TAX ISSUES AT $50 OILALEX PEREZ &KEN KRASNY

May 21, 2015

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Unique Tax Issues Affected by the Price of Oil??

• Debt Modifications• Debt-for-Equity Exchanges• Tax Attribute Limitations due to Equity Transfers• Net Operating Loss Planning Opportunities• Mezzanine Debt• Partnership/Joint Venture Planning Opportunities

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Cash Flow Issues at $50 Oil• 50% Decline in the price of oil since June 2014, low natural gas

prices• Despite the need to adjust to lower commodity prices, Exploration

and Production companies often must continue to produce in order to avoid termination of a mineral lease, etc.

• Drilling and production is expensive, many companies challenged with servicing existing debt obligations, let alone obtaining new financing for operations

• Modifying the terms of existing debt to reduce associated costs is a common reaction

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Debt Modifications to reduce associated expenses

• Companies negotiate with lenders to modify existing credit terms including: value of collateral, maturity date extensions, changes to interest rates, changes to covenants

• But modification of existing credit terms may cause a tax effect(s) if the change is “significant”:– Deemed Exchange of the “Old Debt” for the “New Debt”– Recognition of Gain or Loss– Cancellation of Indebtedness Income– Original Issue Discount created in the “New Debt”– Re-characterization of Debt as “Equity” for tax purposes

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Debt Modifications: Recognition of Gain or Loss

If Debt is “Significantly Modified”: • Treated as an exchange of “Old Debt” for “New Debt”• Debtor satisfies Old Debt for money equal to the Issue Price of

the New Debt– Issue Price = market value if publicly traded debt– Issue Price = stated principal amount if not publicly traded debt

• If stated interest is inadequate, must discount all payments due under the new debt at the “applicable federal rate”

• OID may result if Issue Price is less than Stated Principal Amount

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Debt Modifications: Recognition of Gain Example

EXAMPLE:• Holder acquires Old Debt with a face amount of $100 in the

secondary market for $50 and exchanges its Old Debt for New Debt with an Issue Price of $75. Holder Recognizes $25 of gain though no cash received

OR

Gain recognition is usually not an issue unless the holder bought the “Old Debt” at a discount

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Debt Modifications: Tax Free Reorganization

• Generally: an existing creditor’s (deemed) exchange of “Old Debt” for “New Debt” is a tax free exchange of securities for securities if Debtor is a C-Corporation. Section 368(a)(1)(E)– Note that a “security” has a different meaning for these purposes than

under securities laws– Can exchange stock, warrants or debt instruments as “securities”– Gain is recognized to the extent of “boot”

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Debt Modifications: Cancellation of Debt Income (CODI)

Any exchange of Old Debt for New Debt at a discount results in Cancellation of Debt Income for the Debtor• Debtor acquires old debt for cash or other property• Debt-for-debt (deemed) swap where new debt issue price is less

than Old Debt’s adjusted issue price• Debtor swaps old debt for new stock or partnership interests• Cancellation or forgiveness of Debt

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What is a “Significant Modification”

• Change in Yield of New Debt vs. Old Debt• Principal Amount Change • Change in Timing of payments: if “material deferral of scheduled

payments”• Change in Collateral: if there is a resulting change in payment

expectations• Re-characterization of Debt as “Equity” for tax purposes

– Significant impairment of collateral, financial condition of debtor, subordination to other instruments

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Debt-for-Equity Exchanges

When Debt is converted to Equity of a debtor company:• If the debtor company is a C-Corporation, and the value of the

equity received equals the value of the debt exchanged, the transaction should qualify as a tax free reorganization to both the Debt holder and the Company

• If the debtor company is a partnership (LLC), Section 721 treats the exchange as tax-free if the value of equity received is equal to the value of the debt relinquished

HOWEVER• Gain is recognized by the holder to the extent he receives “boot”,

CODI recognized by debtor if equity value is less than value of debt

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Debt-for-Equity Exchange: CODI and Gain

If Debtor treated as receiving CODI due to a difference in the value of equity received versus value of relinquished debt:• Partnerships: CODI is ordinary income to each of the partners

– NOTE: Insolvency exception may apply to exempt recognition of CODI, but insolvency is tested at the PARTNER level, not the partnership

• Corporation: CODI is income to the corporation– Note that NOL planning can reduce effect of CODI– Must be careful with Section 382 ownership change upon exchange of

debt for equity

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THANKS!ALEX PEREZKEN KRASNY