Recognizing Loss Across Borders: More than Meets the Eye

Transcription

1 Recognizing Loss Across Borders: More than Meets the Eye Daniel C. White Philip B. Wright April 23, 2015 (updated) St. Louis International Tax Group, Inc. 1

2 Overview I. Overview II. III. IV. Loss Recognition Transactions A. Insolvent Subsidiary Liquidations Rev. Rul B. Sale or Exchange Transactions Granite Trust General Loss Tax Consequences Collateral Loss Tax Consequences V. Examples 2

3 II.A Loss Recognition Transactions and Rev. Rul A. Insolvent Subsidiaries and Rev. Rul Section 332 liquidation only applies [when] the [controlling corporate shareholder] receives at least partial payment for the stock which it owns in the liquidating corporation. Section 332 will not apply and transaction will be taxable under Section 1001 if: Subsidiary is balance sheet insolvent. Morton v. Comm r, 38 B.T.A (1938), aff d 112 F.2d 320 (7 th Cir. 1940); or Subsidiary has multiple classes of stock and not all classes held by controlling corporate shareholder receives proceeds in liquidation. Spaulding Bakeries Inc., 27 T.C. 684 (1957), aff d 252 F.2d 693(2 nd Cir. 1958); H. K. Porter, 87 T.C. 689 (1986) Liquidation of corporation, including by classification election, is identifiable event. Rev. Rul

4 II.B Loss Recognition Transactions and Granite Trust Section 331 and 336 apply to solvent corporate liquidations not described in Section 332. If a corporation is solvent but does not have one corporate shareholder controlling the subsidiary, Section 332 will not apply. This generally requires full recognition of gain or loss at the corporate and shareholder level. Section 1504(a)(2) defines control, generally 80% voting power and 80% value Control may be broken in contemplation of the liquidation transaction. Granite Trust Co., 238 F.2d 670 (1st Cir. 1956) Pre-liquidation transfers of subsidiary stock may be taxable or tax-free. Compare Sections 1001, 304 with Sections 170, 351(a) Nature of the transfer may alter the availability of the loss on the transferred portion. See Section 267(f) Transaction could be a tax-free C reorganization if one corporation acquires substantially all properties of the insolvent corporation, limiting loss recognition. See Rev. Rul (upstream C reorganization); Treas. Reg (d)(4)(anti- Bausch & Lomb regulations); Norman Scott, 48 T.C. 598 (1967)(permitting insolvent reorganization with affiliated shareholder/creditor) 4

5 A.M Illustrated US-X US-X Debt FS-Y 20% 80% Debt FS-Y 20% 80% FS-Z FS-Z FS-Z is balance sheet insolvent FS-Z changes its entity classification by election (deemed liquidation) FS-Z is deemed to distribute its assets subject to its liabilities in liquidation, which are deemed contributed to a new partnership 5 After the election, FS-Z is classified as a partnership for US tax purposes.

6 Collateral Loss Tax Consequences: Insolvent Subsidiary - Multiple Owners AM addresses many of the consequences of an insolvent liquidation of a first tier CFC with multiple owners. Debt of CFC is not necessarily worthless. Since CFC becomes partnership, the consolidated return rules do not apply to the FS- Z debt. no deemed satisfaction and reissuance (DSR). Under Treas. Reg , no transfer has occurred since payment expectations of creditors are not altered by classification change. Shareholder takes a cost basis in the assets; but see Est. of Franklin, 544 F.2d 1045 (9 th Cir. 1976)(acquisition of assets for non-recourse debt far in excess of value). Liabilities assumed by new partnership limited to the value of the assets. Section 752(c). 6

7 Granite Trust Illustrated US-X 1 US-X Trust FS-Y 2 Trust Debt 79% 21% FS-Y FS-Y is balance sheet solvent but US-X has a loss in FS-Y stock. 1. US-X transfers 21% of FS-Y stock to Trust. 2. FS-Y elects to be changes its classification by election. After the election, FS-Y is taxed as a partnership. 7

8 III. General Loss Tax Consequences Section 1001(a) loss shall be the excess of the adjusted basis over the amount realized Section 165(a) There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise Closed, completed transaction; fixed by identifiable event. Treas. Reg (b) Section 165(f) Losses from sales of capital assets shall be allowed only to the extent allowed in sections 1211 and 1212 Section 267 may limit any loss on a sale or exchange transaction 8

9 III. General Loss Tax Consequences: Section 165 Section 165(g)(1) If any security which is a capital asset becomes worthless during the taxable year, the resulting loss shall be treated as a loss from the sale, on the last day of the taxable year, of a capital asset. A security means stock in a corporation, a right to receive stock, or evidence of indebtedness, issued by a corporation with interest coupons or in registered form. Section 165(g)(3) -- any security in a corporation affiliated with a taxpayer which is a domestic corporation shall not be treated as a capital asset. A corporation is treated as affiliated if: the taxpayer owns directly stock in such corporation meeting the requirements of section 1504(a)(2), and more than 90 percent of the aggregate of its gross receipts for all taxable years has been from sources other than royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of stocks and securities. Timing -- Stock or debt obligation is worthless when it has neither liquidating value nor potential future value. Remember: Identifiable event requirement under Section

10 III. Classification of Indebtedness True debt, preferred equity, or capital Treatment of related party debt as equity may prevent insolvency. Classification may be challenged if: Excessive advances Lack of attention to form Sweep accounts without clear terms Debt arbitrarily created (pushdowns) Section 385(c)--Debtor cannot contest its own characterization of the instrument. Loss may be permitted if the debt is treated as preferred equity but may be limited to the basis in the common stock. See CCA (if debt enforceable under state law and re-classified as preferred equity, Spaulding Bakeries applies to claim loss). If obligation not respected as enforceable, advances treated as capital contributions. Subsidiary may not be insolvent and could be tax-free. Development Corp. of America Inc., T.C. Memo (1988). 10

11 III. General Loss Tax Consequences: Worthless Indebtedness Section 166(a)(1) deduction permitted when debt becomes worthless in a year Partial worthlessness permitted as well. Section 166(a)(2) Whether debt becomes worthless, in whole or in part, is a factual determination. Boehm v. Comm r, 326 U.S. 287 (1946). When corporate shareholder holds debt of wholly-owned subsidiary and subsidiary transfers all of its assets in partial satisfaction of that debt, corporate shareholder entitled to both worthless stock loss and partial bad debt deduction. Rev. Rul

12 III. Loss Tax Consequences: Subsidiary Tax Consequences Insolvent liquidation is generally a taxable disposition by debtor corporation of all assets subject to all liabilities. A.M Section 61(a)(12) income includes discharge of indebtedness Section 108(a)(1)(B) -- Gross income does not include discharge of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent 12

13 IV. Collateral Loss Tax Consequences Section 1248 Inclusion. Because the stock of the liquidated subsidiary is disposed of at a loss, no section 1248 deemed paid dividend. If the insolvent subsidiary owns stock of a foreign corporation with a value greater than basis, the distribution may result in additional income. Attributes. Section 381 is not applicable thus all attributes of the subsidiary are eliminated, including its E&P and FTCs. Subpart F. Assets should be reviewed as to whether their disposition generates Subpart F income 13 Cancellation of debt ( COD ) income is not Subpart F income. PLR Foreign gain from satisfaction of intercompany indebtedness may not be Subpart F income. Section 954(c)(1)(D)(business needs). Source of Loss. Stock loss and bad debt deductions related to CFCs owned by US corporate shareholders generally US source loss. Sections 861, 865. But see anti-abuse rules. Treas. Reg (b)(4) Dividend recapture provision generally treats loss as foreign source to the extent of dividends from the prior 2 years. Treas. Reg (b)(1); exceptions for passive basket and de minimis dividends. Contingent pay debt instrument rules can alter source of bad debt deduction. Treas. Reg (d) Foreign Currency Gain or Loss. Unless the borrower and lender have the same functional currency, the satisfaction of the intercompany debt will likely result in foreign currency gain or loss to one of the parties. Sections 987/988. Other FX consequences may also flow from the deemed liquidation.

14 IV. Collateral Loss Tax Consequences: Subsequent to the Loss Recognition If the foreign subsidiary was insolvent, it was likely operating at a loss. Following the transaction, the losses of the subsidiary will be earned by the US group and contribute to the consolidated group. Consider how this impacts your ability to use foreign tax credits going forward If you have an overall foreign loss ( OFL ), this will increase the OFL balance If you want to use these losses in the US, consider the dual consolidated loss limitations under Section 1503(d) Consider SRLY implications on domestic use of any such losses If subsidiary turns to operating profit, overall domestic loss rule can apply 14

15 IV. Collateral Loss Tax Consequences: Dual Consolidated Losses Dual Consolidated Loss ( DCL ) is a net operating loss of a dual resident corporation ( DRC ) or separate unit of a US corporation. DRC includes a US corporation subject to tax in a foreign country Separate unit includes a branch or hybrid entity. DCL cannot be used to offset income of US person if it can be used to offset income of a foreign corporation. Treas. Reg (d)-2, -4. But see Domestic use election. Treas. Reg (d)-6(d) Recapture of DCL upon disposition (foreign use, disposition of 50+% in the unit in 12 months, DRC leaves consolidated group, failure of annual certification) 15

16 IV. Collateral Loss Tax Consequences: Consolidated Intercompany Debt Issues If debt of insolvent subsidiary survives the liquidation of the subsidiary, the owner is member of the consolidated group, and the creditor is a member of the consolidated group, the debt is deemed satisfied and reissued ( DSR ) after joining the group. Treas. Reg (g)(5)(i)(A). DSR has the effect of satisfying the old debt at its FMV and then reissuing new debt with an issue price equal to the same price for cash. If the face amount of the debt exceeds this issue price (and the note has a maturity greater than 1 year), the note has original issue discount under Section Items taken into account in the DSR are treated as separate not consolidated items. Treas. Reg (g)(6)(i)(B). 16

17 V. Example: Base Case Considerations in Analyzing Examples Shareholder/Lender Gain/loss on stock Character Gain/loss on debt (worthlessness) FX Source Basis in Acquired Property Other Borrower Gain/loss on assets COD income Subpart F income Attributes (E&P, FTC, etc.) FX Other Ongoing Issues OFL DCL FTC utilization group-wide Other 17

18 V. Example: Base Case FS1 owes USS $100X in debt, its only liability FS1 owns assets with a fair value of $70X. Transaction: USS checks-the-box of FS1 (Rev. Rul ) 18 1 Tax Considerations: 1. Section 165(g)(1), 165(g)(3) for the stock basis in FS1 2. Section 166 loss equal to $30X on debt, extinguished in transaction 3. COD income of FS1 excluded from Subpart F income 4. Section 304 will not apply to the deemed sale of FS3 to USS (Rev. Rul ) but treated as a taxable disposition of stock in a lower tier CFC 5. Attributes of FS1 such as PTI, FTCs permanently lost 6. Assuming no actual or deemed dividends from FS1 in the last 2 years, stock losses are US source 7. Depending on the currency of the debt, FX gain or loss at either USS or FS1. Consider whether FX gain at FS1 is Subpart F income 8. Consider impact of operating losses of FS1 as a branch on tax credits or OFL balance 9. Consider making domestic use election under DCL regime, subject to recapture 10. Review credit agreement to see if FS1 as DRE must pledge 100% of its equity or be a guarantor

19 V. Example: Base Case - USP Debt FS1 owes USP $100X in debt, its only liability FS1 owns assets with a fair value of $70X. Transaction: USS checks-the-box of FS1 1 Tax Considerations: 1. Section 165(g)(1), 165(g)(3) for the stock basis in FS1 2. No bad debt deduction under AM Debt subject to DSR under Treas. Reg (g)(5)(ii), potentially creating OID for future periods (income to USP; deductions to USS) 3. COD income of FS1 excluded from Subpart F income 4. Section 304 will not apply to the deemed sale of FS3 to USS but treated as a taxable disposition of stock in a lower tier CFC 5. Attributes of FS1 such as PTI, FTCs permanently lost 6. Assuming no actual or deemed dividends from FS1 in the last 2 years, stock losses are US source 7. Depending on the currency of the debt, FX gain or loss at either USS or FS1. Consider whether FX gain at FS1 is Subpart F income. If debt is not US dollar denominated, FX items become intercompany items 8. Consider impact of operating losses of FS1 as a branch on tax credits or OFL balance 9. Consider making domestic use election under DCL regime, subject to recapture 10. Review credit agreement to see if FS1 as DRE must pledge 100% of its equity or be a guarantor 19

20 V. Example: Base Case - USP Debt and Contribution FS1 owes USP $100X in debt, its only liability FS1 owns assets with a fair value of $70X. Transaction: USP contributes debt to USS; USS checks-the-box of FS1 Tax Considerations: 1. Contribution of debt by USP to USS tax-free under Section 351. USP gets a basis increase equal to basis of debt under Section 358. No DSR as a result of the contribution. Treas. Reg (g)(3)(i)(B)(1) 2. Section 165(g)(1), 165(g)(3) for the stock basis in FS1 3. Section 166 loss equal to $30X on debt, extinguished in transaction 4. COD income of FS1 excluded from Subpart F income 5. Section 304 will not apply to the deemed sale of FS3 to USS but treated as a taxable disposition of stock in a lower tier CFC 6. Attributes of FS1 such as PTI, FTCs permanently lost 7. Assuming no actual or deemed dividends from FS1 in the last 2 years, stock losses are US source 8. Depending on the currency of the debt, FX gain or loss at either USS or FS1. Consider whether FX gain at FS1 is Subpart F income 9. Consider impact of operating losses of FS1 as a branch on tax credits or OFL balance 10. Consider making domestic use election under DCL regime, subject to recapture 11. Review credit agreement to see if FS1 as DRE must pledge 100% of its equity or be a guarantor 20

21 V. Example: Granite Trust - Section 304 Scenario FS1 owes USS $100X in debt, its only liability FS1 owns assets with a fair value of $70X. Transaction: USP sells 25% of FS1 to FS2 for cash; USS checks-the-box of FS1 21 Tax Considerations: 1. Sale is described in Section 304(a)(1). Dividend depends on E&P of FS1 and FS2. Deemed Section 351 results in GRA requirement under Section 367. Section 362(e)(2) election on where stock loss resides (FS2 stock or FS1 stock) 2. Sections 165(g)(1), 331 for the stock basis in FS1 to USS and FS2. Consider C reorganization risk 3. No bad debt deduction under AM FS1 as a partnership takes assets with a basis equal to $100X. Only $70X of debt taken into account under Section 752(c) 4. COD income of FS1 excluded from Subpart F income 5. Section 304 will not apply to the deemed sale of FS3, but likely treated as a taxable disposition of stock in a lower tier CFC 6. Attributes of FS1 such as PTI, FTCs permanently lost 7. Assuming no actual or deemed dividends from FS1 in the last 2 years, stock losses are US source 8. Depending on the currency of the debt, FX gain or loss at either USS or FS1. Consider whether FX gain at FS1 is Subpart F income 9. Consider impact of operating losses of on tax credits or OFL balance 10. Review credit agreement to see if FS1 must pledge its equity or be a guarantor

22 V. Example: Granite Trust - Sale Scenario FS1 owes USS $100X in debt, its only liability FS1 owns assets with a fair value of $70X. Transaction: USP sells 25% of FS1 to FS2 for non-qualified preferred stock under Section 351(g); USS checks-the-box of FS1 Tax Considerations: 1. Sale is taxable under Section 351(a), 351(g). Gain or loss likely recognized; consider Section 267 limitation. 2. Sections 165(g)(1), 331 for the stock basis in FS1 to USS. Consider C reorganization risk 3. No bad debt deduction under AM FS1 as a partnership takes assets with a basis equal to $100X. Only $70X of debt taken into account under Section 752(c) 4. COD income of FS1 excluded from Subpart F income 5. Section 304 will not apply to the deemed sale of FS3, but likely treated as a taxable disposition of stock in a lower tier CFC 6. Attributes of FS1 such as PTI, FTCs permanently lost 7. Assuming no actual or deemed dividends from FS1 in the last 2 years, stock losses are US source 8. Depending on the currency of the debt, FX gain or loss at either USS or FS1. Consider whether FX gain at FS1 is Subpart F income 9. Consider impact of operating losses of FS1 on tax credits or OFL balance 10. Review credit agreement to see if FS1 must pledge its equity or be a guarantor 22

23 V. Example: Granite Trust Section 351 Scenario FS1 owes USS $100X in debt, its only liability FS1 owns assets with a fair value of $70X. Transaction: USP contributes 25% of FS1 to FS2; USS checks-the-box of FS1 Tax Considerations: 1. Contribution of FS1 stock should be tax-free under Section 351. Section 367 GRA requirements. Section 362(e)(2) election on where stock loss resides (FS2 stock or FS1 stock) 2. Section 165(g)(1), 331 for the stock basis in FS1 to USS and FS2; consider C reorganization risk. 3. No bad debt deduction under AM FS1 as a partnership takes assets with a basis equal to $100X. Only $70X of debt taken into account under Section 752(c) 4. Asset gain or loss recognized under Section Section 304 will not apply to the deemed sale of FS3 but likely treated as a taxable disposition of stock in a lower tier CFC 6. Attributes of FS1 such as PTI, FTCs permanently lost 7. Assuming no actual or deemed dividends from FS1 in the last 2 years, stock loss of USS is US source 8. Depending on the currency of the debt, FX gain or loss at either USS or FS1. Consider whether FX gain at FS1 is Subpart F income 9. Consider impact of operating losses of FS1 on tax credits or OFL balance 10. Review credit agreement to see if FS1 must pledge its equity or be a guarantor 23

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