Tackling Taxes. Tax Planning with Respect to an Insolvent Subsidiary in a Consolidated Return Group: Part I *

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1 Tax Planning with Respect to an Insolvent Subsidiary in a Consolidated Return Group: Part I * April 2014 By Paul C. Lau, Ronald Marcuson and Kurt Piwko TAXES THE TAX MAGAZINE Paul C. Lau is a Tax Partner with Plante Moran in Chicago. Kurt Piwko is a Senior Tax Manager with Plante Moran in Macomb. Ronald Marcuson is a Professor and the Director of MST Program at DePaul University. In 1 an October 2009 tax column, we talked about the liquidation of an insolvent subsidiary in a separate return context. This column is the first of a series of columns that will explore some issues and available guidance regarding an insolvent subsidiary in a consolidated tax return. 2 One of the key concepts to remember is that the federal income tax consequences of a transaction occurring in a consolidated return are governed by the provisions of the Code that apply in a separate return rn to the extent the consolidated regulations do not exclude application. 3 their For this reason, we will rely upon some of the provisions we addressed in our prior column. We will begin our review of the consolidated return regulations by looking at how the consolidated intercompany regulations contained in Reg impact an insolvent subsidiary. In subsequent columns, we will address additional consolidated return regulations that modify the separate return rules. In particular, we will examine how the consolidated return regulations impact such disparate things as cancelation of indebtedness income and attribute reduction, the worthless stock deduction, the amount of loss allowed (including impact of unified loss rule, circular basis provisions and investment adjustment rules) and recognition of any excess loss account. Our final column will look at various planning considerations. We will address options the taxpayer has in dealing with an insolvent subsidiary with a view toward maximizing the amount and character of tax benefits and attributes available 19

2 to the consolidated group. These options include (1) liquidate/dissolve the subsidiary, (2) merge the subsidiary into its parent or a sister corporation, (3) abandon the subsidiary, (4) do nothing, which in some cases may lead to a de facto liquidation, and (5) inject capital. that are not intercompany obligations. The definition of obligations is expansive and includes any debt that constitutes indebtedness under general principles of Federal income tax law. 6 It does not include executory obligations to purchase or provide goods and services. Insolvency In analyzing the federal income tax consequences of an insolvent subsidiary that is a member of a consolidated group, the first step is to determine whether the subsidiary is insolvent. The meaning of insolvency on a separate return context is equally applicable to a member of a consolidated group. In essence, a subsidiary is insolvent if its liabilities exceed the fair market value (FMV) of its assets. 4 Although a subsidiary may be solvent, it can have insolvency like tax issues when the subsidiary has multiple classes of stock ( e.g., common and preferred). If the fair market value of the assets of the subsidiary exceeds the subsidiary s liabilities, the subsidiary is not insolvent. However, the ob tio excess ess of asset value may not exceed the liquida- within one exc tion preference renc of the to satisfy anot preferred ed stock so ow while i t f the subsidiary s sidia preferred stock has value the common stock is worthless. satisf This typically occurs when related-party debt is reclassified using debt/ equity principles contained in Code Sec We will at times address tax issues arising with this type of solvent but financially distressed subsidiary. Intercompany Obligations We will start our analysis by looking at some tax issues with respect to an insolvent subsidiary s debt. It is necessary to put the debt into two categories (1) intercompany obligations, and (2) non-intercompany obligations. Intercompany obligations are obligations between members of a consolidated group, but only for that period during which both parties are members of the consolidated group. 5 Non-intercompany obligations are all obligations A noteworthy point to remember is that these exceptions are not always mutually exclusive and decisive. An intercompany obligation transaction that falls within one exception may still need ed to satisfy another exception before it is exempt from the deemed satisfaction and reissuance rule CCH Incorporated. All Rights Reserved. Cancellation of Debt (COD) Income on Discharge of Non-Intercompany Obligations The rules for computing COD income with respect to non-intercompany obligations of a consolidated subsidiary are the same as the separate return rules. The following discussion assumes that the non-intercompany obligations are debts of the insolvent subsidiary. While that may seem like we are assuming the obvious, there is often a parent guarantee with respect to a third-party debt in the context of a financially distressed subsidiary. In this case, the challenging question is who is the primary obligor; that is, is the lender really looking to the subsidiary for satisfaction of the debt. If it x eptio befo e h d d is determined d that t the lender is really looking to the parent/guarantor, then the loan will be recast as a loan directly to the parent/guarantor with a subsequent contribution to capital by the guarantor. 7 A debt discharge from a property transfer can result in COD income, gain from the transfer of the property or a combination thereof. If the insolvent subsidiary transfers property in exchange for cancellation of a recourse debt, the general rule is that it would have gain on the excess of the fair market value (FMV) of the property over the property s adjusted basis and COD income on the excess of the debt discharge over the FMV of the transferred property. 8 However, if a nonrecourse debt secured by the property is discharged, the debtor would recognize gain on the transfer to the extent of the excess of the discharged nonrecourse debt over the adjusted basis of the transferred property. It does not

3 April 2014 matter if the debt exceeds the FMV of the property. Under Code Sec. 7701(g), the FMV of a property is treated as not being less than the nonrecourse debt attached to the property. 9 Under Code Sec. 108, a debtor can exclude COD income to the extent it is insolvent or the debt discharge occurs in a Title 11 (bankruptcy) proceeding. The income exclusion under Code Sec. 108 applies only to COD income. No income exclusion is available for gain realized from a transfer of property even if the debtor is insolvent or the debt restructuring occurs in a bankruptcy proceeding. In bankruptcy, a debtor can exclude all COD income from debt cancellation. To fall within this provision, the debt must be discharged by the court or pursuant to a plan approved by the court. In an insolvency situation, the insolvent debtor can exclude COD income only to the extent of the debtor s insolvency. 10 In either case, the amount of the exclusion is determined at the time of the discharge. 11 Also, there may be cases where the insolvent subsidiary leaves the consolidated group as part of the discharge transaction. The COD income will be treated as having been realized while the insolvent subsidiary is a member of such consolidated group. The next day rule cannot be applied to treat COD income as realized at the beginning of the day following the day on nwhich the obligation on is discharged ( i.e.,., possibly in different consolidated group). 12 a feren The exclusion ofcod income carries a price in that the debtor is sreq required red to reduce its tax attributes s(e e.g., NOLs). This reduction takes place at the beginning of the year after the year of discharge. As with the timing of the inclusion of COD income, there was a question as to the treatment of the attributes of the insolvent subsidiary if it leaves the consolidated group as part of the discharge transaction. It is now clear that, in such cases, the tax attributes that remain after the determination of the tax imposed on the group are available for reduction. 13 In a subsequent column, we will discuss how the consolidated tax attribute reduction rule under Reg and the circular basis rule under Reg (c) may apply when an insolvent subsidiary leaves the consolidated group in the tax year it has excluded COD income. Intercompany Obligations As defined in Reg (g)(2)(ii), an intercompany obligation is an obligation between members of a consolidated group, but only for the period during which both parties are members. Therefore, an intercompany obligation is an intercompany transaction ( i.e., a transaction between members of a consolidated group). As such, the tax treatment of income, gain, deduction and loss with respect to the intercompany obligation is governed by the matching rule and the acceleration rule under Reg The matching rule advocates the principle of symmetry of matching income and deduction with respect to an intercompany transaction. In its simplest form for an intercompany obligation, it means that the interest income (an intercompany item) of the lender is included in income when the borrower deducts the interest expense (a corresponding item). Similarly, the income tax treatment of a bad debt on an intercompany obligation is governed by the matching rule and the deemed satisfaction and reissuance rule (discussed below), with results different from those in a separate return context. General tax principles under separate return context do not require tax symmetry on a bad debt deduction and a debtor does not automatically report income when the lender claims a bad debt deduction. Deemed Satisfaction and Reissuance Rule In addition to the matching rule and the acceleration rule, there are special provisions under Reg (g) that apply to intercompany ny obligations. In particular, unless an exception is met, a deemed e satisfaction sfacti and reissuance sua rule under Reg (g)(3)(ii) comes into play when an intercompany obligation is involved in a triggering transaction. The type of triggering transaction most likely to occur with respect to an insolvent subsidiary is the intercompany assignment /extinguishment transaction in which a member realizes an amount from the assignment or extinguishment of all or a part of its rights or obligations under an intercompany obligation or any comparable transaction in which a member realizes any amount from an intercompany obligation (including a bad debt deduction). 14 If the deemed satisfaction and reissuance rule applies, the transaction is recast as if the intercompany obligation had been satisfied for cash in an amount equal to its FMV and a new intercompany obligation was reissued for the same amount of cash before the actual transaction. The parties are then treated as engaging in the actual transaction with the new debt. In addition, in determining the consequences of the deemed satisfaction and reissuance rule, Reg. TAXES THE TAX MAGAZINE 21

4 (g)(4)(i)(C) tells us that any income, gain, deduction or loss from the intercompany obligation is not subject to Section 108(a).... In essence, the COD income exclusion rule under Code Sec. 108(a) is turned off for purposes of the deemed satisfaction and reissuance rule. As a result, COD income realized from an intercompany obligation is not excludible under Code Sec. 108(a). Three notable features of the deemed satisfaction and reissuance rule are that: (1) FMV is used as the standard of measure for determining the amount of income and deduction for both the debtor and creditor, (2) the deemed satisfaction and reissuance occur immediately before, and independent of, the actual transaction, and (3) COD income is recognized regardless of insolvency as a result of Code Sec. 108(a) turn-off. Example 1 General Application of Deemed Satisfaction and Reissuance Rule. Assume P is the parent of a consolidated group with two subsidiaries, B and S. On January 1 of year 1, B borrows $100 from S in return for B s note providing for $10 of interest annually at the end of each year and repayment of $100 at the end of year 5. On January 1 of year 3, the FMV of the B note has declined dt to $60, and S sells the B note to P for property with a FMV of $60. B is not insolvent. Because S realizes an amount of loss from the assignment nt of fthe eb note, the transaction actio is a triggering gtransaction. Therefore, B s note is treated as satisfied and reissued for its FMV of $60 immediately before S s sale to P. As a result of the deemed satisfaction of the note for less than its adjusted issue price ($100), B takes into account $40 of COD income under Reg On a separate return basis, S s $40 loss would be a capital loss under Code Sec. 1271(a)(1). Under the matching rule, however, the attributes of S s intercompany item and B s corresponding item must be redetermined to produce the same effect as if the transaction had occurred between divisions of a single corporation. Under Reg (c)(4)(i), the attributes of B s $40 of COD income control the attributes of S s loss. Thus, S s loss is treated as ordinary loss. B is also treated as reissuing, immediately after the satisfaction, a new note to S with a $60 issue price, $100 stated redemption price at maturity and $60 basis in the hands of S. S is then treated as selling the new note to P for the $60 of property received by S in the actual transaction. Because S has a basis of $60 in the new note, S recognizes no gain or loss from the sale to P. After the sale, the note is an intercompany obligation, it has a $60 issue price and a $100 stated redemption price at maturity, and B and P will take the $40 of original issue discount into account under Code Secs. 163(e) and Example 2 Insolvent Subsidiary. Assume the same facts as Example 1 except that B is insolvent at the time that S sells the note to P. The transaction is still a triggering transaction and the B note is treated as satisfied and reissued for its FMV of $60 immediately before S s sale to P. On a separate return basis, S s $40 loss would be capital, B s $40 income would be excluded from gross income under Code Sec. 108(a), and B would reduce attributes under Code Sec. 108(b) or Code Sec However, under Reg (g)(4)(i)(C), Code Sec.108(a) does not apply to characterize B s income as excluded from gross income. Accordingly, the attributes of S s loss and B s income are redetermined in the same manner as in Example 1. Exceptions to the Deemed Satisfaction and Reissuance suance Rule An intercompany transaction will not be recast as a deemed satisfaction and reissuance suanc of the intercompany obligation before the actual transaction if an exception listed in Reg (g)(3)(i) (B) applies. Instead, the tax treatment of the intercompany transaction are determined based on the actual occurrence of the transaction. General tax principles apply in determining the amount of income, gain, loss or deduction for the debtor and the creditor, subject to modified matching and acceleration rules for timing and tax attributes described in Reg (g)(4)(i). The three exceptions to the deemed satisfaction and reissuance rules that are most relevant with respect to an insolvent subsidiary are the intercompany assumption transaction in Reg (g)(3)(i)(B) (2), the intercompany extinguishment transaction of Reg (g)(3)(i)(B)(5) and the exception for certain Code Sec. 361, 332 or 351 exchanges in Reg (g)(3)(i)(B)(1). Other exceptions include (1) reserve accounting, (2) certain events covered by Code Sec. 108(e)(4) in the case of acquisitions CCH Incorporated. All Rights Reserved.

5 April 2014 by security dealers, (3) routine modifications of intercompany obligation, (4) an outbound distribution of a newly issued intercompany obligation, and (5) an outbound subgroup transaction. A noteworthy point to remember is that these exceptions are not always mutually exclusive and decisive ( e.g., when there are multiple triggering events). An intercompany obligation transaction that falls within one exception may still need to satisfy another exception before it is exempt from the deemed satisfaction and reissuance rule. For example, assume an intercompany obligation is extinguished in a liquidation under Code Sec This meets the exception for a nontaxable Code Sec. 332 corporate transaction in Reg (g)(3)(i)(B)(1). However, the deemed satisfaction and reissuance rule still applies unless the extinguishment also meets the intercompany extinguishment transaction exception of Reg (g)(3)(i)(B)(5). Intercompany Assumption Transactions. An intercompany assumption transaction is a sale or other disposition sit of assets in an intercompany transaction nin which h the intercompany obligations are assumed as part of the transaction. n. 15 The exception applies only to a taxable sale (or other taxable able disposition) it on) of assets in an intercompany ny transaction tion in which gain or loss is recognized under Code Sec Intercompany Extinguishment ishment Transactions. An intercompany extinguishment transaction is an intercompany transaction that consists of the following three elements: (1) All or part of the rights and obligations under the intercompany obligation are extinguished in an intercompany transaction (other than an exchange or deemed exchange of an intercompany obligation for newly issues intercompany obligation). (2) The adjusted issue price of the obligation is equal to the creditor s basis in the obligation. (3) After taking into account the special rules of Reg (g)(4)(i)(C), the creditor s intercompany item with respect to the obligation offsets the debtor s corresponding item (or the offsetting intercompany and corresponding item requirement). Intercompany Transactions with Respect to the Insolvent Subsidiary The proposed regulations will make it difficult for the merger to qualify as a tax-free reorganization. Liquidation of Insolvent Subsidiary Since the subsidiary is insolvent, the parent/shareholder will receive nothing with respect to its stock. There is no specific provision dealing with the liquidation of an insolvent subsidiary in the consolidated return regulations so we must look to the separate return rules. At first glance, it seems that the liquidation is governed by Code Sec. 331a nd not Code Sec In Rev. Rul , 16 however, the IRS stated that [i]f a shareholder receives no payment for its stock in a liquidation of a corporation, neither 331 nor 332 applies to the liquidation. Instead, the shareholder has a loss with respect to the stock covered by Code Sec Even if some of the intercompany debt is recast as equity characterized as preferred stock under Code Sec. 385, Code Sec. 332 still does not apply as long as the parent/shareholder receives nothing with respect to the common stock. 17 It seems ems that t Code Sec. 331 should control for shareholders who receive any payment for preferred ed stock. Since the liquidation is taxable, the parent/shareholder of the insolvent subsidiary will recognize gain (if there is an excess loss account) or loss. In determining whether there is an allowable recognized loss, we must consider various consolidated return provisions including the unified loss rule and the circular basis rule that will be discussed in a subsequent column. With gain or loss recognized, the next issue is whether the gain or loss is with respect to an intercompany transaction and accordingly subject to the provisions of Reg An intercompany transaction is a transaction between corporations that are members of the same consolidated group immediately after the transaction. 18 Since the insolvent subsidiary does not exist after the liquidation, it appears there is no intercompany transaction, and any gain or loss recognized by the parent/ shareholder is not subject to the intercompany transaction rules contained in Reg Although Reg provides that any reference to a person TAXES THE TAX MAGAZINE 23

6 includes, as the context may require, a reference to a predecessor or successor, it does not appear that the parent corporation is the successor of the liquidated insolvent subsidiary. 19 Having looked at the tax consequences to the shareholder/parent of the liquidation, we turn to the tax consequences of the liquidation to the debt holders and the insolvent subsidiary. Assume that P forms a subsidiary L by putting in $100 for all its stock. L borrows $100 from each of P, S (another subsidiary in the P group) and X (an unrelated party). In each case, L issues a $100 note. In year 1, L then takes the $400 and buys land. Unfortunately, the land decreased in value to $120. On January 2 of year 2, L sells the land for $120, pays $40 to each of P, S and X in satisfaction of their notes, adopts a plan of liquidation and dissolves. P gets nothing with respect to its stock. On December 31 of year 1, P and S each claim a partial bad debt of $60. This is a triggering event since P and S realize an amount from a comparable transaction through the bad debt deduction. Since a triggering transaction has occurred, the deemed satisfaction and reissuance rule comes into effect unless an exception is met. In reviewing the list of exceptions ( e.g., a Code Sec. 361(a), or 351 exchange, intercompany assumption, extinguishment, t, etc. ) we see none apply. Therefore, L is treated ed as paying $40 to each of S and P in satisfaction of the notes. Then L is treated te as issuing new w$1 $100 0no notes topan and S for $40. This is deemed dto occur immediately before the actual charge off of the bad debt amount. L will have COD income of $120 ($60 with respect to each note). L will include the COD in income since Code Sec. 108(a) is not available. P and S will each have an ordinary loss of $60 on the deemed satisfaction of the notes. In year 2, we have the satisfaction of the notes and the liquidation of L. As noted earlier, different income tax treatments apply for non-intercompany loans and intercompany loans. First, the amount borrowed from X is a non-intercompany obligation. X will have COD income in the amount of $60 ($100 adjusted issue price of note less $40 received by X in satisfaction of the obligation). Since L is insolvent, the COD is not included in income pursuant to Code Sec. 108(a). However, as we will see in a subsequent column, the $60 COD will reduce attributes of the consolidated group (not necessarily just L) pursuant to Reg Circular basis rules under Reg (c) will also apply when COD income is excluded in the same tax year that the debtor is liquidated or disposed of. Second, the amounts borrowed from P and S are intercompany obligations. We now look to see if a triggering transaction has occurred. One type of triggering event is an extinguishment transaction (which includes a comparable transaction in which a member realizes an amount from the intercompany obligation). If S and P received an amount from the extinguishment of all or a part of its remaining rights under an intercompany obligation, then an extinguishment transaction has occurred. Since P and S received $40 each with respect to their intercompany obligations, there has been a triggering transaction. Since a triggering transaction has occurred, the deemed satisfaction and reissuance rule comes into effect unless an exception is met. Since the liquidation is taxable, the exception for nontaxable transactions under Code Sec. 361, 332 or 351 is not met. Similarly, there has been no assumption of the debt so the exception for intercompany assumption transactions is not met. That leaves us to look at whether it qualifies as an intercompany extinguishment transaction. An intercompany extinguishment transaction occurs if (1) all rights are extinguished in an intercompany transaction, (2) the adjusted issue price is equal to the creditor s basis in the obligation, and (3) the debtor s corresponding item offsets the creditor s intercompany item. For purposes of this discussion, we hypothesize that the payment of the $40 by L to P and S is an intercompany transaction. 20 Therefore, all three requirements for an intercompany extinguishment transaction should be met so we do not have a deemed satisfaction and reissuance. Instead we just have a retirement of the obligation. L will be treated as retiring an obligation with an adjusted issue price of $40 for $40 so it has no COD. Similarly, P and S have no gain or loss since the basis in the notes is $40 and the consideration received is $ If the payment of the $40 by L to P and S is not an intercompany transaction, then the deemed satisfaction and reissuance rule applies. However, it is not likely this would change the tax results when the debt is repaid at the time of liquidation. L would be treated as having satisfied and reissued each note to P and S for its FMV of $40 (which is the same amount of L s debt repayment). Since the CCH Incorporated. All Rights Reserved.

7 April 2014 adjusted issue price of $40 equals the FMV of $40, L has no COD income. P and S also have no gain or loss since the deemed repayment of $40 equals the basis in the note. The reissued note would have an issue price of $40 and a stated redemption price of $100. P and S would have a basis of $40 in the new note. Immediately therefore, each new note is repaid for $40. With an issue price of $40, L has no COD income. P and S also have no gain or loss on a payment of $40 in retirement of the new note with a basis of $ Another similar issue occurs when an insolvent subsidiary is indebted to a brother/sister corporation at the time of liquidation and the parent assumes the debt to the brother/sister corporation. In this case, the debt to the brother/sister corporation is not extinguished. Does the intercompany assumption transaction exception under Reg (g) (3)(i)(B)(2) apply? The issue again is whether the liquidation is an intercompany transaction within the meaning of Reg (b)(1)(i). It seems that only an intercompany transaction may qualify for the intercompany assumption transaction exception. The distribution of assets by the insolvent subsidiary may fall within the meaning of a taxable sale or disposition of assets under Code Sec This question is also relevant to the exception of a routine modification of intercompany obligation under Reg (g)(3)(i)(B)(6) 15 (6). Merger of Insolvent Subsidiary into Its Corporate Shareholder/Creditor The merger of a solvent subsidiary into its corporate shareholder is treated as a liquidation pursuant to Code Sec What happens if an insolvent subsidiary is merged into its corporate shareholder? We saw that the liquidation of an insolvent subsidiary is taxable. Does that mean that a merger of such insolvent subsidiary into its corporate shareholder is also a taxable transaction? On March 5, 2005, the Treasury issued proposed regulations dealing with corporate reorganizations of insolvent companies to deal with ambiguity in this area. 23 While these proposed regulations have not been finalized, they do provide guidance. The proposed regulations add two requirements (net value requirements): (1) The fair market value of the property transferred by the target corporation exceeds the sum of the liabilities of the target corporation assumed by the acquiring corporation plus any nonstock boot. Any obligation of the target corporation for which the acquiring corporation is the obligee that is extinguished for federal income tax purposes in connection with the exchange is treated as a liability assumed by the acquiring corporation. (2) The fair market value of the assets of the issuing corporation exceeds the amount of its liabilities immediately after the exchange. 24 The proposed regulations will make it difficult for the merger to qualify as a tax-free reorganization. For example, assume similar facts to our prior example except that P provides all $300 of the financing (X and S provide nothing). After the land goes down in value to $120, L merges into P. In the merger, the $300 of intercompany debt is extinguished. The proposed regulations indicate that the FMV of the assets transferred ($120) must exceed the liabilities assumed. In this case, the liabilities assumed include the intercompany obligation of $300 even though it is extinguished in the merger. Therefore, the first requirement is failed. An interesting situation arises where the subsidiary has two classes of stock ( i.e., common and preferred). In the merger transaction, like the liquidation, consideration may only be given with respect to the preferred stock since the subsidiary, while solvent, is still financially distressed. As we saw before, Code Sec. 332 does not apply ply because the shareholder did not receive consideration n with respect to the common mo stock. If we look further at Proposed Reg (b), we see the following language: Further, if section 332 does not apply and the recipient corporation receives partial payment for at least one class of stock that it owns in the liquidating corporation, see section 368(a)(1) regarding potential qualification of the distribution as a reorganization. It would seem that it is anticipated that in this situation the merger may be able to meet the new net value requirements mentioned above. Since in effect the upstream merger of an insolvent subsidiary is taxable like a liquidation. The tax treatment with respect to the debt (both intercompany and non-intercompany) should be the same in an upstream merger as in a liquidation. Merger of Insolvent Subsidiary into Its Corporate Sister/Creditor In many consolidated groups, there is a sister corporation that handles the financing for the group. This TAXES THE TAX MAGAZINE 25

8 is often done for state tax planning reasons. Let's assume L and S are subsidiaries of P. S has extra cash and lends it to L, which again purchases land that goes down in value. So S has a loan receivable from L in the amount of $500. L has only one asset and the land is worth $300. L merges into S. As part of the transaction, L s payable is offset against S s receivable in identical amount. The first question is whether this is a valid reorganization. If we look at the above mentioned proposed regulation, we see that again the key is that any obligation of the target corporation for which the acquiring corporation is the obligee that is extinguished for federal income tax purposes in connection with the exchange is treated as a liability assumed by the acquiring corporation. So the $500 liability is treated as assumed even though it is extinguished. Since the assumed liabilities exceed the FMV of S s assets, the merger fails to be a tax-free reorganization under the proposed regulations. Instead, it will be treated as a taxable purchase of assets by S. Now if we look at our exceptions to the triggering events, we find the intercompany extinguishment transaction exception under Reg (g)(3)(i) (B)(5) and the intercompany assumption transaction exception eptio in Reg (g)(3)(i)(B)(2). The intercompany assumption transaction exception applies if all of a debtor s so obligations under an intercompany obligation on are deemed to be assumed first (before being extinguished) in connection nection with the debtor s sale or other disposition it on of property in an intercompany ny transaction tion in which gain or loss is recognized under Code Sec That should be the case here if we treated the transaction as an intercompany transaction. 25 So the net result under this assumption is that this should be treated as a taxable purchase of assets by S for $500. What about the intercompany debt extinguishment exception? Reg (g)(3)(i)(B) suggests that we also need to tackle this hurdle even though we meet the intercompany assumption transaction exception. In particular the regulation states, if a creditor or debtor realizes an amount in a transaction in which a creditor assigns all or part of its rights under an intercompany obligation to the debtor, or a debtor assigns all or part of its obligations under an intercompany obligation to the creditor, the transaction will be treated as an extinguishment and will be excepted from the definition of triggering transaction only if either of the exceptions in paragraphs (g)(3)(i) (B)(5) or (6) of this section apply. So an analysis of the requirements of the intercompany extinguishment transaction exception must be made to conclude the deemed satisfaction and reissuance rule does not apply. Conclusion In this column, we looked at the consolidated intercompany transaction regulations and how they apply to insolvent subsidiaries. We focused first on the tax treatment of non-intercompany obligations and intercompany obligations and then on certain corporate transactions. In future columns, we will explore how other consolidated return provisions impact insolvent subsidiaries. s. These include the consolidated d CODand tax attribute reduction provisions, recognition of excess loss accounts, investment adjustment rules, circular basis rules and the unified loss rules. All of these are interrelated and modify the tax treatment under separate returns. This makes planning with respect to insolvent subsidiaries challenging. ENDNOTES * This column represents the views of the authors, and does not necessarily represent the views or professional advice of Plante Moran and DePaul University. 1 Paul C. Lau, Sandy Soltis and Nora Stapleton, Tackling Taxes, Tackling Unsettled Issues in the Liquidation of an Insolvent Subsidiary, TAXES, Oct. 2009, at An insolvent subsidiary can be a member of a consolidated group. See Rev. Rul , CB Reg (a). 4 Code Sec. 108(d)(3) ; Also see supra note 1. 5 Reg (g)(2)(ii). 6 Reg (g)(2)(i). 7 Plantation Patterns, Inc., CA-5, 72-2 USTC 9494, 462 F2d 712, cert. denied, SCt, 409 US 1076, 93 SCt 683 (1972). 8 Reg (c), Ex. 8; Rev. Rul , CB Reg (c), Ex Code Sec. 108(a)(3). 11 Code Sec. 61(a)(12) ; Reg (c), Ex See Reg (b)(11) and (b)(1)(ii)(B)(3) and Preamble to T.D. 9192, CB Id. 14 Reg (g)(3)(i)(A)(1). 15 See Reg (g)(3)(i)(B)(2). 16 Rev. Rul , CB Proposed Reg (b). Section 332 applies only when the recipient corporation receives at least partial payment for each class of stock that it owns in the liquidating corporation. See also Spaulding Bakeries, Inc., CA-2, 58-1 USTC 9320, 252 F2d Reg (b)(1)(i). 19 Under Reg (j)(2), an acquirer of assets is a successor person only if either (1) the predecessor s assets are acquired with a carryover basis or in a Code Sec. 381(a) CCH Incorporated. All Rights Reserved.

9 April 2014 transaction, or (2) substantially all the predecessor s assets are acquired in complete liquidation of the predecessor. Since nothing is distributed to the parent with respect to its stock in the insolvent subsidiary, it might not be treated as acquiring substantially all of the insolvent subsidiary s assets in a complete liquidation even if the parent is the acquiring corporation. Furthermore, the parent does not acquire the insolvent subsidiary s assets with a carryover basis or in a Code Sec. 381(a) transaction since the liquidation does not qualify as a Code Sec. 332 liquidation or a reorganization. See also LTR (Apr. 14, 2009) and LTR (Oct. 13, 2009). 20 In Reg (b)(1)(i), an intercompany transaction is defined as a transaction between corporations that are members of a consolidated group immediately after the transaction. Since the insolvent subsidiary will not be in existence after the liquidation, it would not be a member of the consolidated group after the liquidation. Therefore, the debt payment might not be an intercompany transaction for the purposes of the intercompany extinguishment transaction exception. Although Reg provides that any reference to a person includes, as the context may require, a reference to a predecessor or successor, it does not appear that the parent corporation is treated as the successor of the insolvent subsidiary. Therefore, if the payment of $40 by L occurred at liquidation, a lingering question is whether the payment is an intercompany transaction since L is no longer in existence. 21 The above discussion assumed that there was no accrual of OID for two days from the time P and S claimed a partial business bad debt of $60 and the time the debt was repaid. Even if there were $1 of OID accrual, the three requirements for an intercompany extinguishment transaction should also be met so we are still excluded from a deemed satisfaction and reissuance. First, P and S each have $1 of OID income (an intercompany item) and L has $2 of interest deduction (an offsetting corresponding item). Second, the basis in the note for P and S should then be increased by $1 to $41 under Code Sec. 1272(d)(2), while the adjusted issue price in each note should also be increased by the same amount to $41 under Code Sec. 1272(a)(4). Therefore, the adjusted issue price is still equal to the creditor s basis in the obligation. Finally, the repayment of each note with an adjusted basis and an adjusted issue price of $41 for $40 results in $1 of loss to P and S (an intercompany item) and $2 of COD income to L (an offsetting corresponding item). Under the matching rule, the loss is treated as ordinary loss. Finally note that Reg (e) states that intercompany obligations are not subject to the AHYDO rules in Code Sec. 163(e)(5). 22 This subsidiary liquidation example shows that the debt was repaid with cash and therefore it was not an intercompany assumption ntransaction. What would happen if assets se s other than cash were transferred as part of the debt repayment? It seems that the liquidation could implicate both the intercompany extinguishment exception and the intercompany assumption exception. 23 REG , CB 835, Rev. Rul holds that the principles relevant to liquidations under Code Sec. 332 also apply to reorganizations under Code Sec However, other authorities are not consistent with the approach of Rev. Rul Most notably, in Norman Scott, Inc., 48 TC 598, Dec. 28,551 (1967), the Tax Court held that a transaction involving an insolvent target corporation qualified as a reorganization under Code Sec. 368(a)(1) (A). The IRS and the Treasury have decided to resolve the uncertainties by generally adopting a net value requirement for each of the described nonrecognition rules in subchapter C. 24 Proposed Reg (f)(2). 25 As explained in note 20 regarding liquidation of an insolvent subsidiary, the transaction might not be viewed as an intercompany transaction. Under this opposite view, the transaction is subject to the deemed satisfaction and reissuance rule. Then the intercompany obligation would be satisfied for $300 and a new intercompany obligation issued for $300 just prior to the merger. Then after the merger, S would have a basis of $300 in the land. L would have a loss of $200 from the taxable disposition of the land with FMV of $300 and basis of $500. See FSA (Dec. 9, 1999) and LTR (Oct. 13, 2009). This article is reprinted ed with the publisher s permission from the TAXES THE T TAX MAGAZINE, a month ly journal published by CCH, a part of Wolters Kluwer. Copying or dis tri bu tion without the pub lish er s per mis sion is prohibited. To subscribe eto the TAXES THE T TAX MAGAZINE or other CCH Journals please call or visit CCHGroup.com. All views expressed in the articles and col umns are those of the author and not necessarily those of CCH. TAXES THE TAX MAGAZINE 27