Editor: Mindy Tyson Weber, CPA, M.Tax.
Foreign Income & Taxpayers
The global financial crisis and its aftermath have caused multinational entities to adapt to and struggle with certain new economic externalities. Whether established businesses or burgeoning startups, few companies have been able to continue conducting business as usual. Multinational entities have had to deal with supply-and-demand constraints, budget cuts, resource and capital constraints, reduced purchasing activity at the product level, reduced or nonexistent merger-and-acquisition activity, and insufficient cash/income flow to repay intercompany debt principal or the corresponding interest payments. Consequently, the issues surrounding cancellation of indebtedness have become particularly relevant with respect to multinational entities.
This item addresses the U.S. corporate income tax effects of cancellation of debt (COD) income; the contribution-to-capital exception to COD income; partial cancellation of COD income; the impact of insolvency; and, finally, some COD income issues to consider in the international corporate context.
General Taxation of COD Income
Under the Code, U.S. persons, including corporations, are taxed on their worldwide income. Sec. 61 defines gross income to include COD income. When a debtor recognizes COD income, the creditor may receive a corresponding Sec. 165(g) worthless securities deduction or a Sec. 166 bad debt deduction. Sec. 108 provides several exceptions to the definition of COD income. For example, Sec. 108(e)(6) provides that a capital contribution in the form of debt forgiveness by a shareholder-creditor that does not involve an issuance of stock of the debtor produces COD income only to the extent the outstanding debt exceeds the contributing shareholder’s adjusted tax basis in the debt. In addition, under Sec. 108(e)(8), a corporation recognizes COD income if it transfers stock in satisfaction of its debt and the fair market value (FMV) of the stock is less than the adjusted issue price of the debt.
Thus, when debt is forgiven by a shareholder-creditor and no new stock is issued, the debtor recognizes gain to the extent the adjusted issue price of the debt exceeds the shareholder-creditor’s basis in the debt. The shareholder-creditor increases its basis in the stock of the debtor in an amount equal to the adjusted issue price of the debt (see also Sec. 1016(a)(1), Regs. Sec. 1.1502-19(d)(1), and Letter Ruling 201337007).
The income tax treatment of a partial, as opposed to complete, cancellation of debt is not specifically addressed by the Code. However, just as a complete cancellation of a shareholder-creditor loan without any stock exchange is treated as a repayment of the loan followed by a capital contribution, a partial cancellation of the same without any stock exchange arguably could be treated in the same way, but only with respect to the portion of the loan canceled. If the shareholder-creditor’s tax basis in the portion of the loan canceled is at least equal to the adjusted issue price of the portion of the loan canceled, the partial cancellation could be treated under Sec. 108(e)(6) as though the debtor corporation had satisfied the portion of the debt canceled with an amount of money equal to the shareholder-creditor’s tax basis in the portion of the debt canceled, and the debtor corporation would recognize no COD income.
Another way to characterize a partial cancellation of debt would be to treat it as a debt-for-debt exchange. Finally, a partial cancellation could also be treated as a debt exchange subject to Sec. 108(e)(10) and a capital contribution subject to Sec. 108(e)(6). While an in-depth analysis and review of the tax treatment of partial cancellations of debt is beyond the scope of this item, commentators have explored this topic in greater detail (see, e.g., Levine and Molins, “Partial Debt Cancellations: Slicing Debt With Occam’s Razor,” 129 Tax Notes 311 (Oct. 18, 2010); see also Potter and Harris, ‘‘Unintended Tax Consequences From Intercompany Debt Cancellations,’’ 37 J. Corp. Tax’n 3 (Sept./Oct. 2010)).
Impact of Insolvency
The forgiveness of debt when a debtor is insolvent may have significant federal income tax consequences. Obviously, insolvency has an immediate business impact on a debtor’s ability to repay principal and interest, regardless of whether the debt is owed to related or third parties. When a creditor cancels or forgives debt, the debtor generally recognizes COD income under Sec. 61(a)(12). However, where a creditor forgives debt of its insolvent debtor, the debtor may be eligible for relief from COD income.
Under Sec. 108(a)(1)(B), a debtor may exclude COD income if the debtor is insolvent immediately prior to the discharge of debt. Sec. 108(d)(3) defines insolvency of the taxpayer as the excess of liabilities over the FMV of assets, determined immediately before the discharge of debt. The Sec. 108 COD income exclusion applies only to the extent of insolvency. For example, if the taxpayer has COD income of $150,000 and the excess of liabilities over assets immediately before the discharge is $100,000, the taxpayer includes $50,000 of COD income in his or her gross income and excludes $100,000.
However, this insolvency exclusion comes at a significant cost. In particular, Sec. 108(b) provides that the amount of the exclusion must be applied to reduce the taxpayer’s tax attributes in the following order: (1) the net operating loss in the year of the debt cancellation; (2) any general business credit carryovers to or from the year of the debt cancellation; (3) the minimum tax credit as of the beginning of the year following the year of the debt cancellation; (4) the capital loss in the year of the debt cancellation and any carryover to that year; (5) the basis of depreciable and nondepreciable property under the rules of Sec. 1017; (6) the passive loss carryover from the year of the debt cancellation; and (7) any foreign tax credit carryovers to or from the year of the debt cancellation (but see Sec. 108(b)(5) and Regs. Sec. 1.108-4 (taxpayer may elect to reduce depreciable property before reducing other attributes)). Because excluding COD income under the insolvency exception may affect one or more significant tax attributes, taxpayers should carefully analyze the consequences of the exclusion.
COD income raises some different issues and problems within the cross-border setting than it does in the domestic context. The Code and regulations contain source rules for how and when certain types of income, including dividends, interest, rents, and royalties, are taxed. In the international context, the question arises of whether income realized from the discharge of indebtedness is eligible for exclusion under Sec. 108 or whether it represents some other form of income, such as foreign currency gain, which is taxable under Sec. 988. The legislative history of Sec. 988 appears to answer this question, stating in part that:
[G]ain realized on repayment of a borrowing will be attributed first to foreign currency gain (by calculating the difference between the U.S. dollar value of the face amount when issued and when discharged), and only the balance will be treated as income from discharge of indebtedness. [H. Rep’t No. 99-426, 99th Cong., 2d Sess. 450–51 (1986); S. Rep’t No. 99-313, 99th Cong., 2d Sess. 461 (1986)]
Under Sec. 954, foreign currency gain is subpart F income, while COD income is not. Since subpart F income is currently taxable to U.S. shareholders, whether a taxpayer classifies income from debt forgiveness as foreign currency gain or as COD income can therefore significantly affect the taxpayer’s current tax position.
In addition, recognition of COD income may trigger unintended U.S. withholding and information-reporting obligations (e.g., taxpayers may need to report COD income on Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, or Schedule M of Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations). In particular, because the regulations treat the forgiveness of debt by a U.S. creditor as a deemed payment from the U.S. creditor to the foreign debtor, the creditor may have a withholding tax obligation if the deemed payment is U.S.-source and the debtor has control or custody of assets of the debtor that it may withhold (Regs. Sec. 1.1441-2(d)(2)). Similarly, a forgiveness of debt by a foreign creditor may trigger a withholding obligation for a U.S. debtor (see Field Service Advice 200006003 (capitalization of debt triggered constructive payment of accrued interest to foreign parent-creditor for purposes of the U.S. withholding tax)). Moreover, while it is unclear how the law sources COD income, some cases hold that COD income recognized on the repurchase of debt by a foreign debtor is U.S.-source income where the creditor is a U.S. person and other indicia of U.S. nexus exist (see, e.g., Corporación de Ventas de Salitre y Yoda de Chile, 44 B.T.A. 393 (1941), rev’d on other grounds, 130 F.2d 141 (2d Cir. 1942) (repurchase gain deemed U.S.-source where indenture trustee was based, and debt was purchased and sold, in the United States); but see 1992 WL 1354851 (the IRS notes in an unnumbered field service advice that the source of COD income is unclear)).
Debtors and creditors must also consider whether any debt restructuring triggers withholding or reporting obligations under the Foreign Account Tax Compliance Act (FATCA), P.L. 111-147. FATCA imposes a 30% gross basis tax on U.S.-source investment income paid to foreign entities and arguably applies where a discharge of debt results in a constructive (or actual) payment of income (such as accrued interest or COD income).
In addition, exactly how foreign debtors should apply the insolvency exception remains uncertain. Specifically, it is unclear whether a foreign debtor must include its worldwide assets or only its assets connected with a U.S. trade or business. Obviously, this could have a significant impact on whether the foreign debtor is insolvent and, in turn, whether it may exclude any of its COD income from its gross income.
A cross-border debt restructuring may also directly affect U.S. shareholders of foreign companies. For example, the U.S. shareholder may have to increase its pro rata share of subpart F income from its debtor-subsidiary controlled foreign corporation (CFC) if the CFC previously deducted from its subpart F income interest accrued on a debt obligation that is discharged at a discount (see, e.g., Letter Ruling 9729011 (tax benefit rule requires recapture of subpart F income that is reduced by interest deduction that goes unpaid because of debt forgiveness)). However, COD income is not subpart F income, even though a CFC must take into account COD income in calculating its earnings and profits. Thus, COD income may affect a U.S. shareholder’s foreign tax credit calculation and any other relevant attributes that are based on the CFC’s earnings and profits (Sec. 952(c)).
Finally, creditors and debtors contemplating the cancellation of debt in a cross-border situation should assess whether COD income constitutes “other income” under an applicable tax treaty. Generally, the “other income” article within an income tax treaty or convention addresses the treatment of income not otherwise expressly mentioned in the treaty (see, e.g., Article 21 of the U.S.–Australia income tax treaty (1982)). The provision may state that such income is taxable only in the residence country unless the income has its source in the United States, is effectively connected to a U.S. permanent establishment of the foreign resident, or both. Income tax treaty provisions generally provide relief from double taxation and for potential reduction or elimination of withholding tax imposed on certain types of cross-border payments, and the “other income” article may provide relief in the event COD income recognized by a foreign person is otherwise subject to U.S. income tax.
Over the past several years, many taxpayers have considered restructuring debt obligations involuntarily or to affirmatively use their leveraged structure. These transactions may trigger unanticipated income tax consequences to the debtor or the creditor and should be carefully analyzed by tax professionals to identify all potential exposure that may result. What may otherwise appear to be a harmless way to address a troubled debt obligation may trigger a significant current tax liability and potential tax reporting obligations that could be mitigated with some planning.
Mindy Tyson Weber is a senior director, Washington National Tax, for McGladrey LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with McGladrey LLP.