United States: Important Modifications to Rules Governing Cancellation of Debt in a Consolidated Group Background

Until recently, it was unclear whether a member of a consolidated group that realized cancellation of indebtedness ("COD") income that is excluded from gross income (either because the member is in a Title 11 proceeding ("the bankruptcy exception") or is insolvent ("the insolvency exception") would be required to reduce its separate tax attributes by the excluded COD income, including reduction of the tax basis of lower tier subsidiaries, or whether the attributes of the entire consolidated group would be reduced by such income. For this purpose, tax attributes include, net operating losses, capital losses, tax credits, etc.¹

On August 29, 2003 Treasury issued Treas. Reg. §1.1502- 28T to clarify that the ordering of attribute reduction after an excluded COD event should be as follows:

On March 12, 2004 Treasury issued temporary and final regulations that amend Treas. Reg. §1.1502-28T, Treas. Reg. §1.1502-13(g)(3)(ii)(B), and Prop. Treas. Reg. §1.1502-11(c). These regulations were issued largely in response to three specific problems that the existing regulations did not address (1) Section 1245 recapture, (2) matching of intercompany obligations, and (3) stock basis adjustments with respect to the timing of triggering an excess loss account ("ELA").

The problem arose once the debtor member reduced its stock basis in a subsidiary because of attribute reduction after a COD event. After this, the consolidated group could potentially be taxed more than once on Section 1245 recapture income when the stock or assets of the subsidiary are subsequently disposed of by the parent. Thus, in this context, the debtor member would be required to recapture ordinary income on the sale of subsidiary stock and even if the stock or assets of the subsidiary are not sold or disposed of, this "look-through rule" also required the subsidiary to reduce its tax attributes by the amount of COD income deemed realized when its parent, the debtor member, reduced its stock basis after attribute reduction for excluded COD. See Treas. Reg. §1.1502-28. Thus, if in a subsequent year, the subsidiary distributed its assets to its parent in a Section 332 liquidation or in another disposition event, Section 1245 could apply a second time with regard to the value of the assets. The new regulations were intended to change this result. While the "look-through rule" remains in the amended regulation, the application of Section 1245 appears to be narrower. Now, Section 1245 recapture only comes into play to the extent the debtor member’s stock basis reduction exceeds the total amount of the tax attributes attributable to the subsidiary. Thus, Treas. Reg. §1.1502-28T(b)(4), (b)(5), and (b)(6) (e.g., the three amended provisions) now apply to exclude COD income that is cancelled after August 29, 2003, provided the cancellation occurs during a taxable year for which the return is due after March 12, 2004. However, taxpayers may apply the regulation to COD cancelled after August 29, 2003 and during a taxable year for which the return is due on or before March 12, 2004.

The new regulations also address matching rules with respect to intercompany obligations. In general, the redetermination rule of Treas. Reg. §1.1502-13(c)(6)(i), requires a matching of corresponding intercompany items of income and loss, such that if an item is excluded from gross income of one particular member, it is therefore nondeductible for the other participating member. Thus, an issue was presented as to whether the redetermination rule also applied where the debtor member reduced its basis in an intercompany obligation, and later received payment in excess of its basis in the intercompany obligation. Specifically, would the member’s income be redetermined to be excluded from gross income? Apparently, not. Treas. Reg. §1.1502-13T(g)(3)(ii)(B) provides that the basis reduction in an intercompany obligation is not a realization event for purposes of the redetermination rule. Therefore, the member’s income cannot be excluded from gross income upon payment of the receivable. This result stems from the desire to not create a double benefit from both the exclusion of COD from gross income that is taken into account through attribute reduction, and then excluding the income from repayment over and above the redetermined tax basis in the somewhat unusual circumstance where the debtor member actually fully repays the intercompany obligation. Treas. Reg. §1.1502-13T(g)(3)(ii)(B) applies to transactions that occur during a taxable year for which the tax return is due after March 12, 2004.²

Where a parent disposes of stock of a subsidiary in which it has an ELA (negative tax basis) and in the same year the subsidiary realizes excluded COD income, when must parent take the ELA into income? This particular question arose because under the existing regulations, the timing of parent’s inclusion of the ELA in income and the reduction of the stock basis due to the subsidiary’s excluded COD income are not compatible. The parent would take the ELA into income in the same year that its subsidiary realized the excluded COD income, i.e., the year of disposition. However, the reduction of the subsidiary’s tax attributes would not occur until the year after such income is realized. The rule persisted for several years despite concerns that this result could cause certain circular adjustments - the parent could end up including more ELA in income because income that would otherwise be offset by losses subject to attribute reduction is not offset until the subsequent year. To resolve this issue, the final regulations now require the inclusion of an ELA in the year of the COD event. Treas. Reg. §1.1502-28T(b)(6) applies to transactions that occur during a taxable year for which the tax return is due after March 12, 2004. For rules detailing the calculation of stock basis in these situations and others, Treasury has issued Prop. Treas. Reg. §1.1502-11, which is discussed below.

The proposed regulations set forth a nine-step methodology which applies in two situations: (1) where a departing subsidiary member realizes excluded COD income, and (2) where a member other than the departing subsidiary realizes excluded COD income.³ The purpose of the methodology is to avoid certain circular adjustments that occurred when a parent corporation disposed of a subsidiary in which it had a negative basis, and the corresponding attribute reduction did not occur until the year after the excluded COD income was realized and parent included the ELA in gross income. In summary, the proposed regulations first require a series of tentative calculations with regard to stock basis and consolidated taxable income without regard to attribute reduction, followed by a final calculation which imposes limitations on tax attribute reduction in computing the final stock basis adjustment and consolidated taxable income. The effective date of Prop. Treas. Reg. § 1.1502-11(c) is the date such regulations are published as final or temporary regulations.

Copyright 2004 Gardner Carton & Douglas

This article is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here.