Editor: Lori Anne Johnston, CPA, J.D.
During periods of economic uncertainty, U.S. multinationals may need to modify or restructure the terms of their existing debt. Debt modifications or restructurings can take many forms — such as exchanging existing debt for new debt or for stock or modifying key terms (like interest rates or payback period). Without careful tax planning, these modifications or restructurings may give rise to taxable cancellation-of-debt (COD) income that can compound the economic pain the corporation is already suffering.
On the other hand, in the international context (and before the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, was enacted in 2017), modifying or restructuring the debt of a controlled foreign corporation (CFC) had somewhat limited U.S. tax consequences. Any COD income recognized by a CFC generally did not constitute Subpart F income under Sec. 952, meaning it would not be includible in the income of the U.S. shareholder. But the creation of the global intangible low-taxed income (GILTI) regime has turned this decades-old norm on its head.
The following provides an overview of the federal tax rules that apply to debt modifications and restructurings, with a primary focus on how U.S. corporate shareholders of CFCs are affected.
Taxation of COD income
The principal tax rule that applies to canceled debt is clear-cut. Under Sec. 61(a)(12),a debtor generally must recognize canceled debt as gross income. The creditor, by contrast, is generally permitted to claim a Sec. 165(g) worthless securities deduction or a Sec. 166 bad debt deduction.
COD income occurs where a creditor forgives a debt. It can also occur where a creditor accepts property in satisfaction of an existing debt or where a creditor and debtor agree to modify the terms of an existing debt instrument, provided the modification is considered to be a "significant modification" for U.S. tax purposes. Significant modifications can result from (among other modifications) a change in terms that either changes payment expectations or the yield on the debt, including changes to the interest rate, extending maturity dates, and changes in security packages.
The amount of the COD income is generally equal to the difference between the adjusted issue price of the debt being canceled or modified and the amount used to satisfy the debt. If a debtor repurchases its debt instrument for an amount that is less than the adjusted issue price of that debt instrument, the debtor will generally realize income equal to the excess of the adjusted issue price over the repurchase price.
Several statutory exclusions for COD income are set forth in Sec. 108. For example, Sec. 108(e)(6) provides that debt may be canceled and treated as a contribution to capital. Further, if the debtor is insolvent or in bankruptcy, the debtor may exclude some or all of this COD income from its gross income under Sec. 108(a). But the debtor pays a price for availing itself of the bankruptcy or insolvency exceptions in the form of reductions in debtor tax attributes such as the basis of assets.
For U.S.-based multinational corporations, foreign income earned by a CFC is either taxed in the United States immediately as Subpart F or GILTI or it goes untaxed (because, for example, it was subject to a high rate of tax in the CFC's home country or it was offset by losses of related CFCs).
Subpart F income includes passive income and income earned outside the CFC's country of incorporation from certain sales and service transactions involving related parties. The remaining amount of a CFC's gross income generally is "tested income" that is taken into account in calculating the amount included in the income of the U.S. shareholder as GILTI. The amount of a U.S. shareholder's tested income is reduced by the shareholder's portion of a 10% "routine return" on the CFC's foreign tangible assets. In addition, domestic corporate shareholders are eligible to claim a deduction equal to 50% of their GILTI and foreign tax credits for 80% of foreign taxes paid on GILTI.
Regs. Sec. 1.952-2(a)(1) provides that gross income of a CFC is determined by treating the CFC as a domestic corporation taxable under Sec. 11 and by applying the principles of Sec. 61 and the regulations thereunder. Sec. 61(a)(12) provides that unless otherwise provided, gross income includes COD income. In Letter Ruling 9729011, the IRS, when discussing whether COD income should be classified as Subpart F income, stated, "Under section 61(a)(12), [COD income] is a separate and distinct category of income and thus, generally, it does not fit within any category of subpart F income."
Sec. 951A and the regulations lay out the rules for when U.S. shareholders recognize GILTI on their investment in CFCs. Regs. Sec. 1.951A-2 provides that tested income is calculated by comparing gross tested income with the deductions properly allocated to that income.
Like Subpart F, GILTI tested income is calculated according to Regs. Sec. 1.952-2, but unlike Subpart F, there is no exclusion of COD income from the calculation of GILTI tested income. This means that any GILTI resulting from the COD income will be included in the gross income of the U.S. shareholder. What is more, COD income stemming from a modification or restructuring may not be taxable in the CFC's home country, meaning foreign tax credits may not be available to offset the GILTI inclusion. Further, if COD income is excluded because the CFC is insolvent, then the basis of the CFC's foreign tangible property will be reduced, meaning GILTI tested income will likely be greater in later tax years, since depreciation deductions and the deemed 10% routine return on the CFC's foreign tangible assets will be smaller.
Example: USP owns 100% of CFC. USP has capitalized CFC with $5 million equity and $10 million debt including an interest rate of 8% with a 10-year horizon. CFC also has a $5 million loan with a third party in its home country that has been guaranteed by USP. CFC is unable to meet its credit obligations currently or in the near future and will need a capital infusion to keep its operations viable. CFC plans to restructure its debt obligations with both USP and its third-party creditor.
If USP and CFC were to extend the date of loan maturity by six years and further modify the terms of the instrument to have no interest charged until principal is due, these modifications would likely be classified as significant modifications of debt for U.S. federal income tax purposes. As such, CFC would have approximately $5 million of COD income based on the change in issue price resulting from the waiver of interest and extension of time to pay principal. The COD income realized by CFC would not be classified as Subpart F income; however, the amount would be included in the calculation of GILTI tested income and would be taxable to USP at a rate of 10.5% (provided USP was eligible to take the full 50% GILTI deduction). In addition, under Regs. Sec. 1.988-2(b)(6), CFC may need to recognize a foreign exchange gain or loss on the transaction since the debt is denominated in U.S. dollars, a currency other than CFC's functional currency. Any foreign exchange gain or loss would be Subpart F income for U.S. federal income tax purposes. USP would recognize a $5 million loss on the deemed exchange of debt instruments because of the modification, which would reduce its taxable income and GILTI tax exposure.
Additionally, local tax rules would need to be reviewed with regard to COD income or other tax impacts arising from the restructuring, as local rules may not follow the same principles for debt reorganization, which could result in a reduction of foreign tax credits available to USP, among other things.
With regard to CFC's third-party debt, the U.S. federal income tax consequences would be similar to related-party workouts. With that said, given CFC's financial distress and the guarantee on the loan provided by USP, there may be a question as to whether USP would be treated as the debtor, thereby reducing CFC's interest expense deductions, leading to higher Subpart F and GILTI inclusions (see Plantation Patterns, Inc., 462 F.2d 712 (5th Cir. 1972)).
Worthless stock deduction
If CFC's economic position deteriorates and it becomes unlikely that it will repay its debt to USP, and the fair market value of its assets is less than its liabilities, USP could recognize a worthless security deduction equivalent to $15 million on its investment in CFC related to both its equity and debt positions. To obtain its worthless security deduction, USP can make a check-the-box election to treat CFC as a disregarded entity for U.S. federal income tax purposes (see Rev. Rul. 2003-125). Under Sec. 165(g)(3), USP will need to show that CFC became insolvent in the year of the worthless stock deduction and that identifiable events caused CFC to become insolvent.
As such, because the deemed liquidation is a distribution of all of CFC's assets and liabilities to USP, and USP is assuming more liabilities than the value of assets received, USP is not receiving payment for its stock in CFC and therefore should be entitled to a worthless stock deduction (see Rev. Rul. 2003-125). Note, however, that any loss incurred by USP in excess of $10 million may be a reportable transaction requiring disclosure related to the transaction as well as its basis in CFC stock and debt holdings.
If, however, the stock in CFC has declined in value but has not rendered the entity insolvent, USP would not take a worthless stock deduction but instead would plan to have a taxable liquidation, thereby allowing USP to recognize built-in loss related to CFC stock. To qualify for taxable treatment of the liquidation, USP would have to transfer more than 20% of its stock in CFC to a corporation that is not a member of USP's consolidated group. When USP and the second shareholder elect to treat CFC as a partnership for U.S. federal income tax purposes, the transaction will be a taxable liquidation, thereby releasing USP's built-in loss in its CFC stock (see Granite Trust Co., 238 F.2d 670 (1st Cir. 1956)). Additionally, generating a worthless stock deduction can be beneficial at lower-tier CFCs, as the foreign shareholder can reduce its Subpart F income by a worthless stock loss in its subsidiary.
NOL carryback opportunity
If USP has a net operating loss (NOL) because of its own operations or due to the worthless stock deduction taken on its subsidiary stock, under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, USP may be able to carry back any NOL generated in 2020 to 2015. This carryback may provide USP with an ability to carry its NOL from a year in which corporate rates are 21% to a year in which they were 35%, producing a significant benefit. For example, if USP has a $10 million NOL in 2020 and carries it forward to offset future income, it would receive a tax benefit of $2.1 million. If, however, USP carried back its NOL to a pre-TCJA tax year, then it would receive a tax benefit of $3.5 million. While specifics are beyond the scope of this discussion, companies should be aware that an NOL carryback cannot be used to offset any Sec. 965 inclusion recognized under the transition-tax provisions of Sec. 965 that were enacted under the TCJA.
USP could exchange the debt instrument CFC issued for equity. In this case, the transaction may qualify as a tax-free recapitalization under Sec. 368(a)(1)(E). Because USP would have an equity interest in the debtor with a tax basis equal to the amount of basis it held in the debt instrument, both USP and CFC should not recognize gain or loss on the transaction.
Planning for unanticipated income taxes
The economic downturn created by the COVID-19 pandemic may force many U.S. multinationals or their CFCs to undergo debt exchanges, modifications, and restructurings. These actions may trigger unanticipated income tax consequences to the debtor or creditor and should be reviewed by tax professionals to identify all potential exposures that may result. What may otherwise appear to be an innocuous way to address a troubled debt obligation may trigger a significant current tax liability that could have been mitigated with some careful tax planning.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
Contributors are members of or associated with RSM US LLP.