Cancellation of Indebtedness Income: Navigating Multi...

Cancellation of Indebtedness Income: Navigating Multi-State Tax Challenges

Strategies for State Non Conformity Allocationpresents Strategies for State Non-Conformity, Allocation and Apportionment Policies

presents

A Live 110-Minute Teleconference/Webinar with Interactive Q&AToday's panel features:

Michael Jacobs, Partner, Reed Smith, PhiladelphiaBrian Sullivan, Director, Multi-State Tax Services, Deloitte Tax, Atlanta

Scott Gilefsky, Senior Manager, State and Local Tax Practice, Ernst & Young, BostonSteve Wlodychak, Principal, Transaction Advisory Services/State and Local Tax Practice, Ernst & Young, Los Angeles

Wednesday, January 13, 2010

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State Cancellation Of IndebtednessState Cancellation Of Indebtedness Income: Navigating Multi-State Tax

Challenges Webinar

Jan. 13, 2009

Steve Wlodychak Michael JacobsErnst & Young Reed [email protected] [email protected]

Brian Sullivan Scott GilefskyDeloitte Tax Ernst & [email protected] [email protected]

Today’s Program

• Federal CODI Rules, In Concept, slides 3 through 23 (Steve Wlodychak)

• State CODI Ramifications, In Concept, slides 24 through 46 (Michael Jacobs)

• Federal Sect. 108(i) Drill-Down, slides 47 through 55 (Brian Sullivan)

• State Sect. 108(i)-Related Issues Drill-Down, slides 56 through 73(Brian Sullivan and Scott Gilefsky)

• Related Tax Accounting Issues, slides 74 through 79 (Scott Gilefsky)

22

Federal CODI Rules, In ConceptFederal CODI Rules, In Concept

33

Cancellation Of Debt (COD) InCancellation Of Debt (COD), In General

• Generally, under IRC § 61(a)(12), a taxpayer must recognize income upon a “discharge of its indebtedness” (COD income)

• Amount of COD income is generally:Amount of COD income is generally:– The excess of the principal amount (or adjusted issue price) of the

debt over – The fair market value of any consideration paid in exchange for the– The fair market value of any consideration paid in exchange for the

debt• If the debt has original issue discount (OID) (i.e., it was issued for an

amount less than its stated redemption price) then the COD incomeamount less than its stated redemption price), then the COD income amount is measured by the adjusted issue price of the debt – Treas. Reg. § 1.61-12(c)(2)(ii)

44

COD Income – Related-PartyCOD Income – Related-Party Acquisition Of Debt Instrument

• Related-party acquisitionsUnder IRC § 108(e)(4) if a party related to the debtor purchases– Under IRC § 108(e)(4), if a party related to the debtor purchases debt issued by the debtor at a discount from an unrelated creditor, it is treated as if the debtor repurchased its own debt at a discount, and COD income consequences may resultand COD income consequences may result

– Definition of “related party” for this purpose: • Related parties are determined under the rules of IRC §§

267(b) 707(b)(1) and 414 and require greater than 50% (direct267(b), 707(b)(1) and 414, and require greater than 50% (direct and indirect) ownership

55

COD Income – Related-PartyCOD Income – Related-Party Acquisition Of Debt Instrument (Cont.)

• IRC § 108(e)(4): If a person related to the debtor acquires the debt instrument (DI), debtor is deemed to have acquired (i.e., discharged) it – Debtor is deemed to pay an amount equal to the related party’sDebtor is deemed to pay an amount equal to the related party s

basis in the DI or, depending on the circumstances, the DI’s FMV– The amount deemed paid will equal the DI’s FMV if the related

party:party: • Acquired the DI > Six months before becoming related• Did not purchase the DI (i.e., generally took a carryover basis

in the DI) orin the DI), or• Had a principal purpose of tax avoidance

66

Example Of COD IncomeExample Of COD Income Computation

AssumptionsAssumptions• D Corp. is a holding company that owns 100% of OPCO• D Corp. proposes to restructure its $270 million 10% subordinated

t ff ti S t 1 2008 b i i t th i ti t h ld inotes effective Sept. 1, 2008, by issuing to the existing noteholders in exchange for their existing notes: – (a) $28 million in cash– (b) New 7-year notes having a principal amount of $35 million– (c) Preferred stock having a fair market value of $25 million– (d) New D Corp. common stock representing 100% of the D Corp. ( ) p p g p

outstanding common stock

77

Example Of COD IncomeExample Of COD Income Computation (Cont.)

Assumptions (cont.)• Under the plan the pre existing stock of D Corp will be cancelled• Under the plan, the pre-existing stock of D Corp. will be cancelled,

and new senior debt of $50 million will replace the existing bank debt of $20 million

• At the time of the restructuring, the “enterprise value” of D Corp. and its subsidiary is $230 million, and its non-interest bearing short-term liabilities are $30 millionliabilities are $30 million

88


• D Corp. should obtain an appraisal or fairness opinion to establish its enterprise value and the value of the new equity to be issued

• The value of the common stock is generally the enterprise value lessThe value of the common stock is generally the enterprise value less long-term liabilities less the value of other equity

Enterprise value $230Bank Debt (50)New Notes (35)Preferred Stock (25)Preferred Stock (25)Value of common $120

99


Computation of COD income

Consideration paid to noteholders FMV

C h $ 28Cash $ 28

New debt 35 (New principal balance)

Preferred stock 25 (Fair market value)

Common stock 120(Enterprise value less long-term debt and value of other equity)

Total consideration $ 208Total consideration $ 208

Principal amount of old debt 270

COD income amount $ 62

1010

COD Income – RecognitionCOD Income – Recognition Exceptions IRC §108(a)

• Two common situations in which taxpayers are entitled to relief from the ordinary rules requiring recognition of COD income are:– Title 11 case (bankruptcy) – IRC §108(a)(1)(A)Title 11 case (bankruptcy) IRC §108(a)(1)(A)

• When there is a discharge of debt in bankruptcy pursuant to the bankruptcy plan of reorganization, the entire amount of such COD income is excluded from incomeCOD income is excluded from income

– Insolvency – IRC §108(a)(1)(B)• If the discharge occurs in an out-of-court restructuring or not

pursuant to a plan of reorganization in a Title 11 case the CODpursuant to a plan of reorganization in a Title 11 case, the COD income amount is excluded from income only to the extent the debtor is insolvent

1111

COD Income –COD Income –Recognition Exceptions (Cont.)

• Determination of insolvencyUnder IRC § 108(d)(3) insolvency of the debtor is determined– Under IRC § 108(d)(3), insolvency of the debtor is determined immediately prior to the discharge and is measured by the amount of the debtor’s liabilities over the fair market value of the debtor’s assetsassets

– See Merkel v. Comm’r, 109 T.C. 463 (1997) • Contingent liabilities should not be included in determining

insolvency unless it can be shown that the taxpayer will likelyinsolvency unless it can be shown that the taxpayer will likely be called upon to pay the liability

1212

COD Income –COD Income –Attribute Reduction

• Under IRC § 108(b), the cost of utilizing the income recognition exceptions is that the debtor’s tax attributes must be reduced to the extent of the excluded COD income in the following order:– Net operating losses (NOLs) and NOL carryovers, without regard

to any limit in use by IRC § 382 (annual limitation after change of ownership)

– General business credits– Minimum tax credits– Capital loss and capital loss carryovers– Capital loss and capital loss carryovers– Tax basis in property– Passive activity loss and credit carryovers

13

– Foreign tax credit carryovers

13

COD Income –COD Income –Attribute Reduction (Cont.)

• Attributes other than credits are reduced on a dollar-for-dollar basis by the amount of the COD income excludedthe amount of the COD income excluded

• Credits are reduced at a rate of 33 1/3¢ for each dollar of excluded COD incomeCOD income

• Excluded COD in excess of the debtor’s attributes disappears (i.e., it d t d f t tt ib t d i t i l d d i i )does not reduce future attributes and is not included in income)– “Black hole” COD income

1414


Timing of attribute reduction

• General rule under IRC §108(b)(4) is that attributes are reduced after• General rule under IRC §108(b)(4) is that attributes are reduced afterthe determination of tax for the taxable year of the discharge– Under IRC § 1017(a), reduction of tax basis in property occurs on

the first day of the taxable year following the year of dischargethe first day of the taxable year following the year of discharge– Under IRC § 1017(b)(2), basis in property may not be reduced

below the debtor’s aggregate liabilities measured immediately after the discharge This limitation does not apply if the debtor elects tothe discharge. This limitation does not apply if the debtor elects to reduce basis before other attributes under IRC § 108(b)(5)

1515


Election to reduce tax basis of depreciable property first• Under IRC § 108(b)(5), taxpayers subject to the attribute reduction rules

may elect to first reduce the tax basis of depreciable property• The following non-depreciable assets may be treated as depreciable

property for purposes of this election (IRC § 1017(b)(3)):– Any real property treated as inventoryy p p y y– Stock of a subsidiary that files a consolidated return with the debtor, but

only to the extent the subsidiary reduces the tax basis of its depreciable propertyp p y

– Basis in partnership interests to extent of the partner’s proportionate share of depreciable property in the partnership, but only to the extent the partnership reduces the tax basis in its depreciable property

16

p p p p p y

16


Election to reduce tax basis of depreciable property first• Election is beneficial where taxpayer anticipates that pre-change NOLs

available in post-change years will exceed depreciation deductions• Election is not beneficial if the pre-change NOLs that survive attribute

reduction are significantly limited under IRC § 382– Ownership change may occur as a result of the restructuring, triggering the p g y g, gg g

application of IRC § 382– However, debtor needs to consider special exceptions to the IRC § 382

annual limitation that are available in Title 11 bankruptcy casesp y• IRC §382(l)(5) – No 382 limitation but potential for zero limitation• IRC §382(l)(6) – Election out of (l)(5) and increased enterprise

valuation based on converted debt

17

valuation based on converted debt

17

COD Income – Attribute Reduction –COD Income – Attribute Reduction –Consolidated Groups

• If the debtor is a member of a consolidated group, Treas. Reg. §1.1502-28 requires reduction of consolidated attributes of the other members as follows beginning with the highest tier debtor having excluded COD income

1818

COD Income – Deferral Election IRCCOD Income – Deferral Election IRC § 108(i)

IRC §108(i) – 10-year COD income deferral for reacquired indebtedness

• Enacted as part of the American Recovery and Reinvestment Act ofEnacted as part of the American Recovery and Reinvestment Act of 2009

• Allows taxpayers to elect to defer until 2014 recognition of COD• Allows taxpayers to elect to defer, until 2014, recognition of COD income on debt instruments reacquired in 2009 or 2010

If l ti i d ith t t li bl DI th t ld• If election is made with respect to an applicable DI, the taxpayer would then recognize the income ratably over five years from 2014-2018

1919

COD Income – Deferral Election IRCCOD Income – Deferral Election IRC § 108(i) (Cont.)

• Deferral also applies to debt instruments purchased by a related party and debt exchanged for other outstanding debt, including a deemed exchange arising from a significant modification

• If a debt instrument replaces the debt instrument that had COD income, any OID up to the amount of the COD income would beincome, any OID up to the amount of the COD income would be deferred and recognized ratably over the five years

• The provision applies to certain debt-for-debt exchanges equity-for-• The provision applies to certain debt-for-debt exchanges, equity-for-debt exchanges, debt repurchases for cash, contributions of debt instruments to capital, and outright debt forgiveness

2020

COD Income – Deferral Election IRCCOD Income – Deferral Election IRC § 108(i) (Cont.)

• If election to defer is made with respect to an applicable instrument, the resulting COD income can never be excluded from gross incomethe resulting COD income can never be excluded from gross income under the bankruptcy or insolvency exceptions

• If the taxpayer liquidated or sold all of its assets (including through a• If the taxpayer liquidated or sold all of its assets (including through a Chapter 11 proceeding), recognition of the deferred items would be accelerated

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Disclaimer

• Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited located in the USLimited located in the US.

• The views expressed by panelists in this presentation are not necessarily those of Ernst & Young LLP.

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Circular 230Circular 230

• Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internalavoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

• These slides are for educational purposes only and are not intended and should not be relied upon as accountingintended, and should not be relied upon, as accounting advice.

2323

State CODI Ramifications, In Concept

2424

State Tax Issues Relating To CODState Tax Issues Relating To COD Income

S i State income tax

Exclusions from income

A ib d i Attribute reduction

Allocation and apportionment

O h Other state taxes

Non-income-based business entity taxes

S l d t Sales and use taxes

Real estate transfer taxes

S li bilit

25

Successor liability

25

State Income Tax – Basic Framework Most states adopt bankruptcy and insolvency exclusions under IRCMost states adopt bankruptcy and insolvency exclusions under IRC

§108 and attribute reduction rules of IRC §1017

Federal taxable income adopted as starting point for determining Federal taxable income adopted as starting point for determining state taxable income, or

IRC is incorporated by reference in state law (may not include all amendments to IRC)amendments to IRC)

Significant differences exist with regard to adoption of IRC §108(i)

Considerable uncertainty arises when applying IRC concepts in the state context

2626

State Income Tax – Exclusions FromState Income Tax Exclusions From Income

Some states do not follow all federal exclusions under IRC §108(a)

lif i d l f ll h l i f lifi d California does not currently follow the exclusion for qualified principal residence indebtedness. CA Rev. & Tax Code §17144.5(b)

Pennsylvania does not adopt any IRC §108 exclusions for personal income tax purposes

2727

State Income Tax Exclusions FromState Income Tax – Exclusions From Income (Cont.)

If a specific IRC §108(a) exclusion claimed for federal purposes is not available at the state level, consider alternatives:

Bankruptcy. This exclusion is incorporated in federal bankruptcy Bankruptcy. This exclusion is incorporated in federal bankruptcy code, as well as IRC §108(a). 11 U.S.C. §346(j)(1)

Insolvency

Contingent liabilities. If a liability does not yet exist, its cancelation cannot produce income

P h i dj If ll d d b i h Purchase price adjustment. If cancelled debt is purchase money indebtedness, then its cancellation may be able to be characterized as a purchase price reduction, resulting in a reduction of basis

2828

State Income Tax – Bankruptcy Exclusion

All states allow an exclusion from income for debt cancelled pursuant to a bankruptcy plan, regardless of whether they adopt IRC §108. See 11 U.S.C. §346(j)(1)§ § (j)( ) “For purposes of any State or local law imposing a tax on or

measured by income, income is not realized by the estate, the debtor, or a successor to the debtor by reason of a discharge of indebtedness in a case under this title except to the extent if anyindebtedness in a case under this title, except to the extent, if any, that such income is subject to tax under the Internal Revenue Code of 1986.”

The bankruptcy exclusion applies only to indebtedness of specific p y pp y pentity (or entities) subject to jurisdiction of the Bankruptcy Court

There is a need for caution when the bankruptcy exclusion does not apply to all entities participating in a state combined return

2929

State Income Tax – Insolvency Exclusion

I bi d fili t t i i l d t i d t th tit In combined-filing states, is insolvency determined at the entity or group level?

By analogy to the federal consolidated return rules, determination By analogy to the federal consolidated return rules, determination should be at a separate entity level

Does a separate entity determination make sense when group is being treated as a single entity for apportionment purposes?

3030

State Income Tax – Cancellation Of Inter-Company Indebtedness

Generally, cancellation of indebtedness between two entities that file as part of the same consolidated return is a deferred recognition eventas part of the same consolidated return is a deferred recognition event for federal income tax purposes. See Treas. Reg. §1.1502-13(g)

Some states eliminate income from intercompany transactions within combined group. e.g. Alabama, Maine

Other states follow federal consolidated return rules. e.g: C lif i C l C d R §25106 5 1( )(2) California. Cal. Code Regs. §25106.5-1(a)(2) Illinois. Ill. Admin. Code §100.5270(a)(1) Massachusetts. 830 CMR 63.32B.2(c)(5)( )( ) West Virginia. W.Va. Code §11-24-13d(e)

Some states do not provide for elimination or deferral of income from inter company transactions e g New York separate reporting states

31

inter-company transactions. e.g. New York, separate reporting states.

31

State Income Tax Conformity ToState Income Tax – Conformity To Federal Attribute Reduction Rules

Generally, states adopt federal attribute reduction rules of IRC Bankruptcy Code has its own attribute reduction rule, referring back

to the IRC. See 11 U.S.C. §346(j)(2) “Whenever the Internal Revenue Code of 1986 provides that the

amount excluded from gross income in respect of the discharge of indebtedness in a case under this title shall bee applied to reduce the tax attributes of the debtor or the estate, a similar reduction ,shall be made under any State or local law imposing a tax on or measured by income to the extent such State or local law recognizes such attributes. Such state or local law may also provide for the reduction of other attributes to the extent that the pfull amount of income from the discharge of indebtedness has not been applied.”

3232

State Income Tax – State Variances From Federal Attribute Reduction

RulesRules

Some states have their own attribute reduction rules. For example:Some states have their own attribute reduction rules. For example: Alabama. Only NOLs and basis of depreciable property. Ala.

Code §40-18-14(2) Idaho No attribute reduction outside of bankruptcy Idaho Idaho. No attribute reduction outside of bankruptcy. Idaho

Admin. R. 35.01.01.210 New Jersey. No reduction of NOLs. NJ State Tax News, Vol. 25,

No. 4 (Dec. 1, 1996)( , )

3333

State Income Tax – Attribute S e co e bu eReduction (Net Operating Losses)

In some states any reduction to state NOL carryforward must be In some states, any reduction to state NOL carryforward must be computed on a post-apportionment basis. For example: California. Appeal of Wilshire Restaurant, SBE Case No. 166408,

2003 ( bli h d)2003 (unpublished) Georgia. Ga. Comp. R. & Regs. §560-7-3-.06(5)(c)1 Illinois. 35 Ill. Comp. Stat. 5/207(c)

The apportionment percentage applied to the reduction of state NOL carryforwards in post-apportionment states generally is based on the factors for the year of dischargefactors for the year of discharge

In other states, NOLs are carried forward (and reduced) on a pre-apportionment basis, e.g. Massachusetts, New Jersey and New York

3434

State Income Tax – Attribute Reduction (Net Operating Losses), Cont.( p g ),

State NOL carryforward can differ significantly from federal NOL f dcarryforward

Differences in taxable income computations

Some states do not follow IRC §381 or §382

Some states do not allow for the carryback of NOLs

3535

State Income Tax – Attribute Reduction (Basis of Depreciable

Assets)Assets) There can be significant differences between the tax basis of

depreciable assets, for federal and state income tax purposes

Differences in federal and state depreciation regimes, e.g. not all states follow federal bonus depreciation regimes

Most states have not adopted federal consolidated return rules Most states have not adopted federal consolidated return rules, including the “look-through” basis reduction rule of Treas. Reg. §1.1502-28(a)(3)

States generally follow a federal election under IRC §108(b)(5) to apply attribute reduction first to basis of depreciable property. See, e.g., Or. Rev. Stat. §314.306(a)

3636

State Income Tax – Allocation VsState Income Tax Allocation Vs. Apportionment

Generally, “business income” is subject to apportionment, while “nonbusiness income” is directly allocated to a single statenonbusiness income is directly allocated to a single state

UDITPA definition of business income: “Income arising from transactions and activity in the regular course of the taxpayer's tradetransactions and activity in the regular course of the taxpayer s trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or p p y g p p y gbusiness operations.”

3737

St t I T All ti VState Income Tax – Allocation Vs. Apportionment (Cont.)

State definitions differ. Most definitions include “transactional” and “functional” components

T ti l t t D COD i i f t ti Transactional test: Does COD income arise from a transaction or activity in the regular course of a taxpayer’s trade or business?

Functional test: Is COD income derived from property acquired, p p y qmanaged and disposed of as an integral part of a taxpayer’s regular trade or business operations?

Some states have drafted the “functional” component of theirSome states have drafted the functional component of their definition to apply whenever the acquisition, management ordisposition of the property constitute integral parts of the taxpayer's regular trade or business operations

3838

State Income Tax – Allocation Vs. Apportionment (Cont.)

See Agricultural Building Company v. Wisconsin Department ofSee Agricultural Building Company v. Wisconsin Department of Revenue, Wisconsin Tax Appeals Commission, No. 89-I-402 (October 9, 1990)

Treating COD income as business income may present constitutional Treating COD income as business income may present constitutional issues

Was indebtedness incurred in a period when the taxpayer lacked substantial nexus with the state?

Was indebtedness incurred as part of the same unitary business conducted by taxpayer in year of discharge?y p y y g

3939

St t I T S l F tState Income Tax – Sales Factor Is COD a “receipt,” for purposes of computing the sales factor? p p p p g

Should it matter whether COD is excluded from income? Should it matter whether the debtor enjoyed an increase in assets as a result of the discharged debt?

How should COD be sourced, for sales factor purposes?

Treated as income derived from an intangible property right and sourced to state of commercial domicile?sourced to state of commercial domicile?

Sourced based on location of costs of performance? (What costs?)

For federal purposes, debt-discharge income is sourced based on geographic tracing of use of debt proceeds. See Big Hong Ng v. Commr., T.C. Memo 1997-248

4040

State Income Tax – Sales Factor (Cont.) Some states specifically exclude COD from sales factor See e g Some states specifically exclude COD from sales factor. See, e.g.,

Florida TIP #09C01-03 (July 8, 2009)

In other states, it may be possible to argue that including COD in the l f ld b “di i ” d UDITPA §18sales factor would be “distortive” under UDITPA §18

For purposes of the Texas margin tax, COD is included in the sales factor and sourced to the state of “legal domicile”. Tex. Admin. Code gtit. 34, §3.591(e)(5)

Some states exclude inter-company debt cancellation from computation of sales factor See e g California Code Regscomputation of sales factor. See, e.g., California Code Regs. §25106.5-1(a)(5)(A)1

4141

Non-Income-Based TaxesNon Income Based Taxes Gross receipts-based taxes Michigan Business Tax – COD included in modified gross g g

receipts. MBT FAQ B21 Ohio Commercial Activity Tax – COD included in gross receipts.

Ohio Rev. Code §5751.01(F) Texas franchise (margin) tax – Based on “total revenue”, which is

derived from federal gross income (including COD). Tex. Tax Code §171.1011(c)

Washington B&O tax Unclear Washington B&O tax – Unclear Book income-based taxes Pennsylvania capital stock/franchise tax – COD included in

i “i b k ” Sh D l Icomputing “income per books”. Shawnee Development, Inc. v. Commw., 799 A.2d 882 (PA Commw. Ct. 2002)

Do IRC §108 exclusions apply, for purposes of non-income based taxes?

42

taxes?

42

Sales And Use Tax State sales and use taxes generally apply to “receipts” from sales orState sales and use taxes generally apply to receipts from sales or

other transfers of tangible personal property

“Receipts” may include cancellation of indebtedness of the t ftransferor, e.g:

California Sales Tax Counsel Ruling No. 395.2157 (Jan. 14, 1972).

Commw. v. Sylvan Seal Milk, Inc., 77 Dauph. 54 (Pa. Common Pleas Ct. 1961).

In many cases, transfers of tangible personal property in exchange for cancellation of debt will fall within state exemptions for occasional sales

4343

Real Estate Transfer Taxes Transfer of real property in satisfaction of debt may trigger real estateTransfer of real property in satisfaction of debt may trigger real estate

transfer tax, e.g.:

In the Matter of the Petition of Broadway Mall Properties, Inc., NY Div of Tax Appeals ALJ Determination No 813981 (DecNY Div. of Tax Appeals, ALJ Determination No. 813981 (Dec. 19, 1996)

Some jurisdictions may provide an exemption for transfers of real f d d i li fproperty from a mortgagor to a grantor pursuant to a deed in lieu of

foreclosure or a judicial sale, e.g.:

California. Cal. Rev. & Tax Code §11926§ Philadelphia. Phila. Code §19-1405(14) South Carolina. SC Code §12-24-40(13)

4444

Successor Liability

Creditor’s acquisition of debtor’s business assets in exchange for cancellation of debtor’s indebtedness may cause creditor to be a “ ” ibl f d bt ’ i iti t li biliti“successor” responsible for debtor’s pre-acquisition tax liabilities

See, e.g., W.Va. Code St. R. §110-15-4.9.1, defining “successor” as “any person who directly, indirectly purchases, acquires, or succeedsany person who directly, indirectly purchases, acquires, or succeeds to the business or the stock of goods, whether the consideration is money, property, assumption of liabilities, or cancellation of indebtedness.”

4545

Circular 230 Disclosure

Any U.S. tax advice contained in this presentation was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or applicable state or local tax law provisions.

These slides are intended solely for educational purposes and should These slides are intended solely for educational purposes and should not be relied upon as legal advice.

4646

Federal Sect. 108(i) Drill-Down

4747

Cancellation Of Debt Income – Defined• Cancellation of debt income (CODI)

– Cancellation or repurchase of debt for less than its face amount (or adjusted– Cancellation or repurchase of debt for less than its face amount (or adjusted issue price) results in taxable CODI under IRC § 61

• IRC § 108(e)(4) provides that purchase of debt by related party is treated as• IRC § 108(e)(4) provides that purchase of debt by related party is treated as purchase by the debtor and can trigger CODI

I d bt f d bt h CODI l th f th dj t d i– In a debt-for-debt exchange, CODI equals the excess of the adjusted issue price of old debt over the issue price of the new debt

k f d b h l h f h dj d i– In a stock-for-debt exchange, CODI equals the excess of the adjusted issue price of old debt over the FMV of the stock

Copyright © 2010 Deloitte Development LLC. All rights reserved.48

– If old debt is contributed to capital, CODI is the excess of the adjusted issue price over the shareholder’s adjusted basis in the debt

Cancellation Of Debt Income – General RuleRule

• Unless specifically excluded, CODI is taxable

IRC § 108(a) provides that CODI is generally excluded from gross income if– IRC § 108(a) provides that CODI is generally excluded from gross income if a corporation is insolvent (to the extent of insolvency) or in Chapter 11 bankruptcy

– The exclusion of CODI under IRC § 108(a) results in a reduction to tax attributes, subject to specific ordering rules provided by IRC § 108(b)


2009 ARRA: New Provision - § 108(i)

N § IRC 108(i) El ti t d f CODI i l i f i iti f• New § IRC 108(i) – Election to defer CODI inclusion from a reacquisition of an applicable debt instrument (ADI) after 12/31/08 and before 1/1/11

• ADI is an instrument issued by a C corporation or any other person in connection with the conduct of a trade or business

• CODI inclusion is deferred until 2014 and then included into gross income ratably from 2014–2018


Eligible Transactions

• A reacquisition is any acquisition of an ADI by:– The debtor that issued (or the obligor under) the debt instrument orThe debtor that issued (or the obligor under) the debt instrument, or– Any person related to the debtor under IRC § 108(e)(4)

• An acquisition includes

– A repurchase for cash

A debt for debt e change (incl ding a significant modification)– A debt-for-debt exchange (including a significant modification)

– Stock or partnership interest for debt

– A capital contribution creating CODI under §108(e)(6), andcap ta co t but o c eat g CO u de § 08(e)(6), a d

– A cancellation of debt that is not a capital contribution


Making The § 108(i) Election

• Election is irrevocable and made on an instrument-by-instrument basis (see Rev. Proc. 2009-37))

– Protective election

– Election for part of the CODI

• Election is made on timely filed tax return (including extensions) for year in which CODI is incurred

Can be an information return (i e made at partnership or S corp level)– Can be an information return (i.e., made at partnership or S corp. level)

– Automatic 12-month extension under Treas. Reg. §301.9100-2(a)

• Election precludes any other election under IRC § 108(a)p y § ( )

– If CODI is deferred under IRC § 108(i), it is not eligible to be excluded under IRC § 108(a) (i.e., due to insolvency or bankruptcy) when included in gross income in later years


income in later years

Other Considerations• Original issue discount (OID)

– If an election under IRC § 108(i) is made to defer CODI in a debt-for-debt a e ect o u de C § 08( ) s ade to de e CO a debt o debtexchange that results in OID, then any otherwise allowable deduction for OID on the newly issued debt is deferred and allowed as a deduction ratably over the same five-taxable-year period that the CODI is included (i.e., matches income and deductions in same periods)

• Acceleration of deferred CODI by certain events

– Death of taxpayer

– Liquidation or sale of substantially all of the assetsLiquidation or sale of substantially all of the assets

– Cessation of business or similar circumstances


– Sale or redemption of a pass-through interest

Contacts

Brian SullivanDirector, Atlanta(404) 220-1673, [email protected]

This presentation contains general information only and the respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This


presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you

should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation.

About Deloitte


About DeloitteDeloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.

Copyright © 2009 Deloitte Development LLC. All rights reserved.Member of Deloitte Touche Tohmatsu

State Sect 108(i)-Related Issues Drill-State Sect. 108(i)-Related Issues Drill-Down

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Agenda

• State conformity rules• State conformity rules

• Various state responses to IRC §108(i)

• Uncertain state tax issues

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State Response: Trend To Not Conform

• IRC conformity in general– Most states generally follow the federal treatment of COD income

under IRC §108, and the treatment of AHYDO under IRC §163(e)under IRC §108, and the treatment of AHYDO under IRC §163(e) and OID under IRC §1271-1275

• Use federal taxable income as a starting point for determining state taxable income, orstate taxable income, or

• Incorporate IRC by reference into their state tax law• Non-conformity to IRC §108(i)

Additi ll th th h h t t f h– Additionally, the way they have chosen not to conform has a tremendous impact on taxpayers with COD I\Income

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State Response: Conformity Rules

• Fixed date – State would have to affirmatively update its conformity date to conform to federal changes post-fixed datedate to conform to federal changes post fixed date

• Most have selectively conformed by deliberately choosing not to adopt IRC §108(i)

• Rolling conformity – State would have to enact new legislation to d l f IRC §108(i)decouple from IRC §108(i)

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State Response: Non-Conformity To IRC §108(i)IRC §108(i)

• IRC conformityIRC conformity– State governments face the tension of balancing between:

• Raising revenue, andF t i i th d li iti th d l it• Fostering economic growth and limiting the undue complexity of federal/state tax differences

– Trend appears that most states are eliminating the IRC §108(i) COD i d f l ith bCOD income, deferral either by:

• Ignoring it entirely• Requiring an addback of the benefits • In each case, requiring immediate recognition of COD income

for which a deferral is provided for federal income tax purposes

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State Response: Non-Conformity To IRC §108(i) (C t )IRC §108(i) (Cont.)

• Key states do not conform to these provisions, because their IRC conformity laws have not been updated

• Examples:– California (Jan. 1, 2005)

T (J 1 2007)– Texas (Jan. 1, 2007)

• Result – COD income from reacquired indebtedness for a solvent taxpayer

could be immediately recognizable for state tax purposes

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State Response: 50 states, 50 A hApproaches

• State statutes are dramatically different• Florida

• Updated conformity date to incorporate the ARRA and IRC §108(i) is adoptedTh d t d i i i i ddb k f IRC §108(i) COD• Then adopted a provision requiring addback of any IRC §108(i) COD income deferral

• But, no mention of the other IRC §108(i) relaxation rules in AHYDO or OIDor OID

• Florida Department of Revenue issued TIP #09C01-03 (July 8, 2009)– Clarifies the addback of COD income– Requires the deferral of OID deduction for debt exchanges underRequires the deferral of OID deduction for debt exchanges under

IRC §108(i)(2)– COD income is in base but excluded from apportionment

formula

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State Response: 50 States, 50 A h (C t )Approaches (Cont.)

• California– IRC conformity date is Jan. 1, 2005; therefore:

• IRC §108(i) is not adopted (ignored for California purposes)• IRC §108(i) is not adopted (ignored for California purposes)• Unless another exception applies (e.g., insolvency/bankruptcy

exception under IRC §108(i), COD income will be immediately recognized at tax rate of 8 84% (generalimmediately recognized at tax rate of 8.84% (general corporations) or 10.84% (financial corporations)

• Tax attributes limited – As net operating losses (NOLs) are suspended in 2008 and 2009 NOLs are unable to offset CODsuspended in 2008 and 2009, NOLs are unable to offset COD income; tax credits limited to 50% of taxable income

63

State Response: 50 States, 50 A h (C t )Approaches (Cont.)

• Texas– IRC conformity date is Jan. 1, 2007; therefore:IRC conformity date is Jan. 1, 2007; therefore:

• IRC §108(i) not adopted• Tax not based on net income Taxable margin

– COD income reported as “other income” (Form 1120, Line 10)COD income reported as other income (Form 1120, Line 10)– No deductions from COD income

• BUT Clear regulation on inclusion of COD income in gross receipts factor (Tex Admin. Code tit. 34, §3.537(e)(6))p ( , § ( )( ))

– To state of “legal domicile” – state of formation (TAC tit. 34, §3.537(a)(7))

– Example – Delaware corporation doing business in Texas» Include COD income in denominator but NOT in

numerator» Effect: Dilute apportionment in year COD income

i d

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recognized

State Response: 50 States, 50 Approaches (Cont.)

• Michigan• IRC conformity date

• Jan. 1, 2008 or the Code in effect for the tax year at the option of Ja . , 008 o t e Code e ect o t e ta yea at t e opt o othe taxpayer

• Generally, most taxpayers do not have NOL carryovers from SBT to MBT

• Deferred for purposes of the GRT

• Oregon• Oregon• Specifically adopted IRC § 108 as in effect in 2008

65Copyright © 2010 Deloitte Development LLC. All rights reserved 65

State Response: 50 States, 50 Approaches (C t )(Cont.)

• States that currently appear to conform to IRC § 108(i)• Idaho, Ohio and West Virginia

– Have conformed to the IRC as of date on or after Feb. 17, 2009 ave co o ed to t e C as o date o o a te eb. 7, 009and have not explicitly decoupled

• Illinois– Decoupling language in proposed legislation that did not pass– Decoupling language in proposed legislation that did not pass

during 2009 session• Mississippi, Montana, Pennsylvania and Tennessee

Line 28 of Federal 1120 is starting point for state ta able income– Line 28 of Federal 1120 is starting point for state taxable income computation


State Response: Uncertain Issuesp

• Allocation and apportionmentWill COD i b t t d• Will COD income be treated:

– As non-business income (and wholly allocated to a single state), or

– As business income (and apportioned among all the states where the recipient of the COD income is domiciled)?

• If the COD income is deferred, will it be apportioned or allocated based upon:

– The taxpayer’s apportionment or presence in the year in which the COD income was realized?

– Or, in the years in which it is recognized?» A lot can happen to a business in 10 years!

67

State Response: Uncertain Issues (C t )(Cont.)

• Allocation and apportionmentAllocation and apportionment• Should COD income be included in the numerator and

denominator of the sales factor? • Is it sourced in the year it is realized? Or in the year it is• Is it sourced in the year it is realized? Or in the year it is

recognized?• If so, to which state is the COD income sourced?

I it i f i t ibl i ht?– Is it income from an intangible right? » If so, source to state of commercial domicile?

– If the commercial domicile changes, should it always be allocated to the state of commercial domicile in the year in which it is realized?

– Or, do we just forget about it entirely as distortive?

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State Response: Uncertain Issues (C t )(Cont.)

• How will this provision affect taxes not directly based on federal taxable income?taxable income?– Examples:

1. Ohio CAT and Washington B&O tax (is COD income a “gross receipt”?)gross receipt ?)– Probably not

2. Texas franchise tax (COD income is includable in “gross i ”)margin”)

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Compliance And Other Considerations• Federal pro forma returns will not show deferred CODI amounts

• Need to track states in which CODI was recognized in 2009 and 2010 forNeed to track states in which CODI was recognized in 2009 and 2010 for subtraction when federal recognition begins in 2014

• Consideration for purposes of estimated and extension payments

• Potential decoupling by states in 2010 legislation

• State NOLs

Sh t f d i d– Shorter carryforward periods

– Limitations

» IRC § 382» IRC § 382

» Pennsylvania: Greater of $3M or 12.5% of taxable income


Compliance And Other Considerations (Cont )(Cont.)

• Opportunity to apply insolvency or bankruptcy exceptions under IRC § 108(a) in states that decouple from IRC § 108(i)

• Create deferral through reduction of state attributes• Create deferral through reduction of state attributes

• Consideration of separate vs. consolidated state filings

• Nexus and apportionment planning opportunities



• Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internalavoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

• These slides are for educational purposes only and are not intended and should not be relied upon as accountingintended, and should not be relied upon, as accounting advice.

72

Disclaimer

• Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited located in the USLimited located in the US.


73

Related Tax Accounting Issues

7474

FIN 48: Two-Step Processp

• The application of FIN 48 requires a two-step process that separatesThe application of FIN 48 requires a two step process that separates recognition from measurement– Step one: Recognition threshold

• A tax benefit is recognized when it is “more likely than not” to• A tax benefit is recognized when it is more likely than not to be sustained, based on the technical merits of the position

St t M t f th b fit• Step two: Measurement of the benefit– The largest amount of tax benefit that is greater than 50% likely of

being realized (cumulative probability concept)

• Appropriate unit of account for a tax position is a matter of judgment

75

Uncertain Tax PositionsUncertain Tax Positions

• Challenges:• Challenges:

• Numbers of jurisdictions and entities– Tracking statute of limitations by jurisdiction

• Number of issues– Apportionment sourcing– Business vs. non-business income characterization

How to assess probabilities– How to assess probabilities– Interest and penalties vary by jurisdiction

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Measurement Of Tax Positions

• Only those tax positions meeting the more-likely-than-not threshold for recognition should be measured within financial statements

• Considered the following when conducting measurement analysis:– Nexus– Forced combinationForced combination– Transaction recharacterization– Changes/correction of transfer prices

E di ll– Expense disallowance

77


• Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties thatused, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

• These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.

78

DisclaimerDisclaimer

• Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legalErnst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited located in the US.


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