Deducting your loss on winding up a purchased subsidiary: a lost cause?
Know Your Enemies
1. Stock Loss Disallowance Rule
Treas. Reg. [sections] 1.1502-20 can be traced to 1987.(3) The rule generally was designed to shore up the 1986 repeal of the General Utilities doctrine(4) by barring an array of transactions known as "Son of Mirrors." Although these transactions had been considered innocuous for years, they suddenly became regarded as abusive because they could produce a stock loss -- through the consolidated investment adjustment rules(5) -- to offset a gain on the sale of assets of a purchased subsidiary.(6) The buyer of the subsidiary's assets received the assets with a cost (stepped-up) basis, but effectively no one paid a tax on the asset sale gain. That result contravened the repeal of General Utilities.
Because the loss disallowance rule targets an "artificial" stock low created by the investment adjustment rules, the scope of the loss disallowance rule is somewhat limited. Treas. Reg. [sections] 1.1502-20(c) disallows stock losses only to the extent of the sum of three factors:(7)
* Extraordinary gains reflected in stock basis under the investment adjustment rules;(8)
* Positive investment adjustments reflected in stock basis under the investment adjustment rules (exclusive of extraordinary gains);(9) and
* Duplicated loss.(10)
These three factors limiting loss disallowance are designed to permit a deduction for actual economic losses, while denying a tax benefit for the sort of losses arising in a "Son of Mirrors" transaction. In spite of this goal, these factors are not so finely tuned that they permit a deduction for all economic losses. Furthermore, the presumptions underlying the loss disallowance rule are weighted in favor of the IRS. As a result, unexceptional transactions can unjustly fall prey to loss disallowance. The universe of unexceptional transactions that are swept into the loss disallowance net grew considerably larger when the new intercompany obligation rules became effective. For calendar-year filers, these intercompany obligation rules first applied in 1996, but the potentially disastrous impact of their interaction with the loss disallowance rule may not yet be widely appreciated.
2. Intercompany Obligation Rules
Under Treas. Reg. [sections] 1.1502-13(g)(3), if a consolidated group member holding a receivable from a subsidiary member claims a bad debt deduction, the debt is deemed satisfied with an amount equal to the debt's fair market value, and if the debt remains outstanding, it is deemed reissued for that same amount.(11) Such a satisfaction will cause the subsidiary to have cancellation of indebtedness income equal to the difference between the debt's adjusted issue price (i.e., its principal amount for tax purposes) and its fair market value.(12) Normally, that income would be excluded from gross income by section 108(a) of the Internal Revenue Code to the extent of the subsidiary's insolvency. Treas. Reg. [sections] 1.1502-13(g)(ii)(B)(2) provides, however, that section 108(a) does not apply to intercompany obligations deemed satisfied under Treas. Reg. [sections] 1. 1502-13(g)(3). By making an insolvent subsidiary's debt cancellation income fully reportable, this provision effectively converts (through operation of the investment adjustment rules) the creditor member's bad debt deduction into a worthless stock deduction, which is disallowed under Treas. Reg. [sections] 1.1502-20 by the extraordinary gain factor for debt discharge.(13) The case study that follows illustrates this adverse interaction of Treas. Reg. [subsections] 1.1502-13(g)(3) and -20.
P is the common parent of a consolidated group filing calendar year tax returns. P purchased all of T's stock for $5 million on December 31, 1994, and T was included in P's consolidated return from January 1, 1995, to December 31, 1997. On December 31, 1994, T's only asset was a promising new technology with a zero tax basis and a zero book (i.e., financial statement) basis. T had no tax attribute carryforwards (e.g., NOLs) and no liabilities except for small amounts of trade payables. P did not elect to treat its acquisition of T as a taxable asset acquisition under section 338. For book purposes, however, the acquisition was a purchase (as opposed to a pooling) and the $5 million P paid for the T stock was reflected as an increase in the intangible assets on P's consolidated balance sheet and on T's separate company balance sheet.
At the beginning of 1995, T secured a $1 million loan from an unrelated bank, and P guaranteed the loan. During 1995, 1996, and 1997, P advanced $8 million to T as open account indebtedness. Consistent with P's policy for intercompany open account indebtedness, T neither paid nor accrued interest on the $8 million advance. The bank loan and the intercompany advances were used to fund T's operating expenses. T's gross operating income over the three-year period was $750,000. T deducted its $9 million of operating expenses that were paid and retained the $750,000 from operating income as cash. T's $8,250,000 net loss ($750,000 less $9 million) during the three years was used to offset the income of P and its other subsidiaries on the consolidated return. T did not have net operating income during any of these years. Members of the P group did not make any payments to T for the use of its losses.
Late in 1997, P determined that T's technology was worthless, so P decided to write off the entire unamortized portion of the acquired intangible on its books and to legally dissolve T on December 31, 1997. Immediately before T's dissolution, it repaid $750,000 of the bank loan, and P retired the loan by paying $250,000 pursuant to its guarantee. Under the guarantee arrangement, P was subrogated to the bank's claim for this amount. T's final separate company balance sheet reflects no assets and an intercompany payable to P of $8,250,000 (including the bank's claim subrogated to P).(14) P has sustained an actual loss equal to its original $5 million investment in T, its $8 million of advances to T, plus its $250,000 payment to the bank. P has recovered $8,250,000 of its investment for tax purposes through T's operating losses used on the consolidated return. P's tax director would like to write off P's remaining $5 million investment in T on P's 1997 consolidated tax return.
1. Nature of the Advances -- Debt or Equity
In evaluating the prospects for a tax write-off, P must determine the nature of its investment in T. This determination depends on whether P's advances to T are treated as debt or equity for federal income tax purposes. Statutory and regulatory guidance on this subject is sparse. Section 385 authorizes regulations to set forth factors to be considered in making debt/equity determinations. The statute provides that these factors may include:
* whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest;
* whether there is subordination to or preference over any indebtedness of the corporation;
* the ratio of debt to equity of the corporation;
* whether there is convertibility into the stock of the corporation; and
* the relationship between holdings of stock in the corporation and holdings of the interest in question.
In 1980 the Treasury issued final regulations under section 385,(15) but these regulations spawned harsh criticism and were withdrawn in November 1983.(16) As a result, the proper characterization of an interest in a corporation as debt or equity remains the province of the courts and a facts-and-circumstances analysis. Courts have looked to a number of factors in making debt/equity assessments. The precise number of factors considered by different courts has varied, but the predominant analytical framework is set forth in the seminal article on the subject, which divides the inquiry into three broad categories with specific factors in each category.(17) The three categories are: (1) formal rights and remedies, (2) factors bearing on intention to create debt, and (3) factors bearing on risk and economic reality.
The open account nature of P's advances to T and the fact that no interest had been accrued or paid might suggest that the advances were really contributions to capital. Also, that P was sole shareholder weighs against debt characterization. On the other hand, the advances were recorded on T's books as debt and such movements of cash with out formal indicia of indebtedness are commonplace within consolidated groups. Also affecting debt/equity characterization is the treatment of P's guarantee of T's loan from the unrelated bank. Under Plantation Patterns v. Commissioner,(18) if no reasonable unrelated lender would have loaned T the without P's guarantee, the 1995 money bank loan to T would be recast as a loan to P and a capital contribution to T at that time. If Plantation Patterns applies to the bank debt, it is unlikely that P's intercompany advance to T could pass muster as debt, because T could not be considered creditworthy in any objective sense.
In any event, because the debt/equity determination is essentially one circumstances, it cannot readily be made in the context of a hypothetical situation. The analysis that follows explores both possibilities. In an actual case, there are steps the taxpayer can take to influence the likelihood that the IRS or the courts will deem the advances to be debt or equity. The taxpayer should be aware, however, that it may be bound by the form chosen, although the IRS is not.(19)
2. Application of the Rules if the Advances Are Debt (Plantation Patterns not Applicable)
If the advances are treated as debt, P's investment in T's stock after the three years of losses is negative, that is, excess loss account (ELA):(20)
Initial basis $5,000,000 Taxable income (loss) (8,250,000)(21) Ending basis (ELA) $(3,250,000)
At first blush, P will want to take a bad debt deduction for its $8,000,000 unrecovered intercompany advance upon T's dissolution as well as a $250,000 deduction for P's payment to the bank as T's guarantor.(22) P's expected $3,250,000 of ordinary income attributable to the ELA(23) would leave P with a net deduction of $5,000,000. P, however, will not fare so well.
P's $8 million bad debt deduction for the intercompany advances invokes the deemed satisfaction rule of Treas. Reg. [sections] 1.1502-13(g)(3).(24) As a result of the deemed satisfaction, P has an $8 million ordinary loss and T has $8 million of cancellation-of-indebtedness income.(25)
If P and T were not members of the same consolidated group, T's debt discharge income would be excluded from T's gross income under section 108(a) because of T's insolvency.(26) But Treas. Reg. [sections] 1.1502-13(g)(3)(ii)(B)(2) overrides section 108(a). Therefore, the cancellation of indebtedness income is reportable on P's consolidated return. This income causes an upward adjustment under Treas. Reg. [sections] 1.1502-32 for P's basis in the T stock. P's basis in T's stock is now $4,750,000 (the $3,250,000 ELA computed above adjusted by the $8 million increase to basis resulting from T's cancellation of indebtedness income).
Thus, the ELA is eliminated before being triggered, and P will attempt to take a worthless stock deduction under section 165(g)(3)(27) for its $4,750,000 stock basis in T. Nevertheless, because T's cancellation of indebtedness income is an extraordinary gain item under the loss disallowance rule, P's loss will be completely disallowed.(28)
P may receive better treatment for its $250,000 payment to the bank. If P can satisfy the standards under section 166 for guarantors,(29) treatment of the payment and the bank claim subrogated to P should be analyzed separately. The payment simply gives rise to a deductible $250,000 ordinary loss. Subrogation of the $250,000 claim effectively causes P to acquire the claim from the bank, hence, the claim becomes intercompany debt. This triggers Treas. Reg. [sections] 1.1502-13(g)(4) (non-intercompany debt becoming intercompany debt), causing a deemed satisfaction and reissuance of the claim for an amount equal to P's basis.(30) P's basis in the claim should be zero (the amount P paid the bank is being written off). Thus, the deemed satisfaction causes T to have $250,000 of debt discharge income, but that amount is excluded from T's gross income under section 108(a).(31) The excluded debt discharge income has no effect on T's stock basis.(32) Because of the claim's zero basis, P will have no deduction for the claim. Although Treas. Reg. [sections] 1.1502-13(g)(4) deems the debt to be reissued momentarily before T dissolves, the fair market value, the issue price and P's basis for the deemed new debt are all zero, so there should be no further consequences to P or T when T dissolves. Thus, P will yield a deduction of $250,000 (with no offsetting income in T) if it can satisfy the section 166 standards for guarantors.
This $250,000 deduction is the best that P can hope to achieve if its intercompany advances to T are respected as debt, leaving $4,750,000 of P's investment in T unrecoverable for tax purposes. If P cannot satisfy the section 166 standards for deducting the guarantee payment, the result is even worse. The $250,000 payment would be treated as a capital contribution to T that is used by T to pay off the balance of bank loan.(33) This should produce no debt cancellation for T and an additional $250,000 worthless stock deduction for P. But that deduction also is disallowed by Treas. Reg. [sections] 1.1502-20 because of the remaining extraordinary gain (net of federal income tax) attributable to the $8 million of deemed canceled intercompany debt (i.e., only $4,750,000 of the $5.2 million net extraordinary gain has been used to disallow stock loss, leaving $450,000 -- more than enough -- to disallow this additional $250,000 of stock loss).(34) Thus, none of P's remaining $5 million loss for T is reportable.
3. Application of the Rules if the Advance Are Equity
Plantation Patterns Not Applicable. P fares much better if the intercompany advances are treated as equity, provided Plantation Patterns does not apply to the bank loan. P's basis in the T stock is positive:
Initial basis $5,000,000 Taxable income (loss) (8,250,000) Intercompany advances treated as capital contribution 8,000,000 Ending basis $4,750,000
P will want to claim a worthless stock deduction for this amount, as well as to deduct its $250,000 payment to the bank. Assuming the requirements of section 165(g)(3) are met,(35) a worthless stock deduction is allowed except to the extent of the sum of T's extraordinary gains, T's positive investment adjustments (exclusive of extraordinary gains), and T's duplicated losses.(36) T has no duplicated losses.(37) Moreover, T had no positive investment adjustments (T had no net operating income during any year it was owned by P).(38) Finally, T apparently had no extraordinary gains, aside from possible debt cancellation income.(39) Because the intercompany advances are being treated as equity in this part of the analysis, Treas. Reg. [sections] 1.1502-13(g)(3) does not apply to create debt cancellation income attributable to the advances. Thus, the T stock loss is disallowed only to the extent that the guarantee payment gives rise to debt cancellation income that is treated as extraordinary gain.
As previously discussed, if P claims a section 166 deduction for the guarantee payment, Treas. Reg. [sections] 1.1502-13(g)(4) would apply to the bank's $250,000 claim subrogated to P.(40) This would produce $250,000 of debt cancellation income that is excluded from T's gross income under section 108(a). This debt cancellation does not give rise to extraordinary gain under Treas. Reg. [sections] 1.1502-20(c), however, because the excluded income is not reflected in T's stock basis.(41) Thus, P would yield a worthless stock deduction for its entire $4,750,000 T stock basis and a section 166 deduction of $250,000 for a total tax write-off of $5 million.
P would seem to be in no worse position, even if it cannot satisfy the section 166 standards for deducting the guarantee payment. The payment would be treated as a capital contribution, T would not have any debt cancellation, P's basis in the T stock would be increased to $5 million and there would be no loss disallowance factors under Treas. Reg. [sections] 1.1502-20(c). Thus, P would get a full tax write-off.
Nevertheless, there are two reasons why P should avoid treating the guarantee payment as a capital contribution. As discussed earlier, if the intercompany advances are respected as debt, treatment of the guarantee payment as a capital contribution produces an unfavorable result.(42) Thus, the first reason to avoid capital contribution treatment for these payments is to buttress the case for a maximum deduction should the IRS respect the advances as debt. The second reason is more compelling -- treatment of the guarantee payment as a capital contribution may increase the likelihood that Plantation Patterns applies.(43)
Plantation Patterns Applies. If Plantation Patterns applies, P would be treated as the obligor on the bank loan and as making a contribution of the loan proceeds to T. Also, as discussed earlier, if Plantation Patterns applies, the intercompany advances presumably would have to be treated as equity as well. Crucially, this means T would have no liabilities and thus would be solvent. T's $750,000 payment to the bank would be considered a constructive distribution to P because T would be treated as repaying this amount of the loan on P's behalf. As a result, T's $750,000 repayment would be treated as a distribution pursuant to a plan of complete liquidation of a solvent subsidiary. Such a liquidation satisfies the requirements of section 332, with the result that no gain or loss would be recognized on the liquidation and P's basis in T would disappear. Thus, P would be unable to take any worthless stock deduction for its true economic loss.
Planning. The foregoing analysis demonstrates that the best result in this case occurs where the intercompany advances, but not the bank loan, are treated as equity. Too much debt yields cancellation of debt income under Treas. Reg. [sections] 1.150213(g)(3), causing disallowed stock loss under Treas. Reg. [sections] 1.1502-20. Too much equity produces solvency and nonrecognition of stock loss under section 332. In treading this fine line, P also must be cognizant of section 385(c)(1), which seemingly prevents a taxpayer from treating what is denominated debt as equity (although the IRS is not similarly bound by the taxpayer's form).
One possible solution is for P to fund T entirely with capital contributions instead of advances. This may not be practical, however, especially if T requires frequent cash infusions, because of the greater flexibility afforded by intercompany advances in moving funds between members. Another consideration is that groups frequently prefer intercompany debt over equity to achieve state tax planning (i.e., by using interest deductions to shift income from members reporting in high-tax states to members reporting in low-tax states, where the members do not file combined, consolidated or unitary state tax returns). Although state tax planning for P to fund T through advances (P did not even bother to formalize the debt or provide for interest payments), this may be a factor in many cases. Finally, too much equity funding by P may push T into solvency, tipping the balance in favor of section 332 nonrecognition.
If front-end equity financing by P is not feasible, P might want to consider contributing the advances to equity immediately before dissolving T in an attempt to avoid activating Treas. Reg. [subsections] 1.1502-13(g)(3) and -20. Such an eleventh-hour action is unlikely to be respected, however, because the change in status would be transitory and without substance.(44)
If the beginning and endpoint solutions do not work, try the middle. Suppose P originally denominated the advances to T as debt, but periodically contributed them to equity? These capital contributions could have been accomplished annually and seem administratively feasible. "This approach could compromise state tax planning for some groups, however, by curtailing interest deductions.
But assuming it could be done, would it successfully avoid Treas. Reg. [subsections] 1.1502-13(g)(3) and -20? The risk is that in making these midstream capital contributions, P would be deemed under the "meaningless gesture" doctrine to have constructively received T stock in exchange.(45) If this causes P to realize an amount other than zero with respect to the debt (i.e., if P's basis in the contributed debt did not exactly equal the debt's fair market value at the time of the contribution), Treas. Reg. [subsections] 1.1502-13(g)(3) would apply to the capital contributions, producing a series of debt cancellation income events cumulating to the total amount of the advances by the time T is dissolved.(46) The debt cancellation income would produce corresponding stock loss disallowed by Treas. Reg. [sections] 1.1502-20, as demonstrated earlier. Treas. Reg. [sections] 1.1502-13(g)(3)(i)(B)(3), however, states that Treas. Reg. [sections] 1.1502-13(g)(3) does not apply if "[t]he amount realized is from the conversion of an obligation into stock of the obligor." It is unclear whether a simple contribution to capital of intercompany debt is a "conversion" under this exception, or whether to satisfy the exception's requirements the obligation must be converted to equity pursuant to its terms. One way to ensure that the exception applies is to formalize the intercompany debt with a written instrument (complete with the provision of interest) that permits its conversion to equity, and to periodically convert the debt. If an instrument evidencing a specific debt is not administratively feasible, a formal written policy permitting the conversion of intercompany debt to equity should suffice.(47)
A group using intercompany debt to serve state tax planning may want to defer such conversions until it is clear the subsidiary in question is destined to become worthless. Too long a delay, however, runs the risk that the conversions would not be respected, with the attendant adverse consequences under Treas. Reg. [subsections] 1. 1502-13(g)(3) and -20.(48)
The consolidated return rules present a new challenge for a parent lending money to a purchased subsidiary whose business ultimately fails. The problem arises when the stock loss disallowance rule and intercompany obligation rules intersect. The intercompany obligation rules create reportable cancellation of indebtedness income for the insolvent subsidiary that (through the operation of the investment adjustment rules) effectively converts the parent's bad debt deduction into a worthless stock deduction. Because the cancellation of indebtedness income is an extraordinary gain under the loss disallowance rule, the worthless stock deduction is disallowed. The two rules thus work together to prevent the deduction of an actual economic loss.
This problem can be avoided with careful planning. Intercompany debt representing amounts advanced by a parent to its subsidiary should be convertible by the terms of the debt to the subsidiary's equity, and the parent should periodically convert the debt. The parent's basis in the subsidiary's stock would increase by these conversions without activating the intercompany obligation rules, positioning the parent for an eventual worthless stock deduction unencumbered by the loss disallowance rule.
(*) Notes appear on page 24.
(1) Treas. Reg. [sections] 1.1502-13(g), adopted by T.D. 8597, is generally effective for tax years beginning after July 11, 1995. See Treas. Reg. 1.1502-13(1). All cited sections of the Internal Revenue Code or the regulations are currently in force unless otherwise noted.
(2) Treas. Reg. [sections] 1.1502-20, adopted by T.D. 8364, is generally effective for subsidiary stock dispositions after January 31, 1991. See Treas. Reg. [sections] 1.1502-20(h). Special transitional rules, however, disallow certain stock losses back to January 7, 1987. See Treas. Reg. [subsections] 1.337(d)-1 and -2.
(3) See I.R.S. Notice 87-14, 1987-1 C.B. 445.
(4) This doctrine takes its name from the famous case, General Utilities & Operating Co. v. Helvering, 296 US 200 (1935), which stood for the proposition that a corporation distributing appreciated assets does not recognize gain on the distribution. Amendments to the Code over the years gradually reduced the scope of the doctrine, culminating in its complete repeal by the Tax Reform Act of 1986, Public Law No. 99-514, 100 Stat. 2085.
(5) The investment adjustment rules require the basis of stock of a subsidiary member of a consolidated group to be: increased by the subsidiary's taxable and tax-exempt income; and decreased by the subsidiary's taxable loss (when used by the group), noncapital, nondeductible expenses, and distributions on its stock. Treas. Reg. 1.1502-32(b)(2). These adjustments reflect changes in the group Is investment in the subsidiary so that its income or loss already imported by the consolidated group will not he recognized a second time (or that its tax-exempt income or nondeductible expenses will not become reportable indirectly) when the subsidiary stock is sold.
(6) Treas. Reg. [sections] 1.1502-20(a)(5), Example 1 illustrates a "Son of Mirrors" transaction, as follows:
P buys all the stock of T for $100, and T becomes a member of
the P group. T has an asset with a basis of $0 and a value of
$100. T sells the asset for $100. Under the investment adjustment
system, P's basis in the T stock increases to $200. Five
years later, P sells all the T stock for $100 and recognizes a loss
Absent the loss disallowance rule (which denies P's $100 T stock loss in this example), the stock loss could effectively offset the $100 gain on the sale of T's asset.
(7) Stock losses in excess of the sum of the items enumerated in the text that follows are not disallowed. They can only be secured, however, if the taxpayer files a statement with the consolidated return for the year the subsidiary stock loss is recognized. Treas. Reg. [sections] 1.1502-20(c)(3). To the extent the subsidiary's stock 1088 is disallowed, the common parent of the group generally may elect to reattribute to itself any unused ordinary or capital losses of the subsidiary. See Treas. Reg. [sections] 1.1502-20(g).
(8) Extraordinary gain dispositions (EGDs) are events that occur after November 18, 1990, and include dispositions of (1) capital assets, as defined in section 1221; (2) property used in a trade or business as defined in section 1231(b); (3) assets described in section 1221(1), (3), (4), or (5) (e.g., inventory), provided substantially all the assets in this category from the same trade or business are disposed of in one transaction; and (4) assets disposed of in an EGDs applicable asset acquisition under section 1060. The remaining F are positive section 481(a) adjustments and discharges of indebtedness. Treas. Reg. [sections] 1.1502-20(c)(2)(i). EGDs are reduced by directly related expenses, including federal income tax.
(9) A positive investment adjustment is the sum of taxable income or loss (for the year the loss is incurred), tax-exempt income and noncapital, nondeductible expenses. See Treas. Reg. [sections] 1.1502-20(c)(2)(ii). Netting of positive adjustments with negative adjustments is not permitted outside of a single tax year, subject to a transitional rule. Treas. Reg. [subsections] 1.1502-20(c)(20) and (4), Example 3.
(10) Duplicated losses are the excess of the subsidiary's tax attributes (generally its unused NOLs, capital losses and tax basis in its assets) over its asset value (generally determined by adding its liabilities to its stock value). Treas. Reg. [sections] 1.1502-20(c)(200. Unlike the first two lose disallowance factors, the duplicated loss factor is not designed to combat General Utilities repeal avoidance. Instead it is intended to prevent a consolidated group from taking a low on a subsidiary stock sale that the purchaser of the subsidiary effectively can duplicate when it uses the subsidiary's losses (or built-in losses) after the sale, albeit the purchaser's usage could be severely limited (e.g., by sections 269, 382, 384, and the separate return limitation year rules of Treas. Reg. [sections] 1.1502-21T(c)).
(11) Treas. Reg. [sections] 1.1502-13(g)(3) generally applies whenever a member realizes (as opposed to recognizes) an amount (other than zero) of income, gain, deduction or loss with respect to an intercompany obligation. A bad debt deduction is treated as a comparable transaction. Exceptions to the application of Treas. Reg. [sections] 1.1502-13(g)(3) include where the obligation is converted to equity. Treas. Reg. [sections] 1.1502-13(g)(3)(i)(B)(3). See text following note 46 infra. A separate deemed satisfaction/reissuance rule applies to non-intercompany debt when it becomes intercompany debt. Treas. Reg. [sections] 1.150213(g)(4), discussed in text accompanying notes 30-32 infra. Treas. Reg. [sections] 1.1502-13(g)(4) takes the place of section 108(e)(4) and Treas. Reg. [sections] 1.108-2 (acquisition of debt by related party from unrelated party) for consolidated groups.
(12) See Treas. Reg. [sections] 1.1502-13(g)(5), Example 3; I.R.C. [sections] 108(e)(3). Treas. Reg. [sections] 1.1275-1(b)(1) defines adjusted issue price as the debt's issue price increased by any original issue discount inclusions in the holder's income and reduced by any payments on the debt (other than for certain stated interest).
(13) See note 8 supra. The provision overriding section 108(a) was added in the final regulations without prior notice, ironically, to cure a trap for the unwary created by the proposed regulations. The preamble for T.D. 8597, 1995-2 C.B. 147, 153, states:
The proposed regulations do not affect the application of
section 108 to the cancellation of intercompany indebtedness.
For example, under the proposed regulations if S loans money
to B, a cancellation of the loan subject to section 108(a) may
result in: (i) excluded income to B; (ii) a noncapital, nondeductible
expense to S (under the matching rule); and (iii) a reduction
of B's tax attributes (such as its basis in depreciable property).
As a result, B's tax attributes are reduced even though
the group has not excluded any income on a net basis. Accordingly,
the final regulations provide that section 108(a) does not
apply to the cancellation of intercompany indebtedness. As a
result of this change, the general principles of the matching
rule will prevent transactions to which section 108(a) would
otherwise apply from having inappropriate effects on basis and
consolidated taxable income. In the preceding example, S and
B will have offsetting ordinary income and ordinary loss, and
B's tax attributes will not be reduced.
(14) Consider whether T would be de facto dissolved for tax purposes in 1997, even if it were not dissolved legally then. See, e.g., Treas. Reg. [sections] 1.332-2(c); Wier Long Leaf Lumber Co. v. Commissioner, 173 F.2d 549 (5th Cir. 1949); Winter & Co., Inc. v. Commissioner, 13 T.C. 108 (1949); Rev. Rul. 84-2, 1984-1 C.B. 92; and Rev. Rul. 61-191, 1961-2 C.B. 251.
(15) T.D. 7747, 1981-1 C.B. 141.
(16) T.D. 7920, 1983-2 C.B. 69.
(17) Plumb, The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L. Rev. 369 (1971).
(18) 462 F.2d 712 (5th Cir. 1972), cert denied, 109 U.S. 1076 (1972). Is Section 385(c)(1) states, "[t]he characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary)."
(19) Treas. Reg. [sections] 1.1502-32(a)(3)(ii) provides that an ELA arises when the negative adjustments under Treas. Reg. [sections] 1.1502-32 exceed a subsidiary's stock basis. Treas. Reg. [sections] 1.1502-19 governs the treatment of ELAs. See infra note 23.
(21) Because T was not paid by other group members for the use of its losses, there should be no net effect on P's basis in the T stock attributable to federal income taxes (deemed payment of tax savings to T by other group members reduces the amount of the negative adjustment for T's losses, but this is offset by a deemed distribution of the tax savings because no payment is made). See Treas. Reg. [sections] 1.1502-32(b)(3)(iv)(D). Also, the above computation ignores the effect of section 7872 (deemed interest on related-party loans with below market interest rates), because the deemed interest would produce no net effect on P's basis in the T stock (i.e., the negative adjustment for deemed interest deductions by T is offset by deemed capital contributions by P because no interest is actually paid). See Prop. Reg. [sections] 1.7872-4(d)(1). Presumably, the intercompany advances would be treated as demand loans under section 7872. See KTA-Tator, Inc. v. Commissioner, 108 T.C. 100 (1997); Mason v. Commissioner, T.C. Memo. 1997-352. Although neither federal income taxes nor section 7872 deemed interest payments produce a net effect on T's stock basis, both of these items produce adjustments under Tress. Reg. [sections] 1.1502-32 that could affect the positive investment adjustments factor under Tress. Reg. [sections] 1.1502-20(c). See note 9 supra. For convenience, the authors do not specifically analyze the effects of these items under Treas. Reg. [sections] 1.1502-20(c) because they would not change the results discussed below. See text accompanying note 38 infra.
(22) See Rev. Rul. 70-489, 1970-2 C.B. 53. Tress. Reg. [sections] 1.166-9 prescribes the standards for deducting the guarantee payment. Among other things, either P must have received a payment from T for making the guarantee, or P must have extended the guarantee in accordance with normal business practice or for a good faith business purposes Treas. Reg. [sub-sections] 1.166-9(d) and (e)(1). Also, write-off of the payment is not permitted if at the time P entered into the guarantee arrangement, P intended that any payment it would be called upon to make would be a capital contribution. Treas. Reg. [sections] 1.166-9(c). Presumably, any payment pursuant to a guarantee that cannot satisfy the section 166 standards for a deduction would be treated as a capital contribution.
(23) An ELA becomes reportable as income when a disposition event occurs (including when the subsidiary disposes of substantially all of its assets). Tress. Reg. [subsections] 1.1502-19(1) and (c)(1)(iii)(A). ELA income is ordinary to the extent the subsidiary is insolvent, then capital gain. See Tress. Reg. [subsections] 1.1502-19(b)(1) and (4). T is insolvent because it has $8,250,000 of liabilities but its only asset is a worthless intangible. See I.R.C. [sections] 108(d)(3).
(24) See note 11 supra and accompanying text.
(25) See note 12 supra and accompanying text. The adjusted issue price of the intercompany advances should be their face amount. Generally, no original issue discount (OID) arises on an obligation issued for cash. See Tress. Reg. [subsections] 1.1273-1(a), (b) (OID equals excess of principal amount over issue price) and Treas. Reg. [sections] 1.12732(a)(1) (issue price of debt issued for cash equals the cash). Furthermore, no repayment of the advances has occurred.
(26) See note 23 supra regarding the determination of T's insolvency.
(27) Section 165(g)(3) permits an ordinary low deduction for the stock of an at least 80-percent owned subsidiary when it becomes worthless, provided the subsidiary meets a 90-percent nonpassive gross receipts test. Tress. Reg. [sections] 1.1502-80(c), however, defers this deduction until the subsidiary is considered worthless under the ELA rules (which includes when the subsidiary has disposed of substantially all of its assets).
(28) See note 8 supra and accompanying text. Although the extraordinary gain is reduced for federal income tax directly related to the debt cancellation income, the net amount here is still large enough to disallow P's entire T stock loss. Assuming the P group is taxable at a 35-percent rate, the directly related tax is at most $2.8 million ($8 million debt cancellation income x .35). Thus, the net extraordinary gain is at least $5.2 million ($8 million - 2.8 million), which is greater than P's basis in the T stock.
Also note that P's basis in the T stock is not affected by the federal income tax on the cancellation of debt income. T has no assets, so P will have to pay the tax. Thus, the negative adjustment to T's stock basis for the tax is offset by a deemed capital contribution from P. See Treas. Reg. [sections] 1.1502-32(b)(3)(iv)(D). See also note 21 supra.
(29) See note 22 supra.
(30) See note 11supra. Treas. Reg. [sections] 1.1502-13(g)(4) refers to Treas. Reg. [sections] 1.108-2(f)(1) for determination of the deemed satisfaction and reissuance amounts.
(31) T has debt discharge to the extent the adjusted issue price for the $250,000 portion of the bank loan represented by the subrogated claim exceeds the deemed satisfaction amount. See note 12 supra for the definition of adjusted issue price. Assuming the bank loan was not issued at a discount, the adjusted issue price for this portion of the loan should be its $250,000 face amount. Thus, the deemed satisfaction amount being zero, T has $250,000 of debt discharge. section 108(a) should apply because T is insolvent. See note 23 supra. Moreover, Tress. Reg. [sections] 1.1502-13(g)(4) does not override section 108(a), unlike Tress. Reg. [sections] 1.1502-13(g)(3).
(32) Tress. Reg. [subsections] 1.1502-32(b)(2)(ii) and (b)(3)(ii)(C) do not permit a stock basis increase for excluded cancellation of indebtedness income, unless the debtor has losses or other tax attributes capable of reduction under section 108(b). T has no tax attributes to be reduced.
(33) See note 22 supra.
(34) See note 28 supra.
(35) See note 27 supra.
(36) See notes 7-10 supra and accompanying text.
(37) See note 10 supra. T has no tax attributes.
(38) See notes 9 and 21 supra.
(39) See note 8 supra.
(40) See text accompanying notes 29 - 32 supra.
(41) See note 32 supra and text accompanying note 8 supra.
(42) The deemed cancellation of the intercompany advances under Tress. Reg. [sections] 1.1502-13(g)(3) produced large enough extraordinary gains under Tress. Reg. [sections] 1.1502-20 to disallow the loss on the additional stock basis from the capital contribution. See text accompanying notes 33 - 34 supra.
(43) Plantation Patterns will not necessarily apply if the guarantee payment is treated as a capital contribution. The standards under the case are different from the section 166 standards. Compare text accompanying note 18 supra with supra note 22. Nevertheless, because these standards both relate to the parties' intent at the time the guarantee was made, it is quite possible that a determination as to one would influence the application of the other.
(44) See, e.g., Rev. Rul. 68-602, 1968-2 C.B. 135 (capital contribution of intercompany debt immediately preceding a subsidiary's dissolution did not cure its insolvency to make section 332 apply). Another issue is whether this action, if repeated, would cause Tress. Reg. [sections] 1.1502-13(g)(3) to apply. See discussion in the text that follows.
(45) See, e.g., Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989).
(46) See note 11 supra. In other words, there is a risk that Treas. Reg. [sections] 1.1502-13(g)(3) overrides section 108(e)(6) (contributed debt deemed satisfied to the extent of the contributing shareholders' basis in the debt).
(47) Absent Tress. Reg. [sections] 1.1502-13(g)(3), general tax principles would govern the treatment to P and T. The conversion is not a taxable event to P. See Rev. Rul. 72-265, 1972-1 C.B. 222. P's basis in T's stock would increase by the amount of the converted advances. Any cancellation of indebtedness determined under section 108(e)(8) (debt deemed satisfied to the extent of the value of the debtor's stock received in exchange for the debt) would be excluded from 7s gross income under section 108(a), because T would be insolvent to that extent. Moreover, the excluded debt discharge income would not be an extraordinary gain under Treas. Reg. [sections] 1. 1502-20(c), because it is not reflected in T's stock basis. See note 32 supra and text accompanying note 8 supra.
(48) A special concern here is that both of these rules have broad anti-avoidance provisions. See Tress. Reg. [subsections] 1.1502-13(h) and -20(e). The anti-avoidance provisions are not likely to apply to a group that has established a practice of making periodic conversions, but if the conversions do not occur until the subsidiary is practically defunct, they may invite a challenge. In any event, a taxpayer will want to defend against the anti-avoidance rules by stressing that it is employing self-help measures to avoid the trap for the unwary created for intercompany debt by the combined operation of Tress. Reg. [sub-sections] 1.1502-13(g)(3) and -20.
Richard F. Yates is a principal and National Director of Consolidated Returns with KPMG Peat Marwick LLP's Washington National Tax Practice. A lawyer, Mr. Yates is the co-author of The Consolidated Tax Return: Principles, Practice, Planning (Warren, Gorham & Lamont, 5th Ed. 1993). JAMES W. BANKS is a senior manager in the same office of KPMG Peat Marwick and is a member of the AICPA's Committee on Corporations and Shareholders. Steven K. Rainey is a partner and Associate National Director of Consolidated Returns in the same office. The authors thank Christine W. Booth and Edward Jacobson of KPMG's Washington office for their assistance in the preparation of this article.
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|Author:||Rainey, Steven K.|
|Date:||Jan 1, 1998|
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