Stimulus 2009 – Tax Relief for Debt Repurchase

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Tax Act of 2009. A portion of the bill allows for tax relief to companies that repurchase their own debt at a discount. The bill will provide significant benefits for private equity funds that repurchase debt on behalf of their portfolio companies. The rationale behind the bill is to incent cash strapped, highly levered companies to repurchase their debt; the reduced burden of the high debt service (interest and amortization payments) would leave the companies more nimble and less likely to layoff employees in the downturn. The tax relief is estimated to cost the Treasury $1.6B over the decade; however, it will be more costly in the near term – $42B reduction in tax receipts over the next three years.

Part IV – Rules Relating to Debt Instruments (starting on page 224), Section 1231 lays out the specifics regarding the repurchase of debt; the law firm Sidley Austin LLP provides a good summary of the new legislation as well.

‘‘(1) IN GENERAL.—At the election of the taxpayer, income from the discharge of indebtedness in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument shall be includible in gross income ratably over the 5-taxable-year period beginning (in 2014)

Current tax requires a company that repurchases its own debt at a discount to recognize income in the current year in the amount of the discount of the debt. For instance if the company issued $1.0mm of debt, but repurchased the debt for $700,000 to recognize $300,000 ($1,000,000 - $700,000) of cancellation-of-debt (COD) income -> resulting in a ~$100,000 tax bill if taxed at 34% marginal tax rate.

New tax legislation allows companies or related parties (private equity funds) that repurchase debt a discount in 2009 and 2010 to defer the COD income over a five period beginning in 2014. In the above example, the Company would recognize $60,000 ($100,000 / 5) of COD income in each tax year 2014-2018.

The legislation also allows for tax deferral if the debt is restructured via a debt-for-debt exchange, from significant modification of the existing debt instrument, or from complete debt forgiveness – which may the case for ‘debt’ provided by financial sponsors.

The legislation should provide the appropriate incentives for companies to delever and maintain a prudent capital structure. The reduced leverage and cash savings also should reduce the number of bankruptcies and out of court restructurings, hopefully reducing layoffs. Critics point out that companies with enough cash to repurchase debt are not in need of a stimulus, thus the $42B in tax relief could be more effectively placed in other areas of the economy. While these companies may have the cash today, the bill is designed to reduce the likelihood that currently solvent & liquid companies become insolvent and/or illiquid.