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Cancellation of accrued, but unpaid, interest on intercorporate debt.

It is not uncommon for a corporation to cancel a debt owed to it by its subsidiary, particularly as preparation for a potential disposition. The Federal income tax consequences of such a transaction hinge on a number of factors, including whether the parent or the subsidiary join in the filing of a consolidated return. Often, there is accrued but unpaid interest on the cancelled debt, which the parties also intend to cancel. Although cancellation of intercorporate debt has been addressed extensively, the treatment of the interest component of such obligations is often overlooked. This article briefly discusses the Federal income tax treatment of such interest under both a consolidated- and separate-return analysis.

Example: P, a parent, owns all of the outstanding stock of S, a subsidiary. The money that S owes P is properly characterized as "debt" for tax purposes. The underlying intercorporate debt has no original issue discount (OID). S is solvent when the debt and accrued interest are cancelled. P and S use the same accounting method.

If any of the assumptions in the example are not met, the analysis becomes more complicated, potentially changing the substantive tax consequences.

Interest Constitutes Debt

S must pay the interest, regardless of whether it already has accrued deductions and P has included income. Thus, under general tax law principles, the interest remains S's debt until repaid.

Separate-Return Analysis

The transaction must be analyzed under separate-return tax principles, under which P and S do not join in the filing of a consolidated return. This analysis is appropriate, even when P and S file a consolidated return, to determine state tax treatment, as many states either do not permit the filing of consolidated returns or do not completely adopt the Federal consolidated regulations. Alternatively, P and S reside in different states, thereby requiring separate state filings.

At first glance, it might appear that cancellation of the interest should be treated as a capital contribution under Sec. 118 or 351. (Because S is wholly owned, the issuance of additional shares to P would be meaningless and not required.) Cases decided prior to 1980 supported this proposition; see Putoma, 601 F2d 734 (5th Cir. 1979). However, Sec. 108(e)(6), enacted as part of the Bankruptcy Tax Act of 1980, provides an analysis, which, although intended to reverse the rule enunciated in Putoma, can reach the same result, albeit via a different path.

Sec. 108(e)(6) generally recasts P's contribution of S's debt to the subsidiary's capital, as if S satisfied the debt for cash equal to P's basis in the debt. For debt that has been accrued but remains unpaid (e.g., salary or interest expense deducted by S and included in gross income by P), P'S basis in the debt is increased by the amount it included in gross income. (The legislative history to Sec. 108(e)(6) contains an example that illustrates this rule.) Thus, S will not recognize any cancellation of debt (COD) income if P'S basis in the debt equals the debt's face value.

The interest also may include a current component not yet taken into income by P or deducted by S. As such, the amount owed (the face value) may exceed P's basis in the interest, ostensibly causing S to recognize COD income. However, Sec. 108(e)(2) prevents S from recognizing income for this portion of .the interest. (Because most corporations are accrual-method taxpayers, the application of the analysis outlined below may be bruited.)

Under Sec. 108(e)(2), COD income is not realized if "payment of the liability would have given rise to a deduction." The legislative history of the Bankruptcy Tax Act of 1980 provides the following example: "[A]ssume a cash-basis taxpayer owes $1,000 to its cash-basis employee as salary and has not actually paid such amount. If later the employee forgives the debt (whether or not as a contribution to capital), then the discharge does not give rise to income or require any reduction of tax attributes." In most cases, the interest would give rise to a deduction by S. (The effect of certain interest disqualification provisions is beyond the scope of this item.) Thus, no COD income should be recognized on the cancellation of even the current portion of interest.

Interest Constitutes Intercompany Obligation

In the consolidated-return context, the rules governing "intercompany obligations" are set forth in Regs. Sec. 1.1502-13(g). An intercompany obligation is defined by Regs. Sec, 1.1502-13(g)(2)(ii) as an obligation between members of a consolidated group, but only for the period during which both parties are members of the same group. Under. Regs. Sec. 1.1502-13(g)(2)(i), an "obligation" of a member is any obligation that constitutes debt under general principles of Federal income tax law.

As noted above, the interest remains S's debt until repaid, even if S has already accrued deductions and P has included income. Thus, if (1) the interest is attributable to periods during which P and S were members of the same consolidated group and (2) P and S remain members when the interest is cancelled, the interest represents an additional intercompany obligation and should be treated accordingly.

Current Regulations

Under Regs. Sec. 1.1502-13(g)(3), an intercompany obligation is generally deemed satisfied for all Federal income tax purposes if "a member realizes an amount (other than zero) from the assignment or extinguishment of all or part of its remaining rights or obligations under an intercompany obligation ..." In such case, the obligation is deemed satisfied immediately before the realization event at its fair market value (FMV). Any gain or loss arising under these rules is not subject to Sec. 108(a), 354 or 1091. Thus, the issuer of an intercompany obligation could recognize COD income as a result of a realization event, even if it is insolvent. In the example above, P would have a corresponding bad debt deduction, resulting in no net effect on consolidated taxable income.

The interest should be treated as a demand obligation (absent documentation to the contrary). As such, the interest's FMV should be relatively close (if not equal) to its face amount, as P may demand payment at any time. Thus, neither P nor S generally should recognize income or loss when the interest is cancelled. However, to the extent the FMV is less than the face amount (as a result of factoring or of S's potential insolvency), S would recognize COD income on the difference between the FMV and the interest's face value. P shareholders have a corresponding bad debt deduction, resulting in no net effect on consolidated taxable income.

For the technical purist, Regs. Sec. 1.1502-13(g)(3) presumably would not apply if the interest's FMV equalled its face value (i.e., zero gain or loss recognized on the extinguishment of the obligation). (There is much debate regarding the proper interpretation of these rules.) In such an instance, it appears that the transaction should be analyzed under the separate-return rules outlined above. In any case, a taxpayer may choose to apply the proposed regulations (discussed below).

Proposed Regulations

The transaction also could be analyzed under 1998 proposed regulations. (Although Prop. Regs. Sec. 1.1502-13(g) has not yet been finalized, the preamble states that taxpayers may rely on the proposed regulation, even for transactions entered into before the effective date.)These regulations modify the method of determining the deemed satisfaction amount, emphasizing the use of OID principles, rather than the FMV method contained in the current final regulations. Additionally, Prop. Regs. Sec. 1.1502-13(g)(3) applies to all realization events--even those in which no gain or loss is recognized. Thus, although slightly different in mechanical operation, the proposed regulations generally reach the same result as the current regulations.

When an intercompany obligation is extinguished (e.g., contributed to the capital of a debtor subsidiary), under Prop. Regs. Sec. 1.1502-13(g)(3)(ii)(A), "the obligation is treated as satisfied for an amount equal to the issue price ... of a new debt issued on the date of the transaction, with identical terms, to a third party, for property that is not publicly traded." The issue price of a debt instrument issued for property that is not publicly traded and that bears adequately stated interest, is the stated redemption price at the instrument's maturity. This is "the sum of all payments provided by the debt instrument other than qualified stated interest payments." Again, in the case of a demand note, this amount should be relatively close (if not equal) to the note's face amount, as the holder may demand payment at any time.

As noted above, the interest's FMV should be relatively close (if not equal) to its face amount, as P may demand payment at any time. Thus, no gain or loss generally should be recognized on the cancellation of the interest. S should recognize COD income to the extent that the interest's FMV is less than its face value. In such case, P would have a corresponding bad debt, again resulting in no net effect on consolidated taxable income.


The treatment of the interest component in an intercorporate debt cancellation is often overlooked. Numerous factors may affect the proper Federal tax treatment of interest on its cancellation, resulting in treatment as a capital contribution, COD income or bad debt deduction, or a combination. Additionally, this analysis may assist state and local tax professionals in tax attribute planning, even in circumstances in which there is no net effect on consolidated taxable income.


Annette B. Smith, CPA


Washington National Tax Service

PricewaterhouseCoopers LLP

Washington, DC
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Author:Smith, Annette B.
Publication:The Tax Adviser
Date:Jul 1, 2003
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