Section 108 of the Internal Revenue Code was amended by the American Recovery and Reinvestment Act of 2009 (2009 Recovery Act) to allow qualifying taxpayers to elect to defer cancellation of indebtedness (COD) income resulting from certain debt workouts. Where available, this provision allows a taxpayer that is modifying or repurchasing its own debt directly (or indirectly through certain related parties) to defer the resulting COD income. Although this election is available only for debt modifications and repurchases occurring during calendar years 2009 and 2010, it provides welcome relief where one of the existing exceptions to the recognition of COD income is not otherwise available, and provides an alternative approach in situations where an existing exception is available.
Cancellation of Indebtedness Income
COD income generally equals the excess of the adjusted issue price of the indebtedness being repurchased over the amount paid (or deemed paid) by the taxpayer (or a related party) to satisfy such indebtedness. COD income can also result when debt is being modified even, in certain circumstances, when none of the principal is being forgiven. Unless one of the current exceptions set out in Code Sec. 108(a) applies, COD income is required to be recognized in the year in which the applicable debt modification or repurchase event occurs. Exceptions are provided in Code Sec. 108(a) for debtors in title 11 bankruptcy cases, insolvent debtors, certain student loans, certain farm indebtedness, certain real property business indebtedness and certain qualified principal residence indebtedness. If an exception applies, the taxpayer generally is required to reduce its tax attributes by the amount of the excluded COD income, including its net operating loss carryovers, general business credit carryovers, minimum tax credit carryovers, capital loss carryovers and tax basis in property. An exception from the recognition of COD income is also provided, in certain circumstances, for COD income attributable to “purchase-money debt.”
The 2009 Recovery Act adopted new Code Sec. 108(i), which allows a taxpayer that modifies or repurchases a debt instrument during calendar year 2009 or 2010 to elect to defer the resulting COD income. Deferral is available, however, only for a qualifying “reacquisition” of an eligible debt instrument by the taxpayer or by a related person. A qualifying reacquisition includes the following:
The acquisition of a debt instrument for cash
The exchange of a debt instrument for another debt instrument (including a modification resulting in a deemed exchange)
The exchange of a debt instrument for equity of the issuer
The contribution of a debt instrument to the capital of the issuer by an equity owner
The complete forgiveness of a debt instrument by a holder
An eligible debt instrument is broadly defined as any indebtedness issued by a C corporation, or by any other person in connection with the conduct of a trade or business by such person.
A deferral election is made under this new provision by attaching a statement to the taxpayer’s return for the taxable year in which the qualifying reacquisition occurs. The statement must clearly identify the debt instrument subject to the election, the amount of deferred COD income, and any other information that may be prescribed by the Internal Revenue Service. An election to defer COD income is to be made separately on a debt instrument by debt instrument basis.
Deferral Period and Acceleration Events
COD income that a taxpayer elects to defer pursuant to new Code Sec. 108(i) must be included in the taxpayer’s income ratably over the five-year taxable year period beginning with the fifth taxable year following the taxable year in which the reacquisition event occurs (for calendar year 2009 reacquisitions), or the fourth taxable year following the taxable year in which the reacquisition occurs (for calendar year 2010 reacquisitions). For example, if a calendar year taxpayer realizes COD income as a result of the complete forgiveness of its debt by a holder occurring in calendar year 2009, a deferral election would allow the taxpayer to recognize the COD income ratably over the five-year period beginning 2014 and ending 2018.
Deferred COD income that has not previously been taken into account is accelerated into income in the taxable year in which any of the following acceleration events occur: the taxpayer’s death, the taxpayer’s liquidation or sale of substantially all of its assets (including in a Title 11 or similar case), or the taxpayer’s ceasing to do business. The Internal Revenue Service is authorized to prescribe regulations requiring acceleration in other circumstances where appropriate. In the case of a tax pass-through entity, an acceleration event also includes the sale, exchange or redemption of an equity interest in the entity by a holder of such interest.
Special deferral rules are provided for tax partnerships. Specifically, any income that is deferred under Code Sec. 108(i) must be allocated to the partners in the partnership immediately before the debt repurchase event in the same manner as such amounts would have been included in the distributive shares of such partners under Code Sec. 704 if such income were recognized at the time of the discharge. Any decrease in a partner’s share of liabilities as a result of such discharge is not taken into account for purposes of Code Sec. 752 at the time of the discharge to the extent the deemed distribution under Code Sec. 752 would cause the partner to recognize gain under Code Sec. 731. This means that the deemed distribution under Code Sec. 752 is deferred with respect to a partner to the extent it exceeds such partner’s basis in its partnership interest. Any resulting amounts that are deferred are then taken into account at the same time, and to the extent remaining in the same amount, as income deferred under the provision is recognized by the partner.
If a taxpayer elects to defer COD income resulting from a debt-for-debt exchange in which the newly issued debt instrument is treated as having been issued with original issue discount (OID), the taxpayer is required to defer all or a portion of the otherwise allowable OID deductions on the newly issued debt instrument. This rule applies to any such OID that accrues before the first year of the five-year period in which the deferred COD income is required to be included in the taxpayer’s gross income, but only to the extent such OID does not exceed the amount of deferred COD income; OID deductions in excess of the deferred COD income are not subject to deferral. Any OID deductions that are deferred can be deducted by the issuer ratably over the same five-taxable-year period in which the deferred COD income is recognized.
This OID deferral rule also applies where a taxpayer that elects to defer COD income issues a debt instrument and the proceeds of such issuance are used directly or indirectly to reacquire a debt instrument of the taxpayer. In that case, the newly issued debt instrument is treated as if it were issued in satisfaction of the repurchased debt instrument, and OID deductions with respect to the newly issued debt instrument are subject to the OID deferral rule described above. Note, however, that where only a portion of the proceeds of a new debt instrument are used to satisfy an outstanding debt, the OID deferral rule will apply only to the portion of the OID on the newly issued instrument that equals the portion of such proceeds that were used to repurchase the taxpayer’s outstanding indebtedness.
Any OID deductions that are deferred by reason of an election to defer COD income will be accelerated as a result of the same events that cause deferred COD income to be accelerated, as described above. These OID deferral rules apply only to the issuer, however, and do not affect a holder’s timing of recognition of OID income on such debt instrument.
Coordination with COD Exclusions Under Code Sec. 108(a)
Finally, as noted above, Code Sec. 108(a) includes several exceptions to the requirement that COD income be recognized upon the discharge of a taxpayer’s own indebtedness. In many cases, a taxpayer realizing COD income may have a choice between making a COD deferral election (which does not require the taxpayer to reduce any tax attributes), or relying on an existing exception under Code Sec. 108(a) (which requires the taxpayer to reduce tax attributes as provided for in the Code). In such situations, taxpayers will need to carefully evaluate which approach, under the circumstances, is preferable.