Potential tax pitfalls in debt capitalization.

• Author: Passman, Maury

Under Sec. 362(e)(1), enacted in American Jobs Creation Act of 2004 (AJCA) Section 836(a), certain issues can arise when a foreign parent contributes the debt of a lower-tier U.S. subsidiary to its other U.S. subsidiaries in cascading capital contributions. The new provision is effective for transactions after Oct. 22, 2004.

Example: Foreign corporation FP enters into a new U.S. business. It transfers $250 to its existing top-tier U.S. holding company, US 1, which transfers it to a newly organized, lower-tier operating subsidiary, US2. A year later, FP's new U.S. investment has not succeeded as hoped; FP advances an additional $100 to US2 to enable it to turn its business around. FP expects the advance to be repaid in three years; documentation is executed to memorialize the terms of US2's obligations.

The US2 note has a $100 face amount and value, and bears adequate stated interest; see Sec. 1273(a) and Kegs. Secs. 1.482-2(a)(2)(i) and 1.1273-2(a) (1). US2 pays and deducts interest on the note; see Sec. 163(a) and (j). Over the next two years, US2's note declines in value to $70, due to either a significant rise in market interest rates or a decline in US2's creditworthiness, and FP decides to salvage its investment. Thus, it contributes the US2 note to US1, which contributes it to US2. Neither US1 nor US2 issues any stock in exchange. US1 then offers US2 for sale, expecting a substantial loss.

AJCA Analysis

The following analysis assumes that (1) FP'S $100 advance to US2 is characterized appropriately as debt for Federal income tax purposes; (2) the contributions are motivated by the desire to prepare US2 for sale, not by tax considerations; and (3) there is no reason to disregard the transaction's form.

Evaluation of the tax consequences of FP's contribution of the US2 note to US1 requires consideration of Sec. 362(e)(1). Under that new rule, if a person transfers property to a corporation as a capital contribution, a Sec. 351 exchange or in a Sec. 368 transaction, the transferee's basis in each item of transferred property "shall" be its date-of-transfer value, if two conditions are met. First, there must be an importation into the U.S. tax base, so that gain or loss on the property would not be subject to tax in the transferor's hands immediately before the transfer, but would be subject to tax in the transferee's hands immediately thereafter. Second, there must be a net built-in loss in the transferred properties, so that but for Sec...