Debt for Debt Exchange: Tax Consequences

A debt for debt exchange occurs when a borrower and lender agree to alter an existing debt agreement. If the changes are substantial enough, tax law treats the event not as a simple amendment but as a retirement of the old debt and the issuance of a new one. This “deemed” exchange can trigger tax consequences for both the debtor and the creditor, even when no cash changes hands.

The analysis hinges on whether the modifications to the debt’s terms are considered “significant.” If they are not, the existing debt instrument continues from a tax perspective with limited immediate tax implications. If they are significant, both parties must analyze the transaction as a disposition, potentially recognizing income or loss.

Identifying a Deemed Exchange

The trigger for a debt-for-debt exchange is a “significant modification” of the debt instrument’s terms, a concept detailed in Treasury Regulation Section 1.1001-3. The analysis is a two-step process: first, one must determine if a “modification” has occurred, and second, whether that modification is “significant.” A modification is broadly defined as any alteration to a legal right or obligation of the debtor or creditor.

A modification becomes “significant” if the altered legal rights and obligations are economically meaningful. The regulations provide several specific tests to measure significance, including:

• A change in the yield of a debt instrument that varies from the original yield by more than the greater of 25 basis points (0.25%) or 5% of the annual yield of the unmodified instrument.
• A material deferral of scheduled payments that extends for a period longer than the lesser of five years or 50% of the original term of the instrument.
• A change in the obligor on a recourse debt instrument, unless it falls under specific exceptions, such as a change resulting from a corporate reorganization.
• Changes to the collateral or guarantees securing a debt if they represent a substantial change in the credit enhancement or security.
• Altering the fundamental nature of an instrument, such as converting it from debt to an equity interest or from a recourse to a nonrecourse obligation.

Debtor Tax Implications

When a significant modification results in a deemed exchange, the debtor must determine if it has Cancellation of Debt (COD) income, which is a form of taxable ordinary income. It is calculated by taking the adjusted issue price of the old debt and subtracting the issue price of the new debt. The adjusted issue price of the old debt is its original principal amount, increased by any accrued but unpaid interest or original issue discount, and decreased by any principal payments made.

For example, if the old debt had an adjusted issue price of $1 million and the new debt has an issue price of $800,000, the debtor has $200,000 of COD income. Internal Revenue Code Section 108 provides exceptions that may allow a debtor to exclude this COD income. A debtor does not have to recognize COD income if the debt discharge occurs in a Title 11 bankruptcy case or to the extent the debtor is insolvent immediately before the debt cancellation. Insolvency is defined as the excess of a debtor’s total liabilities over the fair market value of its total assets.

Instead of recognizing income, a debtor qualifying for an exclusion must reduce certain tax attributes by filing IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. This reduction defers the tax impact, and attributes are reduced in the following order:

• Net operating losses (NOLs)
• General business credits
• Minimum tax credits
• Capital loss carryovers
• The basis of the debtor’s property

Creditor Tax Implications

From the creditor’s perspective, a significant modification is treated as a disposition of the old debt instrument in exchange for the new one. This transaction requires the creditor to recognize a gain or loss. The amount of the gain or loss is calculated as the difference between the issue price of the new debt received and the creditor’s adjusted tax basis in the old debt.

The creditor’s adjusted basis is the amount they paid for the debt, adjusted for any accrued discount or premium and reduced by any principal payments received. If the debt instrument is a capital asset in the hands of the creditor, the resulting gain or loss is capital. Its character as long-term or short-term depends on how long the creditor held the old debt. If the creditor had previously taken a bad debt deduction, their basis would be lower, leading to a larger gain or smaller loss on the exchange.

If the exchange qualifies as a tax-free recapitalization under corporate tax rules, the treatment changes. For a recapitalization to apply, both the old and new debt instruments must be “securities.” If the transaction qualifies, the creditor does not recognize a loss and may defer recognition of a gain, except to the extent they receive property other than new securities.

Determining the Issue Price of New Debt

The rules for determining the issue price of the new debt are found in Internal Revenue Code Sections 1273 and 1274. The method depends on whether the debt is publicly traded. If either the new debt or the old debt is traded on an established market, the issue price of the new debt is its fair market value as of the exchange date.

If neither the old nor the new debt is publicly traded, the issue price is the debt’s stated principal amount, provided the instrument has adequate stated interest. To have adequate stated interest, the interest rate must be at least equal to the applicable federal rate (AFR), a rate published monthly by the IRS. If the stated interest rate is below the AFR, the issue price must be recalculated by discounting all payments due under the new debt back to the present value using the AFR.

This recalculation can create Original Issue Discount (OID), which arises when a debt’s issue price is less than its stated redemption price at maturity. The debtor can deduct the OID over the life of the loan, while the creditor must include the OID in their taxable income as it accrues.

In certain situations where a new debt instrument has a very high yield, the Applicable High-Yield Debt Obligation (AHYDO) rules under Section 163 may apply. These rules can defer or even permanently disallow a portion of the debtor’s OID deductions. An obligation is an AHYDO if it has a term of more than five years, a yield to maturity that is significantly higher than the AFR, and has significant OID.