Cancellation of accrued, but unpaid, interest on intercorporate debt.

• Author: Smith, Annette B.

It is not uncommon for a corporation to cancel a debt owed to it by its subsidiary, particularly as preparation for a potential disposition. The Federal income tax consequences of such a transaction hinge on a number of factors, including whether the parent or the subsidiary join in the filing of a consolidated return. Often, there is accrued but unpaid interest on the cancelled debt, which the parties also intend to cancel. Although cancellation of intercorporate debt has been addressed extensively, the treatment of the interest component of such obligations is often overlooked. This article briefly discusses the Federal income tax treatment of such interest under both a consolidated- and separate-return analysis.

Example: P, a parent, owns all of the outstanding stock of S, a subsidiary. The money that S owes P is properly characterized as "debt" for tax purposes. The underlying intercorporate debt has no original issue discount (OID). S is solvent when the debt and accrued interest are cancelled. P and S use the same accounting method.

If any of the assumptions in the example are not met, the analysis becomes more complicated, potentially changing the substantive tax consequences.

Interest Constitutes Debt

S must pay the interest, regardless of whether it already has accrued deductions and P has included income. Thus, under general tax law principles, the interest remains S's debt until repaid.

Separate-Return Analysis

The transaction must be analyzed under separate-return tax principles, under which P and S do not join in the filing of a consolidated return. This analysis is appropriate, even when P and S file a consolidated return, to determine state tax treatment, as many states either do not permit the filing of consolidated returns or do not completely adopt the Federal consolidated regulations. Alternatively, P and S reside in different states, thereby requiring separate state filings.

At first glance, it might appear that cancellation of the interest should be treated as a capital contribution under Sec. 118 or 351. (Because S is wholly owned, the issuance of additional shares to P would be meaningless and not required.) Cases decided prior to 1980 supported this proposition; see Putoma, 601 F2d 734 (5th Cir. 1979). However, Sec. 108(e)(6), enacted as part of the Bankruptcy Tax Act of 1980, provides an analysis, which, although intended to reverse the rule enunciated in Putoma, can reach the same result, albeit via a different...