Tax

Calculating COD Income When a Parent Cancels a Sub’s Debt

To bolster a company’s financial health during a rough economic patch, creditors that are also shareholders sometimes look to cancel a portion of t...
Robert WillensAugust 8, 2011

Last year, as companies began emerging from the economic downturn, the Internal Revenue Service released a private letter ruling on how to calculate income related to when a shareholder cancels a portion of a company’s debt. The situation, one that relates to creditor-shareholders, often arises when there is a single shareholder involved — a parent and wholly owned subsidiary, for example. In other cases, it might be a private-equity firm that cancels the debt.

Regardless of the corporate relationship, the situation arises most often when the shareholder is looking to ease the debt burden of a company to preserve the company as a going concern. In response to a request for a private letter ruling, the IRS released an opinion, using the following example. It’s a beneficial guide for any creditor-shareholder that seeks to lighten the debt load of affiliated companies while still maintaining a prime position as a creditor in case of bankruptcy.

A Step-by-Step Example from the IRS
The IRS letter ruled on a situation presented by a foreign parent company that owned all of the stock of a U.S. parent company (USP), which in turn owned 100% of a subsidiary (SubCo). For purposes of this column, we’ll look at this situation as if it happened at the end of a taxable year.

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Let’s say that prior to September 1, USP owed its foreign parent $25 million. On September 1, USP transferred all of its SubCo stock to its foreign parent in exchange for cash, which was then used to cancel a portion of USP’s indebtness to its parent.

At this point, USP is on the hook to its foreign parent for the remaining debt and one or two notes. By October 1, the foreign parent cancels the debt in exchange for “S” shares of USP stock. Then, on or before December 31 — the last day of the taxable year for USP — the foreign parent voids cancellation of the debt, ab initio, and pays interest accordingly. In addition, the foreign parent cancels the S shares of USP stock.

Following the rescission transaction described above, USP intends to enter an agreement with the foreign parent, pursuant to which the following will take place:

  • The foreign parent will purchase a single share of USP stock in exchange for cancellation of the note (included within the debt) and/or a second note intended to equal the value of the single share.
  • The foreign parent will cancel a predetermined amount of debt under the first note and/or the second note as a capital contribution to USP.
  • The single share will be cancelled within a set number of days of its issuance.

In examining the situation, the IRS released the following private letter ruling to the public in April 2010 (see LTR 201016048, December 22, 2009). The letter concluded the following:

  • The cancellation of the debt and accompanying issuance of shares will be disregarded for federal income-tax purposes (see Revenue Ruling 80-58, 1980-1 C.B. 181). As a result, the rescission transaction will be effective to restore the status quo ante.
  • USP’s transitory single share also will be disregarded.
  • USP will be treated as having satisfied the amount of debt under the first and/or second note. In fact, the IRS states that the debt is satisfied in the amount of money equal to the foreign parent’s adjusted basis for purposes of determining income of USP from discharge of indebtedness.

However, there is one more item to examine. When a debtor corporation acquires its debt from a shareholder as a contribution to capital, the IRS directs companies to
Section 108(e)(6) of the Internal Revenue Code to determine the cancellation of debt income of the debtor. Under that section, if the foreign parent’s adjusted basis in the contributed indebtedness is not less than the adjusted issue price of the debt, USP will not realize any cancellation of indebtedness income as a result of the cancellation of its debt owed to its shareholder.

Robert Willens, founder and principal of Robert Willens LLC, writes a biweekly tax column for CFO.com.

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