Exploring the Unexpected and Often Unwelcome Federal Income Tax Consequences of Debt Modifications

Introduction

As a number of debt instruments issued several years ago in a relatively low interest rate environment now have their maturity date approaching in a much higher interest rate environment, borrowers are increasingly seeking to amend existing debt facilities to extend such maturities as an alternative to refinancing. Some lenders are willing to “amend and extend” their facilities in return for terms such as higher pricing margins, additional fees, and depending on the company’s performance, tightening of certain other terms, such as financial covenants. Each time that a debt instrument is amended—and especially when considering meaningful changes such as extended maturity and changes to pricing and certain covenants—there is the potential to trigger material federal income tax consequences for both lenders and borrowers, primarily hinging upon whether (i) there is a “significant modification”¹ that results in a deemed exchange of the old debt instrument for a new debt instrument (i.e., the modified instrument); and (ii) there is a deemed exchange, whether the debt is considered “publicly traded.”² Many fairly routine modifications to economic terms, such as increasing interest rates, adding a PIK feature, or paying fees, typically result in a significant modification and therefore a deemed exchange. The following is a discussion of certain US federal income tax considerations of which borrowers and lenders should be mindful of in connection with debt restructurings. Given the complexity of these rules, lenders and borrowers should consult with their tax advisers as to the potential ramifications of the modifications they are considering in advance of undertaking any restructuring.  

OID and Other Concerns for Lenders

Two consequences arise for lenders when a change to a debt instrument in a workout is treated as a significant modification: (1) gain or loss could be triggered, and (2) the new instrument could be treated as issued with original issue discount (“OID”). A significant modification results in a deemed exchange of the old debt instrument for a deemed new debt instrument, which may be taxable to the lender to the extent the issue price of the new instrument exceeds the lender’s adjusted tax basis in the instrument unless the exchange qualifies as a “recapitalization” for US federal income tax purposes. Again, the federal income tax consequences depend on whether the old debt instrument or the new debt instrument is treated as “publicly traded” as defined in the Treasury regulations (and as discussed in more detail below). The potential consequences for a lender are best seen by way of example.

Assume that a three-year debt instrument with an outstanding principal amount of $200 million was issued at par on February 1, 2021, pays 5% fixed interest annually, and has a maturity date of February 1, 2024. The debt instrument is modified on February 1, 2023, by raising the interest rate to 8% and extending the maturity date for two years at a time when the debt is actively trading at a 50% discount. As discussed in greater detail below, these amendments would cause a significant modification of the debt instrument. As a result, the old debt instrument with a tax basis of $200 million is treated as exchanged for a new debt instrument with an issue price of $100 million based on the trading price of the debt. Accordingly, a lender of such instrument could have a $100 million loss, which may be a worthless security loss under Section 165 of the Code or a bad debt deduction under Section 166 of the Code, depending on the specific facts and circumstances of the lender.3 In addition, since $100 million is deemed to be the issue price of the instrument under the relevant Treasury regulations, there is $100 million of OID on the new instrument. Unless OID can be treated as de minimis, a US lender of a deemed reissued instrument issued with OID would be required to accrue the $100 million OID as additional interest income over the term of the debt. While a deductible loss can be beneficial, many lenders would rather avoid both the deductible loss and the taxable OID.

If neither the original debt instrument nor the deemed reissued debt instrument were publicly traded, then the old debt instrument with a tax basis of $200 million is treated as exchanged for the $200 million principal amount of the new instrument. Accordingly, a lender would not recognize gain or loss on the deemed reissuance under the foregoing example. 

It is important to note, however, that, unlike in the example above, lenders often have a tax basis less than the face amount of the debt either because the debt was issued at a discount (e.g., because of fees or actual discount) or because such debt was purchased in the secondary market at a discount. If a US lender had acquired the old debt instrument at a discount to its face amount, an amendment resulting in a significant modification could cause the lender to recognize a gain to the extent the US lender’s adjusted tax basis was less than the principal amount, even if the debt is not “publicly traded.”

In addition, lenders may require some incentive to agree to a workout, such as a warrant or other equity in the workout. The tax treatment to the lender depends on whether the debt is modified enough to cause a significant modification, and the value of the warrant or other equity interest. If the warrant or other equity interest has no current value, then there are likely no tax consequences to the lender. To the extent the warrant or other equity interest has value but there is no significant modification of the debt, the lender could be taxed currently on that value. However, if there is a significant modification of the debt, the allocation of a portion of the new debt’s issue price to the warrant or other equity interest likely will cause the new debt to have OID for the lender, even in cases where the old debt instrument was not publicly traded.

If a debt exchange constitutes a tax-free recapitalization, holders of debt securities who receive new securities generally will not recognize gain, subject to limited exceptions, and holders generally may not recognize a loss on the exchange. A deemed or actual exchange of debt can qualify as a tax-free reorganization under Section 368(a)(1)(E) of the Code only if the issuer of the debt is a corporation and the original and modified debt instruments each qualify as a “security” for federal income tax purposes. Although the term “security” is not defined in the Code, stock and debt instruments due more than 10 years from the date of issuance are generally thought to constitute securities. However, the precise limits are unclear and an instrument with an original term of as little as five years may also qualify.

Separately, many non-US entities invest in debt instruments of US issuers. In many cases, care is taken to ensure that such investment activities do not cause a non-US entity to be engaged in a US lending trade or business. If an amendment to a debt instrument is a “significant modification,” the instrument is treated as reissued for federal income tax purposes and treated as newly originated debt, even if the debt instrument is not treated as “publicly traded.” Moreover, to the extent that “fees” are paid in connection with the debt modification, such income may be treated as income from services performed in the United States, which could cause a non-US lender to be treated as engaged in a US trade or business. The question of whether a debt restructuring can result in a non-US entity being treated as engaged in a US trade or business is complex, fact-specific, and not a topic that we delve into here, but as a general matter, frequency and characterization of payments made in connection with the modification as fees may create more risk. 

COD Income and Other Concerns of Borrowers

As a general matter, cancellation of indebtedness (“COD”) income arises if a borrower repurchases its debt for an amount less than the “adjusted issue price” of the outstanding debt. The repurchase can occur through the retirement of debt, the transfer of property such as stock in exchange for the debt, or through the issuance of a new debt instrument. However, whether there has been a discharge of indebtedness is not always as obvious as it appears. The repayment of debt for cash is relatively simple. COD income would be the difference between the adjusted issue price of the debt and the amount of cash used to repay the debt. Similarly, when property is transferred in repayment of debt and the debt is recourse, the debt is treated as repaid for the fair market value of the property transferred in satisfaction of the debt and the borrower would recognize gain or loss on the deemed disposition of the property transferred. In contrast, if property is transferred in connection with the extinguishment of nonrecourse debt, no COD income is recognized, and instead the debtor recognizes gain or loss in an amount equal to the difference between its tax basis in the property transferred and the outstanding amount of the debt. Where many of the complications arise is when debt is repaid with the issuance of a new debt instrument.

The repayment of debt with a new instrument raises two main questions:

• Has a new debt instrument been issued? If there is a “significant modification,” then the answer to that is yes—the old debt instrument is deemed to be exchanged for a new debt instrument. 
• Is there COD income resulting, and if so, how much? If neither the new nor the old debt is considered “publicly traded” and there is no change in principal amount, no COD income is generated, providing for the potential to make changes such as materially reducing the interest rate without giving rise to COD income.⁴ However, if the debt is considered publicly traded, then the old debt instrument is treated as being repaid for an amount equal to the fair market value (ordinarily the sales price or quoted price) of the debt, and the resulting COD income is the difference between such value and the adjusted issue price of the old debt instrument. 

If the debtor is not bankrupt or insolvent when the debt is cancelled, then the COD income is taxable ordinary income to the debtor. However, the debtor can reduce the tax on that income with NOLs from the current year or carried forward from previous years. If, however, the debtor is a corporation and is insolvent or in bankruptcy at the time the COD income is recognized, then some or all of the COD can be excluded from income. Any amount of COD that is excluded from income under the bankruptcy or insolvency exceptions will reduce tax attributes such as any NOLs remaining after those losses are used in the current year and tax basis in assets (subject to certain limits). It is important to note that in the case of partnerships, the bankruptcy and insolvency exceptions are applied at the partner, rather than the partnership, level. Thus, COD income arising from a partnership in bankruptcy will only be excluded if the partner also is in bankruptcy.

It is relatively common for lenders modifying debt to insist on warrants or other equity interests in the borrower as part of the workout package. If the warrants or other equity interests have no value at the time when they are issued, then the COD analysis described above should not change. However, if the warrant or other equity interest has value, then it must be determined how to treat that amount. If there is a significant modification of the debt, then some portion of the new debt instrument would be treated as paid for the warrant or other equity interest (based on the relative fair market values of the debt and warrant/equity). Whether there is COD income on the deemed exchange would depend in part on the adjusted issue price of the new debt and the fair market value of the warrant or other equity interest received.

Although the main focus of the debtor is COD income, the debtor also has to consider other issues that can arise as a result of the significant modification. For example, if the interest rate on the new debt instrument is too high, then the “applicable high yield discount obligation” (“AHYDO”) rules can apply even if those rules did not apply when the original debt was issued. In addition, partnerships have to consider how the reduction in debt will affect the amount of debt allocated to particular partners.

When is Debt Considered Publicly Traded?

 As discussed above, the distinction of whether a debt instrument is publicly traded is pivotal in determining the federal income tax consequences to the parties of a workout that results in a significant modification. A debt instrument is treated as publicly traded if (i) the outstanding principal amount of the issue that includes the debt instrument exceeds $100 million and (ii) at any time during the 31-day period ending 15 days after the issue date (or in the case of a workout that is treated as a significant modification, the deemed reissue date) there is available for the instrument (a) a sales price, (b) a firm quote, or (c) an indicative quote. These rules are generally viewed to cast a wide net in terms of what can cause an instrument to be treated as publicly traded – including, inter alia, private credit loans, despite the term “public.” 

Sales Price: A sales price exists if the price for an executed purchase or sale of the debt instrument is reasonably available within a reasonable period of time after the sale. For this purpose, the price of a debt instrument is considered reasonably available if the sales price appears in a medium that is made available to issuers of debt instruments, persons regularly purchasing or selling debt instruments, or persons brokering purchases or sales of debt instruments (e.g., “Trade Reporting and Comparison Engine” or “TRACE”). 

Firm Quote: A debt instrument has a firm quote where a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or subscribers) for the debt instrument and the quoted price is substantially the same as the price for which the person receiving the quoted price could purchase or sell the instrument (i.e., where the quote functions as a firm quote as a matter of law or industry practice). Note that here, the identity of the person providing the quote must be reasonably ascertainable.

Indicative Quote: A debt instrument has an indicative quote when a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or subscribers) that is not necessarily substantially the same as the price at which the person receiving the quoted price could purchase or sell the instrument. For example, if a debt instrument’s price can be found on a Bloomberg terminal, it likely meets this definition. It often comes as a surprise that indicative quotes are available for debt instruments that are not actively traded based on one or more potential explorations of sale transactions at some point during the period in which a debt instrument is outstanding.

In general, the issuer of a debt instrument makes the determination of whether an instrument is publicly traded.⁵ After making this determination, the issuer must make the information available to holders within 90 days of the issue date of the instrument in a commercially reasonable fashion (which can include electronic publication). The issuer’s determination is generally binding on holders unless such holders disclose the reasoning behind a different determination on their federal income tax return.

When does a “Significant Modification” Occur?

Now that we have discussed why it is so important to determine whether a transaction results in a significant modification, we will discuss in detail when and how this arises so that issuers and lenders have an idea of what could cause a significant modification and how one might structure around this. 

“Modification” is broadly defined in the United States Treasury Regulations as any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise.⁶ A modification can occur from amending the terms of a debt instrument or exchanging one debt instrument for another (including a “deemed exchange”).

An alteration of a legal right or obligation that occurs by operation of the terms of a debt instrument is generally not considered a modification (e.g., an annual resetting of the interest rate based on the value of an index).⁷ However, it’s important to specifically reference the Treasury Regulations, as the foregoing general rule does not apply to certain alterations specified therein. For example, a change in obligor or the addition or deletion of a co-obligor or a change in the nature of the debt instrument (i.e., an alteration that results in a change from recourse to nonrecourse or vice versa), would constitute a modification, whether or not occurring by operation of the terms of a debt instrument.⁸

An alteration that results from the exercise of an option provided to borrower or a lender to change a term of a debt instrument is a modification unless the option is unilateral and, in the case of an option exercisable by a holder, the exercise of the option does not result in a deferral of, or a reduction in, any scheduled payment of interest or principal.⁹ However, if a party to a debt instrument has an option to change a term of the instrument, the failure of the party to exercise that option is not a modification.¹⁰

Under Treasury Regulations Section 1.1001-3(c)(4)(ii), a lender’s agreement to stay collection does not result in a modification (and therefore not a significant modification) unless and until the forbearance period exceeds two years plus any additional period in which the parties are conducting good-faith negotiations. Because this provision is so generous, the mere forbearance by a lender to pursue foreclosure or collection rarely triggers a significant modification. Any forbearance, however, may also involve either an express or implied deferral of any interest or principal payments that are due. It is that deferral that has the potential for triggering a significant modification, as discussed in more detail below.

We have included additional examples of “modifications” that could be treated as significant under the Treasury regulations.

Changes in Interest Rate

 An increase or decrease in the interest rate results in a significant modification if the change in yield of the modified debt exceeds the greater of (i) 25 basis points per year and (ii) 5% of the annual yield on the unmodified debt instrument. The yield of the modified debt is determined by comparing the adjusted issue price of the unmodified debt to the payments that are scheduled to be made on the modified debt from the date of modification.¹¹

For illustrative purposes, consider this example: A five year debt instrument was issued at par on February 1, 2021, for $1,000, and pays 5% fixed interest annually. On February 1, 2023, the parties to the debt instrument agree to increase the 5% annual interest rate to 7%. This will be a significant modification because the 2% increase in yield exceeds the greater of (i) 25 basis points per year and (ii) 5% of the annual yield on the unmodified debt instrument (5% of the annual yield would be 5% of the 5% annual interest rate, which equals 0.25%).

Fees and Equity Kickers 

It is relatively common for lenders modifying debt to insist on being paid fees or receiving warrants or other equity interests in the borrower as part of the workout package, allowing the lenders to share in the upside when things turn around for the borrower. Payment of fees in connection with a modification results in a significant modification if the change in yield is significant under the rule described in the previous section. Similarly, if the lenders receive warrants or other equity of the borrower, the fair market value of the equity is treated as an additional payment received in connection with the modification and should be taken into account in determining whether there is a change in yield giving rise to a significant modification. 

Using the example above, assume the parties agree that the borrower will pay a 2% consent fee. This will be a significant modification because the aggregate 2% increase in yield over three years exceeds the greater of (i) 25 basis points per year and (ii) 0.25% (5% of the annual 5% yield on the unmodified debt instrument). The same result would occur if the borrower instead provided the lenders with equity that had a fair market value equal to 2% of the outstanding principal amount of the debt.

Deferral of Interest

A significant modification occurs if there is a material deferral of interest payments. The materiality of a deferral is generally determined based on the overall facts and circumstances. However, a safe harbor provides that deferrals of payments within a period that begins on the due date of the first payment deferred and ends five years later (or, if a lesser period, 50% of the original term of the debt instrument) will not be a significant modification.¹² Notably, any unused portion of the time limit for deferral periods may be used in respect of a subsequent deferral.

For example, assume a five-year debt instrument pays interest annually at the end of each year. If the first interest payment is deferred until the second interest payment date one year later, the deferral would not be a significant modification because the one-year deferral is less than 30 months (one-half of the original 60-month term). A subsequent payment could be deferred for 18 months without causing a significant modification (the original 30-month deferral term less the 12 months used in the first deferral).

If an interest payment is deferred until some date after the safe harbor period (e.g., at maturity of the debt), whether the deferral is a significant modification will depend on the facts and circumstances such as “the length of the deferral, the original term of the instruments, the amount of the payments that are deferred, and the time period between the modification and the actual deferral of the payments.”¹³

Note that if the deferral is the result of changing a fixed rate of interest into a PIK rate, depending on the economic terms of the debt instrument, there potentially could be a significant modification as the result of a change in yield even if the foregoing safe harbor applies.

Deferral of Principal Amortization; Extension of Maturity Date

Whether a deferral of principal amortization or an extension of maturity is a significant modification is determined by the same safe harbor and “facts-and-circumstances” rules discussed immediately above which are applicable to deferred interest payments. 

Change in Obligor or Security

The substitution of a new obligor on a nonrecourse debt instrument is not a significant modification. Conversely, subject to limited exceptions where there is no change in payment expectations, a substitution of a new obligor on a recourse debt instrument is generally a significant modification.¹⁴ The addition or deletion of a co-obligor on a debt instrument is a significant modification if the addition or deletion of the co-obligor results in a change in payment expectations.¹⁵

For recourse debt instruments, a modification that releases, substitutes, adds, or otherwise alters the collateral for, a guarantee on, or other form of credit enhancement for a recourse debt instrument is a significant modification if the modification results in a change in payment expectations. For nonrecourse debt instruments, a modification that releases, substitutes, adds, or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a nonrecourse debt instrument is a significant modification.¹⁶

Change in the Nature of a Debt Instrument

In general, a change in the nature of a debt instrument from recourse to nonrecourse, or vice versa, is a significant modification. However, a modification that changes a recourse debt instrument to a nonrecourse debt instrument is not a significant modification if the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations. For this purpose, if the original collateral is fungible or otherwise of a type where the particular units pledged are unimportant (e.g., government securities), replacement of some or all units of the original collateral with other units of the same or similar type and aggregate value is not considered a change in the original collateral.¹⁷

A modification of a debt instrument that results in an instrument that is not debt for federal income tax purposes is a significant modification.¹⁸ For purposes of this rule, any deterioration in the financial condition of the obligor between the issue date of the unmodified instrument and the date of modification (as it relates to the obligor’s ability to repay the debt) is not taken into account unless, in connection with the modification, there is a substitution of a new obligor or the addition or deletion of a co-obligor.¹⁹

Changes in Financial and Accounting Covenants 

A modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification.²⁰ This is an important exception, given that most modifications involve multiple changes to the debt covenants.

Looking Ahead

Making modest adjustments to the terms of a debt instrument, even ones that are entirely reasonable in light of the current economic circumstances, can introduce significant and not entirely intuitive federal income tax complexity. There are a variety of ways that lenders can recognize taxable income in circumstances where they do not receive any cash, and borrowers may recognize COD income in situations even if there is no reduction in the outstanding principal amount of the debt. Lenders and borrowers in a debt restructuring need to be mindful when crafting their amendments and need to consult their tax advisers and tax counsel as to the potential ramifications of the alterations they are proposing. 

¹ See Treas. Reg. § 1.1001-3.

² See Treas. Reg. § 1.1273-2(f). As discussed in greater detail in Section IV below, a debt instrument is treated as publicly traded if (i) the outstanding principal amount of the issue that includes the debt instrument exceeds $100 million and (ii) at any time during the 31-day period ending 15 days after the issue date (or in the case of a workout that is treated as a significant modification, the deemed reissue date) there is available for the instrument (a) a sales price, (b) a firm quote, or (c) an indicative quote. Given the breadth of the definition in the Treasury regulations, debt instruments that are not actively traded can often be treated as publicly traded.

³ Note that the character of a worthless security deduction under Section 165 of the Code is capital, and a bad debt deduction under Section 166 is ordinary. The scope of these provisions is beyond the scope of this discussion. 

⁴ Note that any modified interest rate should be at least equal to the applicable federal rate to support characterization of the instrument as debt for US federal income tax purposes. If the instrument were to be recharacterized as equity, the tax treatment could differ.  

⁵ See Treas. Reg. § 1.1273-2(f)(9).

⁶ Treas. Reg. § 1.1001-3(c)(1)(i).

⁷ Treas. Reg. § 1.1001-3(c)(1)(ii).

⁸ Treas. Reg. § 1.1001-3(c)(2)(i). 

⁹ Treas. Reg. § 1.1001-3(c)(2)(iii).

¹⁰ Treas. Reg. § 1.1001-3(c)(5).

¹¹ Treas. Reg. § 1.1001-3(e)(2).

¹² Treas. Reg. § 1.1001-3(e)(3).

¹³ Id.

¹⁴ Treas. Reg. § 1.1001-3(e)(4)(i).

¹⁵ Treas. Reg. § 1.1001-3(e)(4)(iii).

¹⁶ Treas. Reg. § 1.1001-3(e)(4)(iv).

¹⁷ Treas. Reg. § 1.1001-3(e)(5)(ii).

¹⁸ Treas. Reg. § 1.1001-3(e)(5)(i).

¹⁹ Treas. Reg. § 1.1001-3(f)(7).

²⁰ Treas. Reg. § 1.1001-3(e)(6).