PLR 1117021: Tax refund interest was interest, while related gain was not subject to withholding

Plain-English summary

The IRS ruled on the tax treatment of anticipated federal and state tax refunds held through a liquidating trust for creditors of bankrupt companies. It concluded that stated interest on the refund claims was interest for federal income tax purposes. It also ruled that gain from collecting the refunds and distributing related cash was not subject to withholding under the applicable regulation. The ruling did not address income from a later sale of the trust certificates.

Ruling snapshot

• Question: Was interest on tax refund claims treated as interest, and was related gain subject to withholding?
• Outcome: Approved.
• Key authorities: IRC §§ 61(a), 1001(a), and 6611(a); Treas. Reg. §§ 1.61-7(a) and 1.1441-2(b)(2)(i); Rev. Proc. 94-45.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201117021 [Third Party Communication:
Release Date: 4/29/2011 Date of Communication: Month DD, YYYY]
Index Number: 1441.02-00
Person To Contact:
-------------------------- ----------------------, ID No. -------------
-------------------------------------------- Telephone Number:
------------------------ ---------------------
--------------------------------------- Refer Reply To:
----------------------------------- CC:INTL:BR2
PLR-144492-10
Date:
January 18, 2011

Legend

Taxpayer = --------------------------
Country = ---------------------------
Date 1 = ---------------------------
X = --------------------------------
XSub = ------------------------------
State = -------------
Date 2 = ---------------------

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

This is in response to your request dated July 15, 2010, submitted on behalf of
Taxpayer by Taxpayer’s authorized representative, requesting a ruling under section
1441 of the Internal Revenue Code.

FACTS

Taxpayer, an entity organized under the laws of Country, is an investment vehicle that is
treated as a corporation for U.S. tax purposes.

On Date 1, X, a domestic corporation, and XSub, one of X’s subsidiaries (together with
X, the “Debtors”), commenced voluntary cases under chapter 11 of the Bankruptcy
Code in the United States Bankruptcy Court for the District of State. Taxpayer is a
holder of the Debtors’ debt.

On Date 2, the Debtors filed a proposed plan of reorganization under chapter 11 of the
Bankruptcy Code (the “Plan”), premised on the Bankruptcy Court’s approval of a global
settlement agreement between the Debtors and other interested parties. Under the
terms of this agreement, X and other interested parties will jointly direct all tax
authorities to pay certain anticipated tax refunds (and stated interest) to a master

PLR-144492-10 2

escrow account. The funds in this master escrow account will eventually be released to
separate escrow accounts for X and other interested parties. The timing and amount of
the funds to be released is uncertain because it depends, in part, on the receipt of all
tax refunds and the final settlement of tax liabilities.

Under the Plan, a trust will be established for the sole purpose of liquidating the assets
of the Debtors and distributing the resulting proceeds to creditors on account of their
claims against the Debtors, with creditors receiving beneficial interests in the trust.
Taxpayer is expected to receive trust interests pursuant to the Plan.

The trust intends to qualify as a liquidating trust for Federal income tax purposes, which
will be treated as a grantor trust with the holders of trust interests (initially, Taxpayer and
other creditors) treated as the owners and grantors of the trust. See Rev. Proc. 94-45,
1994-2 C.B. 684. The trustee of the trust will be a U.S. citizen and the trust agreement
will provide that the trust will be administered and governed in all respects exclusively
within the United States.

The trust will receive X’s interest in, and be the beneficiary of, X’s separate escrow
account. Thus, the trust interests represent the ownership interests in the underlying
refund claims, and a holder of trust interests, including Taxpayer, will be deemed to own
its pro rata share of each of the refund claims held through the trust.

Consistent with the Plan and Rev. Proc. 94-45, the refund claims transferred to the trust
will be treated for Federal income tax purposes as having been first transferred, at their
fair market value, directly to Taxpayer and other holders of claims in satisfaction of such
claims, followed by the transfer of such assets by Taxpayer and other holders to the
trust in exchange for trust interests. Taxpayer and the trust are expected to receive
certain of the tax refunds at a discount to their face amount (i.e., fair market value basis
is expected to be less than the face amount of the tax refunds) because of the
uncertainty in the timing and the amount of the tax refunds.

In addition, it is expected that if the trust interests are tradable on a secondary market,
the trust interests will also trade at a discount relative to the face amount of the
underlying claims. It is expected that when the trust interests are traded at a discount,
the adjusted basis at which the trust will hold a corresponding portion of the refund
claims will reflect an adjusted discount level (i.e., the basis will reflect the current trading
price). The receipt of tax refunds by the trust will result in income equal to the
difference, if any, between the basis in the trust interests and the underlying amount of
the tax refund received on the trust interests. Thus, when the tax refund proceeds are
received by the trust, it is expected that Taxpayer and other holders of trust interests will
recognize income.

PLR-144492-10 3

RULINGS REQUESTED

You have requested the following two rulings:

1. Stated interest earned on the tax refund claims qualifies as “interest” for Federal
   income tax purposes.
2. Gain from the collection of tax refunds and any distribution by the trust of cash
   related to such gain is not subject to withholding under Treas. Reg. § 1.1441-
   2(b)(2)(i).

LAW & ANALYSIS

Section 61(a)(4) of the Internal Revenue Code provides that gross income means all
income from whatever sourced derived, including interest.

Section 1.61-7(a) of the Income Tax Regulations provides that, as a general rule,
interest received by or credited to the taxpayer constitutes gross income and is fully
taxable. Furthermore, interest income includes interest on refunds of Federal taxes.

Section 6611(a) provides that interest shall be allowed and paid upon any overpayment
in respect of any internal revenue tax.

Section 1001(a) provides that the gain from the sale or other disposition of property is
the excess of the amount realized over the adjusted basis of such property.

Section 1.1441-2(b)(2)(i) provides that gains derived from the sale of property (including
market discount and option premiums) are not subject to withholding.

Under section 6611(a), X is entitled to interest on its refunds due to overpayments of
tax. Such interest falls under Treas. Reg. section 1.61-7 as taxable interest for Federal
income tax purposes. Similarly, interest on state tax refunds is taxable as interest for
Federal income tax purposes. Therefore, under these facts, interest on the tax refund
claims will be “interest” for Federal income tax purposes.

The trust will likely hold the tax refund claims at a discount. Therefore, when the trust
receives the tax refund proceeds in excess of the fair market value of the trust interests,
Taxpayer and other holders of trust interests will recognize gain. Under section
1001(a), such gain should be measured by the difference between the amount a trust
interest holder receives from the tax refunds and the holder’s basis in its trust interest.
However, under Treas. Reg. § 1.1441-2(b)(2)(i), gain that arises on the collection of a
tax refund, and distributions of related cash by the trust, is not subject to withholding.

PLR-144492-10 4

RULINGS

1. Stated interest earned on the tax refund claims during the time that Taxpayer
   holds the trust interest qualifies as “interest” for Federal income tax purposes.
2. Gain from the collection of tax refunds and any distribution by the trust of cash
   related to such gain is not subject to withholding under Treas. Reg. § 1.1441-
   2(b)(2)(i).

Caveats

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. In particular, no opinion is expressed regarding the tax treatment of any
income generated by a subsequent disposition of the trust certificates by Taxpayer to
any subsequent trust certificate holders.

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.

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

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.

                                   Sincerely,



                                   Jeffery G. Mitchell
                                   Chief, Branch 2
                                   (International)