Cancellation of debt income for debtor subsidiary corporations.

• Author: Islam, Adnan

The global financial crisis and its aftermath have caused multinational entities to adapt to and struggle with certain new economic externalities. Whether established businesses or burgeoning startups, few companies have been able to continue conducting business as usual. Multinational entities have had to deal with supply-and-demand constraints, budget cuts, resource and capital constraints, reduced purchasing activity at the product level, reduced or nonexistent merger-and-acquisition activity, and insufficient cash/income flow to repay intercompany debt principal or the corresponding interest payments. Consequently, the issues surrounding cancellation of indebtedness have become particularly relevant with respect to multinational entities.

This item addresses the U.S. corporate income tax effects of cancellation of debt (COD) income; the contribution-to-capital exception to COD income; partial cancellation of COD income; the impact of insolvency; and, finally, some COD income issues to consider in the international corporate context.

General Taxation of COD Income

Under the Code, U.S. persons, including corporations, are taxed on their worldwide income. Sec. 61 defines gross income to include COD income. When a debtor recognizes COD income, the creditor may receive a corresponding Sec. 165(g) worthless securities deduction or a Sec. 166 bad debt deduction. Sec. 108 provides several exceptions to the definition of COD income. For example, Sec. 108(e)(6) provides that a capital contribution in the form of debt forgiveness by a shareholder-creditor that does not involve an issuance of stock of the debtor produces COD income only to the extent the outstanding debt exceeds the contributing shareholder's adjusted tax basis in the debt. In addition, under Sec. 108(e)(8), a corporation recognizes COD income if it transfers stock in satisfaction of its debt and the fair market value (FMV) of the stock is less than the adjusted issue price of the debt.

Thus, when debt is forgiven by a shareholder-creditor and no new stock is issued, the debtor recognizes gain to the extent the adjusted issue price of the debt exceeds the shareholder-creditor's basis in the debt. The shareholder-creditor increases its basis in the stock of the debtor in an amount equal to the adjusted issue price of the debt (see also Sec. 1016(a)(1), Regs. Sec. 1.1502-19(d)(1), and Letter Ruling 201337007).

Partial Cancellations

The income tax treatment of a partial, as opposed to complete, cancellation of debt is not specifically addressed by the Code. However, just as a complete cancellation of a shareholder-creditor loan without any stock exchange is treated as a...