Final IRS Regulations Hurt Consolidated Groups

Temporary Regulations

Historically, it was unclear how tax attributes were to be reduced when the distressed corporation with excluded COD was a member of a consolidated group. In March 2004, the IRS issued temporary regulations that provided for the reduction of the tax attributes of the consolidated group by excluded COD using a hybrid single-entity approach. Under these temporary regulations, the tax attributes of members of a consolidated group were to be reduced as follows:

First, consolidated NOLs attributable to the distressed member would be used to offset the taxable income of other members for the year in which indebtedness is cancelled.

Second, the consolidated tax attributes (other than the tax basis of assets) attributable to the distressed member would be reduced by any excluded COD.

Third, the tax basis of the distressed member's assets (including the basis in the stock of its subsidiaries which are members of the group) would be reduced by any remaining excluded COD.

Fourth, if the distressed member reduced the tax basis in the stock of its subsidiaries, this so-called “deemed COD” would be applied against and would reduce the consolidated tax attributes attributable to such subsidiaries by an amount equal to the amount by which the tax basis of their stock was reduced (the so-called “look-through” rule).

Finally, consolidated NOLs attributable to other members would be reduced to the extent of any remaining excluded COD (the so-called “fan-out” rule).

Thus, under the temporary regulations, consolidated tax attributes attributable to members of a consolidated group other than the distressed member might be subject to reduction by that member's excluded COD. It was unclear under the temporary regulations, however, whether the tax attributes with respect to a member which either left or joined a consolidated group with a member that has excluded COD were to be reduced by such excluded COD. As a consequence, some tax professionals surmised that the tax attributes of former or new members might not be subject to reduction. The final regulations address these situations and other situations where there are changes in the composition of a consolidated group with a member that has excluded COD.

The Final Regulations

Although the new final regulations are quite complicated, the most significant “revisions” to the rules promulgated in the temporary regulations can be summarized as follows:

First, the consolidated tax attributes attributable to a member with excluded COD are subject to reduction even if that member “leaves” the group before the first day of the following tax year because its stock (or its assets in certain tax free transactions) has (have) been acquired.

Second, the consolidated tax attributes attributable to other members are subject to reduction by the excluded COD of another member even if the member with the excluded COD “leaves” the group before the first day of the following tax year.

Third, any excluded COD of a member that “leaves” the group because its stock is issued to creditors in satisfaction of such member's debt is treated as having been realized before such member leaves the group. (The so-called “next-day” rule cannot be used to treat the excluded COD as realized by such member at the beginning of the day following its departure from the group).

Fourth, if a lower-tier subsidiary of the member that has excluded COD would have had “deemed COD” under the “look-through” rules, the consolidated tax attributes attributable to such subsidiary are subject to reduction by such “deemed COD” even if the subsidiary “leaves” the group before the first day of the following tax year.

Fifth, if the stock (or its assets in certain tax free transaction) of a corporation that was not a member of the group with a member that has excluded COD is (are) acquired after the cancellation occurs, but before the first day of the following tax year, the tax attributes of the new member are subject to reduction.

Finally, when a member that has excluded COD transfers its assets to another member of the group, all of the transferee member's tax attributes (and not just the attributes of the transferring member) are subject to reduction.

Conclusion

Although the full repercussions of these final regulations remain to be seen, it would appear that more of the tax attributes of financially troubled consolidated groups with excluded COD may become subject to reduction as a consequence of these new rules, and that such groups' future tax liability may be significantly increased as a result. Thus, where the assets of a member of a financially troubled consolidated group with excluded COD are transferred to another member, tax attributes of the transferee which would otherwise not be subject to reduction may become subject to reduction under the final regulations as a consequence of the transfer. Similarly, tax attributes of a corporation thath was not a member of a financially troubled consolidated group with excluded COD when the cancellation occured may also become subject to reduction under the final regulations if its stock (or its assets in a tax free reorganization) is (are) acquired by the group. Finally, the tax attributes of former members of a financially troubled consolidated group with excluded COD may remain subject to reduction under the final regulations even though they have left the group.

It is perhaps in this latter regard that the final regulations will have the greatest impact, since the tax attributes of a former member of a financially troubled consolidated group with excluded COD that is acquired by a third party may be reduced before, and the taxable income of such former member may be increased after, it is acquired by such third party. Thus, any third party that acquires the stock of any member of a financially troubled consolidated group will have to at least try to estimate how these rules will impact the tax attributes of the company being acquired.

Since the third party will need to know the details of the restructuring plan and tax posture of the financially troubled consolidated group that may not be readily available in order to prepare such an estimate, it may be necessary for the third party to request representations and warranties from the consolidated group with respect to the amount by which the tax attributes of the former member will be reduced and indemnification protection should the final results differ from the estimate. As a consequence, yet another layer of complexity will be added to transactions involving distressed companies. Let the buyer beware!

Just when you thought you had finally mastered the complex temporary regulations issued last March regarding the reduction of tax attributes of members of an affiliated group of corporations filing consolidated income tax returns (“consolidated group” or “group”) following a cancellation of the debt, the IRS has served up another dose of “March Madness.” The IRS has now issued those regulations in final form and has made some significant “revisions” to the provisions of the temporary regulations that focus on how tax attributes are to be reduced when a subsidiary either ceases to be, or becomes, a member of the consolidated group. This article briefly discusses how these significant “revisions” will impact financially troubled consolidated groups.

Background

Where a corporation is in financial distress, a restructuring or reduction of its indebtedness may result in cancellation of indebtedness. Cancellation of indebtedness (COD) is generally taxable, but is not taxable if the distressed corporation is in bankruptcy or is insolvent (but only to the extent of the insolvency). When cancellation of indebtedness is not taxable because the distressed corporation is bankrupt or is insolvent (“excluded COD”), the amount of COD is applied against and reduces the corporation's tax attributes, starting with net operating losses (“NOLs”) and ending with the tax basis of assets (eg, fixed assets, inventory and receivables). If the amount of excluded COD of a distressed corporation exceeds its tax attributes, however, the excluded COD “disappears” and has no further tax effect. Thus, although the distressed corporation will avoid current taxation with respect to excluded COD, the mechanism of reducing tax attributes by excluded COD may serve to increase its corporation's future tax liability by reducing the NOLs and the tax basis of assets (and depreciation with respect thereto) that offset taxable income. Under long-standing rules, the distressed corporation's tax attributes are reduced on the first day of the tax year following the event that resulted in excluded COD. This means that the distressed corporation's tax attributes remain available in determining tax liability for the tax year in which it realizes excluded COD.

Temporary Regulations

Historically, it was unclear how tax attributes were to be reduced when the distressed corporation with excluded COD was a member of a consolidated group. In March 2004, the IRS issued temporary regulations that provided for the reduction of the tax attributes of the consolidated group by excluded COD using a hybrid single-entity approach. Under these temporary regulations, the tax attributes of members of a consolidated group were to be reduced as follows:

First, consolidated NOLs attributable to the distressed member would be used to offset the taxable income of other members for the year in which indebtedness is cancelled.

Second, the consolidated tax attributes (other than the tax basis of assets) attributable to the distressed member would be reduced by any excluded COD.

Third, the tax basis of the distressed member's assets (including the basis in the stock of its subsidiaries which are members of the group) would be reduced by any remaining excluded COD.

Fourth, if the distressed member reduced the tax basis in the stock of its subsidiaries, this so-called “deemed COD” would be applied against and would reduce the consolidated tax attributes attributable to such subsidiaries by an amount equal to the amount by which the tax basis of their stock was reduced (the so-called “look-through” rule).

Finally, consolidated NOLs attributable to other members would be reduced to the extent of any remaining excluded COD (the so-called “fan-out” rule).

Thus, under the temporary regulations, consolidated tax attributes attributable to members of a consolidated group other than the distressed member might be subject to reduction by that member's excluded COD. It was unclear under the temporary regulations, however, whether the tax attributes with respect to a member which either left or joined a consolidated group with a member that has excluded COD were to be reduced by such excluded COD. As a consequence, some tax professionals surmised that the tax attributes of former or new members might not be subject to reduction. The final regulations address these situations and other situations where there are changes in the composition of a consolidated group with a member that has excluded COD.

The Final Regulations

Although the new final regulations are quite complicated, the most significant “revisions” to the rules promulgated in the temporary regulations can be summarized as follows:

First, the consolidated tax attributes attributable to a member with excluded COD are subject to reduction even if that member “leaves” the group before the first day of the following tax year because its stock (or its assets in certain tax free transactions) has (have) been acquired.

Second, the consolidated tax attributes attributable to other members are subject to reduction by the excluded COD of another member even if the member with the excluded COD “leaves” the group before the first day of the following tax year.

Third, any excluded COD of a member that “leaves” the group because its stock is issued to creditors in satisfaction of such member's debt is treated as having been realized before such member leaves the group. (The so-called “next-day” rule cannot be used to treat the excluded COD as realized by such member at the beginning of the day following its departure from the group).

Fourth, if a lower-tier subsidiary of the member that has excluded COD would have had “deemed COD” under the “look-through” rules, the consolidated tax attributes attributable to such subsidiary are subject to reduction by such “deemed COD” even if the subsidiary “leaves” the group before the first day of the following tax year.

Fifth, if the stock (or its assets in certain tax free transaction) of a corporation that was not a member of the group with a member that has excluded COD is (are) acquired after the cancellation occurs, but before the first day of the following tax year, the tax attributes of the new member are subject to reduction.

Finally, when a member that has excluded COD transfers its assets to another member of the group, all of the transferee member's tax attributes (and not just the attributes of the transferring member) are subject to reduction.

Conclusion

Although the full repercussions of these final regulations remain to be seen, it would appear that more of the tax attributes of financially troubled consolidated groups with excluded COD may become subject to reduction as a consequence of these new rules, and that such groups' future tax liability may be significantly increased as a result. Thus, where the assets of a member of a financially troubled consolidated group with excluded COD are transferred to another member, tax attributes of the transferee which would otherwise not be subject to reduction may become subject to reduction under the final regulations as a consequence of the transfer. Similarly, tax attributes of a corporation thath was not a member of a financially troubled consolidated group with excluded COD when the cancellation occured may also become subject to reduction under the final regulations if its stock (or its assets in a tax free reorganization) is (are) acquired by the group. Finally, the tax attributes of former members of a financially troubled consolidated group with excluded COD may remain subject to reduction under the final regulations even though they have left the group.

It is perhaps in this latter regard that the final regulations will have the greatest impact, since the tax attributes of a former member of a financially troubled consolidated group with excluded COD that is acquired by a third party may be reduced before, and the taxable income of such former member may be increased after, it is acquired by such third party. Thus, any third party that acquires the stock of any member of a financially troubled consolidated group will have to at least try to estimate how these rules will impact the tax attributes of the company being acquired.

Since the third party will need to know the details of the restructuring plan and tax posture of the financially troubled consolidated group that may not be readily available in order to prepare such an estimate, it may be necessary for the third party to request representations and warranties from the consolidated group with respect to the amount by which the tax attributes of the former member will be reduced and indemnification protection should the final results differ from the estimate. As a consequence, yet another layer of complexity will be added to transactions involving distressed companies. Let the buyer beware!