Shifting Biases: Troubled Company Debt Restructurings after the 1993 Tax Act
68 Am. Bankr. L.J. 23 (1994)
33 Pages Posted: 5 Nov 2016
Date Written: November 3, 2016
Tax rules that have evolved over a 60-year-period favor certain forms of debt restructurings over others. These tax biases have shifted from time to time, most recently with the enactment of the Omnibus Reconciliation Act of 1993 [hereinafter the 1993 Act]. Although the 1993 Act left in place some of the tax rules governing debt restructurings, it changed the tax rules in a way that significantly alters the manner in which troubled companies will be restructured in the future. The 1993 Act repealed one of the most important pro-debtor tax rules, the "stock for debt exception" to cancellation of indebtedness income.
Since 1990, the stock for debt exception has favored stock for debt exchanges over debt for debt exchanges. The repeal of the exception, which will take effect generally on January 1, 1995, will eliminate the bias in favor of stock for debt exchanges, and will create a new bias in favor of debt for debt exchanges. This new tax bias, which will discourage restructuring companies from "deleveraging," raises troubling fiscal and bankruptcy policy concerns.
The tax rules governing debt restructurings affect a debtor corporation's decisions (1) to restructure its outstanding debt by discharging it in exchange for cash, new debt of the debtor corporation, or new stock of the debtor corporation, and (2) to file a bankruptcy petition or restructure its debt in an out-of-court workout.
The tax biases in debt restructurings are a function of the tax rules regarding cancellation of indebtedness income, net operating loss limitations and original issue discount. A debtor discharging debt for less than the amount owed must include cancellation of indebtedness income in the year of the discharge, unless the debtor qualifies for certain exclusions or exceptions. The cancellation of indebtedness income rules favor stock for debt exchanges over debt for debt exchanges, and favor bankruptcy reorganizations over out-of-court workouts. The 1993 Act will eliminate this bias in favor of stock for debt exchanges, and will reduce but not eliminate the bias in favor of filing a bankruptcy petition. Debt restructurings can also affect the amount of tax paid by the debtor in the years after the restructuring (1) by limiting the debtor's ability to use its net operating losses to shelter its post-restructuring income, and (2) by creating interest deductions (including original issue discount deductions) on any new debt issued in the restructuring to discharge old debt.
A corporation with a net operating loss ("NOL") for a tax year can use the NOL to offset income from other years, on which the corporation would otherwise be required to pay tax. NOLs may be carried back three years and forward 15 years. Financially troubled corporations often have large NOLs going into a restructuring. The NOLs are a valuable asset because they can shelter the corporation's income following the restructuring, and thus reduce the tax that the corporation must pay in the years following the restructuring. A restructuring can affect a corporation's NOLs in two ways. First, any cancellation of indebtedness income excluded from the debtor's taxable income reduces the debtor corporation's aggregate NOLs. Second, the restructuring may limit the rate at which the debtor corporation can use its aggregate pre-restructuring NOLs to offset its post-restructuring income. For debt restructurings not subject to the provisions of the 1993 Act, the NOL rules favor stock for debt exchanges over debt for debt exchanges. Following repeal of the stock for debt exception, debt discharge will reduce the debtor's aggregate NOLs regardless of whether the debt is discharged in exchange for new stock, debt, or cash. Since the debtor will lose NOLs regardless of how the debt is restructured, stock for debt exchanges will no longer be favored. Debt for debt exchanges will instead be favored, because new debt issued in exchange for old debt creates new interest deductions that the debtor can use (in a manner similar to NOLs) to shelter its post-restructuring income. However, the interest deductions may, in some situations, be limited by certain provisions in the IRC.
This article explains the cancellation of indebtedness income, NOL limitations, and interest deduction consequences of discharging debt in exchange for cash, new stock, or new debt, both before and after the 1993 Act takes effect. In addition, it highlights the pre-1993 Act and post-1993 Act tax biases that favor certain forms of debt restructurings, and raises fiscal and bankruptcy policy concerns regarding the post-1993 Act biases. Part II discusses the tax consequences of discharges for cash. Part III discusses the cancellation of indebtedness income and NOL consequences of stock for debt exchanges. Part IV discusses the cancellation of indebtedness income and interest deduction consequences of debt for debt exchanges.
Keywords: "stock for debt" exception, "stock for debt swap", corporate debt discharge, debt discharge income, cancellation of indebtedness income, NOLs, Trump tax returns
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