Corporate financing companies: treatment of losses.

• Author: Mittman, Matthew J.

It is common for hedge funds and private-equity funds that are passthrough entities and have foreign or tax-exempt investors to form and use, or make a "check-the-box" election to be treated as, C corporation "blocker entities" for the origination and servicing of loans. Blocker entities are used to change the character of income or assets to achieve certain tax results. Financial blocker entities (fincos) are used as a mechanism to prevent funds from potentially being engaged in a U.S. trade or business. Absent fincos, interest earned on, and any fees generated from, the loans held by hedge funds and private-equity funds could be "effectively connected income" for foreign investors (Sec. 864(c)), subject to withholding by the funds under Sec. 1446, and "unrelated business taxable income" to tax-exempt investors under Sec. 512.

Amid the economic conditions of the past several years, loans held by many fincos have become fully or partially worthless. The federal income tax treatment of losses from debt instruments that have become wholly or partially worthless is determined by various tax provisions. The determination of the amount, timing, and character of these losses depends on a number of factors including whether the debt is a "security" as defined in Sec. 165(g)(2)(C) and whether the property is a capital or ordinary asset in the fincos' hands. Aside from special rules or exceptions that apply to specific taxpayers such as banks and financial institutions, there are multiple considerations for fincos in determining the timing and treatment of debt instruments that have become wholly or partially worthless.

Background

In general, under Sec. 166(a), taxpayers are permitted an ordinary bad debt deduction for any business debt that becomes partially or wholly worthless within the tax year. For taxpayers other than corporations, Sec. 166(a) does not apply to nonbusiness debt, which is only deductible when it becomes wholly (not partially) worthless and which is deductible by noncorporate taxpayers only as a short-term capital loss (Sec. 166(d)(1)). Additionally, under Sec. 166(e), a Sec. 166(a) bad debt deduction is not permitted if the debt is a "security" as defined in Sec. 165(g)(2)(C).

A "security" under Sec. 165(g)(2)(C) includes a bond, debenture, note, certificate, or other evidence of indebtedness, issued by a corporation, government, or political subdivision with interest coupons or in registered form. So, a debt issued by a...