The recent frenzy of liability management transactions limited quantity and quality of Chapter 11 bankruptcy filings in 2023. While such filings increased modestly in 2023 compared with 2022, filings remained lower than pre-pandemic levels. Loose restrictive covenants in borrower-friendly loan agreements and bond indentures, among other things, caused this surge in liability management transactions.

While a wide range of solutions can be completed outside court, some of these transactions have included:

• Debt exchanges where the borrower issues additional debt to an existing lender that is senior to existing debt (up-tiering)
• Businesses pursuing open market discount debt repurchases
• Transfers of a business or assets to a new subsidiary, which can take on additional debt (drop-down financing)

These transactions can be extremely beneficial to the borrower and often result in substantial reduction of debt on the borrower’s balance sheet. However, when debt exchanges are consummated at a discount to face value, significant tax implications can force borrowers to consummate these transactions through the bankruptcy process.

Cancellation of Indebtedness Income

Understanding tax implications of cancellation of indebtedness income is valuable when evaluating liability management alternatives.

When debt is canceled for less than its face amount, the borrower must recognize CODI. Generally, CODI is taxable, and a borrower contemplating a discounted debt exchange or repurchase that is facing liquidity constraints can’t afford a substantial tax liability.

Tax on CODI may be avoided outside of bankruptcy under Section 108(a)(1)(B) of the Internal Revenue Code. In that case, a borrower can offset CODI by decreasing its tax attributes, including net operating losses and tax basis of assets, and avoid tax liability — but only to the extent of its insolvency. The amount of a borrower’s insolvency is determined by the amount its liabilities exceed the fair market value of its assets.

Proving whether and how much a company is insolvent is often highly scrutinized by the IRS. In our experience, we often performed a granular valuation of the assets to support our determination of fair market value in the context of an insolvency analysis.

In a bankruptcy context, no tax liability is imposed on the borrower/debtor in connection with CODI. However, like an out-of-court borrower, the debtor’s tax attributes will need to be decreased to offset the CODI. The tax attributes aren’t reduced below the amount of debt retained by the company.

The tax attributes are reduced at the beginning of the next tax year, which allows the company to use the attributes in the year the CODI is triggered. By reducing the tax attributes, the company’s future tax liability may be increased.

While most state tax rules for CODI and attribute reduction generally follow the federal rules, there are exceptions and technical issues such as sourcing the CODI.

Outlook

There are myriad considerations in assessing whether a borrower should effectuate a liability management transaction through a bankruptcy.

These include the impact on customers, employee and supplier relationships, incremental cost and negative publicity associated with such a process (which can be mitigated through a pre-packaged or pre-arranged filing), and the flexibility to drag non-consenters. But usually potential exposure to significant cash tax liabilities associated with CODI forces borrowers to file for bankruptcy and avoid an untenable impact to their liquidity and viability.

Understanding the tax impact of restructuring alternatives and a company’s post-restructuring tax posture is critical to evaluating liability management alternatives.

In any liability management transaction, the borrower should obtain credible valuation and tax advice from a reputable firm to determine its tax liability, to make a well-informed decision on how to implement (out-of-court versus bankruptcy), and ideally to protect itself from potential IRS scrutiny of its insolvency determination.

Originally published in Bloomberg Tax.