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Comparative Tax Treatment for Corporate Debt Restructurings
Aspects of Taxation for Creditors and Debtors
Gordon W. Johnson1
Introduction
This paper provides a comparative survey of the tax treatment related to the
write-off or resolution of bad debts, as considered from the standpoint of both
debtors and creditors in a given transaction. The study reviews the tax treatment
across a number of leading industrial jurisdictions, including common law
countries (Australia, U.K. and U.S.) and civil law countries (France, Germany
and Japan). The primary objective is two-fold: first, to identify commonality
among key jurisdictions that might give rise to established best practices; and
second, to identify tax incentives and disincentives to the process of consensual
debt resolution and corporate workouts.
The paper looks at tax treatment for debt in a number of distinct categories:
(i) debt rescheduling or payment deferrals; (ii) debt write-offs; (iii) exchanges of
debt for debt, debt for equity or equity for equity; (iv) sale of distressed debt at a
Mr. Johnson, Lead Counsel in the Finance, Private Sector and Infrastructure practice group of
the World Bank’s Legal Department, is the Bank’s chief legal advisor on corporate insolvency and
restructuring systems. The author is grateful to Peter Aloneftis for assistance in the research of
this article. The views expressed herein are solely those of the author and do not necessarily
reflect the views of the World Bank, its shareholders, directors or its clients. Mr. Johnson can be
reached at gjohnson@worldbank.org.
1
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discounted value; (v) partial recovery through the seizure and sale of collateral,
court executions at a discounted value; and (vi) recoveries through bankruptcy
proceedings.
1.0
AUSTRALIA
1.1
Deductions by the Creditor for Bad Debts
Under section 25-35(1) of the Commonwealth Income Tax Assessment Act 1997
(“ITAA 97”), a deduction is allowable for a debt (or part of a debt) that is written
off as a bad debt in the income year, provided:
a. The amount owed was included as assessable income of the taxpayer in
the current or a previous income year, unless the taxpayer is in the
money-lending business; or
b. The debt arises from money lent in the ordinary course of a business of
lending money by the taxpayer who carries on that business.
To qualify under section 25-35, it is necessary to have an existing bad debt that is
written off during the income year in which the deduction is claimed.
A money-lending business would normally be able to justify a deduction
for writing off both accrued interest under section 25-35(1)(a) and a loss of
principal under section 25-35(1)(b).2 By contrast under this section, a lender that
is not in the money-lending business would only be able to obtain a deduction
for accrued interest (if it was included as assessable income in the current or
previous income year), but not for any loss on the principal of the loan. As the
2
Deutsch et al., Australian Tax Handbook 2001 460 (Sydney: ATP, 2000).
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repayment of principal does not constitute income,3 it follows that it cannot be
assessed as income of a lender that is not in the money-lending business, who,
accordingly, cannot obtain a deduction for this loss under section 25-35(1)(a).
A debt is money that the taxpayer is currently entitled to receive.4 Thus, if
interest payments are to be paid in the future, they cannot be considered as debt
under section 25-35 for the purpose of obtaining a tax deduction. This applies
equally in the case of a money-lending business.
Whether a debt is bad is a question of fact, as demonstrated by a bona fide
conclusion that the debt was bad to the extent that it was written off. It seems
that the section implicitly requires that the debt be bad on an objective basis. 5
If a business is sold, including the book debts, the purchaser cannot, in
general, claim a deduction for debts that prove to be bad, because the amount
would not have been returned as assessable income by the purchaser. Under
section 25-35(2), a money lender who acquires a debt from another money lender
may claim a deduction for any amount written off as bad, but only up to the cost
paid for the debt. If it were not for this specific provision, such a deduction
would not be allowable under section 25-35(1)(b), because the money lender who
purchased the debt would not have been the one who lent the money.
There are specific limitations on the writing off of bad debts by companies
to prevent a company structure being manipulated. For instance, a company
structure can be exploited if shareholders obtain the benefit of a bad debt
deduction when they were not shareholders at the time the income accrued to
the company. Subdivision 165-C ITAA 97 requires a company to satisfy either a
“same ownership and control test” or a “same business test” in order to be
eligible for a bad debt.
Id., at 39.
Id., at 458.
5 Id., at 459.
3
4
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1.2
The General Deduction Provision for Creditors
A general deduction provision for losses and outgoings is found in section 8-1(1)
ITAA 97:
“You can deduct from your assessable income any loss or outgoing
to the extent that:
a. It is incurred in gaining or producing your assessable income; or
b. It is necessarily incurred in carrying on a business for the purpose of
gaining or producing your assessable income.”
Negative limbs under section 8-1(2) exclude the operation of section 8-1(1), so
that one cannot, for example, deduct a loss or outgoing, whether of a capital
nature or of a private or domestic nature.
If a bad debt is not deductible under section 25-35(1), it may be deductible
under this general provision.6 The effect of dicta in AGC (Advances) Ltd v. FCT7 is
that a bad debt deduction may be allowable under the predecessor of section 81(1) and that, at the time the amounts are written off, the deduction would equal
the amount that the creditor could claim from the debtor as a debt. This is now
supported by later case authority and by Tax Reports (“TR”) section 92/18, which
provides that a creditor may also obtain a deduction in circumstances where the
creditor disposes of, settles or otherwise extinguishes a debt at a loss. In addition,
in an appropriate case, deductions may be obtained for expenses associated with
It should be noted that companies must always satisfy subdivision 165-C,
concerning the “same ownership and control” test or the “same business” test.
7
AGC (Advances) Ltd. v. FCT, 132 CLR 175 (1975).
6
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the recovery of the debt through the sale of collateral or by engaging in legal
proceedings.
However, a bad debt would not be deductible if the loss is of a capital
rather than a revenue nature, a consideration which, in turn, depends upon the
facts and circumstances in each case.8 TR 92/18 states:
It is necessary to ascertain the circumstances which occasioned the
loss and the relation that these circumstances bear to the taxpayer’s
income-earning activities. If the loss is an ordinary incident of the
taxpayer’s income-earning activities, then the loss will be on
revenue account. For example, a bad debt incurred by a financial
institution would generally be expected to be a revenue loss.
1.3
Capital Losses for a Creditor
The capital gains tax (“CGT”) provisions are found in the ITAA 97 and generally
apply only to assets acquired on or after 20 September 1985. These assets are
known as “post-CGT assets”.
A taxpayer’s capital gains and capital losses in an income year form part of
the calculation of a net capital gain or a net capital loss for that year. Net capital
gains are included in a taxpayer’s total assessable income in the same manner as
other items of assessable income. By contrast, net capital losses do not form a
deduction in their own right. Capital losses can be offset against capital gains
realized in the same year or may be carried forward as a net capital loss to offset
8
The leading authority for the distinction between capital and revenue is found in Judge Dixon’s
holdings in Sun Newspapers Ltd v. Federal Commissioner of Taxation, 61 CLR 337 (1938), and
Hallstroms Ptd. Ltd. v. Federal Commissioner of Taxation, 72 CLR 634 (1946). A loss relating to the
profit-earning subject would be capital, but a loss relating to the process of operating the profitearning subject would be revenue.
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future capital gains. Capital losses are not available to be offset against other
assessable income.
A creditor can rely on the capital gains tax provisions to calculate a capital
loss in cases of: (a) disposal of a debt at a loss; (b) cancellation of a debt; or (c) a
debt-for-debt swap or any other debt forgiveness arrangement with the debtor.
Under section 108-5 ITAA 97, a debt owed to a taxpayer is listed as a CGT
asset. The CGT provisions may then be utilized if a creditor comes within the
ambit of one of the prescribed “CGT events” that trigger the CGT provisions.
This can occur in one of two ways:
a. CGT event A1, under section 104-10(1), deals with the disposal of a CGT
asset. If a creditor disposes of a debt, then this would attract the operation
of event A1 and a capital loss would arise if the capital proceeds from the
disposal are less than the asset’s reduced cost base.
b. CGT event C2, under section 104-25, deals with the cancellation, surrender
or similar termination of certain types of CGT assets. If a creditor cancels
or forgives an amount of debt that is owed by the debtor, then this would
attract the operation of event C2 and a capital loss would arise if the
capital proceeds from the termination are less than the asset’s reduced
cost base.
The benefit a creditor can obtain as a result of a capital loss is reduced or
eliminated to the extent that such loss has been claimed as a deduction under the
other provisions of the ITAA 97 (such as under section 25-35(1) and section 8-1)
or under any provisions of the Income Tax Assessment Act 1936 (“ITAA 36”).
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1.4
Debt/Equity Swaps for a Creditor
A debt/equity swap is defined in section 63E(1) ITAA 36 as an “arrangement”
under which a taxpayer extinguishes the whole or part of a debt in return for the
issue to the taxpayer of shares (other than redeemable preference shares) or units
in the debtor.
As a result of section 63E(3)(a), a creditor can claim a deduction for losses
incurred as part of a debt/equity swap with the debtor. The deductible “swap
loss” is the amount by which the debt exceeds the value of the equity received.
The value of the equity (shares or units) is the greater of its market value and its
value in the books of the creditor. Under section 63F, a swap loss deduction
permitted under section 63E is reduced to the extent that a deduction was
previously allowed under section 25-35(1) or section 8-1 ITAA 97.
In order to obtain a deduction, it is necessary that a debt: (a) is owed to a
creditor by either a company or a trust that is either a trading trust or a public
unit trust; (b) is extinguished contemporaneously with the issue of the shares or
units; and (c) that either the debt has been included in the taxpayer’s assessable
income of an income year, or the debt arises from money lent by the taxpayer in
the ordinary course of its money-lending business. It is unnecessary for the debt,
or the part of the debt that is swapped, to be a bad debt, provided the statutory
requirements for the deduction are met.
1.5
Scrip-for-Scrip Takeover – An Equity/Equity Swap
Subdivision 124-M of the ITAA 97 is relevant to the tax treatment of shareholders
in a company that is being taken over by another company. It provides for a CGT
rollover when certain post-CGT interests in companies and trusts are exchanged
for interests in another entity. The subdivision is applicable to CGT events
occurring on or after December 10, 1999. A very narrow form of rollover is also
available for certain pre-CGT original interests.
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A rollover allows the taxpayer to defer the consequences of a CGT event to
a later point in time. Under sections 124-780(3)(b) and 124-781(3)(b), a rollover
can only be chosen where a capital gain would have resulted from the exchange
of the share or trust interest.
Rollovers will be available where:
a. A post-CGT interest is exchanged for a share interest in another company.
Post-CGT interests in shares, options, rights or similar interests can attract
the subdivision 124-M rollover. Apart from an exception, the replacement
shares or similar interests must be shares or interests in the acquiring
company.
b. The exchange is a consequence of a “single arrangement” which complies
with prescribed criteria. The arrangement must result in an entity
becoming the owner of 80 percent or more of the specified interests in the
target company.
c. The choice is made for a rollover and specific notice requirements are
fulfilled.
1.6
Commercial Debt Forgiveness – The Debtor’s Perspective
Division 245 of the ITAA 36 applies to debtors after a “commercial debt” has
been forgiven by a creditor. A debt is generally defined as a legally enforceable
obligation of one person to pay an amount to another person. Accrued but
unpaid interest on a debt is treated as part of the debt. A commercial debt is one
where the debtor is entitled to a deduction for interest paid or payable.9 Where
9
This definition still applies, even if a statutory exception prevents the deduction.
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interest is not charged on the debt, it will still be considered to be a commercial
debt if, had interest been charged, it would have been deductible for the debtor.10
Under section 245-35 ITAA 36, a debt is taken to be forgiven when:
 The debtor’s obligation to pay the debt is released, waived, or
otherwise extinguished;
 The debt becomes barred by the statute of limitations;
 A debt/equity swap occurs;
 An “in substance forgiveness” arrangement takes place; or
 A “debt parking” arrangement takes place.
An “in substance forgiveness” arrangement is an agreement between the
debtor and creditor where the debtor is effectively released from the obligation
to pay the debt, apart from liability to pay some nominal or insignificant amount
in the future.11 A “debt parking” arrangement involves an assignment of the debt
by the creditor to a third party that is associated in some way with the debtor.12
This assignment is usually performed for consideration that is lower than the
amount owed. Although the debtor remains legally liable to pay the assignee in
full, there is an understanding that the assignee will not seek recovery of the
debt.
As in n. 8, supra, the debt is still considered commercial, even if a statutory exception prevents
the deduction.
11 Woellner et al., Australian Taxation Law, 773 (9th ed., CCH Australia, 1999).
12 Id.
10
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Where a commercial debt is forgiven, Division 245 allows the net forgiven
amount to be applied to lower the “reducible amounts”13 to which the debtor is
entitled, in the following order:
a. Deductible revenue losses carried forward from a previous year;
b. Deductible net capital losses carried forward from a previous year;
c. Certain deductible expenditure carried forward from a previous year;
and
d. The relevant cost base of reducible assets other than excluded assets.
Where the amount forgiven exceeds the total of the reducible amounts, the
excess will not be assessable. As stated in section 245-2, Division 245 ITAA 36
does not apply to the forgiveness of a debt if the forgiveness arises under an Act
relating to bankruptcy.
1.7
The Debtor and Bankruptcy Considerations
An amount that the debtor is unable to pay, or a gain enjoyed by the debtor as a
result of a debt forgiven by a creditor, is not treated as assessable income for a
bankrupt. Rather, specific provisions exist which result in exemptions and
restrictions for deductions of tax losses and for prior capital losses to reduce
subsequent capital gains.
13
“Reducible amounts” are those amounts that would otherwise have been taken
into account to reduce the debtor’s taxable income in the year of income in which
the debt is forgiven or in a later year of income.
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Section 36-35(1) ITAA 97 bars any deduction for tax losses incurred before
bankruptcy. This is subject to section 36-40(1), which permits a deduction for
amounts paid for debts incurred before bankruptcy. Under section 36-45(1), the
total deductions under section 36-40(1) in the income year (for the payment of
debts incurred in the loss year) cannot exceed the amount of the tax loss, reduced by
the sum of:
a. The deductions under section 36-40(1) for amounts paid in earlier
income years for debts incurred in the loss year; and
b. Any amounts of the tax loss deducted in earlier income years; and
c. Any amounts of the tax loss that, apart from section 36-35, would have
been deductible from the bankrupt’s net exempt income for the income
year or earlier income years.
Section 102-5(3) ITAA 97 prohibits the use of prior net capital losses to
determine whether a net capital gain was made in the year a taxpayer becomes
bankrupt or in the year a taxpayer is released from debts under bankruptcy law
or for any subsequent income year. However, this determination needs to be
considered alongside section 104-210, which provides that where a taxpayer later
pays all or part of a debt that was taken into account in working out the amount
of a net capital loss that could not be applied because of section 102-5(3), some or
all of the denied amount may be reinstated as a new capital loss in the year in
which the payment is made.
2.0
UNITED KINGDOM
2.1
Deductions by the Creditor for Bad and Doubtful Debts
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In the United Kingdom,14 under section 74(1)(j) of the Income and Corporation
Taxes Act 1988 (ICTA), a bad or doubtful debt can be deducted to the extent it is
estimated to be bad, provided it is from a trading transaction brought to credit
on an earnings basis.15 This provision applies whether it relates to the supply of
goods or services, or to a creditor engaged in a business that consists of
advancing money, such as banking or money-lending.16 The question whether a
debt is bad is a question of fact and the onus of proof is on the creditor to show
that the debt was bad.
Further aspects relating to bad and doubtful debts for the creditor include
the following:

If the debtor is bankrupt or insolvent, the debt is deductible except to the
extent that any amount may reasonably be expected to be received on it. 17

Debts or parts released wholly and exclusively for trade purposes as part
of a voluntary arrangement under the Insolvency Act 1986 or a compromise
or arrangement under Companies Act 1985 are also deductible.18
The United Kingdom refers to Great Britain (England, Scotland, Wales) and Northern Ireland.
Tax provisions are enacted and interpreted with a view to producing identical effects, as far as
possible for all countries of the United Kingdom. See Simon’s Direct Tax Service vol. 2, para.
A.1.153 (Butterworths, 2002).
15 Simon’s Direct Tax Service vol. 3, para. B.3.1461 (Butterworths, 2002).
16 Thus, in CIR v. Hagart & Burn-Murdock HL 14 TC 433 (1929), losses on advances to clients by
solicitors were refused, as there was no evidence that they were money-lenders.
17 Glyn Saunders et al., Tolley’s Income Tax 2001-02 para. 71.44 (86th ed., London:
Reed Elsevier).
18 Id.
14
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2.2

Where the market value of an asset accepted in satisfaction of a trading
debt is (on the date of acceptance) less than the outstanding debt, the
deficit may be allowed as a deduction.19

Advances to finance or recoup the losses of subsidiary or associated
companies are treated as capital.
The Capital Gains Tax Provisions for a Creditor
Although debts are specifically included as assets under section 21(1) of the
Taxation of Chargeable Gains Act 1992 (“TCGA”), the general rule is that disposal
by the original creditor of a debt does not give rise to a chargeable gain or an
allowable loss. However, there are several exceptions to this general rule, and
they include:
a. The disposal of a debt on a security (section 251(1) TCGA)
A debt on a security is not defined by statute. Inland Revenue considers the
definition of “security” in section 132 TCGA as exhaustive, but this only
includes loan stock or similar security of the UK or any other government, or
of any public or local authority in the UK or elsewhere, or of any company.
Moreover, it does not have to be secured: a debt on a security does not
include mortgages or charges or other debts in which security is given. It has
been distinguished from an ordinary debt in that it is a debt with “added
characteristics”, which enable it to be realized or dealt with at a profit. Some
of the added characteristics include:20
19
20
Id.
Simon’s Direct Tax Service vol. 4, para. C.1.408 (Butterworths, 2002).
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
The debt is for a fixed long term.

The amount required to repay the debt before the end of the term is linked
to the market value of the debt at the time of repayment, calculated on the
assumption that it would run its full term.

The debt carries interest and consequently produces income for the
creditor.

The debt is marketable, because of the above factors.

If the debt is evidenced in writing, this may be a further indication that it
is more than an ordinary debt, although this is not essential for it to be a
debt on a security.
b. Certain debentures (section 251(6) TCGA)
A debenture issued on or after 16 March 1993 is deemed to be a security
where it is issued on a company reorganization or reconstruction. This means
that on an exchange of shares or securities with accrued gains in return for
such debentures, the gain will be rolled over and will be charged on its
subsequent disposal.21
c. Certain loans to traders (section 253 TCGA)
If a loan is made and used wholly22 for the purposes of a trade by the
borrower and all or part of the loan cannot be recovered, the lender may in
21
22
CCH British Tax Guide vol. 1, para. 234-750 (Oxfordshire: Croner.CCH, 2000).
However, in some situations, there may be an apportionment if a loan is partly used for the
borrower’s trade and partly used for non-trade purposes.
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certain circumstances claim relief for an allowable loss. “Trade” is defined to
include a profession or vocation, but expressly excludes any trade involving
the lending of money. Relief extends only to the principal; interest is
excluded. The borrower must be a resident of the UK and no relief is available
where the amount has become irrecoverable because of the terms of the loan
itself.
2.3
The Loan Relationship Regime
The loan relationship regime under the Finance Act 1996 (“FA 96”) applies to
companies. A “company” is defined as any body corporate or unincorporated
association, but does not include a partnership or local authority or local
authority association.
The aim of the Finance Act is to remove the distinctions in the tax
treatment of the various types of loans and securities for corporate borrowers
and lenders by bringing all “loan relationships” within the corporation tax code
on income.23 The regime covers all profits, gains and losses including those of a
capital nature arising from a company’s loan relationships and related
transactions. A company has a loan relationship if:
a.
It is either a creditor or a debtor for a money debt; and
b.
That debt arises from the lending of money.
A “money debt is defined in section 81 FA 96 as a debt which can be
satisfied by the payment of money or by the transfer of a right which is itself a
money debt (such as a company security). Examples of loan relationships include
mortgages and company securities (other than shares). Unless there is an express
23
Chris Whitehouse, Revenue Law Principles and Practice 547 (16th ed., Butterworths, 1998).
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provision to the contrary, any amounts brought into account under the loan
relationship legislation are not considered for corporation tax purposes under
any other provision.24 An asset representing a loan relationship is treated as a
“qualifying corporate bond” and is exempt from the capital gains tax provisions
of the TCGA.
Income and expenditure come within the scheme when they are credited
or debited to either the company’s profit and loss account or to any reserve other
than a share premium account, provided the company’s accounting treatment is
on either an accrual or mark-to-market basis. Expenses for which relief is
available are restricted to those incurred in bringing the loan relationship into
existence, making payments under that relationship and ensuring that payments
are received; and expenses for a “related transaction”, which is defined under
sections 84(5) and (6) FA 96 as any disposal or acquisition of rights and liabilities
under a loan relationship.25 The concept of “related transaction” is significant,
because all profits, gains, or losses resulting from such transactions have to be
brought into account. It encompasses release, redemption and sale of a debt.
Under section 82(2) FA 96, when a loan is entered into for the purposes of
a company’s trade, profits and gains are taxable and interest charges and
expenses are deductible for calculating the company’s trading profits. Section 83
FA 96 deals with non-trading profits, losses and expenses.
If an accrual basis is used, then it is assumed under section 85(3c) FA 96
that all amounts payable under a loan relationship will be paid in full when they
become due. However, an exception is provided under Schedule 9, paragraph
5(1) FA 96, which allows a deduction to the extent that a debt is a bad debt, or a
doubtful debt that is expected to be bad, or involves a liability that is released. A
24
25
Simon’s Direct Tax Service vol. 5, para. D.2.1107 (Butterworths, 2002).
John Tiley, Revenue Law 836 (4th ed., Oxford: Hart Publishing, 2000).
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debt is only released if the creditor has formally waived the debtor’s obligation to
pay.
2.4
Company Acquisitions Through an Equity/Equity Swap
A sale of a company may take several forms, including a purchase of the assets of
the target company, a purchase of the shares of the target company for cash, and
an equity/equity swap.
An equity/equity swap involves a share exchange where the shareholders
of the target company are left with the shares of the purchaser. Capital gains tax
is not normally payable by the shareholders of the target company, because a
roll-over deferral is available under section 135 TCGA. It is necessary that the
arrangement has a bona fide commercial purpose and that confirmation be
obtained from Inland Revenue that this requirement has been met. Furthermore,
the following conditions must be satisfied:
a. The company issuing the shares owns or acquires more than 25 percent of
the ordinary share capital of the target company; or
b. The company issuing the shares does so as a result of a general offer made
to shareholders of the target company or to a class of shareholders, and
the company issuing the shares holds or, as a result of the exchange,
acquires voting control over the target company. This condition was
introduced to conform to the provisions of the European Union (“EU”)
Directive on cross-border mergers.26
26
Simon’s Direct Tax Service vol. 4, para. C.2.727 (Butterworths, 2002).
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2.5 Debt Release under the Income and Corporation Taxes Act: Implications
for Debtors
Under section 94 of the Income and Corporation Taxes Act 1988 (“ICTA”), if a trader
owes a debt, which the trader deducts as a trade expense, and the debt is later
released by the creditor, then the debt becomes a taxable trade receipt against the
debtor in the year of its release.27 The mere failure to pay a debt does not give rise
to a trading receipt; and the provision only applies if a deduction had been
allowed in an earlier year. Moreover, the view of Inland Revenue is that there is a
release under section 94 ICTA whether the release is gratuitous or for value,
although the extent of any value received would have to be brought into account
to reduce the sum taxable.28
This provision has no application to a release forming part of a voluntary
arrangement under the Insolvency Act 1986 or a compromise or arrangement
under section 425 of the Companies Act 1985.
3.0
UNITED STATES
3.1
Deduction by the Creditor for Bad Debts
In the United States, the law relating to bad debts is subject to special tax
treatment and is dealt with under section 166 of the Internal Revenue Code 1986
(“IRC”). It is mutually exclusive29 from section 165 IRC, which deals with losses
for deduction purposes generally.30
Whitehouse, supra n. 23, at 128.
Tiley, supra n. 24, at 424.
29 G. Newton & Gilbert Bloom, Bankruptcy & Insolvency Taxation 52 (New York: John
Wiley & Sons, 1991).
30 This is to be contrasted with the position in Australia considered earlier.
27
28
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A distinction is drawn between business debts and non-business debts in
section 166 IRC. Under section 166, business bad debts can generally be deducted
from gross income if a debt or part of a debt becomes worthless. By contrast,
non-business bad debts are treated as short-term capital losses, subject to an
annual deduction limitation of US$3000 (US$1500 per year for married
individuals filing separate returns).31 Non-business bad debts can only be
deducted when the entire debt is worthless; deduction for part of a bad debt
(which is allowed for business bad debts) is not available for non-business bad
debts.
Business debts arise from the taxpayer’s trade or business. Under
Treasury Regulation (“reg.”) 1.166-(5b), a business debt is a debt that is either (a)
created or acquired in connection with the trade or business of the taxpayer who
is claiming the deduction; or (b) the loss from the worthlessness of which has
been incurred in the taxpayer’s trade or business.
To qualify for the more favorable tax treatment for business bad debts, the
taxpayer must meet the “dominant motivation test”, under which the taxpayer
must show that the dominant motivation in making the payment was businessrelated. The bad debts of a corporation are always presumed to be business bad
debts.32
In order to obtain a deduction under section 166 IRC, it is necessary that:
a. A debt exists, which arises from a true debtor-creditor relationship based
upon a valid and legally enforceable obligation to pay a fixed or
determinable amount of money.33 The courts will consider both substance
CCH Editorial Staff Publication, 2002 U.S. Master Tax Guide 344 (Chicago: CCH
Inc., 2001).
32Internal Revenue Publication No. 535, Business Expenses, 46, available at
<http://www.irs.gov/pub/irs-pdf/p535.pdf >.
33 CCH Editorial Staff Publication, Federal Tax Manual 2001 para. 2401 (Chicago:
31
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and form in determining whether a debtor-creditor relationship or a
shareholder-corporation relationship exists.
As an exception, a business bad debt deduction is not available to
creditors who hold a debt that is evidenced by a bond, debenture, note or
other evidence of indebtedness that is issued by a corporation or
governmental unit, with interest coupons or in registered form. As stated
in section 165(g)(2c) IRC, this is considered “security” and any loss
resulting from a security is treated as a loss from the sale or exchange, on
the last day of a taxable year, of a capital asset.
b. The debt (or part of a debt for business debts) is “worthless”. The creditor has
the burden of showing that there was no reasonable or practical basis for
hope of any recovery of the debt (or part of the debt) at the time the
deduction was taken.34 Mere refusal of the debtor to pay is not sufficient
proof of worthlessness. Moreover, bankruptcy, by itself, operates only as a
general indication of the collectibility of the claim and is not conclusive by
itself.35
A cash-basis taxpayer can deduct a bad debt only if an actual cash loss has
been sustained or if the amount deducted was included in income. For example,
if a note is received by a cash-basis taxpayer in payment of a debt, and is
included in income at its fair market value when received, such value is
deductible if the note becomes worthless. Nearly all accrual-basis taxpayers must
use the specific charge-off method to deduct business bad debts. Only small
CCH Inc.).
Id.
35 Id.
34
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banks and thrift institutions can use the reserve method36 for computing and
deducting bad debts on receivables.37
3.2
Secured Bad Debts for the Creditor
If secured or mortgaged property is sold for less than the amount of the debt, a
creditor is allowed a bad debt deduction under section 166(a) IRC, equal to the
difference between the amount of the debt and the sale price of the property, to
the extent it can be shown that the difference was wholly or partially
uncollectible.38 Accrued interest may be included as part of the allowable
deduction if it had been previously been included as income.
Under reg. 1.166-6, recognition is given to a creditor that buys mortgaged
or pledged property at a loss, and is measured as the difference between the
amount of the debtor’s obligations applied to the purchase or bid price of the
property (to the extent that such obligations constitute capital or represent an
item the income from which has been returned by the creditor) and the fair
market value of the property. There are special rules applicable for the treatment
of mortgaged or pledged property by certain banking organizations.
3.3
Cancellation of Debt Income – the Debtor’s Perspective
Discharge of Indebtedness
The reserve method involves keeping a reserve account for debts, with the amount in the
account subject to a predetermined limit. Bad debts are charged to this account as they arise
and the account is replenished each year. The amount used to replenish the bad debt reserve
account is allowed as an expense.
37 CCH Editorial Staff Publication, 2002 U.S. Master Tax Guide 345 (Chicago: CCH
Inc., 2001).
38 Id.
36
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Under section 61(a)(12) IRC, gross income is defined to include all income from
whatever source it is derived,39 including income from the discharge of
indebtedness. However, section 108(a) IRC provides for exclusions, so that a gain
from the discharge of indebtedness is not included in gross income in certain
circumstances, irrespective of any other provision. The exclusions include:

A debt discharged in a bankruptcy action under Title 11 of the United States
Code, where the taxpayer is under the court’s jurisdiction and the discharge
is either granted by or is under a plan approved by the court; and

A discharge when the taxpayer is insolvent outside bankruptcy. The amount
excluded is limited to the amount by which the taxpayer is insolvent. The
term “insolvent” refers to the excess of liabilities over the fair market value of
assets immediately prior to discharge.
Under section 108(b) IRC, the amount excluded from gross income as a
result of a discharge of indebtedness in a Title 11 case or a debtor’s insolvency is
applied to reduce the tax attributes of the debtor in the following order:
39

Net operating losses (NOL);

general business credits;

Minimum tax credits;

Capital loss carryovers;

Basis reduction for property of the taxpayer;

Passive activity loss and credit carryovers;
This is in contrast to the United Kingdom and Australia.
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
Foreign tax credit carryovers.
For example, the reduction in the tax attribute for NOLs refers to any NOL
for the taxable year of the discharge and any NOL carryover to such taxable year.
The reduction in general business credit carryovers, minimum tax credits,
passive activity credits and foreign tax credits is made at a rate of 33⅓ cents per
dollar of excluded income.
If the excluded income exceeds the tax attributes available to be reduced,
the excess simply goes untaxed.
Discharge of Indebtedness through Debt/Equity Swaps and Debt-for-Debt Swaps
Specific rules apply for debt-equity swaps and debt-for-debt swaps. Under
section 108(e)(8) IRC, a debtor corporation that transfers stock to a creditor in
satisfaction of its indebtedness is treated as having satisfied the indebtedness
with an amount equal to the fair market value of the stock. The corporation will
therefore have income from the discharge of indebtedness to the extent that the
debt exceeds the value of the stock and other property transferred.40
Under section 108(e)(10) IRC, a similar rule applies to corporate or noncorporate debtors who issue debt instruments in satisfaction of indebtedness. A
debtor will be treated as having satisfied the indebtedness with an amount of
money equal to the issue price of the new debt instrument. The debtor will
40
If $20 cash and $50 cash were issued to cancel a $100 debt, the debtor would recognize income
in the amount of $30. CCH Editorial Staff Publication, CCH Standard Federal Tax Reports 2002
vol. 2, para. 7010.051 (CCH Inc.).
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therefore have income from the discharge of indebtedness to the extent that the
debt41 exceeds the issue price of the new debt instrument that is issued.
3.4
Modification of Debt Instruments for the Debtor
Under reg. 1.1001-1(a), when the terms of a debt are modified, the changes need
to be reviewed to determine whether the new terms differ “materially either in
kind or extent” from the old terms. If they do, the old debt is treated as having
been exchanged for new debt for federal income tax purposes, and the debtor
may recognize cancellation of debt income.
Reg. 1.1001-3 requires a significant modification of a debt instrument to
result in an exchange of the original debt instrument for a modified instrument
that differs materially either in kind or extent. Whether the modification of a
debt instrument is “significant” is determined under the rules of reg. 1.10013(e)(1) to 1.1001-3(e)(6):
41

The general rule is found in reg. 1.1001-3(e)(1). It states that, except as
otherwise provided, a modification is considered as significant only if,
based on all the facts and circumstances, the legal rights or obligations
that are altered and the degree to which they are altered are economically
significant.

An example dealing with a particular type of modification is found in reg.
1.1001-3(e)(2), which deals with changes in the yield. Under reg. 1.10013(e)(2), a change in the yield of a fixed rate or variable rate instrument is
automatically a significant modification if it varies from the annual yield
on the unmodified instrument by more than the greater of:
This refers to the “adjusted issue price” of the old debt and any accrued and unpaid interest
previously deducted.
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a) ¼ of one percent; or
b) 5 percent of the annual yield of the unmodified instrument (.05 x
annual yield).
Such a change under reg. 1.1001-3(e)(2) will often take the form of a
reduction in the interest rate, but it may also occur as a result of having
the principal amount of the loan reduced.

Other particular types of modifications include changes in the timing of
payments42 and changes in the obligor or security.43
As stated in reg. 1.1001-3(c)(4), a holder’s temporary forbearance in waiving
a right is not a modification unless the forbearance remains in effect for more
than two years following the issuer’s initial failure to perform and any additional
period during which the parties conduct good faith negotiations or the debtor is
in bankruptcy.
3.5
Corporate Reorganizations
Under sections 351 and 368 IRC, a corporation recognizes no gain or loss on the
exchange of property solely for shares or securities of another corporation when the
exchange is made pursuant to a plan of reorganization.44 Both sides of the
transaction are eligible for such non-recognition, so that no gain or loss from the
transaction is recognized for tax purposes at either the corporate or the
shareholder level if certain statutory and non-statutory requirements are
U.S. Treas. Reg. 1.1001-3(e)(3).
U.S. Treas. Reg. 1.1001-3(e)(4).
44 CCH Editorial Staff Publication, 2002 U.S. Master Tax Guide 590 (Chicago: CCH
Inc., 2001).
42
43
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fulfilled. A reorganization is thus an exception to the general rule that any gain
or loss realized will be recognized when property is exchanged.
The determination of whether a debt instrument is “security” is a factual
one. Although several factors are taken into account, the one typically considered
the most important is the term to maturity of the debt instrument. A debt with a
term exceeding ten years is considered a security, debt with a maturity between
five and ten years is sometimes considered a security, and debt with a term of
less than five years is subject to significant scrutiny and may not be treated as a
security.45
To qualify as a reorganization, a transaction must be undertaken for a
bona fide business purpose and must culminate in continuation of both the
business enterprise and shareholder interests.46 However, as an exception to this
rule, business and shareholder continuity is not required for a recapitalization
under section 368(a)(1E) IRC (see below).
A reorganization must fall within one of the seven categories listed under
section 368(a) IRC The type of transactions encompassed by the section involve
either asset or share acquisitions or single entity reorganizations. Examples of the
seven categories include:
a.
Statutory Merger or Consolidation under Section 368(a)(1A) IRC
This type of reorganization involves asset acquisition, although a merger
is different from a consolidation. In a merger, the acquiring corporation
“survives” after acquiring all the assets and liabilities of the other,
“disappearing” corporation. By contrast, in a consolidation, the two
corporations combine to form an entirely new corporation.
M. Silberbag & S. Goldring, Tax Considerations in Reorganizing Failing Businesses 22-25 (Weil,
Gotshall & Manges LLP, 1998).
46 G. Newton & Gilbert Bloom., supra n. 28, at 137.
45
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The tax consequences for a merger are as follows:
 The disappearing corporation does not recognize any gain or loss upon
the transfer of its assets to the surviving corporation.
 The surviving corporation does not recognize any gain or loss when it
receives the assets from the disappearing corporation.
 The shareholders of the disappearing corporation do not recognize any
gain or loss when they exchange their shares for shares in the
surviving corporation.
b. Type B Reorganization: Share-for-Share Exchange under Section 368(a)(1B) IRC
This reorganization concerns share acquisition. It involves the acquisition
by one corporation of shares in another corporation, solely in exchange for
some or all of its own voting shares (or the voting shares of its parent),
giving the acquiring corporation control47 over the other immediately after
the acquisition.
c.
Type E Reorganization: Recapitalization under Section 368(a)(1E) IRC
The U.S. Supreme Court has stated that “recapitalization” contemplates
reshuffling a capital structure within the framework of an existing
corporation.48 An example of a recapitalization is where a corporation
discharges outstanding bond indebtedness by issuing preferred stock to
its shareholders in exchange for the bonds.
“Control” refers to the ownership of shares that carry at least 80 percent of the combined voting
power of all classes of shares entitled to vote and at least 80 percent of the total number of
shares of all other classes of shares of the corporation. Section 368 (c) IRC.
48 CCH Editorial Staff Publication, 2002 U.S. Master Tax Guide 592 (Chicago: CCH
Inc., 2001).
47
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A holder of a debt instrument can only ensure non-recognition of gains
and losses for tax purposes if the holder surrenders a security and receives
either shares or securities in the exchange. However, if the issue price of
the security received exceeds the issue price of the security surrendered,
any such excess may be subject to tax.49
d.
4.0
Type G Reorganization: Section 368(a)(1G) IRC
This occurs when a corporation in bankruptcy transfers all or part of its
assets to another corporation, but only if the shares or securities of the
receiving corporation are distributed to the shareholders of the bankrupt
corporation tax-free or partially tax-free.
GERMANY
In Germany, the Income Tax Act (Einkommensteuergesetz, or “EstG”) deals with
the taxation of individuals and the Corporate Income Tax Act
(Körperschaftsteuergesetz, or “KStG”) involves the taxation of corporations, mutual
insurance companies and other legal entities under private law. However, under
section 8(1) KStG, the provisions of the Income Tax Act also apply to the taxation
of legal entities unless the Corporate Income Tax Act provides for special rules.
The Reorganization Tax Act (Umwandlungssteuergesetz, or “UmwStG”) deals with
corporate reorganizations.
4.1 Bad Debts and Allowable Business Expenses for Creditors
A taxpayer can deduct all expenses incurred in the conduct of the taxpayer’s
business, irrespective of whether the expenses are necessary, customary or
49
M Silberbag & S Goldring, supra n. 44, at 22-25.
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useful, so long as the expenses can be regarded as relating to the business activity
concerned and are not associated with the taxpayer’s private endeavors or
personal living expenses.50
Bad debts are one example of an allowable business expense for a creditor
(including a creditor corporation). Doubtful or uncollectable accounts receivable
must be written down to their fair market value.
4.2 Rehabilitation Gains for a Corporate Debtor
Under section 3 EstG, if creditors waive part or all of their claims against a
corporation, no taxable income for the corporation is generated, provided:
a. The corporation needs “rehabilitation”;
b. The transaction is entered into for the express purpose of restoring the
corporation to a sound financial position; and
c. The waiver is capable of achieving this purpose.51
A corporation needs rehabilitation if, in the long run, it would not have
been possible to conduct the business at a profit without the waiver. In
determining whether this is the case, various facts are considered, such as the
corporation’s liquidity, its current profitability and the due dates of its liabilities.
The purpose of the waiver is generally assumed to be rehabilitation of the
corporation if several creditors jointly waive part or all of their claims. 52 If only
one of several creditors waives a claim, it must be established that the purpose of
German Tax & Business Law Guide 2001 paras. 122-350 (CCH Europe).
Id., paras. 133-200.
52 Id.
50
51
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the waiver was to rehabilitate of the corporation. Reasons related merely to the
creditor’s own business are not sufficient. According to a decision of the Federal
Tax Court, a rehabilitation gain may also be recognized if the purpose of the
waiver is not rehabilitation of the corporation, but the avoidance of a formal
bankruptcy and making possible a “silent liquidation” of the company.53
4.3 Corporate Reorganizations
Various types of corporate reorganizations are possible under German
reorganization law. They include the following.
Statutory Mergers (Verschmelzung)
As in other jurisdictions, German statutory mergers can take place either as a
consolidation of two (or more) companies into a newly established third
company (Verschmelzung durch Neubildung) or as a transfer of all assets and
liabilities from one corporation to another, so that the transferor corporation
dissolves, leaving the transferee corporation to continue the business
(Verschmelzung durch Aufnahme). For present purposes, only the latter form of
merger will be considered below.
If the sum of the assets and liabilities transferred in a Verschmelzung durch
Aufnahme is outweighed by the consideration that the transferee corporation
receives, a gain could arise. However, provided that certain conditions are met,
section 11(1) UmwStG allows such mergers to be treated as tax neutral, so that a
gain of the transferor corporation is not taxed, but deferred. The closing financial
statements of the transferor corporation must then be based on book values. It is
further necessary that:
53
Id.
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a. The gain remains taxable at the transferee corporation’s level. This
requirement is deemed to be satisfied when the book values of the
transferor’s assets and liabilities are carried over unchanged to the
transferee corporation.
b. In exchange for their shares, the shareholders of the transferor corporation
receive either no consideration or only shares or other membership rights
in the transferee corporation. If consideration is paid in another form (for
example, in cash), taxation relief is not entirely denied; rather it is denied
only up to the amount of the other consideration.
Exchange of Shares for Shares (Takeover of a Company)
This involves an acquisition of a company through a share deal.54 Under a share
deal, the legal existence of the target company remains unchanged and the buyer
of the shares does not have unlimited personal liability for the business debts of
the target company. Liability for the buyer is normally restricted to the share
capital. Under section 23(4) UmwStG, taxation of the acquired company at the
shareholder level can be deferred, provided the following conditions are
satisfied:
a. Both corporations are tax residents of EU Member States and are not
exempt from taxation. However, the shareholders of an acquired
corporation need not be resident in an EU Member State.
54
A target company’s shares can also be acquired through payment in cash. In such a case, a
selling shareholder realizes a capital gain or loss equal to the difference between the selling
price and the value of the shares in the shareholder’s books.
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b. After the exchange of shares, the acquiring company retains or acquires a
majority of the voting shares in the acquired company.
c. Shares are transferred in exchange for newly issued shares in the acquiring
company.
d. Any consideration received in addition to the shares cannot exceed 10
percent of the nominal value of the shares issued.
The transfer of shares can have an impact on the loss carry-forward of the
target company. To carry losses forward, the target must be economically
identical before and after the transfer of its shares. Consequently, the acquired
company may not use its loss carry-forward after the transfer of shares in a share
deal if:

More than 50 percent of its shares were transferred; and

The company continues or resumes the business with predominantly new
assets, although the introduction of new assets is not harmful if the transfer of
new assets serves to rehabilitate an otherwise loss-making business and if the
company continues the business for five years in the same scope.55
5.0
FRANCE
Guides to European Taxation, The Taxation of Companies in Europe: Germany vol. 2, at 185
(Amsterdam: International Bureau of Fiscal Documentation, April 2001).
55
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5.1 Deduction by the Creditor for Bad Debts
A deduction for bad debts is available in France. The calculation must be based
on a debt assessment that takes into consideration the probability and amount of
payment.56 The tax administration has generally disallowed doubtful debt
provisions calculated on a percentage of turnover or on outstanding receivables.
However, the courts have recently been more liberal, allowing the estimation of
losses by grouping similar types of debts whose risks are based on the same
considerations.57
5.2 Tax Consequences of Mergers
In a merger, the shareholders of the transferor company generally receive shares
of the transferee company in exchange for their contribution. In most cases, such
shares are worth more than the original investment. The gain is then rolled over
until a future disposal of the shares. Corporate shareholders are authorized to
value the new shares at the same price as the cost of the old shares.
Unless a special election is made, the transferor company is not subject to
capital gains tax on the assets contributed to the transferee company. The taxes
that can apply in a merger include registration tax, which is imposed on the
value of the assets transferred to the transferee company as a result of the
merger; corporate income tax that is imposed on the parties to the merger; and
value-added tax (“VAT”) that is imposed on the assets transferred to the
transferee company as a result of the merger.
Guides to European Taxation, The Taxation of Companies in Europe: France vol. 2, at 93 (Amsterdam:
International Bureau of Fiscal Documentation, February 2002).
57 Id.
56
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The pre-merger losses of the transferor company are normally lost, unless
their partial or full transfer to the transferee company is authorized by the
Ministry of Finance or they are used to offset capital gains tax on the transfer.
6.0
JAPAN
6.1 Deduction by the Creditor for Bad Debts
A corporation can write off bad debts when it proves that the account receivable
has become worthless in the following cases:58
a. The amount written off is determined according to a reconstruction plan,
special settlement contract, or composition which is admissible under
legal procedures;
b. The amount written off is determined according to a decision of a
creditors’ meeting or an agreement between two parties through a bank as
intermediary;
c. The creditor has given the debtor notice of exemption from liability in
anticipation of no recovery;
d. It is clear that no recovery can be expected because of the debtor’s
financial position; or
58
Yuji Gomi, Guide to Japanese Taxes 1999-2000 at 195-196 (Tokyo: Zaikei Shoho Sha).
56
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e. At least one year has elapsed since the suspension of transactions with the
debtor, or the cost of collection appears greater than the unsettled account
receivable.
Although the direct write-off of accounts receivable is limited to the above
categories, there are reserve procedures that, to some extent, allow deductions to
be taken earlier. For this purpose, bad debt reserves are permitted.
In the calculation of business income, it is also possible for individuals to
obtain a deduction for bad debts. An allowance for bad debts is deductible to a
limit of 5.5 percent of receivables outstanding at the year-end. The allowable
limit for the allowance of bad debts consists of the allowable limits of doubtful
receivables and other receivables.59
6.2 Restructuring of Troubled Debts
Under Japanese tax law and practice, even if the material terms of a debt
instrument are changed or modified, its holder has traditionally not been allowed
to recognize any loss or gain for tax purposes as a result of the change or
modification.60 This applies to an instrument that does not fall within the
category of a “security” and that is not sold, relinquished or otherwise disposed
of.
Nonetheless, for such an instrument, Japanese tax authorities do have the
capacity to recognize taxable gains or to refuse or accept the recognition of
deductible losses, if any material terms of the debt instrument are changed or
modified.61 For example, if a creditor reduces the interest rate of a loan without
Id., at 116.
Yo Ota, Tax Treatments for Distressed Bank Loans: A Comparative Study of the United States and
Japanese Legal Systems, 10 Pacific Rim Law & Policy Journal 543 (May 2001).
61 Id.
59
60
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any justifiable reason, the tax authority may ignore the reduction in the interest
rate and recognize the accrual of taxable income at the original interest rate for
the creditor.
Guidelines have been issued by Japan’s National Tax Agency regarding
the restructuring of troubled loans. They include the following:62
a. If a corporation relinquishes all or part of its loan principal to a debtor, the
corporation is allowed to recognize a deductible loss corresponding to the
amount of the loan relinquished, as long as the relinquishment is:

For the purpose of avoiding a larger loss to be incurred in the future or
for some other compelling reason; or

To prevent the troubled debtor from going bankrupt and is based
upon a reasonable rehabilitation plan or any other reasonable
justification.
b. If a corporate creditor reduces an interest rate or waives interest, the corporation is
allowed to forego recognition of taxable income in an amount equal to the
difference between the arm’s length interest and the reduced or forgiven interest.
In this case as well, it is necessary that the reduction or waiver be executed to
prevent the troubled debtor from going bankrupt and be based upon a reasonable
rehabilitation plan or other reasonable justification.
62
Id.
58