Insolvent foreign subsidiaries.

• Author: Cummings, Jasper L., Jr.

Overview

The Internal Revenue Service's Generic Legal Advice Memorandum AM2011-003, dated August 18, 2011, is one of the most talked about internal IRS opinions in recent years. (1) This so-called GLAM addresses the check-the-box liquidation of an insolvent foreign corporation and its reformation as an insolvent partnership, owing a liability to its principal partner. The guidance was issued by the National Office of Chief Counsel (specifically, its Passthroughs and Special Industries, or PSI, division) to an Area Counsel in the IRS's Large Business & International Division, which audits retailers among others. The GLAM is understood to be a collaborative effort of at least five divisions of Chief Counsel, including the Corporate, International, Financial Institutions and Products (FIP), and Income Tax and Accounting (IT&A) Divisions. PSI, however, had the primary responsibility and would have ultimately controlled the conclusion, absent intervention by the Chief Counsel himself.

The GLAM builds on Rev. Rul. 2003-125, 2003-2 C.B. 1243, which addressed the check-the-box liquidation of a domestic corporation's insolvent foreign subsidiary that continued to operate its business as a disregarded entity; the insolvency similarly was caused by a liability to the parent. The GLAM's facts differ from the revenue ruling only in that a foreign affiliate of parent owns a minority interest in the subsidiary, and so the entity continued as a partnership under the check-the-box fiction. Whereas the revenue ruling held the parent could deduct an ordinary loss for a bad debt under section 166(a) of the Internal Revenue Code, (2) the GLAM denies the bad debt loss solely because the business continues as a partnership that owes the liability.

Denial of the creditor/shareholder's bad debt loss recognition is one reason for interest in the GLAM. The other is its Crane/Tufts-basis analysis, (3) which gives the former shareholders basis in property equal to the entire amount of the corporate liabilities they are deemed to assume, even though the liabilities exceed the value of the property.

This article demonstrates that the bad debt loss denial is wrong and argues that affected taxpayers should disagree with the GLAM. The Crane/Tufts conclusion is also wrong, but perhaps more understandable. The GLAM's results are limited to the partnership cases and could be avoided by eliminating other owners of the foreign entity. (4)

The GLAM

1. Situation 1 of the GLAM

   There is no easy way to understand this GLAM without digesting the numbers it uses in its Situation 1, in which the foreign corporate subsidiary's debt is owed to the domestic corporate parent:

   Situation 1: X (domestic) owns all of Y (foreign) and 80% (basis of $100) of Z (foreign). Y owns the other 20% of Z (basis of $30). Z owns property worth $100 (basis of $120); Z owes $110 to X (the GLAM does not state that the debt is secured by the Z assets, or whether it is recourse or nonrecourse); Z is insolvent. Z checks the box and thereby is deemed to liquidate as a corporation and to be recreated as a partnership owned by X and Y. Z continues to operate its business unchanged; indeed, it continues as a corporation for foreign local law purposes. The IRS wants to know how much, when, and what character of deduction for losses on stock and debt X and Y can claim as a result of Z's deemed liquidation (X hopes for a $110 ordinary loss, and Y hopes for a $30 capital loss). Also, because Z reforms under the check the box fiction as a partnership owned by X and Y, the parties are interested in basis: what is the basis of the partners in the new partnership interests and what is the partnership's basis in its assets?

   The GLAM is based primarily on Treas. Reg. [section] 301.7701-3(g)(1) (ii), which was drafted by the Chief Counsel's PS&I and International divisions: (5)

   If an eligible entity classified as an association elects under paragraph (c)(1)(i) of this section to be classified as a partnership, the following is deemed to occur: The association distributes all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership. The GLAM concludes:

   * The shareholders of Z can deduct their basis in the stock of Z as losses under section 165(g)(1), meaning deductions of $100 (which may be ordinary loss with respect to X under section 165(g)(3)) and $30 (which will be capital loss with respect to Y); this is consistent with prior guidance. This conclusion is made even though the shareholders engage in a property for property exchange: The property they give up is worth nothing because the property they receive is subject to liabilities in excess of value.

   * The shareholders are deemed to buy the corporate property in exchange for their proportionate assumptions of the corporate recourse liabilities and receipt of property subject to nonrecourse liabilities (meaning X assumes or takes subject to 80 percent of the liabilities to itself).

   * The shareholders obtain a combined basis of $110 in property worth $100. The GLAM only partly explains this conclusion. To the extent the liability is recourse, the assumption of personal liability that the GLAM interprets the regulation to require clearly creates a basis in the property equal to the debt. To the extent the liability is nonrecourse, however, normally the Estate of Franklin/Pleasant Summit analysis would not allow the basis to exceed the value of the property securing the liability. Section 334 does not determine the basis because, according to the GLAM, the entire liquidation regime of subchapter C is inapplicable because no net value is distributed to the shareholders even though actual ownership of property is transferred.

   * The new partnership obtains a basis in its property of $110.

   * The new partners obtain basis in their partnership interests of $108 and $2, respectively, determined under sections 722 and 752, as follows: $110 combined asset basis ($88 and $22), reduced by $100 upon the deemed distribution caused by the liability assumption by Z, (6) to $10 ($8 and $2), increased by $100 because of partner X's deemed liability assumption, totaling $110 ($108 and $2). (7) The GLAM does not bifurcate the creation of the partnership into a "sale" of the property for a liability assumption and the distribution of a valueless partnership interest; it treats the entire transaction as subject to subchapter K, even though the partnership created is instantly under water. (8)

   * X remains a creditor of the new partnership, presumably with its original $110 basis in a receivable (although the GLAM does not specifically state this basis) from the partnership worth $100, which is the same receivable X started with.

2. Economics

   Tax folk like to test the economics of a transaction to determine whether the tax outcome conforms to the economics. The GLAM passes this test if you make the noneconomic assumptions (1) that the creditor would not have been paid first in the liquidation, (2) that X would have assumed a liability to itself, and (3) that anyone would assume recourse liability in excess of value of property received. The economic analysis looks like this:

   * Just before the box was checked on Z, X had invested $210 in Z ($100 in stock and $110 in a loan) and Y had invested $30.

   * Z has gross value of $100, all of which would go to X as the creditor upon an actual liquidation of Z; therefore, X's economic loss is $110 ($100 stock loss and $10 loan loss), and Y's economic loss is $30. (10)

   * The GLAM allows X to deduct a $100 loss, reflecting only its equity investment, apparently to retain its $110 basis in the loan, and to obtain a $108 basis in the equity of the partnership, while the minority partner obtains a basis of $2 in its interest in the partnership.

   Therefore, the tax treatment of subsequent events should allow an additional $10 bad debt loss to X and no other tax consequences to the parties, in order for the tax consequences to match up with the economics, assuming no facts change. This works out as follows if Z sells its property to an unrelated buyer for $100 cash, free of the debt, and pays the $100 to X in discharge of the debt of $110 and Z is dissolved:

   * Z recognizes a $10 loss on the sale.

   * But the loss cannot be deducted by the partners because they have no remaining basis. First, their interest basis must be adjusted for the liability reduction under section 752 by $110, assuming the section 752(c) asset value limit does not apply. (11) This adjustment leaves both partners with a zero basis in the partnership interest. Z is discharged of $10 of debt without payment, but is not made solvent and so the partners do not recognize any COD income or increase their basis therefor. (12) Therefore, there is no partner gain or loss.

   * X as creditor recognizes a $10 bad debt loss.

   Thus, the GLAM's conclusions "work," in that they limit the tax loss recognition to the economic loss, but they delay X's loan loss deduction. The numerical tax consequences of the GLAM are summarized in a table in the Appendix.

3. Alternate Constructs

   Domestic parent corporations that were (or are) owed money by their insolvent foreign subsidiaries that have checked the box and become partnerships should consider the second of these two alternative arguments for why they should be allowed a bad debt loss on checking the box.

   1. No Extinguishment but Real Economics

      Without changing the GLAM's call that the liability to X was not extinguished in the corporate liquidation, the GLAM could still have reached a more realistic and satisfying conclusion on the Crane/Tufts issue, by reasoning, as follows:

      * As to recourse liabilities: The shareholders would not agree to assume personal liability for recourse debt in excess of the value of property received that could be applied by the creditor to the...