The modification of a loan may have tax consequences, and in certain circumstances the tax consequences can be substantial and surprising.
Loan modifications are grouped into two categories: significant and not significant. In general, a loan modification is any alteration, including any deletion or addition, of a legal right or obligation of the issuer or holder of a debt instrument evidencing a loan. A "significant modification" is any modification pursuant to which the legal rights or obligations that are altered are "economically significant." In addition to this general rule of economic significance, there are certain modifications which are deemed to be significant modifications, including the following: (i) a change in the yield of the modified loan as compared to the yield of the unmodified loan of more than the greater of (A) 0.25% (i.e., 25 basis points), or (B) 5% of the annual yield of the unmodified loan; (ii) a change in the timing of payments on the loan; and (iii) a change in security or collateral securing payment of the loan.
If a "significant modification" occurs with respect to a loan, there is a deemed sale or exchange of the "old" unmodified loan for the "new" modified loan. In such a case, it is important to determine the tax consequences, if any, resulting from the deemed sale or exchange.
If the interest rate on the loan is reduced to a rate that equals or exceeds the "applicable federal rate" of interest, and if the loan is not publicly-traded, generally neither the lender nor the borrower will realize gain or cancellation of indebtedness income. On the other hand, if the interest rate on a non-publicly-traded loan is reduced to a rate lower than the "applicable federal rate," the borrower will generally recognize "phantom" cancellation of indebtedness income.
The most draconian tax consequences, however, are reserved for modification of a loan in which the lender's basis in the loan is less than the unpaid principal balance of the loan. This could result, for example, if the loan was previously purchased at a discount by the current lender, or if the lender had previously taken a partial bad debt deduction with respect to the loan (which only certain taxpayers are allowed to do). In these situations, the lender is the party generally at risk for potentially substantial and surprising tax consequences resulting from a significant modification of the loan. For example, assume that a loan in the original principal amount of $10 million was purchased for $6 million, at a time when the entire $10 million obligation remained unpaid. Further assume that the lender and the borrower subsequently modify the terms of the loan in a manner in which a "significant" modification is made. In such a case, the lender will incur $4 million of "phantom" gain from the deemed exchange of the "new" modified debt for the "old" unmodified debt.
Otten Johnson's Business Transactions & Tax practice group has substantial experience dealing with tax consequences of loan modifications. For more information on this Client Alert or on addressing such issues, please contact any of the attorneys in the Business Transactions & Tax practice group (for a listing, click here.)
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