A private letter ruling issued by the Internal Revenue Service in March was emphatic about its finding regarding contingent debt. Basically, the retirement of contingent debt does not produce so-called cancellation of indebtedness income. In the letter, the IRS ruled on a complex transfer of stock, other assets, and obligations to reach its conclusion, which unfolded as follows:
In the IRS example, Widget Corp. owned all the stock of XCorp, and XCorp owned all the stock of three subsidiaries.
XCorp then transferred the stock of the subsidiaries and other assets to a new corporation, which for purposes of this column, we will call the taxpayer. In exchange for all of the taxpayer’s assets, XCorp received the common and preferred stock of the taxpayer; the assumption by taxpayer of certain XCorp liabilities; cash; and the right to receive certain contingent payments scheduled to be made to Widget under a “tax agreement” inked by Widget, XCorp, and the taxpayer. The tax agreement was dated June 3.
The taxpayer claimed that the assets it received in a transfer from XCorp constituted a taxable exchange under the Internal Revenue Code (Section 1001). Therefore the transaction was a “qualified stock purchase” by the taxpayer with respect to the subsidiaries.1
Since the transaction was a qualified stock purchase, Widget and the taxpayer made elections under Section 338(h)(10) of the code with respect to two of the acquired subsidiaries. Then the taxpayer made a “regular” Section 338 election (specifically under Section 338(g)) related to the third subsidiary. Accordingly, the taxpayer secured a “cost basis” with respect to the assets of each of the acquired subsidiaries.
Under the tax agreement, the taxpayer promised to pay Widget a specified percentage (Y%) of the excess of the “hypothetical tax liability.” The hypothetical obligation has to do with the “stepped-up” basis that arises from a Section 338 election in certain situations. In this case, the hypothetical liability refers to what the taxpayer would experience if it used the carryover basis regarding the assets of the acquired subsidiaries, as opposed to its actual tax liability. Indeed, the tax agreement contemplated that any “tax benefit payment” made to Widget would further increase the basis of the assets and therefore further increase the potential tax benefit.
The purpose of the tax-benefit payments was to allow Widget to share any tax benefit the taxpayer actually realized over time as a result of the basis step-up afforded by the Section 338 elections. Further, the taxpayer noted that the obligation to make the tax-benefit payments constituted indebtedness for purposes of the tax code, as is described in Section 61(a)(12).
On August 4, Widget, another firm called Epsilon Inc., and certain other corporations entered into an assignment agreement. Under that agreement, Widget assigned its right to the Y% of the tax-benefit payments to Epsilon. In turn, Epsilon assumed the same percentage of Widget’s liabilities and obligations under the tax agreement.
On September 5, the taxpayer and Epsilon executed a prepayment agreement. Under the pact, the taxpayer agreed to pay Epsilon a certain amount of cash ($D) in “full satisfaction” of the taxpayer’s remaining obligations to make tax-benefit payments to Widget for the portion Widget had assigned to Epsilon. According to IRS ruling, at issue was whether the taxpayer realized any discharge of indebtedness income as a result of the prepayment agreement. The answer was a resounding no. (See IRS LTR 201027035, March 31, 2010.)
Under Section 61(a)(12) of the code, gross income includes “income from discharge of indebtedness.” In United States v. Kirby Lumber Co., 284 US 1 (1931), the Supreme Court held that a taxpayer that purchased its own bonds at a discount in the open market realized income to the extent of such discount. The debt reduction resulted in a “freeing of assets” that were previously subject to the obligation of the bonds, which, in turn, was an “accession to wealth,” and therefore income.
By contrast, in Corporacion de Ventas de Salitre Y Yoda de Chile v. Commissioner, 130 F.2d 141 (2nd Cir. 1942), the court held that the taxpayer’s purchase at a discount of its own bonds that were payable only out of a percentage of future corporate profits did not give rise to income. The court explained that the treatment of the prepayment of contingent debentures in United States v. Kirby Lumber differed from the treatment described in this case because the contingent nature of the debt made it impossible to determine whether or not the transaction was immediately profitable.
In the private letter ruling, the taxpayer’s liability under the tax agreement was contingent upon several circumstances, including its future earnings, future tax rates, and actual realization of tax benefits from the stepped-up basis. Therefore, because the taxpayer’s obligation under the tax agreement was a contingent obligation, the taxpayer does not realize any cancellation of indebtedness income by prepaying “$D” to satisfy its remaining obligation under the tax agreement regarding the portion of the payments assigned to Epsilon.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See Section 338(d)(3). The transfer did not qualify under Section 351, and was therefore a taxable exchange, because the taxpayer was under a binding obligation to dispose of its preferred stock at the time the preferred stock was acquired. Accordingly, the “control” requirement of Section 351 was not satisfied since XCorp, the sole transferor of property to the taxpayer (with respect to the taxpayer’s stock) did not have control of the taxpayer “immediately after the exchange.” In addition, XCorp must have disposed of sufficient amounts of the taxpayer’s common stock based on the plan to ensure that the taxpayer would not be seen as acquiring the stock of the subsidiaries from a person (XCorp) — the ownership of whose stock would be, under Section 318(a), attributed to the taxpayer. See Section 338(h)(3)(A).