As the country gradually emerges from the recession, negotiations between debtors and creditors related to debt modifications have become more prevalent. Creditors have been more likely to work with debtors to restructure loans, thereby making payments more manageable, instead of being inflexible and forcing debtors to default on loans or file for bankruptcy. While many alterations to the terms of the debt may seem minor, they could result in unexpected income tax consequences to both debtors and creditors. This discussion provides some basic guidance on what debtors should be mindful of if they are contemplating a debt modification scenario.
A modification of a debt instrument, including real-estate debt, leveraged buyout debt, and secured or unsecured corporate debt, may result in a deemed taxable exchange of the old debt instrument for a new debt instrument if the modification is considered “significant”. This deemed exchange could cause the debtor to recognize cancellation of debt income. Additionally, a significant modification may also create gain or loss recognition to the creditor.
The first step in analyzing whether a debt modification triggers a taxable event is to determine whether there was a debt modification. The treasury regulations define a modification as “any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise”. The regulations contain a number of items that do not constitute modifications. One example of an exception that is not considered a modification is the annual adjustment to the interest rate based on an interest rate index provided for in the terms of the debt instrument. Most of the exceptions defined in the regulations stem from the contractual obligations contained in the terms of the debt instruments. Assuming we have a debt modification, the second, more crucial step in analyzing whether a taxable event has occurred is to determine whether the modification was significant. The regulations contain six tests to be used to determine whether or not a modification is significant:
1. Changes in yield
2. Changes in timing of payments
3. Changes in obligor or security
4. Changes in nature of debt instrument
5. Change in accounting or financial covenants
The sixth test is the facts and circumstances test. Under this general test, it is important to note that, while individual modifications may not be significant by themselves, the statute requires an aggregate approach whereby multiple modifications must be considered collectively to determine significance. A number of small modifications which are insignificant on their own may constitute a significant change when considered together.
While it is beyond the scope of this alert to discuss the specifics related to the application of each test, if you feel that any modification falls under one or more of these categories, further analysis should be done to determine whether it is significant.
Once a debt modification is deemed to be significant, both the debtor and the creditor will likely have tax consequences. Generally, a significant modification is considered to be an exchange of the old debt instrument for a new debt instrument. If the adjusted issue price (generally the principal amount) of the new debt is less than the adjusted issue price of the old debt, the debtor may have to recognize cancellation of indebtedness income, unless one of the exceptions to such income recognition applies. The creditor’s tax consequences are determined by comparing the new debt issue price and the old debt tax basis. This comparison can result in either gain or loss. Modifications involving publically traded debt add a layer of complexity that is beyond the scope of this discussion.
In addition to the potential tax consequences, debtors should be aware that there may also be ramifications to financial statement accounting and disclosures as a result of debt restructurings or modifications.
There are numerous scenarios that could trigger either tax or financial accounting issues. The following is an example of one common fact pattern:
On April 30, 2012, Borrower and Lender enter into a loan agreement with the following terms:
- Principal amount of loan = $3,500,000
- Loan Term = 5 years – entire principal balance due at April 30, 2017
- Interest rate = 6% and is payable annually
Additionally, the loan agreement provides for various debt covenants that must be met on a quarterly basis. The Borrower realizes that they will not be in compliance with the covenants as of September 30, 2015 and requests that the Lender revise the covenants to ensure compliance. Furthermore, the maturity date is extended until April 30, 2018, and the interest rate is increased to 7%. A fee of $50,000 is paid by the Borrower to the Lender in connection with the restructuring. While this fact pattern clearly describes a modification, whether it is a significant modification triggering tax consequences can only be determined after further analysis.
Familiarity with the potential tax consequences of debt modifications is necessary in order to mitigate the risk of unintentionally creating taxable income. Since the regulations include a very broad definition of what is considered to be a modification, careful planning and analysis is needed when faced with the possibility of a debt restructuring or modification. As stated above, only debt modifications that fall under the definition of “significant” create tax consequences. Analyzing debt modifications for significance requires specialized knowledge. Whether you are a debtor or a creditor involved in a debt restructuring, please contact your Wilkin & Guttenplan tax advisor to discuss the potential implications.