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 portfolio companies or in other companies, in each case believing the debt was undervalued and would recover along with the issuer’s fortunes. The emergence 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 predictable 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 spectrum 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 classification 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 integrated 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 significant 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.
All of these themes raise the question: Would broader changes in the tax law be appropriate to address distressed debt and other problem areas in debt–equity characterization and treatment? For example, one could retain the debt–equity distinction and reclassify distressed debt as equity when the debt trades below a certain level—but that approach exacerbates the cliff effect of a regime that pigeonholes instruments as either debt or equity. Another approach would be to do away with the debt–equity distinction and adopt a uniform approach for both. For example, holders could be required to accrue a fixed percentage of their basis into income each year, regardless of whether the holder holds debt or equity, or holders could be required to mark-to-market (i.e., to recognize gain or loss annually based on changes in value of the debt or equity that they hold). A third paradigm would be a system in which quintessential debt and equity instruments are taxed according to different rules, and instruments that lie between the poles are taxed according to a graduated system. For example, an instrument could be given a rating based on where it falls along the debt–equity spectrum and taxed according to such rating.
This Article uses a “life cycle” paradigm to illustrate the pressures that distressed debt places on the debt–equity distinction in tax law. The life cycle of a distressed debt investment typically involves an investment in troubled debt, followed by an exchange for new debt or a modification of the terms of the debt, and finally, an exchange of the debt for equity. Frequently, a restructuring is on the horizon when a firm makes an investment in distressed debt because the issuer is unable to meet its payment obligations or satisfy financial covenants contained in the debt. An exchange for equity, for example, is an acknowledgment that the holders have been taking equity-like risks.
Rules that work comfortably in the context of regular debt often appear anomalous in the case of distressed debt. Working within the confines of the current-law debt–equity distinction, there are two principal remedies to many of the issues discussed in this Article. First, the market discount rules that generally apply to debt instruments should not apply to distressed debt. Such rules are designed to address timing issues and presuppose a relatively steady and secure flow of income from an instrument, an unwarranted assumption in the case of distressed debt. Moreover, turning off the market discount rules does not create a disparity between issuer and holder treatment because the issuer does not deduct the market discount. Second, the concept of “recapitalization” in section 368(a)(1)(E) should be understood broadly in the context of a distressed debt exchange. In a recapitalization, a holder exchanges one instrument of an issuer for another without recognizing gain or loss. A broad understanding of “recapitalization” avoids anomalies that would otherwise apply in the case of exchanges of debt for debt or debt for equity. These exchanges do not seem like the appropriate time to tax holders, or worse, disallow losses, as can be the case under current law.
As discussed in Part II, during the investment phase of the life cycle of a distressed debt investment, a holder confronts the market discount accrual rules. Those rules emulate, for the holder, the original issue discount (OID) rules, which in turn emulate rules relating to interest—none of which are a proper paradigm for an instrument that behaves like equity, such as distressed debt. Just as the OID rules apply when a debt instrument is issued for a price less than its principal amount, the market discount rules apply when a debt instrument is purchased from an existing holder for a price less than its principal amount. The OID rules treat such excess as being akin to interest and require holders to accrue it into income over the term of the note. The market discount rules take a similar tack but allow a holder to refrain from including the market discount in income as long as gain on a disposition is treated as ordinary. The theory behind the market discount rules is that the market discount is generally caused by a rise in prevailing interest rates and thus that the market discount relates to the time value of money, like interest. However, under circumstances of distress, where the note trades at a significant discount to its issue price, the spread no longer bears any resemblance to interest. Hence, as argued in Part II.A, neither the theory nor the policy goals underlying the market discount rules have relevance in the context of distressed debt.
Moreover, the application of an interest paradigm to distressed debt, which behaves like equity, leads to anomalous results, as illustrated in Parts II.B and C. Part II.B argues that, assuming the market discount rules apply in the first place, a holder of a bridge loan in circumstances of distress should be entitled to accrue market discount over the entire term of the bridge loan, rather than a shorter period that might be suggested by the OID rules.
Part II.C addresses a scenario in which a taxpayer contributes a market discount bond to a partnership at a time when market discount has accrued but no gain is built into the bond (i.e., value is less than or equal to basis). For example, a private equity fund holding a market discount bond may wish to move the bond around within the fund structure, including by contributing the bond to a partnership. This Article argues that if the market discount bond is subsequently sold by the partnership at a gain, the gain should be ordinary to the extent of the accrued market discount. The contributing partner should not be treated in any special way because the appreciation occurs after the contribution. The gain, and the ordinary income taint, should be allocated according to the partnership’s usual sharing ratios.
As in the first phase, in the second phase of the life cycle of distressed debt—a modification or exchange of the debt for new debt (sometimes referred to as an “amend and extend” transaction)—the market discount rules lead to unintuitive and harsh results for holders, as discussed in Parts III.A and B. For example, if the transaction is a recognition event, a holder that owns a significant stake in the issuer might realize and recognize a loss that is permanently disallowed. Other holders might recognize a capital loss. In either case, a holder might face ordinary income OID inclusions going forward, despite there being little prospect of recovering the full principal amount of the loan. Further, capital losses cannot be used against ordinary income, thus whipsawing a holder who has recognized a capital loss (or worse, who has recognized a loss that was disallowed).
Recapitalization treatment of the exchange avoids some of those undesirable consequences. Whether the transaction qualifies as a recapitalization depends, among other things, on whether the old debt and the new debt qualify as “securities,” which is largely a function of the debt instruments’ term to maturity. Part III.C argues that bank debt should not be precluded from being viewed as a security by reason of the issuer’s right to repay the debt at any time. Part III.D describes another possibility for ameliorating the harsh results—qualification as a transaction that is not a realization event under Regulation section 1.1001-3. This Article argues that, under certain circumstances, bank debt might qualify for a relatively liberal measure as to whether the yield on the debt has changed sufficiently to trigger a realization event.
Part IV discusses the last phase of the life cycle, an exchange of distressed debt for equity (sometimes called a “loan to own” transaction). In these transactions, the economic similarity of distressed debt to equity is formalized by transferring equity interests to the debt holders in exchange for their debt. Part IV.A challenges the commonly received view that if debt is recapitalized into stock, the accrued market discount should carry over to the stock. Instead, the accrued market discount should carry over—but not in excess of the amount of gain built into the debt at the time of the exchange. Appreciation that occurs while the holder holds stock should never be characterized as ordinary under the market discount rules because it is plainly not interest-like, even if market discount on the debt had accrued prior to the exchange of debt for stock.
Part IV.B focuses on another common debt-for-equity scenario, a scenario where debt has been issued by an operating subsidiary and, in the exchange, debt holders receive parent company stock for the operating subsidiary’s debt. There are at least three models for characterizing such a transaction. Moreover, if steps are taken to liquidate the subsidiary for tax purposes, additional characterizations are possible. This Part argues that taxpayers should be able to choose among these alternative characterizations by formally structuring the transaction in the desired manner.
In another vein, Part IV.C argues that the similarity of distressed debt to equity means that restructurings of distressed debt should not give rise to a trade or business on the part of non-U.S. holders of the debt. If a fund acquires distressed debt and leads a workout where the distressed debt is exchanged for equity, or for a combination of equity and debt, such activities should not give rise to a trade or business because the transaction formalizes the equity-like nature of the debt and no new cash is introduced into the system.
Ultimately, the tax problems and anomalies discussed in this Article arise from applying tax rules designed for quintessential debt instruments to distressed debt, which behaves like equity. Tax law should be flexible enough to adapt to this economic reality notwithstanding the long-standing conceptual view of debt and equity as sharply distinguishable types of investments. The contrast between the way financial actors think about debt and the way tax law addresses debt has long been recognized, but this Article’s analysis of distressed debt further illustrates the pervasiveness of the issue.