The tax code allows insolvent US corporations to defer or permanently avoid income taxes on cancellation of indebtedness income, even if they’re not in bankruptcy. As a result, some large US corporations have been able to favorably materially restructure, or obtain forgiveness of, existing debt outside of bankruptcy without triggering immediate corporate income tax. This is true even where large inclusions of COD income have been reported for GAAP financial statement purposes.
Consider the mid-2020 debt restructuring of Party City Holdco Inc., a publicly traded Delaware corporation. It is one of the largest retailers of party goods in the US, selling through hundreds of owned and franchised retail outlets and online.
In early 2020, the Covid-19 pandemic triggered a drastic downturn in business, including a temporary closure of all stores. In mid-2020, Party City succeeded in reducing much of its existing debt in a negotiated settlement and not through bankruptcy. It issued a combination of new debt with smaller principal, plus approximately 14% of its post-restructuring shares, to exchanging holders of the old debt.
Per its Form 10-K, Party City recorded pretax gain on a troubled debt restructuring of approximately $270 million on its 2020 GAAP financial statements. Nevertheless, due to Party City’s $960 million GAAP pretax loss from other operations, it reported a $690 million net overall GAAP pretax loss in 2020.
Party City’s Form 10-K also noted that for 2020 federal income tax purposes, it reported approximately $550 million of pretax cancellation of debt income. The company said its insolvency was $500 million immediately before the debt restructuring and thus excluded $500 million of the $550 million COD income under the insolvency exception of Sections 108(a)(1)(B), 108(a)(3) and 108(d)(3) of the tax code. Of this excluded amount, $220 million was used to reduce loss carryforwards to 2021 or other attributes as required by Section 108(b)(2).
The company’s $690 million net overall GAAP pretax loss in 2020 took into account a non-tax-deductible 2020 GAAP impairment deduction of approximately $580 million. That is, the 2020 net operating losses for federal income tax purposes were apparently much smaller than its $690 million net overall GAAP pretax loss. This may explain why its $220 million net operating loss and other attribute reduction under Section 108(b)(2) was smaller than $500 million.
Party City posited that its remaining 2020 $280 million tax-excludable COD income, in excess of the $220 million reduction of the 2020 net operating loss or other attribute reduction, wasn’t required to be applied to reduce asset basis because of the limitation in Section 1017(b)(2). It generally provides that any COD income in excess of that applied to the required attribute reduction other than reduction of asset basis, and in excess of that applied to the required reduction of asset basis to the amount of post-discharge liabilities, is permanently forgiven without tax inclusion. Some commentators and IRS Notice 2023-7 call such debtor-favorable Section 1017(b)(2) amount as “black hole excluded COD income” because it isn’t treated as either COD income or as a reduction of asset basis.
Party City filed for Chapter 11 bankruptcy in January, but a restructuring plan hasn’t yet been confirmed.
Corporate Alternative Minimum Tax
The new CAMT takes effect in 2023, so it wasn’t an issue for Party City’s 2020 restructuring. But if the company restructures its debt this year—and if that restructuring could trigger GAAP COD income, or if other transactions could create 2023 CAMT liability—Party City will wish to consider whether there could be adverse 2023 or post-2023 CAMT implications from that 2023 restructuring. In this connection, Notice 2023-7 could have both favorable and unfavorable implications to the company and other large corporate debtors facing COD income.
The CAMT only applies to applicable corporations. These generally include US corporations that, considering certain aggregation rules, have had average applicable financial statement income exceeding $1 billion over the preceding three years. AFSI is usually pretax GAAP income or loss, adjusted by certain items. The CAMT is generally 15% of AFSI less a CAMT foreign tax credit to the extent, if any, such amount exceeds the regular corporate tax and any base erosion tax.
Party City reported a pretax GAAP loss of approximately $690 million loss in 2020, a pretax GAAP loss of less than $1 million in 2021, and, based on third quarter 2022 results, an annualized 2022 pretax GAAP loss of $310 million. In the absence of aggregation or very large net positive AFSI adjustments, it seems unlikely to be an applicable corporation in 2023.
Section 5.03 of Notice 2023-7 provides a favorable optional simplified method for corporations whose average 2020 through 2022 AFSI doesn’t exceed $500 million (taking into account limited adjustments from GAAP) to establish they’re not applicable corporations for this year. Notice 2023-7 could provide Party City an alternative simplified method to demonstrate a lack of applicable corporation status.
Section 3.06 of Notice 2023-7 contains a favorable rule concerning COD income, which is that an amount equal to the federal-income-tax-excludable COD income is excluded from AFSI. But it also includes an unfavorable rule. Under the principles of Sections 108(b) and 1017, financial accounting attributes must be reduced by the amount of the excluded income that results in a reduction of tax attributes—that is, the total amount of excluded COD income, minus the black hole excluded COD income. Section 3.07 generally ignores any GAAP gain or loss recognized, and any adjustments to GAAP book value, resulting from a corporation’s emergence from bankruptcy.
Part 2 of this article will look at some implications of Section 3.06 of Notice 2023-7.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Alan S. Lederman is a shareholder at Gunster, Yoakley & Stewart, P.A. in Fort Lauderdale, Fla.
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