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DEFERRAL OF CERTAIN INCOME FROM DISCHARGE OF INDEBTEDNESS

Key Points

·        Provision would allow businesses to defer tax on income that is recognized when they buy back or exchange their debt at a discount in either 2009 or 2010.

·        Deleveraging is beneficial in today’s economy. However, since debt repurchase or exchange benefits companies by boosting earnings, these transactions may already be occurring without the new tax break. Thus, the additional tax benefit may be a windfall to companies that are already buying back their debt.

·        Deferring tax could remove an impediment that keeps firms from shedding devalued debt and improving their balance sheets.

·        JCT estimates the proposal would cost $1.6 billion over 10 years.    

Current Law

Under current law, if a borrower or related party buys back or exchanges its own debt at less than the issue price, it must pay tax on the difference between the original price and the debt’s current value when purchased or exchanged.

For example, consider a business that borrowed $100,000 three years ago. Today, due to the credit crunch, interest rates on corporate debt are far higher than they were. And, as a result of the recession, the firm’s credit rating may be much lower. Consequently, that $100,000 bond may now be worth only $60,000. If the issuer buys back that debt at today’s price (or exchanges it for other debt also worth $60,000), the $40,000 difference is considered income and is subject to tax.  

The Internal Revenue Code has, in the past, allowed all businesses in these circumstances to defer income even if they repurchased their debt at a discount.  However, today, debt forgiveness results in income except under limited circumstances such as bankruptcy.

Stimulus Proposal

The proposal would permit any business to defer income if it buys back or exchanges its own debt at a discount in 2009 and 2010. Any income realized in 2009 due to a debt buyback must be included ratably in income in each of the five taxable years beginning five years after the year of realization. Any income realized in 2010 due to a debt buyback must be included ratably in income in each of the five taxable years beginning four years after the year of realization.

Discussion

Supporters of this proposal argue that it would encourage firms to repurchase or exchange debt, which would make them more liquid and put them in a better position to withstand the economic downturn. In 2007, Congress allowed homeowners to avoid tax in cases where lenders restructured their mortgages.

However, because these transactions may both reduce leverage and boost earnings, they appear to already be occurring, despite the tax businesses must pay on the trades. Thus, in many cases the new tax benefit may subsidize debt repurchase or exchange that would occur anyway, resulting in a windfall and generating little new economic activity.

In addition, the beneficiaries of this tax break are those firms that have sufficient cash to repurchase debt. Almost by definition, these businesses are in less need of assistance than cash-constrained competitors. Similarly, this tax break would provide no additional cash flow to unprofitable companies that are paying no tax.

Grade: C-

This proposal may help some companies deleverage, but much of the benefit would go to those businesses that least need assistance.

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