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September 24, 2009
As part of a bankruptcy proceeding, stock of a debtor company is often exchanged for outstanding debt to satisfy creditor claims. Where debtor stock is used in satisfaction of debt, the value of the stock issued to the creditor must be compared with the amount of the debt to determine the amount of debt that is discharged. This exchange may, depending on the solvency and whether or not the debtor has filed for bankruptcy protection, be taxable as income to the debtor. Where the debtor is a subsidiary of a consolidated group of companies, the issuance of stock to the creditors is likely accompanied by a cancellation of stock owned by a parent corporation. A result of such debt satisfaction and stock cancellation is that the subsidiary ceases to be a member of the consolidated tax group of the parent.
In this instance, two sets of rules apply concurrently to debt discharged for companies that are part of a consolidated group. The standard rules around income exclusion and attribute reduction apply together, with another set of rules applicable only to consolidated groups of corporations. These rules generally apply to companies that have filed for bankruptcy and to companies that seek an out-of-court debt restructuring.
With the following example in mind, we identify the various rules companies must consider when debt satisfaction is accompanied by a deconsolidation and apply such rules to illustrate some potentially unexpected tax consequences.
Assume Parent owns all of Debtor, which in turn owns all of Subsidiary. Parent, Debtor and Sub file returns on a consolidated basis. Debtor borrows $100 from Lender and uses the proceeds to fund its operations.
As a result of a decline in sales, Debtor decides to file bankruptcy for both itself and Sub. Pursuant to a plan of reorganization, Lender’s $100 claim against Debtor is discharged in exchange for 100 percent of Debtor stock, which is worth $20 at the time of Debtor’s emergence from bankruptcy. Also at the time of Debtor’s emergence from bankruptcy, Parent’s shares in Debtor will be cancelled. The tax attributes for each member of the consolidated group are as follows:
- Parent share of consolidated net operating losses (CNOLs) = $30 and excess loss amount (ELA) in Debtor = $20.
- Debtor share of CNOLs = $10, basis in assets = $10, basis in Sub = $8.
- Sub share of CNOLs = $10.
It is a fundamental principle that the receipt of proceeds from a loan is not a taxable event. However, if a taxpayer is forgiven of such indebtedness, then that taxpayer is generally perceived as having been enriched by the amount of debt it no longer must repay.1 Therefore, and subject to certain important exceptions discussed below, gross income generally includes income from discharge of indebtedness.2
Internal Revenue Code Section 108 provides an important exception to income inclusion for companies that are either in a Title 11 case or are economically insolvent. For such companies, debt discharge is not includable as income, despite the general rule for inclusion under Section 61(a)(12).3 For insolvent corporations that do not file for bankruptcy court protection, the amount of income exclusion is limited to the amount of insolvency.4
To avoid permanent income exclusion, however, Section 108 contains a mechanism to adjust attributes of the company experiencing debt discharge. Specifically, on the first day of the year after the debt discharge, attributes of the company are reduced up to the amount of income excluded under Section 108. The corporation’s tax attributes are reduced in the following order:
To the extent the amount of the debt discharge exceeds the amount of the first four layers of attribute reduction (i.e., NOLs, business credits, minimum tax credits, and capital loss carryovers) and affects the fifth layer of attribute reduction (i.e., basis in property), the rules of Section 1017(b)(2) prevent the corporation’s basis in its assets from being reduced below the amount of the corporation’s liabilities immediately after the discharge has taken place.
The regulations take a top-to-bottom approach in determining the extent of debt discharge and the impact on attributes. Working down the chain of corporations, the amount of debt discharge for any group member is made of two potential components: actual debt discharge and deemed debt discharge. An actual debt discharge may create a deemed debt discharge in a subsidiary only to the extent the debtor reduces basis in the stock of such subsidiary. To the extent attributes are exhausted down the chain of corporations, then consolidated attributes are reduced, theoretically from the top, down.
Specifically, the regulations adopt the following three-step approach to consolidated attribute reduction:6
Perhaps as important as the top-to-bottom approach adopted by the regulations, the consolidated regulations change the timing of attribute reduction for departing members when excluded debt discharge income is incurred during the consolidated return year.10 In circumstances where the debtor member deconsolidates on the same day that it realizes excluded debt discharge income, the next day rule does not apply to move the debt discharge event outside the group and into the next year.11 This rule ensures that the NOL and other consolidated attributes remain available for attribute reduction.
Generally, if unabsorbed debt discharge income remains after reducing all consolidated attributes, the excluded debt discharge income, also referred to as black hole cancellation of debt (COD), is generally forgiven without incurring an additional tax liability. The existence of black hole COD will trigger the recognition of all or a portion of any excess loss account (ELA) in the stock of the debtor.12 The consolidated COD regulations require the ELA to be included in income up to the amount of the black hole COD.13 Consistent with the timing of consolidated attribute reduction, any ELA recapture must be taken into account in the year the COD is realized.14
Applying the regulations to the example above, Debtor will realize $80 of debt discharge income (for a debt of $100 in exchange for Debtor stock with a fair market value of $20). The consolidated debt discharge regulations require the following approach:
- Debtor realizes actual debt discharge and no deemed discharge. Therefore, Debtor reduces its portion of the CNOL carryforward of $10, then reduces asset and stock basis of $10 and $8, respectively;
- Sub realizes a deemed debt discharge amount of $8 (i.e., the amount Debtor reduced stock basis in Sub). Therefore, Sub reduces its portion of CNOL carryforward of $8; and
- Since no more attribute reduction is available at the Debtor level or below, the regulations require that other consolidated attributes be reduced. Since $28 of the $80 debt discharge was absorbed down the chain, $52 in debt discharge is applied to other consolidated tax attributes (i.e., the group’s remaining CNOL of $32).
The unabsorbed debt forgiveness income of $20 will therefore trigger the recognition of the $20 ELA in the stock of the Debtor.
In the above example, it is important to note that although attribute reduction occurs on the first day of the following year under Section 108(b)(4), the consolidated return regulations accelerate attribute reduction to the current tax year where the deconsolidation of Debtor coincides with the debt forgiveness and causes an inclusion of income for the amount of black hole COD that is applied to the debtor ELA.
1. U.S. v. Kirby Lumber, 284 U.S. 1 (1931).
2. Section 61(a)(12).
3. Section 108(a)(1)(A), (B).
4. Section 108(a)(3).
5. Section 108(b)(2).
6. Dunn, Switzer and Harding, Section 108(b) Attribute Reduction In the Consolidated Return Context – A Primer, 2007 Practising Law Institute — Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings, paragraph 355, p. 439.
7. Reg. Section 1.1502-28(a)(1) and (2).
8. Reg. Section 1.1502-28(a)(3).
9. Reg. Section 1.1502-28(a)(4).
10. Reg. Section 1.1502-28(b)(8) and (11).
11. Reg. Section 1.1502-28(b)(11). See also PLR 200442011.
12. Reg. Sections 1.1502-19(c)(1)(iii)(B), -32(b)(3)(ii)(C). Henderson and Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings, p. 411 (CCH, 2009).
13. Reg. Section 1.1502-19(b)(1)(ii).
14. Reg. Section 1.1502-28(b)(6)(ii).
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
Cardell McKinstry, Senior Director, contributed to this article.
Senior Director, New York
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