Treatment of Intercompany Debt in a Reorganization

Suppose Corporation B lends $25,000 to Corporation A. Later, A and B merge under state law, in a transaction that qualifies as an A reorganization. In the merger, B obtains all of A's assets and assumes A's $25,000 debt. B cannot owe itself money; therefore, the debt is extinguished. As a result, will A have to realize the extinguishment of the debt as cancellation of debt (COD) income? Will B have any tax consequences? The answers to these questions can be surprising and can vary depending on whether the transaction also qualifies as a D reorganization or occurs between members of a consolidated group.

As a base case, suppose the two corporations do not join in filing a consolidated return and the merger of A and B does not qualify as a D reorganization. A similar situation was addressed in Rev. Rul. 72-464. That ruling involved Corporation X, which acquired $25,000 face amount of notes from (then-unrelated) Corporation Y for $20,000. Later, in an unrelated transaction, Y merged into X in a transaction that qualified as an A reorganization. By operation of state merger law, X received all of Y's assets and assumed all of Y's liabilities, including the notes (which were worth $25,000 at the time of the merger). The IRS considered whether X or Y would recognize income as a result of an extinguishment of the notes.

Under Sec. 361(a), a corporation that is a party to a reorganization will not recognize gain or loss if it exchanges its properties solely for stock or securities of a second corporation that is also a party to the reorganization. Sec. 357(a) extends the Sec. 361(a) nonrecognition provisions to include assumptions of the transferring corporation's debt by the transferee corporation. In Rev. Rul. 72-464, the IRS questioned whether Y's transfer of its assets to X should be viewed as a transfer in settlement of its debt to X, and if so, whether that transfer could fall outside of Sec. 361.

To determine whether the extinguishment of Y's debt to X in the merger should be part of the merger (and therefore protected under Sec. 361), the IRS looked to Kniffen, 39 TC 553 (1962). Kniffen was engaged in a real estate business through a sole proprietorship. Through his proprietorship, he owed approximately $45,000 to a controlled corporation. Kniffen transferred the assets of his sole proprietorship, which had a basis of approximately $286,000, to the controlled corporation in a Sec. 351 transaction. The controlled corporation assumed approximately $294,000 of liabilities, including Kniffen's $45,000 debt. Because the controlled corporation could not owe itself money, the debt was effectively extinguished. The IRS examined Kniffen's return and concluded that he realized COD income as a result of the extinguishment of the $45,000 debt. Kniffen brought suit.

The Tax Court reasoned that the controlled corporation's assumption of Kniffen's debt extinguished the $45,000 debt as a matter of law. The debt could not have been considered extinguished if the corporation had not assumed it. Further, because assumptions of debt in connection with a Sec. 351 transfer are governed by Secs. 351 and 357, the tax consequences of Kniffen's incorporation were determined under those sections. Kniffen was subject to tax solely on the amount by which the total liabilities assumed exceeded the transferred assets' basis, as required by Sec. 357(c)(1).

Applying the Kniffen rationale to Rev. Rul. 72-464, the IRS concluded that Y's $25,000 face amount of notes could not have been extinguished in the merger, unless X assumed the notes. Under Secs. 361 and 357, Y recognized no gain or loss on the transfer of assets in satisfaction of the notes. However, the IRS ruled that X recognized gain to the extent of the difference between the notes' $25,000 face amount and X's $20,000 basis in the notes. Y's notes were extinguished, but X recognized income.

Under the original facts, the A and B merger qualifies as an A reorganization. Applying Rev. Rul. 72-464, A recognizes no gain on the transfer of assets to satisfy its $25,000 debt to B. B recognizes no gain because there is no difference between the debt's amount and B's basis in the debt.

A different result might occur if the merger also qualifies as a D reorganization. In Rev. Rul. 75-161, the IRS ruled that a statutory merger of two corporations with a common 90% shareholder would also qualify as a D reorganization. If the merger qualifies as a D reorganization, the income tax consequences might be different. In certain transactions, including a D reorganization, under Sec. 357(c)(1)(B) a transferor corporation will recognize gain to the extent that total liabilities assumed by the transferee corporation exceed the aggregate tax basis of the transferred assets.

In the original facts, suppose that one individual owns 100% of the shares of both A and B. A has assets with a $15,000 basis. In addition to the $25,000 debt owed to B, A has other liabilities totaling $75,000. A merges into B. Under Rev. Rul. 75-161, A's merger into B is a D reorganization. Under Sec. 357(c)(1)(B), A recognizes $85,000 of taxable income, the amount by which its total liabilities assumed exceed its aggregate tax basis in the transferred assets.

Yet a third conclusion will result if A and B are members of a group of corporations that file a consolidated return. The consolidated-intercompany-transaction rules include special provisions for transactions involving debt instruments of consolidated group members. Regs. Sec. 1.1502-13(g) governs the tax consequences of a group member's debt instrument held by another consolidated group member, and of debt instruments acquired from outside the group by a group member. Under certain circumstances, the debt will be treated for all Federal income tax purposes as satisfied immediately before the transaction. In addition, Regs. Sec. 1.1502-80(d) provides that Sec. 357(c) will not apply to a transaction between consolidated group members.

Suppose that in the original facts Corporation C owns all stock in A and B and the three corporations file a consolidated return. In the open market, B purchases A's $25,000 debt for $20,000. Sec. 1.1502-13(g)(4) treats A as satisfying the $25,000 debt for $20,000 (B's basis in the purchased debt). Thus, as soon as B purchases the debt, A recognizes $5,000 COD income ( B recognizes no gain because there is no difference between the amount of the debt and its basis). A would then be treated as if it reissued the $25,000 face amount of the note for $20,000. The note would be an original issue discount obligation.

Later, in an unrelated transaction, A merges into B. A is treated as satisfying the debt for its adjusted issue price ($20,000, plus interest accrued but unpaid since the deemed reissuance). B is treated as receiving payment for the accrued but unpaid interest. Finally, even though the merger of A into B will be a D reorganization, A will not recognize gain under Sec. 357(c), due to Regs. Sec. 1.1502-80(d).

From Jim Tansey, CPA, Chicago, IL