IRS Chief Counsel Memorandum Considers a Loan Subject to Cancellation True Debt

Published by Julie Treppa on Wednesday, May 1, 2013
Journal thumb May 2013

You’ve heard about this issue for years: a forgivable loan to a qualified active low-income community business (QALICB) may be characterized as a grant, and grants to QALICBs do not fit within the definition of qualified low-income community investments (QLICIs). Concerns surrounding this issue peaked when the Internal Revenue Service (IRS) published its New Markets Tax Credit (NMTC) Audit Technique Guide wherein it sketched out NMTC transactions for its auditors and stated, “In some instances, as an exit strategy, the CDE may intend to eventually forgive or otherwise not collect on the debt after the end of the 7-year credit period. Loans with such pre-arranged forgiveness options are not bona fide debt for federal tax purposes and, therefore, the investment is not a QLICI…” The NMTC audit technique guide went on to state that “true debt” must satisfy certain factors as set forth in IRS Notice 94-47.

Although we have followed the guidance issued by the IRS on this point, the “true debt” test as applied in NMTC transactions has had many of us who call ourselves tax counsel scratching our heads. We know that the factors cited in Notice 94-47 and in relevant case law are generally not used to distinguish debt from a grant; rather they are used to distinguish debt from an equity investment, both of which would constitute valid QLICIs. Moreover, we know that the term “grant” is not generally defined in the Internal Revenue Code (IRC) and that, in the charitable giving context, a “grant” may take the form of a loan or equity investment. That said, it appears the IRS has now issued some guidance on debt characterization that may prove useful in structuring and analyzing NMTC deals. In Chief Counsel Memorandum, FAA 20124103F, the IRS determined that an advance from a state to a company that was partially or completely cancelable depending upon how many jobs the company created was, “a genuine loan in both substance and form.”

In FAA 20124103F, IRS Associate Area Counsel considered whether an accrual-basis taxpayer earned ordinary income, realized income from discharge of indebtedness or received a non-shareholder capital contribution from a loan issued by a state government. The taxpayer was a manufacturing corporation that was contemplating closing its factory within the state and consolidating its business elsewhere. To discourage the corporation from taking these actions, the state entered into a contract whereby it agreed to make a loan to the company in exchange for it making certain capital improvements, retaining a number of existing jobs and creating a set amount of additional jobs. If these goals were satisfied as of a specified date, all principal and accumulated interest on the loan would be canceled. In the event that fewer jobs were created, the loan would be partially canceled and the company would be obligated to pay the state a fixed dollar amount plus accrued interest for every job short of the goal. The loan had a set maturity date and incurred interest at a fixed annual rate, but none of the interest was payable during the loan term; it all accumulated and was due on maturity.

In the memo, the IRS concluded that the loan at issue was true debt because it was made pursuant to a written loan agreement, principal was transferred, interest was incurred at a given interest rate, and repayment was required in a reasonable period of time. With respect to the intent on the part of the state to potentially forgive the loan, the memo says, “While it is probably true that the state prefers that the loan never be repaid (i.e., it prefers that jobs be created), it is clear that, under the contract, the state has the right to receive repayment, in whole or part (according to the number of jobs created), and there is no indication that the state wouldn’t pursue repayment if the taxpayer failed to uphold its end of the bargain. There is no indication that the loan cancellation was intended from the beginning, nor that such cancellation was inevitable or even highly probable. The loan is genuine; the circumstances where it might not be repaid (or might not be repaid in full) are contingent.”

The IRS further concluded that the amount of the loan that was forgiven by the state was not income from the discharge of debt under IRC Section 61(a)(12), because that section contemplates the discharge or forgiveness of a loan. In this case, the state did not “forgive” anything as the loan agreement itself provided a formula for determining the amount owed. Nevertheless, according to the IRS, the resulting accession to wealth that is derived from the principal not being subject to repayment is includible in income under the general rule of IRC Section 61(a) that state that gross income includes all income from whatever source derived.

Finally, the memo addressed the timing of the inclusion of this wealth in the company’s gross income. Because the corporation at issue was an accrual basis taxpayer, the memo concluded that the income should be subject to taxation when all events have occurred that fix the right to receive such income and the amount can be determined with reasonable accuracy. In this instance, the terms of the loan provided that the taxpayer’s obligation to repay the loan ceased to exist as of a specified date set forth in the loan agreement, provided the required jobs were created. Thus, the IRS concluded that the income was includible in income as of that date. There is uncertainty whether the result would be any different in the case of a cash basis taxpayer as the ascension to wealth does not in fact exist until the loan is actually canceled.

The conclusions set forth in FAA 20124103F could prove to be valuable in an NMTC transaction where the goals of a community development entity (CDE) lender might very well be to generate jobs or otherwise ensure that a QLICI produces certain community benefits. As it is desirable under IRC Section 45D for a CDE to argue that it had a reasonable expectation that a QALICB would remain a QALICB throughout the entire seven-year tax credit period, structuring a QLICI whereby debt cancellation was triggered solely by satisfying this requirement probably would not be sufficient to satisfy the true debt test as the reasoning applied in this memo relies on the contingency of the factors leading to the debt’s cancellation. However, it would not be a stretch for most CDEs to outline loan cancellation contingencies that are truly contingent and that have a legitimate business purpose consistent with the objectives of the CDE.

While Chief Counsel Memorandum may not be cited as precedent like a court case or Treasury Regulations, the Internal Revenue Manual nevertheless suggests that any IRS written determination has some relevance to revenue agents and other IRS employees and may be used as a guide with other research materials in formulating a local office’s position on an issue. Moreover, in keeping with the IRS’s goal to treat similarly situated taxpayers alike, the treatment that another taxpayer received should be considered. However, as a practical matter, it may be time for practitioners or perhaps the NMTC Working Group to seek guidance from the IRS on the issue of true debt as applied to NMTC transactions.

Julie Treppa is a partner with Coblentz Patch Duffy & Bass where she specializes in new markets tax credits, counseling investors, businesses and community-based organizations seeking to use tax incentives and tax credits to maximize profits while achieving social, financial and environmental goals. She can be reached at 415.772.5765 or [email protected].