Resolving intercompany debt in consolidations

Taxpayers filing consolidated federal returns often look to eliminate legal entities to reduce administrative costs and simplify the corporate structure. One of the first considerations in this process is to determine how intercompany accounts will be resolved. Once balances are netted between members and available cash is used for repayment, it may be necessary to transfer the receivable balances within the group from the holders until they can be contributed to the debtor member in a capital contribution. Although such resolutions are commonly carried out without any overall federal tax impact, there are traps for the unwary, especially when entities being eliminated have experienced financial hardship.

An unintended taxable liquidation

Rev. Rul. 68-602 presents one such trap to be avoided before reorganizing a member. In the ruling, parent corporation P and its wholly owned subsidiary S filed a consolidated federal return, and P had loaned funds to S such that S was considered insolvent. To resolve the insolvency and liquidate S in a tax-free manner, P canceled the indebtedness from S, treating the cancellation as a contribution of capital pursuant to Regs. Sec. 1.61-12. As part of a single plan, S then liquidated into P. However, the ruling held the cancellation of S’s indebtedness to be transitory, integral to the liquidation, and having no independent significance other than to secure for P the historic tax benefits of S’s net operating losses. As Regs. Sec. 1.332-2(b) requires at least partial payment in exchange for the stock of the liquidating corporation, disregarding the intercompany resolution ultimately meant S was not solvent at the time of the liquidation and therefore did not qualify for Sec. 332 treatment, resulting in a taxable liquidation.

Tax-free status under Rev. Rul. 78-330

Rev. Rul. 78-330 may provide an alternative to the Rev. Rul. 68-602 problem for certain taxpayers. In this ruling, P wholly owned two subsidiaries, S1 and S2, and intended to eliminate S2, a member in a similar situation to that of the subsidiary in Rev. Rul. 68-602. In this case, however, following the intercompany resolution, S2 was then merged sideways with and into S1 in a statutory merger under Sec. 368(a)(1)(A). Unlike in Rev. Rul. 68-602, the debt cancellation was attributed independent economic significance because the deemed contribution genuinely altered the previous debtor-creditor relationship between P and S2. The ruling appears to offer an out for eliminating a previously insolvent member where a sister member can act as the acquirer.

Merging entities under Rev. Rul. 72-464

The next question is: What happens when brother-sister members combine and have intercompany accounts between them? Although not a consolidated return scenario, Rev. Rul. 72-464 involves a situation in which corporation Y intended to merge with and into X in a statutory merger under Sec. 368(a)(1)(A), but at the time of the merger, X held notes issued by Y. The ruling held that when Y merged with and into X, Secs. 357(a) and 361(a) prevented Y from recognizing gain or loss, even where its assets could be viewed as paying off the existing note held by X. While this is good news for Y, an added trap in this ruling is that X was held to recognize gain or loss on the debt extinguishment as a result of market discount on the note (X purchased the note from a third party for less than its face amount). Although intercompany accounts rarely carry a discount in the hands of the holder, this element of the ruling has to be addressed in a simplification exercise.

Application to third parties

The application of the aforementioned rulings may not be limited to intercompany reorganizations but may also be considered in a third-party sale. Specifically, solvency may be an issue in the context of a deemed asset sale transaction under either Sec. 336(e) or 338(h)(10). In these cases, the “old” target is deemed to liquidate following the hypothetical sale of its assets to “new” target. Even deemed liquidations are governed by Sec. 332, and so the pre-transaction insolvency of the target may require consideration of Rev. Rul. 68-602. This was the case in Chief Counsel Advice 200818005, where, citing Rev. Rul. 68-602 and contrasting with Rev. Rul. 78-330, the IRS held a Sec. 332 liquidation did not occur in the context of a deemed asset sale election because the target member’s intercompany balances resolved prior to the sale resulted in its solvency.

Many taxpayers expect simplifying the corporate structure to be a benign exercise. While this may be the case, the aforementioned authorities illustrate the importance of assessing the resolution of intercompany balances early in such a project. Careful planning can help taxpayers filing consolidated returns to avoid unexpected tax consequences in an otherwise tax-free transaction.

— By Zach Meyers, CPA, an M&A tax manager with BDO USA LLP in Grand Rapids, Mich.