Debt is an important component of a company’s capital structure since it creates leverage to fund growth without the need to raise capital for every expansion. Although interest rates continue to be historically low, concerns about increasing interest rates have caused many companies to consider refinancing existing indebtedness to “lock-in” current rates.
When undertaking or contemplating any debt refinancing transactions during the tax year, companies should carefully consider the potential tax implications. Transactions that result in a “significant modification” of the debt under applicable regulations can have disparate tax consequences depending on the specific circumstances.
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The U.S. federal income tax treatment of debt refinancing transactions is highly fact-specific and requires careful analysis. Certain refinancing transactions may be treated as a taxable retirement of the existing (refinanced) debt, which may give rise to the ability to write-off any unamortized debt issuance costs and original issue discount, the latter as “repurchase premium.” However, in certain situations a refinancing transaction may also give rise to taxable ordinary income in the form of “cancellation of indebtedness income.”
Debt Modifications – Generally
The tax consequences of a debt refinancing transaction hinge in part on whether the transaction results in a “significant modification” of the debt under rules set out in Treas. Reg. § 1.1001-3. In the case of a significant modification, the materiality of the changes from the modification results in a deemed retirement of the existing debt in exchange for a newly issued debt instrument.
As a threshold matter, a modification includes not only a change to the terms of an existing debt instrument but would also include an exchange of an old debt instrument for a new one or the retirement of an existing debt instrument using the proceeds of a new debt instrument. Stated differently – it is the substance, not the form, that governs whether debt has been modified for federal income tax purposes.
Whether a modification of a debt instrument constitutes a significant modification depends on the materiality of the changes. The regulations provide a general “economic significance” rule and several specific rules for testing whether a modification is significant. In practice, most debt modifications are covered by two specific rules governing changes in the yield to maturity of a debt instrument (the change in yield test) and deferrals of scheduled payments (the deferral test).
Under the change in yield test, a modification will be significant if the yield of the modified debt instrument varies from the yield of the unmodified debt instrument by more than the greater of 25 basis points (i.e., 1/4 of 1%) or 5% of the unmodified yield. The regulations include specific rules for making this determination. However, it is important to observe that a number of changes to a debt instrument may cause a change in the yield. Examples include changes to the interest rate, deferral (or acceleration) of scheduled payments, and payment of a modification or consent fee in connection with the modification. It is not uncommon for a modification with only a minor (or no) change to the stated interest rate to result in a significant modification due to changes in the yield to maturity that result from the payment of modification fees or changes to the due dates for certain payments. This issue is often overlooked.
Under the deferral test, a modification will be significant if it results in a material deferral of scheduled payments. Notably, the deferral test does not define what constitutes a material deferral (though it does provide guidance on the factors to be considered), but instead provides a deferral safe harbor. Under the deferral safe harbor, a modification to defer payments will not be significant as long as all deferred payments are unconditionally payable by the end of the safe harbor period. The safe harbor period begins on the due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50% of the original term (e.g., the deferral safe harbor for a five-year debt instrument would be two and a half years).
In applying both the change in yield test and the deferral test, taxpayers are required to consider the cumulative effect of the current modification with any prior modifications (or, in the case of a change in yield, modifications occurring in the past five years). This cumulative rule is particularly noteworthy for taxpayers who routinely modify their indebtedness (and often incur modification fees in connection with the modification), as the results of certain modifications may not be significant when viewed in isolation but may be significant when combined with prior modifications.
Tax Implications of Debt Modifications
A significant modification results in the deemed retirement of the existing debt instrument in exchange for a newly issued debt instrument. The existing debt instrument will be deemed retired for an amount equal to the “issue price” of the newly issued debt instrument, together with any additional consideration paid to the lenders as consideration for the modification.
The issue price of a debt instrument depends on whether the debt instrument was issued for cash or property. If a significant amount (generally 10%) of the debt was issued for money, the issue price will be the cash purchase price. Otherwise, assuming the debt instrument is in excess of $100 million, the issue price will be its fair market value (or the fair market value of the property for which it was issued) if it is “publicly traded.” In all other cases, the issue price of the debt instrument will generally be its stated principal amount.
If the issue price of the modified debt instrument (i.e., the repurchase price) is less than the tax adjusted issue price of the old debt instrument, a borrower will incur cancellation of indebtedness income, which is generally taxed as ordinary income. If instead the repurchase price exceeds the adjusted issue price (this may occur when the old debt instrument had unamortized original issue discount or where the debt is publicly traded and has a fair market value in excess of its face amount), the borrower will incur a “repurchase premium.” Repurchase premium is deductible as interest expense. Special rules apply to determine whether such repurchase premium is currently deductible or is instead amortized over the term of the newly issued debt instrument.
The retirement of an existing debt instrument may also give rise to the ability to deduct any unamortized debt issuance costs. As a general matter, the determination of whether any unamortized debt issuance costs should be written off or carried over and amortized over the term of the new debt instrument generally follows the same analysis as repurchase premium. Notably, debt issuance costs are deducted as ordinary business expenses under section 162, and therefore are not subject to the limitation on business interest expense deductions under section 163(j).
Finally, a significant modification may give rise to a number of additional tax implications that companies should consider, including the potential for foreign currency gain or loss and the need to “mark-to-market” existing tax hedging transactions.
