Business must act quickly, but cautiously, in assessing whether to take advantage of the temporary relaxation of cancellation-of-debt-income (CODI) rules and applicable high-yield discount obligation (AHYDO) restrictions that are now operative, thanks to the 2009 Recovery Act.

Once made, however, an election to come under either of these rules becomes irrevocable. Timing also becomes an issue in coordinating debt restructuring to account for different effective dates: CODI relief for 2009 and 2010, and AHYDO relief for 2008 and 2009. Finally, for many taxpayers, the IRS must provide clear-cut answers to some pending issues before a full commitment to use or pass on these new provisions can be made.

The new CODI and AHYDO provisions provide encouragement to businesses with outstanding debt to restructure their balance sheets at a time when they otherwise could least afford to shoulder the normal tax burdens associated with doing so. Under the 2009 Recovery Act, the tax on CODI arising from debt repurchases may be deferred and original issue discount (OID) interest not ordinarily deductible on AHYDO used in a debt workout will be deductible.

The reasons for a business to elect these debt workout provisions generally tracks Congress's intentions in making them available: Businesses operating in survival mode don't need to deal with the tax liability ordinarily triggered by cancellation-of-indebtedness rules while initiating a debt restructuring plan that, hopefully, will keep them afloat.

Both CODI and AHYDO relief work on the principle of deferral, rather than complete tax forgiveness.

As with many other economic recovery provisions, Congress wanted to encourage debt workouts, but at the least possible cost to the government. That is the reason why under the new law, CODI is deferred, rather than forgiven, and AHYDO deductions are deferred. This treatment represents a compromise from S. 31, which would have eliminated any tax on CODI for discharged debt in 2009 and 2010.


New Code Sec. 108(i) allows a business to elect to defer CODI occurring in 2009 or 2010 until 2014 and, thereafter, to recognize the income ratably over the next five years. CODI deferral under Code Sec. 108(i) applies broadly to debt for cash, debt for debt, debt for equity, debt forgiven by the creditor, and debt contributed to capital. The CODI deferral for repurchases of debt occurring in 2009 or 2010 covers repurchases by the issuer of the debt or a related party. In debt-for-debt exchanges, any deferred CODI also must be reflected in deferred OID deductions that would otherwise be allowed on the new debt.


The election under Code Sec. 108(i) must be made on the return for the tax year in which the debt is repurchased. It must be made at the entity level and must clearly identify the amount of CODI that is deferred. The election is irrevocable, which should give taxpayers pause before the IRS issues complete guidance on the election.

Use of Code Sec 108(i) is not an all-or-nothing proposition. A debtor is free to defer income for one class of debt instrument and recognize income on the repurchase of other debt.

In the case of a partnership in which the debt is made at the partnership level, an election applies to all the partners. This may create a fiduciary issue for general partners who must chose a path favorable to some, but not all, of the partners.

While CODI relief under the new law primarily targets CODI that otherwise would be immediately taxed, CODI deferral also may be elected by a business that qualifies for a Section 108(a) exclusion, particularly the 108 (a)(1)(B) insolvency exclusion. The advantage to deferring income over excluding it is that the Section 108 exclusion requires the taxpayer to reduce tax attributes (net operating losses, basis, etc.) that in fact may trigger or increase income recognition well prior to the 2014-2018 CODI recognition period under Section 108(i).

Unfortunately, CODI that is deferred until 2014 (or earlier if accelerated) does not get a second chance at being excluded again at that time under one of the Code Sec. 108 exclusions; the exclusion must be taken in 2009 or 2010 or not at all.

Businesses not entirely certain about whether the new deferral rules apply to their situation should consider a protective election. This is especially true for the AHYDO 2008 tax year deadline that is coming up. We have heard that guidance from the IRS is expected soon on the details for making this protective election.


The use of CODI deferral under Code Section 108(i) must be matched with deferral of original issue discount deductions. Under this regime, deductions are deferred until the 2014-2018 period over which the deferred CODI is ratably recognized. Thus, in the case of any OID with respect to the debt instrument being issued (because the stated redemption price at maturity exceeds its issue price), no deduction is allowed to the issuer on the portion of that OID that accrues within five tax years and earlier, to the extent that OID does not exceed the CODI with respect to the debt instrument being re-acquired.


If the debtor merges or liquidates in a tax-free re-organization, a companion issue is whether the deferred CODI should be accelerated or recognized by the successor under the same post-2013 schedule. In case of the cessation of business, any income deferred under Code Sec. 108(i) must be accelerated and taken into account in the year in which cessation occurs. Acceleration also has been raised as an issue, yet unresolved, in circumstances under which a partner or other pass-through owner disposes of its interest in the electing entity.


Under the Code Sec. 108(i)(6) special rules for pass-through entities, deferred CODI is allocated to each partner immediately prior to the discharge of the debt, just as it would be if the CODI had been recognized at that time.

Further, the law specifically provides that a decrease in a partner's share of partnership liabilities because of CODI is not to be taken into account for Code Sec. 752 purposes at the time of discharge, to the extent that the partner would recognize any gain under Code Sec. 731 (that is, to the extent it exceeds a partner's basis). Any excess is deferred and taken into account by the partner at the same time and to the same extent as deferred CODI under Code Sec. 108(i) is recognized. Questions remain over how to allocate deferred deductions.

The same time delay between the election and the start of income recognition under the general rule also impacts a partner that leaves a partnership after an election to use Code Sec. 108(i) is made at the partnership level. The question remains unsolved at press time whether this departing partner may be burdened with any Schedule K-1 income in a later year.


Original issue discount is the difference between the issue price of a debt instrument and its stated, higher redemption price at maturity. OID is generally deductible by the issuer as interest and recognized by the holder annually as it accrues, even though it is not yet paid.

Congress obviously intended the coordination of the OID rules with the CODI deferral under Code Sec. 108(i). Clearly, the OID that is CODI is now deferred along with the CODI. IRS guidance is needed, however, over the treatment of additional OID that may not precisely track the CODI.


The issue of when to adjust earnings and profits if CODI is deferred under Code Sec. 108(i) also appears to require further guidance. It has been clear that, if CODI income is recognized, E&P is increased; and if CODI is excluded as under the insolvency exclusion but tax attributes are reduced, E&P remains unchanged. In the case of Code Section 108(i), however, a hybrid situation exists and the issue arises of whether at least some immediate recognition to E&P should be required because of the election.


While it was felt that Code Section 108(i) would provide the bulk of the relief to encourage debt restructuring, the suspension of the AHYDO rules under Code Section 163(e)(5)(F) was also needed in many situations because of the unusually high interest rates being demanded of businesses with less-than-perfect credit ratings. In a second installment of good news for issuers unexpectedly having to refinance during a depressed credit market, the 2009 Recovery Act also temporarily suspends the AHYDO interest deferral and interest disallowance rules for certain debt instruments issued in debt-for-debt exchanges between Sept. 1, 2008, and Dec. 31, 2009.

Specifically, the 2009 Recovery Act has temporarily turned off the AHYDO rules that disallowed a deduction to corporations for a portion of the OID on high-yield discount obligations and deferred the deduction for the rest of the OID until paid. The suspension applies to debt-for-debt exchanges involving any AHYDO issued during the Sept. 1, 2008-Dec. 31, 2009, period in exchange for a non-AHYDO, provided the issuer or obligor is the same for both the AHYDO and the non-AHYDO. An "exchange" for purposes of the suspension also includes a significant modification of the debt instrument.

Congress has provided further relief beyond the 2009 end date for the AHYDO exception by permitting the IRS to issue regs allowing for a rate higher than the AFR for debt instruments issued after Dec. 31, 2009, in testing for AHYDO in light of distressed conditions in the debt capital markets.


Under regular AHYDO rules, a debt instrument with a maturity of more than five years, carrying five percentage points above AFR at issuance, and with significant OID was subject to bifurcated tax treatment of the discount by the issuer: A portion was treated as equity (to the extent of "disqualified yield") and the other OID portion was not deductible until paid (even though holders continue to be required to recognize OID currently). While the five-percentage point benchmark in the past had been a good measure of what approached being a return on equity, rather than interest, rates during the credit crisis have easily spiked beyond that frontier.

The AHYDO provision in the new law was an expansion of IRS attempts in Revenue Procedure 2008-51 to provide relief to borrowers holding financing commitments under which the issue price suddenly was coming in at significantly less than the money received because of the unexpected seismic shift in the credit markets. Revenue Procedure 2008-51 sought to exclude refinancing from the AHYDO rules by re-defining the extent to which new or modified debt was AHYDO.

The new law, on the other hand, allows certain debt that is AHYDO to avoid the rules applicable to AHYDO characterization, allowing relief to be applied with much more flexibility in many more situations.


The suspension applies to an AHYDO issued in exchange or modification for a non-AHYDO if the issuer for each is the same. The AHYDO exception, in contrast to the OID exclusion, does not apply to debt acquired by a related party. This twist was added largely to prevent private equity-type loans from benefiting. The suspension of the AHYDO rules also does not apply to certain contingent debt obligations.

AHYDO rules apply to corporate partners of a partnership that issues an AHYDO, but not to debt issued while a corporation was operating under S corporation status.

The suspension does not generally apply to any newly issued debt obligation that is issued for an AHYDO (including significant modifications). However, any newly issued debt obligation for which the AHYDO rules are suspended will not be treated as an AHYDO for purposes of a subsequent application of the suspension rule.


Debt restructuring is a necessary, albeit sometimes painful, part of major economic upheaval. Over the next five years, no business incentive within the 2009 Recovery Act even comes close in terms of impact to the $42 billion in tax benefits projected under the CODI and AHYDO relief. With the help of these provisions, and some additional guidance from the IRS to clarify some of the finer points, debt restructuring should prove to be one of the major engines toward economic recovery for many businesses.

George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.

(c) 2009 Accounting Today and SourceMedia, Inc. All Rights Reserved.

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