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Debt restructuring alternatives for the financially troubled corporation: possible risks and benefits.

Many companies currently find themselves in serious financial trouble because of the so-called "rolling recession" that has plagued the United States for most of the 1980s and the broader recession that has existed for the last few years. It is not uncommon for companies to be burdened with large amounts of debt that were taken on in better times. With the economy now showing some signs of recovery, the debt service payments on these borrowings can at best make the turnaround of the troubled company slower and more difficult and, at worst, ma threaten to take the company's survival.

Creditors, already faced with numerous delinquent loans, may be willing to reorganize the debt to enable the company to survive in some form and be able to repay at least a part of the debt. Tax executives charged with advising management on the most advantageous manner in which a company can restructure debt are faced with a complex system of laws concerning the recognition of cancellation of debt income (CODI). Several proposed changes to the tax laws have made it more difficult to restructure debt while avoiding either giving up too much control of the company or recognizing CODI.

This article briefly discusses the tax rules concerning debt restructuring and analyzes alternative forms that a debt restructuring might take. This analysis includes a summary of the advantages and disadvantages of each alternative, including the possible risk involved concerning the tax treatment of each alternative. (See Exhibit 1.) Specifically discussed are the rules for recognition of CODI and tax attribute carryover (TAC) reduction under section 108 of the Internal Revenue Code, as well as the rules restricting the use of Net Operating Losses (NOLs) in future years under section 382. Developments in the area of debt restructuring are also outlined and evaluated. The overall focus of this article is on the rules applicable to solvent and insolvent companies that are not in bankruptcy; special rules that apply to companies in bankruptcy are beyond the scope of this article.

APPLICABLE RULES UNDER SECTIONS 108

AND 382

The major tax aspects of a troubled debt restructuring that the financially troubled company should consider include:

* the possibility that section 382 will impose restrictions

on the availability of NOL carryovers in the

event of an "ownership change,"(1)

* the possibility of having to recognize CODI,(2) or, in

lieu of the recognition of CODI,

* the possibility of being forced to reduce certain TACS

(listed in the order in which they generally must be

reduced) such as NOL carryovers,(3)

general business credit

carryovers,(4) capital loss carryover

overs,(5) the bases of assets,(6) or foreign

tax credit carryovers.(7)

Section 382 restricts the availability of NOL carryovers in the event of a "change in ownership" of a corporation. A "change in ownership" occurs when there is a shift in ownership of more than 50 percent among five-percent shareholders within a three-year period.(8) A five-percent shareholder is any person holding five percent or more of the stock at any time during this three-year period.(9) If an ownership change occurs, the amount of NOL carryforward deductible each year is generally limited to the product of the value of the loss corporation multiplied by the longterm tax-exempt rate.(10)

Of course, if the stock of the corporation involved has a relatively large fair market value (FMV), the NOL deduction allowed under section 382 each year in the future can still be quite large. In addition, the annual unused NOL limitation accumulates and carries forward to succeeding years;(11) hence, if the loss corporation expects to endure a few more years of losses before generating income, the limit may never actually come into play. For the corporation with a small FMV and a large NOL carryover, however, the section 382 limitation can significantly reduce the present value of the tax benefits of the NOL carryforward. Exhibit 2 illustrates these provisions.

In general, section 108 requires a solvent corporation that is not in bankruptcy or is not being relieved of qualified farm indebtedness"(12) to include CODI in taxable income. If, on the other hand, the corporation is insolvent, it will reduce the amounts of various TACs in the order stated above.(13) The TACs can only be reduced, however, up to the amount of insolvency, and any excess of debt forgiveness above the amount of insolvency must be recognized as income.(14) For example, if a company's assets have a FMV of $25 million and these assets are encumbered with $35 million of debt, then the company would be insolvent in the amount of $10 million and any debt forgiveness in excess of $10,000,000 would require CODI recognition.

Special rules can apply if stock of the debtor is issued in exchange for the debt. If stock is issued in exchange for debt, a corporation is generally deemed to have satisfied the debt with an amount of money equal to the FMV of the stock exchanged.(15) Where the corporation is solvent, this generally means that the corporation would have CODI equal to the difference between the face value of the debt transferred and the FMV of the stock exchanged. There is an exception to this treatment for insolvent taxpayers.(16) Insolvent taxpayers who exchange stock for debt are not required to recognize CODI or reduce TACS, but this exclusion only applies to the extent the corporation is insolvent. To the extent that CODI exceeds the amount of insolvency, it must be recognized. This stock-for-debt exception only applies if the stock exchanged is not "disqualified stock."(17) Disqualified stock is defined as stock with a stated redemption price if (1) there is a fixed redemption date, (2) the issuer has a right of redemption at one or more times, or (3) the holder has a right of redemption at one or more times.(18)

In order to avoid the recognition of CODI or the reduction of TACS under the stock-for-debt exception, the stock exchanged must also not be "nominal or token."19 Some taxpayers have argued that the determination of whether shares are nominal or not should be based on the ratio of the FMV of the stock transferred to the FMV of the debt exchanged. The IRS, however, has taken a somewhat different view in Prop. Reg. SS 1.108-1, which was published in the Federal Register on December 6, 1990. The regulations provide that the "nominal or token" determination depends on the facts and circumstances as they relate to three tests. The first and most important of these tests turns on the ratio of (1) the FMV of the stock transferred to (2) the principal amount of the debt exchanged - the "Stock to Debt Ratio."(20) If this ratio is low, it is deemed to be evidence that the shares are nominal or token. This test, in and of itself, seems to be the most stringent test of the three since the stock that is swapped by an insolvent corporation may or may not have a FMV high enough to qualify for the stock-for-debt exception. Thus, if the corporation in question remains insolvent after the stock-for-partial-debt swap occurs, the stock exchanged would probably have a very low value. The Stock to Debt Ratio would therefore also be very low, and a strict application of this test might result in the shares being deemed to be "nominal or token."

The reliance of this first test on the Stock to Debt Ratio follows the IRS position taken in Technical Advice Memorandum (TAM) 8837001.(21) This TAM concluded that the taxpayer satisfied the nominal value test where a creditor received stock in return for his debt and the FMV of the stock constituted approximately 10 percent of the stated value of the debt being exchanged for the stock and 15 percent of the total consideration received by the debtor. Although TAM 8837001 involves a Stock to Debt Ratio of 10 percent, neither section 108 nor its legislative history supports any particular "safe harbor" ratio of stock to debt in determining if stock should be considered token or nominal.

The second test in the proposed regulations looks to the ratio of (1) the FMV of the stock received by a creditor to (2) the FMV of the total consideration received by that creditor in a stock-for-debt exchange - the "Stock to Total Consideration Ratio."(22) If this ratio is low, the stock transferred is deemed to be nominal or token. This test was designed to prohibit taxpayers from obtaining exception to CODI recognition simply by adding a few shares of stock to a debt restructure without changing the underlying economics of the transaction. Recall that TAM 8837001 provided that stock would not be nominal or token if it exceeds 10 percent of debt canceled and 15 percent of total consideration received by the debtor. Accordingly, it could reasonably be anticipated that the IRS may not accept a stock-to-total-consideration ratio of less than 15 percent in order for this test regarding nominal or token shares to be satisfied.

The third test in the proposed regulations relies on the ratio of (1) the FMV of the stock issued to the creditors as a group to (2) the total FMV of the outstanding stock after the bankruptcy reorganization or insolvency workout - the "Stock to Total Stock Ratio."(12) This ratio is used because of the likelihood that, if the FMV of the stock issued to the creditors as a group is low compared with the FMV of all of the debtor corporation's outstanding stock, then the creditors really are not receiving an equity interest. Therefore, the stock transferred is deemed to be nominal or token.

The preamble to the proposed regulations contains several "safe harbor" combinations of ratios that the IRS is considering making effective through the issuance of a revenue procedure or other appropriate publication:(24)

* 10-percent Stock to Debt Ratio and 25-percent Stock

to Total Consideration Ratio,

* 25-percent Stock to Total Consideration Ratio and

25-percent Stock to Total Stock Ratio, or

* with respect to unsecured creditors, 100-percent

Stock to Total Consideration Ratio and 90-percent

Stock to Total Stock Ratio.

Ironically, the effect of the proposed regulations is to make it more unlikely that companies most needing the stock-for-debt exception (those that are most insolvent) will qualify for it. The more insolvent a corporation is, the lower will be the FMV of its stock, which will in turn make it harder for the corporation to meet any of the tests where the value of the stock exchanged must be relatively large.

HYPOTHETICAL SCENARIO

The facts in actual cases of financially troubled firms vary from case to case, but the following scenario is fairly typical. Corporation X was once a successful and profitable corporation. Corporation X has a good product line and has grown to a fairly large size. Its product, experienced personnel, and long-term relationships with several large clients allow X to compete in its market effectively. In recent years, however, the weakening of the economy has caused X to suffer significant losses. As the economy has slowed, X's commitment with respect to fixed expenses has made a continual weakening of X's financial position unavoidable.

X's managers realize that, although the long-term prospects for the company are good, the cost of servicing the large amount of debt that the company has incurred over the years threatens to pull the company under in the near future. Their main creditor recognizes that X is, in the long run, a viable concern. This creditor also realizes that if X goes out of business or into bankruptcy, the creditor will realize a much smaller return on the debt owed by X, even though debt covenants provide the creditor first access to all of company X's assets.

Another factor is the effect that the large debt on Xs balance sheet has on the running of X's business. Customers who are aware of the debt might begin to question the viability of X, and might consider developing relationships with other suppliers to assure an uninterrupted source of what to them are raw materials. Suppliers, on the other hand, could become concerned about the ability of X to continue to pay for their purchases; they could also question the wisdom of planning to produce large orders for X when in fact X might not be able to use large quantities. This latter concern could weaken the business relationship between X and its suppliers and reduce the quantity discounts that have been enjoyed by X until now.

X has liabilities of $100 million and assets with a fair market value of $70 million. Section 108 defines insolvency as the excess of liabilities over the fair market value of total assets.(25) Under this definition, Corporation X is insolvent in the amount of $30 million ($100 million liabilities minus $70 million of assets). NOL carryovers for Corporation X amount to $40 million, and the bases of Xs assets amounts to $35 million. Of that amount, depreciable assets make up $20 million.

TAX ISSUES OF CONCERN

X and X's major creditor agree that some kind of debt restructuring is in order and that such restructure must take place in the near future before X's financial strength declines further. X has three primary tax concerns with respect to the type of proposed restructuring that takes place:

1. Avoidance of the Recognition of CODI or Reduction

of TACs from the Forgiveness or Conversion of Debt

In a reorganization of debt, section 108 would require that a solvent company recognize CODI for all amounts forgiven. If a solvent company has CODI of $50 million, it must recognize the full $50 million as income, but it will generally be able to offset that income with any NOL carryovers. An insolvent company must generally reduce TACs to the extent of the amount of insolvency[26] and recognize CODI for any excess over the amount of insolvency. An insolvent corporation such as X will have two options with respect to which TACs are reduced first. One option is for X to reduce its TACs in the order given above, starting first with the NOL carryover, by the amount of its insolvency ($30 million). The NOL carryover will be reduced to $10 million ($40 million NOL less $30 million), and X will recognize the other $20 million of CODI. Of the $20 million of CODI, $10 million would be offset by the remaining $10 million NOL carryover, leaving $10 million of regular taxable income (the taxpayer will have to go through a similar calculation for AMT purposes).

X's other option is to elect to reduce the basis of depreciable property first before reducing the other TACs.(27) For X, this will mean that the bases of depreciable assets will be reduced to zero, and the NOL carryover would then be reduced by the remainder of the insolvency amount - $10 million ($30 million insolvency less $20 million basis). This will leave $30 million of the NOL available to offset the rest of the CODI ($20 million) that must be recognized. An NOL carryover of $10 million will be left to offset future income.

This latter option has the advantage of preserving the NOL carryover, which can offset income immediately, at the expense of reducing the bases of depreciable assets, which provide deductions over a number of years in the future. Another advantage is that this option leaves more of the NOL carryover available to offset the CODI in excess of insolvency that must be recognized. This option also differs from the previous option in its effect on the alternative minimum tax (AMT). If income from debt forgiveness is included in taxable income, it will also be included in AMT income (AMTI). An AMT NOL can only reduce AMTI by 90 percent of the AMTI, so the inclusion of gain from debt forgiveness, even if fully offset by the regular NOL carryforward, may result in an increase in the AMT.(28) This problem would at the worst result in what is essentially a two-percent tax on the CODI up to the amount of the NOL carryover (assuming sufficient AMT NOLs exist, the ultimate AMT tax rate will equal 10 percent of 20 percent, or approximately 2 percent). The taxpayer, however, will also have created a minimum tax credit carryover equal to the amount of the AMT.

If Corporation X chooses to reduce depreciable assets first, the CODI in excess of insolvency ($20 million) will be, for regular tax purposes, fully offset by the NOL carryover. For AMT purposes, however, only 90 percent of AMTI can be offset by an AMT NOL, so AMTI will still be increased by $2 million ($20 million x 10 percent) as a result of the restructuring. If Corporation X chooses to reduce NOLs first, then only $10 million of the NOL carryover will be available to offset CODI. AMTI will therefore be inereased by $1 million ($10 million x 10 percent) under this option. Of course, the preceding analysis assumes that the NOL and the AMT NOL carryovers are approximately equal.(29)

In this example, X has large NOL carryovers that may be used to offset any CODI that must be recognized. These NOL carryovers, however, may be more valuable to X if they are used to offset taxable income generated as the corporation recovers. The value of these benefits to companies in X's position depends somewhat on the particular circumstances of each company. If a company has NOLs that are close to expiration, then it may actually prefer to have gain from debt forgiveness or conversion, so that it can use the NOL carryovers in some way before they expire. The value of the NOLs could also be affected by the expectations with respect to the turnaround. The present value of the NOL carryovers is higher if a company expects a turnaround (return to profitability) in a reasonably short period of time since a portion of the tax liability that will normally accrue could be offset by these carryovers.

2. Restriction on the Availability of NOL Carryovers

The possibility that section 382 could come into play to reduce the value of the NOL carryover should also be considered in planning any sort of reorganization of the debt. Section 382 applies if there is a "change of ownership" of more than 50 percent among five-percent owners within a three-year period.(30) Suppose a reorganization results in the issuance of 30 percent of the outstanding common stock in exchange for some of the debt, and assume further that section 108 is not triggered to produce CODI. The struggling corporation (and its owners) is now limited to a 20-percent ownership change (among its five-percent owners) within the next three years or section 382 will limit the yearly deduction of the NOL carryover. Under these circumstances, some kind of restrictions on the transferability of shares of stock should be considered.

Since section 382 limits the annual amount of NOL to be deducted, companies not expecting to have large taxable incomes for a few years may not be significantly affected. Because of the computation of the annual limitation, companies that have large FMVs will have larger annual limitations and will also be less affected by the section 382 limitation. The worst situation will probably be encountered by a company that has had a change of ownership, has a small FMV, has large NOL carryovers that are nearing expiration, and expects its turnaround to be weak initially with low taxable incomes in the first few years. For these companies the best course of action may be to recognize CODI, since the NOL and other TACS will not be restricted in offsetting any gain resulting from the restructure; rather, the section 382 provisions only restrict TACS from offsetting post-restructure income. (An AMT problem, however, may still be caused or exacerbated by recognition of CODI under these circumstances.) The ability to shelter income with NOL carryovers can be a critical benefit for turnaround companies that are having cash-flow difficulties, and every effort should be made to enable the company to utilize them wisely. An illustration of the section 382 limitation is provided in Exhibit 2.

3. Level of Uncertainty Associated with the Ultimate

Tax Treatment Resulting from the Course of Action

Taken

The managers of X prefer to weigh the risks of each debt reorganization alternative against the benefits and costs associated with that alternative. In general, the greater the benefit, the greater the risk that the IRS will challenge some aspect of the alternative and attempt to disallow some of the anticipated benefits (e.g., full use of NOL carryovers).

POSSIBLE ALTERNATIVES, CONSEQUENCES,

AND LEVELS OF RISK

In reorganizing the debt in question, Corporation X could, in exchange for the old debt, issue:

* new debt,

* common stock,

* common stock with preferred stock warrants,

* a second class of common stock that includes an automatic

conversion feature that would trigger the

conversion into redeemable preferred if certain future

events transpire,

* nonredeemable preferred stock with contingent future

voting powers,

* a hybrid security classified as debt for tax purposes

and classified as equity for financial statement purposes,

* a "net profits interest" (NPI), or

* "disqualified" stock.

The tax risks associated with these eight alternatives are briefly discussed seriatim and are summarized in Exhibit 1.

1. Debt-for-Debt Exchange

Under this alternative, a new debt issue would be created and issued to the creditors in exchange for the outstanding debt. Under section 108, the debtor in this situation has CODI in the amount of the excess of the "adjusted issue price" of the old debt over the "issue price" of the new debt. The general rules for determining this "issue price" are found in sections 1273 and 1274 and are the same as the rules used for determining original issue discount (OID) on the issuance of debt.(31) The adjusted issue price of the outstanding debt is generally the sum of (1) the issue price of the outstanding debt, plus (2) cumulative accrued OID, minus (3) payments other than qualified periodic interest payments.(32) The issue price of debt is generally the amount of cash paid when the debt is originally issued.(33) When debt is issued in exchange for already outstanding debt, and neither the outstanding debt nor the new debt is publicly traded on an established securities market (ESM), the issue price of the new debt is its principal amount- except where the stated interest rate on the new debt is less than the applicable federal rate (AFR).(35) If the stated interest rate on the new debt is less than the AFR, then the issue price of the new debt will be the present value (discounted at the AFR) of all of the payments required to be made on the new debt.(36)

The market determines the issue price of the instrument that is traded on an ESM, whereas the AFR interest rate is used to determine the issue price of the debt instrument not so traded. This is a significant difference. In most cases the market-imposed discount rate will be much higher than the AFR since the market rate evaluates the risk associated with the specific instrument in determining an interest rate, whereas the AFR reflects market interest rates in general. Accordingly, since the risk associated with a company that is restructuring its debt is usually much higher than the risk factor used in determining the AFR, the discount (interest) rate required on an ESM will most likely greatly exceed the AFR.

The potential income or reduction of TAC from debt forgiveness in a debt-for-debt exchange, when neither debt issue is traded on an ESM, is measured by the excess of the adjusted issue price of the old debt over the issue price of the new debt. The issue price of the new debt can be either the principal amount of the debt or the present value of the payments the debtor is required to make. The adjusted issue price of the old debt is not subject to being changed by the debtor. Therefore, the only way the debtor can affect the potential CODI in a debt-for-debt swap is by stipulating a stated rate on the new debt that is less than the AFR or by manipulating the stated maturity value of the new debt. Since most companies that find themselves in a debt restructuring situation desire a reduction in near-term interest payments, the natural tendency is for the debtor to negotiate a lower interest rate on the replacement debt. If the negotiation yields an interest rate lower than the AFR, the replacement debt must have a higher stated maturity value than the old debt to maximize the "issue price" of the new debt and avoid CODI recognition or TAC reduction.

Another way to achieve issue price maximization and short-term cash outflow minimization is to have the interest payments on the new debt begin in a later period, after interest on the debt has accrued and compounded for the first few years. Hence, interest would continue to accrue annually but payment of this interest is deferred for a stipulated period of time. This type of arrangement is illustrated in Exhibit 3.

A third means of maximizing the issue price of the replacement debt and minimizing short-term cash outflow is to have at least part of the interest on the debt be payable in new debt instruments or in the common stock of the corporation, rather than in cash. This method of issuing additional debt instruments in lieu of cash payments is referred to as paying-in-kind or issuing PIKs. Taxpayers have even issued common stock instead of additional debt instruments in lieu of cash payments (interest) on debt instruments. One draw- back to this technique is that, when used to pay out dividends on common stock, it can result in a continual decline in the ownership percentage of the original shareholders and the section 382 limitation provisions may subsequently become applicable, even though these provisions were not originally applicable to the debt restructure.

If either the old debt or replacement debt is traded on an ESM, the issue price of the replacement debt will be its FMV (determined under section 1273(bX3)) rather then its stated maturity value. Prop. Reg.[section] 1.1273-2(c)(l) provides that FMV is determined as the quoted price on the first date that the debt instrument is traded on an ESM. If the new debt is not traded on an ESM but a portion of the remaining old debt is traded on an ESM after the swap, then the issue price of the new debt is determined by the trading price of the old debt on the exchange date.(37) Finally, property is treated as traded if it is traded on an ESM on or within 10 trading days after the date it is issued.(38)

A straightforward debt-for-debt exchange (assuming neither debt issue is traded on an ESM) can be the least risky of the alternatives faced by a financially troubled corporation, at least in terms of the certainty of the eventual tax treatment to which a reorganization will be subject. The rules for determining the issue price of the new debt are relatively straightforward, and the corporation can be relatively certain, based on the facts of the situation, how its particular approach will be viewed by the IRS. Another benefit of using a debt-for-debt exchange is that, if done carefully, the use of the NOLs following the exchange will not be subject to the various limitation provisions. The only situation in which the post-exchange NOLs may be affected is where the issue price of the new debt is lower than the adjusted issue price of the old debt. In such a case, CODI will be triggered, resulting in an offset of the NOL carryover. Exhibit 3 illustrates of a debt-for-debt exchange that results in a reduction of an NOL carryover because of the recognition of CODI.

On the other hand, there are distinct disadvantages to the use of a debt-for-debt exchange. If the financially troubled firm merely exchanges one debt issue for another, the interest payments on the new debt, even though possibly smaller than those of the old debt, can still be onerous enough to prevent an otherwise viable company from making its way back to profitability. In addition, exchanging one issue for another will do nothing to improve the debt/equity ratio of the company. Based on the company's financial statements, their purchasers and suppliers may have the same reservations about the survivability of the enterprise as they had before the debt-for-debt reorganization. The attitudes of the purchasers and suppliers may be improved, however, by the restructuring if the old debt is fully secured by specific assets of the corporation and the new debt is unsecured by specific assets of the corporation.

2. Common Stock for Reduction in Old Debt

Under this alternative, some of the debt will be exchanged for common stock of the financially troubled company. There are several advantages to this approach. Use of this approach can ensure that the NOL carryforwards remain fully intact and available to offset future income of the company. Replacement of some debt with equity will also improve the debt/equity ratio. In addition, replacement of some of the debt with equity will reduce the near- term cash payments needed to service the remaining outstanding debt.

Even with an exchange of common stock for debt, care must be taken in structuring the transaction if the unrestricted use of the NOL carryforwards is to be retained. If the common stock issued in a debt/equity swap is of nominal value, the IRS could maintain that the substance of the transaction is actually a forgiveness of the debt rather than an exchange of debt for stock. If the transaction is treated as a forgiveness of the debt, then either CODI will be recognized or TACs of the company will be reduced up to the amount of insolvency. Any excess of the amount of debt forgiveness over the amount of insolvency will be treated as regular taxable income, which can be further offset by any remaining NOLS and possibly other TACs. This excess of debt forgiveness over the amount of insolvency, however, will also create AMTI, and the AMT NOL 90-percent limitation could cause the debtor to have an increased AMT liability.

Section 382 may restrict the use of NOL carryforwards in this type of exchange if there is a 50-percent ownership change among five-percent shareholders within a three-year period. If a significant portion of the stock of the company is issued in the exchange (which is very possible if the "nominal value" requirement is to be satisfied), the ability of the current shareholders to trade their shares without reducing the future value of the NOLS may be restricted.

The common stock altemative must not have the characteristics of disqualified stock or the exception to CODI recognition or TAC reduction will not apply. The Revenue Reconciliation Act of 1990 defined disqualified stock as stock with a stated redemption price that (a) has a fixed redemption date; (b) the issuer can redeem at one or more times; or (c) the holder of the stock can demand that it be redeemed at one or more times. Although the disqualified stock attributes are those normally associated with preferred stock, the statute does not restrict application of these provisions to preferred stock. Accordingly, common stock can be deemed to be disqualified stock for these purposes, and thus the issuance of common stock with some of the "disqualified stock" attributes could cause the stock to be disqualified. The result of disqualification in this situation is that any excess of the amount of the debt above the fair market value of the stock will result in CODI that either has to be recognized or causes the reduction of TACS to the extent of insolvency.

3. Common Stock with Warrants to Acquire Redeemable

Preferred for Reduction in Outstanding Debt

This option involves the issuance of common stock in exchange for a reduction in the debt outstanding. Under this alternative, however, a portion of the common stock will have warrants attached, allowing the conversion of the common stock into redeemable preferred stock with a stated redemption price. The common stock will not have a stated redemption price or redemption date and the issuer or holder of the stock will not have a right to redeem the stock or require redemption at any time in the future. The common stock may have a stated dividend rate subject to certain agreed-upon performance goals with a cumulative clause in the event that the annual dividend cannot be paid.

The advantages of this option are similar to the advantages of the exchange of straight common stock for debt. If certain requirements are met, there will be an unlimited ability to utilize any NOL carryforwards that exist. This option has the potential to improve significantly the debt equity position of the balance sheet since debt will be reduced and equity will be increased. This option will also reduce the amount of the fixed interest payments (and therefore the cash outflow) required of the financially troubled corporation. Finally, the creditors should prefer this option to a strict common stock-for-debt exchange because they can potentially substitute a preferred equity interest for at least part of their common interest if the company actually does succeed in their turnaround effort; this attribute provides the creditor with a more defined exit strategy than if a strict common-stock-for-debt exchange was consummated.

There are, however, several disadvantages associated with this course of action. If the value of the common stock exchanged in this instance is nominal or token, then TACs will be reduced to the extent of insolvency, and CODI will be recognized for the excess amount. Care should be taken that there is not a 50-percent change of ownership among the five-percent owners within three years. As in an exchange where only common stock is involved, an ownership change will significantly reduce the amount of the NOL carryforward available to offset against income in any future year. Another disadvantage is that the IRS may assert that the warrants do not constitute "stock" for purposes of the stock-for-debt exception and, therefore, trigger the recognition of some amount of CODI.

A further disadvantage is the risk that the IRS will not agree with the anticipated tax treatment of the transaction. The IRS could maintain that the issuance of the warrants for redeemable preferred stock is substantially the same as issuing redeemable preferred stock directly. Since this would mean that "disqualified stock" (within the meaning of section 108) had been exchanged for the debt, either the CODI would have to be recognized in full or TACs would have to be reduced to the extent of insolvency, and CODI would have to be recognized to the extent that it exceeded the amount of insolvency.

4. A Second Class of Common Stock that Includes an
 Automatic Conversion Feature to Convert into Redeemable
 Preferred Stock if Certain Events Occur


Under this alternative, all or a portion of the second class of common stock will include a conversion feature requiring the conversion of that particular common stock into redeemable preferred stock with a stated redemption price if certain future events transpire. The "future events" criteria likely will include certain financial indicia clearly indicating that the company is well on its way to recovery and can safely handle a conversion to preferred stock with the intention that this preferred stock will be redeemed in the future. The common stock will not have a stated redemption price or redemption date and the issuer or holder of the stock will not have a right to redeem the stock or require redemption at any time in the future. Accordingly, such stock will arguably constitute qualified stock and thus not be subject to the disqualified stock provisions. Additionally, the common stock may have a stated dividend rate subject to certain agreed-upon performance goals with a cumulative clause in the event that the annual dividend cannot be paid.

The objectives of this alternative are threefold: (a) to reduce near-term cash payments (i.e., interest) that the corporation will be required to make, (b) to improve the debt/equity ratio of the corporation, and (c) to provide the creditor an opportunity to obtain an equity interest and some voting rights in the corporation while providing an exit avenue through the use of preferred stock (upon the occurrence of certain future events).

There is a risk, however, that the IRS will not agree with the anticipated tax treatment of the transaction. The IRS may argue that the issuance of common stock with such a conversion feature is substantially the same as issuing redeemable preferred stock directly. This would mean that "disqualified stock" had been exchanged for the debt, requiring either the recognition of CODI, the reduction of TACs, or both.

5. Nonredeemable Preferred Stock (with Special Provision

to Become Voting) for Reduction in Old Debt

Under this option, the issuer or holder of the nonredeemable preferred stock will not have a "right" to redeem such stock at any time in the future, but the preferred stock will have a clause allowing the stock to become voting stock if certain financial (or nonfinancial if desired) goals are not achieved. The dividends on the preferred stock may be either cumulative or noncumulative. This option has the advantage of reducing the cash outflow necessary to make fixed interest payments on the surviving debt without substituting an instrument that requires some other current outflow. If successful, it should also allow for unlimited use of the NOL carryforwards and improve the company's debt/equity ratio.

A disadvantage to this alternative is that the IRS may contend that the holders of the prefe"ed shares are virtually assured of securing voting rights, which can then be used to force the company to redeem the shares. Hence, the IRS may maintain that the contingent voting clause is substantially equivalent to a "right" to redeem the stock at a future time. If the IRS were successful in upholding this contention, the preferred stock would be considered "disqualified stock" under section 108, and either reduction of Tacs or recognition of CODI would be required. The tax risk can be minimized, however, if the voting power conveyed to the preferred shareholders is less then a controlling interest. In such a case, the presumption would be that there could not be a forced redemption of the preferred shares at one or more times. Consequently, the preferred stock would not be considered "disqualified stock."

As with previous options, if the stock issued is of only nominal or token value, either TACs will be reduced or CODI must be recognized. There must also not be a 50-percent ownership change among five-percent owners during any three years or the use of the NOL carryforwards in any future year may be sharply curtailed pursuant to section 382.

6. Issuance of a hybrid Security Classified as Debt for
 Tax Purposes and as Equity for Financial Statement
 Purposes


Historically, financial debt and equity instruments have been treated in approximately the same manner for U.S. financial statement and tax purposes. On some occasions, however, taxpayers have taken aggressive positions suggesting that an instrument treated as equity or hybrid equity for financial statement purposes should be treated as debt or hybrid debt for tax purposes. The advantage of this alternative is that it will reduce the debt shown on the balance sheet and therefore allow for some improvement in the debt/equity ratio, but potentially avoid CODI recognition or TAC reduction. If successfully structured, this option will also allow for the unlimited use of any NOL carryforwards.

The financial and tax treatment of such a security, of course, will turn on the characteristics of the security. Since the tax and financial characteristics of debt (or equity) are so similar, maintaining that an instrument is one thing for tax purposes and another for financial purposes will be very risky. In fact, to have a chance of having a security be treated as equity for financial purposes, the instrument will have to have so many "tax equity" characteristics that its tax treatment as debt will be problematic. If the IRS maintained a position that the instrument is equity, the foregoing discussion of common stock-for-debt section exchanges would be relevant. In addition to treating the issue as equity, the IRS may argue that the characteristics that were intended to allow the issue to be treated as debt for tax purposes (e.g., a stated maturity date) transmute the security into "disqualified stock" under section 108. Since having an instrument treated as disqualified stock automatically causes a CODI recognition or TAC reduction event, it may be prudent to avoid this aggressive alternative and issue qualified common stock instead.

7. Transfer of a Net Profits Interest to the Creditor in

Exchange for a Reduction in the Debt

Under this option, an instrument is created that entitles the holder to share directly in the future revenue the company. For example, the instrument may transfer to the holder a percentage of the net sales price of a certain segment of the company's sales (e.g., a certain product line). This NPI instrument (gross sales price less operating expenses) will then be transferred to the creditor in exchange for a part of the debt owed. This transfer will likely be treated as a taxable exchange to the extent of the FMV of the NPI instrument. Additionally, the tax pin will likely be substantial since the debtor will have a tax basis of zero in its NPI.

If the reduction in the debt is greater than the FMV of the NPI, then the incremental difference will be treated as a recognition of CODI or as a reduction in TACs by the financially troubled corporation. Thus, the NOL carryforward and other TACs will probably be significantly reduced or eliminated owing to the large gain on the taxable exchange and any excess CODI or TACs that may occur. Offsetting the adverse effect of reducing or eliminating the NOL carryover and/or other TACs is the company's reducing its taxable income in future years by the amount of gross sales diverted to the creditor as a result of the NPI instrument. On the other hand, the creditor will offset all of, or a good portion of, this NPI income by amortizing its tax basis in the NPI instrument. The creditor's tax basis in its NPI will equal its adjusted tax basis in the debt surrendered in the exchange.

The NPI alternative provides a great opportunity for those taxpayers with expiring NOLs and other TACs because it accelerates income into the cu"ent tax period. Accordingly, expiring NOLs and other TACs can be currently utilized against this accelerated income before they expire. This alternative may also provide some benefit where limitations on the future utilization of these NOLs and other TACs arise as a consequence of the restructuring or are expected to result as a consequence of some future event. Additionally, this alternative may provide some benefit by favorably affecting the debtor corporation's debt/equity ratio. Such an instrument, however, will likely have to be disclosed in the debtor's financial statements; the benefit of improving the company's debt/equity ratio will therefore be tempered by the detriment created by the disclosure of the NPI instrument.

Since the disadvantages of using an NPI instrument are very significant, the benefits of using an NPI instrument must also be substantial to justify using it. Anytime a large current income item is offset by NOL carryovers or other TACs for regular tax purposes, an AMT problem is usually created or exacerbated. The AMT problem arises from the 90-percent limitation on utilizing NOL and ITC carryovers to offset AMTI and AMT, respectively. Accordingly, the NPI alternative will likely create a current AMT liability by triggering a large taxable gain for regular and AMT purposes that can only be 90-percent offset for AMT purposes. This current AMT however, will also create a minimum tax credit carryover that the taxpayer may be able to utilize in the future.

Another disadvantage of this alternative is that although no future interest payments will be required (since debt will no longer exist), the company's future cash flow will suffer since NPI payments to the old debt holder will have to be made out of the proceeds received by the company from future sales. Therefore, this alternative will reduce current cash flow in much the same manner that required interest payments would reduce cash flow.

The major tax-related risk of this option is that the IRS will contest the value assigned to the NPI instrument. Since the main value of the instrument lies in the possibility of a turnaround in the company, there may be difficulties in attaching an accurate and defensible value to it. If the value of the instrument is set lower than the adjusted issue price of the forgiven debt, then CODI recognition or TAC reduction may result.

8. Issue of Disqualified Stock (as Defined in the 1990

Tax Act) for Reduction of Old Debt

This option involves the issuance of stock defined as disqualified by the Revenue Reconciliation Act of 1990 in exchange for a reduction in the outstanding debt of the corporation. The term "disqualified stock" includes such forms as redeemable preferred stock and preferred stock with existing put options. One of the main benefits of this course of action is that the company can reduce the interest payments required under the old debt. There will also be some improvement in the balance sheet position since debt will be reduced and equity will be increased.

Because the use of disqualified stock will trigger CODI recognition or TAC reduction, this could be the most disadvantageous option of all from a tax perspective. The corporation will certainly have CODI under this option, with the likely result that the future availability of the NOL carryforwards will be substantially reduced. Future taxable income may also be increased because any dividends on the disqualified stock will not be deductible, whereas the interest payments on the debt instrument would have been deductible.

CONCLUSION

A financially troubled company that is attempting to restructure its debt burden will generally have a number of goals. The primary nontax objectives are often (1) to reduce the cash outflow required to service its debt, (2) to give creditors a limited interest in the voting stock of the company, and (3) to improve the balance sheet position of the company. These goals can conflict with the financially troubled corporation's tax objectives: (1) to retain the unrestricted use of any NOL and other TACs, and (2) to avoid recognition of CODI. Even when these goals can be harmonized, they are frequently inconsistent with the goals of the creditors.

Of the options discussed in this article, Options 2, 3, 4, and 5 (from Exhibit 1) probably are the beat at meeting the goals of the financially troubled corporation without creating undue risk that the IRS will impose a disadvantageous tax treatment. In addition, these options also appear likely to be consistent with the goals of the creditor. A corporation considering a debt restructuring should be very careful, since the consequences of a mistake or failure to consider some aspect of the reorganization can be costly. If diligent consideration is made of all facets of the situation, a financially troubled corporation should be able to secure some relief from debt service payments, avoid recognition of CODI, and maintain some or most of its TACs for subsequent use.

(1) I.R.C. [section] 382(a). (2) I.R.C. [section] 108(a). (3) I.R.C. [section] 108(b)(2)(A). (4) I.R.C. [section] 108(b)(2)(B). (5) I.R.C. [section] 108(b)(2)(C). (6) I.R.C. [section] 108(b)(2)(D). (7) I.R.C. [section] 108(b)(2)(E). (8) I.R.C. [section] 382(g). (9) I.R.C. [section] 382(k)(7). (10) I.R.C. [section] 382(b)(1). (11) I.R.C. [section] 382(b)(2). (12) I.R.C. [section] 108(A)(1)(C). (13) I.R.C. [section] 108(b)(2). (14) I.R.C. [section] 108(a)(3). (15) I.R.C. [section] 108(e)(10). (16) I.R.C. [section] 108(e)(10)(B)(i)(II). (17) I.R.C. [section] 108(e)(10)(B)(i). (18) I.R.C. [section] 108(e)(10)(b)(ii). (19) I.R.C. [section] 108(e)(8). (20) Prop. Reg. [section] 1.108-1(b)(1)(i). (21) TAM 8837001 (May 10, 1988). (22) Prop. Reg. [section] 1.108-1(b)(l)(ii). (23) Prop. Reg. [section] 1.108-1(b)(1)(iii). (24) CO-76-90, 1990-2 C.B. 690. (25) I.R.C. [section] 108(d)(3). (26) I.R.C. [subsection] 108(a)(1) and (3). (27) I.R.C. [section] 108(b)(5). (28) I.R.C. [section] 56(d)(1). (29) Income excluded under section 108 or any corresponding provision is not included in the computation of adjusted current earnings and consequently does not inerease the ACE adjustments. See I.R.C. [section] 56(g)(4)(B)(i). (30) I.R.C. [section] 382(g). (31) I.R.C. [section] 108(e)(11). (32) I.R.C. [section] 1272(a)(4). (33) I.R.C. [section] 1273(b). (34) I.R.C. [section] 1274(a)(l). (35) I.R.C. [subsection] 1274(a)(l) and (b). (36) I.R.C. [section] 1274(b)(2). (37) Prop. Reg. [subsection] 1.1273-2(c)(l). (38) Id.

RONALD C. MAIORANO is a Senior Tax Manager in the Detroit office of KPMG Peat Marwick. He is a graduate of Western Michigan University and has taken post-graduate courses in taxation and accounting from the University of Texas-Arlington. Mr. Mairano is a certified public accountant, and he specializes in corporate tax planning.

P. LAWRENCE TUNNEL is an Assistant Professor of Accounting at the University of Texas-El Paso. He holds a Ph.D. degree from Oklahoma State University and B.S. and M.S. degrees from the University of Texas-Arlington. Mr. Tunnel is a certified public accountant and has public accounting experience.
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Author:Tunnell, P. Lawrence
Publication:Tax Executive
Date:May 1, 1992
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