Wednesday, January 13, 2010 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific

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1 presents Cancellation of Indebtedness Income: Navigating Multi-State Tax Challenges Strategies for State Non-Conformity, Allocation and Apportionment Policies A Live 110-Minute Teleconference/Webinar with Interactive Q&A Today's panel features: Michael Jacobs, Partner, Reed Smith, Philadelphia Brian Sullivan, Director, Multi-State Tax Services, Deloitte Tax, Atlanta Scott Gilefsky, Senior Manager, State and Local Tax Practice, Ernst & Young, Boston Steve Wlodychak, Principal, Transaction Advisory Services/State and Local Tax Practice, Ernst & Young, Los Angeles Wednesday, January 13, 2010 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific You can access the audio portion of the conference on the telephone or by using your computer's speakers. Please refer to the dial in/ log in instructions ed to registrations. CLICK ON EACH FILE IN THE LEFT HAND COLUMN TO SEE INDIVIDUAL PRESENTATIONS. If no column is present: click Bookmarks or Pages on the left side of the window. If no icons are present: Click View, select Navigational Panels, and chose either Bookmarks or Pages. If you need assistance or to register for the audio portion, please call Strafford customer service at ext. 10

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3 State Cancellation Of Indebtedness Income: Navigating Multi-State Tax Challenges Webinar Jan. 13, 2009 Steve Wlodychak Ernst & Young Michael Jacobs Reed Smith Brian Sullivan Deloitte Tax Scott Gilefsky Ernst & Young

4 Today s Program Federal CODI Rules, In Concept, slides 3 through 23 (Steve Wlodychak) State CODI Ramifications, In Concept, slides 24 through 46 (Michael Jacobs) Federal Sect. 108(i) Drill-Down, slides 47 through 55 (Brian Sullivan) State Sect. 108(i)-Related Issues Drill-Down, slides 56 through 73(Brian Sullivan and Scott Gilefsky) Related Tax Accounting Issues, slides 74 through 79 (Scott Gilefsky) 2

5 Federal CODI Rules, In Concept 3

6 Cancellation Of Debt (COD), In General Generally, under IRC 61(a)(12), a taxpayer must recognize income upon a discharge of its indebtedness (COD income) Amount of COD income is generally: The excess of the principal amount (or adjusted issue price) of the debt over The fair market value of any consideration paid in exchange for the debt If the debt has original issue discount (OID) (i.e., it was issued for an amount less than its stated redemption price), then the COD income amount is measured by the adjusted issue price of the debt Treas. Reg (c)(2)(ii) 4

7 COD Income Related-Party Acquisition Of Debt Instrument Related-party acquisitions Under IRC 108(e)(4), if a party related to the debtor purchases debt issued by the debtor at a discount from an unrelated creditor, it is treated as if the debtor repurchased its own debt at a discount, and COD income consequences may result Definition of related party for this purpose: Related parties are determined under the rules of IRC 267(b), 707(b)(1) and 414, and require greater than 50% (direct and indirect) ownership 5

8 COD Income Related-Party Acquisition Of Debt Instrument (Cont.) IRC 108(e)(4): If a person related to the debtor acquires the debt instrument (DI), debtor is deemed to have acquired (i.e., discharged) it Debtor is deemed to pay an amount equal to the related party s basis in the DI or, depending on the circumstances, the DI s FMV The amount deemed paid will equal the DI s FMV if the related party: Acquired the DI > Six months before becoming related Did not purchase the DI (i.e., generally took a carryover basis in the DI), or Had a principal purpose of tax avoidance 6

9 Assumptions Example Of COD Income Computation D Corp. is a holding company that owns 100% of OPCO D Corp. proposes to restructure its $270 million 10% subordinated notes effective Sept. 1, 2008, by issuing i to the existing noteholders in exchange for their existing notes: (a) $28 million in cash (b) New 7-year notes having a principal amount of $35 million (c) Preferred stock having a fair market value of $25 million (d) New D Corp. common stock representing 100% of the D Corp. outstanding common stock 7

10 Example Of COD Income Computation (Cont.) Assumptions (cont.) Under the plan, the pre-existing existing stock of D Corp. will be cancelled, and new senior debt of $50 million will replace the existing bank debt of $20 million At the time of the restructuring, the enterprise value of D Corp. and its subsidiary is $230 million, and its non-interest bearing short-term liabilities are $30 million 8

11 Example Of COD Income Computation (Cont.) D Corp. should obtain an appraisal or fairness opinion to establish its enterprise value and the value of the new equity to be issued The value of the common stock is generally the enterprise value less long-term liabilities less the value of other equity Enterprise value $230 Bank Debt (50) New Notes (35) Preferred Stock (25) Value of common $120 9

12 Computation of COD income Example Of COD Income Consideration paid to noteholders Computation (Cont.) FMV Cash $ 28 New debt 35 (New principal balance) Preferred stock 25 (Fair market value) Common stock 120 Total consideration $ 208 Principal amount of old debt 270 COD income amount $ 62 (Enterprise value less long-term debt and value of other equity) 10

13 COD Income Recognition Exceptions IRC 108(a) Two common situations in which taxpayers are entitled to relief from the ordinary rules requiring recognition of COD income are: Title 11 case (bankruptcy) IRC 108(a)(1)(A) When there is a discharge of debt in bankruptcy pursuant to the bankruptcy plan of reorganization, the entire amount of such COD income is excluded from income Insolvency IRC 108(a)(1)(B) If the discharge occurs in an out-of-court restructuring or not pursuant to a plan of reorganization in a Title 11 case, the COD income amount is excluded from income only to the extent the debtor is insolvent 11

14 COD Income Recognition Exceptions (Cont.) Determination of insolvency Under IRC 108(d)(3), insolvency of the debtor is determined immediately prior to the discharge and is measured by the amount of the debtor s liabilities over the fair market value of the debtor s assets See Merkel v. Comm r, 109 T.C. 463 (1997) Contingent liabilities should not be included in determining insolvency unless it can be shown that the taxpayer will likely be called upon to pay the liability 12

15 COD Income Attribute Reduction Under IRC 108(b), the cost of utilizing the income recognition exceptions is that the debtor s tax attributes must be reduced to the extent of the excluded COD income in the following order: Net operating losses (NOLs) and NOL carryovers, without regard to any limit in use by IRC 382 (annual limitation after change of ownership) General business credits Minimum tax credits Capital loss and capital loss carryovers Tax basis in property Passive activity loss and credit carryovers Foreign tax credit carryovers 13

16 COD Income Attribute Reduction (Cont.) Attributes other than credits are reduced on a dollar-for-dollar basis by the amount of the COD income excluded Credits are reduced at a rate of 33 1/3 for each dollar of excluded COD income Excluded COD in excess of the debtor s attributes disappears (i.e., it does not reduce future attributes ttib t and dis not tincluded din income) Black hole COD income 14

17 COD Income Attribute Reduction (Cont.) Timing of attribute reduction General rule under IRC 108(b)(4) is that attributes are reduced after the determination of tax for the taxable year of the discharge Under IRC 1017(a), reduction of tax basis in property occurs on the first day of the taxable year following the year of discharge Under IRC 1017(b)(2), basis in property may not be reduced below the debtor s aggregate liabilities measured immediately after the discharge. This limitation does not apply if the debtor elects to reduce basis before other attributes under IRC 108(b)(5) 15

18 COD Income Attribute Reduction (Cont.) Election to reduce tax basis of depreciable property first Under IRC 108(b)(5), taxpayers subject to the attribute reduction rules may elect to first reduce the tax basis of depreciable property The following non-depreciable assets may be treated as depreciable property for purposes of this election (IRC 1017(b)(3)): Any real property p treated as inventory Stock of a subsidiary that files a consolidated return with the debtor, but only to the extent the subsidiary reduces the tax basis of its depreciable property p Basis in partnership interests to extent of the partner s proportionate share of depreciable property in the partnership, but only to the extent the partnership preduces the tax basis in its depreciable propertyp 16

19 COD Income Attribute Reduction (Cont.) Election to reduce tax basis of depreciable property first Election is beneficial where taxpayer anticipates that pre-change NOLs available in post-change years will exceed depreciation deductions Election is not beneficial if the pre-change NOLs that survive attribute reduction are significantly limited under IRC 382 Ownership change may occur as a result of the restructuring, triggering gthe application of IRC 382 However, debtor needs to consider special exceptions to the IRC 382 annual limitation that are available in Title 11 bankruptcy cases IRC 382(l)(5) No 382 limitation but potential for zero limitation IRC 382(l)(6) Election out of (l)(5) and increased enterprise valuation based on converted debt 17

20 COD Income Attribute Reduction Consolidated Groups If the debtor is a member of a consolidated group, Treas. Reg requires reduction of consolidated attributes of the other members as follows beginning with the highest tier debtor having excluded COD income 18

21 COD Income Deferral Election IRC 108(i) IRC 108(i) 10-year COD income deferral for reacquired indebtedness Enacted as part of the American Recovery and Reinvestment Act of 2009 Allows taxpayers to elect to defer, until 2014, recognition of COD income on debt instruments reacquired in 2009 or 2010 If election is made with respect to an applicable DI, the taxpayer would then recognize the income ratably over five years from

22 COD Income Deferral Election IRC 108(i) (Cont.) Deferral also applies to debt instruments purchased by a related party and debt exchanged for other outstanding debt, including a deemed exchange arising from a significant modification If a debt instrument replaces the debt instrument that had COD income, any OID up to the amount of the COD income would be deferred and recognized ratably over the five years The provision applies to certain debt-for-debt exchanges, equity-fordebt exchanges, debt repurchases for cash, contributions of debt instruments to capital, and outright debt forgiveness 20

23 COD Income Deferral Election IRC 108(i) (Cont.) If election to defer is made with respect to an applicable instrument, the resulting COD income can never be excluded from gross income under the bankruptcy or insolvency exceptions If the taxpayer liquidated or sold all of its assets (including through a Chapter 11 proceeding), recognition of the deferred items would be accelerated 21

24 Disclaimer Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited located in the US. The views expressed by panelists in this presentation are not necessarily those of Ernst & Young LLP. 22

25 Circular 230 Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. 23

26 State CODI Ramifications, In Concept 24

27 State Tax Issues Relating To COD State income tax Exclusions from income Attribute reduction Income Allocation and apportionment Oh Other state taxes Non-income-based business entity taxes Sl Sales and use taxes Real estate transfer taxes Successor liability 25

28 State Income Tax Basic Framework Most states adopt bankruptcy and insolvency exclusions under IRC 108 and attribute reduction rules of IRC 1017 Federal taxable income adopted as starting point for determining state taxable income, or IRC is incorporated by reference in state law (may not include all amendments to IRC) Significant differences exist with regard to adoption of IRC 108(i) Considerable uncertainty arises when applying IRC concepts in the state context 26

29 State Income Tax Exclusions From Income Some states do not follow all federal exclusions under IRC 108(a) California i does not currently follow the exclusion for qualified principal residence indebtedness. CA Rev. & Tax Code (b) Pennsylvania does not adopt any IRC 108 exclusions for personal income tax purposes 27

30 State Income Tax Exclusions From Income (Cont.) If a specific IRC 108(a) exclusion claimed for federal purposes is not available at the state level, consider alternatives: Bankruptcy. This exclusion is incorporated in federal bankruptcy code, as well as IRC 108(a). 11 U.S.C. 346(j)(1) Insolvency Contingent liabilities. If a liability does not yet exist, its cancelation cannot produce income Purchase price adjustment. If cancelled llddbi debt is purchase money indebtedness, then its cancellation may be able to be characterized as a purchase price reduction, resulting in a reduction of basis 28

31 State Income Tax Bankruptcy Exclusion All states allow an exclusion from income for debt cancelled pursuant to a bankruptcy plan, regardless of whether they adopt IRC 108. See 11 U.S.C. 346(j)(1) ) For purposes of any State or local law imposing a tax on or measured by income, income is not realized by the estate, the debtor, or a successor to the debtor by reason of a discharge of indebtedness in a case under this title, except to the extent, if any, that such income is subject to tax under the Internal Revenue Code of The bankruptcy exclusion applies only to indebtedness of specific entity (or entities) subject to jurisdiction of the Bankruptcy Court There is a need for caution when the bankruptcy exclusion does not apply to all entities participating in a state combined return 29

32 State Income Tax Insolvency Exclusion In combined-filing states, t is insolvency determined d at the entity or group level? By analogy to the federal consolidated return rules, determination should be at a separate entity level Does a separate entity determination make sense when group is being treated as a single entity for apportionment purposes? 30

33 State Income Tax Cancellation Of Inter-Company Indebtedness Generally, cancellation of indebtedness between two entities that file as part of the same consolidated return is a deferred recognition event for federal income tax purposes. See Treas. Reg (g) Some states eliminate income from intercompany transactions within combined group. e.g. Alabama, Maine Other states follow federal consolidated return rules. e.g: California. i ClCd Cal. Code Regs (a)(2) 5 1( Illinois. Ill. Admin. Code (a)(1) Massachusetts. 830 CMR 63.32B.2(c)(5) ()() West Virginia. W.Va. Code d(e) Some states do not provide for elimination or deferral of income from inter-company transactions. eg e.g. New York, separate reporting states. 31

34 State Income Tax Conformity To Federal Attribute Reduction Rules Generally, states adopt federal attribute reduction rules of IRC Bankruptcy Code has its own attribute reduction rule, referring back to the IRC. See 11 U.S.C. 346(j)(2) Whenever the Internal Revenue Code of 1986 provides that the amount excluded from gross income in respect of the discharge of indebtedness in a case under this title shall bee applied to reduce the tax attributes of the debtor or the estate, a similar reduction shall be made under any State or local law imposing a tax on or measured by income to the extent such State or local law recognizes such attributes. Such state or local law may also provide for the reduction of other attributes to the extent that the full amount of income from the discharge of indebtedness has not been applied. 32

35 State Income Tax State Variances From Federal Attribute Reduction Rules Some states have their own attribute reduction rules. For example: Alabama. Only NOLs and basis of depreciable property. Ala. Code (2) Idaho. No attribute reduction outside of bankruptcy. Idaho Admin. R New Jersey. No reduction of NOLs. NJ State Tax News, Vol. 25, No. 4 (Dec. 1, 1996) 33

36 State Income Tax Attribute Reduction (Net Operating Losses) In some states, any reduction to state NOL carryforward must be computed on a post-apportionment basis. For example: California. Appeal of Wilshire Restaurant, SBE Case No , 2003 (unpublished) Georgia. Ga. Comp. R. & Regs (5)(c)1 Illinois. 35 Ill. Comp. Stat. 5/207(c) The apportionment percentage applied to the reduction of state NOL carryforwards in post-apportionment states generally is based on the factors for the year of discharge In other states, NOLs are carried forward (and reduced) on a preapportionment basis, e.g. Massachusetts, New Jersey and New York 34

37 State Income Tax Attribute Reduction (Net Operating Losses), Cont. State NOL carryforward can differ significantly from federal NOL carryforward Differences in taxable income computations Some states do not follow IRC 381 or 382 Some states do not allow for the carryback of NOLs 35

38 State Income Tax Attribute Reduction (Basis of Depreciable Assets) There can be significant differences between the tax basis of depreciable assets, for federal and state income tax purposes Differences in federal and state depreciation regimes, e.g. not all states follow federal bonus depreciation regimes Most states have not adopted federal consolidated return rules, including the look-through basis reduction rule of Treas. Reg (a)(3) States generally follow a federal election under IRC 108(b)(5) to apply attribute reduction first to basis of depreciable property. See, e.g., Or. Rev. Stat (a) 36

39 State Income Tax Allocation Vs. Apportionment Generally, business income is subject to apportionment, while nonbusiness income is directly allocated to a single state UDITPA definition of business income: Income arising from transactions and activity in the regular course of the taxpayer'strade trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property p constitute integral parts of the taxpayer's regular trade or business operations. 37

40 State t Income Tax Allocation Vs. Apportionment (Cont.) State definitions differ. Most definitions include transactional and functional components Transactional ltest: t Does COD income arise from a transaction ti or activity in the regular course of a taxpayer s trade or business? Functional test: Is COD income derived from property p acquired, managed and disposed of as an integral part of a taxpayer s regular trade or business operations? Some states have drafted the functional component of their definition to apply whenever the acquisition, management or disposition of the property constitute integral parts of the taxpayer's regular trade or business operations 38

41 State Income Tax Allocation Vs. Apportionment (Cont.) See Agricultural Building Company v. Wisconsin Department of Revenue, Wisconsin Tax Appeals Commission, No. 89-I-402 (October 9, 1990) Treating COD income as business income may present constitutional issues Was indebtedness incurred in a period when the taxpayer lacked substantial nexus with the state? Was indebtedness incurred as part of the same unitary business conducted by taxpayer in year of discharge? 39

42 State t Income Tax Sales Factor Is COD a receipt, for purposes p of computing the sales factor? Should it matter whether COD is excluded from income? Should it matter whether the debtor enjoyed an increase in assets as a result of the discharged debt? How should COD be sourced, for sales factor purposes? Treated as income derived from an intangible property right and sourced to state of commercial domicile? Sourced based on location of costs of performance? (What costs?) For federal purposes, debt-discharge income is sourced based on geographic tracing of use of debt proceeds. See Big Hong Ng v. Commr., T.C. Memo

43 State Income Tax Sales Factor (Cont.) Some states specifically exclude COD from sales factor. See, eg e.g., Florida TIP #09C01-03 (July 8, 2009) In other states, it may be possible to argue that including COD in the sales factor would be distortive i under UDITPA 18 For purposes of the Texas margin tax, COD is included in the sales factor and sourced to the state of legal domicile. Tex. Admin. Code tit. 34, 3.591(e)(5) Some states exclude inter-company debt cancellation from computation of sales factor. See, e.g., California Code Regs (a)(5)(A)1 41

44 Non-Income-Based Taxes Gross receipts-based taxes Michigan Business Tax COD included in modified gross receipts. MBT FAQ B21 Ohio Commercial Activity Tax COD included in gross receipts. Ohio Rev. Code (F) Texas franchise (margin) tax Based on total revenue, which is derived from federal gross income (including COD). Tex. Tax Code (c) Washington B&O tax Unclear Book income-based taxes Pennsylvania capital stock/franchise tax COD included in computing income per books. Shawnee Development, Inc. v. Commw., 799 A.2d 882 (PA Commw. Ct. 2002) Do IRC 108 exclusions apply, for purposes of non-income based taxes? 42

45 Sales And Use Tax State sales and use taxes generally apply to receipts from sales or other transfers of tangible personal property Receipts may include cancellation of indebtedness of the transferor, e.g: California Sales Tax Counsel Ruling No (Jan. 14, 1972). Commw. v. Sylvan Seal Milk, Inc., 77 Dauph. 54 (Pa. Common Pleas Ct. 1961). In many cases, transfers of tangible personal property in exchange for cancellation of debt will fall within state exemptions for occasional sales 43

46 Real Estate Transfer Taxes Transfer of real property in satisfaction of debt may trigger real estate transfer tax, e.g.: In the Matter of the Petition of Broadway Mall Properties, Inc., NY Div. of Tax Appeals, ALJ Determination No (Dec. 19, 1996) Some jurisdictions may provide an exemption for transfers of real property from a mortgagor to a grantor pursuant to a deed d in lieu of foreclosure or a judicial sale, e.g.: California. Cal. Rev. & Tax Code Philadelphia. Phila. Code (14) South Carolina. SC Code (13) 44

47 Successor Liability Creditor s acquisition of debtor s business assets in exchange for cancellation of debtor s indebtedness may cause creditor to be a successor responsible for debtor s pre-acquisition iti tax liabilities See, e.g., W.Va. Code St. R , defining successor as any person who directly, indirectly purchases, acquires, or succeeds to the business or the stock of goods, whether the consideration is money, property, assumption of liabilities, or cancellation of indebtedness. 45

48 Circular 230 Disclosure Any U.S. tax advice contained in this presentation was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or applicable state or local tax law provisions. These slides are intended solely for educational purposes and should not be relied upon as legal advice. 46

49 Federal Sect. 108(i) Drill-Down 47

50 Cancellation Of Debt Income Defined Cancellation of debt income (CODI) Cancellation or repurchase of debt for less than its face amount (or adjusted issue price) results in taxable CODI under IRC 61 IRC 108(e)(4) provides that purchase of debt by related party is treated as purchase by the debtor and can trigger CODI In a debt-for-debt d exchange, CODI equals the excess of the adjusted d issue price of old debt over the issue price of the new debt In a stock-for-debt dbexchange, CODI equals the excess of fh the adjusted dissue price of old debt over the FMV of the stock If old debt is contributed to capital, CODI is the excess of the adjusted issue price over the shareholder s adjusted basis in the debt 48 Copyright 2010 Deloitte Development LLC. All rights reserved.

51 Cancellation Of Debt Income General Rule Unless specifically excluded, CODI is taxable IRC 108(a) provides that CODI is generally excluded from gross income if a corporation is insolvent (to the extent of insolvency) or in Chapter 11 bankruptcy The exclusion of CODI under IRC 108(a) results in a reduction to tax attributes, subject to specific ordering rules provided by IRC 108(b) 49 Copyright 2010 Deloitte Development LLC. All rights reserved.

52 2009 ARRA: New Provision - 108(i) New IRC 108(i) Election to defer CODI inclusion i from a reacquisition iti of an applicable debt instrument (ADI) after 12/31/08 and before 1/1/11 ADI is an instrument issued by a C corporation or any other person in connection with the conduct of a trade or business CODI inclusion is deferred until 2014 and then included into gross income ratably from Copyright 2010 Deloitte Development LLC. All rights reserved.

53 Eligible Transactions A reacquisition is any acquisition of an ADI by: The debtor that issued (or the obligor under) the debt instrument, or Any person related to the debtor under IRC 108(e)(4) An acquisition includes A repurchase for cash Adebt debt-for-debt exchange (including a significant modification) Stock or partnership interest for debt A capital contribution o creating CODI under 108(e)(6), and A cancellation of debt that is not a capital contribution 51 Copyright 2010 Deloitte Development LLC. All rights reserved.

54 Making The 108(i) Election Election is irrevocable and made on an instrument-by-instrument basis (see Rev. Proc ) Protective election Election for part of the CODI Election is made on timely filed tax return (including extensions) for year in which CODI is incurred Can be an information return (i.e., made at partnership or S corp. level) Automatic 12-month extension under Treas. Reg (a) Election precludes any other election under IRC 108(a) () If CODI is deferred under IRC 108(i), it is not eligible to be excluded under IRC 108(a) (i.e., due to insolvency or bankruptcy) when included in gross income in later years 52 Copyright 2010 Deloitte Development LLC. All rights reserved.

55 Original issue discount (OID) Other Considerations If an election ect under IRC 108(i) is made to defer e CODI in a debt-for-debt exchange that results in OID, then any otherwise allowable deduction for OID on the newly issued debt is deferred and allowed as a deduction ratably over the same five-taxable-year period that the CODI is included (i.e., matches income and deductions in same periods) Acceleration of deferred CODI by certain events Death of taxpayer Liquidation or sale of substantially all of the assets Cessation of business or similar circumstances Sale or redemption of a pass-through interest 53 Copyright 2010 Deloitte Development LLC. All rights reserved.

56 Contacts Brian Sullivan Director, Atlanta (404) , This presentation contains general information only and the respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation. 54 Copyright 2010 Deloitte Development LLC. All rights reserved.

57 About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, and its network of member firms, each of which is a legally separate and independent entity. Please see for a detailed description of the legal structure of Deloitte Touche Tohmatsu and its member firms. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Copyright 2009 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu 55 Copyright 2010 Deloitte Development LLC. All rights reserved.

58 State Sect. 108(i)-Related Issues Drill- Down 56

59 Agenda State conformity rules Various state responses to IRC 108(i) Uncertain state tax issues 57

60 State Response: Trend To Not Conform IRC conformity in general Most states generally follow the federal treatment of COD income under IRC 108, and the treatment of AHYDO under IRC 163(e) and OID under IRC Use federal taxable income as a starting point for determining state taxable income, or Incorporate IRC by reference into their state tax law Non-conformity to IRC 108(i) Additionally, the way they have chosen not to conform has a tremendous impact on taxpayers with COD I\Income 58

61 State Response: Conformity Rules Fixed date State would have to affirmatively update its conformity date to conform to federal changes post-fixed date Most have selectively conformed by deliberately choosing not to adopt IRC 108(i) Rolling conformity State would have to enact new legislation to decouple from IRC 108(i) 59

62 State Response: Non-Conformity To IRC 108(i) IRC conformity State governments face the tension of balancing between: Raising revenue, and Fostering economic growth and limiting iti the undue complexity of federal/state tax differences Trend appears that most states are eliminating the IRC 108(i) COD income, deferral either by: Ignoring it entirely Requiring an addback of the benefits In each case, requiring immediate recognition of COD income for which a deferral is provided for federal income tax purposes 60

63 State Response: Non-Conformity To IRC 108(i) (Cont.) Key states do not conform to these provisions, because their IRC conformity laws have not been updated Examples: California (Jan. 1, 2005) Texas (Jan. 1, 2007) Result COD income from reacquired indebtedness for a solvent taxpayer could be immediately recognizable for state tax purposes 61

64 State Response: 50 states, 50 Approaches State statutes are dramatically different Florida Updated conformity date to incorporate the ARRA and IRC 108(i) is adopted Then adopted d a provision i requiring i addback of any IRC 108(i) COD income deferral But, no mention of the other IRC 108(i) relaxation rules in AHYDO or OID Florida Department of Revenue issued TIP #09C01-03 (July 8, 2009) Clarifies the addback of COD income Requires the deferral of OID deduction for debt exchanges under IRC 108(i)(2) COD income is in base but excluded from apportionment formula 62

65 State Response: 50 States, 50 Approaches (Cont.) California IRC conformity date is Jan. 1, 2005; therefore: IRC 108(i) is not adopted (ignored for California purposes) Unless another exception applies (e.g., insolvency/bankruptcy exception under IRC 108(i), COD income will be immediately recognized at tax rate of 8.84% 84% (general corporations) or 10.84% (financial corporations) Tax attributes limited As net operating losses (NOLs) are suspended in 2008 and 2009, NOLs are unable to offset COD income; tax credits limited to 50% of taxable income 63

66 Texas State Response: 50 States, 50 Approaches (Cont.) IRC conformity date is Jan. 1, 2007; therefore: IRC 108(i) not adopted Tax not based on net income Taxable margin COD income reported as other income (Form 1120, Line 10) No deductions from COD income BUT Clear regulation on inclusion of COD income in gross receipts factor (Tex Admin. Code tit. 34, 3.537(e)(6)) ()()) To state of legal domicile state of formation (TAC tit. 34, 3.537(a)(7)) Example Delaware corporation doing business in Texas» Include COD income in denominator but NOT in numerator» Effect: Dilute apportionment in year COD income recognized 64

67 State Response: 50 States, 50 Approaches (Cont.) Michigan IRC conformity date Jan. 1, 2008 or the Code in effect ect for the tax year at the option o of the taxpayer Generally, most taxpayers do not have NOL carryovers from SBT to MBT Deferred for purposes of the GRT Oregon Specifically adopted IRC 108 as in effect in 2008 Copyright 2010 Deloitte Development LLC. All rights reserved 65

68 State Response: 50 States, 50 Approaches (Cont.) States that currently appear to conform to IRC 108(i) Idaho, Ohio and West Virginia Have conformed o to the IRC as of date on or after Feb. 17, 2009 and have not explicitly decoupled Illinois Decoupling language in proposed legislation that did not pass during 2009 session Mississippi, Montana, Pennsylvania and Tennessee Line 28 of Federal 1120 is starting point for state taxable able income computation Copyright 2010 Deloitte Development LLC. All rights reserved 66

69 State Response: Uncertain Issues Allocation and apportionment Will COD income be treated: t As non-business income (and wholly allocated to a single state), or As business income (and apportioned among all the states where the recipient of the COD income is domiciled)? If the COD income is deferred, will it be apportioned or allocated based upon: The taxpayer s apportionment or presence in the year in which the COD income was realized? Or, in the years in which it is recognized?» A lot can happen to a business in 10 years! 67

70 State Response: Uncertain Issues (Cont.) Allocation and apportionment Should COD income be included in the numerator and denominator of the sales factor? Is it sourced in the year it is realized? Or in the year it is recognized? If so, to which state is the COD income sourced? Is itincome from an intangible ibl right?» If so, source to state of commercial domicile? If the commercial domicile changes, should it always be allocated to the state of commercial domicile in the year in which it is realized? Or, do we just forget about it entirely as distortive? 68

71 State Response: Uncertain Issues (Cont.) How will this provision affect taxes not directly based on federal taxable income? Examples: 1. Ohio CAT and Washington B&O tax (is COD income a gross receipt?) Probably not 2. Texas franchise tax (COD income is includable in gross margin ) 69

72 Compliance And Other Considerations Federal pro forma returns will not show deferred CODI amounts Need to track states in which CODI was recognized in 2009 and 2010 for subtraction when federal recognition begins in 2014 Consideration for purposes of estimated and extension payments Potential decoupling by states in 2010 legislation State NOLs Shorter carryforward periods Limitations» IRC 382» Pennsylvania: Greater of $3M or 12.5% of taxable income Copyright 2010 Deloitte Development LLC. All rights reserved 70

73 Compliance And Other Considerations (Cont.) Opportunity to apply insolvency or bankruptcy exceptions under IRC 108(a) in states that decouple from IRC 108(i) Create deferral through reduction of state attributes Consideration of separate vs. consolidated state filings Nexus and apportionment planning opportunities Copyright 2010 Deloitte Development LLC. All rights reserved 71

74 Circular 230 Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. 72

75 Disclaimer Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited located in the US. The views expressed by panelists in this presentation are not necessarily those of Ernst & Young LLP. 73

76 Related Tax Accounting Issues 74

77 FIN 48: Two-Step Process The application of FIN 48 requires a two-step process that separates recognition from measurement Step one: Recognition threshold A tax benefit is recognized when it is more likely than not to be sustained, based on the technical merits of the position Step two: Measurement of the benefit The largest amount of tax benefit that is greater than 50% likely of being realized (cumulative probability concept) Appropriate unit of account for a tax position is a matter of judgment 75

78 Uncertain Tax Positions Challenges: Numbers of jurisdictions and entities Tracking statute of limitations by jurisdiction Number of issues Apportionment sourcing Business vs. non-business income characterization How to assess probabilities Interest and penalties vary by jurisdiction 76

79 Measurement Of Tax Positions Only those tax positions meeting the more-likely-than-not threshold for recognition should be measured within financial statements Considered the following when conducting measurement analysis: Nexus Forced combination Transaction recharacterization Changes/correction of transfer prices Expense disallowance 77

80 Circular 230 Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. 78

81 Disclaimer Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited located in the US. The views expressed by panelists in this presentation are not necessarily those of Ernst & Young LLP. 79