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Sec. 108 income from discharge of indebtedness - correlative adjustments.

Generally, if Sec. 108 applies to any indebtedness, it is treated as newly issued by the debtor to the related holder on the acquisition date with an issue price equal to its fair market value (FMV). Consequently, the excess of the stated redemption price at maturity over the deemed issue price is original issue discount (OID) that the debtor can deduct and the holder must include in gross income.

The determination of issue price based on the indebtedness' FMV under the correlative adjustments overrides the OID issue price rules under Secs. 1273 and 1274.

Note that the preamble to the Sec. 108 regulations states that treatment of the debt as being newly issued applies for all purposes of the Code. This raises the possibility that the deemed new debt may be subject to provisions concerning earnings stripping or applicable high yield discount obligations (Sec. 163(j) or (c)(5), respectively), even though the old debt was not.

The correlative adjustment rules do not address all the consequences to a holder that issues its own debt in exchange for that of a related debtor in a direct acquisition. Presumably, the issue price of the holder's debt and the holder's basis in the old debt in such an exchange are determined under the regular OID rules.

If the holder's basis in the old debt is not equal to the old debt's FMV, how should this difference be handled? One possibility is to treat the holder as immediately disposing of the old debt to an unrelated person, as in the case of an indirect acquisition. This could generate short-term capital gain or loss. (The preamble supports this approach to some extent.) Another possibility is to treat the holder as exchanging the old debt for new debt of the related debtor in a recapitalization. If either the old debt or the new debt is not a security, the holder again would have short-term capital gain or loss. If the related debtor's new and old debt are securities, however, the holder would carry over its basis from the old debt to the new, resulting in a market discount or premium, depending on whether the new debt's FMV (its deemed issue price under the proposed regulations) is greater or less, respectively, than the holder's basis. Ordinarily, discount would be taken into account as ordinary income when the new debt matures. The holder should be able to offset the premium against OID income (see Prop. Regs. Sec. 1.1272-2).

Yet another possibility is to recast the transaction so the debtor, not the holder, is treated as acquiring its debt from the unrelated holders for the related holder's debt, which the debtor acquires from the related holder by issuing new debt. Most likely, the result to the holder under this approach would be similar to the holder's treatment when securities are exchanged for securities in a recapitalization. Thus, the related holder's basis in the debtor's new debt would be the issue price of the holder's debt determined under the OID rules. This would create a market discount or premium to the extent the basis 's less or greater than the FMV (i.e., the deemed issue price) of the debtor's new debt. The related debtor would have no additional tax consequences beyond the normal Sec. 108(e)(4) results of cancellation of indebtedness income and OID creation. In particular, the debtor's basis in the related holder's debt would be its FMV, so the debtor would have no gain or loss on the deemed exchange with the unrelated holders.
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Author:Yates, Richard F.
Publication:The Tax Adviser
Date:Apr 1, 1992
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