Consolidated loss disallowance regulation and subsidiary debt.

On Nov. 19, 1990, the Treasury issued revised loss disallowance regulations by revoking Temp. Regs. Sec. 1.1502-20T and replacing it with new Prop. Regs. Sec. 1.1502-20. The new rules are effective for dispositions occurring after Jan. 31, 1991. Final regulations were issued on Sept. 13, 1991.

The regulations retain the basic premise of the temporary regulations, that is, disallowing losses on the sale of stock of subsidiaries that join in the filing of a consolidated return. Regs. Sec. 1.1502-20(c) differs from the temporary regulations in that the final regulations provide taxpayers with relief from the general rule when a loss on the sale of stock is "economic" in nature and not attributable to built-in gain or "loss duplication."

One basic planning technique available to taxpayers to reduce the impact of these rules is to capitalize a subsidiary with debt rather than equity, or to the extent that a company is already capitalized with equity, converting such equity to debt. By doing this, taxpayers may obtain a tax benefit from a decrease in the subsidiary's value, as losses on the disposition or worthlessness of debt are not subject to Regs. Sec. 1.1509.-20 and are still deductible.

To convert existing equity into debt, a subsidiary may distribute a note with respect to its stock or, alternatively, exchange debt for its existing stock. A distribution of a note will be treated as a dividend under Sec. 316 to the extent of current or accumulated earnings and profits. This dividend will be eliminated in computing the group's taxable income under Regs. Sec. 1.1502-1 41 a)(1). The dividend reduces the tax basis in the stock of the distributing subsidiary via the investment adjustments of Regs. Sec. 1.1502-32. To the extent the distribution does not constitute a dividend, the distribution will reduce the tax basis in the stock of the distributing subsidiary. Further, if an amount in excess of basis is desired to be distributed, an excess loss account will be created for that amount of the nondividend distribution that exceeds the adjusted basis of such stock under Regs. Sec. 1.1502-14(a)(2).

The amount of the distribution is determined by taking into account the application of the original issue discount rules. Assuming the note distributed is not publicly traded and has adequate stated interest, the amount of the distribution will equal the stated principal amount of the note distributed.

The recipient will receive a basis in the note equal to the amount of the distribution, pursuant to Regs. Sees. 1.301-1(h)(2) and 1.1502-31. By distributing the note, the taxpayer has shifted basis from its stock in the subsidiary to the note, thus preserving "deductible" basis in the event the value of the subsidiary substantially decreases in the future.

The results received by distributing a note for stock may also be obtained by having a taxpayer exchange its stock for debt of the subsidiary. Assuming that the exchange does not qualify as a recapitalization under Sec. 368(a)(1)(E) (since the note is not a security), the receipt of the note by the taxpayer is treated as a redemption under Sec. 317. The redemption should fail to meet any of the requirements of Sec. 309.1b1 to be treated as an exchange in payment of the stock under Sec. 3021a1. Accordingly, the exchange should be treated as a distribution of property to which Sec. 301 applies, under Sec. 302(d). Therefore, an exchange of subsidiary stock for the subsidiary's note that is treated as a redemption also effectively shifts basis from equity to debt. The decision to exchange or not exchange shares will generally be dictated by corporate law and other business requirements (such as loan covenants).

Even if the exchange of stock for debt qualifies as a recapitalization under Sec. 368(a)(1)(E) the result will still be a shift in basis from equity to debt. In a recapitalization, the excess of the principal amount of debt received over principal of debt surrendered by the taxpayer is not protected by Secs. 354 and 356. Since the concept is to convert equity to debt, the entire debt received should be "excess." Assuming the debt in excess of basis would not be distributed, the transaction would not produce a taxable gain; basis in the debt instrument should be equal to the basis of the stock surrendered. Since no property that may be received "tax free" was received (that is, no stock), it is likely that the transaction would be treated as a redemption as described earlier, pursuant to Rev. Rul. 77-415. Thus, whether or not stock is exchanged, the transaction will merely result in the shifting of basis from equity to debt.

In using this technique, the taxpayer should not create an amount of debt that might, in effect, convert the "debt instrument" into stock. If the IRS can demonstrate that a taxpayer is "thinly capitalized," it can reclassify debt as equity, thereby negating the benefit of the attempted restructuring. Obviously, the entire equity basis may not be shifted, the amount of debt that may be created will vary with each factual situation.

Further, a careful review of state and local laws, as well as international implications, must be made. For example, will the states tax a dividend? How do the applicable states tax redemptions? Is interest deductible by the subsidiary for state purposes? Will there be any effect on foreign tax credit planning? All of these questions must be carefully reviewed.

From Kevin A. Duvall, CPA, Washington, D.C.