Tax Court Schedules Special Conference Hearing in YA Global Case

YA GLOBAL INVESTMENTS, LP F.K.A. CORNELL CAPITAL PARTNERS, LP, ET AL.,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent

United States Tax Court

ORDER

In these cases, we review notices of final partnership administrative adjustment (FPAA) in which respondent adjusted various partnership items reported by YA Global Investments, LP (YA Global, or the partnership) for the taxable years ended December 31, 2006, 2007, 2008, and 2009.¹ Among other adjustments, the FPAA for the partnership's 2009 taxable year disallowed a deduction described as a “[w]rite-off” of “interest receivable deemed uncollectible.” The partnership's tax matters partners timely filed petitions that assigned error to the FPAAs' determinations. We tried the cases during October 2020, and the parties have submitted extensive briefs. The issues addressed at trial remain under consideration. Despite the thoroughness of the parties' briefs, their treatment of the interest write-off issue leaves us with questions that warrant discussion. Therefore, the Court will schedule the case for a conference hearing with the undersigned. Judge Halpern asks that the parties be prepared to address at that conference the following questions:

1. Respondent argues that “YA Global may not deduct the Interest Write-Off unless the indebtedness on which the interest was accrued became worthless under section 166 during 2009.” But respondent also contends that the partnership was a dealer in securities, within the meaning of section 475(c)(1),² and that the securities the partnership held at the end of 2009, including its convertible debentures and promissory notes, were subject to the mark-to-market rule of section 475(a)(2). Does respondent agree with petitioners that the accrual of interest on a debenture held by the partnership created an asset separate from the underlying debenture? We would expect that respondent instead contends that accrued interest is an element of the underlying security. If so, would it not follow that the interest would be taken into account in determining the security's basis and fair market value for the purpose of determining the gain or loss that the partnership would recognize under section 475(a)(2) if it had sold the security for its fair market value on the last business day of the taxable year? In that event, while the partnership would not be allowed a deduction for uncollectible interest under either section 165 or 166, doubts about the collectability of the interest could reduce the gain or increase the loss recognized by the partnership under section 475(a)(2).

2. In determining the gain recognized by YA Global under section 475(a)(2), respondent relied in part on the partnership's financial reporting. The partnership's Statement of Financial Condition lists Interest Receivable on debentures separately from the underlying debentures. The debentures are included in Investments and, as such, are stated at fair value. By contrast, accrued interest is apparently stated at its nominal amount, unless “management determines that payment by the debtor is unlikely,” in which case the accrued interest is written-off (i.e., stated at zero). As we understand respondent's computations, he has accepted the values at which the partnership stated its debentures but disregarded the partnership's write-off of accrued interest.³ Can respondent explain his inconsistent reliance on the partnership's financial reporting? Does the record establish whether any of the partnership's debentures in regard to which the partnership wrote off accrued interest were stated on its Schedule of Investments at a value less than their face amount? If the record identifies debentures that meet those criteria, can respondent explain why his mark-to-market adjustment effectively assumes that accrued interest increased the value of a debenture dollar-for-dollar even though respondent accepts the partnership's use of a discount in valuing the underlying debenture?

3. Respondent's contention that YA Global is entitled to a deduction for uncollectible accrued interest only if the underlying debentures are worthless suggests that, if the debentures are not subject to section 475(a)(2), a deduction for uncollectible interest could be allowed only under section 166(a)(1) and not section 166(a)(2). Section 166(a)(1) allows as a deduction “any debt which becomes worthless within the taxable year.” Section 166(a)(2) gives respondent, as the Secretary's delegatee, discretion to allow a deduction for “debts” that are “recoverable only in part,” up to the amount the taxpayer “charged off within the taxable year.” Thus, if section 166(a)(2), rather than section 166(a)(1) or 165, governs the deductibility of allegedly uncollectible accrued interest, petitioners would have to establish that respondent abused his discretion in disallowing the deduction. Does respondent go further and contend that section 166(a)(2) cannot apply? If so, what is the basis of respondent's contention?

4. Petitioners' position, as we understand it, rests on the premise that the accrual of interest creates an asset separate from the underlying debenture. Without citing any authority, petitioners write in their opening brief: “When YA Global accrued interest income and reported it on its return, YA Global acquired an asset, i.e., interest receivable, with basis equal to the amount accrued.”

In their answering brief, petitioners refer to YA Global's financial reporting in identifying accrued interest receivable as an asset separate from the underlying debentures. “[I]nterest that YA Global accrued and included in taxable income before 2009, but that it did not collect,” they write, “became an asset/receivable on YA Global's balance sheet.” “As such,” they argue, the accrued interest “was deductible under section 165 when it became uncollectible.” “Even Respondent's own Regulations,” they observe, “suggest that previously earned and taxed interest 'may,' but does not have to be, deducted under section 166 when it becomes uncollectible.” Petitioners refer to Treasury Regulation § 1.166-6(a)(2). Treasury Regulation § 1.166-6(a) addresses the bad debt deduction allowed to a mortgagee when mortgaged property is sold for an amount less than the debt (that is, when the application of the proceeds from the foreclosure sale leaves a deficiency). Treasury Regulation § 1.166-6(a)(1) provides that, if the unsatisfied debt “is wholly or partially uncollectible, the mortgagee or pledgee may deduct such amount under section 166(a) . . . as a bad debt for the taxable year in which it becomes wholly worthless or is charged off as partially worthless.” Treasury Regulation § 1.166-6(a)(2) adds: “Accrued interest may be included as part of the deduction allowable under this paragraph, but only if it has previously been returned as income.”

Petitioners also invoke prior revenue rulings. “[E]ven if previously taxed but uncollectible interest is deductible only under section 166,” they assert, “the deduction is not dependent on the worthlessness of the underlying debt, as Respondent claims.” According to petitioners, “Respondent's own revenue rulings . . . do not require a taxpayer to demonstrate the worthlessness of the underlying debt to deduct accrued but uncollectible interest; a taxpayer need only show that the earned but uncollected interest is worthless.” In that regard, petitioners cite Revenue Rulings 81-18, 1981-1 C.B. 295, and 2007-32, 2007-1 C.B. 1278.

5. Although petitioners allow for the possibility that the partnership's deduction for uncollectible accrued interest might be governed by section 166, their primary position is that the reported deduction should be allowed under section 165. They purport to rely on the principle that, “[w]hen an accrual-basis taxpayer has included income in its tax return that it had a right to receive but has not in fact received, the taxpayer can deduct the amount as an uncompensated loss under section 165 if the receivable becomes uncollectible.”⁴

By its terms, section 166 applies to “debts.” Treasury Regulation § 1.166-1(c) provides: “Only a bona fide debt qualifies for purposes of section 166. A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Receivables of an accrual method taxpayer can also qualify as debts for purposes of section 166. Treasury Regulation § 1.166-1(c) goes on to provide:

The parties' arguments regarding whether YA Global was engaged in a U.S. trade or business during the years in issue (another of the issues raised by the FPAAs) may be relevant to the issue of the partnership's entitlement to a deduction for its write-off of “interest” receivables. Respondent contends, among other things, that the partnership was in the lending business. In disputing that contention, petitioners argue that the convertible debentures the partnership acquired from portfolio companies were, in substance, equity.

6. Petitioners' argument that the convertible debentures were, in substance, equity may prove too much in regard to the interest write-off issue. If the convertible debentures were, in substance, equity, and thus treated as such for Federal income tax purposes, we assume those debentures could not be classified as “bona fide debt,” within the meaning of Treasury Regulation § 1.166-1(c). It would then follow that section 166 would not allow a deduction for previously accrued amounts that prove uncollectible. But if the convertible debentures were really equity, the accrued amounts would not have been interest. Those amounts ought not to have been included in income as they accrued.⁶

7. If we reject petitioners' contention that the convertible debentures that the partnership acquired from portfolio companies were, in substance, equity, would petitioners have any other grounds for contending that the deductibility of uncollectible interest would be governed by section 165 rather than section 166?

8. Are we correct that YA Global reported a deduction for uncollectible accrued interest but reported no deduction for tax purposes attributable to doubts about the collectability of the underlying principal? If so, did the differential treatment of principal and interest for tax purposes reflect a conscious decision, or was it simply an artifact of the partnership's financial reporting? If the differential treatment was advertent, can it be reconciled with the general rule (reflected, for example, in Treasury Regulation § 1.446-2(e)) that partial payments on a debt instrument are applied first to unpaid accrued interest before reducing principal?

9. In an amendment to their petition, petitioners advance the affirmative claim that YA Global's “income for the taxable year 2009 must be reduced by $17,137,938, which represents interest income that the Partnership erroneously accrued in 2009 despite the fact that collection of such interest was doubtful, and it was reasonably certain that such interest income would never be paid.” The petition, both as originally submitted and as amended, assigns error to respondent's disallowance of “the Partnership's deduction in the amount of $46,506,023 for interest write off.” Are we correct that the $17,137,938 that petitioners seek to exclude from YA Global's income for 2009 is included in the $46,506,023 that the partnership reported as a deduction for uncollectible accrued interest? If so, we do not understand how petitioners can ask that we both uphold YA Global's deduction of $46,506,023 and reduce the partnership's income by $17,137,938. Does petitioners' affirmative claim regarding the accrual of interest for 2009 arise only in the event that we uphold respondent's disallowance of the deduction? Or, do petitioners concede that, if we accept their affirmative claim, we should disallow at least $17,137,938 of the deduction in issue?

11. According to the description of significant accounting policies included in YA Global's 2009 financial statements, “[t]he accrual of interest is discontinued when, in the opinion of the General Partner, there is reasonable doubt as to collectability.” And, as noted above, “[t]he Partnership also records a charge to operations for interest receivable that is written-off when management determines that payment by the debtor is unlikely.” The $17,137,938 of accrued interest that is the subject of petitioners' affirmative claim was both accrued into income for 2009 and written off in the same year. Given the description of YA Global's accounting policies included in its financial statements, does that treatment of accrued interest not indicate that the General Partner determined that there was no “reasonable doubt as to collectability” when the interest accrued and that any doubts arose only thereafter?

It is hereby

ORDERED that these cases are set for hearing at a remote Special Session scheduled to commence on Wednesday, August 31, 2022, at 2:00 PM (Eastern Time). It is further

ORDERED that the undersigned will preside over this Special Session. It is further

ORDERED that the Clerk of the Court shall issue a Notice of Remote Proceeding to the parties that contains comprehensive instructions on how to participate in the proceeding.

(Signed) James S. Halpern
Judge