adjusted basis in the debt. I.R.C. § 166(b); Treas.Reg. § 1.66-1(d)(1). The basis of a purchased debt is its cost. I.R.C. § 1012; Treas.Reg. § 1.66-1(d)(2)(i).
Glenfed has not taken the position it is prohibited from taking Section 166 deductions under any of the foregoing rules. Notwithstanding the standards for claiming bad debt deductions under Section 166, however, Glenfed argues such deductions, which would require reductions in "basis," would have been precluded by other tax treatment called for under the Merger Agreement and applicable tax rules.
As indicated, the purchase price paid for assets was divided into two components: a cash payment of $ 57 million and the execution of the Note in the amount of $ 20 million. Glenfed's argument that bad debt deductions (and corresponding reductions in basis) could not be effected under Section 166 relates to the fact that part of the purchase price constituted "purchase money debt" which was to be reduced pursuant to the indemnity provision. As described above, to the extent Glenfed suffered Credit Losses, it was entitled, pursuant to the indemnity provision in the Merger Agreement, to reduce the amount of the Note.
The parties agree that under Section 108(e)(5) of the Code Glenfed must treat its indemnification by Armco as an adjustment to its purchase price for the assets of AFC, rather than as receipt of taxable income.
Noting that application of the principle of Section 108(e)(5) is mandatory in this case (Merger Agreement § 6.2),
Glenfed essentially argues that the additional application of Section 166 (for bad debt deductions) as proposed by plaintiffs would result in an anomolous situation as far as the "adjusted basis" in Glenfed's newly acquired assets is concerned.
Plaintiffs' approach would involve Glenfed, in the first instance, claiming deductions for the Credit Losses which were suffered. At the time of such deductions, Glenfed would be required to make corresponding reductions in the basis it had in the loan and lease accounts. Next, pursuant to the Merger Agreement, Glenfed would be indemnified by plaintiffs for the Credit Losses sustained. As indicated, indemnification would not come in the form of a cash reimbursement but instead as a reduction in the principal amount of the Note to be paid by Glenfed to Armco.
This procedure would constitute a reduction in the amount of purchase money debt under Section 108(e)(5). Such a purchase price reduction will not give rise to taxable income to the debtor, but, according to Glenfed, "the debtor is required to reduce its basis in the property for which the debt was consideration." (Emphasis added) Defendant's First Brief at 8.
Glenfed's particular problem with plaintiffs' approach to the dual application of Sections 166 and 108(e)(5) of the Code is that, once the basis in the bad loan accounts has been reduced to reflect the bad debt expense deduction, there will be no basis remaining in the loan accounts to reflect the subsequent basis reduction pursuant to Section 108(e)(5). Glenfed considers it inappropriate or unusual to reflect the downward adjustment in the purchase price by reducing the basis Glenfed has in assets other than the loans, whose worthlessness initially triggered the purchase price reduction. In the words of Glenfed:
the rule surmised (sic) by Armco's advisers, however, would permit a current deduction under section 166 even though the expenditure underlying that deduction was recovered in the year of the deduction, with such recovery taken into account merely as an adjustment to the adjusted basis of other acquired assets.
Defendant's First Brief at 10 (emphasis added). Stated alternatively, "the tax cost of an improper current deduction would be a potential tax increase in the indeterminate future (upon the sale of other property the basis of which was adjusted)."
While Glenfed argues that the proposed Section 166 deductions would be "improper current deductions," at most it is suggesting that the result of subsequently reflecting the downward basis adjustment (resulting from the deemed purchase price reduction under Section 108(e)(5)) in other assets seems anomolous. No authority has been presented which indicates that Armco's proposed treatment of the Credit Losses is improper. Glenfed itself has indicated that regulations interpreting the operation of Section 108(e)(5) have not been issued and it has not located any authorities bearing directly on this issue. Defendant's First Brief, p. 10.
It is noted, moreover, that Glenfed's proposed reconciliation of the application of Sections 166 and 108 (e)(5), in situations such as this one, gives rise to a strange result as well. Under Glenfed's construction of the rules, the owner of loan and lease accounts would be flatly denied a bad debt expense deduction for the Credit Losses, simply because of the fact that the purchase price for AFC was comprised of both cash and purchase money debt (which implicates Section 108(e) (5) of the Code). There appears to be no direct authority for such a result.
Glenfed's position supports a result that, as between the anomolies of (1) effecting the purchase price reduction under Section 108 (e)(5) by reducing the basis in assets other than in the loan accounts which gave rise to the purchase price adjustment and (2) eliminating altogether the availability of a deduction for bad debt expenses (which were in fact incurred), the former anomoly is more important to avoid than the latter.
Because it is concluded that, even if Glenfed had claimed deductions for all of the Credit Losses, it would not have "realized tax benefits" within the meaning of the Merger Agreement, it is not necessary to explicitly reject Glenfed's interpretation of the interrelationship between Sections 166 and 108(e)(5) in this situation. Accordingly, for purposes of the Tax Motion, plaintiffs' construction of the applicable rules is accepted and it is assumed that Glenfed, under applicable tax law, could have claimed Section 166 deductions for the Credit Losses in the year they were sustained.
Glenfed next argues that, even if it is assumed Section 108(e)(5) does not preclude the applicability of Section 166, it was not required under federal tax principles, or explicitly by the Merger Agreement, to take deductions for the Credit Losses. The Board of Tax Appeals noted in a 1925 case that "a taxpayer may neglect or refuse to make a correct computation of income in a given year and pay a greater tax than he owes -- and nobody will force the excess tax back upon him." Even Realty Co. v. Commissioner, 1 B.T.A. 355, 362 (1925).
It is pursuant to the Merger Agreement (although not explicitly provided for)
that Glenfed was duty-bound to take advantage of the Section 166 deductions for the Credit Losses to the extent available. As persuasively explained in plaintiffs' brief, in interpreting a contract, a court must give all of its terms a reasonable and lawful meaning. See Restatement (Second) of Contracts, § 203(a) (1979).
Section 6.7(b) of the Merger Agreement provides:
Notwithstanding anything to the contrary contained in sections 6.1 through 6.4 and this section 6.7, the Indemnitee shall be entitled to indemnification hereunder for any loss, damage, or expense which it suffered only after giving effect to, and taking the net amount after, all realized tax benefits, realized insurance proceeds, and other realized recoveries relating thereto.