2. Definition of issue price. Congress could add a special rule to provide that the issue price of a debt security could not be less than the adjusted issue price of the debt security for which it is exchanged. Such a rule once was
contained in section 1275(a)(4) before that section was repealed in 1990. Conventional wisdom is that section 1275(a)(4) was drafted too narrowly, providing taxpayers inappropriate flexibility in the timing of income recognition.
Section 1275(a)(4) generally provided that the issue price of a new debt instrument issued by a corporation in a reorganization was equal to the adjusted issue price of the original debt if its issue price otherwise would be less than the adjusted issue price of the original debt. When section 1275(a)(4) was repealed, it was replaced by section 108(e)(11) (now section 108(e)(10)) which provides that (A) a debtor that issues a new debt instrument in satisfaction of an old debt instrument is treated as having satisfied the old debt with an amount of money equal to the issue price of the new instrument, and (B) the issue price of the new instrument is generally to be determined under sections 1273 and 1274.
The effect of these changes on the taxation of debt-for debt exchanges was to substitute a ‘‘theoretical value’’ approach for a ‘‘substitution of obligation’’ approach. The theoretical value approach taken by current law deems the debtor to have issued a new instrument for cash proceeds equal to its issue price and to have used those proceeds to redeem the old debt instrument. In contrast, under the substitution of obligation approach, a debt-for debt exchange is viewed as a substitution of the new debt for the old one, with the issue price of the new instrument equal to the adjusted issue price of the old instrument.
In 1993 the American Bar Association Section of Taxation adopted resolutions supporting the reinstatement of a version of section 1275(a)(4) expanded to address the concerns that led to its repeal.82 The report that accompanied the resolutions described the current law (post repeal of section 1275(a)(4)) as ‘‘primarily a trap for the unwary’’ citing anecdotal evidence that a number of debtors had, even then, inadvertently triggered COD income by failing to either plan a debt workout to take advantage of exceptions for bankruptcy or insolvency or take steps to ensure that the new debt does not have an issue price lower than the adjusted issue price of the old debt. Also, the ABA report described the law after repeal of section 1275(a)(4) as (1) poorly reflecting the economic reality of debt workouts (by ignoring the continuity of the debtor’s obligation to the creditor), (2)
increasing the complexity and cost of workouts (because recognition of COD income can generally be avoided by taking advantage of exceptions for bankruptcy or insolvency, or in some cases by carefully managing the issue
price of the new instrument), and (3) creating new opportunities for taxpayer selectivity (by providing taxpayers a way to refresh net operating losses though creating COD income in debt-for-debt exchanges).
Before its repeal, it was felt that taxpayers were selectively applying various interpretations of section 1275(a)(4) to minimize federal income tax. For example, the rule did not expressly require reducing the issue price
of the new instrument when the principal amount of the borrowing was reduced. Also, a debtor could elect to avoid section 1275(a)(4) by arranging for an affiliate to issue its debt in exchange for the debtor’s existing debt
securities, structuring the new debt so that it did not constitute a security for purposes of section 354, or issuing properly structured investment units in exchange for existing debt securities.
The ABA report recommended that old section 1275(a)(4) be expanded to apply to all types of debtors and debt instruments and account for reductions in principal amount to address these concerns. A new rule modeled after the tax section’s recommendations would prevent inappropriate triggering of both COD income and the AHYDO rules regardless of market conditions. Such a fix would provide taxpayers increased predictability in the law because it would more reliably function as intended in a wide variety of economic environments, and require fewer (if any) temporary fixes in the future.