 to $80. Borrower recognizes $20 of COD income. Lender recognizes $20 of bad debt loss.
Example 2: Lender agrees to interest rate reduction on publicly traded debt. Principal amount of debt is $100 and the fair market value (“FMV”) is $80. Borrower recognizes $20 of COD income and due to newly created OID of $20, recognizes $20 of interest deductions over the remaining term of the loan. Lender recognizes $20 of bad debt loss and recognizes $20 of OID income over the remaining term of the loan.
The current crisis will certainly result in numerous debt workouts as borrowers and lenders negotiate solutions to address the economic impact. While the tax consequences should not drive the process, they will be important considerations. Both parties will need to determine whether any modification triggers a deemed exchange and the specific tax implications of that exchange.
Please contact your Mazars USA professional for additional information.