Another tax stimulus proposal

Everett Ehrlich has written a paper on behalf of the U.S. Chamber of Commerce urging another business tax stimulus measure: permitting companies, for the next two years, to avoid paying tax when they repurchase their debts at a discount. Thus, to use his lead example, suppose a company that owes the banks a dollar gets to buy back the debt for only 75 cents. Under present law, the company would have twenty-five cents of cancellation of indebtedness income ("CODI"). The Chamber of Commerce proposal apparently would use a tax credit (though I don't know the exact mechanics - presumably based on the 35 percent corporate rate?) to negate this tax liability.

Ehrlich's paper reads like an intelligent and fair-minded effort, rather than as any sort of a hack advocacy piece. But I am skeptical on the merits. A starting point to keep in mind is that, under present law, insolvent companies avoid paying current tax on CODI. Instead, they have their tax attributes reduced - e.g., net operating losses or excess credits or basis of assets that would reduce their tax liability in future years. So apparently we are not talking about these companies, which avoid current tax anyway - unless the legislation would permit them to avoid having their tax attributes reduced, a benefit that would not give them any current cash but rather permit them to avoid taxes in future years if they continue operations and return to profitability. This doesn't sound like good stimulus, if the legislation would have this effect.

For companies that are not insolvent (or can't show it for federal income tax purposes), I find the whole thing a bit more perplexing. The scenario is that, even though are solvent, they get to repurchase their debts at a discount because of the general uncertainties in the business climate. Admittedly, it would be perverse if, absent the legislation, all that would happen is that companies headed down the drain would need to postpone their debt workouts until they were demonstrably insolvent. But how important is this scenario overall? Are desperate banks trying to settle right and left at a discount even with solvent lenders? Is the problem that the transactions effectively produce net taxable income because, while the CODI would otherwise be taxable, the bank's offsetting bad debt loss is useless in the face of an already big net operating loss?

From the stimulus standpoint, one wonders as well. A firm that uses cash on hand to pay down its debt on favorable terms doesn't use that cash for something else, such as hiring new workers. On the other hand, the bank has more cash on hand once it has sold back the debt. But is the bank more likely to lend it out again to someone who would use it productively than the debtor would have been to make such use itself absent the debt cancellation? I seem to recall all those stage 1 TARP funds simply disappearing, rather than being lent out again.

Even if one does excuse current CODI, I would hope that tax attributes are reduced, as with insolvent debtors under present law. Somehow I doubt that the proposal currently has this feature.

Certainly far from my first choice regarding how to achieve stimulus through business tax breaks - unless, as per my discussion of the NOL proposal in the previous post, it's a question of doing either this or something that's affirmatively worse.

UPDATE: More nefarious than I realized, apparently.

FURTHER UPDATE: Apparently this is all about relief for private equity firms, which are buying up their debt at a discount because they can't think of anything better to do with their cash. Just the guys who need relief & stimulus right now. They don't want taxable income, for which I can hardly blame them (I would welcome legislation exempting my salary, and would even promise to spend some of the tax savings), and they also don't want reduction of tax attributes. A proposal by Senator Baucus that would merely defer the private equity firms' tax liability is estimated to cost $26 billion over 3 years, but Senator Ensign wants to permanently forgive it. And why not. They've had a lot of stress lately.