1. Debt Restructuring Poses
Various Income Tax Challenges
and Valuation Considerations
Jason M. Muraco, CFA – jmuraco@srr.com
Michelle M. Brower, CFA – mbrower@srr.com
Overview1 ■ ■ ■
Scenario A
The restructuring of debt has become a common trend in recent
Original Debt Balance $ 100,000,000 New Debt Balance $ 80,000,000
periods due to the continuing economic downturn. Many lenders
are currently faced with the prospect of restructuring existing
debt arrangements in an effort to prevent bankruptcy for the
Assuming the terms of the debt are substantially the same pre-
borrower (thereby protecting their investment in the borrower).
and post-restructuring, the borrower is improving its debt position
This situation is particularly prevalent in the private equity arena,
by $20 million under Scenario A. As such, COD income of $20
where highly-leveraged portfolio company investments are
million would be recognized under Scenario A.
customary. Debt restructuring poses a number of income tax
challenges and resulting valuation concepts that can have a real COD income is not always recognized in a company’s gross
dollar impact for a firm. income. Rather, there are a number of exceptions to the
recognition requirement under Section 108, as follows:
Cancellation of Debt Income ■ ■ ■
■ The discharge occurs in a Chapter 11 bankruptcy case;
If a company repurchases (whether through a restructuring/
recapitalization event or other means) its existing debt at a ■ The discharge occurs when the taxpayer is insolvent;
discount, the company is required to recognize cancellation of ■ The indebtedness discharged is qualified farm
debt (“COD”) income in the amount of the discount pursuant to indebtedness;
Section 108 of the Internal Revenue Code (“Section 108”). The
■ In the case of a taxpayer other than a C corporation,
recognition of COD income essentially equals the economic
the indebtedness discharged is qualified real property
improvement in the borrower’s position following the restructuring
business indebtedness; or
event. Consider the following example:
■ The indebtedness discharged is qualified principal
residence indebtedness which is discharged before
January 1, 2010.
1
Any tax discussion contained in the body of this article is not to be considered tax advice
and is not intended or written to be used, and cannot be used, by the recipient for the
purpose of avoiding penalties that may be imposed under the Internal Revenue Code or
applicable state or local tax law provisions.
1 ©2010

2. However, it is important to note that in most instances COD Insolvency Considerations ■ ■ ■
income impacts a company’s tax position whether or not any
income is actually recognized. According to Section 108, COD One of the most common Section 108 exceptions to the
income reduces the following tax attributes of a taxpayer, in the recognition of COD income is the insolvency exclusion, particularly
following order: in today’s economic environment. Section 108 defines “insolvent”
to mean that there is an excess of liabilities over the fair market
■ NOL – Any net operating loss (“NOL”) for the taxable value of assets. Section 108 also provides that the amount by
year of the discharge, and any NOL carryover to such which the taxpayer is insolvent shall be determined on the basis
taxable year; of the taxpayer’s assets and liabilities immediately prior to the
■ General Business Credit – Any carryover to or from the indebtedness discharge. Moreover, the amount of COD income
taxable year of a discharge of a credit generated under excluded due to this exception shall not exceed the amount by
Section 38 of the Internal Revenue Code (the “Code”); which the taxpayer is insolvent.
■ Minimum Tax Credit – The amount of the minimum tax Given that the determination of insolvency is based on an estimation
credit available under Section 53(b) of the Code as of the of the fair market value of a company’s assets, a valuation of the
beginning of the taxable year immediately following the company is a critical element. The valuation should consider
taxable year of the discharge; the concept of “highest and best use” (i.e., are the assets more
■ Capital Loss Carryovers – Any net capital loss for
the taxable year of the discharge, and any capital
Scenario C
loss carryover to such taxable year under Section
1212 of the Code; Original Debt Balance $ 100,000,000 New Debt Balance $ 80,000,000
■ Basis Reduction – In general, the basis of the Book Value Insolvency Test
property of the tax payer; Total Assets $ 250,000,000 Fair Market Value $ 230,000,000
of Assets
■ Passive Activity Loss and Credit Carryovers – Operating Liabilities 150,000,000 Operating Liabilities 150,000,000
Any passive activity loss or credit carryover of the Interest-Bearing Debt 100,000,000 Interest-Bearing Debt 100,000,000
taxpayer under Section 469(b) of the Code from the Insolvency Amount (20,000,000)
taxable year of the discharge; and
Implied COD Income $ 20,000,000
■ Foreign Tax Credit Carryovers – Any carryover to Insolvency Amount (20,000,000)
or from the taxable year of the discharge of a credit COD Income Realized 0
allowable under Section 27 of the Code.
valuable under a going concern or liquidation basis). Under
Scenario B a going concern premise, an income-based and/or market-
Original Debt Balance $ 100,000,000 New Debt Balance $ 80,000,000 based approach is often utilized to estimate asset value,
NOL Balance $ 20,000,000 while an asset-based approach is more common under a
liquidation premise.
An Exception is Not Applicable An Exception is Applicable
Implied COD Income $ 20,000,000 Implied COD Income $0 Once the fair market value of the assets is determined,
Use of NOL Balance (20,000,000) Use of NOL Balance n/a the company’s level of insolvency is assessed and
COD Income Realized 0 COD Income Realized 0 netted against recognizable COD income. Consider the
Tax Attribute Reduction $ 20,000,000 Tax Attribute Reduction $ 20,000,000 example above.
(Due to NOL Usage) (Due to Section 108)
Under Scenario C, a valuation is performed and it is
determined that the fair market value of the company’s net
To exemplify the tax attribute concept, consider Scenario B
assets is $80 million (i.e., assets of $230 million less operating
above. If one assumes that the $20 million of COD income is
liabilities of $150 million). Subtracting the company’s indebtedness
recognizable, the company may be able to use its existing NOL
(prior to the restructuring) from this amount yields a negative equity
carryover balance of $20 million against the income, thereby
value of $20 million, implying that the company is insolvent by $20
reducing the actual realizable COD income amount to zero. If it is
million. Since the company is also improving its debt position by
determined that the $20 million of COD income is excluded from
$20 million under Scenario C, the implied COD income amount
gross income (due to one of the aforementioned exceptions), no
is $20 million. Netting the insolvency amount from the implied
income is realized; however, the company’s tax attributes (e.g.,
COD income amount yields a realizable amount of COD income
NOL carryover balance) are still reduced by $20 million according
of zero.
to Section 108.
©2010 2

3. Complex Debt Recapitalizations ■ ■ ■ American Recovery and
Reinvestment Act of 2009 ■ ■ ■
Estimating the amount of COD income from a debt restructuring is
not always a straightforward exercise. Many lenders are reluctant Under the American Recovery and Reinvestment Act of 2009 (also
to simply reduce the amount of debt outstanding. Rather, lenders referred to as the stimulus bill and signed into law on February 17,
are often requiring compensating securities (e.g., preferred stock, 2009), a company can elect to defer recognition of certain COD
warrants, etc.) as added incentive for restructuring existing debt income that is realized during 2009 and 2010 under Section 108(i)
arrangements. The addition of new securities to the capital structure of the Code. Specifically, if the deferral option is elected, the COD
introduces a complex valuation component to the estimation of income is required to be initially recognized by 2014 at the latest.
COD income. Consider the following example: However, if a company chooses to do so, the COD income can
be recognized ratably over a five-year period (and thus
a company could recognize the COD income over the
Scenario D
period from 2014 through 2018). Further, in order to
Original Debt Balance $ 100,000,000 New Debt Balance $ 80,000,000 qualify for the election, the COD income must result from
Preferred Stock n/a Preferred Stock 500 Shares the forgiveness of applicable debt instruments. These
Warrants n/a Warrants 100,000 Units debt instruments include bonds, debentures, notes, and
certificates issued by a party in connection with the conduct
New Debt Balance $ 80,000,000 Original Debt Balance $ 100,000,000
Preferred Stock Value 7,500,000 New Lender Value (90,000,000)
of a trade or business.
▼
Warrant Value 2,500,000
In essence, this new tax provision assists companies that
New Lender Value 90,000,000 COD Income Realized 10,000,000
are conducting restructuring activities by enabling them to
more easily adjust the amount of debt capital recorded on
Under Scenario D, the lender receives 500 shares of preferred their balance sheet (i.e., they are not immediately encumbered
stock and 100,000 warrants in addition to the reduced debt with an additional tax liability related to the COD income). From
balance of $80 million. As such, in order to estimate the economic a tax strategy perspective, however, there can be advantages
improvement in the borrower’s position following the restructuring, and disadvantages to deferring recognition of COD income. For
the preferred stock and warrants must be valued. Given the more example, if a company anticipates that its overall effective tax rate
complex capital structure of the company post-restructuring, will increase in the future, it may be more advantageous to decline
valuation techniques such as the “Option-Pricing Method” or the election to defer COD income recognition.
“Probability-Weighted Expected Return Method” as described
in the AICPA’s practice aid, Valuation of Privately-Held-Company Finally, as noted above, Section 108 details several exceptions to
Equity Securities Issued as Compensation, may be required, the requirement that COD income be recognized upon a company’s
particularly if the preferred stock is able to be converted into cancellation of debt. In certain instances, a company may be able
common equity. to choose to either (i) Recognize COD income and make a deferral
election (which does not require the company to reduce any tax
It is important to further note that the borrower’s ability to attributes) or (ii) Utilize an existing exception under Section 108
negotiate certain aspects of the debt recapitalization can play (which requires the company to reduce tax attributes). As a result,
an important role in potential tax strategies. As presented in a company must carefully consider the benefits and detriments
Scenario D, the market value of the “junior” securities (i.e., preferred resulting from making the election to defer COD income when
stock and warrants), which is largely dependent on the negotiated faced with this situation.
terms of the securities (e.g., convertibility, dividend rate, PIK vs.
cash pay, strike price, etc.), can influence the amount of COD Jason M. Muraco, CFA is a Director in the Valuation & Financial
income realized. Opinions Group at Stout Risius Ross (SRR). His valuation experience
includes solvency opinions, purchase price allocations, impairment
Additionally, the recapitalized balance sheet can have a meaningful testing, equity compensation, going-private transactions, transfer
impact on the residual value of a company’s common equity. pricing, and blockage opinions. Mr. Muraco can be reached at
Specifically, common equity value is substantially enhanced if a 216.373.2989 or jmuraco@srr.com.
company is going to remain a going concern versus a bankruptcy
or liquidation scenario since the “life” of the company is being Michelle M. Brower is a Manager in the Valuation & Financial Opinions
extended. Although this equity value enhancement is essentially Group at Stout Risius Ross (SRR). Her valuation experience includes
extracted from the value of other security classes (e.g., debt corporate strategic planning, intangible asset valuation, goodwill
holders), other security classes likely still benefit from the debt impairment testing, stock options, and valuation discounts. She can
restructuring due to the company’s improved economic position be reached at 248.432.1213 or mbrower@srr.com.
and avoidance of bankruptcy costs, which could be significant.
3 ©2010