Presented by: Frank M. O’Connell, Georgia Department of Revenue Michael Fatale, Massachusetts Department of Revenue

1. Multistate Tax Commission 2007 State Tax Attorney Teleconference SeriesState Tax and Bankruptcy: Attribute Reduction under IRC Sec. 108 or Bankruptcy Code Sec. 346? Presented by: Frank M. O’Connell, Georgia Department of Revenue Michael Fatale, Massachusetts Department of Revenue

2. Agenda • Introduction and Case Example • Overview of Bankruptcy and Attribute Reduction under IRC Sec. 108 • Bankruptcy Law & State Tax • Provisions of Bankruptcy Code Sec. 346 • Differences Between Bankr. Code Sec. 346 and IRC Sec. 108 • Why Different Federal and State Rules? • Did Taxpayers and States Comply with Bankr. Code Sec. 346? • Why is this Issue Coming Up Now? • Should States Apply Bankr. Code Sec. 346? • Additional Argument - Uniformity • Additional State Administrative Rulings • Virginia • Northeastern State • Southeastern State • MCI Statistics • Significant Companies Recently in Chapter 11 • Plan of Action • MTC Coordinate Drafting of a State Bulletin (implicate FIN 48) • Development of Audit Checklist

3. Cancellation of Indebtedness Income • Outside Bankruptcy • General rule – a discharge of debt for less than the amount due must be recognized as taxable income. See U.S. v. Kirby Lumber, 284 U.S. 1 (1931). • Codified in I.R.C. Sec. 61(a)(12) – gross income includes income from the discharge of indebtedness. • Income recognized is generally the difference between the face amount of the instrument and the amount paid on discharge. • Inside Bankruptcy • I.R.C. Sec. 108(a)(1)(A) - gross income does not include any amount which would be includible in gross income by reason of the discharge of indebtedness if the discharge occurs in a title 11 case. • Quid pro quo for this favorable exclusion of what would otherwise be taxable income – taxpayer is required to reduce certain tax attributes.

4. Attribute Reduction - I.R.C. Sec. 108(b) • Tax attributes are required to be reduced in the following order: • NOLs for the current taxable year and any NOL carryovers. • General business credits under I.R.C. Sec. 38. • Minimum tax credits available under I.R.C. Sec. 53(b). • Capital loss carryovers. • Basis in property, with ordering rules in I.R.C. Sec. 1017. • Passive activity loss and credit carryovers under I.R.C. Sec. 469(b). • Foreign tax credit carryovers.

5. Miscellaneous Rules Affecting Attribute Reduction Under IRC Sec. 108 • Attribute reduction is done after the determination of tax for the taxable year of the discharge. I.R.C. Sec. 108(b)(4)(A). • Attributes are reduced on a dollar-for-dollar basis, except for credit carryovers which are reduced by 33 and 1/3 cents for each dollar of excluded income. • Reduction of NOLs are first applied to current year losses and then to loss carryovers in the order of the taxable years for which they arose.

6. Former Stock for Debt Exception in IRC Sec. 108 • Historically, a corporate debtor did not realize income from the discharge of indebtedness in exchange for the issuance of its stock. • Exception was progressively limited beginning with the Bankruptcy Tax Act of 1980. • Exception was repealed in its entirety by the Revenue Reconciliation Act of 1993. • Current I.R.C. Sec. 108(e)(8). If a corporation transfers stock to a creditor in satisfaction of its debt, such corporation shall be treated as having satisfied its debt in an amount of money equal to the fair market value of the stock.

7. Bankruptcy Law & State Tax – What Law Controls? • Bankruptcy Clause - The Congress shall have the power to . . . establish . . . uniform Laws on the subject of Bankruptcies throughout the United States. Art. I, Sec. 8 of the U.S. Constitution. • Supremacy Clause - This Constitution and the Laws of the United States which shall be made in Pursuance thereof . . . shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby. Art. VI of the U.S. Constitution.

8. Former Bankruptcy Code Sec. 346 • (Note that Bankr. Code Sec. 346 was revised to conform to IRC Sec. 108 for petitions filed on or after Oct. 17, 2005. This presentation deals only with the prior version of Sec. 346, which is still a major concern for states due to the future tax effect of attribute reductions made by taxpayers relying on former Sec. 346.) • (Former) 11 U.S.C.A. Sec. 346(a): Application of Sec. 346 • Except to the extent otherwise provided in this section, subsections (b), (c), (d), (e), (g), (h), (i), and (j) of this section apply notwithstanding any State or local law imposing a tax, but subject to the Internal Revenue Code of 1986. (Emphasis added.) • (Former) 11 U.S.C.A. Sec. 346(j)(1): No COD Income Realized (analogous to IRC Sec. 108(a)) • Except as otherwise provided in this subsection, income is not realized by the estate, the debtor, or a successor to the debtor by reason of forgiveness or discharge of indebtedness in a case under this title.

9. Some Significant Differences Under Old 346(j) Compared to IRC Sec. 108 Old Bankruptcy Code Sec. 346, unlike IRC Sec. 108: • Retains the Stock-for-Debt Exception in Bankr. Code 346(j)(7). • Provides for attribute reduction only to NOLs and asset basis. • Attribute reduction thus does not include credit carryovers, capital loss carryovers and passive activity losses. • Does not allow an election to adjust basis in depreciable assets first.

10. Why Two Sets of Rules? • The US Constitution provides that all tax legislation must originate in the House; the Bankruptcy Tax Act of 1980 (“BTA”) originated in the Senate Judiciary Committee. • The initial draft of the BTA, though, did contain tax provisions applicable to both state and federal. • The Chair of the House W & M Cmte informed the Chair of the Judiciary Cmte of the potential jurisdictional conflict. • The “Special Tax Provisions” in Sec. 346 were thus removed from the draft Senate bill in their entirety, “pending adoption of Federal rules on these issues in the next Congress.” • The House Jud. Cmte then returned the tax provisions to Sec. 346 “so that they may be studied by the bankruptcy and tax bars who may wish to submit comments to Congress.”

11. Why Two Sets of Rules? (continued) • The legis history further indicates the House Jud. Cmte’s intent: • “It is anticipated that early in the 96th Congress, and before the effective date of the bankruptcy code (Oct. 1, 1979), the tax committees of Congress will have an opportunity to consider action with respect to amendments to the IRC (title 26) and the special tax provisions in title 11.” • After a delay of two years, the President signed the BTA of 1980. Note that the federal tax provisions were worked on, as the BTA made substantial changes to IRC Sec. 108 and introduced the concept of tax attribute reduction as the price paid for nonrecognition of COD income. • But, Bankr. Code Sec. 346 was not changed to conform state law to the IRC (esp. to Sec. 108). • Why not?

12. Did Taxpayers and States Comply with Old Sec. 346? • Unequivocally, NO! • 2003 BNA Survey – “Almost all of the [42] states indicated that they conformed to the federal exclusion of discharge of income, reduction of tax attributes, and election to reduce basis. Most of the respondents also said that [the federal election was binding for state purposes as well]”. • Idaho alone cited Bankr. Code Sec. 346 as authority • 2003 ABA Midyear Meeting – Breakout Session – State Bankruptcy Taxation • 2001 Trustee’s Bankr. Tax Manual – “State taxing authorities seem to rely for the most part on the debt discharge and bankruptcy tax provisions of the Internal Revenue Code.”

13. Why Is This Issue Coming Up Now? • Big $$$! • Consultants sometime around 2000 discovered Bankr. Code Sec. 346 and its profit potential. • Example – Taxpayer w/ $1.8B of federal COD attributable to the issuance of new TP stock in satisfaction of debt; estimated that $1B of state NOLs could be preserved using Bankr. Code Sec. 346 instead of IRC Sec. 108. ($60M of state benefit) • Many candidates! Bankruptcy became a viable option for more and more huge multistate businesses. (See chart next page).

14. Introduction – 15 Largest Bankruptcies

15. Should States Apply (former) Bankr. Code Sec. 346? • Statutory argument: Sec. 346 applies “subject to the Internal Revenue Code of 1986.” • Although, with general state conformity to fed, Sec. 346 would then apply to only a few states: • there would be greater overall conformity, federal and state (which is actually what happened); and • Sec. 346 was put back in the bill for study purposes and to elicit comments from the bankruptcy and tax bars. • Counterargument: the intent of adding the phrase, “but subject to the Internal Revenue Code of 1986”, was to make it clear that the Special Tax Provisions would not apply for federal tax purposes.

16. Assuming Bankr. Code Sec. 346 was Meant to Apply to (All) States, Should it be Applied? • Yes - the Bankruptcy Code clearly preempts state law to the contrary; also, the fact that there has been no change even through several significant amendments to the Bankruptcy Code overall implicates the doctrine of “legislative reenactment.” • No, Sec. 346 does not have the force and effect of law: • Sec. 346 was for study purposes and to express the policy that the House Jud. Cmte felt should be applied to state and federal taxes; • Legis history shows that Congress clearly intended uniformity between state and federal bankruptcy tax provisions; • Sec. 346, until recently, had been universally ignored in practice;

17. Bankr. Code Sec. 346: Should it be Applied? (continued) • The inconsistency of Sec. 346 and the federal rules would create tremendous computational difficulties for taxpayers who conform to federal and would have to undo some of the effects of Sec. 108. A few differences of Sec. 346 are that, unlike IRC Sec. 108, Sec. 346: • Could result in a different tax basis affecting depreciation and taxable gain for many years into the future; • Requires tax returns only if the debtor has taxable income during the bankruptcy period; • Suspends the periods of limitations on the use of NOL’s and credits during the pendency of the bankruptcy; • Could lead to some different federal and state tax years; • Is silent with respect to the duty to report income received or accrued for tax years not closed prior to dismissal of the case; and it • Allows the carryback of postpetition NOLs to prepetition years.

18. Do States Really Have to Follow Old 346?Uniformity is Not Promoted • [The Congress shall have power] To establish…uniform Laws on the subject of Bankruptcies throughout the United States. (Emphasis added.) U.S. CONST. art. I, § 8, cl. 4. • The Bankruptcy Clause, which grants Congress the power to make bankruptcy laws, stresses that such rules must be “uniform.” (Emphasis added.) Sherwood Partners, Inc. v. Lycos, Inc., 394 F.3d 1198, 1201 (9th Cir. 2005). • The states’ taxing powers are an attribute of their sovereignty. Can a state argue that it is not bound by old Sec. 346 because it does not promote the purposes of the Bankruptcy Clause? • The supremacy of the bankruptcy code over state law flows from the need for a national uniform law to efficiently and effectively administer the bankruptcy estate and provide a fresh start for the debtor. Following Sec. 346 is opposed to that goal since it prescribes state tax treatment that is substantially different from federal treatment under Sec. 108. • Is there a counterargument that old Sec. 346 at least created uniformity among the 50 states if not with the federal government?

19. Virginia Administrative Ruling • In 2003, the Va. Cmm’r of Rev. ruled that IRC § 108(d)(6) applied over Bankr. Code § 346(a) and (j). Va. Pub. Dec. 03-72 (2003). • In his ruling, the Cmm’r cited the legislative history of the special bankruptcy tax provisions from the 1978 Bankruptcy Reform Act: [T]here is a strong bankruptcy policy that these provisions apply equally to Federal, State, and local taxes. However, in order to avoid any possible jurisdictional conflict with the Ways and Means Committee over the applicability of these provisions to Federal taxes, H.R. 8200 has been amended to make the sections inapplicable to Federal taxes . . . . (Emphasis added.) • Though the bill has been amended to remove Federal taxes from the scope of the four sections, the discussion in this section will proceed as though the bill has not been so amended. This will give a better picture of how these provisions would apply to Federal taxes should the Ways and Means Committee decide in its bankruptcy-tax bill to follow with respect to Federal taxes the proposals made here with respect to State and local taxes. (Emphasis added.) H.R. Rep. No. 595 (1978). (Emphasis added.)

20. Virginia (continued) • Based on this expressed legislative intent, the Va. Cmm’r reasoned: • “The clear intention of Congress is to treat federal, state, and local taxes equally. To treat state and local taxes differently from the federal tax laws after they were excluded from the 1978 Act would be inconsistent with the clear congressional intent of the bankruptcy laws. .” • Thus the Va. Cmm’r, despite the supremacy of federal bankruptcy law, ruled that Va. treatment of COD income should not be different from federal treatment; Va. would therefore apply IRC § 108(d)(6), and not follow Bankr. Code § 346.

21. Current State Cases – Bankr. Code § 346 v IRC § 108?1. A Northeastern State • Northeastern State - TP reduced federal asset basis by $600M, from $700M to $100M. • Federal 1120 depreciation expense was based on $100M and was approx. $10M. • TP took an “Other” subtraction of $50M add’l depreciation expense based on restoring the $600M federal asset basis reduction • $50M X 11% state apportionment = $5.5M add’l state expense • $5.5M X 6% tax rate = $330,000 tax assessment per year

22. Taxpayer’s Argument • The federal asset basis reduction was caused by COD from a stock for debt exchange. Federally this required attribute reduction. TP noted that Sec. 346 retained the stock for debt exception to attribute reduction: • Pursuant to 11 U.S.C.A. Sec. 346(j)(7), “[i]ndebtedness with respect to which an equity security . . . is issued to the creditor to whom such indebtedness was owed, or that is forgiven as a contribution to capital by an equity security holder . . . is not forgiven or discharged in a case under this title . . . .” • Therefore the TP argued that it was entitled to restore the $600M of asset basis and take the add’l $50M of depreciation expense.

23. One State’s Argument • BUT, the state’s Line 28 FTI starting point already includes the effect of the federal asset basis reduction! • Nothing in old 346 requires a state to disregard or adjust the federal reduction of attributes. • The issue is merely the result of the inconsistencies in applying BR Sec. 346 to state taxation and IRC Sec. 108 to federal taxation • SO, we have to follow Sec. 346 but we can essentially give it no effect. • Does TP have an argument that in order to give effect to Sec. 346, it has to be treated as a state subtraction or addition? Or are the specific mechanics required?

24. Current State Cases – Bankr. Code § 346 v IRC § 108?2. Southeastern State • Taxpayer refund claim for $1.6M driven by fed-state adjustments • 2004 return showed the following subtraction • IRC Sec. 382 Bad Debt Deduction = ($189.3M) • Refund Claim of $1.6M was based on 4% apportionment • Note: The 2005 return showed the following addback to federal income • Attribute Reduction Allowed for State Purposes = $45.6M

25. Current State Cases – Bankr. Code § 346 v IRC § 108?3. MCI/Worldcom • Per TP’s 2005 10-k, it estimated the following effects of the reduction of tax attributes for federal and state purposes: • After federal attribute reduction, MCI/Worldcom would have • Zero NOL Carryovers • Zero Capital Loss Carryovers • Zero Credit Carryforwards • And a further $7.2 Billion reduction in asset basis (of which $5.7 B is a reduction in depreciable asset basis) • After state attribute reduction, MCI/Worldcom would have • $557Million in State NOL Carryovers • Presumably no other attributes would be reduced

26. Companies Recently in Chapter 11

27. Companies Recently in Chapter 11

28. Companies Recently in Chapter 11

29. Companies Recently in Chapter 11

30. Companies Recently in Chapter 11 2002 Companies (Continued)

31. Plan of Action • MTC Coordination of the Drafting of a State Bulletin (implicating the new FASB standards in FIN 48) • Development of an Audit Checklist