The purchase of debt by a party related to the debtor—a taxable event?

Executive summary

When a debtor (a borrower) buys its debt back from the creditor who holds it, the debt is extinguished. If the debtor has bought the debt at a discount, taxable cancellation of debt income (CODI) for the debtor typically results. In some situations, however, CODI can be excluded from taxable income.

Can taxable CODI be avoided where the creditor sells the debt to a friendly party related to the debtor rather than to the debtor itself? The answer frequently is “no.” A creditor’s sale of debt to a party related to the debtor at a discount also can—sometimes inadvertently—generate CODI taxable to the debtor.

The tax rules surrounding related party debt purchases can bring cumbersome filing requirements along with the CODI. Proper understand and navigation of these tax rules can help avoid unintended results.

Cancellation of debt income (CODI) and section 108(e)(4)

Cancellation of a debt or repayment of debt at a discount generally results in CODI to the debtor.^[1] A debtor might attempt to avoid CODI by arranging for a related party to acquire its debt from the creditor at a discount. Section 108(e)(4) was enacted to prevent this tactic. Section 108(e)(4) provides that if a person or entity related to the debtor purchases debt from an unrelated creditor, the purchase is treated for federal tax purposes as if the debtor purchased the debt from the creditor. The purchase would therefore generate CODI to the extent of the discount.

Related entities for this purpose include, among others, controlled partnerships and entities treated as a single employer.^[2]

Various transaction structures can implicate the section 108(e)(4) CODI trigger.^[3] For example, use of an unrelated entity to purchase debt from a creditor followed by an acquisition (of that entity or of the debtor) can be drawn into section 108(e)(4)’s ambit. This is because a section 108(e)(4) CODI event can occur in two situations—via a “direct acquisition” or an “indirect acquisition.”^[4]

A direct acquisition occurs where an acquirer acquires debt from a party unrelated to the debtor and either (i) the debtor and the acquiror are related at the time of the acquisition or (ii) the debtor and creditor become related on the date the debt is acquired.^[5]

An indirect acquisition occurs where the holder of debt becomes related to the debtor after the transaction, if the holder acquired the debt in anticipation of becoming related to the debtor.^[6] To determine whether debt was acquired in anticipation of the creditor and debtor becoming related, all relevant facts and circumstances must be examined.^[7] If, however, the creditor acquires the debt less than six months before the parties became related, the debt is presumed to be acquired in anticipation of the debtor and creditor being related, and this presumption cannot be rebutted.^[8]

Traps for the unwary

The section 108(e)(4) rules can present traps for unwary taxpayers. For instance, a debtor must disclose to the IRS in the event of an indirect acquisition if its debt was acquired between six and 24 months prior to the date the holder and debtor become related.^[9] It is easy to imagine a scenario in which an unwary taxpayer stumbles over this requirement.

Example: a private equity (PE) fund acquires a debt instrument from an unrelated party and twenty-three months later the same private equity fund acquires the original debtor on the debt instrument.

In such a scenario, under the indirect acquisition rules, the PE fund is required to disclose that it acquired the debt instrument, despite the nearly two-year gap between the two acquisitions of (i) the debt and (ii) the debtor.

Another illustration of a transaction that cause CODI recognition for an unwary taxpayer:

Example: A C corporation (ABC Inc.) owned by a PE fund issues publicly traded debt of $10 million. ABC Inc. later encounters financial distress and rising interest rates, so the PE fund acquires $6 million of the total outstanding debt for $2 million.

This acquisition would trigger section 108(e)(4). As a result of this transaction, ABC Inc. realizes up to $4 million of CODI. The $2 million of debt acquired is treated as reissued with (i) an issue price of $2 million, (ii) a stated purchase price of $6 million, and (iii) $4 million of original issue discount (OID). The PE fund holding the debt generally must include the OID in income as it accrues.^[10]

Conclusion

The purchase of debt by a party related to a debtor is a fairly common occurrence. The associated tax rules are somewhat complex. Failure to properly document and report such transactions may result in additional taxes and/or penalties. Accordingly, when entering into such a transaction it is important to consult with your tax advisor.

^{_{[1] Section 61(a)(11); Reg. section 1.61-12.}}

^{_{[2] Section 108(e)(4) (citing sections 267(b), 707(b), and 414).}}

^{_{[3] See generally Reg. section 1.108-2.}}

^{_{[4] Reg. sections 1.108-2(b) and (c).}}

^{_{[5] Reg. section 1.108-2(b).}}

^{_{[6] Reg. section 1.108-2(c).}}

^{_{[7] Reg. section 1.108-2(C)(2) lists several factors for determining if debt was acquired in anticipation of the creditor and debtor becoming related. Notably, the regulations state that this list is not exhaustive of all the factors which may be considered. The factors listed are: (i) the intent of the parties at the time of the acquisition; (ii) the nature of any agreements between the debtor and creditor; (iii) how long the debt has been held; and (iv) the amount of debt compared to the assets held by the creditor group.}}

^{_{[8] Reg. section 1.108-2(c)(3).}}

^{_{[9] Reg. section 1.108-2(c)(4).}}

^{_{[10] Section 1272(a)(1); Reg. section 1.1272-1.}}