During the course of the financial crisis, many private equity professionals learned a bitter tax lesson—if the terms of a debt instrument are modified while the debt is considered “traded on an established market” for tax purposes, the issuer of the debt can have immediate taxable income if (and to the extent that) the face amount of the debt exceeds its trading price. Many fortunate taxpayers were able to escape large tax bills by concluding that the debt instrument being modified did not meet the tax law’s definition of “traded on an established market.”

Last month the IRS changed the applicable rules so that going forward pretty much every debt instrument (including bank debt) held by unrelated parties will be considered to be “traded on an established market” (unless the principal amount of the debt does not exceed $100 million). These changes are likely to cause more companies to recognize “cancellation of indebtedness income” (“COD income”) when restructuring (or even modifying) their debt outside of bankruptcy. Further, these changes make it more likely that taxpayers will recognize COD income when a bridge loan is exchanged for more permanent financing.

Some Background

If a taxpayer satisfies a debt instrument for an amount less than the “adjusted issue price” of the debt, the taxpayer has COD income equal to the difference. When the debt is satisfied with cash, the calculation is easy. For example, if a taxpayer satisfies $100 of debt with $80 of cash, the taxpayer has $20 of COD income.

When debt is satisfied with property other than cash (including the issuance of another debt instrument), the analysis is more difficult because the value of the property must be determined. Years ago, Congress adopted a simplifying convention that was designed to avoid valuation disputes: If the debt being satisfied or the property being used to satisfy the debt is “traded on an established market,” the tax law will generally treat the debt as having been satisfied for an amount equal to the trading price. However, if neither the debt nor the property is “traded on an established market,” the tax law will generally treat the debt as having been satisfied for an amount equal to its face amount.

Suppose, for example, that a taxpayer has $100 of outstanding debt that is trading at $80 on an established market. If the debt instrument is exchanged for a “new” debt instrument with a $100 face amount, the “old” debt will be generally treated as having been satisfied for $80 (meaning the issuer will have $20 of COD income) and the new debt will generally be treated as having been issued for $80 (meaning there will be $20 of OID on the new debt instrument). While the OID on the new debt instrument will generally match the COD income, the deductions for the OID may be deferred or disallowed under the so-called AHYDO rules if the yield exceeds the “applicable federal rate” plus 500 basis points.

If neither the “old” debt nor the “new” debt is traded on an established market, the tax law will generally treat the old debt as having been satisfied for an amount equal to the face amount of the new debt (which, assuming the same face amount, would typically mean that the issuer has no COD income as a result of the exchange and that there would be no OID on the new debt).

If there is a “modification” to the terms of a debt instrument and the modification is considered economically significant, the debt instrument will be treated for tax purposes (including the COD income and OID rules described above) as having been satisfied in exchange for a new debt instrument. Suppose, for example, that a significant modification is made to a $100 debt instrument. The tax law would deem there to be an exchange of the “old” (pre-modification) debt instrument for a new (post-modification) debt instrument. If the debt was trading for $80 on an established market, the issuer would generally have $20 of COD as a result of the deemed exchange and the “new debt” would generally have $20 of OID (possibly subject to the AHYDO rules). By contrast, if the debt were not traded on an established market, the “old debt instrument” would generally be treated as having been satisfied for $100 (meaning no COD income) and the new debt instrument would be treated as having been issued $100 (meaning no OID).

Various types of changes to the terms of a debt instrument can create a deemed exchange of the debt instrument, including even modest changes to the timing or amount of any payments and changes to the collateral or priority of the debt instrument.

The New Definition of “Traded on an Established Market”

Under the new regulations, debt will be treated as traded on an established market if, within an applicable time period, there is either a sales price for the debt or there is a quote (either firm or indicative) available from at least one broker, dealer, or pricing service. The applicable time period for which a sales price or quote must occur is any time during the 31-day period ending 15 days after the issue date. In the event there is more than one sales price or quote, the issuer may use any reasonable method to determine the fair market value of the debt and must consistently apply such method in similar circumstances.

The IRS has not defined the term “available” for these purposes. However, if calling one banker and receiving a quote counts as “available,” then virtually all debt is likely to be treated as traded on an established market. Under the new regulations, the issuer is expressly required to determine whether a debt instrument (or other property) is traded on an established market and, if so, the fair market value. Further, if the issuer determines that a debt instrument is traded on an established market, the issuer is required to make that determination (as well as the issuer’s fair market value determination) available to the holders of the debt instrument in a commercially reasonable fashion within 90 days. The regulations also generally require that the issuer and the holders report the issue price consistently on their tax returns.

The new rules for determining when debt is treated as traded on an established market apply to debt instruments issued on or after November 13, 2012. However, the new regulations do not apply to any issuance of debt if the outstanding stated principal amount of the debt does not exceed $100 million at the time the determination is made.