An Exception to the Mirror Image

Income on One Side of a Debt Transaction Does Not Always Produce Loss on the Other

A mirror image is usually reflected in the tax impacts for the two parties to a debt instrument transaction. When the holder recognizes interest income, the issuer can take the interest expense deduction. When the debt is discharged, the issuer can recognize cancellation of debt (“COD”) income, and the holder will take ordinary or capital loss. But what if the holder recognizes income? Does the issuer always recognize loss?

Let’s consider this in the context of distressed debt. As we know, a corporation in financial distress often seeks to modify the terms of its debt or exchange the old debt for new debt or stock. To determine if the transaction is taxable and if any tax gain or loss is to be recognized for federal income tax purposes, a tax analysis of the modifications must be performed.

Let’s consider a scenario where old debt with two years of maturity is exchanged for stock.

The first step is the significant modification test. We can determine that the recapitalization transaction above is a significant modification since the alteration results in a property that is not debt for federal income tax purposes [1].

The second step is to see if it qualifies for a tax-free reorganization, which requires a security-for-security exchange[2]. Since the new equity is security, we will need to check to see if the old debt is also security.

IRS and Treasury regulations do not define the term “security.” Case law is relied upon to determine whether a debt instrument is security. Usually, a debt instrument with a term of less than 5 years is not likely to constitute a security, while a debt instrument with a term of more than 10 years qualifies (additional factors need to be considered for the debt instruments with term of 6-10 years). Since the old debt in our scenario has two years of maturity, it is not a security based on case law. Therefore, the recapitalization does not qualify as a tax-free reorganization, and the debt holder will need to recognize income or loss.

In most cases of distressed debt, the fair market value (FMV) of the new stock is lower than the value of the old debt. Sometimes the FMV of the stock received is higher than the “adjusted issue price” of the old debt. Then COD income for the holder of the stock is generated on the excess of the “adjusted issue price” of the old debt over the FMV of the new equity[3].

The issuer of the stock might be expected to reflect the mirror image of the holder’s position and to recognize loss on the extinguished debt. But in actuality, an exchange of new stock for existing debt by the issuer qualifies as a “recapitalization” for tax purposes, and the issuer recognizes no gain or loss. The old debt doesn’t have to be a security for the recapitalization to be treated as a tax-free transaction to the issuer[4].

Vivian Peng
Tax & Business Services Director
Marcum LLP*
vivian.peng@marcumllp.com

[1] Regs §1.1001-3(c)(2)(ii).

[2] §368(a)(1)(E).;§354(a)(1).

[3] §108(e)(8).

[4] Regs §1.368-2(e)(1).

*Marcum LLP is the exclusive associated partner of ECOVIS International for accounting, tax and audit in the United States of America.