This client advisory addresses selected federal tax issues arising in connection with distressed debt transactions. Part I of the client advisory addresses tax issues arising at the debt holder (“Holder”) level and Part II, which focuses upon distressed debt issued by entities classified as a partnership for federal tax purposes, addresses tax issues arising at the debtor level.

Part 1: Holder Tax Issues

The tax treatment of a distressed debt transaction at the Holder level is often uncertain or counterintuitive.

Although the tax law distinguishes between debt and equity, distressed debt often constitutes a form of “quasi-equity,” incorporating features of both debt and equity investments.
The determination of whether an instrument constitutes debt or equity for federal tax purposes is generally made as of the date of issuance, and an instrument will not cease to be treated as debt solely as a result of a deterioration in the creditworthiness of the issuer.
When applied to distressed debt, the “market discount” rules, discussed below, produce incongruous results because these rules assume that the debt will be repaid in accordance with its terms, and this assumption is often inappropriate, particularly in the case of highly-distressed debt.

A. Market Discount

1. Basic Market Discount Rules

Gain realized in connection with the disposition of a “market discount bond” is generally treated as ordinary income to the extent that it does not exceed the “accrued market discount” on the bond at the time of disposition. Section 1276(a)(1).
Any partial principal payment on a market discount bond is included in gross income as ordinary income to the extent such payment does not exceed the accrued market discount on such bond. Section 1276(a)(3)(A).
A market discount bond is defined as a bond having market discount. Section 1278(a)(1)(A). Market discount is generally defined as the excess (if any) of (i) the stated redemption price of the bond at maturity over (ii) the basis of such bond immediately after its acquisition by the taxpayer.
Market discount generally accrues ratably, beginning the day after the taxpayer acquired the bond and ending on the maturity date of the bond. Section 1276(b)(1).
Holder may elect to include market discount currently as it accrues. Section 1278(b).
Holder may also elect to compute market discount based upon the constant-yield to-maturity method.
If Holder has not made the current accrual election, the net direct interest expense attributable to debt that was incurred or continued to purchase or carry the market discount obligation is limited to the amount of interest income Holder includes in gross income from the investment.

2. Application of Market Discount Rules to Distressed Debt

It will often be uncertain whether the market discount rules apply in the case of distressed debt, particularly, highly-distressed debt.
If the market discount rules apply to distressed debt, this could give rise to an overstatement of ordinary income and a capital loss upon sale or redemption of the debt instrument because Holder will be required to recognize a significant amount of ordinary income in connection with a partial payment even though it could be clear that Holder will not fully recover its capital investment.
The market discount rules were enacted as part of the 1984 Deficit Reduction Act to eliminate a specific tax shelter that involved a leveraged acquisition of a debt investment that traded at a discount as a result of increases in interest rates.
If Holder acquires post-maturity defaulted debt, then query whether the debt could be excluded from the market discount tax regime because there would be no period between the date of acquisition by Holder and the maturity date of the debt, as required by Section 1276(b)(1).
The 1984 legislative history supports the proposition that demand loans should not be subject to the market discount rules. The 1984 Bluebook states:
It is expected that Treasury Regulations will provide that the term market discount bond does not include an obligation that was demand debt when issued. Demand debt is insusceptible to treatment under the rules prescribed for computing accrued market discount (which rules are applied by reference to a maturity date).
It is arguable that enactment of the market discount legislation did not supersede common law, which allowed basis recovery (or “open transaction” treatment) with respect to speculative debt. See Liftin v. Commissioner, 36 T.C. 909, aff’d. 317 F.2d 234 (4th Cir. 1963) and Underhill v. Commissioner, 45 T.C. 489 (1966).

B. “Doubtful Collectability Exception”

Under the “Doubtful Collectability Exception” (the “DCE”), an accrual basis taxpayer is not required to include interest in gross income if at the time the interest arises, the income is “of doubtful collectability or it is reasonably certain that it will not be collected.” In the seminal case, Corn Exchange Bank v. U.S., 37 F.2d 34 (2nd Cir. 1930), the Second Circuit stated:

When a tax is lawfully imposed on income not actually received, it is upon the basis of a reasonable expectancy of its receipt, but a taxpayer should not be required to pay a tax when it is reasonably certain that such alleged accrued income will not be received and when, in point of fact, it never was received. A taxpayer even though keeping his books upon an accrual basis, should not be required to pay a tax on an accrued income unless it is good and collectible and where it is of doubtful collectability, or it is reasonably certain it will not be collected, it would be an injustice to the taxpayer to insist upon taxation.
In Technical Advice Memorandum 9538007 (September 22, 1995), the IRS held that the DCE doctrine does not apply with respect to original issue discount (“OID”) accruals.
Many commentators and taxpayers disagree with TAM 9538007 and take the position that OID accruals are not required in certain cases if the issuer is financially distressed.
If a principal payment is made with respect to a market discount bond, could Holder take the position that the payment should not be includable in gross income pursuant to the DCE if it is doubtful that the full principal will be paid?
Some taxpayers stop accruing interest with respect to market discount if the underlying debt instrument trades at a discount of at least 50% to its face amount.

C. “Significant Modification” of a Debt Instrument

If a debt instrument is “modified” and the modification is deemed “significant,” as defined in Treasury Regulations Section 1.1001-3, then the original debt instrument will be deemed exchanged for a new debt instrument.
A significant modification occurs if there is a change in the yield of a debt instrument by more than the greater of (i) 25 basis points or (ii) 5% of the annual yield of the original debt instrument. Treasury Regulations Section 1.1001-3(e)(2)(ii).
A modification that changes the timing of payments is also deemed a significant modification if it results in the “material” deferral of payments. Deferral of one or more payments is not deemed material if the deferred payments are unconditionally payable not later than at the end of an applicable safe harbor period. The safe harbor begins on the original due date that is deferred and extends for a period equal to the lesser of five years or 50% of the original term of the debt instrument.

D. Original Issue Discount (OID)

A debt instrument has OID if its stated redemption price at maturity exceeds its issue price (subject to a de minimus rule). Section 1273(a).
The issue price of a debt instrument is generally the initial offering price to the public.
If Holder owns a debt instrument with OID, it is generally required to include the OID in gross income over the term of the issue, regardless of its method of accounting.

E. “Publicly Traded” Debt

In an actual or a “deemed” debt-for-debt exchange arising as a result of a significant modification of debt instrument, the tax consequences of the exchange will depend, in part, upon whether the old and new debt instruments constitute “publicly traded debt.”
Treasury regulations finalized in 2012 greatly expanded the category of publicly traded debt. Under Treasury Regulations Section 1.1273-(2)(f), debt will be treated as publicly traded if (i) the outstanding stated principal amount of the issue that includes the debt instrument exceeds $100 million, and (ii) the debt is traded on an established market during the 31-day period ending 15 days after the issue date. An established market does not have to be a formal market. It is sufficient if there are one or more firm quotes or indicative quotes for that debt. Treasury Regulations Section 1.1275-3(f)(4) broadly defines the term “indicative quotes” as follows:

An indicative quote is considered to exist when a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or to subscribers) for property and the price quote is not a firm quote.
In many cases, it will be difficult to determine if debt is publicly traded.

F. Actual or Deemed Debt-for-Debt Exchange

Trap for the Unwary: If a non-publicly traded market discount debt instrument is acquired, and then significantly modified, Holder would generally recognize taxable gain in an amount equal to the excess, if any, of the debt instrument’s stated redemption price at maturity over Holder’s tax basis in the debt instrument.
- The amount realized would reflect the issue price of the new debt instrument, which in turn would reflect the principal amount if it is not publicly traded. See Treasury Regulations Section 1.1001-1(g) and Section 1274. The gain could be reported under the installment method if Holder is not a dealer, but an interest charge for the deferred tax liability may be payable under Section 453A.
- Tax-free Recapitalization under Section 368(a)(1)(E): Taxable gain could be avoided if the issuer is a corporation and the debt constitutes a “security” for tax purposes.
- If the term of the debt is 10 years or more, it would probably qualify as a security; if the term of the debt is less than five years, it would probably not qualify as a security; and if the term of the debt ranges between five and 10 years, the law may be uncertain, but many taxpayers take the reporting position that the debt in such a case constitutes a security.
- Example: Assume that Holder purchases a debt instrument with a face amount of $150 million for a purchase price of $70 million, the debt is not publicly traded and it does not constitute a security for tax purposes. Following the purchase, the terms of the debt are renegotiated and the modification of the debt is deemed significant under Treasury Regulations Section 1.1001-3. Holder recognizes taxable gain in the amount of $80 million ($150 million less $70 million) as a result of the deemed debt-for-debt exchange (in the absence of installment reporting).
If a publicly traded market discount debt instrument is significantly modified, then the deemed debt-for-debt exchange would convert a market discount debt instrument to an OID instrument.
- The amount of OID would reflect the excess of the debt instrument’s stated redemption price at maturity over the fair market value of the debt as of the date of the deemed exchange.
- If the issuer is financially distressed, then query whether Holder could avoid OID accruals pursuant to the DCE, notwithstanding the IRS’s position in TAM 9538007.
An actual or deemed exchange of a non-publicly traded debt instrument will not give rise to OID if the stated redemption price at maturity is not reduced and the interest rate on the debt instrument is at least equal to the applicable federal rate.
If Holder recognizes a taxable loss in connection with an actual or deemed debt-for-debt exchange, the loss may be disallowed if the parties are “related” under Section 267(b).

G. Foreclosures and Deeds-in-Lieu of Foreclosure

Holder will recognize taxable gain to the extent that the fair market value of property acquired in connection with a foreclosure or a deed-in-lieu of foreclosure exceeds Holder’s tax basis in the debt instrument.
- If Holder acquired the debt instrument at a discount, then all or a portion of the gain could be taxable at ordinary income rates pursuant to the market discount rules.
Holder will recognize a taxable loss to the extent that the fair market value of the property is less than Holder’s tax basis in the debt.

H. Non-U.S. Holders

If a nonresident alien individual or a non-U.S. corporation is engaged in a U.S. trade or business, then it is generally subject to U.S. federal income tax on a net income basis with respect to income “effectively connected” with the U.S. trade or business (“ECI”).
- A non-U.S. corporation engaged in a U.S. trade or business could also incur the branch profits tax, subject to applicable U.S. tax treaties.
A non-U.S. person that trades stocks and securities for its own account is not engaged in a U.S. trade or business as a result of such activities pursuant to the safe harbor in Section 864(b)(2).
Loan origination activities conducted by a non-U.S. person do not qualify for the Section 864(b)(2) securities trading safe harbor.
A distressed debt fund that acquires and modifies distressed debt could derive ECI, because the modification of the debt could be deemed loan origination.
Leveraged Blocker Corporation: A non-U.S. Holder could minimize U.S. tax exposure by investing through a leveraged blocker corporation, which is a U.S. corporation capitalized with debt and equity. Interest payments by the blocker, which would be tax deductible, subject to Section 163(j), could be exempt from the U.S. withholding tax pursuant to an applicable tax treaty or the “portfolio interest” exemption. (To qualify for the portfolio interest exemption, the interest must be paid to a foreign person that owns (actually and constructively) less than 10% of the blocker.) Although dividend distributions from the blocker would be subject to the U.S. dividend withholding tax, liquidating distributions would be exempt.
The IRS recently started an audit campaign addressing whether non-U.S. investors are subject to U.S. tax on ECI derived in connection with the acquisition of loans.
A non-U.S. corporation that derives ECI and fails to file a U.S. federal tax return on a “timely” basis may not be allowed to claim deductions and credits. See Section 882(b).
A non-U.S. corporation may consider filing a “protective” federal corporate tax return to preserve its right to claim deductions and credits.
If a non-U.S. Holder does not file a U.S. federal tax return, then no statute of limitations would apply with respect to the potential assessment of a federal tax deficiency.

Part II: Debtor Tax Issues

A. Cancellation of Indebtedness (“COD”) Income vs. Section 1001 Gain

Debt restructurings could generate taxable gain under Section 1001 or COD income. The different tax treatment may depend upon whether the debt is “recourse” or “non-course.”
In some cases, a debtor will have incentives to structure a distressed debt workout to generate Section 1001 gain, rather than COD income, because, except to the extent of depreciation recapture, the Section 1001 gain could be taxable at preferential capital gains rates, while COD income would be taxable at ordinary income rates.
In other cases, a debtor will have incentives to structure a distressed debt workout to generate COD income, rather than Section 1001 gain, because, as discussed below, COD income can sometimes be excluded from gross income.

B. Bankruptcy and Insolvency COD Exclusions

COD income is excluded from gross income if (i) the debt discharge occurs in a title 11 case, or (ii) the taxpayer is insolvent, but only to the extent the taxpayer is insolvent. Section 108(a)(1)(A) and (B).
If the debtor is an entity classified as a partnership for federal tax purposes, the bankruptcy and insolvency COD exclusions apply at the partner, rather than the partnership, level. Thus, if a partnership is insolvent or subject to a title 11 case but a partner is solvent and not subject to a title 11 case, the bankruptcy and insolvency COD exclusions would not apply regarding that partner.

C. Reduction of Tax Attributes

A taxpayer that excludes COD income from gross income in accordance with the bankruptcy or insolvency exceptions is required to reduce its tax attributes by the amount of excluded COD income in the following order: (i) net operating losses; (ii) general business credits; (iii) minimum tax credits; (iv) capital loss carryovers; (v) tax basis in property; (vi) passive activity loss and credit carryovers; and (vii) foreign tax credit carryovers. Section 108(b).

D. Qualified Real Property Business Indebtedness

For a taxpayer other than a C corporation, COD income can be excluded from gross income if the debt discharged is “qualified real property business indebtedness.”
Qualified real property business indebtedness is defined as indebtedness that (i) was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by that property, (ii) was incurred or assumed before January 1, 1993, or if incurred or assumed after that date, is incurred or assumed to acquire, construct, reconstruct, or substantially improve that property, and (iii) for which the taxpayer makes an election. Section 108(c).
COD income excluded from gross income under this exception cannot exceed the excess, if any, of (i) the outstanding principal of the qualified real property business indebtedness immediately before the discharge over (ii) the net fair market value of the real property immediately before the discharge. Section 108(c)(2)(A).
Under a second limitation, the amount of COD income excluded from gross income for qualified real property business indebtedness cannot exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the debt discharge (other than depreciable property acquired in contemplation of the debt discharge). Section 108(c)(2)(B).

E. Purchase Money Debt Reduction

If the debt of a purchaser of property to the seller of that property that arose from the purchase of the property is reduced, the debt reduction could then be treated as a nontaxable purchase price adjustment, which would not give rise to COD income. This COD exclusion is not available, however, if (i) the debtor is bankrupt or insolvent, (ii) the original seller of the property assigned the debt, or (iii) the debtor transferred the purchased property. Section 108(e)(5).

F. Acquisition of Debt by a Third Party

In some cases, a debtor may attempt to avoid COD income by having a “friendly” third party acquire its debt at a discount. If the purchaser is related to the debtor, as defined for purposes of Section 108(e)(4), the acquisition would trigger COD income to the debtor, subject to the exclusions described earlier.
The purchaser and debtor would be deemed related for Section 108(e)(4) purposes if (i) they are related under Section 267(b) or 707(b) (after applying slightly modified family attribution rules), or (ii) they are deemed a single employer under Section 414(b) or (c).

G. Actual or Deemed Debt-for-Debt Exchange

In a debt-for-debt exchange, COD income is computed as if the debtor discharged its existing debt with an amount of money equal to the issue price of the new debt instrument. Section 108(e)(10).
Thus, a debt-for-debt exchange will generally give rise to COD income if the issue price of the new debt instrument, as determined under Sections 1273 and 1274, is less than the adjusted issue price of the old debt, even if there is no reduction in the stated principal amount of the debt.
In the case of publicly traded debt instrument, the issue price is equal to the fair market value of the debt as of the issue date. Section 1273(a)(4).
Thus, assume that a debtor has debt outstanding with a stated principal amount and an adjusted issue price of $120 million, and it issues a new debt instrument with a stated principal amount of $120 million and a fair market value of $70 million (reflecting the debtor’s distressed financial condition) in exchange for its old debt. If the debt is classified as publicly traded, the debtor would realize COD income in the amount of $50 million ($120 million less $70 million) because the issue price of the new debt instrument would reflect its $70 million fair market value as of the issue date. By contrast, if the old and new debt are not classified as publicly traded, the debtor would not realize COD income assuming the interest rate on the new debt is at least equal to the applicable federal rate because the issue price of the new debt instrument would reflect its $120 million stated principal amount.

H. OID

If a debt-for-debt exchange triggers COD income, it would generally give rise to OID as well, in which case, Holder would be required to include OID in gross income as it accrues over the term of the new debt, using the constant yield method, and before receiving cash payments.

I. Applicable High-Yield Debt Obligation

If the debt-for-debt exchange triggers OID and the issuer is a corporation or a partnership in which one or more of the partners in the partnership is a corporation, then all or a portion of the partnership’s interest deduction for the OID could be deferred or disallowed as a result of the “applicable high-yield debt obligation” (“AHYDO”) rules.
An AHYDO is a corporate debt instrument that (i) has a term in excess of five years, (ii) has a yield-to-maturity exceeding the applicable federal rate plus five percentage points, and (iii) has “significant OID.” Section 163(i)(1). A debt instrument is treated as having significant OID if, as of the end of the first accrual period following the fifth anniversary of issuance, an amount greater than one year’s worth of OID can remain unpaid. Section 163(i)(2).
Under the AHYDO rules, no deduction is allowed for the disqualified portion of OID, which generally reflects yield in excess of six percentage points above the applicable federal rate. Section 163(e)(5)(A)(i). The balance of OID is allowed as a deduction, but only when and as paid. Section 163(e)(5)(A)(ii).
Treasury Regulations Section 1.701-2(f), Example 1, treats a partnership as an aggregate of its partners for purposes of applying the AHYDO rules to a debt instrument issued by a partnership. Thus, if a partnership has corporate and non-corporate partners, the AHYDO rules could limit or disallow the interest deduction, but only for the corporate partners.

Tax Issues Arising in Connection with Distressed Debt Transactions