LOS ANGELES COUNTY BAR ASSOCIATION TAXATION SECTION EXEMPT ORGANIZATIONS COMMITTEE 1

Transcription

1 LOS ANGELES COUNTY BAR ASSOCIATION TAXATION SECTION EXEMPT ORGANIZATIONS COMMITTEE 1 TREATMENT OF THE DISCHARGE OF INDEBTEDNESS UNDER THE UNRELATED BUSINESS TAXABLE INCOME RULES This proposal was principally prepared by Ofer Lion, a member of the State Bar of California Taxation Section and the Exempt Organizations Committee of the Los Angeles County Bar Association Taxation Section. The author wishes to thank Professor Ellen Aprill, David O. Kahn, and David W. Newman for their helpful insights and valuable assistance in reviewing and commenting on earlier drafts of this paper. 2 Contact Person: Ofer Lion Latham & Watkins LLP 355 South Grand Avenue Los Angeles, California (213) ofer.lion@lw.com 1 The comments contained in this paper are the individual views of the authors who prepared them and do not represent the position of the State Bar of California, the Los Angeles County Bar Association, or Latham & Watkins LLP. 2 Although the authors and/or presenters of this paper might have clients affected by the rules applicable to the subject matter of this paper and have advised such clients on applicable law, no such participant has been specifically engaged by a client to participate on this paper. Ofer Lion

2 EXECUTIVE SUMMARY In this recession, reported to be the worst since the Great Depression, tax-exempt organizations are struggling along with the rest of the economy. Contributions and other revenue are down, decreasing their ability to service debt. Assume a situation where a cash-strapped and overextended tax-exempt organization has the opportunity to reduce or cancel its debt. Gross income includes income from the discharge of indebtedness (cancellation of debt, or COD ) under section 61(a)(12) of the Code. 3 Section 511(a) provides for the imposition of tax on the unrelated business taxable income ( UBTI ) of organizations otherwise exempt from federal income taxation pursuant to Section 501(c). If a tax-exempt organization has too much UBTI relative to its charitable operations, it may jeopardize its tax-exempt status under the commensurate in scope test. It is unclear whether the COD income ( CODI ) of a taxexempt organization constitutes UBTI. There does not appear to be any regulation or other guidance addressing this topic. If CODI is treated as UBTI, tax-exempt organizations could be caught between the continuing threat of insolvency on the one hand, and a tax liability and possible loss of tax-exempt status on the other. Without guidance as to whether or under what circumstances CODI constitutes UBTI, boards of directors may choose to continue to service unsustainable amounts of debt rather than face a substantial tax liability and possibly risk the organization s tax-exempt status under the commensurate in scope test. Section I of this Taxation Section proposal (the Proposal ) requests that a Revenue Ruling be issued providing guidance on this topic. Section II provides a brief summary of the reasons for the proposed guidance. Section III examines the legal backgrounds of both CODI and UBTI and the question of whether CODI should constitute UBTI. Section IV discusses the reasons for the proposed guidance in detail. Section V briefly concludes and provides a draft of the proposed Revenue Ruling. 3 Unless indicated otherwise, references to the Code are references to the Internal Revenue Code of 1986, as amended, and references to Sections are references to the Code. 2 Ofer Lion

3 DISCUSSION I. PROPOSED ACTION When a tax-exempt organization has COD and none of the statutory exceptions under Section 108 are applicable, 4 it is unclear whether the resulting CODI is taxable as UBTI. We respectfully ask the Service to address this uncertainty by issuing a Revenue Ruling that affirmatively states that CODI does not constitute UBTI, primarily because the cancellation of debt is not a trade or business, and the use of the proceeds of cancelled debt is not relevant to determining whether CODI constitutes UBTI. In addition, we respectfully request that the Revenue Ruling state that CODI will not be considered a financial resource for purposes of the commensurate in scope test. II. REASONS FOR PROPOSED ACTION If CODI is treated as UBTI, tax-exempt organizations could be confronted by insolvency on the one hand, and on the other, a tax liability and, potentially, loss of tax-exempt status under the commensurate in scope 5 test. With no way to evaluate whether or under what circumstances CODI constitutes UBTI, boards of directors may choose to continue to service unsustainable amounts of debt rather than a face a potentially material cash tax liability and/or jeopardize the organization s tax-exempt status. A Revenue Ruling providing guidance in this area would ensure that tax-exempt organizations are not paying taxes on deemed income that 6 should not be considered UBTI. Uncertainty in this area impedes taxexempt organizations, their creditors and other constituents seeking to (i) reduce, restructure or eliminate debt obligations associated with so-called troubled or underwater investments and other transactions, or (ii) 4 It is assumed herein that net operating losses ( NOLs ) are either unavailable to offset the UBTI, or that an affected tax-exempt organization would not want to utilize its available NOLs for such purpose. It is likewise assumed herein that no exceptions to CODI are applicable. 5 See infra at This Proposal does not address the possibility of debt being cancelled as a form of charitable contribution by the creditor. This Proposal assumes that donative intent is lacking on the part of the creditor. See the discussion of the donative intent requirement for charitable contributions, infra at Ofer Lion

4 repurchase their own bonds or other debt at a discount. IRS or Treasury Department guidance would significantly reduce or eliminate this uncertainty, which should facilitate a return of credit markets to normal functioning. Third, debt forgiveness with respect to tax-exempt organizations should be encouraged in concert with established tax policies benefiting tax-exempt organizations. Finally, guidance would lead to consistent treatment among tax-exempt organizations with CODI. III. CURRENT LAW AND ANALYSIS Current law provides no guidance to tax-exempt organizations with COD where none of the statutory exceptions under Section 108 are applicable. However, an analysis of current authorities indicates that CODI generally should not give rise to UBTI. UBTI is the income from a trade or business regularly carried on by a tax-exempt organization that is not substantially related to the organization s exempt purposes. The threshold question is what should be the analytical focus for purposes of determining whether CODI should constitute UBTI - the fact of debt being cancelled, and/or the use of the proceeds of such debt? It is the COD event itself that is to be analyzed the use of the debt proceeds is not relevant, as discussed below. 7 As such, it will be a rare circumstance where CODI should be categorized as UBTI. First, having debt cancelled can not sensibly be described as a trade or business. It is not an activity carried on for the production of income from the sale of goods or performance of services. No goods are sold, and no services provided. Second, in the overwhelming majority of situations, cancellations of debt will not be regularly carried on. Accordingly, an analysis of the COD itself leads to the conclusion that CODI deemed received by a taxexempt borrower should not be treated as UBTI. The following discussion provides a basic overview of CODI, UBTI, the donative intent requirement for charitable contributions and the commensurate in scope test. 7 See infra at Ofer Lion

5 A. CODI Section 61(a)(12) codifies the Supreme Court s 1931 ruling in United States v. Kirby Lumber, 8 and provides that gross income includes income from the discharge of indebtedness. Such income (also known as cancellation of indebtedness income, or CODI) is ordinary in nature and generally is equal to the difference between what is owed and what is actually paid to satisfy the liability. 9 Certain modifications of a debt obligation may cause a deemed exchange of the applicable debt instrument, 10 which can give rise to CODI. 1. Source of CODI A UBTI analysis of CODI should both look through legal entities as appropriate 11 and look to the underlying source of the CODI. 12 The income underlying CODI arises from the transfer from lender to borrower when the loan was made coupled with the subsequent cancellation of the corresponding liability. 13 CODI generally is rooted in an economic gain or increase in net worth associated with COD, and is taxable as ordinary income under Section Of course, money for nothing (i.e. the U.S. 1 (1931). Kirby Lumber s two-paragraph opinion has produced a long history of uncertainty as to the theoretical underpinnings for treating the cancellation of debt as gross income. See, e.g., Boris I. Bittker & Barton H. Thompson, Jr., Income From the Discharge of Indebtedness: The Progeny of United States v. Kirby Lumber Co., CALIFORNIA LAW REVIEW, Dec. 1978; Katherine Pratt, Corporate Cancellation of Indebtedness Income and the Debt-Equity Distinction, VIRGINIA TAX REVIEW, Fall 2004; Lawrence Zelenak, Cancellation of Indebtedness and Transactional Accounting, VIRGINIA TAX REVIEW, forthcoming, electronic copy available at 9 Id. See also Treas. Reg (c)(2)(ii). 10 Treas. Reg Income is often traced to its source for UBTI purposes, for example, through partnerships, S corporations and Subpart F income from controlled foreign corporations. See I.R.C. 512(c), I.R.C. 512(e), and Priv. Ltr. Rul (March 13, 2006), respectively. 12 See, e.g, Priv. Ltr. Rul (March 13, 2006) (Subpart F income is treated as a deemed dividend under Section 951(a)(1)(A), and because the underlying income (passive investment income of a controlled foreign corporation ) giving rise to the Subpart F income inclusion was not debt-financed or insurance-related, the Subpart F income did not constitute UBTI). 13 See U.S. v. Centennial Sav. Bank FSB, 499 U.S. 573, 582 (1991) ( Borrowed funds are excluded from income in the first instance because the taxpayer's obligation to repay the funds offsets any increase in the taxpayer's assets; if the taxpayer is thereafter released from his obligation to repay, the taxpayer enjoys a net increase in assets equal to the forgiven portion of the debt, and the basis for the original exclusion thus evaporates. ). 14 Id. See also Kirby Lumber at 5 ( The defendant in error has realized within the year an accession to income. ). 5 Ofer Lion

6 economic gain and increase in net worth from the receipt of funds without consideration) is principally what tax-exempt organizations are not taxed on. Likewise, the economic gain or increase in net worth arising from COD should not give rise to UBTI. The deemed income from COD generally does not take into account the use of the loan proceeds. More specifically, the source of CODI cannot logically be said to arise from or be connected with (debtfinanced) property purchased with the loan proceeds, or the business in which the loan proceeds were invested. The courts and the IRS have already been down that road. In Revenue Ruling 92-99, the IRS noted that Hirsch v. Commissioner 15 and Allen v. Courts 16 relied on Bowers v. Kerbaugh-Empire Company 17 to conclude that no CODI resulted from a reduction of thirdparty debt, reasoning that the proceeds of third-party debt should be traced to the investment for which the proceeds were used, and any loss (realized or unrealized) on that investment may be used to offset any income from the discharge of the debt. 18 The IRS continued, [h]owever, subsequent Supreme Court decisions and other court cases, when viewed together, have discredited Kerbaugh-Empire. 19 As a result, it appears that the use of the loan proceeds are not, or at least are no longer, relevant to a COD analysis. Thus, even if debt proceeds were used to support an unrelated business or to purchase debt-financed property, that would not be relevant to the CODI analysis and, as a result, should not be taken into account for purposes of analyzing whether CODI is UBTI. 2. Section 382(l)(5)(B) Interest Expense Recapture The bankruptcy exception to CODI sometimes comes at a cost to taxpayers in the form of a reduction of tax attributes in an amount equal to the amount of cancelled debt. The Code provides two alternative bankruptcy exceptions from the Section 382 limitation for the net operating loss carryforwards of loss corporations undergoing an ownership change F.2d 656 (7th Cir. 1940) F.2d 127 (5th Cir. 1942) U.S. 170 (1926). 18 Rev. Rul Id. 6 Ofer Lion

7 pursuant to a bankruptcy proceeding. 20 Under the first exception, a debtor s pre-ownership change net operating losses are not subject to the Section 382 limitation but are instead reduced by the amount of any interest deductions allowed during the three taxable years preceding the taxable year in which the ownership change occurs, and during the part of the taxable year prior to and including the effective date of the bankruptcy reorganization, in respect of the debt converted into stock of the debtor corporation in the reorganization. 21 In other words, interest expense deductions on the debt being cancelled that gave rise to net operating losses are recaptured (by a corresponding reduction in the net operating losses permitted to be carried over) where the creditor is converted into a stockholder pursuant to the bankruptcy reorganization. By analogy, initially it would appear that historic interest expense deductions from UBTI arising from debt being cancelled should be recaptured and included in current UBTI. However, Section 382(l)(5)(B) only applies to indebtedness being converted into stock, so that the lender does not receive the benefit of both the receipt of interest income and the net operating losses derived from the deductions taken with respect to the same interest. Where a lender to a tax-exempt organization cancels debt, the lender could not have received the benefit of the interest expense deductions from UBTI taken by the borrower. As a result, there does not appear to be an analogous rationale to recapture the interest expense deductions from UBTI upon the cancellation of the debt that gave rise to such deductions from UBTI. B. UBTI The Code defines UBTI under Section 512(a)(1) as the gross income derived by any organization from any unrelated trade or business regularly carried on by it, less any allowable deductions directly connected with the carrying on of such trade or business, both computed with the modifications provided in Section 512(b). Treasury Regulation section (a) provides that gross income is UBTI, unless one of the specific exceptions is applicable, where: (1) it is income from a trade or business ; 20 I.R.C. 382(l)(5), (6). 21 I.R.C. 382(l)(5)(b). 7 Ofer Lion

8 (2) such trade or business is regularly carried on by the organization; and (3) the conduct of such trade or business is not substantially related (other than through the production of funds) to the organization's performance of its exempt functions. The term trade or business generally includes any activity carried on for the production of income from the sale of goods or performance of services. 22 The primary objective of adoption of the unrelated business income tax was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete. On the other hand, where an activity does not possess the characteristics of a trade or business the unrelated business income tax does not apply since the organization is not in competition with taxable organizations. However, in general, any activity which is carried on for the production of income and which otherwise possesses the characteristics required to constitute trade or business and which is not substantially related to the performance of exempt functions presents sufficient likelihood of unfair competition to be within the policy of the tax. 23 [S]pecific business activities of an exempt organization will ordinarily be deemed to be regularly carried on if they manifest a frequency and continuity, and are pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations. 24 [F]or the conduct of trade or business from which a particular amount of gross income is derived to be substantially related to purposes for which exemption is granted, the production or distribution of the goods 22 Treas. Reg (b) (emphasis added). 23 Id. 24 Treas. Reg (c)(1) (emphasis added). 8 Ofer Lion

9 or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of those purposes. 25 Tax-exempt organizations are not taxed on ordinary income unless such income constitutes UBTI. As discussed above, it is the COD itself that should be the touchstone when determining whether CODI constitutes UBTI, rather than how the proceeds of the debt were used. As a result, it is not apparent how the discharge from indebtedness could be characterized as a regularly carried on trade or business the threshold requirement for income to be considered UBTI. 1. Legislative Intent The UBTI rules were originally enacted by the Revenue Act of 1950 and were directed at unfair competition by tax-exempt organizations engaging in businesses unrelated to their exempt purposes. 26 Not treating CODI as UBTI will not create any such unfair competition. A tax-exempt organization may invest the charitable contributions it receives in an unrelated trade or business without consequence to the deductibility of such donation. Thus, recognizing that CODI is not UBTI is no more unfair than the general policy allowing for the existence tax-exempt organizations in the first place. Further, to the extent an unrelated trade or business continues after the reduction or elimination of debt, there would almost certainly be a corresponding reduction in the available interest deduction from UBTI. 2. Debt-Financed Property Section 512(b) provides several exclusions from UBTI for certain generally passive investment activities, including dividends, interest, royalties, rents from real property and capital gains. Section 512(b)(4), however, establishes an exception to such exclusions where the 25 Treas. Reg (d)(2) (emphasis added). 26 The Senate Finance Committee indicated that [t]he problem at which the tax on unrelated business income is directed is primarily that of unfair competition. The tax-free status of [organizations exempt from taxation pursuant to Section 501(c)] enables them to use their profits tax-free to expand operations, while their competitors can expand only with the profits remaining after taxes. S. REP. NO. 2375, 81st Cong., 2d Sess., reprinted in CB 483, 504. See also Treas. Reg (b) ( The primary objective of adoption of the unrelated business income tax was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete. ). 9 Ofer Lion

10 passive income or capital gain producing asset is debt-financed property. Thus, where the debt-financed property s use is not substantially related to the organization s exempt purposes, the income from debt-financed property may be UBTI notwithstanding the exceptions described above. 27 [T]he basic purpose of Section 514 is to tax otherwise nontaxable income derived from leveraged investments unrelated to an exempt purpose in order to discourage the incurrence of substantial debt by tax-exempt organizations for purposes unrelated to exemption and to reduce opportunities for structuring transactions (such as three-party leveraged buyouts) that trade on the tax-exempt status of the organization. 28 COD may reduce the extent to which property is debt-financed, while a decrease in the amount of interest due may increase the UBTI attributable to the debt-financed property (by reducing the deduction for interest). It is also worth noting that even if CODI is not treated as UBTI, the debt-financed income exclusion from the general exceptions to UBTI would continue to hinder abuse and unfair competition by tax-exempt organizations. 3. Depreciation Recapture Section 512(b)(5) excludes from UBTI all gains or losses from the sale, exchange, or other disposition of property other than (A) stock in trade or other property of a kind which would properly be included in the inventory of the organization if on hand at the close of the taxable year, or (B) property held primarily for sale to customers in the ordinary course of the trade or business. Section 1250 provides certain rules for the recapture of depreciation as ordinary income upon the disposition of property for which an accelerated depreciation method was utilized. Depreciation recapture under Section 1250 overrides Section 512(b)(5) I.R.C Section 514(b)(1)(A) provides that debt-financed property does not include property substantially all of which is used for a purpose substantially related to the organization s exempt purposes, or if not substantially all so used, to the extent that its use is so substantially related. In addition, Section 514(c)(9) generally provides that acquisition indebtedness does not include indebtedness incurred by certain qualified organizations or, where certain conditions are met, partnerships whose partners include one or more qualified organizations. 28 FRANCES R. HILL & DOUGLAS M. MANCINO, TAXATION OF EXEMPT ORGANIZATIONS (Warren, Gorham & Lamont 2002). 29 Treas. Reg (c)(2). 10 Ofer Lion

11 For example, assume that a building that has been depreciated is sold at a gain. Section 512(b)(5) may exclude such gain from UBTI, unless (and to the extent) that some portion of the property was debtfinanced within the meaning of Section 514(b). Assume further that the taxexempt organization owned the building free and clear of any mortgage or any other debt, so that Section 512(b)(5) fully excludes any gain from UBTI. While Section 1250 recapture could override Section 512(b)(5) and cause some of the gain to be recaptured and taxed as ordinary income (UBTI), 30 there would be no Section 1250 recapture if the building was depreciated on the straight line method. 31 In addition, if none of the depreciation was used to reduce UBTI, Section 1250 recapture would not apply even if an accelerated depreciation was utilized. 32 Since CODI is ordinary income, it appears doubtful that Section 512(b)(5), which applies to gains, would be applicable. As an analogy, however, the Section 1250 recapture override may be instructive. Upon a sale of certain property, Section 1250 generally requires an inclusion in UBTI of the amount by which certain accelerated depreciation was used to reduce UBTI arising from such property. Note also that no income is realized as CODI to the extent that payment of the liability would have given rise to a deduction. 33 Thus, the cancellation of any interest payment obligation (if not previously expensed) generally would not give rise to CODI. The reduction in principal likewise is implicated, as it was not used to reduce UBTI (although the loan s existence may have been the causal factor for certain income to be derived from debt-financed property). With a reduction in principal on a loan, there is no lost UBTI to recapture. C. Charitable Contributions and Donative Intent Donative or charitable intent is a prerequisite for claiming a charitable contribution deduction. To claim a charitable contribution deduction, the burden is on the taxpayer to show that all or part of payment 30 Even if the property is not debt-financed, this could be the case where, for example, rents did not qualify as rents from real property excluded from UBTI pursuant to Section 512(b)(3). 31 This example is drawn from Technical Advice Memorandum (March 3,1995). 32 Recapture generally only relates to depreciation adjustments allowed or allowable in computing UBTI. See Treas. Reg (d)(6). 33 I.R.C. 108(e)(2). 11 Ofer Lion

12 is a charitable contribution or gift. 34 No part of a contribution that is in consideration for goods or services is considered a deductible contribution or gift unless the taxpayer (i) Intends to make a payment in an amount that exceeds the fair market value of the goods or services; and (ii) Makes a payment in an amount that exceeds the fair market value of the goods or services. 35 A lender cancelling debt as a means of making a charitable contribution may have difficulty meeting its burden of proof in demonstrating donative intent where the borrower is financially distressed. Instead, the lender may be eligible for a bad debt deduction or a loss. 36 Nonetheless, COD without donative intent can be analogized to a charitable contribution deduction disallowed for lack of donative intent. Assume that a lender transferred cash to a troubled borrower but required that the cash immediately be used to prepay principal on the loan (i.e., in substance, a cancellation of debt). Such a transfer could be viewed as lacking in donative intent. Thus, if the borrower was an individual, the cash would be ordinary income (rather than a nontaxable gift) in an amount equal to the CODI that would have arisen had a like amount of debt been cancelled directly. If the borrower was a tax-exempt organization, the transfer would not qualify as a charitable contribution. Unlike the individual, however, unless the lack of donative intent was the result of the provision of a good or service (consideration for the cash received) by the tax-exempt borrower in connection with its operation of a regularly carried on unrelated trade or business, the cash, while included in the organization s gross income and reported as such, 34 Treas. Reg A-1(h)(1). 35 Id. (Emphasis added.) See also Rev. Rul ( Another element which is important in establishing that a gift was made in such circumstances, is evidence that the payment in excess of the value received was made with the intention of making a gift. While proof of such intention may not be an essential requirement under all circumstances and may sometimes be inferred from surrounding circumstances, the intention to make a gift is, nevertheless, highly relevant in overcoming doubt in those cases in which there is a question whether an amount was in fact paid as a purchase price or as a gift. ); Comr. v.duberstein, 363 U.S. 278, (1960) ( [t]he mere absence of a legal or moral obligation to make such a payment does not establish that it is a gift. [T]he most critical consideration is the transferor's intention. What controls is the intention with which payment, however voluntary, has been made. ) (internal citations omitted). 36 See I.R.C. 166 (bad debts) and 165 (losses). 12 Ofer Lion

13 generally should not be UBTI. It follows that had the debt been cancelled directly, the resulting CODI likewise should not be UBTI. D. The Commensurate in Scope Test A tax-exempt organization may risk its tax-exempt status if it has too much UBTI under what is known as the commensurate in scope test. An organization may meet the requirements of Section 501(c)(3) although it operates a trade or business as a substantial part of its activities if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business. 37 In Private Letter Ruling , the IRS found that [i]n determining the existence or nonexistence of such primary purpose, all the circumstances must be considered, including the size and extent of the trade or business and the size and extent of the activities which are in furtherance of one or more exempt purposes. 38 The IRS continued: In Rev. Rul , C.B. 186, a corporation organized exclusively for charitable purposes derives its income principally from the rental of space in a large commercial office building which it owns, maintains and operates. The charitable purposes of the corporation are carried out by aiding other charitable organizations, selected in the discretion of its governing body, through contributions and grants to such organizations for charitable purposes. The ruling holds that the corporation is deemed to meet the primary purpose test of section 1.501(c)(3)-1(e)(1) of the regulations, and to be entitled to exemption under section 501(c)(3) of the Code, where it is shown to be carrying on through such contribution and grants a charitable program commensurate in scope with its 39 financial resources. 37 Treas. Reg (c)(3)-1(e)(1). 38 Priv. Ltr. Rul (Feb. 25, 2005). 39 Id. (Emphasis added.) See also G.C.M ( [T]here is no quantitative limitation on the amount of unrelated business an organization may engage in under section 501(c)(3), other than that implicit in the fundamental requirement of charity law that charity properties must be administered exclusively in the beneficial interest of the charitable purpose to which the property is dedicated. ). 13 Ofer Lion

14 The commensurate in scope test has received increased attention from Congress and the IRS over the last few years. 40 Several practitioners have raised questions as to the rationale for and the actual application of the test. A report from the New York State Bar Association Tax Section found that [d]espite this recent Congressional and IRS focus on the commensurate test, the commensurate test has been poorly defined and unevenly applied (if at all) from its inception. 41 An article in Taxation of Exempts indicates that: The Service has begun to use what is a rather obscure test in instances where there are already well-established tools to the [sic] address the question of tax-exempt status. Moreover, the Service has applied the test in ways that are not supported by GCM In large part this reflects an inversion that has taken place. Early on, the Service used the test to support taxpayer-favorable results. As of late, the Service has used the 42 test to reach results adverse to taxpayers. The lack of clarity as to the application of the commensurate in scope test, in combination with an increased focus on the test by the IRS and its use of the test to reach unfavorable results for tax-exempt organizations, amplifies the concerns of tax-exempt organizations contemplating the cancellation of debt. Boards of directors may rightly wonder whether and how CODI would be applied under the commensurate in scope test. COD is not a trade or business, as discussed above. 43 As such, COD is not a trade or business for purposes of Treasury Regulation section 1.501(c)(3)-1(e)(1). Accordingly, the resulting CODI should not be considered a financial resource for purposes of the commensurate in scope test under Revenue Ruling For examples, see New York State Bar Association Tax Section, Report to Treasury Regarding the Use of the Commensurate in Scope Test, (Nov. 17, 2008), under the heading Introduction Congress and IRS Renew Interest in Commensurate in Scope Test, pp. 3-5, available at: Content/ContentFolders20/TaxLawSection/TaxReports/1169Report.pdf. 41 Id. at 5. See generally id. at 5-8 under the heading Uncertainties Surrounding the Commensurate in Scope Test. 42 Jack B. Siegel, Commensurate in Scope: Myth, Mystery, or Ghost? Part One, 20 EXEMPTS 3, at 32 (Nov./Dec. 2008). 43 See supra at Ofer Lion

15 IV. BENEFITS OF CLARIFICATION A Revenue Ruling providing guidance in this area would ensure that tax-exempt organizations are not paying taxes on deemed income that should not be considered UBTI. Clarification would provide several additional benefits, would likely have minimal fiscal impact, should not require an excessive administrative burden, and should not significantly increase the potential for abuse. A. Additional Benefits 1. Facilitating a Return of Credit Markets to Normal Functioning Tax-exempt organizations, their creditors and other constituents should be encouraged to reduce, restructure or eliminate the nonrecourse and other debt obligations associated with so-called troubled or underwater investments and transactions to align such debts with their fair market value. Creditors contemplating a reduction of the debt obligation of a tax-exempt borrower may seek to condition any such COD on the borrower s continuing exempt status. Further, creditors may condition any COD on the receipt of an opinion of counsel that the CODI will not be taxable as UBTI. After all, the creditor likely will want all or a significant portion of a struggling tax-exempt borrower s available cash used to service any remaining debt, not to pay a federal income tax liability senior to its claim. To ensure compliance with the UBTI rules, a tax-exempt organization may engage legal or other expert advisors to conduct research into the appropriate treatment of CODI. Due to the lack of authority, such advisors might arrive at conflicting results or be unable to provide reliable guidance. Guidance would significantly reduce or eliminate the uncertainty as to whether a COD event will give rise to UBTI. Further, guidance would permit tax-exempt organizations to seek debt reductions without fear of a CODI related tax liability or the potential loss of taxexempt status under the commensurate in scope test. As a result, the requested Revenue Ruling could help facilitate a return of credit markets to normal functioning. The federal government already has taken legislative and regulatory steps towards this end, including several moves easing the 15 Ofer Lion

16 effects of the COD and related rules. 44 Revenue Ruling guidance allowing lenders to reduce or cancel the debt obligations of tax-exempt organizations without giving rise to UBTI would facilitate those efforts. 2. Encouraging Debt Forgiveness The federal income tax system is designed to encourage giving to tax-exempt organizations, and should likewise encourage debt forgiveness in this sector. A lender would not likely need to demonstrate the donative intent necessary to claim a charitable contribution deduction for forgiven debt, 45 as such a lender could instead claim a bad debt deduction or a loss. 46 Nonetheless, forgiveness of the debt of tax-exempt organizations should be encouraged in concert with tax policies benefitting charitable organizations. Guidance indicating that CODI generally does not give rise to UBTI would be effective towards that end. 3. Consistent Treatment There does not appear to be any regulation or other guidance addressing whether CODI is UBTI. As a result, different taxexempt organizations and their tax advisors could (and quite possibly would) reach different conclusions in substantially similar circumstances. Clarification in this area would promote uniformity by encouraging similar tax outcomes for similarly situated organizations. B. Fiscal and Administrative Impact The suggested guidance is not intended to reduce the scope of the CODI or the UBTI rules. Rather, guidance in this area should provide 44 Legislative examples include the American Recovery and Reinventment Act of 2009 (the 2009 Act ) (permitting the deferral of certain CODI, among other things), the Emergency Economic Stabilization Act of 2008 (under which the Troubled Assets Relief Program (known as TARP) was established), the Capital Purchase Program (direct investment by the U.S. in financial institutions), and the Capital Assistance Program (banks failing stress tests required to privately raise capital or issue convertible preferred stock to the U.S.). General information is available at: roadtostability/ programs.htm. Regulatory examples include Treasury Notice (no Section 382 limitation would be applied to limit the use by certain banks of losses on loans or bad debts after an ownership change the rule change was revoked (but not retrospectively) by the 2009 Act) and Treasury Notice (capital contributions made during a two-year period prior to an ownership change will not be presumed to be part of a plan to avoid or increase Section 382 limitations). 45 See the example described under Charitable Contributions and Donative Intent supra at See I.R.C. 166 (bad debts) and 165 (losses). 16 Ofer Lion

17 tax-exempt organizations with the ability to determine with certainty that contemplated CODI will not constitute UBTI under current law. Clarification in this area of uncertainty would promote the fair and efficient administration of the tax law. The suggested guidance should not significantly increase the potential for abuse. Lenders seek to avoid cancelling debts. The primary purpose test and the related commensurate in scope test will continue to hinder abuse and unfair competition by tax-exempt organizations. The debtfinanced income rules serve to prevent the abuse of leveraged investments or other transactions by tax-exempt organizations. 47 Further, existing partnership regulations and the substantial economic effect test should prevent abusive allocations of CODI to the tax-exempt partners of a partnership with both taxable and tax-exempt partners. 48 With respect to the Section 514(c)(9) debt-financed property exception applicable to real property acquired by partnerships that have one or more qualified organizations as partners, a similar goal is achieved by the qualification requirements for any such partnership under Section 514(c)(9)(B)(vi). 49 From a fiscal perspective, the suggested guidance does not seem likely to result in a material or undue revenue decrease. Administratively, the issuance of an appropriate Revenue Ruling in this area should not be an excessive administrative burden. V. CONCLUSION AND REQUESTED REVENUE RULING There is currently no guidance as to whether CODI constitutes UBTI. A Revenue Ruling in this area would ensure that tax-exempt organizations 47 See discussion of debt-financed property, supra at See, e.g., Treas. Reg (b)(1)(i) ( Under section 704(b) if a partnership agreement does not provide for the allocation of income, gain, loss, deduction, or credit (or item thereof) to a partner, or if the partnership agreement provides for the allocation of income, gain, loss, deduction, or credit (or item thereof) to a partner but such allocation does not have substantial economic effect, then the partner's distributive share of such income, gain, loss, deduction, or credit (or item thereof) shall be determined in accordance with such partner's interest in the partnership (taking into account all facts and circumstances) ). 49 Section 514(c)(9)(B)(vi) provides that the debt-financed income exclusion applicable to qualified organizations shall not apply to real property held by a partnership unless (i) all of the partners are qualified organizations, (ii) each allocation to a partner which is a qualified organization is a qualified allocation within the meaning of Section 168(h)(6), or (iii) the partnership meets the requirements set forth in Section 514(c)(9)(E), including the so-called fractions rule. The latter two provisions require that partnership allocations have substantial economic effect. 17 Ofer Lion

18 are not paying taxes on income that, as discussed herein, should not be considered UBTI. Guidance would eliminate the uncertainty, facilitating a return of credit markets to normal functioning by allowing tax-exempt organizations to pursue the reduction of debt obligations to their current market values and/or to sustainable levels, without fear of an unwarranted tax burden or loss of exempt status. Debt forgiveness would be encouraged in concert with tax policies benefitting charitable organizations. Clarification in this area would promote consistent treatment and the fair and efficient administration of the tax law. An appropriate Revenue Ruling would not create an unreasonable administrative burden and should not lead to a material revenue reduction. Finally, the suggested guidance should not significantly increase the potential for abuse. We respectfully ask the Service to issue a Revenue Ruling that affirmatively states that CODI does not constitute UBTI, primarily because the cancellation of debt is not a trade or business, and the use of the proceeds of cancelled debt is not relevant to determining whether CODI constitutes UBTI. In addition, we respectfully request that the Revenue Ruling state that CODI will not be considered a financial resource for purposes of the commensurate in scope test. A draft of the proposed revenue ruling follows: Rev. Rul : Unrelated business taxable income cancellation of indebtedness income. Headnote: IRS ruled that the cancellation of indebtedness income (CODI) of an exempt organization does not constitute unrelated business taxable income (UBTI) and will not be considered a financial resource for purposes of the commensurate in scope test. Full Text: Issues 1. Whether, under the facts below, the CODI of an exempt organization constitutes UBTI under section Ofer Lion

19 2. Whether, under the same facts, the CODI of an exempt organization constitutes a financial resource for purposes of the commensurate in scope test. Facts C is a corporation recognized as exempt from Federal income tax under section 501(a) as an organization described in section 501(c)(3). C owns real property, P, acquired using the proceeds of a loan, L. The principal balance of L exceeds the current fair market value of P. C reports the rental income from P as unrelated debt-financed income within the meaning of section 514 and therefore subject to the unrelated business income tax under section 511. C seeks to renegotiate L to reduce the principal amount due. C will recognize gross income from the cancellation of indebtedness arising from any such reduction in the principal amount of L. Law Section 61(a)(12) provides that, in general, gross income includes income from the discharge of indebtedness. The Supreme Court in U.S. v. Centennial Sav. Bank FSB, 499 U.S. 573, 582 (1991) stated that [b]orrowed funds are excluded from income in the first instance because the taxpayer's obligation to repay the funds offsets any increase in the taxpayer's assets; if the taxpayer is thereafter released from his obligation to repay, the taxpayer enjoys a net increase in assets equal to the forgiven portion of the debt, and the basis for the original exclusion thus evaporates. Revenue Ruling 92-99, C.B. 35, provides that Hirsch v. Commissioner, 115 F.2d 656 (7th Cir. 1940), and Allen v. Courts, 127 F.2d 127 (5th Cir. 1942), relied on Bowers v. Kerbaugh-Empire Company, 271 U.S. 170 (1926), to conclude that no CODI resulted from a reduction of third-party debt, reasoning that the proceeds of third-party debt should be traced to the investment for which the proceeds were used, and any loss (realized or unrealized) on that investment may be used to offset any income from the discharge of the debt. Revenue Ruling further provides that subsequent Supreme Court decisions and other court cases, when viewed together, have discredited Kerbaugh-Empire. 19 Ofer Lion

20 Section 511(a) generally imposes a tax on the UBTI of organizations otherwise exempt from Federal income tax under section 501(a) and certain other entities. Section 512(a)(1) generally provides that the term unrelated business taxable income means the gross income derived by any organization from any unrelated trade or business, as defined in section 513, regularly carried on by it, less certain deductions and subject to the modifications provided in section 512(b). For the purpose of section 513, the term trade or business generally includes any activity carried on for the production of income from the sale of goods or performance of services. See section (b) of the regulations. Section 512(b)(3)(A)(i) excludes rents from real property from unrelated business taxable income. Section 512(b)(4) generally provides that notwithstanding the exclusions set out in section 512(b)(3), UBTI includes certain income, less deductions, derived from debt-financed property, as defined in section 514. Section 514(b)(1) defines the term debt-financed property as any property that is held to produce income and with respect to which there is acquisition indebtedness at any time during the taxable year (or during the 12 months preceding disposition in the case of property disposed of during the taxable year). Section 514(c)(1) provides that the term acquisition indebtedness means, with respect to any debt-financed property, the unpaid amount of (A) indebtedness incurred by the organization in acquiring or improving the property, (B) indebtedness incurred before the acquisition or improvement of the property if the indebtedness would not have been incurred but for the acquisition or improvement, and (C) indebtedness incurred after the acquisition or improvement of the property if the indebtedness would not have been incurred but for the acquisition or improvement and the incurrence of the indebtedness was reasonably foreseeable at the time of the acquisition or improvement. Section 501(c)(3) provides, in part, for the exemption from federal income tax of corporations organized and operated exclusively for charitable, scientific, or educational purposes, provided no part of the organization's net earnings inures to the benefit of any private shareholder or individual. 20 Ofer Lion

21 Section 1.501(c)(3)-1(e)(1) of the regulations provides that an organization may meet the requirements of section 501(c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade business, as defined in section 513. In determining the existence or nonexistence of such primary purpose, all the circumstances must be considered, including the size and extent of the trade or business and the size and extent of the activities which are in furtherance of one or more exempt purposes. In Revenue Ruling , C.B. 186, a corporation organized exclusively for charitable purposes derives its income principally from the rental of space in a large commercial office building which it owns, maintains and operates. The charitable purposes of the corporation are carried out by aiding other charitable organizations, selected in the discretion of its governing body, through contributions and grants to such organizations for charitable purposes. The ruling holds that the corporation is deemed to meet the primary purpose test of section 1.501(c)(3)-1(e)(1) of the regulations, and to be entitled to exemption under section 501(c)(3), where it is shown to be carrying on through such contribution and grants a charitable program commensurate in scope with its financial resources. Analysis Section 512(a)(1) provides that UBTI is the income from a trade or business regularly carried on by a tax-exempt organization that is not substantially related to the organization s exempt purposes. The income underlying CODI arises from the transfer from lender to borrower when the loan was made coupled with the subsequent cancellation of the corresponding liability. U.S. v. Centennial Sav. Bank FSB, 499 U.S. 573, 582 (1991). Revenue Ruling describes cases which indicate that the use of the debt s proceeds is not relevant to determining whether and to the extent the discharge of indebtedness gives rise to CODI. The cancellation of debt inherent in the reduction in the principal balance of L is not an activity carried on for the production of income from the sale of goods or performance of services. Accordingly, such cancellation of debt is not a trade or business under section 513 and section (b) of the regulations. 21 Ofer Lion

22 In addition, the reduction of C s debt is not a trade or business for purposes of section 1.501(c)(3)-1(e)(1) of the regulations. Accordingly, the resulting CODI is not a financial resource for purposes of the commensurate in scope test under Revenue Ruling Holding Under the circumstances described, the CODI recognized by C from the reduction in the principal amount due under L will not constitute UBTI. Under the circumstances described, the CODI recognized by C from the reduction in the principal amount of L will not constitute a financial resource for purposes of the commensurate in scope test under Revenue Ruling Ofer Lion