PE funds buying distressed debt
Opportunities abound for private equity, but so do risks
ELIZABETH MCGINLEY AND MICHELE ALEXANDER, BRACEWELL LLP, NEW YORK CITY
ALTHOUGH OIL prices have rebounded from their lows earlier this year, persistent low oil prices have driven the price of debt of many highly leveraged oil and gas companies to distressed levels. Some private equity firms have seized this opportunity to purchase debt of struggling issuers at reduced prices and benefit from the anticipated rise in the debt price as oil prices rise or the issuer otherwise increases its creditworthiness.
There are a number of potential federal income tax consequences related to acquisitions of distressed debt that are important to private equity firms. First, if the purchase price of the debt is less than the amount payable to the holder at maturity (or if the debt was issued with original issue discount (OID), less than the adjusted issue price of the debt at the time of the acquisition) the debt will be have market discount. For example, if a note without OID and a principal amount of $1,000 is trading at $800, that note will be acquired with $200 of market discount, which is the $1,000 amount due at maturity over the $800 purchase price in the secondary market.
Holders of market discount debt may elect to include such discount in taxable income over the remaining term of the debt. If, however, no election is made, the holder of the market discount debt will recognize the accrued market discount as ordinary income when the debt is sold or matures, up to the amount of the total gain recognized. In other words, when there is market discount and no election to include such discount in income over the term of the debt, all of part of the gain on disposition or maturity that otherwise may be capital gain will be re-characterized as ordinary income. For example, if a note issued without OID and $1,000 due at maturity is purchased in 2016 as a capital asset for $900, and $30 of market discount accrues, but is not included in the holder's income, prior to the sale of the note in 2018 for $950, the seller would recognize $50 of gain upon the sale, consisting of $30 of ordinary income and $20 of long-term capital gain. Accordingly, individual domestic investors in the fund would be subject to tax at ordinary income rates on a portion of the gain, rather than the lower long term capital gains rates. If the note were sold at a loss, no market discount would be recognized.
Some funds may purchase debt of distressed oil and gas companies with the goal of restructuring the debt to achieve more advantageous terms or convert the debt to equity in or out of bankruptcy. Frequently, distressed issuers will negotiate with debt holders to modify the terms of the debt to increase the term, raise the interest rate, adjust covenant terms or otherwise manage the issuer's debt service obligations while providing sufficient compensation to the creditor.
Even seemingly minor modifications of outstanding debt, however, can have dramatic tax consequences. Generally, all the changes to the terms of the debt are considered collectively and, if they are determined to be "significant," will result in a deemed exchange of the old debt for new debt for federal income tax purposes, even if no exchange of debt instruments actually occurs. Unless an exception applies, such exchange is taxable and gain or loss is recognized by the holder in an amount equal to the difference between the amount realized, which is the issue price of the new debt, and the holder's tax basis in the old debt.
When debt is publicly traded, the issue price is its fair market value and, otherwise, it is the face amount of the debt. "Publicly traded" is specifically defined for federal income tax purposes and can include debt that would not be considered to be traded under the common meaning of that term. Distressed debt purchased in the secondary market often is treated as publicly traded for federal income tax purposes.
For example, if a fund acquires distressed debt, with a principal amount of $1,000 and no OID for $920 in secondary market trading, and the debt is significantly modified to extend the term and increase the interest rate, and the resulting the fair market value of the debt is $970, the holder will recognize $50 of gain, the excess of the $970 amount realized over the tax basis of $920 in the debt, which will be ordinary to the extent of accrued and unrecognized market discount. Because this type of transaction can generate taxable gain without the receipt of cash to pay the related tax, funds generally seek to avoid them, particularly those with the potential for significant taxable gain. Following the exchange, the fund will have a basis in the new debt equal to the amount realized in the exchange, which is, the issue price of the new debt, and a new holding period will begin the day after the exchange.
One exception to significant debt modifications resulting in taxable exchanges is when the exchange qualifies as a non-taxable corporate recapitalization. Generally, the exchange can qualify as a non-taxable reorganization when both the old debt and the new debt are "securities" of the same corporation and the principal amount of the new debt does not exceed that of the old debt. If the exchange is a non-taxable corporate recapitalization, and the principal amount of the new debt does not exceed that of the old debt, the gain or loss realized in the transaction is deferred. The fund will carry over its tax basis in the old debt to its tax basis in the new debt and recognize gain or loss when the new debt is paid or is sold.
The term "security" is not specifically defined in the Internal Revenue Code, Treasury Regulations, or other guidance. Instead, whether a debt instrument is a security is a facts and circumstances analysis but, one of the most significant factors considered in determining whether a debt instrument is a security is its term. Generally, debt obligations issued with a term of less than five years do not constitute securities, whereas debt obligations with a term of 10 years or more do constitute securities. It is unclear whether debt with a term between five and 10 years constitutes a security, but, debt with a term of five years or more may qualify as a security and many practitioners take the position that such debt common qualifies as a security.
Finally, funds may acquire debt of a distressed oil and gas company with the goal of converting such investment into equity of the issuer, possibly acquiring control over the operation of the issuer. Funds must proceed with caution in these transactions.
First, the transaction may result in taxable gain if the debt is purchased at a discount to its face amount, and it is not a security, or the issuer is not a corporation for federal income tax purposes, preventing a non-taxable corporate reorganization.
Second, the issuer may recognize cancellation of debt income, which is taxable income not related to the receipt of cash, if and to the extent the value of the equity issued is below the face amount of the debt exchanged. If the issuer is insolvent or in bankruptcy, the issuer may exclude such cancellation of debt income from its taxable income, but instead must reduce its tax attributes, including net operating losses and tax basis in its assets by the amount of the excluded cancellation of debt income.
Further, if the issuer is a corporation, the issuance of equity can trigger an ownership change, generally wiping out much of the value of its net operating losses. Both events can create significant cash tax liability to the issuer, further reducing its ability to service debt and fund operations.
Third, the ownership of equity rather than debt can have negative tax consequences for foreign and tax exempt investors in a fund, and some fund agreements include undertakings to avoid or mitigate such consequences.
If the issuer of the equity is a partnership, including an LLC treated as a partnership, for federal income tax purposes, ownership of such equity may cause such investors to be treated as engaged in a US trade or business which both can result in the recognition of US taxable income from such investment as well as create other adverse tax results.
Alternatively, if the issuer is a corporation, or an LLC treated as a corporation, for federal income tax purposes, and its assets primarily are interests in US real property, as is common for upstream oil and gas companies, the issuer may be treated as a US real property holding company (USRPHC). When equity of a USRPHC is sold, the gain allocated to foreign investors in the fund is subject to US federal income tax and tax reporting. Various structures can mitigate the impact of these rules, but also can create other negative tax consequences.
In summary, there are many opportunities for private equity funds to invest in debt of oil and gas companies, some of which is heavily discounted from its initial issue price. However, private equity firms should be well advised on potential adverse tax consequences before purchasing, modifying, or converting such debt.
ABOUT THE AUTHORS
Elizabeth McGinley is the head of the tax practice at Bracewell LLP. She represents a variety of 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 as experience with volumetric production payment (VPP) transactions. In addition, McGinley has experience in partnership and corporate transactions including mergers and acquisitions and spin-off transactions.
Michele Alexander is a partner in Bracewell's tax practice. In her years of practice, Alexander has counseled clients on an array of transactions, including mergers and acquisitions, capital markets, and securities offerings, financings, joint ventures, and restructurings. In recent years, her practice has evolved to include a strong focus on private equity and hedge funds and similar investment vehicles.