New Law on Cancellation of Indebtedness Income

American Recovery and Reinvestment Tax Act of 2009. Under the American Recovery and Reinvestment Tax Act of 2009 ( P.L. 111-5), at the election of the taxpayer, discharge of indebtedness income resulting from the reacquisition after December 31, 2008, and before January 1, 2011, of a corporate or business debt instrument is includible in gross income ratably over a five-tax-year period ( Code Sec. 108(i), added by the American Recovery and Reinvestment Tax Act of 2009 ( P.L. 111-5)).
Income from Discharge of Indebtedness: Deferral of discharge of indebtedness income from reacquisition of debt instruments

At the election of the taxpayer, income from the discharge of indebtedness in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument is includible in gross income ratably over the five-tax-year period beginning with:
 The fifth tax year following the tax year in which the reacquisition occurs for a reacquisition occurring in 2009; and

 The fourth tax year following the tax year in which the reacquisition occurs for a reacquisition occurring in 2010 ( Code Sec. 108(i)(1), as added by the American Recovery and Reinvestment Tax Act of 2009 ( P.L. 111-5)).

Deferral of deduction for OID in debt-for-debt exchanges. If a debt instrument is issued for the applicable debt instrument being reacquired (or is treated as issued under Code Sec. 108(e)(4), which concerns acquisition of indebtedness by a person related to the debtor), and there is any original issue discount (OID) with respect to the debt instrument:
 no deduction otherwise allowable shall be allowed to the issuer with respect to the portion of such OID which (a) accrues before the first tax year in the five-tax-year period in which income from the discharge of indebtedness attributable to the reacquisition of the debt instrument is includible in gross income, and does not exceed the income from the discharge of indebtedness with respect to the debt instrument being reacquired; and

 the aggregate amount of deductions disallowed shall be allowed as a deduction ratably over the five-tax-year period.

If the amount of OID accruing before the first tax year in which the OID income is to be recognized exceeds the income from the discharge of indebtedness with respect to the applicable debt instrument being reacquired, the deductions are be disallowed in the order in which the OID is accrued ( Code Sec. 108(i)(2)(A), as added by P.L. 111-5).

Deemed debt-for-debt exchanges. If any debt instrument is issued by an issuer and the proceeds are used directly or indirectly by the issuer to reacquire an applicable debt instrument of the issuer, the newly issued debt instrument is treated as issued for the debt instrument being reacquired. If only a portion of the proceeds from a debt instrument are used for this purpose, the deferral rules apply to the portion of any OID on the newly issued debt instrument which is equal to the portion of the proceeds from such instrument used to reacquire the outstanding instrument ( Code Sec. 108(i)(2)(B), as added by P.L. 111-5). Thus, if a taxpayer makes the deferral election for a debt-for-debt exchange in which the newly issued debt instrument issued (or deemed issued, including by operation of Reg. §1.108-2(g)) in satisfaction of an outstanding debt instrument of the debtor has OID, then any otherwise allowable deduction for OID with respect to such newly issued debt instrument that (a) accrues before the first year of the five-tax-year period in which the related, deferred discharge of indebtedness income is included in the gross income of the taxpayer, and (b) does not exceed such related, deferred discharge of indebtedness income, is deferred and allowed as a deduction ratably over the same five-tax-year period in which the deferred discharge of indebtedness income is included in gross income (Conference Committee Report for American Recovery and Reinvestment Act of 2009).

This rule can apply in certain cases when a debtor reacquires its debt for cash. If the taxpayer issues a debt instrument and the proceeds of such issuance are used to reacquire a debt instrument of the taxpayer, the newly issued debt instrument is treated as if it were issued in satisfaction of the retired debt instrument. If the newly issued debt instrument has OID, this rule applies. Thus, all or a portion of the interest deductions with respect to OID on the newly issued debt instrument are deferred into the five-tax-year period in which the discharge of indebtedness income is recognized. Where only a portion of the proceeds of a new issuance are used to satisfy outstanding debt, the deferral rule applies to the portion of the OID on the newly issued debt instrument that is equal to the portion of the proceeds of such newly issued instrument used to retire outstanding debt of the taxpayer (Conference Committee Report for American Recovery and Reinvestment Act of 2009).

Applicable debt instrument. An applicable debt instrument is any debt instrument issued by: (i) a C corporation, or (ii) any other person in connection with the conduct of a trade or business by such person ( Code Sec. 108(i)(3)(A), as added by P.L. 111-5). A debt instrument for these purposes is broadly defined to include bonds, debentures, notes, certificates, or any other instrument or contractual arrangement constituting indebtedness within the meaning of Code Sec. 1275(a)(1) (which excludes certain annuity contracts) ( Code Sec. 108(i)(3)(B), as added by P.L. 111-5).

Reacquisition. Reacquisition for these purposes includes any acquisition of an applicable debt instrument by (i) the debtor which issued (or is otherwise the obligor under) the debt instrument, or (ii) a related person to such debtor ( Code Sec. 108(i)(4)(A), as added by P.L. 111-5). The determination of whether a person is related to another person is made in the same manner as Code Sec. 108(e)(4) concerning acquisition of indebtedness by a person related to the debtor ( Code Sec. 108(i)(5)(A), as added by P.L. 111-5.

Acquisition. Acquisition for these purposes includes an acquisition of an applicable debt instrument for cash, the exchange of the debt instrument for another debt instrument (including an exchange resulting from a modification of the debt instrument), the exchange of the debt instrument for corporate stock or a partnership interest, the contribution of the debt instrument to capital, and the complete forgiveness of the indebtedness by the holder of the debt instrument ( Code Sec. 108(i)(4)(B), as added by P.L. 111-5).

Election. The election to defer OID income is to be made on an instrument by instrument basis. Once made, the election is irrevocable. A taxpayer makes an election with respect to a debt instrument by including with its return for the tax year in which the reacquisition of the debt instrument occurs a statement that: (a) clearly identifies the debt instrument, and (b) includes the amount of deferred income under this provision, plus any other information that may be prescribed by the IRS. The IRS is authorized to require reporting of the election (and other information with respect to the reacquisition) for years subsequent to the year of the reacquisition. In the case of a pass-through entity, such as a partnership or S corporation, the election is made at the entity level ( Code Sec. 108(i)(5)(B), as added by P.L. 111-5; Conference Committee Report for American Recovery and Reinvestment Act of 2009).

Coordination with other exclusions. If a taxpayer elects to defer discharge of indebtedness income, the exclusions for discharge under a Chapter 11 bankruptcy, when the taxpayer is insolvent, qualified farm indebtedness, and qualified real property business indebtedness ( Code Sec. 108(a)(1)(A), (B), (C) and (D))) do not apply to the income from the discharge of indebtedness for the tax year of the election or any subsequent tax year ( Code Sec. 108(i)(5)(C), as added by P.L. 111-5). Thus, for example, an insolvent taxpayer may elect to defer income from the discharge of indebtedness rather than excluding the income and reducing tax attributes by a corresponding amount (Conference Committee Report for American Recovery and Reinvestment Act of 2009).

Acceleration of deferred items. In the case of the death of the taxpayer, the liquidation or sale of substantially all the assets of the taxpayer (including in a title 11 bankruptcy or similar case), the cessation of business by the taxpayer, or similar circumstances, any item of income or deduction which is deferred (and has not previously been taken into account) must be taken into account in the tax year in which such event occurs (or in the case of a title 11 bankruptcy or similar case, the day before the petition is filed). This rule applies in the case of the sale or exchange or redemption of an interest in a partnership, S corporation, or other pass-through entity by a partner, shareholder, or other person holding an ownership interest in such entity ( Code Sec. 108(i)(5)(D), as added by P.L. 111-5).

Special rule for partnerships. In the case of a partnership, any income deferred under this provision is to be allocated to the partners in the partnership immediately before the discharge in the manner such amounts would have been included in the distributive shares of the partners under Code Sec. 704 if the income were recognized at such time. Any decrease in a partner's share of partnership liabilities as a result of such discharge is not be taken into account for purposes of Code Sec. 752 (concerning the treatment of certain liabilities) at the time of the discharge to the extent it would cause the partner to recognize gain under Code Sec. 731. Thus, the deemed distribution under Code Sec. 752 is deferred with respect to a partner to the extent it exceeds such partner's basis. Amounts so deferred are taken into account at the same time, and to the extent remaining in the same amount, as income deferred under the provision is recognized by the partner ( Code Sec. 108(i)(6), as added by P.L. 111-5; Conference Committee Report for American Recovery and Reinvestment Act of 2009).

The Secretary of the Treasury may prescribe rules and regulations regarding the application of this provision, including: (a) extending the application of the rules regarding the acceleration of deferred items to other circumstances where appropriate, (b) requiring reporting of the election (and such other information as the Secretary may require) on returns of tax for subsequent tax years, and (c) rules for the application of the provision to partnerships, S corporations, and other pass-through entities including for the allocation of deferred deductions ( Code Sec. 108(i)(7), as added by P.L. 111-5).

Treasury Working on Guidance for New Law Deferring Cancellation of Debt Income
Treasury Associate Tax Legislative Counsel Michael Novey stated on April 29 that the Treasury is actively working on guidance projects on cancellation of debt (COD) income (Code Sec. 108(i)) and applicable high-yield discount obligations (AHYDO) (Code Sec. 163(e)(5)(7)). Both provisions were enacted in the American Recovery and Reinvestment Act of 2009 (P.L. 111-5). Speaking at a D.C. Bar program on the taxation of distressed debt, Novey said that the Treasury may publish initial guidance that can be done most quickly and follow this up with later guidance on other issues.


108(i) DEFERRAL AND RATABLE INCLUSION OF INCOME ARISING FROM BUSINESS INDEBTEDNESS DISCHARGED BY THE REACQUISITION OF A DEBT INSTRUMENT. --

108(i)(1) IN GENERAL. --At the election of the taxpayer, income from the discharge of indebtedness in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument shall be includible in gross income ratably over the 5-taxable-year period beginning with --

108(i)(1)(A) in the case of a reacquisition occurring in 2009, the fifth taxable year following the taxable year in which the reacquisition occurs, and

108(i)(1)(B) in the case of a reacquisition occurring in 2010, the fourth taxable year following the taxable year in which the reacquisition occurs.

108(i)(2) DEFERRAL OF DEDUCTION FOR ORIGINAL ISSUE DISCOUNT IN DEBT FOR DEBT EXCHANGES. --

108(i)(2)(A) IN GENERAL. --If, as part of a reacquisition to which paragraph (1) applies, any debt instrument is issued for the applicable debt instrument being reacquired (or is treated as so issued under subsection (e)(4) and the regulations thereunder) and there is any original issue discount determined under subpart A of part V of subchapter P of this chapter with respect to the debt instrument so issued --

108(i)(2)(A)(i) except as provided in clause (ii), no deduction otherwise allowable under this chapter shall be allowed to the issuer of such debt instrument with respect to the portion of such original issue discount which --

108(i)(2)(A)(i)(I) accrues before the 1st taxable year in the 5-taxable-year period in which income from the discharge of indebtedness attributable to the reacquisition of the debt instrument is includible under paragraph (1), and

108(i)(2)(A)(i)(II) does not exceed the income from the discharge of indebtedness with respect to the debt instrument being reacquired, and

108(i)(2)(A)(ii) the aggregate amount of deductions disallowed under clause (i) shall be allowed as a deduction ratably over the 5-taxable-year period described in clause (i)(I).

If the amount of the original issue discount accruing before such 1st taxable year exceeds the income from the discharge of indebtedness with respect to the applicable debt instrument being reacquired, the deductions shall be disallowed in the order in which the original issue discount is accrued.

108(i)(2)(B) DEEMED DEBT FOR DEBT EXCHANGES. --For purposes of subparagraph (A), if any debt instrument is issued by an issuer and the proceeds of such debt instrument are used directly or indirectly by the issuer to reacquire an applicable debt instrument of the issuer, the debt instrument so issued shall be treated as issued for the debt instrument being reacquired. If only a portion of the proceeds from a debt instrument are so used, the rules of subparagraph (A) shall apply to the portion of any original issue discount on the newly issued debt instrument which is equal to the portion of the proceeds from such instrument used to reacquire the outstanding instrument.

108(i)(3) APPLICABLE DEBT INSTRUMENT. --For purposes of this subsection --

108(i)(3)(A) APPLICABLE DEBT INSTRUMENT. --The term "applicable debt instrument" means any debt instrument which was issued by --

108(i)(3)(A)(i) a C corporation, or

108(i)(3)(A)(ii) any other person in connection with the conduct of a trade or business by such person.

108(i)(3)(B) DEBT INSTRUMENT. --The term "debt instrument" means a bond, debenture, note, certificate, or any other instrument or contractual arrangement constituting indebtedness (within the meaning of section 1275(a)(1)).

108(i)(4) REACQUISITION. --For purposes of this subsection --

108(i)(4)(A) IN GENERAL. --The term "reacquisition" means, with respect to any applicable debt instrument, any acquisition of the debt instrument by --

108(i)(4)(A)(i) the debtor which issued (or is otherwise the obligor under) the debt instrument, or

108(i)(4)(A)(ii) a related person to such debtor.

108(i)(4)(B) ACQUISITION. --The term "acquisition" shall, with respect to any applicable debt instrument, include an acquisition of the debt instrument for cash, the exchange of the debt instrument for another debt instrument (including an exchange resulting from a modification of the debt instrument), the exchange of the debt instrument for corporate stock or a partnership interest, and the contribution of the debt instrument to capital. Such term shall also include the complete forgiveness of the indebtedness by the holder of the debt instrument.

108(i)(5) OTHER DEFINITIONS AND RULES. --For purposes of this subsection --

108(i)(5)(A) RELATED PERSON. --The determination of whether a person is related to another person shall be made in the same manner as under subsection (e)(4).

108(i)(5)(B) ELECTION. --

108(i)(5)(B)(i) IN GENERAL. --An election under this subsection with respect to any applicable debt instrument shall be made by including with the return of tax imposed by chapter 1 for the taxable year in which the reacquisition of the debt instrument occurs a statement which --

108(i)(5)(B)(i)(I) clearly identifies such instrument, and

108(i)(5)(B)(i)(II) includes the amount of income to which paragraph (1) applies and such other information as the Secretary may prescribe.

108(i)(5)(B)(ii) ELECTION IRREVOCABLE. --Such election, once made, is irrevocable.

108(i)(5)(B)(iii) PASS- THRU ENTITIES. --In the case of a partnership, S corporation, or other pass-thru entity, the election under this subsection shall be made by the partnership, the S corporation, or other entity involved.

108(i)(5)(C) COORDINATION WITH OTHER EXCLUSIONS. --If a taxpayer elects to have this subsection apply to an applicable debt instrument, subparagraphs (A), (B), (C), and (D) of subsection (a)(1) shall not apply to the income from the discharge of such indebtedness for the taxable year of the election or any subsequent taxable year.

108(i)(5)(D) ACCELERATION OF DEFERRED ITEMS. --

108(i)(5)(D)(i) IN GENERAL. --In the case of the death of the taxpayer, the liquidation or sale of substantially all the assets of the taxpayer (including in a title 11 or similar case), the cessation of business by the taxpayer, or similar circumstances, any item of income or deduction which is deferred under this subsection (and has not previously been taken into account) shall be taken into account in the taxable year in which such event occurs (or in the case of a title 11 or similar case, the day before the petition is filed).

108(i)(5)(D)(ii) SPECIAL RULE FOR PASSTHRU ENTITIES. --The rule of clause (i) shall also apply in the case of the sale or exchange or redemption of an interest in a partnership, S corporation, or other passthru entity by a partner, shareholder, or other person holding an ownership interest in such entity.

108(i)(6) SPECIAL RULE FOR PARTNERSHIPS. --In the case of a partnership, any income deferred under this subsection shall be allocated to the partners in the partnership immediately before the discharge in the manner such amounts would have been included in the distributive shares of such partners under section 704 if such income were recognized at such time. Any decrease in a partner's share of partnership liabilities as a result of such discharge shall not be taken into account for purposes of section 752 at the time of the discharge to the extent it would cause the partner to recognize gain under section 731. Any decrease in partnership liabilities deferred under the preceding sentence shall be taken into account by such partner at the same time, and to the extent remaining in the same amount, as income deferred under this subsection is recognized.

108(i)(7) SECRETARIAL AUTHORITY. --The Secretary may prescribe such regulations, rules, or other guidance as may be necessary or appropriate for purposes of applying this subsection, including --

108(i)(7)(A) extending the application of the rules of paragraph (5)(D) to other circumstances where appropriate,

108(i)(7)(B) requiring reporting of the election (and such other information as the Secretary may require) on returns of tax for subsequent taxable years, and

108(i)(7)(C) rules for the application of this subsection to partnerships, S corporations, and other pass-thru entities, including for the allocation of deferred deductions.