IRS Tax Attorney

JCT examines tax treatment of business debt

JCX-41-11, Present Law And Background Relating To Tax Treatment Of Business Debt

Due to growing concern about the level of corporate debt (along with household and Federal debt), the Joint Committee on Taxation (JCT) has released a report on the Federal tax rules on the use of debt leverage by businesses in the U.S. From '87 to 2010, corporate debt, as a percentage of gross national product (GNP), has risen from 42.8% to 48.3%, a significant increase (although less dramatic than the 57.9% to 90.2% increase in household debt and the 41% to 63.2% increase in Federal debt).

Background on issuer treatment of debt and equity. In general, interest paid or accrued by a business is deductible under Code Sec. 163(a) , subject to a number of limitations. Interest generally is deducted as it is paid or accrues. But, original issue discount (OID) interest (where the amount to be paid at the maturity of a debt instrument exceeds the issue price by more than a de minimis amount) is deducted in advance of actual payment or other accrual under the terms of the instrument. ( Code Sec. 163(e) )

Dividends or other returns on equity aren't deductible. The issuance of a debt or equity instrument for cash is not a taxable event to the issuer. Purchased assets generally have a cost basis for purposes of determining deprecation or gain or loss on sale, regardless of whether the purchase was financed with debt (including nonrecourse debt) or equity. If dividends are not paid on equity, or the capital contributed by an equity holder isn't returned, there is generally no taxable income, gain, or other consequence to the issuer.

If debt is cancelled, modified, or repurchased, the borrower generally realizes income from the discharge of indebtedness. Exceptions to this income inclusion are provided for bankruptcy and insolvency, other situations including seller financing of purchased property, qualified farm indebtedness, qualified real property business indebtedness, and contributions of debt by an equity holder. The exceptions usually require the taxpayer to reduce the basis of property, or to reduce tax attributes such as net operating losses. A significant modification of a debt instrument is treated as the disposition of the old instrument in exchange for the new instrument.

If nonrecourse debt is satisfied by foreclosure on the assets securing the debt, the borrower generally realizes gain from the disposition of the assets for the amount of the debt (even if the assets are not worth that amount).

Background on holder treatment of debt and equity. Interest on debt is taxed to a taxable individual or corporate holder at the ordinary income tax rate of the holder (currently, up to 35%). Dividends paid by a taxable C corporation are generally taxed to an individual shareholder at a maximum rate of 15%. Dividends are generally taxed to a C corporation shareholder at a maximum rate of 10.5% (or less, depending on the percentage ownership the corporate shareholder has in the issuing corporation). Gain on the sale of an equity interest in a C corporation or in an S corporation is generally capital gain. If the stock has been held for at least one year, such gain is generally taxable to an individual shareholder at a maximum rate of 15%. Gain on the sale of C corporation stock is taxed to a corporate shareholder at regular corporate rates (generally 35%). Gain on the sale of an equity interest in a partnership is also generally capital gain of the partner, except for amounts attributable to unrealized receivables and inventory items of the partnership, which are taxable as ordinary income. Interest is generally taxable when paid or accrued.

Interest is generally includable in income and taxable before any cash payment if the OID rules apply. Dividends are generally not taxable until paid. However, in limited circumstances, certain preferred stock dividends may be accrued under rules similar to the rules for debt. A shareholder may also be treated as having received a dividend if his percentage of stock ownership increases as a result of the payment of dividends to other shareholders.

A tax-exempt investor is generally not taxed on investment interest, subject to certain unrelated business income tax rules for debt-financed income. Although U.S.-source interest paid to a foreign investor is generally subject to a 30% withholding tax, various exceptions exist in the Code and in Treaties.

JCT's analysis. The JCT Report concludes that the Federal income tax treatment of debt and equity creates incentives to utilize one or the other depending on the tax characteristics of the issuer and of the particular investor. Taxpayers have considerable flexibility to design instruments treated as either debt or equity but which blend features traditionally associated with both. In general, a corporate issuer isn't subject to corporate tax on amounts that it deducts as interest on debt. On the other hand, dividends, which aren't deductible by the payor, come out of the corporation's after-tax income.

Debt instruments can allow the accrual of the interest deduction along with the inclusion in income by the holder at a time before the payment of cash. Interest income may be taxed at a higher rate to a taxable holder than the holder's dividends or capital gains attributable to corporate retained earnings (to which lower tax rates currently apply). While some forms of debt investments aren't subject to U.S. tax or are taxed at reduced rates in the hands of a tax-exempt or foreign investor—resulting in tax arbitrage that can shelter otherwise taxable income—special rules in the Code apply in these situations to limit interest deductions.

In some situations, business may have an incentive to borrow. Debt allows owners of business or investment assets to extract cash or obtain a higher basis in the leveraged asset without an additional equity investment. For example, a higher basis in a leveraged asset that is depreciable can increase depreciation deductions.

The discharge or restructuring of debt in the event of financial difficulty can cause the issuer to recognize discharge of indebtedness income or gain with respect to the satisfaction of nonrecourse indebtedness for less than the outstanding amount. The income tax treatment of debt discharge depends on whether the debt is recourse or nonrecourse, the nature of the borrower's assets and of the borrowing, and the circumstances of the restructuring or discharge. In a number of instances, no current income is recognized, though tax attributes such as net operating losses, credits, or the basis of assets may be reduced. On the other hand, the failure to pay dividends or return an equity investment in full doesn't cause income or gain to be recognized by the issuer.

The tax law generally contains no fixed definition of debt or equity. In classifying an instrument as debt or equity, the courts have applied many factors. In general, a debt instrument requires a fixed obligation to pay a certain amount at a specified date. Debt instruments provide for remedies including priorities in bankruptcy in the event of default. Conversely, an instrument designated and respected as equity for tax purposes may have features that are more economically burdensome to the issuer.

Equity can be beneficial for tax purposes in certain cases. Although corporate distributions and sales of corporate stock subject the holder to tax in addition to any tax paid by the corporation, reduced tax rates apply to holders with respect to such distributions or gain. Dividends on corporate equity are largely excludable by corporate holders (currently resulting in a maximum 10.5% tax rate under the 70% dividends received deduction). For individual shareholders, both dividends and capital gains on the sale of corporate stock are generally subject to a maximum 15% rate (compared to the top individual rate of 35%).

Different treatment of an instrument for purposes of financial reporting, for regulatory capital purposes in a regulated industry (such as an insurance or banking), for ratings agency purposes, and under foreign tax and nontax laws, may result in more favorable overall business treatment when combined with the benefits of debt or equity for Federal income tax purposes.

PRESENT LAW AND BACKGROUND RELATING

TO TAX TREATMENT OF BUSINESS DEBT

A REPORT TO THE

JOINT COMMITTEE ON TAXATION

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

July 11, 2011

JCX-41-11 i

CONTENTS

Page

INTRODUCTION AND SUMMARY ........................................................................................... 1

I. PRESENT LAW AND LEGISLATIVE BACKGROUND ........................................................ 5

A. General Rules ...................................................................................................................... 5

1. Issuer treatment of debt and equity ............................................................................... 5

2. Holder treatment of debt and equity ............................................................................. 9

3. Acquisitions and dispositions ..................................................................................... 13

B. Definition of Debt and Equity ........................................................................................... 15

1. Distinguishing debt from equity ................................................................................. 15

2. Regulatory authority pursuant to section 385 ............................................................. 17

C. Rules to Address Stripping of U.S. Corporate Tax Base in the Case of Nontaxed

Holders .............................................................................................................................. 20

1. Earnings stripping ....................................................................................................... 20

2. Tax treatment of certain payments to controlling exempt organizations .................... 23

D. Rules to Address Corporate Base Erosion Without Regard to Holders’ Tax Status ........ 25

1. Corporate Equity Reduction Transactions .................................................................. 25

2. Debt expected to be paid in equity .............................................................................. 27

3. Applicable high-yield discount obligations ................................................................ 28

4. Interest on certain acquisition indebtedness ............................................................... 30

E. Rules to Address Tax Arbitrage in the Case of Borrowing to Fund Untaxed Income ..... 31

1. Interest related to tax-exempt income ......................................................................... 31

2. Debt with respect to certain insurance products ......................................................... 35

3. Debt-financed income of tax-exempt organizations ................................................... 39

4. Dividends received deduction reduction for debt-financed portfolio stock ................ 41

F. Rules to Match Timing of Tax Deduction and Income Inclusion Relating to Debt ......... 43

1. Interest and OID on amounts payable to related foreign lenders ................................ 43

2. Construction period interest ........................................................................................ 45

3. Interest in the case of straddles ................................................................................... 46

G. Other Rules Relating to Business Debt and Equity .......................................................... 48

1. Employee Stock Ownership Plans .............................................................................. 48

2. Nonqualified preferred stock not treated as stock for certain purposes ...................... 52

II. DATA WITH RESPECT TO BUSINESS DEBT .................................................................. 56

III. ECONOMIC INCENTIVES CREATED UNDER PRESENT LAW FOR BUSINESS

DEBT ...................................................................................................................................... 64

A. Incentives Related to Firm Capital Structure .................................................................... 64

1. Tax incentives for debt ................................................................................................ 67

2. Tax incentives related to equity .................................................................................. 78

3. Incentives to create hybrid instruments ...................................................................... 80

4. Incentives to substitute other arrangements for debt .................................................. 85ii

5. Incentives to use leveraged ESOPs ............................................................................. 86

6. Financial accounting and other considerations ........................................................... 90

IV. TAX TREATMENT OF CORPORATE DEBT IN SELECTED COUNTRIES ................... 95

A. Summary ........................................................................................................................... 95

B. Law Library of Congress: Tax Treatment of Corporate Debt .......................................... 971

INTRODUCTION AND SUMMARY

Introduction

This document

has been prepared by the staff of the Joint Committee on Taxation, in

response to the request of the Chairman and Vice Chairman of the Joint Committee on Taxation

for a report of Federal tax rules relating to the use of leverage by households and businesses in

the United States.

There has been concern about the level of debt in the U.S. economy. Below is a table

illustrating corporate debt, household debt, and Federal debt as a percentage of gross national

product (GNP), 1987-2010. This document relates to business debt; corporate data is shown in

column one of Table 1, below.

Table 1.−Corporate Debt, Household Debt, and Federal Debt, as a Percentage

of Gross National Product (GNP), 1987-2010

Year

Corporate Debt

as a Percentage of

GNP

Household Debt

as a Percentage of

GNP

Federal Debt

as a Percentage of

GNP

1987 42.8 57.9 41.0

1990 43.6 61.4 42.8

1995 39.5 65.0 48.9

2000 46.4 69.9 33.9

2005 43.0 92.4 36.9

2010 48.3 90.2 63.2

Corporate debt of nonfinancial C corporations and S corporations excluding farms.

Household debt includes debt of personal trusts, nonprofit organizations, partnerships and sole

proprietorships.

Federal debt excludes federal debt held by Federal agency trust funds.

Sources: Debt levels from The Board of Governors of the Federal Reserve System Flow of Funds Accounts

of the United States: Flows and Outstandings First Quarter 2011 Table D.3. GNP levels from the Federal

Reserve Bank of St. Louis.

The first part of this document presents an overview of Federal income tax rules relating

to debt and equity, and some of the statutory limitations on the benefits of each. The overview

includes the treatment of issuers as well as holders, and the treatment of each in the event of a

business downturn in which the instrument becomes worthless.

This document may be cited as follows: Joint Committee on Taxation, Present Law and Background

Relating to Tax Treatment of Business Debt (JCX-41-11), July 11, 2011. This document can be found on our

website at www.jct.gov.

The request was made at the 112

Congress Organizational Meeting of the Joint Committee on Taxation

on March 15, 2011. 2

The second part of this document presents data regarding nonfinancial business sector

debt and other business debt over several decades.

The third part of this document describes incentives for debt or equity that exist in the

absence of tax considerations, a discussion of the incentives that may be created by the presentlaw tax treatment of instruments as debt or as equity.

A companion document

provides economic data with respect to household debt and

provides a description of Federal tax rules governing household debt and economic incentives

under present law.

Summary

Business enterprises and their investors have business reasons to structure capital

investment as either debt or equity. For example, investors may prefer varying levels of risk.

Investors may seek different levels of priority in the event of bankruptcy of the business.

Businesses can issue interests to investors that have varying levels of control over the enterprise

and degrees of participation in profitability or growth of the enterprise.

The tax law generally contains no fixed definition of debt or equity. Taxpayers have

considerable flexibility to design instruments treated as either debt or equity but which blend

features traditionally associated with both.

The Federal income tax treatment of debt and of equity creates incentives to utilize one or

the other depending on the tax characteristics of the issuer and of the particular investor. In

general, a corporate issuer is not subject to corporate tax on amounts that it deducts as interest on

debt. By contrast, dividends, which are not deductible by the payor, come out of after-tax

income of the corporation.

Debt instruments can permit the accrual of the interest deduction along with the inclusion

in income by the holder at a time prior to the payment of cash. Interest income may be taxed at a

higher rate to a taxable holder than the holder’s dividends or capital gains attributable to

corporate retained earnings (to which lower tax rates currently apply). However, some forms of

debt investments are not subject to U.S. tax or are taxed at reduced rates in the hands of a taxexempt or foreign investor. A number of special rules in the Code are designed to limit the tax

benefits that can be obtained from interest deductions to protect the corporate tax base.

To the extent that debt finances assets that produce tax-exempt or otherwise tax-favored

income, the interest deduction is available to offset other income taxed at higher rates. The

resulting tax arbitrage can shelter otherwise taxable income. A number of special rules in the

Code are directed at limiting this effect.

Joint Committee on Taxation, Present Law and Background Relating to Tax Treatment of Household

Debt (JCX-40-11), July 11, 2011 (hereinafter “Tax Treatment of Household Debt”). This document can be found on

our website at www.jct.gov. 3

In addition to the tax benefits of interest deductibility, debt permits owners of business or

investment assets to extract cash or to obtain a higher basis in the leveraged asset without an

additional equity investment. A higher basis in a leveraged asset that is depreciable, for

example, can increase depreciation deductions. This effect may in some situations create an

incentive for a business to borrow.

In the event of financial difficulty, the discharge or restructuring of debt can cause the

issuer to recognize discharge of indebtedness income or alternatively, gain with respect to the

satisfaction of nonrecourse indebtedness for less than the outstanding amount. The income tax

treatment of debt discharge depends on whether the debt is recourse or nonrecourse, the nature of

the borrower’s assets and of the borrowing, and the circumstances of the restructuring or

discharge. In a number of instances, no current income is recognized, though tax attributes such

as net operating losses, credits, or the basis of assets may be reduced. By contrast, the failure to

pay dividends or return an equity investment in full does not cause income or gain to be

recognized by the issuer.

In classifying an instrument as debt or equity, many factors have been applied by courts.

In general, a debt instrument requires a fixed obligation to pay a certain amount at a specified

date. Debt instruments provide for remedies including priorities in bankruptcy in the event of

default. However, an instrument designated and respected as debt for tax purposes might have

features that make it less likely to cause bankruptcy in the event of a downturn − for example, a

delayed period before payment is due, the ability to miss scheduled payments over a long period

of time before default occurs, the ability to satisfy required payments with instruments other than

cash, thin capitalization of the issuer, or ownership of the debt by equity owners who may be

willing to modify its terms rather than cause bankruptcy. Conversely, an instrument designated

and respected as equity for tax purposes may have features that are more economically

burdensome to the issuer, such as significantly increased dividend payment requirements after a

specified period, puts and calls having the effect of requiring a cash redemption by a specified

date, or provisions giving the holders certain corporate governance rights in the event scheduled

payments are not made.

Equity can be beneficial for tax purposes in certain cases. Although corporate

distributions and sales of corporate stock subject the holder to tax in addition to any tax paid by

the corporation, reduced tax rates apply to holders with respect to such distributions or gain.

Dividends on corporate equity are largely excludable by corporate holders (currently resulting in

a maximum 10.5-percent tax rate under the 70-percent dividends received deduction). For

individual shareholders, both dividends and capital gains on the sale of corporate stock are

generally subject to a maximum 15 percent rate (compared to the top individual rate of 35

percent).

The present value of the shareholder-level tax on corporate earnings may be reduced

to the extent earnings are retained and to the extent shareholders do not sell their stock. This

second level of tax and may be eliminated entirely to the extent non-dividend-paying stock is

The top individual rate on dividends of individuals is scheduled to increase to 39.6 percent after 2012, as

is the top rate on other individual ordinary income. The top rate on long term capital gains of individuals is

scheduled to increase to 20 percent after 2012. 4

held until the death of the owner. Receipt of equity also permits tax-free business combinations

and distributions, both in the case of corporations and partnerships.

The treatment of an instrument for purposes of financial reporting, for regulatory capital

purposes in a regulated industry (such as an insurance or banking), for ratings agency purposes,

and under foreign tax and nontax laws, may differ from it’s Federal income tax treatment.

These differences may result in more favorable overall business treatment when the benefits of

debt or of equity for a Federal income tax purpose are combined with the benefits of a different

treatment for another purpose.

I. PRESENT LAW AND LEGISLATIVE BACKGROUND

A. General Rules

1. Issuer treatment of debt and equity

Interest and dividend payments

Interest paid or accrued by a business is generally deductible, subject to a number of

limitations.

By contrast, dividends or other returns to equity are not deductible.

Timing of interest deduction

Interest generally is deducted as it is paid or accrues. However, interest can be deducted

in advance of actual payment or other accrual under the terms of the instrument when the amount

to be paid at the maturity of a debt instrument exceeds the issue price by more than a de minimis

amount. In such cases, a portion of the amount to be paid at maturity is treated as interest

accruing on a constant yield basis over the life of the instrument and is thus deducted in advance

of actual payment.

Such interest is referred to as original issue discount (“OID”).

Principal payments and return of equity capital

Principal payments on business debt are not generally deductible.

The return of capital

to investors in an equity investment likewise is not deductible.

Receipt of cash from debt or equity investors

The issuance of a debt or equity instrument for cash is not a taxable event to the issuer.

Basis of assets purchased with debt or equity

Purchased assets generally have a cost basis for purposes of determining deprecation or

gain or loss on sale, regardless of whether the purchase was financed with debt (including

nonrecourse debt) or equity.

Effect of entity level debt on partnership and S corporation equity holders

Equity investors in a partnership or an S corporation

can deduct their allocable share of

partnership deductions (including depreciation, interest, or loss, for example.) only to the extent

Sec. 163(a). Some of these limitations are discussed below.

Secs. 1273-1275.

There is an exception for certain debt incurred through a leveraged employee stock ownership plan

(“ESOP”). ESOPs are discussed at Part I.G.1. 6

the basis of their interest in the partnership or S corporation.

A partner’s share of entity level

debt is included in the partner’s basis in his partnership interest. An S corporation shareholder

does not include entity level debt in his S corporation stock basis. However, the S corporation

shareholder may deduct losses to the extent of his basis in stock and his basis in debt that the

corporation owes to him.

Nonpayments on equity compared to discharge or restructuring of indebtedness

If dividends are not paid on equity, or the capital contributed by an equity holder is not

returned, there is generally no taxable income, gain, or other consequence to the issuer.

The effects to the issuer if debt is modified, cancelled, or repurchased depend upon the

type of debt, the nature of the holder, and whether or not the debt (or property given in exchange

for it) is traded on an established securities market. If debt is cancelled, modified, or

repurchased, the borrower generally realizes income from the discharge of indebtedness.

Exceptions to this income inclusion are provided for bankruptcy and insolvency, for other

situations including seller financing of purchased property, qualified farm indebtedness, qualified

real property business indebtedness, and contributions of debt by an equity holder. The

exceptions usually require the taxpayer to reduce the basis of property, or to reduce tax attributes

such as net operating losses.

If nonrecourse debt is satisfied by foreclosure on the assets

securing the debt, the borrower generally realizes gain from the disposition of the assets for the

amount of the debt (even if the assets are not worth that amount).

Recourse indebtedness

If a taxpayer’s recourse debt is discharged, the taxpayer generally recognizes income

from the discharge of indebtedness at that time.

A satisfaction of the debt with property worth

less than the debt,

or a repurchase of debt for less than its face amount by the taxpayer or a

An S corporation is a corporation that has only one class of stock, has no more than 100 shareholders

(after applying attribution rules), meets specific other requirements, and makes an election enabling its income and

deductions to pass through to its shareholders without entity level tax. Sec. 1371 et seq.

Other limitations on a partner’s or S corporation shareholder’s deductions also can apply, such as the

limitation on passive activity losses (sec. 469), or the at-risk limitation (sec. 465).

Under certain circumstances an additional tax at the maximum individual rate on dividends (in addition

to the corporate income tax) applies to certain unreasonably accumulated income and to certain undistributed

income of a closely held corporation whose income is largely passive. Secs. 531-537 and secs. 541-547.

Sec. 108. The rules relating to debt cancellation are discussed more fully at Part III.B. 2.

Commissioner v. Tufts, 461 U.S. 300 (1983); cf., Crane v. Commissioner, 331 U.S. 1 (1947).

Sec. 108.

For example, if a creditor contributes its debt to a corporation and receives corporate stock in exchange,

the corporation generally recognizes cancellation of indebtedness income to the extent the value of the stock given is

less than the amount of the debt cancelled. However, if the debt was held by a person that was also a shareholder, 7

related party, is treated as a discharge of the taxpayer’s debt to the extent of the difference

between the outstanding debt and (generally) the value of the property.

A significant modification of a debt instrument is treated as the disposition of the old

instrument in exchange for the new instrument.

Such modifications include a change in the

obligor, a change in term or interest rate; a change in principal amount, and certain modifications

of security. The modification of a debt instrument can thus cause the issuer to recognize

discharge of indebtedness income, measured by the difference between the adjusted issue price

of the old debt and the fair market value (or other applicable issue price) of the new debt.

the debt instrument is publicly traded or is issued in exchange for property (including other debt)

that is publicly traded, then the issue price of the new debt is deemed to be the fair market value

of the debt or other property that is publicly traded.

If neither the old nor the new debt

instrument is traded on an established securities market the issue price of the new debt is

generally the stated principal amount unless there is inadequate stated interest (i.e., interest less

than the Treasury rate for an instrument of comparable term).

Thus, in such traded situations,

discharge of indebtedness income is likely to be recognized if troubled debt is modified or

satisfied with other debt instruments. However, in private situations there may be no discharge of

indebtedness income.

In 2008, special temporary rules were enacted allowing any taxpayer that experiences

discharge of indebtedness income arising from the reacquisition of its debt (including

modifications treated as a reacquisition) to defer including that income for a period of years and

then recognize the income ratably over a number of subsequent years. These rules applied to any

debt issued by a corporate taxpayer and to debt issued by any other taxpayer in connection with

the conduct of trade or business. They expired at the end of 2010.

the debt may be considered contributed in a nontaxable contribution to capital, not creating discharge of

indebtedness income.

Sec. 249.

Treas. Reg. sec. 1.1001-3.

The discharge of indebtedness income is taken into income at the time of the exchange. The new debt

may be deemed to be issued with original issue discount (to the extent the amount payable at maturity exceeds the

issue price) that the issuer can deduct, which can offset the amount of debt discharge income, but the deductions

occur in the future over the period of the new debt, while the income is recognized immediately.

Thus, if a distressed debt instrument is modified and the transaction is treated as an exchange of the old

instrument for the new one, the debtor can experience discharge of indebtedness income in the amount of the

difference between the adjusted issue price of the old debt and its fair market value at the time of the modification.

In certain “potentially abusive” cases, the principal amount of debt given in exchange for other property

(including other debt) is the fair market value of the property exchanged.

Pub. L. No.111-5, sec. 1231. Section 1232 gives the Treasury Department authority to suspend the

AHYDO rules or modify the rate for determining what is an AHYDO in certain distressed debt capital market

conditions. 8

Special rules allow a taxpayer not to recognize discharge of indebtedness income if the

taxpayer is in bankruptcy or is insolvent. These rules permit such taxpayers to reduce net

operating loss carryovers, depreciable asset basis, and other tax attributes that would provide tax

benefits in the future, in lieu of recognizing current income from the discharge of indebtedness.

The rules differ depending on whether the issuer is insolvent or is in a bankruptcy or similar

proceeding.

If the discharge of indebtedness occurs in a Title 11 bankruptcy case, the full amount of

any debt discharged is excluded from income. If the taxpayer is insolvent, cancellation of debt

income is excludable only to the extent of the insolvency. In either case, if the tax attributes

subject to reduction are insufficient to cover the amount of the discharge, there is no inclusion of

debt discharge income for the excess. In the case of an entity that is taxed as a partnership, the

determinations whether the discharge occurs in a Title 11 bankruptcy case, whether the taxpayer

is insolvent, and the reduction of tax attributes, all occur at the partner level.

Tax attributes are generally reduced in the following order: (1) net operating losses, (2)

general business credits, ( 3) minimum tax credits, (4) capital loss carryovers, (5) basis reduction

of property, (6) passive activity loss and credit carryovers, and (7) foreign tax credits. A

taxpayer may elect to apply the reduction first against the basis of depreciable property.

Other special rules allow a taxpayer that is not in bankruptcy or insolvent to exclude

discharge of indebtedness income and instead reduce the basis of certain real property. These

rules apply only for discharge of certain qualified real estate indebtedness or qualified farm

indebtedness. The rules relating to qualified real estate indebtedness are available only to

noncorporate taxpayers.

Purchase money financing

If debt that is discharged was seller-financing for a purchase of property by the debtor,

and if the debtor is not insolvent or in a bankruptcy proceeding, then instead of income from the

discharge of indebtedness, the debtor-purchaser has a purchase price reduction (which reduces

the basis of the property acquired).

Nonrecourse indebtedness

Nonrecourse debt is subject to different rules than recourse debt.

Because the taxpayer

is not personally liable on the debt, there is no cancellation of indebtedness income. However, if

the creditor forecloses or otherwise takes the property securing the debt, the borrower treats the

transaction as a sale of the property for a price equal to the outstanding indebtedness (even if the

The distinction between recourse and nonrecourse debt may be less obvious than it would appear.

Recourse debt might be issued by an entity that has limited liability and limited assets, while nonrecourse debt might

be oversecured. 9

property securing the debt is worth less than the debt at the time of foreclosure).

Such a

transaction generally produces capital gain (rather than ordinary income) to the debtor.

2. Holder treatment of debt and equity

Current income and sales of interests

Taxable investors

Interest on debt is taxed to a taxable individual or corporate holder at the ordinary income

tax rate of the holder (currently, up to 35 percent).

Dividends paid by a taxable C

corporation,

are generally taxed to a taxable individual shareholder at a maximum rate of 15

percent.

Such dividends are generally taxed to a taxable C corporation shareholder at a

maximum rate of 10.5 percent (or less, depending on the percentage ownership the corporate

shareholder has in the issuing corporation).

Gain on the sale of an equity interest in a C

corporation or in an S corporation is generally capital gain. If the stock has been held for at least

one year, such gain is generally taxable to a taxable individual shareholder at a maximum rate of

15 percent.

Gain on the sale of C corporation stock

is taxed to a taxable corporate

shareholder

at regular corporate rates (generally 35 percent). Gain on the sale of an equity

Commissioner v. Tufts, 461 U.S. 300 (1983); cf., Crane v. Commissioner, 331 U.S. 1 (1947).

The ordinary income rate for individuals is scheduled to increase to 39.6 percent after 2012.

A C corporation is defined by reference to subchapter C of the Code (tax rules relating to corporations

and shareholders) and is taxable as a separate entity with no deduction for dividends or other equity distributions.

For purposes of the discussion in this document,, such corporations are distinguished from certain corporations that

meet specific tests relating to organization, functions, assets, and income types can deduct dividends and certain

other equity distributions to shareholders, (e.g., real estate investment trusts (REITs) or regulated investment

companies (RICs)). A C corporation is also distinguished from an S corporation, governed by the additional rules

of subchapter S. An S corporation is a corporation that has only one class of stock, has no more than 100

shareholders (after applying attribution rules), meets other specific requirements, and makes an election enabling its

income and deductions to pass through to its shareholders without entity level tax. Sec. 1371 et seq.

The maximum 15 percent rate on dividends of individuals is scheduled to increase to 39.6 percent after

2012.

The lower rate on dividends received by a corporate shareholder results from the corporate “dividends

received deduction,” which is generally 70 percent of the dividend received if the shareholder owns below 20

percent of the issuer, 80 percent of the dividend received if the shareholder owns at least 20 percent and less than 80

percent of the issuer, and 100 percent of the dividend if the shareholder owns 80 percent of more of the issuer (sec.

243). A corporation subject to the maximum 35 percent corporate tax rate and entitled to deduction 70 percent of a

dividend would pay a maximum tax on the dividend of 10.5 percent (the 30 percent of the dividend that is taxable,

multiplied by the 35 percent tax rate).

The maximum 15 percent rate on long-term capital gains of individuals is scheduled to increase to 20

percent after 2012.

A corporate shareholder cannot own S corporation stock. 10

interest in a partnership is generally also capital gain of the partner, except for amounts

attributable to unrealized receivables and inventory items of the partnership, which are taxable

as ordinary income.

Interest is generally taxable when paid or accrued. Interest generally is includable in

income, and thus taxable, before any cash payment if the original issue discount rules apply.

Dividends are generally not taxable until paid. However, in limited circumstances certain

preferred stock dividends may be accrued under rules similar to the rules for debt. Also, a

shareholder may be treated as having received a dividend if his percentage stock ownership

increases as a result of the payment of dividends to other shareholders.

Tax-exempt investors

A tax-exempt investor (for example, a university endowment fund or a pension plan

investor) is generally not taxed on investment interest, subject to certain unrelated business

income tax (UBTI) rules for debt-financed income.

This is true whether the debt is issued by a

C corporation or by any other entity.

Tax-exempt investors also are generally not subject to tax on sale of C corporation stock,

unless the stock investment is debt-financed.

However, tax-exempt equity investors in a partnership are taxed as engaged in an

unrelated trade or business on their distributive share of partnership income from such a

business, as if they had conducted the business directly. And tax-exempt equity investors in an S

corporation (other than an ESOP investor) are taxed on their entire share of S corporation income

or gain on sale of the stock.

Foreign investors

Debt interests in U.S. entities

Although U.S.-source interest paid to a foreign investor is generally subject to a 30-

percent gross basis withholding tax, various exceptions exist in the Code and in bilateral income

A C corporation is not an eligible S corporation shareholder and therefore cannot own S corporation

stock.

Sec. 751.

Sec. 305(c). Certain situations in which some shareholders receive cash and others experience an

increase in their percentage ownership can also cause both groups of shareholders to be treated as receiving a

dividend under that section.

Secs. 512, 514.

Sec. 512(b). 11

tax treaties.

Interest is generally derived from U.S. sources if it is paid by the United States or

any agency or instrumentality thereof, a State or any political subdivision thereof, or the District

of Columbia. Interest is also from U.S. sources if it is paid by a noncorporate resident or a

domestic corporation on a bond, note, or other interest-bearing obligation.

For this purpose, a

noncorporate resident includes a domestic partnership which at any time during the year was

engaged in a U.S. trade or business.

Additionally, interest paid by the U.S. branch of a foreign

corporation is also treated as U.S.-source income.

Statutory exceptions to this general rule apply for interest on bank deposits as well as

portfolio interest. Interest on bank deposits may qualify for exemption on two grounds,

depending on where the underlying principal is held on deposit. Interest paid with respect to

deposits with domestic banks and savings and loan associations, and certain amounts held by

insurance companies, are U.S.-source income but are not subject to the U.S. withholding tax

when paid to a foreign person, unless the interest is effectively connected with a U.S. trade or

business of the recipient.

Interest on deposits with foreign branches of domestic banks and

domestic savings and loan associations is not treated as U.S.-source income and is thus exempt

from U.S. withholding tax (regardless of whether the recipient is a U.S. or foreign person).

Similarly, interest and original issue discount on certain short-term obligations is also exempt

from U.S. withholding tax when paid to a foreign person.

Portfolio interest received by a nonresident individual or foreign corporation from

sources within the United States is exempt from U.S. withholding tax.

For obligations issued

before March 19, 2012, the term “portfolio interest” means any interest (including original issue

Where a foreign investor is engaged in a U.S. trade or business, any U.S. source interest income or U.S.

source dividend income (see “Equity interest in U.S. Entities” below) derived from assets used in or held for use in

the conduct of the U.S. trade or business where the activities of the trade or business were material factor in the

realization of such income will be treated as effectively connected with that U.S. trade or business. Sec. 864(a)(2).

Sec. 861(a)(1); Treas. Reg. sec. 1.861-2(a)(1). However, special rules apply to treat as foreign source

certain amounts paid on deposits with foreign commercial banking branches of U.S. corporations or partnerships and

certain other amounts paid by foreign branches of domestic financial institutions. Sec. 861(a)(1). Prior to January

1, 2011, all (or a portion) of a payment of interest by a resident alien individual or domestic corporation was treated

as foreign source if such individual or corporation met an 80-percent foreign business requirement. This provision

was generally repealed for tax years beginning after December 31, 2010.

Treas. Reg. sec. 1.861-2(a)(2).

Sec. 884(f)(1).

Secs. 871(i)(2)(A), 881(d); Treas. Reg. sec. 1.1441-1(b)(4)(ii).

Sec. 861(a)(1)(B); Treas. Reg. sec. 1.1441-1(b)(4)(iii).

Secs. 871(g)(1)(B), 881(a)(3); Treas. Reg. sec. 1.1441-1(b)(4)(iv).

Secs. 871(h), 881(c). In 1984, to facilitate access to the global market for U.S. dollar-denominated debt

obligations, Congress repealed the withholding tax on portfolio interest paid on debt obligations issued by U.S.

persons. See Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction

Act of 1984 (JCS-41-84), December 31, 1984, pp. 391-92. 12

discount) that is paid on an obligation that is in registered form and for which the beneficial

owner has provided to the U.S. withholding agent a statement certifying that the beneficial owner

is not a U.S. person, as well as interest paid on an obligation that is not in registered form and

that meets the foreign targeting requirements of section 163(f)(2)(B). Portfolio interest,

however, does not include interest received by a 10-percent shareholder,

certain contingent

interest,

interest received by a controlled foreign corporation from a related person,

or interest

received by a bank on an extension of credit made pursuant to a loan agreement entered into in

the ordinary course of its trade or business.

For obligations issued after March 18, 2012, the term “portfolio interest” no longer

includes interest paid with respect to an obligation not in registered form. This narrowing of the

scope of the portfolio interest exemption is a result of the repeal of the exception to the

registration requirements for foreign targeted securities in 2010, effective for obligations issued

two years after enactment.

U.S.-source interest payments that do not qualify for a statutory exemption from the 30-

percent withholding tax often are exempt from withholding under U.S. bilateral income tax

treaties. Many treaties, including, for example, those with Canada, Germany, and the United

Kingdom, broadly eliminate the withholding tax on U.S.-source interest payments. The result is

that large volumes of interest payments are exempt from withholding under the Code or a treaty.

Equity interests in U.S. entities

A foreign equity investor’s receipt of U.S.-source dividend income from a U.S. domestic

corporation is generally subject to a 30-percent gross basis withholding tax. Dividend income is

generally sourced by reference to the payor’s place of incorporation such that dividends paid by

a domestic corporation are generally treated as entirely U.S.-source income.

As with interest,

the 30-percent withholding tax on dividends received by foreign investors may be reduced or

eliminated under U.S. bilateral income tax treaties. In general, the dividend withholding tax

rates in treaties vary based on the percentage of stock of the dividend-paying company owned by

the recipient of the dividend. Treaties typically provide lower withholding tax rates (five

percent, for example) at ownership levels of ten percent and greater. Twelve treaties, including

those with Germany, Japan, and the United Kingdom, eliminate the withholding tax on dividends

in circumstances in which, among other requirements, the foreign treaty resident is a company

that owns at least 80 percent (in the case of Japan, 50 percent) of the U.S. corporation paying the

dividend.

42JCT examines tax treatment of business debt