Deducting your loss on winding up a purchased subsidiary: a lost cause?

• Author: Yates, Richard F.

You may think that your company is entitled to a tax write-off for a bad investment in a purchased subsidiary Changes in the consolidated return regulations, however, have made that once-modest goal a challenge. The recently adopted intercompany obligation rules(1)(*) and the now-familiar stock loss disallowance rule(2) can work together insidiously to deprive your company of its loss if, as is usually the case, the subsidiary's operations were funded with inter-company advances. Long-range planning is essential to avoid the trap.

Know Your Enemies

1. Stock Loss Disallowance Rule

   Treas. Reg. [sections] 1.1502-20 can be traced to 1987.(3) The rule generally was designed to shore up the 1986 repeal of the General Utilities doctrine(4) by barring an array of transactions known as "Son of Mirrors." Although these transactions had been considered innocuous for years, they suddenly became regarded as abusive because they could produce a stock loss -- through the consolidated investment adjustment rules(5) -- to offset a gain on the sale of assets of a purchased subsidiary.(6) The buyer of the subsidiary's assets received the assets with a cost (stepped-up) basis, but effectively no one paid a tax on the asset sale gain. That result contravened the repeal of General Utilities.

   Because the loss disallowance rule targets an "artificial" stock low created by the investment adjustment rules, the scope of the loss disallowance rule is somewhat limited. Treas. Reg. [sections] 1.1502-20(c) disallows stock losses only to the extent of the sum of three factors:(7)

   * Extraordinary gains reflected in stock basis under the investment adjustment rules;(8)

   * Positive investment adjustments reflected in stock basis under the investment adjustment rules (exclusive of extraordinary gains);(9) and

   * Duplicated loss.(10)

   These three factors limiting loss disallowance are designed to permit a deduction for actual economic losses, while denying a tax benefit for the sort of losses arising in a "Son of Mirrors" transaction. In spite of this goal, these factors are not so finely tuned that they permit a deduction for all economic losses. Furthermore, the presumptions underlying the loss disallowance rule are weighted in favor of the IRS. As a result, unexceptional transactions can unjustly fall prey to loss disallowance. The universe of unexceptional transactions that are swept into the loss disallowance net grew considerably larger when the new intercompany obligation rules became effective. For calendar-year filers, these intercompany obligation rules first applied in 1996, but the potentially disastrous impact of their interaction with the loss disallowance rule may not yet be widely appreciated.

2. Intercompany Obligation Rules

   Under Treas. Reg. [sections] 1.1502-13(g)(3), if a consolidated group member holding a receivable from a subsidiary member claims a bad debt deduction, the debt is deemed satisfied with an amount equal to the debt's fair market value, and if the debt remains outstanding, it is deemed reissued for that same amount.(11) Such a satisfaction will cause the subsidiary to have cancellation of indebtedness income equal to the difference between the debt's adjusted issue price (i.e., its principal amount for tax purposes) and its fair market value.(12) Normally, that income would be excluded from gross income by section 108(a) of the Internal Revenue Code to the extent of the subsidiary's insolvency. Treas. Reg. [sections] 1.1502-13(g)(ii)(B)(2) provides, however, that section 108(a) does not apply to intercompany obligations deemed satisfied under Treas. Reg. [sections] 1. 1502-13(g)(3). By making an insolvent subsidiary's debt cancellation income fully reportable, this provision effectively converts (through operation of the investment adjustment rules) the creditor member's bad debt deduction into a worthless stock deduction, which is disallowed under Treas. Reg. [sections] 1.1502-20 by the extraordinary gain factor for debt discharge.(13) The case study that follows illustrates this adverse interaction of Treas. Reg. [subsections] 1.1502-13(g)(3) and -20.

   Can Study

   P is the common parent of a consolidated group filing calendar year tax returns. P purchased all of T's stock for $5 million on December 31, 1994, and T was included in P's consolidated return from January 1, 1995, to December 31, 1997. On December 31, 1994, T's only asset was a promising new technology with a zero tax basis and a zero book (i.e., financial statement) basis. T had no tax attribute carryforwards (e.g., NOLs) and no liabilities except for small amounts of trade payables. P did not elect to treat its acquisition of T as a taxable asset acquisition under section 338. For book purposes, however, the acquisition was a purchase (as opposed to a pooling) and the $5 million P paid for the T stock was reflected as an increase in the intangible assets on P's consolidated balance sheet and on T's separate company balance sheet.

   At the beginning of 1995, T secured a $1 million loan from an unrelated bank, and P guaranteed the loan. During 1995, 1996, and 1997, P advanced $8 million to T as open account indebtedness. Consistent with P's policy for intercompany open account indebtedness, T neither paid nor accrued interest on the $8 million advance. The bank loan and the intercompany advances were used to fund T's operating expenses. T's gross operating income over the three-year period was $750,000. T deducted its $9 million of operating expenses that were paid and retained the $750,000 from operating income as cash. T's $8,250,000 net loss ($750,000 less $9 million) during the three years was used to offset the income of P and its other subsidiaries on the consolidated return. T did not have net operating income during any of these years. Members of the P group did not make any payments to T for the use of its losses.

   Late in 1997, P determined that T's technology was worthless, so P decided to write off the entire unamortized portion of the acquired intangible on its books and to legally dissolve T on December 31, 1997. Immediately before T's dissolution, it repaid $750,000 of the bank loan, and P retired the loan by paying $250,000 pursuant to its guarantee. Under the guarantee arrangement, P was subrogated to the bank's claim for this amount. T's final separate company balance sheet reflects no assets and an intercompany payable to P of $8,250,000 (including the bank's claim subrogated to P).(14) P has sustained an actual loss equal to its original $5 million investment in T, its $8 million of advances to T, plus its $250,000 payment to the bank. P has recovered $8,250,000 of its investment for tax purposes through T's operating losses used on the consolidated return. P's tax director would like to write off P's remaining $5 million investment in T on P's 1997 consolidated tax return.

   Analysis

1. Nature of the Advances -- Debt or Equity

   In evaluating the prospects for a tax write-off, P must determine the nature of its investment in T. This determination depends on whether P's advances to T are treated as debt or equity for federal income tax purposes. Statutory and regulatory guidance on this subject is sparse. Section 385 authorizes regulations to set forth factors to be considered in making debt/equity determinations. The statute provides that these factors may include:

   * whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest;

   * whether there is subordination to or preference over any indebtedness of the corporation;

   * the ratio of debt to equity of the corporation;

   * whether there is convertibility into the stock of the corporation; and

   * the relationship between holdings of stock in the corporation and holdings of the interest in question.

   In 1980 the Treasury issued final regulations under section 385,(15) but these regulations spawned harsh criticism and were withdrawn in November 1983.(16) As a result, the proper characterization of an interest in a corporation as debt or equity remains the province of the courts and a facts-and-circumstances analysis. Courts have looked to a number of factors in making debt/equity assessments. The precise number of factors considered by different courts has varied, but the predominant analytical framework is set forth in the seminal article on the subject, which divides the inquiry into three broad categories with specific factors in each category.(17) The three categories are: (1) formal rights and remedies, (2) factors bearing on intention to create debt, and (3) factors bearing on risk and economic reality.

   The open account nature of P's advances to T and the fact that no interest had been accrued or paid might suggest that the advances were really contributions to capital. Also, that P was sole shareholder weighs against debt characterization. On the other hand, the advances were recorded on T's books as debt and such movements of cash with out formal indicia of indebtedness are commonplace within consolidated groups. Also affecting debt/equity characterization is the treatment of P's guarantee of T's loan from the unrelated bank. Under...