Navigating the complex interplay between Secs. 108(e)(6) and 367(c)(2)

Editor: Jeffrey N. Bilsky, CPA

Under Sec. 108(e)(6), a debtor corporation can acquire its indebtedness from a shareholder as a contribution to capital, with the indebtedness treated as satisfied for an amount of money equal to the shareholder’s basis in the debt.

Example: P, a domestic corporation, holds a note from its wholly owned domestic subsidiary S with an adjusted basis of $100. If P contributes the indebtedness to the capital of S, P is treated as having received $100 of cash in satisfaction of the note. If P’s adjusted basis in the debt is equal to the debt’s adjusted issue price, S’s deemed satisfaction of its debt does not result in cancellation-of-debt income (CODI). However, if the adjusted issue price of the debt is greater than P’s adjusted basis, the difference must be recognized by S as CODI.

Sec. 108(e)(6) explicitly turns off the Sec. 118(a) exclusion of capital contributions from gross income. Moreover, Sec. 108(e) applies “for purposes of this title,” meaning for all federal income tax purposes. Notably, Sec. 108(e)(6) does not apply to an exchange of property (i.e., the indebtedness) for additional shares of the debtor corporation. If additional shares are issued in exchange for the debt, the transaction is covered by Sec. 108(e)(8) instead (see IRS Letter Ruling 9822005).

Sec. 108(e)(6) is a common tool in the context of resolving intercompany debt. However, when the debtor is a foreign corporation, questions arise regarding the interplay between Sec. 108(e)(6) and Sec. 367(c)(2). If Sec. 367(c)(2) overrides Sec. 108(e)(6), the potential exists for Sec. 108(e)(8) to apply, possibly resulting in more CODI. Such questions have been left unanswered to date (see the AICPA’s 2022 and 2024 comment letters on the IRS Guidance Priority Plan (in response to Notices 2022–21 and 2024–28, items 15 and 12, respectively).

Application of Sec. 367(c)(2)

The application of Sec. 367 in general is limited to certain gain deferral transactions — specifically those under Secs. 332, 351, 354, 355, 356, or 361 (Secs. 367(a)(1) and (b)(1)) — to deny their preferential nontaxable treatment when such transactions, either outbound (most common) or inbound, involve foreign entities. IRS guidance (Rev. Rul. 72–420, obsoleted by Rev. Rul. 78–381) as well as case law (Abegg, 50 T.C. 145 (1968), aff’d, 429 F.2d 1209 (2d Cir. 1970),discussed below) have confirmed that the list of transactions to which Sec. 367 applies is exhaustive. If a transaction is not included in the list, Sec. 367 will not apply.

Sec. 367(c)(2) provides that any transfer of property to a foreign corporation as a contribution to capital by shareholders who directly or constructively (under Sec. 318) possess at least 80% of the voting power of the corporation’s stock is treated as an exchange of property for stock of the foreign corporation, valued at the fair market value (FMV) of the transferred property. While Sec. 367(c)(2) does not define “contribution to capital,” its provisions are “for purposes of this chapter.” This seemingly indicates that it refers to transactions qualified under Sec. 351, which fall under the general purview of Sec. 367. The history of Sec. 367(c)(2) also indicates the statute refers to Sec. 351 transactions.

Congress enacted Sec. 367(c)(2) as a response to the Tax Court’s decision in Abegg. In Abegg,the issue was whether a capital contribution by a domestic corporation to the capital of its wholly owned foreign subsidiary qualified as a Sec. 351 transaction and, therefore, was subject to Sec. 367(a), when no shares of the transferee were issued to the transferor in the exchange. The IRS argued that in substance the transaction was a Sec. 351 exchange, consistent with previous guidance published in Rev. Rul. 64–155. However, the Tax Court held that a transfer of property to a corporation without issuance of additional shares in exchange for such property was not a Sec. 351 transaction and consequently was not subject to Sec. 367(a).

Shortly after the Abegg decision, to prevent any future circumvention of Sec. 367, Congress added Sec. 367(c)(2) to clarify that Sec. 367(a) applies to all Sec. 351 transactions, whether or not shares of the transferee are issued in exchange for property. After the meaningless–gesturedoctrine was established (see Lessinger,872 F.2d 519 (2d Cir. 1989)), Sec. 367(c)(2) is no longer needed to ensure the applicability of Sec. 367 to all transactions under Sec. 351. Nonetheless, Sec. 367(c)(2) continues to be the statutory umbrella for transactions similar to Abegg (see Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders,¶15.81[1][d][i] (WG&L, 2010)).

The interplay of Sec. 367(c)(2) with Sec. 108(e)(6)

Given the history of Sec. 367(c)(2) and its intended purpose (i.e., to ensure the application of Sec. 367 to contributions of capital under Sec. 351 where no additional shares are issued in exchange for property), a question emerges: Can a transaction under Sec. 108(e)(6), which, as mentioned earlier, is structured as a capital contribution without issuance of new shares, be viewed as a Sec. 351 exchange, thus falling under the provisions of Sec. 367(a) and Sec. 367(c)(2) when the transferee is a foreign corporation?

If the debt is not classified as a security, Sec. 351(d)(2) applies to exclude the applicability of Sec. 351(a). If the debt is a security, the answer — although not as clear as in the nonsecurity scenario — appears to be the same.

As the IRS argued in Abegg and the court in Lessinger concluded, the meaningless–gesture doctrine applies to characterize a contribution to capital without the issuance of additional shares as a Sec. 351 exchange if the issuance of the additional shares for the contributed property would not change the taxpayer’s economic position. However, in the case of Sec. 108(e)(6) transactions, the IRS has taken the rare position that form, not substance, controls the tax treatment (see IRS Letter Rulings 200537026 and 201016048). Therefore, the forgiveness of a debt security under Sec. 108(e)(6) is not deemed to be in exchange for an issuance of new shares, as such a position would render Sec. 108(e)(6) useless by causing Sec. 108(e)(8) to apply to the transaction (see Garlock et al., Federal Income Taxation of Debt Instruments, ¶1502.08 (Wolters Kluwer 2024)).

Sec. 367(f) and lack of regulatory guidance

Congress appears to have recognized that Sec. 367(c)(2) might not capture all contributions to capital that might potentially be brought under the purview of Sec. 367. In 1997, aiming to close any loopholes left by Sec. 367(c)(2), Congress amended Sec. 367 to include subsection (f) (by §1131 of the Taxpayer Relief Act of 1997, P.L. 105–34). Sec. 367(f) extends the application of Sec. 367 by providing that sale or exchange at FMV treatment applies to any transfer of property not otherwise described in Sec. 367 by a U.S. person to a foreign corporation, whether as paid–in surplus or as a contribution to capital. The caveat is that the application of Sec. 367(f) is “to the extent provided in regulations.” However, to date, no regulations have been issued under Sec. 367(f).

In the absence of regulations under Sec. 367(f), we can infer from other, related areas of the Code how the IRS views Sec. 108(e)(6) transactions when foreign corporations are involved. In the context of exchange gain or loss calculations, Regs. Sec. 1.988–2(b)(13)(ii) provides that Sec. 988 and the regulations thereunder apply before Sec. 108. Further, Example 2 under Regs. Sec. 1.988–2(b)(13)(iv) details the coordination between Secs. 988 and 108(e)(6): Foreign exchange gain under Sec. 988 is recognized first, reducing the amount of the liability for purposes of computing the debtor’s potential CODI under Sec. 108(e)(6). One could conclude that if the IRS thought Sec. 367, either under paragraph (c)(2) or under subsection (f), should apply to Sec. 108(e)(6) transactions, the example in Regs. Sec. 1.988–2(b)(13)(iv) would include a reference to Sec. 367(c)(2) or Sec. 367(f).

The persistence of ambiguity

The interplay between Secs. 367(c)(2) and 108(e)(6) highlights the complexities inherent in U.S. tax law. While Sec. 367(c)(2) was designed to ensure that contributions to the capital of foreign corporations under Sec. 351 without the issuance of new shares fall under the purview of Sec. 367, its application to Sec. 108(e)(6) transactions remains ambiguous. The absence of explicit IRS guidance or regulations under Sec. 367(f) leaves open questions about the treatment of such transactions.

The IRS’s position, as reflected in the previously noted letter rulings, asserts that the transaction’s form (issuance of new shares or no issuance of new shares), rather than its substance, dictates the tax treatment under Sec. 108(e)(6). This approach underscores the distinct nature of Sec. 108(e)(6) transactions, which do not involve a deemed issuance of new shares and, thus, may not be captured by Sec. 367(c)(2).

Absent definitive IRS guidance, the courts may ultimately be tasked with reconciling these statutes. The principles for harmonizing conflicting statutes suggest that both Secs. 367(c)(2) and 108(e)(6) should be interpreted in a manner that gives “effect to the language and intent of both, so long as doing so does not deprive one or the other of its essential meaning” (Wilderness Soc’y v. Morton, 479 F.2d 842, 881 (D.C. Cir. 1973)).

In essence, under the conflicting–statutes principles, Sec. 108(e)(6) seems to be best interpreted as the satisfaction of a debt instrument for money (see also Field Service Advice memos 199922034, 199926018, and 200006003, where the IRS extended the deemed–payment treatment to apply withholding tax to accrued and unpaid interest contributed by the shareholder creditor to the capital of the debtor corporation). This interpretation preserves the language and intent of both provisions. There is no violation of Sec. 367(c)(2) because Sec. 108(e)(6) does not fit the limited reach of capital contributions subject to Secs. 367(a) and 367(c)(2), i.e., exchanges governed by Sec. 351, with or without the issuance of shares.

Conversely, if Sec. 367(c)(2) is applied first, it would create a significant exception to Sec. 108(e)(6), making its provisions inapplicable to any foreign subsidiary with a U.S. shareholder contributing the subsidiary’s debt to its capital. However, excluding Sec. 108(e)(6) transactions from Sec. 367(c)(2) causes minimal, if any, harm to the scope and intent of Sec. 367(c)(2), which primarily targets gain transactions.

Until further clarity is provided, understanding the nuances of these provisions and their potential implications remains critical for effective tax planning and compliance in the context of international transactions.

Editor Notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA LLP.