Tax considerations when consent fees are paid to modify a debt

ARTICLE | December 05, 2023

Authored by RSM US LLP

Executive summary:

Tax consequences of consent fee payments and what you need to know

The combination of approaching debt maturities and a broader economic slowdown has led to an increase in debt refinancings and modifications. Payment of a consent fee (or similar fee) by a borrower to a lender frequently occurs in refinancings. The tax rules surrounding consent fees are not always black and white, and a consent fee payment can contribute to surprising tax results to a borrower, including taxable cancellation of debt (COD) income. As a best practice and to the extent possible, businesses entering debt negotiations should identify this potential tax implication prior to finalizing the deal.

Tax considerations of consent fees paid to modify a debt

Consent fees and debt amendments

Borrowers often pay consent fees to lenders as compensation for agreeing to modify their debt. The modification could arise from various items—a change in the payment terms, maturity date or financial ratios, the waiver of a default or the debt’s subordination to other debt. Consent fees are often paid in cash, but are also frequently paid through the issuance of either (1) equity (e.g., stock, warrants or LLC units) of the debtor or (2) additional debt. It is important to understand the particular fees and the other economic aspects of any proposed debt modification, as those particulars can affect the tax treatment.

While the consent fee sometimes appears separate from the payment terms under the debt instrument, the fee paid to the lender must be considered when determining whether the modification changed the yield on the debt.¹If the change in yield effected by a debt modification or amendment refinancing exceeds the tax regulations’ 'significant modification’ threshold, the regulations require treating the transaction as a debt-for-debt exchange, which may result in COD income. A significant modification occurs if the combination of the consent fee and any other changes in terms results in a change in the debt’s annual yield by more than the greater of: (1) 25 basis points (0.25%) or (2) 5% of the annual yield of the unmodified debt.²

Example: Debtor corporation (DC) issued $500 million of debt at 8% to a group of lenders. DC and the lenders later negotiated a debt modification that included an increase to the interest rate of .25% and a consent fee of 25 basis points. The combination of the consent fee and the increase in interest rate exceeds 5% of the annual yield, giving rise a significant modification and debt for debt exchange treatment under tax rules.

Cancellation of debt income concerns

When a debt-for-debt exchange occurs, the old debt is treated as satisfied for an amount equal to the issue price of the new debt.³ For debt that is not traded on an established market (i.e., is not Traded), the regulations provide a favorable rule to determine the issue price, which generally results in little or no COD income. For non-Traded debt that is modified resulting in a debt-for-debt exchange, the issue price is generally equal to its principal amount, provided it bears adequate stated interest.⁴ This generally results in debt being satisfied for the face amount even if the value is significantly less.

However, where the debt exceeds $100 million and is Traded, the potential for a COD income event increases significantly. The definition of Traded debt is much broader than some may think. For a more detailed discussion on this issue, refer to our article Modifying debt over $100 million. To the extent the debt is Traded, the debt is treated as satisfied for its fair market value, which if less than the face amount will result in COD income.

Assuming that the debtor is a solvent company that is not in a bankruptcy proceeding, this COD income is generally taxable income and not eligible for exclusion. While an insolvent corporate debtor can exclude COD income from current taxation to the extent of its insolvency, an insolvent partnership debtor cannot similarly benefit from the insolvency exclusion.⁵

Summary

Consent fees and similar payments are common in debt refinancings. When negotiating a change to a debt’s terms, including payment of a consent fee, it is important to remember that a debt-for-debt exchange may result for tax purposes. The tax consequences to a debtor are not limited to unfavorable items. Certain tax deductions may be triggered by debt for debt exchange treatment. However, the potential for COD income is the primary area of concern. Consult with a tax advisor when entering a debt refinancing or modification.

1 Reg. section1.1001-3(e)(2)(iii)(A)(1).
2 Reg. section1.1001-3(e)(2)(ii).
3 Section108(e)(10).
4 Sections 1273(b)(4) and 1274.
5 Sections108(a)(1)(B) and 108(d)(6).