Electric utilities will use the proceeds of securitization to retire existing debt and equity capital as part of a restructuring of the utilities' capitalization. These changes to the debt and equity sections of an electric utility's balance sheet can have significant federal income tax effects depending on how they are structured. This article briefly discusses selected federal income tax issues associated with the redemption of equity securities, the refunding or modification of debt securities, the exchange of debt for equity or equity for debt and finally the exchange of new equity for old equity.
Redemption of Stock
Overview
A redemption of the outstanding stock of a corporation will be treated either as an exchange of the stock or as a distribution with respect to the stock. If the redemption qualifies as an exchange, the amount received by the shareholder in excess of the shareholder's basis in the shares redeemed will be subject to tax. Such excess will be subject to tax at capital gains rates. If a redemption does not qualify as an exchange, the transaction will be treated as a distribution with respect to the stock. The characterization of this distribution would depend on the amount of the redeeming corporation's earnings and profits, although in most cases, the entire amount received would be taxed as a dividend at ordinary income tax rates. The redeeming corporation will recognize no loss from the redemption, and it will recognize gain only if it distributes appreciated property in the redemption.
Corporate shareholders generally will prefer that a redemption qualify as a dividend because the distribution can be largely offset by the intercorporate dividend received deduction. Individual shareholders, on the other hand, will prefer that a redemption qualify as an exchange because only the amount by which the amount received exceeds their basis in the stock redeemed will be subject to tax and then only at favorable capital gains rates.
Exchange Treatment
For a redemption of stock to qualify as an exchange, it must be (i) not essentially equivalent to a dividend, (ii) a termination of the shareholder's interest or (iii) substantially disproportionate.
1. Not Essentially Equivalent to a Dividend
The inquiry into whether a redemption is not essentially equivalent to a dividend is based on all the facts and circumstances, but to qualify it must result in a meaningful reduction in the shareholder's proportionate interest in the corporation. Some factors to consider when making the inquiry include any reduction of the shareholder's right to (i) vote, (ii) participate in current earnings and accumulated surplus, or (iii) share in the corporation's net assets on liquidation. Because the inquiry is based on all the facts and circumstances, a letter ruling is often needed before proceeding with most significant redemptions based on this provision.
2. Termination of Interest
A redemption of all the stock of a redeeming corporation owned by a shareholder (and other persons whose shares are deemed to be owned by the shareholder under the attribution rules) is treated as a payment in exchange for the stock of the shareholder. A shareholder who receives or holds only debt of the corporation after a redemption will be considered to be only a creditor (and therefore as having had its stock interest terminated) if his or her rights are no greater than necessary for the enforcement of the debt. The debt must not in any way be proprietary or subordinate to the claims of general creditors. For example, if the debt participated in or is dependent upon the earnings of the corporation, the holder of the debt will be more than a mere creditor of the corporation, and therefore, the redemption will not be of all the stock of the corporation owned by the person.
3. Substantially Disproportionate
A redemption of shares qualifies as an exchange if it is substantially disproportionate with respect to the shareholder (and other persons whose shares are deemed to be owned by the shareholder under the attribution rules). A redemption is substantially disproportionate if, immediately after the redemption, the shareholder owns less than 50% of the total combined voting power of all classes of stock entitled to vote and less than 80% of the proportionate interest in all voting stock (whether common or preferred) and all common stock (whether voting or nonvoting) that he or she owned immediately before the redemption.
4. Attribution Rules
Although the tests for determining whether a redemption is a termination of the shareholder's interest or is substantially disproportionate are fairly straightforward, it is important to note that ownership of shares of stock in the redeeming corporation by certain persons related to the shareholder will be attributed to the shareholder.
While the attribution rules are very technical, the most important attribution rules to keep in mind are:
(i) Family Members. An individual is considered as owning the stock owned, directly or indirectly, by or for his or her spouse, children, grandchildren, and parents.
(ii) Partnerships and Estates. Stock owned, directly or indirectly, by or for a partnership or estate is considered as owned proportionately by its partners or beneficiaries, respectively. Stock owned, directly or indirectly, by or for a partner or a beneficiary of an estate is considered as owned by the partnership or estate, respectively.
(iii) Trusts. Stock owned, directly or indirectly, by or for most trusts (except grantor trusts and certain exempt trusts) is considered as owned by its beneficiaries in proportion to the beneficiaries' actuarial interest in such trust. Stock owned, directly or indirectly, by or for a beneficiary of a trust is considered as owned by the trust (unless the beneficiary's interest is a remote contingent interest). Stock owned, directly or indirectly, by or for a grantor trust is considered as owned by the grantor. Stock owned, directly or indirectly, by or for a grantor of a grantor trust is considered as owned by the trust.
(iv) Corporations. If a person owns, directly or indirectly, 50 percent or more in value of the stock in a corporation, such person will be considered as owning the stock owned, directly or indirectly, by or for such corporation, in proportion to the proportionate value of the person's stock, and the corporation will be considered as owning the stock owned, directly or indirectly, by or for such person.
(v) Options. If a person has an option to acquire stock, such stock will be considered as owned by such person. For these purposes, an option to acquire such an option, and each one of a series of such options, will be considered as an option to acquire such stock.
5. Redemption of Preferred Stock
For shareholders owning only preferred stock, a redemption of their preferred stock will qualify as an exchange in most cases because it will be a complete termination of their interest in the corporation. For shareholders who own both common and preferred stock and have some or all of both redeemed, the redemption of shares will qualify as an exchange if it is either a termination of the shareholder's interest or substantially disproportionate. For shareholders who own both common and preferred but have only preferred stock redeemed, the redemption cannot qualify as an exchange based on being a termination of interest because the shareholder would still have a stock interest via his or her common stock, and the redemption cannot qualify as an exchange based on being substantially disproportionate because the shareholder would own at least 80% of the proportionate interest in all common stock that he or she owned immediately before the redemption. Therefore, the redemption must be "not essentially equivalent to a dividend" to qualify as an exchange.
C. Treatment of the Corporation upon Redemption
A corporation will recognize no loss from a redemption of its own stock, and it will recognize gain only if it distributes appreciated property in the redemption.
Debt Tenders, Exchanges and Modifications
Taxpayers generally recognize gain and loss upon an exchange of property, which includes a "significant modification" of a debt instrument. A significant modification of a debt instrument can occur upon an actual exchange of instruments or an amendment to the terms of a debt instrument, and to the extent that the "issue price" of the modified instrument (plus any money and fair market value of any other property exchanged) is different from the "adjusted issue price" (for a debtor) or adjusted basis (for a creditor) of the original instrument, any income, gain or loss that would be otherwise be recognized on an exchange will be recognized.
What is a Significant Modification?
In order to structure a tender, exchange or modification to meet the parties' needs, it is important to understand the extent to which a debt instrument can be modified before it is deemed to be exchanged. To have a significant modification, there must be a modification. For this purpose, "modification" means any alteration, addition or deletion of a legal right or obligation of the issuer or holder of a debt instrument, whether the alteration is evidenced by express agreement (oral or written), conduct of the parties or otherwise. An alteration is generally a modification at the time the issuer and the holder enter into an agreement to change a term of a debt instrument, even if such alteration is not immediately effective.
The most common alterations that are modifications are discussed in detail below but some general rules are as follows:
- An alteration occurring by operation of the original terms of the instrument is generally not a modification.
- An alteration resulting from the exercise of an option (except an option to convert debt to equity) is a modification unless the option is unilateral and, in the case of an option exercisable by a holder, does not result in a deferral of, or reduction in, any scheduled payment of interest or principal. The failure to exercise an option is not a modification.
- The failure of an issuer to perform its obligations under a debt instrument is not a modification.
- An agreement by the holder of an instrument to stay collection or temporarily waive an acceleration clause or similar default right is not itself a modification unless the forbearance remains in effect for a period of at least two years.
Bright lines for determining whether an alteration is a significant modification are provided for changes in the yield, the timing of payments, the obligor or security, the nature of the instrument and the accounting or financial covenants. In the case of modifications not described above, "a modification is a significant modification only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant." All modifications to the debt instrument (except those for which specific tests are provided) are considered collectively, and all modifications occurring within five years of a modification result in a significant modification if, had they been done as a single alteration, would have resulted in a significant modification.
Tax issues associated with common types of modifications are described below.
1. Change in Yield. For most debt instruments, a change in the yield is a significant modification if the annual yield on the modified instrument varies by more than the greater of 0.25% (25 basis points) or 5% of the yield on the original instrument. However, alterations to contingent payment debt instruments are determined based on all facts and circumstances. A commercially reasonable prepayment penalty is not taken into account in determining the yield of a modified debt instrument.
2. Change in Timing. A change in the timing and/or amounts of payments is a significant modification if it materially defers scheduled payments. However, extending scheduled payments less than the lesser of five years or 50% of the original term is not a significant modification.
3. Change of Obligor or Security. For recourse instruments, the substitution of a new obligor is generally a significant modification (unless the new obligor is an acquiring corporation in certain liquidations and reorganizations, the new obligor acquires substantially all the assets of the original obligor or the new obligor on a tax-exempt bond is a related entity to the original obligor and the collateral securing the instrument continues to include the original collateral). The filing of a petition in a Title 11 or similar case by itself does not result in the substitution of a new obligor. The addition of a co-obligor on an instrument is not a significant modification unless the addition results in a change in payment expectations. Similarly, a modification that releases, substitutes, adds or otherwise changes the collateral for, a guaranty on, or other form of credit enhancement for, or changes the priority of, a recourse debt instrument is a significant modification only if it results in a change in payment expectations.
For nonrecourse instruments, the substitution of a new obligor is not a significant modification. However, the addition of a co-obligor that results in a change in payment expectations is a significant modification. The release, substitution, addition or alteration of the collateral for, guarantee on, or other form of credit enhancement for or the changes in the priority of a nonrecourse debt instrument are also significant modifications if they result in a change in payment expectations. However, the substitution of fungible collateral is not a significant modification.
A change in payment expectations occurs if the obligor's capacity to meet the payment obligations under the debt instrument was primarily speculative prior to the modification and is substantially enhanced after the modification, or vice versa.
4. Change in the Nature of the Instrument. A modification is generally significant if it changes a debt instrument into an instrument that is not debt for Federal tax purposes, or if it changes a debt instrument from recourse to nonrecourse or nonrecourse to recourse. Exceptions exist for certain modifications if the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations.
5. Accounting and Financial Covenants. The addition, deletion or alteration of any customary accounting or financial covenants is not a significant modification.
Tax Consequences as a Result of a Significant Modification to Terms of Existing Debt
To the extent that the "issue price" of the modified instrument (plus any money and fair market value of any other property exchanged) is different from the "adjusted issue price" (for a debtor) or adjusted basis (for a creditor) of the original instrument, any income, gain or loss that would be otherwise be recognized on an exchange will be recognized.
The "issue price" of an instrument that was issued for money is the amount of money that was paid. The "issue price" of an instrument that is not publicly traded or was not issued for money or publicly traded property is the aggregate amount of all principal payments due under the instrument, unless the instrument does not provide for adequate stated interest. If an instrument (other than one that is publicly traded or was issued for money or publicly traded property) does not provide for adequate stated interest, the issue price is the present value of all payments due under the instrument using the lowest applicable Federal rate in effect during the three months prior to the month in which a binding written contract is entered or the exchange takes place. An instrument does not provide for adequate stated interest if the present value of all payments as determined in the preceding sentence is less than the aggregate amount of all principal payments due under the instrument. The "adjusted issue price" of an instrument is its issue price plus any original issue discount ("OID") includible in the income of a holder less any payments (other than payments of stated interest).
When the issue price of a modified instrument (plus fair market value of other property) is less than the adjusted issue price of the original instrument, the debtor generally will recognize income from discharge of indebtedness (unless excluded under Section 108 of the Code); the creditor generally will realize a business-related loss, a bad-debt loss or a capital loss; and the new or modified instrument generally will produce OID deductions for the debtor and OID income for the creditor over the remaining term of the instrument. For original issuers and holders, a significant modification changing the effective interest rate of an instrument without more, generally, will have no effect on the debtor or creditor if the effective interest rate on the modified instrument is equal to, or greater than, the lowest applicable Federal rate during the preceding three months. That is because the issue price of the modified instrument generally will be equal to the issuer's adjusted issue price and the holder's adjusted basis.
Retirement of Debt
When the amount paid to retire debt is less than the adjusted issue price of the debt, the debtor corporation generally will recognize income from discharge of indebtedness (unless excluded under Section 108 of the Code--see brief discussion under "Exchange of Debt for Equity" below). Assuming that the creditor's basis in such debt is more than the amount received, the creditor generally will realize a business-related loss, a bad-debt loss or a capital loss depending on the creditor's circumstances.
When the amount paid to retire debt is equal to the adjusted issue price of the debt, the debtor corporation will recognize no income or loss upon retirement. The creditor may recognize gain or loss depending on the creditor's basis in such debt. The character of any such gain or loss will depend on the creditor's circumstances.
Refund Existing Debt with New Debt
When the amount paid to refund debt is less than the adjusted issue price of the original instrument, the debtor corporation generally will recognize income from discharge of indebtedness (unless excluded under Section 108 of the Code). Assuming that the creditor's basis in such debt is less than the amount received, the creditor generally will realize a business-related loss, a bad-debt loss or a capital loss depending on the creditor's circumstances.
When the amount paid to refund debt is equal to the adjusted issue price of the debt, the debtor corporation will recognize no income or loss upon retirement. Any premium or prepayment penalty will be deductible as interest expense. The creditor may recognize gain or loss depending on the creditor's basis in such debt. The character of any such gain or loss will depend on the creditor's circumstances.
Exchange of Securities
Exchange of Debt for Equity
A recapitalization in which a debt holder exchanges debt and receives equity can qualify as a "reorganization" if it occurs pursuant to a plan of reorganization. However, despite qualifying as a reorganization, the exchange may still result in discharge of indebtedness income to the corporation. The amount by which the corporation's debt exceeds the value of equity given in exchange for the debt will be includible in the gross income of a corporation as discharge of indebtedness income. Discharge of indebtedness income can be excluded from gross income, however, if the discharge occurs in a title 11 bankruptcy case or the discharge occurs when the corporation is insolvent. If discharge of indebtedness income is excluded because the corporation is insolvent, the amount that can be so excluded is limited to the amount by which the corporation is insolvent. As a "cost" of excluding the discharge of indebtedness income, the amount excluded from gross income is applied to reduce the tax attributes of the corporation.
Exchange of Equity for Debt
A recapitalization in which a stockholder exchanges shares of stock and receives debt can qualify as a "reorganization" if it occurs pursuant to a plan of reorganization and the debt is considered a security. However, despite the exchange qualifying as a reorganization, the shareholder will treat the debt as property not qualifying for nonrecognition treatment.
If the shareholder receives only debt in the recapitalization, the transaction will be treated as a redemption, and determination of whether the redemption qualifies as an exchange will be made under the rules applicable to any other redemption. See the "Redemption of Stock" discussion above. If the recapitalization qualifies as an exchange, the value of the debt will be treated as received in exchange for the stock. In determining gain, the value received will be offset by the shareholder's basis in the shares redeemed, and the excess will be subject to tax at capital gains rates. If a redemption does not qualify as an exchange, the value of the debt will probably be taxed as a dividend at ordinary income tax rates.
If the shareholder receives debt and stock, the debt will be considered as "boot," and the shareholder will recognize any gain inherent in the stock to the extent of the value of the debt. Any such gain will be subject to tax at capital gains rates.
The redeeming corporation, on the other hand, will recognize no gain or loss on the acquisition of its own stock.
Exchange of Common Stock for Common Stock
No gain or loss is recognized by the shareholder or a corporation upon an exchange of solely common stock of the corporation for other common stock of the same corporation.
Exchange of Preferred Stock for Preferred Stock
No gain or loss is recognized by the shareholder or a corporation upon an exchange of solely preferred stock of the corporation for other preferred stock of the same corporation.