USE OF INTERMEDIARY DOES NOT AVOID DISCHARGE OF INDEBTEDNESS INCOME.

Rev. Rul. 91-47

ISSUE

If a person unrelated to a debtor forms or avails of a corporation to acquire the debtor's indebtedness and shortly thereafter sells all the corporation's stock to the debtor, does the debtor realize income from discharge of indebtedness where the unrelated person forms or avails of the corporation based on the knowledge that the debtor was seeking to reduce its outstanding indebtedness and the use of the corporation was for the primary purpose of avoiding the discharge of indebtedness income the debtor would have realized if it had acquired its indebtedness directly or through a related party?

FACTS

In 1990, D, a corporation, had outstanding indebtedness with an issue price of $500x and a fair market value of $350x. The indebtedness was issued at par and was held by persons unrelated to D.

P, a person unrelated to D who may or may not hold D indebtedness, learned that D was seeking to reduce its outstanding indebtedness. D and P discussed P's formation of a corporation (Newco) to acquire D's indebtedness and the subsequent sale of the Newco stock to D. D and P anticipated that acquiring D's indebtedness through Newco would allow D to avoid the discharge of indebtedness income D would realize if D acquired its indebtedness directly or through a related party.

In 1990, based on the knowledge that D was seeking to reduce its outstanding indebtedness and the expectation that it would acquire Newco's stock from P, P formed and funded Newco, which purchased for $70x a portion of D's indebtedness with an issue price of $100x. In 1990, shortly after Newco purchased the indebtedness, D purchased 100% of the stock of Newco from P for $70x. P formed Newco primarily for the purpose of enabling D to avoid the discharge of indebtedness income D would realize if D acquired its indebtedness directly or through a related party. P's formation of Newco served no important business purpose.

In making acquisitions on behalf of, or for resale to, unrelated persons, P does not ordinarily acquire stock or indebtedness through a special-purpose corporation.

LAW AND ANALYSIS

Section 61(a)(12) of the Code provides that gross income includes income from discharge of indebtedness. A taxpayer generally has discharge of indebtedness income on the repurchase of its indebtedness for less than the amount owed. United States v. Kirby Number Co., 284 U.S. 1, X-2 C.B. 356 (1931); section 1.61-12(a) and (c)(3) of the Income Tax Regulations.

Section 108(e)(4)(A) of the Code generally provides that for purposes of determining income of a debtor from the discharge of indebtedness, the acquisition of outstanding indebtedness by a person bearing a relationship to the debtor specified in section 267(b) or 707(b)(1) from a person who does not bear such a relationship is treated as the acquisition of such indebtedness by the debtor (a "related party acquisition"). A purchase by a related party effectively eliminates the debtor's liability to outside interests, and the debtor receives the same economic benefit as if it had directly acquired its own indebtedness. S. Rep. No. 1035, 96th Cong., 2d Sess. 10, 19 (1980), 1980-2 C.B. 620, 625, 630. Thus, section 108(e)(4) requires the debtor to realize income from discharge of indebtedness (to the extent required by sections 61(a)(12) and 108) upon the purchase of its indebtedness by a related party.

Under section 267(b)(3) of the Code, two corporations are related if they are members of the same "controlled group." Under section 1563(a), as modified for this purpose by section 267(f), a controlled group includes a chain of corporations connected through stock ownership with a common parent, if more than 50 percent of the stock (by voting power or value) of each of the corporations (except the common parent) is owned by one or more of the other corporations, and the common parent corporation owns more than 50 percent (by voting power or value) of the stock of at least one of the corporations.

In the instant case, respecting the form of the transaction, in which Newco acquired D's indebtedness before D acquired the Newco stock (i.e., before D and Newco became related) would permit the circumvention of section 61(a)(12) and section 108(e)(4). However, notwithstanding the formalities adhered to by the parties, the substance of the transaction, rather than its form, controls for federal income tax purposes. Gregory v. Helvering, 293 U.S. 465, XIV- 1 C.B. 193 (1935); Knetsch v. United States, 364 U.S. 361, 1961-1 C.B. 34 (1960).

Transactions undertaken as part of a single plan may be recharacterized for federal income tax purposes to ensure that "a given result at the end of a straight path is not made a different result because reached by following a devious path." Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938). Intermediate steps undertaken pursuant to a plan to avoid related party status under section 707(b) or 267 may be disregarded. Davis v. Commissioner, 88 T.C. 122 (1987), aff'd, 866 F.2d 852 (6th Cir. 1989); Hassen v. Commissioner, 599 F.2d 305 (9th Cir. 1979). Steps may be disregarded where there is a pre-existing understanding between the parties, even if there is no binding commitment. Blake v. Commissioner, 697 F.2d 473 (2d Cir. 1982).

In Rev. Rul. 70-140, 1970-1 C.B. 73, pursuant to a prearranged plan, assets were transferred to an existing controlled corporation in exchange for additional stock of the transferee corporation in a transaction intended to qualify under section 351. All of the transferee corporation stock was then exchanged for stock of an unrelated corporation in a transaction intended to qualify as a section 368(a)(1)(B) reorganization. The ownership of the additional transferee stock was disregarded and the transaction was treated as a taxable sale of the transferred assets to the second corporation.

Moreover, the use of an entity may be disregarded where no significant business purpose exists for its use even if the larger transaction has a business purpose. Gregory v. Helvering, supra; Merryman v. Commissioner, 873 F.2d 879 (5th Cir. 1989); Packard v. Commissioner, 85 T.C. 397 (1985); Valley Camp Coal Co. v. Commissioner, 26 T.C.M. 1147 (1967), aff'd per curiam, 405 F.2d 1208 (6th Cir. 1969).

In this case, the substance of the transaction controls to prevent the avoidance of section 61(a)(12) and section 108(e)(4) and to carry out the clear policy underlying enactment of section 108(e)(4). That underlying policy is to prevent taxpayer avoidance of the realization of discharge of indebtedness income through indirect acquisitions of indebtedness. If D had acquired its indebtedness directly from its historic creditors or P, or if it had acquired its indebtedness indirectly through a related person, D would have realized discharge of indebtedness income. Because P's formation of Newco to acquire D's debt did not serve an important business purpose and was for the primary purpose of avoiding the discharge of indebtedness income D would realize if it acquired its indebtedness directly or through a related party, P's ownership of Newco is disregarded. Accordingly, the transaction entered into by D and P is treated as though D acquired its indebtedness from P directly or through a related party. Thus, as a result of the acquisition of its indebtedness, D realizes $30x in income from discharge of indebtedness equal to the difference between the issue price of the indebtedness ($100x) and the price paid for the Newco stock ($70x).

HOLDING

If a person unrelated to a debtor forms or avails of a corporation to acquire the debtor's indebtedness and shortly thereafter sells all the corporation's stock to the debtor under the circumstances described in this revenue ruling, the debtor realizes income from the discharge of indebtedness, which is excludible under section 108(a) if the discharge occurs in a title 11 case, if D is insolvent (to the extent of the insolvency), or if the indebtedness is qualified farm indebtedness.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Mark Schneider of the Office of Assistant Chief Counsel (Income Tax and Accounting) and Keith Engel of the Office of Assistant Chief Counsel (Corporate). For further information regarding this revenue ruling contact Mr. Schneider on (202) 566-3802 or Mr. Engel on (202) 566-3265 (not a toll-free call).