Tax Reform Part 2: Restructuring & Insolvency Related Provisions - Cancellation of Debt Income
This is the second part in a series of articles discussing certain restructuring and insolvency related provisions of the Tax Reform. Previously we discussed net operating losses (“NOLs”), and noted that the House and Senate plans are quite similar when it comes to NOLs. That is not the case with the provisions in H.R. 1 that relate to cancellation of the debt (“COD”).
What reads as an afterthought in the legislative text, H.R. 1 would repeal IRC Section 108(e)(6). This section applies when a creditor-shareholder (“A”) of a corporation (“X”) contributes debt issued by X (“Debt”) to X. This section excludes from COD income all amounts, except to the extent the amount of COD exceeds A’s tax basis in the Debt.
Thus, Section 108(e)(6) allows creditor-shareholders to contribute underwater debt to the capital of the issuing corporation while minimizing COD, taking full advantage of the creditor-shareholder’s tax basis in the debt (often the full cost). This section is useful for many companies who may have equity owners interested in rehabilitating their company, either alone or in conjunction with third-party lenders (who may condition their lending on participation by the equity owners).
Also, Section 108(e)(6) can allow for creative structured financing for companies, in a way that would minimize future COD income. There are many examples of this, but one would be that a large equity owner (such as a private equity fund) could buy up publicly traded (or private debt) at above market prices and contribute such debt to the company, thereby retiring the debt and shoring up the balance sheet while minimizing COD. This is often done when trying to “ride out the storm” during cyclical downturns.
Under H.R. 1, as currently crafted, these rehabilitation and financing strategies would result in greater COD income. In our simple example above, if A contributed the Debt to X, such contribution would be fully taxable to X, unless X issued stock as part of the exchange, and then in that case, COD income would only be avoided to the extent of the fair market value of the X stock received by A, under IRC Section 108(e)(8).
Thus, one significant impact of H.R. 1’s repeal of Section 108(e)(6), is that it makes all creditor-shareholder contributions to the capital of a debtor corporation, that do not result in the debtor corporation (following the contribution) becoming solvent, subject to the attribution reduction rules of Section 108(b).
The repeal of Section 108(e)(6) certainly does away with many of the uncertainties in the Code, such as when Section 108(e)(6) should apply, versus Section 108(e)(8) (or Section 108(e)(10)), or whether Section 108(e)(6) should apply when the debtor-corporation is hopelessly insolvent, or whether Section 108(e)(6) should apply when the shareholder only owns a small fraction of stock. However, for the most part, these are academic matters, as historically the IRS has allowed the taxpayer to follow the chosen form of its transaction (except in the extreme cases) and thus, the repeal of Section 108(e)(6), like the limitations on NOLs discussed in the prior article, simply further reduces the value of distressed companies.
H.R. 1 accomplishes the above in the context of its proposed repeal of the corporation-friendly IRC Section 118, which excludes from a corporation’s income the value of property contributed to the corporation. Current law does not require that a corporation issue stock in exchange for a property contribution. H.R. 1 would repeal Section 118 and replace it with new Section 76. New Section 76 would provide that a contribution of property will only be tax-free to the corporate transferee if the corporate transferee issues stock in the exchange, and then only to the extent of the value of such stock issued.
For many corporations this will, at a minimum, present valuation and bookkeeping issues, but at worst the added requirement could be a trap for the unwary, as under current law, pro rata contributions, including those to wholly-owned subsidiaries, would unlikely be accompanied by an issuance of stock, under the theory that it was a “meaningless gesture” and unnecessary. If H.R. 1 becomes law in its present form, failure to issue stock would result in tax. Therefore, it will be necessary for companies to have updated stock registries and be prepared to take positions regarding the value of stock they issue (and when the contributions are not in cash, the value of the property contributed).
The Senate proposal for tax reform does not include a repeal of Sections 108(e)(6) or 118.