Restructuring and Repurchasing Distressed Debt: Risks and Opportunities for Borrowers

Todd Hatcher, Esq.
Published Date:
Sep 1, 2020

Amid an almost unprecedented (in the modern era) pandemic, debt restructuring and workout transactions are accelerating. Similarly, dislocations in the debt markets have presented and continue to present opportunities for relatively well-situated borrowers or their affiliates to capitalize on substantial discounts. These transactions can have significant federal and state income tax implications, including cancellation of debt (COD) income that may exacerbate (or create) financial distress for a corporate borrower or the owners of a flow-through entity.

This article discusses certain federal income tax ramifications of modifying debt instruments or repurchasing debt in secondary markets, as well as related planning techniques.

Amendments to Debt Instruments May Cause COD Income

Pursuant to Treasury regulations governing modifications of debt instruments, many common amendments to existing debt instruments (e.g., change in interest rate, reduction of principal, extension of maturity date, or deferral of interest payments) will cause a deemed exchange of the old debt instrument for a deemed new debt instrument.

The applicable rules are generally intended to result in a deemed exchange whenever an economically significant modification has taken place. Fortunately, several bright-line tests provide a fair measure of certainty in most cases. For example, changes in yield that exceed the greater of 25 basis points and 5% of the annual yield on the unmodified debt instrument will result in a deemed exchange.

If a modification of a debt instrument is a “significant modification” pursuant to the applicable Treasury regulations, the federal income tax consequences of the deemed exchange are generally determined by comparing the issue price of the new debt instrument to the adjusted issue price of the old debt instrument. Generally, the adjusted issue price of a debt instrument is the original issue price, plus the amount of any accrued original issue discount (OID), minus the amount of payments previously made on the debt instrument other than qualified stated interest.

If the new debt instrument’s issue price is less than the old debt instrument’s adjusted issue price, the transaction is treated as if the old debt instrument were satisfied at a discount, and the discount is generally COD income. In today’s climate, publicly traded debt instruments trading at a significant discount to par may have a deemed new issue price based on the depressed trading price. Thus, the borrower could have a significant amount of COD income.

An amendment resulting in a deemed exchange may have other collateral consequences, particularly for lenders who may have a taxable gain on such deemed exchange. Other potential issues include—

  • the conversion of market discount into OID, which can result in “phantom” income for lenders,
  • potential new or increased limitations on borrower deductions for interest and unamortized debt issuance costs, and
  • lack of fungibility (i.e., the ability to trade interchangeably) of the deemed new debt instrument with other unmodified debt instruments from the same issuance (if any), which may impact trading liquidity.

COD Income and the Bankruptcy and Insolvency Exclusions

COD income is included in the borrower’s gross income, unless a specific exclusion applies. In a distressed environment, many borrowers may seek to rely on the applicable bankruptcy and insolvency exclusions.

The bankruptcy exclusion applies to the extent the COD income occurs in a Title 11 case, and the discharge is granted by the bankruptcy court or pursuant to a bankruptcy plan approved by the court. The insolvency exclusion applies to the extent the borrower is insolvent, measured by reference to the excess of the liabilities of the borrower over the fair market value of the borrower’s assets immediately before the applicable discharge, whether or not the borrower is in bankruptcy.

The bankruptcy and insolvency exclusions allow borrowers to exclude COD income from gross income, but this comes at the cost of tax attribute reduction, including net operating losses (NOL), certain tax credits, and asset basis. Notably, the determination of the tax attributes subject to reduction is generally made after determining the borrower’s tax for the tax year of the COD income event.

As a result, borrowers that have or expect to have NOLs eligible for the expanded five-year carryback under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) may be able to utilize such NOLs to obtain a refund with respect to prior tax years (rather than losing such NOLs through tax attribute reduction), while still benefiting from applicable COD income exclusions.

In addition, the tax attribute reduction described above is generally limited: the tax basis of the borrower is not reduced below the liabilities of the borrower immediately after the COD income event (the so-called liability floor). As a result, in some cases, the quantum of the tax attribute reduction may be less (sometimes significantly less) than the excluded COD income.

This excess COD income that’s excluded but doesn’t reduce tax attributes is referred to as “black hole” COD income and represents a permanent benefit to the borrower when available. The incurrence of black hole COD income in the context of consolidated groups of corporations can create special problems and should be carefully evaluated.

COD Income Issues for Insolvent Partnerships

Debt restructurings and workouts involving borrowers taxed as partnerships for federal income tax purposes present special COD income concerns. Tax partnerships (including LLCs that haven’t elected to be taxed as corporations for federal income tax purposes) are generally not subject to entity-level federal income taxes. Instead, the partners of the applicable partnership are taxed on their distributive share of the partnership’s taxable income on a flow-through basis.

In addition, for purposes of the exclusions discussed above, insolvency and bankruptcy are measured at the partner level rather than at the partnership level. Therefore, COD income incurred by an insolvent or bankrupt partnership will not be excluded from taxable income by the partners unless the partners themselves satisfy the insolvency or bankruptcy requirements.

As a result, a partnership facing financial difficulties may want to consider—ideally well in advance of any debt restructuring—converting from a partnership to a corporation for federal income tax purposes. Any such conversion effectuated via a “check the box” election or an actual state law conversion or merger would present complicated issues and should be carefully evaluated for tax and nontax risks.

For example, the transaction itself may be taxable to the partners if the liabilities of the partnership exceed its tax basis in assets, could result in a step-down in tax basis in assets if there’s an aggregate built-in loss in the partnership’s assets, and may be subject to challenge by the IRS under a special antiabuse rule or by applying substance over form principles.

Purchase or Refinance of Debt at a Discount

In light of depressed debt trading prices—

  • borrowers may consider repurchasing their outstanding debt in secondary market transactions or refinancing debt at a discount, and
  • private equity firms or their affiliates may consider purchasing discounted debt of their portfolio companies as an investment or for deleveraging.

These transactions can have significant tax consequences for the applicable borrower/portfolio company and should be carefully analyzed.

If a portfolio company repurchases its own debt for less than the amount owed, subject to the exclusions discussed above, it will generally recognize COD income equal to the difference between the adjusted issue price and the repurchase or refinancing price of the debt. To the extent the portfolio company has or expects to have NOLs or can otherwise exclude such COD income through the applicable COD income bankruptcy or insolvency exclusions, the cash tax impact from the COD income inclusion may be mitigated.

Taxpayers should carefully consider the timing of any such transaction in light of the expanded ability to carryback NOLs under the CARES Act and the 80% limitation on the utilization of carryover NOLs (generally suspended by the CARES Act for 2018, 2019, and 2020, but returning in 2021).

Similarly, the acquisition of portfolio company debt by a related party of the borrower (e.g., the investment fund that owns the portfolio company or an affiliate of the borrower’s private equity sponsor, potentially including another investment fund of the sponsor) generally would be treated as if the portfolio company had repurchased its own debt at a discount and issued a new debt instrument with an issue price equal to the purchase price paid by the related party. This transaction would generate COD income to the portfolio company, as described in the paragraph above.

Additionally, the discount on the new debt instrument would constitute OID that is required to be included as “phantom” income by the related party as it accrues over the remaining term of the debt instrument. The portfolio company and the related party could be subject to other adverse consequences (e.g., the new debt instrument may no longer be fungible with the remaining debt in the original issue, and there may be new or increased limitations on borrower deductions for interest and unamortized debt issuance costs on the new debt instrument).

For this purpose, a related party is generally one that’s related by more than 50% overlapping beneficial ownership; however, the applicable attribution rules are complex. In certain circumstances, a portfolio company debt acquisition may be structured in a manner that doesn’t trigger the related party debt acquisition rules, even if there’s substantial overlapping beneficial ownership.

Any such planning needs to be tailored to the applicable situation to address interest deductibility on debt owed to a related party, withholding concerns on debt owed to foreigners, and other issues that may arise.

Todd Hatcher, Esq., is a partner in the transactional tax planning department of Katten Muchin Rosenman LLP. His practice focuses on the U.S. federal income tax law aspects of transactional matters, including representing publicly traded and privately held companies in both domestic and cross-border merger and acquisition transactions, negotiating private equity fund agreements and operating partnership agreements, negotiating credit and financing agreements, reviewing capital market debt and equity offering materials, and planning bankruptcy and insolvency restructurings. He can be reached at 212-940-6506 or via email at

Note: This article is adapted from a Katten Muchin Rosenman, LLP client advisory entitled “Tax Implications of Debt Restructuring and Workouts During Difficult Times,” published Apr. 27, 2020. Accordingly, the author is indebted to, and thankful for the efforts of, the attorneys who participated in the drafting of the original advisory: Saul Rudo, Valentina Famparska, Brandon D. Hadley, Matthew J. Hubenschmidt, Jeffrey Ng, and Mitchell Fagen. Any errors or omissions in this article are the author’s own. The views expressed in this article are solely those of the author, are not to be attributed to any other person, and are not to be construed as legal advice or opinion of any kind.

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