Low Applicable Federal Rates Provide Flexibility in Reducing or Forgiving Interest without Adverse Tax Consequences
This alert addresses the tax consequences of a lender and borrower agreeing to restructure a loan by either: (1) reducing the loan’s interest rate on a prospective basis, (2) forgiving part or all of the accrued interest arising in 2020 on a retroactive basis, or (3) deferring interest to the end of 2020 or beyond.
All else being equal, a borrower may be more successful in persuading a lender to agree on restructuring interest payments if such restructuring can be done in manner that avoids subjecting the lender to imputed interest income under the original issue discount rules, which could result in accelerated taxable income to certain types of lenders. (This alert assumes the holder of the debt is the original lender and not a secondary purchaser of the debt.) A lender will also seek to avoid triggering a taxable deemed exchange of a debt instrument that results in a gain to the lender.
Reducing the Interest Rate
Reducing a loan’s interest rate on a prospective basis might be able to be accomplished without adverse tax consequences to the lender or borrower, so long as the modified interest rate is at or above the applicable federal rate (which is published by the Internal Revenue Service (IRS) on a monthly basis). Currently, applicable federal rates are at historic lows.
For loans modified in October 2020, the applicable federal rates are:
- 1.12% for the long-term rate (applicable to a loan with a remaining term of more than nine years)
- 0.38% for the mid-term rate (applicable to a loan with a remaining term of more than three years and no more than nine years); and
- 0.14% for the short-term rate (applicable to a loan with a remaining term of no more than three years)
Example. In October 2020, lender and borrower agree to reduce a loan’s interest rate on a prospective basis from 7% to 2%. The loan term has twelve years remaining. Because under the original issue discount rules the 2% interest rate will still give rise to “qualified stated interest” (that is, interest payments that are due at least annually) and will be above the applicable federal rate, the loan will not for lender become an original issue discount instrument with imputed interest above the stated interest amount.
A significant modification of a debt instrument can, under certain circumstances, result in a deemed exchange of debt instruments that can give rise to taxable gain or loss. Under tax regulations, a reduction in an interest rate will be a significant modification if the change in yield of the modified loan exceeds the greater of 25 basis points and 5% of the yield on the loan agreement before it was modified. If a significant modification occurs, the holder of the debt instrument is treated as exchanging the “old” debt instrument for a “new” debt instrument with the modified terms. Such exchange is generally a taxable exchange, potentially resulting in cancellation of indebtedness (COD) income to the borrower and gain or loss to the holder of the debt instrument. For this purpose, it does not matter whether an actual exchange of debt instruments occurs.
The issue price of the “new” debt instrument is generally determined with reference to its fair market value if a substantial amount of the new debt instrument is not issued for money, and either the new debt instrument or the old debt instrument is “publicly traded.” Although the definition of “publicly traded” is quite broad, an exception applies for small debt issuances (i.e., if the outstanding stated principal amount of the debt instrument does not exceed $100 million). In the case of a non-publicly traded debt instrument (including a small debt issuance), the “issue price” of the new debt instrument will equal its stated principal amount, provided the debt instrument bears adequate stated interest (i.e., in excess of the applicable federal rate).
Thus, where the interest rate on a non-publicly traded debt instrument is reduced (but the debt instrument still provides for payments of interest not less than the applicable federal rate), although a “significant modification” may result in a taxable deemed exchange, there may not be gain or loss that results from such deemed exchange (thereby avoiding COD income for the borrower and gain or loss to a lender).
In the above example, a significant modification of the loan occurs as a result of the modification (because the 5% decrease in the interest rate exceeds the greater of 0.25% or 0.35% (i.e., 5% of the original 7% interest rate)). As a result, there will be a deemed taxable exchange of a new debt instrument for the old debt instrument. However, assuming the debt instrument is not publicly traded, because the new 2% interest rate will still give rise to “qualified stated interest” and will be above the applicable federal rate of 1.12%, the modified debt instrument should have an “issue price” equal to the principal amount of the debt instrument. Accordingly, the borrower should not have any COD income and the lender should not recognize any gain or loss.
Another approach is for the lender to forgive part or all of interest that accrued on the loan earlier in 2020. In general, forgiveness of indebtedness results in COD income, subject to a number of exceptions (which we do not address fully here). If the borrower is on the cash basis of accounting for tax purposes, an exception may be available under Section 108(e)(2) of the Internal Revenue Code of 1986, as amended (the “Code”). In that case, no COD income would arise if the payment of the interest would have given rise to a deduction. The principle behind this rule is that the interest (or other items) would have been deductible had it been paid, so imputing income and then permitting a deemed deduction would be superfluous.
There is an argument that the same rule should apply in the case of a borrower on the accrual basis of accounting, on the theory that the accrued interest has not yet been claimed as a deduction on a tax return. This argument is stronger if the interest is forgiven on a prospective basis for the remainder of 2020—that is, forgiving the interest before it has accrued.
If the “offset” approach is not used, the borrower would have COD income and claim an offsetting interest expense. However, claiming the deduction in 2020 may not be available if a loss limitation rule applies (such as the interest expense limitation rule of Section 163(j) of the Code), although we note that the CARES Act temporarily loosened such restrictions for the 2019 and 2020, as discussed in our client alert available here. In the event a loss limitation does apply, the deduction would be deferred for use in a subsequent year.
An accrual basis borrower that has interest forgiven in 2021, where it claimed a deduction for such interest in 2020, should recognize the interest income in 2021. However, an exception to the COD rules could apply to avoid recognizing such income.
The lender may be required to accrue the interest income that has accrued in the earlier part of 2020 and offset such income with a bad debt deduction for the forgiven interest. A lender is less likely to be subject to loss limitation rules, but it is still possible the lender could be subject to them. Alternatively, the lender may consider if it can report no income or deduction on its 2020 tax return, similar to the offset approach the borrower might be able to use.
Any such loan restructuring also needs to be tested to determine if forgiving the interest would be treated as a significant modification that triggers a deemed taxable exchange of debt instruments, and, if there is such a taxable exchange, whether gain or loss would result, taking into consideration the special rules applicable to small debt issuances (as discussed above). Even if there is a deemed taxable exchange, as a result of the small debt issuance exception, there may be no adverse tax consequences for either the lender or the borrower.
Another approach is to defer the payment of interest, rather than forgiving the interest entirely. In general, deferring interest due from earlier in 2020 to year-end should not cause any tax complications.
Deferring interest to beyond the close of 2020 to 2021 might not generate any original issue discount issues with the lender either. If the deferral does not result in a “significant modification” of the debt instrument (see second-to-last paragraph below), then the instrument should not have to be retested under the original issue discount rules. Even if there is a significant modification, if the deferred interest must be paid within one year of the deferral, and interest is payable at least annually thereafter, then the lender generally should not be subject to the original issue discount rules.
When the deferral approach is used, consideration must be given to whether or not the deferral would result in a taxable exchange of the original debt instrument and the modified debt instrument. A modification that changes the timing of payments is significant if it results in the “material” deferral of scheduled payments. This will be the case if the payment period is extended more than 5 years or more than half of the original term of the loan, whichever is less. This safe harbor provides leeway for avoiding a significant modification for limited deferrals.
As discussed above, if there is a significant modification of a non-publicly traded debt instrument, and a deemed taxable exchange results, there may not be gain or loss where the modified debt instrument provides for payments of interest not less than the applicable federal rate.
Arent Fox LLP tax advisors would be glad to discuss with owners of hotels and other hospitality facilities any plans to restructure debt in order to minimize any adverse tax implications that might result.
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