International Tax Aspects of Cancellation of Indebtedness Income, Journal of Taxation, Jun 2003

[Sufaud Dupont]

International Tax Aspects of Cancellation of Indebtedness Income, Journal of Taxation, Jun 2003

INTERNATIONAL

International Tax Aspects of Cancellation of Indebtedness Income
Author: By Jeffrey L. Rubinger and Daniel Mayo

JEFFREY L. RUBINGER is an associate in the Miami office of the law firm of Baker & McKenzie. Also a CPA, he is a member of both the American Bar Association and the AICPA, and has previously written for The Journal. DANIEL
MAYO is an associate in the New York City office of the law firm of Baker Botts LLP.

Significant complications can accompany COD income when one party to the debt is not a U.S. person. There are source of income issues and questions concerning the insolvency exception. No bright lines exist, and analogies have been drawn from cases involving state law. Given the current condition of the global economy, many more cases in this area are likely, and perhaps some definitive answers may be forthcoming. [pg. 365]

With companies worldwide defaulting on a record $181.7 billion in debt last year, 1 a taxpayer's ability to exclude cancellation of indebtedness (COD) income has become increasingly significant. Under Section 108, a taxpayer whose income is subject to U.S. federal income tax is able to exclude COD income in certain situations. The price of this exclusion is the requirement that the taxpayer reduce specified "tax attributes" in an amount generally equal to the income excluded.

While the operation of these rules is relatively straightforward in a purely domestic setting, their application is less clear when one of the parties to the cancelled debt is a foreign person. 2 For example, if a foreign person borrows money from a U.S. person to finance the purchase of certain assets located in the U.S. and the loan subsequently is forgiven, should the resulting COD income be U.S. source or foreign source income for U.S. federal income tax purposes? If a foreign person does recognize U.S. source COD income, but would like to exclude such income under the Section 108 "insolvency" exception, which assets should be considered in determining "insolvency"-U.S.-situs assets only or all of the person's assets? These and other issues that may arise when one of the parties to a cancelled debt is a foreign person will be examined below.

COD INCOME AND SECTION 108 IN GENERAL

Section 61(a)(12) provides that a taxpayer must include in gross income "[i]ncome from discharge of indebtedness." This provision codifies the decision in Kirby Lumber Co., 10 AFTR 458, 284 US 1, 76 L Ed 131, 2 USTC ¶814 (1931), in which the Supreme Court held that a corporation realized COD income
when it purchased in the open market its bonds, which were issued at par, for an amount less than par.

The Court noted that the taxpayer had "made available" certain assets that previously were unavailable because of the obligation to repay. In addition to a debtor purchasing its obligations at a discount, COD income may arise when a defaulting debtor transfers property in satisfaction of a debt obligation or when a creditor forgives all or a portion of a debt. 3

As noted above, a taxpayer may exclude COD income in limited situations. Section 108(a)(1) provides that gross income does not include any amount which would be includable in gross income "by reason of the discharge (in whole or in part) of indebtedness" of the taxpayer if (1) the discharge occurs in a title 11 bankruptcy case, (2) the discharge occurs when the taxpayer is "insolvent," (3) the debt discharged is "qualified farm indebtedness," or (4) for taxpayers other than a C corporation, the debt discharged is "qualified real property business indebtedness." If one of these conditions is satisfied, the COD income will be excluded from the [pg. 366] taxpayer's gross income but under Section 108(b) the taxpayer will be required to reduce the following tax
attributes, if applicable:
(1) NOLs.
(2) General business credits.
(3) Minimum tax credits.
(4) Capital loss carryovers.
(5) The basis of its property.
(6) Passive activity losses and credit carryovers.
(7) Foreign tax credit carryovers. 4

COD income may be avoided in other situations as well. For example, under Section 108(e)(2), COD income will not arise "to the extent that payment of the liability would have given rise to a deduction." This rule typically applies to cash-method debtors, although it also may apply to an accrual-method debtor that is related to its creditor. 5 Moreover, Section 108(e)(6) provides that if a debtor corporation acquires its debt from a shareholder as a contribution to capital, the debtor corporation will be treated as having satisfied the debt with an amount of money equal to the shareholder's adjusted basis in the indebtedness.

In this situation, the debtor corporation will not realize COD income to the extent of the shareholder's basis in the contributed debt. Under these rules, the debtor is not required to reduce the specified tax attributes listed above. 6 Section 108 will not provide relief to taxpayers in all situations involving the discharge of indebtedness.

Rather, Section 108 applies only to "pure" COD income. It does not, however, apply to "spurious" COD income, 7 which is COD income that represents "a medium for the payment of some other form of income." 8 Consider an employee who owes a debt of $100 to his employer. If the employee renders $100 worth of services to the employer in satisfaction of the debt, the employee will not recognize COD income under Section 61(a)(12); rather, the employee has earned $100 of personal service income under Section 61(a)(1) that he used to extinguish the debt. Such income is not excludable under Section 108. 9

TAXATION OF FOREIGN PERSONS IN GENERAL

Foreign persons are subject to U.S. federal income taxation on a limited basis. Unlike U.S. persons who are subject to U.S. federal income tax on their worldwide income, foreign persons generally are subject to U.S. taxation on two categories of income:
• Certain passive types of U.S. source income (e.g., interest, dividends, rents, annuities, and other types of "fixed or determinable annual or periodical income," collectively known as FDAP). 10
• Income that is effectively connected 11 to a U.S. trade or business (ECI). 12

FDAP income is subject to a 30% withholding tax that is imposed on a foreign person's gross income (subject to reduction or elimination by an applicable income tax treaty) and ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. persons. Although ECI typically consists of U.S. source income, 13 certain categories of foreign source income (e.g., rents, royalties, dividends, interest, and certain income from the sale or exchange of inventory property) may be treated as ECI, if the income is attributable to an office or other fixed place of business within the U.S. 14

COD INCOME OR FOREIGN CURRENCY GAIN?

Just as in the domestic setting, a preliminary issue that arises in the international context with respect to income arising from the discharge of indebtedness is whether such income [pg. 367] is realized "by reason" of the discharge of indebtedness (i.e., COD income) or whether it represents some other form of income. One common scenario arises when a U.S. person realizes income by borrowing money in a foreign currency and then repaying the debt after the foreign currency has declined in value relative to the U.S. dollar. In this situation, the threshold inquiry is whether the resulting gain is COD income, eligible for exclusion under Section 108, or foreign currency gain, taxable under Section 988.

Before the enactment of Section 988 in 1986, there was a split in the circuits as to the proper characterization of this type of gain. In Kentucky & Indiana Terminal R.R. Co., 13 AFTR 2d 1148, 330 F2d 520, 64-1 USTC ¶9374 (CA-6, 1964), a taxpayer sold bonds denominated in pounds sterling when the exchange rate was $4.8666 per pound. Approximately 40 years later, the taxpayer repurchased the bonds on the open market for an amount less than face value after the pound had been devalued to $2.80. The difference between the face amount of the bonds and the taxpayer's purchase price consisted of two elements, (1) the portion attributable to the repurchase of the bonds for less than their face value, and (2) the portion attributable to the decline in value of the pound. The IRS argued that only the portion attributable to the repurchase of the bonds for less than face value constituted COD income that was excludable by the taxpayer under the predecessor to Section 108. 15 The Sixth Circuit disagreed and held that the entire amount of the gain constituted COD income because the taxpayer would not have realized any foreign currency gain "except for the discharge of the indebtedness incurred."

The Second Circuit, in Philip Morris Inc., 76 AFTR 2d 95-8002, 71 F3d 1040, 96-1 USTC ¶50007 (CA-2, 1995), adopted a view different from that of the Sixth Circuit and held that none of the gain was excludable COD income. In Philip Morris, the U.S. taxpayer recognized gain from the repayment of loans denominated in foreign currencies when the foreign currencies had declined in value relative to the dollar.

As in Kentucky & Indiana, the issue in Philip Morris centered on whether the resulting gain constituted excludable COD income or gain from dealings in property. 16 The court acknowledged the Kentucky & Indiana decision but thought that its precedential value had been undermined by the Supreme Court's intervening decision in Centennial Savings Bank FSB, 67 AFTR 2d 91-816, 499 US 573, 113 L Ed 2d 608, 91-1 USTC ¶50188 (1991). 17 Thus, the Second Circuit ruled against the taxpayer and held that the gain was not income realized "by reason" of the discharge of indebtedness because there was no "forgiveness or release of an obligation imposed in connection with the underlying debt."

The enactment of Section 988 resolved the split between the Sixth and Second Circuits in favor of the approach originally espoused by the IRS in Kentucky & Indiana. According to the legislative history of Section 988, "gain realized on repayment of a borrowing will be attributed first to foreign currency gain (by calculating the difference between the U.S. dollar value of the face amount when issued and when discharged), and only the balance will be treated as income from discharge of indebtedness." 18 This language was expressly intended to overrule the Kentucky & Indiana decision. 19

The application of this rule is illustrated by an example in the TRA '86 Blue Book. A debtor, whose functional currency is the U.S. dollar, borrows £100 when the exchange rate is $1 per pound and repays the debt with £80 after the pound has depreciated to $0.50. Because the debtor in effect borrowed $100 but only repaid the equivalent of $40, the debtor's total gain realized is $60, $50 of which is attributable to the exchange rate fluctuation. Thus, the drafters of the Blue Book concluded that only the balance of $10 would be COD income. 20

SOURCE OF COD INCOME

Once it is determined that COD income exists, it is necessary to determine the source of such income for U.S. federal income tax purposes. As discussed above, the source of COD income is significant to foreign persons because they generally are subject to U.S. federal income tax only on U.S. source income. U.S. persons are concerned with the source of COD income because they need to establish the amount of their foreign source income for foreign tax credit limitation purposes. 21

The most recent position of the IRS is that the determination of the source of COD income is "unclear." 22 There are, however, four general theories on how COD income should be sourced. [pg. 368]
• The first is that COD income should be sourced according to the location where the purchase of the debt occurs. This theory is derived from an old (and now obsolete) ruling in which the IRS looked solely to the place of purchase to determine the source of COD income. In IT 3119, 1937-2 CB 227IT 3119, 1937-2 CB 227, 23 the taxpayer was a foreign corporation that conducted a business outside the U.S. but maintained an office in the U.S. The Service ruled that the taxpayer realized COD income at the time that it repurchased its bonds. Addressing the issue of source, the IRS simply stated that the COD income was U.S. source because "the purchase was made in the United States." 24
• A second theory is that COD income should be sourced in the same manner as the interest payments on the debt would have been sourced (i.e., generally by the residence or place of formation of the debtor). 25 While this approach seems to have some support, 26 its simplicity may be undermined by the fact that it would allow indebtedness of foreign persons to escape the U.S. tax system, even in an extreme case where a debt was issued in the U.S., repurchased in the U.S., and denominated in the U.S. dollar.
• A third theory is that COD income should be sourced by reference to the source of the gross income to which a debtor's interest deductions would have been allocated and apportioned under Temp. Reg. 1.861-9T. 27 Support for this position is found in Rev. Rul. 92-92, 1992-2 CB 103, in which the IRS stated that to determine whether COD income was income from a passive activity, it is appropriate to allocate the COD income in the same manner as the Temp. Reg. 1.163-8T interest allocation rules allocate the debt at the time of the discharge. 28
• The fourth approach would source COD income by tracing the loan proceeds to particular assets or activities of the debtor.

This last approach was taken recently by the Tax Court in Big Hong Ng, TC Memo 1997-248, RIA TC Memo ¶97248, 73 CCH TCM 2900 . The taxpayer was a foreign corporation whose sole business activity consisted of the rental of an interest in U.S. real property. It had outstanding indebtedness owed to two related corporations, one U.S. and one foreign. In 1989, the taxpayer distributed its interest in the U.S. real property to its shareholder without satisfying the two outstanding debt obligations. The corporation ceased doing business on the distribution of its interest in the real property and its debts effectively were discharged at that time.

After the IRS asserted that the taxpayer was liable for tax on the COD income arising from the two discharged debt obligations, the taxpayer argued that any resulting COD income was neither U.S. source income nor ECI. The Tax Court explicitly rejected these arguments and stated that the taxpayer's rental activity constituted a U.S. trade or business and that its indebtedness was related to that business activity. Thus, the court held that the taxpayer realized taxable COD income (i.e., ECI).

Although the Tax Court did not explicitly state that the COD income was U.S. source, that conclusion is implicit in the court's reasoning. This is because only certain types of foreign source income constitute ECI, such as rents, royalties, interest, dividends, and certain gains from the sale of inventory, 29 and COD income does not fall into any of these enumerated categories. Thus, the Tax Court must have treated the COD income as arising from U.S. sources, and the method by which it reached that conclusion was to trace the loan proceeds to the taxpayer's activities in the U.S. Although only a memorandum decision, 30 Big Hong Ng is significant because it is the first reported case in over 50 years to address the source of COD income and may have resolved the debate as to the appropriate method
for doing so.

WITHHOLDING TAX CONSEQUENCES

If a foreign person recognizes U.S. source COD income, one must consider whether such income is subject to withholding tax in the U.S. Under Sections 1441 and 1442, withholding is required on payments of U.S. source FDAP income to foreign individuals, partnerships, and corporations. The withholding rate generally is 30%, although most income tax treaties concluded with the U.S. reduce this rate, depending on the type of income. [pg. 369] Withholding is not required on U.S. source ECI. 31

Although not all commentators agree, 32 COD income appears to constitute FDAP income. 33 As a result, unless an exception applies (e.g., the COD income is ECI), withholding is required on U.S. source COD income. 34 Withholding on COD income is atypical, however, because unlike other forms of income where a payment is made at the time of income recognition, a debtor realizing COD income receives no funds from which an amount may be withheld. Reg. 1.1441-2(d)(2) acknowledges this result and creates a deemed payment of income to the borrower at the time the event of forgiveness occurs.

Withholding is not required on COD income in every situation, however. Specifically, withholding is not required if the withholding agent does not have custody of, or control over, property of the borrower at any time between the time that the loan is forgiven and the due date (including extensions) of the Form 1042 for the year in which the payment is deemed to occur. 35 For this purpose, a partial payment by the borrower is not treated as a payment over which the lender has custody or control. 36 Relief also is provided where the withholding agent does not have knowledge of the events that give rise to the deemed payment. 37 Neither of these relief provisions will apply to deemed payments that are part of a prearranged plan to avoid withholding. 38

Given that withholding is required in other situations where no actual payments are made, such as under Sections 482 39 and 7872, 40 it is not all that surprising that withholding is required on COD income in certain situations. What is surprising, however-and a potential trap-is that withholding may be required when a foreign person capita izes (i.e., discharges) a debt owed to it by a U.S. subsidiary and there is accrued interest that has not been paid. The IRS has concluded that the U.S. subsidiary will be treated as if it constructively paid the accrued interest to the foreign parent, thereby triggering a withholding
obligation under Section 1442. 41

For example, in FSA 200006003, the taxpayer was a U.S. corporation (USCO) wholly owned by a foreign corporation (FCO). FCO was not engaged in a U.S. trade or business. Beginning in 1987, FCO loaned funds to USCO. In January 1992, the parties memorialized the loan in a note. From 1992 through 1995, USCO made some but not all of the interest payments required on the note, but did not make any of the required payments of principal. In connection with an internal restructuring of USCO, FCO, and other related corporations, FCO cancelled and forgave all of the accrued interest on USCO's note and reported such cancellation as a contribution to capital. As a result, FCO's economic stake in USCO changed from debt to equity, despite the fact that no additional shares of USCO were issued to FCO at the time of the
conversion.

The IRS treated the capitalization of the debt as though USCO had made a constructive payment of the accrued but unpaid interest to FCO, requiring withholding under Section 1442. 42 According to the IRS, this result is analogous to Fender Sales, Inc., 14 AFTR 2d 6076, 338 F2d 924, 65-1 USTC ¶9104 (CA-9, 1964), cert. den., where the Ninth Circuit held that a corporation's pro rata issuance of stock to its two equal shareholders in satisfaction of accrued but unpaid salary obligations was the payment of salary. 43

Although USCO did not issue additional shares of stock to FCO like the taxpayer had in Fender Sales, the Service nonetheless found the analogy compelling, citing Rev. Rul. 67-402, 1967-2 CB 135, for the proposition that a stock issuance constitutes the payment of income regardless of any change in the proportionate interests of the shareholders/employees.

In sum, quoting Fender Sales, the IRS stated that it was "not prepared to hold that the voluntary surrender or [pg. 370] forgiveness of a receivable which, if collected, would represent taxable income, is, in all circumstances, a non-taxable event."

The IRS reached the same conclusion where a foreign parent corporation contributed an entire debt obligation (not just the accrued but unpaid interest) to the capital of a U.S. subsidiary. 44 As to the portion of the cancelled debt obligation that resulted in a deemed payment of interest, the IRS stated: "Once the constructive 'payment' ... has been established, we believe there is little problem with deeming a portion of that payment to be interest. Although there has been no apparent allocation between outstanding amounts of principal and interest on the loans at issue, we believe holding the [taxpayer] to the form of its transaction would compel a finding that accrued interest was constructively paid out by virtue of the corporate capital adjustment."

As indicated by these FSAs, the forgiveness of a debt owed by a U.S. subsidiary to its foreign corporate parent may give rise to unanticipated tax consequences. Where there is an actual payment made by the U.S. subsidiary to its foreign parent in connection with the capitalization of a debt (or a dividend that is considered part of a plan involving the capitalization of a debt), such payment (or related dividend) may be treated as a substitute for any accrued but unpaid interest. Where, however, no actual "payment" is made in connection with the capitalization, taxpayers should be cognizant of the Service's position on this issue, given the withholding obligations that may arise.

COD INCOME AND SUBPART F

In addition to U.S. withholding tax, COD income also may be subject to tax in the U.S. as Subpart F income under the controlled foreign corporation (CFC) rules. 45

In general, the Subpart F provisions of the Code (Sections 951 through 964) were designed to address the concern that certain types of passive income and operating income from related-party transactions earned by U.S.-controlled foreign corporations would not be subject to U.S. federal income tax until such income was repatriated to the U.S. Accordingly, Congress required that any Subpart F income earned by a CFC 46 be included in the current income of its "U.S. shareholders" 47 in the year in which such income is earned, regardless of whether such income is actually distributed to those shareholders. 48

When the CFC's E&P is subsequently distributed to its U.S. shareholders, these amounts are not included in the shareholders' gross income because they will have been taxed previously under the Subpart F rules. 49

In Ltr. Rul. 9729011, the IRS ruled that COD income would not result in Subpart F income. The Service based its determination on the fact that COD income "is a separate and distinct category of income" that does not fall within any of the relevant categories of Subpart F income, namely, foreign personal holding company income, which includes (1) dividends, interest, rents, and royalties, (2) gains from certain property transactions, (3) gains from certain commodities transactions, (4) certain foreign currency gains, and (5) income equivalent to interest. 50

Nevertheless, the IRS employed a tax benefit analysis and ruled that if a debtor took a deduction for any accrued but unpaid interest that was payable on the cancelled debt, and such deduction had the effect of reducing the taxpayer's Subpart F income, then the COD income could give rise to Subpart F income in the year of the debt cancellation. 51 In this situation, the amount of current inclusion would equal the amount of Subpart F income that was reduced by the deduction. Consequently, despite the generally favorable result in the ruling, taxpayers should be aware of the consequences that may arise when a CFC previously reduced its Subpart F income by interest accrued on a debt obligation that is discharged at a discount.

INTERPRETING THE INSOLVENCY RULE

If a foreign person recognizes U.S. source COD income that is taxable in the U.S. (either as FDAP income or ECI), such income still may be eligible for exclusion under Section 108. As noted earlier, one of
the situations in which a taxpayer can exclude COD income arises when the discharge occurs when that taxpayer is "insolvent." 52 For this purpose, a taxpayer is insolvent when the amount of the taxpayer's liabilities exceeds the FMV of the taxpayer's assets. 53 The amount of the exclusion [pg. 371] will be limited to the amount of the taxpayer's insolvency. 54

There is no clear rule governing which assets of a foreign person will be counted in the determination of insolvency under Section 108. A plausible argument exists that only U.S.-situs assets should be included in this calculation. This position is based on Van Der Horst, 20 AFTR 2d 5598, 270 F Supp 365, 67-2 USTC ¶9669 (DC Del., 1967), which held that foreign-situs assets should not be considered in determining whether a foreign person was insolvent for purposes of the Uniform Fraudulent Conveyance Act.

Equally forceful, however, is the position that all of the foreign person's assets-both U.S.- and foreign-situs assets-should be considered in making this determination. Proponents of this view draw support from the recent decision in Carlson, 116 TC 87 (2001), and several IRS rulings 55 holding that assets exempt from the claims of creditors under applicable state law should be counted in the insolvency calculation. 56 Not surprisingly, foreign persons realizing COD income would prefer to reduce the asset base used in this calculation in order to create or increase the amount of their insolvency and therefore their exclusion.

The only-U.S.-assets argument.

In Van Der Horst, the IRS attempted to set aside an allegedly fraudulent conveyance of stock by the taxpayer, a citizen of the Netherlands and a resident of Switzerland. Under applicable Delaware law, the transfer would have been considered fraudulent only if it rendered the taxpayer "insolvent." A person is insolvent under Delaware law if "the present fair salable value of his assets is less than the amount that will be required to pay his probable liability on his existing debts as they become absolute and matured." Any asset that was "not exempt from liability" for a taxpayer's debts was included in the insolvency calculation.

The taxpayer argued that certain of his property located in the Netherlands should be included in the insolvency determination because such property was not exempt from liability as a result of the "collection assistance" [pg. 372] provision in Article XXII of the then-applicable U.S.-Netherlands income tax treaty (now Article XXXI of the current treaty), which states, in relevant part:

"(1) The Contracting States undertake to lend assistance and support to each other in the collection of the taxes which are the subject of the present Convention, together with interest, costs, and additions to the taxes and fines not being of a penal character. "(2) In the case of applications for enforcement of taxes, revenue claims of each of the Contracting States which have been finally determined may be accepted for enforcement by the other Contracting State and collected in that State in accordance with the laws applicable to the enforcement and collection of its own taxes. The State to which application is made shall not be required to enforce executory measures for which there is no provision in the law of the State making the application. "(3) Any application shall be accompanied by documents establishing that under the laws of the State making the application the taxes have been finally determined. "(4) The assistance provided for in this Article shall not be accorded with respect to the citizens, corporations, or other entities of the State to which application is made, except as is necessary to insure that the exemption or reduced rate of tax granted under the convention to such citizens, corporations or other entities shall not be enjoyed by persons not entitled to such benefits."

The taxpayer reasoned that because the U.S. was able to secure the assistance of the Netherlands in the collection of a U.S. tax liability, his property in the Netherlands was not "exempt property" under Delaware law. The court disagreed, stating that the collection assistance provision was of "no aid" to the taxpayer because he did not satisfy its specific provisions. First, the court noted that by its express terms, paragraph 2 of Article XXII would not apply until any tax claims have been "finally determined." According to the court, no "final determination" occurred in his case. Second, the court observed that paragraph 4 did not empower the Netherlands to assist the U.S. in collecting tax against a Netherlands citizen, except for specific situations that were not relevant in the case. Finally, the court highlighted the discretionary nature of the Dutch obligation to assist the U.S. in its collection activities. The court therefore held that the taxpayer's foreign-situs assets should not be included in the insolvency determination.

Currently, four other income tax treaties concluded with the U.S. contain collection assistance provisions similar to those at issue in Van Der Horst: (1) Article XXVIA of the U.S.-Canada treaty, (2) Article XVIII of the U.S.-Denmark treaty, (3) Article XXVIII of the U.S.-France treaty, and (4) Article XVII of the U.S.-Sweden treaty. Based on Van Der Horst, foreign persons 57 may take the position that their foreign-situs assets should not be [pg. 374] included in the Section 108 insolvency determination unless such assets are located in one of these five jurisdictions and the specific conditions of the relevant treaty are satisfied. 58

The all-assets argument. The decision in Carlson supports the view that all assets of a foreign person should be included in the insolvency calculation. In Carlson, the court considered whether an Alaskan fishing permit-an exempt asset under Alaska law-should be included in Section 108's insolvency calculation. The Tax Court held that it should, stating that in enacting the Bankruptcy Tax Act of 1980, Congress intended all assets, including those exempt under applicable state law, to be included in the insolvency calculation. The court noted that "although an asset of a debtor may be exempt from the claims of creditors under applicable state law, if that asset and the debtor's other assets exceed the debtor's liabilities, the taxpayer has the ability to pay an immediate tax on income from discharged indebtedness."

Although Carlson dealt with assets exempt from the claims of creditors under state law (rather than international law), there does not appear to be any policy reason to limit its application. Thus, if the value a foreign person's foreign-situs assets, together with such person's U.S.-situs assets, exceed the taxpayer's liabilities, such person has "the ability to pay an immediate tax" on COD income. Nonetheless, because Carlson did not specifically deal with assets other than those exempt under state law, its precedential value may be limited. THE 108(e)(2)

'DEDUCTION' QUESTION

Finally, another issue that arises in the international context with respect to COD income is the extent to which Section 108(e)(2) may apply. As noted earlier, that section states that COD income will not arise "to the extent that payment of the liability would have given rise to a deduction." The question becomes whether Section 108(e)(2) will be limited to situations in which a taxpayer actually claims a deduction or whether it may be extended to other situations, e.g., where a taxpayer claims a foreign tax credit in lieu of taking a deduction for foreign taxes paid. This was the issue in TAM 8617003.

In the TAM, the taxpayer was a domestic corporation engaged in the commercial banking business, part of which involved making cross-border loans. The loans at issue were "net" loans, meaning that each borrower was required to pay the bank a specified amount of interest unreduced by any foreign withholding tax (i.e., the loans obligated the borrower to pay the taxpayer's foreign tax liability). As a result, the taxpayer would include in income, as additional interest, an amount equal to the foreign taxes assumed by the borrower in the year in which the foreign taxes accrued. If, however, the borrower defaulted on its obligation to pay the taxpayer's foreign tax liability, the taxpayer might be entitled to take a bad debt deduction if otherwise permitted by Section 166. The taxpayer elected to claim the foreign tax credit in lieu of taking a deduction for foreign taxes paid. 59

The IRS observed that, assuming the taxpayer properly accrued income and properly made a charge to its bad debt reserve when a foreign borrower did not discharge the taxpayer's foreign tax liability, it might be argued that the taxpayer would realize COD income when the foreign government failed to collect the delinquent taxes from the taxpayer. The Service then acknowledged that if the taxpayer had not elected to claim a foreign tax credit, it could have claimed a deduction for the payment of the foreign taxes.

Therefore, even assuming there could have been COD income, the COD income would have been excluded from the taxpayer's gross income under Section 108(e)(2) because payment of the foreign tax liability "could have given rise to a deduction under Section 164 of the Code, had [the taxpayer] not elected to claim a foreign tax credit under Section 901 of the Code." The IRS stated, without elaboration, that "[i]t is the Service's position that Section 108(e)(2) was intended to cover the situation presented here, notwithstanding that section's specific reference to a deduction instead of a credit."

Because Section 108(e)(2) explicitly requires a deduction rather than a credit, the result reached by the IRS in TAM 8617003 is somewhat curious. Perhaps the Service applied Section 108(e)(2) on the theory that both deductions and credits produce a tax benefit. 60 If this were the standard, arguably Section 108(e)(2) could apply where payment of a liability gives rise to basis, as some practitioners maintain. 61 Alternatively, the IRS could simply have ignored the taxpayer's election to take the foreign tax credit in lieu of the deduction for foreign taxes paid. In either event, the ruling seems to indicate that Section 108(e)(2) may have greater relevance in the international context than its literal wording would imply. 62

CONCLUSION

With the global default rate on corporate debt not expecting to show any perceptible improvement until 2004, 63 the amount of COD income potentially subject to U.S. federal income tax may be significant in the coming years. Assuming a portion of these debt obligations arise in a cross-border setting, the importance of these issues will remain undiminished.

Practice Notes
The recognition of cancellation of indebtedness (COD) income in a cross-border setting may give rise to unanticipated tax consequences as well as tax planning opportunities, including:
• A U.S. debtor's recognition of foreign currency gain and COD income on the repayment of a loan denominated in a foreign currency for an amount less than face value at a time when the foreign currency has declined in value relative to the U.S. dollar.
• A foreign debtor's recognition of U.S. source COD income and the attendant U.S. withholding tax obligations of a U.S. creditor that may result from a cancellation of a loan, the proceeds of which are used to finance the purchase of property located in the U.S.
• A foreign creditor's receipt of constructive interest payments and the related U.S. withholding tax consequences to a U.S. debtor that may arise from the foreign creditor's capitalization (i.e., discharge) of a debt obligation with accrued but unpaid interest to the U.S. debtor.
• The recognition of Subpart F income by U.S. shareholders of a controlled foreign corporation (CFC) when the CFC previously reduced its Subpart F income by interest accrued on a debt obligation that has been discharged at a discount.
• A foreign debtor's exclusion of COD income under the Section 108 insolvency determination by not including any foreign-situs assets in the insolvency calculation.
• A debtor's avoidance of COD income on the discharge of a debt obligation, the payment of which would have given rise to a deduction, credit, or possibly even basis.

1 Standard & Poor's, S&P Global Bond Markets' Weakest Links & Monthly Default Rates.
2 For this purpose, " foreign person" refers to a taxpayer other than a "U.S. person." Under Section 7701(a)(30), a U.S. person is (1) a citizen or resident of the U.S., (2) a domestic partnership, (3) a domestic corporation, (4) an estate the income of which is subject to U.S. federal income tax without
regard to its source, or (5) a trust if a U.S. court is able to exercise primary supervision over the administration of the trust and one or more U.S. persons have the authority to control all substantial decisions of the trust, or if the trust has a valid election in effect to be treated as a U.S. person.
3 Reg. 1.61-12.
4 Alternatively, under Section 108(b)(5) a taxpayer can elect to reduce the basis of its depreciable property first. See also Reg. 1.108-4.
5 Section 267(a)(2) in effect puts an accrual-method debtor on the cash method with respect to liabilities owed to a related creditor. For this purpose, a related creditor is one that owns more than 50% of the stock, by vote or value, of the debtor. Section 267(a)(3) has the same effect on an accrual-method U.S. debtor with respect to liabilities owed to a related foreign creditor. See Square D. Company, 118 TC 299 (2002); Tate & Lyle, Inc., 103 TC 656 (1994), rev'd and rem'd 78 AFTR 2d 96-5240, 87 F3d 99, 96-2 USTC ¶50340 (CA-3, 1996).
6 COD income also may be excluded under Section 108(e)(5) (purchase price adjustment), Section 108(e)(8) (transfer of debtor stock to a creditor in satisfaction of a debt obligation), and Section 108(e)(10) (transfer of debt instrument in satisfaction of a debt obligation).
7 Bittker and Thompson, "Income from the Discharge of Indebtedness: The Progeny of United States v. Kirby Lumber Co.," 66 Calif. L. Rev. 1159 (1978).
8 See, e.g., Rev. Rul. 84-176, 1984-2 CB 34 (amount owed by a taxpayer under a contract that was forgiven by the seller in return for a release of a contract counterclaim was not COD income).
9 See Spartan Petroleum Co., 40 AFTR 2d 77-5695, 437 F Supp 733, 77-2 USTC ¶9631 (DC S.Car., 1977).
10 Sections 871(a) and 881(a).
11 In determining whether U.S. source FDAP income and U.S. source capital gains are effectively connected with the conduct of a U.S. trade or business, the factors taken into account include (1) whether the income or gain was derived from assets used in the conduct of such trade or business, or (2) whether the activities of such trade or business were a material factor in the realization of such income; see Section 864(c)(2). All other U.S. source income, other than FDAP income and capital gains, is treated as ECI under a "force of attraction" principle; see Section 864(c)(3).
12 Sections 871(b) and 882(a).
13 Section 864(c)(4)(A).
14 Section 864(c)(4)(B).
15 See also GCM 39294, 10/5/84 (reiterating the Service's disagreement with the Sixth Circuit's decision and stating that the IRS should continue to litigate the COD income issue).
16 In this case, the loans were repaid prior to the enactment of Section 988 in 1986.
17 In that case, the Supreme Court considered whether a bank could treat amounts that were penalties received from customers' early withdrawal of certificates of deposit as income "by reason" of the discharge of indebtedness. The Court held that the bank could not, explaining that "discharge of indebtedness" conveys forgiveness of, or release from, an obligation to repay. The Supreme Court noted that because the prepayment penalty income was an original term of the certificate of deposit and not the result of the "release of any legal obligation," the prepayment penalty did not constitute income by reason of a discharge. See generally Sax, "Supreme Court Decides Fundamental Debt Discharge, Loss Realization Issues," 75 JTAX 54 (July 1991).
18 H. Rep't No. 99-426, 99th Cong., 2d Sess. 450-51 (1986); S. Rep't No. 99-313, 99th Cong., 2d Sess. 461 (1986).
19 Id.
20 Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, page 1070.
21 Section 904.
22 Unnumbered FSA dated 1/1/92, 1992 WL 1354851.
23 Declared obsolete in Rev. Rul. 70-293, 1970-1 CB 282.
24 See also Corporacion de Ventas de Salitre Y Yoda de Chile, 44 BTA 393 (1941) (COD income sourced to place where debentures were purchased), rev'd on other grounds 29 AFTR 1074, 130 F2d 141, 42-2 USTC ¶9599 (CA-2, 1942). Commentators seem to agree with this methodology as well. See Kuntz and Peroni, U.S. International Taxation (Warren, Gorham & Lamont, 2002), ¶A2.03[31], page A2-179 ("[This] approach ... is both simple and practical because it sources the income to a readily identifiable place that has an economic nexus with the income").
25 Section 861(a)(1). See Isenbergh, 900 T.M. (BNA), Foundations of U.S. International Taxation, page A-21. Other analogies that reach the same result include equating the purchase of bonds with a sale of bonds and comparing COD income to market discount because both arise when there is an increase in interest rates, a decrease in the creditworthiness of the taxpayer, or a combination of both. See Kuntz and Peroni, supra note 24; Blessing, 905 T.M. (BNA), Source of Income Rules, page A-114.
26 See Bank of America, 50 AFTR 2d 82-5043, 230 Ct Cl 679, 680 F2d 142, 82-1 USTC ¶9415 (Ct. Cl., 1982) (acceptance commissions sourced by analogy to the source of interest income rules).
27 See Kuntz and Peroni, supra note 24, ¶A2.03[31], page SA2-48 (2003 Cum. Supp. No. 1).
28 Thus, because 60% of the debt was allocated to passive activity expenditures and 40% was allocated to other expenditures, the IRS allocated 60% of the COD income to income from a passive activity and 40% to income from a nonpassive activity.
29 See Section 864(c)(4).
30 Memorandum decisions generally do not have precedential value in the Tax Court. See, e.g., Newman, 68 TC 494 (1977), fn 4; Mosteirin, TC Memo 1995-419, RIA TC Memo ¶95419, 70 CCH TCM 548; Trapp, TC Memo 1980-49, PH TCM ¶80049, 39 CCH TCM 1085 . Where the facts in a memorandum decision are substantially similar to the facts of a case before it, however, the Tax Court may follow the analytical approach in the prior decision. See Convergent Technologies, Inc., TC Memo 1995-320, RIA TC Memo ¶95320, 70 CCH TCM 87 .
31 Reg. 1.1441-4(a).
32 See Blessing, supra note 25, page A-113 ("[u]nder today's Code, cancellation of indebtedness income realized by a foreign person should not be considered 'fixed or determinable annual or periodical income' within the meaning of §§871(a)(1) and 881(a)...").
33 See Reg. 1.1441-2(d)(3); unnumbered FSA, supra note 22.
34 COD income always has been characterized as ordinary income rather than capital gain. See, e.g., Gershkowitz, 88 TC 984 (1987). Thus, it would be difficult for a foreign individual to argue that COD income should be not be subject to tax as a result of Section 871(a)(2) (foreign individual is subject to U.S. federal income tax on U.S. source capital gains only if such person is present in the U.S. for 183 days or more during the tax year and certain other conditions are satisfied).
35 Form 1042 is the annual tax return filed by withholding agents that make payments of U.S. source income to a foreign person; see Reg. 1.1461-1(b).
36 Reg. 1.1441-2(d)(2).
37 Reg. 1.1441-2(d)(1). This could occur, for example, when a borrower repurchases its debt on the open market.
38 Id.
39 See Central de Gas de Chihuahua, 102 TC 515 (1994). See also Stark and Baillif, "Do Section 482 Allocations to Foreign Entities Trigger a Withholding Obligation?," 82 JTAX 178 (March 1995).
40 See Climaco, 77 AFTR 2d 96-1252, 96-1 USTC ¶50153 (DC N.Y., 1996).
41 See unnumbered FSA dated 1/1/02, 2002 WL 1315677; FSA 200006003; FSA 199926018; FSA 199922034; 1998 FSA LEXIS 383 (4/23/99); 1998 FSA LEXIS 129 (8/1/98).
42 Although not specifically discussed in FSA 200006003, it is assumed that USCO did not recognize COD income as a result of the cancelled interest under Section 108(e)(2) (because the payment of the interest would have given rise to a deduction) or 108(e)(6) (because USCO is treated as satisfying the debt for an amount of money equal to FCO's basis in the obligation).
43 The IRS relied on Fender Sales, Inc., 14 AFTR 2d 6076, 338 F2d 924, 65-1 USTC ¶9104 (CA-9, 1964), cert. den., even though that case was questioned and not followed by the Tax Court and Fifth Circuit in Putoma Corp., 66 TC 652 , aff'd 44 AFTR 2d 79-5576, 601 F2d 734, 79-2 USTC ¶9557 (CA-5, 1979). The IRS disregarded Putoma because the taxpayer in the FSA was in the Ninth Circuit (and the Golsen rule would compel the Tax Court to follow Fender Sales). Moreover, the Fifth Circuit in Putoma recognized that the issuance of shares of stock was an important part of the decision in Fender Sales. Although stock was not issued in the FSA, the IRS explained that such issuance would have been unnecessary because the taxpayer was a wholly owned corporation and it was undisputed that the foreign corporation's economic stake in the taxpayer was converted from debt into equity.
44 1998 FSA LEXIS 129 (8/1/98).
45 Reg. 1.952-1(b)(2). If COD income is U.S. source ECI, it generally will not be subject to the CFC provisions; see Section 952(b).
46 In general, a CFC is a foreign corporation that is more than 50% owned (by vote or value) directly, indirectly, or constructively, by U.S. shareholders (as defined below); see Section 957(a).
47 Section 951(b) defines a "U.S. shareholder" as a U.S. person who owns directly, indirectly, or constructively, 10% or more of the voting power of a CFC.
48 Section 951(a).
49 Section 959.
50 Given that both the passive foreign investment company (PFIC) rules and the foreign tax credit provisions define "passive income" as any income of a kind that would be " foreign personal holding company income" under Section 954(c) (i.e., the CFC rules), it is likely that COD income would not be treated as passive income for purposes of determining (1) whether a foreign corporation is a PFIC and (2) whether a U.S. person's foreign source income falls into the passive income basket under the foreign tax credit rules. See Sections 1297(b)(1) and 904(d)(2)(A)(i), respectively.
51 See Hillsboro National Bank, 51 AFTR 2d 83-874, 460 US 370, 75 L Ed 2d 130, 83-1 USTC ¶9229 (1983).
52 Section 108(a)(1)(B).
53 Section 108(d)(3). The inclusion of a liability in this calculation does not depend on where the liability was incurred; rather, the test is whether it is "more probable than not" that the taxpayer will be called on to pay the obligation. Merkel, 109 TC 463 (1997), aff'd 84 AFTR 2d 99-6119, 192 F3d 844, 99-2 USTC ¶50848 (CA-9, 1999).
54 Section 108(a)(3).
55 See Ltr. Rul. 199932013; TAM 199935002; FSA 199932019.
56 But see Babin, TC Memo 1992-673, RIA TC Memo ¶92673, 64 CCH TCM 1357 , aff'd 73 AFTR 2d 94-1961, 23 F3d 1032, 94-1 USTC ¶50224 (CA-6, 1994); Hunt, TC Memo 1989-335, PH TCM ¶89335, 57 CCH TCM 919 ; Marcus Estate, TC Memo 1975-9, PH TCM ¶75009, 34 CCH TCM 38 ; Cole, 42 BTA 1110 (1940); TAM 9130005; Ltr. Rul. 9125010; Ltr. Rul. 8920019. In these cases and rulings, the courts and the IRS have ruled that assets exempt from the claims of creditors under applicable state law should not be included in the Section 1 8 insolvency determination. In fact, at least one court-the Board of Tax Appeals in Cole (citing Underleak v. Scott, 117 Minn. 136 (1912))-has looked to the state law definition of insolvency for fraudulent conveyance purposes in applying the predecessor to the Section 108 insolvency rule.
57 While Van Der Horst, 20 AFTR 2d 5598, 270 F Supp 365, 67-2 USTC ¶9669 (DC Del., 1967), involved a foreign person, it appears its rationale could extend to a U.S. person.
58 In Van Der Horst, supra note 57, the IRS argued for exclusion of the taxpayer's foreign-situs assets (in order to have a conveyance set aside as fraudulent). Under Section 108, it will be the foreign person who argues for exclusion and the IRS will argue for inclusion of the foreign taxpayer's foreign-situs assets.
59 See Sections 901(a) (allowing taxpayer to elect to claim foreign tax credit), 164(a) (allowing a deduction for foreign taxes paid) and 275(a)(4)(A) (providing that foreign taxes are not deductible under Section 164 if the taxpayer elects to claim a foreign tax credit under Section 901).
60 Of course, tax credits offset tax dollar for dollar, while deductions reduce taxable income by a percentage amount.
61 See Cowan, "Recent Cases Reflect Continuing IRS Uncertainties About COD Income From Contingent Debt," 84 JTAX 261 (May 1996); "ABA Task Force Analyzes Debt-Discharge Rules," 92 TNT 162-58 (8/10/92) (discussing comments made by Peter Faber, then chair of the ABA Section of Taxation).
62 For example, under the first theory, Section 108(e)(2) may apply where a foreign person incurs a liability the payment of which would be subject to the Section 263 capitalization rules (i.e., results in basis).
63 See note 1, supra.