IRS Rules on Contingent Debt

Guidance issued by the IRS nixes the idea that retirement of contingent debt is tied to cancellation of indebtedness income.

A private letter ruling issued by the Internal Revenue Service in March was emphatic about its finding regarding contingent debt. Basically, the retirement of contingent debt does not produce so-called cancellation of indebtedness income. In the letter, the IRS ruled on a complex transfer of stock, other assets, and obligations to reach its conclusion, which unfolded as follows:

In the IRS example, Widget Corp. owned all the stock of XCorp, and XCorp owned all the stock of three subsidiaries.

XCorp then transferred the stock of the subsidiaries and other assets to a new corporation, which for purposes of this column, we will call the taxpayer. In exchange for all of the taxpayer’s assets, XCorp received the common and preferred stock of the taxpayer; the assumption by taxpayer of certain XCorp liabilities; cash; and the right to receive certain contingent payments scheduled to be made to Widget under a “tax agreement” inked by Widget, XCorp, and the taxpayer. The tax agreement was dated June 3.

The taxpayer claimed that the assets it received in a transfer from XCorp constituted a taxable exchange under the Internal Revenue Code (Section 1001). Therefore the transaction was a “qualified stock purchase” by the taxpayer with respect to the subsidiaries.1

Since the transaction was a qualified stock purchase, Widget and the taxpayer made elections under Section 338(h)(10) of the code with respect to two of the acquired subsidiaries. Then the taxpayer made a “regular” Section 338 election (specifically under Section 338(g)) related to the third subsidiary. Accordingly, the taxpayer secured a “cost basis” with respect to the assets of each of the acquired subsidiaries.

Willens 08-02-10

Under the tax agreement, the taxpayer promised to pay Widget a specified percentage (Y%) of the excess of the “hypothetical tax liability.” The hypothetical obligation has to do with the “stepped-up” basis that arises from a Section 338 election in certain situations. In this case, the hypothetical liability refers to what the taxpayer would experience if it used the carryover basis regarding the assets of the acquired subsidiaries, as opposed to its actual tax liability. Indeed, the tax agreement contemplated that any “tax benefit payment” made to Widget would further increase the basis of the assets and therefore further increase the potential tax benefit.

The purpose of the tax-benefit payments was to allow Widget to share any tax benefit the taxpayer actually realized over time as a result of the basis step-up afforded by the Section 338 elections. Further, the taxpayer noted that the obligation to make the tax-benefit payments constituted indebtedness for purposes of the tax code, as is described in Section 61(a)(12).

On August 4, Widget, another firm called Epsilon Inc., and certain other corporations entered into an assignment agreement. Under that agreement, Widget assigned its right to the Y% of the tax-benefit payments to Epsilon. In turn, Epsilon assumed the same percentage of Widget’s liabilities and obligations under the tax agreement.


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