Debt restructuring alternatives for the financially troubled corporation: possible risks and benefits

Tax Executive, The, May-June, 1992 by Ronald C. Maiorano, P. Lawrence Tunnell

The potential income or reduction of TAC from debt forgiveness in a debt-for-debt exchange, when neither debt issue is traded on an ESM, is measured by the excess of the adjusted issue price of the old debt over the issue price of the new debt. The issue price of the new debt can be either the principal amount of the debt or the present value of the payments the debtor is required to make. The adjusted issue price of the old debt is not subject to being changed by the debtor. Therefore, the only way the debtor can affect the potential CODI in a debt-for-debt swap is by stipulating a stated rate on the new debt that is less than the AFR or by manipulating the stated maturity value of the new debt. Since most companies that find themselves in a debt restructuring situation desire a reduction in near-term interest payments, the natural tendency is for the debtor to negotiate a lower interest rate on the replacement debt. If the negotiation yields an interest rate lower than the AFR, the replacement debt must have a higher stated maturity value than the old debt to maximize the "issue price" of the new debt and avoid CODI recognition or TAC reduction.

Another way to achieve issue price maximization and short-term cash outflow minimization is to have the interest payments on the new debt begin in a later period, after interest on the debt has accrued and compounded for the first few years. Hence, interest would continue to accrue annually but payment of this interest is deferred for a stipulated period of time. This type of arrangement is illustrated in Exhibit 3.

A third means of maximizing the issue price of the replacement debt and minimizing short-term cash outflow is to have at least part of the interest on the debt be payable in new debt instruments or in the common stock of the corporation, rather than in cash. This method of issuing additional debt instruments in lieu of cash payments is referred to as paying-in-kind or issuing PIKs. Taxpayers have even issued common stock instead of additional debt instruments in lieu of cash payments (interest) on debt instruments. One draw- back to this technique is that, when used to pay out dividends on common stock, it can result in a continual decline in the ownership percentage of the original shareholders and the section 382 limitation provisions may subsequently become applicable, even though these provisions were not originally applicable to the debt restructure.

If either the old debt or replacement debt is traded on an ESM, the issue price of the replacement debt will be its FMV (determined under section 1273(bX3)) rather then its stated maturity value. Prop. Reg.[section] 1.1273-2(c)(l) provides that FMV is determined as the quoted price on the first date that the debt instrument is traded on an ESM. If the new debt is not traded on an ESM but a portion of the remaining old debt is traded on an ESM after the swap, then the issue price of the new debt is determined by the trading price of the old debt on the exchange date.(37) Finally, property is treated as traded if it is traded on an ESM on or within 10 trading days after the date it is issued.(38)