Can a foreign person exclude foreign-situs assets in determining insolvency exception to cancellation of indebtedness income?

With the worldwide global default rate on corporate debt continuing to rise, a taxpayer’s ability to exclude cancellation of indebtedness income from gross income has become increasingly relevant.  This remains true for foreign persons who are also subject to U.S. federal income tax on U.S.-source COD income.

Section 61(a)(12) of the Internal Revenue Code (the “Code”) requires a taxpayer to include in gross income “[i]ncome from discharge of indebtedness” (otherwise known as cancellation of indebtedness income or “COD income.”)  This provision codifies the decision in Kirby Lumber Co., 284 US 1, 76 L Ed 131, 2 USTC ¶814 (1931), in which the U.S. Supreme Court held that a corporation realized COD income when it purchased in the open market its bonds, which were issued at par, for an amount less than par. The Court noted that the taxpayer had “made available” certain assets that previously were unavailable because of the obligation to repay.

A taxpayer may exclude, however, COD income from its gross income under Code Section 108(a)(1) if, among reasons, the discharge occurs when the taxpayer is “insolvent.” For this purpose, a taxpayer is insolvent when the amount of the taxpayer’s liabilities exceeds the FMV of the taxpayer’s assets. The amount of the exclusion will be limited to the amount of the taxpayer’s insolvency.

If a foreign person recognizes U.S. source COD income that is taxable in the U.S., such income still may be eligible for exclusion under the Section 108 insolvency exception. There is no clear rule governing which assets of a foreign person will be counted in the determination of insolvency under Section 108.  A plausible argument exists that only U.S.-situs assets should be included in this calculation. This position is based on Van Der Horst, 270 F Supp 365, 67-2 USTC ¶9669 (DC Del., 1967), which held that foreign-situs assets should not be considered in determining whether a foreign person was insolvent for purposes of the Uniform Fraudulent Conveyance Act.

Equally forceful, however, is the position that all of the foreign person’s assets—both U.S.- and foreign-situs assets—should be considered in making this determination. Proponents of this view draw support from the recent decision in Carlson, 116 T.C. 87 (2001), and several IRS rulings holding that assets exempt from the claims of creditors under applicable state law should be counted in the insolvency calculation. Not surprisingly, foreign persons realizing COD income would prefer to reduce the asset base used in this calculation in order to create or increase the amount of their insolvency and therefore their exclusion.

The Only-U.S.-Assets Argument

In Van Der Horst, the IRS attempted to set aside an allegedly fraudulent conveyance of stock by the taxpayer, a citizen of the Netherlands and a resident of Switzerland. Under applicable Delaware law, the transfer would have been considered fraudulent only if it rendered the taxpayer “insolvent.” A person is insolvent under Delaware law if:

“the present fair salable value of his assets is less than the amount that will be required to pay his probable liability on his existing debts as they become absolute and matured.”

Any asset that was “not exempt from liability” for a taxpayer’s debts was included in the insolvency calculation.

The taxpayer argued that certain of his property located in the Netherlands should be included in the insolvency determination because such property was not exempt from liability as a result of the “collection assistance” provision in Article XXII of the then-applicable U.S.-Netherlands income tax treaty (now Article XXXI of the current treaty), which states, in relevant part:

The taxpayer reasoned that because the U.S. was able to secure the assistance of the Netherlands in the collection of a U.S. tax liability, his property in the Netherlands was not “exempt property” under Delaware law. The court disagreed, stating that the collection assistance provision was of “no aid” to the taxpayer because he did not satisfy its specific provisions. First, the court noted that by its express terms, paragraph 2 of Article XXII would not apply until any tax claims have been “finally determined.” According to the court, no “final determination” occurred in his case. Second, the court observed that paragraph 4 did not empower the Netherlands to assist the U.S. in collecting tax against a Netherlands citizen, except for specific situations that were not relevant in the case. Finally, the court highlighted the discretionary nature of the Dutch obligation to assist the U.S. in its collection activities. The court therefore held that the taxpayer’s foreign-situs assets should not be included in the insolvency determination.

Currently, four other income tax treaties concluded with the U.S. contain collection assistance provisions similar to those at issue in Van Der Horst:

1. Article XXVIA of the U.S.-Canada treaty
2. Article XVIII of the U.S.-Denmark treaty
3. Article XXVIII of the U.S.-France treaty
4. Article XVII of the U.S.-Sweden treaty

Based on Van Der Horst, foreign persons may take the position that their foreign-situs assets should not be included in the Section 108 insolvency determination, unless such assets are located in one of these five jurisdictions and the specific conditions of the relevant treaty are satisfied.

The All-assets Argument

The decision in Carlson supports the view that all assets of a foreign person should be included in the insolvency calculation. In Carlson, the court considered whether an Alaskan fishing permit—an exempt asset under Alaska law—should be included in Section 108's insolvency calculation. The Tax Court held that it should, stating that in enacting the Bankruptcy Tax Act of 1980, Congress intended all assets, including those exempt under applicable state law, to be included in the insolvency calculation. The court noted that:

 ”although an asset of a debtor may be exempt from the claims of creditors under applicable state law, if that asset and the debtor’s other assets exceed the debtor’s liabilities, the taxpayer has the ability to pay an immediate tax on income from discharged indebtedness.”

Although Carlson dealt with assets exempt from the claims of creditors under state law (rather than international law), there does not appear to be any policy reason to limit its application. Thus, if the value a foreign person’s foreign-situs assets, together with such person’s U.S.-situs assets, exceed the taxpayer’s liabilities, such person has “the ability to pay an immediate tax” on COD income.  Nonetheless, because Carlson did not specifically deal with assets other than those exempt under state law, its precedential value may be limited.