Out-of-court restructurings and workouts have become more common in recent years due to the sophistication of the debt markets, the availability of capital—even for high-risk borrowers—and the inherent reluctance of companies to utilize the chapter 11 process to restructure debt except as a last resort. This trend accounts for some of the decline in the number of chapter 11 filings since 2001 and the increase in high-yield debt outstanding for a wide range of companies, including those still far from chapter 11's doorstep. Such restructurings may involve an actual exchange of old debt instruments for new ones, or only modifications to the terms of an existing debt instrument. When a debt instrument is amended (e.g., to increase the interest rate) as part of a restructuring without changing the face amount of the obligation, it is possible that the amendment may create cancellation of indebtedness (COD) income. The key is whether the changes to the terms of the debt constitute a "significant modification" in accordance with the Internal Revenue Service (IRS) regulations. If a cash-strapped company facing imminent default needs more flexibility in its financing arrangements, it may suddenly find that amendments to the terms of its debt that address these problems may come with a cash cost in the form of taxes due for a transaction that, on its surface, does not appear to generate taxable income. The cash impact of such a restructuring may be immediate if it is achieved out of court by borrowers who do not have sufficient net operating losses (NOL) to offset the COD income. Even for borrowers with sufficient NOL, the Alternative Minimum Tax (AMT) may apply with an effective 2 percent cost. If the amendments occur in a chapter 11 proceeding, however, the tax impact may be deferred until well after emergence.

The following example, suggested by a real transaction, illustrates one of the bright-line rules or tests under these IRS regulations. This test requires a calculation of the change in total yield of the restructured debt, and in this instance, results in the creation of taxable COD income. Company X issued publicly traded debt in 2002 with the following terms:

Original Notes
Issue Amount: $200,000,000
Issue Date: June 28, 2002
Maturity Date: July 1, 2010
Coupon: 11.00%
Yield to Maturity at Issuance: 11.00%

In June 2004, when the notes were trading at 92 cents on the dollar, the company triggered an event of default under terms of the debt. The company negotiated a waiver from its creditors and, in consideration thereof, agreed to increase the interest rate on the debt and pay a consent fee as follows:

June 2004 Amendments
Consent Fee: 1.00%
Amended Coupon: 11.40%
Yield After Modification: 11.61%
(calculated after reducing the original issue price by the consent fee)

The combination of the change in interest rate and the consent fee effected a change in yield of more than 5 percent of the original annual yield. Under the change-of-yield rule or test of the IRS regulation, this change in yield constituted a "significant modification".

Change-in-yield Rule
Yield-Restructured: 11.61%
Yield-Original: 11.00%
Threshold for Significant Modification: 11.55%

As will be discussed in more detail in the following text, this change in yield, and resultant "significant modification," will have the following tax effect:

Cancellation of Indebtedness Income
Face Value (per note): $1,000
Market Price at date of restructuring (per note): $920
COD Income (%): 8.0%
COD Income ($): $16,000,000
Tax Cost (regular tax rate or AMT)
Regular tax (35%): $5,600,000
AMT (2%): $320,000

This change in yield rule or test is only one of the rules or tests used to determine whether there has been a "significant modification" of a debt instrument. Before completing an assessment of whether to proceed with amending its debt, a company and its advisors must analyze the proposed amendments under each of the rules or tests discussed below.

This article will discuss this trap for the unwary where one or more simultaneous or serial amendments to a debt instrument issued by a company may result in taxable COD income.

Background

Historically, there has been a well-developed body of law concerning the tax treatment of debt modifications. Although there were areas of uncertainty, under the case law and rulings, a debt modification usually did not result in a taxable exchange unless the obligor with respect to the debt was changed or the yield on the debt instrument was materially changed. See Rev. Rul. 89-122, 1989-2 C.B. 200; Rev. Rul. 87-19, 1987-1 C.B. 249; Rev. Rul. 73-160, 1973-1 C.B. 365. Thus, for example, there generally were no tax consequences with respect to debt modifications that effected an alteration of collateral, the addition or subtraction of guarantees, an extension of maturity date, a deferral of payments or a waiver of an event of default. See Rev. Rul. 87-19, 1987-1 C.B. 249 (change in yield); Rev. Rul. 77-416, 1977-2 C.B. 34 (change in collateral); Rev. Rul. 73-160, supra (extension of maturity). In its 1991 decision in Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991), however, the Supreme Court held that the exchange of mortgage portfolios by two savings and loans was a taxable event, even though the portfolios were substantially identical in an economic sense. Many commentators interpreted the Supreme Court's decision in Cottage Savings as establishing a "hair trigger" for determining whether a debt modification would result in a taxable exchange. In response to the uncertainty caused by the Supreme Court's decision, the IRS issued regulations in June 1996 on the issue of when the modification of a debt instrument would result in a deemed taxable exchange of the original debt instrument for a "new" debt instrument. Treas. Reg. §1.1001-3, T.D. 8675, 61 Fed. Reg. 32926 (June 26, 1996).

The IRS Regulations

The so-called Cottage Savings regulations establish a two-part test to determine if alterations of the legal rights or obligations under a debt instrument will be treated as an exchange of the original debt instrument for a "new" debt instrument. Treas. Reg. §1.1001-3(b). First, the regulations require a determination as to whether the alterations constitute a "modification." Treas. Reg. §1.1001-3(c) and (d). Second, if the alterations constitute a "modification," the regulations require that the modification must be tested under a series of specific rules or a general "catch-all" rule to determine if the modification is "significant." Treas. Reg. §1.1001-3(e) and (f). If a significant modification has occurred, the borrower and holders of the debt will be deemed to have exchanged the original debt instrument for a new debt instrument in a taxable exchange. Treas. Reg. §1.1001-3(b).

What Is a Debt Modification?

The regulations define a modification as any change (whether oral or written) of a legal right or obligation of the issuer or holder of a debt instrument. Treas. Reg. §1.1001-3(c)(1)(i). The regulations, however, contain three exceptions to this seemingly all-encompassing definition.

First, an alteration of rights or obligations will not be treated as a modification if the alteration of rights occurs pursuant to the original terms of the debt instrument, provided that the change does not result in the substitution of a new obligor, the addition or deletion of a co-obligor, or a change from a recourse to a non-recourse debt or vice versa. Treas. Reg. §1.1001-3(c)(1)(ii).

Similarly, the exercise of an option afforded to the issuer or holder under a debt instrument is not a modification unless the option is "unilateral" and, in the case of an option exercised by a holder of a debt instrument, does not result in a deferral of, or reduction in, a scheduled payment. Treas. Reg. §1.1001-3(c)(2)(iii). For this purpose, an option is unilateral if it does not require the consent of the other party to the debt instrument (or a party related ) or a court, and the exercise does not require consideration other than a de minimus amount, specified amount or amount based on a formula established on the issue date. Treas. Reg. §1.1001-3(c)(3).

Finally, an alteration of rights or obligations will not be treated as a modification if the alteration results from a failure by the issuer of the debt instrument to perform its obligations under the instrument or a waiver by a holder of such instrument of a default right, unless such holder's forbearance continues for more than two years. Treas. Reg. §1.1001-3(c)(4). Thus, a temporary stay of collection or a waiver of an event of default under a debt instrument will not, in and of itself, constitute a modification so long as the issuer and holder do not agree to alter any other terms of the debt instrument during the two-year period following the forbearance. Accordingly, a mere waiver of an event of default will not, in and of itself, be treated as a modification.

When Is a Debt Modification Significant?

In defining a "significant modification," the regulations adopt a number of specific bright-line rules and a general rule. Treas. Reg. §1.1001-3(e)(1) and 3(c)(2) through (6). Under the general rule, which generally only applies if a specific bright-line rule does not, a modification is significant if the legal rights or obligations are changed in an "economically significant" manner. Treas. Reg. §1.1001-3(f)(1)(i). In making this determination, all modifications to a debt instrument other than those subject to a bright-line rule are considered so that a series of modifications taken together may constitute a significant modification even though each modification alone would not be "economically significant." Treas. Reg. §1.1001-3(e)(1).

Under the specific bright-line rules, any of the following changes will be considered a "significant modification".

1. Changes in Yield: The first rule characterizes any change in legal rights or obligations that effects a change of yield exceeding the greater of 25 basis points or 5 percent of the annual yield of the original unmodified debt instrument as a "significant" modification. Treas. Reg. §1.1001-3(e)(2)(i) and (ii). In calculating yield for this purpose, yield is determined by reference to the issue price of the unmodified debt instrument as increased for any payments by the holders to the issuer and decreased by any payments by the issuer to the holders of the debt. Treas. Reg. §1.1001-3(e)(2)(iii)(A). Thus, a consent or inducement fee, such as the inducement fee discussed in the example which introduced this article, paid by an issuer to holders of its debt would, by dint of this deduction, result in an increase in yield.
2. Changes in Timing and Amount of Payment: The second specific bright-line rule provides that a "material" deferral (based on all of the facts and circumstances) in the timing of scheduled payments under a debt instrument, either by reason of the extension of the maturity date of such instrument or a deferral of payments due, is a "significant" modification. Treas. Reg. §1.1001-3(e)(3)(i). The regulations do, however, provide a safe-harbor for this purpose. Under the safe harbor, an extension of the maturity date of a debt instrument that is shorter than five years or 50 percent of the instrument's original term is not a "significant" modification. Treas. Reg. §1.1001-3(e)(3)(ii).
3. Changes in Obligor: The third specific bright-line rule provides that the replacement of the obligor on a recourse debt instrument is a "significant" modification, unless the change results from a tax-free reorganization or liquidation or an acquisition of substantially all the original obligor's assets, the debt is not otherwise modified and the transaction does not result in a "change in payment expectations." Treas. Reg. §1.1001-3(e)(4)(i). Interestingly, a change in obligor on a non-recourse debt instrument is not a "significant" modification. Treas. Reg. §1.1001-3(e)(4)(ii).
4. Changes in Payment Expectations: The next several specific bright-line rules require that the change or alteration of the debt instrument will not be treated as a "significant" modification unless it results in a "change in payment expectations." For this purpose, a change in payment expectations occurs if the obligor's capacity to satisfy the debt is (1) enhanced, and the change in the debt instrument reduces the credit risk with respect to the debt from speculative to adequate, or (2) impaired, and the change in the debt instrument increases the credit risk from adequate to speculative. Treas. Reg. §1.1001-3(e)(4)(v). Where payment expectations change, the regulations provide that the following changes in a debt instrument will be treated as a "significant" modification: (1) an addition or deletion of a co-obligor; (2) the release, substitution, addition or alteration of collateral (including any guarantee or other credit enhancement) securing a recourse debt; (3) the release, substitution, addition or other alteration of a substantial amount of the collateral (including any guarantee or other credit enhancement, but excluding a substitution involving commercially fungible collateral or commercially available credit enhancements) for a non-recourse debt; and (4) a change in the "priority" (seniority or subordination) of a debt instrument. Treas. Reg. §1.1001-3(e)(4)(iii) (addition/deletion of obligor); Treas. Reg. §1.1001-3(e)(4)(iv)(A) (collateral on recourse debt); Treas. Reg. §1.1001-3(e)(4)(iv)(B) (col-lateral on non-recourse debt); Treas. Reg. §1.1001-3(e)(4)(v) (change in priority).
5. Changes in the Nature of a Debt Instrument: The final bright-line rule provides that a change in a debt instrument that converts that instrument to equity for tax purposes, or that converts that debt from recourse to non-recourse or vice versa, is a "significant" modification. Treas. Reg. §1.1001-3(e)(5)(i) and (ii). Thus, for example, a legal defeasance of a debt instrument that releases the obligor from all liability to make payments on such debt is a "significant" modification. Treas. Reg. §1.1001-3(e)(5) (ii)(A). Importantly, however, a modification that adds, deletes or alters customary accounting or financial covenants is not a "significant" modification. Treas. Reg. §1.1001-3(e)(6). Accordingly, a mere change in financial covenants will not, in and of itself, result in a "significant" modification.

In aid of determining whether a change or alteration of a debt instrument is a "significant" modification, the regulations provide that changes in the terms of the instrument of a lesser degree than the degree of change that is considered a "significant" modification under the regulations is not a "significant" modification. Treas. Reg. §1.1001-3(f)(2). Similarly, modifications of different terms under an instrument, none of which separately would constitute a "significant" modification, do not collectively constitute a "significant" modification. Treas. Reg. §1.1001-3(f)(4). The regulation does, however, provide that a series of modifications to a particular term of a debt instrument over a period of time (up to five years) must be combined to determine if the changes would have resulted in a "significant" modification had the changes been made as a single change. Treas. Reg. §1.1001-3(f)(3). Thus, for example, a change in financial covenants accompanied by an inducement fee, followed at some later point during the following five years by a change in interest rate, will be treated as a single change in determining whether there has been a change in yield that exceeds the 25 basis points/5 percent rule discussed above.

Consequences of Significant Modifications

If a debt instrument has been significantly modified under these regulations, the original debt instrument is deemed to have been exchanged by the obligor and holders for a new debt instrument. From the perspective of the obligor, cancellation of indebtedness income will result from the deemed exchange if the "issue price" of the new debt instrument is less than the "adjusted issue price" for federal income tax purposes (i.e., the original issue price as increased by any original issue discount previously included in the income of any holder) of the original debt instrument. Internal Revenue Code §108(e)(10); Treas. Reg. §1.1275-1(b). Where the original debt instrument is publicly traded, the issue price of the new debt instrument will equal the trading price of the original debt instrument. Treas. Reg. §1.1273-2(c)(1). Thus, as discussed in the example that introduced this article, the obligor on a publicly traded debt instrument will recognize COD income if the original debt instrument is traded at less than its "adjusted issue price" for federal income tax purposes. From the perspective of the holder, gain or loss will be recognized on the deemed exchange of the original and "new" debt instruments, unless the original and "new" debt instruments each qualify as a "security" (generally an instrument due more than 10 years from the date of issuance) for federal income tax purposes.

Conclusion

Where a company is negotiating an amendment or a series of amendments to the terms of its debt in order to avoid or cure a default or gain more flexibility in its financing arrangements, it is critical to be aware of this possible tax issue and consult tax advisors to determine how the amendment(s) will be treated under IRS regulations. Failing to evaluate the amendment(s) under these IRS regulations may result in the company inadvertently generating taxable COD income and incurring a current tax cost as a consequence. Although the tax effect of a debt amendment(s) may be the same in and out of court, a chapter 11 filing may allow the company to defer the cash tax impact until well after emergence.