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.
U.S. Trade or Business Implications of Distressed-Debt Investing
Peter A. Furci*
Over the past several years, we witnessed a tremendous increase in the amount of debt issued to finance corporate transactions (and, it appears, real estate in Florida and Nevada). During that frothy period of time, many tax practitioners advised clients, especially private equity and hedge funds, on the U.S. trade or business implications of investing in debt securities and, in particular, whether their proposed activities would give rise to income effectively connected with the conduct of a trade or business within the United States (ECI) from a U.S. lending business.
The massive disruptions in the credit markets, which began in the summer of 2007, resulting in a severe tightening of liquidity, significant declines in debt trading prices, and overall deleveraging, now appear to be joined by the possibility of an extended period of difficulty in the so-called “real economy,” further jeopardizing the fortunes of the issuers (corporate and individual) of the trillions of dollars of already troubled debt assets in the market. Not surprisingly, the questions now regularly confronting the tax practitioner reflect the current state of affairs, covering such issues as cancellation of debt income and applicable high yield discount obligation (AHYDO) implications of debt buybacks and loan modifications, as well as the topic of this Article: whether transactions involving distressed debt can constitute a U.S. trade or business for non-U.S. taxpayers.
This Article focuses on a few discrete issues which recur with some frequency: (1) whether significant modifications of debt instruments and participation in so-called “debtor in possession” (DIP) financings can give rise to a U.S. lending business; (2) whether participation in the restructuring of distressed debt causes the income and gain from the restructured securities to be ECI derived in a trade or business of “promoting” issuers; and (3) if not viewed as ECI from promotion activity, whether purchases of debt securities, followed by restructuring and resale, can in certain circumstances give rise to dealer status.
*Debevoise & Plimpton LLP