The Tax Lawyer
Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.

The Taxation of Distressed Debt Investments: Taking Stock

Deborah L. Paul*

In the most recent economic downturn, mergers and acquisitions deal-making became a story about debt. While conventional strategic and private equity acquisitions subsided, debt of potential acquisition targets traded well below its face amount, tempting buyers seeking an equity-type return to invest in debt. Private equity firms and other investors bought debt in their own port¬folio companies or in other companies, in each case believing the debt was undervalued and would recover along with the issuer’s fortunes. The emer¬gence of a vibrant market in distressed debt puts pressure on many concepts relating to debt in the tax law, and highlights the contrasts between the way the tax law addresses debt and the way financial actors in the real world think about debt.

Tax law is premised on conventional views about the nature of debt and equity. Under those views, debt is a stable investment with a steady predict¬able cash flow, while common stock is volatile and reflects the fortunes of the issuer and the residual value of the company. Distressed debt undercuts these conventional views. The value of distressed debt is much lower than its face amount, and the economics of the instrument behave like equity. If the company’s fortunes improve, the debt holders will benefit; if the company’s fortunes decline, the debt will plunge further in value. Indeed, an instrument can start off behaving like traditional debt and then, as the condition of the issuer, its industry, or markets as a whole deteriorates, the instrument may slide in value and behave in an increasingly equity-like fashion.

The sharp distinction in tax law between debt and equity—including its “all or nothing” aspect and relatively immutable fixing of states at the time of issuance—does not reflect reality, as has long been recognized; but distressed debt challenges the conceptual basis of the debt–equity distinction in a new way. Most debt–equity hybrids are “structured” in the sense that the terms of the debt are designed to incorporate debt- and equity-like features, while the typical terms of distressed debt are “plain vanilla,” i.e., purely debt-like. The equity nature of distressed debt arises through market forces. Distressed debt thus highlights that the difficulties with the debt–equity distinction are basic and inherent.

Financial actors recognize that there is a debt–equity gradient rather than a debt–equity distinction. For example, rating agencies rate debt along a spec¬trum according to risk; the most secure debt instruments receive the highest rating and the most speculative receive the lowest. Moreover, not only does tax law reject the idea of a debt–equity gradient, insisting on classifying the instrument as debt or equity, but tax law classifies instruments as debt or equity based on the facts at the time the instrument is issued. This classifica¬tion is generally not reevaluated after issuance—investors in the financial world, by contrast, continually reevaluate whether the assets they hold are consistent with the investor’s risk profile.

Furthermore, tax law generally aims for conformity between the treatment of a creditor and debtor. The tax treatment of debt is considered to be an inte¬grated regime that applies to holders and issuers; likewise, the tax treatment of stock is considered to be an integrated regime that applies to shareholders and issuers. But this insistence on conformity between holder and issuer has its pitfalls. What is appropriate for the issuer is not always appropriate for the holder and vice versa. Integrating issuer and holder rules sometimes means that, in the name of conformity, the most appropriate rule is not adopted for one group or the other.

This Article focuses primarily on creditor issues. For example, a signifi¬cant focus of the Article is the “market discount” rules—the regime relating to a purchase of debt from a holder (as distinguished from the issuer) at a discount. The market discount rules relate to the timing and character of a holder’s income, but do not affect the issuer at all. The Article also discusses issues relating to whether an exchange of debt for new debt or equity is a recapitalization, also purely a creditor issue. Other rules discussed affect both issuers and holders, such as rules relating to reissuances of debt instruments and the creation of original issue discount. Different sets of pressures exist when both issuer and holder consequences are at stake.

*Partner, Wachtell, Lipton, Rosen & Katz; Harvard University, A.B., 1986; J.D., 1989; New York University School of Law, LL.M., 1994. The author thanks Tijana Dvornic for superb research assistance, Peter Canellos and Joshua MacLeod for helpful comments, and Vincent Kalafat and Rachel Carlton for excellent work on selected sections. All errors are the author’s own.

Published by
Section of Taxation,
American Bar Association
in Collaboration with the
Georgetown University Law Center

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