COVID-19 has impacted many U.S. multinationals’ foreign operations, and companies are now considering numerous operational and tax issues amidst the uncertain economic environment. Two tax issues related to the pandemic’s impact on global operations are to evaluate when a U.S. corporate shareholder (or “taxpayer”) of a controlled foreign corporation (CFC) can claim (a) worthless security deduction with respect to its investment in a CFC (i.e., shares of the CFC) and securities, other than stock, issued by the CFC to the U.S. shareholder; and (b) bad debt deduction with regards to debt owed by an insolvent CFC to a U.S. shareholder.
The opportunity to take such deductions should also be considered in light of the CARES Act, which provides that net operating losses arising in a tax year beginning after Dec. 31, 2017, and before Jan. 1, 2021, may be carried back to each of the five tax years preceding the tax year of the loss.
Section 165(g)(1), in general, provides that the loss resulting from a “security” that is a capital asset which becomes “worthless” during the taxable year shall be treated as a capital loss arising on the last day of the taxable year. Section 165(g)(3) provides an exception to capital loss treatment as provided in section 165(g)(1) if two conditions are satisfied:
Under section 165(g)(2), a security is generally defined to mean a stock, bond, debenture, note or certificate or other evidence of indebtedness with interest coupons or in registered form.
The question then arises, when does a security become worthless? Section 165(g)(3) and the regulations thereunder do not provide any guidance with respect to when a security becomes worthless and, therefore, the relevant understanding is mainly derived by case law (examples include Morton v. Commissioner, 38 B.T.A. 1270, 1278 (1938), affd. 112 F.2d 320 (7th Cir. 1940); Textron, Inc. v. United States of America, 418 F. Supp. 39; Austin Co. v. Commissioner, 71 T.C. 955, 970 (1979); Emhart Corporation v. Commissioner, T.C. Memo 1998-162; Flint Industries, Inc. and subsidiaries v. Commissioner T.C. Memo 2001-276).
Based upon case law, in order to establish worthlessness in a given tax year, a taxpayer must establish that the corporation had value at some point in the year but by year end had ceased to have both liquidating value ( i.e., its liabilities equaled or exceeded its assets) and potential value (i.e., no realistic possibility that its assets would exceed its liabilities in the future through business operations).
In Morton, 38 B.T.A. 1270 (1938), aff’d, 112 F.2d 320 (7th Cir. 1940), the Board of Tax Appeal provided that a loss of potential value is ordinarily established by the occurrence of an “identifiable event” that puts an end to any hope and expectation that the shares will become valuable in the future. Identifiable events that the IRS and the courts have frequently held to indicate worthlessness include: (1) bankruptcy, (2) termination of business operations (or a sale of substantially all of the company’s assets), (3) liquidation and (4) receivership.
Further, the amount of loss in worthless shares of a CFC is measured by determining the tax basis of U.S. shareholders in the CFC. Therefore, basis adjustments rules under section 961 and regulations thereunder would apply, which in general provide (1) to increase the basis in the CFC shares by the amount included in gross income of the U.S. shareholder under section 951(a), and (2) to decrease the basis when a U.S. shareholder receives a distribution from previously taxed earnings and profits of a CFC.
Under section 166(a)(1), a deduction is allowed for a debt that becomes worthless during the taxable year. In addition, section 166(a)(2) permits a deduction for partially worthless debts if the taxpayer writes off an appropriate amount on the taxpayer’s books and records and the IRS is satisfied that the debt is recoverable only in part.
There is no bright line test for determining whether a debt is worthless. In many situations, no single factor or identifiable event clearly demonstrates whether a debt has become worthless. Instead, the IRS and the courts have relied on a series of factors or events in the aggregate to determine whether the debt is worthless. Such factors include: a debtor’s serious financial reverse, insolvency, lack of assets, continued refusal to respond to demands for payment, abandonment of business, and bankruptcy. Treas. Reg. 1.166-2(b) requires consideration of all pertinent evidence and provides that a deduction is warranted if the surrounding circumstances indicate that the debt is uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment.
Note: The above is a high-level summary of relevant laws and should not be construed as specific tax advice. The establishment of security worthlessness is a factual determination that should be carefully evaluated under applicable law and supported with evidence.
For a detailed discussion on how these provisions may apply to your organization’s specific facts, reach out our international tax team.
July 31, 2020
