Related-party debt cancellation.

In Rev. Rul. 91-47, the IRS applied "substance over form" and "step-transaction" principles to find that cancellation of debt (COD) income was realized by a corporate debtor. The Service ruled that the transaction in question was undertaken primarily to avoid application of the general rule that COD income is taxable under Sec. 61(a)(12) and the extension of this principle under Sec. 108(e)(4) to the acquisition of debt at a discount by a related party.

Under Sec. 108(e)(4), the acquisition of debt by a party related to the debtor for less than the debt's face amount will generally give rise to COD income to the debtor equal to the discount from face value. Proposed regulations under Sec. 108(e)(4) were issued in March 1991 that address not only "direct acquisitions" of debt by a party related to the debtor (within the meaning of Sec. 267(b) or 707(b)(1)) at the time of the acquisition, but also a variety of situations involving so-called indirect acquisitions. A transaction that is either a direct or indirect acquisition by a related party generally results in the debtor realizing COD income.

Overview of indirect acquisition rules

The indirect acquisition rules create a number of presumptions that make Sec. 108(e)(4) applicable to situations in which the acquisition of debt from a party unrelated to the debtor (D) is made by a person (P) who becomes related to the debtor following the acquisition. In general, an indirect acquisition results if P becomes related to D within six months of the debt acquisition (Prop. Regs. Sec. 1.108-2 (b)(2)(ii)(A)). If P becomes related to D six months or more after the acquisition but less than 24 months thereafter, a rebuttable presumption arises that P has made an indirect acquisition (Prop. Regs. Sec. 1.108-2 (b)(2)(ii)(C)); unless the presumption is rebutted, D will realize COD income. Finally, indirect acquisitions generally include any acquisition by P if, at the time P becomes related to D, more than 25% of P's assets consist of D's indebtedness (Prop. Regs. Sec. 1.108-2(b)(2)(ii)(B)).

The proposed regulations were slated to be effective for transactions occurring on or after Mar. 21, 1991. However, the preamble to the regulations indicates that the general principles of Sec. 108(e)(4) apply to any transaction occurring after Dec. 31, 1980. Since Sec. 108(e)(4) states that the rules for acquisitions by related parties shall apply "to the extent provided in regulations prescribed by the Secretary," the propriety of applying these rules to transactions occurring before the issuance of the regulations has been questioned; moreover, the validity of the "indirect acquisition" rules proposed by the regulations may be suspect, since they arguably are broader than what was contemplated by Congress when it enacted Sec. 108(e)(4). Consequently, the statute's retroactive effective date or the regulations' substantive rules may very well be the subject of future litigation--perhaps the taxpayer in Rev. Rul. 91-47 may be a candidate for initiating such a challenge.

Rev. Rul. 91-47

D had outstanding debt owed to unrelated parties with an issue price of $500x and a fair market value of $350x. P, an unrelated person, learned that D was seeking to reduce its outstanding indebtedness. P formed Newco, and Newco purchased $100x of D's indebtedness for $70x from an unrelated creditor of D. Shortly thereafter, D acquired the stock of Newco for $70x.

The IRS ruled that respecting the form of the transaction would result in D circumventing the COD rules of Secs. 61(a)(12) and 108(e)(4). The Service found that the formation of Newco did not serve a valid business purpose other than tax avoidance; quite to the contrary, it determined that Newco was created (1) with the expectation that D would acquire P's Newco stock and (2) was primarily to enable D to avoid the COD income that would have been realized if it acquired the debt directly from either its historic creditors or from Newco (Sec. 61(a)(12)), or if the debt had been acquired through a related party (under the IRS's self-executing view of Sec. 108(e)(4)).

The Service ruled, in effect, that Newco's existence should either be disregarded, so that D could be treated as acquiring the debt directly from its historic creditors or, alternatively, that the steps of the transaction should be collapsed, so that Newco could be treated as related to D at the time it acquired D's debt. Under either theory, D would be forced to realize $30x of COD income--the $100x debt issue price less the $70x paid to acquire the debt.

The technique used by D had been well-publicized by tax professionals before Rev. Rul. 91-47 and the proposed regulations under Sec. 108(e)(4) were issued. Many believed that the transaction would not create COD income, either because Sec. 108(e)(4) would not become effective until regulations were issued that defined the scope of the related-party rules, or because the "step-transaction" doctrine was not applicable (since D had no binding commitment to acquire P's stock). Some may continue to argue that the technique avoids debt cancellation income even after the effective date of the proposed regulations, because the indirect acquisition rules are invalid or because the "step-transaction" doctrine was inappropriately applied in Rev. Rul. 91-47. Only time will tell if the Service has successfully deterred taxpayers from further attempts to dodge Sec. 108(e)(4), or whether taxpayers and the IRS will continue to fight this battle in the courts.