Select Tax Provisions in the American Recovery and Reinvestment Act of 2009
February 13, 2009
On February 11, 2009, House and Senate conferees reached an agreement on the American Recovery and Reinvestment Act of 2009. The bill was just passed by the House of Representatives, and it is expected to be passed by the Senate and presented to the President for signature by February 16, 2009.
Although the bill contains a number of tax-related provisions, we would like to highlight the following:
- No General Expansion of NOL Carryback. In contrast to language approved earlier this week by the Senate, the bill does not contain a provision that generally extends the two-year carryback period for net operating losses (“NOLs”). Instead, the bill contains a more limited provision that permits only a small business (generally, a corporation or partnership with average annual gross receipts of $15 million or less for the three-year period prior to the year that the NOL arose) to carry back NOLs for up to five years (instead of two).
- COD Income Deferral. The bill permits deferral of the recognition of cancellation of debt (“COD”) income arising from repurchases by the issuer or a related party of certain debt instruments during 2009 or 2010. Deferred COD income would be recognized over a five-year period beginning in 2014. In contrast to the version of this provision approved by the Senate, which applied only to cash repurchases, the provision also applies to debt-for-stock and debt-for-debt exchanges (including deemed exchanges resulting from significant modifications), contributions of debt to capital, and complete cancellations of indebtedness. The election is available with respect to debt issued by a C corporation and debt issued by any other person in connection with the conduct of a trade or business (but would not apply, for example, to debt issued by an investment partnership that was not engaged in the conduct of a trade or business).
An issuer that elects to defer COD income under this provision must recognize the deferred amounts, regardless of whether the COD income otherwise would have been excluded from income under exceptions contained in the COD rules (e.g., insolvency or bankruptcy). In connection with the election, all or a portion of the deductions related to any original issue discount (“OID”) on new debt issued in a debt-for-debt exchange (or on debt used to finance a repurchase) will be deferred until the five-year period during which the COD income is recognized. Moreover, any deferred COD income would be accelerated and recognized in the taxable year in which the issuer (among other things) liquidates, sells substantially all of its assets or ceases its business.
By potentially lowering the tax costs associated with repurchases, exchanges or modifications of outstanding debt (including convertible debt) at a discount, this provision is likely to be helpful to issuers that are not otherwise in a position to take advantage of the insolvency or bankruptcy exceptions to the COD rules.
- Temporary Suspension of the AHYDO Rules. The bill temporarily suspends the application of the “applicable high yield discount obligation” (“AHYDO”) rules to debt instruments issued in exchange (including a deemed exchange resulting from a significant modification) for debt that is not subject to the AHYDO rules. The relief does not apply to debt instruments that have certain types of contingent interest (generally, interest determined by reference to cash flows, income, profits, property, or distributions of the issuer or a related person) or that are issued to a related person. While the provision applies only to AHYDOs issued (or deemed issued) between September 1, 2008 and December 31, 2009, the provision grants Treasury broad authority to extend the suspension of the AHYDO rules. In addition, for debt issued in 2010 and thereafter, the bill grants Treasury the authority to temporarily increase the threshold interest rate that is used to determine if a debt instrument is an AHYDO, if such increase is appropriate in light of continued market distress.
In general, the AHYDO rules apply to defer and, in certain cases, disallow interest deductions with respect to certain high-yield debt instruments issued with significant OID. Market distress has resulted in the application of the AHYDO rules to many debt instruments issued in debt-for-debt exchanges or deemed exchanges, as the “new” debt is often treated as issued at a significant discount to par. Under current law, the issuer of the new AHYDO is required to recognize a significant amount of COD income upon exchange, but is generally required to defer deduction of the corresponding OID until actually paid in cash, and may be prohibited altogether from deducting a substantial portion of that OID (this portion, the “dividend-equivalent OID”).
A consequence of this provision for issuers who elect to defer COD income, as above, on a debt-for-debt exchange in which the new debt would be an AHYDO is that their OID will be deductible beginning in 2014, even if not yet paid and even if otherwise constituting dividend-equivalent OID.
- Override of Special Section 382 Notice for Banks. Notice 2008-83, released on September 30, 2008 generally provides that if a bank is properly allowed a deduction with respect to losses on bad debts after an ownership change, that deduction will not be treated as a built-in loss or deduction subject to limitation under Section 382. The bill provides that Notice 2008-83 does not apply in the case of any ownership change occurring after January 16, 2009, with an exception for ownership changes pursuant to certain written agreements entered into on or before that date.
The provision does not negate the application of Notice 2008-83 to transactions that occurred on or prior to January 16, 2009. While Notice 2008-83 is silent as to its application to transactions occurring prior to its release, Treasury officials have indicated that Notice 2008-83 was intended to apply to all open tax years, and the provision does not appear to change this result.
If you have any questions about the matters covered in this newsflash, please call your regular Davis Polk contact.
To ensure compliance with requirements imposed by the IRS, we inform you that, unless explicitly provided otherwise, any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Davis Polk & Wardwell