It seemed like a good idea at the time. … The stimulus bill tossed a lifeline to companies that are having trouble meeting their debt obligations by allowing them to defer income tax on forgiven debt over five years and then spread the payments over another five years.

Critics argued that the main beneficiaries of the tax break would be private-equity-owned firms that were among the most aggressive borrowers in the years leading up to the credit crisis.

Seems that the critics were right.

Private-equity-owned outfits are lining up to take advantage of the tax break, known as delayed recognition of cancellation of debt income (CODI). Among them are casino operator Harrah’s Entertainment, lender GMAC, and technology firm Freescale Semiconductor, according to the Wall Street Journal (in a story covered here by Reuters.) Essentially, the CODI provision eases the income tax treatment that arises for these firms when bondholders forgive part of their debt in exchange for a higher interest rate on new notes or a more senior position in the capital structure.

This type of deal, called a debt-exchange offer, comes at a price: It routinely triggers a rating downgrade. Last month, Fitch downgraded Freescale’s issuer default rating to C from CCC, noting that the company’s debt-exchange offer “constitutes a distressed debt exchange.” In December, Standard & Poor’s lowered Harrah’s rating from CC to SD — Selective Default — after it completed an exchange of debt securities for some 2.1 billion dollars’ worth of new notes with later maturities.

There may be other costs, too. In January, Harrah’s was slapped with a class-action lawsuit by two bondholders who claim that the company’s debt-exchange deal benefited some big bondholders at the expense of smaller investors. The complaint alleges that “plaintiff’s bond holdings have been subordinated to the newly issued bonds and, as a result, have been likely rendered worthless as the specter of Harrah’s insolvency approaches,” according to a report in the Las Vegas Sun.

Indeed, the CODI tax break seems to be emerging as a kind of under-the-radar bailout for mega-leveraged firms hovering on the brink of bankruptcy. And that’s cause for concern. Bailing out a General Motors or a Citigroup is one thing. But a casino company? ###