Hidden tax dangers
TAX CONSEQUENCES IN OIL AND GAS RESTRUCTURINGS
ELIZABETH MCGINLEY AND VIVIAN OUYANG, BRACEWELL & GIULIANI LLP, NEW YORK
AS OIL AND GAS PRICES continue to languish, some upstream, midstream and oilfield services companies have been forced to consider restructuring their debt, out of court or through the bankruptcy process. While a successful restructuring can increase liquidity and eliminate disputes with creditors, the unwary debtor or its investors can have significant negative tax consequences.
Two significant federal income tax consequences that often result from restructuring transactions are the recognition of cancellation of debt income ("CODI") and the limitation of available net operating losses ("NOLs"). CODI generally arises when a taxpayer settles a debt claim for less than the amount due. It is taxable income recognized by the debtor which is not related to the immediate receipt of cash or liquid assets which can be used to pay the resulting cash tax liability. The rationale for the recognition of CODI generally is, when a taxpayer increases its assets by an amount borrowed, no taxable income is recognized because such asset is offset with the related liability and there is no net increase in the taxpayer's wealth. However, if the debt is released through a payment of less than the amount borrowed, the resulting net increase in assets is treated as taxable income. The federal tax law provides certain exemptions from the current recognition of CODI, including exemptions when the debtor is insolvent or in bankruptcy.
NOLs are net losses of a corporation that can be carried back or carried forward, to offset taxable income in years prior to, or after, the year they were incurred, reducing cash tax liability in those years. Accordingly, corporations experiencing losses attributable to the drop in oil prices are generating a tax asset in the form of NOLs that will reduce their cash taxes in the future when they generate income. Preserving the ability to utilize those NOLs is important to building future liquidity. Certain restructuring transactions can severely limit a debtor corporation's ability to utilize its remaining NOLs. Thus, without careful tax planning, restructuring transactions can cause corporations to inadvertently lose much of the value of their unutilized losses, raising cash tax liability in future years.
RENEGOTIATION OF THE TERMS OF EXISTING DEBT
The simplest way to relieve the pressure of existing debt service obligations often is to renegotiate the terms of the debt. The debtor and creditor can agree to extend the maturity, defer interest payments or make the covenants less onerous. Though not intuitive to many debtors, for federal income tax purposes, a negotiated reduction in the principal amount of the debt generally will result in CODI. In addition, the aggregate changes to the terms of a debt obligation can be deemed to constitute an exchange of "old debt" for "new debt" for federal income tax purposes, which also may result in CODI.
If the modifications, in the aggregate, are determined to constitute a "significant modification" of the debt, the debtor will be treated as satisfying the old debt with new debt. If the old debt or the new debt is publicly traded, and the fair market value of the new debt is below its face amount, the principal amount of the old debt could be treated as satisfied with the fair market value of the new debt. The result is that the debtor may realize CODI equal to the excess of the principal amount of the old debt over the fair market value of the new debt.
DISPOSITION OF ASSETS IN SATISFACTION OF DEBT
When creditors, lenders or distressed debt investors are willing to accept assets in exchange for their claims, they can offer their debt claim in exchange for the assets, or credit bid for the assets. If the debt is non-recourse debt, the transaction is treated as a sale of the property for the amount of the debt. As a result, the debtor recognizes gain or loss equal to the difference between the amount of the debt and the tax basis of the property. If, however, the debt is recourse debt, the debtor is treated as selling the property for its fair market value, resulting in gain or loss, and satisfying the debt for the fair market value of such property. The excess of the amount of the debt discharged over the fair market value of the property is CODI. As discussed below, debtors that are insolvent or in bankruptcy may prefer to recognize CODI rather than gain on the sale of the assets because there are exceptions that allow the debtor to avoid current recognition of CODI.
Tax planning such as negotiating the discharge of a portion of the debt prior to the exchange of assets for the remainder of the debt, or converting the debt from nonrecourse to recourse can increase the amount of CODI recognized and reduce the taxable income resulting from the transaction. However, careful planning is necessary for these transactions to be respected and not disregarded for federal income tax purposes.
EXCHANGES OF DEBT FOR EQUITY
Often, when the debtor is seeking to reduce its debt service costs without a current cash expenditure, it will offer creditors the opportunity to convert their debt into equity. While these exchanges can be achieved in transactions that are not taxable to the creditor, they can result in CODI to the debtor. Generally, when a creditor exchanges debt for equity, the debtor recognizes CODI equal to the excess of the amount of the debt discharged and the fair market value of the equity received in exchange. Such CODI can be significant when the debtor is highly leveraged and the equity value is low.
EXCEPTIONS TO CURRENT RECOGNITION OF CODI
The federal income tax law provides that, if a debtor is insolvent, it can exclude CODI from its taxable income to the extent to which it is insolvent. A debtor is insolvent to the extent its liabilities exceed the fair market value of its assets immediately before the debt discharge. However, debtors must evaluate all relevant authority in making this determination, as certain liabilities are excluded and assets of the taxpayer are broadly defined, which may limit the availability of the exemption. A critical aspect of this exemption is, when the debtor is a partnership, or a limited liability company ("LLC") treated as a partnership for federal income tax purposes, the exemption applies at the partner or member level. Thus, even if the partnership or LLC is insolvent, the partner or member allocated income of the partnership often is not, making the exemption unavailable with respect to the CODI allocated to such partner or member.
There also is an exemption from recognition of CODI available for entities in bankruptcy. Generally, a debtor in bankruptcy may exclude all CODI from current taxable income, so the exemption is much broader than the insolvency exemption. Like the insolvency exemption, however, when the debtor is a partnership, or an LLC treated as a partnership for federal income tax purposes, the exemption applies at the partner or member level. So, if the partner or member is not, itself, in bankruptcy, it cannot utilize the exemption with respect to CODI of the partnership or LLC allocated to it.
While these exemptions may allow taxpayers to avoid current cash tax liability, there is a cost to the taxpayer. The amount of CODI excluded from taxable income must be applied to reduce the taxpayer's tax attributes, in a specified order. Generally, the taxpayer reduces its NOLs, tax credits, and basis in its assets. Accordingly, the taxpayer's future taxable income will be increased as a result of the reduction in favorable tax attributes. The debtor, or its partner or member, can elect to apply the CODI exemption first to reduce taxable basis in its assets. Such alternative may be advantageous if such assets are not expected to be sold for an extended period of time or have long depreciable lives, as the detriment of the reduced basis will have less impact in the short term. Careful tax planning is necessary to optimize the results of the CODI exclusions.
POTENTIAL LOSS OF NOLS
To prevent corporations from acquiring other corporations primarily to obtain the value of their NOLs, and not for any other valid business purpose, the tax law significantly limits a corporation's ability to utilize its NOLs after an ownership change. The rules for determining when an ownership change has occurred are extremely complex, but, generally, an ownership change occurs when there is a change in ownership of the corporation's stock aggregating more than 50 percentage points over a three-year period. Stock offerings, issuances of equity in exchange for debt, conversions, redemptions and recapitalizations all are counted for this purpose. Upon an ownership change, the annual limitation on the use of the existing NOLs generally is equal to the product of the value of the old loss corporation's stock immediately prior to the ownership change, multiplied by the long-term tax-exempt rate, which currently is about 2.6%. Accordingly, for example, a corporation with an equity value of $100 million that experiences an ownership change upon the conversion of debt to equity could utilize no more than $2.6M of NOLs per year, until those NOLs expire.
However, if the debtor corporation is in bankruptcy, there are special exceptions to these rules. The primary exception is that, if the debtor corporation is in bankruptcy, and the shareholders and creditors of the old loss corporation own at least 50% of the stock of the corporation after such ownership change, the annual limitation on NOLs will not apply. However, the NOLs are reduced by the last three years of interest deductions on the debt converted to equity.
Accordingly, if a debtor corporation is contemplating transactions that could trigger an ownership change, it must consider the lost value from a limitation on NOLs, particularly if the debtor has significant NOLs, currently has a low equity valuation, and anticipates recognizing taxable income shortly after the ownership change. Careful planning can help the debtor maximize the value of its NOLs when an ownership change is anticipated.
CONCLUSION
Clearly, when negotiating the settlement of debt of a corporation or partnership, it is critical to evaluate the federal income tax consequences to avoid or minimize the recognition of CODI when the debtor or its partners or members may have limited liquidity to pay the resulting cash tax liability. Further, with respect to corporations that have suffered tax losses for multiple years, the corporation's NOL may be one of its most valuable assets. Ignoring the tax consequences of restructuring transactions can result in the unintended loss of that tax asset. Sophisticated tax advisors working closely with finance and bankruptcy attorneys and financial advisors can mitigate the potential negative tax consequences to the debtor, including reducing CODI and protecting losses.
ABOUT THE AUTHORS
Elizabeth McGinley is a partner at Bracewell & Giuliani LLP and serves as head of the firm's tax practice. She represents clients in the oil and gas and electric power industries, including private equity firms investing in oil and gas exploration, production and infrastructure. Her experience includes complex debt and equity financing, joint ventures and project finance, as well volumetric production payment transactions. She earned a bachelor's degree from Lehigh University and a JD and LLM from New York University School of Law.
Vivian Ouyang serves as senior counsel at Bracewell & Giuliani LLP. She focuses on federal tax issues in a wide range of transactions, including mergers, acquisitions, divestitures, joint ventures, project finance, partnerships and cross-border transactions. Ouyang has represented clients with regard to the federal tax issues applicable to the energy sector in various transactions. She received a bachelor's degree from Beijing University, a master's degree from Princeton University, and her JD from Columbia Law School.