Section 1106 of the Coronavirus Aid, Relief, and Economic Security Act or the “CARES Act” provides a framework whereby small businesses can obtain loans from the SBA that may be forgiven to the extent of certain business expenses, including rent. Generally, when a loan is forgiven, the debtor is taxed on the amount forgiven under Internal Revenue Code §108 (subject to statutory exceptions). This is a positive temporary measure of relief for many struggling small businesses, but it may not be enough. Furthermore, businesses that do not depend upon the SBA program as a source of financing may find themselves in a cash squeeze, whether they are commercial landlords with distressed retail tenants or manufacturers with supply chain problems. While taxes are generally the last thing on a borrower’s mind when in negotiations with a lender, an unexpected tax liability can arise even when no money changes hands. As a result, it is in the interest of both lenders and borrowers to consider certain factors that could result in a “significant modification” of the debt that could generate cancellation of indebtedness income for the debtor and/or taxable gain for the lender.
How can a change in debt terms trigger tax?
The definition of an exchange under Code §1001 is very broad and can trigger unexpected consequences for the lender and borrower when the terms of a debt instrument are modified. When negotiating changes to debt instruments it is important to keep in mind two questions: (1) Is there a “modification” of the debt instrument, and (2) if so, is the modification “significant”? If the changes are considered a significant modification of the debt, then the lender and borrower could be treated as having swapped the original debt instrument for a new debt instrument. For the lender/holder of the debt, this could trigger taxable gain (just as if the lender had sold a piece of property). For the borrower, this could result in cancellation of indebtedness income taxable at ordinary income rates. Thus, it may be in the best interest of both parties to the negotiation to be cognizant of the debt modification rules set forth in Treasury Regulation § 1.1001-3.
Is there a modification?
For a change in a debt instrument to be treated as a taxable exchange, there must first be a modification. A modification is broadly defined as any alteration of a legal right or obligation of the issuer or holder of the debt instrument. This would seem to capture any change in the terms of the debt. Fortunately, the Treasury Regulations provide some exceptions.
First, if the alteration of the terms is a result of the automatic operation of the debt instrument, then there is no modification. For example, if the interest rate of the debt automatically adjusts due to a decrease in the value of the collateral, then there is no modification. In contrast, if lender and borrower mutually agree to increase the interest rate because of a decrease in the value of collateral, then there is a debt modification.
Second, a unilateral exercise of an option granted to the issuer or holder by the debt instrument to change the debt terms is also not a modification. For example, the unilateral right of the borrower to convert from a fixed rate of interest to a variable rate is not a modification. It is important to stress that this option must be unilateral. If the borrower needs the consent of the lender to convert the interest rate, then a modification occurs because the lender is basically giving its consent to a change made by the debtor. Also, this unilateral option exercise exception is further limited by a prohibition on the exercise resulting in a deferral or decrease in the amount of a payment of interest or principal. It should be noted that this should not apply to a forbearance by the lender of the exercise of its rights under a debt in default. Under a forbearance, there is typically no change in the payment terms. Rather, the debtor is still considered in default and must cure the default by making the payment under the current terms of the debt instrument. A modification occurs when the terms are modified to allow a deferral of payments without triggering a default.
Unfortunately, like many other areas of the Code and Treasury Regulations, nothing is ever straightforward. The Treasury Regulations provide exceptions to these exceptions to what constitutes a modification. For example, if there a change in the identity of the obligor or the nature of the debt instrument (i.e., from recourse to nonrecourse), then the change may be a modification, even if the change arises out of the unilateral option granted by the original debt instrument. Also, if there are changes to the debt to the extent that it is no longer considered “debt” for federal income taxes, then the change is a modification.
Is the modification significant?
Even if the actions by the borrower and/or lender meet the definition of a modification, the actual or deemed changes to the debt instrument must still be material enough to rise to the level of “significant” to trigger an exchange under Code § 1001. The Treasury Regulations provide both a general rule and specific rules for making this determination. The general rule provides that a modification is significant if, based on all facts and circumstances, the legal rights or obligations are altered and the degree to which they are altered is economically significant. This rule generally acts as a backstop to economically significant changes to debt instruments that do not fall under one of the specific rules.
In addition to the not very helpful general rule are rules that provide specific circumstances in which a modification will be considered significant. First, a change in yield of the debt instrument is a significant modification if the yield on the modified instrument varies from the annual yield on the unmodified instrument by more than the greater of (1) 25 basis points or (2) 5% of the annual yield of the unmodified instrument. This can occur as a result of an agreed change in interest, as well as a reduction in principal and applies to debt instruments with fixed interest rates, variable rates, and other listed types of debt.
Second, a material deferral of a scheduled payment is significant unless the deferral qualifies under a safe harbor period. The safe harbor period begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50% of the original term of the instrument. Again, this is different from a forbearance because the actual terms of the instrument are being changed instead of the lender agreeing to not exercise its rights under the debt instrument.
Third, a change in the identity of the obligor or the security of the debt is also considered significant. This factor is also addressed in analyzing whether a modification occurs, except that the change is subject to certain qualifications primarily centered around a change in payment expectations. A change in payment expectations occurs when there is either a substantial enhancement of the obligor’s capacity to meet a payment obligation and such capacity was primarily speculative before the modification, or there is a substantial impairment to the obligor’s capacity to meet a payment obligation and the capacity goes from adequate prior to the modification to speculative. When analyzing an obligor’s capacity, you look to the source of payment, including guarantees, collateral and other credit enhancements. To summarize, if the change in obligor or security either increases or decreases the likelihood of the lender getting paid, then there is a change in payment expectations.
The following changes to obligors or debt security are considered significant:
- A substitution of new obligor on recourse debt if there is a change in payment expectations;
- An addition or deletion of a co-obligor if there is a change in payment expectations;
- A change in security or credit enhancement for recourse debt if there is a change in payment expectations;
- A change in a substantial amount of collateral, guaranty or other credit enhancement for nonrecourse debt unless the security is fungible or there is a substitute of commercially similar credit enhancement or improvement to the property serving as collateral; or
- A change in priority of the debt.
Changes in the nature of the debt instrument may also be significant. Again, you must look to see if the debt is no longer considered “debt” for federal income tax purposes. Also, changes to the debt from recourse to nonrecourse are considered significant; however, defeasance of tax-exempt bonds are not considered significant where a trust is funded with governmental securities that provide a reasonably possibility of paying off the defeased bonds.
There are many other nuances to the Treasury Regulations that have not been discussed here, particularly when the debt consists of tax-exempt bonds or conduit loans. Nevertheless, the above can serve as a useful reference for identifying potential tax consequences from a debt restructuring. Bradley is here to help guide you through these discussions and plan for these and other tax issues that may arise.