PLR 1027035: Prepayment of contingent tax-benefit obligations did not create discharge-of-indebtedness income

Plain-English summary

The IRS ruled that a taxpayer did not realize cancellation-of-indebtedness income by making a lump-sum prepayment to settle its remaining contingent tax-benefit obligations. The obligations depended on future earnings, future tax rates, and the taxpayer's actual realization of tax benefits from stepped-up asset basis. Applying the distinction between a fixed debt purchased at a discount and contingent obligations, the IRS concluded that the prepayment did not produce income under section 61(a)(12). The ruling did not address the effect of section 483 on the tax-benefit payments.

Ruling snapshot

• Question: Did the taxpayer recognize cancellation-of-indebtedness income when it prepaid contingent tax-benefit obligations?
• Outcome: approved
• Key authorities: IRC § 61(a)(12); United States v. Kirby Lumber Co.; Corporacion de Ventas de Salitre Y Yoda de Chile v. Commissioner

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201027035 Third Party Communication: None
Release Date: 7/9/2010 Date of Communication: Not Applicable
Index Number: 61.09-18
Person To Contact:
------------------------ ------------------------, ID No. ------------------
---------------------------------- ----------------------------------------------------
------------------------------------- Telephone Number:
------------------------- ---------------------
------------------------------------------- Refer Reply To:
CC:ITA:B04
PLR-149298-09
Date: March 31, 2010

Legend

Taxpayer = -------------------------------------
R Company = ---------------------------
Group = ----------------
State = -------------
W Corporation = -----------------------------
X Corporation = ---------------------------------------------------
Y Corporation = -----------
Tax Agreement = ------------------------------------
Assignment Agreement = ----------------------------------------------------
Prepayment Agreement = -------------------------------------------------------
Date 1 = --------------------
Date 2 = -------------------------
Date 3 = -------------------------
Date 4 = ------------------
Date 5 = -------------------
$c= -------------------
$d= -----------------
p%= ------
q%= --------

Dear ------------:

This letter is in response to your letter requesting a ruling whether Taxpayer realized
cancellation of indebtedness income under § 61(a)(12) of the Internal Revenue Code
when it prepaid $d to settle a portion of its obligations under the Tax Agreement.
PLR-149298-09 2

FACTS

Background

During Date 1, W Corporation, a State corporation, was the common parent of a federal
consolidated group. X Corporation was a wholly-owned indirect subsidiary of W
Corporation. R Company, a State limited liability company, was a wholly-owned
subsidiary of X Corporation and was a disregarded entity treated as a division of X
Corporation for federal income tax purposes.

Conversion

On Date 2, R Company was converted into Taxpayer pursuant to State laws and all of R
Company’s outstanding membership interests were converted into shares of common
stock and preferred stock of Taxpayer (Conversion). As a result of the Conversion,
Taxpayer acquired and directly owned all of the outstanding stock of three different
corporations (Subsidiaries) as well as outstanding membership interests of a limited
liability company. Taxpayer and its Subsidiaries comprise the Group and file a
consolidated return for federal income tax purposes. Taxpayer uses the accrual method
of accounting and files its returns on a calendar year basis.

Taxpayer represents that the Conversion was a taxable exchange under § 1001 and a
qualified stock purchase under §338(d)(3) by Taxpayer with respect to the Subsidiaries.
Following the Conversion, W Corporation and Taxpayer made § 338(h)(10) elections
with respect to two Subsidiaries and Taxpayer made a § 338(g) election with respect to
the third Subsidiary. The tax basis in the Taxpayer’s assets, and assets held by each of
Taxpayer’s subsidiaries, was stepped up to fair-market value.

In exchange for Taxpayer’s assets, X Corporation received (i) the common and
preferred stock of Taxpayer, (ii) the assumption by Taxpayer of the liabilities of R
Company immediately prior to the Conversion, (iii) $c, and (iv) the right to receive
certain contingent payments that were to be made to W corporation under the Tax
Agreement dated Date 3, among W Corporation, X Corporation, and Taxpayer.

Tax Agreement

Pursuant to Tax Agreement, Taxpayer was required to pay to W Corporation p% of the
excess, if any, of the Hypothetical Tax Liability (HTL) Taxpayer would have incurred
using the tax basis of the assets as recorded on W Corporation’s tax books and records
immediately prior to the Conversion, over Taxpayer’s actual tax liability using the
stepped-up basis in the assets resulting from the Conversion and § 338 elections (Tax
Benefit Payments). The HTL was also computed by (i) assuming that any losses or tax
attributes would be carried forward to future taxable years and (ii) excluding deductions
for imputed interest (for example, interest under §§ 483, 1272, and 1274). The taxes to
PLR-149298-09 3

which the agreement applied were all taxes and other assessments imposed by the
Internal Revenue Service and any other state, local, foreign or other governmental
entity responsible for the administration of taxes. The Tax Agreement was based on the
actual tax rates in effect from time to time in the jurisdictions that Taxpayer was subject
to tax. The Tax Agreement also contemplated that any Tax Benefit Payment made to
W Corporation would further increase the adjusted basis of the assets and thus, further
increase the potential tax benefit. Taxpayer represents that it did not have any basis in
the assets as a result of incurring its obligation under the Tax Agreement. Instead,
Taxpayer receives basis when a Tax Benefit Payment becomes fixed and is paid.

Taxpayer was required to make payments under the Tax Agreement on the due date of
estimated taxes under § 6655 or any comparable provision of state or local law. The
payments were also subject to a true-up after Taxpayer filed its income tax returns for
the year. In addition, Taxpayer’s liability for the payments was recomputed if there was
a change in Taxpayer’s tax liability as a result of a final determination under § 1313(a)
or a similar provision of state, local, or foreign law.

The purpose of the Tax Benefit Payments was to allow W Corporation to share any tax
benefit Taxpayer actually realized over time as a result of the stepped-up tax basis in
the assets. The Taxpayer represents that the obligation to make the Tax Benefit
Payments is indebtedness for purposes of § 61(a)(12).

Assignment

The Tax Agreement permitted W Corporation to assign some of its rights, interest or
entitlements and obligations under the Tax Agreement to any W Corporation affiliate
without the permission of Taxpayer. On Date 4, W Corporation, Y Corporation and
certain other corporations entered into Assignment Agreement, under which W
Corporation assigned its right to q% of the Tax Benefit Payments to Y Corporation and
Y Corporation assumed q% of W Corporation’s liabilities and obligations under the Tax
Agreement. Taxpayer continued to make Tax Benefit Payments to W Corporation
following the execution of Assignment Agreement and, W Corporation transferred q% of
these payments to Y Corporation.

Prepayment Agreement

On Date 5, Taxpayer and Y Corporation executed the Prepayment Agreement because
Y Corporation preferred a lump-sum payment instead of future contingent payments.
Pursuant to the Prepayment Agreement, Taxpayer agreed to pay Y Corporation $d (less
certain expenses) in full satisfaction of Taxpayer’s remaining obligations to make Tax
Benefit Payments under Tax Agreement to W Corporation for the portion W Corporation
assigned to Y Corporation. This amount represents the portion of the rights assigned
by W Corporation to Y Corporation.
PLR-149298-09 4

LAW AND ANALYSIS

Under § 61, gross income includes all income from whatever source derived, including
income from discharge of indebtedness (under §61(a)(12)).

In United States v. Kirby Lumber Co., 284 U.S. 1 (1931), the Supreme Court held that a
taxpayer that purchased its own bonds at a discount in the open market realized income
to the extent of the gain realized as a result of the discount. The Supreme Court
reasoned that the debt reduction resulted in a “freeing of assets” that were previously
subject to obligation of the bonds, which was clearly an accession to the taxpayer's
wealth, and therefore income to the taxpayer.

By contrast in Corporacion de Ventas de Salitre Y Yoda de Chile v. Commissioner, 130
F.2d. 141 (2d Cir. 1942), the court held that the taxpayer’s purchase at a discount of its
own bonds that were payable only out of a percentage of future corporate profits did not
give rise to income. The court explained that the treatment of the prepayment of
contingent debentures differed from the treatment described in Kirby Lumber because
the contingent nature of the debt made it impossible to determine whether or not the
transaction was immediately profitable. Id. at 143.

Taxpayer’s liability under the Tax Agreement is analogous to the taxpayer’s liability in
Corporacion de Ventas because it was contingent upon its future earnings. In addition,
Taxpayer’s liability was contingent upon future tax rates in the jurisdictions in which
Taxpayer was subject to tax and, ultimately, Taxpayer’s actual realization of tax benefits
from the stepped-up basis in the assets. Therefore, because Taxpayer’s obligation
under the Tax Agreement was a contingent obligation, Taxpayer does not realize any
cancellation of indebtedness income by prepaying $d to satisfy its remaining obligation
under the Tax Agreement of the portion of the payments assigned to Y Corporation.

CONCLUSION

Based on Taxpayer’s representations and submission, we conclude that Taxpayer does
not realize any cancellation of indebtedness income because of its prepayment of $d to
Y Corporation, in satisfaction of its remaining obligation to make Tax Benefit Payments
to W Corporation for the portion of the rights Y Corporation received under the
Assignment Agreement.

Except as expressly provided in the preceding paragraph, we do not express or imply
an opinion concerning the tax consequences of any aspect of any transaction or item
discussed or referenced in this letter. For example, this ruling does not address the
effect of § 483 on any of the Tax Benefit Payments, including the prepayment of $d.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.
PLR-149298-09 5

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

                                   Sincerely,



                                   Michael J. Montemurro
                                   Chief, Branch 4
                                   Office of Associate Chief Counsel
                                   (Income Tax & Accounting)