The one thing distressed companies need, in or out of bankruptcy, is cash, and unfortunately for them, the new corporate alternative minimum tax (CAMT), which is effective this year, could wreak havoc on their tax planning. While the IRS released initial guidance (IRS Notice 2023-7) on December 27, 2022 (discussed in our earlier alert), it leaves many questions unanswered and for those it did answer, it suggests that the financial relief that many troubled companies expect from restructuring transactions could be less. This is because the CAMT is based on a company’s financial statement income or loss, with certain adjustments, and so book-tax differences, including those associated with the treatment of cancellation of indebtedness (COD) income and tax-free reorganizations, could increase a company’s post-restructuring U.S. tax liability and its U.S. tax liability during the pendency of a bankruptcy.
As discussed in more detail in our earlier alert, the CAMT is designed to ensure applicable corporations pay taxes equal to at least 15% based on their adjusted financial statement income (AFSI) reduced by certain credits. At a very high level, an applicable corporation is generally a corporation that has at least $1 billion of average AFSI over a three-year period, considering certain aggregation rules.
For distressed companies, discharged debt is generally excluded from gross income for tax purposes if the debtor is insolvent or the discharge occurs by order of the U.S. bankruptcy court, with the exclusion limited for insolvent taxpayers to the amount of their insolvency. The income exclusion, however, comes at a cost — a required reduction in the company’s tax attributes, such as net operating losses (NOLs), certain tax credits, and tax basis of its assets. On the other hand, for book purposes, COD income is included in income. For the CAMT, the Notice allows a reduction in AFSI for certain COD income excluded for tax purposes and requires a corresponding reduction in CAMT attributes based on the tax rules.
A&M Insight: The proposed exclusion of COD income from AFSI is welcome news. However, distressed companies still have reasons to worry because the amount of book COD income could exceed the excluded tax COD income and the CAMT exclusion would be limited to the amount of tax COD income that is excluded. For example, assume Company X is insolvent for tax purposes by $800x and incurs $180x of tax COD income but $300x of book COD income. Even though all $300x of Company X’s COD income would have been excluded if it was realized for tax purposes, because only $180x was recognized for tax purposes, $180x of Company X’s $300x book COD income would be excluded for CAMT purposes.
Additionally, the Notice does not apply to all excluded COD income. Therefore, COD income attributable to loans received and forgiven under the government’s payroll protection program (PPP) provided under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) would not be excluded for CAMT purposes. Lastly, the Notice does not explain how the tax attribute reduction principles will be implemented in calculating CAMT. Depending on the methodology adopted, a taxpayer could be subject to double attribute reduction under the CAMT rules.
While in bankruptcy, companies might choose to undergo a restructuring, either as a tax-free transaction, such as a “G” reorganization under the Tax Code, or as a taxable transaction, such as a section 363 sale under the Bankruptcy Code.
Under the Notice, a complex set of rules would apply to determine the CAMT implications for corporate restructurings while in bankruptcy, with each “component” being analyzed. If the transaction is completely tax-free, the book gain or loss would be excluded from AFSI and any associated book basis adjustments that occur because of the transaction would also be ignored. On the other hand, if a component of a transaction is subject to tax, for example a taxable debt-for-debt exchange, the corresponding book gain or loss would be included in AFSI and the book basis of the assets would be adjusted.
A&M Insight: In the world of CAMT, as described in the Notice, form matters, and the rules could be fraught with potential traps for the unwary. Certain bankruptcy restructuring decisions could have drastic CAMT implications, including giving rise to an IRS administrative claim for taxes or subjecting the company to the CAMT post-emergence. Further guidance is needed (and anticipated), but in the meantime companies should model the potential ramifications.
The Notice also addresses the book-tax differences that occur when a consolidated group (based on financial statement reporting) or a single entity emerges from bankruptcy. Under generally accepted accounting principles (GAAP), “fresh start” accounting rules require that the basis of the assets acquired be reflected at “fair value” and gain or loss recognized. The Notice provides that the financial statement gain or loss from a company’s emergence from bankruptcy would be excluded in computing AFSI for the taxable year of emergence and any corresponding basis adjustments of property of the group member emerging from bankruptcy would be ignored, except for basis adjustments resulting from the treatment of excluded COD income discussed above.
A&M Insight: Eliminating the book gain or loss from fresh start accounting for purposes of CAMT is also good news but additional clarifications are needed. The Notice does not define transactions that constitute an emergence from bankruptcy and so it is possible that a Bruno’s transaction, a common taxable restructuring upon emergence from bankruptcy in which the debtor transfers the business to its creditors in exchange for their debt, would be included. As a result, a Bruno’s transaction could be more favorable than a 363 sale, which is generally not viewed as occurring as part of the company’s emergence from bankruptcy.
Additionally, the Notice does not address situations in which some, but not all, of a consolidated group emerges from bankruptcy; what constitutes an ownership change such that an applicable corporation sheds its status; and how to determine whether a company is a successor (i.e., whether it would be based on book rules, tax rules, or a hybrid approach).
How the IRS proceeds with CAMT guidance could affect the fate of distressed companies. Not only could companies have to navigate highly complex rules just to assess if the CAMT applies, but the effects could be devasting with increased compliance costs and cash tax liabilities. That raises the question of why shouldn’t companies in bankruptcy be excluded from the CAMT rules like other tax policy decisions aimed at helping companies successfully emerge? But until that happens, companies should determine potential implications of the recent IRS Notice on their planning efforts. If you would like to discuss how the new tax law could affect your restructuring plans and transaction modeling, please reach out to Kevin M. Jacobs of our National Tax Office.