Recapitalization transactions
A corporate recapitalization or debt amendment transaction will often have the corporation’s creditors receive new or modified debt to replace their old debt. For example, this may occur when a financially distressed corporation needs to raise new funds, but is unable to repay its old debt. On the other hand, this type of debt modification transaction can also arise when the corporation is financially strong, its borrowing capacity is growing, and it is issuing new debt. In either situation, the creditors should address whether the transaction is taxable to them.
Debt-for-debt exchanges
In many of these recapitalization and debt amendment transactions, the corporation’s creditors are treated as engaging in a debt-for-debt exchange. Whether debt-for debt exchange applies depends on whether new debt’s terms represent a “significant modification” of the old debt under the rules of Reg. section 1.1001-3.
This article addresses only transactions that are treated as debt-for-debt exchanges. We discuss the tax analysis of debt modifications further in other articles: Distressed companies and debt modifications, Tax considerations when consent fees are paid to modify a debt and Modified intercompany debt: is it still recognized as debt?
Taxable or tax-free
In the context of debt-for-debt exchanges, the classification of debt instruments as securities may be critical since the tax consequences largely hinge on whether the exchanged debts are treated as securities. If the debt qualifies as a security, it may open the door to tax-fee (i.e., tax-deferred) treatment for the creditors.
First, consider a taxable debt-for-debt exchange: an exchanging creditor generally recognizes gain or loss in an amount equal to the excess (or deficit) of (A) the new debt’s issue price, over (or under) (B) the creditor’s adjusted tax basis of its old debt.1 The issue price for the new debt drives the gain or loss amount, but the issue price is not determined the same way in every situation. The issue price is in some circumstances driven by its fair market value (FMV), and in other circumstances driven by its principal amount.2 We discuss the tax issue price rules in our article Distressed companies and debt modifications; this article does not discuss those rules. Here is an example illustrating why the issue price determination is important to creditors.
Example: In a debt-for-debt exchange, Corporation C issues new debt in exchange for its old debt. The new debt has a principal amount of $100 million and a FMV of 70 (i.e., 70% of the principal amount). Creditor A and Creditor B both held old debt and participated in the debt-for-debt exchange. Creditor A’s basis in the old debt was 100 (i.e., 100% of the principal amount) and Creditor B’s basis was 75. If the new debt’s issue price is driven by its FMV of 70, Creditor A would realize a loss of 30 on the exchange and Creditor B would realize a loss of 5. If instead the new debt’s issue price for tax is driven by its principal amount, Creditor A would realize no gain or loss, but Creditor B would realize 25 of noneconomic gain.
Now, consider a tax-free debt-for-debt exchange. If the exchange meets the requirements of a tax-free recapitalization under Section 368(a)(1)(E), then the creditor’s taxable gain or loss recognition is deferred, with the creditor’s tax basis in the new debt carrying over from its basis in the old debt.3 However, accrued interest on the old debt does not receive this tax-deferred treatment.4 Similarly, tax-free treatment generally does not apply to the extent that the creditor receives either value or debt principal amount in excess of the amount it previously held.5
If either the new debt received or the old debt exchanged for it is not a “security,” the debt-for-debt exchange is taxable to the creditor and not tax-deferred.6 For corporate debtors, the distinction of security for debt instruments is less meaningful. Parallel to the creditors’ measurement of gain and loss discussed above, the debtor realizes either cancellation of debt (COD) income or repurchase premium. In a debt-for-debt exchange, the debtor is treated as having satisfied the existing debt by payment of an amount equal to the issue price of the new debt.7 The debtor’s realization of COD income or repurchase premium occurs without regard to whether the debt meets the definition of a security.8
When is debt a “security?”
There are multiple definitions of a “security” in the Tax Code, which apply for different purposes.9 However, the Tax Code does not define “security” for purposes of the question this article focuses on – whether a debt-for-debt exchange qualifies as a tax-free recapitalization under section 368(a)(1)(E). Instead, it is federal tax case law and Revenue Rulings that provide guidance. These authorities do not lay out any bright-line approach, but require a facts and circumstances analysis.
The authorities do agree that a debt’s term to maturity is an important factor. Many court decisions support the view that a term to maturity below five years is too short to be classified as a security, while a maturity of more than ten years is sufficiently long to qualify for security treatment.10
While a debt’s term to maturity is important, it is not the only relevant factor. Courts have generally upheld that debt instruments are securities if they grant the creditor a continued interest in the existence and success of the underlying corporation. The Tax Court has stated that courts should look at factors including the degree of creditor’s participation, the purpose of the advances, and the nature of the debt terms.11 The debt instruments characterized as securities in Revenue Ruling 59-98 had an average life of 6.5 years. The IRS determined that the instruments were securities, noting that they were purchased for investment purposes by creditors.
In some situations, even a debt with a relatively short term to maturity can qualify as a security. In Mills,12 a one-year promissory note was held a security despite its short term to maturity. One reasons for that holding was the creditor’s testimony stating that rather than complete repayment of the note in one year, he and the corporation renewed the maturity date allowing the annual interest to supplement to his income. The court in Aqualane Shores,13 held that a five year installment note was a security. Payment on the note depended upon the debtor corporation’s ability to develop and sell tracts of land, so the court considered the creditors to have a continuing interest in the corporation.
The IRS has ruled that amendment of a debt that qualifies as a security may result in continuing “security” status for the amended debt. In Revenue Ruling 2004-78, a target corporation issued debt securities with a maturity date of 12 years. Ten years later, the target corporation entered into a reorganization where the creditors exchanged their debt securities for new debt issued by the corporation that acquired target, which had nearly identical terms as the old debt. The IRS considered the new debt a reflection of the holders’ continuing interest in the target, and held the new debt a security even though its term to maturity was only two years.
Conclusion
Creditors of a corporation receiving new or modified debt to replace their old debt should consider this question: are the debt instruments viewed as securities under the federal tax reorganization rules? Whether the creditors’ debt-for-debt exchanges qualify for tax-free treatment may depend on the answer to that question. There is no bright-line rule supplying the answer; a facts and circumstances inquiry is required. Tax-free qualification can prevent creditors from claiming a tax loss, but tax-free treatment also can protect creditors who purchased their debt at a discount from recognizing taxable gain. Creditors considering a debt recapitalization or exchange transaction should consult with their tax advisors to address these issues.
1 Section 1001(a) and Reg. section 1.1001-1(g).
2 See generally Reg. section 1.1273-2.
3 Sections 354(a)(1), 358(a), and 368(a)(1)(E).
4 Section 354(a)(2)(B).
5 See generally Section 354(a)(2)(A), Rev. Rul. 74-269.
6 Sections 354(a) (1) and 368(a)(1)(E). In the case of an exchange of old debt for new stock, the exchanging creditors may receive tax-free treatment (i.e., deferral of gain and loss) under this recapitalization rule and/or under other tax rules. This article addresses only debt-for-debt exchanges, and does not address exchanges of old debt for new stock.
7 See generally section 108(e)(10)(A) and Reg. section 1.1001-3.
8 See Section 108(e)(10) and Reg. sections 1.61-12(c)(2)(ii), 1.61-12(c)(2)(iii) and 1.163-7(c). Qualification of the debt-for-debt exchange as a section 368(a)(1)(E) recapitalization would, for the debtor, not counteract or defer realization of this COD income (generally included in income, but may be excluded from income in certain situations) or repurchase premium (generally deductible as interest but potentially subject to various deferral or disallowance rules).
9 See, e.g., Section 165(g)(2) (defining “security” for purposes of bad debt deduction and worthless securities rules), section 475(c)(2) (defining “securities” for purposes of the mark-to-market account rules for securities dealers and electing securities traders), and section 851(c)(6) (defining “securities” for purposes of certain regulated investment company rules with reference to the definition in the Investment Company Act of 1940 (codified at 15 U.S.C. §80a-2(a)(36)).
10 See, e.g., Burnham v. Commissioner, 86 F.2d 776 (7th Cir. 1936); Commissioner v. Neustadt’s Trust, 131 F.2d 528 (2d Cir. 1942); Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462 (1933); Commissioner v. Sisto Financial Corp., 139 F.2d 253 (2d Cir. 1943); Neville Coke & Chemical Co. v. Commissioner, 148 F.2d 599 (3d Cir. 1945). Reg. section 1.368-1(b) similarly indicates that short term notes should not be viewed as securities.
11 Camp Wolters Enterprises, Inc. v. Commissioner, 22 T.C. 737 (1954); D’Angelo Associates, Inc. v. Commissioner, 70 T.C. 121 (1978).
12 United States v. Mills, 399 F.2d 944 (5th Cir. 1968).
13 Aqualane Shores, Inc. v. Commissioner, 30 T.C. 519 (1958).
