Restructuring the troubled company: the tax on profligacy. (includes related article)by Willens, Robert
Just as surely as the 1980s were characterized by frenzied acquisition activity and what may in retrospect be viewed as excessive leverage, the 1990s are shaping up to be the decade of restructuring. Capital structures fashioned in an era of unbridled optimism will have to be reshaped to accommodate an economic environment of slower growth. Leveraged buyout operatives who oftentimes made promises on an implied ability to dismember companies to repay acquisition debt, are now encountering an increasingly hostile climate.
In addition, companies whose capital structures are burdened with that singularly 1980s' product-reset notes- are in particularly dire straits. Such notes require a prospective readjustment of the coupon rate to a level designed to insure that they trade at 101% of par value. Many borrowers are finding that their particular financial profile will mandate reset rates on the order of 30% if the desired trading value is to be attained. Thus, in an alarmingly large number of cases, a restructuring of the entity's capital is essential. These transactions, of course, are heavily freighted with tax implications that allow the CPA to occupy a central role in the process of extricating a client from its plight with minimum negative tax implications.
DEBT DISCHARGE INCOME
It is well settled that a taxpayer realizes gross income under Sec. 61(a)(12) if its indebtedness is discharged at a discount to its adjusted issue price-its original issue price increased by accrued original issue discount or reduced by amortized issuance premium. in cases where debt is retired for cash, the computation of debt discharge income (DDI) is straightforward. moreover, since the Deficit Reduction Act of 1984, a discharge by a solvent taxpayer of debt for equity will be treated as if the debt had been discharged for an amount of cash equal to the fair market value of the stock conveyed. Further, an acquisition of debt from an unrelated party by a person "related" to the debtor-for example, by the debtor's more than 50% shareholder-will be treated, for purposes of ascertaining DDI, as an acquisition by the debtor itself.
Debt for Debt
A dramatically different regime applies, however, in cases where debt is extinguished for newly-created debt. Generally, in these cases, DDI is measured by the excess of the adjusted issue price of the old debt over the "issue price" of the replacement security. issue price, in turn, is the initial trading price of the new debt-if it trades on an established securities market on or within 10 trading days of issuance- or, if it is not publicly traded and bears "adequate stated interest," the instrument's stated principal amount.
This general rule is subject to a major exception found in Sec. 1275(a)(4) in cases where: 1) the issue price of the new debt would otherwise be smaller than the adjusted issue price of the old; and 2) the debt swap constitutes a recapitalization within the meaning of Sec. 368(a)(1)(E). in situations where these twin conditions are satisfied, the issue price of the new securities is presumed to be equivalent to the adjusted issue price of the old, with the consequence that no DDI is created. The exception to the rule, however, has been subject to increasing scrutiny and in fact was eliminated by RRA 90. The reach of the exception is exceedingly broad in light of the fact that the recapitalization condition imposes no meaningful limitation on its scope. A recapitalization is defined as any reshuffling of the capital structure within the framework of an existing corporation, and it conflicts with the IRS's longstanding view that the extent of DDI arising in debt swaps should be measured solely by the difference in face amounts (Rev. Rul. 77-437).
The literal application of Sec. 1275(a)(4) can produce curious results. For example, a debtor might issue a bond with a principal amount of $600 to extinguish an existing instrument with an adjusted issue price of $1,000. The IRS would like to attribute $400 of DDI to the debtor, but Sec. 1275(a)(4) presents an insurmountable obstacle. That provision suggests that the issue price of the new bond should be $1,000 and, thus, no DDI is generated. instead, because the new bond's deemed issue price exceeds its redemption price at maturity ($600), the excess is considered amortizable issue premium to be included in income over the life of the new bond. Thus, in many instances, the principles of Sec. 1275(a)(4) achieve coveted tax deferral by "converting" DDI into issuance premium. Quite obviously, awareness of Sec. 1275(a)(4)'s ameliorative rule for transactions prior to RRA 90's effective date is a key weapon in a planner's strategic arsenal.
EXCEPTIONS TO RECOGNITION OF DDI
There are several exceptions to the general rule of Sec. 61(a)(12) regarding the inclusion of DDI in gross income. Initially, Sec. 108(e)(2) excludes DDI in cases where a payment of the discharged liability would have given rise to a tax deduction. Similarly, DDI will not arise on discharge of an amount that was taken as a deduction in a prior year, but only to the extent such deduction has not produced a tax benefit. Unfortunately, the conception of "tax benefit" is exceedingly broad. it is not required that the deduction has actually generated a reduction in tax liability; it is sufficient that the item has merely contributed to a loss carryover that, as of the beginning of the year of discharge, has not yet expired.
Another exception, found in Sec. 108(e)(5), which pertains only to solvent debtors, involves the reduction of purchase money indebtedness. in these cases, the reduction is regarded as a retrospective adjustment of the initial bargain and, therefore, is treated not as DDI but, instead, as a purchase price adjustment.
Another category of exception is found in Sec. 108(e)(6). It deals with cases in which a shareholder/creditor contributes debt to the capital of the debtor. in these instances, the debtor is deemed to satisfy the debt with an amount of money equal to the creditor's basis in the debt. Because creditors rarely possess a basis in debt that is less than its face value, this rule generally results in avoidance of DDI. Moreover, even in the case of an S corporation creditor, whose basis in debt is reduced to the extent of corporate losses passed- through to such creditor, such basis reductions are ignored by virtue of Sec. 108(d)(7)(C) for purposes of determining the extent of DDI generated by a contribution. Interestingly, however, the IRS has ruled that these basis reductions are not ignored for purposes of ascertaining the creditor's addition to his stock basis associated with the contribution.
Bankruptcy and Insolvency
The most prominent exceptions to DDI arise in cases where the taxpayer is under the jurisdiction of a court in a Title 11 bankruptcy proceeding or, alternatively, is insolvent. in the former case, DDI is entirely excluded, while in the latter instance such exclusion is limited to the extent of the taxpayer's insolvency immediately before the debt is discharged. insolvency, for this purpose, means an excess of liabilities over the fair market value of the debtor's assets. It is relatively well-settled that "off-balance sheet" assets, such as goodwill, going concern value and similar intangibles are taken into account for this purpose. Conversely, the degree to which a liability needs to be fixed and determinable to contribute towards insolvency is uncertain. At a minimum, it would appear that a reasonable reserve for contingent liabilities would be eligible for inclusion, and the fact that an "investor's" approach to the question of insolvency seems ingrained in this tax definition suggests that more speculative claims might properly be included.
The Penalty of Attribute Reduction
These "troubled corporation" exceptions carry with them a severe penalty in the form of "tax attribute" reduction. In fact, from an overall transaction perspective, the practical effect of attribute reduction is often indistinguishable from the results that would occur if the DDI was currently included in gross income. Attribute reduction, which takes place after the determination of the tax liability for the year of discharge, must adhere to specified priorities described in Sec. 108(b)(2). Thus, attributes are reduced in the following order:
* Net operating loss for the year of discharge and loss carryovers to such year;
* Carryovers of general business credits to or from the year of discharge;
* Net capital loss for the discharge year and carryovers to such year;
* The basis in the taxpayer's assets, but basis cannot be reduced below the level of remaining undischarged liabilities; and
* Foreign tax credit carryovers to or from the year of discharge. In each of these situations, moreover, losses and asset basis are reduced by excluded DDI on a dollar for dollar basis whereas credits are diminished by 33 1/3 cents for each dollar of DDI avoided.
Alternatively, Sec. 108(b)(5) permits a debtor to elect to reduce its basis in depreciable property already owned or acquired by the close of the year of discharge by the amount of excluded DDI. For this purpose, depreciable property includes real estate held primarily for sale to customers in the ordinary course of the debtor's business (so called dealer realty), and the phrase also includes, for parent corporations filing consolidated tax returns, stock in subsidiaries. However, such stock can only be utilized to absorb a basis truncation if the subsidiary agrees to a "look-through" reduction to the basis of its depreciable assets. If this election is availed of, the basis reduction is regarded as depreciation taken, so that such reduction will be recaptured as ordinary income in connection with a later disposition of the affected property.
STOCK FOR DEBT EXCEPTION
The loss of prospective tax benefits can be avoided, however, in cases in which the troubled debtor cancels its debt for stock in a manner that entitles it to avail itself of the "stock for debt" exception to the realization of DDI. This exception, developed by the courts, was acknowledged and appropriately circumscribed by Congress in the Deficit Reduction Act of 1984.
Thus, for companies involved in Title 11 cases, and those that are insolvent, to the extent of their insolvency, the stock for debt exception applies unless the quantum of stock issued is merely "nominal or taken," or the manner in which it is issued violates a proportionality rule.
In a 1988 private letter ruling (LTR 8837001) the IRS shed light on guidelines to ascertain whether stock issued is nominal or taken. Although the ultimate determination is based on the unique facts of each case, the central inquiry is whether a "real equity interest" will be created. Such an interest is created when the bargaining parties possess adverse economic interests and the value of the stock issued is meaningful in relation to: 1) the face amount of debt canceled for stock (10% seems sufficient); and 2) the total consideration delivered in discharge of debt (15% carried the day). Further, it was ruled irrelevant that the stock comprised only 3.4% of the debtor's voting power and that such stock was redeemable at the issuer's option after five years. This ruling, the principles of which were recently confirmed by regulations, gives debtors wide latitude in structuring successful debt for equity swaps.
Will Preferred Stock be Viewed as Equity?
Currently, the debate in this area has centered around the question of whether preferred stock will be treated as equity for purposes of the exception. Although the governing statute is silent on this question, and LTR 8837001 sanctioned the use of preferred-stock redeemable at an issuer's option is treated as preferred stock for tax purposes-the IRS feels that preferred stock should be ineligible, because it can never grow in value to an amount equal to the adjusted issue price of the debt for which it is swapped. In RRA 90, Congress enacted a rule that would treat "straight" preferred stock as other than equity for purposes of the stock for debt exception.
The other major limitation in the use of the debt for stock rule focuses on the value of the stock received by the various classes of unsecured creditors. Thus, stock issued to such a creditor is ineligible for the benefits of the exception if his or her ratio of stock value received to unsecured debt to be canceled is less than 50% of a similar ratio computed for all unsecured creditors participating in the workout. The rationale for this curious rule has never been adequately explained and, in practice, is a thorny problem because it fails to give credence to the bankruptcy law priorities existing among classes of unsecured claimants.
SEC. 382: NOL RESTRICTIONS
The issuance of substantial amounts of stock necessarily raises the specter of Sec, 382, the provision that imposes limits on the use of loss carryovers (NOLs) in the event of an "ownership change." Such a change is deemed to occur in cases where, over a three-year testing period, the entity's 5% shareholders" have increased their percentage of ownership of the value of the issuer's stock by more than 50 percentage points. In these cases, the amount of income such NOLs can offset in any year ending after the change date, is limited to the product of the corporation's equity value immediately before the change and the long- term tax-exempt bond rate, a figure published monthly by the IRS. For this purpose, moreover, NOLs include "built-in" losses and expense items recognized within the five-year interval beginning as of the change date. A corporation may be impacted by this built-in loss rule in any case in which the basis of its assets on the change date exceeds the value thereof by more than the smaller of: 1) 15% of aggregate asset value; or 2) $10 million. Conversely, for a corporation with built-in gains including income items, its annual limitation on NOL usage will be enhanced if, and to the extent, such income gains are recognized during the five-year period commencing on the change date.
An Escape Clause
The troubled corporation can escape these onerous rules if its ownership change results in its shareholders and "historic" creditors owning at least 50% of the value and voting power of its stock. For this purpose, an historic creditor is one whose claim originated at least 18 months before the filing of the bankruptcy petition and whose claim arose in the ordinary course of business and who, at all times, has held the beneficial interest in such claim.
An interesting private letter ruling (LTR 8902047) indicated that the second category should be afforded an expansive interpretation and included retired employees possessing claims for medical benefits who were issued stock in the workout.
Relief from the general rule of Sec. 382 is not without its own unique set of strictures. Accordingly, the corporation's NOL balance is reduced in an amount equal to: 1) interest expense deducted on debt converted to stock during the pre-change portion of the current year and any year ending during the three-year interval ending on the date of change; and 2) 50% of the amount that would have been applied to reduce tax attributes were it not for the stock for debt exception. Moreover, if such a taxpayer experiences a second ownership change within two years of the initial change, the benefits of the exception to the general rule are retroactively withdrawn, and the taxable income limits on NOL usage with respect to the second change is zero. To avoid this penalty, affected corporations may seek to adopt charter amendments that would restrict transfers of its stock. If such a charter amendment is both legal and enforceable, and is in fact enforced according to its terms, the IRS acknowledges (see LTR 8949040) its effectiveness in preventing a second ownership change. Finally, for troubled corporations that prefer the general rule to the exception, a special benefit is provided if they opt out of such exception. Equity value, for purposes of computing the annual limit on NOL absorption, is calculated after the enhancement of this figure resulting from surrender of creditor claims in the reorganization.
Using NOL to Offset DDI
A final problem confronting troubled corporations seeking to navigate the delicate balance between the stock for debt exception and the penalties of Sec. 382 is to ensure that the full amount of DDI realized can be offset by NOLs. Although the limits of Sec. 382 do not apply to income allocable to periods ending on or before the change date, Sec. 382(b)(3) indicates that income for the year of change, including DDI, is allocated ratably to each day in the year. Thus, a portion of DDI might be assigned to the post-change portion of the year. in these instances, the IRS has announced, in Notice 87-79, that a taxpayer may elect to allocate change year income on the basis of an actual closing of its books.
If an advance ruling is obtained, the DDI realized on the change date can be allocated to the period ending on such date. This approach, however, can backfire if the change dateprecedes the date on which the DDI is realized. This can occur in instances where an "option" to acquire stock is created more than 120 days prior to the date of consummation of the actual stock transfer. In the context of an exchange offer, an option comes into existence on the date the formal plan of exchange is adopted. if a ruling under Notice 87-79 is obtained and if the option date precedes the actual consummation date by more than the critical 120-day grace period, the corporation will find that the DDI resulting from the exchange will be entirely allocated to the period following the change date and, thus, fully subject to Sec. 382's limits.
DDI May be Treated as Built-In Gains
Although such a miscalculation regarding the creation of an option appears to be a prescription for disaster, tax benefits can still be enjoyed if DDI can be characterized as a built-in gain. In these instances, the NOL limitation is increased on a dollar for dollar basis. Because the term expressly includes post-change income items attributable to pre-change periods, it seems likely that DDI economically accrued on the change date should attain built-in gain designation. Moreover, in LTR 8932049, the IRS acknowledged the built-in gain status of accrued DDI. Accordingly, although a properly structured Notice 87-79 transaction is still the preferred approach to ensuring full absorption of DDI, the willingness of the IRS to characterize DDI as a built-in gain eliminates the draconian effects of a failure to adhere to a timetable that is often outside the tax adviser's control.
ALTERNATIVE MINIMUM TAX
Troubled debtors enjoying an exclusion of DDI for regular tax purposes must still confront the alternative minimum tax (AMT). In general, AMT is assessed at a rate of 20% and is applied to the corporation's balance of alternative minimum taxable Income (AMTI). AMTI, in turn, consists of regular taxable income augmented by a series of "preference" items, the most pervasive of which is 75% of the amount by which the debtor's "adjusted current earnings" (ACE) exceeds pre-adjustment AMTI. ACE consists, generally, of an amount equal to pre-adjustment AMTI increased by income items excluded from AMTI but included in the computation of earnings and profits (E&P) and deduction items not available as a deduction for both AMTI and E&P purposes.
on its face, therefore, DDI excluded from regular taxable income would appear to be an element of ACE because such DDI is included in E&P. Fortunately, Sec. 56(g)(4)(B) revises this rule in the case of excluded DDI. Although such DDI is contained within E&P, it is not added to preadjustment AMTI to arrive at ACE. A companion rule, applicable to corporations that experience an ownership change for regular tax purposes, requires a write-down of the asset's ACE basis (to reflect its fair value) in cases where the aggregate bases exceed asset value by more than the lesser of 15% of asset value or $10 million.
SAVE THE BENEFITS FOR THE FUTURE
Although a restructuring of the troubled corporation's debt-laden capital structure is painful and arduous, the prospects for successful post-restructuring results can be enhanced if the debtor's tax liabilities are minimized and its favorable tax attributes preserved for future use. It is in this latter area that the CPA's counsel can prove to be of vital importance.
TROUBLED DEBT RESTRUCTURING: SOME ACCOUNTING OBSERVATIONS
SFAS 15 deals with the restructuring of troubled debt. A troubled debt restructuring exists only if the creditor for legal or economic reasons related to the debtor's Financial difficulties grants the latter a concession it would not otherwise consider.
Thus, if a debtor issues stock to a creditor in full settlement of existing debt, the transaction is accounted for as a troubled debt restructuring if the value of the equity is less than the payable. in such a case, the debtor will record the excess of the carrying value of the payable over the fair value of the stock as an extraordinary gain.
When the terms of existing debt are modified-a transaction that would be treated as a deemed exchange of old debt for new debt for tax purposes-the debtor must compare the Future gross cash outlays under the new terms with the carrying value of the existing payable. If such carrying value exceeds the outlays, a restructuring gain will result, the payable is written down to an amount equal to the future outlays, and all subsequent debt payments are treated as principal with no interest recognized.
In cases where the future gross cash outlays exceed the carrying value of the old payable, the effects of debt modification are accounted for on a prospective basis. It is necessary, in this instance, to ascertain the discount rate that, when applied to the gross outlays, produces an amount equal to the carrying amount of the old payable. This new rate is then used to allocate note payments between interest and note amortization. In these cases, no gain is recognized at the time of restructuring and there is no write-down of the payable.
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