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Distressed debts for the occasional lender
Given the recent economic downturn, lingering losses still plague the balance sheets of many companies holding debt. As if an anemic economic recovery were not enough, these companies must contend with uncertain tax rules that can produce different results among taxpayers that are in identical situations in all material respects. Taxand USA focuses on how this effects occasional lenders with uncollected business debts.
The framework of uncollected debt
The character of uncollectible debt losses is governed by 3 statutes: IRC Sections 165(g), 1271(a)(1), and 166. To understand the pecking order of these statutes, first consider that debt instruments can be divided into 3 buckets: (1) ordinary assets, (2) capital assets that are securities and (3) capital assets that are not securities.
The first 2 buckets are fairly straightforward to identify and analyse for tax purposes. If a lender can escape capital asset characterisation through 1 of the statutory exceptions under Section 1221, losses will be characterised as ordinary. For the lender holding debts that are capital assets that qualify as securities, the treatment of losses is governed by a well-established body of law under Section 165(g), including a carve out from the bad debt rules under Section 166(e).
The character issue arises through unresolved conflicts created within the third and last bucket. Depending on how a debt in this bucket is settled or extinguished, the transaction may be treated as either a "retirement" under Section 1271(a)(1) or a bad debt under Section 166.
How do I get a bad debt reduction?
The occasional lender's route to an ordinary bad debt deduction may best be achieved prior to any future retirement event by availing itself of the partial worthlessness rules. This strategy typically requires a bit of planning, awareness of the performance of the debt, and visibility into how the debt is being accounted for on the books and records. In general, the lender should be allowed an ordinary bad debt deduction if it "charges off" some a portion of the debt and can demonstrate the extent to which the debt was partially worthless. There is little guidance on what constitutes a valid charge-off for this purpose, but this can actually work to a taxpayer's favour. The courts have historically applied this requirement liberally by allowing mere "notations" in sub-ledgers or other "shadow" accounting systems as long as such notation is with respect to a specific debt.
If an organisation is an occasional lender with distressed debt, the best bet to mitigate risk of capital loss characterisation is to be proactive and rely on partial worthlessness provisions, keeping in mind the need for sufficient temporal difference between the partial charge-off and the retirement. As the old idiom goes, "the best defense is a good offense." Multinationals should educate their teams about potential missteps, their adverse consequences and the need to keep the tax department informed of impending losses. Lastly, corporations should not minimise the importance of documentation. Even the best planned write-offs may be susceptible to challenge if they are not properly memorialised.