Magazine article Business Credit

Restructuring Corporate Debt

Magazine article Business Credit

Restructuring Corporate Debt

Article excerpt

Major bankruptcies and restructurings are a familiar feature of the 1990s business landscape. Creditors are finding it necessary to understand the complex and arcane world of restructuring and to develop a variety of strategies to maximize the value of their involvement in distressed companies.

Credit managers should be aware of the tax and accounting concepts relating to the burgeoning area of restructuring troubled companies. Tax effects usually impact cash flow, and accounting issues influence financial condition, debt/equity ratios, and coverage rations.

TAX ATTRIBUTES MAY BE MAJOR ELEMENT OF VALUE

Often, troubled companies have been experiencing losses for a number of years. For a company in this situation, tax attributes such as net operating loss carryforwards (NOLs) may be one of the major elements of value. Careful planning is required to minimize restrictions on use of NOLs in the entity which emerges from the restructuring.

From a restructuring viewpoint, the issuance of stock in exchange for debt or for fresh equity can severely limit the use of existing NOLs. A limitation arises if, within three years, there is a greater than 50 percentage point increase in value in the direct or indirect ownership of a corporation. This simple formula may lead to some less than obvious results.

In Table One, an ownership change has occurred since there has been a greater than 50 percentage point increase in ownership. However, no single shareholder has gained control. Because the rules focus only on value, it is possible to provide voting control or common equity to a new investor without triggering a change--such as by having historic shareholders retain a sufficient preferred stock interest.

If all ownership change occurs, then the annual limitation on use of NOLs thereafter is equal to the fair market value of all classes of equity immediately prior to the transaction multiplied by a "federal long-term tax-exempt rate," currently at about 7 percent. Any unused annual limit is added to the next year's limit.

BANKRUPTCY AND INSOLVENCY AFFECT TAX FACTORS

In general, there are no immediate tax effects from a filing for Chapter 11 bankruptcy protection. However, a company that is either reorganizing under bankruptcy, or is "insolvent," will receive more favorable tax treatment to assist it in its rehabilitation. Indeed, tax factors may cause a company to consider a bankruptcy filing, especially if the settlement can be pre-approved.

The limitation on NOLs is imposed somewhat less stringently on companies that undergo an ownership change while in Chapter 11. In such cases, the limitation is based on the company's equity value increased to reflect any debt forgiven as a result of the reorganization plan.

In addition, where control of the reorganized company is awarded to "historic" creditors, the company can alternatively elect to reduce its NOLs for a portion of the debt forgiveness, plus certain prior periods' interest expense, instead of any limitation on NOLs going forward. However, if after electing this option another change in ownership occurs within two years of the reorganization, remaining pre-reorganization NOLs are entirely lost thereafter. Normal trading activity does not foreclose this route for deals with public bondholders.

CANCELLATION OF INDEBTEDNESS INCOME

Although preserving NOLs is important, it is the potential for taxable income to be recognized by the debtor as a result of restructuring which drives the structure of many deals. In general, when debt is retired or restructured at less than its carrying value, the difference is considered to be cancellation of debt (COD) taxable income.

There is no relief from the recognition of COD income for solvent corporations--not in Chapter 11. Insolvent and bankrupt corporations, however, can exclude COD income from taxable income. The exclusion only applies to an insolvent corporation to the extent of its insolvency, but applies to a corporation in bankruptcy without limit. …

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