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May 13‚ 2011
Amended IRS Regulation
Facilitates Tax-Exempt Bond Restructurings
By Leonard Weiser-Varon and Maxwell D. Solet
Restructurings of tax-exempt bonds payable by an entity
experiencing financial difficulties typically feature the yin of an
obligor seeking debt relief that will permit it to operate without the
stigma of potential insolvency and the yang of creditors
who may wish to accommodate but do not want to leave money on the
table. This frequently leads to an agreement between the obligor and
the bondholders to reduce or defer principal and/or reset the interest
rate. It also may lead to some variant on an “A/B” structure involving a
reduced amount of debt that is unconditionally payable (the “A piece”) and
a balance that is deferred and often payable on a flexible schedule
dictated by available cash flow (the “B piece”).
However, maintaining tax-exemption of the bonds often
presents obstacles to restructurings, including A/B restructurings. If
principal is deferred beyond a safe harbor period and/or the interest rate
is altered, the restructured bonds may be considered “reissued” for tax
purposes. A tax reissuance generally is not overly problematic for
financially healthy bonds, as in most cases it merely requires the filing
of an IRS tax report (Form 8038) by the issuer, some due diligence by bond
counsel, and the issuance of a new tax opinion confirming that the reissued
bonds are tax-exempt. In the case of a financially troubled obligor,
however, a reissuance has raised vexing questions as to whether the
restructured bonds continue to qualify as debt.
Tax practitioners generally consider a reasonable expectation
of full repayment a significant factor in distinguishing a debt investment
from an equity or other non-debt investment. Restructurings that involve a
tax reissuance, therefore, have presented the dilemma of requiring a high
degree of confidence as to the repayment of the restructured debt in the
face of financial difficulties that are causing the debt to be
restructured. Even if the restructuring involves a mere deferral of
scheduled principal payments or resetting of interest outside the
reissuance safe harbors, a need to update the repayment expectations as of
the reissuance date can be problematic.
Although the expectation of repayment requirement creates
tax-exemption opinion issues for a variety of restructurings, it has been
of particular concern in A/B restructurings, where there is almost by
definition a reduced expectation of repayment of the “B piece,” which is
sometimes referred to as a “hope note” and often represents more a wish
than an expectation of repayment. If bond counsel is uncertain as to
whether an instrument is debt at the time it is issued, bond counsel will
be unable to give an unqualified opinion that the payments on such
instrument constitute interest or tax-exempt interest. In fact,
because the A and B pieces are issued simultaneously, in some circumstances
a tax-exemption question relating to the B piece may also affect the
ability to obtain a tax-exemption opinion on the A piece.
An IRS regulation finalized earlier this year substantially
simplifies the tax analysis for restructurings of tax-exempt debt involving
principal deferral or reduction and/or interest resets outside the
reissuance safe harbors. The new regulation also may facilitate A/B restructurings
involving tax-exempt bonds. The regulation amends the § 1.1001-3 tax
regulations governing modifications of debt instruments to make the
expectation of repayment at the time of a bond restructuring unnecessary
provided that such an expectation existed at the time the bonds were
originally issued. More specifically, the regulation states:
… [I]n making a determination as to whether an
instrument resulting from an alteration or modification of a debt
instrument will be recharacterized as an instrument … that is not debt, any
deterioration in the financial condition of the obligor between the issue
date of the debt instrument and the date of the alteration or modification
(as it relates to the obligor’s ability to repay the debt instrument) is
not taken into account. For example, any decrease in the fair market value
of a debt instrument … between the issue date of the debt instrument and
the date of the alteration or modification is not taken into account to the
extent that the decrease in fair market value is attributable to the
deterioration in the financial condition of the obligor and not to a
modification of the terms of the instrument.
The above relief from the debt repayment expectation is not
available in cases involving a change in the debt obligor(s). It also
remains the case, as noted in the preamble to the new regulation, that “all
relevant factors (for example, creditor rights or subordination) other than
any deterioration in the financial condition of the issuer are taken into
account in determining whether a modified instrument is properly classified
as debt…” Accordingly, the restructured instrument must promise repayment
by some maturity date, even if the repayment schedule is flexible and even
if the financial ability of the obligor to make such repayment is
questionable as a practical matter (i.e., the failure to repay the bond at
maturity must constitute a default and entitle the holder to exercise
remedies). In addition, although subordination is not inconsistent
with debt treatment, the reference to subordination as a relevant factor in
the regulatory preamble may cause practitioners to look carefully at
subordination features in the restructuring context. So there will still be
some tax-related constraints around the structuring of a “B piece” in an
A/B restructuring. However, through this new regulation, the IRS has
put an important new tool into the tool box for bondholders of distressed
debt by favorably addressing a long-standing problem facing workout
practitioners.
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