Investing in Distressed Debt: Tax Consequences Private Equity Firms Should Know
The financial repercussions of the COVID-19 global pandemic are being felt broadly by a variety of companies, and many businesses are desperate for credit to stay afloat. In the U.S. alone, the amount of distressed debt is approaching $1 trillion. This situation may open the door for private equity (PE) and venture capital (VC) firms to make investments in distressed debt, where the firm purchases a company’s debt instead of its stock.
Distressed debt arrangements provide solutions for both the company that receives relief from servicing the debt it owes as well as the PE/VC firm, which may use the debt purchase to take control of the failing company during bankruptcy or restructuring, turn it around, and reap the benefits of making it profitable. Caution with pursuing a distressed debt investment strategy is advised, however, not only from a risk perspective but also because purchasing distressed debt will have tax implications for your funds.
The Appeal of Investing in Distressed Debt
Investing in distressed debt can be particularly appealing when major world crises affect the finances of companies everywhere. Investors typically purchase the debt at a deep discount. If the distressed debt investors can make the company profitable, they can receive a high rate of return on their investment. If the company whose debt was purchased has to file for bankruptcy, investors still typically walk away with something for their distressed debt investment. In fact, distressed debt investors can achieve priority status in being paid back during bankruptcy proceedings.
While the current climate seems suitable for investing in distressed debt, it’s crucial to understand what those investments mean for your firm’s tax obligations.
Market discount arises in connection with the acquisition of a debt instrument (other than at issuance) at a price that is less than the instrument’s Stated Redemption Price at Maturity (SRPM). SRPM includes any accrued and unpaid interest that had been deferred to maturity.
The market discount rules provide that any gain recognized by a debt holder that purchased debt subsequent to its original issuance upon a sale or other disposition of a debt instrument will be treated as ordinary income rather than capital gain to the extent of that portion of the market discount that accrued prior to such disposition. The market discount rules are based in part on the premise that market discounts associated with secondary debt purchases are caused by changes to interest rates (rather than the credit quality of the borrower or market conditions in general) and as such should be taxed as ordinary interest income rather than as capital gains.
Market discount debt instruments ultimately determined to not be “distressed” typically accrue market discount based on a constant yield method in accordance with IRC Section 1276(b)(2). This election is the most tax advantageous method of accruing market discount and can also provide significant tax savings relative to the industry standard ratable method. However, annual accruals of ordinary income (as market discount) may be turned off and therefore all gain upon sale is treated as preferential capital gain rates when a market discount bond becomes “distressed” and is instead under cost recovery.
Cost Recovery Considerations
If speculative or distressed debt meets certain conditions, debt holders can apply cost recovery principles, which means that any payments received would instead be applied to the principal before recognizing the income attributable to the market discount. This is a significant tax benefit because the result would be no ordinary income pickup and all capital gains on the back end.
A debt instrument is classified as “distressed” when either:
- The purchase price is less than 60% of par value (or SRPM), or
- When it has a yield of greater than AFR + 15%.
Workouts of Distressed Loans and ECI Considerations
A workout agreement is a mutual agreement between a lender and borrower to renegotiate the terms on a loan that is in default. Generally, the workout includes waiving any existing defaults and restructuring the loan’s terms and covenants. A workout agreement is only possible if it serves the interests of both the borrower and the lender. There are many ways to structure a debt workout and can include one or more of the following:
- Lender’s agreement to forbear any foreclosure/collection efforts for a period of time following a failure to timely pay or meet financial covenants,
- Deferral of interest or principal amortization,
- Reduction of interest rate,
- Forgiveness of interest for a period of time,
- Reduction of principal obligation,
- Extension of maturity date, or
- Debtor’s issuance of warrants or other equity interests to lender.
Funds should be cognizant that such a workout can have significant tax impacts for the portfolio company.
Some PE or VC funds may have foreign investors that are sensitive to income “effectively connected” with the conduct of a U.S. trade or business (ECI). Workouts of distressed loans require careful tax planning to avoid the PE or VC fund from being classified as being in the U.S. trade or business of lending and, as a result, having the foreign investor being subject to U.S. federal income tax on that “effectively connected” income. If a foreign investor owns an interest in a partnership, and the partnership is considered to be engaged in a U.S. trade or business, the partnership that recognizes ECI must withhold tax at the highest applicable tax rate on each foreign partner’s distributive share of such ECI. Absent a treaty exemption or reduction, a foreign corporation could also be subject to a 30% branch profits tax on its ECI.
One common way to shelter foreign investors from the risk of ECI is to have them participate through a special purpose entity within the investment structure. This special purpose entity is typically referred to as a “blocker” that would be owned by the foreign investors and invests in the fund. Although there is typically tax drag associated with a corporate blocker, it allows foreign investors to avoid ECI and, as a result, they are not required to file U.S. federal income tax returns.
There are several factors to consider in determining if the lender will be classified as being in the U.S. trade or business of lending, including the frequency and number of workouts performed.
Recharacterization of Debt as Equity
There are certain debt modifications where the new instrument is not characterized as debt, and instead is treated as equity for tax purposes. In this case, the transaction would be treated as an exchange of the old debt instrument for equity of the issuer. This debt modification may result in an unanticipated exposure to unrelated business taxable income (UBTI) for tax-exempt investors. Similar to the ECI considerations, PE and VC firms can use blockers between the tax-exempt investors and the fund so that the tax-exempt investor can avoid reporting UBTI on their tax returns.
What Should You Do?
You must perform a thorough analysis of risk before investing in a company’s distressed debt. It is recommended that your firm use advanced models and test scenarios to determine the risk in the investment and spread it out, a practice common among larger hedge funds. It is also important to be well versed in whether you have investors who may have additional tax considerations as well as how market discount rules and cost recovery will ultimately affect your investments.
Working with a tax advisor can help you understand the tax implications specific to your investments. For more information about the tax implications of investing in distressed debt, please contact us.
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