Final Regs on Stock-for-Debt Exception to Discharge of Debt Income Rule

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations under section 108(e)(8) of the Internal Revenue Code of 1986, which provides that the common law stock-for-debt exception to the realization of discharge of indebtedness income does not apply where stock issued for indebtedness is nominal or token or fails to satisfy a proportionality test. The final regulations are necessary to provide guidance in applying section 108(e)(8). The regulations provide rules for determining whether stock issued for indebtedness is nominal or token under section 108(e)(8)(A) and rules for applying the proportionality test of section 108(e)(8)(B).

 EFFECTIVE DATE: Effective May 17, 1994.

 FOR FURTHER INFORMATION CONTACT: Annette Ahlers (202) 622-7750 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

This document adds final regulations section 1.108-1 under sections 108(e)(8)(A) and (B) of the Internal Revenue Code (Code). Sections 108(e)(8)(A) and (B) were added by section 2(a) of the Bankruptcy Tax Act of 1980 [Pub. L. 96-589, 94 Stat. 3389] and amended by section 11325 of the Revenue Reconciliation Act of 1990 [Pub. L. 101-508, 104 Stat. 1368]. On November 4, 1992, [57 FR 52601] the Service published these regulations in proposed form in a Notice of Proposed Rulemaking. Subsequent to the publication of the proposed regulations, section 13226 of the Omnibus Budget Reconciliation Act of 1993 repealed the stock- for-debt exception. The amendments made by section 13226 of the Omnibus Budget Reconciliation Act of 1993 apply to stock transferred after December 31, 1994, in satisfaction of any indebtedness unless such transfer is in a title 11 or similar case (as defined in section 368(a)(3)(A)) that was filed on or before December 31, 1993.

 The rules of the final regulations are effective with respect to any issuance of stock for indebtedness on or before December 31, 1994, or any issuance of stock for indebtedness in a title 11 or similar case (as defined in section 368(a)(3)(A) of the Code) that was filed on or before December 31, 1993, pursuant to (1) a plan confirmed by the court in a title 11 case after May 17, 1994. insolvency workout in which all issuances of stock for indebtedness occur after May 17, 1994. No inference is intended concerning the interpretation of sections 108(e)(8)(A) and (B) of the Code prior to the effective date of the regulations.

 These final regulations adopt the proposed regulations with a few minor changes in response to comments. As indicated in the preamble to the proposed regulations, the Service is also publishing Rev. Proc. 94-26, I.R.B. 1994-13, containing ruling guidelines for the nominal or token determination under section 108(e)(8)(A).

 One commentator suggested that the final regulations contain safe harbors or a list of specified factors for the nominal or token determination required by section 108(e)(8)(A) and that a revenue procedure be published for determining whether preferred stock meets the nominal or token requirement of section 108(e)(8)(A). Prior proposed regulations under section 108(e)(8) included factors that would be considered in determining whether stock was nominal or token. Commentators, with respect to those regulations, asserted that the list of factors was incomplete. The Service and Treasury agree that the determination of whether a stock issuance is nominal or token must be based on all the facts and circumstances, and that a list of specified factors would not fully address the relevant considerations in many cases. Rev. Proc. 94-26, I.R.B. 1994-13, provides one safe harbor on when common stock is not nominal or token. In the future, the Service and Treasury will consider issuing additional ruling guidelines as circumstances warrant.

 The commentator suggested that the final regulations provide that for purposes of computing both the common stock and preferred stock proportionality tests the definition of adjusted issue price should be modified to include accrued interest that the issuer of the debt instrument has not paid. The Service and Treasury agree with the recommendation. The final regulations clarify that for purposes of the proportionality tests of section 108(e)(8)(B), the denominator includes any indebtedness that is discharged in the title 11 case or workout, including accrued but unpaid stated interest.

 The commentator suggested that the final regulations provide that, for purposes of determining whether certain stock is preferred stock for purposes of the regulations, preferred stock that is convertible into common stock should be considered participating stock if the conversion right represents, in substance, a meaningful right to participate in corporate growth. This suggestion is adopted in the final regulations.

 In addition, the commentator suggested that a conversion right permitting a holder to receive common stock should always be treated as affording such holder a meaningful right to participate in corporate growth. The Service and Treasury have rejected this suggestion, because a conversion right does not necessarily afford the holder a meaningful right to participate in corporate growth. Whether a conversion right affords a meaningful right to participate in corporate growth must be determined on a case-by-case basis.

 The preamble to the proposed regulations requested comments on the treatment of contingent liabilities under section 108(e)(8). No comments, however, were received on this issue. Although the regulations contain no provision for the treatment of contingent liabilities, contingent liabilities may not be used to increase the denominator inappropriately for purposes of meeting the proportionality tests. For example, the mere assertion by a claimant that it is owed a specific amount does not by itself warrant inclusion of the asserted liability in the denominator for purposes of determining the group ratios.

SPECIAL ANALYSES

 It has been determined that this treasury decision is not a significant regulatory action as defined in Executive Order 12866. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these final regulations is Annette M. Ahlers, Office of Assistant Chief Counsel (Corporate), Office of Chief Counsel, Internal Revenue Service. However, other personnel from the IRS and the Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR PART 1

 Income taxes, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.108-1 also issued under 26 U.S.C. 108(e)(8) and 108(e)(10)(B). * * *

Par. 2. Section 1.108-1 is added to read as follows:

SECTION 1.108-1 STOCK-FOR-DEBT EXCEPTION NOT TO APPLY IN DE MINIMIS CASES.

(a) OVERVIEW. Section 108(e)(8) provides that the common law stock-for-debt exception does not apply if stock issued for indebtedness is nominal or token or if a proportionality test is not met. Paragraph (b) of this section provides rules for the nominal or token determination under section 108(e)(8)(A). Paragraph (c) of this section provides rules for the proportionality test under section 108(e)(8)(B). Paragraph (d) of this section provides certain general rules and definitions. Paragraph (e) of this section provides an effective date.

(b) ISSUANCE OF NOMINAL OR TOKEN STOCK. Under section 108(e)(8)(A), the common law stock-for-debt exception does not apply to indebtedness discharged for stock that is nominal or token. All relevant facts and circumstances must be considered in making this determination. If common and preferred stock are issued for indebtedness, the determination is made separately with respect to the common stock and the preferred stock. The determination of whether common stock issued for unsecured indebtedness is nominal or token is made on an aggregate basis with respect to all common stock issued for unsecured indebtedness in the title 11 case or insolvency workout. Preferred stock issued for unsecured indebtedness is also tested on an aggregate basis with respect to all preferred stock issued for unsecured indebtedness in the title 11 case or insolvency workout.

(c) ISSUANCE OF A DISPROPORTIONATELY SMALL AMOUNT OF STOCK FOR UNSECURED INDEBTEDNESS -- (1) COMMON STOCK ISSUED FOR UNSECURED INDEBTEDNESS -- (i) IN GENERAL. The common law stock- for-debt exception does not apply to an unsecured indebtedness discharged for common stock in a title 11 case or insolvency workout if the individual common stock ratio does not equal at least one-half of the group common stock ratio.

(ii) INDIVIDUAL COMMON STOCK RATIO DEFINED. The individual common stock ratio is the ratio of the value of the common stock issued for an unsecured indebtedness to the amount of the unsecured indebtedness allocated to that common stock. The amount of unsecured indebtedness allocated to the common stock is the amount of the indebtedness for which the common stock is issued (as defined in paragraph (d)(5) of this section), reduced by the amount of other consideration, if any, transferred in exchange for the indebtedness, including --

(A) The amount of any money;

(B) The issue price (determined under section 1273 or 1274) of any new indebtedness;

(C) With respect to any preferred stock, the amount of indebtedness allocated to the preferred stock under paragraph (c)(2)(ii) of this section; and

(D) The value of any other property, including any disqualified stock.

(iii) GROUP COMMON STOCK RATIO DEFINED. The group common stock ratio is the ratio of the aggregate value of all common stock issued for unsecured indebtedness in the title 11 case or insolvency workout to the aggregate amount of unsecured indebtedness allocated to that common stock. The amount of unsecured indebtedness allocated to the common stock is the aggregate amount of all unsecured indebtedness exchanged for stock or cancelled in the title 11 case or insolvency workout, reduced by the amount of other consideration, if any, issued for that indebtedness, including --

(A) The amount of any money;

(B) The issue price (determined under section 1273 or 1274) of any new indebtedness;

(C) With respect to any preferred stock, the amount of indebtedness allocated to the preferred stock under paragraph (c)(2)(iii) of this section; and

(D) The value of any other property, including any disqualified stock.

(iv) EXAMPLE. THE FOLLOWING EXAMPLE ILLUSTRATES THESE provisions.

EXAMPLE. (A) X Corporation has three outstanding debts, Debt 1, Debt 2, and Debt 3. Debts 1 and 2 are unsecured and each has an adjusted issue price of $100,000. Debt 3 is also unsecured, and it has an adjusted issue price of $90,000 and accrued but unpaid interest of $10,000. In a title 11 case, Debt 1 is exchanged for $50,000 cash and $20,000 of common stock, Debt 2 is exchanged for $10,000 cash, and Debt 3 is exchanged for $5,000 common stock. The individual common stock ratio for Debt 1 is 40 percent, which is determined by comparing the value of the common stock issued for the indebtedness ($20,000) to the amount of unsecured indebtedness allocated to that stock ($100,000 adjusted issue price less $50,000 cash received). The individual common stock ratio for Debt 2 is 0 percent because no stock is received in exchange for the indebtedness. The individual common stock ratio for Debt 3 is 5 percent, which is determined by comparing the value of the common stock issued for the indebtedness ($5,000) to the amount of unsecured indebtedness allocated to that stock ($100,000 = $90,000 adjusted issue price and $10,000 of accrued but unpaid interest).

(B) The group common stock ratio is 10.4 percent, which is determined by comparing the value of all of the common stock issued for unsecured indebtedness in the title 11 case ($25,000) to the amount of unsecured indebtedness allocated to the stock ($290,000 aggregate adjusted issue price of all indebtedness exchanged for stock or cancelled in the title 11 case plus $10,000 accrued but unpaid interest less $60,000 cash received). Accordingly, section 108(e)(8)(B) is satisfied only with respect to the common stock issued for Debt 1. The stock-for-debt exception does not apply to Debt 2 or Debt 3.

(2) PREFERRED STOCK ISSUED FOR UNSECURED INDEBTEDNESS -- (i) IN GENERAL. The common law stock-for-debt exception does not apply to an unsecured indebtedness discharged for preferred stock in a title 11 case or insolvency workout if the individual preferred stock ratio does not equal at least one-half of the group preferred stock ratio.

(ii) INDIVIDUAL PREFERRED STOCK RATIO DEFINED. The individual preferred stock ratio is the ratio of the value of the preferred stock issued for an unsecured indebtedness to the amount of the unsecured indebtedness allocated to the preferred stock. The amount of the unsecured indebtedness allocated to preferred stock is equal to the lesser of the lowest redemption price (if any) or lowest liquidation preference (if any) of the preferred stock (determined at issuance). However, the allocable indebtedness may not be less than the fair market value of the preferred stock or greater than the amount of the unsecured indebtedness.

(iii) GROUP PREFERRED STOCK RATIO DEFINED. The group preferred stock ratio is the ratio of the aggregate value of all preferred stock issued for unsecured indebtedness in the title 11 case or insolvency workout to the aggregate amount of unsecured indebtedness allocated to the preferred stock under paragraph (c)(2)(ii) of this section.

(d) DEFINITIONS AND SPECIAL RULES. For purposes of this section:

(1) COMMON STOCK. Common stock is all stock other than disqualified stock and preferred stock.

(2) DISQUALIFIED STOCK. Disqualified stock is disqualified stock as defined in section 108(e)(10)(B)(ii).

(3) LIQUIDATION PREFERENCE. A liquidation preference exists if the stock's right to share in liquidation proceeds is limited and preferred.

(4) PREFERRED STOCK. Preferred stock is any stock (other than disqualified stock) that has a limited or fixed redemption price or liquidation preference and does not upon issuance have a right to participate in corporate growth to a meaningful extent. Preferred stock that is convertible into common stock is not treated as preferred stock if the conversion right represents, in substance, a meaningful right to participate in corporate growth. Solely for purposes of this paragraph (d)(4), a right to participate in corporate growth is not established by the fact that the redemption price or liquidation preference exceeds the fair market value of the preferred stock.

(5) AMOUNT OF INDEBTEDNESS. Generally, the amount of indebtedness is the adjusted issue price of the indebtedness. Appropriate adjustments are made for accrued but unpaid stated interest. (See the example in paragraph (c)(1)(iv) of this section.)

(6) UNDERSECURED INDEBTEDNESS -- (i) GENERAL RULE. If an indebtedness is secured by property with a value less than its adjusted issue price, the indebtedness is considered to be two separate debts: a secured indebtedness with an adjusted issue price equal to the value of the property, and an unsecured indebtedness with an adjusted issue price equal to the remainder. Absent strong evidence to the contrary, the value of the property securing the indebtedness is presumed to be equal to the issue price of any new secured indebtedness received for the indebtedness plus the value of any other consideration (except stock or new unsecured indebtedness) received for the indebtedness. A valuation of that property by a court in a title 11 case is a factor in determining value, but is not controlling.

(ii) EXAMPLE. The following example illustrates these provisions:

EXAMPLE. Corporation X owes an indebtedness with an adjusted issue price of $100,000. The indebtedness is secured by certain property owned by Corporation X. Corporation X exchanges the indebtedness for $10,000 of stock and new secured indebtedness with an issue price of $70,000. Under paragraph (d)(6)(i) of this section, the indebtedness is bifurcated into a secured indebtedness of $70,000 (the issue price of the new secured indebtedness received in exchange therefor) and an unsecured indebtedness of $30,000 (the remainder of the adjusted issue price of the indebtedness).

(e) EFFECTIVE DATE. This section is effective with respect to any issuance of stock for indebtedness on or before December 31, 1994, or any issuance of stock for indebtedness in a title 11 or similar case (as defined in section 368(a)(3)(A) of the Internal Revenue Code) that was filed on or before December 31, 1993 --

(1) Pursuant to a plan confirmed by the court in a title 11 case after May 17, 1994, or

(2) If there is no title 11 case, pursuant to an insolvency workout in which all issuances of stock for indebtedness occur after May 17, 1994.