an administration expense but only to the extent of the value of the retained interest.

Discussion

This provision represents a departure from current law under which gains from the sale of assets, other non-operating income, and operating income are subject to tax. The proposal also differs from the proposed treatment of straight bankruptcy proceedings which would exempt from tax operating as well as nonoperating income (proposed § 5-104 (a)). It is worth noting at the outset that it is doubtful whether the proposed disallowance of losses realized from the sale of assets not in the ordinary course of business will amount to a quid pro quo för the proposed nonrecognition of gains on such sales. The symmetry is probably more apparent than real since a debtor could avoid having his losses disallowed by merely selling his loss assets prior to the Initiation of the reorganization proceeding.

Although the Commission proposes to tax operating income generated during a chapter VII reorganization it believes that to tax gains on sales made out of the ordinary course of business ". . . unfairly burdens the creditors, whose recovery would not have been reduced by the amount of such tax if they had simply seized the debtor's assets without resorting to proceedings under the Act..." (Commission Report, Part I, page 281.) We are not persuaded by this reasoning. If a debtor conveyed an asset to his creditor in payment of a debt the tax consequences to the debtor would be the same as if he had sold the asset for the amount of the debt and then turned the proceeds over to the creditor. We see no reason why the tax consequences should be different merely because the asset is sold during the course of a reorganization proceeding. Accordingly, it is our view that non-operating as well as operating income should be taxed when generated during the course of a debtor rehabilitation proceeding such as the proposed chapter VII reorganization.

An additional reason for taxing non-operating income such as gain from the sale of assets not in the ordinary course of business is that such assets may be subject to substantial nonrecourse liens, i.e., liens on which the debtor is not personally liable.

Nonrecourse liens form the cornerstone for so-called tax shelters since they can be used to generate depreciation deductions far in excess of the amount of money which the taxpayer pays out or becomes obligated to pay out. In theory the taxpayer must pay the piper when he subsequently sells the asset since the balance due on the lien must be included in the "amount realized" on the sale. It appears to us that if the Commission's tax exemption proposal is enacted then a convenient method of cheating the piper would be to sell assets of this nature in a chapter VII or IX reorganization.

In a similar vein the proposal to exempt gain on the sale of assets not in the ordinary course of business would nullify the depreciation recapture provisions of sections 1245 and 1250 of the Internal Revenue Code. Normally these depreciation recapture provisions override other provisions that provide for nonrecognition of gain sinee both sections provide that, ". . . Such gain shall be recognized nonwithstanding any other provision of this subtitle." (Emphasis added, sections 1245 (a) (1) and 1250 (a)(1).) However, by their terms, these provisions only override nonrecognition provisions in Subtitle A of Title 26 of the United States Code. It seems clear that sections 1245 and 1250 would be overridden by proposed section 7-315(c) since the latter section provides that,

"No taxes on or measured by income shall be payable and no loss shall be allowed under any law of the United States. . . now in force or hereafter enacted... in respect to sales of assets not in the ordinary course of business. . . ." (emphasis added).

As indicated above we are not in favor of exempting gains from tax merely because they arise from the sale of assets not in the ordinary course of business. The proposed provision to the effect that the tax on such gains will be allowed as an administrative expense to the extent of the value of any interest which the owners retain in the debtor does little to alter our opinion on this score. We believe that this provision would be hard to administer since the type of proceeding in question can span a number of years and the value of any retained Interest would generally be ascertainable only toward the end of the proceeding. For example sales may be made in years 1, 2 and 3 but the proceeding might not be terminated until year 5. In this circumstance a question would arise as to how to treat the sales on the income tax returns for years 1, 2 and 3. Moreover,

there is always a degree of uncertainty when tax consequences hinge on a "valuation factor". In this regard it appears that valuation could be difficult in the area of proposed chapter VII reorganizations since section 7-301(a) provides that a plan of reorganization may include provisions for "delayed participation rights" in favor of the former owners "... conditioned on the court's determination within a period specified in the plan but not later than five years from the date of confirmation that the reorganized debtor or the successor under the plan has attained a financial status that warrants such participation."

Lastly, we suggest that debtor rehabilitation proceedings should be subject to the same tax rules as liquidating bankruptcy proceedings since the two types of proceedings are readily interchangeable. For example under the current Bankruptcy Act a debtor may convert a pending liquidation bankruptcy proceeding into a chapter XI arrangement proceeding by filing a petition under section 321, and the chapter XI proceeding may in turn be converted back into a liquidating proceeding. Liquidation and rehabilitation proceeding will also remain readily convertible under sections 5-103 and 7-112 of the proposed legislation.

Recommendation

The Internal Revenue Service recommends that the same tax rules be made applicable to rehabilitation and liquidating bankrutcy proceedings. It is further recommended that gains from the sale of assets not in the ordinary course of business, other nonoperating income, and operating income should remain subject to taxation.

Subdivisions (b) and (d) of Section 7-315 and Proposed I.R.C. § 172 (d) (7)

The above provisions pertain to (1) the nonrealization of income due to debt cancellation (2) the disallowance of loss carryovers and other deductions to the extent that they are traceable to cancelled obligations and (3) basis reduction. Subdivision (b)—Exemption From Income Taxes as a Result of Adjustment of

Indebtedness

Proposed section 7-315(b) provides, in essence, that a debtor shall not realize income by reason of debt adjustment; however, deductions for current expenses and loss carryovers shall be disallowed to the extent that the obligation to pay such items is cancelled in the proceeding.

The first portion of section 7-315(b) to the effect that no income shall “. . accrue to or be realized by a debtor. . ." in a chapter VII case by reason of debt cancellation is consistent with existing sections 268, 395 and 520 of the Bankruptcy Act pertaining to chapter X reorganizations, chapter XI arrangements and chapter XII real property arrangements, respectively. Also see Treas. Reg. § 1.61-12(b) to the same effect.

The latter portion of section 7-315(b) to the effect that, for taxable periods ending after the confirmation of a plan, deductions and loss carryovers are to be disallowed to the extent that the obligations to pay such items or the costs entering into their determination or the obligations to repay funds borrowed for the purpose of paying such items or costs are cancelled or reduced would represent a change in the law. See Rev. Rul. 58-600, 1958-2 C.B. 29 which provides, in part, that the cancellation of a taxpayer's debts does not affect his net operating loss carryovers from prior years if he was insolvent before and after the cancellation. Subdivision (d)—Tax Basis of Property

Proposed section 7-315(d) provides that the tax basis of the debtor's property shall be decreased by the lesser of:

(a) The amount of cancelled debt “. which is excluded from gross income under this section (emphasis added), or

the amount by which the debtor is solvent after the cancella

However, in lieu of reducing basis the debtor may elect to treat the cancelled debt as income in the year in which the plan is consummated. Proposed subdivision (d) also provides that a debt cancelled in exchange for an equity security shall not be considered to have been cancelled for purposes of the subdivisions. In addition subdivision (d) would not apply to the extent that the debt cancellation resulted in the disallowance of deductions, including loss carryovers, under proposed section 7-315(b).

Although not readily apparent from the proposed statutory language the purpose of limiting the downward adjustment to basis to the lesser of the amount of

cancelled debt "excluded from gross income under this section" (emphasis added) or the amount by which the debtor is solvent after the cancellation is to equate the adjustment to basis under proposed chapter VII to that which would occur outside of bankruptcy by reason of debt cancellation.

Under section 61(a)(12) of the Internal Revenue Code discharge of indebtedness results in the realization gross income. However, under section 108(a) of the Internal Revenue Code the taxpayer need not include the discharged amount in income if he consents to a decrease in the basis of his assets under section 1017. The general rule that income results from the discharge of indebtedness is subject to the judicially created exception that income is not realized when the debtor remains insolvent after the cancellation. This exception is also recognized in Treas. Reg. § 1.61-12(b). If the cancellation of a debt does not result in the realization of income by virtue of the fact that the debtor remained insolvent after the cancellation then sections 108(a) and 1017 would not be applicable since there would be no need to rely on section 108(a) to exclude income which was not deemed to have been realized in the first place. Thus, the cancellation of a debt will not result in the realization of income or in a decrease in the basis of the debtor's assets when he remains insolvent.

By the way of contrast if the debt cancellation occurred in a "chapter proceeding" under the Bankruptcy Act then under the literal terms of sections 270, 396 and 522 (relating to chapter X reorganizations, chapter XI arrangements and chapter XI arrangements and chapter XII real property arrangements, respectively) the debtor would have to reduce basis in an amount equal to the debt cancelled in the proceeding even though basis would not have been reduced (or reduced only to the extent of solvency) had he accomplished the same result outside of bankruptcy. As indicated, the proposed legislation is designed to eliminate this discrepancy.

Proposed Section 172(d) (7) of the Internal Revenue Code-Net Operating Losses

Proposed section 172(d) (7) provides, in essence, that net operating losses shall be reduced to the extent such losses reflect obligations that are cancelled or reduced in a proceeding under the Bankruptcy Act or otherwise. The amount by which net operating losses are reduced shall not be included in gross income or result in the reduction of basis under section 1017 of the Internal Revenue Code or chapters VII and IX of the proposed Bankruptcy Act.

Discussion

Under the combined provisions of proposed Bankruptcy Act sections 7-315(b) and (d) and proposed Internal Revenue Code section 172 (d) (7) debt cancellation would have the following effect.

(1) The first adjustment would be to disallow for any taxable year ending after the confirmation of the plan of reorganization any deduction for:

... expenses, interests, taxes, losses, depreciation, and other items and for loss carryovers reflecting such items, to the extent that the obligation to pay such items or the costs entering into their determination, or the obligation to repay funds borrowed for the purpose of paying such items or costs, is cancelled or reduced in a proceeding under this chapter. (Section 7-315(b).)

In non-bankruptcy cases the same result would be reached under proposed section 172(d) (7) of the I.R.C. with the exception that the adjustment would be limited to net operating losses.

It seems clear that the above adjustment prescribed by section 7-315(b) is to be made first (i.e., before any adjustment to basis) since section 7-315(d) provides, in effect, that basis shall not be reduced by reason of a cancelled debt which resulted in the disallowance of a deduction for a loss carryover or other item under subdivision (b). The last sentence of the proposed amendment to I.R.C. § 172(d) contains a similar provision which applies to non-bankruptcy situations in addition to chapter VII and IX proceedings under the proposed Bankruptcy Act.

(2) The second adjustment would be to the basis of the debtor's property under section 7-315(d). Basis would be reduced by the lesser of:

(a) The amount of cancelled debt, “. . . which is excluded from gross income under this section..." (emphasis added), or

(b) "... the amount by which the debtor is solvent after the cancellation..." It is clear from the Commission Report that the above provision is intended to alter the existing basis reduction provisions of sections 270, 396 and 522 of the Bankruptcy Act under which basis is reduced by the amount of debt cancellation

(but not below fair market value) even though the debtor remained insolvent after the cancellation and therefore did not have to rely on the Bankruptcy Act to avoid the realization of income. Commission Report, Part I, page 289.

Elimination of Deductions

We support the proposal to scale down deductions to reflect debt cancellation. However, in its proposed form the legislation may prove ineffective since it appears to require that a cancelled debt be traced to a particular deduction or loss carryover. As a practical matter the tracing requirement will often be difficult if not impossible. For example, if a taxpayer borrowed cash and deposited it in his checking account along with his other cash and daily receipts there would be no way to trace a particular disbursement to the borrowed cash. As a result situations will arise in which debt cancellation will not be taken into account for tax purposes. A cancellation would not result in the realization of income (proposed section 7–315(b)), and if a cancelled debt cannot be traced to a particular deduction or loss carryover then the only potential adjustment would be to basis. However, as a practical matter basis will not be able to be adjusted in many cases since the potential adjustment cannot exceed the amount by which the debtor is solvent.

In view of the foregoing we suggest that the proposed legislation be revised to provide that net operating loss carryover shall be scaled down by an amount equal to the total amount of debt cancelled in the proceeding regardless of whether it can be shown that the cancelled debt contributed to the net operating loss. If the amount of cancelled debt exceeds the net operating loss carryovers then the excess would be applied to reduce basis to the extent that the debtor is solvent.

Reduction of Basis

We agree with the proposal to limit basis reduction to the extent that the debtor is solvent following debt cancellation. The proposal would put debtors in a chapter VII reorganization proceeding on a par with debtors who manage to have their debts reduced in a non-bankruptcy proceeding. In a non-bankruptcy case a debtor would realize cancellation of indebtedness income only to the extent that he is solvent after the cancellation. Thus any basis reduction under section 1017 of the Internal Revenue Code would be limited by the extent of the debtor's solvency since the debtor would only have to rely on a section 108 (a) election to that extent.

However, we think that the mechanics of reducing basis may need further study. For example, are the basis of all the assets to be reduced prorata or when feasible is a cancelled debt to be traced to the basis of a particular asset? Should the basis of depreciable property be reduced before reducing the basis of nondepreciable property? Currently the regulations under section 1017 of the Internal Revenue Code and Treas. Reg. §1.1016–7 provide detailed rules covering basis reduction resulting from debt adjustment. We suggest that the proposed legislation be revised to provide that basis shall be reduced in the manner prescribed by regulations to be used by the Secretary or his delegate. This approach seems particularly appropriate since under the proposed legislation the primary adjustment reflecting debt cancellation will be to net operating loss carryovers, etc., and such adjustments may affect the mechanical aspects of reducing basis. Proposed section 7-315(d) is silent with respect to what happens when a debtor's basis is smaller than the amount by which basis is to be reduced. We think it would be desirable if proposed section 7-315(d) contained a provision indicating whether the excess, if any, of the amount by which basis is to be reduced under that subdivision over the debtor's adjusted basis shall constitute income to the debtor. In the non-bankruptcy area the amount of cancellation of indebtedness income that can be excluded from income under section 108(a) of the Internal Revenue Code cannot exceed the adjusted basis of the debtor's assets. Any excess amount is includible in the debtor's gross income. Rev. Rul. 67-200, 1967-1 C.B. 15 and Rev. Rul. 70-406, 1970-2 C.B. 16.

Recommendation

The Internal Revenue Service recommends the enactment of proposed sections 7-315(b) and (d) and proposed section 172(d) (7) of the Internal Revenue Code subject to the following modifications. It is suggested that proposed section 7315 (b) be modified to provide that loss carryovers are to be reduced by the full amount of debt cancellation regardless of whether a particular cancelled debt contributed to the loss. It is also suggested that a provision be inserted in proposed

section 7-315(d) to the effect that basis shall be reduced in the manner prescribed by regulations to be issued by the Secretary or his delegate. Lastly, we think that it would be desirable if proposed section 7-315(d) specified whether income shall be realized and recognized in the event that the basis of the debtor's assets is less than the amount by which basis is to be reduced under that section.

Section 7-815 (ƒ)—Taw Avoidance

Subdivision (f) of proposed section 7-315 provides as follows:

"Tax Avoidance-If the principal purpose of a chapter VII case was the obtaining of tax benefit, that tax benefit shall be disallowed."

The Commission Report indicates that proposed subdivision (f) is derived from sections 395 and 679 of the Bankruptcy Act. However, sections 395 and 679 operate differently than the proposed subdivision. Sections 395 and 679, which provide that income shall not be realized by reason of debt cancellation, contain the provision"... that if it shall be made to appear that the arrangement had for one of its principal purposes the evasion of any income tax, the exemption provided by this section shall be disallowed." (emphasis added)

Under proposed subdivision (f) if the principal purpose of the chapter VII reorganization was to obtain a tax benefit then that tax benefit will be disallowed, but the subdivision “. . . does not require disallowance of other tax benefits if obtaining them was not the principal purpose of initiating the case..." Com. mission Report, Part II, page 261.

It is questionable whether there can be more than one "principal purpose". In Bobsee Corp v. United States, the Fifth Circuit considered the term "principal purpose" in connection with section 269 of the Internal Revenue Code and held "... that the principal purpose is the purpose which exceeds all other purposes in importance..." 411 F. 2d 231, 238 (1969).

If there can in fact be only one principal purpose then the proposed subdivision seems objectionable. If the purpose of the debtor in initiating a chapter VII reorganization is to obtain tax benefits A, B and C then it is possible that the proposed subdivision will operate to disallow only one of such benefits. If the debtor's principal purpose was to secure tax benefit "A" then that benefit may be disallowed, but the subdivision, “. . . does not require disallowance of other tax benefits if obtaining them was not the principal purpose of initiating the case..." Commission Report, Part II, page 261.

The Internal Revenue Service favors the enactment of a provision similar to proposed section 7-315(f). However, we offer the following suggestions.

(1) It would be desirable to define the meaning of the term "principal purpose" in the statute.

(2) The proposed section should be modified to provide that if the principal purpose is determined to be tax avoidance or evasion then all deductions, credits, allowances and other tax benefits may be disallowed to the extent that they could not otherwise have been enjoyed but for the reorganization proceeding.

(3) In the event that proposed section 5-104 (a) is enacted (exempting estates in liquidating bankruptcy proceedings from taxation) it would be desirable to incorporate a similar provision in proposed chapter V.

(4) A provision should be incorporated in proposed section 7-315(f) to the effect that the subdivision is intended to apply in addition to rather than in lieu of section 269 of the Internal Revenue Code.

Section 269 operates to disallow deductions, credits and other allowances when the principal purpose of an acquisition is to evade or avoid income tax by securing the benefit of such items.

Proposed Amendments to the Internal Revenue Code Proposed I.R.C. § 47(d)— Investment Credit Recapture

The proposed legislation would amend I.R.C. § 47 by adding a new subsection (d) which would read as follows:

(d) Property shall not be deemed to any extent to have been disposed or to have ceased to be section 38 property with respect to a taxpayer solely because title to such property is acquired from a taxpayer by his trustee in bankruptcy, or solely because the basis of such property is reduced pursuant to section 1017 of this title or chapter VII or IX of the Bankruptcy Act of 1973.

Discussion

Revenue Ruling 74-26, 1974-1 C.B. 7 holds that the transfer of section 38 property to a trustee in bankruptcy who does not continue the bankrupt's business constitutes a disposition requiring the recapture of investment credit. The Tax