On September 13, 2012, the U.S. Treasury Department and the Internal Revenue Service (the “IRS”) published final regulations that will affect the U.S. federal income tax treatment of debt restructurings, amend-and-extend agreements, debt exchange offers, further issuances of outstanding debt, and other liability management transactions.
- These “publicly traded” regulations will increase the tax cost to some U.S. issuers of restructuring or amending the terms of distressed debt, particularly syndicated loans, and may increase the tax cost of such transactions for U.S. investors in illiquid distressed debt, particularly middle-market loans, whole loans, credit card and other receivables and ABS, MBS and CDO tranches with outstanding amounts of $100 million or less.
- For issuers of bonds, however, the regulations provide increased flexibility for further issuances – in tax parlance, “reopenings” – of outstanding debt, particularly debt trading below par.
- The new rules apply to both U.S. and foreign issuers and to U.S. investors, including U.S. investors in funds that invest in debt instruments such as hedge funds.
These rules will have different effects in different markets, in part because of the different economic characteristics of those markets and in part because of historic tax positions taken in different markets. We summarize those effects below, and then discuss the effect of the regulations on loans, structured finance and whole loan transactions, and bonds in more detail.
- Syndicated loans. The final regulations generally increase the likelihood that a U.S. borrower with loans trading below par will recognize cancellation of indebtedness income (“COD income”) in an amendment or restructuring of its debt. As a result U.S. borrowers may be required to pay current tax, or may see a deferred tax asset (“DTA”) disappear, as a result of a restructuring, even though they still owe the same principal amount and have not gained access to any new cash.
The COD income on the “old” debt generally will be offset by deductions for original issue discount (“OID”) on the “new” debt if the par amount of the debt is not reduced, but the issuer will suffer a timing mismatch (income today, deductions tomorrow). If the yield on the “new debt” is high, the issuer’s interest deductions for the OID may be deferred or disallowed, in which case there could be a permanent tax cost to the amendment or restructuring.
- Middle-market loans/“small issue” exception. For loans or other debt instruments with an outstanding face amount of $100 million or less (a “small issue”) that have a value of less than par, the final regulations generally do not treat an amendment or restructuring as giving rise to COD income. However, an investor that purchased the loan for less than par will recognize tax gain in an amount that may exceed – substantially, in the case of highly distressed debt – its economic gain. While that uneconomic tax gain would be offset by a tax loss on the sale of the modified loan, there may be timing mismatches or character differences (ordinary income, capital loss) between the gain and the loss.
- ABS, MBS, CDOs, whole loans and receivables. The “small issue” exception just described may create uneconomic tax gains for investors in restructured or amended mezzanine or junior tranches of MBS, CDOs, and ABS, which often have less than $100 million in principal upon issuance. Investors in pools of whole loans or receivables with individual amounts below that threshold, such as residential mortgages or credit card receivables, similarly will recognize uneconomic gain as the individual loans are restructured. As with middle-market loans, while that uneconomic tax gain would be offset by a tax loss on the sale of the modified loan, there may be timing mismatches or character differences between the gain and the loss.
- Corporate and sovereign bonds/further issuances. The final regulations will apply in the same manner to restructurings and exchange offers for corporate and sovereign bonds as described above, but are less likely to give rise to uneconomic gain to investors or to change the current tax treatment of those transactions if the bonds’ outstanding principal amount exceeds $100 million. The regulations may increase the risk that restructurings or exchange offers involving relatively illiquid bonds will give rise to COD income to issuers of bonds trading at a discount, or conversely may permit current deductions for issuers of bonds trading at a premium. Of more general significance is that the regulations provide new opportunities to reopen bonds trading below par, which should allow some issuers more flexibility to increase the liquidity of outstanding bonds and thereby lower their cost of capital.
- Increased compliance burdens on debtors. Borrowers and issuers must use “reasonable diligence” to discover sales and price quotations in order to determine whether debt with a principal amount exceeding $100 million that is the subject of a restructuring, exchange offer or similar transaction qualifies as “publicly traded,” and to determine its fair market value. Issuers also must make this information available to investors. Ideally, the information would be provided, possibly through a third party service provider, in a manner readily accessible to market participants for as long as the debt is outstanding.
Because issuers do not generally have full access to information of this kind, issuers may seek such information from the agent bank, underwriter or other financial institution managing the transaction, with potential liability issues for those institutions. These dynamics may affect liability management negotiations and standard documentation.
- Valuations. The regulations rely on sales prices and price quotations to establish the fair market value of an issuer’s debt, based on the premise that market information, even if imperfect, is the soundest basis for valuation. An issuer generally may use any reasonable method, consistently applied, to determine the fair market value of its debt, which may prove useful where fire sales have occurred or where there is a wide bid-ask spread. If the sole pricing information available consists of indicative quotes, and the issuer believes that those quotes materially misrepresent the fair market value of the debt, the issuer may use another more accurate method to value the debt. If an issuer’s reasonable diligence turns up only one sale price or firm price quote during the relevant period, however, that price is presumed correct.
- Foreign issuers and borrowers. The compliance rules described above do not contain an exception for foreign issuers and borrowers, even when a restructuring or the like takes place primarily outside the United States. If an issuer does not provide the required information to investors, then investors must carry out the same diligence described above in order to make their own determination. Accordingly, either a foreign issuer or its U.S. investors will have increased compliance obligations.
- Effective dates. The final regulations affecting debt restructurings, exchange offers and similar transactions will take effect for transactions carried out on or after November 13, 2012.The final regulations establishing a more permissive regime for further issuances took effect on September 13, 2012.
As described in more detail below, the principal effect of the regulations is on transactions that amend or modify the terms of a bond or loan, for example by changing coupons or maturities, in such a way that for U.S. federal income tax purposes the debt instrument is treated as retired and a new debt instrument is treated as issued. In transactions of this kind, the issuer may recognize COD income if the “old” debt is treated as retired for its fair market value, which would generally be the case if either the old or new debt is treated as “publicly traded.” Conversely, investors may recognize uneconomic gain if the “old” debt is instead treated as retired for its face amount, which would generally be the case if neither the old nor the new debt is treated as “publicly traded.” 
The new “publicly traded” regulations generally expand the definition of “publicly traded” to include any debt instrument for which there are sales transactions, or for which firm or indicative price quotes are available, within a 31-day period beginning 15 days prior to the issue date for the new debt and ending 15 days thereafter. As a result, they make it more likely that debt, including distressed debt with limited trading, will be treated as retired for its fair market value in a debt restructuring, exchange offer or similar transaction. In the case of debt with an outstanding amount of $100 million or less, however, the regulations treat the “old” debt generally as not publicly traded, and therefore as retired for its par amount.
Part II of this memorandum discusses the effect of the regulations on the loan market, and Parts III and IV discuss their effect on structured finance and whole loan transactions, and on the bond market, respectively. Part V provides a more detailed description of the law.
The full publication is available here.
 The discussion in this memorandum assumes that there is no increase or decrease to the principal amount of a debt instrument in a restructuring, exchange offer or the like; that the debt pays adequate stated interest and has a principal amount exceeding $250,000; and that transactions take place on arm’s length terms.