Debt Restructuring Tax Relief Included in Stimulus Package

The American Recovery and Reinvestment Act of 2009, known as the stimulus bill, includes few provisions that will have an impact on private equity and venture capital funds. One provision that could affect private equity funds and their portfolio companies is a tax provision that will permit companies to restructure their outstanding troubled debt and defer the tax consequences thereof for five years. The provision will allow companies to more easily deleverage their balance sheets, and thus should be considered by private equity funds and their portfolio companies which have outstanding debt.

When the stimulus bill was signed into law on February 17, 2009, it created a tax break that will allow companies which repurchase their troubled debt to defer taxes on such transactions for up to five years. Normally, when a company buys back its debt at a lower price than that at which the debt was originally issued, the difference results in cancellation of debt (COD) income. COD income arises whether the company repurchases the debt for cash, equity or by issuing new debt, and the company is taxed on such COD income in the year in which the buyback occurs. Prior to the bill, generally a company could only avoid the tax implications of COD income if it was in bankruptcy proceedings, insolvent or was able to offset the tax cost by applying net operating losses. Under the bill, such COD income which arises in 2009 or 2010 can be deferred until 2014, and thereafter such COD income will be includible as gross income ratably over the next five years.

Included as Section 108(i) of the Internal Revenue Code, as amended (the Code), an issuer can elect to defer COD income resulting from the repurchase of "applicable debt instruments." Applicable debt instruments include bonds, debentures, notes and certificates that were issued by a C corporation or other person "in connection with the conduct of a trade or business." Thus, private equity funds should ensure that the repurchasing company was the entity that in fact issued the original debt, and not the private equity fund itself. However, most private equity investments are structured in a manner that will allow a reacquisition to be eligible for the new debt buyback provision.

Furthermore, a wide array of debt restructuring methods are available to companies to take advantage of these new provisions under the bill. Debt that is reacquired for cash, exchanged for another debt instrument, exchanged for corporate stock or a partnership interest, contributed to capital or completely forgiven by the debtholder qualifies as a reacquisition under the bill. However, the repurchase must occur in 2009 or 2010. Then, if the business affirmatively elects to apply the deferral provision under Section 108(i) of the Code, it must recognize the COD income no later than 2014, but even then the tax cost can be spread ratably over five years after 2014. It should be noted that in the event the electing company liquidates, files for bankruptcy, sells its assets or terminates its business, such deferred income is accelerated and due in the taxable year in which such an event occurs.

If the reacquisition occurs by issuing a new debt instrument, original issue discount (OID) complications may develop. OID implications can arise when a debt instrument is repurchased via the issuance of a new debt instrument, is bought back by a related party or the outstanding debt instrument is significantly modified. Normally, the issuer of a debt instrument with OID can deduct the value of the OID over the life of the instrument. However, if the issuer elects to apply the debt buyback provisions under Section 108(i) of the Code, it must also defer the OID deductions during the same time period in which the COD income is deferred. Correspondingly, the issuer may apply the OID deduction ratably over the years in which it finally recognizes the COD income tax.

Due to the fact that many portfolio companies of private equity funds issued debt that is now distressed, the bill will allow these companies to repurchase that debt without having to face immediate COD income tax consequences. This welcome development comes at a time when troubled companies are searching for any avenue that will allow them additional financial flexibility. Thus, the bill's debt buyback provision should be considered by all companies with debt, and the private equity funds that have invested in them.

The above discussion of the bill's impact on the taxation of COD income is general in nature and should not be construed as legal advice. For more information on how to best take advantage of these new opportunities, please feel free to contact Kristine Danz, Mark Alson or Thomas Schnellenberger.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.