The New COD Deferral Election

In this Emerging Issues Analysis, four partners from the law firm of Jones Day offer their perspective on new section 108(i) of the Internal Revenue Code. The new provision creates a mechanism that will allow many borrowers to substantially reduce or avoid the adverse tax consequences that may be generated by exchanges or deemed exchanges of old debt for new debt, as well as repurchases or other retirements of debt at a discount.
The authors write: The American Recovery and Reinvestment Tax Act of 2009 (ARRTA) inserted a new section 108(i) into the Internal Revenue Code. That new section permits corporations and certain non-corporate borrowers to elect to defer cancellation of debt (COD) income for up to five years, followed by ratable inclusion of the COD income over the next five years. In the simple case in which an obligor (or a related party) buys back or settles its own debt for less than face, this new election will allow borrowers to postpone reflecting COD income on their tax returns for a substantial period of time, thereby obtaining a time value benefit. More importantly perhaps, this election will often permit borrowers who have syndicated bank debt outstanding to negotiate significant modifications to that debt without running the risk that COD income will be generated as a result.
*     *     *
The current economic crisis has created severe financial problems for many businesses, but also some opportunities to work out of those difficulties. Unfortunately, in many cases the COD rules work against those opportunities. The opportunities arise because much business debt is currently trading at well below par, because of the general loss of market confidence in the creditworthiness--or ability to reliably assess creditworthiness--of many, if not most, borrowers. Historical investors in such debt are now more interested in trying to purge their portfolios of doubtful debts than in investing in more. This presents a great opportunity for debtors--or their owners--with sufficient resources to strengthen their balance sheets by buying back their debt at substantial discounts. But they are inhibited from doing so by the COD rules that would impose significant current or future tax, through recognition of current taxable income or loss of valuable tax attributes, on the debtors' COD income resulting from such a debt buyback.
*     *     *
ARRTA creates a mechanism that will allow many borrowers to substantially reduce or avoid the adverse tax consequences that may be generated by exchanges or deemed exchanges of old debt for new debt, as well as repurchases or other retirements of debt at a discount. However, the new election will not always produce the best tax result, and considerable complexity will arise where the borrower is a pass-thru entity like a partnership or an LLC. State and local tax complications also abound.
ARRTA permits taxpayers to elect to defer COD income arising from an acquisition of business debt by the debtor or certain related parties in 2009 or 2010, in a variety of contexts: where the debt is bought back by the issuer (or a related party); where there is an actual or a deemed exchange of new debt for old; where there is a taxable exchange of debt for stock or an interest in an entity treated as a partnership; where debt is contributed to capital; and where debt is completely forgiven. In lieu of current inclusion, the debtor may irrevocably elect to include the COD income ratably over five years beginning in 2014.
If a debtor elects to defer COD income in the case of a debt exchange that results in new debt with original issue discount (OID), the debtor's OID deductions will be deferred to the same extent as the COD income.  In addition, high rates of OID resulting from such transactions in 2009 will be exempted from the deduction limitations set forth in the AHYDO rules if the new debt was exchanged for a debt that was not itself an AHYDO debt.  As a result of these provisions, if the remaining life of the new debt is between five and ten years, the combination of the deferred and later OID deductions will offset or more than offset the deferred COD income, potentially causing the deemed exchange to produce a small net deduction to the borrower on a present value basis.
The deferral election is in lieu of other exclusions currently available under section 108. Thus, a taxpayer that is insolvent or in bankruptcy at the time of the COD event or the later income inclusion will give up its existing rights of exclusion under 108 if it elects to defer the COD income under section 108(i).  Each situation must be examined on an individual basis, taking all relevant facts into account, before one can decide whether making the deferral election would be wise.
*     *     *
The potential tax costs to debtors of modifying, exchanging, repurchasing, or otherwise settling their outstanding debt to relieve financial distress (and ultimately rationalize the debt market) have significantly inhibited such activities, to the detriment of the economy as a whole. Provisions in ARRTA have been designed to provide short-term relief for these tax costs and to encourage debt workouts. These provisions include optional four-to-five-year deferral of COD income resulting from debt workouts, with inclusion in the succeeding five years, an OID-matching provision, and a provision providing relief from the AHYDO restrictions on deductibility for certain exchanges occurring in 2009. These provisions may substantially reduce or even eliminate the adverse tax consequences to debtors of engaging in debt workout transactions. Every taxpayer considering such a transaction must, however, carefully evaluate whether, in its particular situation, the general tax rules or the special rules under ARRTA provide the better tax answer. [footnotes omitted]