A new private letter ruling issued by the Internal Revenue Service uses a cascade of interconnected tax rules to illustrate that selling off some toxic assets to a government entity will produce a tax deduction. The breadcrumb trail of tax rules that lead to the final determination are fairly straightforward, but they do require a methodical look at the situation. Here is how the IRS letter lays out its conclusion.
A corporate taxpayer that we will call Alpha Inc. for illustrative purposes is the parent of Beta Cos. Beta owns interests in assets that have declined in value vis à vis the price it originally paid for the assets. The assets impair the ability of Alpha and Beta to continue normal business operations, which has “adversely affected financial markets worldwide.” So we surmise that the assets are “toxic” loans and securities, and that Alpha and Beta are financial institutions.
At this point, the U.S. Treasury Department (or an instrumentality of the U.S. government) owns “percent 1″ of Alpha’s stock, and also owns warrants to purchase Alpha shares. Meanwhile, Beta says it intends to remove the assets from its financial statements, and the government seems willing to help.
As a result, an instrumentality of the U.S. government called GovBank establishes a limited liability company for the purpose of buying the assets. The asset purchase will work like this: GovBank will lend the LLC “amount 1″ in cash. Then the LLC will use the proceeds to purchase the assets from Beta. As payments are made on the assets, GovBank will be entitled to receive from LLC the following: (1) an amount equal to the loan, (2) compounded interest on the unpaid portion of the loan at LIBOR plus a “spread,” and (3) “fraction 1″ of the remaining cash flow from the assets, after Beta has received its portion of the “deferred purchase price.”
Under the asset purchase agreement, the aggregate purchase price paid by the LLC will consist of four components: (1) cash in the amount of the loan (from GovBank to the LLC); (2) a deferred purchase price of “amount 2″ to be paid by the LLC as payments are received on the assets, which will happen when the LLC has repaid the loan plus interest; (3) interest on the unpaid portion of the amount 2 at LIBOR plus a “spread”; and (4) a “contingent purchase price” of “fraction 2″ of the remaining cash flow on the assets, after amount 2 has been paid with interest.
“At issue in the private letter ruling is whether the loss can be currently deducted, or is the loss instead subject to disallowance or deferral.” — Robert Willens
When all is said and done, Beta realizes a loss on the sale of the assets to the LLC. At issue in the private letter ruling is whether the loss can be currently deducted, or is the loss instead subject to disallowance or deferral. The IRS concluded that the loss is currently deductible.1
The IRS based its conclusion on a string of rules, beginning with Section 1001(a), which states that the loss from the sale or other disposition of property should be the excess of the adjusted basis over the amount realized. However, in Section 267(a)(1), the law states that no deduction will be allowed related to any loss from the sale or exchange of property, directly or indirectly, between persons specified in Section 267(b), which includes, among other descriptions, two corporations that are members of the same controlled group (as defined in Section 267(f)).
Members of a controlled group are companies that are interconnected through some chain of control, and Section 267(f)(1) uses the same definition of controlled group as Section 1563(a) — except that it replaces the phrase “more than 50 percent” when referring to stock ownership with the phrase “at least 80 percent” in each place it appears.
The August private letter ruling concludes that the sole membership interest in LLC is owned by GovBank, resulting in the LLC being disregarded as an entity separate from GovBank. Accordingly, the transfer of the assets is treated as a direct transfer from Beta Cos. to GovBank.
In addition, “percent 1″ of the shares of Alpha Inc. is owned by the U.S. Treasury, or an instrumentality of the government. However, neither the Treasury Department nor GovBank can be a member of a controlled group for purposes of Section 267. That’s because a corporation that is a member of such a group must be treated as an “excluded member” if the corporation is “exempt from taxation.” A corporation that is an instrumentality of the United States fits the description.2
Indeed, the transfer of the assets is a sale or exchange under the tax code, specifically Section 1001(a). Most notably, the losses sustained from the sale or exchange will not be subject to loss deferral or disallowance at the hands of Section 267.
Moreover, the loss from the sale or exchange will be an ordinary loss rather than a capital loss. Section 582(c) provides that, in the case of a financial institution (including a bank), the sale or exchange of a bond, debenture, note, or certificate or other evidence of indebtedness shall not be considered the sale or exchange of a capital asset.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See LTR 200932004, January 21, 2009, issued August 7, 2009.
2 See the Tax Code’s Section 501(a) and Section 501(c)(1).