Due to the current state of the credit and bond markets, many investors are being presented with opportunities to acquire debt obligations from lenders at significant discounts. These opportunities are increasingly being capitalized upon not only by current borrowers, who are taking advantage of opportunities to redeem their own debt at a significant discount, but also by unrelated investors who are raising funds to acquire third-party distressed debt, often with an eye towards ultimately securing ownership of the underlying collateral. These transactions are attractive because they have the potential to create significant investment returns with relatively low risk due to the superior capital structure position. However, the tax consequences associated with these types of transactions are very complex and often counterintuitive. This alert will highlight some of the more significant tax issues that arise in connection with these types of market transactions.
Related Party Purchases Can Trigger Phantom Tax for Both the Borrower and Investor
It is a fairly well known principal of the tax law that a borrower who repurchases or retires debt for an amount less than the amounts owing on the debt will be required to recognized cancellation of indebtedness (COD) income for tax purposes. What is perhaps not as well known, however, is that a borrower can be required to recognize COD income even in certain circumstances where the full amount of the debt remains owing. For example, if an investor who is “related” to the borrower acquires debt from the lender at a discount, then even though the full amount of indebtedness is still owing, the acquisition also will generally trigger taxable COD income to the borrower in an amount equal to the discount. The critical issue here is whether the investor is related to the borrower.1
The tax code has very detailed rules (including complex and broad “constructive” ownership and attribution rules) that define related parties for this purpose. Generally speaking, an investor entity that purchases the debt will be treated as related to the borrowing entity if the investor entity owns (or is treated as owning) more than 50 percent of the borrowing entity or the same persons own (or are treated as owning), directly or indirectly, more than 50 percent of both the purchasing entity and the borrower entity.
In addition to the potential negative income tax consequences to the borrower as described above, if a related investor purchases debt at a discount under circumstances that trigger COD income to the borrower, the tax law requires the investor to include the “discount” into income as interest over the remaining term of the debt (so-called “original issue discount”) thereby creating potential phantom taxable income to the investor. In other words, if the debt instrument has a face amount of $10 million and a related-party investor purchases the debt from the lender for $7 million, the $3 million of discount is required to be included in taxable income to the investor as phantom-interest income over the remaining term of the debt, regardless of whether it is actually paid. In order to avoid double taxation in this circumstance, the borrower receives a concomitant tax deduction for the same amounts. Please see Foley’s March 20, 2009 Real Estate Tax Strategies alert at www.foley.com/publications/pub_detail.aspx?pubid=5853 for a more comprehensive discussion.
Tax Strategies. First and foremost, if the borrow encounters an opportunity to acquire a debt instrument at a discount, the borrower will not escape the recognition of COD income merely by acquiring the debt instrument using a related-party investor. However, the tax law has several possible exceptions that, if applicable, might allow the borrower to either totally exclude this COD income from tax or defer it to future years. These exceptions are fairly limited, very complex, and require an analysis of the exact facts and circumstances surrounding the transaction to determine the extent to which they apply. In addition, for COD income occurring in 2009 or 2010, newly enacted Section 108(i) of the tax code may, if applicable, allow the borrower to elect to defer the recognition of this COD income until 2014 – 2018.
Unrelated Purchases — Additional Phantom Tax for Investors Triggered by Debt Modifications
Perhaps the most surprising tax consequences associated with a purchase of a debt instrument at a discount are those associated with a significant modification of the debt. Under the tax law, if an outstanding debt instrument is acquired at a discount by an investor who is unrelated to the borrower, and the debt is thereafter “significantly modified,” the investor is deemed, for tax purposes, to have exchanged the “old” note for a “new” note containing the modified terms. For non-publicly traded notes, this “deemed” exchange will (under the general rules) create taxable gain or loss to the investor based on the difference between the face amount of the modified note and the investor’s tax basis in the original note.
To illustrate how these rules would operate, assume that an investment fund purchases a non-publicly traded note with a $15 million face amount for $10 million (i.e., a $5 million discount) and then shortly thereafter enters into various modifications of the note with the borrower (perhaps extending the maturity, reducing interest, increase collateral, and so forth). If these modifications are deemed to be “significant,” then for tax purposes, the investment fund will be deemed as having exchanged the original note for a brand-new note containing the modified terms. The investment fund would then be required to recognize a short-term capital gain equal to $5 million in this example, which is measured by excess of the face amount of the “new” note ($15 million) over the investment fund’s tax basis in the “old” note ($10 million). This is pure phantom taxable income that certainly does not have any basis in economic reality.
Tax Strategies. For private debt, this result can sometimes be avoided by entering into the modifications prior to the time the debt is purchased at a discount by the investment fund. However, this is not always practical. In cases where the amendments cannot be consummated prior to the purchase, the investment fund might be able to mitigate this phantom tax liability through use of the installment method of reporting tax gains under the tax code (although this method has limitations).
Market Discount Rules Create Ordinary Income for Investors
For investors who purchase debt instruments at a discount without making significant modifications, a different set of tax rules come into play. These rules are known as the “market discount” rules.
In general, the purchase of debt in the secondary market at a discount by an unrelated third party creates what is known in the tax code as “market discount” in an amount equal to the discount. For tax purposes, the market discount will accrue over the remaining term of the debt pursuant to a formula and then is required to be recognized as ordinary income (rather than capital gains) upon redemption or disposition of the note.2 For example, if an investor purchases a $15 million face amount note in the secondary market for $10 million and then holds the note to maturity and collects the full $15 million, the $5 million “accrued” market discount will be taxable as ordinary income rather than as capital gains. Moreover, partial principal payments that are made prior to maturity can often accelerate the recognition of this ordinary income for the investor.
These market discount rules are very broad and apply to most types of discount debt transactions in the secondary market. However, for distressed debt that perhaps is even in default (and thus immediately due and payable) at the time of the investor’s purchase in the secondary market, there are some arguments that the market discount rules of the tax code do not apply. Accordingly, investors in these types of instruments (i.e., distressed, deeply discounted, and/or perhaps in default) may have an argument to support a position that some or all of their gains from such transactions can be reported as capital gains. The strength of this position and/or advisability of taking such a position in any given transaction will depend on the exact facts and circumstances surrounding the investment.
Phantom Tax Issues to Creditor From Foreclosures
Many investments in distressed debt are made by an investor with an eye towards obtaining ownership of the collateral securing the loan. These types of “loan to own” transactions also can give rise to phantom tax liabilities. Very generally speaking, the investor will recognize taxable income to the extent that the fair market value of the property received exceeds the creditor’s tax basis in the debt, and the investor will recognize a taxable loss to the extent the value of the property received is less than the creditor’s tax basis in the debt. In any event, the investor will take the property with a tax basis that is equal to the fair market value of the property as of that time. For example, if an investor purchases a debt instrument with a face amount of $10 million for $5 million and then shortly thereafter obtains ownership of the underlying collateral (either through deed in lieu or foreclosure, and so forth) in full satisfaction of the debt at a time when the value of the collateral is $7 million, the investor will recognize $2 million of taxable income as of that time.
Tax Issues for Foreign Investors
Special tax issues apply in transactions involving non-U.S. investors, including potential withholding taxes and/or U.S. tax return filing requirements for such non-U.S. investors. Investment funds that are taxed as “partnerships” and that have non-U.S. investors as partners need to analyze these rules carefully as these withholding tax obligations and/or reporting obligations also can be imposed upon the investment fund.
Interest income, for example, from a debt issued by a U.S. borrower can be subject to 30-percent withholding taxes to the extent allocable to non-U.S. persons. Certain exemptions are available under the U.S. tax law (most notably the “portfolio” interest exemption) for transactions that qualify and that are otherwise structured properly. In addition, there is some concern under the tax law that a foreign investment fund that purchases distressed debt and restructures such debt may be deemed to be engaged in a “U.S. trade or business” for tax purposes, thereby subjecting any non-U.S. partners in the investment fund to U.S. regular income tax obligations and return filing requirements, and also potentially to an additional layer of taxation known as the “branch profits” tax (applicable to foreign corporations). Finally, an investment fund that forecloses upon or otherwise takes title to a U.S. real estate asset also can subject non-U.S. investors to these same adverse tax consequences (namely, regular income tax, plus reporting, plus possibly branch profits, and so forth). In each case, these obligations of the non-U.S. partner also are often an obligation of the U.S. investment fund through mandatory withholding obligations. These are all issues that should be carefully analyzed and managed by any U.S. investment fund with non-U.S. participants.
1 This can often arise, for example, when a private equity fund purchases from the lender a promissory note that has been issued by one of the fund’s portfolio companies. If the investment fund is related to the underlying borrower through stock or other ownership, the COD income and other issues described above come into play.
2 Alternatively, the debt holder is permitted to elect to include the market discount into taxable income over the remaining term of the debt as it accrues (and regardless of whether paid).
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.
If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:
Peter J. Elias
San Diego, California
Van A. Tengberg
San Diego, California
Adam B. O’Farrell
San Diego, California
Internal Revenue Service regulations generally require that, for purposes of avoiding United States federal tax penalties, a taxpayer may only rely on formal written opinions meeting specific requirements described in those regulations. This newsletter does not meet those requirements. To the extent this newsletter contains written information relating to United States federal tax issues, the written information is not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal tax penalties, and it was not written to support the promotion or marketing of any transaction or matter discussed in the newsletter.