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Purchasing or Modifying Debt Instruments

Tax Law Update Thomas J. Phillips, Jeffrey B. Fugal

Purchasing or Modifying Debt Instruments

With the economy and credit markets in turmoil, many questions have arisen regarding the U.S. federal income tax consequences of working out distressed debt with borrowers and purchasing distressed debt at a discount. The income tax rules dealing with distressed debt can produce surprising results that may affect the holder's expected return on investment.

Debt Work-Outs

Holders of distressed or troubled debt commonly work with borrowers to maximize the holder's potential return. Most understand that a borrower is at risk of recognizing income or gain in the event of a debt work-out. However, holders may not realize that, if these work-outs are not carefully structured, the holder may also be obligated to recognize income or gain by reason of a "significant" modification to the original debt instrument. Many view this type of gain as "phantom" gain because the gain must be recognized at a time when the holder may not receive payments from the borrower. If a holder of a debt instrument (which is not publicly traded) previously issued the debt at a discount, charged off a portion of the debt or purchased the debt instrument at a discount, then the amount of "phantom" gain generally will equal the difference between the principal amount of the modified debt, less the holder's tax basis in the debt instrument. However, the installment sale method may be available to report this gain over several years, subject to a special interest charge imposed on certain nondealer holders who have outstanding installment sale obligations that first arose during the tax year and at the end of the tax year in which the outstanding amount of those installment sale obligations exceeds $5,000,000. Certain holders, such as banks, may be able to offset such phantom gains by claiming a deduction for a partially worthless debt if such holder has previously taken a charge off for partial worthlessness on the debt.

Treasury regulations contain complex rules governing whether a modification is "significant" enough to trigger a taxable event. A full recitation of these rules is beyond the scope of this communication; however, a few examples of "significant" modifications include the following: 

  • Change in Yield: A change in yield may be a "significant" modification if the annual yield for the modified instrument differs from the original instrument by more than the greater of 25 basis points or 5% of the annual yield of the original instrument.

  • Deferral of Payments/Extension of Maturity Date: A deferral of payment may be a "significant" modification if there is an extension of the final maturity date or a deferral of payments prior to the maturity date and, in either case, the modifications exceed certain safe harbor thresholds. The safe harbor period begins on the original due date of the first deferred payment and extends for the shorter of five years or 50% of the instrument's original term.

  • Change in Obligor or Security: An addition or deletion of an obligor may be a significant modification if the obligor's capacity to meet payment obligations is enhanced from primarily speculative to adequate or impaired from adequate to primarily speculative. The obligor's capacity includes collateral, guarantees or other credit enhancements.

Market Discount

When a debt instrument is purchased from a person at a discount from the face amount of the debt instrument, the debt instrument will generally have market discount to the extent of the discount, except for any portion of such discount which constitutes original issue discount. For the holder of a debt instrument with market discount, any gain on disposition of the debt instrument or payment of principal thereon will be treated as ordinary income to the extent of the accrued market discount. Accrued market discount is market discount that accrues on a ratable basis in equal daily installments during the period in which the holder held the debt instrument. (To figure accrued market discount, first figure the daily installments by dividing the market discount by the number of days after the date the holder acquired the debt, up to and including its maturity date, and then multiply the daily installments by the number of days the holder held the debt.) A holder may instead elect to compute accrued market discount on the basis of a constant interest rate. There are other elections a holder may make regarding the treatment of market discount, which could affect the character and timing of the recognition of income.

There are limitations on a holder's ability to take current interest deductions with respect to indebtedness incurred to purchase or carry a debt instrument with market discount.

Given the rules discussed above, holders of debt instruments should carefully consider the income tax consequences of debt work-outs before entering into work-out arrangements with borrowers.

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Questions about the subject matter of this communication should be addressed to Thomas J. Phillips at 414-277-5831 / tjp@quarles.com in Milwaukee, Jeffrey B. Fugal at 602-229-5257 / jfugal@quarles.com in Phoenix or your Quarles & Brady LLP attorney.