[Work in Progress: Do Not Quote or Cite Without Author s Permission] Comparative Tax Treatment for Corporate Debt Restructurings

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1 [Work in Progress: Do Not Quote or Cite Without Author s Permission] Comparative Tax Treatment for Corporate Debt Restructurings Aspects of Taxation for Creditors and Debtors Gordon W. Johnson 1 Introduction This paper provides a comparative survey of tax treatment related to the write-off or resolution of bad debts, as considered from the standpoint of both debtors and creditors in a given transaction. The study reviews the tax treatment across a number of leading industrial jurisdictions, including common law countries (Australia, UK and US) and civil law countries (France, Germany and Japan). The primary objective is two-fold: first, to identify commonality among key jurisdictions that might give rise to established best practices; and second, to identify tax incentives and disincentives to the process of consensual debt resolution and corporate workouts. The paper looks at tax treatment for debt in a number of distinct categories: (i) debt rescheduling or payment deferrals; (ii) debt write-offs; (iii) exchanges of debt for debt, debt for equity or equity for equity; (iv) sale of distressed debt at a discounted value; (v) partial recovery through the seizure and sale of collateral, court executions at a discounted value; and (vi) recoveries through bankruptcy proceedings. 1.0 AUSTRALIA 1.1 Deductions by the Creditor for Bad Debts Under section 25-35(1) of the Commonwealth Income Tax Assessment Act 1997 ( ITAA 97 ), a deduction is allowable for a debt (or part of a debt) that is written off as a bad debt in the income year, provided: 1 Mr. Johnson, Lead Counsel in the Finance, Private Sector and Infrastructure practice group of the World Bank s Legal Department, is the Bank s chief legal advisor on corporate insolvency and restructuring systems. The author is grateful to Peter Aloneftis for assistance in the research of this article. The views expressed herein are solely those of the author and do not necessarily reflect the views of the World Bank, its shareholders, directors or its clients. Mr. Johnson can be reached at gjohnson@worldbank.org. World Bank

2 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 2 a. the amount owed was included as assessable income of the taxpayer in the current or a previous income year, unless the taxpayer is in the money-lending business; or b. the debt arises from money lent in the ordinary course of a business of lending money by the taxpayer who carries on that business. To qualify under section 25-35, it is necessary to have an existing bad debt that is written off during the income year in which the deduction is claimed. A money-lending business would normally be able to justify a deduction for writing off both accrued interest under section 25-35(1)(a) and a loss of principal under section 25-35(1)(b). 2 By contrast under this section, a lender that is not in the money-lending business would only be able to obtain a deduction for accrued interest (if it was included as assessable income in the current or previous income year), but not for any loss on the principal of the loan. As the repayment of principal does not constitute income, 3 it follows that it cannot be assessed as income of a lender that is not in the moneylending business, who, accordingly, cannot obtain a deduction for this loss under section 25-35(1)(a). A debt is money that the taxpayer is currently entitled to receive. 4 Thus, if interest payments are to be paid in the future, they cannot be considered as debt under section for the purpose of obtaining a tax deduction. This applies equally in the case of a money-lending business. Whether a debt is bad is a question of fact, as demonstrated by a bona fide conclusion that the debt was bad to the extent that it was written off. It seems that the section implicitly requires that the debt be bad on an objective basis. 5 If a business is sold, including the book debts, the purchaser cannot, in general, claim a deduction for debts that prove to be bad, because the amount would not have been returned as assessable income by the purchaser. Under section 25-35(2), a money lender who acquires a debt from another money lender may claim a deduction for any amount written off as bad, but only up to the cost paid for the debt. If it were not for this specific provision, such a deduction would not be allowable under section 25-35(1)(b), because the money lender who purchased the debt would not have been the one who lent the money. There are specific limitations on the writing off of bad debts by companies to prevent a company structure being manipulated. For instance, a 2 Deutsch et al., Australian Tax Handbook (Sydney: ATP, 2000). 3 Id., at Id., at Id., at 459. World Bank 2

3 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 3 company structure can be exploited if shareholders obtain the benefit of a bad debt deduction when they were not shareholders at the time the income accrued to the company. Subdivision 165-C ITAA 97 requires a company to satisfy either a same ownership and control test or a same business test in order to be eligible for a bad debt. 1.2 The General Deduction Provision for Creditors A general deduction provision for losses and outgoings is found in section 8-1(1) ITAA 97: You can deduct from your assessable income any loss or outgoing to the extent that: a. it is incurred in gaining or producing your assessable income; or b. it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. Negative limbs under section 8-1(2) exclude the operation of section 8-1(1), so that one cannot, for example, deduct a loss or outgoing, whether of a capital nature or of a private or domestic nature. If a bad debt is not deductible under section 25-35(1), it may be deductible under this general provision. 6 The effect of dicta in AGC (Advances) Ltd v. FCT 7 is that a bad debt deduction may be allowable under the predecessor of section 8-1(1) and that, at the time the amounts are written off, the deduction would equal the amount that the creditor could claim from the debtor as a debt. This is now supported by later case authority and by Tax Reports ( TR ) section 92/18, which provides that a creditor may also obtain a deduction in circumstances where the creditor disposes of, settles or otherwise extinguishes a debt at a loss. In addition, in an appropriate case, deductions may be obtained for expenses associated with the recovery of the debt through the sale of collateral or by engaging in legal proceedings. However, a bad debt would not be deductible if the loss is of a capital rather than a revenue nature, a consideration which, in turn, depends upon the facts and circumstances in each case. 8 TR 92/18 states: 6 It should be noted that companies must always satisfy subdivision 165-C, concerning the same ownership and control test or the same business test. 7 AGC (Advances) Ltd. v. FCT, 132 CLR 175 (1975). 8 The leading authority for the distinction between capital and revenue is found in Judge Dixon s holdings in Sun Newspapers Ltd v. Federal Commissioner of Taxation, 61 CLR 337 (1938), and Hallstroms Ptd. Ltd. v. Federal Commissioner of Taxation, 72 CLR 634 (1946). A loss World Bank 3

4 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 4 It is necessary to ascertain the circumstances which occasioned the loss and the relation that these circumstances bear to the taxpayer s income earning activities. If the loss is an ordinary incident of the taxpayer s income earning activities then the loss will be on revenue account. For example, a bad debt incurred by a financial institution would generally be expected to be a revenue loss. 1.3 Capital Losses for a Creditor The capital gains tax ( CGT ) provisions are found in the ITAA 97 and generally apply only to assets acquired on or after 20 September These assets are known as post-cgt assets. A taxpayer s capital gains and capital losses in an income year form part of the calculation of a net capital gain or a net capital loss for that year. Net capital gains are included in a taxpayer s total assessable income in the same manner as other items of assessable income. By contrast, net capital losses do not form a deduction in their own right. Capital losses can be offset against capital gains realized in the same year or may be carried forward as a net capital loss to offset future capital gains. Capital losses are not available to be offset against other assessable income. A creditor can rely on the capital gains tax provisions to calculate a capital loss in cases of: (a) disposal of a debt at a loss; (b) cancellation of a debt; or (c) a debt-for-debt swap or any other debt forgiveness arrangement with the debtor. Under section ITAA 97, a debt owed to a taxpayer is listed as a CGT asset. The CGT provisions may then be utilized if a creditor comes within the ambit of one of the prescribed CGT events that trigger the CGT provisions. This can occur in one of two ways: a. CGT event A1, under section (1), deals with the disposal of a CGT asset. If a creditor disposes of a debt, then this would attract the operation of event A1 and a capital loss would arise if the capital proceeds from the disposal are less than the asset s reduced cost base. b. CGT event C2, under section , deals with the cancellation, surrender or similar termination of certain types of CGT assets. If a creditor cancels or forgives an amount of debt that is owed by the debtor, then this would attract the operation of event C2 and a capital relating to the profit-earning subject would be capital, but a loss relating to the process of operating the profit-earning subject would be revenue. World Bank 4

5 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 5 loss would arise if the capital proceeds from the termination are less than the asset s reduced cost base. The benefit a creditor can obtain as a result of a capital loss is reduced or eliminated to the extent that such loss has been claimed as a deduction under the other provisions of the ITAA 97 (such as under section 25-35(1) and section 8-1) or under any provisions of the Income Tax Assessment Act 1936 ( ITAA 36 ). 1.4 Debt/Equity Swaps for a Creditor A debt/equity swap is defined in section 63E(1) ITAA 36 as an arrangement under which a taxpayer extinguishes the whole or part of a debt in return for the issue to the taxpayer of shares (other than redeemable preference shares) or units in the debtor. As a result of section 63E(3)(a), a creditor can claim a deduction for losses incurred as part of a debt/equity swap with the debtor. The deductible swap loss is the amount by which the debt exceeds the value of the equity received. The value of the equity (shares or units) is the greater of its market value and its value in the books of the creditor. Under section 63F, a swap loss deduction permitted under section 63E is reduced to the extent that a deduction was previously allowed under section 25-35(1) or section 8-1 ITAA 97. In order to obtain a deduction, it is necessary that a debt (a) is owed to a creditor by either a company or a trust that is either a trading trust or a public unit trust; (b) is extinguished contemporaneously with the issue of the shares or units; and (c) that either the debt has been included in the taxpayer s assessable income of an income year, or the debt arises from money lent by the taxpayer in the ordinary course of its money-lending business. It is unnecessary for the debt, or the part of the debt that is swapped, to be a bad debt, provided the statutory requirements for the deduction are met. 1.5 Scrip-for-Scrip Takeover An Equity/Equity Swap Subdivision 124-M of the ITAA 97 is relevant to the tax treatment of shareholders in a company that is being taken over by another company. It provides for a CGT rollover when certain post-cgt interests in companies and trusts are exchanged for interests in another entity. The subdivision is applicable to CGT events occurring on or after 10 December A very narrow form of rollover is also available for certain pre-cgt original interests. A rollover allows the taxpayer to defer the consequences of a CGT event to a later point in time. Under sections (3)(b) and (3)(b), a World Bank 5

6 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 6 rollover can only be chosen where a capital gain would have resulted from the exchange of the share or trust interest. Rollovers will be available where: a. A post-cgt interest is exchanged for a share interest in another company. Post-CGT interests in shares, options, rights or similar interests can attract the subdivision 124-M rollover. Apart from an exception, the replacement shares or similar interests must be shares or interests in the acquiring company. b. The exchange is a consequence of a single arrangement which complies with prescribed criteria. The arrangement must result in an entity becoming the owner of 80 percent or more of the specified interests in the target company. c. The choice is made for a rollover and specific notice requirements are fulfilled. 1.6 Commercial Debt Forgiveness The Debtor s Perspective Division 245 of the ITAA 36 applies to debtors after a commercial debt has been forgiven by a creditor. A debt is generally defined as a legally enforceable obligation of one person to pay an amount to another person. Accrued but unpaid interest on a debt is treated as part of the debt. A commercial debt is one where the debtor is entitled to a deduction for interest paid or payable. 9 Where interest is not charged on the debt, it will still be considered to be a commercial debt if, had interest been charged, it would have been deductible for the debtor. 10 Under section ITAA 36, a debt is taken to be forgiven when: the debtor s obligation to pay the debt is released, waived, or otherwise extinguished; the debt becomes barred by the statute of limitations; a debt/equity swap occurs; an in substance forgiveness arrangement takes place; or a debt parking arrangement takes place. 9 This definition still applies, even if a statutory exception prevents the deduction. 10 As in n. 8, infra, the debt is still considered commercial, even if a statutory exception prevents the deduction. World Bank 6

7 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 7 An in substance forgiveness arrangement is an agreement between the debtor and creditor where the debtor is effectively released from the obligation to pay the debt, apart from liability to pay some nominal or insignificant amount in the future. 11 A debt parking arrangement involves an assignment of the debt by the creditor to a third party that is associated in some way with the debtor. 12 This assignment is usually performed for consideration that is lower than the amount owed. Although the debtor remains legally liable to pay the assignee in full, there is an understanding that the assignee will not seek recovery of the debt. Where a commercial debt is forgiven, Division 245 allows the net forgiven amount to be applied to lower the reducible amounts 13 to which the debtor is entitled, in the following order: a. Deductible revenue losses carried forward from a previous year; b. Deductible net capital losses carried forward from a previous year; c. Certain deductible expenditure carried forward from a previous year; and d. The relevant cost base of reducible assets other than excluded assets. Where the amount forgiven exceeds the total of the reducible amounts, the excess will not be assessable. As stated in section 245-2, Division 245 ITAA 36 does not apply to the forgiveness of a debt if the forgiveness arises under an Act relating to bankruptcy. 1.7 The Debtor and Bankruptcy Considerations An amount that the debtor is unable to pay, or a gain enjoyed by the debtor as a result of a debt forgiven by a creditor, is not treated as assessable income for a bankrupt. Rather, specific provisions exist which result in exemptions and restrictions for deductions of tax losses and for prior capital losses to reduce subsequent capital gains. Section 36-35(1) ITAA 97 bars any deduction for tax losses incurred before bankruptcy. This is subject to section 36-40(1), which permits a 11 Woellner et al., Australian Taxation Law, 773 (9 th ed., CCH Australia, 1999). 12 Id. 13 Reducible amounts are those amounts that would otherwise have been taken into account to reduce the debtor s taxable income in the year of income in which the debt is forgiven or in a later year of income. World Bank 7

8 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 8 deduction for amounts paid for debts incurred before bankruptcy. Under section 36-45(1), the total deductions under section 36-40(1) in the income year (for the payment of debts incurred in the loss year) cannot exceed the amount of the tax loss, reduced by the sum of: a. the deductions under section 36-40(1) for amounts paid in earlier income years for debts incurred in the loss year; and b. any amounts of the tax loss deducted in earlier income years; and c. any amounts of the tax loss that, apart from section 36-35, would have been deductible from the bankrupt s net exempt income for the income year or earlier income years. Section 102-5(3) ITAA 97 prohibits the use of prior net capital losses to determine whether a net capital gain was made in the year a taxpayer becomes bankrupt or in the year a taxpayer is released from debts under bankruptcy law or for any subsequent income year. However, this determination needs to be considered alongside section , which provides that where a taxpayer later pays all or part of a debt that was taken into account in working out the amount of a net capital loss that could not be applied because of section 102-5(3), some or all of the denied amount may be reinstated as a new capital loss in the year in which the payment is made. 2.0 UNITED KINGDOM 2.1 Deductions by the Creditor for Bad and Doubtful Debts In the United Kingdom, 14 under section 74(1)(j) of the Income and Corporation Taxes Act 1988 (ICTA), a bad or doubtful debt can be deducted to the extent it is estimated to be bad, provided it is from a trading transaction brought to credit on an earnings basis. 15 This provision applies whether it relates to the supply of goods or services, or to a creditor engaged in a business that consists of advancing money, such as banking or money-lending. 16 The question whether a debt is bad is a question of fact and the onus of proof is on the creditor to show that the debt was bad. 14 The United Kingdom refers to Great Britain (England, Scotland, Wales) and Northern Ireland. Tax provisions are enacted and interpreted with a view to producing identical effects, as far as possible for all countries of the United Kingdom. See Simon s Direct Tax Service vol. 2, para. A (Butterworths, 2002). 15 Simon s Direct Tax Service vol. 3, para. B (Butterworths, 2002). 16 Thus, in CIR v. Hagart & Burn-Murdock HL 14 TC 433 (1929), losses on advances to clients by solicitors were refused, as there was no evidence that they were money-lenders. World Bank 8

9 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 9 Further aspects relating to bad and doubtful debts for the creditor include the following: If the debtor is bankrupt or insolvent, the debt is deductible except to the extent that any amount may reasonably be expected to be received on it. 17 Debts or parts released wholly and exclusively for trade purposes as part of a voluntary arrangement under the Insolvency Act 1986 or a compromise or arrangement under Companies Act 1985 are also deductible. 18 Where the market value of an asset accepted in satisfaction of a trading debt is (on the date of acceptance) less than the outstanding debt, the deficit may be allowed as a deduction. 19 Advances to finance or recoup the losses of subsidiary or associated companies are treated as capital. 2.2 The Capital Gains Tax Provisions for a Creditor Although debts are specifically included as assets under section 21(1) of the Taxation of Chargeable Gains Act 1992 ( TCGA ), the general rule is that disposal by the original creditor of a debt does not give rise to a chargeable gain or an allowable loss. However, there are several exceptions to this general rule, and they include: a. The disposal of a debt on a security (section 251(1) TCGA) A debt on a security is not defined by statute. Inland Revenue considers the definition of security in section 132 TCGA as exhaustive, but this only includes loan stock or similar security of the UK or any other government, or of any public or local authority in the UK or elsewhere, or of any company. Moreover, it does not have to be secured: a debt on a security does not include mortgages or charges or other debts in which security is given. It has been distinguished from an ordinary debt in that it is a debt with added characteristics, which enable it to be realized or dealt with at a 17 Glyn Saunders et al., Tolley s Income Tax para (86 th ed., London: Reed Elsevier). 18 Id. 19 Id. World Bank 9

10 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 10 profit. Some of the added characteristics include: 20 The debt is for a fixed long term. The amount required to repay the debt before the end of the term is linked to the market value of the debt at the time of repayment, calculated on the assumption that it would run its full term. The debt carries interest and consequently produces income for the creditor. The debt is marketable, because of the above factors. If the debt is evidenced in writing, this may be a further indication that it is more than an ordinary debt, although this is not essential for it to be a debt on a security. b. Certain debentures (section 251(6) TCGA) A debenture issued on or after 16 March 1993 is deemed to be a security where it is issued on a company reorganization or reconstruction. This means that on an exchange of shares or securities with accrued gains in return for such debentures, the gain will be rolled over and will be charged on its subsequent disposal. 21 c. Certain loans to traders (section 253 TCGA) If a loan is made and used wholly 22 for the purposes of a trade by the borrower and all or part of the loan cannot be recovered, the lender may in certain circumstances claim relief for an allowable loss. Trade is defined to include a profession or vocation, but expressly excludes any trade involving the lending of money. Relief extends only to the principal; interest is excluded. The borrower must be a resident of the UK and no relief is available where the amount has become irrecoverable because of the terms of the loan itself. 2.3 The Loan Relationship Regime The loan relationship regime under the Finance Act 1996 ( FA 96 ) applies to companies. A company is defined as any body corporate or unincorporated 20 Simon s Direct Tax Service vol. 4, para. C (Butterworths, 2002). 21 CCH British Tax Guide vol. 1, para (Oxfordshire: Croner.CCH, 2000). 22 However, in some situations, there may be an apportionment if a loan is partly used for the borrower s trade and partly used for non-trade purposes. World Bank 10

11 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 11 association, but does not include a partnership or local authority or local authority association. The aim of the Finance Act is to remove the distinctions in the tax treatment of the various types of loans and securities for corporate borrowers and lenders by bringing all loan relationships within the corporation tax code on income. 23 The regime covers all profits, gains and losses including those of a capital nature arising from a company s loan relationships and related transactions. A company has a loan relationship if: a. it is either a creditor or a debtor for a money debt; and b. that debt arises from the lending of money. A money debt is defined in section 81 FA 96 as a debt which can be satisfied by the payment of money or by the transfer of a right which is itself a money debt (such as a company security). Examples of loan relationships include mortgages and company securities (other than shares). Unless there is an express provision to the contrary, any amounts brought into account under the loan relationship legislation are not considered for corporation tax purposes under any other provision. 24 An asset representing a loan relationship is treated as a qualifying corporate bond and is exempt from the capital gains tax provisions of the TCGA. Income and expenditure come within the scheme when they are credited or debited to either the company s profit and loss account or to any reserve other than a share premium account, provided the company s accounting treatment is on either an accrual or mark-to-market basis. Expenses for which relief is available are restricted to those incurred in bringing the loan relationship into existence, making payments under that relationship and ensuring that payments are received; and expenses for a related transaction, which is defined under sections 84(5) and (6) FA 96 as any disposal or acquisition of rights and liabilities under a loan relationship. 25 The concept of related transaction is significant, because all profits, gains, or losses resulting from such transactions have to be brought into account. It encompasses release, redemption and sale of a debt. Under section 82(2) FA 96, when a loan is entered into for the purposes of a company s trade, profits and gains are taxable and interest charges and expenses are deductible for calculating the company s trading profits. Section 83 FA 96 deals with non-trading profits, losses and expenses. 23 Chris Whitehouse, Revenue Law Principles and Practice 547 (16 th ed., Butterworths, 1998). 24 Simon s Direct Tax Service vol. 5, para. D (Butterworths, 2002). 25 John Tiley, Revenue Law 836 (4 th ed., Oxford: Hart Publishing, 2000). World Bank 11

12 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 12 If an accrual basis is used, then it is assumed under section 85(3c) FA 96 that all amounts payable under a loan relationship will be paid in full when they become due. However, an exception is provided under Schedule 9, paragraph 5(1) FA 96, which allows a deduction to the extent that a debt is a bad debt, or a doubtful debt that is expected to be bad, or involves a liability that is released. A debt is only released if the creditor has formally waived the debtor s obligation to pay. 2.4 Company Acquisitions Through an Equity/Equity Swap A sale of a company may take several forms, including a purchase of the assets of the target company, a purchase of the shares of the target company for cash, and an equity/equity swap. An equity/equity swap involves a share exchange where the shareholders of the target company are left with the shares of the purchaser. Capital gains tax is not normally payable by the shareholders of the target company, because a roll-over deferral is available under section 135 TCGA. It is necessary that the arrangement has a bona fide commercial purpose and that confirmation be obtained from Inland Revenue that this requirement has been met. Furthermore, the following conditions must be satisfied: a. The company issuing the shares owns or acquires more than 25 percent of the ordinary share capital of the target company; or b. The company issuing the shares does so as a result of a general offer made to shareholders of the target company or to a class of shareholders, and the company issuing the shares holds or, as a result of the exchange, acquires voting control over the target company. This condition was introduced to conform to the provisions of the European Union ( EU ) Directive on cross-border mergers Debt Release under the Income and Corporation Taxes Act: Implications for Debtors Under section 94 of the Income and Corporation Taxes Act 1988 ( ICTA ), if a trader owes a debt, which the trader deducts as a trade expense, and the debt is later released by the creditor, then the debt becomes a taxable trade receipt against the debtor in the year of its release. 27 The mere failure to pay a debt does not give rise to a trading receipt; and the provision only applies if a deduction had been allowed in an earlier year. Moreover, the view of Inland 26 Simon s Direct Tax Service vol. 4, para. C (Butterworths, 2002). 27 Whitehouse, supra n. 22, at 128. World Bank 12

13 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 13 Revenue is that there is a release under section 94 ICTA whether the release is gratuitous or for value, although the extent of any value received would have to be brought into account to reduce the sum taxable. 28 This provision has no application to a release forming part of a voluntary arrangement under the Insolvency Act 1986 or a compromise or arrangement under section 425 of the Companies Act UNITED STATES 3.1 Deduction by the Creditor for Bad Debts In the United States, the law relating to bad debts is subject to special tax treatment and is dealt with under section 166 of the Internal Revenue Code 1986 ( IRC ). It is mutually exclusive 29 from section 165 IRC, which deals with losses for deduction purposes generally. 30 A distinction is drawn between business debts and non-business debts in section 166 IRC. Under section 166, business bad debts can generally be deducted from gross income if a debt or part of a debt becomes worthless. By contrast, non-business bad debts are treated as short-term capital losses, subject to an annual deduction limitation of US$3000 (US$1500 per year for married individuals filing separate returns). 31 Non-business bad debts can only be deducted when the entire debt is worthless; deduction for part of a bad debt (which is allowed for business bad debts) is not available for nonbusiness bad debts. Business debts arise from the taxpayer s trade or business. Under Treasury Regulation ( reg. ) (5b), a business debt is a debt that is either (a) created or acquired in connection with the trade or business of the taxpayer who is claiming the deduction; or (b) the loss from the worthlessness of which has been incurred in the taxpayer s trade or business. To qualify for the more favorable tax treatment for business bad debts, the taxpayer must meet the dominant motivation test, under which the taxpayer must show that the dominant motivation in making the payment was business-related. The bad debts of a corporation are always presumed to be business bad debts Tiley, supra n. 24, at G. Newton & Gilbert Bloom, Bankruptcy & Insolvency Taxation 52 (New York: John Wiley & Sons, 1991). 30 This is to be contrasted with the position in Australia considered earlier. 31 CCH Editorial Staff Publication, 2002 U.S. Master Tax Guide 344 (Chicago: CCH Inc., 2001). 32 Internal Revenue Publication No. 535, Business Expenses, 46, available at < >. World Bank 13

14 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 14 that: In order to obtain a deduction under section 166 IRC, it is necessary a. A debt exists, which arises from a true debtor-creditor relationship based upon a valid and legally enforceable obligation to pay a fixed or determinable amount of money. 33 The courts will consider both substance and form in determining whether a debtor-creditor relationship or a shareholder-corporation relationship exists. As an exception, a business bad debt deduction is not available to creditors who hold a debt that is evidenced by a bond, debenture, note or other evidence of indebtedness that is issued by a corporation or governmental unit, with interest coupons or in registered form. As stated in section 165(g)(2c) IRC, this is considered security and any loss resulting from a security is treated as a loss from the sale or exchange, on the last day of a taxable year, of a capital asset. b. The debt (or part of a debt for business debts) is worthless. The creditor has the burden of showing that there was no reasonable or practical basis for hope of any recovery of the debt (or part of the debt) at the time the deduction was taken. 34 Mere refusal of the debtor to pay is not sufficient proof of worthlessness. Moreover, bankruptcy, by itself, operates only as a general indication of the collectibility of the claim and is not conclusive by itself. 35 A cash-basis taxpayer can deduct a bad debt only if an actual cash loss has been sustained or if the amount deducted was included in income. For example, if a note is received by a cash-basis taxpayer in payment of a debt, and is included in income at its fair market value when received, such value is deductible if the note becomes worthless. Nearly all accrual-basis taxpayers must use the specific charge-off method to deduct business bad debts. Only small banks and thrift institutions can use the reserve method 36 for computing and deducting bad debts on receivables CCH Editorial Staff Publication, Federal Tax Manual 2001 para (Chicago: CCH Inc.). 34 Id. 35 Id. 36 The reserve method involves keeping a reserve account for debts, with the amount in the account subject to a predetermined limit. Bad debts are charged to this account as they arise and the account is replenished each year. The amount used to replenish the bad debt reserve account is allowed as an expense. 37 CCH Editorial Staff Publication, 2002 U.S. Master Tax Guide 345 (Chicago: CCH Inc., 2001). World Bank 14

15 [Work in Progress: Do Not Quote or Cite Without Author s Permission] Secured Bad Debts for the Creditor If secured or mortgaged property is sold for less than the amount of the debt, a creditor is allowed a bad debt deduction under section 166(a) IRC, equal to the difference between the amount of the debt and the sale price of the property, to the extent it can be shown that the difference was wholly or partially uncollectible. 38 Accrued interest may be included as part of the allowable deduction if it had been previously been included as income. Under reg , recognition is given to a creditor that buys mortgaged or pledged property at a loss, and is measured as the difference between the amount of the debtor s obligations applied to the purchase or bid price of the property (to the extent that such obligations constitute capital or represent an item the income from which has been returned by the creditor) and the fair market value of the property. There are special rules applicable for the treatment of mortgaged or pledged property by certain banking organizations. 3.3 Cancellation of Debt Income the Debtor s Perspective Discharge of Indebtedness Under section 61(a)(12) IRC, gross income is defined to include all income from whatever source it is derived, 39 including income from the discharge of indebtedness. However, section 108(a) IRC provides for exclusions, so that a gain from the discharge of indebtedness is not included in gross income in certain circumstances, irrespective of any other provision. The exclusions include: a debt discharged in a bankruptcy action under Title 11 of the United States Code, where the taxpayer is under the court s jurisdiction and the discharge is either granted by or is under a plan approved by the court; and a discharge when the taxpayer is insolvent outside bankruptcy. The amount excluded under the insolvency exclusion listed under 1) above is limited to the amount by which the taxpayer is insolvent. The term insolvent refers to the excess of liabilities over the fair market value of assets immediately prior to discharge. 38 Id. 39 This is in contrast to the United Kingdom and Australia. World Bank 15

16 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 16 Under section 108(b) IRC, the amount excluded from gross income as a result of a discharge of indebtedness in a Title 11 case or a debtor s insolvency is applied to reduce the tax attributes of the debtor in the following order: net operating losses (NOL); general business credits; minimum tax credits; capital loss carryovers; basis reduction for property of the taxpayer; passive activity loss and credit carryovers; foreign tax credit carryovers. For example, the reduction in the tax attribute for NOLs refers to any NOL for the taxable year of the discharge and any NOL carryover to such taxable year. The reduction in general business credit carryovers, minimum tax credits, passive activity credits and foreign tax credits is made at a rate of 33⅓ cents per dollar of excluded income. If the excluded income exceeds the tax attributes available to be reduced, the excess simply goes untaxed. Discharge of Indebtedness through Debt/Equity Swaps and Debt-for-Debt Swaps Specific rules apply for debt-equity swaps and debt for debt swaps. Under section 108(e)(8) IRC, a debtor corporation that transfers stock to a creditor in satisfaction of its indebtedness is treated as having satisfied the indebtedness with an amount equal to the fair market value of the stock. The corporation will therefore have income from the discharge of indebtedness to the extent that the debt exceeds the value of the stock and other property transferred. 40 Under section 108(e)(10) IRC, a similar rule applies to corporate or noncorporate debtors who issue debt instruments in satisfaction of indebtedness. A debtor will be treated as having satisfied the indebtedness with an amount of money equal to the issue price of the new debt instrument. The debtor will 40 If $20 cash and $50 cash were issued to cancel a $100 debt, the debtor would recognize income in the amount of $30. CCH Editorial Staff Publication, CCH Standard Federal Tax Reports 2002 vol. 2, para (CCH Inc.). World Bank 16

17 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 17 therefore have income from the discharge of indebtedness to the extent that the debt 41 exceeds the issue price of the new debt instrument that is issued. 3.4 Modification of Debt Instruments for the Debtor Under reg (a), when the terms of a debt are modified, the changes need to be reviewed to determine whether the new terms differ materially either in kind or extent from the old terms. If they do, the old debt is treated as having been exchanged for new debt for federal income tax purposes, and the debtor may recognize cancellation of debt income. Reg requires a significant modification of a debt instrument to result in an exchange of the original debt instrument for a modified instrument that differs materially either in kind or extent. Whether the modification of a debt instrument is significant is determined under the rules of reg (e)(1) to (e)(6): The general rule is found in reg (e)(1). It states that, except as otherwise provided, a modification is considered as significant only if, based on all the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant. An example dealing with a particular type of modification is found in reg (e)(2), which deals with changes in the yield. Under reg (e)(2), a change in the yield of a fixed rate or variable rate instrument is automatically a significant modification if it varies from the annual yield on the unmodified instrument by more than the greater of: a) ¼ of one percent; or b) 5 percent of the annual yield of the unmodified instrument (.05 x annual yield). Such a change under reg (e)(2) will often take the form of a reduction in the interest rate, but it may also occur as a result of having the principal amount of the loan reduced. Other particular types of modifications include changes in the timing of payments 42 and changes in the obligor or security This refers to the adjusted issue price of the old debt and any accrued and unpaid interest previously deducted. 42 U.S. Treas. Reg (e)(3). 43 U.S. Treas. Reg (e)(4). World Bank 17

18 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 18 As stated in reg (c)(4), a holder s temporary forbearance in waiving a right is not a modification unless the forbearance remains in effect for more than two years following the issuer s initial failure to perform and any additional period during which the parties conduct good faith negotiations or the debtor is in bankruptcy. 3.5 Corporate Reorganizations Under sections 351 and 368 IRC, a corporation recognizes no gain or loss on the exchange of property solely for shares or securities of another corporation when the exchange is made pursuant to a plan of reorganization. 44 Both sides of the transaction are eligible for such non-recognition, so that no gain or loss from the transaction is recognized for tax purposes at either the corporate or the shareholder level if certain statutory and non-statutory requirements are fulfilled. A reorganization is thus an exception to the general rule that any gain or loss realized will be recognized when property is exchanged. The determination of whether a debt instrument is security is a factual one. Although several factors are taken into account, the one typically considered the most important is the term to maturity of the debt instrument. A debt with a term exceeding ten years is considered a security, debt with a maturity between five and ten years is sometimes considered a security, and debt with a term of less than five years is subject to significant scrutiny and may not be treated as a security. 45 To qualify as a reorganization, a transaction must be undertaken for a bona fide business purpose and must culminate in continuation of both the business enterprise and shareholder interests. 46 However, as an exception to this rule, business and shareholder continuity is not required for a recapitalization under section 368(a)(1E) IRC (see below). A reorganization must fall within one of the seven categories listed under section 368(a) IRC The type of transactions encompassed by the section involve either asset or share acquisitions or single entity reorganizations. Examples of the seven categories include: a. Statutory Merger or Consolidation under Section 368(a)(1A) IRC This type of reorganization involves asset acquisition, although a merger is different from a consolidation. In a merger, the acquiring corporation survives after acquiring all the assets and liabilities of 44 CCH Editorial Staff Publication, 2002 U.S. Master Tax Guide 590 (Chicago: CCH Inc., 2001). 45 M. Silberbag & S. Goldring, Tax Considerations in Reorganizing Failing Businesses (Weil, Gotshall & Manges LLP, 1998). 46 G. Newton & Gilbert Bloom., supra n. 28, at 137. World Bank 18

19 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 19 the other, disappearing corporation. By contrast, in a consolidation, the two corporations combine to form an entirely new corporation. The tax consequences for a merger are as follows: The disappearing corporation does not recognize any gain or loss upon the transfer of its assets to the surviving corporation. The surviving corporation does not recognize any gain or loss when it receives the assets from the disappearing corporation. The shareholders of the disappearing corporation do not recognize any gain or loss when they exchange their shares for shares in the surviving corporation. b. Type B Reorganization: Share-for-Share Exchange under Section 368(a)(1B) IRC This reorganization concerns share acquisition. It involves the acquisition by one corporation of shares in another corporation, solely in exchange for some or all of its own voting shares (or the voting shares of its parent), giving the acquiring corporation control 47 over the other immediately after the acquisition. c. Type E Reorganization: Recapitalization under Section 368(a)(1E) IRC The U.S. Supreme Court has stated that recapitalization contemplates reshuffling a capital structure within the framework of an existing corporation. 48 An example of a recapitalization is where a corporation discharges outstanding bond indebtedness by issuing preferred stock to its shareholders in exchange for the bonds. A holder of a debt instrument can only ensure non-recognition of gains and losses for tax purposes if the holder surrenders a security and receives either shares or securities in the exchange. However, if the issue price of the security received exceeds the issue price of the security surrendered, any such excess may be subject to tax. 49 d. Type G Reorganization: Section 368(a)(1G) IRC This occurs when a corporation in bankruptcy transfers all or part of its assets to another corporation, but only if the shares or securities of the 47 Control refers to the ownership of shares that carry at least 80 percent of the combined voting power of all classes of shares entitled to vote and at least 80 percent of the total number of shares of all other classes of shares of the corporation. Section 368 (c) IRC. 48 CCH Editorial Staff Publication, 2002 U.S. Master Tax Guide 592 (Chicago: CCH Inc., 2001). 49 M Silberbag & S Goldring, supra n. 44, at World Bank 19

20 [Work in Progress: Do Not Quote or Cite Without Author s Permission] 20 receiving corporation are distributed to the shareholders of the bankrupt corporation tax-free or partially tax-free. 4.0 GERMANY In Germany, the Income Tax Act (Einkommensteuergesetz, or EstG ) deals with the taxation of individuals and the Corporate Income Tax Act (Körperschaftsteuergesetz, or KStG ) involves the taxation of corporations, mutual insurance companies and other legal entities under private law. However, under section 8(1) KStG, the provisions of the Income Tax Act also apply to the taxation of legal entities unless the Corporate Income Tax Act provides for special rules. The Reorganization Tax Act (Umwandlungssteuergesetz, or UmwStG ) deals with corporate reorganizations. 4.1 Bad Debts and Allowable Business Expenses for Creditors A taxpayer can deduct all expenses incurred in the conduct of the taxpayer s business, irrespective of whether the expenses are necessary, customary or useful, so long as the expenses can be regarded as relating to the business activity concerned and are not associated with the taxpayer s private endeavors or personal living expenses. 50 Bad debts are one example of an allowable business expense for a creditor (including a creditor corporation). Doubtful or uncollectable accounts receivable must be written down to their fair market value. 4.2 Rehabilitation Gains for a Corporate Debtor Under section 3 EstG, if creditors waive part or all of their claims against a corporation, no taxable income for the corporation is generated, provided: a. the corporation needs rehabilitation ; b. the transaction is entered into for the express purpose of restoring the corporation to a sound financial position; and c. the waiver is capable of achieving this purpose. 51 A corporation needs rehabilitation if, in the long run, it would not have been possible to conduct the business at a profit without the waiver. In 50 German Tax & Business Law Guide 2001 paras (CCH Europe). 51 Id., paras World Bank 20