DEBT RESTRUCTURING: The owners of a distressed hydroelectric project tried — apparently without success — to avoid having to report taxable income after its lenders wrote off part of the project debt. The IRS suggested the scheme would have worked if the debt had been “recourse” debt.

The IRS analysis is in a memorandum — called a “field service advice” — that the IRS national office sent an agent who was questioning the scheme on audit.

A power company formed a special-purpose subsidiary to own a hydroelectric project. The subsidiary borrowed the money it needed to build the project on a “limited recourse” basis from a bank. The parent company pledged the shares in the subsidiary to the bank and guaranteed repayment of the loan.

The project lost money. The parent decided to sell the project. Its subsidiary, the lender and the company that planned to buy the project entered into a three-way agreement where the bank agreed to write down the debt to the purchase price the buyer was willing to pay, and the buyer took over the project and assumed this debt. Ordinarily, when a lender cancels part of a debt from a borrower, the borrower must report the amount cancelled as income. However, this rule does not apply if the borrower is insolvent. The borrower in this case claimed it was insolvent. However, the IRS national office said that insolvency is a shield to having to report income only if the loan was a “recourse” loan. It said the loan is this case was “nonrecourse,” despite the fact that the parent had guaranteed repayment. It went on to say the rule for nonrecourse loans is that a project is always assumed to be worth the full amount of the outstanding nonrecourse debt to which the property is subject when it is sold. The IRS appears to have recast the transaction in this case as a sale by of the project by the borrower back to the bank for the full debt, and then a resale by the bank to the new buyer at a reduced price.

The bottom line was the taxpayer had to report a large capital gain measured by the full amount of the nonrecourse debt. The field service advice is FSA 200135002. It suggests a number of planning possibilities.