Effect of Debt Recharacterization on Worthless Securities Deductions

The Sec. 165(g) worthless securities deduction has attracted increased attention in light of the current bleak economic conditions. The IRS recently addressed concerns that the recharacterization of intercompany debt as common equity might prevent a worthless securities deduction (Field Attorney Advice (FAA) 20040301F; Chief Counsel Advice (CCA) 200706011).

This guidance concluded that debt treated as equity for tax purposes will be recharacterized as preferred, rather than common, equity. Consequently, equity owners who are also creditors may still access their common equity basis even if they continue to loan money as a lender of last resort, thereby subjecting their debt to potential recharacterization.

Background

FAA 20040301F provided that recharacterized debt is treated as preferred equity, so a worthless securities deduction could be claimed on common equity. The taxpayer owned two controlled foreign corporations (CFCs) and began lending foreign currencies to them. When the CFCs failed to make timely payment, the loans were rolled into new loans issued by the taxpayer. An independent valuation determined that the CFCs’ equity had no positive value. The taxpayer made check-the-box (CTB) elections to treat the CFCs as disregarded entities, triggering worthless securities and bad debt losses under Rev. Ruls. 70-489 and 2003-125.

Following a debt-equity analysis of the intercompany loans, an audit team reviewing the transaction determined that a significant portion of the loans should be reclassified as equity. As a result of the reclassification, the CFCs were solvent at the time of the deemed liquidation.

Where equity owners, owning at least 80% of the vote and value, receive property in exchange for all their interests in complete liquidation, Sec. 332 governs. H. K. Porter Co., 87 T.C. 689 (1986), held that a liquidating corporation is deemed to distribute its property in the following order: (1) to creditors, (2) to preferred equity holders, and (3) to common equity holders. Therefore, if common equity holders receive no property in exchange for their interests upon liquidation, Sec. 332 will not apply. In FAA 20040301F, the IRS concluded that the terms of the notes should be respected for tax purposes. Because the notes provided for a preference to the companies’ earnings in the form of interest payments, they were recharacterized as preferred equity.

In CCA 200706011, the Service determined that a foreign subsidiary had negative liquidation and going concern value due in part to debt guaranteed by the common parent of its consolidated group. The IRS concluded that because the debt had all the formal indicia of indebtedness and because the taxpayer made interest payments on the obligation, the debt, if recharacterized as equity, should be treated as preferred equity.

The following example illustrates the differences in the tax results between treating debt as debt, preferred equity, or common equity when converting a corporation to a disregarded entity.

Example: P owns all the equity interests of S, which have a basis of $5 million. Both P and S are eligible entities within the meaning of Regs. Sec. 301.7701-3(a), and neither files consolidated returns. S’s balance sheet lists $3 million of basis and fair market value in assets and $4 million in liabilities from a revolving credit agreement with P that provides for a market interest rate. S’s gross receipts have all derived from its manufacturing operations. P makes a CTB election to classify S as a disregarded entity.

Debt treated as debt: Upon S’s conversion, S is deemed to transfer its $3 million in assets in partial satisfaction of the $4 million owed to P. S recognizes gain or loss on the disposition of its assets under Sec. 1001. S also will recognize ordinary cancellation of debt (COD) income of $1 million under Sec. 61(a)(12). S, insolvent by $1 million, may exclude the $1 million COD income under Sec. 108(a) by reducing attributes under Sec. 108(b). Assuming the debt is excluded from Sec. 1271(a), P will receive an ordinary bad debt deduction of $1 million under Sec. 166(a). P then is entitled to an ordinary worthless securities deduction of $5 million under Sec. 165(g)(3).

Debt recharacterized as preferred equity: As discussed above, the terms of the recharacterized debt should be respected. The preference to the earnings in the form of interest payments, as well as its legally enforceable liquidation rights, should ensure that as equity it would be treated as a preferred class of equity. Upon S’s conversion, S is deemed to transfer its $3 million in assets to its preferred interest holder, P. S will recognize gain or loss under Sec. 336(a). P recognizes a capital loss of $1 million on its preferred equity under Sec. 331(a), assuming the C reorganization requirements would not be satisfied. P will be entitled to an ordinary worthless securities deduction of $5 million on its common equity, under Sec. 165(g)(3).

Debt recharacterized as common equity: Upon S’s conversion, S is deemed to transfer its $3 million in assets to its common unit holder, P. S and P recognize no gain or loss under Secs. 332(a) and 337(a). P’s $5 million basis in its original common equity and its $4 million basis in its recharacterized common equity will simply disappear. P will have a carryover basis in the assets of $3 million under Sec. 334(b).

Observations

In the above example, the recharacterization of debt as common equity eliminates all losses otherwise resulting from the debt and equity; therefore, such a recharacterization should be avoided by ensuring that the debt provides for real and enforceable legal entitlements over the common equity. Debt recharacterized as preferred equity may result in a capital loss as opposed to an ordinary loss; by creating a second class of equity, however, this disadvantage may be greatly outweighed by the benefits of salvaging an otherwise lost worthless securities deduction. Treated as debt, the intercompany loans produce an ordinary bad debt deduction, assuming the debt is excluded from Sec. 1271(a), while maximizing the benefit of the basis through a worthless securities deduction, and produce the best results in the above example.

It is important to note that the relative values of the worthless securities and bad debt deductions and the likelihood of reclassification may create the need to reevaluate a CTB election. In order to predict the susceptibility of debt-to-equity reclassification, a debt equity analysis should be performed.

Debt Equity Analysis

In determining the true substance of an intercompany advance, the legal rights and obligations of the parties should be considered. One threshold question, addressed in Scriptomatic, Inc., 555 F.2d 364 (3d Cir. 1977), in determining if an equity holder is a lender of last resort is whether “an outside investor [would] have advanced funds on terms similar to those agreed by the shareholder.” A thorough debt equity discussion is beyond the scope of this item. For further discussion of this topic, see Plumb, “The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal,” 26 Tax Law Rev. 369, 526 (1971); Sec. 385; and Notice 94-47.

Conclusion

While the reclassification of debt from its intended category may cause concern, FAA 20040301F and CCA 200706011 may help allay the concerns of equityowning creditors seeking deductions for the growing number of worthless securities that the current turbulent economy has produced.

EditorNotes

Annette Smith is with Price-waterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.

Unless otherwise noted, contributors are members of or associated with Pricewater-houseCoopers LLP.

For additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.