Tax Alert
March 2009
Authors:
Thomas J. Lyden
tom.lyden@klgates.com
+1.202.778.9449
Jared D. Mobley
jared.mobley@klgates.com
+1.704.331.7535
Theodore L. Press
ted.press@klgates.com
+1.202.778.9025
Roger S. Wise
roger.wise@klgates.com
+1.202.778.9023
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American Recovery and Reinvestment Act of
2009 Permits Deferral of COD Income,
Suspends AHYDO Rules, Creates Other
Business Incentives
The American Recovery and Reinvestment Act of 2009 ( Act ), passed by the
House and Senate on February 13, 2009, and signed into law by President Obama on
February 17, 2009, contains a number of temporary tax incentives for businesses,
and especially small businesses. In particular, the Act:
permits many businesses to defer tax on income realized in 2009 or 2010 when
debt is forgiven, restructured or reacquired for less than its face amount;
temporarily suspends application of the rules that limit a corporate issuer s
deduction for original issue discount ( OID ) on an applicable high-yield
discount obligation (an AHYDO ) for debt instruments issued in certain debtfor-debt exchanges;
permits up to a five-year carryback (rather than the normal two-year carryback)
for net operating losses ( NOLs ) realized by certain small businesses in 2008
and clarifies certain other rules relating to NOLs and built-in losses;
extends by one year certain provisions allowing bonus first-year depreciation, an
election to take alternative minimum tax ( AMT ) and research and
development credits in lieu of such bonus depreciation, and increased limits on
the amount of property that may be expensed in the year of purchase;
temporarily suspends the corporate-level tax that would otherwise apply to
certain gains recognized by corporations that converted to S corporation status at
least seven years ago; and
increases the exclusion for gain from sales of certain small business stock
acquired in 2009 and 2010.
For our alerts discussing the provisions in the Act dealing with alternative energy tax
incentives and tax-exempt and tax credit bonds, please click here and here.
Deferral of COD Income
A taxpayer generally must include in income any amount realized from the discharge
of indebtedness (often referred to as cancellation of debt or COD income). The
theory is that, while a taxpayer does not treat amounts received on the issuance of
debt as income because of the offsetting liability to repay the debt, the taxpayer
should have income when that offsetting liability is removed. These rules generally
apply when debt is forgiven by the debt holder or the issuer or a related party
reacquires the debt for less than its face amount.
Tax Alert
COD income can also arise in the current market
environment if an issuer of publicly traded debt
makes a modification to the terms of the debt that
is considered to be significant under standards
set out in Treasury regulations. For example,
assume an issuer had outstanding a class of
publicly traded notes, originally issued at par,
with a stated principal amount of $250 million
and a stated interest rate of 8.00%. Assume
further that, to get note holders to waive a
potential covenant default, the issuer agrees to
increase the interest rate to 9.00%. Finally,
assume that, because of the current market
disruption, the modified notes, despite the interest
rate increase, trade at a price equal to 70% of their
stated principal balance. The modification would
result in a deemed debt-for-debt exchange in
which the modified notes would have an issue
price of $175 million (70% of $250 million). The
issuer would recognize COD income of $75
million, which is the difference between the
adjusted issue price of the unmodified notes
$250 million and the issue price of the modified
notes.
In certain circumstances, such as the bankruptcy
or insolvency of the debtor, a taxpayer can avoid
taking COD income into account, but at the cost
of reducing attributes such as net operating losses,
credits and asset basis, so that the exclusion will
ultimately be taken into income.
In December 2007, a new exclusion was created
for certain discharges of indebtedness relating to
an individual s principal residence. For our alert
discussing this provision, please click here. The
congressional negotiations leading up to the Act
included various provisions to create a similar
benefit for business. In its final form, this
provision does not exclude COD income but
rather permits corporations and certain other
entities to elect to defer the tax on COD income
under a 5-plus-5 rule: for discharges of
indebtedness occurring in 2009 or 2010, no COD
income is taken into account until 2014, and the
COD income is then spread evenly over five
years.1 In the case of a partnership electing this
1
Because the reacquisition must occur in calendar year
2009 or 2010, but the deferral is based on the taxpayer s
taxable year, the deferral may be different than expected.
For example, a taxpayer with a June 30 taxable year that
provision, any deferred COD income is allocated to
the partners in the partnership immediately before
the discharge occurred, in the same manner as if
there had been no deferral. Thus, the deferred
income, when ultimately taken into account, could be
allocated back to a person who is no longer a partner
or in proportion to that person s prior ownership
interest.
The provision applies to any applicable debt
instrument, defined as any debt instrument issued
by a C corporation or any other person in connection
with the conduct of a trade or business by that
person. The second category would cover a
partnership or sole proprietorship conducting a
business but would exclude many private equity
partnerships (though not their portfolio companies).
Debt instrument is broadly defined to include any
bond, debenture, note, certificate or other instrument
or contractual arrangement that is treated as
indebtedness for U.S. federal income tax purposes.
The provision applies when a debt instrument is
acquired by the issuer (or a person that is otherwise
the obligor) or a related person. For this purpose,
acquisition includes a purchase for cash; an
exchange of the debt instrument for another debt
instrument (including a deemed exchange resulting
from a modification of an existing debt instrument),
corporate stock or a partnership interest; and a
contribution of the debt instrument to capital. The
provision thus applies to a broader array of
transactions creating COD income than the original
Senate proposal, which had only applied to cash
repurchases.
A taxpayer electing this provision cannot also
exclude the COD income under exclusions for
discharges of debt occurring when the taxpayer is in
bankruptcy or insolvent or when the indebtedness is
qualified farm indebtedness or qualified real property
business indebtedness.
realizes COD income on a June 30, 2009 reacquisition of its
debt would begin taking the income into account in its June 30,
2014 taxable year. A July 1, 2009 reacquisition by that
taxpayer, however, would start being taken into account in the
June 30, 2015 taxable year. The creation of a short taxable
year (for example, because of the technical termination of a
qualifying partnership borrower) could also accelerate the
inclusion of COD income deferred under this provision.
March 2009
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Tax Alert
The provision contains a special rule limiting
deductions that would otherwise be available to
the issuer in a debt-for-debt exchange. If the new
debt is issued with OID as in the hypothetical
debt modification transaction described above,
the issuer would normally be entitled to an
interest deduction each year equal to a portion of
the OID. Under the provision, the issuer s OID
deductions that accrue before 2014, to the extent
they do not exceed the related COD income, are
deferred and taken into account ratably over the
five-year period as the COD income is taken into
account. The amount of OID accrued before
2014 could exceed the amount of COD income if
all or part of the stated interest were not
qualified stated interest (generally, interest
required to be paid in cash at least annually at a
single fixed rate or a single floating rate). If the
terms of a debt instrument provide for deferral of
interest payments or have a payment-in-kind
provision, the stated interest would be treated as
OID and would be subject to the deduction
deferral rule even if the interest was in fact paid
currently. This limitation can also apply if a debt
instrument with OID is issued for cash and the
proceeds are used directly or indirectly by the
issuer to reacquire an applicable debt instrument.
Income that is deferred under this provision is
accelerated if the taxpayer dies, liquidates, sells
substantially all of its assets or ceases business or
in similar circumstances. This acceleration rule
also applies in the case of a sale, exchange or
redemption of an interest in a partnership,
S corporation or other pass-through entity.
Because of the reference to a single interest in
such an entity, it appears that the sale, exchange
or redemption by one member could cause an
acceleration of all of the entity s COD income
(rather than just that member s pro rata share
thereof).
A taxpayer contemplating an election under this
provision will need to consider the benefits of
deferral against the expected utilization of NOLs
and tax credits and the possibility of increases in
tax rates.
AHYDO
Generally, if a corporation issues a debt instrument
with OID, the issuer is allowed an interest expense
deduction for the OID that accrues on the debt
instrument. If, however, a corporation issues a debt
instrument that is an AHYDO, the corporation is not
allowed a deduction for the disqualified portion of
the OID that accrues on the debt instrument, and the
corporation s deduction for the remaining portion of
the OID is deferred until it is actually paid in cash.
An AHYDO is any debt instrument (i) issued by a
corporation, (ii) having a maturity date more than
five years from the date of issue, (iii) having a yield
to maturity at issuance in excess of the AFR2 plus
5.00%, and (iv) having significant OID. A debt
instrument will be considered to have been issued
with significant OID if (1) the aggregate amount of
qualified stated interest and OID required to be
accrued on the debt instrument as of the close of any
accrual period ending five years after the issue date
of the debt instrument exceeds (2) the interest
required to be paid during that period minus the
product of the debt instrument s issue price and its
yield to maturity. Any provision in a debt instrument
that would allow an issuer to defer a payment is
presumed to be exercised for purposes of applying
these tests.
The Act provides that the above-described rules will
not apply to any AHYDO issued during the period
beginning on September 1, 2008 and ending on
December 31, 2009 in a debt-for-debt exchange
(including a deemed debt-for-debt exchange
resulting from a debt modification) if the original
debt instrument was not an AHYDO. Consider again
the example of the note issuer who agrees to increase
the interest rate on a debt instrument to induce the
note holders to waive a covenant default. Because
the increase in interest rate gives rise to a deemed
debt-for-debt exchange, the deemed newly issued
modified instrument could, in light of the current
market conditions, be an AHYDO because its issue
price would be significantly less than par even
2
The term AFR (i.e., applicable federal rate ) refers to rates
published monthly by the Internal Revenue Service for use in
various tax calculations. Each month, there is a short-term,
mid-term, and long-term AFR. The rates are based on the
weighted average yields of Treasury securities. The long-term
AFR for March 2009, which would apply to debt instruments
with maturities over nine years, is 3.52% (expressed as an
annual rate).
March 2009
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Tax Alert
though the stated principal amount was
unchanged. The Act exempts such an issuer from
application of those rules so the issuer would be
able to deduct the full amount of interest and OID
accrued on the modified note. Relief is not
provided, however, for any debt instrument that
provides for payments that are contingent on the
revenue or profits of the issuer or a related
person.
Any note issued in a debt-for-debt exchange for a
note that was itself issued in an exchange that was
exempted from the application of the AHYDO
rules will also be exempted, provided the
succeeding debt-for-debt exchange occurs within
the period specified in the Act. Moreover, the
Treasury Department is given authority to apply
the exception in subsequent periods to the extent
it determines that such application is appropriate
in light of distressed market conditions in the debt
capital markets. Furthermore, for debt
obligations issued after December 31, 2009, the
Treasury Department is authorized to permit, on a
temporary basis, the use of a rate higher than the
AFR in determining whether a debt instrument is
an AHYDO to the extent it determines that such
an increased rate is appropriate in light of
distressed conditions in the debt capital markets.
NOLs and Built-in Losses
Taxpayers are generally permitted to carry NOLs
back for two years and forward for 20 years.
Under the Act, an eligible small business
defined as a corporation or partnership with no
more than $15 million of gross receipts in its
taxable year ending (or, if elected, beginning) in
2008 may elect to carry back its 2008 NOL for
up to five years. The NOL can then be carried
forward only for that number of years minus one
(so, five years back, four years forward, etc.).
Prior versions of this proposal would have applied
to 2008 and 2009 NOLs, would not have been
limited to small businesses and would have
excepted these NOLs from a 10% limitation that
applies under the AMT. It is possible that this
provision will be expanded along these lines in
future legislation. A non-calendar year taxpayer
could elect to apply this provision to NOLs
arising in the taxable year beginning in 2008, in
which case the extended carryback may apply to
losses generated in calendar year 2009.
The Act also prospectively repeals guidance issued
by the Internal Revenue Service in October 2008
(Notice 2008-83) that had allowed purchasers of
banks to avoid limitations on the built-in losses that
would otherwise have applied. In addition, the Act
provides that limitations that would otherwise apply
under section 382 to a company s NOLs following
an ownership change will not apply if the ownership
change occurs as a result of restructuring required
under a loan agreement or a commitment for a line of
credit entered into as part of the Emergency
Economic Stabilization Act of 2008. This latter
provision would, for example, protect General
Motors if its restructuring would otherwise trigger an
ownership change.
Extension of First-Year Bonus
Depreciation, Monetization of AMT and
R&D Credits in Lieu of Bonus
Depreciation, and Expensing
The Act extends for one year generally through
2009, or 2010 for certain longer-lived or
transportation property a rule permitting bonus
first-year depreciation equal to 50% of the adjusted
basis of certain property placed in service during the
year, and a companion rule permitting corporations
to use accumulated AMT and research and
development credits in lieu of bonus depreciation.
Finally, the Act extends for one year the increased
limitations that apply to the ability of certain
taxpayers to expense (rather than depreciate)
property placed in service.
Temporary Suspension of CorporateLevel Tax for Converted S
Corporations
An S corporation that has converted from C
corporation status must generally pay corporate-level
tax on built-in gains at the time of the conversion
that are recognized during the first ten years that the
subchapter S election is in effect ( recognition
period ); similar rules apply when a C corporation
that converts, or transfers property, to a regulated
investment company or real estate investment trust.
The Act modifies these rules so that a corporation
that converted to S corporation status between 2000
March 2009
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Tax Alert
and 2003 may recognize built-in gains in 2009
and/or 2010 without paying corporate-level tax.3
This provision does not change the recognition
period for corporations converting to S
corporation status in 2009 or 2010.
Temporary Increase in Exclusion for
Gain from Sales of Small Business
Stock
Section 1202 provides a 50% exclusion for gain
realized on the sale of qualified small business
stock held for more than five years. For such
stock acquired after February 17, 2008 and before
January 1, 2011, this exclusion is increased to
75%.
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in each entity is available for inspection at any K&L Gates office.
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied
upon in regard to any particular facts or circumstances without first consulting a lawyer.
©2009 K&L Gates LLP. All Rights Reserved.
3
Specifically, no corporate-level tax is imposed on built-in
gains recognized in 2009 or 2010 if the seventh year of the
recognition period has already passed. For example, a
calendar-year corporation that made a subchapter S
election effective as of January 1, 2002, could avoid
corporate-level tax on built-in gains recognized in 2009 and
2010 (the eighth and ninth years of the recognition period,
respectively), but would be subject to corporate-level tax on
any built-in gains recognized in 2011.
March 2009
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