By James J. Tobin, Esq.
Nothing is ever as easy as it seems, which generally is good because it keeps things interesting. So add to the list of "harder than it looks" the area of deemed liquidations under the check-the-box rules. The IRS recently issued GLAM 2011-003 (that's a "Generic Legal Advice Memorandum," not a "glamorous" tax issue — although in this case maybe it's a bit of both) with respect to a check-the-box liquidation of an insolvent foreign subsidiary that was owned 80/20 by a U.S. company and a wholly owned foreign subsidiary of the U.S. company.
With the economy again teetering or worse, this is a very timely topic. Check-the-box liquidations of insolvent or depreciated subsidiaries within a global group can result in ordinary or capital losses in the United States or earnings and profits (E&P) deductions for foreign subsidiaries in the right circumstances. So the GLAM, if nothing else, is a good reminder for companies that are doing some restructuring to consider whether the corporate group includes any subsidiaries with depressed values.
The general rules in the area seem pretty straightforward. If a subsidiary's assets, including any goodwill, have a fair market value less than its total liabilities, a liquidation either by checking the box or under corporate law will result in a deductible loss to its shareholders. The loss will be capital rather than ordinary, except where the requirements of §165(g)(3) are satisfied, which will often be the case if the situation involves the liquidation of a wholly owned operating subsidiary. Moreover, capital-versus-ordinary treatment will not be as relevant in situations involving the liquidation of an insolvent second-tier CFC as there will be an E&P deduction either way. For a subsidiary with positive net equity value but where the value is less than the shareholders' basis in the stock, a liquidation will produce a capital loss as long as the requirements for a tax-free transaction under §332 are not satisfied. And there is ample authority based on the principles of Granite Trust Co. v. U.S., 238 F.2d 670 (1st Cir. 1956), that a taxpayer can "plan" into a taxable liquidation if, for example, the transaction involves a depressed subsidiary that initially was 100% owned. So a good reminder and some potentially interesting opportunities, but no real new ground here.
Of course, the two big issues regarding recognition of losses in this context — beyond the basic valuation questions — are when did the worthlessness occur and was all of the debt of the subsidiary true debt and not equity. On the latter point, careful documentation and coordination with the corporate treasury department is always a prudent practice, never more so than today when debt-equity challenges by tax authorities are becoming increasingly common in the United States and in many foreign countries.
All of this relates to the treatment of the shareholders of the insolvent subsidiary. However, from my perspective, the more interesting but less-focused-upon issues discussed in the GLAM are those that deal with the treatment of the liabilities of the insolvent subsidiary. And the overlay of the Subchapter K issues stemming from the split ownership of the insolvent subsidiary compounds the fun, reinforcing the benefits of having your favorite Sub K guru on speed dial.
The GLAM lays out the IRS thinking on the liabilities issues and, while not constituting authority for an opinion, it certainly is helpful guidance. For the most part, the conclusions with respect to the non-international issues seem reasonable to me (although these are areas I don't have to worry about every day so my standard for reasonableness might be a bit more relaxed). That said, there are some surprises, some subtleties that seem somewhat inconsistent with prior guidance, and some unanswered questions.
So in getting to the issues, let's start a bit farther back in history, with Rev. Rul. 2003-125. That ruling involved a wholly owned insolvent subsidiary that had liabilities owed to its parent and to other creditors. The ruling held that the check-the-box election for the subsidiary resulted in a §165(g)(3) loss due to the subsidiary's insolvency. It also held that there was a loss realized and recognized by the parent to the extent the value of the assets attributable to its debt claim was less than its basis in the debt. This result was largely dictated by the fact that the debt became disregarded in the liquidation when the subsidiary became a disregarded entity, even though the liability obviously survived under local corporate law. The holding in Rev. Rul. 2003-125 was not clear on whether the parent's loss as a creditor was an ordinary bad debt deduction or a capital loss. The ruling seemed to imply that other creditors also could recognize a loss even though their liabilities or receivables both survived under corporate law and continued to be regarded for tax purposes with the parent having become the new obligor on the debt.
The GLAM deals with this issue directly. The fact pattern reviewed in the GLAM involved an insolvent foreign subsidiary (Z) that was owned 80% by P, a U.S. corporation, and 20% by X, a wholly owned foreign subsidiary of P. Z had outstanding liabilities owed to P and owed to third parties. But given the fact that Z was not 100% owned, the consequence of the check-the-box election was to convert Z into a partnership and not into a disregarded entity. Therefore, the debt owing to P did not become disregarded after Z's deemed liquidation.
The threshold issue with respect to the debt is whether Z's creditors would be able to recognize a deductible loss. This issue turns on whether under §1001 there has been a significant modification of the debt. Regs. §1.1001-3 provides that the substitution of an obligor on a recourse liability generally will be considered to be a modification of the debt. So the first point to address is whether the definition of the obligor for this purpose is determined under corporate law or under U.S. tax rules. Because Z as a partnership after the check-the-box election is still the same legal entity for foreign law purposes, one would think that the obligor has not changed. Certainly it seems the economic positions of the parties have not changed, which is what I would think would be the right focus of this regulation. Nonetheless, the IRS in the GLAM concludes that the U.S. tax identity of the obligor is the more appropriate test and that a modification has occurred. However, before getting too excited about the prospect of a deduction for the creditors, one has to consider whether this modification is significant. And here the IRS concludes it is not significant, based on the exception in the regulations that applies where a new obligor acquires substantially all of the assets of the old obligor and the transaction does not result in a change in "payment expectations" (i.e., the credit position of the "new obligor" is not better or worse than that of the "old obligor"). Because in this case Z's economic position is unchanged, this exception would be satisfied. Therefore, no loss to the creditor under §1001 yet. And as to a bad debt deduction under §166, likewise the IRS concludes that the check-the-box liquidation itself does not impact the position of the creditor so no bad debt deduction either.
A particularly complicated and confusing aspect of the GLAM deals with the interaction of the check-the-box rules with a technical construction of the deemed liquidation event. Under Regs. §301.7701-3(g)(1)(ii), Z is considered to distribute all its assets and liabilities proportionally to its partners, which are then deemed to recontribute them to the new Z partnership in a §721 transaction. Under that construct, the debtor and creditor positions with respect to the receivable held by P would merge such that those positions would disappear and a new liability would spring into existence when the assets are deemed recontributed to the Z partnership. The GLAM refers to these regulations and acknowledges the deemed construct, but ignores the potential effect of such construct and simply considers the liabilities of Z always to remain in existence. There are many other collateral consequences under Subchapter K that could be triggered with respect to this up and down construction. So one cannot help wondering why and how the IRS reaches this conclusion, on which it does not elaborate much in the GLAM.
Another interesting question regarding Z's liabilities relates to the basis of the assets in the hands of the Z partnership and its partners. The GLAM concludes based on §1012 that this basis is the consideration paid for the assets, which in this case includes the liabilities assumed. Therefore, because the liabilities exceed the value of Z's assets, the asset basis to the Z partnership will exceed the value of the assets and there will be an inherent built-in loss after the check-the-box liquidation. Were this a tax-free liquidation under §332, the loss importation rule of §362(e)(1)(B) would apply requiring a step down of the asset basis to fair market value. However, that provision does not apply in this case because it is a taxable liquidation. Thus, for a liquidation of a CFC there could be a U.S. tax benefit in excess of the loss on the shares in certain cases.
The §1001 rules touched on above specifically focus on whether a creditor has a realization event with respect to its loan receivable. But what about the treatment of the debtor? Does a modification that is not a substantial modification result in any consequences to Z, either old corporate Z or new partnership Z? Issues that come to mind include whether the debt needs to be retested under the §385 standards as debt or equity (which might be tough to satisfy given that Z is insolvent), whether the terms of the debt need to be retested under §482, and whether any bad things might happen under §988. One would think that a creditor non-event should equate to a debtor non-event. However, there is no discussion of these issues in either the GLAM or Rev. Rul. 2003-125.
The §1001 regulations (Regs. §1.1001-3(e)(5) and (f)(7), for example) discuss retesting an instrument as debt versus equity. Generally, they require a retesting in the event of any modification of a debt instrument, but in the case of a modification where there is no change of obligor, the regulations allow the retesting without taking into account any changes in the creditworthiness of the obligor. Because in the GLAM the IRS found there to be a change in obligor, presumably retesting as debt versus equity would be required to take into account Z's credit position.
The lack of discussion in the GLAM on this point would lead one to conclude either that the IRS determined the retested liabilities remained debt, Z's insolvency notwithstanding, or that perhaps for some reason retesting the debt as equity was not required. It would be good to have guidance on this issue.
I will leave the Subchapter K aspects of the GLAM for others to elaborate on as they are complex enough to merit their own commentary. It seems to me there is enough to worry about with regard to the "simple" debt analysis above.
To me, the GLAM clearly highlights the traps for the unwary which lurk in this area, one that not many practitioners deal with on a day-to-day basis. As one can see, the analysis of the issues and outcomes can be fairly nuanced, with slight differences in fact patterns making a potentially big difference in result. My view is that the better technical approach to dealing with debt issues in the check-the-box context is not to view the deemed liquidation as creating a new obligor, given that the legal and economic relationships are unchanged. However, regardless of whether the IRS ultimately changes its view on this threshold issue, I would encourage it to provide full guidance on all of the aspects of the issue and to give its rationale for the positions reflected in such guidance. The GLAM clearly is a step in this direction as compared to the 2003 revenue ruling. But it still raises as many questions as it answers.
This commentary also will appear in the November 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, and Zarlenga, 784 T.M., Corporate Liquidations, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.
* The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.
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