Interest Deductions for Bankrupt Corporations

At the end of a business cycle, the tax laws related to bankruptcy play a critical role for troubled companies that must restructure balance sheets or liquidate assets. Often, general tax rules do not apply and are superseded by arcane rules that attempt to recognize the economic reality for each troubled company. Under chapter 11 of the Bankruptcy Code, a company can petition a bankruptcy court to continue its operations by restructuring its debt and equity under the aegis of bankruptcy laws. The troubled company's reorganization almost always results in the reduction of unsecured creditors' claims.

A practical issue that arises for a company in bankruptcy is whether post-petition interest is deductible. Additional interest deductions may lower taxable income, if any, or increase a company's net operating loss (NOL). This issue of how to treat interest deductions for corporate debt in bankruptcy was most recently addressed by the bankruptcy court in In re Dow Corning Corp., 270 BR 393 (DC MI, 2001).

Interest Deductions

Generally, Sec. 163 allows taxpayers to deduct "all interest paid or accrued within the taxable year of indebtedness." According to Sec. 7701(a)(25), the term "paid or accrued" means "according to the method of accounting upon the basis of which the taxable income is computed." Therefore, the proper time for deducting interest depends on the taxpayer's method of accounting.

Because of Sec. 448, most C corporations are accrual-method taxpayers. Under the accrual method (as set forth in Sec. 461(h)), a taxpayer incurs a liability when it meets the "all events test," under which "the fact of liability and the amount of such liability can be determined with reasonable accuracy." As a general rule, the all-events test is not met earlier than when economic performance occurs. For interest, economic performance occurs with the passage of time. Therefore, interest deductions are appropriate in the year in which the taxpayer accrues interest, rather than the year it pays the interest.

The IRS's central and most successful argument in denying a corporate taxpayer in bankruptcy an interest deduction is its claim that the "fact of the liability" has not occured. In other words, the interest deduction is not fixed and determinable. The IRS supports this point by asserting that the interest is contingent because the corporate taxpayer is insolvent. However, a company's solvency is not a requirement of Sec. 163. Further, as discussed in Dow Corning, the legislative history of Sec. 163 "cannot be justified as reflecting the manifest will of Congress" imposing some kind of solvency requirement. However, prior case law, in certain circumstances, has held that solvency is a determining factor in whether a taxpayer can deduct accrued interest.

Prior case law. In In re Continental Vending Machine Corporation, DC NY, 11/19/76, a taxpayer in a Chapter 10 bankruptcy proceeding claimed deductions for interest on debt to both its secured and unsecured creditors. The IRS took the position that deductions for interest on secured creditors' claims was proper, provided that a taxpayer takes a deduction in the year it actually accrued the interest. As to deducting interest on unsecured claims, the IRS contended that because of the debtor's financial condition, "full payment of principal let alone interest will not be made to...general unsecured claims." Therefore, the IRS asserted that deductions for interest on the unsecured claims were improper and the court concurred.

The court stated in "either circumstance—no actual liability for the interest until the happening of a future event or the economic improbability of payment—furnishes grounds for disallowing the accrual and deduction of interest on unsecured claims." It cited Burlington-Rock Island R.R. Co., 321 F2d 817 (5th Cir. 1963) (taxpayer's duty to pay statutory interest was contingent on its financial situation, and no legal obligation could arise under the agreement until the occurrence of that contingency) and Prudence Securities Corp., 135 F2d 340 (2d Cir. 1943) (a taxpayer was denied a deduction on accrued interest from bonds because the interest and principal were to be paid only in the unlikely event of (1) a default and (2) after the principal and interest had been paid on an earlier series of bonds) to sustain its conclusion.

The court in Continental Vending denied the taxpayer's reliance on Fahs v. Martin, 224 F2d 387 (5th Cir. 1955), in support of deducting interest on accrued debt. In Fahs, a railway corporation filed a bankruptcy petition, claiming that it was insolvent and unable to meet its bond obligations. In case of a default on the bonds, the taxpayer was obligated to pay penalty interest on the overdue interest. It was this penalty interest that the taxpayer sought to accrue, and which the IRS disallowed. The Fifth Circuit ruled that improbability of payment was not a ground for disallowing a future expense; as long as a valid obligation existed, the fact that an interest claim may be subordinated to other claims did not prevent deduction on an accrual basis.

The court reached a similar conclusion in Zimmerman Steel Co., 130 F2d 1011 (8th Cir. 1942) ("where interest actually accrues on a debt of a taxpayer in a tax year the statute plainly says he may deduct it. That he has no intention or expectation of paying it, but must go into bankruptcy as this taxpayer was obliged to do, cannot of itself justify denial of deduction"), and Rev. Rul. 70-367 ("doubt as to the payment of such interest is not a contingency of a kind that postpones the accrual of the liability until the contingency is resolved").

In denying the taxpayer's claims, the court in Continental Vending first noted that Fahs was distinguishable because the debt was a secured obligation. Further, the court noted that "[t]he Fahs case is out-of-step" with cases such as Schlude, 372 US 128 (1963), and American Auto. Ass'n, 367 US 688 (1961) (deferral of taxable income cases), "espousing the 'all events test,' which is designed to ensure that the accrual-based taxpayer will not deduct expenses that might never occur"; see Mooney Aircraft, Inc., 420 F2d 400 (5th Cir. 1969).

In re Dow Corning. In Dow Corning, the debtor, an accrual-method corporate taxpayer, deducted in prior-year tax returns interest incurred on post-petition interest on bank debt and other capital borrowings (institutional debt). The interest on the institutional debt was calculated based on the interest rates specified in the underlying loan agreements.

The IRS subsequently audited the returns. In the midst of the audit, Dow Corning submitted a claim for additional amounts of post-petition interest that it did not include in the prior-year returns. The additional interest claimed was attributable to trade payables, forward contracts, swaps and various settlement agreements (trade debt). Unlike the interest on institutional debt, the interest on the trade debt was not based on contractual provisions, but rather a Federal judgment rate pursuant to Bankruptcy (Bkr.) Code Section 726(a). Both the institutional debt and the trade debt were unsecured.

The IRS disallowed the interest deductions for the institutional debt and rejected the interest claims on the trade debt. Dow Corning appealed that decision to the Federal bankruptcy court, where both Dow Corning and the IRS immediately filed for summary judgment.

Among other points, the IRS argued that the apparent inability to pay an obligation meant that the obligation had not accrued. The court summarily rejected the proposition that an unconditional payment obligation became contingent (i.e., conditional) in the event the obligor "went broke" by stating, "solvency is irrelevant to the question of whether a debt is contingent." Because Sec. 163's statutory language and legislative history do not identify solvency as a condition to take an interest deduction, the court dismissed previous court rulings that suggest solvency is an appropriate consideration in determining a taxpayer's right under Sec.163 to deduct accrued expenses; see, e.g., Continental Vending; Mooney Aircraft; Guardian Inv. Corp. v. Phinney, 253 F2d 326 (5th Cir. 1958); and In re Southwestern States Mktg. Corp., 179 BR 813 (1994), aff'd, 82 F3d 413 (5th Cir. 1996).

The court acknowledged that if a "taxpayer is hopelessly insolvent, then it does seem a bit odd to nevertheless permit the expenses to be deducted." (The same reasoning underlies the Continental Vending conclusion.) However, the court noted countervailing factors that nullify this argument, including:

• The complexity of defining the nature and extent of insolvency; and
• The burden and cost of enforcing solvency requirements would not be worthwhile.

Further, the court believed that various Code provisions indicated that Congress had not intended to make solvency a pre-condition to expense accrual. If the IRS's insolvency argument were accepted, the court could find that Secs. 163(j) (interest limits based on certain debt-to-equity ratios), 166 (worthless debt deduction), 61(a)(12) (cancellation of debt (COD) income) and 108(a)(1)(B) (the insolvency exception from COD) would be superfluous. Finally, the court did not see any inconsistency (or relevance for that matter) in the Fifth Circuit's decision in Mooney Aircraft, suggesting that disregarding a taxpayer's ability to pay in assessing the validity of a deduction for accrued interest was inconsistent with Schlude and American Auto. Ass'n.

For these reasons, the court rejected the argument that Sec. 163 applied only to solvent taxpayers, citing Fahs, Zimmerman Steel and Rev. Rul. 70-367. Thus, unlike the holding in Continental Vending, Dow Corning permits interest deductions for unsecured debt for insolvent companies.

Other Limits on Interest

Although the bankruptcy court in Dow Corning ruled that a taxpayer could deduct interest despite insolvency, Dow Corning was not entitled to deduct all the interest claimed. The IRS successfully argued that Bkr. Code Section 726(a) denied interest deductibility for Dow Corning's trade debt.

Dow Corning deducted the interest on the trade debt under Bkr. Code Section 726. Bkr. Code Section 726(a) applies in a liquidation when creditors are entitled to post-petition interest only if the estate is sufficiently solvent to pay such interest. The IRS argued that the right to post-petition interest was contingent, and not fixed, because Dow Corning's solvency was a necessary condition to make a distribution. The court agreed, relying on Burlington-Rock Island R.R. Co. In a chapter 7 bankruptcy proceeding, the Fifth Circuit in In re West Texas Marketing, 54 F3d 1194 (1995), reached a similar decision that unsecured interest was not deductible under Bkr. Code Section 726(a) due to a contingency.

The court analyzed the institutional debt under different standards. Because interest on this debt was derived under contractual provisions, the issue was whether that provision impinged on a creditor's contractual right for post-petition interest in a chapter 11 bankruptcy. The IRS argued that Continental Vending, which assumed a paradigm for distribution of estate assets in a liquidation proceeding (now codified in Bkr. Code Section 726(a)), applied with equal force to reorganization. However, the court disagreed. Thus, it concluded that Bkr. Code Section 726(a) did not supplant or otherwise invalidate Dow Corning's creditor's chapter 11 contractual right to post-petition interest on the institutional debt.

Conclusion

The Bankruptcy Court's decision in Dow Corning emphasized the discrepancies in the appellate-level courts on the deductibility of interest for companies in a chapter 11 bankruptcy. This conflicting authority may permit taxpayers some latitude in determining the appropriate treatment for deducting interest. However, this decision is far from a panacea; bankruptcy law may deny interest deductions based on other grounds (such as Bkr. Code Section 726(a)). Additionally, although a taxpayer may deduct interest on unsecured debt, forgiveness of the interest would also create COD income for a taxpayer, which in many cases will cancel the benefits derived from the interest deduction. However, because each troubled company in bankruptcy has unique facts and circumstances, a corporate taxpayer may still benefit when the additional interest deduction results in a carryback refund, or the taxpayer elects to reduce the tax basis in assets rather than decrease its NOL.

From William W. Potter, CPA, Boston, MA