Executive summary: Debt restructuring involving contingent value rights raises issues
In an increasingly challenging economic environment, more companies are restructuring their debt obligations. Some companies are presented with the opportunity to retire their outstanding debt obligation, in at least a partial satisfaction, in exchange for a contingent value right (“CVR”). These CVRs are often used when the parties have difficulty valuing the underlying business to which the right is tied. Generally, these rights provide cash payments to the CVR holder that are contingent on the subsequent success of a particular business. CVRs can either be issued in the form of a non-assignable contract right or a tradeable instrument that can be sold on the open market.
Where a debt instrument is retired in whole or in part for the issuance of a CVR, there may be cancellation of indebtedness income (“CODI”), the tax treatment of which is not completely clear. Typically, CODI would be equal to the excess of the fair market value of the CVR over the adjusted issue price of the retired debt. Given the inherent difficulty in valuing CVRs, this calculation is less than straight-forward.
Contingent value rights
CVRs are generally understood to refer to cash payments that are contingent upon the occurrence of specified events. For U.S. tax purposes, a CVR could either be debt, property rights, or equity. While not completely clear, and subject to a case-by-case analysis, many practitioners agree that CVRs are often most akin to that of a contractual right.
Cancellation of debt
As mentioned above, in general, where a debt is retired in exchange for new debt, equity, or property (or a mix) and the adjusted issue price of the debt exchanged exceeds the value of what is received, there is cancellation of indebtedness income (CODI).1 This CODI is either currently recognized or may be subject to exclusion, for example, under the bankruptcy or insolvency exclusions set forth in section 108 of the Internal Revenue Code. To the extent an exclusion applies, the debtor entity generally must reduce its tax attributes (including tax basis in assets) in the order and amount specified in section 108(b).
As a basic example, assume a solvent Debtor Corporation has $100x of debt outstanding with Creditor. Debtor then retires the debt with Creditor for a new debt instrument with an issue price of $60x. Thus, Debtor has CODI of $40x.
Exchange for CVR
The tax treatment behind an exchange of Debt for a CVR is somewhat more complex. Same as the example above, solvent Debtor Corporation has $100x of debt outstanding with Creditor. In Year 1, Debtor retires the $100x of debt with Creditor in exchange for a CVR, which the parties valued at $40x at the time of the exchange. In Year 3, Debtor, under the terms of the CVR, receives $50x.
On its face, and based on the valuation, Debtor would appear to have $60x CODI in Year 1 (the difference between the amount of the debt and the apparent value of the CVR at issuance). Assuming Debtor reports it as such, what then happens when it pays out the $50x in Year 3 – that is, what happens when it pays out $10X more than what the CVR was initially valued at (arguably overstating CODI in Year 1)? One approach might be to apply the “relation back to the underlying transaction” doctrine of Arrowsmith.2 Under that approach and viewing the underlying debt as having initially been written down to $40x, retiring it at $50x would generally be considered a repurchase premium and potentially generate a $10 interest deduction under Reg. section 1.162-7(c).
On the other hand, some might take the view that open-transaction reporting is justified, due to the inherent difficulty of pinpointing a value for the CVR in Year 1. In such a case, no CODI would be reported in Year 1. Instead, the CODI calculation would take place in Year 3, when the CVR is paid out, resulting in $50x of CODI. Ultimately, open-transaction reporting may benefit or hurt a taxpayer depending upon their solvency or insolvency as of the CODI event. As the Treasury and IRS generally frown on open transaction reporting, limiting it to “rare and unusual circumstances,” parties probably should be ready for a challenge if they ultimately go down this road.
Conclusion
While there are no definitive answers, when dealing with CVRs in the context of potential debt cancellation, taxpayers need to understand the potential tax impacts of these arrangements. As the law is currently unclear, taxpayers may have some flexibility in choosing an approach which may be beneficial to them.
