Distressed Debt Advanced Lesson: CODI

Consideration of cancellation of debt income (CODI) is a factor that have affected how bankruptcy plans have been implemented and constructed in a number of major Chapter 11 cases over the past few years. With that said, recently the IRS released their final regulations for determining the issue price of a debt instrument which has a direct effect on amount of cancellation of debt income to be calculated. A few weeks ago, LCD ran a fantastic article penned by the LSTA discussing these new regulations and how they will affect amendments in the syndicated loan market. The LSTA has allowed me to reprint the article below. For more information, readers can contact Tess Virmani at the LSTA. Enjoy!

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In October, the LSTA reported that the IRS released the final regulations on debt exchanges. While this may sound less than riveting, in reality the new Cancellation of Indebtedness Income (CODI) final rules (“CODI Rules”) will profoundly impact the syndicated loan market when borrowers seek to amend or modify their loans.   To briefly review, under the final regulations, virtually any amendment of a loan would be treated, from a tax perspective, as the retirement of the pre-modified loan in exchange for the “modified loan”, which is treated as newly issued (a “deemed exchange”). The “issue price” for the modified loan is different depending on whether the pre-modified loan is “publicly traded”. If it is publicly traded, the issue price is the market price of the pre-modified loan at the time of the modification. If it is not publicly traded, the issue price is par. As explained below, the “publicly traded” status is critical and could have significant adverse tax implications for stressed and distressed borrowers and/or distressed investors. Here are the Top 10 takeaways:

1. Virtually any amendment, revision, compromise or workout leads to a “deemed exchange” triggering the CODI Rules. Indeed, the threshold here is very low, with any change in maturity, change in obligor, shift in recourse to non-recourse and changes in annual yield as low as 25 bps cause a “deemed exchange”. (According to LCD data, there were more than $700 billion of such amendments since 2008. The average spread change on these loans was more than 100 bps, thus usually triggering CODI.)
2. The CODI Rules make it abundantly clear that most of the loans in our market, i.e. large syndicated loans for which market prices are quoted, are now deemed “publicly traded” whether or not they are actually actively traded.
3. Loans and tranches of loans under $100M, whether or not actively traded, are considered not publicly traded under a new per se rule. 
4. If a debt instrument is publicly traded, the price of the exchanged debt is deemed to be the market price at the time of the exchange.
5. If the debt instrument is not publicly traded (or under $100M), the exchange price is par.
6. A borrower must recognize – and pay tax on – current CODI equal to: i) in the case of a publicly traded loan, the difference between the issue price of the old loan and the market price at the time of the exchange, or ii) in the case of a loan that is not publicly traded (or under $100M), the difference between the issue price and the par price of the new debt at the time of the deemed exchanged, even though there is no actual cancellation of debt and no source of cash to pay the tax liability.
7. A lender may have a current taxable gain equal to: i) in the case of a publicly traded loan, the difference between the price at which the debt was purchased and the market price at the time of the exchange, or ii) in the case of a loan that is not publicly traded (or under $100M), the difference between the price at which the debt was purchased and the par price of the new debt at the time of the deemed exchanged, even though it did not sell its position.
8. A borrower is obligated to determine whether a loan is publicly traded and if so, what the price is, and the borrower is obligated to advise its lenders of that price. Furthermore, lenders are bound by the borrower’s determination. (CODI Rules contain an anti-abuse provision so that borrowers may not simply determine the loan is not publicly traded to avoid the CODI Rules.)
9. For a borrower, to the extent it has current losses or deferred tax assets (like net operating losses), it can offset the CODI against those. Also, as a result of the deemed exchange, it also gets original issue discount (“OID”) in an amount equal to the amount of the CODI. In many cases, it can amortize the OID on a constant yield basis over the remaining life of the modified loan. However, this would still leave the borrower with a timing mismatch, i.e., a taxable gain in year one and deductions over a period of a few years. This will surely impact borrower restructurings.  Also, there could be circumstances that prevent the borrower from amortizing the OID.
10. For a lender, unless it sells the loan in the same year as the loan modification, it, too, will have a timing mismatch, having to recognize income for the deemed exchange in year one, while not being able to recognize a loss until an actual sale of the loan. Moreover, according to a memo by Cleary Gottlieb, the lender “may be required to treat part of its gain as ordinary income, under the market discount rules”, creating a “character mismatch” (ordinary income vs. capital loss) that might result in a net tax cost to the lender. 

A practical example may illustrate the dangers. Assume a loan was originally syndicated at par, is currently trading at 80 and was purchased by a lender at 60.  Under the CODI rules, if the loan is publicly traded, the borrower will recognize – and pay tax on – 20 cents of CODI (from par issue price to 80 “repayment” price) and the lender will recognize – and pay tax on – current income of 20 cents (from 60 purchase price to 80 “repayment” price).  If the loan is not publicly traded, the borrower will not recognize any CODI and the lender will recognize – and pay tax on – 40 cents of current income (from 60 purchase price to par “repayment” price).  Importantly, if a loan is quoted above par (currently 47% of loans in the index), then the borrower is entitled to a current deduction in the amount of the premium if such old or new loan is "publicly traded" and the lender generally would be required to measure its gain based on the par-plus market price.

It is unclear how the market will respond to the CODI Rules - if it will curb amendment activity (particularly opportunistic deals), further encourage a move to covenant lite loans, or increase wariness of distressed investors in middle market deals - but one thing is certain, these new tax consequences will have to be examined closely each time a loan is modified.