On 17 February 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (Pub. L. No. 111-5) which contains the American Recovery and Reinvestment Tax Act of 2009 (2009 Tax Act). This permits taxpayers to elect deferred inclusion of certain cancellation of indebtedness income (CODI) realised in 2009 or 2010 over a five-taxable-year period that generally begins, for calendar-year taxpayers, in 2014.

Businesses should examine the opportunities available to them in the credit markets, as explained below, and carefully consider taking advantage of the tax incentives provided by the 2009 Tax Act in respect of their outstanding debt in 2009 or 2010.

When a taxpayer purchases its debt for less than the adjusted issue price (this is generally the issue price of a debt instrument, increased by the amount of original issue discount previously includible in the gross income of any holder and decreased by the amount of any payment previously made on the debt instrument other than a payment of qualified stated interest) or otherwise restructures its debt in a way that results in a cancellation of all or part of the debt, the taxpayer generally must include the amount of debt discharged in its gross income for the taxable year during which the debt was cancelled.

Purchases of the taxpayer's debt by certain related persons (from a non-related person) are treated as purchases by the taxpayer for purposes of calculating CODI. Likewise, the exchange by a debtor of stock for its outstanding debt, or of new debt instruments for outstanding debt instruments, may produce CODI.

Furthermore, CODI can result from changes that are made to the terms of outstanding debt that is trading at a discount, where the changes are deemed "significant". Section 108(a) of the Internal Revenue Code of 1986, as amended, provides for the exclusion from the debtor's gross income of part or all of the CODI realised if the debt was cancelled in a US bankruptcy case or to the extent that the taxpayer was insolvent, among other things. The exclusion of CODI in these cases generally requires a corresponding reduction in the tax attributes of the debtor, including net operating loss carryforwards, general business credit carryforwards, and tax basis in assets.

The 2009 Tax Act permits debtors to elect to defer the inclusion of CODI that results from the "re-acquisition" of a debt instrument that was issued by a C corporation or otherwise in connection with the conduct of a trade or business. The 2009 Tax Act affects only the treatment of income that results from a cancellation occurring in 2009 or 2010 and results from a re-acquisition, meaning that the debt was acquired either by the debtor or by a person treated as related to the debtor for these purposes.

CODI will qualify for elective deferral if the debtor (or a related party) acquires the debt by transferring cash, a debt instrument, or stock or partnership interests (including interests deemed distributed under a contribution of the debt to the capital of the debtor). For example, a taxpayer may defer income that results from an exchange of debt for debt or equity for debt, provided that the debtor files an appropriate statement of election with the tax return for the year in which the exchange occurred.

CODI resulting from a significant modification of the terms of a debt instrument likewise is eligible for deferral, as is CODI from a complete forgiveness.

Once a debtor has elected to defer CODI resulting from the re-acquisition of a debt instrument, none of the CODI realised by the debtor from the cancellation of that debt instrument may be excluded in any taxable year under the standard exceptions of Section 108(a) (Internal Revenue Code of 1986, as amended) (that is, bankruptcy, insolvency, and so on).

The reduction of tax attributes that corresponds with CODI excluded under other Code provisions is not required in connection with the new election to defer CODI.

CODI that is deferred generally must be included in gross income ratably over a period of five consecutive taxable years of the debtor (inclusion period). In the case of a re-acquisition occurring in 2009, the first year of the inclusion period is the fifth taxable year of the debtor following the taxable year of the re-acquisition. In the case of a re-acquisition occurring in 2010, the first year of the inclusion period is the fourth taxable year of the debtor following the taxable year of the re-acquisition.

Generally, 20 percent of the deferred income is to be included in each taxable year of the inclusion period. Calendar-year taxpayers that elect deferral therefore generally will include deferred CODI starting in 2014, whether the income was realised in 2009 or 2010.

The amount of CODI ultimately to be included by the debtor is not affected by the 2009 Tax Act. If the debtor dies, ceases its business, or transfers substantially all of its assets in liquidation or in a sale (including in a title 11 case), the outstanding balance of the CODI being deferred under this provision is accelerated and included in gross income in the year when such event occurs (or, for a title 11 case, the day before the petition is filed).

In the case of electing partnerships or other pass-through entities that elect deferral, this rule also applies to a disposition of an ownership interest in the entity. The Secretary of the Treasury is authorised to prescribe regulations requiring the accelerated inclusion of deferred income in other appropriate circumstances.

If the debtor is a partnership, S corporation, or other pass-through entity, then the election to defer CODI from a re-acquisition of debt is to be made by the debtor entity, not by its owners. The deferred CODI of an electing partnership is to be allocated to its partners immediately before the cancellation in the manner in which such income would have been allocated if it were recognised at such time.

The 2009 Tax Act requires the debtor to defer deductions otherwise allowable for original issue discount (OID) accruing on any instrument issued, or deemed issued, in a transaction that is the subject of a CODI deferral election, to the extent of the amount of CODI that has been deferred. Deferred deductions are allowed ratably over the period of the inclusion of the deferred CODI. The situations in which an OID instrument is deemed to be issued in an exchange subject to a CODI deferral election include:

In addition to the deferral of CODI arising from transactions in 2009 or 2010, the 2009 Tax Act provides that the so-called "AHYDO" rules, that defer or disallow interest deductions on certain high-yield obligations, do not apply to debt-for-debt swaps occurring after 31 August 2008 and before 1 January 2010, provided that the outstanding debt retired in the swap is not AHYDO debt. These rules ordinarily affect certain OID bonds with a term in excess of five years on which the yield to maturity equals or exceeds the applicable federal rate plus five percentage points.