LSTA requests change in tax code for debt income

By Sara Rosenberg

New York, Feb. 2 - LSTA is asking the U.S. Treasury Department to change, in part, the tax code covering cancellation of debt income as part of the stimulus package now moving through Congress, according to a news release.

The LSTA said that the problem with the current tax code is that any significant modification of debt could be considered a "deemed exchange," which would mean that borrowers may face steep tax liabilities when they agree to fees and interest rate increases in order to obtain covenant modifications, even though they do not benefit from any actual debt cancellation.

Also, if a waiver is deemed an exchange, the tax code treats the modified debt as a new loan even if the amount borrowed and the maturity remain the same.

The LSTA explained that the problem facing the loan market is intensified because loan prices have dropped dramatically, with the average price of performing loans in the secondary market hovering between 60 and 70. Under the current tax rule, a borrower's tax gain is measured by the difference between the price at which the loan was originally issued, usually par, and the current market price. So, for example, a company with a $1 billion dollar loan whose debt is trading at 70 might face a tax on $300 million of income.

"There are serious ramifications here," said Bram Smith, interim executive director of the LSTA, in the release. "Companies seeking amendments may not be able to pay the tax bill and could be forced to file for bankruptcy protection, putting even more pressure on the capital markets and the economy."

The LSTA is looking for the government to provide regulatory relief by dropping the current definition of an exchange if a borrower remains obligated to repay the same principal amount on the same schedule.

Another possible solution would be to provide that any cancellation of debt income be timed to match offsetting discount accruals, reflecting the fact that the borrower will not actually experience any relief from the requirement of repaying its loan in full.

Lastly, the LSTA is suggesting that the current economic stimulus bill could provide a vehicle for a substantive change in the tax code addressing cancellation of debt income, deemed exchanges, and/or determination of the issue price of newly issued debt.

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