Tax-Free Debt Exchanges Are Crucial Part of Transactions Toolbox

Debt-for-equity and debt-for-debt exchanges are a critical and complex component of many tax-free spin-offs and split-offs. If structured properly, such an exchange generally enables ParentCo to de-lever from the transaction, effectively monetizing its stake in the entity being spun or split off on a tax-free basis.

Because of the continued emphasis in the public markets on “pure-play” enterprises and the overall trend toward de-conglomeration, there are an increasing number of spin-off and split-off transactions in the market, with an accompanying rise in the number of these tax-free financings.

The IRS’s position on debt exchanges, however, has become uncertain in recent years. Taxpayers should consider seeking counsel on the acceptable parameters of these exchanges.

Typical Use Cases

In a spin-off, ParentCo typically can’t, on a tax-free basis, extract cash (or cause SpinCo to assume ParentCo debt) in excess of ParentCo’s tax basis in its SpinCo stock. But debt-for-equity and debt-for-debt exchanges facilitate ParentCo’s ability to de-lever in a tax-efficient manner regardless of this basis limitation.

Debt-for-equity exchanges generally are made either pre-spin-off or post-spin-off. A pre-spin-off exchange may be used to effect the initial public offering of SpinCo. In such a structure, ParentCo transfers a portion of SpinCo’s stock to its creditors, who then sell such stock in the IPO.

In a post-spin-off exchange, ParentCo first spins off 80% or more of its SpinCo stock while retaining a portion of its SpinCo stock. ParentCo typically transfers its SpinCo stock to creditors within 12 months of the initial spin-off.

A debt-for-equity exchange enables ParentCo to exchange a portion of its SpinCo stock as consideration for the repayment of ParentCo’s debt. As a result, ParentCo doesn’t recognize taxable gain on the difference between its basis in the SpinCo stock and the SpinCo stock’s value.

A debt-for-debt exchange is done in a similar manner to a post-spin-off debt-for-equity exchange, except that ParentCo uses SpinCo debt received on formation of SpinCo (instead of SpinCo stock) to repay ParentCo debt on a tax-free basis.

For a debt-for-debt exchange to qualify for its intended tax-free treatment, the newly issued SpinCo debt instruments must qualify as “securities” for tax purposes. This generally requires the debt to have a term of at least seven years and be non-callable for at least the first five years. These requirements may make a debt-for-debt exchange where SpinCo would prefer a shorter tenor debt instrument as part of its go-forward capital structure less attractive.

The ParentCo debt exchanged as part of a debt-for-equity or debt-for-debt exchange doesn’t need to have any particular tenor, provided the requirements described below are met. Thus, short-term debt instruments can be exchanged if the relevant holder at the time of the exchange is respected as a “historic” creditor, as further described below.

Typical Financing Steps

In general, either exchange involves the following financing steps.

First, an investment bank holds ParentCo’s debt or acquires it in the market. In a debt-for-equity exchange, SpinCo’s stock, which is owned by ParentCo, is then priced in anticipation of a post-exchange Securities and Exchange Commission-registered offering of the exchange shares to the market. In a debt-for-equity exchange, SpinCo’s debt is then priced in anticipation of a post-exchange sale of the exchange debt pursuant to a Rule 144A offering.

Following the investment bank’s acquisition of ParentCo’s debt and on or after the pricing date, ParentCo and the bank enter into the exchange agreement—under which ParentCo agrees to exchange the exchange shares/debt for ParentCo’s debt. The exchange and equity/debt offering close substantially at the same time.

Tax Considerations

Although it’s possible from a tax perspective to structure these transactions as direct exchanges between a historic creditor and ParentCo, the investment bank’s involvement is critical from an execution perspective. This is because creditors of ParentCo will generally be reluctant to hold debt or equity of SpinCo. Including an investment bank in the exchange process generally lowers transaction costs and is the market standard to make debt-for-equity and debt-for-debt exchanges.

Tax considerations play an important role in several aspects of any debt-for-equity or debt-for-debt exchange, including the timing of the bank’s acquisition of debt, the timing of the exchange agreement’s execution, the closing date of the transaction, and the nature of the ParentCo debt acquired by the bank. The goal behind these considerations is to ensure the investment bank is considered to be acting as a “historic” creditor of ParentCo rather than an agent of ParentCo.

Taxpayers long have received comfort on the parameters of debt-for-equity and debt-for-debt exchanges in IRS private letter rulings. For many years, the IRS consistently ruled that the investment bank must acquire ParentCo debt at least 14 days before the debt-for-equity or debt-for-debt exchange is completed and at least five days before the exchange agreement is executed (the “5/14 standard”).

Private letter rulings issued before the release of Revenue Procedure 2024-24 in May 2024 were even more generous to taxpayers, permitting investment banks to acquire the ParentCo debt up to one day before the closing of the exchange and the execution of the exchange agreement.

These private letter rulings often permitted newly issued debt to qualify as historic debt as long as the proceeds of the new issuance were used to refinance historic debt. This was known as the “refinancing exception.”

Investments banks also could directly acquire debt from ParentCo in a new issuance as long as the refinancing exception was satisfied. Direct issuances obviated the need for an investment bank to acquire ParentCo debt in the market from existing creditors before entering into the debt-for-equity or debt-for-debt exchange.

However, the IRS in 2024 sharply curtailed the parameters of debt-for-equity and debt-for-debt exchanges on which it would rule. Revenue Procedure 2024-24 and related guidance didn’t endorse any safe harbor (such as the 5/14 standard) or adopt a refinancing exception.

Although proposed regulations issued in 2025 (and subsequently withdrawn) indicated that the IRS may have been reconsidering these issues, the agency’s ruling practice is unclear. Taxpayers may need to rely on the advice of their tax counsel and accounting firms on the acceptable scope of debt-for-equity and debt-for-debt exchanges.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Andrew B. Purcell is a partner in Simpson Thacher’s tax practice who advises on tax matters including financing, credit, M&A, spin off, private equity transactions, and fund formations.

Alec Jarvis is a partner in the Simpson Thacher’s tax practice who advises on US and international tax matters including public and private mergers, acquisitions, and divestitures.

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