[Federal Register Volume 68, Number 138 (Friday, July 18, 2003)]
[Rules and Regulations]
[Pages 42590-42593]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-18145]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9080]
RIN 1545-BC47


Reduction of Tax Attributes Due to Discharge of Indebtedness

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains regulations relating to the reduction 
of tax attributes under sections 108 and 1017 of the Internal Revenue 
Code. These temporary regulations affect taxpayers that exclude 
discharge of indebtedness income from gross income under section 108. 
The text of the temporary regulations also serves as the text of the 
proposed regulations set forth in the notice of proposed rulemaking on 
this subject in the Proposed Rules section in this issue of the Federal 
Register.

DATES: Effective Date: These temporary regulations are effective July 
17, 2003.
    Applicability Date: These temporary regulations apply to discharges 
of indebtedness occurring after July 17, 2003.

FOR FURTHER INFORMATION CONTACT: Theresa M. Kolish (202) 622-7930 of 
the Office of the Associate Chief Counsel (Corporate) (not a toll-free 
number).

SUPPLEMENTARY INFORMATION:

Background

The Debt Discharge Rules

    Pursuant to section 61(a)(12), gross income includes income from 
the discharge of indebtedness (COD income). Section 108(a)(1), which 
reflects the amendments enacted in the Bankruptcy Tax Act of 1980, 
Public Law 96-589, section 2, 94 Stat. 3389 (1980) (1980-2 C.B. 607), 
however, provides that, where the discharge occurs in a title 11 case, 
where the taxpayer is insolvent, or where the indebtedness is 
``qualified farm indebtedness'' or ``qualified real property business 
indebtedness,'' gross income does not include any amount that otherwise 
would be includible in gross income by reason of that discharge (in 
whole or in part) of the indebtedness of the taxpayer.
    Although section 108(a) excludes COD income from gross income under 
those circumstances, section 108(b) requires the reduction of certain 
tax attributes in an amount that reflects the amount excluded from 
gross income, thereby generally deferring, rather than permanently 
eliminating, the inclusion of COD income. Section 108(b)(2) requires 
the reduction of the following tax attributes of the taxpayer in the 
following order: (A) Net operating losses; (B) general business 
credits; (C) minimum tax credits; (D) capital loss carryovers; (E) 
adjusted basis of property; (F) passive activity losses and credit 
carryovers; and (G) foreign tax credit carryovers. Section 108(b)(4)(A) 
provides that the reductions are made after the determination of the 
tax imposed for the taxable year of the discharge. Section 108(b)(4)(B) 
provides that the reductions of net operating losses and capital loss 
carryovers are made first in the loss for the taxable year of the 
discharge and then in the carryovers to such taxable year in the order 
of the taxable years from which each such carryover arose. If the 
excluded COD income exceeds the sum of the taxpayer's tax attributes, 
the excess is disregarded such that it does not result in income or 
have other tax consequences. See H.R. Rep. No. 96-833, at 11 (1980).
    Instead of reducing tax attributes in the order set forth in 
section 108(b)(2), a taxpayer may elect under section 108(b)(5) to 
reduce first the adjusted bases of depreciable property to the extent 
of the excluded COD income. The amount to which the election applies is 
limited to the aggregate adjusted basis of the depreciable property 
held by the taxpayer as of the beginning of the taxable year following 
the taxable year in which the discharge occurs. If the adjusted bases 
of depreciable property are insufficient to offset the entire amount of 
excluded COD income, the taxpayer must then reduce any remaining tax 
attributes in the order set forth in section 108(b)(2). Congress 
intended the election under section 108(b)(5) to allow debtors, 
including debtors in bankruptcy, to account for a debt discharge amount 
in a manner most favorable to their tax situations. See S. Rep. No. 96-
1035, at 10 (1980); H.R. Rep. No. 96-833, at 9 (1980).
    Section 1017(a) provides that when any portion of COD income 
excluded from gross income under section 108(a) is to be applied to 
reduce basis, then such portion shall be applied to reduce the basis of 
any property held by the taxpayer at the beginning of the taxable year 
following the taxable year in which the discharge occurs. Section 
1017(b)(1) provides that the amount of reduction under section 1017(a), 
and the particular properties the bases of which

[[Page 42591]]

are to be reduced, shall be determined under regulations.

The Reorganization Rules

    Section 368(a)(1) defines a reorganization to include certain types 
of asset acquisitions. Under section 361, a corporation that is a party 
to a reorganization recognizes neither gain nor loss when it exchanges 
property, in pursuance of the plan of reorganization, solely for stock 
or securities in another corporation that is a party to the 
reorganization. If the corporation receives in the exchange not only 
stock or securities permitted to be received without the recognition of 
gain, but also other property or money, then the corporation may be 
required to recognize gain. Under section 362(b), if property is 
acquired by a corporation in connection with a reorganization, then the 
basis is the same as it would be in the hands of the transferor, 
increased by the amount of gain recognized to the transferor on such 
transfer.
    Section 332(a) provides that a corporation recognizes no gain or 
loss on the receipt of property distributed in complete liquidation of 
another corporation. Section 337(a) provides that a liquidating 
corporation recognizes no gain or loss on the distribution to the 80-
percent distributee of any property in a complete liquidation to which 
section 332 applies. Under section 334(b)(1), if property is received 
by a corporate distributee in a distribution in a complete liquidation 
to which section 332 applies, the basis of such property in the hands 
of such distributee is the same as it would be in the hands of the 
transferor. However, in any case in which gain or loss is recognized by 
the liquidating corporation with respect to such property, the basis of 
such property in the hands of such distributee is the fair market value 
of the property at the time of the distribution.
    Section 381 provides that a corporation that acquires the assets of 
another corporation in a distribution to which section 332 applies or 
in a transfer to which section 361 applies (but only if the transfer is 
in connection with certain reorganizations described in sections 
368(a)(1)(A), (C), (D), (F), or (G)) shall succeed to, and take into 
account, as of the close of the day of distribution or transfer, the 
items described in section 381(c) of the distributor or transferor 
corporation, subject to certain conditions and limitations. Among those 
items described in section 381(c) are net operating loss carryovers, 
capital loss carryovers, general business credits, and minimum tax 
credits. With respect to net operating loss carryovers and capital loss 
carryovers, the regulations under section 381 reflect that the 
acquiring corporation succeeds to only those carryovers that remain 
after the application of sections 172 and 1212 and their carryforward 
and carryback provisions. See Sec. Sec.  1.381(c)(1)-1; 1.381(c)(3)-1. 
Furthermore, those regulations provide that the acquiring corporation 
succeeds to only those general business credits that remain unused by 
the transferor corporation after computing its taxable income for the 
year of the transfer. See Sec.  1.381(c)(23)-1. Section 381(b)(1) 
provides that, except in the case of an acquisition in connection with 
a reorganization described in section 368(a)(1)(F), the taxable year of 
the distributor or transferor corporation ends on the date of 
distribution or transfer.

Interaction Between Debt Discharge and Reorganization Rules

    Questions have arisen regarding the application of the attribute 
reduction rules of sections 108 and 1017 when a transaction described 
in section 381(a) ends a taxable year in which the transferor excludes 
COD income from gross income. If section 108(b)(4)(A) and section 1017 
were interpreted to require attribute reduction to occur after the 
close of the taxable year of discharge and after the transfer of assets 
and carryover of items described in section 381(c), then arguably no 
attributes described in section 108(b)(2) would be available for 
reduction.

Explanation of Provisions

    The IRS and Treasury Department believe that the rule of section 
108(b)(4)(A) prescribes an ordering of calculations. First, section 
108(b)(4)(A) requires a determination of the taxpayer's tax for the 
taxable year of discharge in order to identify the amounts, if any, of 
the tax attributes described in section 108(b)(2) that remain available 
for reduction. Second, section 108(b)(4)(A) requires the reduction of 
those attributes. This ordering rule affords the taxpayer the use of 
certain of its tax attributes described in section 108(b)(2), including 
any losses carried forward to the taxable year of discharge, for 
purposes of determining its tax for the taxable year of discharge, 
before subjecting those attributes to reduction.
    Similarly, the IRS and Treasury believe that the rule of section 
1017 prescribes an ordering of calculations. The Bankruptcy Tax Act of 
1980 reflects that Congress enacted the rule of section 1017 ``to avoid 
interaction between basis reduction and reduction of other 
attributes.'' S. Rep. No. 96-1035, at 14 (1980); H. Rep. No. 96-833, at 
11 (1980). Without this rule, a circular calculation could be required. 
The taxpayer's net operating loss for the year of the discharge of 
indebtedness might be based in part on the amount of cost recovery 
deductions allowed to the taxpayer. The amount of cost recovery 
deductions, however, would depend on the taxpayer's basis in its 
depreciable or amortizable property at the end of the year. Because net 
operating losses are reduced by excluded COD income prior to the 
reduction of asset basis absent an election under section 108(b)(5), 
the amount of basis required to be reduced would depend on the amount 
of net operating losses. Reducing the basis of property held by the 
taxpayer at the beginning of the taxable year following the taxable 
year in which the discharge occurs avoids this circularity.
    The position that sections 108 and 1017 require the reduction of 
attributes, including the basis of transferred assets, in cases where 
the debtor's taxable year ends with a transfer of assets in a 
transaction described in section 381 is consistent with the policies 
underlying sections 108 and 1017 and the corporate reorganization 
provisions, including ``deferring, but eventually collecting within a 
reasonable period, tax on ordinary income realized from debt 
discharge.'' S. Rep. No. 96-1035, at 10 (1980). For example, assume 
that a debt of corporation X is discharged in a title 11 case. X's 
attributes described in section 108(b)(2) consist solely of basis in 
property. As part of a plan of reorganization, X transfers all of its 
assets to a newly formed corporation, Y. Under section 368(a)(3)(C), 
even though the transaction also qualifies as a reorganization under 
section 368(a)(1)(F), the transaction is treated as qualifying as a 
reorganization only under section 368(a)(1)(G). If sections 108 and 
1017 were interpreted to not require a reduction of the bases of the 
property transferred, X would permanently exclude from gross income the 
COD income, notwithstanding that X underwent nothing more than a mere 
change in identity, form, or place of organization. Accordingly, 
consistent with the legislative history of the Bankruptcy Tax Act of 
1980, the IRS and Treasury Department believe that the basis reduction 
rules of sections 108 and 1017 apply to property of a debtor 
transferred in a transaction described in section 381(a).
    The legislative history of the Bankruptcy Tax Act of 1980 reflects 
that Congress specifically anticipated that amounts that carry over in 
a transaction described in section 381, including the

[[Page 42592]]

basis of transferred property, are to be adjusted under the rules of 
sections 108 and 1017 to account for excluded COD income. See H.R. Rep. 
No. 96-833, at 32-34 (1980). The legislative history states:

    Assume that Corporation A is in a bankruptcy case commenced 
after October 1, 1979. Immediately prior to a transfer under a plan 
of reorganization, A's assets have an adjusted basis of $75,000 and 
a fair market value of $100,000. A has a net operating loss 
carryover of $200,000. A has outstanding bonds of $100,000 (on which 
there is no accrued but unpaid interest) and trade debts of 
$100,000.
    Under the plan of reorganization, A is to transfer all its 
assets to Corporation B in exchange for $100,000 of B stock. 
Corporation A will distribute the stock, in exchange for their 
claims against A, one-half to the security holders and one-half to 
the trade creditors. A's shareholders will receive nothing.
    The transaction would qualify as a reorganization under new 
section 368(a)(1)(G) of the Code, since all the creditors are here 
treated as proprietors for continuity of interest purposes. Thus, A 
would recognize no gain or loss on the transfer of its assets to B 
(sec. 361). B's basis in the assets would be $75,000 (sec. 362), and 
B would succeed to A's net operating loss carryover (sec. 381).
    Under the bill, * * * [o]n the distribution of B stock to A's 
trade creditors, A excludes from gross income the debt discharge 
amount of $50,000--i.e., the difference between the $100,000 debt 
held by non-security creditors and the $50,000 worth of stock given 
for such debt. A may elect to reduce the basis of its depreciable 
assets transferred to B by all or part of the $50,000 debt discharge 
amount; to the extent the election is not made, the debt discharge 
amount reduces A's net operating loss carryover by the remainder of 
the debt discharge amount.

H.R. Rep. No. 96-833, at 34 (1980). The treatment of the net operating 
loss and basis in the legislative history demonstrates that, in a 
transaction described in section 381, the transferor's attributes, 
including the basis of transferred property, that carry over to the 
transferee are reduced.
    Accordingly, these temporary regulations clarify that, in the case 
of a transaction described in section 381(a) that ends a year in which 
the distributor or transferor corporation excludes COD income from 
gross income under section 108(a), any tax attributes to which the 
acquiring corporation succeeds and the basis of property acquired by 
the acquiring corporation in the transaction shall reflect the 
reductions required by sections 108 and 1017. For this purpose, all 
attributes listed in section 108(b)(2) of the distributor or transferor 
corporation immediately prior to the transaction described in section 
381(a), including the basis of property, but after the determination of 
tax for the year of the discharge, are available for reduction under 
section 108(b)(2).
    These temporary regulations also clarify that the tax attributes 
subject to reduction under section 108(b)(2) that are carryovers to the 
taxable year of the discharge, or that may be carried back to taxable 
years preceding the year of the discharge, are first taken into account 
by the taxpayer for the taxable year of the discharge or the preceding 
years, as the case may be, before such attributes are reduced pursuant 
to section 108(b)(2).
    These temporary regulations apply to discharges of indebtedness 
occurring after July 17, 2003.

Special Analyses

    It has been determined that these temporary regulations are not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedures Act (5 
U.S.C. chapter 5) does not apply to these temporary regulations, and, 
because no preceding notice of proposed rulemaking is required for 
these temporary regulations, the provisions of the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) do not apply. Pursuant to section 
7805(f) of the Internal Revenue Code, these temporary regulations will 
be 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 temporary regulations is Theresa M. 
Kolish, Office of Associate Chief Counsel (Corporate). However, other 
personnel from the IRS and Treasury Department participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding the 
following entry in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.108-7T also issued under 26 U.S.C. 108. * * *


0
Par. 2. Section 1.108-7T is added to read as follows:


Sec.  1.108-7T  Reduction of attributes (temporary).

    (a) In general. (1) If a taxpayer excludes discharge of 
indebtedness income (COD income) from gross income under section 
108(a)(1)(A), (B), or (C), then the amount excluded shall be applied to 
reduce the following tax attributes of the taxpayer in the following 
order:
    (i) Net operating losses.
    (ii) General business credits.
    (iii) Minimum tax credits.
    (iv) Capital loss carryovers.
    (v) Basis of property.
    (vi) Passive activity loss and credit carryovers.
    (vii) Foreign tax credit carryovers.
    (2) The taxpayer may elect under section 108(b)(5), however, to 
reduce first the basis of depreciable property to the extent of the 
excluded COD income. If the basis of depreciable property is 
insufficient to offset the entire amount of the excluded COD income, 
the taxpayer must then reduce any remaining tax attributes in the order 
specified in section 108(b)(2). If the excluded COD income exceeds the 
sum of the taxpayer's tax attributes, the excess is permanently 
excluded from the taxpayer's gross income. For rules relating to basis 
reductions required by sections 108(b)(2)(E) and 108(b)(5), see 
sections 1017 and 1.1017-1. For rules relating to the time and manner 
for making an election under section 108(b)(5), see Sec.  1.108-4.
    (b) Carryovers and carrybacks. The tax attributes subject to 
reduction under section 108(b)(2) and paragraph (a)(1) of this section 
that are carryovers to the taxable year of the discharge, or that may 
be carried back to taxable years preceding the year of the discharge, 
are taken into account by the taxpayer for the taxable year of the 
discharge or the preceding years, as the case may be, before such 
attributes are reduced pursuant to section 108(b)(2) and paragraph 
(a)(1) of this section.
    (c) Transactions to which section 381 applies. In the case of a 
transaction described in section 381(a) that ends a taxable year in 
which the distributor or transferor corporation excludes COD income 
under section 108(a), any tax attributes to which the acquiring 
corporation succeeds and the basis of property acquired by the 
acquiring corporation in the transaction shall reflect the reductions 
required by section 108(b). For this purpose, all attributes listed in 
section 108(b)(2) of the distributor or transferor corporation 
immediately prior to the transaction described in section 381(a), but 
after the determination of tax for the year of the discharge, including 
basis of property,

[[Page 42593]]

shall be available for reduction under section 108(b)(2).
    (d) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) Facts. In Year 4, X, a corporation in a title 11 
case, is entitled under section 108(a)(1)(A) to exclude from gross 
income $100,000 of COD income. For Year 4, X has gross income in the 
amount of $50,000. In each of Years 1 and 2, X had no taxable income 
or loss. In Year 3, X had a net operating loss of $100,000, the use 
of which when carried over to Year 4 is not subject to any 
restrictions other than those of section 172.
    (ii) Analysis. Pursuant to paragraph (b) of this section, X 
takes into account the net operating loss carryover from Year 3 in 
computing its taxable income for Year 4 before any portion of the 
COD income excluded under section 108(a)(1)(A) is applied to reduce 
tax attributes. Thus, the amount of the net operating loss carryover 
that is reduced under section 108(b)(2) and paragraph (a) of this 
section is $50,000.
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that in Year 4 X sustains a net operating loss in the amount 
of $100,000. In addition, in each of Years 2 and 3, X reported 
taxable income in the amount of $25,000.
    (ii) Analysis. Pursuant to paragraph (b) of this section and 
section 172, the net operating loss sustained in Year 4 is carried 
back to Years 2 and 3 before any portion of the COD income excluded 
under section 108(a)(1)(A) is applied to reduce tax attributes. 
Thus, the amount of the net operating loss that is reduced under 
section 108(b)(2) and paragraph (a) of this section is $50,000.
    Example 3. (i) Facts. In Year 2, X, a corporation in a title 11 
case, has outstanding trade debts of $200,000 and a depreciable 
asset that has an adjusted basis of $75,000 and a fair market value 
of $100,000. X has no other assets or liabilities. X has a net 
operating loss of $80,000 that is carried over to Year 2 but has no 
general business credit, minimum tax credit, or capital loss 
carryovers. Under a plan of reorganization, X transfers its asset to 
Corporation Y in exchange for Y stock with a value of $100,000. X 
distributes the Y stock to its trade creditors in exchange for 
release of their claims against X. X's shareholders receive nothing 
in the transaction. The transaction qualifies as a reorganization 
under section 368(a)(1)(G) that satisfies the requirements of 
section 354(a)(1)(A) and (B). For Year 2, X has gross income of 
$10,000 (without regard to any income from the discharge of 
indebtedness) and is allowed a depreciation deduction of $10,000 in 
respect of the asset. In addition, it generates no general business 
credits.
    (ii) Analysis. On the distribution of Y stock to X's trade 
creditors, under section 108(a)(1)(A), X is entitled to exclude from 
gross income the debt discharge amount of $100,000. (Under section 
108(e)(8), X is treated as satisfying $100,000 of the debt owed the 
trade creditors for $100,000, the fair market value of the Y stock 
transferred to those creditors.) In Year 2, X has no taxable income 
or loss because its gross income is exactly offset by the 
depreciation deduction. As a result of the depreciation deduction, 
X's basis in the asset is reduced by $10,000 to $65,000. Pursuant to 
paragraph (c) of this section, the amount of X's net operating loss 
to which Y succeeds pursuant to section 381 and the basis of X's 
property transferred to Y must take into account the reductions 
required by section 108(b). Pursuant to paragraph (a) of this 
section, X's net operating loss carryover in the amount of $80,000 
is reduced by $80,000 of the COD income excluded under section 
108(a)(1). In addition, X's basis in the asset is reduced by 
$20,000, the extent to which the COD income excluded under section 
108(a)(1) did not reduce the net operating loss. Accordingly, as a 
result of the reorganization, there is no net operating loss to 
which Y succeeds under section 381. Pursuant to section 361, X 
recognizes no gain or loss on the transfer of its property to Y. 
Pursuant to section 362(b), Y's basis in the asset acquired from X 
is $45,000.
    Example 4. (i) Facts. The facts are the same as in Example 3, 
except that X elects under section 108(b)(5) to reduce first the 
basis of its depreciable asset.
    (ii) Analysis. As in Example 3, on the distribution of Y stock 
to X's trade creditors, under section 108(a)(1)(A), X is entitled to 
exclude from gross income the debt discharge amount of $100,000. In 
addition, in Year 2, X has no taxable income or loss because its 
gross income is exactly offset by the depreciation deduction. As a 
result of the depreciation deduction, X's basis in the asset is 
reduced by $10,000 to $65,000. Pursuant to paragraph (c) of this 
section, the amount of X's net operating loss to which Y succeeds 
pursuant to section 381 and the basis of X's property transferred to 
Y must take into account the reductions required by section 108(b). 
As a result of the election under section 108(b)(5), X's basis in 
the asset is reduced by $65,000 to $0. In addition, X's net 
operating loss is reduced by $35,000, the extent to which the amount 
excluded from income under section 108(a)(1)(A) does not reduce X's 
asset basis. Accordingly, as a result of the reorganization, Y 
succeeds to X's net operating loss in the amount of $45,000 under 
section 381. Pursuant to section 361, X recognizes no gain or loss 
on the transfer of its property to Y. Pursuant to section 362(b), 
Y's basis in the asset acquired from X is $0.

    (e) Effective date. This section applies to discharges of 
indebtedness occurring after July 17, 2003.

0
Par. 3. Section 1.1017-1 is amended by adding paragraph (b)(4) to read 
as follows:


Sec.  1.1017-1  Basis reductions following a discharge of indebtedness.

* * * * *
    (b) * * *
    (4) For further guidance, see Sec.  1.1017-1T(b)(4).
* * * * *

0
Par. 4. Section 1.1017-1T is added to read as follows:


Sec.  1.1017-1T  Basis reductions following a discharge of indebtedness 
(temporary).

    (a) Through (b)(3) [Reserved]. For further guidance, see Sec.  
1.1017-1(a) through (b)(3).
    (4) Transactions to which section 381 applies. In the case of a 
transaction described in section 381(a) that ends a taxable year in 
which the distributor or transferor corporation excludes COD income 
from gross income under section 108(a), the basis of property acquired 
by the acquiring corporation in the transaction shall reflect the 
reductions required by section 1017 and this section. For this purpose, 
the basis of property of the distributor or transferor corporation 
immediately prior to the transaction described in section 381(a), but 
after the determination of tax for the year of the discharge, shall be 
available for reduction under section 108(b)(2). See Sec.  1.108-7T. 
This paragraph (b)(4) applies to discharges of indebtedness occurring 
after July 17, 2003.
    (c) Through (i) [Reserved]. For further guidance, see Sec.  1.1017-
1(c) through (i).

Robert E. Wenzel,
Deputy Commissioner for Services and Enforcement.
    Approved: July 9, 2003.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-18145 Filed 7-17-03; 8:45 am]
BILLING CODE 4830-01-P