Focus on Finance: Debt Restructuring Under the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (TCJA) has far-reaching implications for the banking and finance industry. In our last installment, we noted certain issues that troubled companies might consider when restructuring debt – namely, whether to exchange equity for debt in light of the new rules limiting deductions on payments of interest to an amount generally equal to the sum of business interest income and 30% of adjusted gross income (Interest Deduction Limit).
A debt for equity exchange, like most restructurings, raises many tax issues. One of the biggest concerns when restructuring a company’s debt is the likelihood of cancellation of indebtedness income (COD income). Generally, when debt is forgiven or reduced, borrowers are taxed on the amount of debt from which they are relieved (or deemed to be relieved). Special rules subject debtors to COD income even where debt is not actually forgiven, such as when the debt is publicly traded (or so treated for tax purposes) at a discount and undergoes a “significant modification” or where a person “related” to the borrower for tax purposes acquires the debt at a discount. Historically, troubled borrowers could rely on two things: (1) large net operating loss (NOL) carryovers to shield taxable COD income and (2) an exclusion of COD income from taxable income for a debtor who is (a) the debtor in a bankruptcy case or (b) insolvent (but only to the extent the debtor’s liabilities exceed its assets). Where the COD income is excluded, such exclusion comes at the cost of reducing certain attributes of the debtor, notably NOLs and depreciable tax basis. NOLs are reduced first unless an election is made to first reduce tax basis.
As a result of the TCJA, corporations generally will be limited in their ability to utilize NOL carryovers to 80% of current year taxable income, and carrybacks are eliminated. This limit is a particularly salient issue for a taxpayer who neither is in bankruptcy nor sufficiently insolvent to fully exclude COD income. If the taxpayer has (noncash) taxable income from cancellation of debt and insufficient current year losses to shield such income, it could have tax for the year of the restructuring as a result of no longer having a full NOL carryover – and no related cash with which to pay it. Note that the 80% limit and carryover repeal applies to losses arising in taxable years beginning in 2018 and later years, so restructurings in 2018 should not be impacted.
The TCJA also may affect the availability and ordering of basis reduction under the excluded COD rules. As we noted in our last alert, the corporate tax rate has been reduced to 21%, and the tax rate on the specified income of certain partnerships and other pass-through entities also effectively is reduced due to a “deduction” for qualifying income. Also, a new provision allows businesses to immediately deduct the full cost of new and used property placed into service between September 27, 2017 and (generally) January 1, 2023, at which point the percentage that may be expensed begins to be phased down through January 1, 2027. The lower rates and immediate expensing rules raise new issues for a potentially insolvent or bankrupt debtor that may have to reduce depreciable basis. First, the value of tax basis may be lower where the value of depreciation deductions is limited – such as by a lower tax rate, which generally reduces the value of tax benefits such as deductions and credits. Second, basis itself may be lower in the first instance, because immediately expensed amounts immediately are deducted from basis, as opposed to prior law, where the purchase price for assets generally was included in basis with depreciation spread out over prescribed periods (but subject to bonus depreciation rules; see here for more information. Debtors can choose to reduce depreciable basis first to preserve NOL carryforwards, which could be a better choice if basis is less valuable in light of the foregoing. However, NOL carryforwards also are potentially less valuable since the 80% limit is applied against taxable income, which a troubled borrower may lack for a period of time. These new considerations may play out differently based on each debtor’s facts – such as relative size of tax attributes and income projections – but these changes certainly have the potential to impact a company’s COD analysis and related restructuring decisions.
The indefinite carryover of interest not currently deductible due to the Interest Deduction Limit also impacts the COD analysis. Generally, there is no COD income recognized to the extent the payment of a liability would have given rise to a deduction. If one looks to the year in which the debt is restructured or forgiven – which the exception does not specifically require – it may be concluded that this exception applies only to the extent that the interest is deductible in the year after the Interest Deduction Limit is applied. However, with an indefinite carryover, it is reasonable to take the position that the interest could be deductible in the future and thus any unpaid interest should continue to be excluded from COD income. To the extent this issue remains unclear, it could impact the ability of debtors to restructure. Of course, accrued and unpaid interest should continue to be ineligible for the exception for accrual method taxpayers to the extent the interest already has been deducted.
The carryover also has business implications for outstanding debt where an issuer may consider an early call in light of the restricted ability to deduct interest currently. Both publicly issued and privately placed debt may provide for the right to redeem the notes by the issuer if, as a result of a change in law, the interest on the notes no longer is deductible. The carryforward, which by its terms is unlimited, could be read as a deferral of the interest deduction for any given taxable year. As a result, to the extent a right to redeem is triggered only by a disallowance of the deduction, there is a position that the issuer does not have the right to redeem. However, given the possible materiality of losing a substantial portion of a current interest deduction without any certainty as to when, if ever, the interest will be deducted, the issuer reasonably could determine that the right to redeem is triggered. This particularly could be the case for an issuer who is not projected to have significant taxable income and for whom the Interest Deduction Limit is a materially adverse limit for the foreseeable future.