Proposed Relief for Cancellation of Debt Income
January 27, 2009
On January 23, Senate Finance Committee Chairman Max Baucus released a markup of the draft “economic stimulus” bill, known as the American Recovery and Reinvestment Act of 2009. A proposal included in that package would permit a taxpayer to defer cancellation of debt income (“COD Income”), making it possible for debtors to repurchase their own debt at a discount without suffering an immediate U.S. federal income tax liability.
Current law requires that a debtor recognize COD Income when its outstanding debt is discharged because the issuer or a related party purchases the debt at a discount or, in some cases, the debt is significantly modified. The amount of COD Income generally is equal to the excess of the amount of debt retired or acquired by a related party and the amount paid, if any, by the debtor or related party to retire or acquire the debt. In the case of an exchange of new debt for existing debt (or a significant modification of debt that is treated as an exchange), the debtor is treated as retiring its “old” debt for an amount equal to the issue price of the new debt. If either the new or the old debt is publicly traded, the issue price of the new debt is the fair market value (i.e., the trading price) of the new or old debt, as applicable, leading to potentially significant amounts of COD Income in the context of distressed debt. Some exceptions to the cancellation of debt rule exist, in particular for bankrupt or insolvent companies, but those companies are required, in lieu of a current inclusion, to reduce their tax attributes (for example, their net operating losses) to the extent of the amount of excluded COD Income.
The Senate Finance Committee proposal would allow a debtor to elect to defer recognition of COD Income where the debtor (or a related person) repurchases for cash, during 2009 or 2010, a debt instrument issued by the debtor. No relief is provided for COD Income realized on an actual or deemed debt-for-debt exchange, or on the issuance of the debtor’s stock in exchange for outstanding debt. As a result, the proposal may be of limited utility for many debtors unless they can obtain financing for the repurchase, which may lead some debtors to attempt to structure what are effectively debt exchanges in the form of cash repurchases. An electing issuer would be required to include in income an amount equal to 25% of the deferred COD Income in each of the four taxable years beginning in the year following the year of the debt repurchase. It is not clear how the existing exceptions to COD Income inclusion would interact with the proposed provision, for example where the debtor becomes bankrupt or insolvent during the four-year deferral period.
Perhaps reflecting some momentum in favor of legislation addressing COD Income, the Senate Finance Committee proposal follows on the heels of a similar bill introduced by Senator John Ensign on January 6 (the “Ensign Proposal”). The Ensign Proposal is more useful, as a practical matter, to many debtors in that it would, if enacted, apply to actual or “deemed” debt-for-debt exchanges and issuances of stock in exchange for debt, as well as cash repurchases. Moreover, while the Senate Finance Committee proposal would only defer COD Income, the Ensign Proposal would exclude it entirely, and would not require a corresponding reduction in the debtor’s tax attributes (unlike the present-law exceptions to COD Income for bankrupt or insolvent debtors). The Ensign Proposal would apply to acquisitions or significant modifications, occurring either in 2009 or 2010, of “applicable financial indebtedness” of a corporation or a partnership engaged in a business other than trading stocks and securities for its own account. “Applicable financial indebtedness” is defined broadly to include debt that is (i) originally issued or syndicated by certain financial institutions, (ii) a security under the Securities Act of 1933, or (iii) traded on an “established market.”
The Senate Finance Committee proposal is currently scheduled for markup by the Senate Finance Committee on January 27.
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.
1. If a non-U.S. party related to the debtor were to acquire the debt, the Ensign Proposal would broaden the application of the “portfolio interest exemption” to interest paid on the debt in order to make it exempt from the 30% withholding tax that would ordinarily apply (in the absence of a treaty reduction in or elimination of the tax). This proposal is presumably intended to enable profitable foreign affiliates of the debtor to assist in retiring the debtor’s outstanding debt; however, under current law, ownership by a foreign subsidiary of a U.S. affiliate’s debt may in any event give rise to a “deemed dividend” under the Subpart F rules