2.10.2010

Bankruptcy Investing and Restructuring

Grant, a member of the Distressed Debt Investors Club and guest contributor at Distressed Debt Investing writes an interesting piece on tax considerations in restructuring. Enjoy.


Some Key Tax Issues in Restructuring

Tax considerations can have a material impact on the value of a distressed business. The following contains a brief introduction to three important issues that investors in distressed securities might consider when estimating the impact of tax consequences on returns.

Modifications and Exchanges of Debt

While generally modifications of debt do not have tax consequences and exchanges can, the IRS may determine a modification to be effectively an exchange. Even altering an instrument’s interest rate by as little as 25 basis points, or by over 5% of the original yield, can trigger the IRS to treat a modification as an exchange. Internal Revenue Code (“IRC”) §108(e)(11) states cancellation of debt (“COD”) income on an exchange equals the difference between (a) the adjusted issue price of the old debt minus (b) the adjusted issue price of the new debt. Market price is the relevant metric for public debt instruments. For private debt instruments, the stated principal amount is used, unless the instrument does not yield adequate stated interest. In that case, the IRS discounts by the applicable federal rate as per IRC §1274.

Debt Discharge and COD Income

While debt discharge normally creates a taxable gain under IRC §61, IRC §108 allows exclusion of COD income from gross income under any of the following four conditions:

Occurs in a Bankruptcy Code (“BRC”) case
Occurs when taxpayer is insolvent
Is qualified farm indebtedness
Is qualified real property indebtedness1
The amount of excludable COD income is capped at the amount of the debtor’s insolvency, determined by the value of assets and liabilities immediately before discharge. Consider an out-of-court restructuring for a debtor with the following characteristics:

Debt outstanding: $20M

Market value of assets: $10M

Debt discharged: $12M

This debtor meets condition (2) and is insolvent by $10M: accordingly, $10M of the discharge is excludable. However, $12M of debt has been discharged, so the debtor will owe tax on $2M of COD income ($12M - $10M).

For debt discharged that is excluded (the $10M in the above example):

The debtor may make a IRC §108(b)(5) election, which allows the debtor to reduce its basis in depreciable assets by the amount of the excluded debt discharge. This reduction cannot exceed the debtor’s basis in depreciable property during the first tax year after the discharge (no negative basis).

If the debtor does not make the IRC §108(b)(5) election, there is a “waterfall” of tax attributes that must be reduced in the following order:

Net Operating Losses (“NOL”s)
General Business Credits
Alternative Minimum Tax (“AMT”) Credits
Capital Loss Carryovers
Basis of Assets
Passive Activity Loss and Credits
Foreign Tax Credits
(2), (3), (6) and (7) above are reduced by 33⅓ cents per dollar of debt discharged, while (1), (4) and (5) are reduced dollar-for-dollar.

NOLs and Section 382

Under IRC §172(b), NOL can be carried back two prior taxable years and carried forward twenty. IRC §382 limits NOL utilization by a company that has undergone an ownership change: the maximum deduction is the value of the loss corporation's equity times the IRS “long term tax exempt rate”. Consider the following example:

Value of loss corporation’s equity: $100M

Value of loss corporation’s NOL: $10M

Long term tax exempt rate: 5%

The use of the NOL by an acquirer is limited to $5M per annum (5% * $100M). Additional time-based limitations apply if the loss corporation’s NOL is greater than 25% of the loss corporation’s equity. NOL treatment is particularly pertinent in bankruptcy, as the debtor may have made significant prior losses, and may undergo a change of control as a result of restructuring.

There is a “bankruptcy exception” under IRC §382(l)(5): if historical shareholders and creditors2 of a loss corporation in bankruptcy own more than 50% of the loss corporation’s equity after the reorganization, the loss limitation on NOL usage does not apply. However:

Per IRC §382(l)(5)(B), NOLs will be reduced by any interest deducted by the debtor over the three past taxable years plus interest deducted in the current year on any debt converted into equity. However, if the debtor makes an election under IRC §382(l)(6), the IRC §382 limitation on NOL usage is calculated using the equity value of the debtor after the conversion of debt to equity. Making this election can make sense for a debtor which has converted a large amount of debt to equity, as more NOLs may be preserved after making this election than under the bankruptcy exception.

IRC §382(l)(5)(B) mandates that a second ownership change within two years of the ownership change resulting from bankruptcy will trigger the elimination of any NOL carryforwards that arose before the ownership change that resulted from bankruptcy.

Tax issues can have a major present and future cash flow impact on a company undergoing restructuring, with attendant value implications that a distressed investor ought to consider. Fortunately, most disclosure statements now include detailed explanations of a plan’s expected tax consequences. The CIT Group, Inc. bankruptcy provides one recent example of the management of tax concerns during a particularly complicated proceeding.

2 comments:

julia 2/10/2010  

Their largest positions were in "low priced senior corporate credit in challenged industries such as auto finance and residential real estate." This is very similar to the approach of Marty Whitman's team at Third Avenue and frankly my approach as well. As the letter continues to point out, the up-side / down-side in that trade is very good when you are buying the most senior bank debt in the 60s/70s.
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robert
http://www.easyfinancialbliss.com

Kyle S 2/10/2010  

That looks a lot like CIRA material. Is "Grant" really Grant Newton?

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I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.