[authors: A. Tracy Gomes and Cym H. Lowell]
When a multinational enterprise (MNE) has affiliates that have become insolvent, the overall tax planning objective frequently is to secure a U.S. tax deduction (often ordinary) for worthless stock or debt. The essential requirement to qualify for such treatment is that the owner of the stock receive no assets on a hypothetical liquidation. There are a number of transfer pricing and valuation issues that should be taken into account to ensure a full and consistent determination, and to mitigate potential exposure upon examination.
When a multinational enterprise (MNE) has affiliates that have become insolvent for one reason or another, the overall tax planning objective frequently is to secure a U.S. tax deduction (often ordinary) for worthless stock or debt under Section 165(g)(3). (If the requirements of this section cannot be satisfied, a liquidation of a subsidiary corporation would be a capital transaction under Section 331 or the potential stock loss would be eliminated under Section 332,which would have entirely different U.S. tax consequences.) The essential requirement to qualify for such treatment is that the owner of the stock receive no assets on a hypothetical liquidation. In determining whether this is the case, a variety of valuation and transfer pricing issues can be taken into account, as indicated by the following illustration.
Illustration
USCo is a U.S.-based MNE engaged in the development, production, distribution and servicing of Unique Products. In the United States, USCo files a consolidated income tax return with its affiliates. The U.S. corporate structure is as follows:
ProdCo is responsible for the production process for Unique Products. It has U.S. subsidiaries that handle various aspects of the supply chain. B (which may be a domestic or foreign subsidiary) is believed to be insolvent, and ProdCo would like to claim an ordinary worthless stock deduction under Section 165(g)(3).
The financial statement of B is as follows:
In such a situation, the availability of a Section 165(g)(3) and/or a Section 166 deduction will depend upon a variety of valuation, transfer pricing and technical matters.
Valuation
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Valuation of assets (book versus fair market value)
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Valuation of liabilities, such as discounts for aging, collectability and so on
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Others depending on the situation
Transfer Pricing
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Do accounts receivable and payable meet arm’s-length requirements under Section 482?
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Are there guarantees or other inter-company matters to be addressed?
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Are historic transfer pricing arrangements arm’s length under Section 482—i.e., is there any basis for a belief that B received inadequate returns on its functions and risks, or paid excessive amounts to affiliates?
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Others depending on the situation
Technical Tax
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What is the “identifiable event” that triggers the worthlessness determination?
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Does B have sufficient active gross receipts to qualify the deduction as ordinary in character?
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Is B worthless for Section 165(g)(3) purposes?
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Are B’s inter-company obligations wholly or partially worthless?
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Are B’s inter-company obligations properly treated as debt or equity?
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Will ProdCo receive so much as a “peppercorn” (a very small payment, a nominal consideration, used to satisfy the requirements for the creation of a legal contract) of consideration in its capacity as a shareholder (as opposed to other capacities)?
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If B is a member of the USCo consolidated group, how do the unified loss rules apply?
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Others depending on the situation
This newsletter was developed with contributions from Carlo Carpino, director of American Appraisal’s financial valuation practice. American Appraisal has teamed with McDermott’s international tax and transfer pricing practice to deliver transfer pricing solutions on a global basis.
