Is Harrah’s in a Hurry to Exchange Debt?

A new tax deferral written into the stimulus bill will likely affect Harrah's recently announced bond exchange, and prod the company to complete it...
Robert WillensMarch 24, 2009

Bob Willens 2

Faced with the potential prospect of defaulting on final bond payments, some struggling companies will choose to exchange notes that have fast-approaching due dates and swap them for new bonds that have extended maturity dates. In many cases, the move is aimed at buying more time for companies that are working to restructure debt loads.

Interestingly, such debt exchanges may be helped by a tax deferral that is part of the recently enacted stimulus legislation. The debt swap announced by Harrah’s Entertainment Inc. earlier this month is one example of how the new legislation — which reportedly Harrah’s lobbied for — may put a positive spin on tax implications.

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In the deal, Harrah’s would make a swap with is wholly-owned subsidiary Harrah’s Operating Company Inc. (HOC). Specifically, HOC plans to issue up to $2.8 billion (in aggregate principal amount) of new 10 percent second-priority senior secured notes, due 2018, in exchange for a substantial amount of its existing debt, the aggregate principal amount of which appears to exceed $10 billion.


When bonds are repurchased in exchange for new debt instruments, the first order of business is to determine whether income from cancellation of debt (COD income) will be realized as a result of the exchange. To do that, companies should look to Section 108(e)(10) of the tax code.

That section states that if a company issues a new bond – or any debt instrument for that matter – to pay off existing debt, the company is treated as having satisfied the indebtedness with an amount of money equal to the issue price of the instrument. For this purpose, the issue price of any debt instrument is determined by the guidelines laid out in Section 1273 and 1274 of the tax code.

As a result, the debt exchange will give rise to COD income in an amount equal to the excess, if any, of the adjusted issue price of the retired debt instrument over the issue price of the new debt instrument issued in exchange.

In cases like Harrah’s, in which debt instruments are issued in exchange for property other than money, the issue price depends largely on whether the retired instruments or the new instruments are considered “traded on an established market.” If a substantial amount of the new bonds are traded on an established market, the issue price of each bond is the fair market value of the instrument, determined as of the issue date (See Regulation Section 1.1273-2(b).)

Alternatively, if a substantial amount of the bonds are not so traded but, instead, are issued for property that is itself traded on an established market, the issue price of each bond is the fair market value of the property (for which the new instrument is issued), determined as of the issue date.

In addition, property is regarded as being traded on an established market if at any time during the  60-day period ending 30 days after the issue date, the following criteria are met:

  • The property is listed on a national securities exchange registered under Section 6 of the Securities Exchange Act of 1934;
  • The property is listed on an “interdealer quotation system”; or
  • The property appears on a system of general circulation that provides a “reasonable basis” to determine fair market value by disseminating either recent price quotations of one or more identified brokers, dealers, or traders or actual prices of recent sales transactions.

If neither the relinquished nor replacement securities is traded on an established market within the relevant period, the issue price of the replacement bond will be its “stated principal amount,” assuming the replacement securities bear “adequate stated interest.” If they do not, the issue price will be the so-called “imputed principal amount.”

Presumably, the amount of COD income Harrah’s will realize from this debt exchange will be minimized if neither set of securities is regarded as traded on an established market. In that event, the amount of COD income that will accrue will be the amount by which the adjusted issue price of the old securities exceeds the stated principal amount of the replacement securities.

With that background in mind, let’s look at Section 108(i), which was added to the code when the stimulus bill became law. That subsection addresses companies that have a powerful incentive to embark on a program of deleveraging. In other words, the subsection is aimed at companies focused on getting rid of debt.

Section 108(i) relates to the reacquisition of an “applicable debt instrument” (ADI) that is issued after December 31, 2008, and before January 1, 2011. It basically provides a deferral for when COD income is included in gross income. Indeed, at the election of the taxpayer, COD income related to the ADI is included in gross income ratably over the five-year period beginning with the fifth taxable year following the taxable year in which the reacquisition occurred. Before Section 108(i) was put in place, that same COD income would have been included in gross income for the taxable year in which the discharge occurred.

In this situation, the reacquisition of an ADI includes cases such as the Harrah deal, in which there is an exchange of a bond for another debt instrument. Moreover, the debt to be retired here is an ADI because that term is broadly defined to include any debt instrument issued by a C corporation, such as HOC.

There is something else to keep in mind regarding the new subsection. When debt is issued and the redemption price at maturity exceeds its issue price, the excess is classified as “original issue discount” (OID). To be sure, OID can be deducted by the issuer, on an economic accrual basis, over the life of the new debt instrument.

However, a taxpayer who elects the benefits of Section 108(i) must defer the deduction of OID associated with the bond issued to satisfy the existing debt instrument. Therefore, if a bond is issued for the ADI being reacquired, and there is any OID linked to the debt instrument, no otherwise allowable deduction is granted with respect to the portion of the OID that: (1) accrues before the first taxable year in the five taxable year period – in which the deferred COD income must be included in gross income; and (2) does not exceed the COD income with respect to the debt instrument being reacquired.

These OID deductions, however, are merely deferred. The aggregate amount of the OID deductions disallowed as a result of the rule is allowed ratably over the five taxable year period within which the deferred COD income will be reported. As a result, it is likely that more than $7 billion of COD income realized by Harrah’s will be eligible for the deferral benefits ushered in by Section 108(i).

The deferral provides Harrah’s with an incentive to accomplish the massive deleveraging it has now embarked on as expeditiously as possible. 

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for


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