Tax Group Client Alert: Tax Consequences of Re-Pricing to CLOs

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1 April 16, 2013 CONTACTS: Bruce Kayle Andrew Walker Randy Clark Lysondra Ludwig Tax Group Client Alert: Tax Consequences of Re-Pricing to CLOs Re-pricings of debt instruments have increased over the last year. Re-pricing involves resetting the interest rate of the debt instrument, with the holders either accepting the new terms or being redeemed. Re-pricings frequently affect offshore securitization vehicles, such as collateralized loan obligation and collateralized debt obligation issuers (which we refer to collectively in this Client Alert as CLO issuers ), and may involve either debt issued by the CLO issuer or debt instruments held by the CLO issuer in its portfolio. Due to the tightening of spreads on notes issued by CLO issuers, the end of no-call periods for notes issued by CLO issuers in 2010 and 2011 and, often times, repricing being less cost-prohibitive than refinancing, re-pricing has become an appealing option for CLO issuers to reduce their debt load and enhance the return of equity holders. 1 However, debt instruments in a CLO issuer s portfolio may also be repriced leading to lower portfolio returns. This Client Alert describes certain tax issues presented by both types of re-pricings. DEEMED EXCHANGE RULES For instruments that are properly characterized as debt for U.S. federal income tax purposes, re-pricing could be considered a deemed exchange of the instrument for a new instrument leading to a potential taxable event for holders of the instrument (including holders that are not actually redeemed). Under Treasury regulations, there is a two-step analysis to determine whether a deemed exchange of a debt instrument has occurred. 2 First, one must determine whether the terms of the debt instrument have been modified. Second, one must determine whether the modification is a significant modification. A modification of the debt instrument can occur whether (1) the terms of the debt instrument are formally amended or (2) the debt instrument is actually exchanged for another 1 Karen Sibayan, Tighter Spreads Mean More Calls on CLOs, Leveraged Finance News (Feb. 14, 2013). 2 Treas. Reg Milbank.com 1

2 instrument with different terms. 3 In either case, the revised terms must be compared to the original terms. 4 If a modification has occurred, the significance of that modification generally is evaluated under one of six tests: general facts and circumstances, change in yield, change in payment timing, change in obligor or security, change in the debt instrument s nature, and/or change in accounting or financial covenants. 5 Re-pricings generally will implicate the change in yield test. A change in yield is significant if the difference in yield between the unmodified and modified instrument is more than the greater of: 1. ¼ of one percent, or 2. 5 percent of the annual yield of the unmodified instrument. 6 Importantly, the yield test takes into account not only explicit changes to the stated interest rate but also the effect on yield of other related payments such as consent fees. If the re-pricing causes a change in yield that is significant under this test, then the repricing would be viewed as causing an exchange of the unmodified instrument for the new modified instrument. DEEMED EXCHANGE TAX CONSEQUENCES A re-pricing that is a deemed exchange may require the holder to recognize gain or loss measured by the difference between the issue price of the modified instrument and the tax basis of the unmodified instrument, although the holder may not receive any actual cash, unless the exchange qualifies as a recapitalization. 7 The deemed 3 Treas. Reg (c)(2)(iii). 4 In some cases, a CLO indenture may provide for a re-pricing procedure, which may make it less clear whether the re-pricing of an instrument constitutes a modification. Alterations to the terms of a debt instrument resulting from the exercise of a unilateral option by the issuer are specifically defined to not be modifications. An option is unilateral where (1) there is no right of the other party to alter or terminate the instrument (or to sell the instrument to a person related to the issuer) in connection with the exercise of the option, (2) the exercise of the option does not require consent of the other party, persons related to the other party or a court or arbitrator and (3) subject to certain exceptions, the exercise of the option does not require consideration. 5 Treas. Reg (e). 6 Treas. Reg (e). 7 IRC 108(e)(10); Treas. Reg (c); The re-pricing may qualify for recapitalization treatment if the repricing has a business purpose and a plan of reorganization. If those two requirements are met, the exchange of unmodified instruments, classified as securities, solely for modified instruments having no greater face value than the unmodified instruments will be tax-free for holders. IRC 368(a)(1)(E). MILBANK CLIENT ALERT: Tax Group April 16,

3 modified instrument may have original issue discount ( OID ), if the principal amount exceeds the issue price of the deemed modified instrument by more than a de minimis amount, or amortizable bond premium, if the issue price exceeds the principal amount. A deemed reissuance at a discount could also generate taxable cancellation of debt income ( CODI ) for a CLO issuer. The issue price of the new modified instrument will be determined by whether the instrument is publicly traded for U.S. federal income tax purposes. If the instrument is publicly traded, the issue price is equal to the fair market value of the instrument. If neither the instrument received nor the property surrendered is publicly traded, the instrument received will have an issue price equal to the principal amount of the debt instrument if the instrument has adequate stated interest. In most cases, however, debt will be considered publicly traded under a test in recent regulations. Re-pricings generally are designed to re-price the debt to a market yield. As a result, in most cases the re-priced debt will trade at close to par. Consequently, material OID, amortizable bond premium and CODI is unlikely in practice. U.S. TRADE OR BUSINESS CONSIDERATIONS Another consideration for CLO issuers is the effect of the re-pricing of a loan in its portfolio. As a result of a deemed exchange in a loan in its portfolio for a new loan, the CLO issuer might be viewed as having originated a new loan resulting in a risk that it could be deemed to be engaged in a U.S. trade or business and thus subject to U.S. net income tax. A deemed exchange for a new loan should not necessarily be considered equivalent to the making of a new loan for that purpose. Most counsel view this as a question highly dependent on the factual context of the related amendments and CLO issuers should consult their own tax advisers about this issue when faced with a repricing of a loan. RE-PRICING AND FATCA Re-pricing may subject a debt instrument to potential withholding under the recently enacted Foreign Account Tax Compliance Act (colloquially known as FATCA ). FATCA was implemented to detect and deter offshore tax abuses and requires increased transparency and reporting by non-us foreign financial institutions and non-us non-financial entities by requiring identification and disclosure of their U.S. account holders. Failure to provide the required information for U.S. account holders results in a 30% U.S. withholding tax with respect to (i) any payment of U.S. source income and (ii) proceeds from the sale of equity or debt instruments of U.S. issuers. 8 The requirements of FATCA are currently being phased in with a multi-year process. 8 IRC.1471(a); Treas. Reg (a). MILBANK CLIENT ALERT: Tax Group April 16,

4 Debt instruments issued before January 1, 2014 are grandfathered and not subject to FATCA s required transparency, enhanced reporting or withholding requirements. 9 However, a re-pricing of a debt instrument on or after January 1, 2014 may result in a new instrument that is not grandfathered and therefore potentially subject to FATCA withholding. The ability of CLO issuers to comply with FATCA may therefore influence the decision of such issuers to consent to any re-pricing on or after January 1, * * * * * Investors should be aware of these tax consequences of a re-pricing in determining whether to be redeemed in full or accept the new terms. 9 Treas. Reg (b). MILBANK CLIENT ALERT: Tax Group April 16,

5 TAX GROUP Please feel free to discuss any aspects of this Client Alert with your regular Milbank contacts or any of the members of our Tax Group. If you would like copies of our other Client Alerts, please visit our website at and choose Client Alerts under News. This Client Alert is a source of general information for clients and friends of Milbank, Tweed, Hadley & McCloy LLP. Its content should not be construed as legal advice, and readers should not act upon the information in this Client Alert without consulting counsel Milbank, Tweed, Hadley & McCloy LLP. All rights reserved. Attorney Advertising. Prior results do not guarantee a similar outcome. NEW YORK One Chase Manhattan Plaza, New York, NY Bruce Kayle bkayle@milbank.com Andrew Walker awalker@milbank.com Russell Kestenbaum rkestenbaum@milbank.com Joel Krasnow jkrasnow@milbank.com Dale Ponikvar dponikvar@milbank.com Mark Regante mregante@milbank.com Washington DC 1850 K Street, NW, Suite 1100, Washington, DC Glenn Gerstell gerstell@milbank.com MUNICH Maximilianstrasse 15, (Maximilianhoefe), Munich 80539, Germany Dr. Rolf Füger rfueger@milbank.com Dr. Thomas Kleinheisterkamp tkleinheisterkamp@milbank.com Dr. Norbert Rieger, LL.M. nrieger@milbank.com London 10 Gresham Street, London EC2V 7JD, England Russell Jacobs rljacobs@milbank.com Naomi Ishikawa nishikawa@milbank.com MILBANK CLIENT ALERT: Tax Group April 16,