Businesses may be facing long-term economic difficulty due to COVID-19. Many of them will have to work out the terms of existing loans with their lenders, for example to extend the maturity date of a term loan until operations can resume. Although it may be helpful to the debtor to have the liquidity, a debt workout may have unforeseen and unexpectedly expensive tax consequences, so businesses should take them into account before they agree to any changes. That is true whichever of the two basic routes you take.
A restructuring is when you renegotiate the terms of a loan you’re still paying. In essence, you are “renegotiating” your loan. A settlement is when you pay off a loan with less money than the loan balance. Think of debt settlement as the classic “I’ll pay you less, take it or leave it.” If you pay off a debt for less than its adjusted issue price, the difference is cancellation of debt income. That’s taxable income, unless you’re in bankruptcy or insolvent. A restructuring that doesn’t change the loan terms in a significant way isn’t treated as an exchange, and a significant modification of a non-traded debt generally doesn’t create cancellation of debt income if there’s no reduction in principal and the interest rate isn’t below the applicable federal rate.
A Significant Modification
Start with restructuring. For tax purposes, a debtor needs to look at whether a change in an existing loan is significant. If the modification is significant, the old loan is treated as being exchanged for a new loan instrument. If it isn’t significant, the old debt is not treated as exchanged, so there’s less chance of income tax consequences. A modification is significant if the legal rights or obligations are altered and the extent of the alteration is economically significant. There are clear rules for changes in things like interest rates, timing of payments, who has to pay and whether the loan is secured or not. Costs associated with a change in the terms of a debt instrument are considered to affect the interest rate. Two or more modifications to the loan over its life are a significant modification if they would have been significant if combined into a single modification.
For a non-traded debt, the “issue price” is usually the stated face amount of the loan if the stated interest is higher than the applicable federal rate (AFR). Thus, if the interest in a non-traded debt is above the AFR, there is generally little or no cancellation of debt income to the extent there is no reduction in the principal amount of the debt in a significant modification. If the old loan is publicly traded during the 15 days before or after the modification, then the “issue price” of the new one is its market value. If the market value of the old debt is low (maybe because of a downturn) you will realize cancellation of debt income to the extent that the old loan balance (for tax purposes) is higher. Debt counts as publicly traded if there is a reported sales price or a quote from at least one broker, dealer or pricing service. There is a rule that says that as long as your loan is no more than $100 million, it isn’t publicly traded for tax purposes.
If you haven’t filed for bankruptcy or you aren’t insolvent, you will owe taxes on the COD income to the extent you don’t have tax attributes you can use against it, such as net operating losses or tax credits. If you’re in bankruptcy or insolvent, you can exclude the income from taxable income, but must reduce tax attributes like net operating losses and tax credits by the amount of the excluded income. It’s a temporary exclusion and you will owe more taxes in future years.
Changes to the Loan
The changes owners usually ask for each carry their own test. Usually, lengthening the loan’s due date won’t be a significant change if the extension is for the shorter of five years or half the original loan term. If you’re the borrower, it might be smart to try to get an extension that falls within that safe harbor time range. Taking a payment holiday, skipping a principal or interest payment, is a modification. A short holiday might not be enough to make a significant modification all by itself. But if there have been other changes to the loan over time, the payment holiday might turn that loan into a significant modification. If you change the interest rate of the loan, and the gap is bigger than the greater of .25% or 5% of the original rate, that’s likely a significant modification. One point to keep in mind is that a change that would be considered significant if you figured yield the way the tax code says you have to, might not be significant if you figured yield the way you do for financial accounting purposes.
If you want extra cash flow, you may seek to convert some or all of your cash interest payments to payment-in-kind (PIK) interest, where the amount of the loan (the principal) increases by the amount of the interest payment. The debtor must analyze whether this is a significant modification to the timing of payments. Independently, for non-traded debt, a change that makes some part of the principal contingent is likely a significant modification, and because contingent amounts are not part of the issue price, COD income results even if some contingent payments are expected.
If you are struggling to pay your debt, you may enter into a “standstill agreement” with creditors. Such agreements will often result in changes to the loan that qualify as a “significant modification” and, in the case of publicly traded debt, trigger cancellation of debt income. The safe harbor for forbearance of defaults covers only defaults that have already occurred, not those that may occur in the future. Lenders sometimes charge a fee when they change a loan’s covenants, so your accountant should check whether that fee creates a significant modification. Converting debt to equity can also trigger COD income, if your note lets you convert it to stock, and you exercise that right. If that’s so, your COD income would be whatever the debt’s tax-basis balance is over the stock’s FMV.
A Settlement Creates Cancellation of Debt Income
Settlement is more direct. If you repay your own loan for less than its adjusted issue price, you have cancellation of debt income. And if a shareholder or other related party that owns more than 50% of your stock buys your debt for less than that amount, that may be a cancellation of debt income, too. This could happen if your publicly traded debt is selling at historically low prices. Whether that income is taxed turns on the same bankruptcy and insolvency rules described above.
So the choice is not only about which deal lowers the payment. A settlement creates cancellation of debt income on the amount forgiven. A restructuring may create none, or a great deal, depending on whether it is a significant modification, whether the debt is publicly traded, and how the new terms compare with the AFR. Before changing your loan, think both about how you need your business to work and about the tax consequences of the change, both what your cash tax bill will be now and what it will be later. If you plan carefully, you can be sure you’re making the change that leaves you with the most cash in your pocket.
