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Potential tax pitfalls in debt capitalization.

Under Sec. 362(e)(1), enacted in American Jobs Creation Act of 2004 (AJCA) Section 836(a), certain issues can arise when a foreign parent contributes the debt of a lower-tier U.S. subsidiary to its other U.S. subsidiaries in cascading capital contributions. The new provision is effective for transactions after Oct. 22, 2004.

Example: Foreign corporation FP enters into a new U.S. business. It transfers $250 to its existing top-tier U.S. holding company, US 1, which transfers it to a newly organized, lower-tier operating subsidiary, US2. A year later, FP's new U.S. investment has not succeeded as hoped; FP advances an additional $100 to US2 to enable it to turn its business around. FP expects the advance to be repaid in three years; documentation is executed to memorialize the terms of US2's obligations.

The US2 note has a $100 face amount and value, and bears adequate stated interest; see Sec. 1273(a) and Kegs. Secs. 1.482-2(a)(2)(i) and 1.1273-2(a) (1). US2 pays and deducts interest on the note; see Sec. 163(a) and (j). Over the next two years, US2's note declines in value to $70, due to either a significant rise in market interest rates or a decline in US2's creditworthiness, and FP decides to salvage its investment. Thus, it contributes the US2 note to US1, which contributes it to US2. Neither US1 nor US2 issues any stock in exchange. US1 then offers US2 for sale, expecting a substantial loss.

AJCA Analysis

The following analysis assumes that (1) FP'S $100 advance to US2 is characterized appropriately as debt for Federal income tax purposes; (2) the contributions are motivated by the desire to prepare US2 for sale, not by tax considerations; and (3) there is no reason to disregard the transaction's form.

Evaluation of the tax consequences of FP's contribution of the US2 note to US1 requires consideration of Sec. 362(e)(1). Under that new rule, if a person transfers property to a corporation as a capital contribution, a Sec. 351 exchange or in a Sec. 368 transaction, the transferee's basis in each item of transferred property "shall" be its date-of-transfer value, if two conditions are met. First, there must be an importation into the U.S. tax base, so that gain or loss on the property would not be subject to tax in the transferor's hands immediately before the transfer, but would be subject to tax in the transferee's hands immediately thereafter. Second, there must be a net built-in loss in the transferred properties, so that but for Sec. 362(e), the transferee's aggregate basis in the imported properties would exceed the aggregate value immediately after the transfer. In the above example's fact pattern, it is assumed that both conditions are met.

The analysis differs depending on whether US1 and US2 file separate or consolidated returns. If US1 and US2 are parent and subsidiary members of a consolidated group, respectively, the analysis must take into account the application of Kegs. Sec. 1.1502-13(g)(4)'s deemed satisfaction and reissuance rule. Under that rule, a debt that becomes an intercompany obligation is treated for all Federal income tax purposes, immediately after becoming an intercompany debt, as though it had been satisfied and then reissued to the holder. If the debt was not acquired by purchase in the past six months, the deemed satisfaction will be for the obligation's fair market value (FMV); see Kegs. Sec. 1.108-2(f).

Surprising Results

Using the above example, Situations 1 and 2 below show what happens if US1 and US2 do not file consolidated returns. As seen in Situation 2, the AJCA changes the result, by creating cancellation of debt (COD) income for US2. In the consolidated return context, Situations 3 and 4 below show that while there was an unfortunate character mismatch prior to the AJCA, the legislation might further exacerbate the group's problem.

Situation 1--Pre-AJCA separate-company analysis: Prior to the AJCA's enactment, the rules applicable to the transaction were fairly clear. The FP-to-US1 transfer is a realization event as to both parties, but neither recognizes gain or loss on the contribution. Likewise, the USI-to-US2 transfer of the US2 note is a realization event to both parties; neither recognizes gain or loss on the second contribution; see Secs. 108(e)(6), 118(a), 263(a)(1), 351(a) and 1032(a). FP's stock basis in US1 increases by $100 (the amount of its adjusted basis in the US2 note) on the first transfer. US1 takes a transferred basis in the US2 note, which results in USI's stock basis in US2 increasing by $100 on the second transfer; see Secs. 358(a)(1), 362(a)(2) and 1016(a)(1). The second contribution results in the extinguishment of US2's note. US2 does not recognize COD income, because it is treated as retiring its note for US l's basis therein, or $100, under Sec. 108(e)(6).

Situation 2--Post-AJCA separate-company analysis: If, instead, FP contributes the US2 note to US1 after Sec. 362(e)'s effective date, the analysis is largely the same as before the AJCA, except that US 1 will not take a transferred basis in the US2 debt but, rather, a $70 FMV basis under Sec. 362(e)(1). Thus, on the second contribution, US1's stock basis in US2 increases by $70, and US2 has $30 of COD income, because it is treated as retiring its debt instrument for US1's $70 basis therein, under Sec. 108(e)(6). US2's COD income might be excludible under Sec. 108(a) to the extent it is insolvent; however, the exclusion could come at the cost of a reduction in its net operating losses (NOLs) or other favorable tax attributes under Sec. 108(b).

Situation 3--Pre-AJCA consolidated group analysis: As in the separate-company context, FP recognizes no gain or loss on the first contribution; its basis in US1 stock increases by $100. US1 recognizes no gain or loss on the first contribution and takes a $100 transferred basis in the US2 debt. Immediately thereafter, US2 is treated as satisfying its $70 note; see Regs. Secs. 1.1502-13(g)(4)(ii)(B) and 1.108-2(f). US1 recognizes a $30 loss (likely capital in character under Sec. 1271(a)(1)), and US2 has $30 of COD income (ordinary under Sec. 61(a)(12)), both of which are taken into account in determining consolidated taxable income, resulting in a character mismatch; see Regs. Sec. 1.1502-13(g)(4)(ii)(C). Sec. 108(a) might exclude US2's COD income to the extent it is insolvent, at the cost of a reduction in NOLs or other attributes of US2 or other members of the US1 consolidated group; see Secs. 108(b) and 1017 and Regs. Sec. 1.1502-28.

Also, US2 is deemed to issue a second debt instrument to US1 with a $70 issue price and a $100 stated redemption price at maturity. On the second contribution, the note is extinguished and likely deemed satisfied under Regs. Sec. 1.1502-13(g) (3). The amount for which it is deemed satisfied has been the subject of debate; however, regardless of whether it is deemed satisfied for its FMV ($70) or its stated redemption price at maturity ($100), any income recognized by US1 as the note's holder should be offset on the consolidated return by a corresponding deduction to US2 as the obligor. Moreover, pursuant to the matching principle, the character of any such amounts will be the same; see Regs. Sec. 1.1502-13(c). (A discussion of the resulting consolidated return stock basis and earnings and profits adjustments under Regs. Sec. 1.1502-32 and -33 is outside this item's scope.) The net result is a character mismatch on the deemed satisfaction that occurred when the note became an intercompany obligation, which could present a problem for the US1 group, unless it has sufficient capital gains to offset; see Sec. 1211(a).

Situation 4--Post-AJCA consolidated group analysis: If, instead, FP contributes the US2 note after Sec. 362(e)(1)'s effective date, FP would again not recognize gain or loss on the first contribution; its US1 stock basis would increase by $100. US1 recognizes no gain or loss on the first contribution; however, under Sec. 362(e)(1), its basis in the US2 note "shall" be its $70 value immediately after the transaction, apparently ab initio (and not as a reduction in basis otherwise determined under Sec. 362(a), 1012 or 1016(a)(1)). The consolidated return rules provide that US2 is treated as though it had satisfied its debt instrument for $70, also immediately after the FP-US1 contribution. There is no indication as to which rule is given priority:

1. If the loss importation rule were to apply first, US1 would take a $70 basis in the US2 note; that note would then be deemed satisfied for $70. The result is similar to that obtained before the AJCA, with one significant difference: the pre-AJCA character mismatch disappears, but at the cost of US1's $30 capital loss.

2. If the consolidated return rule were to apply first, US1 would recognize a $30 capital loss and US2 would have $30 COD income under Sec. 61(a)(12). US2 would then be deemed to have issued a second debt instrument directly to US1, with a $70 issue price and a $100 stated redemption price at maturity. At that point, a predicate condition of Sec. 362(e)(1) would not be met and, thus, the new rule would not apply, either because the value of the reissued US2 debt instrument is not less than US1's basis therein, or because the initial US2 debt instrument no longer exists (under the deemed-satisfaction rule), and Sec. 362(e)(1) does not incorporate a successor asset rule. This result is the same as that obtained before Sec. 362(e)(1)'s enactment.


Developing the facts and analysis further (and incorporating US2's interest deductions) would illustrate more clearly how Sec. 362(e)(1) effectuates Congress's intent to protect the U.S. corporate income tax base from the importation of losses. With planning and foresight, however, the results above, both before and after the AJCA, could be manageable under the right circumstances.

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Author:Pellervo, Patricia W.
Publication:The Tax Adviser
Date:Jul 1, 2005
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