On December 24, the Internal Revenue Service issued final regulations governing debt obligations issued by corporations that are members of consolidated return groups (Treasury Decision 9442). The regulations take effect for transactions involving intercompany debt obligations (IOs) occurring in tax years beginning on or after December 24, 2008, which in practice means they will generally take effect for calendar or fiscal years beginning 2009. The regulations represent the latest development in an ongoing project to revise the regulations governing intercompany corporate transactions, and their issuance at a time of severe economic and financial distress is particularly timely.

An IO is a debt obligation that at some point in time has been held between a debtor and a creditor member of a consolidated return group of corporations. It is important to recognize that the debt obligation need neither have been initially created nor currently held within a consolidated return group in order for the tax consequences prescribed by these regulations to apply. The regulations govern three basic types of transactions:   (1) intragroup transactions involving the transfer or extinguishment of IOs; (2)"inbound" transactions in which an obligation becomes an IO, whether through acquisition of the obligation by a member of the consolidated return group or by a corporation holding the obligation becoming a member; and (3)"outbound" transactions in which an obligation ceases to be an IO either because it is transferred outside the group or the corporation holding it ceases to be a member of the group.

In each of these three cases, the regulations adopt a satisfaction and reissuance model to describe situations in which the obligation remains outstanding after the relevant transaction. Under this model, the obligation is deemed satisfied for cash in an amount equal to its fair market value and then immediately reissued as a new obligation for the same amount of cash. In the case of intragroup and outbound transactions, the new obligation is deemed to be reissued to the same creditor, and the actual transfer (to another member or outside the group) is treated as involving the new obligation and as occurring immediately afterward. In the case of an inbound transaction, the new obligation is deemed to be issued to the new creditor member immediately after the transaction in which the obligation has entered the group.

The deemed satisfaction and reissuance model has the effect of creating debt discharge income (or repurchase premium expense) with respect to the debtor member and bad debt loss (or gain from retirement of the obligation) with respect to the creditor member. The regulations generally apply attribute matching principles to assure that the offsetting realization of these corresponding items will have no effect on the consolidated taxable income of the group in the case of intragroup and outbound transactions. However, in the case of an inbound transaction, the regulations will not offset the ordinary income or deduction realized by the debtor member against the capital gain or loss realized by the creditor. In all cases, the location of the tax consequences within the corporate entity that is   the creditor or debtor is preserved by the regulations in determining earnings and profits and inside and outside tax basis. The regulations thereby prevent the use of liability transfers to shift economically realized income or losses between corporations that are members of the same group.

It is important to note that the IO regulations depart from the regular federal income tax rules governing the cancellation of debt in two key respects. First, although Section 108(e)(4) of the Internal Revenue Code imposes a similar satisfaction and reissuance model on acquisitions of obligations by persons related to any type of debtor (transactions analogous to the inbound transactions of the IO regulations but which do not require consolidated return group membership), this "separate return" tax rule creates a tax realization event only for the debtor and does not affect the tax consequences of the transaction to the related party acquiring the obligation. Second, outbound transactions involving a transfer of an obligation from a party related to the debtor to an unrelated party are generally governed by the market discount and acquisition premium rules of the Code, which permit the new holder to elect to defer the tax consequences of the discount or premium until the obligation is retired. Under the IO regulations, all future holders -- non-members of the consolidated return group and potentially the public at large -- are required to accrue original issue discount (OID) income on the former IO, just as if the obligation had been newly issued. Moreover, it would appear that the member transferring an IO outside the group is required to legend the obligation to disclose the amount of OID that it bears and, if the transfer was by means of a public offering, to report the deemed issuance of the obligation to the IRS.

The IRS requests comments on the possible use of simplifying presumptions in determining the fair market value of IOs for purposes of the calculations required by the deemed satisfaction and reissuance model and on the possible entire exemption of certain outbound transactions of newly issued obligations from such deemed satisfaction and reissuance calculations. The Tax Group of Ballard Spahr Andrews & Ingersoll, LLP is able to assist corporations in the development and submission of written comments in response to this request. We also advise creditors and debtors in planning distressed debt transactions that may implicate the IO regulations and on the opportunities for acceleration or deferral of income and deductions that are afforded by these new rules.


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