Transcript Legislative Developments

Legislative Developments
1
Administration’s Fiscal Year 2014
Revenue Proposals –
• Repeal of Section 197 Anti-Churning Rules
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Repeal of Section 197 Anti-Churning Rules
•
In enacting section 197 in 1993, Congress included a provision, section
197(f)(9), to “prevent taxpayers from converting existing goodwill, going
concern value, or any other section 197 intangible for which a depreciation
or amortization deduction would not have been allowable under [prior] law
into amortizable property.”
– Section 197(f)(9) excludes an intangible from the definition of
amortizable section 197 intangible if (i) the intangible was held or used
at any time on or after July 25, 1991, and on or before August 10, 1993
(the “transition period”), by the taxpayer or related person; (ii) the
taxpayer acquired the intangible from a person who held it at any time
during the transition period, and, as part of the transaction, the user of
the intangible does not change; or (iii) the taxpayer grants the right to
use the intangible to a person (or a person related to that person) who
held or used the intangible at any time during the transition period.
•
The proposal would repeal section 197(f)(9) effective for acquisitions after
December 31, 2013.
– The explanation of the provision notes that most of the intangibles that
exist today did not exist during the transition period and would not be
subject to section 197(f)(9), and concludes that the complexity and
administrative burden associated with section 197(f)(9) outweigh the
current need for the provision.
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Codification of Economic Substance
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Economic Substance Codification
•
On March 30, 2010, the Health Care and Education Reconciliation Act of 2010, H.R.
4872 (the “Health Care Reconciliation Act”) was signed by President Obama (P.L.
111-152).
– Section 1409 of the Health Care Reconciliation Act “codified” the economic
substance doctrine (the “ES doctrine”).
– The statute adds new subsection 7701(o), “Clarification of Economic Substance
Doctrine.”
– The statute provides for a strict liability penalty for transactions that lack ES.
•
The statute generally applies to transactions entered into after the date of enactment.
See section 1409(e) of the Health Care Reconciliation Act.
•
On June 28, 2012, the U.S. Supreme Court, in Nat’l Fed’n of Indep. Bus. v. Sebelius,
132 S. Ct. 2566 (2012), upheld key provisions of the Patient Protection and
Affordable Care Act, P.L. 111-148, which was enacted in 2010 along with the Health
Care Reconciliation Act as part of health care reform.
– Accordingly, based on the Supreme Court’s decision, the codified ES doctrine
remains intact.
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Economic Substance Codification
•
The Health Care Reconciliation Act does not as a technical matter codify the ES
doctrine but rather codifies standards for the ES doctrine, if the doctrine is first
determined to be “relevant.” Further, the provision imposes penalties, which is a
critical feature of the enactment.
•
The codification ultimately results from a combination of influences: (1) it carries a
$4.5B revenue estimate (over 10 years) and so was used to help offset the cost of
the health care bill, of which it was a part; (2) eliminates differences among courts in
applying the ES standard; (3) politically it is viewed as part of a crack down on
abusive taxpayers; and (4) it was a political football, first in favor during the last days
of the Clinton administration, then out of favor during the Bush administration, then
Senator Obama co-sponsored one of the earlier bills in 2007, then it passed during
the Obama administration, after having been included in the President’s 2010 Budget
proposal.
•
The most thorough official review of the ES doctrine and codification proposals is in
JCS-3-09 (Sept. 2009) Description of Revenue Provisions in 2010 Budget, Part Two,
pp. 34-72 (“JCT 9/09”).
•
The JCT explanation was continuously refashioned as various bills were introduced,
ultimately resulting in JCX-18-10 (3/21/2010), with the final bill; see also H. Rep. No.
111-443 (3/17/2010) (describing a prior version of the ES provision, and less detailed,
but containing a “reasons for change” section).
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Economic Substance Codification
The JCT 9/09 Description stated the goals of codification as follows:
•
provide partial certainty by resolving the lack of uniformity in different judicial versions
of the tests;
•
possibly lead to more IRS success in asserting ES doctrine by overruling courts that
require taxpayers to satisfy only one “prong” of test;
•
increase level of profit and business purpose required relative to some tests stated by
courts;
•
not change the “existing judicial framework” under which applicability of ES doctrine is
determined;
•
no intent to modify the application or development of other interpretive rules or
prevent the IRS from proceeding on multiple grounds;
•
change taxpayers’ cost-benefit analysis and deter some aggressive taxpayer
behavior; and
•
not displace the common law ES doctrine in cases to which the statute is inapplicable
(such as individual non business/investment activities).
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Economic Substance Codification
•
The statute does not contain certain provisions that were included in prior
versions:
– A statement that other common law doctrines are not affected by
codification of the ES doctrine,
– A grant of general authority to issue regulations to carry out the
purposes of the codified ES doctrine,
– A revision of the penalty rules for certain large and publicly-traded
corporations,
– A prerequisite that a court determine that the ES doctrine is relevant,
and
– A requirement that IRS Chief Counsel assert the strict-liability penalty
(which applied to understatements rather than underpayments).
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Economic Substance –
Section 7701(o)
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New Section 7701(o)
(o) CLARIFICATION OF ECONOMIC SUBSTANCE DOCTRINE.—
(1) APPLICATION OF DOCTRINE.—In the case of any transaction to which the economic
substance doctrine is relevant, such transaction shall be treated as having economic substance
only if—
(A) the transaction changes in a meaningful way (apart from Federal income tax effects)
the taxpayer’s economic position, and
(B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for
entering into such transaction.
(2) SPECIAL RULE WHERE TAXPAYER RELIES ON PROFIT POTENTIAL.—
(A) IN GENERAL.—The potential for profit of a transaction shall be taken into
account in determining whether the requirements of subparagraphs (A) and (B) of
paragraph (1) are met with respect to the transaction only if the present value of the
reasonably expected pre-tax profit from the transaction is substantial in relation to the
present value of the expected net tax benefits that would be allowed if the transaction
were respected.
(B) TREATMENT OF FEES AND FOREIGN TAXES.— Fees and other transaction
expenses shall be taken into account as expenses in determining pre-tax profit under
subparagraph (A). The Secretary shall issue regulations requiring foreign taxes to be
treated as expenses in determining pre-tax profit in appropriate cases.
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New Section 7701(o)
(3) STATE AND LOCAL TAX BENEFITS.—For purposes of paragraph (1), any State or local
income tax effect which is related to a Federal income tax effect shall be treated in the same
manner as a Federal income tax effect.
(4) FINANCIAL ACCOUNTING BENEFITS.—For purposes of paragraph (1)(B), achieving a
financial accounting benefit shall not be taken into account as a purpose for entering into a
transaction if the origin of such financial accounting benefit is a reduction of Federal income tax.
(5) DEFINITIONS AND SPECIAL RULES.—For purposes of this subsection—
(A) ECONOMIC SUBSTANCE DOCTRINE.— The term ‘economic substance doctrine’
means the common law doctrine under which tax benefits under subtitle A with
respect to a transaction are not allowable if the transaction does not have economic
substance or lacks a business purpose.
(B) EXCEPTION FOR PERSONAL TRANSACTIONS OF INDIVIDUALS.—In the case of
an individual, paragraph (1) shall apply only to transactions entered into in
connection with a trade or business or an activity engaged in for the production of
income.
(C) DETERMINATION OF APPLICATION OF DOCTRINE NOT AFFECTED.—The
determination of whether the economic substance doctrine is relevant to a
transaction shall be made in the same manner as if this subsection had never been
enacted.
(D) TRANSACTION.—The term ‘transaction’ includes a series of transactions.
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Notice 2010-62
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Notice 2010-62
•
On September 13, 2010, the IRS issued Notice 2010-62, which provides interim guidance under section
7701(o).
IRS Position on Section 7701(o) Guidance
•
Notwithstanding concerns regarding the need for guidance on section 7701(o), Treasury and the IRS “do
not intend to issue general administrative guidance regarding the types of transactions to which the
economic substance doctrine either applies or does not apply.”
•
Further, the IRS will not issue a private letter ruling or determination letter regarding whether the
economic substance doctrine is relevant to any transaction or whether any transaction complies with the
requirements of section 7701(o).
•
Notice 2010-62 provides that “the IRS will continue to analyze when the economic substance doctrine will
apply in the same fashion as it did prior to the enactment of section 7701(o).”
– Thus, according to the IRS, if authorities provided that the economic substance doctrine was not
relevant to whether certain tax benefits were allowable prior to the enactment of section 7701(o),
the IRS will continue to take the position that the economic substance doctrine is not relevant to
whether those tax benefits are allowable.
– However, an IRS official recently warned that the economic substance doctrine may be relevant in
cases in which the IRS has not previously raised economic substance or considered it in a private
letter ruling.
•
The IRS anticipates that the case law regarding the circumstances in which the economic substance
doctrine is relevant will continue to develop, and states that the codification of the economic substance
doctrine should not affect the ongoing development of authorities on this issue.
Application of Conjunctive Test
•
In Notice 2010-62, the IRS states that it will continue to rely on relevant case law under the common-law
economic substance doctrine in applying the two-prong conjunctive test in section 7701(o)(1).
•
The IRS will challenge taxpayers who seek to rely on prior case law for the proposition that a transaction
will be treated as having economic substance because it satisfies either prong of the two-prong test.
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Notice 2010-62
Reasonably Expected Pre-Tax Profit
•
Under section 7701(o)(2)(A), a transaction’s profit potential is taken into account in determining
whether the two-prong economic substance test is met if the present value of the reasonably
expected pre-tax profit is substantial in relation to the present value of the expected net tax
benefits that would be allowed if the transaction were respected for tax purposes.
– According to Notice 2010-62, the IRS will apply existing relevant case law and other
published guidance in performing this calculation.
•
Treasury and the IRS also intend to issue regulations pursuant to section 7701(o)(2)(B) on the
treatment of foreign taxes as expenses in determining pre-tax profit in appropriate cases.
– In the interim, the IRS notes in Notice 2010-62 that the enactment of section 7701(o) does
not restrict the ability of courts to consider the appropriate treatment of foreign taxes in
economic substance cases.
Accuracy-Related Penalties
•
Notice 2010-62 provides details on what constitutes adequate disclosure under section 6662(i) for
purposes of reducing the no-fault penalty from 40 to 20%.
•
The disclosure will be considered adequate under section 6662(i) if made on a Form 8275 or
8275-R, or in a manner consistent with Rev. Proc. 94-69.
•
If a transaction lacking economic substance is a reportable transaction, the adequate disclosure
requirement under section 6662(i)(2) will be satisfied only if (i) the taxpayer meets the disclosure
requirements described above, and (ii) the disclosure requirements under the section 6011
regulations.
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When Does the Doctrine Apply –
In General
•
A number of considerations must be taken into account in applying the ES doctrine –
–
Whether the ES doctrine is relevant
• Does the transaction tested satisfy the terms of the Code and Treasury regulations
• Whether the benefits claimed are consistent with a Congressional purpose or plan
• What step(s) of the transaction are to be tested
• Whether any “safe harbors” can be applied
• Whether the transaction has been respected under longstanding judicial and administrative
practice, based on meaningful economic alternatives based on comparative tax
advantages
• Whether the transaction falls under the exception for individual transactions
•
–
How the IRS will audit transactions and assert the ES doctrine in light of codification
–
Where the burden of proof will fall on the taxpayers and the IRS
–
Whether it is the ES doctrine that may be relevant (as, for example, compared to other judicial
doctrines)
If the ES doctrine is determined to be relevant, then it must be decided whether the transaction
satisfies the codified ES statute:
–
The taxpayer’s economic position must change in a meaningful way
–
The taxpayer must have a substantial non-tax purpose
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When Does the Doctrine Apply –
In General
•
Definition of ES doctrine
– The statute defines the ES doctrine as the “common law doctrine” under which
benefits “under subtitle A” are not allowable if the transaction does not have
“economic substance or lacks a business purpose.” (emphasis added.) See
section 7701(o)(5)(A).
– What is the purpose of this definition? The statute says that the determination
of whether the ES doctrine is relevant shall be made as if the statute was never
enacted. See section 7701(o)(5)(C).
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When Does the Doctrine Apply –
Congressional Plan or Purpose
•
The statute does not define when the doctrine will be treated as relevant.
•
Statute and JCT report (JCX-18-10) states that “[t]he determination of whether the
economic substance doctrine is relevant to a transaction is made in the same
manner as if the provision had never been enacted.”
– The JCT report further confirms that the provision “does not change present
law standards in determining when to utilize an economic substance
analysis.”
•
Footnote 344 in the JCT report states that “[i]f the realization of the tax benefits of
a transaction is consistent with the Congressional purpose or plan that the tax
benefits were designed by Congress to effectuate, it is not intended that such tax
benefits be disallowed.” (emphasis added.)
– JCT reports for prior versions of ES codification used the term “clearly
consistent.”
– In effect, the “safe harbor” defines the ES doctrine as applying to tax benefits
that IRS perceives not to be consistent with purposes of the particular Code
provision the taxpayer relies on for the tax benefits.
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When Does the Doctrine Apply –
Congressional Plan or Purpose
•
•
What does being consistent with Congressional purpose or plan mean?
–
Congress may not use language that reflects its intent and purpose.
–
Without an explicit statement by Congress, its intent and purpose may be defined
narrowly or broadly.
–
Will the IRS view all benefits that are “unintended” or even “not contemplated” by
Congress to be inconsistent with Congressional purpose and intent and subject to the ES
doctrine?
–
If a taxpayer satisfies the technical requirements of the Code and regulations, should the
ES doctrine apply if no clear statutory purpose or plan is circumvented?
How does the IRS agent determine the intent or plan?
–
Rev. Proc. 64-22, 1964-1 C.B. 689: “It is the responsibility of each person in the Service,
charged with the duty of interpreting the law, to try to find the true meaning of the statutory
provision and not to adopt a strained construction in the belief that he is “protecting the
revenue.” The revenue is properly protected only when we ascertain and apply the true
meaning of the statute.”
–
“The proper method for conveying the positions of the Office and the policies of the
Service is through published guidance. In contrast, litigation should be used as an
enforcement tool to advance and defend established positions, not as a vehicle for making
policy.” I.R.M. 31.1.1.1.3(1).
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When Does the Doctrine Apply –
Congressional Plan or Purpose
Application of the ES doctrine to landmark cases won by taxpayers:
•
Cottage Savings Assn. v. Commissioner, 499 U.S. 554 (1991): Overall transaction of mortgage pool
interest swaps had no possible economic profit and no business purpose; motivated entirely by
desire for tax benefit of loss recognition, and losses were not booked for accounting purposes. [may
be an allowed “longstanding choice” discussed below]
•
Esmark, Inc. v. Commissioner, 90 T.C. 171 (1988), aff’d, 886 F.2d 1318 (7th Cir. 1989): Overall
transaction had business purpose and economic effect, but arguably not the steps by which Mobil
purchased Esmark stock from public, followed by stock’s redemption for stock of Vickers subsidiary
of Esmark; not economically different from sale of Vickers by Esmark.
•
Chamberlin v. Commissioner, 207 F.2d 462 (6th Cir. 1953): No business purpose to distribute
preferred pro rata on common, with plan for preferred to be bought by friendly insurance company.
Ruled for taxpayer; Congress had to change law (section 306).
•
United States v. Cumberland Public Service Co., 338 U.S. 451 (1950): Same overall business
purpose as in Gregory v. Helvering, but no business purpose for step of distributing assets before
their sale, allegedly by shareholders; no economic impact of steps on either corporation or
shareholders other than tax reduction.
•
Frank Lyon v. United States, 435 U.S. 561 (1978): Business purpose for Lyon’s seller/lessee (the
bank) not to have borrowed the money and built its own building; alleged lease economically similar
to that result; no economic savings but tax savings.
•
Gitlitz v. Commissioner, 531 U.S. 206 (2001): Taxpayer allowed to deduct presumably real losses on
account of phantom income providing basis; is this protected from ES doctrine simply because
taxpayer and S corp. did not engage in any “transaction” that they could control in the year at issue?
Should the timing of the discharge of indebtedness of the S corp in that year have been questioned?
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When Does the Doctrine Apply – Certain Credits
•
The JCT report (JCX-18-10) footnote 344 further provides that “it is not intended” that
certain tax credits (e.g., section 42, 45, 45D, 47, and 48 credits) be disallowed in a
transaction “pursuant to which, in form and substance, a taxpayer makes the type of
investment or undertakes the type of activity that the credit was intended to
encourage.”
– The footnote does not cite, but is similar to Rev. Rul. 79-300 (section 183 not
applicable to low income housing partnership even though cannot make any
money, but depends on tax benefit of losses).
•
Does the structure of the investment or the taxpayer’s intent matter if an investment
encouraged by Congress is made?
•
Does the same standard for credits apply for deductions and other tax benefits?
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When Does the Doctrine Apply – “Safe Harbors”
•
According to the JCT report: “The provision is not intended to alter the tax treatment
of certain basic business transactions that, under longstanding judicial and
administrative practice are respected, merely because the choice between
meaningful economic alternatives is largely or entirely based on comparative tax
advantages. Among these basic transactions are[:]
(1) the choice between capitalizing a business enterprise with debt or equity;
(2) a U.S. person’s choice between utilizing a foreign corporation or a domestic
corporation to make a foreign investment;
(3) the choice to enter a transaction or series of transactions that constitute a
corporate organization or reorganization under subchapter C; and
(4) the choice to utilize a related-party entity in a transaction, provided that the arm’s
length standard of section 482 and other applicable concepts are satisfied.”
•
What does the choice between meaningful economic alternatives require?
•
Will the IRS expand the list of “safe harbor” transactions?
•
Noteworthy that these four “safe harbors” provide taxpayers with the ability to avoid
or defer US tax.
•
Often, these “safe harbors” may form part of a larger transaction that will (or will not)
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pass the two prong test in the codified ES statute.
When Does the Doctrine Apply – “Safe Harbors”
1.
2.
The choice between capitalizing a business enterprise with debt or equity -–
The use of debt is the biggest “tax shelter” there is, due to the interest deduction; why is it
excluded? What does this say about perceived Congressional view of debt? Will this be
useful in future debt/equity disputes? Does it matter that the creditor is related (not
according to later “safe harbor”)?
–
Note that the “safe harbor” applies to using debt to capitalize an entity rather than the use of
debt in transactions that the IRS has viewed as “tax shelters” – e.g., Knetsch; Rice’s Toyota;
ACM.
–
What is a “business enterprise”? Is the term limited to entities or does it include sole
proprietorship -- what if the undertaking being financed is an investment and not a business?
–
Does this “safe harbor” support the disaggregation approach since capitalizing a business
enterprise may form part of an integrated transaction that passes the two prong test?
A U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make
a foreign investment;
–
Once again, this “safe harbor” shows the ES doctrine dodging the 2nd biggest “tax shelter”:
the ability to defer tax on foreign income.
–
Does this mean that the “reality” of foreign corporations will be unquestioned?
• JCX-18-10 fn. 347 indicates Bollinger applies to prevent subsidiary from being parent’s
agent except for specific cases.
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When Does the Doctrine Apply – “Safe Harbors”
3. The choice to enter a transaction or series of transactions that constitute a corporate
organization or reorganization under subchapter C;
– How does this square with IRS position when it cites Caruth, 688 F. Supp. 1189,
for “business purpose” requirement for section 351?
– How about Mrs. Gregory, cited in footnote 348 in JCX-18-10?
– JCX-18-10 justifies this “safe harbor” by fact that IRS Chief Counsel will not give
comfort rulings on these transactions.
– Does the “choice” for tax-free treatment include transactions structured to avoid
such treatment?
– Are the reasons for protecting reorganizations and organizations the same?
Corporate reorganizations are subject to several case law and regulatory antiabuse rules, and could be viewed as exempt from the economic substance
doctrine for that reason. Conversely, a thin set of authority purports to require
business purpose for section 351 exchanges and the Treas. Reg. § 1.701-2 antiabuse rule applies to partnership formation.
– What about Treas. Reg. § 1.1002-1 strict construction for nonrecognition rules?
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When Does the Doctrine Apply – “Safe Harbors”
4.
The choice to “utilize a related-party entity in a transaction, provided that the arm’s length
standard of section 482 and other applicable concepts are satisfied.”
–
Why are not all related party transactions particularly suspect?
• This “safe harbor” appears inconsistent with Coltec analysis.
–
Is a related party partnership safer to use than a related party corporation?
–
Doesn’t section 482 rule for intangibles assume that arm’s length prices cannot be trusted
between related parties?
–
Does ES doctrine defer totally to section 482?
–
Who determines whether the arm’s length standard and the applicable concepts are satisfied
– the IRS, a court?
–
Footnote 349 in JCX-18-10 cites to National Carbide and Moline Properties and contrasts
Aiken Industries (back-to-back loans); section 7701(l) and the conduit regulations; and
Bollinger (losses imputed to shareholder from nominee corporation).
• Are these examples of the “other applicable concepts” referred to in the footnote?
• Note Reg. 1.881-3(a)(4) (being related is primary way to trigger conduit financing regs)
• How about Gregory, Higgins v. Smith (sale of loss property to wholly-owned
corporation), McWilliams (“indirect” sales of loss shares between related parties)?
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When Does the Doctrine Apply –
Disaggregation
•
•
•
The statute defines the “transaction” as including a series of transactions.
The JCT report supports not only the aggregation of a series of steps but also a disaggregation of
multiple steps to an isolated step.
According to the JCT report: “The provision does not alter the court’s ability to aggregate,
disaggregate, or otherwise recharacterize a transaction when applying the doctrine. For example,
the provision reiterates the present-law ability of the courts to bifurcate a transaction in which
independent activities with non-tax objectives are combined with an unrelated item having only
tax-avoidance objectives in order to disallow those tax-motivated benefits.”
– The statute as enacted does not provide for a disaggregation approach.
– The JCT report endorses the Coltec approach to disaggregating a transaction in contrast to
other authorities. Cf. Notice 98-5; but see Shell Petroleum 2008-2 USTC ¶ 50,422 (S.D.
Tex. 2008) (refused “slicing and dicing”).
– Does the JCT report accurately summarize how courts have historically applied the ES
doctrine?
• If not, can the disaggregation approach be squared with the general principle that
“present law standards” of applying the ES doctrine not be changed?
• The IRS will likely assert a narrow definition of the transaction.
• Will the IRS approach and legislative history lead courts to shift toward a disaggregate
approach (i.e., will a court be more likely to disaggregate post-codification as compared
to prior periods)?
• See Sala v. United States, 613 F.3d 1249 (10th Cir. 2010) (only the portion of the
transaction that gave rise to the loss should be evaluated for economic substance; this
is the first appellate case after codification but did not refer to the statute).
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If the ES Doctrine is Determined to be Relevant
The Two Prong Test –
The Objective Component
•
The transaction must change the taxpayer’s economic position in a meaningful
way (apart from Federal income tax effects). See section 7701(o)(1)(A).
•
The taxpayer can rely on profit potential to satisfy the objective prong only if the
“present value of the reasonably expected pre-tax profit from the transaction is
substantial in relation to the present value of the expected net tax benefits that
would be allowed if the transaction were respected.” See section 7701(o)(2)(A).
– Satisfaction of the substantial net profit standard in section 7701(o)(2)(A) does
not ensure that objective component is met.
– Note that can rely on profit potential if profit is “reasonably expected” but need
to show “actual” economic change to satisfy the objective prong.
– What else would a taxpayer be required to show? Can a taxpayer satisfy the
prong without actual profit?
– See Sala v. United States, 613 F.3d 1249 (10th Cir. 2010) (1:50 profit potential
to tax savings not enough on relative basis; this is the first appellate case after
codification but did not refer to the statute).
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The Two Prong Test –
The Objective Component
•
A taxpayer may rely on measures other than profit potential to establish that the objective
prong is satisfied.
–
When would a taxpayer need to rely on an alternative measure to show meaningful
change in economic position?
• Examples given in JCS-3-09, but not in the final JCT explanation: financial
transactions and reorganizations may not have quantifiable profit aims.
– A tax free-reorganization should already fall within the “safe harbor” in the JCT
report.
– What about “financial transactions”? Wouldn’t this normally refer to straddles,
hedges, notional principal contracts?
• Transactions designed to claim tax credits may also present difficulties in proving a
pre-tax profit.
– Like tax-free reorganizations, however, these transactions may have another
basis to avoid ES analysis (i.e., consistent with statutory intent and plan).
–
If necessary, how would a taxpayer show a meaningful change in economic position
absent profit potential?
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The Two Prong Test –
The Objective Component
•
Reliance on pre-tax profit
–
How much profit is required?
• There is no absolute minimum dollar amount of profit required.
• However, a small amount of profit may not be treated as substantial in relation to the
tax benefits claimed.
–
What does “reasonably expected” mean?
• JCS-3-09, p. 45, indicates intended to be higher standard than “reasonable
possibility,” used in Rice’s Toyota;
• Note: “reasonable possibility” is too high a standard for section 183, which requires
only “objective to make a profit”
–
How to calculate present value amounts?
• What is the appropriate discount rate?
• Can the taxpayer rely on its normal internal method?
–
What does it mean for net profit to be “substantial” relative to net Federal tax benefits?
• Treas. Reg. § 1.170A-9(f) defines substantial as 1:3.
• Notice 98-5 – 1:12 and ~ 1:8 deemed insubstantial.
• Old “tax shelter” cases in 1980s – any amount of profit may be sufficient
• Con Ed decided on relatively small profit.
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The Two Prong Test –
The Objective Component
•
Reliance on pre-tax profit (cont’d)
–
Fees and transaction expenses must be counted in determining net pre tax profit. See
section 7701(o)(2)(B).
• Consistent with historic approach to ES doctrine.
–
Statute provides that the Secretary “shall” issue regulations to treat foreign taxes as
expenses and transaction fees in “appropriate cases.”
• Treatment of foreign taxes changed repeatedly during days up to codification: “shall
be” treated as expenses, to no reference, to “shall” treat in appropriate cases.
• JCT explanation (JCX-18-10) indicates belief that foreign taxes should be treated as
expenses.
– However, there is no clarity as to what the “appropriate cases” will be.
Transactions described in Notice 98-5?
– The “shall” delegation in the statute should not be treated as self-executing.
But see footnote 357 in JCX-18-10.
• Cf. Notice 98-5: proposed to deny foreign tax credits to transactions that were not
entered into for profit and to deduct foreign taxes as an expense in that analysis;
withdrawn by Notice 2004-19.
• Contra Compaq and IES, which applied ES doctrine to pre-foreign tax profits.
– Theory is that US taxes are not counted, and so neither should foreign taxes
that are creditable.
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The Two Prong Test –
The Subjective Component
•
•
The taxpayer must have a substantial purpose (apart from Federal income tax effects) for
entering into such transaction. See section 7701(o)(1)(B).
–
What was original purpose of this prong in the caselaw? (likely to protect transactions
such as incorporation that could not logically be related to profit motive?) Has this purpose
been lost?
–
Do courts treat the subjective prong as equal to the objective prong?
–
JCT viewed this as the “dominant issue” and an “absolute requirement.” JCT 9/09
The taxpayer can rely on the substantial net profit standard to satisfy the subjective prong as
well as the objective prong. See section 7701(o)(2)(A).
–
Can the two prongs be collapsed into a single prong? See Coltec Industries Inc. v. United
States, 454 F.3d 1340 (Fed. Cir. 2006); Consolidated Edison Co. v. United States, 90
Fed. Cl. 228 (2009).
–
Note that, as with the objective prong, the satisfaction of the substantial net profit standard
technically does not ensure that the subjective prong is satisfied.
• Is anything else needed to be shown?
–
•
If there is no substantial non-tax purpose for the transaction, but the transactions results in
a substantial profit, is the subjective prong satisfied?
Who is the taxpayer tested for subjective intent?
–
For example, a partner in a partnership should be the taxpayer. What if the activities or
motive in question relate to the other partner or the partnership?
30
The Two Prong Test –
The Subjective Component
•
What does “substantial” mean?
• Cf. Treas. Reg. § 1.701-2(a)(1), the partnership anti-abuse rule, requires a transaction be
entered into for a substantial business purpose;
• Cf. Treas. Reg. § 1.355-2(b)(1), which in effect requires a substantial business purpose for a
spin-off: a “substantial part” business purpose is thought not to require either a primary or
more than 50% purpose; 1/3 purpose seems sufficient.
• Cf. Treas. Reg. § 1.355-2(b)(2), as to non Federal tax benefits.
•
Financial accounting benefits derived from Federal income tax savings and state tax benefits that are
related to the Federal tax benefits will not be accepted.
–
•
Accounting benefit concern derived from Enron usage of accounting profits attributable to additions
to deferred tax asset account for future expected acquisition of depreciable property, for example.
Closer to core business the better?
–
Compare Consolidated Edison Co. v. United States, 90 Fed. Cl. 228 (2009) (LILO case won where
property leased was used in same business Con Ed was in); Shell Petroleum, Inc. v. United
States, 2008-2 USTC ¶ 50,422 (S.D. Tex 2008) (property sold was business property)
–
But section 7701(o) says nothing about usual course of business transactions.
• Query: does not fact that Congress chose to make the test a profits test, and to allow it to
satisfy both prongs indicate that Congress understands all businesses and investors intend to
make money any way they can, and so there should be no “regular course of business” test?
Cf. section 162.
31
ES Doctrine
Individual Exception
•
•
•
The statute carves out transactions of individuals unless “entered into in connection with a trade or
business or an activity engaged in for the production of income.”
–
As a technical matter, section 7701(o)(5)(B) only excludes “personal transactions” from the
two prong test set forth in section 7701(o)(1).
–
Thus, the ES doctrine, as codified, technically can still apply to these transactions. What is
the effect?
The exception presumably would not cover transactions where there is an expectation of gross
income (as in section 212)
–
Thus, section 212, the section 183 hobby loss rule, and ES doctrine can all apply to activity
expected to produce gross income
–
Note that section 183 is much easier for taxpayer to prove out of than ES doctrine (need not
even have reasonable expectation of profit)
Does the exception cover transactions designed to reduce taxes?
–
Charitable contribution planning
–
Estate planning
32
Economic Substance –
Strict Liability Penalty
33
ES Codification – Penalties
Section 6662(b)(6) (20% accuracy-related penalty)
Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance
(within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of
law.
Section 6662(i) -- INCREASE IN PENALTY IN CASE OF NONDISCLOSED NONECONOMIC
SUBSTANCE TRANSACTION
(1) IN GENERAL.—In the case of any portion of an underpayment which is attributable to one or
more nondisclosed noneconomic substance transactions, subsection (a) shall be applied with
respect to such portion by substituting ‘40 percent’ for ‘20 percent’.
(2) NONDISCLOSED NONECONOMIC SUBSTANCE TRANSACTIONS.—For purposes of this
subsection, the term ‘nondisclosed noneconomic substance transaction’ means any portion of a
transaction described in subsection (b)(6) with respect to which the relevant facts affecting the
tax treatment are not adequately disclosed in the return nor in a statement attached to the return.
(3) SPECIAL RULE FOR AMENDED RETURNS.—In no event shall any amendment or
supplement to a return of tax be taken into account for purposes of this subsection if the
amendment or supplement is filed after the earlier of the date the taxpayer is first contacted by
the Secretary regarding the examination of the return or such other date as is specified by the
Secretary.
34
ES Codification – Penalties
Section 6664(c)(2):
Paragraph (1) [reasonable cause exception for underpayments] shall not apply to any portion of
an underpayment which is attributable to one or more transactions described in section
6662(b)(6).
Section 6664(d):
(2) EXCEPTION.—Paragraph (1) [reasonable cause exception for reportable transaction
understatements] shall not apply to any portion of a reportable transaction understatement which
is attributable to one or more transactions described in section 6662(b)(6)
Section 6676(c) (erroneous claim for refund penalty):
(c) NONECONOMIC SUBSTANCE TRANSACTIONS TREATED AS LACKING REASONABLE
BASIS.—For purposes of this section, any excessive amount which is attributable to any
transaction described in section 6662(b)(6) shall not be treated as having a reasonable basis.
Section 6662A(e)(2) (coordination of section 6662A penalty with 40% nondisclosed noneconomic
substance transaction penalty)
This section [section 6662A] shall not apply to any portion of an understatement on which a
penalty is imposed under section 6662 if the rate of the penalty is determined under subsections
(h) or (i) of section 6662.
35
ES Codification – Penalties
•
The 20-percent penalty for noneconomic substance transaction applies to any underpayment
attributable to the disallowance of claimed tax benefits by reason of a transaction lacking
economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of
any similar rule of law.
–
What is “any similar rule of law”? Not defined in the statute.
–
See JCX-18-10, fn 359: “It is intended that the penalty would apply to a transaction the tax
benefits of which are disallowed as a result of the application of the similar factors and
analysis that is required under the provision for an economic substance analysis, even if a
different term is used to describe the doctrine.”
• Prior JCT reports did not contain this clarification.
• Based on JCT report, a “similar rule of law” must mean the disallowance of tax benefits
through application of the ES doctrine but not in name (e.g., where the court referred to
the ES doctrine incorrectly (perhaps “sham transaction doctrine” or “business purpose
doctrine”).
• The phrase “similar rule of law” should not mean “sham transaction doctrine” or even
lack of “economic substance,” when those terms actually refer to fact finding (for
example, the business was not actually operated in the corporation), or if they refer to
interpreting a requirement into the statute (“business purpose doctrine”) as in case of
Gregory v. Helvering.
• Beware of tendency of IRS to view all fact finding methods (step transaction doctrine,
etc.) and interpretive methods as “similar rule of law.”
36
ES Codification – Penalties
•
20-Percent Strict Liability Penalty
–
•
An opinion from an outside tax advisor does not provide protection.
Calculation of the Penalty
–
The strict liability penalty applies to the underpayment attributable to a disallowance of
claimed tax benefits by reason of a transaction lacking economic substance.
• What is the connection between the assessment and disallowance required? “But for”
standard?
–
Prior versions of ES contained penalties based on understatement (i.e., under section
6662A).
–
The section 6662A penalty may apply to a non-ES transaction if it is a listed transaction or
reportable transaction with significant purpose of tax avoidance or evasion. See section
6662A(b)(2).
• The section 6662 penalty normally only applies to the excess of the substantial
understatement over the reportable transaction understatement. See section
6662A(e)(1).
• If the transaction is not disclosed and the 40% strict liability penalty applies, then the
section 6662A penalty will not apply to that portion of the understatement. See section
6662A(e)(2)(B).
37
ES Codification – Penalties
•
•
Coordination with the fraud penalty
–
The strict liability penalty does not replace the fraud penalty (a 75-percent penalty on the
underpayment). See section 6663.
–
The ES penalty will not apply to the extent the fraud penalty applies. See section 6662(b)
(flush language)
Coordination with the gross valuation misstatement penalty
–
•
Does the section 6662(h) gross valuation misstatement penalty apply in economic substance
cases?
Amended returns
–
Coordination with section 6676
• The 20-percent strict liability penalty applies equally if the taxpayer claims benefits on
an amended return.
• Compare treatment of “tax shelters” – reasonable basis to avoid penalty on amended
return but MLTN to reduce understatement under section 6662.
–
Cannot disclose a transaction to reduce the strict liability penalty to 20 percent after first
contact.
• Limitation applies even if examination has not raised the issue of ES.
–
What happens if a taxpayer files an amended return after first contact to claim no tax
benefits?
38
ES Codification – Penalties
•
40-Percent Penalty
–
Reduced to 20 percent if taxpayer makes adequate disclosure on return or in statement
attached to return.
–
This is same language as used in section 6664(d)(2)(A) with respect to reportable
transactions.
• Under section 6664(d)(2)(A), the relevant facts affecting the tax treatment of the item
must be adequately disclosed in accordance with the regulations prescribed under
section 6011.
• The section 6011 regulations provide a form for disclosure of (a) the expected tax
treatment and all potential tax benefits, (b) any tax result protection, and (c) describe the
transaction in sufficient detail for the IRS to be able to understand the structure and
identify the parties.
•
IRS assertion of the strict liability penalty
–
Can the IRS assert the ES doctrine and not assert the strict liability penalty?
• If so, can the IRS then assert the substantial understatement penalty?
–
Can the IRS abate the penalty proportionately to the abatement of the tax? No indication in
the bill.
–
What is the last point at which IRS can assert the strict liability penalty? Does it inevitably
follow assertion of the ES doctrine and not have to be separately assessed?
39
Economic Substance –
LMSB Directive on Imposition of
Penalty
40
LMSB Directive
•
LMSB directive on penalty imposition
– On September 14, 2010, the IRS Large and Mid Size Business Division
issued a directive on the imposition of a penalty on a transaction lacking
economic substance.
– According to the directive, “[t]o ensure consistent administration of the
accuracy-related penalty imposed under section 6662(b)(6), any
proposal to impose a section 6662(b)(6) penalty at the examination level
must be reviewed and approved by the appropriate Director of Field
Operations before the penalty is proposed.”
41
Economic Substance –
LB&I Directive
42
LB&I Directive
•
•
On July 15, 2011, the IRS issued an LB&I directive to instruct examiners on how to determine
when it is appropriate to seek the approval of the appropriate Director of Field Operations in
asserting the codified economic substance doctrine.
The directive provides that the examiner must develop and analyze a series of inquiries in order to
seek approval for the ultimate application of the doctrine in the examination.
– As a first inquiry, an examiner should evaluate whether the circumstances in the case are
those under which application of the economic substance doctrine to a transaction is likely
not appropriate.
• The directive provides a list of facts and circumstances that tend to show that
application of the doctrine is likely not appropriate.
– Second, an examiner should evaluate whether the circumstances in the case are those
under which application of the doctrine to the transaction may be appropriate.
• The directive provides a list of facts and circumstances that tend to show that
application of the doctrine may be appropriate.
– Third, if an examiner determines that the application of the doctrine may be appropriate, the
directive provides a series of inquiries an examiner must make before seeking approval to
apply the doctrine.
– Fourth, if an examiner and his or her manager and territory manager determine that
application of the economic substance doctrine is merited, guidance is provided on how to
request approval of the appropriate Director of Field Operations.
43
LB&I Directive
•
•
•
•
The directive provides that, until further guidance is issued, the penalties in sections
6662(b)(6) and (i) and 6676 are limited to the application of the economic substance
doctrine and may not be imposed with respect to the application of any other “similar rule of
law” or judicial doctrine, such as step transaction, substance over form, or sham
transaction.
The directive indicates that the examiner should notify the taxpayer that he or she is
planning to perform an economic substance analysis before commencing that analysis,
and that if the Director of Field Operations decides to proceed, the taxpayer should be
given an opportunity to be heard regarding whether the doctrine should apply.
Depending on the nature of the transaction, the directive provides for various levels of
review of an examiner’s decisions before assertion of the doctrine may proceed.
In applying the directive, when a transaction involves a series of interconnected steps with
a common objective, the term “transaction” generally refers to all of the steps taken
together.
– The directive indicates that in certain circumstances it may be appropriate to analyze
separately one or more steps that are included within a series of interconnected steps,
such as situations where an integrated transaction includes one or more tax-motivated
steps that bear a minor or incidental relationship to a single common business or
financial transaction.
44
Chief Counsel Notice –
Economic Substance
45
Chief Counsel Notice – Economic Substance
• On April 3, 2012, the IRS Office of Chief Counsel issued a notice (CC-2012008) providing instructions to counsel regarding the application of the ES
doctrine, under common law or section 7701(o).
• The Notice provides instructions regarding (i) Counsel’s role in an
examination involving the ES doctrine, (ii) the review of a proposed
statutory notice of deficiency (“statutory notice”) or a proposed notice of
final partnership administrative adjustment (“FPAA”) concluding that a
transaction lacks ES, (iii) required coordination procedures when litigating
the ES doctrine, and (iv) required coordination procedures involving
administrative pronouncements.
• The Notice principally reinforces the procedures outlined in the LB&I
Directive issued in July 2011.
• The Notice expressly provides that the procedures outlined in the Notice
do not create any substantive or procedural rights for taxpayers, and that
the failure to follow any of the prescribed procedures does not invalidate
an otherwise valid notice of deficiency or other IRS action.
46
Chief Counsel Notice – Economic Substance
Examination
• When providing advice during an examination with respect to whether the assertion of
ES is appropriate, Counsel should consider the factors outlined in the two prior LB&I
Directives on ES (even if the case originates from a division other than LB&I) as well as
appropriate case law.
• If the taxpayer under examination previously received a favorable letter ruling or
determination letter involving the transaction under examination, Counsel is to
request that Associate Chief Counsel review and, if appropriate, revoke the ruling
or letter.
• If revocation is appropriate, a proposed adjustment applying the ES doctrine should
not be issued prior to confirmation of such revocation (pursuant to Rev. Proc. 20121).
Statutory Notice and FPAA
• If a proposed statutory notice or FPAA concludes that a transaction lacks ES, Counsel
attorneys must coordinate their review with Division Counsel headquarters and the
Office of the Associate Chief Counsel (Procedure and Administration) (“ACC(PA)”)
• ACC(PA) is to coordinate further National Office review with other Counsel offices
having substantive jurisdiction over the issues involved.
47
Chief Counsel Notice – Economic Substance
Litigation
•
Before raising ES (and any related penalty) as an issue in a Tax Court case or a
defense or suit letter to the DOJ, (i) the same procedures required for a
statutory notice and a FPAA apply and (ii) the same procedures required in the
examination setting for prior favorable rulings or letters apply.
•
Further, National Office review is required before briefs, motions, or letters
involving ES issues are filed or sent.
Administrative Pronouncements
•
Division or Associate Offices with subject matter jurisdiction over administrative
pronouncements (e.g., Appeals Settlement Guidelines and Coordinated Issue
Papers) must review administrative pronouncements to ensure that any
discussion of ES is consistent with the statute, the LB&I Directives, relevant
case law, and the notice. Such review must also be coordinated with ACC(PA).
48
Economic Substance –
Practice and Procedure
49
When Does the Doctrine Apply –
Practice and Procedure
•
Does the IRS have to assert the doctrine?
–
The statute only states that the ES doctrine will apply when relevant.
–
Can a court apply the ES doctrine if the IRS does not raise the issue?
• “..if economic substance as such is not explicitly stated as one of the grounds for
disallowance of tax benefits, the application of the companion penalty provisions may
be in doubt.” JCS 9/09 at p. 47.
–
•
Will a court be likely to independently raise the ES doctrine given the strict liability penalty?
What is the proper time to raise the doctrine?
–
Can the doctrine be raised for the first time in litigation? In appeals?
–
Is RAR expected to be the proper place for assertion of ES doctrine?
–
What legal consequences hinge on timely assertion?
• Applicability vel non – will the doctrine apply?
• The burden of proof shifts to IRS in Tax Court if the doctrine is raised after the petition
is filed. See Tax Court Rule 142(a).
• The ES doctrine or any similar rule of law must be asserted in order to apply the 40percent penalty (even though a 20-percent penalty may be applied for a substantial
understatement apart from a non-ES transaction).
50
When Does the Doctrine Apply –
Practice and Procedure
•
How will the IRS administer the ES doctrine
– What role will LB&I / Chief Counsel have in determinations as to whether tax
benefits are (i) consistent with Congressional plan or purpose, (ii) respected
under longstanding practice, or (iii) permitted under specified safe-harbors?
• Should IRS exam make these decisions? Must these decisions be
confirmed with LB&I / Chief Counsel?
• Will LB&I / Chief Counsel provide guidelines to IRS exam?
– Will taxpayers be able to obtain advance certainty on transactions?
• There will be a strict liability penalty that cannot be avoided by obtaining
opinions from counsel.
• Will the IRS entertain PLRs? Pre-filing agreements? Technical advice?
See Notice 2010-62.
51
When Does the Doctrine Apply –
Practice and Procedure
•
IRS guidance on ES doctrine
– Definition of critical terms (e.g., substantial profit, calculation of pre-tax profit,
substantial purpose)
– Clarification of the scope of the ES doctrine –
• Confirmation that deductions and other benefits treated as credits cited in
JCT report
• Expansion of the four “safe harbors” listed in the JCT report
• List of general criteria that will not cause the ES doctrine to apply
• Reliance on anti-abuse rules
– Should the doctrine be applied when anti-abuse applies and ES
doctrine not traditionally at issue?
52
When Does the Doctrine Apply –
Practice and Procedure
•
How will the IRS audit transactions in practice under the ES doctrine?
– Assert the doctrine any time the two prong test is viewed as failed
– Assert the doctrine any time it is relevant
•
Default Possibility # 1 -- Assert the doctrine any time the two prong test is viewed as
failed
– Example: IRS auditor concludes transaction (a) resulted in favorable tax
reporting; (b) did not have business purpose; (c) was not expected to make much
money.
• Isn’t that likely to be the end of the auditor’s analysis?
• Isn’t the “relevance” issue likely to be skipped or assumed?
• Once the deficiency is set up, what realistic opportunity will taxpayer have to
prove satisfaction of law as written and prove facts as occurred, or to contest
ES doctrine relevance short of court?
• JCS 9/09 and 2007 S. Rep. say flunking 2 prong test not dispositive, but isn’t
it likely to work out that way in practice?
53
When Does the Doctrine Apply –
Practice and Procedure
•
Default Possibility # 1 -- Assert the doctrine any time the two prong test is viewed as failed
(cont’d)
–
In fact, courts do not necessarily determine that the taxpayer’s facts satisfy the law as
written before applying the ES doctrine, nor do they spend much time analyzing the
relevance of the ES doctrine.
• Country Pine Finance LLC v. Commissioner, T.C. Memo. 2009-251 (CARDS case;
analysis portion of opinion only involved application of ES doctrine, citing Am. Elec.
Power)
• Am. Elec. Power Co. v. United States, 326 F.3d 737, 741 (6th Cir. 2003) (rejected trial
court “sham in fact” finding, while applying 6th Cir. version ES doctrine).
• Two recent BLISS cases analyze and decide only ES doctrine: Palm Canyon, T.C.
Memo. 2009-228; New Phoenix Sunrise Corp., 132 T.C. 161 (2009).
•
•
Default Possibility # 2 -- Assert the doctrine any time it is relevant
–
Assuming the IRS agent will not tend to assert the ES doctrine unless the agent perceives a
tax motivated transaction (which is not hard to perceive), is it likely as a practical matter that
the dispute may be over once the “relevance” issue is resolved by the agent/LB&I?
–
IRS Chief Counsel cannot advise agent on the factual analysis specifically.
–
Chief Counsel, or LB&I, or agent, or Appeals determination of relevance will be
determinative absent litigation?
Isn’t the threshold decision made by the agent to assert the ES doctrine likely to go unchanged
54
absent litigation?
When Does the Doctrine Apply –
Practice and Procedure
•
Venue
–
Does the choice of circuit matter?
• The mechanics of the test have been standardized – e.g., conjunctive test.
• Will judicial application of the codified statute lead to differences between circuits?
– Will some courts be more reluctant to apply the doctrine given the strict liability
penalties?
• Different circuits treat economic substance as issue of fact or issue or law, which
impacts the scope of appeal. See Sala v. United States, 613 F.3d 1249 (10th Cir.
2010) (question of law; citing contrary circuits).
–
Will taxpayers choose Tax Court to avoid paying heavy penalties first?
• Note that, if not raising separate grounds to challenge the penalty, prepayment of the
penalty may not be required. See Shore v. United States, 9 F.3d 1524 (Fed. Cir.
1993).
• What grounds are there to challenge the penalty?
55
When Does the Doctrine Apply –
Practice and Procedure
•
Burden of Proof
– As to the “consistent with” purposes of the Code, this is a legal issue, not a
factual issue.
– The IRS is asserting a rule contrary to statute and regulations and so should
have some sort of burden to justify that.
– Will Chevron deference play a role in the application of the ES doctrine?
– Even if taxpayer has normal burden of proof as to the two prong test if ES
doctrine is asserted, the taxpayer should not be tasked with any burden to
counter the IRS’s assertion of the generally applicability of the ES doctrine, but
rather the court should carry out its duty to determine the true meaning of the
law.
56
Economic Substance Doctrine –
Summary
57
ES Doctrine – Summary
•
The economic substance doctrine is the conflation of statutory interpretation and common law fact finding into
a court-made rule of law that, regardless of whether a taxpayer meets all the requirements of the Code and
all facts are developed applying relevant common law doctrines, the taxpayer will not prevail if the taxpayer
cannot satisfy the subjective and objective standards applied by the courts
•
The codified ES doctrine requires that the ES doctrine be relevant
•
The legislative history identifies two exceptions to the application of the ES doctrine --
–
Whether the benefits claimed are consistent with a Congressional purpose or plan
–
Whether the transaction has been respected under longstanding judicial and administrative practice,
based on meaningful economic alternatives based on comparative tax advantages
•
•
•
A safe-harbor may be available
Will the IRS adopt other approaches to determine when the ES doctrine is relevant
–
Adopt a similar approach as under 355(e) regulations – general safe-harbor, specific safe-harbors,
factors indicating plan / non-plan
–
What characteristics can be used –
•
Reliance on significantly detailed statute or regulations (e.g., consolidated return regs)
•
Anti-abuse rules that are relevant but satisfied (e.g., Treas. Reg. § 1.701-2; section 269)
•
Involving an area that has been well considered (e.g., election for taxable treatment)
•
Electivity permitted under the law (e.g., a section 332 liquidation, COBE regulations)
Early guidance from the IRS
–
The IRS must issue early guidance to provide some certainty for taxpayers entering into transactions
post-codification – Rev. Rul., Rev. Proc., Announcement
–
The IRS will continue to issue private letter rulings on substantive issues in transactions
•
What level of confidence will these rulings provide for taxpayers on the risk of ES doctrine?
58
Recent Economic Substance Cases
59
Coltec Transaction
C/S
Class A Stock
Coltec
$14 million
(3)
(2)
7% C/S
Assumption of Liabilities
7% Garrison C/S
Unrelated
Banks
Garlock
$50,000
(1)
Garrison
$375 million Note
Facts: Coltec, a publicly traded company with numerous subsidiaries, sold the stock of one of its businesses in 1996 and
recognized a gain of approximately $240.9 million. Garlock, a subsidiary of Coltec, and its own subsidiary had both previously
manufactured or distributed asbestos products and faced substantial asbestos-related litigation claims. Coltec caused another
one of its subsidiaries, Garrison, to issue common stock and Class A stock to Coltec in exchange for approximately $14 million.
In a separate transaction, Garrison issued common stock to Garlock that represented approximately a 6.6% interest in Garrison
and assumed all liabilities incurred in connection with asbestos related claims against Garlock, as well as the managerial
responsibility for handling such claims. In return, Garlock transferred the stock of its subsidiary, certain relevant records to the
asbestos-related claims, and a promissory note (from one of its other subsidiaries) in the amount of $375 million. Garlock then
sold its recently acquired Garrison stock to unrelated banks for $500,000. As a condition of sale, Coltec agreed to indemnify
the banks against any veil-piercing claims for asbestos liabilities. On its 1996 tax return, Coltec’s consolidated group claimed a
$378.7 million capital loss on the sale of Garrison stock, which equaled the difference between Garlock’s basis in the stock
($379.2 million) and the sale proceeds ($500,000).
60
Coltec Decision – Court of Federal Claims
•
•
The Court of Federal Claims entered a decision after trial in favor of Coltec, upholding the
capital loss claimed by Coltec from the contingent liability transaction at issue in this tax
refund litigation. See Coltec Industries, Inc. v. United States, 63 Fed. Cl. 716 (2004).
The Court of Federal Claims relied on the District Court analysis in Black & Decker
(discussed below) to hold that the operation of the applicable code sections justified a capital
loss.
– The contribution of assets in exchange for stock and the assumption of the liabilities
qualified as a nontaxable exchange under section 351.
– Under section 358, the transferor received a basis in the stock equal to the basis of the
assets contributed. Ordinarily, when a transferee in a section 351 exchange assumes
liabilities of the transferor, the transferor’s basis in the transferee’s stock is reduced by
the amount of the liabilities. However, under sections 358(d)(2) and 357(c)(3), if the
satisfaction of the liabilities would have given rise to a deduction to the transferor, the
assumption of such liabilities does not reduce basis. Because satisfaction of the
liabilities assumed by the transferee would have given rise to a deduction to the
transferors (had the liabilities not been transferred), the basis of the stock is not reduced
by the liabilities assumed under section 358(d)(2). After the transfer, payment of the
liabilities would give rise to a deduction by the transferee. See Rev. Rul. 95-74, 1995-2
C.B. 36 (1995). The government argued that section 357(c)(3) requires that payment of
the liabilities would give rise to a deduction by the transferor. The court held that this
interpretation was incorrect.
– In addition, the court held that section 357(b) did not require basis to be reduced
because there was a bona fide business purpose for the assumption of the liabilities.
61
Coltec Decision – Court of Federal Claims
• The Court of Federal Claims rejected the government’s argument that
the capital loss should nonetheless be disallowed under the economic
substance doctrine.
• The court refused to apply the economic substance doctrine to the
transaction because the transaction satisfied the statutory
requirements of the Code. The court stated: “[I]t is Congress, not the
court, that should determine how the federal tax laws should be used
to promote economic welfare…. Where the taxpayer has satisfied all
statutory requirements established by Congress, as Coltec did in this
case, the use of the ‘economic substance’ doctrine to trump ‘mere
compliance with the Code’ would violate the separation of powers.”
62
Coltec on Appeal – Federal Circuit
•
•
•
•
The Federal Circuit (Judges Bryson, Gajarsa and Dyk) reversed the opinion
of the Court of Federal Claims and held that the taxpayer was not entitled to
a capital loss because the assumption of the contingent liabilities in
exchange for the note lacked economic substance. See Coltec Industries,
Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006).
The Federal Circuit upheld the technical analysis of the Court of Federal
Claims in favor of the taxpayer.
The court concluded that section 357(c)(3) applies because payment of the
liability would give rise to a deduction. The court stated that the
government’s interpretation that the liabilities must be transferred with the
underlying business was plainly inconsistent with the statute.
The court concluded that if a liability was excluded by section 357(c)(3),
then section 357(b)(1) was not relevant. The court reasoned that the
exception in section 358(d)(2) for liabilities excluded under section
357(c)(3) does not contain any reference to section 357(b), nor does
section 357(b) contain any reference to the basis provisions in section 358.
63
Coltec on Appeal – Federal Circuit
•
•
However, the Federal Circuit reversed the Court of Federal Claims decision
with respect to economic substance and held that the transfer of liabilities in
exchange for the note should be disregarded.
The Federal Circuit identified five (5) principles of economic substance.
– The law does not permit the taxpayer to reap tax benefits from a
transaction that lacks economic reality;
– It is the taxpayer that has the burden of proving economic substance;
– The economic substance of a transaction must be viewed objectively
rather than subjectively;
– The transaction to be analyzed is the one that gave rise to the alleged
tax benefit;
– Arrangements with subsidiaries that do not affect the economic interest
of independent third parties deserve particularly close scrutiny.
64
Coltec on Appeal – Federal Circuit
• In applying the economic substance test, the Federal Circuit
focused solely on the transaction giving Coltec the high stock
basis (i.e., the assumption of the liabilities in exchange for the
note) and concluded that Coltec had not demonstrated any
business purpose for that transaction.
• The court rejected Coltec’s claim that it would strengthen its
position against potential veil-piercing claims, since it only
affected relations among Coltec and its own subsidiaries and
had no effect on third parties.
65
Coltec Certiorari Petition
•
•
Coltec filed a petition requesting certiorari with the Supreme Court.
One of the two questions presented for review in the cert petition relates to the
disjunctive vs. conjunctive nature of the economic substance test and the current circuit
split.
– The cert petition stated the question as follows: "Where a taxpayer made a good-faith
business judgment that the transaction served its economic interests, and would have
executed the transaction regardless of tax benefits, did the court of appeals (in
acknowledged conflict with the rule of other circuits) properly deny the favorable tax
treatment afforded by the Internal Revenue Code to the transaction based solely on the
court’s “objective” conclusion that a narrow part of the transaction lacked economic
benefits for the taxpayer?”
•
The other question presented for review in the cert petition relates to the standard of
review in economic substance cases.
– The cert petition stated the question as follows: "In determining that a transaction may be
disregarded for tax purposes, should a federal court of appeals review the trial court’s
findings that the transaction had economic substance de novo (as three courts of appeals
have held), or for clear error (as five courts of appeals have held)?"
•
•
Dow Chemical Co. filed a cert petition on October 4, 2006 that presented similar
questions.
On February 16, 2007, the Supreme Court denied certiorari in Coltec and Dow Chemical.
66
Heinz Transaction
PUBLIC
PUBLIC
PUBLIC
$130M
Heinz
3.5M
Heinz
shares
Heinz
3.325M
Heinz
shares
Heinz
~ $7.0M
Note
HCC
HCC
HCC
.175M
Heinz shares
Facts: Between August 11, 1994, and November 15, 1994, H.J. Heinz Credit Company (“HCC”), a subsidiary
of the H.J. Heinz Company (“Heinz”), purchased 3.5 million shares of Heinz common stock in the public
market for $130 million. In January of 1995, HCC transferred 3.325 million of the 3.5 million shares to Heinz
in exchange for a zero coupon convertible note issued by Heinz. In May of 1995, HCC sold the remaining
175,000 shares to AT&T Investment Management Corp. (“AT&T”), an unrelated party, for a discounted rate of
$39.80 per share, or $6,966,120, in cash. As a result of this sale, HCC claimed a capital loss and carried this
loss back to 1994, 1993, and 1992. The IRS disallowed Heinz’s claimed capital loss arguing, among other
things, that the transaction lacked economic substance and a business purpose. Heinz paid the tax and filed
a $42.6 million refund action with the Court of Federal Claims.
67
Heinz – Court of Federal Claims
•
H. J. Heinz Company and Subsidiaries v. United States, United States Court
of Federal Claims, 76 Fed. Cl. 570 (2007).
•
All parties agreed that HCC had a basis of $124 million in the 3.325 million
shares that were transferred to Heinz.
•
Heinz asserted that the redemption qualified as a redemption under section
317(b), that the redemption should be taxed as a dividend, and that HCC’s
basis in the redeemed stock should be added to its basis in the 175,000
shares which it retained. Accordingly, Heinz claimed that, when HCC sold its
remaining 175,000 shares, it should recognize a large capital loss. Heinz
then claimed it was entitled to carry back HCC’s capital loss to reduce the
consolidated group’s taxes in 1994, 1993 and 1992.
•
The IRS asserted that the Heinz acquisition was not a redemption because:
(i) Heinz did not exchange property for the stock within the meaning of
section 317(b); (ii) the transaction lacked economic substance and had no
bona fide business purpose other than to produce tax benefits; and (iii) under
the “step transaction doctrine,” HCC’s purchase and exchange of the stock
for the note should be viewed as a direct purchase of the stock by Heinz.
68
Heinz – Court of Federal Claims
•
The Court of Federal Claims dismissed the IRS’s first argument that no
redemption occurred, but held that the acquisition and redemption of Heinz
shares lacked economic substance and that the step transaction doctrine
applied.
•
The court followed the economic substance analysis set forth Coltec in
addressing the IRS’s second argument, quoting the following language from
Coltec – “the transaction to be analyzed is the one that gave rise to the
alleged tax benefit.”
•
Accordingly, the court stated that transaction in question is the purchase of
Heinz shares from the public and the subsequent redemption. The court did
not analyze the entire transaction (including the disposition) when applying
the economic substance doctrine.
•
The court in Heinz held that the acquisition and subsequent redemption of
Heinz shares lacked economic substance.
69
Heinz – Court of Federal Claims
•
•
•
The Court of Federal Claims was not persuaded by the taxpayer’s assertion that HCC
acquired the Heinz stock for non-tax, business purposes: as an investment and to add
“substance” to HCC’s operations for state tax purposes.
In the eyes of the court, the taxpayer’s claim of an investment purpose was undercut by the
factual record, as evidenced by the following factors.
– First, the convertible notes were contemplated and, in fact, were in the process of being
drafted well before HCC purchased the Heinz stock.
– Second, because the acquired stock was not registered, HCC purchased the stock at full
price in the market and sold the Heinz stock at a deep discount.
– Third, the purpose of the stock purchase program -- the funding of stock option
programs – could not be achieved so long as HCC held the Heinz stock.
The court also found the factual record to be inconsistent with the taxpayer’s second claim of
business purpose, which was to bolster the taxpayer’s tax return position that HCC should be
respected as a Delaware holding company. The court cited three factors in support of its
position.
– First, the record did not suggest that the taxpayer was motivated by this non-tax
purpose.
– Second, internal communications indicated that any tax return exposure could not be
limited at the time of the stock acquisition or on a going forward basis.
– Third, the record indicated that, at the time of the stock acquisition, Heinz was
considering eliminating HCC’s lending operations, which raised the very issue that the
taxpayer sought to mitigate through the stock acquisition.
70
Jade Trading – Son-of-Boss Transaction
AIG
Spread Options
Net $150,000
Payment
(w/ premium of ~ $15m)
(1)
LLC 1
LLC 2
LLC 2
LLC 3
LLC 3
Spread Options &
$75,000 cash
(2)
LLC 1
Euros
&
stock
(worth
$125k)
Interests
Jade
Jade
Facts: In March 1999, three taxpayers sold their cable business and realized an aggregate $40.2 million capital
gain. Each of the three taxpayers created a single-member LLC on September 17, 1999. On September 23, 1999,
Jade Trading LLC was formed by Sentinel Advisors, LLC (“Sentinel”) and a foreign financial institution. [Sentinel
pitched the transaction to BDO Seidman, which marketed the transaction.] On September 29, 1999, each of the
three LLCs purchased offsetting currency options for net premium paid of $150,000 to AIG. For each LLC, the
options purchased and sold had a premium of $15 million and $14.85 million, respectively. On October 6, 1999, the
LLCs contributed their spread options and $75,000 cash to Jade Trading LLC (“Jade”), in exchange for membership
interests. About 60 days after the contribution, the three LLCs exited Jade with each receiving euros and Xerox
stock (with a market value of approximately $125,000) in exchange for their interests.
71
Jade Trading – Taxpayer’s Position
•
Each taxpayer claimed that the LLCs’ basis in the interest in Jade was increased by the value of the option
purchased ($15 million), but not decreased by the value of the options sold ($14.85 million). Accordingly,
each taxpayer claimed a large capital loss upon exiting the partnership (approximately $14.9 million).
•
The primary Code sections at issue in Jade Trading were section 752(b) and section 722.
–
Section 752(b) provides that a decrease in a partner’s liabilities by reason of a partnership’s
assumption of those liabilities will be treated as a distribution of money to the partner by the
partnership (with the effect of reducing the partner’s basis).
–
Under section 722, a partner’s basis acquired by a contribution of property, including money, is equal
to the amount of money and basis of such property contributed.
•
The taxpayers relied principally on Helmer v. Commissioner, T.C. Memo. 1975-60, which provided that a
contingent obligation (such as an option) was not a liability for purposes of section 752.
•
At the time of the transaction, the principle set forth in Helmer was good law.
–
The IRS subsequently issued temporary regulations on June 24, 2003, which would have treated the
sold option as a liability for purposes of section 752. See Treas. Reg. § 1.752-6T.
–
The temporary regulations had retroactive effect to October 18, 1999 (the LLCs contributed the
spread options on October 6, 1999).
–
The Preamble to the temporary regulations explicitly states that the regulations do not follow Helmer.
72
Jade Trading – Court of Federal Claims
•
•
•
The Court of Federal Claims held that the transaction creating the basis increase lacked economic
substance. See Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (2007).
The court found that basis increase claimed by each LLC satisfied the technical provisions of the Code.
The court then analyzed the transaction under the economic substance doctrine.
– The court stated that Coltec unequivocally reaffirmed the vitality of the economic substance
doctrine in the Federal Circuit.
– The court found that –
1. The transaction lacked economic reality because (i) the losses claimed were not tied to any
economic loss (i.e., the LLCs did not incur a $15 million loss) and (ii) the use of the
partnership structure had no real economic purpose.
2. The taxpayer had the burden of proving that the transaction had economic substance.
3. The objective reality of the transaction was the relevant criterion rather than any subjective
intent of the taxpayer.
4. The transaction to be analyzed was the spread transaction that gave rise to the inflated basis
(rather than any hypothetical transactions that could have occurred and/or any other trades).
– The court found that there was no objective profit potential, because the maximum
profit potential on the spread ($140,000) was exceeded by the high fees ($934,100).
– The court also noted that transaction was marketed as a tax avoidance mechanism.
– The court also noted that the options had to be viewed together rather than as two
distinct legal entitlements because of the economic realities of the transaction.
5. The transaction did not alter the economic interests of independent third parties (i.e., the
other partners in Jade).
– The court held that the transaction lacked economic substance on the basis of the above
conclusions, which the court viewed as relevant based upon its interpretation of Coltec.
73
Jade Trading – Court of Appeals for the
Federal Circuit
•
•
The U.S. Court of Appeals for the Federal Circuit affirmed the Court of Federal
Claim’s finding that the contributions to the spread transactions to the Jade
partnership lacked economic substance and should be disregarded for tax purposes.
See Jade Trading, LLC v. United States, 598 F.3d 1372 (Fed. Cir. 2010).
The court relied on the principles established in Coltec Indus., Inc. v. United States,
454 F.3d 1340 (Fed. Cir. 2006) for purposes of conducting its economic substance
analysis.
– The court agreed with the determinations made by the Court of Federal Claims,
noting that the loss generated was “purely fictional,” the formation of the Jade
partnership had no economic purpose, the spread transaction was virtually
guaranteed to be unprofitable, and the transaction was developed as a tax
avoidance scheme and not an investment strategy.
– The court also rejected the argument that the contribution of the spread
transactions to the Jade partnership had economic substance because the
spread strategy options were separate assets with separate documentation that
were owned by unrelated parties.
– The court agreed with the finding by the Court of Federal Claims that the
transactions could not be separated because they were totally dependent on one
another from an economic and pragmatic standpoint.
74
Sala v. United States
•
•
•
The District Court of Colorado held in favor of a taxpayer that entered into a transaction
similar to the transaction described in Jade Trading. See Sala v. United States, 552 F.
Supp. 2d 1167 (D.C. Co. 2008).
The IRS has referred to the Sala decision as an “anomaly” in the government’s continued
litigation of “Son-of-Boss” transactions.
Relevant Facts
–
The taxpayer in Sala realized $60 million of income in 2000 in connection with the
exercise of stock options.
–
In 2000, the taxpayer invested approximately $9 million in a foreign currency investment
program (the “Deerhurst Program”).
–
In connection with the “Deerhurst Program,” the investment manager acquired long and
short options on foreign currencies for a net cost of approximately $730,000.
–
On November 8, 2000, the taxpayer formed an S corporation as its sole shareholder
(“Solid”). On November 28, 2000, the taxpayer transferred the long and short options
and approximately $8 million of cash to Solid. On the same date, Solid transferred the
options and cash to a general partnership (“Deerhurst GP”).
–
Deerhurst GP liquidated prior to December 31, 2000. In the liquidation, Solid received
approximately $8 million in cash and two foreign currency contracts.
–
Solid subsequently sold the foreign currency contracts prior to December 31, 2000.
–
Solid reinvested the liquidation proceeds into Deerhurst LLC for a minimum of five
years.
75
Sala v. United States
•
•
Taxpayer Position
–
Solid claimed a basis in Deerhurst GP equal to the value of the cash plus the long options, or
approximately $69 million. See Helmer v. Commissioner, T.C. Memo 1975-60.
–
Solid claimed a basis in the two foreign currency contracts received in liquidation of Deerhurst
GP equal to its partnership basis (~ $69 million) less the cash received in liquidation (~ $8
million), or approximately $61 million.
–
Upon the sale of the two foreign currency contracts, Solid claimed a loss equal to approximately
$60 million.
–
The taxpayer claimed the $60 million loss on its original 2000 tax return, but filed a subsequent
amended return that did not claim the $60 million loss and paid tax, interest, and penalties of
over $26 million in connection with the amended return. The taxpayer subsequently filed a
second amended return that claimed the $60 million loss. The taxpayer sued in District Court to
claim a tax refund on the basis of the second amended return.
The Deerhurst Program
–
The District Court found the facts of the Deerhurst Program particularly persuasive.
–
In the program, investors place a minimum of $500,000 in an account for an initial trial period.
The account was managed by Deerhurst Management Company, Inc., which was owned and
operated by a well-known foreign currency trader.
–
Investors that were interested in remaining in the Deerhurst Program were then required to place
additional funds into the program equal to at least 15% of the expected tax loss (for the taxpayer,
15% of ~ $60 million, or ~ $9 million).
–
If the account was profitable after the liquidation in late 2000, investors had to reinvest their
liquidation proceeds in Deerhurst LLC for a minimum of five years or be subject to a withdrawal
penalty.
76
Sala v. United States – District Court Decision
The District Court made the following rulings with respect to the Deerhurst Program:
1.
The transactions entered into in connection with the Deerhurst Program satisfied the sham
transaction / economic substance standard -–
The court refused to focus its inquiry on the “Son-of-Boss” aspect of the Deerhurst
Program and considered the entire investment program.
–
The court found that taxpayer had a potential (albeit small) of obtaining an economic
return in excess of the $60 million loss and that the taxpayer entered into the
transaction for profit.
–
The court found that the transaction had a good faith business purpose other than tax
avoidance, concluding that –
–
–
–
–
–
–
The taxpayer’s stated purpose of creating Solid to reduce liability exposure was a valid
purpose;
The creation of Deerhurst GP had the valid purpose of investing in currency options and
its liquidation had the valid purpose of “easier accounting and redistribution of the
partnership assets”;
The investment “test period” in the Deerhurst Program had a valid purpose since it
permitted taxpayers to gauge their interest in the program at little cost;
The fact that “digital options” were not purchased (that would not have created the large
tax loss) was immaterial; and
The Deerhurst Program, as a whole, had a legitimate business purpose – a good faith
and reasonable belief in profitability beyond mere tax benefits.
Compare Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d 537 (5th Cir.
2009) (held that the transaction did not have economic substance; court applied a
conjunctive economic substance test)
77
Sala v. United States – District Court Decision
2.
3.
4.
The tax loss was permitted under the Code and applicable regulations -–
The basis obtained in Solid and Deerhurst GP was equal to the value of long
options and contributed cash and was not decreased by liabilities associated with
the short options.
–
The at-risk rules of section 465 and the loss limitation rule of section 1366(d) did
not apply.
–
Each of the 24 options contributed to Solid and Deerhurst GP were separate
financial instruments. Accordingly, offsetting options were not offset against each
other for purposes of determining the “net” value of property contributed to Solid
and Deerhurst GP.
–
The two foreign currency contracts received by Solid upon liquidation of
Deerhurst GP constituted “property” within the meaning of section 732. As a
result, Solid obtained a basis in such property equal to Solid’s basis in the
partnership reduced by any money distributed.
Treasury exceeded its authority when issuing Treas. Reg. § 1.752-6(b)(2) and when
making the regulations retroactive. Compare Klamath Strategic Inv. Fund, LLC v.
United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006) with Cemco Investors, LLC v.
United States, 515 F.3d 749 (7th Cir. 2008).
The taxpayer filed a valid qualified amended return, and the IRS was not entitled to
offset excess interest payments made by the taxpayer with an accuracy-related
penalty.
78
Sala v. United States – Tenth Circuit Decision
•
•
•
•
On appeal, the Tenth Circuit Court of Appeals reversed the district court’s decision. See Sala v. United
States, 613 F.3d 1249 (10th Cir. 2010).
The Court focused its economic substance analysis on Deerhurst GP, unlike the district court, which had
reviewed the entire Deerhurst Program as a single transaction.
– According to the Court, the Deerhurst GP phase could not be legitimized merely because it was on
the “periphery of some legitimate transactions,” as a “loss-generating transaction must stand or fall
on its own merit.”
In setting out the applicable standard for its economic substance analysis, the Court noted that
transactions lacking an appreciable effect aside from tax benefits will be not be respected for tax
purposes, that a transaction having some profit potential does not necessarily require the finding that a
transaction has economic substance, and that tax benefits must be linked to actual losses.
The Court determined that Sala’s participation in Deerhurst GP lacked economic substance, relying on
the following findings:
– The claimed loss generated by the program was structured from the outset to be a complete fiction
and was designed primarily to create a reportable tax loss with little actual economic risk.
– Deerhurst GP was designed to exist for only a short time, as its liquidation before the end of 2000
was pre-determined in order to generate a tax loss to offset Sala’s income.
– The expected tax benefit of around $24 million dwarfed the potential gain from Sala’s participation
in Deerhurst GP (projected to earn profits of $550,000 over the course of one year), making the
economic realities of the transaction insignificant in relation to the tax benefits.
– The court disregarded the business explanations for the various components of the Deerhurst GP
stage, stating that any anticipated economic benefit from the brief participation in Deerhurst GP was
negligible in comparison to the asserted tax benefit.
– The district court’s finding that Sala entered into the Deerhurst Program primarily for profit did not
alter the Court’s conclusion. The Court stated that the presence of an individual’s profit objective
did not require it to recognize a transaction lacking economic substance. The Court also
discounted the district court’s findings on this issue, as they were based on the Deerhurst Program
as a whole.
79
Countryside – Facts of Transaction
C W
Other partners
1
6
$8.5 million
Note
Sale of real
property for Cash
Countryside
Loan
Repayment
8
Distribution of 99% interest in CLPP in complete
termination of W and C’s interest
7
99%
2
$8.5 million
$8.5 million
CLPP
4
$3.4 million
Note
5
3
99%
MP
Facts: W and C are individual partners in a partnership (“Countryside”). W possessed a 70-percent interest and C possessed
a 25-percent interest in Countryside. Two other partners held the remaining interests. On or about September 18, 2000, W,
acting as president of two separate corporations, formed two separate LLCs (“CLPP” and “MP”). On October 27, 2000, each
of the corporations contributed cash to obtain a 1-percent interest in the LLCs. Countryside borrowed $8.5 million from a thirdparty bank. On October 30, 2000, Countryside contributed the cash to CLPP in exchange for a 99-percent interest and CLPP
contributed the borrowed funds to MP for a 99-percent interest. On or about that day, MP borrowed an additional $3.4 million
from the third-party bank. On or about October 31, 2000, MP used the borrowed proceeds to acquire four privately issued
notes (the “AIG Notes”) in the aggregate principal amount of $11.9 million. On December 26, 2000, Countryside distributed its
99-percent interest in CLPP to W and C in complete liquidation of their respective partnership interests. As a result of the
distribution, both W and C were relieved of their share of Countryside’s liabilities, although each retained a share of MP’s
liabilities. In April 2001, Countryside sold real property and used the sale proceeds to repay the $8.5 million obligation to the
third-party bank. In 2003, the AIG Notes were redeemed from MP by AIG. In 2004, MP repaid the $3.4 million loan.
80
Countryside – Tax Issues
•
•
•
•
The IRS issued a notice of final partnership administrative adjustment (the FPAA) on October 8,
2004. The FPAA contained the following adjustments –
– The distribution in liquidation of W and C’s interest in Countryside constituted a taxable event
resulting in a large capital gain,
– A denial of Countrywide’s election to receive a basis step-up under section 734(b)(1)(B) for
the property remaining after the liquidating distribution (including the real property sold in
2001), and
– A basis reduction in the AIG Notes held by MP.
W filed a partial motion for summary judgment in the Tax Court to resolve the first of the above
issues raised by the IRS in the FPAA.
The IRS argued that Countryside’s distribution of its 99-percent interest in CLPP constituted a
distribution of marketable securities for purposes of section 731(a)(1) or, alternatively, it should be
treated as such under the economic substance doctrine.
– Section 731(a) provides that a partner does not recognize gain on a partnership distribution,
except to the extent that money distributed (including “marketable securities”) exceeds the
partner’s adjusted basis in the partnership.
– If the distribution was treated as a distribution of money, then W and C would recognize
substantial gain because both would have a low basis in their interests in Countryside (in part,
because the relief of Countryside liabilities assumed by W and C would be treated as a
distribution under section 752 that would reduce W and C’s outside basis).
– Note that W and C claimed that the $3.4 million borrowing by MP increased their outside
basis and thus offset potential gain on the liquidating distribution.
The Tax Court decided this issue in favor of the taxpayer. See Countryside Limited Partners v.
Commissioner, T.C. Memo. 2008-3.
81
Countryside – Economic Substance
•
•
•
•
•
•
•
The Tax Court rejected that IRS argument that the distribution of the 99-percent interest in
CLPP constituted a distribution of marketable securities under section 731(a)(1).
The Tax Court also rejected the IRS argument that the economic substance doctrine should
apply to treat the distribution as a distribution of money for purposes of section 731(a)(1).
The crux of the IRS position was that W and C effectively permanently deferred the
recognition of gain on their share of the sale proceeds Countryside received in the 2001 sale
of real property.
The IRS unsuccessfully argued that Countryside had no potential for profit in the transaction
because of interest and transaction costs and, thus, the transaction lacked a business
purpose and should be recast under the economic substance doctrine.
– The Tax Court rejected this IRS argument because it focused on Countryside’s pre-tax
profit rather than the partners, W and C, who were the focus of the motion before the
court.
– At most, the Tax Court stated that this argument could support a challenge to any
interest deductions claimed by Countryside with respect to the $8.5 million loan.
The Tax Court concluded that the means of the transaction (i.e., the liquidation of W and C’s
interest in Countryside) were designed to avoid recognition of gain, but that these means
also served “a genuine, nontax, business purpose” – to convert W and C’s investments in
Countryside into a 10-year promissory note.
The Tax Court observed that these two forms of investment were economically distinct and
therefore, in form and substance, the transaction constituted a redemption of W and C’s
interest for non-marketable securities.
The Tax Court clearly viewed the tax benefits of the transaction as being incidental to the
legitimate business purpose of the transaction. Accordingly, the Tax Court found no harm in
structuring the transaction in a manner to minimize the tax burden of W and C
82
Countryside – Effect of Continued Litigation?
•
•
•
•
•
The Tax Court only resolved the issue addressed by the partial motion for summary
judgment.
The Tax Court did not resolve the remaining issues raised by the FPAA, and it is
uncertain whether W, C, Countryside or MP will retain any tax benefits claimed in
connection with the transaction if and when the remaining issues are addressed.
A footnote in the decision suggests that the Tax Court believes that the tax benefits
claimed may not be warranted.
Footnote 29 states that, given the totality of the circumstances, including (i) the
formation of CLPP and MP and (ii) the section 754 elections made by Countryside and
CLPP (but not by MP), there may be grounds to invoke the partnership anti-abuse rule
of Treas. Reg. § 1.701-2 and/or the economic substance doctrine in order to determine–
– Whether Countryside should obtain a basis step-up in the retained assets and/or
– Disregard CLPP and MP as sham entities, and/or
– Require a basis step-down in the AIG Notes held by MP.
The remaining issues have been consolidated before the Tax Court judge.
83
Countryside and Valero – Section 7525
•
•
On June 8, 2009, the Tax Court in Countryside denied an IRS motion to compel the production of “meeting
minutes” and handwritten notes that memorialized conversations between the partnership (Countryside) and
its outside tax advisor in respect of the transaction.
– The documents were generally protected under section 7525.
– However, the IRS argued that the section 7525 privilege did not apply because the underlying advice
constituted “written communication” in connection with the “promotion” of a “tax shelter.” See section
7525(b).
– The Tax Court held that the IRS did not meet its burden in establishing the elements of the “tax shelter”
exception since (i) the handwritten notes, which were not communicated with anyone, did not constitute
a “written communication” for purposes of section 7525(b) and (ii) the minutes were not prepared in
connection with the “promotion” of a tax shelter for purposes of section 7525(b) since the tax advisor
provided advice as part of a long-standing and ongoing relationship with the partnership. See
Countryside v. Commissioner, 132 T.C. 347 (2009).
In Valero Energy Corp. v. United States, 569 F.3d 626 (7th Cir. 2009), the 7th Circuit also recently addressed
the tax shelter exception to the section 7525 privilege.
– In Valero, the taxpayer raised the section 7525 privilege in respect of a summons issued to Arthur
Andersen in connection with a transaction recommended to the taxpayer by Ernst & Young and reviewed
by and supplemented by the taxpayer’s long-time advisors at Arthur Andersen.
– The recommended transaction was specific to the taxpayer, and was neither “prepackaged” nor
marketed to other taxpayers.
– The 7th Circuit refused to limit the tax shelter exception in section 7525(b) to only “actively marketed tax
shelters or prepackaged products” and upheld the District Court decision in favor of the government.
– Thus, the 7th Circuit’s interpretation would extend the tax shelter exception to instances where a taxpayer
receives specific advice (rather than marketed or “one-size-fits-all” advice) in connection with a
transaction that qualifies as a tax shelter (i.e., there is a significant purpose of tax avoidance or evasion).
84
Shell Petroleum – Facts of Transaction
Shell
Energy
Resources
Shell
Offshore
Unrelated
Investors
Shell
Western
Shell
Royalties
Shell
Frontier
•
Facts: Step 1 – Formation of Shell Frontier. In August 1992, three lower-tier subsidiaries of Shell Petroleum transferred
assets to newly formed Shell Frontier in exchange for voting common stock and nonvoting preferred stock. The assets
consisted of producing and nonproducing properties. In addition, unrelated investors purchased 1100 shares of auctionrate preferred stock in exchange for $110 million. The auction-rate preferred stock entitled the unrelated investors to
25.88% of the vote in Shell Frontier. One of the three lower-tier Shell Petroleum subsidiaries, Shell Western, also
transferred additional assets to Shell Frontier in exchange for 900 shares of auction-rate preferred stock. The assets
transferred by Shell Western consisted of non-producing Colorado oil shale properties and offshore oil leases in
California and Alaska. Shell Western had an aggregate basis in these assets of $679,335,936. (cont’d on next slide)
85
Shell Petroleum – Facts of Transaction
Shell
Energy
Resources
Shell
Offshore
540 shares of
Shell Frontier stock
Shell
Western
cash
Shell
Royalties
Unrelated
Investors
>20%
Shell
Frontier
•
Facts: Step 2 – Sale of stock. In December 1992, Shell Western sold 540 shares of Shell Frontier
stock to unrelated investors for $54 million. Shell Frontier was not a member of the Shell
consolidated group for tax purposes because more 20% of the voting power in Shell Frontier was
owned by outside investors. Accordingly, this transaction caused the Shell Group to recognize a
capital loss of approximately $354 million and created a consolidated net operating loss of
approximately $320 million. The carryback of a portion of this net operating loss to 1990 resulted in a
refund of approximately $19 million. In addition, a portion of the NOL was carried back to 1989 and
1991 and a portion was carried forward to years after 1992.
86
Shell Petroleum – IRS Challenge
•
•
•
•
The IRS challenged the capital loss claimed by the Shell Group as a result of Shell
Western’s sale of auction rate preferred stock in Shell Frontier to the unrelated
investors.
The IRS argued that the auction rate preferred stock was not issued in exchange
for property under section 351 because the nonproducing real estate properties did
not earn income and therefore were without value.
In addition, the IRS argued that the transaction should be disregarded because it
lacked economic substance. In making this argument, the IRS relied heavily on
the Federal Circuit’s decision in Coltec.
Note that this transaction would not result in a capital loss today because of
section 362(e)(2). Section 362(e)(2) requires taxpayers that transfer built-in loss
property in a section 351 exchange to take a fair market basis in such property.
Section 362(e)(2), however, was not enacted at the time of the transactions in
Shell Petroleum.
87
Shell Petroleum – District Court Decision
•
•
•
•
The United States District Court for the Southern District of Texas rejected the IRS argument and upheld the
taxpayer’s capital loss. See Shell Petroleum Inc. v. United States, 2008-2 USTC ¶ 50,422 (S.D. Tex. 2008).
The court determined that the transfer of property to Shell Frontier qualified as a tax-free section 351
transaction and therefore Shell Western obtained a basis in the stock received in the exchange equal to its
basis in the transferred assets.
– The court determined that the nonproducing real estate properties transferred to Shell Frontier had
value, even though they weren’t earning income, and therefore such properties were “property” under
section 351.
The court rejected the government’s economic substance argument.
– The court noted that different courts apply different versions of the economic substance test and that
some require both objective economic substance and business purpose and others require only one or
the other. The court did not identify which standard it was applying, but determined that the transaction
had both economic substance and business purpose. The court concluded that the transaction
allowed Shell to monetize certain assets and also established a better management structure by
containing the assets at issue within a single subsidiary. The court acknowledged that the structure of
the transaction was motivated in part by the tax consequences and that the use of Shell Frontier was
proposed by Shell’s tax department. However, the court determined that the overall transaction was not
proposed by the tax department, but rather by Shell business people. Further the court determined that
the overall transaction had a legitimate business purpose and economic substance.
The court criticized and declined to follow the step-by-step approach to economic substance analysis applied
in Coltec: “Moreover, the Court has found no Fifth circuit cases, and the parties have cited none, similarly
dissecting, or “slicing and dicing” as it was referred to in oral arguments, an integrated transaction solely
because the Government aggressively chooses to challenge only an isolated component of the overall
transaction.”
88
Klamath Strategic Investment Fund v. United States –
Facts
Patterson
$1.5M
NatWest
Loan of $41.7M plus a
loan premium of $25M
(total of $66.7M)
Presidio
Resources
LLC
St. Croix
LLC
90%
9%
1%
Investment of $66.7M
plus $1.5M
This example shows the facts for Patterson, St. Croix and Klamath; the
facts are the same for Nix, Rogue, and Kinabalu.
Presidio
Growth
LLC
Klamath
LLC
Facts: On January 20, 2000, St. Croix LLC (“St. Croix”) and Rogue Ventures LLC (“Rogue”) were formed as single-member
Delaware LLCs. Individuals Patterson and Nix each contributed $1.5M to St. Croix and Rogue, respectively. On March 29,
2000, St. Croix and Rogue each borrowed $41.7M from National Westminster Bank plc (“NatWest”) for seven years at a fixed
interest rate. St. Croix and Rogue opted to pay an increased interest rate (17.97%) on their loans in return for NatWest paying
St. Croix and Rogue premiums of $25M each. On April 6, 2000, St. Croix and Rogue each invested $68.2M to Klamath and
Kinabalu, respectively, in exchange for a 90% partnership interest. Klamath and Kinabalu used these funds to purchase very
low risk contracts on U.S. dollars and Euros and short 60- to 90-day term forward contract trades in foreign currencies. The
investments involved three stages – I, II, and II – with the risk increasing with each stage.
89
Klamath Strategic Investment Fund v. United States –
District Court Decision
Taxpayer’s Position
–
On their income tax returns for 2000, 2001, and 2002, Patterson claimed total losses of
$25,277,202 arising from Klamath’s activities and Nix claimed total losses of $25,272,344 arising
from Kinabalu’s activities.
–
Patterson and Nix calculated their basis in the partnership as the $66.7M plus $1.5M, minus the
liability assumption of $41.7M and, thus, were able to deduct over $25M from their taxable income.
Government’s Position
–
The IRS disagreed with the basis calculation and stated that under Section 752, the partners
should have treated the entire $66.7M as a liability.
–
Alternatively, the IRS argued that the transactions were shams or lacked economic substance and
should be disregarded for tax purposes.
District Court
–
The Partnership filed suit against the Government under section 6226 for readjustment of
partnership items. The Partnerships moved for partial summary judgment, and the Government
cross-moved for summary judgment on the issue of whether the partners’ tax bases were properly
calculated; specifically whether the loan premiums constituted liabilities under section 752 of the
Code.
–
The district court granted the Partnership’s motion and denied the Government’s, holding that the
loan premiums were not liabilities under section 752 and therefore the partners’ bases were
properly calculated.
–
However, following a bench trial the district court held that the loan transactions must nonetheless
be disregarded for Federal tax purposes because they lacked economic substance.
–
The Government appealed the district court’s partial summary judgment in favor of the
Partnerships, arguing that the “loan premiums” constitute liabilities under section 752.
90
Klamath Strategic Investment Fund v. United States –
Fifth Circuit Decision
Fifth Circuit
•
The Fifth Circuit applied the majority view of the economic substance doctrine – that a lack of economic substance is
sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax avoidance (i.e.,
the conjunctive test).
•
The court went on to explain that the Supreme Court in Frank Lyon set up a multi-factor test for when a transaction
must be honored as legitimate for tax purposes. These factors include
–
Whether the transaction has economic substance compelled by business or regulatory realities,
–
Whether the transaction is imbued with tax-independent considerations, and
–
Whether the transaction is not shaped totally by tax avoidance features.
•
The Fifth Circuit found that the evidence supported the district court’s conclusion that the loan transactions lacked
economic substance.
–
Numerous bank documents stated that despite the purported seven-year term, the loans would only be
outstanding for about 70 days.
–
NatWest’s profit in the loan transaction was calculated based on a 72-day period.
–
In the event that the investors wanted to remain with the plan beyond 72 days, NatWest would force them out.
–
The Partnerships contend that the loan funds were critical to the high-risk foreign currency transactions;
however, the structure of the plan shows that these high-risk transactions could not occur until Stage III, which
was never intended to be reached.
•
The Fifth Circuit noted that various courts have held that when applying the economic substance doctrine, the proper
focus is on the particular transaction that gives rise to the tax benefit, not collateral transactions that do not produce
tax benefits.
–
In this case, the transactions that provided the tax benefits at issue were the loans from NatWest. Therefore,
the court found that the proper focus is on whether the loan transactions presented a reasonable possibility of
profit.
–
The Fifth Circuit found that the evidence clearly shows that Presidio and NatWest designed the loan
transactions and the investment strategy so that no reasonable possibility of profit existed and so that the
funding amount would create massive tax benefits but would never actually be at risk.
•
The Fifth Circuit also held that the Government lacked standing to appeal the district court’s partial summary
judgment ruling that Section 752 operates to eliminate the claimed tax benefits arising from the Partnerships’
participation in the loan transactions.
91
Schering-Plough Corp. v. United States
(1)
SP
$690.4
million
interest rate swaps
ABN
(US)
SC
(US)
SPI
(US)
SPL
(Swiss)
SL
(Swiss)
(2)
Assignment of
“receipt leg” of swaps
Facts: Schering-Plough Corporation (“SP”) owned all
of the stock of Schering Corporation (“SC”), which
owned all of the stock of Schering Plough-International
(“SPI”). SP, SC, and SPI were U.S. corporations.
SPI owned a majority of the voting stock of ScheringPlough Ltd. (“SPL”), which owned a majority share in
Scherico, Ltd. (“SL”). SPL and SL were Swiss
corporations.
SP entered into 20-year interest rate swaps with ABN,
a Dutch investment bank, in 1991 and 1992. The
swap agreements obligated SP to make payments to
ABN based on LIBOR and for ABN to make payments
to SP based on the federal funds rate for the 1991
swap and on a 30-day commercial paper rate (plus
.05%) for the 1992 swap.
The swap agreements permitted SP to assign its right
to receive payments under the swaps (the “receipt leg”
of the swap). Upon an assignment, SP’s payment to
ABN and ABN’s payment to the assignee could not be
offset against each other.
SP assigned substantially all of its rights to receive
interest payments to SPL and SL in exchange for
lump-sum payments totaling $690.4 million.
92
Schering-Plough Corp. v. United States
•
•
Taxpayer Position
– SP relied on Notice 89-21 to treat the swap and assignment transaction as a sale of the receipt leg
of the swap to its foreign subsidiaries (SPL and SL) for a non-periodic payment that could be
accrued over the life of the swap.
– The IRS issued Notice 89-21 to provide guidance on the treatment of lump-sum payments received
in connection with certain notional principal contracts in advance of issuing final regulations.
• Notice 89-21 required that a lump-sum payment be recognized over the life of a swap in order
to clearly reflect income.
• Notice 89-21 stated that regulations would provide the precise manner in which a taxpayer
must account for a lump-sum payment over the life of a swap and that similar rules would
apply to the assignment of a “receipt leg” of a swap transaction in exchange for a lump-sum
payment.
• Notice 89-21 permitted taxpayers to use a reasonable method of allocation over the life of a
swap prior to the effective date of the regulations.
• Notice 89-21 cautioned that no inference should be drawn as to the treatment of “transactions
that are not properly characterized as notional principal contracts, for instance, to the extent
that such transactions are in substance properly characterized as loans.”
– The IRS issued final regulations in 1993 that reversed the basic conclusion of Notice 89-21 and
provided that an assignment of the “receipt leg” of a swap for an up-front payment (when the other
leg remained substantially unperformed) could be treated as a loan. See Treas. Reg. 1.446-3(h)(4)
and (5), ex. 4.
IRS position
– The IRS argued that the swap and assignment transaction should be treated as a loan from the
foreign subsidiaries to SP, which would trigger a deemed dividend under section 956.
93
Schering-Plough Corp. v. United States
•
Court Decision
– The District Court found in favor of the government on four separate grounds that, in the court’s view,
would be sufficient to deny the taxpayer's claim for tax-deferred treatment under Notice 89-21. See
Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219 (D.C. N.J. 2009).
1. Substance Over Form
• The court noted that the integrated transaction had the effect of a loan in which SP borrowed an
amount from its foreign subsidiaries in exchange for principal and interest payments that were routed
through ABN.
• The court discounted SP’s arguments (i) that there was an absence of customary loan
documentation, (ii) that SP did not directly owe an amount to the foreign subsidiaries (even if ABN
failed to fulfill its obligations), and (iii) that the amount of interest paid by SP to ABN would not equal
the amount received by its foreign subsidiaries because of the different interest rate bases used
under the swap.
• The court determined that SP’s efforts to structure the transactions as sales failed to overcome the
parties’ contemporaneous intent and the objective indicia of a loan.
– The court stated that the foreign subsidiaries received the “economic equivalent” of interest and
noted that SP “consistently, materially, and timely made repayments” to its foreign subsidiaries.
– The court found that SP officials considered the transaction to be a loan.
– The court observed that SP did not use customary loan documentation for intercompany loans.
• The court also concluded that ABN was a mere conduit for the transactions which, according to the
court, further supported its holding that the transactions were, in substance, loans.
– ABN faced no material risk since it entered into “mirror swaps” to eliminate interest rate risk
(but not the credit risk of SP).
– The court found that ABN did not have a bona fide participatory role in the transactions,
operating merely as a pass-through that routed SP’s repayments to the Swiss subsidiaries.
94
Schering-Plough Corp. v. United States
•
Court Decision (cont’d)
2. Step Transaction
• The court also applied the step transaction doctrine as part of its substance over form
analysis to treat the swap and assignment transaction as a loan.
• In applying the “end-result test,” the court determined that the steps of the swap and
assignment transaction could be collapsed because they all functioned to achieve the
underlying goal of repatriating funds from the foreign subsidiaries (SPL and SL).
– In the court’s view, the evidence established that the swaps and subsequent
assignments were pre-arranged and indispensable parts of a “broader initiative” of
repatriating earnings from the foreign subsidiaries.
• The court also concluded the steps of the swap-and-assign transactions to be
interdependent under the “interdependence test.”
– The court found that the goal of the interlocking transactions was to repatriate
foreign-earned funds, and the interest rate swaps would have been pointless had
SP not subsequently entered into the assignments with its subsidiaries.
• The court rejected SP’s argument that, in applying the step transaction doctrine, the
IRS created the fictitious steps that (i) the foreign subsidiaries loaned funds to SP, (ii)
SP entered into an interest rate swap for less than the full notional amount with ABN,
and (iii) SP satisfied its obligation under the imaginary loans by directing ABN to make
future payments under the swap to its foreign subsidiaries.
• The court also rejected SP’s argument that the step transaction doctrine should not
apply because the IRS failed to identify any meaningless or unnecessary steps.
95
Schering-Plough Corp. v. United States
•
Court Decision (cont’d)
Economic Substance
•
The court concluded that the swap and assignment transaction failed the economic substance doctrine and,
thus, SP was not entitled to tax-deferred treatment.
•
The court followed 3rd Circuit precedent, ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998),
which treats the "objective" and "subjective" elements of the doctrine as relevant factors (rather than applying
a rigid conjunctive or disjunctive standard).
•
The court rejected the taxpayer's position that the repatriation proceeds represented "profit" from the
transaction. The court also noted that any interest rate risk due to the swaps was hedged and that SP incurred
significant costs in executing the transaction. In sum, the court found that there was little, if any, possibility of a
pre-tax profit.
•
The court concluded that both the swap and assignment lacked a business motive.
–
SP contended that it entered into both swaps for cash management and financial reporting objectives,
the 1991 swap for hedging purposes, and the 1992 swap for a yield enhancement function. The court
rejected each of these non-tax motivations.
–
Notably, the court avoided the difficult legal determination of whether the court must examine the whole
transaction or, as the government argued, just the component part that gave rise to the tax benefit (here,
the assignment step of the transaction).
4.
Subpart F Principles
•
The court determined that permitting the repatriation of $690 million in offshore earnings without at least a
portion of those earnings being captured under subpart F would contradict Congressional intent.
•
The court noted that Notice 89-21 did not supplant, qualify, or displace subpart F, nor was the notice intended
to permit U.S. shareholders of controlled foreign corporations to repatriate offshore revenues without incurring
an immediate tax.
•
In the court’s view, the notice only dealt with the timing of income recognition.
Third Circuit Decision
–
On appeal, the Court of Appeals for the Third Circuit upheld the District Court’s decision. See Merck & Co., Inc. v.
United States, 652 F.3d 475 (3d Cir. 2011).
–
The Third Circuit held that the District Court correctly found that the transactions were in substance loans, not sales.
–
Because the Third Circuit upheld the District Court’s characterization of the transactions as loans, it did not address
the District Court’s alternative conclusion that the transactions lacked economic substance.
3.
•
96
ConEd v. United States
ConEd
HBU
$
Periodic
Rent (debt portion)
CEL
Upfront and deferred rent
Headlease
CEL Trust
Sublease
EZH
Facts: ConEd, a U.S.-based utility, entered into a leveraged lease with EZH, a Dutch utility, on December 15, 1997. The lease property was an
undivided 47.7% interest in a gas fired cogeneration power plant located in the Netherlands (the “RoCa3 Facility”). Under the “Headlease,” ERZ
leased the interest in the RoCa3 Facility to CEL Trust, a trust formed by a subsidiary of ConEd, for a period of 43.2 years. CEL Trust leased the
interest back to EZH under the “Sublease” for a period of 20.1 years. CEL Trust was required under the Headlease to make an upfront rental payment
($120.1m), which was financed by an equity commitment of $39.3 million and a nonrecourse loan ($80.8m) from a third-party bank (“HBU”), and a
deferred rent payment ($831.5m) due at the end of the Headlease term. Pursuant to the Sublease, EZH was required to make periodic rent payments,
exclusive of certain payments, directly to HBU in satisfaction of CEL Trust’s obligations under the non-recourse loan. At the end of the Sublease term,
three options could be exercised: (1) EZH could exercise the Sublease Purchase Option for the price of $215.4 million, (2) CEL Trust could exercise
the Sublease Renewal Option to extend the lease term for approximately 16.5 years, or (3) CEL Trust could exercise the Retention Option pursuant to
which EZH would return its interest in the RoCa3 Facility to CEL Trust.
The parties entered into defeasance arrangements to finance their obligations under the LILO arrangement. EZH established a defeasance account
with the upfront payment attributable to the nonrecourse financing ($80.8m) to fund the “debt portion” of the periodic rental payments under the
Sublease. EZH also established a defeasance account with a portion of the upfront payment attributable to the equity commitment ($31.2m) to fund
the ”equity portion” of the periodic rental payments and the equity portion of the Sublease Purchase Option, if exercised by EZH. ConEd received a
pledge of the equity and debt defeasance investments and re-pledged the debt defeasance to the nonrecourse lender, HBU, to secure its obligations
under the nonrecourse note. For simplicity, the precise mechanics of the defeasance arrangements are not shown in the above diagram.
CED, as a subsidiary of ConEd, claimed deductions in 1997 for the prepaid rent transferred to EZH and for the interest attributable to the nonrecourse
financing.
97
ConEd v. United States – Court of Federal Claims
•
Spoliation Claim
– The government alleged that, at the time of the change to a new email system in late 2000,
ConEd had a duty to preserve evidence relevant to the LILO arrangement because it
anticipated litigation starting in 1997.
• The government’s argument was based on the fact that Con Ed claimed work product
protection for three memoranda drafted in 1997 that evaluated the tax consequences
of the LILO arrangement.
• In the alternative, the government argued that ConEd anticipated litigation in 1999
when Rev. Rul. 99-14 was issued.
• The government sought an inference in its favor regarding open factual issues as to
ConEd’s intent and understanding of the LILO arrangement.
– The Court of Federal Claims ruled in favor of ConEd. See Consolidated Edison Co. v.
United States, 90 Fed. Cl. 228 (2009).
• The court already had concluded that the memoranda at issue were not work product.
• The court also held that Rev. Rul. 99-14 by itself was not sufficient to give rise to an
anticipation of litigation.
• Accordingly, the court held that ConEd did not have a duty to preserve documents at
the time of the email conversion.
98
ConEd v. United States – Court of Federal Claims
•
Substance Over Form
– The government argued that the taxpayer did not qualify as the “true owner” of the leasehold
interest in the RoCa3 Facility such that it possessed the “benefits and burdens” of ownership.
– The Court of Federal Claims rejected the government’s argument.
– The court found that there was some risk of loss and some opportunity for profit.
• The court acknowledged that, if EZH does not, or is not certain to, exercise the
Sublease Purchase Option, then ConEd would likely satisfy the benefits and burdens
standard due to the risk incurred during the retention period.
• The court referred extensively to the record (using both taxpayer and government
experts) and, on the totality of the factual circumstances, concluded that the purchase
option was not compelled to be exercised.
– From an economic perspective, the court relied on expert testimony that
confirmed that the cost of exercising the purchase option would exceed the
remaining value in the RoCa3 Facility interest at the end of the Sublease term.
– In addition, the court found persuasive the fact that numerous conditions that may
affect the decision to make the election could change over time (e.g., discount
rates, inflation, market changes, technological evolution, state of Dutch utility
industry) and, thus, it was unlikely that an election was “virtually certain” at the
time of the transaction.
– The court discounted government expert testimony (used in multiple LILO
litigation cases) to the effect that the option would be exercised, in part, because it
failed to address the specific facts at issue in the case.
• The court relied on ConEd expert testimony regarding the various risks that may arise
upon an early termination of the LILO arrangement.
99
ConEd v. United States – Court of Federal Claims
•
Substance Over Form (cont’d)
–
The Court of Federal Claims rejected the government’s argument that only a future interest was acquired
because EZH held possession of the property during the Sublease period.
•
–
•
The court noted that possession is transferred in almost all true leases, including the lease in Frank
Lyon.
The Court of Federal Claims also concluded that the nonrecourse debt was valid.
•
The court noted that all leveraged leases involve nonrecourse debt, that the nonrecourse loan
permitted ConEd to acquire property, and that ConEd’s property rights had substantial value such that
ConEd would not walk away from the property and default on the loan.
•
The court rejected the government’s circular funds argument and found that the defeasance
arrangements, which only reduced risk, did not disqualify the debt as valid debt.
Economic Substance
–
The Court of Federal Claims viewed the Coltec decision as consistent with past economic substance
decisions that, in the aggregate, set forth the “general approach” to reviewing economic substance rather
than “formulaic prescriptions” for determining which elements will result in a finding of economic substance.
–
The court stated that the Coltec decision reduced the relative weight afforded to subjective business
motivations when applying the economic substance standard, although the court considered non-tax
business purposes to remain relevant, if not necessary, for the economic substance analysis.
–
The court articulated the standard in the opinion’s conclusion as follows –
“Coltec expands on the guidance in Frank Lyon, offering a methodology to analyze economic substance by
reviewing whether the taxpayer’s sole motivation was tax avoidance, which party bears the burden of proof
and, if the evidence does not demonstrate that the taxpayer’s sole motive was tax avoidance, a requirement
for objective evidence of economic substance in the transaction at issue.”
100
ConEd v. United States – Court of Federal Claims
•
•
Economic Substance (cont’d)
– Subjective Factors
• The Court of Federal Claims lists numerous non-tax business reasons for entering into
the LILO arrangement based on testimony offered by ConEd, including (i) the ability to
pursue new opportunities and alternatives in the deregulated market, (ii) the expectation
of making a pre-tax profit, (iii) ConEd’s entry into Western European energy markets,
(iv) potential to benefit from the residual value of the RoCa3 Facility, and (v) technical
benefits from operating a high tech plant in its own field of expertise.
– Objective Factors
• The Court of Federal Claims states that a “significant consideration” in the economic
substance analysis is whether there is a reasonable opportunity for profit at the time of
the transaction.
• The court concludes that Con Ed had a reasonable opportunity for profit under each of
the possible scenarios at the end of the Sublease (i.e., purchase option, renewal,
retention).
– The court noted that other decisions have accepted relatively low percentage of
pretax profit (e.g., 3 percent or more) for leasing transactions.
– In determining the profit percentage, the court did not accept the government’s
position that a discount rate must be used.
In sum, in applying the substance over form doctrine and the economic substance standard, the
court reiterated that it was applying the judicial standards to unique set of facts and cited
extensively to the record in this regard. On the basis of the totality of factual evidence, the court
distinguished recent court decisions (BB&T, Altria, Fifth Third) involving LILO arrangements that
were decided in favor of the government.
101
Wells Fargo v. United States – Court of
Federal Claims
•
•
•
•
•
In a subsequent decision, the Court of Federal Claims distinguished ConEd in Wells Fargo
v. United States, 91 Fed. Cl. 35 (2010), holding that a similar SILO (“sale in/lease out”)
transaction failed a substance-over-form analysis and lacked economic substance.
The court described ConEd as a “distinctly unique case” that was “easily distinguishable”
from Wells Fargo’s SILO transactions.
The court noted that, in ConEd, it repeatedly emphasized the fact-dependent basis for its
holding.
– The court went so far as to list a series of quotations from its earlier ConEd opinion in
which it stressed the uniqueness of the facts presented and the intended limited
application of its holding.
Accordingly, analyzing economic substance with respect to the specific SILO transactions
at issue, the court determined that Wells Fargo’s transactions were more similar to the
SILO/LILO transactions disregarded in AWG Leasing Trust v. United States, 592 F. Supp.
2d 953 (N.D. Ohio 2008), and BB&T Corp. v. United States, 2007-1 USTC ¶ 50,130
(M.D.N.C. 2007), aff’d, 523 F.3d 461 (4th Cir. 2008).
– Thus, the court denied Wells Fargo’s refund claim for the tax deductions stemming
from its SILO transactions.
On appeal, the Court of Appeals for the Federal Circuit affirmed the decision by the Court
of Federal Claims. Wells Fargo v. United States, 641 F.3d 1319 (Fed. Cir. 2011).
– The Federal Circuit upheld the decision of the Court of Federal Claims based solely on
the substance-over-form doctrine.
102
Southgate Master Fund v. United States
CCB
$
NPLs
Cinda
MCA
$100k &
note
NPLs
Cinda
Beal
1%
89.1% interest
in Southgate
99%
NPLs
Southgate
1%
$19.6m
Martel
Eastgate
MCA
Eastgate
99%
Southgate
NPLs
Facts: China Cinda, an entity owned and operated by the Chinese government (“Cinda”), paid face value (approx. $1.1
billion) for certain nonperforming loans (“NPLs”) held by the state-owned Chinese Construction Bank (the “CCB”). On
July 31, 2002, Cinda contributed these NPLs to Eastgate, a Delaware limited liability company, in exchange for 100% of
the interests in Eastgate. On or about July 31, 2002, Eastgate contributed the NPLs to Southgate, a Delaware limited
liability company, in exchange for a 99-percent membership interest. The remaining 1% membership interest was
acquired for $100,000 cash and a note by Montgomery Capital Advisers, a Delaware limited liability company formed to
pursue investment opportunities in China (“MCA”). D. Andrew Beal (“Beal”) formed Martel Associates, LLC, a Delaware
limited liability company (“Martel”), which purchased 90% of Eastgate’s interests in Southgate for approximately $19.4
million on August 30, 2002. After the acquisition, Martel owned an 89.1-percent interest in Southgate, and Eastgate and
MCA owned a 9.9-percent interest and a 1-percent interest, respectively.
103
Southgate Master Fund v. United States
Other
partners
Beal
$162m
(1)
Other
partners
GNMAs
(FMV = $180.5m)
89.1%
Southgate
interest
(3)
Beal
Martel
(1)
(2)
(2)
GNMA Repo
Martel
89.1%
UBS
$162m
Martel
Southgate
89.1%
GNMAs
Southgate
NPLs
Southgate
NPLs
Martel
GNMAs
Facts (cont’d): Southgate adopted a strategy to monetize the NPLs by selling a portion of low-quality NPLs to third parties and collecting on the
remaining high-quality NPLs. Southgate planned to sell 20 to 25 percent of the NPLs in 2002, which would trigger a substantial amount of built-in
losses to shelter Beal’s personal income in 2002. In late 2002, Beal and Martel entered in a sale-repurchase transaction (a “repo” transaction) and
a restructuring of Beal’s interest in Martel (collectively, the “Repo/Restructuring”) in order to increase Beal’s outside basis in Southgate so that he
could recognize the built-in losses that would be allocable to Beal (approx. $265 million).
The repo transaction consisted of the following steps: (i) Beal contributed Ginnie Mae securities (“GNMA” securities) with a basis and value of
approximately $180.5 million to Martel, (ii) Martel entered into a repo transaction with UBS in exchange for $162 million and an agreement to
repurchase identical GNMAs from UBS, and (iii) Martel distributed the $162 million to Beal and Beal guaranteed Martel’s obligation to repurchase.
In the restructuring, (i) Martel distributed its interest in Southgate to Beal and (ii) Beal contributed his interest in Martel to Southgate. Beal became
the sole manager of Martel under amended operating agreements and, in such capacity, held sole discretion inter alia to direct the purchase and
sale of securities by Martel and the use of all proceeds from the repo transaction. After the restructuring, Beal’s percentage interest in Southgate
increased to approximately 93.3 percent while Eastgate’s percentage interest decreased to 5 percent.
104
Southgate Master Fund v. United States
•
•
Taxpayer’s position
– Allocation of Southgate Losses
• Southgate incurred approximately $294.8 million in losses in 2002, of which approximately $292.8 million
were built-in losses (within the meaning of section 704(c)) and $2.0 million were post-contribution losses.
• Beal was allocated 90 percent of both the built-in losses and post-contribution losses in 2002 (approx.
$265 million) pursuant to section 704(c) and Treas. Reg. § 1.704-3(a)(7) (as those provisions were in
effect in 2002).
– Beal’s Outside Basis in Southgate
• Beal’s acquired a cost basis in Southgate upon acquisition from Eastgate (increased prior to the
Repo/Restructuring by a payment of a placement fee on behalf of Southgate and a loan to Southgate).
• Beal’s contribution of the GNMAs to Southgate increased his outside basis in Southgate by his basis in the
GNMAs, or $180 million.
• The $162 million in repo liabilities assumed by Southgate in connection with the restructuring (through its
ownership of Martel), and Beal’s guarantee of such liabilities, resulted in offsetting basis adjustments.
• Beal’s basis in Southgate was approximately $210.5 million as of December 31, 2002, and he reported an
ordinary deduction of approximately $216.3 million arising from his interest in Southgate.
IRS position
– The IRS argued that judicial doctrines (economic substance, sham partnership, and substance over form)
prevented Beal’s outside basis increase from the Repo/Restructuring.
– The IRS also raised three separate so-called “basis killer” arguments that would require a step-down in the basis
of the NPLs contributed to Southgate and, thus, deny all of built-in losses claimed by the partnership and
allocated to Beal:
• The IRS argued that Cinda was a dealer in securities and therefore Cinda would be required to mark-tomarket the NPLs transferred to Southgate.
• The IRS argued that section 482 should apply to reallocate income from the purchase of the NPLs by
Cinda from the CCB at face value.
• The IRS argued that NPLs were worthless at the time they were acquired by Cinda.
105
Southgate Master Fund v. United States
•
Court Decision
– The district court held that the judicial doctrines of economic substance, sham partnership, and substance
over form applied to deny Beal the increase in basis from the Repo/Restructuring. See Southgate Master
Fund v. United States, 651 F. Supp. 2d 596 (N.D. Tex. 2009).
– Economic Substance
• The district court stated that the transaction as a whole must be divided for purposes of the economic
substance analysis: (i) the partnership between Cinda, MCA, and Beal in the Southgate acquisition of
the NPLs and (ii) the Repo/Restructuring that increased Beal’s basis in Southgate.
• The district court held that Southgate itself had economic substance on the basis that the formation
was not shaped solely by tax-avoidance features. In that regard, the district court found that there was
a potential for profit (even though the venture turned out unprofitable) and noted that section 704(c),
as it existed prior to 2004, arguably encouraged these types of transactions.
• The district court held that the basis-increasing steps undertaken by Beal lacked economic substance.
The court found that Southgate did not have a reasonable possibility for profit from the transaction
(even though Southgate did in the original NPL transaction), in part, because Beal controlled the
income streams from the GNMAs and had sole discretion to award gains or losses to the partnership.
Furthermore, in the court’s opinion, the taxpayer also did not establish a valid business purpose other
than the tax benefits obtained by Beal.
– Sham Partnership
• The district court held that the Repo/Restructuring resulted in a sham partnership thereby denying
Beal any resulting basis increase. Note that the district court did not disregard the partnership for all
purposes.
• The district court found, as described above, that there was no substantive non-tax business reason
for structuring the Repo/Restructuring.
– Substance Over Form
• The district court also applied the substance over form doctrine to deny Beal the basis increase
resulting from the Repo/Restructuring.
• The district court appears to conclude that the Beal should be treated as entering into the repo
transactions directly, thereby disregarding the use of Martel in the transaction.
106
Southgate Master Fund v. United States
•
Court Decision (cont’d)
– Basis-Killer Arguments
• Dealer status of Cinda
– The district court rejected the government’s argument that Cinda should be treated as a
dealer in securities required to mark-to-market the NPLs contributed to Southgate.
– The district court noted that Cinda commonly entered into debt-to-equity swaps and
other non-sale transactions in which it collected for its own account in the years
preceding the transaction.
• Section 482 adjustment
– The district court rejected the government’s argument that section 482 should apply to
adjust the consideration paid by Cinda to acquire the NPLs from the CCB.
– The district court concluded that section 482 could not apply to the sale between Cinda
and the CCB because the adjustments contemplated by section 482 must be made to
entities having a U.S. tax liability.
– The district court also questioned whether Cinda and CCB could be viewed as related
parties for purposes of section 482.
• Worthlessness of NPLs
– The district court rejected the government’s argument that the NPLs were worthless
when acquired by Cinda and therefore Southgate could not recognize a taxable loss on
their disposition.
– The district court cited evidence that the NPLs were sold for consideration.
– The district court did not impose accuracy-related penalties asserted by the government, finding
that Beal acted in good faith and with reasonable cause.
107
Southgate Master Fund v. United States – Fifth Circuit Decision
•
On appeal, the Court of Appeals for the Fifth Circuit affirmed the district court’s decision. Southgate Master Fund, LLC v.
United States, 659 F.3d 466 (5th Cir. 2011).
Economic substance
•
The court affirmed the district court’s conclusion that Southgate’s acquisition of the NPLs had economic substance, applying
the standard adopted by the court in Klamath Strategic Inv. Fund – a transaction will be respected for tax purposes if it
exhibits objective economic reality, a subjectively genuine business purpose, and some motivation other than tax avoidance.
– The court found that the transaction had objective economic reality, noting that Southgate and its members entered
into the NPL investment with a reasonable possibility of making a profit.
– The court also agreed with the district court that Southgate and its members acquired the NPLs for legitimate
purposes and that they believed they could earn a profit from the NPLs.
•
The court rejected the government’s argument that the transaction lacked economic substance because the profit potential of
the transaction was insubstantial relative to its expected tax benefits.
– The court noted that this was factually incorrect, as the district court had found that the NPLs had a more than de
minimis potential for profit.
– From a legal standpoint, the court stated that the government’s argument conflated the court’s analysis of the
acquisition of the NPLs under the economic substance doctrine with the court’s analysis of the formation of Southgate
under the sham partnership doctrine.
– According to the court, “The acquisition of the NPLs did not, by itself, generate any tax benefits. It was the funneling
of that acquisition through the partnership structure that generated massive deductions for Beal. The fact that an
economically substantial transaction comes wrapped in a dubious form is not reason to disregard the transaction; it is
a reason to disregard the form.”
Sham partnership
•
The court agreed with the district court that Southgate was a sham partnership that must be disregarded for federal income
tax purposes, finding that (i) Montgomery, Beal, and Cinda did not intend to come together jointly to conduct the business of
collecting on the NPLs, and (ii) the parties lacked any genuine business purpose for their decision to form Southgate.
Substance over form
•
The court stated that, because it had concluded that the acquisition of the NPLs had economic substance but that the formal
partnership structure through which the acquisition took place was a sham, it had to determine what transactional form most
closely followed the substance of that acquisition.
•
The court held that Southgate’s acquisition of the portfolio of NPLs should be recharacterized as a direct sale of the NPLs by
Cinda to Beal.
Penalties
•
The court affirmed the district court’s decision to disallow the imposition of any accuracy-related penalties.
108
Country Pine Finance, LLC v. Commissioner
€1.9 note
€1.0
Members
J&S liability on
€16.6 million note
U.K. Residents
1
3
€16.6 million
4
€1.9 note
€1.0
note
Country
Pine
Fairlop
5
Currency rate swap
€16.6 million
Zurich
Bank
€13.6 note 2
€1.9 note
€1.0
Facts: In 2001, several individual taxpayers sold stock in the Burnham Insurance Group (“BIG”) to HUB International (“HUB”) (referred to as the
“Members”), recognizing gain on the exchange of BIG stock for HUB stock and cash.
In the CARDS transaction entered into in 2001, Fairlop Trading, LLC (“Fairlop”), an entity formed by two U.K. residents, borrowed €16.6 million
from Zurich Bank. Fairlop used the loan proceeds to purchase two promissory notes from Zurich Bank to collateralize the loan: one for €13.6
million and another for €2.9 million. Fairlop later exchanged the €2.9 million note for a new note of €1.9 million and €1.0. [Note that this
exchange not shown in diagram above.]
The Members formed Country Pine Finance, LLC (“Country Pine”) to participate in the CARDS transaction. The Members purchased the €1.9
million note and €1.0 from Fairlop in exchange for an agreement to become jointly and severally liable for the entire €16.6 loan from Zurich Bank
to Fairlop. The Members then contributed the €1.9 million note and €1.0 to Country Pine. In exchange, Country Pine guaranteed the loan to
Fairlop. The Members and Country Pine pledged the contributed property as collateral for the loan.
Country Pine and Zurich Bank entered into a currency swap pursuant to which Country Pine exchanged the €1.9 million note and €1.0 for $2.6
million in cash. Country Pine claimed a $11,952,871 loss on the exchange (allocated between a short-term capital loss on the note and an
ordinary loss on the euro) since it claimed a basis in the exchanged property equal to the full amount of the joint and several liability assumed by
the Members -- €16.6 million or $14.6 million.
The amounts exchanged served as the notional amounts under the swap. The swap required Zurich Bank to pay interest on €2.9 million
received from Country Pine (that equaled Country Pine’s payments to Zurich Bank on the assumed loan) and Country Pine to pay interest on the
$2.6 million received from Zurich Bank (that Country Pine used to obtain a promissory note from Zurich Bank, which was pledged back to Zurich
Bank as collateral).
109
Country Pine Finance, LLC v. Commissioner
•
•
•
•
IRS argued that the claimed losses should be denied because (i) the CARDS transaction lacked
economic substance, (ii) substance-over-form principles should apply to disallow the loss, and (iii)
neither Country Pine nor the Members could claim deductions under section 165, 465, or 988.
The Tax Court held that the transaction did not have economic substance under either the
standard applied in the 6th Circuit (no rigid test) or D.C. Circuit (disjunctive test), and denied the
claims for losses in the CARDS transaction. See Country Pine Finance, LLC v. Commissioner,
T.C. Memo. 2009-251.
– The Tax Court did not address other arguments in the T.C. Memo. opinion raised by the
government.
The taxpayer argued that the CARDS transaction had economic substance and was entered into
to permit Country Pine to finance real estate investments on the members’ behalf.
– Taxpayer argues that Country Pine and the Members were jointly and severally liable for the
entire € 16.6 million, and that Fairlop, the Members and Country Pine were at risk for the
loan proceeds.
– Taxpayer also argues that there was profit potential since real estate could have been
substituted for collateral on the loans.
The IRS argued that transaction had no economic substance and no practical effect other than
creating tax losses.
110
Country Pine Finance, LLC v. Commissioner
•
•
•
The Tax Court held that the tax losses must be denied under both an objective and a subjective analysis.
Objective Analysis
– Tax Court concluded that the transaction did not have a profit potential.
• None of the loan proceeds ever left Zurich Bank’s control as loans acquired promissory notes
that were pledged as collateral.
• Expert testimony established that the transaction had a negative net present value and rate of
return – fees of $700,000 paid in order to borrow €2.9 million for 1 year, the funds from which
purchased investments that could never earn a profit (e.g., promissory notes from Zurich
Bank).
– Tax Court concluded that the transaction should not be analyzed as if real estate were substituted
as collateral.
• Country Pine could only earn a profit if it could substitute collateral and earn a return in excess
of the cost of the initial loans.
• However, the court found that Zurich Bank would not have permitted the substitution without
imposing more onerous terms to account for its increased risk and that the Members knew
prior to the transaction that real estate could not be substituted as collateral without a
“haircut.”
• The Tax Court further held that any substitution would be viewed as a separate transaction so
that the currency exchange creating the tax loss would still have no pre-tax profit, citing
Coltec.
Subjective Analysis
– Tax Court held that the Members did not have a nontax business purpose for entering into the
CARDS transaction.
– Tax Court noted that the Members knew that real estate could not be substituted prior to the
transaction, the petitioner testified that the decision to enter into the transaction was to take
advantage of tax benefits, and that Members repeatedly testified that they did not read any of the
relevant documents or otherwise engage in due diligence.
111
Fidelity Int’l v. United States
•
The District Court of Massachusetts recently held that certain Son-of-BOSS type transactions should be
disregarded because they lacked economic substance. See Fidelity Int’l Currency Advisor A Fund LLC v. United
States, 2010-1 USTC ¶ 50,418 (D.C. Mass. 2010), aff’d, 661 F.3d 667 (1st Cir. 2011) (application of ES doctrine
not contested in appeal).
Relevant Facts:
•
Taxpayers owned approximately 25 million shares of EMC stock. In 2000, taxpayers’ basis in the stock was
extremely small in comparison to the stock’s trading price, and the sale of any portion of the stock would have
resulted in substantial capital gains. Taxpayers also owned options to purchase an additional 8 million shares of
EMC stock at very low strike prices. The exercise of the options would generate significant amounts of ordinary
income.
•
To avoid the large tax liabilities that would result from a stock sale or exercise of the stock options, taxpayers
invested in son-of-BOSS style tax shelters promoted by KPMG.
•
The first transaction involved the contribution of offsetting options (in large notional amounts) and EMC stock to
Fidelity High Tech Advisor A Fund, LLC, which was taxed as a partnership.
– Taxpayers treated the purchased option as an asset, but the sold option was not treated as a liability. Thus,
the taxpayers contributed assets to the partnership entity but not liabilities, creating an inflated basis in their
membership interest of more than $163 million. In 2002, the taxpayers sold all of the stock in Fidelity High
Tech and claimed a significant capital loss.
•
Taxpayers used a second transaction, the Financial Derivatives Investment Strategy (“FDIS”), a variation of the
scheme discussed above, to shelter ordinary income resulting from the exercise of their EMC stock options.
– The FDIS transaction, executed through Fidelity International Currency Advisor A Fund, LLC, generated
paper losses for taxpayers by assigning any offsetting "gains” offshore to one of two Irish confederates of
the tax promoters (neither of whom filed U.S. tax returns).
– The Fidelity International transaction resulted in the creation of artificial losses of $158.6 million in 2001,
which the taxpayers used to offset the ordinary income of $162.9 million from the option exercise on their
income tax return that year.
112
Fidelity Int’l v. United States –
District Court Decision
Taxpayer’s Economic Substance Arguments:
•
Taxpayers had a business purpose for the transactions.
– The Fidelity High Tech transaction was to serve as a hedge against a downward movement in the price of EMC stock.
– The Fidelity International transaction was to serve as a hedge against fluctuating interest rates and foreign currency
exchange rates.
•
The transactions possessed objective substance.
– Both transactions were reasonably designed and implemented to serve a hedging function, and there was a
reasonable possibility that the taxpayers could profit on the transactions.
Court’s Decision:
•
Economic Substance Analysis:
– The court stated that the First Circuit appears to have adopted a version of the economic substance doctrine that
looks to both the subjective and objective features of the transactions, without applying a rigid two-part test (citing
Dewees v. Commissioner, 870 F.2d 21 (1st Cir. 1989)).
– Taxpayers relied on several other First Circuit opinions, including Granite Trust Co. v. United States, 238 F.2d 670
(1st Cir. 1956), for the proposition that a transaction that is not fictitious should be upheld, without regard to the
subjective intent of the taxpayer.
– The court, however, stated that the Dewees opinion effectively overruled Granite Trust (as well the other cases cited
by taxpayers), “at least as to the broad contours of the economic substance doctrine.”
• The court stated that Dewees is in accordance with the view shared by most circuits, that a court may take into
account both objective and subjective factors in assessing whether a particular transaction had economic
substance.
• Accordingly, to the extent the cases cited by taxpayers may be read to support the proposition that a taxpayer’s
subjective intent is irrelevant, that proposition cannot survive the holding or the reasoning of Dewees.
– The court concluded that, in making an economic substance determination, it considers both the objective features of
the transactions and the subjective intent of the participants, including the overall features of the tax shelter scheme
and the intentions of the promoters.
• The court noted, however, that it was not necessary to decide whether the objective or subjective factors,
standing alone, would be sufficient to support a finding of a lack of economic substance in this case, as the
transactions at issue were without economic substance under either an objective or subjective analysis.
113
Fidelity Int’l v. United States –
District Court Decision
Overview of Court Analysis:
•
From a subjective standpoint, the transactions had no business purpose of any kind. The taxpayers did not enter
into the transactions for profit or to provide a hedge or other protection against economic risk, but to shelter capital
gains and ordinary income from taxation.
•
The transactions also had no economic substance from an objective standpoint.
Relevant Findings for Particular Transactions:
•
Fidelity High Tech
– The transaction served no reasonable hedging function
• Option trades were not a rational economic hedge
• Various components of the transaction served no hedging function
– There was no reasonable possibility of profit
• Transaction costs and fees were extremely high
• Expected return on the transaction was negative
• Net present value of the options was negative
• One-option payout was not a real possibility
• Options were not profitable
•
Fidelity International
– The transaction served no reasonable hedging function
• Interest rate and currency option transactions were not rational economic hedges
• Various components of the transaction served no hedging function
– There was no reasonable possibility of profit
• Capital structure was not rational
• Costs and fees for the transaction were extremely high
• Expected rate of return for the transaction was negative
• One-option payout was not a real possibility
• Transaction was intended to be profitless
114
Canal Corp. v. Commissioner
C
Indemnity
Agreement
GP
Guaranty of
LLC Loan
W
Assets
5% Interest +
Cash
Distribution
Financed by
LLC Loan
BOA
Assets
95% Interest
LLC
Loan
Facts: W, a wholly-owned subsidiary of C, proposed to transfer its assets and most of its liabilities to a newly-formed LLC
in which W and GP, an unrelated corporation, would have ownership interests. In 1999, GP transferred assets valued at
$376.4 million to the LLC in exchange for a 95-percent LLC interest. W contributed $775 million in assets to the LLC in
exchange for a 5-percent LLC interest. On the same day it received the contributions from W and GP, the LLC borrowed
$755.2 million from Bank of America and immediately transferred the loan proceeds to W as a special cash distribution.
GP guaranteed payment of the Bank of America loan, and W agreed to indemnify GP for any principal payments made
pursuant to its guaranty. W used a portion of the cash distribution it received to make a loan to C. W’s only assets after
the transaction were its LLC interest, a note from C, and a corporate jet. The LLC thereafter borrowed funds from a
financial subsidiary of GP to retire the bank loan.
In 2001, GP entered into a separate transaction that required it to divest its entire interest in the LLC. W subsequently
sold its LLC interest to GP, and GP then sold the entire interest in the LLC to an unrelated party. C reported gain from the
sale on its consolidated income tax return for 2001. The IRS determined that the joint venture transaction was a
disguised sale that resulted in capital gain includible in C’s consolidated income for 1999. The IRS also asserted a
115
substantial understatement penalty under section 6662(a).
Canal Corp. v. Commissioner
•
The Tax Court found that the facts and circumstances evidenced a disguised sale, and held that W sold its
business assets to GP in 1999, the year it contributed the assets to the LLC, not the year it sold its LLC interest.
See Canal Corp. v. Commissioner, 135 T.C. 199 (2010).
•
Under Treas. Reg. 1.707-3(c)(1), W’s transfer of assets to the LLC and simultaneous cash distribution were
presumed to effect a sale unless the facts and circumstances clearly established otherwise.
•
The taxpayer asserted that the LLC’s special distribution of cash to W was not part of a disguised sale, but was a
debt-financed transfer of consideration (an exception to the disguised sale rules).
– The regulations except certain debt-financed distributions in determining whether a partner received money
or other consideration for disguised sale purposes. See Treas. Reg. § 1.707-5. A distribution financed from
the proceeds of a partnership liability may be taken into account for disguised sale purposes to the extent
the distribution exceeds the distributee partner’s applicable share of the partnership liability.
•
The taxpayer further asserted that the transaction should not be recast as a sale because the anti-abuse rule
under Treas. Reg. § 1.752-2(j) did not disregard W’s agreement to indemnify GP, which, according to the
taxpayer, imposed on W the economic risk of loss for the LLC debt.
– Under the anti-abuse rule, a partner’s obligation to make a payment may be disregarded if (i) the facts and
circumstances indicate that a principal purpose of the arrangement between the parties is to eliminate the
partner’s risk of loss or to create a facade of the partner’s bearing the economic risk of loss with respect to
the obligation, or (2) the facts and circumstances of the transaction evidence a plan to circumvent or avoid
the obligation. See Treas. Reg. § 1.752-2(j)(1), (3).
•
The IRS argued that the taxpayer structured the transaction to defer capital gain, contending that W did not bear
any economic risk of loss when it entered the joint venture agreement because the anti-abuse rule under Treas.
Reg. § 1.752-2(j) disregards W’s obligation to indemnify GP. Thus, according to the IRS, the transaction should
be treated as a disguised sale.
Tax Court’s Disguised Sale Analysis
•
Addressing the taxpayer's argument that the distribution was not part of a disguised sale because it was a debtfinanced transfer of consideration, the court examined whether W had any allocable share of the LLC’s liability to
finance the distribution. To make this determination, the court focused on whether W bore any economic risk
under its agreement to indemnify GP.
116
Canal Corp. v. Commissioner
Disguised Sale Analysis (cont’d)
•
The court found that the taxpayer crafted the indemnity agreement to limit any potential liability to W’s assets.
– GP did not require the indemnity, and the indemnity agreement did not require W to maintain a certain net
worth.
– W was chosen as the indemnitor because it would cause the economic risk of loss to be borne only by W’s
assets rather than C’s.
– Contractual provisions reduced the likelihood of GP invoking the indemnity against W.
•
The court also noted that, regardless of how remote the possibility was that W would have to pay anything under
the indemnity agreement, W lacked sufficient assets to cover the maximum exposure on the indemnity.
– In particular, the court noted that C could remove W’s main asset, the intercompany note, from W’s books at
any time.
•
The court concluded that W’s agreement to indemnify GP’s guaranty lacked economic substance and afforded no
real protection to GP.
Section 6662(a) Penalty
•
The taxpayer claimed that it reasonably relied in good faith on tax advice from PwC, including legal analysis
detailed in a “should” level PwC opinion, and that no penalty should be imposed.
•
The court, however, determined that PwC based its advice on unreasonable assumptions, noting the following:
– The draft opinion submitted into evidence was disorganized and incomplete.
– The opinion was filled with questionable conclusions and unreasonable assumptions. The opinion assumed
the indemnity would be effective and that W would hold assets sufficient to avoid the anti-abuse rule, failing
to consider whether the indemnity lacked substance.
– The rendering of a “should” level opinion was unreasonable given the dubious legal reasoning provided in
the opinion.
– It was unreasonable for the taxpayer to have relied on an analysis based on erroneous legal assumptions.
•
The court also found that the taxpayer did not act with reasonable cause or in good faith in relying on PwC’s
advice, finding that any advice received was tainted by an inherent conflict of interest because a member of the
PwC team helped plan the transaction.
– The court also noted that the opinion was issued for an exorbitant fixed fee of $800,000, which was
contingent on the closing of the transaction.
117
Flextronics America, LLC v. Commissioner
C-MAC
Industries
Bank
Cash
(1)
Pledge of Inventory
as Security for
$51.6 million liability
Cash
Nortel
C-MAC
Holdings
Stock
(2)
C-MAC
Interconnect
Inventory
Inventory
(subject to $51.6
million liability)
C-MAC
Holdings
C-MAC Holdings
Stock + Note
Facts: C-MAC Industries, a Canadian corporation and the parent company of all C-MAC entities (the “C-MAC group”), owned CMAC Interconnect, a Canadian company, and C-MAC Holdings, a U.S. subsidiary. In 1998, C-MAC Industries agreed to acquire a
manufacturing facility from Nortel, an unrelated party who was of the largest purchasers of the C-MAC group’s products. Before
closing, C-MAC Interconnect acquired the facility’s inventory from Nortel for $12.1 million. C-MAC Interconnect and Nortel also
executed a bailment agreement, which provided that the inventory was to be kept and maintained by Nortel at the facility pending the
closing, but also provided that C-MAC Interconnect and its affiliates had the authority to pledge and encumber the inventory and
transfer rights to, title to, and interest in the inventory. The acquisition was financed through loans totaling $51.6 million from a bank
to various C-MAC entities, with the acquired inventory pledged by C-MAC Interconnect as security. Following its purchase of the
inventory, C-MAC Interconnect sold a portion of the inventory to C-MAC Quartz, another member of the CMAC group that operated a
facility in the United Kingdom, which transferred the purchased inventory to another facility maintained by Nortel. Subsequently, CMAC Interconnect transferred the inventory to C-MAC Holdings in exchange for 10,107 shares of C-MAC Holdings stock and a $9.5
million promissory note. Concurrently, C-MAC Industries transferred $4 million to C-MAC Holdings in exchange for 17,124 shares of
C-MAC Holdings stock.
118
Flextronics America, LLC v. Commissioner
C-MAC
Industries
(2)
(1)
Inventory (subject to
$51.6 million liability) +
Cash
C-MAC
Holdings
C-MAC
Network
Systems
C-MAC
Network
Systems
Stock +
Note
Nortel
Cash
Noninventory
Assets
Facts (cont’d): C-MAC Holdings transferred the inventory and $2.3 million to C-MAC Network Systems, a newly-formed
U.S. subsidiary, in exchange for 10,107 shares of C-MAC Network System’s stock and a $9.5 million promissory note.
Another entity within the C-MAC group then loaned $42.2 million to C-MAC Network Systems, which purchased the
remaining noninventory facility assets from Nortel. On its 1998 federal income tax return, Taxpayer claimed a $37.3
million loss on the disposal of the inventory. This amount was based on a $39.8 million increase in the inventory’s basis
under sections 357(c) and 362(a)(1). Under section 357(c), in a section 351 exchange, if the sum of the liabilities
assumed by a transferee and the amount of the liabilities to which transferred property is subject exceeds the adjusted
basis of the transferred property, the excess is recognized as gain to the transferor. Under section 362(a)(1), the basis of
property transferred to the transferee in the section 351 transaction is equal to the basis of the transferred assets in the
hands of the transferor, increased by the gain recognized by the transferor on the transfer.
119
Flextronics America, LLC v. Commissioner
•
•
•
•
Although the IRS agreed that the inventory transactions involving C-MAC Holdings and C-MAC Network Systems
met the literal requirements of section 351, the IRS contended that the inventory transactions should be
disregarded because they fell outside the statutory purpose of section 351, lacked section 351 business purpose,
lacked economic substance, and were subject to disallowance under the step transaction doctrine.
The Tax Court, however, held that the inventory transactions were valid transactions, and rejected each of the
IRS’s contentions, stating that it was “not inclined to stretch inapplicable judicial doctrines to corral a transaction
that escaped before Congress closed the barn door.” See Flextronics America, LLC v. Commissioner, T.C.
Memo. 2010-245, aff’d mem., No. 11-70949 (9th Cir. 2012).
– In 1999, Congress amended section 357(c) and added sections 357(d) and 362(d), which effectively provide
that the bump-up in basis could not exceed the fair market value of the transferred property.
Scope of Section 351
– The IRS, citing Wolf v. Commissioner, 357 F.2d 483, and Gregory v. Helvering, 293 U.S. 465 (1935),
asserted that the section 351 inventory transactions fell outside the statutory purpose of section 351
because the purpose of that section is the deferral of gain or loss recognition, not total avoidance.
• The IRS focused on the fact that C-MAC Network Systems received the tax benefit of the loss, while
C-MAC Interconnect was not subject to U.S. tax and did not incur a corresponding gain.
– The Tax Court distinguished the case law relied on by the IRS, noting that, although the creation and use of
entities and transactions that lack substance falls outside the purpose of section 351, the inventory
transactions at issue were valid substantive transactions.
Business Purpose
– The IRS contended that the inventory transactions lacked a business purpose as required under section
351.
– The Tax Court, while noting that the existence of a business purpose requirement under section 351 was
unclear, found that there was a business purpose for the inventory transactions, which provided for part of
the capitalization of C-MAC Network Systems and enabled the acquired facility to be operated as a separate
subsidiary of C-MAC Industries’ U.S. consolidated group.
– The Court disregarded the role of the tax advisors who encouraged the use of the planning technique, noting
that such advice did not nullify the Taxpayer’s business purpose.
120
Flextronics America, LLC v. Commissioner
•
•
Economic Substance
– The Tax Court rejected the IRS’s argument that the inventory transactions should be disregarded for lack of economic
substance, holding that the inventory transactions had economic substance and were legally valid transactions that
did what they purported to do.
• According to the Court, C-MAC Interconnect purchased the inventory from Nortel, sold part of the inventory to
C-MAC Quartz (which needed the inventory for its business), pledged the inventory as security for the bank
loans needed to purchase the facility, and transferred the remaining inventory to C-MAC Holdings. C-MAC
Holdings capitalized C-MAC Network Systems by contributing the inventory and other assets, which was legally
transferred and subject to a valid lien.
– The Court rejected the IRS’s argument that C-MAC Interconnect’s purchase of the inventory was in substance an
advance deposit on the inventory acquired at closing, and that C-MAC Interconnect had no right to possession or
control of, nor did it benefit from, the inventory until after closing.
• According to the Court, upon the purchase of the inventory the C-MAC group had the right to pledge and
encumber the inventory and transfer rights to, title to, and interest in the inventory. The C-MAC group also
benefitted from the inventory purchase, as C-MAC Interconnect sold some of the inventory and made it
available for use in its other operations.
• The Court rejected the IRS’s argument that C-MAC Interconnect’s sale of the inventory to C-MAC Quartz was
contrived or invalid.
• The Court thus concluded that the advance inventory purchase had economic substance.
Step Transaction Doctrine
– The IRS argued that C-MAC Interconnect and C-MAC Holdings were mere conduits for C-MAC Network’s purchase of
the inventory and that the transfers were without economic effect because neither conducted any business with the
inventory and their ownership of the inventory was transitory.
– The Tax Court, however, found that C-MAC Interconnect and C-MAC Holdings were bona fide entities that used the
inventory in their businesses.
• C-MAC Interconnect sold part of the inventory to C-MAC Quartz for use in C-MAC Quartz’s business, and CMAC Holdings used the inventory to capitalize C-MAC Network Systems.
• The inventory transactions also allowed the C-MAC group to create a separate U.S. subsidiary to operate the
acquired facility and for that subsidiary to obtain the capital it needed.
– The Tax Court thus concluded that the step transaction doctrine was inapplicable.
121
Sundrup v. Commissioner
Payments for
Residence
Sundrups
Residence
Transfer
Consulting
Leasing
Management Services
Payment
Management Services
Payment
Facts: Ronald and Helen Sundrup (the “Sundrups”), had operated a trucking business as a sole proprietorship since 1967. In 2000,
the Sundrups formed three separate entities – Sundrup Transfer, Inc. (“Transfer”), Sundrup Leasing, LLC (“Leasing”), and Sundrup
Consulting, Inc. (“Consulting”). The Sundrups were the sole owners of the entities and the only members of their boards. Transfer
operated as a trucking business and engaged in the same types of business activities previously conducted by the Sundrups in their
sole proprietorship. The Sundrups transferred to Leasing certain assets that had been used in the trucking business, which Leasing
leased to Transfer for use in Transfer’s trucking business. Consulting executed separate, but substantially similar, “management
consulting agreements” with both Transfer and Leasing. Under these agreements, Consulting agreed to consult with Transfer and
Leasing on matters related to the management and operation of their businesses. Transfer and Leasing made monthly payments to
Consulting under the management consulting agreements. The Sundrups and Consulting also entered into a real estate contract
whereby the Sundrups agreed to sell their residence to Consulting. The Sundrups, however, did not execute a deed in favor of
Consulting with respect to their residence, and the Sundrups continued to live in their residence. Consulting paid to the Sundrups
certain amounts described as interest and principal. Consulting also paid virtually all expenses relating to the Sundrups’ residence,
in addition to other personal expenses. The IRS issued notices of deficiency to the Sundrups, Transfer, and Consulting that
disallowed various deductions arising from the transactions between the parties. The IRS also determined that the Sundrups,
Transfer, and Consulting were liable for accuracy-related penalties under section 6662.
122
Sundrup v. Commissioner
Parties’ Arguments
•
The IRS argued that the transactions between (i) Transfer and Consulting, and (ii) Leasing and Consulting, in which
Consulting purported to provide services to each of these companies, should not be respected for tax purposes. The IRS
also argued that the transaction between the Sundrups and Consulting, under which Consulting purported to agree to buy
the Sundrups’ residence, should not be respected for tax purposes.
– According to the IRS, there was no non-tax business purpose for any of the transactions, and each of the transactions
was without economic substance and a sham.
– The IRS contended that Transfer and Leasing’s payments to Consulting enabled the Sundrups to live a tax-free
lifestyle through Consulting’s payment of their personal living expenses, and that such payments were not deductible.
– The IRS also argued that the Sundrups’ sale of their residence was part of a scheme to deduct their personal living
expenses.
•
The petitioners contended that the transactions should be respected for tax purposes, arguing that Transfer, Leasing, and
Consulting were created primarily for corporate protection in the form of premises liability, and that the companies were not
part of a scheme to deduct the taxpayer’s personal expenses.
Tax Court Holding
•
The Tax Court agreed with the IRS and held that the transactions lacked economic substance. Sundrup v. Commissioner,
T.C. Memo. 2010-249.
– The court stated that it was unwilling to rely on the respective testimonies of Mr. and Mrs. Sundrup (the only witnesses
at trial) as to why they incorporated Consulting.
– According to the court, the only intended purpose of the respective transactions was the tax-avoidance objective of
having Consulting pay the Sundrups’ personal living expenses with the funds that Transfer and Leasing paid to
Consulting and for which Transfer and Leasing claimed tax deductions.
– Thus, the court found the transactions were entered into only for tax-avoidance reasons and did not have economic
substance.
•
Accordingly, the court concluded that the transactions should not be respected for tax purposes.
– As a result, (i) Transfer was not entitled to deduct its payments to Consulting, (ii) Leasing was not entitled to deduct its
payments to Consulting, and (iii) the Sundrups did not have interest income from the purported interest payments
received from Consulting.
•
The court also upheld the section 6662 accuracy-related penalties asserted against the Sundrups, Transfer, and Consulting,
rejecting the petitioners’ claim that they had reasonable cause and acted in good faith in taking their tax return positions.
– The court repeated its conclusion that the transactions at issue should not be respected for tax purposes.
– The court found that, based on the evidence in the record, the Sundrups, Transfer, and Consulting were negligent and
disregarded rules or regulations, or otherwise did not do what a reasonable person would do, with respect to the items
that resulted in their respective underpayments.
– The court further held that there was not reasonable cause for, and that the Sundrups, Transfer, and Consulting did
not do what a reasonable person would do, with respect to any portion of their underpayments of tax.
123
Historic Boardwalk Hall, LLC v.
Commissioner
NJSEA
PB
(.01% ownership interest)
(99.9% ownership interest)
Section 47
Credits
Section 47
Credits
Boardwalk
Facts: The New Jersey Sports and Exposition Authority (“NJSEA”), a State instrumentality, and PB Historic Renovations, LLC (“PB”)
formed Historic Boardwalk Hall, LLC (“Boardwalk”), which was treated as a partnership for federal tax purposes, to invest in the
historic rehabilitation of East Hall, a convention center in Atlantic City, New Jersey. PB had a 99.9% ownership interest in
Boardwalk, and NJSEA had the remaining .01% interest. Because it was a historic structure, the rehabilitation of East Hall had the
potential to earn historic rehabilitation credits under section 47. The formation of Boardwalk was intended to allow PB, a private
party, to earn these historic rehabilitation credits from the rehabilitation of the government-owned East Hall. PB lent funds to
Boardwalk and made capital contributions totaling $18 million. PB was entitled to a preferred return equal to 3% of its adjusted
capital contribution. The transaction documents also included various purchase options in favor of NJSEA and put options in favor of
PB. East Hall underwent significant rehabilitation during the years at issue, and Boardwalk claimed qualified rehabilitation
expenditures. Boardwalk allocated these expenditures to PB, and PB claimed historic rehabilitation tax credits under section 47.
The IRS issued an FPAA in which it determined that (i) Boardwalk was created for the express purpose of improperly passing along
tax benefits to PB and was a sham, (ii) that PB’s interest in Boardwalk was not a bona fide partnership interest because it had no
meaningful stake in the success or failure of Boardwalk, (iii) that East Hall was not sold to Boardwalk because the benefits and
burdens of ownership did not pass to Boardwalk, and (iv) that Boardwalk should be disregarded under Treas. Reg. § 1.701-2(b).
The IRS also imposed an accuracy-related penalty under section 6662.
124
Historic Boardwalk Hall, LLC v.
Commissioner
Economic Substance
• The Tax Court held that Boardwalk was not a sham and did not lack economic substance. Historic Boardwalk Hall, LLC v.
Commissioner, 136 T.C. 1 (2011).
• The Tax Court applied the economic substance doctrine as interpreted by the Third Circuit, which requires a court to “analyze two
aspects of a transaction to determine if it has economic substance: its objective economic substance and the subjective
motivation behind it.”
• The court further noted that these aspects do not constitute prongs of a rigid two-step analysis, but are related factors that
inform the analysis of whether a transaction had sufficient substance apart from tax consequences.
• Under this test, a transaction that affects a taxpayer’s net economic position, legal relations, or non-tax business interests
will not be disregarded merely because it was motivated by tax considerations.
• IRS Arguments:
• The IRS argued that Boardwalk was a sham because it lacked objective economic substance.
• According to the IRS, NJSEA and PB negotiated and executed a transaction in anticipation of a limited number of
possible outcomes, none of which would appreciably affect PB’s economic position aside from a reduction of its tax
liabilities.
• The IRS also argued that, even though PB was entitled to a 3% return on the transaction, such return was less than
PB could have earned had it invested in other financial instruments.
• The IRS also argued that Boardwalk served no subjective business purpose because it was intended solely to facilitate
NJSEA’s sale of rehabilitation tax credits to PB.
• The IRS’s arguments relied significantly on the conclusion that the rehabilitation credits were to be ignored in evaluating
economic substance.
• In support of this position, the IRS cited Friendship Dairies, Inc. v. Commissioner, 90 T.C. 1054 (1988), for the
proposition that investment tax credits are never to be taken into account in determining the economic substance of
a transaction.
• Petitioner’s Arguments:
• Petitioner argued that the economic substance doctrine was inapplicable because Congress intended section 47 to spur
investment in historic rehabilitation projects that would otherwise not be economically feasible.
• Relying on Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), petitioner also argued that the rehabilitation tax credits
should be taken into account in determining whether the transaction had economic substance and provided a net
economic benefit to PB.
125
Historic Boardwalk Hall, LLC v. Commissioner
Economic Substance (cont’d)
• The Tax Court determined that PB did not invest in the Boardwalk transaction solely to earn rehabilitation tax
credits.
• The court stated that, taking into account both PB’s 3% return and the expected tax credits, the
transactions, when viewed as a whole, had economic substance.
• The court also found that PB, NJSEA, and Boardwalk had a legitimate business purpose, to allow PB to
invest in the rehabilitation of East Hall.
• The court rejected the IRS’s argument that the structure of the transactions prevented the transactions from
affecting NJSEA and PB’s economic positions.
• The court pointed to the legislative history of section 47, which the court found indicated that section 47 was
intended to encourage taxpayers to participate in what would otherwise be an unprofitable activity.
• The court noted that, without the rehabilitation credit, PB would not have invested in the rehabilitation of
East Hall, because it could not have earned a sufficient net economic benefit on its investment.
• The court found that Congress intended the credit to address this very issue.
• The court rejected the IRS’s attempt to read the Tax Court’s holding in Friendship Dairies as establishing that
the investment tax credit is never taken into account in considering the economic substance of a transaction.
• The court stated that Friendship Dairies did not make such a broad holding.
• The court also found that Friendship Dairies was distinguishable on its facts because the transaction at
issue had no chance of profitability.
Other Holdings
• The Tax Court also held that (i) Boardwalk was a valid partnership, (ii) NJSEA transferred the benefits and
burdens of ownership of East Hall to Boardwalk, and (iii) the IRS’s attempt to recast the transaction under
Treas. Reg. § 1.701-1(b) was inappropriate.
• The court also found that the section 6662 accuracy-related penalty asserted by the IRS was inapplicable.
Third Circuit Appeal
• The government has appealed to the Court of Appeals for the Third Circuit.
• Questioning during oral arguments focused on whether PB had actual economic risk in Boardwalk and
126
whether PB was a bona fide partner.
Historic Boardwalk Hall, LLC v. Commissioner –
Third Circuit Decision
Third Circuit
• The Third Circuit reversed the Tax Court, holding that PB should not be treated as a bona fide partner in
Boardwalk, because PB did not have a meaningful stake in the success or failure of the partnership.
• Bona Fide Partner
• The court found that PB had no meaningful downside risk because it was certain to recoup its
contributions to Boardwalk, and to receive either the tax credits or their cash equivalent.
• There was no risk that PB would not receive tax credits in an amount that was at least equivalent
to installments it had made to date. Its investment and return were protected by a Tax Benefits
Guaranty. Further, it was protected from the possibility that the rehabilitation would not be
completed, because the project was fully funded before PB provided contributions to Boardwalk.
• The court also found that PB had no meaningful upside potential.
• The court noted that the financial projections for the project were “smoke and mirrors,” and that
“the parties and their advisors were imaginative in creating financial projections to make it appear
that HBH would be a profit-making enterprise.”
• The court followed TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) and Virginia Historic
Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011) in construing when a
partnership exists under Culbertson v. Commissioner, 337 U.S. 733 (1949).
• No Decision on Economic Substance
• The court assumed, without deciding, that the transaction had economic substance. It expressly did
not address the dispute as to whether it could consider the tax credits in evaluating whether the
transaction had economic substance.
• “Sham Partnership Theory”
• The court refused to give credence to the Commissioner’s “sham partnership theory.” The
Commissioner described this theory as a “variant of the economic substance (sham-transaction)
doctrine.” This “sham partnership theory” looks at whether the formation of the partnership made sense
from an economic standpoint, and if there was otherwise a legitimate business purpose for using the
partnership form. The court seemed to agree with PB, which argued that the “sham partnership theory”
“inappropriately blurs the lines between the economic substance doctrine and the substance over form
doctrine,” which the court pointed out are distinct doctrines.
127
Superior Trading, LLC v. Commissioner
Arapua
Holding Company
Membership Interests
Membership
Interests
U.S.
Investors
(2)
Receivables
(1)
Trading Company
Membership Interests
Warwick
Membership
Interests
Cash / assets
(3)
Receivables
Holding Company
Membership Interests
Holding
Companies
Trading
Companies
Facts: In 2003, Arapua, a retail company headquartered in Brazil, contributed past due consumer receivables to Warwick, an
Illinois LLC, in exchange for 99% of the membership interests in Warwick. Warwick contributed portions of the consumer
receivables to 14 different LLCs (trading companies) in exchange for 99% membership interests. Individual U.S. investors acquired
membership interests in the trading companies through another set of LLCs (holding companies), to which Warwick had contributed
most of its membership interests in each trading company in exchange for holding company membership interests. Each of the
LLCs elected to be treated as a partnership for federal tax purposes, and Warwick and the trading companies claimed a carryover
basis in the consumer receivables under section 723. During 2003 and 2004, the trading companies liquidated the distressed
receivables for their FMV, with the resulting loss (the difference between the face amount and the FMV of the receivables) allocated
to the individual U.S. investors owning membership interests in the holding companies. Each of the individual U.S. investors
owning membership interests in a trading company through a holding company claimed the benefits of these deductions on their
respective federal income tax return. The individual U.S. investors had to contribute significant cash or other assets to the holding
companies to generate the needed outside basis in his/her holding company interest to claim his/her share of the loss. Warwick
also claimed losses on the sale of membership interests in the holding companies to the individual U.S. investors. The IRS issued
FPAAs attacking the characterization of the transactions by Warwick and the trading companies on several grounds, including lack
of economic substance.
128
Superior Trading, LLC v. Commissioner
• The Tax Court held for the IRS, but declined to apply the economic substance doctrine. Superior
Trading, LLC v. Commissioner, 137 T.C. 70 (2011).
• The Tax Court stated that the tax benefits produced by the transaction were confined to timing gains
(each individual U.S. investor’s outside basis was reduced by the amount of the loss resulting from the
distressed receivables, so that the U.S. investor would later have gain on the redemption of his/her
partnership interest), and that the claiming of the tax benefits required sufficient outside basis, which
necessitated an investment of real assets.
• The court found that it could “safely address [the transaction’s] sought-after tax characterization
without resorting to sweeping economic substance arguments.”
• According to the court, “[the transaction] requires a minimum of two parties, with one willing to
give up something of substantive value. In an arm’s length world, this would happen only if
adequate compensation changed hands. Consequently, we need only look at the substance
lurking behind the posited form, and where appropriate, step together artificially separated
transactions, to get to the proper tax characterization.”
• The Tax Court noted the IRS’s argument that the transactions had no independent economic
substance.
• The court stated that it was not convinced by the IRS’s argument that the trading companies had
no chance of earning a pre-tax profit.
• However, the court found that it did not need to resolve these fact-intensive issues to rule on the
losses claimed by Warwick and the trading companies.
• The Tax Court ultimately held that Warwick was not a valid partnership and that a sale, rather than a
contribution to such partnership, had taken place, and applied the substance-over-form and step
transaction doctrines.
129
WFC Holdings Corp. v. United States
Cash
(2)
Charter
Preferred
Stock
WFC
Cash
Charter
Preferred
Stock
Lehman
Brothers
(3)
(1)
Banks
Securities +
Leasehold
Interests
Charter
Charter Preferred
Stock +
Assumption of
lease obligations
Facts: WFC was the parent corporation of an affiliated group of corporations, including Wells Fargo Bank, N.A. and Wells
Fargo Bank (Texas), N.A. (“Banks”), and Charter Holdings, Inc. (“Charter”). On December 17, 1998, the Banks transferred (i)
government securities with an aggregate FMV of $429,899,099 and a basis of $427,849,534 and (ii) leasehold interests in
twenty-one commercial properties to Charter in exchange for (i) 4,000 shares of preferred stock in Charter and (ii) Charter’s
assumption of lease obligations (the rent payable under the transferred leases). The transferred leases were “underwater,”
with the present value of the future cash flows associated with such leases estimated to be negative $425,900,099. On
December 17, 1998, the Banks sold their 4,000 shares of Charter preferred stock to WFC for $4,000,000. On February 26,
1999, WFC sold 4,000 preferred Charter shares to Lehman Brothers, Inc. for $3,750,022. On its consolidated federal income
tax return for 1999, WFC included a deduction for a capital loss in the amount of $423,849,534. WFC did not utilize any
portion of the 1999 capital loss on its 1999 return, and in 2003 filed a refund claim for taxes previously paid in 1996 based on
an NOL carryback from its 1999 return. The IRS disallowed the refund claim filed by WFC.
130
WFC Holdings Corp. v. United States
• The district court held in favor of the government and found that the transaction should not be
respected under the economic substance doctrine. WFC Holdings Corp. v. United States, 2011-2
USTC ¶ 50,650 (D.C. Minn. 2011).
Statutory Requirements
• The capital loss claimed by WFC resulted from its position that the transfer/assumption of liabilities in
the Banks’ section 351 exchange with Charter did not reduce the basis in the Charter stock received
by the Banks under sections 358(d)(2) and 357(c)(3).
• The government, relying on section 357(b), contended that the amount of liabilities should be
subtracted from the taxpayer’s basis in the Charter stock.
• The court rejected the government’s interpretation and concluded that section 357(b) did not operate
to reduce WFC’s basis in the Charter stock.
• The court agreed with the decisions in Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed.
Cir. 2006) and Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006) and the
finding that section 357(b) applies only to determine whether gain is recognized in a section 351
exchange, not to calculate the basis of stock received in the exchange.
• The court also rejected the government’s argument that the transaction should be separated into two
parts: (i) the Banks’ transfer of $426 million of securities in exchange for Charter’s assumption of
lease liabilities with a projected value of negative $426 million, and (ii) the Banks transfer of $4 million
of securities in exchange for $4 million of Charter stock (with only the second transfer qualifying as a
section 351 exchange).
• The court noted that the government failed to provide any evidentiary support or case law that
supported its position.
131
WFC Holdings Corp. v. United States
Economic Substance Doctrine
• Although the court found that the government did not show that WFC failed to comply with the technical requirements of the
Code, it stated that WFC was not entitled to a refund unless the transaction passed muster under the common law “sham
transaction” or “economic substance” doctrine.
• In conducting its analysis, the court applied the test set forth in Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th
Cir. 1985) – that a transaction will be characterized as a sham if (i) it is not motivated by any economic purpose outside of
tax considerations (the business purpose test), and (ii) if it is without economic substance because no real potential for profit
exists (the economic substance test).
• The court noted that, because the transaction did not pass muster under either prong of the test in Rice’s Toyota
World, it did not have to consider the consequence of failing to prove only one of the two prongs.
• The court found that the transaction lacked a legitimate business purpose aside from tax benefits, citing the following
factors—
• The evolution and development of the transaction strongly suggested that it was designed and understood as a tax
shelter.
• WFC failed to show that the asserted regulatory benefits of transferring the leases to Charter drove the transfer of
the selected leases, and that such purpose motivated the transaction as a whole.
• WFC failed to establish that it conducted the transaction to immunize its lease negotiators from pressure to cut
unfavorable deals with bank customers leveraging their banking relationship with WFC.
• The record did not support the finding that the transaction enabled any financial benefit from increased management
efficiency through centralization and the avoidance of bureaucracy.
• The court also held that the transaction lacked objective economic substance—
• The sale of the Charter stock to Lehman Brothers lacked economic substance, and did not enhance WFC’s ability to
dispose of the underwater leases and otherwise had no non-tax economic value to WFC.
• WFC could not show that the transaction had the potential to generate profits anywhere close to the loss it claimed
as a result of the sale of the Charter stock.
• Even excluding the purported $423 million capital loss, it was not clear that WFC had a reasonable expectation of
profit absent tax considerations.
• The purported $423 million loss on the stock sale was fictitious; the actual rent expense deductions to be taken by
Charter were real losses to be deducted as incurred.
132
Pritired 1, LLC v. United States
Citibank
Principal
Other
Owners
Pritired
$300
million
Pritired
SAS
B Shares +
Perpetual
Certificates
SAS
Foreign Tax
Credits
SAS
Facts: Principal partnered with Citibank to create a partnership (Pritired), which invested in class B shares and
perpetual certificates issued by two French entities (collectively, the “SAS”) that had been created by two
French banks. The SAS invested in an existing portfolio of debt securities from the French banks, as well as
other securities for which the French banks were counterparties. The SAS paid French income taxes on the
income from the investments. These French taxes were allocated among the owners of the SAS, primarily to
Pritired. As a partner in Pritired, Principal claimed approximately $21 million in foreign tax credits. The IRS
determined that Pritired was not entitled to claim an allocation of foreign taxes and disallowed its claimed share
of foreign taxes. Correspondingly, the foreign tax credits claimed by Principal were disallowed.
133
Pritired 1, LLC v. United States
• The district court found for the government and upheld the disallowance of the foreign tax credits claimed by Principal.
Pritired 1, LLC v. United States, 816 F. Supp. 2d. 693 (S.D.C. Iowa 2011).
• The court upheld the following determinations made by the IRS: (i) the transaction was properly characterized as a
loan and therefore no partnership existed, (ii) the transaction lacked economic substance, and (iii) the transaction
violated the partnership anti-abuse rule.
• Cf. Hewlett-Packard Co. v. Commissioner, T.C. Memo. 2012-135 (in case also involving foreign tax credit
generator transaction, Tax Court chose not to disallow claimed credits on economic substance grounds, relying
solely on finding that relevant investment was more appropriately characterized as debt rather than equity).
Characterization as a Loan
• The court held that the transaction was in substance a loan. Therefore, Pritired was not a partner and its partners
could not claim foreign tax credits for French taxes paid.
• In making this determination, the court evaluated the debt and equity characteristics of the perpetual certificates and
class B shares in SAS, focusing on (i) characterization (i.e., form), (ii) market risk, (iii) credit risk, and (iv) voting rights.
• The court determined that, although the class B shares were labeled as equity, those shares were tied to the
perpetual certificates, which the parties labeled as debt in certain circumstances and equity in others. Thus, the
court determined that the characterization factor was mixed.
• With respect to market risk, the court observed that the transaction had a certain expected maturity date and
was expected to provide “predicable, stable returns.” Thus, the court determined that the market risk factor was
more consistent with debt treatment than equity treatment.
• On the credit risk factor, the court determined that the perpetual certificates had ongoing payment attributes and
liquidation priorities more akin to debt, while the class B shares had payment attributes and liquidation priorities
more akin to equity.
• With respect to voting rights, the court found that the perpetual certificates had no voting rights, which was
consistent with debt treatment. Although the class B shares had certain voting rights, the court found that those
voting rights “were more in the form of controls seen in debt covenants.”
• After considering the characteristics of both the perpetual certificates and class B shares, the court concluded
that they both “had attributes that more closely resembled debt rather than equity” and, thus, the taxpayers’
investment was in the nature of a loan.
134
Pritired 1, LLC v. United States
Economic Substance
• Applying the Eight Circuit’s two-prong test for economic substance, the court determined that the transaction lacked
both a subjective business purpose and objective economic substance.
• The court stated that it could not find any credible business purpose for the transaction other than to generate and
claim foreign tax credits.
• According to the court, the business purpose of the transaction was to enhance low yield investments through
foreign tax credits.
• The court also found no realistic opportunity to earn a meaningful profit independent of the foreign tax credits.
• The court stated that the existence of some profit potential was insufficient to impute substance into an
otherwise sham transaction where a common-sense examination of the evidence as a whole indicates the
transaction lacked economic substance.
• The court noted that the transaction would have a cash return and IRR lower than an otherwise
comparable investment in a general obligation municipal bond.
• The court also rejected the argument that the transaction had economic substance because it complied with
Notice 98-5 in that the transaction was structured so that the ratio of foreign tax credits to expected profit
(approximately 2 to 1) was in accord with the examples described in Notice 98-5.
• The court stated that Notice 98-5 did not indicate that a transaction would have economic substance and
be “saved” by staying within a certain ratio, and found that the transaction represented the type of
behavior Notice 98-5 was intended to address.
Partnership Anti-Abuse Rule
• The court held that the transaction violated each of the requirements in Treas. Reg. § 1.701-2—
• The transaction was not a bona fide partnership and did not have a “substantial business purpose” because it
was “designed to transfer and shift the payment of French taxes to instruments that otherwise have a low and
undesirable return.”
• The transaction was in substance a loan and therefore no partnership existed.
• The economic agreement did not accurately reflect the partners’ income and the transaction improperly shifted
foreign tax credits to Pritired.
135
K2 Trading Ventures, LLC v. United States –
Court of Federal Claims Decision
•
•
In K2 Trading Ventures, LLC v. United States, 101 Fed. Cl. 365 (2011), on facts
substantially similar to those in Jade Trading, the Court of Federal Claims again held in
favor of the government and found that the spread transactions at issue lacked economic
substance.
The court disregarded the taxpayer’s argument that, because the particular spread
transactions at issue had some potential for profit (unlike the transaction in Jade Trading),
the transactions had economic substance.
– The court found that profit potential is one of several factors a court must look to when
assessing economic substance.
• According to the court, the transactions exhibited the same attributes that defined
the strategy as a tax avoidance mechanism in Jade Trading – a fictional loss, a
meaningless contribution to a partnership, and a disproportionate tax advantage
as compared to the amount invested and potential return.
– The court stated that the “essence of the K2 transaction, i.e., the generation of artificial
inflated basis and a fictional tax loss, did not change merely because there was a
potential for profit. In short, profit potential did not imbue the K-2 transaction with
economic substance.”
• Although the court recognized that lack of reasonable profit-making potential is
one indicator that a transaction does not possess economic substance, the court
held that potential for profit alone does not establish economic substance,
especially where profit potential is dwarfed by tax benefits.
• The court discounted the taxpayer’s argument that the transactions could have
resulted in more significant profits, characterizing such profits as speculative.
136
Gerdau MacSteel, Inc. v. Commissioner
Cash
(1)
(2)
CS
QHMC
Class B Stock
Q
QS
Stock
Cash
QHMC
Class C Stock
$38 million +
Medical Plan
Liabilities
(3)
QHMC
QHMC
Class C Stock
$38 million +
Medical Plan
Liabilities
(4)
Cash
QS
Former Q
Group
Employee
QHMC
Class C Stock
Facts: Q was the common parent of an affiliated group of corporations that included QS and QHMC. Q entered into a transaction
intended to generate losses to offset capital gain resulting from Q’s sale of two of its other subsidiaries. Q recapitalized QHMC, a
preexisting, inactive subsidiary, with class A, B, and C stock. Q held all of the QHMC Class A and B stock. Q transferred $38 million
to QS in exchange for additional QS stock, along with the assumption by QS of certain contingent liabilities related to Q’s obligation
to pay medical plan benefits under its employee group benefits plan (valued at approximately $38 million). Q then sold its QHMC
class B stock to CS, a health care management firm retained by Q to aid in the administration of its health care benefits, for $13,000
(CS also contributed $2,000 to QHMC for 20 shares of class C stock). Shortly thereafter, QS transferred the $38 million to QHMC,
which assumed the medical plan obligations, in exchange for the remaining authorized shares of QHMC class C stock. QS later sold
its QHMC class C stock to a former employee of another Q subsidiary for $11,000. Additionally, QHMC loaned the $38 million to
Piper, another Q subsidiary, with the interest on such loan representing QHMC’s only source of income.
Q treated the exchange between QS and QHMC as qualifying under section 351, with QS’s basis in the QHMC class C stock
determined by taking into account the $38 million transferred by QS to QHMC, but not the value of the medical plan obligations. On
its consolidated return, Q claimed a $37,989,000 capital loss on QS’s sale of the QHMC stock. The IRS disallowed the loss,
asserting, inter alia, that the transactions (i) did not satisfy the requirements of section 351, and (ii) lacked economic substance.
137
Gerdau MacSteel, Inc. v. Commissioner
•
The Tax Court held that the IRS properly disallowed the capital loss resulting from the sale by QS of the QHMC
class C stock. Gerdau MacSteel, Inc. v. Commissioner, 139 T.C. No. 5 (2012).
Nonqualified Preferred Stock
•
The Tax Court held that the QHMC class C stock was nonqualified preferred stock under section 351(g), finding
that such stock did not participate in corporate growth to any significant extent (as defined in section 351(g)(3)(A)).
– The court, which looked to language in Treas. Reg. § 1.305-5(a) for guidance, found that the class C stock
had pre-established limited rights and privileges as to dividends and liquidation proceeds and did not
sufficiently participate in QHMC’s growth.
•
The court found that the class C stock gave its holders a guaranteed fixed annual income preference in the form of
a set, cumulative dividend. The class C shareholders could not participate in or receive any dividends or share of
profits in excess of such dividends.
•
The court determined that, upon the redemption of the class C stock (including incident to QHMC’s liquidation),
class C shareholders would have received a fixed payout unrelated to QHMC’s corporate growth.
– Generally, a class C shareholder was entitled to receive the greater of $125 a share or the “formula value,”
which was the amount that is the lesser of (i) 45 percent of the cumulative cost savings as to the medical
plan benefits, or (ii) 50 percent of net equity as of the time of the redemption.
– The court stated that any participation rights were illusory because it was reasonably foreseeable that the
class C shareholders would, on the redemption of their stock, only be entitled to receive a preferred or
limited amount of QHMC’s assets equal to $125 a share.
– The court rejected petitioners’ argument that the formula value allowed for the possibility that the class C
shareholders could participate in QHMC’s growth beyond their preferred interest.
• If the class C shareholders were entitled to receive the formula value (because it exceeded $125 a
share), the court determined that any redemption payment would always depend solely on cost
savings rather than net equity, regardless of how much QHMC could grow, because 50 percent equity
would always exceed 45 percent cost savings. Thus, under the formula value, there was no realistic
possibility that the class C stock would participate in QHMC’s net equity.
• The court also concluded that the cost savings component of the formula value did not amount to a
participation in QHMC’s corporate growth, as reducing the medical plan obligations would not
necessarily generate earnings for QHMC or otherwise cause QHMC to grow.
•
Because the only stock received by QS in the exchange was nonqualified preferred stock, the court concluded that
the transaction was outside the nonrecognition rule of section 351(a); as such, the basis of the QHMC stock held
by QS was $11,000 at the time it was sold.
138
Gerdau MacSteel, Inc. v. Commissioner
Economic Substance
•
The Tax Court also determined that the transactions should be disregarded under the economic substance
doctrine.
•
The court applied the multi-factor conjunctive test used by the Court of Appeals for the Fifth Circuit in
Klamath Strategic Inv. Fund, LLC v. Commissioner, 568 F.3d 537 (5th Cir. 2009).
– The court found that the transactions did not have objective economic substance, relying primarily on
the following factors:
• The lack of substantive changes as a result of the transactions with respect to the administration
of Q’s medical plan benefits; QHMC served no meaningful purpose and nothing of substance
changed as a result of the transactions.
• The lack of a reasonable expectation of non-tax benefits produced by the transactions.
– The court also found that the transactions lacked a subjective business purpose, pointing to the
following factors:
• The transactions were designed to generate an artificial tax loss to offset unrelated capital gains
and were not implemented for a non-tax business reason.
• The selected medical plan obligations were transferred to QHMC without regard to considerations
related to effective medical cost management.
• The equity interest in QHMC granted to CS was meaningless as an incentive to reduce health
care costs, since CS managed the medical expenses in the same manner both before and after
the transactions. There was also no indication that the equity interest in QHMC granted to the
former Q group employee operated as an incentive to achieve cost savings.
• QHMC’s assumption of the medical plan obligations was unnecessary to achieve the stated goal
of reducing health care costs.
• The lack of a non-tax reason for the transfer of the QHMC class C stock to QS prior to the sale of
such stock to the former Q group employee.
Penalties
•
The court upheld a 20-percent accuracy-related penalty under section 6662. The court rejected the IRS’s
assertion of a 40-percent gross valuation misstatement penalty under section 6662(h) in connection with the
disallowed capital loss, but denied petitioners’ attempt to establish reasonable cause under section 6664(c).
139
Economic Substance –
Transaction Planning
140
Sale to Recognize Loss
P
P has built-in
loss in S stock
•
•
Sale of S stock
Third
Party
S
May a taxpayer sell stock solely to recognize a loss under the Federal Circuit’s
analysis in Coltec? No profit, no business purpose. Presumably not contrary to intent
of Congress? How do you know that?
The Supreme Court in Cottage Savings allowed a taxpayer to exchange mortgage
securities for other mortgage securities and recognize a loss. The transaction was
done solely for tax purposes and was disregarded for regulatory purposes.
141
Accelerating a Built-In Gain
P
100%
100%
asset
S1
S2
cash
50%
50%
LLC
Contribute
asset
Facts: P, a domestic corporation, owns 100% of the stock of S1 and S2, and they file a
consolidated return. In Year 1, S1 sells an asset to S2 for cash, resulting in a deferred
intercompany capital gain. In Year 3, the P group has a capital loss that it would like to use,
so S2 contributes the asset to a newly formed LLC owned by S1 and S2.
Result: Because the asset is no longer owned by a member of the P consolidated group, the
deferred capital gain should be triggered, which P wants in order to utilize other losses.
Analysis: No business purposes, no profit potential from contribution. Contrary to intent of
Congress?
142
Busting Consolidation – Example 1
FP
100%
P
50%
S
50%
LLC
X
Facts: FP, a foreign corporation, owns 100% of the stock of P, which owns all of the stock of S,
which owns all of the stock of X. P, S, and X file a consolidated return. In order to deconsolidate X,
S contributes the stock of X to an LLC formed by S and FP.
Result: Because X is no longer an includible corporation, it should not be a member of P’s
consolidated group.
Analysis: No business purpose and no profit potential.
143
Busting Consolidation – Example 2
P
100%
100%
S1
S2
50%
50%
LLC
X
Facts: P, a domestic corporation, owns 100% of the stock of S1, S2, and X, and they
file a consolidated return. In order to deconsolidate X, P contributes 50% of the X stock
to each of S1 and S2, and S1 and S2 contribute the X stock to a newly formed LLC.
Result: Because X is no longer an includible corporation, it should not be a member of
P’s consolidated group. No business purpose and no profit potential.
144
Avoiding Loss Disallowance Rules
P
100%
100%
S1
S2
50%
50%
X Stock
Z
LLC
Cash
X
X
Facts: P, a domestic corporation, owns 100% of the stock of S1 and S2. The P group wants
to purchase the stock of X from Z, but X has built-in gain assets that could trigger the
application of the loss disallowance rules if the P group later disposes of the stock of X. To
avoid the potential application of the loss disallowance rules, S1 and S2 form LLC, and LLC
acquires the stock of X.
Result: Because X is not an includible corporation, it should not be a member of P’s
consolidated group. The use of the LLC had no business purpose and no profit potential.
145
Section 331 Liquidation
P
100%
S
25% S stock
Liquidation
cash
FS
P
75%
S
25%
FS
Facts: P, a domestic corporation, owns all of the stock of S, which is a domestic
subsidiary, and FS, which is a foreign subsidiary. P has a $100 basis in its S stock.
The value of its S stock is $10. If P liquidates S, the loss in the S stock will not be
realized. P therefore sells 25% of the S stock to FS and, after a period of time, S
liquidates into P.
Result: P should recognize the loss on the remaining 75% of stock in S. There was no
business purpose or non-tax profit potential for the division of ownership.
146
Section 332 Liquidation
25% S stock
P
cash
75%
S
Liquidation
25%
FS
P
100%
S
FS
Facts: P, a domestic corporation, owns 75% of the stock of S, which is a domestic
subsidiary, and 100% of FS, which is a foreign subsidiary. P has a $10 basis in its S
stock. The value of its S stock is $100. If P liquidates S, the gain in the S stock will be
realized. P therefore purchases 25% of the S stock from FS before a decision to
liquidate is made, and, after a period of time, S liquidates into P.
Result: P should not recognize the gain on the liquidation under section 332. Business
purpose and non-tax profit potential?
147
Check-and-Sell Transaction
P
CFC1
Deemed
Liquidation
Bus. 2
X
Bus. 1
CFC2
Bus. 2
Facts: P owns 100% of CFC1, which engages in business 1. CFC1 owns 100% of CFC2, which
engages in business 2. CFC1 and CFC2 are controlled foreign corporations incorporated in the
United Kingdom. On Date 1, P causes CFC1 to check-the-box for CFC2, which results in a
deemed section 332 liquidation of CFC2. Immediately thereafter, P causes CFC1 sells all of the
assets of business 2 (i.e., CFC2 assets) to X for cash.
Issue: Under the rationale of Dover Corp. v. Commissioner, 122 T.C. 324 (2004), the income
generated from the sale does not constitute Subpart F income. Was there a business purpose or
profit potential from checking the box?
148
Check-the-box Election to Claim Worthless
Security Deduction
X
Worthless
Security
Deduction
Deemed
Liquidation
Y
Facts: X makes an election to change the classification of Y, a foreign corporation, to a
disregarded entity for federal tax purposes. Immediately before the effective date of the
election, the fair market value of Y’s assets does not exceed the sum of its liabilities.
Analysis: Under Rev. Rul. 2003-125, 2003-2 C.B. 1243, X is allowed to claim a
worthless security deduction under section 165(g)(3) because the fair market value of
Y’s assets do not exceed the entity's liabilities (i.e., on the deemed liquidation of Y, X
receives no payment on its stock).
Question: Is this result affected by the ES doctrine if there was no business purpose for
the check-the-box election?
149
Checking and Unchecking
USCO
CFC
HOLDCO
Cash
Newco
•
USCO decides to start doing business in Country A
•
USCO already owns CFC Holdco
•
CFC Holdco contributes cash into Newco, organized in Country A and makes a
check the box election to treat Newco as a disregarded entity
150
Use of a blocker to avoid UBTI
•
X owns an operating business that
requires additional funds to expand
•
Tax-Exempt Investor (“TE”) is
interested in making an investment in
the X business
X and Investor Form Partnership
TE
Cash
2
P’ship interest
– Income produced by the X
business would be UBTI to TE
1
X
Blocker
1
business
•
X and TE form a partnership, with X
contributing its business and TE
contributing cash
•
TE forms a corporation (“Blocker”) to
acquire and hold its investment in the
partnership in order to avoid exposure
to UBTI
P’ship
Operating
business
151
Purchase and Liquidation
A
T stock
P
P
$
Liquidation
T
•
•
T
Section 269(b) states deductions, credits, or other allowances may be disallowed,
but only if the liquidation occurs within 2 years after a QSP.
Does Coltec and other recent caselaw replace section 269(b), or mean that a
liquidation 2 years and a day after a QSP can result in such a disallowance?
152
Liquidation and Sale
P
Sale of S
assets
Third
Party
Liquidation
S
•
•
In Commissioner v. Court Holding, the Supreme Court held that a liquidation of a corporation
followed by a sale of the corporation’s assets resulted in tax to the corporation because “a sale
by one person cannot be transformed into a sale by another by using the latter as a conduit
through which to pass title.” However, five years later, in United States v. Cumberland Public
Service Co., the Court held that a liquidation followed by a sale did not result in tax to the
corporation. The Court stated, “The subsidiary finding that a major motive of the shareholders
was to reduce taxes does not bar this conclusion. Whatever the motive and however relevant it
may be in determining whether the transaction was real or a sham, sales of physical properties
by shareholders following a genuine liquidation distribution cannot be attributed to the
corporation for tax purposes.”
In both Court Holding and Cumberland the sole purpose of the liquidation was to reduce tax;
why did Cumberland win? Did the S. Ct. not understand the ES doctrine?
153
Busted Section 351 Transaction to Make Section 338(h)(10)
Election
(3) N stock
P
PUBLIC
(2) X & Y Stock
Z
N
X
•
•
(1) Newco formed
Y
A corporation transfers stock of a subsidiary to a newly formed subsidiary (“Newco”)
for its stock and sells that stock to the public to “bust” the section 351 transaction and
to be eligible to make the section 338(h)(10) election for Newco.
Was there a business purpose or profit potential for the step of busting the 351?
154
Section 351 Transaction with Built-in Loss Asset
P
S stock
Built-in loss asset
S
•
•
•
A corporation transfers an asset with a built-in loss to its subsidiary in exchange for
subsidiary stock. Does S hold the transferred asset with a carryover basis and/or
does P obtain the S stock with an exchanged basis?
Is duplicating a loss through a corporation inherently subject to ES doctrine, despite
enactment of section 362(e)(2)?
What if section 362(e)(2) does not apply? See Shell Petroleum Inc. v. United States,
2008-2 USTC ¶ 50,422 (S.D. Tex. 2008); Klamath Strategic Investment Fund v.
United States, 568 F.3d 537 (5th Cir. 2009).
155
“C” Reorganization
T S/H’s
P S/H’s
T S/H’s
P S/H’s
T
P Stock
P
T
T Assets
T Assets
•
P
T Assets
T S/H’s
P S/H’s
Liquidates
P
T Assets
What if, as is likely the case, certain steps are undertaken solely to come within the
reorganization provisions in section 368? For example, assume that substantially all
of a target corporation’s assets are acquired by another corporation solely in
exchange for voting stock. If that corporation liquidates following the asset
transaction to come within the terms of a “C” reorganization, is the liquidation step
subject to risk because it occurred solely for tax reasons?
156
“D” Reorganizations – Cash – Rev. Rul. 70-240
Step One
Step Two
Liquidation
P
Assets
X
Y
X
P
Y
Cash
Facts: P, X, and Y are corporations. P owns all of the stock of X and Y. X transfers all
of its assets to Y in exchange for cash. X then liquidates into P.
Result: This transaction qualifies as a tax-free “D” reorganization under section
368(a)(1)(D), according to Rev. Rul. 70-240.
Analysis: Assume the business purpose was to extract cash from Y tax free (under
section 356, the boot was limited to the gain in the X stock, which here was zero). There
was no other business purpose or economic change of ownership.
157
All-Cash “D” Reorganizations – Consolidation
P
X
Liquidation
Y
(1)
X Assets
(2)
Cash
T
Facts: P owns all of the stock of X and Y. X owns the stock of T. P, X, Y, and T are members of a
consolidated group. T transfers its assets to Y in exchange for cash and immediately thereafter liquidates into
X.
Result: In the consolidated return context, the following events are deemed to occur: (i) Y is treated as issuing
its stock to T in exchange for T’s assets; (ii) T is treated as distributing the Y stock to X in a liquidation; and (iii)
Y is treated as redeeming its stock from X for cash. See Treas. Reg. § 1.1502-13(f) and (f)(7), ex. 3.
The final D regulations confirm that the remaining basis or ELA in the Y stock treated as redeemed will shift to a
“nominal share” issued by Y. See Treas. Reg. § 1.368-2(l). An ELA will give rise to a deferred gain when the
nominal share is treated as distributed from X to P in order to reflect actual stock ownership.
P may be able to avoid this result by having Y actually issue a single share of stock to T or by contributing a
share of Y stock to X.
Question: Does the issuance of the one share have business purpose or economic substance?
158
All-Cash “D” Reorganizations – Foreign-to-Foreign
(2)
Liquidation
P
CFC1 Assets
CFC1
Cash
CFC2
(1)
Facts: P owns all of the stock of CFC1 and CFC 2. CFC 1 and CFC 2 are foreign
corporations. CFC 1 transfers its assets to CFC 2 in exchange for cash and immediately
thereafter liquidates into P.
Result: This transaction should be treated as a valid “D” reorganization. See Treas.
Reg. § 1.368-2(l); but see Schering-Plough v. Corp. v. United States, F. Supp. 2d 219
(D.C. N.J. 2009), aff’d, Merck & Co., Inc. v. United States, 652 F.3d 475 (3d Cir. 2011)
(implying that efforts to repatriate foreign income without income inclusion will be
rejected under the ES doctrine).
159
Section 304 Cross-Border Transaction
P
cash
F1
stock
F1
F2
Facts: P, a domestic corporation, owns all of the stock of F1 and F2, both of which are
foreign corporations. F2 has excess foreign tax credits. P sells F1 stock to F2 in
exchange for cash in a transaction the sole purpose of which is to pull foreign tax credits
out of F2.
Result: Section 304 applies to the transaction so that earnings are repatriated and
foreign tax credits are pulled out of F2.
Question: Is this result questionable under the ES doctrine because there was no
business purpose or profit potential?
160
Roll-up Transaction
P
A
Ownership interests in
LLC1, LLC, and LLC3
B
C
LLC1
LLC2
Newco
LLC3
•
•
Assume that a parent corporation converts several LLCs or partnerships into a
corporation in a roll-up transaction. Is this transaction subject to review if the roll-up
was done in part to combine income and loss?
Proposals indicate may be within “safe harbor”?
161
Administrative Developments and
Caselaw
162
Section 338 Overview
163
Section 338
SH
T Stock
P
$
T
SH
Old
T
P
Asset
Sale
New
T
164
Section 338(h)(10)
S
T Stock
P
T
S
P
332
Liquidation
Old
T
Asset
Sale
New
T
165
Section 338 Regulations: Organization
•
§ 1.338-1 General principles; status of old and new T
•
§ 1.338-2 Nomenclature and definitions; mechanics of
the section 338 election.
•
§ 1.338-3 Qualification
•
§ 1.338-4 Seller’s side – aggregate deemed sales price (ADSP)
•
§ 1.338-5 Buyer’s side – adjusted grossed up basis (AGUB)
•
§ 1.338-6 Allocation
•
§ 1.338-7 Redeterminations
•
§ 1.338-8 Consistency
•
§ 1.338-9 International
•
§ 1.338-10 Returns
•
§ 1.338(h)(10)-1 Section 338(h)(10)
166
Section 338 Regulations: Accounting Rules
•
Under the regulations ADSP is the sum of:
•
(1) the grossed-up amount realized on the sale to P of P's recently purchased T stock; and
(2) the liabilities of old T.
•
The amount realized is determined as if old T itself were the selling shareholder. Old T may use
the installment method of section 453 in the calculation of the first element of ADSP.
General principles of tax law apply in determining the timing and amount of the elements of
ADSP.
ADSP is redetermined at such time and in such amount as an increase or decrease would be
required, under general principles of tax law, to the individual elements of ADSP.
The same rules apply for purposes of determining (and redetermining) AGUB.
These changes replace the “fixed and determinable” standard of the old regulations.
The regulations make clear that, old T's tax liability incurred on its deemed asset sale is deemed
assumed unless the parties have agreed (or the tax or non-tax rules operate such that) the seller,
and not T, will bear the economic cost of that tax liability.
The amount of liabilities of old T taken into account to calculate ADSP is determined as if old T
had sold its assets to an unrelated person for consideration that included the unrelated person’s
assumption of, or taking subject to, the liability.
In order to be taken into account in AGUB, a liability must be a liability of T that is properly
taken into account under general principles of tax law that would apply if new T had acquired its
assets from an unrelated person for consideration that included the assumption of, or taking
subject to, the liability.
•
•
•
•
•
•
•
167
Section 338 Regulations: Allocation Rules
•
Seven asset classes under the regulations
• Class I -- cash and general deposit accounts (including savings and checking
accounts) other than certificates of deposit held in banks, savings and loan
associations, and other depository institutions.
• Class II -- actively traded personal property within the meaning of section 1092(d)(1)
and Treas. Reg. § 1.1092(d)-1, certificates of deposits, and foreign currency. Class II
assets do not include stock of target affiliates, other than actively traded stock
described in section 1504(a)(4)).
• Class III -- assets that the taxpayer marks to market at least annually for Federal
income tax purposes and debt instruments (including accounts receivable but
excluding certain other debt instruments).
• Class IV -- stock in the trade of the taxpayer or other property of a kind which would
properly be included in the inventory of taxpayer if on hand at the close of the taxable
year, or property held by the taxpayer primarily for sale to customers in the ordinary
course of its trade or business.
• Class V -- all assets other than Class I, II, III, IV, VI, and VII assets.
• Class VI -- all section 197 intangibles, as defined in section 197, except goodwill and
going concern value.
• Class VII -- goodwill and going concern value (whether or not the goodwill and going
concern value qualifies as a section 197 intangible).
168
Treas. Reg. § 1.338-3
Qualification for the Section 338 Election
• The regulations include a single definition of purchase applicable to both targets
and target affiliates. Under this definition, stock in a target (or target affiliate) may
be considered purchased if, under general principles of tax law, the purchasing
corporation is considered to own the stock of the target (or the target affiliate)
meeting the requirements of section 1504(a)(2), notwithstanding that no amount
may be paid for (or allocated to) the stock. See Treas. Reg. § 1.338-3(b)(2).
• For purposes of determining whether the parties are related at the time of the
purchase of the T stock, the relationship between the purchaser and seller is
tested immediately after the transaction. See Treas. Reg. § 1.338-3(b)(3)(ii).
169
Treas. Reg. § 1.338(h)(10)-1
Deemed Asset Sale and Liquidation
•
Treas. Reg. § 1.338(h)(10)-1 describes the model on which taxation of the section 338(h)(10)
election is based. Under the regulations:
•
Old T is treated as transferring all of its assets by sale to an unrelated person.
•
Old T recognizes the deemed sale gain while a member of the selling consolidated
group, or owned by the selling affiliate, or owned by the S corporation shareholders
(both those who actually sell their shares and any who do not).
•
Old T is then treated as transferring all of its assets to members of the selling
consolidated group, the selling affiliate, or S corporation shareholders and ceasing to
exist.
•
If T is an S corporation, the deemed asset sale and deemed liquidation are considered
as occurring while it is still an S corporation.
•
The preamble to the proposed regulations stated that the proposed regulations treat all
parties concerned as if the transactions that are deemed to occur under section 338(h)(10)
actually did occur, or as closely thereto as possible.
•
Old T generally may not obtain any tax benefit from the section 338(h)(10) election that it
would not obtain if it actually sold the assets and liquidated. Treas. Reg.§ 1.338(h)(10)1(d)(9).
170
Reporting Requirements
•
Forms 8023 and 8883
•
Form 8023 is used to make an election under section 338.
• A purchasing corporation makes a section 338(g) election by filing a Form
8023.
• If a section 338(h)(10) election is made, Form 8023 must be filed jointly by
the purchasing corporation and the common parent of the selling affiliated
group (or the selling affiliate or S corporation shareholder(s)).
•
Form 8883, “Asset Allocation Statement under Section 338,” must also be filed to
supply information relevant to the election.
• For elections under section 338(h)(10), both the old and new target
corporation must file Form 8883.
• Form 8883 must generally be attached to the return on which the effects of
the section 338 deemed sale are required to be reported.
171
Purchase
172
Section 338 Regulations
•
Definition of “Purchase”
•
The regulations include a single definition of purchase applicable to both targets and target
affiliates. Under this definition, stock in a target (or target affiliate) may be considered purchased
if, under general principles of tax law, the purchasing corporation is considered to own the stock
of the target (or the target affiliate) meeting the requirements of section 1504(a)(2),
notwithstanding that no amount may be paid for (or allocated to) the stock.
–
Section 338(h)(3)(A) defines the term "purchase" as "any acquisition of stock," subject to the
following conditions:
• The basis of the T stock in the hands of P is not determined (i) in whole or part by reference
to the adjusted basis of such stock in the hands of T's former shareholders, or (ii) under
section 1014(a) (property acquired from a decedent);
• The T stock is not acquired in an exchange to which section 351, 354, 355 or 356 applies or
in any other transaction described in the regulations in which the transferor recognizes less
than all of its realized gain or loss; and
• The T stock is not acquired from a person the ownership of whose stock would, under
section 318(a) (other than paragraph (4) -- the option attribution provision), be attributed to
P. The regulations provide that the relationship between the purchaser and seller is tested
immediately after the transaction. See Treas. Reg. § 1.338-3(b)(3)(ii).
Treas. Reg. § 1.338-3(b)(1)
• “An individual cannot make a qualified stock purchase of target. Section 338(d)(3) requires,
as a condition of a qualified stock purchase, that a corporation purchase the stock of target.
If an individual forms a corporation (new P) to acquire target stock, new P can make a
qualified stock purchase of target if new P is considered for tax purposes to purchase the
target stock. Facts that may indicate that new P does not purchase the target stock include
new P's merging downstream into target, liquidating, or otherwise disposing of the target
stock following the purported qualified stock purchase.”
–
173
Section 338 – Purchase
Has a Corporation Made the Purchase?
P
S
$
T
Newco
1. Newco buys T stock from S.
174
Section 338 – Purchase
Has a Corporation Made the Purchase? (cont’d)
P
332
Liquidation
Newco
T
2. Newco is liquidated into P.
175
Section 338 – Purchase
Has a Corporation Made the Purchase? (cont’d)
P
T
X
T Stock
$
GP
3. P and X form a partnership. P transfers the T stock to the
partnership.
176
Section 338 – Purchase
Has a Corporation Made the Purchase? (cont’d)
P
X
GP
Liquidate T
T
177
Section 338 – Purchase
Has a Corporation Made the Purchase? (cont’d)
X
A
T Shareholders
P
$
T1 Stock
N
T stock
T
T1
Facts: Corporation X and Individual A own Partnership P. Corporation T’s only significant asset is
100 percent of the stock of T1. T1 owns intellectual property. P wishes to acquire the stock of T1
and achieve a step-up in the basis of T1’s assets. P forms Newco N, which acquires 100 percent of
the T stock in a QSP. A section 338 election is made for both T and T1. Immediately thereafter, T
distributes the T1 stock to N, who in turn distributes the T1 stock to P.
Question: Has a “purchase” been made? See PLR 200122007; Treas. Reg. section 1.338-3(b)(1). 178
Section 338 – Purchase
Contemporaneous Sale of Affiliate Stock
T shareholders
$
P
T1 stock
$
T
T stock
T
T1
T1
Facts: P purchases 100 percent of the stock of T and makes a section 338 election
for T. Before the close of the day, P causes T to sell all of the T1 stock to a third
party.
Question: Is T considered to have purchased the stock of T1 prior to the sale of T1
stock? See Treas. Reg. section 1.338-1(d); Former Temp. Treas. Reg. section
1.338-3T(b)(4)(ii) Ex. 2; Treas. Reg. 1.338-3(b)(1).
179
Section 338 – Purchase
Common Ownership of S and P
A
25%
C
B
A
D
25%
25% 25% 25%
C
B
D
25% 25% 25%
T Stock
S
P
$
T
Has P purchased the T stock?
180
Section 338 – Purchase
Cash Investment
A
P
$
T
1.
2.
3.
4.
A owns all T stock.
P transfers cash to T for 90 percent of T stock.
Has P purchased the T stock?
What if T also has non-voting preferred stock that is not bought?
181
Section 338 – Purchase
Cash Investment Followed by Redemption
A
T Stock
P
$
$
T
1.
2.
3.
4.
A owns all T stock.
P transfers cash to T for 1 share of T stock.
A is redeemed by T (using funds other than those provided by P).
Has P purchased the T stock?
182
Section 338 – Purchase
A
S
45%
55%
T
1. T redeems S’s T stock and then S purchases A’s T stock
2. Recap S’s T stock to § 1504(a)(4) preferred stock and then S purchases
A’s T Stock
3. S sells T stock to P and then S buys T stock from A and P
Are any of these transactions Qualified Stock Purchases?
183
Qualified Stock Purchase – Effect of Section 351
S
I
$
T
(1)
P
1. Investor (“I”) transfers cash to Newco (“P”)
2. S transfers T stock to P.
3. P transfers cash and 5 percent of P stock to S.
184
Qualified Stock Purchase – Effect of Section 351 (cont’d)
I
S
95%
5%
P
T
Variations
•
•
S is several individuals, some shareholders sell P stock, while
others do not.
The transaction is leveraged.
185
Qualified Stock Purchase – Section 351 (cont’d)
Investor
Shareholder
20% T Stock
N Stock
N Stock
T
80% T
Stock
$
N
$
N1
loan
Bank
Facts: Shareholder contributes 20 percent of the T stock to N in exchange for N stock, and
Investor contributes cash to N in exchange for N stock. N forms N1. N borrows money from
Bank. Shareholder sells 80 percent of the T stock to N1 in exchange solely for cash.
Issues: Is the acquisition by N1 of T stock a qualified stock purchase transactions? How is
N’s non-purchased stock treated?
186
Participation by T Management – Section 351
5%
M
95%
SH
T
X
cash
P
$15
merger
S
1.
2.
3.
4.
5.
6.
7.
8.
Bank
$80
P is formed.
Management contributes 5 percent of T stock and X contributes $15 in cash, in exchange
for 25 percent and 75 percent interest in P, respectively.
P forms S.
$80 is borrowed, secured by the T assets, to acquire the T stock.
S is merged into T with T surviving.
Acquisition of T stock with borrowed funds constitutes redemption.
T stock from management – section 351 – is not purchased.
Section 338 will not apply unless X contributes cash equal to four times the value of
187
management’s stock and that cash is used to purchase T stock.
Sale by T Management to P – Newly Formed P
$5
95%
SH
X
cash
5%
M
P
T
S
Bank
$80
1.
2.
3.
4.
5.
6.
7.
P is formed.
Management contributes $5 in cash and X contributes $15 in cash.
P forms S.
$80 is borrowed, secured by the T assets, to acquire the T stock.
S is merged into T with T surviving. M receives $5 in the transaction.
The Service might ignore the $5 contribution by M and treat the transaction as if M
transferred its T stock to P in a section 351 exchange. Alternately, the Service could treat
the transaction as if M contributed its T stock and $5 in cash to P in exchange for P stock
and $5 in cash (boot).
188
The result is the same as the prior example – Section 338 is not available.
Special Issues – Use of P Stock
S
T
P
99% P stock
1% cash
1. Can P and S make a Section 338(h)(10) election and
with what consequences?
2. What if T liquidates/merges into P?
189
Special Issues – Use of P Stock
Public
T Stock
P
P Stock
T
T Stock
P Stock
S
1. P and S each acquire less than 80 percent of T stock in
exchange for P stock (but together acquire more than 80
percent of T stock).
2. Is this a QSP?
3. See PLR 200414001.
190
Qualified Stock Purchase
191
Section 338 – Purchase
Has a Corporation Made the Purchase?
•
Section 338(d)(3)
– “The term ‘qualified stock purchase’ means any transaction or series of
transactions in which stock (meeting the requirements of section
1504(a)(2)) of 1 corporation is acquired by another corporation by
purchase during the 12-month acquisition period.”
192
Section 338 – Qualified Stock Purchase
Target Stock Owned by Subsidiary
T Stock
PUBLIC
$
P
60%
T
100%
X
1. The public owns 60 percent of
T stock. X owns the
remaining 40 percent of T stock.
40%
2. P purchases the T stock
held by the public.
3. Has P made a QSP of T?
See PLR 8425120.
193
Acquisition of Partnership Interests
P
100% of
GP
Partners
S
GP
80%
T
Facts: GP owns 80 percent of the stock of Target T. P acquires 100
percent of the partnership interests of GP.
Question: Has P made a QSP of T? See Rev. Rul. 99-6, 1999-1 C.B.
432 (situation 2).
194
Deemed Purchase Rule
195
Deemed Purchase
• Section 338(h)(3)(B) provides that the term “purchase”
includes a deemed purchase under section 338(a)(2) (as
a result of making, or being treated as making, a section
338 election).
196
Section 338 Election Rules
Chain of Corporations
$
S
T stock
P
T
X
Y
Z
1. P purchases the stock of T from S and makes a section 338 election for T.
2. May P make a section 338 election for X, Y and Z?
3. May P make a section 338(h)(10) election for X, Y and Z?
197
Section 338(h)(10)
198
Section 338(h)(10) and “Busted 351” Transaction
P
X
Y
Z
Facts
1. P, X, Y, and Z file a consolidated return.
2. P wishes to sell X and Y to the public and to step up the basis of
the X and Y assets.
199
Section 338(h)(10) and “Busted 351” Transaction (cont’d)
PUBLIC
P
Z
(1) Newco formed
(2)
X&Y
Stock
N
X
Y
3. P forms Newco (N) and P transfers the X and Y stock to N.
Pursuant to a prearranged plan, P sells the N stock to the Public.
200
Section 338(h)(10) and “Busted 351” Transaction (cont’d)
Results
1. The transfer of the X and Y stock to N should not qualify as a section 351 transaction. P is
not in control of N immediately after the transfer. See Rev. Rul. 79-194, 1979-1 C.B. 145;
TAM 9747001; PLR 9541039, as modified by PLR 9549036; PLR 9142013.
2. Thus, N is deemed to purchase the X and Y stock.
3. In this event, P and N can file a section 338(h)(10) election to treat the transaction as a sale
of assets by X and Y followed by section 332 liquidations.
4. The regulations contain a similar example. See Treas. Reg. § 1.338-3(b)(3)(iv), ex. 1.
5. How much stock does P have to sell?
•
P must sell more than 20 percent of N stock for section 351 not to apply. See sections
351(a) and 368(c).
•
P must sell at least 50 percent of the N stock so that P and N are not related for
purposes of section 338(h)(3)(A)(iii).
•
P must sell more than 80 percent of the N stock to avoid the application of the antichurning rules of section 197(f)(9).
•
Prior to the effective date of Treas. Reg. § 1.197-2 it was possible that the antichurning rules could have applied even if P sold all of the N stock because of the
momentary relationship between P and N. See Old Prop. Treas. Reg. § 1.1972(h)(6)(ii).
201
Section 338(h)(10) and “Busted 351” Transaction Variation
PUBLIC
P
Z
(1) Newco
formed
(2)
X&Y
Stock
N
X
•
•
•
Y
Both P and N Sell to the Public.
Does section 351 apply? If so, section 338(h)(10) is not available.
Does the answer change if P and N each use different investment bankers?
202
PLR 200427011
Newco Stock, Convertible
Instruments & Non-Cash
Consideration
Stock of
Purchased Subs
(1) (immediately)
21% Newco
Common Stock
Public
P
(2) (within 2 years)
30% Newco
Common Stock
Public
Newco
Purchased
Subs
Facts: P was a holding company for a group of corporations (the “purchased subs”) which operated in the financial services and
insurance industry. P’s ultimate owner wanted to reduce its investment in the financial services and insurance business. Accordingly,
P’s ultimate owner adopted a plan of divestiture and took the following steps: (a) P created a new corporation, “Newco,” to which it
transferred the purchased subs in exchange for 100 percent of Newco’s common stock, 100 percent of a convertible debt instrument,
Newco’s assumption of certain P liabilities, and additional non-stock consideration; (b) P entered into a firm commitment to sell more
than 20 percent of the Newco common stock and substantially all of the convertible debt instrument in a public offering within a certain
number of days; and (c) within a certain number of months, P would make a second public offering, reducing its stock interest in Newco
to less than 50 percent.
Ruling: The Service ruled that as long as P completed the additional offerings and sales (thereby reducing its direct and indirect
ownership of Newco stock to below 50 percent), Newco’s acquisition of the purchased subs from P would qualify as a QSP within the
meaning of section 338(d)(3), thus making P and Newco eligible to make a section 338(h)(10) election. Thus, the Service effectively
ruled that
1. Newco would not have such a carryover basis in the stock of the target subsidiaries (i.e., in the absence of a section
338(h)(10) election, section 302(a) would apply to the deemed payment) and
2. P and Newco would not be in a related party relationship at the time of the exchange. See Treas. Reg. § 1.338-3(b)(3)(iv),
Example 1.
203
Situation 1
Form of Transaction
Recharacterized Transaction
Public
Subsequent Sale
Public
21% Newco stock
21% Newco stock
P
P
30%
Newco stock
P
21%
T stock
T
liquidates
T
Newco
Newco
New T
New T
Newco
P and Newco make
a section 338(h)(10) election
•
Public
T
T
assets
P transfers all of the stock of T to Newco and pursuant to a binding commitment sells
21 percent of the stock of Newco to the public. In addition, pursuant to an integrated
plan, P sells an additional 30 percent of the stock of Newco to the public within two
years. P and Newco make a section 338(h)(10) election with respect to Newco’s
“qualified stock purchase” of T.
204
Situation 2
Public
30%
Newco stock
21% Newco stock
P
Public
P
21%
T
liquidates
T
Newco
Newco
T assets
•
T transfers all of its assets to Newco and P sells 21 percent of the stock of Newco to
the public pursuant to a binding commitment. In addition, pursuant to an integrated
plan, P sells an additional 30 percent of the stock of Newco to the public within two
years.
205
Situation 3
30%
Newco stock
Public
21% Newco stock
P
Public
P
21%
T stock
Public
P
21%
Newco
T
Merger
Newco
Newco
T
•
P transfers all of the stock of T to Newco and pursuant to a binding agreement sells
21 percent of the stock of Newco to the public. T merges upstream into Newco. In
addition, pursuant to an integrated plan, P plans to sell an additional 30 percent of the
stock of Newco to the public within two years.
206
Situation 4
21% Newco stock
T liquidates
Public
P
P
30%
Newco
stock
Public
Public
P
T1 stock
21%
21%
Newco
T
T1
T assets
•
Newco
Merger
Newco
T1
T transfers all of its assets to Newco and then liquidates. P transfers all of the stock
of T1 to Newco. T1 then liquidates into Newco. Pursuant to a binding agreement, P
sells 21 percent of the stock of Newco to the public. In addition, pursuant to an
integrated plan, P sells an additional 30 percent of the stock of Newco to the public
within two years.
207
PLR 201228011
Parent
Seller
100% Target Stock
Target
NewCo
Facts
• Parent is the common parent of an affiliated group of corporations filing a consolidated
return. Its stock is publicly traded.
• Seller is a holding company.
• NewCo is a newly organized corporation created by Seller to participate in the Proposed
Transaction.
Proposed Transaction
• Seller will transfer all of Target’s common stock to NewCo in exchange for NewCo preferred
stock and NewCo common stock.
• NewCo’s only outstanding securities will be the common and preferred stock owned by
Seller.
208
PLR 201228011
Public
(1) 20% NewCo Stock
(2) > 30% NewCo Stock
(3) > 30% NewCo Stock
Parent
Seller
NewCo
Target
Proposed Transaction (cont’d)
• Seller will sell to the public more than 20 percent of the NewCo common stock.
• A section 338(h)(10) election will be made with respect to NewCo’s acquisition of
Target stock.
• Within X months of the IPO, Seller will sell to the public more than 30 percent of the
total shares of NewCo stock, reducing Parent’s direct and indirect ownership of
NewCo stock to less than 50 percent of the value of NewCo stock.
• Within Y months of the IPO and the 30 percent sale, Seller will sell to the public more
than 30 percent of the total shares of NewCo stock, reducing Parent’s direct and
indirect ownership of NewCo stock to 20 percent or less of the value of NewCo stock.
• Seller thereafter intends to dispose of any remaining NewCo stock.
209
PLR 201228011
Representations
• “Parent and Seller plan to dispose of at least 80 percent of the vote and value of the
NewCo stock in the Proposed Transaction within a certain number of months of the
IPO.”
• “NewCo [and] Target will cease to be members of the Parent Group at the end of the
day upon which more than 20 percent of the NewCo common stock is disposed of in
the Initial Sales.”
Rulings
• “NewCo’s acquisition of all of Target’s common stock from Seller in the Exchange will
be a ‘qualified stock purchase’ within the meaning of section 338(d)(3).”
• “Seller and NewCo will be eligible to make the election under section 338(h)(10) with
respect to NewCo’s acquisition of the Target common stock in the Exchange.”
• “Seller will recognize as a corresponding item any loss or deduction it would recognize
if section 331 applied to the Deemed Liquidation, subject to the limitations imposed by
Treas. Reg. § 1.1502-13(f)(5)(ii)(C)(2).”
• “Provided that neither Parent and NewCo nor Seller and NewCo are members of a
controlled group immediately after the Proposed Transaction, the anti-churning rules
of section 197(f)(9) and Treas. Reg. § 1.197-2(h) will not apply to any section 197(f)(9)
intangible deemed acquired under section 338(h)(10) from Target.”
210
PLR 201216026
Public
Parent
Group
> 80 %
Foreign
Target
Facts
• Parent, a publicly traded corporation, is the parent of an affiliated group (Parent
Group) of corporations filing a consolidated U.S. federal income tax return.
• Through a number of transactions, Parent Group purchased more than 80 percent
(but less than 100 percent) of the stock of Target within a 12 month period.
• Target is a publicly traded company under the laws of Country Y.
• Under Country Y’s securities laws, a publicly traded company must have public
shareholders holding more than a 20 percent interest.
• Parent Group does not have the financial capacity to purchase the remaining
outstanding Target stock within the required time period.
211
PLR 201216026
Public
Parent
Group
> 80 %
Target
Facts
• To comply with Country Y’s laws, Parent Group proposes to sell stock reducing its
interest in Target to below 80 percent. When it has the financial capacity to do so,
Parent Group intends to acquire all of the Target stock.
Ruling
• “Notwithstanding the proposed … stock sale, the acquisition of Target constitutes a
qualified stock purchase within the meaning of section 338(h)(10).”
212
Intragroup Section 338(h)(10) Election
Example – Recent PLRs
P Stock
Buyer
Shareholders
Newco
Common Stock
(4)
Cash
(5)
Newco
Preferred Stock
P
(3)
Third-Party
Cash
(1)
T Stock
Business B
T
Business
A
Newco Stock –
Common and
Preferred
(2)
Newco
Business
B
Facts: P is the common parent of a consolidated group. T operates Businesses A and B. T
distributes Business B to P. P forms Newco and transfers the stock of T to Newco in exchange for
Newco common and preferred stock. Pursuant to a binding obligation, P sells the Newco preferred
stock to an unrelated third party. P distributes all of the Newco common stock to its public
shareholders. P’s shareholders sell their P stock to Buyer.
Result
• Newco’s acquisition of T is a qualified stock purchase under section 338(d)(3). P and Newco
are permitted to make an election under section 338(h)(10) with respect to the retained Business
A held by T. See PLR 201126003; see also PLRs 201203004 and 201145007.
213
PLR 201126003
NewCo 1
preferred
interests
Current
Shareholders
Current
Shareholders
(4)
3rd Party
Parent
Parent
NewCo 1 common
and preferred
interests
(1)
(2)
Business B, cash, other
properties
Target
NewCo 1
Business
B
NewCo 1
Target
(4)
Business
B
Business
A
NewCo 2
Business
A
(3)
NewCo 1 common
and preferred interests
NewCo 2
NewCo 1 common
and preferred interests
Target
Sub
NewCo 3
Target
Sub
Target stock
NewCo 3
Step 1: Parent will form NewCo 1. NewCo 1 will form NewCo 2. NewCo 2 will form NewCo 3. The three entities will be formed as
LLCs and will elect to be treated as corporations for federal income tax purposes.
Step 2: Target will distribute cash, Business B and various other properties to Parent. This distribution is intended to be part of the
deemed section 332 liquidation in connection with the section 338(h)(10) election for Target.
Step 3: NewCo 1 will contribute its common membership interests and preferred membership interests to NewCo 2. NewCo 2 will
contribute the NewCo 1 common and preferred membership interests to NewCo 3.
Step 4: Parent will transfer 100 percent of the stock of Target to NewCo 3 in exchange for NewCo 1 common and preferred
membership interests. Pursuant to a binding obligation, Parent will transfer the NewCo preferred interests to an unrelated third party.
A section 338(h)(10) election will be made with respect to the acquisition of the stock of Target.
214
PLR 201126003
Current
Shareholders
(6)
Public
NewCo 1
common interests
$
Parent
Stock
REIT
(5)
Business
B
Parent
REIT
Parent
NewCo 2
Business
B
NewCo 3
Current
Shareholders
Less than 10%
NewCo 1
Parent
Final
Structure
Business
B
NewCo 1
NewCo 2
NewCo 3
Target
Target
Business
A
Business
A
Target
Sub
Target
Sub
Step 5: Parent will distribute 100 percent of the NewCo 1 common membership interests to the Current Shareholders.
The distribution is intended to constitute a dividend pursuant to sections 301 and 316.
Step 6: Current Shareholders will sell their parent stock to REIT and Parent and Business B will elect REIT status. Upon
exercise of an option, REIT may acquire 9.9 percent of NewCo 1’s common interests from NewCo 1.
215
PLR 201145007
(2)
LLC1
Investors
Sub 2 –
Sub 5
Sub 6
NewCo
Preferred
Stock
P
Sub 7 –
Sub 12
Sub 1
Sub 7
Sub 2 –
Sub 5
Sub 8
Sub 9 –
Sub 12
NewCo
(1)
NewCo
Sub
Facts: Parent was the parent of an affiliated group of corporations filing a life-nonlife consolidated return that conducted Business
A and Business B. Parent owned all of the stock of Sub 1. Parent also owned (i) all of the interests in LLC1, a disregarded entity
that conducted a part of Business A, and (ii) the stock of Subs 2 through 5. Sub 1 owned (i) all of the outstanding stock of Sub 6,
which conducted the majority of Business A and a portion of Business B; (ii) Sub 7, which conducted a part of Business B and a
part of Business A; (iii) Sub 8, which conducted a part of Business B; and (iv) the stock of Subs 9 through 12.
Parent formed NewCo, which formed NewCo Sub. NewCo issued NewCo common stock and NewCo preferred stock to NewCo
Sub. All assets and liabilities relating to Business A were transferred and consolidated in S1, LLC1, and Sub 6, and all assets and
liabilities relating to Business B were transferred and consolidated into the remaining applicable Subs.
To separate Business B from Business A, Parent transferred Subs 2 through 5 to NewCo Sub, and Sub 1 transferred Subs 7
through 12 to NewCo Sub. In exchange, Parent and Sub 1 each received a pro rata share of the NewCo common and preferred
stock held by NewCo Sub. Parent and Sub 1 immediately sold the NewCo preferred stock to certain investors for cash pursuant
to a preexisting agreement, which Parent used to repay certain indebtedness (Sub 1 distributed the cash and NewCo common
stock it received to Parent).
216
PLR 201145007
P
Acquiring
Acquiring
NewCo
LLC1
Sub 1
Sub 6
Merger
Sub
NewCo
P
NewCo
Sub
LLC1
NewCo
Sub
Sub 2 –
Sub 5
Sub 2 –
Sub 5
Sub 7 –
Sub 12
Sub 1
Sub 7 –
Sub 12
Sub 6
Facts (cont’d): Acquiring formed Merger Sub, which merged with Parent, with Parent surviving. In the merger, (i) holders of Parent
common and preferred stock received NewCo common stock and cash in exchange for their Parent stock, and (ii) Acquiring's
membership interests in Merger Sub were converted into shares of Parent common stock. Immediately after the Merger, Acquiring
owned 100 percent of Parent, the investors held all of the NewCo preferred stock, Parent’s former common and preferred
shareholders had received cash and held all of the NewCo common stock, and neither Parent nor Sub 1 owned any stock in NewCo.
The parties intended to make section 338(h)(10) elections with respect to the transfers of the subsidiary stock made by Parent and
Sub 1 (Subs 2-5 and Subs 7-12, respectively) and with respect to the deemed transfers of stock of certain direct and indirect
subsidiaries owned by such subsidiaries (Subs 13-39). Parent expected that the deemed asset sales resulting from the section
338(h)(10) elections with respect to the transferred subsidiaries would generate a net ordinary loss, life insurance company loss from
operations, or both, and net capital gain.
217
PLR 201145007
Rulings
• NewCo Sub’s acquisitions of the stock of the subsidiaries transferred by Parent and
Sub 1 qualify as “qualified stock purchases” under section 338(d)(3), and, assuming a
section 338(h)(10) election is made with respect to its direct shareholder, the deemed
sale of the stock of each of the lower-tiered subsidiaries (Subs 13-39) resulting from
the deemed asset sale of the respective transferred subsidiary will qualify as a QSP.
• Parent (as the common parent of the selling consolidated group) and NewCo Sub (by
the common parent of its consolidated group) will be eligible to make section
338(h)(10) elections with respect to such QSPs.
• Parent’s group will be entitled to deduct in the taxable year ending on the closing date
of the Merger, to the extent otherwise deductible, losses recognized by the
subsidiaries transferred (directly and indirectly) by Parent and Sub 1 on the deemed
sales of their assets.
• Neither NewCo nor NewCo Sub will be a successor to Parent for purposes of section
1504(a)(3), and NewCo and its direct and indirect subsidiaries that are includible
corporations and that satisfy the ownership requirements of section 1504(a)(2) will be
members of an affiliated group of corporations entitled to file a consolidated federal
income tax return immediately following the Merger.
218
PLR 201203004
Public
(4)
C Stock
(1)
Newco
Preferred Stock
Newco Common/
Preferred Stock
Cash
D
(3)
Investors
C Stock
T Stock
Newco
Common Stock
(2)
Newco
S
Business A
T
C
Business B
(Built-in Losses)
Facts
• D, a publicly-traded corporation, owns all of the stock of S (which operates Business A) and T (which operates Business
B). T’s assets have built-in loss.
• To separate Business A from Business B, D engages in the following steps:
• D forms Newco and transfers the T stock to Newco in exchange for all of the stock in Newco, which includes
common stock and non-voting preferred stock. D and Newco file a section 338(h)(10) election. D expects to
recognize substantial tax losses with respect to the Business B assets held by T in connection with the contribution
to Newco.
• D forms C and contributes all of the Newco common stock to C in exchange for all of the stock of C.
• D sells all of the Newco non-voting preferred stock to unrelated Investors.
219
• D distributes all of the C stock to its shareholders (pro rata).
PLR 201203004
Public
D
Business
A
S
Investors
C
Newco
Common
Stock
Newco
Preferred Stock
Newco
T
Business B
Rulings
• D’s transfer of the T stock to Newco is a sale, Newco’s acquisition of T will be a “qualified stock
purchase,” and D and Newco will be eligible to make a section 338(h)(10) election. Section
338(d)(3), (h)(3).
– The transaction is a “busted” section 351 exchange, and thus taxable, because of D’s sale of
the Newco preferred stock. Section 338(h)(3)(A)(i), (ii).
– No attribution of ownership (section 318(a)) from D to Newco (section 338(h)(3)(A)(iii)), because
relatedness is determined immediately after the spin-off of C. Treas. Reg. § 1.338-3(b)(3)
(Stock acquired from a related corporation is generally not considered acquired by purchase).
– T recognizes built-in loss on deemed asset sale to New T. Treas. Reg. §§ 1.338(h)(10)-1(d)(2)(4).
– T’s loss is taken into account immediately before the spin-off of C. Treas. Reg. §§ 1.267(f)1(a)(2), 1.1502-13(d).
220
PLR 201203004
Public
D
Business
A
S
Investors
C
Newco
Common
Stock
Newco
Preferred Stock
Newco
T
Business B
Rulings
• D’s contribution to C and its distribution of the C stock qualify as a “D” reorganization.
– No gain or loss is recognized by D’s shareholders or D on the distribution of C
stock. Sections 355, 361.
– D controls C under section 368(c); it does not matter that C does not control
Newco.
– S’s Business A qualifies as D’s active trade or business (“ATB”), because S is a
member of D’s separate affiliated group (“SAG”). Section 355(b)(3); Prop. Treas.
Reg. § 1.355-3(b)(1)(ii).
– T’s Business B qualifies as C’s ATB (T is a member of C’s SAG). Section
355(b)(3); Notice 2007-60.
221
PLR 201213013
Buyer Investors
Seller Parent
Group
(3) Target Stock
Partnership
Buyer Parent
Group
Target
(1) Buyer
Parent Stock
(2) Assets
FSub
Buyer
(4) Buyer
Parent Stock
Target
Facts
• Seller Parent Group and its shareholders wish to sell the stock of Target.
• Buyer Investors want to purchase the assets of Target.
• (1) Buyer Investors transfer stock of Buyer Parent Group to Buyer. Buyer and Partnership were
formed for purposes of the transaction.
• (2) Buyer purchases for cash consideration certain assets of Target and FSub.
• (3) Buyer purchases for cash consideration the stock of Target.
• (4) Buyer transfers Buyer Parent into Target
Outcome
• Because there is no corporate purchaser, there is no qualified stock purchase and section 338
and its consistency rules will not apply.
• The section 1060 allocation will only apply to the purchased assets, so Buyer can choose the
assets which will be subject to section 1060.
222
Final Section 336(e) Regulations
223
Final Section 336(e) Regulations – Background
•
•
•
•
•
Section 336(e), adopted as part of General Utilities repeal in 1986, provides
that, “under regulations prescribed by the Secretary,” a corporation (“Parent”)
may treat a disposition of stock of a subsidiary (“Target”) as a disposition of the
assets of Target (not a disposition of the Target stock), if –
– Parent owns enough stock in Target to satisfy section 1504(a)(2), i.e., 80
percent of total voting power and 80 percent of fair market value, and
– Parent sells, exchanges or distributes all of such Target stock.
This provision is viewed as an expression of section 338(h)(10) principles
beyond situations in which –
- Parent sells 80 percent or more of the stock of Target to another
corporation, or
- S corporation shareholders sell more than 80 percent of their stock to a
corporation.
The IRS had made it clear that its position was that section 336(e) was not selfexecuting, i.e., that no election could be made until regulations became
effective. CCA 201009013 (March 5, 2010).
On August 25, 2008, IRS and Treasury issued proposed regulations under
section 336(e).
On May 10, 2013, IRS and Treasury issued final section 336(e) regulations.
– The final regulations apply to any qualified stock disposition for which the
224
disposition date is on or after May 15, 2013.
Final Section 336(e) Regulations – Overview
•
The final regulations expand the scope of elective deemed asset sale treatment to cover any taxable
“disposition” (a term with a meaning similar to “purchase” under section 338 but broader, to include
distributions as well as sales) or series of dispositions by a domestic corporation (or its consolidated
group) or S corporation shareholder(s) (“Seller”) of stock of a domestic target (“Target”), if the total
stock disposed of, to non-related persons within 12 months, satisfies section 1504(a)(2). Seller would
not need to dispose of all of its Target stock.
•
The final regulations generally adopt the structure and principles established under section 338 and
the underlying regulations. Treas. Reg. § 1.336-1(a).
•
•
Unlike a section 338(h)(10) election, the regulations do not require a corporate acquirer.
•
The regulations also permit the aggregation of all Target stock sold, exchanged, or distributed by
Seller to different acquirers.
Examples of covered transactions include:
-
Sale of Target stock to a partnership, individual or group of individuals, domestic or foreign.
-
Distribution of Target stock to shareholders to which section 355 does not apply, either a pro rata
dividend or a non pro rata redemption.
-
Distribution of Target stock to which section 355 applies but is taxable to Seller under section
355(d) or section 355(e), either a pro rata dividend or a non pro rata redemption.
-
Combinations of the above.
•
The regulations generally prohibit a section 336(e) election with respect to a sale or distribution of
Target stock to a related party.
•
Under the regulations, the deemed sale and purchase involving Old and New Target both occur on the
disposition date (Cf. section 338 – deemed sale involving old target treated as occurring on acquisition
date, and new target treated as purchasing assets as of beginning of day after acquisition date).
225
Final Section 336(e) Regulations –
Notable Changes from Proposed Regulations
•
Section 336(e) election available for S corporation targets
•
Narrowed loss disallowance rule
•
Related party rule regarding partnerships
•
Consistency rules
•
Joint election made by Seller and Target
226
Final Section 336(e) Regulations –
S Corporations
•
The final regulations (unlike the proposed regulations) permit a section 336(e)
election to be made for S corporation Targets.
•
•
If a section 336(e) election is made with respect to an S corporation Target, all of
the S corporation shareholders, including those who do not sell their S
corporation Target stock, must consent to the election.
•
•
The regulations provide additional and special rules to allow section 336(e)
elections to be made for S corporation Targets.
Consent is established by all of the S corporation shareholders and Target
entering into a written, binding agreement to make the election, on or before
the due date (including extensions) of the S corporation's tax return. The
section 336(e) election statement is filed with the return of the S corporation
Target.
If a section 336(e) election is made for an S corporation Target, Old Target's S
election continues in effect through the close of the disposition date (including
the time of the deemed asset disposition and the deemed liquidation) at which
time Old Target's S election terminates, and Old Target ceases to exist.
•
If New Target qualifies under section 1361(b) and wants to be an S
corporation, a new election for New Target under section 1362(a) must be
made.
227
Final Section 336(e) Regulations –
Disallowed Loss Rule
•
•
If the qualified stock disposition consisted of one or more distributions of Target stock, the
disallowed loss rule in the proposed regulations denied the recognition of losses resulting
from a deemed asset disposition, on an asset-by-asset basis.
•
The final regulations narrow the disallowed loss rule by generally permitting Target's
realized losses in the deemed asset disposition to offset Target's realized gains.
•
Thus, the final regulations only disallow the net loss of Target (losses realized in
excess of Target's realized gains) recognized on a deemed asset disposition (in
proportion to the portion of Target stock that was disposed of by Seller in one or
more distributions).
The final regulations also modify the disallowed loss rule in the proposed regulations to
take into account Target stock distributed at any time within the 12-month disposition
period, (i) not just on or before the disposition date, and (ii) whether or not part of the
qualified stock disposition (e.g., including stock distributed to a related person).
•
Accordingly, if a section 336(e) election is made and any stock of Target is
distributed during the 12-month disposition period, whether or not as part of the
qualified stock disposition, any net loss attributable to such distribution is disallowed.
228
Final Regulations Under Section 336(e) –
Related Party Rule
•
The final regulations provide that a transaction is not a disposition
(and therefore is ineligible to count towards a qualified stock
disposition) if Target stock is sold, exchanged, or distributed to a
related person. Treas. Reg. § 1.336-1(b)(5)(i)(C).
• The regulations, like the section 338 regulations, treat persons as
related if stock in a corporation owned by one of the persons
would be attributed to the other person under section 318(a),
other than section 318(a)(4). Treas. Reg. § 1.336-1(b)(12).
• Related party status is determined after the disposition: if there
is a series of dispositions making up a “qualified disposition,”
after the last disposition; or, if there is a series of transactions
“effected pursuant to a plan to dispose of [T]arget stock,” after the
last transaction. Treas. Reg. § 1.336-1(b)(5)(iii); Treas. Reg.
§1.338-3(b)(3)(ii).
229
Final Regulations Under Section 336(e) –
Related Party Rule
•
The IRS and Treasury agreed with comments that the attribution
rules in the proposed regulations with respect to partnerships were
overly inclusive.
• Noting that the attribution rules in section 318(a) for partnerships
do not have a minimum ownership threshold, the IRS and
Treasury stated that deemed asset disposition treatment should
not be prohibited if cross ownership is minimal.
•
The final regulations modify the definition of related persons for
partnerships by providing that the attribution rules of sections
318(a)(2)(A) and 318(a)(3)(A) do not apply to attribute stock
ownership from a partnership to a partner, or from a partner to a
partnership if such partner owns, directly or indirectly, less than five
percent of the value of the partnership. Treas. Reg. § 1.3361(b)(12).
230
Final Regulations Under Section 336(e) –
Related Party Rule
• The legislative history contemplates that a disposition to a related
person could be eligible for a section 336(e) election:
– “The conferees intend that the regulations under this elective
procedure will account for appropriate principles that underlie the
liquidation-reincorporation doctrine. For example, to the extent
that regulations make available an election to treat a stock
transfer of controlled corporation stock to persons related to such
corporation within the meaning of section 368(c)(2), it may be
appropriate to provide special rules for such corporation's
section 381(c) tax attributes so that net operating losses may not
be used to offset liquidation gains, earnings and profits may not
be manipulated, or accounting methods may not be changed.”
• The IRS and Treasury stated that they will continue to study whether
related party transactions should qualify for a section 336(e)
election.
231
Final Section 336(e) Regulations –
Consistency Rules
• In response to concerns regarding the potential breadth of the
consistency rules as applied to section 336(e), the final regulations
provide that the consistency rules apply to an asset only if the asset
is owned, immediately after its acquisition and on the disposition
date, by a person (or related person) that acquires five percent or
more, by value, of the stock of Target in a qualified stock disposition.
• The IRS and Treasury stated that they did not believe that the
purposes of the consistency rules mandated a carryover basis for an
asset unless the same person (or a related person) acquires both
the asset of the Target (or subsidiary of Target) and more than a
minimal amount of the stock of Target.
– The IRS and Treasury also believe it would be inappropriate to
limit the consistency rules for section 336(e) purposes to
corporate purchasers.
232
Final Section 336(e) Regulations –
Time and Manner for Making Section 336(e) Election
•
Under the proposed regulations, the section 336(e) election was made
unilaterally by the Seller.
•
The final regulations modify this rule by requiring the Seller (or, if the
Target is an S corporation, all S corporation shareholders) and Target to
enter into a written, binding agreement to make a section 336(e) election.
The election must be attached to the relevant tax return (Cf. Form 8023,
“Elections Under Section 338 for Corporations Making Qualified Stock
Purchases”).
– If Seller and Target are members of a consolidated group, the election
statement is filed on a consolidated return and the common parent of
the consolidated group must provide a copy of the section 336(e)
election statement to Target on or before the due date (including
extensions) of the group's return.
– If Target is an S corporation, the election statement is filed on the S
corporation's return.
– If Seller and Target are members of an affiliated group but do not join
in the filing of a consolidated return, the election statement is filed with
both Seller's and Target's returns.
233
Final Section 336(e) Regulations –
Time and Manner for Making Section 336(e) Election
• The final regulations retain the rule that a section 336(e) election must
be made by the due date of the relevant tax return.
– The IRS and Treasury believe that a suggested due date of the
15th day of the ninth month after the disposition date would have
added administrative burden to both taxpayers and the IRS.
• The IRS intends to modify Form 8883 ("Asset Allocation Statement
Under Section 338“), or create a new form, to include an election
under section 336(e).
– Until Form 8883 is modified or a new form is created, Old Target
and New Target should file Form 8883 to report the results of the
deemed asset disposition, making appropriate adjustments as
necessary to account for a section 336(e) election.
234
Final Section 336(e) Regulations – Deemed Transactions
Basic Model
• If Seller makes a section 336(e) election in a stock sale, the construct is similar to
that of a section 338(h)(10) stock sale. The following transactions are deemed to
occur:
– Target is deemed to sell all its assets to “New Target.”
– Target’s amount realized is equal to the aggregate deemed asset disposition
price (“ADADP”), allocated among the assets, as under sections 1060 and 338.
ADADP is the sum of:
• Amount realized on the sale of the Target stock (or, in the case of a
distribution of Target stock, the fair market value of the distributed stock).
– Grossed up to take into account the stock not disposed of.
• Plus Target’s liabilities.
• New Target’s asset basis is determined by adjusted gross up basis of recently
purchased stock (“AGUB”), as under section 338. But only non-recently purchased
stock owned by 10-percent stockholders is used in the AGUB formula.
• Thereafter Target is deemed to transfer the consideration received in the deemed
asset sale to Seller, generally in a section 332 liquidation.
• If the assets deemed sold include the stock of a subsidiary (“Sub”), the deemed sale
of the Sub stock is eligible for a section 336(e) election (not a section 338(h)(10)
election).
• Seller’s sales of Target stock are disregarded so long as they occurred during the 12month disposition period.
235
Final Section 336(e) Regulations – Deemed Transactions
Basic Model (cont’d)
• If Seller makes a section 336(e) election for a taxable (non-section 355) stock
distribution (pro rata or non-pro rata), the deemed transactions are similar to those in a
sale, with twists:
– Target is deemed to sell all its assets to New Target.
– Gains are recognized, but net losses are disallowed in proportion to the amount of
stock distributed (vs. sold).
– Target is deemed to distribute the consideration deemed received for the assets to
Seller (generally a section 332 liquidation).
– Seller’s earnings and profits are adjusted to reflect gain or loss on the deemed
asset sale and transfer by Target.
– Seller is deemed to purchase the New Target stock that is distributed or retained
from an unrelated person in a taxable transaction.
• Note: The final regulations modify the proposed regulations to avoid the
potential application of section 351 by providing that Seller is deemed to
purchase the New Target stock from an unrelated person rather than from New
Target.
– No gain or loss is recognized to Seller in the deemed distribution of New Target
stock.
– The distributees take fair market value basis in the New Target stock, as in any
other taxable distribution.
236
Final Section 336(e) Regulations – Deemed Transactions
Sale-to-Self Model
•
If Seller distributes Target stock in a distribution subject to section 355(d) or section 355(e), a
section 336(e) election is available. If the election is made, the deemed transactions are as
follows:
– Target is deemed to sell all its assets to an unrelated person and then re-acquire the assets
(“sale-to-self” treatment).
• Target’s amount realized on the deemed sale is determined under ADADP principles.
• Target’s basis in the assets deemed sold and re-acquired is determined under AGUB
principles.
– In a spinoff under section 355(d) or section 355(e), the distributee shareholders do not take a
fair market value basis in the stock, and the AGUB formula would produce a mismatch
between amount realized and basis in the deemed asset sale.
•
There is no deemed liquidation of Target or any other deemed transfer of asset sale
consideration.
•
Seller’s distribution of the Target stock is given effect.
–
•
Thus, Target’s tax attributes generally remain intact. Treas. Reg. § 1.312-10 applies, and
Target’s earnings and profits are further adjusted to reflect gain or loss on the deemed asset
sale.
Target’s gains in the deemed asset sale are recognized in full, but Target’s net losses are
disallowed in proportion to the amount of stock distributed.
–
If Target’s assets include stock of Sub, that stock is deemed sold. A section 336(e) election
is available for that transaction. The deemed transactions are those for a stock sale.
•
The final section 336(e) regulations clarify that the sale-to-self model does not cause sections
197(f) (anti-churning rules) or 1091 (wash sale rules) to apply.
•
Section 355(b)(2)(C) does not apply to the deemed asset sale.
237
Final Section 336(e) Regulations –
Retained Stock
•
•
The proposed regulations provided that, if Seller retains any stock in Target after the
12-month disposition period, Seller is treated as purchasing the stock so retained on
the day after the disposition date for its fair market value. The proposed regulations
provided the holding period and purchase price (and thus the basis) of the retained
stock.
– Under the proposed regulations, if Seller sells, exchanges, or distributes less
than all of its stock prior to the disposition date, but sells, exchanges, or
distributes additional stock after the disposition date but before the end of the 12month disposition period, the regulations are silent as to holding period and
purchase price (and thus the basis) of such stock.
– If the later transaction is part of the qualified stock disposition, the basis and
holding period may not be relevant, because no gain or loss is recognized on
that transaction. However, if the stock is transferred in a transaction not part of
the qualified stock disposition, such as a sale to a related person, the basis and
holding period will be relevant.
The final regulations modify the rule of the proposed regulations by providing that
stock is retained if owned by the Seller after the disposition date.
238
Final Section 336(e) Regulations – Minority Shareholders
• A minority shareholder who sells, exchanges, or distributes Target
stock recognizes gain or loss under general principles of tax law.
Treas. Reg. § 1.336-2(d)(2).
• A minority shareholder who retains Target stock has no tax
consequences, unless it makes a “gain recognition election” to
recognize gain on the stock and obtain a stepped-up basis in the stock
retained. Treas. Reg. § 1.336-2(d)(3), -4(c).
– If a minority shareholder buys Target stock, and is an 80-percent
purchaser (or related to such a purchaser), it has a mandatory gain
recognition election. Treas. Reg. § 1.336-4(c)(2). The result is
the same as the result in a section 338(h)(10) sale of stock to a
minority shareholder. Treas. Reg. § 1.338(h)(10)-1(d)(1).
239
Requirements for Section 336(e) Election
• Seller is domestic corporation or S corporation
shareholder(s).
• Qualified stock disposition.
– One or more dispositions of stock if the stock
disposed of, in total, meets the requirements of
section 1504(a)(2) (80 percent vote and value).
– Taxable sale, exchange or distribution.
– During 12-month disposition period.
• Not a qualified stock purchase under section
338(d)(3).
• Election filed under Treas. Reg. § 1.336-2(h).
240
Section 338(h)(10) vs. Section 336(e)
338(h)(10)
336(e)
Election jointly made by Seller and Buyer
Election jointly made by Seller and Target
Seller must be a corporation or Target must be an
S Corp
Seller must be a corporation or Target must be an
S Corp
Buyer must be a corporation
Buyer need not be a corporation
Requires a sale of 80%
Requires any combination of sales and
distributions totaling 80%
Sale
Sale/Exchange – treated similarly to 338(h)(10)
Distribution – not available
Distribution – applies to non-section 355
distributions, and to section 355 distributions
taxable under section 355(d) or (e)
Not available for a disposition to related person
Not available for a disposition to related person
Not available if Seller or Target is foreign
Not available if Seller or Target is foreign
If eligible for 338(h)(10) and 336(e), can only elect
under (h)(10)
241
Section 338(h)(10) vs. Section 336(e)
Modifications to Terms in Treas. Reg. § 1.338-5
338
Section 338 or 338(h)(10) election
Purchasing corporation
Selling consolidated group/affiliate
Qualified stock purchase
Acquisition date
12-month acquisition period
Recently/nonrecently purchased
stock
Aggregate deemed sales price
(ADSP)
336(e)
Section 336(e) election
Purchaser
Seller
Qualified stock disposition
Disposition date
12-month disposition period
Recently/nonrecently disposed
stock
Aggregate deemed asset
disposition price (ADADP)
242
Sales
At close of Day 1, Old T deemed
to sell all assets to unrelated
party for FMV and liquidate
2
Seller
Target Stock
Buyer
Cash
1
Target
Old T has gain/loss on deemed
sale
Liquidates
On Day 1, B purchases
stock of T from S for Cash
Old Target
All Assets
S and T make 336(e)
election
3
Buyer
Seller
Also on Day 1, New T deemed to
buy all Old T assets from
unrelated party for FMV (Cf. 338
– purchase deemed made day
after acquisition date)
Unrelated
Party
FMV
Buyer
Seller
Tax Attributes of Old
Target if a 332
New Target
All Assets
FMV
Unrelated
Party
New Target
Stepped Up Basis in Assets
No Tax Attributes
243
Qualified Stock Purchase
T stock
P
A
$
T
S
• P sells all the T stock to A for cash.
- Joint section 338(h)(10) election available at T and S levels.
- Because the joint section 338(h)(10) election is available, no
election would be available under section 336(e). Treas. Reg. §
1.336-1(b)(6)(ii)(A).
244
Qualified Stock Disposition – Sale – General
80% of T stock
P
T1
T
Public
$
S
•
•
•
•
•
If P sells its T stock directly to Public, there is no corporate purchaser and thus no qualified stock
purchase. Thus, no joint section 338(h)(10) election is available.
Treas. Reg. § 1.338-3(b)(3)(iv), Example (1) provides a way to accomplish this transaction, by P
transferring the T stock to T1 in a taxable “busted B/busted 351” transfer and selling the T1 stock to the
Public. These transactions, however, are complex and have pitfalls.
Under Treas. Reg. § 1.336-2(a), P would be able to elect to treat a sale of the T stock directly to Public
as a sale of T assets to “New T” and a generally tax-free liquidation of T. P and T would make this
election.
P would need to determine if more than 20 percent of the T stock is sold to related persons. If so, no
section 336(e) election would be available.
Since the T assets include the S stock, that stock would be deemed sold to New T. This deemed sale
can be subject to a section 336(e) election, but not a section 338(h)(10) election. Treas. Reg. § 1.3361(b)(6)(ii)(B).
245
Stock Sale with Section 336(e) Election
T stock
(2)
A
S
Cash
Old
T
Deemed assets
(1)
ADADP
New
T
• S disregards the sale of Old T stock.
• Instead Old T is deemed to sell its assets to New T and liquidate into S.
• New T has no tax attributes.
• A is still treated as purchasing Old T stock.
246
Qualified Stock Disposition – Sale – Timing
P
Date 1
80% T stock
$
Date 2
20% T stock
$
Public
T
S
•
P sells 80 percent of the T stock to the Public on Date 1 and the remaining 20 percent to the
Public on Date 2.
• If P makes a section 336(e) election, T would be deemed to sell all its assets (including the S
stock) to New T at the close of Date 1, the “disposition date.” T would recognize its gains and
losses on asset sale.
• P’s Date 1 sale of T stock would be disregarded.
• If Date 2 is within 12 months of Date 1, P’s Date 2 sale of T stock would be disregarded
because the sale is part of the qualified stock disposition.
• If P’s Date 2 sale of T stock is outside of 12 months after Date 1, it would be a taxable sale, but
P’s gain or loss would be the appreciation or depreciation in the T stock between Date 1 and
Date 2.
247
Treas. Reg. § 1.336-2(b)(2)(iv).
Qualified Stock Disposition – Sale – Asset Basis
Date 1
15 sh T stock
Date 2
85 sh T stock
P
3 Individuals
$150
($10/sh)
100 sh
T
17 Individuals
$1,700
($20/sh)
S
•
•
•
•
•
•
•
On Date 1, P sells 15 shares of T stock to 3 unrelated individuals, 5 shares each, for a
total of $150 ($10/share).
On Date 2, more than 12 months after Date 1, P sells the remaining 85 shares of T stock
to 17 unrelated individuals, 5 shares each, for a total of $1,700 ($20/share).
If P and T make a section 336(e) election, T is deemed at the close of Date 2 to sell all
its assets to “New T” and liquidate. T recognizes all its gains and losses on this sale.
Among the assets deemed sold is the stock of S. This transaction is also eligible for a
section 336(e) election.
T’s amount realized on the deemed asset sale is based on ADADP principles – here
equal to the sale price for the stock plus T’s liabilities.
T’s basis for its deemed purchased assets is based on AGUB principles, but the only
non-recently purchased stock that counts is stock owned by more-than-10-percent
shareholders (none here).
Variation: The 3 individuals who buy T stock on Date 1 pay $300 ($30/share) and form a
partnership to buy the T stock immediately before Date 1.
248
Consolidation Issues
• In general, if a section 336(e) election is made, Seller is not
treated as having sold, exchanged or distributed the stock
disposed of in the qualified stock disposition. See Treas. Reg. §
1.336-2(b)(1)(i)(A).
– Instead, for federal income tax purposes, the transactions
specified in Treas. Reg. § 1.336-2(b) are deemed to occur
on the disposition date.
• However, a section 336(e) election does not affect the federal
income tax consequences to the purchaser that would have
resulted from the acquisition of Target stock had a section
336(e) election not been made. Treas. Reg. § 1.336-2(c).
– Thus, a purchaser is treated as having purchased, received
in exchange or received in a distribution the stock of Target
acquired on the date it is actually acquired. Treas. Reg. §
1.336-2(c).
249
Consolidation Issues – Example
July 1, Year 1
June 30, Year 2
20% T stock
60% T stock
A
P
A
P
$
$
20%
80%
T
•
•
•
•
B
20%
80%
T
P owns 80 percent of T, and A owns the remaining 20 percent of T’s stock. P and T file a
consolidated return. A is the common parent of a separate consolidated group.
– On July 1, Year 1, P sells 60 percent of T’s stock to A.
– On June 30, Year 2, P sells its remaining T stock to B. On this date, P has made a qualified
stock disposition, and P and T make a section 336(e) election.
For federal income tax purposes, P is not treated as selling the stock of T that is part of the qualified
stock disposition; thus, because of the section 336(e) election, P is treated as owning 80 percent of
the stock of T until June 30, Year 2 (the disposition date). See Treas. Reg. 1.336-2(k), Ex. 6.
However, A actually owns an 80-percent interest in T as of July 1, Year 1, and a section 336(e)
election generally does not affect the federal income tax consequences of the purchaser. See Treas.
Reg. 1.336-2(k), Ex. 6.
Query: Is T a member of the P or A group between July 1, Year 1 and June 30, Year 2?
250
Consolidation Issues – Example (cont’d)
July 1, Year 1
June 30, Year 2
20% T stock
60% T stock
A
P
A
P
$
$
20%
80%
T
B
20%
80%
T
Issues
•
Between July 1, Year 1 and June 30, Year 2 –
– Should transactions between T and the P group or T and the A group be treated as intercompany
transactions?
– How should the investment basis adjustment rules in Treas. Reg. § 1.1502-32 apply?
– Which group includes T’s tax items in computing consolidated taxable income?
– How should the P or A group apply Treas. Reg. § 1.1502-28?
– Can the P or A group engage in a section 1031 exchange with T?
•
How should the P and A groups treat a section 301 distribution that T makes to A between July 1, Year 1, and
June 30, Year 2?
•
Should T be severally liable for the P group’s Year 2 tax? For the A group’s Year 1 tax?
•
Why should the answers to the above questions depend on whether a section 336(e) election is made?
251
Non-Section 355 Distributions
1
Shareholder
Distributor
Target
Stock
D distributes stock of T to
S/H
D and T make a 336(e)
election
Old T has gain/loss on deemed
sale
Distributor
Old Target
All Assets
Target
Distributor
Old T deemed to sell all assets to
unrelated party for FMV
2
Unrelated
Party
FMV
3
New T deemed to buy all assets
from unrelated party for FMV
4
Old T deemed to liquidate
D deemed to purchase New T
stock from unrelated party and
distribute such stock to S/H
5
Shareholder
Tax consequences to S/H are
generally the same as when 336(e)
election not made
New T
Stock
Liquidates
Old Target
Distributor
FMV
All Assets
Unrelated
Party
New Target
FMV
Tax Attributes
of Old T
New T
Stock
Unrelated
Party
New T: Stepped Up Basis in
Assets; No Tax Attributes or
E&P
252
Qualified Stock Disposition – Non-Section 355 Intra Group and
Non Pro Rata External Distributions
A
B
40 sh
D
S
25 sh D stock
(1)
T stock
T
No 5-Year ATB
•
•
•
•
•
•
S distributes the T stock to D.
D distributes the T stock to its shareholder B.
T has no 5-year active trade or business, and so both distributions flunk section 355 and are
taxable.
The first distribution is not eligible for a section 336(e) election, because S and D are related.
Treas. Reg. § 1.336-2(k) Example (9).
The second distribution is eligible for a section 336(e) election, because thereafter D and B are
not related persons. Treas. Reg. § 1.336-2(k), Example (8). In the deemed asset sale, T
recognizes its gains, but its net losses are disallowed. Treas. Reg. § 1.336-2(b)(1)(i)(B).
Variation: In the second distribution, D distributes the T stock to A and B pro rata. The second
distribution would not qualify for a section 336(e) election, because B and D are related persons.
Only the distribution to A is a “ disposition” of T stock, and it involves less than 80 percent of the T
stock.
253
Section 355 Distributions
1
Shareholder
Distributor
Target
Stock
D distributes stock of T to S/H
in a 355 distribution to which
355(d)(2) or (e)(2) applies
(taxable to D, not to S/H)
2
Old T has gain/loss on deemed
sale
Distributor
D and T make a 336(e)
election
Old Target
All Assets
Target
3
Old T deemed to repurchase all
assets for FMV
4
D distributes Old T stock to S/H
Distributor
Old Target
Unrelated
Party
FMV
Shareholder
Old T
Stock
Old T deemed to sell all assets to
unrelated party for FMV
Shareholder
Old Target
FMV
Unrelated
Party
Distributor
Stepped Up Basis in Assets
Retains Tax Attributes
and E&P
All Assets
254
Section 355(d) or (e) Stock Distribution
with Section 336(e) Election
SH’s
S
A
Merge
Deemed asset sale
Old T
Deemed asset acquisition
Unrelated
Person
• The controlled corporation, Old T, is deemed to sell its assets to an unrelated person and
reacquire those assets (sale-to-self treatment).
• The distributing corporation, S, is treated as distributing the stock of Old T to its shareholders
in the spin-off. Old T recognizes gain but net losses are disallowed. The shareholders
determine their basis under section 358.
• Old T retains its tax attributes, including E&P from the deemed asset sale, which is further
adjusted under Treas. Reg. § 1.312-10.
• The deemed sale and reacquisition will not cause the transaction to fail to satisfy the
requirements of section 355.
255
Deemed Treatment as Result of
Section 336(e) Election
Sales and
Exchanges
Deemed
Asset Sale
by Target
Yes
Section 301 / 311
Distributions
Section
355(d) and (e)
Spins
Yes
Yes
Limited
Losses
Recognized
Yes
Limited
Deemed
Liquidation
of Target
Yes
Yes
No
256
Disallowed Loss Example — Facts
Shareholders
Target
Stock
Seller
FMV 100
Basis 50
Basis
Realized Gain 50
Asset 1 40
Target
Asset 2
10
Section 336 (e)
Realized Gain or
Loss
FMV
10
(30)
90
80
– On Date 1, Seller forms Target and contributes Asset 1 and Asset 2 to Target.
Asset 1 has a basis and fair market value of 40, Asset 2 has a basis and fair
market value of 10. Seller takes a 50 basis in the stock of Target, which is worth
50. On Date 2, when Asset 1 is worth 10 and Asset 2 is worth 90, Seller
distributes all the Target stock to Seller shareholders in a transaction to which a
section 336(e) election applies. At the time of the distribution, the stock of Target
is worth 100.
257
Disallowed Loss Example — Results
Shareholders
Target
Stock
Seller
FMV 100
Basis 50
Realized Gain 50
Target
Basis
FMV
Section 336 (e)
Realized Gain or
Loss
Asset 1
40
10
(30)
Asset 2
10
90
80
– If no section 336(e) election is made, 50 of gain under section 311(b).
– Under the proposed section 336(e) regulations, 80 of gain. 30 loss is disallowed.
– Under the “netting” approach in the final section 336(e) regulations, the 30 loss
could be used up to the amount of the gain. Thus, all 30 would be allowed for an
overall gain of 50 (equal to 80 of gain on Asset 2 less 30 of loss on Asset 1).
• If Asset 1 had a basis of 100 (i.e., 90 loss), the loss could offset all of the 80 of
gain, while the remaining 10 of the loss would be disallowed.
258
Section 351 Transactions
• Following section 338 and a reference in the legislative history to
permitting section 336(e) elections in the case of “taxable”
transactions, the proposed regulations required that, in order to
make a section 336(e) election, the Target stock may not, in
general, be “sold, exchanged, or distributed in a transaction to which
section 351, 354, 355, or 356 applies.” Prop. Treas. Reg. § 1.3361(b)(4)(i)(B).
• However, unlike section 338, the statute does not impose this
“purchase” requirement for section 336(e) elections. Thus, the IRS
could expand the regulations to permit a section 336(e) election in
the case of a disposition covered by section 351.
259
Final Regulations Under Section 336(e) –
Non-Taxable Transactions
•
The IRS and Treasury considered whether the scope of the section
336(e) regulations should be broadened to include certain nontaxable transactions.
• However, the final regulations do not permit an election to be
made in non-taxable transfers of target stock.
• In the preamble, the IRS and Treasury indicated that
attempting to develop rules in this area would have significantly
delayed the finalization of the regulations.
• The IRS and Treasury will continue to study this issue and may
address the issue in future guidance. The IRS and Treasury
have requested comments, including recommendations on the
scope of the regulations and the specific means and models for
implementing any suggestions.
260
Section 351 Transactions – Example
Seller
Target
Stock
Investors
Acquiror
Stock
Target
•
•
•
•
•
•
Acquiror
Stock
and
Cash
Cash
Acquiror
Seller owns the stock of Target.
Investors form Acquiror by contributing cash to Acquiror.
Seller transfers its Target stock to Acquiror in exchange for Acquiror stock and cash.
The transaction is a section 351 transaction. As a result, no section 338 election may
be made. Under the final section 336(e) regulations, no section 336(e) election can
be made either.
Absent a section 336(e) election, Seller would recognize all the gain on its Target
stock up to the amount of cash received (but no loss).
If a section 336(e) election were permitted and were made, Target would recognize
the gain and loss in its assets and then would be deemed to liquidate into Seller.
261
Intercompany Sale or Spin followed by External Sale or Spin
•
If the stock of Target is transferred within an affiliated group and then transferred to a
third party in a transaction for which a section 336(e) election is made, there could
potentially be a double tax at the corporate level. Treas. Reg. § 1.1502-13(f)(5)(ii)(C)
should ameliorate the double tax, however.
•
Example:
– Seller owns Sub 1 and Sub 2. Sub 1 owns Target. Sub 1 sells the stock of
Target to Sub 2 for cash resulting in a deferred intercompany gain in the stock of
Target. Then, Sub 2 sells the stock of Target in a separate transaction in which
either a section 336(e) or a section 338(h)(10) election is made. The election
results in recognition of gain in the assets of Target. Further, the deemed
liquidation resulting from the election results in the deferred intercompany gain
being taken into income. Thus, both asset level gain and stock level gain in
Target are apparently recognized. However, Treas. Reg. § 1.1502-13(f)(5)(ii)(C)
should permit the taxpayer to elect to treat the deemed liquidation of Target into
Sub 2 as a section 331 liquidation for the sole purpose of providing Sub 2 with a
loss, which offsets Sub 1’s deferred intercompany gain that arose on the
disposition of Target to Sub 2.
262
Final Section 336(e) Regulations –
Treas. Reg. § 1.1502-13(f)(5) Election
•
The final regulations modify Treas. Reg. § 1.1502-13(f)(5)(ii)(C) to clarify
that a Treas. Reg. § 1.1502-13(f)(5) election is available for a section
336(e) election.
• Consequently, a taxpayer is able to make a Treas. Reg. § 1.150213(f)(5) election to treat the deemed liquidation of Target into Seller
as a result of a section 336(e) election as a taxable liquidation.
•
The IRS and Treasury also acknowledged that an external distribution
under section 355(d)(2) or (e)(2) preceded by an intragroup transaction
raises the same concerns, but a Treas. Reg. § 1.1502-13(f)(5) election
would not provide relief because there is no deemed liquidation of
Target.
• The final regulations provide that, in the case of a section 355(d)(2)
or (e)(2) transaction that is preceded by an intragroup transaction,
for the limited purpose of a Treas. Reg. § 1.1502-13(f)(5) election,
immediately after the deemed asset disposition of Target's assets,
Target is deemed to liquidate into Seller, thus providing Seller with a
stock loss that can offset some or all of the group's intercompany
gain with respect to the intragroup transfer of Target stock.
263
Section 336(e) Election –
Foreign Corporations
•
•
•
•
•
Under the final regulations, a section 336(e) election is only available where both the
Seller and the Target are domestic corporations. Treas. Reg. § 1.336-1(b)(1) and (3).
– The IRS and Treasury indicated that they will continue to study the application of
section 336(e) to transactions in which either Seller or Target is a foreign
corporation, and may consider expanding the scope of the regulations to address
these transactions in future guidance.
Section 338 elections apply to foreign and domestic target corporations. Is there a
principled way to distinguish the section 336(e) election in this regard?
Issues: U.S. Seller – Foreign Target
– Gain on inbound section 332 liquidation (section 367(b))
– Sourcing of earnings and profits for foreign tax credit purposes?
– Application of section 338(h)(16) principles?
Issues: Foreign Seller – U.S. Target
– FIRPTA purge?
– Avoid Subpart F income where Seller is a CFC?
– Double taxation on “carried over” earnings and profits?
Issues: Foreign Seller – Foreign Target
– Expand the Dover Corp. v. Commissioner results to situations where a check-thebox election is unavailable?
264
Contingent Liabilities
265
Contingent Liabilities in Taxable Asset Acquisitions
•
•
Unfortunately almost every deal involves contingent liabilities.
– Examples:
• Environmental liabilities
• Tort liabilities
• Warranty claims
• Retiree medical expenses
– Complex area with very few answers.
– Conflicting authority.
Issue arises when a buyer purchases assets of a business and after the
acquisition the buyer pays or incurs a liability that is attributable to the
acquired business.
– It is not clear whether that liability is a liability of the seller that is
assumed by the buyer;
OR
– Whether it is simply a liability that arose after the acquisition and is
properly treated as the buyer’s liability.
266
Contingent Liabilities in Taxable Asset Acquisitions
•
•
•
•
Whose liability is it?
– Is it a seller liability assumed by the buyer?
– Or a liability of the buyer arising after closing?
If the buyer is not assuming a debt of the seller.
– Buyer should get a deduction on the payment of the liabilities. (Under
normal rules of the all events test and economic performance. See section
461(b).
– Ability to get a deduction is subject to the capitalization rules.
If the liability is the seller’s liability assumed by the buyer, there are numerous
issues:
– Income to the seller
– Offsetting deduction to the seller
– Basis to the Buyer
Threshold question is when will contingent liability be treated as a seller liability
assumed by the buyer and when will it be treated as the buyer’s liability.
– Each case decided on its own facts and circumstances.
– Cases and rulings provide some guidance on factors as to when a liability
will be treated as assumed by the buyer.
267
Contingent Liabilities: Assumed Obligation?
Factors
•
Results from Buyer’s Operation
•
Arises Out of Post-Acquisition Events
•
Buyer Aware of Liability
•
When Did Legal Liability Arise
•
Reflection in Price
•
Express Assumption by the Buyer
•
Balance Sheet Reserve
268
Contingent Liabilities: Assumed Obligation?
•
First factor: Results from Buyer’s Operation
–
–
–
–
–
Whether the liability relates to:
• Buyer’s operation of the business
• Activity performed by the buyer
• Events under the buyer’s control
• Liability arising from buyers decision
Goal is to separate the occurrence of the liability from the seller and the acquisition (i.e., not a seller liability).
If it does not relate to the seller’s operation of the business, then the Buyer can deduct the payment.
Holdcroft Transportation Co. v. Commissioner, 153 F.2d 323 (8th Cir. 1946)
• Corporation acquires assets of partnership in exchange for stock and assumption of liabilities—including two tort
claims filed against the partnership.
• Corporation pays on the claims and deducts the payments.
– Corporation argues it should be treated as stepping into the shoes of the partnership and therefore should
be able to deduct the payments.
– Corporation also argues it should be able to deduct the payments because the claims were contingent.
• Court holds: (i) claims did not arise out of buyer’s business; (ii) rather, expenses related to the seller’s business; (iii)
buyer cannot deduct costs relating to seller; (iv) fact that liability was liability was contingent did not matter; (v)
buyer assumed the liability as part of the costs of the assets; (vi) section 381 – step into the shoes.
Other authorities
• Albany Car Wheel v. Commissioner, 333 F.2d 653 (2d Cir. 1964) – liability arose after acquisition due to buyer’s
decision to close plant.
• Rev. Rul. 76-520 – buyer acquired a newspaper business.
– Costs of filling prepaid subscriptions was assumed liability because it relates to sellers operation.
– Costs incurred to sell newspapers at newsstand were deductible because they related to the buyer’s
operation.
• TAM 9721002 – acquisition and severance pay.
– “[A]lthough severance payments here were coincidental with Buyer's acquisition of Target, the severance
payments had their origin in Buyer's termination of Target employees. While the acquisition may have been
the catalyst for the employees' receipt of the severance payments, the acquisition was not itself the basis for
the payments. Accordingly, the severance payments need not be capitalized and added to the basis of the
stock purchased.”
• Illinois Tool Works v. Commissioner, 355 F.3d 997 (7th Cir. 2004)
– Because the taxpayer knew of the pending patent infringement lawsuit, and agreed to pay that contingent
liability in exchange for purchasing the company, the taxpayer was not entitled to currently deduct the
judgment as a business expense.
269
Contingent Liabilities: Assumed Obligation?
•
Second factor: Arises Out of Post-acquisition Events
– A closely related factor is whether the liability arises out of post-acquisition events.
– For example, employee benefit cases –
• Where there is a contract in place at the time of the acquisition to pay death
benefits when an employee dies.
• If employee dies after closing, then the liability should be a buyer liability.
– Even though contract in place, it’s contingent because you know he will die
eventually.
• If employee has already died and seller is obligated to pay, the buyer assumes
the obligation—No deduction.
– M. Buten & Sons, Inc. v. Commissioner, T.C. Memo. 1972-44
• Corporation agreed to assume liabilities of partnership in section 351 transaction,
including death benefits to surviving widows.
– Court held no deduction for payments to widow of employee who died before
the acquisition; payments were deductible if employee died after the
acquisition.
– David R. Webb Company, Inc. v. Commissioner, 708 F.2d 1254 (7th Cir. 1983)
• Buyer assumed seller’s obligation to make pension payments to wife of previously
deceased employee.
• Court – no deduction to buyer.
270
Contingent Liabilities: Assumed Obligation?
•
Third factor: Buyer Aware of Liability
– The third factor is whether the buyer was aware of the liability.
– In Pacific Transport v. Commissioner, T.C. Memo. 1970-41, rev’d per curiam, 483
F.2d 209 (9th Cir. 1973), a parent corporation liquidated its subsidiary (section
334(b)(2) and took assets and assumed the liabilities of the subsidiary, including a
lawsuit that was asserted against the subsidiary.
• The parent corporation believed its risk exposure on the claim was remote.
• The parent corporation’s risk assessment was wrong and it ultimately had to pay
the claim.
• Tax court held that a deduction should be allowed because the claim was
speculative and remote.
• Appeals court reversed and held that contingency was irrelevant. Because the
buyer was aware of the liability, payment of the claim was a cost of acquiring the
assets.
– No exception to capitalization for bad bargains.
– Therefore, if buyer is aware of the claim at the time of the acquisition, there is no
deduction for payment of the claim.
– On the other hand, if buyer is not aware of the claim, then the court might permit the
buyer to deduct.
– But see Holdcroft Transportation v. Commissioner. Court might not care whether the
buyer knew of the liability and may instead look to when the liability arose. If the
liability relates to the seller, then no deduction.
271
Contingent Liabilities: Assumed Obligation?
•
Fourth Factor: When did legal liability arise?
– The fourth factor used by some courts to determine if a liability has been assumed is when
the legal liability arose.
– This factor can be used to explain the tort cases. Courts have stated that legal liability for a
tort arises when the tort occurs.
• Therefore using this factor would lead a court to conclude that a pre-closing cause of
action is a liability of the seller. If the buyer pays the liability, there is no deduction.
• Holdcroft and Pacific Transport support the notion that the contingent nature of the tort
is not relevant.
– Compare this result to the contract cases where the liability represents a contractual claim,
not a tort.
– Albany Car Wheel Co. v. Commissioner, 40 T.C. 831 (1963), aff’d, 333 F.2d 653 (2d Cir.
1964)
• There was a collective bargaining agreement that required payment of severance
wages to employees upon a plant shutdown.
• The purchase agreement called for an express assumption of the severance pay
liabilities.
• After the assets were transferred, the plant was shut down and severance payments
were made by the buyer.
• Court held that the liability did not arise until after the closing when the plant shut down.
Therefore the liability arose on the buyer’s side.
– Contract required payment upon certain contingent, future events. Liability arose
when the event occurred.
– Event was post-closing.
272
Contingent Liabilities: Assumed Obligation?
•
Fifth Factor: Liability Reflected in Price
– The next factor is whether the contingent liability is reflected in the price.
– Courts look to see if the purchase price was reduced on account of the contingent
liability.
– If the purchase price was reduced, then the liability looks like an assumed liability.
– This factor comes up often where –
• Purchase price based on balance sheet
• Reserve on balance sheet (e.g., for employee medical benefits)
– Allows IRS to argue that the liability was reflected in the price.
•
Sixth Factor: Liability Expressly Assumed by the Buyer
– The sixth factor is whether the buyer expressly assumed the liability.
– If the buyer expressly assumes a liability of the seller, courts generally conclude that
the buyer is assuming the liability.
– However, this factor alone is not fatal. In Albany Car Wheel the buyer expressly
assumed a collective bargaining liability (severance pay in the event of a plant
shutdown). However, the court said that the liability in fact was assumed.
273
Consequences of an Assumed Liability
To the Seller:
•
Income Inclusion – When
What Amount
•
Installment Reporting
•
Offsetting Deduction
•
Imputed Interest Income
To the Buyer
•
Capitalize Payment
•
Deduct Payment
•
Report Income
•
Imputed Interest Expense
274
Consequences of an Assumed Liability: To the Seller
•
•
First Issue: Income Inclusion
– Seller is being relieved of a liability.
– Seller’s amount realized is increased.
• Not clear when amount realized increased and by how much.
• One approach is to value the liability at closing and increase the amount
realized by that amount.
• Second approach is to increase seller’s amount realized only when the
contingency becomes fixed and determinable (however that standard is
defined). This is sometimes referred to as the “Wait and See” approach.
Second Issue: Installment Reporting
– If the “wait and see” approach is taken, then the issue arises as to whether the
sale is converted to an installment sale because of the possible future payment
when liability becomes fixed.
• Section 453 regulations (relating to installment sales) do not discuss
assumption of contingent liabilities.
• However, if you treat the payment of the liability as a payment of the
purchase price, then the sale literally falls within the definition of contingent
payment installment sale.
275
Consequences of an Assumed Liability: To the Seller
•
Third Issue: Does the Seller get an offsetting deduction against the amount realized
resulting in no net income?
– Most practitioners would conclude the seller should get a deduction under James
M. Pierce Corp. v. Commissioner, 326 F.2d 67 (8th Cir. 1964) and Commercial
Security Bank v. Commissioner, 77 T.C. 145 (1981).
– In Pierce, the seller operated a newspaper business.
• Seller received prepaid subscription fees.
• Seller initially set up a reserve and deferred the income under section 453.
• Court said that when seller sold the business the seller must accelerate the
reserve into income.
• But, the court also gave the seller a deduction.
– Buyer paid cash for reserve.
– Seller turned around and paid buyer for assuming the liability to fill
newspaper subscriptions.
– Thus income was offset with a deduction.
– In Commercial Security Bank there was a slightly different rationale.
• Court said that liability assumed by the buyer reduced the cash received by the
seller.
• Such reduction in cash received treated as if seller actually paid the liability.
• Seller gets a deduction to offset income.
276
Consequences of an Assumed Liability: To the Seller
•
Third Issue (cont’d): Does the Seller get an offsetting deduction against the amount realized
resulting in no net income?
– Problem arises because a seller can have all kinds of liabilities and the timing rules for
deductions must be considered.
• For example, if the all events test is satisfied but there is no economic performance, does
the seller still get a deduction?
• Section 461(h) regulations reserve treatment of contingent liabilities. See Treas. Reg. §
1.461-4(j).
• Section 461 regulations do provide that in a sale of a business if the buyer “expressly
assumes” a fixed liability then economic performance occurs as the liability is included in
the seller’s amount realized.
• Problem is that the regulation is too narrow because it requires an express assumption.
• If the regulation test is failed, then the seller may have income without a matching
deduction.
– Presumably the deduction is deferred until the buyer makes payment.
» This is the wrong answer – in the acquisition context the seller should not be
subject to economic performance.
» Section 461(h) was intended to prevent premature accrual. If the seller has
income recognition, then accrual is not premature.
» If the seller doesn’t get a deduction at the time of the acquisition, then there is
not a clear reflection of income.
» Query whether Pierce and Commercial Security Bank apply if the requirements
of section 461(h) are not met.
– Similar problem arises where the liability is to make payment to nonqualifying deferred
compensation plan.
• Section 404(a)(5) – employer gets deduction when employee has income.
• IRS position in TAM 8939002 is that deemed payment found in Commercial Security Bank,
Pierce, etc. doesn’t support a deduction without income to the employee.
277
Consequences of an Assumed Liability: To the Seller
• Fourth Issue: Whether Interest Imputed on Deemed Payment
– This issue should only apply to the “wait and see” approach.
• Arguably there is no imputed interest because section 1274
does not apply to assumed debt. See section 1274(c)(4).
278
Consequences of an Assumed Liability: To the Buyer
•
First Approach: Capitalization
– Treat liability as cost of the assets.
– Add to the assets’ basis when the liability becomes fixed.
– Capitalization approach has the greatest support in the case law
• See Webb v. Commissioner, 77 T.C. 1134 (1981), aff’d, 708 F.2d
1254 (7th Cir. 1983).
– Unfunded pension liability assumed in asset acquisition.
– Payments treated as cost of acquired assets.
• See also Holdcroft, Pacific Transport, M. Buten & Sons.
– Uncertain whether buyer can treat a portion of the payments as interest.
279
Consequences of an Assumed Liability: To the Buyer
•
Second Approach: Deduction
– This method says that even if the liability is assumed by the buyer the
buyer should still get a deduction when the liability is fixed.
– There is some support for this approach in the case law.
• Albany Car Wheel, 333 F.2d 653 (2d Cir. 1964)
– Agreement specifically said liability to pay severance pursuant to
collective bargaining agreement in the event of a plant shutdown
was assumed.
– But court said that facts showed that the liability was not assumed
and the buyer had made a decision that resulted in the liability to
pay severance (i.e., shutting down the plant).
• United States v. Minneapolis and St. Louis Railway Co., 260 F.3d 663
(8th Cir. 1958)
– Suggests deductibility method.
– But case can also be read as saying nothing was assumed.
• F&D Rentals, Inc., 365 F.2d 64 (7th Cir. 1966)
– Court said in dicta that taxpayer could deduct if payment had
been made.
280
– ABA and NYSBA support the deductibility approach.
Consequences of an Assumed Liability: To the Buyer
•
Third Approach: Income Approach
– The third approach is the income approach. This approach comes from
the Pierce case.
• Seller sold a newspaper.
• Court required seller to include reserve for prepaid subscriptions in
income on sale.
• Court permitted seller an offsetting deduction.
• Court’s theory was to construe a deemed payment from seller to
buyer in an amount equal to the reserve.
– The income approach has not received much support outside of the
publication industry.
• Doesn’t make sense to say buyer has income on a purchase.
281
Contingent Liabilities: Section 338(h)(10)
Result under the Section 338 Regulations
SELLER’S ADSP
ADSP = G + L
•
Regulations eliminate the “Fixed and Determinable” standard for
determining the Liabilities of Old T.
•
General principles of tax law apply in determining the timing and the
amount of liabilities to be included in ADSP.
•
ADSP is redetermined at such time and in such amount as an
increase or decrease would be required, under general principles of tax
law, for the elements of ADSP.
BUYER’S BASIS
•
•
Use AGUB Formula
Regulations eliminate the “Fixed and Determinable” standard.
•
In order to be taken into account for AGUB, a liability must be a
liability of T that is properly taken into account in basis under general
principles of tax law.
282
IRS Ruling Policy
283
IRS Ruling Policy for Corporate Transactions –
Rev. Proc. 2013-32
•
•
•
•
•
In Rev. Proc. 2013-32, 2013-28 I.R.B. 55, the IRS announced that it will broaden its no-ruling policy with respect to
whether a transaction qualifies for nonrecognition treatment under section 332, 351, 355, or 1036, or on whether a
transaction constitutes a reorganization within the meaning of section 368.
Under its current policy, unless the IRS determines that there is a significant issue, the IRS will not issue a letter ruling
on (i) whether a transaction qualifies for nonrecognition treatment under section 332, 351 (except for certain transfers
undertaken before section 355 distributions), or 1036; (ii) whether a transaction constitutes a reorganization under
section 368(a)(1)(A), (B), (C), (E), or (F); or (iii) the tax consequences (such as nonrecognition and basis) that result
from the application of those sections.
– If the IRS determines that there is a significant issue, and to the extent the transaction is not described in another
no-rule area, the IRS will rule on the entire transaction and not just the significant issue.
Under Rev. Proc. 2013-32, the IRS will no longer rule on whether a transaction qualifies for nonrecognition treatment
under section 332, 351, 355, or 1036, or on whether a transaction constitutes a reorganization within the meaning of
section 368, regardless of whether the transaction presents a significant issue and regardless of whether the
transaction is an integral part of a larger transaction that involves other issues upon which the IRS will rule.
– The IRS will rule, however, on one or more issues under the above-cited sections (or on issues arising under
related sections) to the extent that such issue or issues are significant.
– A “significant issue” is defined as “an issue of law the resolution of which is not essentially free from doubt and
that is germane to determining the tax consequences of the transaction.”
The revenue procedure also discontinues the pilot program for letter rulings on issues arising in the context of section
355 distributions (Rev. Proc. 2009-25, 2009-24 I.R.B. 1088).
– Under this program, a taxpayer could request a letter ruling on part of a larger transaction or on a particular issue
under a section that a transaction presented. The IRS would issue a letter ruling on the particular issue raised in
the letter ruling request and not on any other issue (including, in some cases, qualification of the distribution
under section 355) or on any other aspect of the transaction.
The revenue procedure cites the need to conserve IRS resources as the reason behind the more restrictive letter ruling
policy. The revenue procedure applies to all ruling requests received (or postmarked if mailed) after August 23, 2013.
284
IRS – Specific No-Rule Areas
•
In Rev. Proc. 2013-3, 2013-1 I.R.B. 113, the IRS added several new areas as under study with
respect to which letter rulings will no longer be issued pending the issuance of formal guidance –
– Use of Controlled Stock/Securities to Satisfy Distributing Debt – “Whether either § 355 or § 361
applies to a distributing corporation’s distribution of stock or securities of a controlled corporation
in exchange for, and in retirement of, any putative debt of the distributing corporation if such
distributing corporation debt is issued in anticipation of the distribution.”
– Control Requirement – “Whether a corporation is a ‘controlled corporation’ within the meaning of
§ 355(a)(1)(A) if, in anticipation of a distribution of the stock of the corporation, a distributing
corporation acquires putative control of the controlled corporation (directly or through one or
more corporations) in any transaction (including a recapitalization) in which stock or securities
were exchanged for stock having a greater voting power than the stock or securities relinquished
in the exchange, or if, in anticipation of a distribution of the stock of the putative controlled
corporation, such corporation issues stock to another person having different voting power per
share than the stock held by the distributing corporation.”
– North-South Transactions – “Whether transfers of stock, money, or property by a person to a
corporation and transfers of stock, money, or property by that corporation to that person (or a
person related to such person) in what are ostensibly two separate transactions (so-called ‘northsouth’ transactions), at least one of which is a distribution with respect to the corporation’s stock,
a contribution to the corporation’s capital, or an acquisition of stock, are respected as separate
transactions for Federal income tax purposes.”
285
Transfers to Creditors in Divisive
Reorganizations
286
Treatment of Transfers to Creditors in
Divisive Reorganizations
•
•
Under section 361(b)(3), the amount of money plus the FMV of other property that a
distributing corporation can distribute to its creditors without gain recognition under
section 361(b) is limited to the amount of the basis of the assets contributed to the
controlled corporation.
– Such limitation does not apply to securities of a controlled corporation that a
distributing corporation receives and distributes to its creditors as part of the
reorganization.
Several recent legislative proposals would have treated securities as “other property”
under section 361, so that a distributing corporation would recognize gain to the extent
that securities it receives and transfers to creditors exceed the adjusted basis of the
assets transferred by the corporation (net of liabilities). See, e.g., Section 302 of the
Small Business and Infrastructure Jobs Tax Act of 2010, H.R. 4849.
– Such proposals were intended to address concerns with respect to the levels of debt
incurred in divisive transactions in which one corporation is relieved of debt while the
newly-separate corporation is burdened.
– However, unlike the distribution of cash, a distributing corporation’s creditors have to
agree to take the controlled corporation debt securities in satisfaction of the
distributing corporation’s debt, which such creditors would be unlikely to do if the
controlled corporation were unduly burdened with debt in relation to its assets.
287
Treatment of Transfers to Creditors in
Divisive Reorganizations – Example
D Shareholders
(3)
(2)
D Creditors
$300 Cash
D
Business A Assets
Aggregate FMV = $500
Aggregate Basis = $250
$200 C Stock
$300 Cash
(1)
C Stock
C
Facts: D owns all of the stock of C in which it has a basis of $100. D conducts Businesses A and B, and C
conducts Business A. D contributes its Business A assets, which have an aggregate FMV of $500 and an
adjusted basis of $250, to C in exchange for $200 worth of C stock and $300. D uses the cash to repay
currently outstanding debt. D then distributes all of its C stock to its shareholders.
Analysis: The amount of money and the FMV of other properties that D can receive tax-free under section
361(b) and then distribute to D creditors without gain recognition is limited to the total adjusted basis of the
properties transferred by D to C. Therefore, D has $50 of gain ($300 cash distributed to its creditors - $250
aggregate basis in property contributed to C). See section 361(b)(3).
If, instead of cash, D received C securities worth $300 and used such securities to satisfy its debt, D would not
recognize any gain, as the limitation in section 361(b)(3) would not apply.
288
Treatment of Transfers to Creditors in
Divisive Reorganizations – IRS Rulings
•
•
•
The IRS has issued private letter rulings approving the use of controlled securities received in a
divisive “D” reorganization to satisfy debt of the distributing corporation.
Formerly, the IRS only approved such exchanges if the distributing corporation debt satisfied by the
controlled securities was “old and cold” debt that was not incurred as part of the transaction.
– More recently, the IRS has approved transactions where the distributing company’s debt is newly
issued and short–term, and the exchange between distributing and controlled is facilitated by an
intermediary (e.g., an investment bank or an underwriter).
– In such rulings, the IRS has generally limited the amount of distributing debt that can be retired
with controlled securities to historic average outstanding debt levels.
In a typical transaction, an investment bank purchases distributing debt (on the open market or
directly from distributing) and enters into an exchange agreement with the distributing corporation. In
connection with the distribution of controlled, distributing transfers controlled securities to the
investment bank in exchange for the distributing debt, with the investment bank selling the controlled
securities on the open market.
– The IRS has generally required a “5-14 representation” in connection with such transactions,
which is intended to ensure the existence of event risk and credit risk (i.e., that the investment
bank was a real creditor and not merely an agent of distributing).
– Generally, the IRS has defined event risk as the investment bank holding the distributing debt for
at least 5 days before entering into the exchange agreement, and credit risk as the investment
bank holding the distributing debt for at least 14 days before executing the exchange of
distributing for controlled debt.
289
PLR 201138021
Investment
Banks
Public
(2)
D Debt
C Stock
D
C Securities
Cash
C Securities
Unrelated
Third
Parties
(4)
(3)
(1)
C Stock,
C Securities,
Liability Assumption
Business A
C
Facts: D contributes Business A to newly formed C in exchange for all of C’s stock, the assumption of certain D liabilities
by C, and C securities. D distributes the C stock to its shareholders, and D exchanges the C securities for debt of D. The
debt exchange is facilitated by investment banks that will acquire the D debt at least m days (believed to be 14 days) prior
to the date of the exchange. D and the investment banks will enter into exchange agreements no sooner than n days
(believed to be 5 days) after the investment banks acquire the D debt. The investment banks enter into agreements to
sell the C securities received in the exchange to unrelated third parties. The D debt exchanged for the C securities will
not exceed the weighted quarterly average of D’s third-party debt for the 12-month period ending on the date before the
date D’s board of directors directed management to pursue actively the distribution transaction.
Rulings:
• The contribution to C and the distribution by D qualify as a reorganization under section 368(a)(1)(D).
• D will generally not recognize any gain or loss with respect to the C securities under section 361(c).
• See also PLRs 200808006, 200802009.
290
Treatment of Transfers to Creditors in
Divisive Reorganizations – IRS Rulings
•
•
Taxpayers have also obtained rulings from the IRS in debt-for-debt exchanges
where distributing securities are issued directly to third-party creditors/investors
without the use of an intermediary.
– In this type of transaction, involving so-called “traveling debt,” there is no
exchange agreement; rather, the terms of such instruments generally
permit the distributing corporation to exchange the debt for securities of
controlled.
The IRS has generally required a similar 5-14 representation to ensure
sufficient event and credit risk is assumed by the third-party creditors/investors.
291
Repayment of Distributing Debt in 355 Spin-off –
PLR 201029007
Debt holders
(1)
D issues Debt to
unrelated investors
D
(3) D distributes C stock to D’s
(2)
D contributes assets
to C in exchange for
C stock and C Debt
shareholders and exchanges
C Debt for D Debt
C
•
The IRS ruled that D will not recognize gain or loss on the transfer of C
Debt under section 361(c) (with certain exceptions).
•
The taxpayer represented that D Debt exchanged for C Debt “will not
exceed the daily average outstanding third party indebtedness of D for the
365 day period ending” at the close of the last business day before D’s
Board directed management to pursue the distribution.
•
Compare to prior rulings requiring D Debt to be “old and cold”. See PLRs
200716024, 200345050, and 200137011.
292
PLR 201029007 (cont’d)
•
The ruling provides that D Debt will be issued to investors at least g
days prior to distribution. The ruling does not specify when D and the
investors will agree to the exchange of C Debt for D Debt.
•
Compare PLR 201032017:
•
The Investment Banks acquired D debt (either by direct
issuance or on secondary markets) at least ii days prior to
date of exchange (assumed to be 14 days based on PLR
200802009).
•
An Exchange Agreement was entered into by the Investment
Banks and D no sooner than jj days after the Banks acquired
the debt (assumed to be 5 days based on PLR 200802009).
•
It was anticipated that the Investment Banks would sell the C
debt they received in the debt exchange.
293
PLR 201232014
Third-Party
Investors
Public
(3)
Cash
(2)
C Stock
D Securities
D
(1)
C stock,
Cash,
C Securities,
Liability Assumption
Business A
C
Facts: D is a publicly-traded corporation that operates Businesses A and B. D operates
Business A through a disregarded entity, C, which elects to be treated as a corporation. D
contributes to C certain Business A assets and interests in exchange for C stock, cash, C
securities, and the assumption of certain liabilities by C. D issues new securities to third-party
investors at least 5 days prior to the declaration of its distribution of C stock and 14 days
before such distribution. D distributes C stock to its shareholders.
294
PLR 201232014
Third-Party
Investors /
D Creditors
(5)
D Creditors
C
Securities
C Cash
Public
(4)
D Securities /
Debt
D
C
Facts (cont’d): Around the same time as the distribution, and at least 14 days after D’s issuance of new
securities, D delivers C securities in satisfaction of its recently issued securities and certain other debt
related to Business A. D also uses all of the cash received from C to repay outstanding D debt.
Rulings:
•
The contribution to C and the distribution by D qualify as a reorganization under section 368(a)(1)(D).
– D recognizes no gain or loss on the contribution and the distribution, and no gain or loss is
recognized by the D shareholders on the receipt of the C stock.
•
D will generally not recognize any gain or loss with respect to the C securities under section 361(c).
– The taxpayer represented that the amount of D debt (including the newly issued D securities)
exchanged for the C securities would not exceed the average of D’s outstanding third party
indebtedness at the end of each of the four calendar quarters preceding the date on which the
distribution was first presented to D’s board of directors.
295
PLR 201232014
Rulings (cont’d):
•
The ruling required a 5-14 representation, with event risk tied to the distributing
corporation’s declaration of the distribution of its C stock instead of the entering into of
an exchange agreement (i.e., requiring the third-party investors to hold the distributing
securities for at least 5 days before D declared the C stock distribution).
– The risk that the distribution would not be consummated was presumably viewed
by the IRS as sufficient event risk, subjecting the bank to the risk that it would be
stuck with distributing securities rather than controlled securities.
– Such terms appear to place greater risk on the investment bank, which would
effectively be subject to 14 days of both event and credit risk because it had no
rights to effectuate the exchange of D securities for C securities with the
distributing corporation.
296
Control Requirement
297
Recap into Control for 355 Spin-off, followed
by Unwind of Recap – PLR 201007050
(4)
D1 distributes
Class B stock of C
to D2 (“Internal
Spin-off”)
(3)
D2
(2) shares of Class A
stock are issued
to D2 for assets
D1
Public
shares of Class A
stock are issued to
the public in an IPO
(1)
C
C is recapped to create
Class A & B stock; D1 is
issued Class B stock
Step 5: D2 offers to exchange its Class A stock in C for D2 stock owned by the D2
shareholders (“Exchange Offer” resulting in an “External Split-off” to the D2
shareholders).
Step 6: If the conditions to the Exchange Offer are met, then D2 will convert the
Class B stock received in the Internal Spin-off to Class A stock (the “Unwind”) prior to
consummation of the Exchange Offer/External Split-off.
298
PLR 201007050 (cont’d)
•
•
•
The IRS ruled that “The Unwind will not cause the Internal Spin-off to fail to
satisfy the control immediately before requirement of Section 355(a)(1)(A).”
The taxpayer represented that immediately after the Internal Spin-off, there
would be “no legally binding obligation to change the capital structure or the
Charter of Controlled” and “no legally binding obligation to proceed with the
remainder of the Proposed Transaction.”
• Compare to prior PLRs requiring no plan or intention. See
PLRs 200731025 and 200705016.
Consummation of the Exchange Offer/External Split-off was conditioned
upon a minimum level of participation in the Exchange Offer.
• The exchange ratio for the Exchange Offer was set at a level intended
to encourage the D2 shareholders to tender their D2 stock.
299
Spin-Off of “Born-To-Die” Controlled
(3)
>50% X Stock
X
Public
(2)
C Stock
D
Bus.
A
Bus.
B
(1)
Bus. B
(3)
Merger
C
D wants to separate Business B from Business A. X wants to acquire D’s Business B.
1) D forms C and transfers Business B to C.
2) D distributes the C stock to Public.
3) C merges into X; in the merger, Public receives >50 percent of the X stock (i.e., a
reverse Morris Trust transaction).
Good spin-off notwithstanding the transitory existence of C. See Rev. Rul. 2003-79; S.
Rep. No. 105-174, 1998-3 C.B. 537, 712 (examples 1-3).
300
.
PLR 201032017 –
Born-to-Die Controlled
D5
(3)
(2)
Section 355
distribution of
C1 to D5
Section 355
distribution of
C1 to D4
(4)
C1 merges into a
DE owned by D5
D4
D1
(1)
D1 contributes
ATB to C1
C1
(Newco)
•
•
•
PLR 201032017 respects the transaction as a section 368(a)(1)(D)/355 double distribution, followed
by a merger of C1 into D5 (and does not recast the transaction as an asset distribution by D1).
See Gregory v. Helvering, Rev. Rul. 98-27, Rev. Rul. 98-44, Rev. Rul. 2003-79, and the legislative
history for the Taxpayer Relief Act of 1997 and the Tax Technical Corrections Act of 1998.
Cf. PLRs re: newly formed Controlled merged into sister after spin-off and PLRs re pre-existing
Controlled merged upstream after spin-off.
301
Rev. Rul. 63-260 – D Shareholder Contribution
of C Stock to D Before Spin of C Not Respected
Shareholder
(2)
80% of
C Stock
(1)
10% of
C Stock
D
30%
70%
C
1) Shareholder contributes 10 percent of the C stock to D, increasing
D’s ownership to 80 percent of the C stock (section 368(c) “control”).
2) D distributes all of its C stock (80 percent) to Shareholder.
• IRS rules that D’s “control” of C is “transitory and illusory” so that D’s
distribution of its C stock does not qualify under section 355.
302
Rev. Rul. 71-593 – Divisive “D” Reorganization to
Exchange Stock Ownership Between Shareholders
A
(2)
900 sh
Y Stock
(2)
25 sh
X Stock
B
50 sh
50 sh
X
25 sh
(1)
900 sh
Y Stock
(1)
Asset
75 sh
Y
1) X transfers Asset to Y in exchange for 900 shares (90 percent) of Y stock.
2) X distributes its 900 shares of Y stock to A in exchange for A’s 25 shares (25
percent) of the X stock (split-off).
• IRS rules that, because step 1 was value-for-value, X’s resulting section 368(c)
“control” of Y is respected, and split-off qualifies under section 355.
303
PLR 201132009 Simplified –
Acquisition of “Control” from Shareholder Before Spin
Public
(3)
Class A
C1 Stock
(2)
Class A
C1 Stock
C1
Asset
Y
D2
C2
D1
[new]
Asset Y
Bus. X
Bus. Y
D2 wants to separate Business Y from Business X.
1) C1 authorizes new Class A common stock (80-percent vote, 10- percent value); C1 exchanges its
C1 common stock for Class B C1 stock (20-percent vote, 90-percent value).
2) D1 transfers Asset Y to C1 in exchange for all the Class A C1 stock.
3) D1 distributes the Class A C1 stock to D2.
304
PLR 201132009 Simplified –
Acquisition of “Control” from Shareholder Before Spin (cont’d)
Public
(5)
C2
Stock
D2
D1
Class B
Class A
C1
Bus. Y
(4)
C1 Class A & B Stock
C2
[new]
Bus. X
Asset
Y
4) D2 transfers the C1 stock (Class A and Class B) to C2.
5) D2 distributes the C2 stock to Public pro rata.
•
IRS rules that the distribution of the C1 stock by D1 (step 3) qualifies under
section 355.
305
North-South
Transactions
306
North-South Transactions
• Transfers of property (e.g., cash, assets) from a
shareholder to a corporation that occur near in time to a
distribution of property from the corporation to the
shareholder.
• Are the contribution and distribution respected as
separate transactions or are they treated as an
exchange?
• Issue often arises in the context of a spin-off transaction,
but can also arise in section 351 transactions or other
corporate reorganizations.
307
North-South Issues – Spin-Off Transactions
Transactions Between Shareholder and Distributing
•
The IRS has issued non-exchange rulings that effectively treat asset
transfers to distributing as separate from the section 355 distribution.
– See, e.g., PLR 200611006 (shareholder's contribution of property to
distributing, followed by distributing’s distribution of controlled to
shareholder and shareholder’s distribution of distributing stock to its
shareholders); PLR 200411021 (parent contributed property to
distributing, followed by distribution of controlled stock), PLR 200215031
(distributing’s parent contributed cash to distributing); PLR 9708012
(parent contributed property to distributing, followed by distribution of
controlled stock).
– These rulings generally contain the representation that no part of the
consideration distributed by distributing will be received by a
shareholder as a creditor, employee, or in any capacity other than that
of a shareholder of the corporation.
308
North-South Issues – Spin-Off Transactions
Transactions Between Shareholder and Distributing
•
•
In more recent rulings, the IRS has required a more specific taxpayer representation
to avoid exchange treatment. See, e.g., PLR 201033007.
– These rulings require the taxpayer to represent that there is no regulatory, legal,
or economic compulsion or requirement that the contribution be made as a
condition of the distribution of controlled stock.
– The taxpayer must also represent that the fact that the value of distributing will
decrease as a result of the distribution was not a consideration in the decision to
contribute property to distributing, and that the distribution is not contingent on
there being contributed to distributing assets having a specified (or roughly
specified) value.
– Such rulings appear to reflect a position that North-South transfers should be
treated as an exchange if the property transferred by the shareholder/distributee
to distributing is required to enable the distribution of controlled.
However, the IRS required a shorter representation in an even more recent nonexchange ruling. See PLR 201149012 (in ruling that contribution will not be treated
as having been received by distributing in exchange for distribution of controlled
stock, requiring taxpayer representation that there “is no regulatory, legal,
contractual, or economic compulsion or requirement that [shareholder] make part or
all of the [shareholder contribution] to [distributing] as a condition to the Distribution”).
309
PLR 201033007 –
North-South Transactions Between Shareholder and Distributing
P
(1) P contributes
ATB1 to D
(2) D spins C to
P
D
ATB1
C
ATB2
•
•
•
•
Facts: P contributes ATB 1 (active business relied on by D in spin-off) to D. D distributes the stock of C to P. Taxpayer
made the following representation: “There is no regulatory, legal, or economic compulsion or requirement that the
[contribution by P] be made as a condition of the [internal distribution of C]. The fact that the value of [D] will decrease as a
result of the [internal distribution] was not a consideration in the decision to contribute property to [D]. The [internal
distribution] is not contingent on there being contributed to [D] assets having a specified (or roughly specified) value.”
Result: The ruling held that the contribution by P will not be treated as having been received by D in exchange for the C stock
distributed by D. What if D’s distribution to P was a split-off? Does it matter if the shares redeemed include the D shares
issued (or deemed issued) in the contribution by P?
Other recent North-South rulings have required a similar representation. See, e.g., PLRs 201034005, 201030005, and
201007050; see also PLR 201202007 (non-exchange ruling involving north-south transfers between shareholder and
distributing, where distributing made both a distribution of stock under section 355 and a separate distribution of assets under
section 301); PLR 201047016 (cash investment by significant D shareholder into D, followed by D’s distribution of C and cash
to public shareholders in a split-off, not treated as purchase of D shares by significant D shareholder; transaction was
respected as cash investment into D followed by split-off with boot).
Cf. PLR 201149012 (in ruling that contribution will not be treated as having been received by distributing in exchange for
distribution of controlled stock, requiring taxpayer representation that there “is no regulatory, legal, contractual, or economic
compulsion or requirement that [shareholder] make part or all of the [shareholder contribution] to [distributing] as a condition
to the Distribution”).
310
PLR 201136009 – North-South Transactions
Between Distributing and Controlled
Shareholder
(2)
D contributes
assets to C
(3)
D distributes
C stock to
Shareholder
D
(1)
C distributes
cash to D
C
•
•
•
•
•
Facts: C distributes cash to D, and D contributes assets to C. D distributes the stock of C to its shareholder.
– If the cash distribution and asset contribution are integrated and treated as an exchange, the cash distribution would be
treated as boot received by D.
– If the cash distribution and asset contribution are respected as separate, the cash distribution would be treated as a
dividend separate from the “D” reorganization.
The taxpayer made the following representation: “There is no regulatory, legal, contractual, or economic compulsion or
requirement that [D] make part or all of the [D] Contribution as a condition to the distribution by [C] of the Cash Distribution.”
Result: The IRS ruled that the cash distribution was a section 301(a) distribution (i.e., not “boot” in a divisive “D” reorganization).
As with North-South transactions between shareholder and distributing, earlier rulings involving north-south transactions between
distributing and controlled required a more significant taxpayer representation. See, e.g., PLR 201106004 (taxpayer represented
that there “is no regulatory, legal, contractual, or economic compulsion or requirement that the [controlled distribution] be made as
a condition to the distribution of [controlled] by [distributing]. The fact that the value of [distributing] will decrease as a result of the
distribution of [controlled] by [distributing] was not a consideration in the decision to make the [controlled distribution]. The
distribution of [controlled] by [distributing] is not contingent on there being distributed to [distributing] assets having a specified (or
roughly specified) value.”).
Query: What if C is a Newco and the distribution is supported by an equity infusion?
311
Tax-Free Acquisitions
312
What Is This Transaction?
P
(2)
Merger
(1)
S
Sub all of S
assets
Newco
•
•
•
•
•
S transfers substantially all of its assets to Newco in exchange for Newco stock.
S merges into P. S transfers its remaining assets and Newco stock to P.
What is this transaction?
– Downstream section 368(a)(1)(D) reorganization with section 361/356 asset
distribution to P?
– Section 368(a)(1)(F) reorganization with section 301 asset distribution to P?
(What if S transfers all of its assets to Newco before the merger)?
– Section 351 asset transfer to Newco followed by section 368(a)(1)(A) merger?
See PLRs 201026010 and 200733002.
– Upstream section 368(a)(1)(A) merger followed by section 368(a)(2)(C) asset
drop to Newco? See Rev. Rul. 58-93.
What is P’s basis in the Newco stock?
313
Where do S’s attributes end up?
Treas. Reg. §1.368-2(k)(1)
• 2007 version: “Except as otherwise provided in this section, a
transaction otherwise qualifying under section 368(a)(1)(A), (B), (C),
or (G) (where the requirements of sections 354(b)(1)(A) and (B) are
met) shall not be disqualified by reason of the fact that part or all
of the acquired assets or stock acquired in the transaction are
transferred or successively transferred to one or more corporations
controlled in each transfer by the transferor corporation.”
• 2009 version: “A transaction otherwise qualifying as a reorganization
under section 368(a) shall not be disqualified or recharacterized
as a result of one or more subsequent transfers (or successive
transfers) of assets or stock, provided that the requirements of
§1.368-1(d) are satisfied and the transfer(s) are described in either
paragraph (k)(1)(i) or (k)(1)(ii) of this section.”
314
Step Transaction Issues
315
King Enterprises Transaction
Step 1
Public
Step 2
50% P voting
stock and 50%
cash
Public
P
Merge
T
100% T stock
P
T
Facts: The shareholders of T exchange all of their T stock for consideration
consisting of 50 percent P voting stock and 50 percent cash. Immediately
following the exchange, and as part of the overall plan, P causes T to merge
upstream into P. The transaction should qualify as an “A” reorganization. See
King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969); Rev. Rul.
2001-26, 2001-1 C.B. 1297.
316
Rev. Rul. 2001-46 – Situation 1
Step 2
Step 1
100% T stock
T Shareholders
70% P voting
stock and
30% cash
T
Merge
P
P
100%
S
Merge
T
Facts: P owns all of the stock of S, a newly formed wholly owned subsidiary. Pursuant to an integrated plan, P
acquires all of the stock of T, an unrelated corporation, in a statutory merger of S into T, with T surviving. In the
merger, the T shareholders exchange their stock for consideration of 70 percent P voting stock and 30 percent cash.
Immediately thereafter, T merges upstream into P.
Step vs. No Step: If the acquisition were viewed independently from the upstream merger of T into P, the result
should be a QSP of T stock followed by a section 332 liquidation. See Rev. Rul. 90-95, 1990-2 C.B. 67. If step
transaction principles applied, the transaction should be treated as a single statutory merger of T into P under section
368(a)(1)(A). See King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969). If so, P would acquire the T
assets with a carry-over basis under section 362, and P may not make a section 338 election for T.
Result: On July 8, 2003, the Service issued new final and temporary regulations that permit taxpayers to turn off the
step transaction doctrine and to make a section 338(h)(10) election in the transaction described above. See Treas.
Reg. § 1.338-3(c)(1)(i), (2) and Temp. Treas. Reg. § 1.338(h)(10)-1T. In 2006, the Service finalized the regulations
issued in 2003.
317
Final Treas. Reg. § 1.338(h)(10)-1(c)(2), (e)
•
•
•
•
•
The IRS issued final regulations on July 3, 2006, which adopted the substance of temporary regulations
issued in 2003.
The final regulations provide that “a section 338(h)(10) election may be made for T where P’s acquisition
of T stock, viewed independently, constitutes a qualified stock purchase and, after the stock acquisition,
T merges or liquidates into P (or another member of the affiliated group that includes P) . . . ” Treas. Reg.
§ 1.338(h)(10)-1(c)(2).
– This rule applies regardless of whether, under the step transaction doctrine, the acquisition of T
stock and subsequent merger or liquidation of T into P (or P affiliate) qualifies as a reorganization
under section 368(a). Id.
– If a section 338(h)(10) election is made under these facts, P’s acquisition of T stock will be treated
as a qualified stock purchase (a “QSP”) for all federal tax purposes and will not be treated as a
reorganization under section 368(a). See Treas. Reg. § 1.338(h)(10)-1(e), Ex. 12 & 13.
– However, if taxpayers do not make a section 338(h)(10) election, Rev. Rul. 2001-46 will continue to
apply so as to recharacterize the transaction as a reorganization under section 368(a). See id. at
Ex. 11.
In issuing the final regulations, the IRS rejected a recommendation that the final regulations allow section
338(g) elections, as well as section 338(h)(10) elections, to turn off the step transaction doctrine,
because extending the election as such would allow the acquiring corporation to unilaterally elect to treat
the transaction, for all parties, as other than a reorganization under section 368(a).
The IRS stated in the Preamble to the final regulations that it would continue to study whether the
corporate purchaser requirement of -3(b) should be amended (e.g., an individual cannot make a QSP,
although an individual can form a corporation to satisfy the QSP requirement if that corporation is treated
as purchasing the target stock, which it may not be if that corporation liquidates following the stock
purchase).
The final regulations are effective for stock acquisitions occurring on or after July 5, 2006.
318
Rev. Rul. 2001-46 – Situation 2
Step 1
T Shareholders
Step 2
100% T stock
100% P voting
stock
P
P
100%
Merge
Merge
T
S
T
Facts: Same facts as in Situation 1, except that the T shareholders receive solely P stock
in exchange for their T stock, so that the merger of S into T, if viewed independently of the
upstream merger of T into P, would qualify as a reorganization under section 368(a)(1)(A)
by reason of section 368(a)(2)(E).
Result: Step transaction principles apply to treat the transaction as a merger of T directly
into P.
319
King Enterprises Transaction – Variation
Step 1
Public
Step 2
Public
50% P stock &
50% cash
Step 3
P
T assets
Merge
P
X
Cash
T
100%
T stock
P
T
Facts: Same facts as in King Enterprises, except P sells T’s assets to X a third party
immediately after the merger of T into P.
Questions: (1) Does the Step-Transaction Doctrine apply?
(2) What is the result of this transaction for federal income tax purposes?
Variation: P shareholders exchange 100% P stock for T stock, and T sells its assets
immediately after the reorganization.
320
King Enterprises Transaction – Variation
Step 1:
S/H’s
C
Stock
T
Businesses
1+2
C
Step 3:
Step 2:
P
Voting
Stock
S/H’s
100% T Stock
Business 2
assets
C
T
Business 2
Business 1
S/H’s
P
S/H’s
C
Business 2
S/H’s
P
T
Liquidates
T
Business 1
Facts: T currently operates two businesses. T contributes all of its Business 2 assets to C, a newly formed wholly owned
subsidiary. T distributes the stock of C to T shareholders in a spin-off. P acquires T from the T shareholders in exchange
for P stock. Immediately thereafter, T is liquidated into P.
Form: The above steps in form constitute a section 355 transaction, a “B” reorganization, and a section 332 liquidation.
Result: Step transaction principles apply to treat P’s acquisition of T as if: (1) P acquired a portion of T’s assets (Business
1) and (2) T liquidated. See Rev. Rul. 67-274; Elkhorn Coal. Under Rev. Rul. 67-274, P’s acquisition of T is not a valid “B”
reorganization. Because T liquidates into P, Rev. Rul. 67-274 combines the steps and treats the transaction as an
acquisition by P of T’s Business 1 assets. In this transaction, the acquisition does not qualify as a “C” reorganization
because Elkhorn Coal steps together the spin-off and the acquisition such that P cannot be said to acquire substantially all
of T’s assets. Therefore, the transaction will be a taxable acquisition and not a tax-free reorganization.
Issue: Can P’s acquisition of T be treated as a qualified stock purchase followed by a section 332 liquidation? See Rev.
Rul. 2001-46; Treas. Reg. § 1.338-3(c)(1)(i), (2); Treas. Reg. § 1.338(h)(10)-1(c)(2), (e).
321
Rev. Rul. 2008-25
Step One
P
(2)
$90 P Voting Stock
$10 Cash
Old P Sh. A
A
T Stock
Liquidation
(1)
P forms X
(2)
X
Step Two
P
T
Assets = $150
Liabilities = $50
T
Facts: A, an individual, owns all of the stock of T. T holds assets worth $150 and has $50 of liabilities. P, an unrelated
corporation, has net assets worth $410. P forms X for the sole purpose of acquiring the stock of T in a reverse subsidiary
merger. In the merger, P acquires all of the stock of T, and A exchanges the T stock for $10 in cash and P voting stock worth
$90. Following the merger and as part of an integrated plan that included the merger, T completely liquidates into P. In the
liquidation, T transfers all of its assets to P, and P assumes all of T’s liabilities.
Result: The merger does not constitute a tax-free reorganization because T’s liquidation does not fall within the safe harbor
from the application of the step transaction doctrine (i.e., Treas. Reg. § 1.368-2k). When the merger and liquidation are
integrated, the transaction fails the requirements of a tax-free reverse subsidiary merger set forth in section 368(a)(2)(E)
because T does not hold substantially all of its properties and the properties of the merged corporation. Moreover, viewing the
merger and the liquidation as integrated steps does not cause the transaction to be treated as a tax-free “A”, “C” or “D”
reorganization or a section 351 exchange. For example, the transaction would not constitute a tax-free “C” reorganization
because 40% of the consideration exchanged by P is not solely P voting stock (i.e., $50 assumption of liabilities and $10 cash).
The deemed taxable exchange of T assets to P would not permit P to obtain a cost basis in the T assets because Rev. Rul. 9095 and Treas. Reg. § 1.338-3(d) reject the step transaction approach in so far as a taxpayer may obtain a cost basis in assets
acquired in a stock purchase in absence of a section 338 election.
322
Merrill Lynch v. Commissioner
GATX/BCE
STEP 4
$
MLC
STEP 2
MLCR Stock
MLCR Stock
1987
Transaction
STEP 3
$
Dividend
MLCMH
Stock
MLCMH
STEP 1
$
MLCR
MLCR
Subsidiaries
Stock
MLC
Subsidiaries
MLCR
Subsidiaries
Step One: MLCR sells MLCR Subsidiaries to MLC Subsidiaries in section 304 transactions.
Step Two: MLC forms MLCMH to hold the stock of MLCR.
Step Three: MLCR distributes the gross sale proceeds to MLCMH as a dividend.
Step Four: MLCMH sells MLCR to GATX/BCE, an unrelated third party.
323
MLC entered into a similar transaction using subsidiaries of MLCR in 1986
Merrill Lynch v. Commissioner
Position of Merrill Lynch: Under the consolidated return regulations in effect during 1986,
Merrill Lynch took the position that the cross-chain sales of MLCR Subsidiaries and the
dividend to MLCMH should be treated as a deemed redemption under section 304 subject to
dividend treatment under section 301. Merrill Lynch argued that the transaction did not qualify
for sale or exchange treatment under section 302 due to the fact that MLC’s interest in MLCR
was not terminated at the time of the cross-chain sale. Therefore, Merrill Lynch claimed that
MLCMH was entitled to a step-up in its basis in its MLCR stock to the extent of the dividend
and recognized a loss on its sale of MLCR stock to GATX/BCE.
Decision of Tax Court: The Tax Court ruled that the cross-chain sales, dividend,
and sale of MLCR to GATX/BCE were steps in a plan to terminate MLC’s ownership of
MLCR and the section 304 redemption was therefore subject to sale or exchange
treatment because it represented a complete termination of MLC’s interest in MLCR under
section 302(b)(3). The court concluded that the cross-chain sales and sale of MLCR to
GATX/BCE represented a “firm and fixed” plan to terminate MLC’s interest in MLCR for
purposes of determining whether the section 304 redemption should be treated as a sale or
exchange or a dividend. See Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954); Niedermeyer
v. Commissioner, 62 T.C. 280 (1974). In reaching its decision, the Court focused on the
fact that the complete plan to sell MLCR was presented to Merrill Lynch’s board of directors
only three weeks after the cross-chain sales and while the sale was not finalized, it was
sufficiently mature at that time that a tax reserve for the transaction was established.
324
Merrill Lynch v. Commissioner
Decision of Second Circuit: The Second Circuit affirmed the Tax
Court decision finding that there was a “firm and fixed” plan to sell
MLCR at the time of the cross-chain sale and, thus, the cross-chain
sale qualified for sale or exchange treatment.
Additional Merrill Position: On appeal, Merrill Lynch took the
position that for section 302 purposes, the stock ownership of the
parent company, MLC, was to be considered rather than the stock
ownership of MLCR. Because the issue of law was first raised on
appeal, the Second Circuit remanded the issue back to the Tax
Court.
325
Merrill Lynch v. Commissioner
Position of Merrill Lynch on Remand: Relying on section 304(a)(1), Merrill Lynch
took the position that because section 318 gives MLC constructive ownership of the
stock of the MCLR Subsidiaries both before and after cross-chain sales, through its
continued ownership of the MLC Subsidiaries, the complete termination
requirement of section 302(b)(3) was not met. Thus, Merrill Lynch properly treated
the proceeds of the cross-chain sales as dividends.
Decision of Tax Court: The Tax Court held that the plain language of section 304
and its regulations do not support Merrill Lynch’s position. According to the court,
section 304 requires that the person in control must actually receive property in
exchange for the stock being sold cross-chain. As a result, the attribution rules of
section 318 only apply to combine the ownership of more than one person to meet
the control requirement of section 304(a)(1)(A), but not the requirement of section
304(a)(1)(B) that the controlling corporation receives property from a controlled
corporation in exchange for controlled corporation stock. In addition, the court
found that section 302 only applies to persons that transfer stock in exchange for
property. See Treas. Reg. § 1.304-2(a).
326
PLR 200427011
Newco Stock, Convertible
Instruments & Non-Cash
Consideration
S1, S2, and
P
S3 Stock
Newco
30% Newco
Common
Stock
S1
Public
S2
S3
Facts: P forms Newco with a minimal amount of capital. P executes a “firm commitment” underwriting
agreement to sell Newco stock and convertible instruments in an IPO. P then contributes the shares of
subsidiaries S1, S2, and S3 to Newco in exchange for all of the outstanding Newco common stock, Newco
convertible instruments, and other non-stock consideration (e.g., short-term promissory notes or cash).
Pursuant to the underwriting agreement, P sells 30% of the common stock to the public. P also
represents that, although not legally obligated to do so, it fully intends to reduce its interest in Newco
below 50% within two years of completing the sale of the 30% of the common stock to the public.
Issue: Can P and Newco make a section 338(h)(10) election with respect to the contributed subsidiaries?
See PLR 200427011; Merrill Lynch & Co., Inc. v. Commissioner.
327
Heinz Transaction
PUBLIC
PUBLIC
PUBLIC
$130M
Heinz
3.5M
Heinz
shares
Heinz
3.325M
Heinz
shares
Heinz
~ $7.0M
Note
HCC
HCC
HCC
.175M
Heinz shares
Facts: Between August 11, 1994, and November 15, 1994, H.J. Heinz Credit Company (“HCC”), a
subsidiary of the H.J. Heinz Company (“Heinz”), purchased 3.5 million shares of Heinz common stock in
the public market for $130 million. In January of 1995, HCC transferred 3.325 million of the 3.5 million
shares to Heinz in exchange for a zero coupon convertible note issued by Heinz. In May of 1995, HCC
sold the remaining 175,000 shares to AT&T Investment Management Corp. (“AT&T”), an unrelated party,
for a discounted rate of $39.80 per share, or $6,966,120, in cash. As a result of this sale, HCC claimed a
capital loss and carried this loss back to 1994, 1993, and 1992. The IRS disallowed Heinz’s claimed
capital loss arguing, among other things, that the transaction lacked economic substance and a business
purpose. Heinz paid the tax and filed a $42.6 million refund action with the Court of Federal Claims.
328
Heinz – Court of Federal Claims
•
H. J. Heinz Company and Subsidiaries v. United States, United States Court
of Federal Claims, 76 Fed. Cl. 570 (2007).
•
All parties agreed that HCC had a basis of $124 million in the 3.325 million
shares that were transferred to Heinz.
•
Heinz asserted that the redemption qualified as a redemption under section
317(b), that the redemption should be taxed as a dividend, and that HCC’s
basis in the redeemed stock should be added to its basis in the 175,000
shares which it retained. Accordingly, Heinz claimed that, when HCC sold its
remaining 175,000 shares, it should recognize a large capital loss. Heinz then
claimed it was entitled to carry back HCC’s capital loss to reduce the
consolidated group’s taxes in 1994, 1993 and 1992.
•
The IRS asserted that the Heinz acquisition was not a redemption because:
(i) Heinz did not exchange property for the stock within the meaning of
section 317(b); (ii) the transaction lacked economic substance and had no
bona fide business purpose other than to produce tax benefits; and (iii) under
the “step transaction doctrine,” HCC’s purchase and exchange of the stock
for the note should be viewed as a direct purchase of the stock by Heinz.
329
Heinz – Court of Federal Claims
•
The Court of Federal Claims dismissed the IRS’s first argument that no
redemption occurred, but held that the acquisition and redemption of Heinz
shares lacked economic substance and that the step transaction doctrine
applied.
•
The court followed the economic substance analysis set forth Coltec in
addressing the IRS’s second argument, quoting the following language from
Coltec – “the transaction to be analyzed is the one that gave rise to the
alleged tax benefit.”
•
Accordingly, the court stated that transaction in question is the purchase of
Heinz shares from the public and the subsequent redemption. The court did
not analyze the entire transaction (including the disposition) when applying
the economic substance doctrine.
•
The court in Heinz held that the acquisition and subsequent redemption of
Heinz shares lacked economic substance.
330
Heinz – Court of Federal Claims
•
•
•
The Court of Federal Claims was not persuaded by the taxpayer’s assertion that HCC
acquired the Heinz stock for non-tax, business purposes: as an investment and to add
“substance” to HCC’s operations for state tax purposes.
In the eyes of the court, the taxpayer’s claim of an investment purpose was undercut by
the factual record, as evidenced by the following factors.
– First, the convertible notes were contemplated and, in fact, were in the process of
being drafted well before HCC purchased the Heinz stock.
– Second, because the acquired stock was not registered, HCC purchased the stock
at full price in the market and sold the Heinz stock at a deep discount.
– Third, the purpose of the stock purchase program -- the funding of stock option
programs – could not be achieved so long as HCC held the Heinz stock.
The court also found the factual record to be inconsistent with the taxpayer’s second
claim of business purpose, which was to bolster the taxpayer’s tax return position that
HCC should be respected as a Delaware holding company. The court cited three
factors in support of its position.
– First, the record did not suggest that the taxpayer was motivated by this non-tax
purpose.
– Second, internal communications indicated that any tax return exposure could not
be limited at the time of the stock acquisition or on a going forward basis.
– Third, the record indicated that, at the time of the stock acquisition, Heinz was
considering eliminating HCC’s lending operations, which raised the very issue that
the taxpayer sought to mitigate through the stock acquisition.
331
Schering-Plough Corp. v. United States
(1)
SP
$690.4
million
interest rate swaps
ABN
(US)
(2)
SC
(US)
SPI
(US)
SPL
(Swiss)
SL
(Swiss)
Assignment of
“receipt leg” of swaps
Facts: Schering-Plough Corporation (“SP”) owned all
of the stock of Schering Corporation (“SC”), which
owned all of the stock of Schering Plough-International
(“SPI”). SP, SC, and SPI were U.S. corporations.
SPI owned a majority of the voting stock of ScheringPlough Ltd. (“SPL”), which owned a majority share in
Scherico, Ltd. (“SL”). SPL and SL were Swiss
corporations.
SP entered into 20-year interest rate swaps with ABN,
a Dutch investment bank, in 1991 and 1992. The
swap agreements obligated SP to make payments to
ABN based on LIBOR and for ABN to make payments
to SP based on the federal funds rate for the 1991
swap and on a 30-day commercial paper rate (plus
.05%) for the 1992 swap.
The swap agreements permitted SP to assign its right
to receive payments under the swaps (the “receipt leg”
of the swap). Upon an assignment, SP’s payment to
ABN and ABN’s payment to the assignee could not be
offset against each other.
SP assigned substantially all of its rights to receive
interest payments to SPL and SL in exchange for
lump-sum payments totaling $690.4 million.
332
Schering-Plough Corp. v. United States
•
•
Taxpayer Position
– SP relied on Notice 89-21 to treat the swap and assignment transaction as a sale of the
receipt leg of the swap to its foreign subsidiaries (SPL and SL) for a non-periodic payment
that could be accrued over the life of the swap.
– The IRS issued Notice 89-21 to provide guidance on the treatment of lump-sum payments
received in connection with certain notional principal contracts in advance of issuing final
regulations.
• Notice 89-21 required that a lump-sum payment be recognized over the life of a swap in
order to clearly reflect income.
• Notice 89-21 stated that regulations would provide the precise manner in which a
taxpayer must account for a lump-sum payment over the life of a swap and that similar
rules would apply to the assignment of a “receipt leg” of a swap transaction in exchange
for a lump-sum payment.
• Notice 89-21 permitted taxpayers to use a reasonable method of allocation over the life
of a swap prior to the effective date of the regulations.
• Notice 89-21 cautioned that no inference should be drawn as to the treatment of
“transactions that are not properly characterized as notional principal contracts, for
instance, to the extent that such transactions are in substance properly characterized as
loans.”
– The IRS issued final regulations in 1993 that reversed the basic conclusion of Notice 89-21
and provided that an assignment of the “receipt leg” of a swap for an up-front payment (when
the other leg remained substantially unperformed) could be treated as a loan. See Treas.
Reg. 1.446-3(h)(4) and (5), ex. 4.
IRS position
– The IRS argued that the swap and assignment transaction should be treated as a loan from
the foreign subsidiaries to SP, which would trigger a deemed dividend under section 956.
333
Schering-Plough Corp. v. United States
•
Court Decision
– The District Court found in favor of the government on four separate grounds that, in the court’s view,
would be sufficient to deny the taxpayer's claim for tax-deferred treatment under Notice 89-21. See
Schering-Plough Corp. v. United States, F. Supp. 2d 219 (D.C. N.J. 2009).
1. Substance Over Form
• The court noted that the integrated transaction had the effect of a loan in which SP borrowed an
amount from its foreign subsidiaries in exchange for principal and interest payments that were routed
through ABN.
• The court discounted SP’s arguments (i) that there was an absence of customary loan
documentation, (ii) that SP did not directly owe an amount to the foreign subsidiaries (even if ABN
failed to fulfill its obligations), and (iii) that the amount of interest paid by SP to ABN would not equal
the amount received by its foreign subsidiaries because of the different interest rate bases used
under the swap.
• The court determined that SP’s efforts to structure the transactions as sales failed to overcome the
parties’ contemporaneous intent and the objective indicia of a loan.
– The court stated that the foreign subsidiaries received the “economic equivalent” of interest and
noted that SP “consistently, materially, and timely made repayments” to its foreign subsidiaries.
– The court found that SP officials considered the transaction to be a loan.
– The court observed that SP did not use customary loan documentation for intercompany loans.
• The court also concluded that ABN was a mere conduit for the transactions which, according to the
court, further supported its holding that the transactions were, in substance, loans.
– ABN faced no material risk since it entered into “mirror swaps” to eliminate interest rate risk
(but not the credit risk of SP).
– The court found that ABN did not have a bona fide participatory role in the transactions,
operating merely as a pass-through that routed SP’s repayments to the Swiss subsidiaries.
334
Schering-Plough Corp. v. United States
•
Court Decision (cont’d)
2. Step Transaction
• The court also applied the step transaction doctrine as part of its substance over form
analysis to treat the swap and assignment transaction as a loan.
• In applying the “end-result test,” the court determined that the steps of the swap and
assignment transaction could be collapsed because they all functioned to achieve the
underlying goal of repatriating funds from the foreign subsidiaries (SPL and SL).
– In the court’s view, the evidence established that the swaps and subsequent
assignments were pre-arranged and indispensable parts of a “broader initiative” of
repatriating earnings from the foreign subsidiaries.
• The court also concluded the steps of the swap-and-assign transactions to be
interdependent under the “interdependence test.”
– The court found that the goal of the interlocking transactions was to repatriate
foreign-earned funds, and the interest rate swaps would have been pointless had
SP not subsequently entered into the assignments with its subsidiaries.
• The court rejected SP’s argument that, in applying the step transaction doctrine, the
IRS created the fictitious steps that (i) the foreign subsidiaries loaned funds to SP, (ii)
SP entered into an interest rate swap for less than the full notional amount with ABN,
and (iii) SP satisfied its obligation under the imaginary loans by directing ABN to make
future payments under the swap to its foreign subsidiaries.
• The court also rejected SP’s argument that the step transaction doctrine should not
apply because the IRS failed to identify any meaningless or unnecessary steps.
335
Schering-Plough Corp. v. United States
•
•
Court Decision (cont’d)
3.
Economic Substance
•
The court concluded that the swap and assignment transaction failed the economic substance doctrine and,
thus, SP was not entitled to tax-deferred treatment.
•
The court followed 3rd Circuit precedent, ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998),
which treats the "objective" and "subjective" elements of the doctrine as relevant factors (rather than
applying a rigid conjunctive or disjunctive standard).
•
The court rejected the taxpayer's position that the repatriation proceeds represented "profit" from the
transaction. The court also noted that any interest rate risk due to the swaps was hedged and that SP
incurred significant costs in executing the transaction. In sum, the court found that there was little, if any,
possibility of a pre-tax profit.
•
The court concluded that both the swap and assignment lacked a business motive.
–
SP contended that it entered into both swaps for cash management and financial reporting objectives,
the 1991 swap for hedging purposes, and the 1992 swap for a yield enhancement function. The court
rejected each of these non-tax motivations.
–
Notably, the court avoided the difficult legal determination of whether the court must examine the
whole transaction or, as the government argued, just the component part that gave rise to the tax
benefit (here, the assignment step of the transaction).
4.
Subpart F Principles
•
The court determined that permitting the repatriation of $690 million in offshore earnings without at least a
portion of those earnings being captured under subpart F would contradict Congressional intent.
•
The court noted that Notice 89-21 did not supplant, qualify, or displace subpart F, nor was the notice
intended to permit U.S. shareholders of controlled foreign corporations to repatriate offshore revenues
without incurring an immediate tax.
•
In the court’s view, the notice only dealt with the timing of income recognition.
Third Circuit Decision
–
On appeal, the Court of Appeals for the Third Circuit upheld the District Court’s decision. See Merck & Co., Inc. v.
United States, 652 F.3d 475 (3d Cir. 2011).
–
The Third Circuit held that the District Court correctly found that the transactions were in substance loans, not
sales.
–
Because the Third Circuit upheld the District Court’s characterization of the transactions as loans, it did not
address the District Court’s alternative conclusion that the transactions lacked economic substance.
336
Barnes Group, Inc. & Subs. v. Commissioner
Barnes
Group, Inc.
BGF Bermuda CS +
Foreign Currency
(3)
Barnes
Group, Inc.
BGF
Delaware CS
Loan
(2)
CS
ASA
(Singapore)
Foreign
Currency
(i.e., excess /
borrowed
cash)
(1)
Foreign
Currency
BGF
Bermuda
CS
BGF
Bermuda
CS
BGF
Bermuda
BGF
Delaware
BGF
Delaware
PS
BGF Bermuda CS +
Foreign Currency
ASA
(Singapore)
BGF
Delaware
CS
CS
BGF
Bermuda
BGF
Delaware
PS
Facts: Barnes Group, Inc. (“Barnes”) wanted to utilize the excess cash and borrowing capacity of its profitable second-tier subsidiary
ASA, a Singapore corporation, without triggering a federal tax liability. To this end, Barnes implemented a “Reinvestment Plan” that
involved a series of section 351 exchanges. The Reinvestment Plan was structured to occur in two substantially similar parts in
December 2000 and July 2001. Barnes first formed BGF Delaware (a Delaware corporation) and BGF Bermuda (a Bermuda
corporation). Then, in Part 1 of the Reinvestment Plan, Barnes and ASA transferred foreign currency to BGF Bermuda for BGF
Bermuda common stock in a section 351 exchange. Pursuant to another section 351 exchange, Barnes and BGF Bermuda
transferred BGF Bermuda common stock and foreign currency to BGF Delaware in exchange for BGF Delaware stock, with Barnes
receiving BGF Delaware common stock and BGF Bermuda receiving BGF Delaware preferred stock. Following these exchanges,
BGF Delaware converted the foreign currencies to U.S. dollars and loaned the resulting funds to Barnes. Part 2 of the Reinvestment
Plan was similar to Part 1, except that ASA first borrowed funds from a Singapore bank before engaging in the section 351
exchanges described above. After the completion of the Reinvestment Plan, ASA and BGF Delaware owned all of the common
stock of BGF Bermuda, and BGF Bermuda owned all of the preferred stock of BGF Delaware.
337
Barnes Group, Inc. & Subs. v. Commissioner
• The IRS challenged the Reinvestment Plan, asserting that, in substance, the plan should be
characterized as either a dividend from ASA to Barnes taxable under section 301 or as a loan
from ASA to Barnes taxable under sections 951(a) and 956.
• The Tax Court held for the IRS, concluding that BGF Bermuda and BGF Delaware did not have a
valid business purpose and that, under the step transaction doctrine, the intermediate steps of
the Reinvestment Plan should be collapsed into a single transaction under the interdependence
test. See Barnes Group, Inc. & Subs. v. Commissioner, T.C. Memo. 2013-109.
Step Transaction Doctrine
• The court, after describing the alternative tests under the step transaction doctrine, determined
that the interdependence test was the appropriate standard to apply in the case.
• In applying the interdependence test, the court focused on whether any valid and independent
economic or business purpose was served by the inclusion of BGF Bermuda and BGF Delaware
in the Reinvestment Plan.
• The court noted that the Reinvestment Plan warranted extra scrutiny because it was
executed between related parties.
• The court rejected petitioners’ argument that BGF Bermuda was formed and included in the
plan because Singapore corporate law did not allow ASA to make the type of equity
investment contemplated by the plan.
• The court found that petitioners failed to explain how this restriction required the
involvement of BGF Bermuda.
• The court also found that petitioners failed to support adequately their argument that BGF
Delaware was necessary to provide Barnes with a state tax benefit and to facilitate the
more effective control over the funds invested by ASA.
338
Barnes Group, Inc. & Subs. v. Commissioner
Step Transaction Doctrine (cont’d)
• The court found that petitioners’ failure to show that the form of the Reinvestment Plan was respected further
undermined any legitimate nontax business purpose for the inclusion of BGF Bermuda and BGF Delaware.
• The court held that the loans from BGF Delaware to Barnes were not bona fide debt, finding that the
parties failed to show that they had complied with the terms of the agreements (noting, in particular, that
Barnes had failed to make adequate interest payments).
• The court also found that it was unclear whether BGF Delaware made any preferred dividend payments to
BGF Bermuda.
• The court concluded that, because petitioners failed to establish that BGF Bermuda and BGF Delaware were
created for legitimate nontax business purposes, the Reinvestment Plan was in substance dividend payments
from ASA to Barnes that were taxable under section 301.
Rev. Rul. 74-503
• The court rejected petitioners’ argument that the IRS was precluded from challenging the Reinvestment Plan
because petitioners reasonably relied on Rev. Rul. 74-503, 1974-2 C.B. 117 (which holds that, where a
corporation exchanges its own stock for newly issued stock in another corporation in a section 351 exchange, the
basis of the stock received by each corporation in the exchange is zero).
• Petitioners argued that BGF Bermuda had a zero basis in its BGF Delaware preferred stock, and,
therefore, Barnes’ section 951 income inclusion was zero.
• According to the court, Rev. Rul. 74-503 did not prevent the IRS’s challenge because the substance of the
Reinvestment Plan was a dividend from ASA to Barnes.
• Further, even if the form of the transaction were respected, the court found that there were significant
factual differences between Rev. Rul. 74-503 and the Reinvestment Plan, and that the plan far exceeded
the scope of the issues addressed in the ruling.
Penalties
• The court found that petitioners were liable for the section 6662(a) accuracy-related penalty.
• The court rejected petitioners’ argument that petitioners had substantial authority for their treatment of the
Reinvestment Plan based on Rev. Rul. 74-503.
• The court found that petitioners failed to establish that they acted with reasonable cause and in good faith,
ruling that petitioners did not actually rely on or respect the details of the plan as set up by their adviser.
339
Liquidation / Reincorporation
340
Rev. Rul. 69-617
P
Step 2: All of S’s Assets
Step 1: Merge
S
X
Facts: P owns all of the stock of S and X. S merges into P pursuant to state
law. P then transfers all of the assets received from S to X.
341
Rev. Rul. 69-617 (Variation)
P
1. Merge
2. 50% of S’s Assets
S
X
Facts: P owns all of the stock of S and X. S merges into P pursuant to state law.
P then transfers 50% of the assets received from S to X. Although this transaction
appears to raise “liquidation/reincorporation” issues, private letter rulings allow the
partial drop of S’s assets to X following the section 368(a)(1)(A) reorganization.
See, e.g., PLRs 9422057, 9222059, and 8710067. These rulings rely on Rev. Rul.
69-617 and treat the transaction as a merger followed by a section 368(a)(2)(C)
drop of assets. At least one ruling would allow a double-drop of S’s assets
following the reorganization. See PLR 9222059.
342
Rev. Rul. 69-617 &
The Bausch & Lomb Regulations
P
2. Some of S’s Assets
1. Liquidate
S
X
Facts: P owns all of the stock of S and X. S liquidates, distributing all of its
assets to P. P then transfers some of the assets received from S to X. Can
this transaction be treated under the analysis of Rev. Rul. 69-617 as a “C”
reorganization followed by a drop of assets under section 368(a)(2)(C),
given the Bausch & Lomb regulations? See Treas. Reg. § 1.368-2(d)(4).
What if X were a newly formed corporation?
343
Rev. Rul. 69-617 (Variation) &
The Bausch & Lomb Regulations
P
2. Transfer of 1/3 S’s Assets
to each of X, Y, and Z
1b. Deemed
Liquidation
LLC
S
X
Y
Z
1a. Merge
Facts: P owns all of the stock of S, X, Y, and Z. S merges into an LLC
created by P, causing a deemed liquidation of S for tax purposes. LLC then
transfers 1/3 of S’s historic assets to X, Y, and Z respectively. (P will be
treated as transferring such assets to X, Y, and Z for tax purposes).
344
Rev. Rul. 58-93
Individual
Minority
Shareholders
X
(2)
Merger
(1)
Y
Z stock
Y
Assets
Z
Facts: Y’s stock is owned by X (79%) and various other individual shareholders. A plan of
reorganization is adopted under which Y transfers all of its assets, subject to its liabilities, to newlyformed Z in exchange for all of the stock of Z. Immediately thereafter, Y merges into X. Under the
merger, Y’s individual shareholders exchange their Y stock for stock of X.
Ruling: The transaction is treated as though Y merged into X and thereafter X transferred the Y
assets to Z. The transaction thus constitutes an upstream “A” reorganization under section
368(a)(1)(A), followed by a transfer under section 368(a)(2)(C). See Rev. Rul. 58-93, 1958-1 C.B.
345
188.
PLRs 200733002 and 201026010
P
(2)
Merger
(1)
T
50%
T Assets
A stock
A
Facts: P owns all of the stock of T. T drops 50% of its assets into a newly
formed corporation (“A”) and merges up and into P.
Result: Can this transaction be treated as a valid upstream “A”
reorganization? See PLRs 201026010 and 200733002.
346
PLR 200733002 – Variation – Double Drop and Liquidation
P
(2)
Liquidation
50% T
Assets
T
50% T
Assets
(1)
A1
A2
Facts: P owns all of the stock of T. T drops 50% of its assets into each of two newly
formed corporations (“A1” and “A2”) and liquidates into P. The requirements of
section 355 are not satisfied.
Result: What is this transaction? Can it be two section 351 exchanges followed by an
upstream “C” reorganization? What if the section 355 requirements are satisfied?
What if the A1 transaction satisfies the section 355 requirements but not the A2
347
transaction? What if substantially all of T’s assets were transferred in one drop?
PLR 200952032
Liquidation-Reincorporation
(1)
H
S1-Corp1 converts
to S1-LLC
S1-Corp1
(State X & State Y)
(2)
S2
TIC assets
(3)
Other Assets
•
•
•
•
•
•
•
S1 converts
to S1-Corp2
TIC assets
Other Assets
H owns domestic corporations S1-Corp1 and S2
S1-Corp1 and S2 hold assets as a tenancy-in-common (TIC) and other assets
S1-Corp1 is incorporated in both State X and State Y
H wants S1-Corp1 to transfer its TIC assets to S2 in a tax-free manner and
eliminate S1-Corp1’s State Y affiliation
S1-Corp1 converts to State X S1-LLC, a disregarded entity
S1-LLC transfers the TIC assets to S2 for no consideration
S1-LLC converts to S1-Corp2, incorporated only in State X
348
PLR 200952032
Liquidation-Reincorporation (cont’d)
After Transactions:
H
S1-Corp2
(State X)
Other
Assets
S2
TIC
Assets
Other
Assets
349
PLR 200952032
Liquidation-Reincorporation (cont’d)
•
•
•
•
•
IRS rules that conversion of S1-Corp1 to S1-LLC is a transfer of substantially all
of S1-Corp1’s assets to H in deemed exchange for H stock, followed by deemed
distribution of the H stock received by S1-Corp1 back to H in complete liquidation
of S1-Corp.
– Upstream type-C reorganization with two section 368(a)(2)(C) asset drops, as
in Rev. Rul. 69-617, 1969-2 C.B. 57.
– PLR does not state whether S1-Corp’s interest in the TIC Assets or its Other
Assets constitutes “substantially all” of S1-Corp’s assets.
IRS rules that transfer of S1-Corp1’s former interest in TIC Assets is section
351/368(a)(2)(C) transfer by H to S2.
IRS rules that conversion of S1-LLC into S1-Corp2 is section 351/368(a)(2)(C)
transfer of former S1-Corp1 Other Assets by H to S1-Corp2.
Why is the transaction not an “F” reorganization with a distribution? See Treas.
Reg. §1.368-2(k) (“shall not be recharacterized”); But see TASCO v.
Commissioner, 63 T.C. 423 (1974), aff’d without opinion, 546 F.2d 423 (4th Cir.
1976).
What if instead S1-Corp1 had converted to S1-LLC and transferred all its assets
to a newco, without reincorporating? See section 368(a)(1)(F) (“however
effected”); Treas. Reg. §1.368-2(k).
350
Movement of Attributes
351
Movement of Attributes Following an Asset
Reorganization
T
Acquirer
T assets
Sub
• What if Acquirer transfers all the T assets to Sub?
• What if Acquirer retains $1?
• What if Acquirer transfers 50 percent of the T assets?
• What if Acquirer transfers the T assets for $?
352
Movement of Attributes
•
Treas. Reg. § 1.381(a)-1(b)(1) provides that section 381(c) tax attributes carry over in a
reorganization to the “acquiring corporation.”
•
Treas. Reg. § 1.381(a)-1(b)(2) directs that only a single corporation can be the acquiring
corporation, and defines it as the corporation that ultimately acquires, directly or indirectly, all of the
assets pursuant to the plan of reorganization.
•
Treas. Reg. § 1.381(a)-1(b)(2) also describes a case in which no single corporation ultimately
acquires all the assets, which means that the one corporation that formally or legally acquires all
the assets is the acquiring corporation.
•
Treas. Reg. § 1.381(c)(2)-1(d) provides that when assets are transferred to a subsidiary or
subsidiaries in connection with a reorganization “then whether any portion of the earnings and
profits received by the acquiring corporation under § 381(c)(2) is allocable to such controlled
corporation or corporations shall be determined without regard to § 381. See paragraph (a) of §
1.312-11”, which provides that “proper adjustment and allocation of the earnings and profits of
the transferor shall be made as between the transferor and the transferee.”
•
Treas. Reg. § 1.312-11(a) cross-references the section 381 regulations for “specific rules as to
allocation of earnings and profits in certain reorganizations under section 368.” Accordingly, it is
generally believed that Treas. Reg. § 1.312-11(a) does not support an allocation of E&P outside of
the “single corporation” rule of Treas. Reg. § 1.381(a)-1(b). See, e.g., PLR 9231068 and PLR
201026010 (no allocation of E&P permitted for controlled asset transfer pursuant to a plan of
reorganization).
353
Key Cases Related to Movement of E&P
•
Commissioner v. Sansome, 60 F.2d 931 (2d Cir. 1932), cert. denied (the
transfer of all of a corporation’s assets to a new corporation in a reorganization
moved the attributes to the successor corporation to ensure the shareholder is
appropriately taxed on distributions from the successor).
•
Commissioner v. Phipps, 336 U.S. 410 (1949), rev’g, 167 F.2d 117 (10th Cir.
1948) (distributee corporation in a section 332 liquidation inherits the positive
E&P of the liquidated subsidiary, but not a deficit in E&P, on the ground that “the
Sansome rule is grounded not on a theory of continuity of the corporate
enterprise but on the necessity to prevent escape of earnings and profits from
taxation”).
•
Mansfield v. United States, 141 Ct. Cl. 579 (1958) (the transfer by a corporation
of part of its assets to a newly formed subsidiary in return for all the subsidiary's
stock in a section 351 exchange did not shift any of the parent's earnings or
profits to the subsidiary where the parent remained in existence after the
transfer).
•
Bennett v. United States, 427 F.2d 1202 (Ct. Cl. 1970) (allocation of E&P in a
spin-off is necessary to ensure shareholders are appropriately taxed on
distributions following the spin-off).
354
Proposed Regulations Under
Section 312
355
Existing Law – Section 381
•
•
Under Treas. Reg. § 1.381(a)-1(b)(2), in the context of a reorganization,
attributes other than E&P move to the acquiring corporation.
•
Only a single corporation may be an acquiring corporation for section 381
purposes.
•
If no one corporation ultimately acquires all of the assets transferred by the
transferor corporation, the corporation that directly acquires the assets
transferred is the acquiring corporation for section 381 purposes, even
though that corporation ultimately retains none of the assets transferred.
Accordingly, the initial transferee corporation is effectively permitted to elect
where attributes move:
•
If, under section 368(a)(2)(C), that corporation drops all of the assets
acquired into a single lower-tier subsidiary, such subsidiary would be the
acquiring corporation and succeed to the attributes of the transferor
corporation.
•
Alternatively, if only a portion of the assets acquired are dropped into a
lower-tier subsidiary, the lower-tier subsidiary does not succeed to any of
the attributes of the transferor corporation.
356
Existing Law – Section 312
•
•
The IRS has historically interpreted the section 312 regulations as providing that E&P of
the transferor corporation moves in the same manner as do other attributes under
section 381 (or in a divisive reorganization, to the extent provided in Treas. Reg. §
1.312-10).
Some practitioners have suggested that the IRS’s interpretation was unclear under
current guidance and that E&P could be allocated between the transferor and
transferee. See –
•
Treas. Reg. § 1.381(c)(2)-1(d) (providing that where part of the acquired assets is
transferred to one or more controlled corporations, or all of the acquired assets are
transferred to two or more controlled corporations, the allocation of E&P is made
without regard to section 381)).
•
Treas. Reg. § 1.312-11(a) (providing for proper adjustment and allocation of E&P
with respect to asset transfers in connection with reorganizations, and cross
referencing the regulations under section 381 for specific rules).
357
Prop. Treas. Reg. § 1.312-11
•
•
On April 13, 2012, Treasury issued proposed regulations clarifying how E&P is
allocated in tax-free corporate acquisitions.
Consistent with the IRS’s historical position, the proposed regulations clarify
that:
•
Except as provided in Treas. Reg. § 1.312-10 (divisive reorganization), if
property is transferred from one corporation to another and no gain or loss
is recognized, no allocation of the E&P of the transferor is made to the
transferee unless the transfer is described in section 381(a).
•
In a transfer described in section 381(a), only the acquiring corporation
that acquires all the assets succeeds to the E&P of the distributor or
transferor corporation.
358
Prop. Treas. Reg. § 1.312-11
•
•
According to Treasury, the proposed rule is appropriate because E&P measures a
corporation's capacity to pay dividends to its shareholders – the corporation that has
an interest (directly or indirectly) in all of the target’s assets has the dividend-paying
capacity most comparable to that of the target.
•
Treasury also believes that the rules for the allocation of E&P should conform
to the rules for the allocation of other tax attributes under section 381.
This proposed rule retains the electivity that exists under the IRS historic position. If
the initial acquiring corporation drops down all the assets to a single subsidiary, the
E&P moves to that subsidiary. If the acquiring corporation keeps $1 of assets, all
the E&P stays with that corporation.
359
“D” Reorganizations
360
“D” Reorganizations – Stock
Step One
Step Two
Liquidation
P
Assets
X
Y
X
P
Y
Stock
Facts: P, X, and Y are corporations. P owns all of the stock of X and Y. X transfers all of its
assets to Y in exchange for stock. X then liquidates into P.
Result: This transaction qualifies as a tax-free “D” reorganization under section
368(a)(1)(D). A transfer by one corporation (X) of substantially all of its assets to another
corporation (Y) qualifies as a reorganization described in section 368(a)(1)(D) if,
immediately after the transfer, one or more of the transferor corporation’s shareholders (P)
is in control of the acquiring corporation (Y), and if stock or securities of the acquiring
corporation (Y) are distributed in a transaction which qualifies under section 354, 355, or
356. See Section 354(b)(1).
361
“D” Reorganizations – Cash – Rev. Rul. 70-240
P
Liquidation
(2)
(1)
X Assets
X
Cash
Y
Facts: P, X, and Y are corporations. P owns all of the stock of X and Y. X transfers all
of its assets to Y in exchange for cash. X then liquidates into P.
Result: This transaction qualifies as a tax-free “D” reorganization under section
368(a)(1)(D). In the transaction, X distributes substantially all of its assets to D and its
shareholder (P) is in control of Y after the exchange. However, the requirement that
stock or securities of the acquiring corporation (Y) be distributed is not technically
satisfied. This requirement is treated as satisfied because a distribution of Y stock in
this example would be a meaningless gesture. See Rev. Rul. 70-240; see also Rev.
362
Rul. 2004-83.
“D” Reorganizations – Temporary Regulations
•
•
•
On December 18, 2006, Treasury and the IRS issued temporary under sections
368(a)(1)(D) and 354(b)(1)(B) in response to requests for immediate guidance
regarding whether certain all-cash acquisitive transactions can qualify as a “D”
reorganization. See Temp. Treas. Reg. § 1.368-2T(l).
On March 1, 2007, Treasury and the IRS amended the temporary regulations so that
certain related party triangular reorganizations that qualify as tax-free triangular
reorganizations under section 368 would not be treated as “D” reorganizations with
boot under the temporary regulations.
The temporary regulations provided that a transaction may be treated as satisfying
the requirements of sections 368(a)(1)(D) and 354(b)(1)(B) even if there is no actual
issuance of stock and / or securities of the transferee corporation if the same person
or persons own, directly or indirectly, all of the stock of the transferor and transferee
corporations in identical proportions.
– In such cases, transferee will be deemed to issue a nominal share of stock to the
transferor corporation in addition to the actual consideration exchanged for the
transferor’s assets.
– The nominal share of stock in the transferee will then be deemed distributed by
the transferor to its shareholders and, where appropriate, further transferred
through chains of ownership to the extent necessary to reflect the actual
ownership of the transferor and transferee.
363
“D” Reorganizations – Final Regulations
•
•
•
On December 17, 2009, Treasury and the IRS issued final regulations on the treatment of
transactions as acquisitive “D” reorganizations where no stock and/or securities of the transferee
is issued and distributed in the transaction.
– The final regulations also confirm the determination of basis in stock of the transferee and
the treatment where the reorganization involves consolidated group members.
The final regulations generally are effective for December 18, 2009 and apply the nominal share
and deemed stock rule to transactions occurring on or after that date.
Nominal Share and Deemed Stock Rule
– The final regulations adopt the general approach set forth in the temporary regulations and
deem the issuance of stock where no stock and/or securities is issued and distributed in the
transaction, provided that the same person or persons own, directly or indirectly, all of the
stock of the transferor and transferee in identical proportions.
– The final regulations clarify that the transferee will only be deemed to issue a nominal share
if the transferor corporation receives full consideration in exchange for its assets.
– In cases where no consideration is received, or the value of the consideration received is
less than the fair market value of the transferor's assets, the transferee is treated as issuing
stock with a value equal to the excess of the value of the assets over the value of the
consideration received.
– As under the temporary regulations, the final regulations provide that the nominal share or
the deemed stock will be deemed to be distributed by the transferor corporation in
satisfaction of the distribution requirement under section 354(b)(1)(B), and then further
transferred through chains of ownership to reflect the actual ownership of the transferor and
transferee.
364
“D” Reorganizations – Final Regulations
•
Nominal Share and Deemed Stock Rule (cont’d)
– The constructive ownership rules of section 318 apply with modification.
• Section 318(a)(1) applies such that an individual and all members of his or
her family described in section 318(a)(1) will be treated as one individual.
• Section 318(a)(2) applies without regard to the 50-percent limitation in
section 318(a)(2)(C).
– De minimis variation in shareholder identity or proportionality of ownership is
permitted.
• The final regulations do not define what level of variation would be treated as
de minimis, although an example does conclude that a 1-percent ownership
in the stock of the transferee by an individual who owns no stock in the
transferor is de minimis variation in identity and proportionality where the
other three shareholders own 34, 33, and 33 percent of the stock of the
transferor and each owns 33 percent of the stock of the transferee. See
Treas. Reg. § 1.368-2(l)(3), ex. 4.
– Section 1504(a)(4) stock is not taken into account.
– Triangular Reorganizations
• The nominal share and deemed stock rule does not apply to triangular
reorganizations (i.e., transaction otherwise described in Treas. Reg. § 1.3586(b)(2) or section 368(a)(1)(G) by reason of section 368(a)(2)(D).
– These rules of application were included in the temporary regulations.
365
“D” Reorganizations – Final Regulations
•
Basis Allocation Issues
– The final regulations did not adopt comments that would treat the nominal share
as having tax significance solely to satisfy the distribution requirement in section
354(b)(1)(B).
– Instead, the final regulations treat the nominal share as qualifying property for
purposes of basis allocation and future stock gain or loss recognition.
– The final regulations clarify that, in case of a reorganization in which the property
received consists solely of non-qualifying property equal to the value of the assets
transferred (as well as the nominal share), the shareholder or security holder may
designate the share of stock of the transferee to which basis, if any, of the stock
or securities surrendered will attach.
– This is distinguished from current Treas. Reg. § 1.358-2(a)(2)(iii), which the
preamble notes technically only applies to reorganizations in which no
consideration is received or the value of the consideration received is less than
the fair market value of the transferor's assets.
– That regulation provides for a substituted basis in the stock deemed received
followed by a deemed recapitalization for the shares actually held by the
transferor immediately after the reorganization.
366
“D” Reorganizations – Final Regulations
•
Application of the Nominal Share and Deemed Stock Rule in Consolidation
– The final regulations confirm that the nominal share will be given effect in
connection with all-cash “D” reorganizations involving consolidated
return members.
– Under the consolidated return regulations, an all-cash “D” reorganization
involving consolidated return members will result in a deemed issuance
of stock by the transferee corporation followed by a redemption of the
deemed stock for the consideration actually received in the exchange.
– The final regulations confirm that, upon the deemed issuance and
redemption, the remaining stock basis or excess loss account ("ELA")
will shift to the nominal share.
– Thus, gain or loss inherent in that basis or ELA may be triggered upon
the deemed transfer of the nominal share through chains of ownership,
subject to the intercompany transaction rules of Treas. Reg. § 1.150213.
367
“D” Reorganizations – Direct Ownership
P
Liquidation
(2)
(1)
X
X Assets
Y
Cash
Facts: P owns all of the stock of X and Y. X transfers its assets to Y in exchange for cash
and immediately thereafter liquidates into P.
Result: The transaction will be treated as a “D” reorganization because the distribution of Y
stock would constitute a meaningless gesture. See Rev. Rul. 70-240. Note that the same
result would be obtained if P transferred X stock to Y in exchange for cash and, immediately
thereafter, X liquidated into Y. See Rev. Rul. 2004-83.
The result does not change under the final regulations because there is complete
shareholder identity and proportionality of ownership in X and Y. See Treas. Reg. § 1.3682(l)(2); Cf. Treas. Reg. § 1.368-2(l)(3), ex. 1.
368
“D” Reorganizations – Indirect Ownership
P
S
Liquidation
(2)
S1
(1)
X Assets
X
Cash
Y
Facts: P owns all of the stock of S and S1. S owns the stock of X and S1 owns the stock of Y. X
transfers its assets to Y in exchange for cash and immediately thereafter liquidates into S.
Result: The transaction will be treated as a “D” reorganization because there is complete shareholder
identity and proportionality of ownership in X and Y under section 318 principles. See Treas. Reg. §
1.368-2(l)(3), ex. 3. The nominal share of Y stock will be treated as going up to P and back down to S1.
In the consolidated return context, the following events are deemed to occur: (i) Y is treated as issuing
its stock to X in exchange for X’s assets; (ii) X is treated as distributing Y stock to S in a liquidation; and
(iii) Y is treated as redeeming its stock from S for cash. See Treas. Reg. § 1.1502-13(f) and (f)(7), ex. 3.
The final regulations confirm that the remaining basis or ELA in the Y stock treated as redeemed will
shift to the nominal share. What happens when the nominal share is treated as distributed from S to P
and then contributed to S1?
369
“D” Reorganizations – Constructive Ownership
A
B
S
Liquidation
(1)
(2)
X Assets
X
Cash
Y
Facts: A and B are mother and son. A owns the stock of S which owns the stock of X. B owns
the stock of Y. X transfers its assets to Y and immediately thereafter liquidates into S.
Result: Has there been a “D” reorganization? Does S control Y after the transaction? Would a
distribution of Y stock be a meaningless gesture?
The final regulations adopt the constructive ownership rules of section 318(a)(1) to treat A and B
as the same person and, thus, there is complete shareholder identity and proportional
ownership in X and Y. The transaction is treated as a valid “D” reorganization under the
temporary regulations. See Treas. Reg. § 1.368-2(l)(3), ex. 2; See also PLR 9111055.
370
“D” Reorganizations – PLR 200551018
A
50%
Liquidation
(2)
B
50%
C
90%
10%
(1)
X Assets
X
Newco
Two Notes
Facts: A and B own 50% of the stock of X. B and C own Newco, with B owning 90 percent and
C owning 10 percent of the stock, respectively. X Corporation transfers its assets to Newco in
exchange for two notes. Immediately thereafter, X liquidates, distributing one note to each A
and B.
Result: PLR 200551018 assumes that the transaction does not qualify as a “D” reorganization
in holding that Newco is entitled to amortize the cost of goodwill acquired as a result of the
purchase of X assets.
Under the final regulations, there is no shareholder identity and proportionality of ownership in X
and Newco and, thus, this transaction does not qualify as a tax-free “D” reorganization. See
Treas. Reg. § 1.368-2(l)(3), ex. 6.
371
“D” Reorganizations – PLR 200551018 Variation
A
50%
Liquidation
(2)
B
50%
C
90%
10%
(1)
X Assets
X
Newco
Cash + Share
of Newco
Stock
Facts: A and B own 50 percent of the stock of X. B and C own Newco, with B owning 90
percent and C owning 10 percent of the stock, respectively. X Corporation transfers its
assets to Newco in exchange for cash and one share of Newco stock. Immediately
thereafter, X liquidates, distributing cash to A and cash and the one share of Newco stock
to B.
Result: The transaction qualifies as a valid “D” reorganization. The technical
requirements of section 368(a)(1)(D) are satisfied through the transfer of the one share of
Newco stock.
372
Final Regulations – Deemed Stock
Liquidation
P
X assets
X
Y
Facts: P owns all of the stock of X and Y. X transfers all of its assets to Y and then
liquidates.
Result: This transaction should qualify as a “D” reorganization because Y is deemed to
issue stock to X in exchange for the X assets and X is treated as distributing the deemed
stock to P in the liquidation. As a technical matter, the temporary regulations treated Y as
issuing a nominal share in exchange for the X assets even though prior guidance
suggested that Y would be treated as issuing deemed shares equal in value to X assets
received in the exchange. The final regulations clarify that Y will be treated as issuing
deemed stock rather than a nominal share.
373
Final Regulations – Triangular Reorganizations
P stock
P
T assets
S
T
P stock
Facts: P owns all of the stock of S and T. T transfers substantially all of its assets to S solely in
exchange for P stock and T liquidates.
Result: This transaction satisfies the technical requirements of a “C” reorganization and is not treated
as a “D” reorganization by reason of the nominal share and deemed stock rules. Prior to the March
2007 amendment to the temporary regulations, this transaction was treated as a valid “D”
reorganization under the temporary regulations, even though no stock of the acquiring corporation, S, is
transferred in exchange for T’s assets. Because section 368(a)(2)(A) precludes the transaction from
being treated as a “C” reorganization if it also a “D” reorganization, the temporary regulations would
have treated the transfer of P stock as boot in a “D” reorganization. The March 2007 amendment
prevents this transaction from being treated as a “D” reorganization under the temporary regulations.
The final regulations retain this amendment. See Treas. Reg. 1.368-2(l)(2)(iv).
374
“D” Reorganizations – Stock Sale & Deemed Liquidation
P
Cash
(1)
T stock
T
X
Deemed
Liquidation
(2)
T
Facts: P, T, and X are corporations. P owns all of the stock of T and X. P transfers the
stock of T to X in exchange for cash. In connection with the transfer of stock, T elects to be
treated as a disregarded entity for federal income tax purposes.
Result: This transaction qualifies as a tax-free “D” reorganization under section
368(a)(1)(D). See Rev. Rul. 2004-83. T is treated as transferring its assets to X in
exchange for X stock, which it distributes to P in a transaction described in section 356.
375
Check-and-Sell Transaction
Deemed
Liquidation
P
(1)
Cash
(2)
T
T’s LLC
Interests
X
Facts: P, T, and X are corporations. P owns all of the stock of T and X. T
checks the box to be treated as disregarded entity and P sells T’s LLC
interests to X.
Result: Is the transfer treated as an asset transfer or a stock transaction?
See Dover Corp. v. Commissioner, 122 T.C. 324 (2004).
376
Check-and-Sell Transaction – Variation
P
(1)
X
(2)
Y
Cash
Deemed
Liquidation
T
T’s LLC
Interests
Z
Facts: P, X, Y, T and Z are corporations. P owns all of the stock of X and Y, and X and
Y own all of the interests in T and Z, respectively. T checks the box to be treated as a
disregarded entity and X sells T’s LLC interests to Z.
Result: Is the transfer treated as a liquidation followed by a sale? See Dover Corp. v.
Commissioner, 122 T.C. 324 (2004). What result if X sells only part of its LLC interests
in T?
377
Cross-Chain Section 351 Exchange
P
S1
Assets
S2
Facts: P owns all of the stock of S1 and S2. P and S1 are members of a consolidated group. S2 files a
separate return. S1 transfers assets to S2 but does not receive stock or other consideration in exchange.
S1 continues its business activities after the transfer of property.
Result: To qualify as a section 351 exchange, S1 must transfer property to S2 in exchange for stock and
be in control of S2 immediately after the exchange. S1 satisfies the control requirement because it is
treated as owning the S2 stock held by P, a member of its consolidated group under the consolidated
stock attribution rule of Treas. Reg. § 1.1502-34. However, it is unclear whether S1 can satisfy the
exchange requirement because it does not receive S2 stock in the exchange. Consistent with the final
regulations on “D” reorganizations, should S2 be deemed to issue stock to S1, with the S2 stock
distributed up to P? See GLAM 2012-006 (analysis of Situation 4).
378
Boot-Within-Gain Limitation – Effect on E&P
(2)
Liquidation
P
Assets
CFC1
CFC2
Cash
(1)
Facts: P owns all of the stock of CFC1 and CFC2, which are foreign corporations. P’s
basis in its CFC1 stock is $100. CFC1 transfers its assets to CFC2 in exchange for $100
cash and immediately thereafter liquidates into P.
Result: This transaction should be treated as a valid “D” reorganization. See Treas.
Reg. § 1.368-2(l). P does not recognize any income under the boot-within-gain limitation
rule in section 356 – P did not realize any gain in its CFC1 stock and, therefore, none of
the $100 boot is taxable.
Issue: What is the amount of the reduction to the E&P of CFC1, if any, prior to carryover
under section 381 to CFC2? See section 312(a), (d), (n)(7); Treas. Reg. § 1.312-11(c);
Rev. Rul. 72-327, 1972-2 C.B. 197.
379
Temporary Regulations –
Allocation of Basis in All Cash “D”
Reorganizations
380
Temporary Regulations on Allocation of Basis in
All Cash “D” Reorganizations
•
•
On November 18, 2011, Treasury and the IRS issued temporary regulations to clarify that
the ability to designate the share of stock of the issuing corporation to which the basis, if
any, of the stock or securities surrendered will attach applies only to a shareholder that
owns actual shares in the issuing corporation.
– Treasury and the IRS stated that they issued the regulations in response to comments
that the mechanics of preserving basis in the shares of stock or securities surrendered
in the basis of the stock of the issuing corporation were unclear under current law.
Treasury and the IRS acknowledged the argument that the current rules could be
interpreted to allow what they deemed an inappropriate allocation of basis.
– The rules could be interpreted to allow persons who do not own actual shares of stock
of the issuing corporation to allocate the adjusted basis of the nominal share to an
actual share of stock of the issuing corporation directly owned by someone else before
the nominal share is deemed to be further transferred through the chains of
ownership.
– Under this interpretation, the actual share to which the basis was allocated could be
sold to recognize a loss. As a result, a taxpayer would avoid losing the nominal
share’s basis, which otherwise could be zero following its deemed transfer through
chains of ownership to the actual shareholder of the issuing corporation.
381
Temporary Regulations on Allocation of Basis in
All Cash “D” Reorganizations
•
•
The temporary regulations clarify and amend the final regulations under
Treas. Reg. § 1.358-2(a)(2)(iii).
– If an actual shareholder of the issuing (acquiring) corporation is
deemed to receive a nominal share of issuing corporation stock as
described in Treas. Reg. § 1.368-2(l), the shareholder must, after
allocating and adjusting the basis of the nominal share and
adjusting the basis in the nominal share for any transfers described
in Treas. Reg. 1.368-2(l), designate the share of stock of the issuing
corporation to which the basis, if any, of the nominal share will
attach.
– If the shareholder that receives the nominal share is not an actual
shareholder of the issuing corporation, that shareholder may not
designate any particular share to which the basis of the nominal
share will attach.
The temporary regulations apply to exchanges and distributions of
stock and securities occurring on or after November 21, 2011.
382
Temporary Regulations on Allocation of Basis in All Cash “D” Reorganizations
– Acquisition of Lower-Tier Subsidiary by Upper-Tier Subsidiary
P
Nominal
Y Share
(Deemed)
X
Y
Liquidation
Assets
T
$100 +
Nominal Y
Share
Facts and All Cash “D” Reorganization Construct: P owns all the stock of X and Y, and X owns all of the stock of T. X has
$150 basis in its T stock. T sells all of its assets to Y for $100 cash, their FMV, and liquidates. Under Treas. Reg. § 1.368-2(l),
Y is deemed to issue a nominal share of Y stock to T in addition to the $100, and T is deemed to distribute the nominal share
of Y stock to X. Under section 358(a), X will have a $50 basis in the nominal Y share. X is deemed to distribute the nominal Y
share to P. Under section 311(a), X does not recognize the loss on the deemed distribution of the nominal share to P. Under
section 301(d), P’s basis in the nominal Y share would be zero, its FMV.
Prior Law: Arguably, X may allocate the $50 basis in the nominal Y share to an actual Y share owned by P.
Temporary Regulations: X is deemed to receive the nominal Y share described in Treas. Reg. § 1.368-2(l). However, under
Treas. Reg. § 1.358-2T(a)(2)(iii)(C), X is not an actual shareholder of Y, the issuing corporation. Thus, X may not designate
any share of Y stock to which the $50 basis of the nominal Y share will attach. Also, P may not designate a Y share to which
basis will attach, because P receives the nominal Y share with a zero basis. Treas. Reg. § 1.358-2T(a)(2)(iii), ex. 16.
383
Temporary Regulations on Allocation of Basis in All Cash “D” Reorganizations
– Acquisition of Upper-Tier Subsidiary by Lower-Tier Subsidiary
P
Liquidation
T
Assets
$100 +
Nominal
Y Share
Nominal
Y Share
(Deemed)
X
Y
Facts and All Cash “D” Reorganization Construct: P owns all the stock of T and X, and X owns all the stock of Y. P
has $150 basis in its T stock. T sells all of its assets to Y for $100 cash, their FMV, and liquidates. Under Treas.
Reg. § 1.368-2(l), Y is deemed to issue a nominal share of Y stock to T in addition to the $100, and T is deemed to
distribute the nominal Y share to P in liquidation. P is deemed to contribute the nominal Y share to X. Under section
358(a), X will have a $50 basis in the nominal Y share.
Temporary Regulations: P is deemed to receive the nominal Y share described in Treas. Reg. § 1.368-2(l).
However, under Treas. Reg. § 1.358-2T(a)(2)(iii), P is not an actual shareholder of Y, the issuing corporation. Thus,
P may not designate a share of Y or X stock, and X may not designate a share of Y stock, to which the $50 basis of
the nominal Y share will attach.
384
Continuity of Interest –
Final and Proposed Regulations
385
Continuity of Interest – In General
•
•
•
•
•
•
To be treated as a tax-free reorganization under section 368, a transaction must
satisfy the continuity of interest (“COI”) requirement, as well as other statutory
requirements.
COI requires that, in substance, a substantial part of the value of the proprietary
interests in the target corporation must be preserved in the reorganization. Treas.
Reg. § 1.368-1(e)(1)(i).
A proprietary interest is preserved if, in a potential reorganization, it is exchanged by
the acquiring corporation for a direct interest in the target corporation, or it otherwise
continues as a proprietary interest in the target corporation.
However, a proprietary interest in the target corporation is not preserved if it is
acquired by the issuing corporation (or a related party) for consideration other than
stock of the issuing corporation, or stock of the issuing corporation furnished in
exchange for a proprietary interest in the target corporation in the potential
reorganization is redeemed.
The IRS considers the continuity of interest requirement as satisfied if, following the
transaction, historic shareholders of the target corporation hold stock of the issuing
corporation (as a result of prior ownership of target stock) representing at least 40%
of the value of the stock of the target corporation. Treas. Reg. § 1.368-1(e)(2)(v), ex.
1.
Cases have approved reorganizations with lower percentages of stock consideration.
See, e.g., John A. Nelson Co. v. Helvering, 296 U.S. 374 (1934) (38 percent stock);
Miller v. Commissioner, 84 F.2d 415 (6th Cir. 1936) (25 percent stock).
386
Measuring Continuity of Interest
Signing Date Rule – Background
• Historically, consistent with normal realization concepts, continuity of interest has been measured
based on values at the closing date. Treas. Reg. § 1.1001-1(a); Rev. Proc. 77-37 §3.02.
• On August 10, 2004, Treasury and the IRS proposed regulations under section 368 to address
concerns that the fluctuation in the value of issuing corporation stock between the date the parties
agree to the terms of the transaction and the date the transaction closes may cause a transaction
to fail the COI requirement.
– In general, the proposed regulations provided for a “binding contract” rule under which the
consideration to be exchanged for target corporation stock is valued as of the end of the last
business day before the first date there is a binding contract to effect the potential
reorganization (i.e., the signing date), provided that such consideration is fixed.
– The signing date rule is based on the principle that, where a binding contract provides for fixed
consideration, the target corporation shareholders can generally be viewed as being subject to
the economic fortunes of the issuing corporation as of the signing date.
• On September 16, 2005, Treasury and the IRS published final regulations that retained the
general framework of the 2004 proposed regulations, but contained several modifications.
• On March 20, 2007, Treasury and the IRS published proposed and temporary regulations that
amended the final regulations in several significant respects.
– In general, the 2007 temporary regulations retained the signing date rule, but provided
taxpayers with greater flexibility in structuring transactions to satisfy the COI requirement.
– The 2007 temporary regulations expired on March 19, 2010, although taxpayers could generally
elect to apply the rules in the concurrently issued proposed regulations, which had the same
text as the expiring temporary regulations. Notice 2010-25, 2010-1 C.B. 527.
387
Measuring Continuity of Interest
Signing Date Rule – Contract Modifications
• On December 16, 2011, Treasury and the IRS finalized the signing date rule of the
2007 temporary regulations with only minor changes.
• The final signing date rule values consideration transferred in a potential
reorganization on the last business day before the first date a contract is a binding
contract (i.e., the signing date). Treas. Reg. § 1.368-1(e)(2)(i).
• In general, contract modifications result in a new signing date (i.e., the last business
day before the first date a modification is a binding contract). Treas. Reg. § 1.3681(e)(2)(ii)(B)(1).
• Certain modifications do not result in a new signing date if the COI requirement would
have been satisfied in the absence of the modification—
– Modifications that have the sole effect of providing for the issuance of additional
shares of issuing corporation stock.
– Modifications that have the sole effect of decreasing the amount of money (or other
property) to be transferred to target shareholders.
– Modifications that have the effect of decreasing the amount of money or other
property to be delivered to the target corporation shareholders and providing for the
issuance of additional shares of issuing corporation stock to the target corporation
shareholders.
388
Measuring Continuity of Interest
Signing Date Rule – Fixed Consideration
• The signing date rule only applies if the binding contract provides for fixed
consideration. Treas. Reg. § 1.368-1(e)(2)(i).
• A contract provides for fixed consideration if it provides the number of shares of
each class of stock of the issuing corporation, the amount of money, and the
other property to be exchanged for all of the proprietary interests of the target
corporation. Treas. Reg. § 1.368-1(e)(2)(iii)(A).
• The 2007 temporary regulations treated a shareholder election as providing for
fixed consideration so long as the amount of stock to be received is determined
using its value on the signing date.
• The final regulations clarify that a shareholder election does not prevent a
contract from satisfying the general definition of fixed consideration if that
requirement is otherwise met.
389
Measuring Continuity of Interest
Signing Date Rule – Contingent Consideration
• Binding contracts providing for contingent consideration will be
treated as providing for fixed consideration unless the contingent
adjustments prevent (to any extent) the target shareholders from
being subject to the economic benefits and burdens of ownership of
the issuing corporation as of the signing date. Treas. Reg. § 1.3681(e)(2)(iii)(C).
• Examples of contingent consideration causing a binding contract not
to be treated as providing for fixed consideration –
– Adjustments to the consideration in the event that the value of
issuing corporation stock or its assets (or any surrogate of either)
increases or decreases after the signing date, and
– Adjustments to the number of issuing corporation shares computed
using a share value as of a date after the signing date.
390
Measuring COI – Example 1: Signing Date Rule
40 P Shares ($40)
$60
P
Merger
January 2 Signing Date
(P share = $1)
T shs
T
40 P Shares ($10)
$60
P
Merger
T shs
T
June 1 Merger
(P share = $.25)
Facts: On January 3, P and T sign a binding contract pursuant to which T will merge with and into P on
June 1 of that year. The contract provides that T shareholders will receive 40 P shares and $60 in
exchange for all of T stock. On January 2, a P share is worth $1. On June 1, T merges with and into P.
On that date, a P share is worth $0.25.
Result: There is a binding contract providing for fixed consideration because the contract provides for
the number of P shares and cash transferred in exchange for all of the proprietary interests in T. Thus,
the value of P shares on the signing date ($1 per share) is used to determine whether the COI
requirement has been satisfied. Using that share value ($1), the 40 P shares constitute 40 percent of
the total consideration transferred to T shareholders. The COI requirement is satisfied. Treas. Reg. §
1.368-1(e)(2)(v), ex. 1.
391
Measuring COI – Example 2: Contract Modification
40 P Shares ($40)
$60
P
T shs
Merger
January 2 Signing Date
(P share = $1)
T
50 P Shares ($25)
$75
P
T shs
Merger
T
March 31 Signing Date
(P share = $.50)
Facts: The facts are the same as in Example 1, except that the parties modify the binding contract on
April 1 to provide that the T shareholders will receive 50 P shares and $75. The modified contract is a
binding contract. On March 31, a P share was worth $.50.
Result: Because the modification provides for additional P shares and cash to be exchanged for all of
the proprietary interests of T, the modification results in a new signing date (March 31). Thus, the value
of P shares on March 31 is used to determine whether the COI requirement has been satisfied. Using
that share value ($.50), the 50 P shares constitute 25 percent of the total consideration received by T
shareholders. As a result, the COI requirement is not satisfied. Note that the COI requirement would
have been satisfied if the modification provided only for additional P shares. See Treas. Reg. § 1.3681(e)(2)(v), ex. 4 and 5.
392
Measuring COI – Example 3:
Contingent Consideration
40 P Shares ($40)
$60
P
Merger
T shs
T
Contract (without Contingent
Consideration)
64 P Shares ($25.60)
$75
P
Merger
T shs
T
June 1 Merger (with Contingent
Consideration)
Facts: On January 3, P and T sign a binding contract pursuant to which T will merge with and into P on June 1 of
that year. On January 2, a P share is worth $1. The contract provides that T shareholders will receive 40 P
shares and $60 in exchange for all of the T stock. The contract also provides that the T shareholders will receive
$.16 of additional P shares and $.24 for every $.01 decrease in the value of a P share after January 2. On June
1, T merges with and into P. On that date, a P share is worth $.40. As a result of the provision for contingent
consideration, T shareholders receive 64 P shares (worth $25.60) and $74.40 in the merger.
Result: The signing date rule does not apply because the binding contract does not provide for fixed
consideration. The additional consideration received by T shareholders is contingent upon a decrease in the
value of a P share after the signing date (January 2). As a result, the T shareholders are not subject to the
economic benefits and burdens of P after that date. Because the signing date rule does not apply, the value of P
shares as of January 2 is not used to determine whether the COI requirement is satisfied, but the value on the
date of the merger (June 1). Using that share value ($.40), the value of the P shares ($25.60) constitutes
approximately 25 percent of the total consideration, and the COI requirement is not satisfied. See Treas. Reg. §
393
1.368-1(e)(2), ex. 10.
Measuring COI – Example 4:
Contingent Consideration
40 P Shares ($40)
$60
P
Merger
T shs
T
Contract (without Contingent
Consideration)
28 P Shares ($21)
$42
P
Merger
T shs
T
June 1 Merger (with Contingent
Consideration)
Facts: On January 3, P and T sign a binding contract pursuant to which T will merge with and into P on June 1 of
that year. On January 2, a P share is worth $1 and a T share is worth $1. The contract provides that T
shareholders will receive 40 P shares and $60 in exchange for all of the T stock. The contract also provides that
the T shareholders will receive $.40 less P shares and $.60 less for every $.01 decrease in the value of a T share
after January 3. On June 1, T merges with and into P. On that date, a P share is worth $.75 and a T share is
worth $.70. As a result of the provision for contingent consideration, T shareholders receive 28 P shares ($21)
and $42 in the merger.
Result: The signing date rule applies because the binding contract provides for fixed consideration. The
additional consideration received by T shareholders is contingent upon a decrease in the value of a T share (and
not a P share). Thus, the T shareholders are subject to the economic benefits and burdens of P. Because the
signing date rule applies, the value of P shares on January 2 is used to determine whether the COI requirement
is satisfied. Using that share value ($1), the value of the P shares ($28) constitutes two-thirds of the total
394
consideration, and the COI requirement is satisfied. See Treas. Reg. § 1.368-1(e)(2), ex. 12.
Final Regulations – Effective Date
• The final regulations apply to transactions occurring pursuant to binding
contracts entered into after December 19, 2011.
• For transactions entered into after March 19, 2010, and occurring pursuant to
binding contracts entered into on or before December 19, 2011, the parties to
the transaction may elect to apply the provisions of the 2007 temporary
regulations.
– The election by any party to the transaction is contingent upon all parties
making the election.
– The parties to the transaction include the target corporation, issuing
corporation, controlling corporation (if parent stock is transferred), and any
direct or indirect transferee of transferred basis property.
– The election requirement will be satisfied if none of the parties adopt
inconsistent treatment.
395
Measuring Continuity of Interest
Proposed Regulations – Average Value
• In addition to the final regulations, Treasury and the IRS also issued
proposed regulations further clarifying the scope of the signing date
rule.
– The proposed regulations permit the use of an average value for
issuing corporation stock in certain circumstances in lieu of the
value of issuing corporation stock on the Closing Date (the date
upon which the exchange of consideration in the potential
reorganization occurs).
– The proposed regulations provide that an average value may be
used if it is based upon issuing corporation stock values occurring
after the signing date and before the Closing Date, and the binding
contract utilizes the average price, so computed, in determining the
number of shares of each class of stock of the issuing corporation,
the amount of money, and the other property to be exchange for all
the proprietary interests in the target corporation.
– The IRS has indicated that, notwithstanding the permissive
language in the proposed regulations, the use of an average value
is intended to be mandatory.
396
Measuring Continuity of Interest
Proposed Regulations – Floor and Ceiling Rules
Floor Rule
• If—
- Transaction is pursuant to binding contract
- On the day before the Signing Date, the FMV of a share of P stock is greater than or
equal to a designated “Floor Price” (but average price rule may apply)
- Under contract, amount of “an item of consideration” to be exchanged for T stock
changes as FMV of a share of P stock varies at or above Floor Price but does not vary
further if FMV falls below Floor Price
- On the Closing Date, FMV of a share of P stock is less than the Floor Price
• Then, for COI purposes, FMV of a share of P stock is deemed to be the Floor Price
Ceiling Rule
• If—
- Transaction is pursuant to binding contract
- On the day before the Signing Date, the FMV of a share of P stock is less than or equal to
a designated “Ceiling Price” (but average price rule may apply)
- Under contract, amount of “an item of consideration” to be exchanged for T stock
changes as FMV of a share of P stock varies at or below Ceiling Price but does not vary
further if FMV rises above Ceiling Price
- On the Closing Date, FMV of a share of P stock is greater than the Ceiling Price
• Then, for COI purposes, FMV of a share of P stock is deemed to be the Ceiling Price
Floor Rule and Ceiling Rule operate independently of each other and also independently
of rules relating to average price valuation of P stock
397
Measuring COI – Floor and Ceiling Rules
Example: Collar
Facts
• On January 2, FMV of P stock is $1/share
• On January 3, P and T sign a binding contract to merge T into P
• T shareholders will receive 50 shares of P stock and $50 cash, subject to adjustment based on
average traded price of P stock over a designated post-signing, pre-closing time period:
- If average price is > $1/share, cash is reduced by 50x excess of average price over $1, but
not to < $40
- If average price is < $1/share, cash is increased by 50x excess of $1 over average price, but
not to > $60
• Adjustment ensures receipt of total consideration with $100 FMV if average price of P stock is:
- At least $0.80 “Floor Price”
$60 maximum cash = $50 + (50 ($1.00 $0.80))
- No higher than $1.20 “Ceiling Price”
$40 minimum cash = $50 – (50 ($1.20 $1.00))
• On June 1, T merges into P, when the average price is $0.25 per share
• Thus, the T shareholders receive $60 cash and 50 shares of P stock with total $12.50 FMV.
Conclusions
• COI is determined as if the average price were the Floor Price ($60 cash and $40 P stock)
- Cash consideration did not vary as average price fell below Floor Price ($.80/share)
- FMV on day before signing > Floor Price
- FMV on Closing Date < Floor Price
398
• If P stock price had increased to above Ceiling Price, Ceiling rule would have applied
Final Regulations Under Section 267(f)
399
Final Regulations Under Section 267(f)
•
•
On April 13, 2012, Treasury and the IRS issued final regulations on the
deferral of losses on the sale or exchange of property between members of
a controlled group.
– The regulations adopt proposed regulations issued in April 2011, with
minor modifications.
Treas. Reg. § 1.267(f)-1(c)(1)(iv), also known as the “supersecret rule,”
contains a special rule with respect to losses that would have been
redetermined to be a noncapital, nondeductible amount if the consolidated
return attribute redetermination rule in Treas. Reg. § 1.1502-13(c)(1)
applied.
– If an intercompany loss between members of a consolidated group
would have been redetermined to be a noncapital, nondeductible
amount as a result of the attribute redetermination rule applicable to
consolidated groups, but is not redetermined because the sale or
exchange occurred between members of a controlled group, then the
loss is deferred and generally taken into account when the selling and
buying members are no longer in a controlled group relationship.
400
Final Regulations Under Section 267(f)
•
•
•
The final regulations modify the supersecret rule by adopting a new aggregation rule intended to
prevent the recognition of a selling member’s intercompany loss on the sale of target company stock
to the buying member by triggering the loss on a section 331 liquidation of the target company.
– Under the final regulations, for purposes of determining whether a deferred loss is redetermined
to be a noncapital, nondeductible amount under the principles of Treas. Reg. § 1.1502-13, the
following are taken into account –
• stock held by the selling member,
• stock held by the buying member,
• stock held by all members of the selling member's consolidated group,
• stock held by any member of a controlled group of which the selling member is a member
that was acquired from a member of the selling member’s consolidated group,
• and stock issued by the target to a member of the controlled group.
– The final regulations modified the proposed regulations to include stock issued to a member of a
controlled group by a target company to ensure that taxpayers cannot circumvent the purposes
of the regulations through issuances of target corporation stock to controlled group members.
The final regulations clarify the interaction between section 267(f) and Treas. Reg. § 1.1502-13 by
removing a provision in the proposed regulations that stated that deferred loss is taken into account
to the extent of any corresponding gain that the member acquiring the property recognizes with
respect to the property, because the timing of taking into account such a loss is provided for under
Treas. Reg. § 1.1502-13.
The final regulations apply to a loss that continues to be deferred under Treas. Reg. § 1.267(f)1(c)(1)(iv) if the event that would cause the loss to be redetermined as a noncapital, nondeductible
amount under the principles of Treas. Reg. § 1.1502-13 occurs on or after April 16, 2012.
401
Example – Sale of Stock by Consolidated Group Member
to Controlled Group Member
P1
P1
75%
75%
P
M
Cash
25%
S
Liquidation
of L
25%
50%
L
P
M
S
50%
L
stock
50%
L
Facts: P1, a domestic corporation, owns 75 percent of P, the common parent of a consolidated group. P owns all of M and S (both
members of P’s consolidated group), who in turn each own 50 percent of L, a nonmember life insurance company. In Year 1, S sells
25 percent of L’s stock to P1 for $50. At the time of the sale, S’s aggregate basis in the transferred L shares was $80, and S
recognizes a $30 loss. In Year 2, when the L shares held by P1 are worth $60, L liquidates, with P1 recognizing a $10 gain.
Result
•
Under Treas. Reg. § 1.267(f)-1(a)(2), S’s loss on the sale of the L stock to P1 is deferred. Under Treas. Reg. § 1.267(f)1(c)(1)(iv), upon the liquidation of L, to the extent S’s loss would be redetermined to be a noncapital, nondeductible amount
under the principles of Treas. Reg. § 1.1502–13, S’s loss continues to be deferred.
•
Under the principles of Treas. Reg. § 1.1502–13, S’s loss is not redetermined to be a noncapital, nondeductible amount to the
extent of P1’s $10 of gain recognized. Accordingly, S takes into account $10 of loss as a result of the liquidation.
•
In determining whether the remainder of S’s $20 loss would be redetermined to be a noncapital, nondeductible amount, stock
held by P1, M, and S is taken into account. Accordingly, under the principles of Treas. Reg. § 1.1502–13, the liquidation of L
would be treated as a section 332 liquidation, and S’s remaining $20 loss would be redetermined to be a noncapital,
nondeductible amount. Thus, such loss continues to be deferred until S and P1 are no longer in a controlled group relationship.
•
See Treas. Reg. § 1.267(f)-1(j), ex. 9.
402
Example – Issuance of Stock to Controlled Group Member
(2)
FP
FP
T Stock
Cash
FS
P
FS
60%
(3)
Cash
(1)
T Stock
P
T
40%
T
Deemed
Liquidation of T
Facts: FP, a foreign corporation, owns all of FS, a foreign corporation, and all of P, a domestic corporation. P owns all
of T. In Year 1, FS contributes cash to T in exchange for newly issued T stock that constitutes 40 percent of T’s
outstanding stock. In Year 2, when the value of the T stock owned by P is less than its basis in P’s hands, P sells all of
its T stock to FP. In Year 3, in an unrelated transaction, T converts under state law to an LLC that is treated as a
partnership for federal income tax purposes.
Result
•
Under Treas. Reg. § 1.267(f)-1(a)(2), P’s loss on the sale of its T stock is deferred. Under Treas. Reg. § 1.267(f)1(c)(1)(iv), on the conversion of T, to the extent P’s loss would be redetermined to be a noncapital, nondeductible
amount under the principles of Treas. Reg. § 1.1502–13, P’s loss continues to be deferred. In making this
determination, stock held by FS (which was acquired from T) and stock held by FP (the buyer of the T stock from
P and a member of P’s controlled group) is taken into account.
•
Accordingly, under the principles of Treas. Reg. § 1.1502–13, the deemed liquidation of T resulting from its
conversion would be treated as a liquidation under section 332, and P’s loss would be redetermined to be a
noncapital, nondeductible amount. Thus, under Treas. Reg. § 1.267(f)-1(c)(1)(iv), P’s loss continues to be
deferred until P and FP are no longer in a controlled group relationship.
403
•
See Treas. Reg. § 1.267(f)-1(j), ex. 10.
Final Regulations on Methods of
Accounting in Section 381(a) Asset
Acquisitions
404
Final Regulations on Methods of Accounting in
Section 381(a) Asset Acquisitions
•
•
On August 1, 2011, Treasury and the IRS issued final regulations under section 381(c)(4) and (5)
relating to the methods of accounting, including the inventory methods, to be used by a
corporation that acquires the assets of another corporation in a section 381(a) transaction.
– The final regulations under section 381(c)(4) (method of accounting) and section 381(c)(5)
(inventories) are intended to mirror each other to the greatest extent possible.
Under the final regulations, the key determination is whether the acquiring corporation operates
the trades or businesess of the parties to the section 381(a) transaction as separate and distinct
trades or businesses following the distribution or transfer.
– When the acquiring corporation operates the trades or businesses of the parties as separate
and distinct trades or businesses after the distribution or transfer, the acquiring corporation
uses a carryover method.
– When the acquiring corporation does not operate the trades or businesses of the parties as
separate and distinct trades or businesses after the distribution or transfer, the acquiring
corporation uses a principal method.
– Whether an acquiring corporation operates the trades or businesses of the parties as
separate and distinct trades or businesses after the distribution or transfer is determined as
of the date of distribution or transfer based upon the facts and circumstances.
– These rules do not apply when a carryover or principal method (as applicable) is not a
permissible method, or when the acquiring corporation elects not to use a carryover or
principal method. In such cases, the general rules under section 446(e) governing methods
of accounting apply.
405
Final Regulations on Methods of Accounting in
Section 381(a) Asset Acquisitions
•
•
•
•
A carryover method is generally the method of accounting that each party to a section
381(a) transaction uses for each separate and distinct trade or business immediately prior
to the distribution or transfer.
For each integrated trade or business, the principal method is generally the method of
accounting used by the component trade or business of the acquiring corporation
immediately prior to the distribution or transfer.
– However, if the component trade or business of the distributor or transferor corporation
is larger than the component trade or business of the acquiring corporation, the
principal method is the method used by the distributor or transferor immediately prior
to that date.
– The determination of whether the distributor or transferor corporation is larger than the
acquiring corporation is made by comparing certain attributes (under section 381(c)(4)
the adjusted bases of the assets and gross receipts, and under section 381(c)(5) the
fair market value of the inventory) of only the trades or businesses that will be
integrated after the distribution or transfer rather than comparing the attributes for the
entire entity.
The final regulations do not provide audit protection when an acquiring corporation uses a
principal method after the distribution or transfer.
The final regulations apply to corporate reorganizations or tax-free liquidations described in
section 381(a) that occur on or after August 31, 2011.
406
Rev. Proc. 2012-39 – Change in Accounting Method
Procedures for Section 381(a) Transactions
•
•
•
•
•
On September 4, 2012, the IRS issued Rev. Proc. 2012-39, 2012-41 I.R.B. 1, which modifies the
procedures for obtaining consent for a change in method of accounting in connection with a
transaction to which section 381(a) applies.
Rev. Proc. 2011-14, 2011-4 I.R.B. 330, provides the procedures for obtaining automatic consent
for a change in accounting method under section 446(e).
– A taxpayer was generally precluded from using such automatic consent procedures to
change its method of accounting for a taxable year in which it (i) engages in a transaction to
which section 381 applies, or (ii) ceases to engage in the trade or business to which the
change in method of accounting relates or terminates its existence.
– A taxpayer precluded from using the automatic consent procedures in Rev. Proc. 2011-14 is
subject to Rev. Proc. 97-27, 1997-1 C.B. 680, which provides the general procedures for
obtaining non-automatic consent to change a method of accounting under section 446(e).
Rev. Proc. 2012-39 modifies Rev. Proc. 2011-14 by permitting taxpayers to make otherwise
qualifying automatic accounting method changes in the year of the section 381(a) transaction.
– Rev. Proc. 2012-39 further clarifies that the limitation relating to the final year of a trade or
business will not apply to a taxpayer that changes its method of accounting in the final year
of a trade or business terminated as a result of a section 381(a) transaction.
Rev. Proc. 2012-39 also modifies Rev. Proc. 2011-14 and Rev. Proc. 97-27 by waiving the
limitation that precludes taxpayers under examination from seeking consent to change to an
accounting method other than the principal or carryover method.
The above changes apply to section 381(a) transactions occurring on or after August 31, 2011.
407
Section 382 Guidance
408
Notice 2010-49: Small Shareholders
•
•
•
•
Notice 2010-49 requests comments relating to possible modifications to the treatment of
shareholders who are not 5-percent shareholders (“Small Shareholders”) for purposes of
determining whether there is an ownership change.
Under section 382, there is generally an ownership change if the ownership of one or more 5percent shareholders has increased by more than 50 percentage points.
– Under section 382(g)(4)(A), Small Shareholders are aggregated and treated as one 5percent shareholder for purposes of applying this rule.
– This rule is modified, however, by section 382(g)(4)(B) and section 382(g)(4)(C). Section
382(g)(4)(B) provides that the aggregation rule must be applied separately to Small
Shareholders of parties to certain reorganizations and section 382(g)(4)(C) provides that,
except as provided in regulations, similar segregation rules apply in determining whether
there has been an owner shift involving a 5-percent shareholder and whether such shift
results in an ownership change.
The Notice describes two general approaches to the treatment of Small Shareholders that may be
incorporated into modified regulations: (i) the Ownership Tracking Approach, and (ii) the
Purposive Approach.
Ownership Tracking Approach:
– Under this approach, all changes in ownership are tracked without regard to the particular
circumstances, so that it is generally of no significance whether the shareholders who
increase their ownership are Small Shareholders or 5-percent shareholders.
– Thus, any transaction that allows the corporation to track the increase in ownership interests
held by Small Shareholders results in the segregation of Small Shareholders into a new
public group, which is treated as a single 5-percent shareholder. The creation of the new,
segregated public group results in an increase in ownership for that public group.
– However, “public trading,” the purchase by one Small Shareholder of stock from another
Small Shareholder, is not taken into account because it is unduly burdensome for a
corporation to account for all such transactions.
409
Notice 2010-49: Small Shareholders
•
•
Purposive Approach
– Under this approach, the rules would seek to identify more specifically
the circumstances in which abuses are likely to arise.
– The Purposive Approach reflects the view that it is unnecessary to take
into account all readily-identifiable acquisitions of stock by Small
Shareholders, because Small Shareholders are generally not in a
position to acquire loss corporation stock in order to contribute incomeproducing assets or divert income-producing opportunities.
– Special rules generally would provide for a lesser percentage change in
ownership for acquisitions of stock by Small Shareholders.
The current regulations primarily reflect the Ownership Tracking approach.
– The notice requests comments concerning whether the regulations
should follow the Ownership Tracking Approach, the Purposive
Approach, or another approach.
410
Proposed Regulations – Application of
Segregation Rules
•
•
•
•
On November 22, 2011, Treasury and the IRS issued proposed regulations providing
guidance on the application of the segregation rules to public groups under section 382.
The proposed regulations propose revisions following the Purposive Approach within the
existing regulatory framework, which are intended to lessen the administrative burden and
section 382 implications associated with transactions that are unlikely to implicate section
382 policy concerns.
The proposed regulations would generally render the segregation rules inapplicable to
transfers of loss corporation stock to Small Shareholders by 5-percent entities or
individuals who are 5-percent shareholders.
– The stock transferred would be treated as being acquired proportionately by the public
groups existing at the time of the transfer.
– This rule would also apply to transfers of ownership interests in 5-percent entities to
public owners and to 5-percent owners who are not 5-percent shareholders.
The proposed regulations also contain an exception for certain redemptions.
– The exception would exempt from segregation, at the loss corporation’s option, either
10% of the total value of the loss corporation’s stock at the beginning of the taxable
year, or 10% of the number of shares of the redeemed class outstanding at the
beginning of the taxable year.
– Where the exception applies, each public group existing immediately before the
redemption would be treated as redeeming its proportionate share of exempted stock.
411
Proposed Regulations – Application of
Segregation Rules
•
•
•
•
The proposed regulations attempt to limit the situations in which the segregation rules would apply
to those that potentially implicate the policies underlying section 382.
– The segregation rules would not apply to a transaction if, on a testing date on which the rules
would otherwise apply (i) the 5-percent entity owns 10 percent or less (by value) of all the
outstanding stock of the loss corporation, and (ii) the 5-percent entity’s direct or indirect
investment in the loss corporation does not exceed 25 percent of the entity’s gross assets.
– According to Treasury and the IRS, this proposal strikes an appropriate balance between
reducing complexity and safeguarding section 382 policies.
The proposed regulations would also clarify Treas. Reg. § 1.382-2T(j)(3), which provides that, in
general, the segregation rules apply to sales of loss corporation stock by individual 5-percent
shareholders and by first tier entities, and that the principles of the foregoing apply to transactions
in which an ownership interest in a higher tier entity that owns 5 percent or more of the loss
corporation or first tier entity is transferred to a public owner or a 5-percent owner who is not a 5percent shareholder.
– The proposed regulations would clarify that the segregation rules apply to such a transfer
only if the seller indirectly owns 5 percent or more of the loss corporation.
Treasury and the IRS requested comments as to whether the small issuance or cash issuance
exceptions need further refinement in the context of any potential expansion of the exceptions in
the proposed regulations.
Treasury and the IRS also requested comments as to circumstances under which a group of
investors should be aggregated into a single entity based on their understandings or
communications with each other or with third persons, such as the loss corporation or an
underwriter.
412
Section 382(l)(3)(C):
Fluctuations in Value
413
Section 382(l)(3)(C): Fluctuations in Value
•
Section 382 limits NOL carryforwards and built-in losses when there has
been an ownership change of more than 50 percent of the stock (by value)
in a loss corporation over the testing period.
•
Under section 382(g)(1), an ownership change occurs if the percentage (by
value) of stock of the loss corporation owned by one or more 5-percent
shareholders has increased by more than 50 percent over the lowest
percentage ownership of such shareholders at any time during the testing
period.
– The determination of the percentage of stock owned by a person shall
be made on the basis of the relative fair market value of the stock
owned by such person to the total fair market value of the corporation's
outstanding stock. See Treas. Reg. § 1.382-2(a)(3).
•
Section 382(l)(3)(C) provides that in the absence of regulations stating
otherwise, changes in the ownership of a corporation attributable solely to
fluctuations in the relative value of the different classes of stock are not be
taken into account in the ownership change calculation.
– The temporary regulations reserve a paragraph under which changes in
percentage ownership may be disregarded if they are attributable solely
to fluctuations in value. See Temp. Reg. § 1.382-2T(l).
414
Section 382(l)(3)(C): Fluctuations in Value
•
The IRS has articulated its position on how Section 382(l)(3)(C) should
apply, as evidenced by recent PLRs. See PLRs 200901003, 200901001,
200622011, 200520011, 200511008, and 200411012.
– In each of these PLRs, the IRS stated that the value of shares within a
class of stock relative to all other stock outstanding would be considered
to remain constant since the date the shareholder acquired the stock for
purposes of the ownership change calculation.
– In addition, the PLRs provide that the value of such shareholder’s stock
relative to the value of all other stock of the corporation issued
subsequent to such acquisition date shall also be considered to remain
constant since that subsequent date.
415
Fluctuation in Value – Example 1
Year 1
A
Year 2
B
$80 C/S
$20 P/S
A
B
$5 C/S
$20 P/S
L Corp
L Corp
$100 Value
$25 Value
Facts: A and B form a corporation (“L Corp”) in Year 1. A contributes $80 in exchange for the C/S of L
Corp and B contributes $20 in exchange for the P/S of L Corp. In Year 2, the value of L Corp decreases to
$25. The value of the P/S remains at $20 and the value of the C/S decreases to $5.
Result: In testing B’s ownership of L Corp under section 382, the IRS position in the PLRs suggests that
the value of B’s P/S relative to all other stock of L Corp (here, the C/S) shall be considered to remain
constant since the date B acquired the P/S. The value of P/S relative to the value of the C/S was 25%
($20 / $80) at the date of acquisition. If this relative value remains constant, then B’s ownership
percentage (20 percent) should be unchanged. The same analysis would apply to the A’s ownership so
that A’s ownership percentage would be unchanged by reason of the fluctuation in value.
416
Fluctuation in Value – Example 2
Year 1
A
B
$80 C/S
Year 2
$5
$20 P/S
C
C/S
A
B
$20 P/S
$5 C/S
L Corp
L Corp
$100 Value
$25 Value
Facts: A and B form a corporation (“L Corp”) in Year 1. A contributes $80 in exchange for the C/S of L
Corp and B contributes $20 in exchange for the P/S of L Corp. In Year 2, the value of L Corp decreases
to $25. The value of the P/S remains at $20 and the value of the C/S decreases to $5. At the end of
Year 2, A sells the C/S to C for $5.
Result: The IRS position in the PLRs suggests that, in testing for ownership, the relative value of a
shareholder’s stock in L Corp to all other stock in L Corp shall remain constant since the acquisition of
the stock. In applying the IRS approach, there would be no change in percentage ownership held by B
(even though B’s ownership actually increased by 60% from acquisition to the date of the sale – from
$20/$100 or 20 percent to $20/$25 or 80 percent). C’s ownership should be treated as increasing by
20%.
Variation: What if the value of L Corp dropped below $20 at the time A sold the C/S to C?
417
Fluctuation in Value – Example 3
Year 1
A
Year 2
B
A
$20
B
C
C/S
$80 P/S
$20 P/S
$20 P/S
$5 C/S
L Corp
L Corp
$100 Value
$25 Value
Facts: A and B form a corporation (“L Corp”) in Year 1. A contributes $80 in exchange for the C/S of L
Corp and B contributes $20 in exchange for the P/S of L Corp. In Year 2, the value of L Corp decreases
to $25. The value of the P/S remains at $20 and the value of the C/S decreases to $5. At the end of
Year 2, B sells the P/S to C for $5.
Result: C’s ownership should be treated as increasing by 80% and an ownership change should arise.
Variation: What if B sold only 50 percent of the P/S to C for $10? C’s ownership should be treated as
increasing by 40 percent. B’s remaining P/S in L Corp represents an ownership interest of 40 percent
also, which exceeds B’s ownership interest at acquisition in those shares by 30 percent. Has there been
an ownership change? Under the IRS position in the PLRs, the remaining P/S held by B should be
treated as holding their relative value against all other shares of L Corp so that B’s percentage
ownership does not increase even though there has been a sale of the other P/S.
418
Fluctuation in Value – Example 4
Year 1
A
$20
B
P/S
C/S = $80
P/S = $20
Year 2
$5
C
D
A
C
C/S
C/S = $5
P/S = $20
L Corp
L Corp
$100 Value
$25 Value
Facts: A and B form a corporation (“L Corp”) in Year 1. A contributes $80 in exchange for
the C/S of L Corp and B contributes $20 in exchange for the P/S of L Corp. B sells the P/S
to C for $20. Later in Year 1, the value of L Corp decreases to $25. The value of the P/S
held remains at $20 and the value of the C/S decreases to $5. A then sells the C/S to D for
$5.
Result: How is C’s ownership interest measured as of the date C and D own all of the
stock of L Corp? Under the IRS position in the PLRs, C should have a 20-percent interest.
If so, does D also have a 20-percent interest? If so, has there been an ownership change?
Variation: What if B acquired all of A’s stock in Year 2?
419
Fluctuation in Value – Example 5
Year 1
Year 2
Year 3
$
A
A
B
A
$10 C/S
$100 C/S
L Corp
$90 C/S
L Corp
B
$10 C/S
IPO
$85 C/S
$90 C/S
L Corp
Facts: A forms a corporation (“L Corp”) in Year 1. A contributes $100 in exchange for the C/S of L Corp.
In Year 2, A sells a 10-percent interest in L Corp to B for $10. In Year 3, L Corp issues additional C/S to
the public (“Public”) representing approximately 44 percent of the total value of L Corp for $85. Assume
that B’s interest in L Corp is diluted as a result of the public offering to approximately 6 percent.
Result: Public’s percentage ownership has changed by approximately 44 percent. How much has B’s
percentage ownership changed? B owned 10 percent of the value of L Corp immediately prior to the
public offering. As a result of the public offering, B’s interest was diluted to approximately 6 percent. If
the lower figure is used, then there would be no ownership change (as there would be a 50-percent
change in ownership). Is the value change from 10 percent to approximately 6 percent a fluctuation in
value ignored for purposes of section 382(l)(3)(C) such that there would be an ownership change? The
IRS position in the PLR suggests that, for any testing date, B’s shares will retain their relative value
against other shares held at acquisition (and still outstanding) as well as subsequently issued shares.
420
Notice 2010-50: Fluctuations in Stock Value
•
•
•
•
Notice 2010-50 provides guidance regarding the effect of fluctuations in the value of one class of stock
relative to another class of stock for purposes of measuring owner shifts of loss corporations that have more
than one class of stock outstanding.
Section 382(l)(3)(C) provides that, except as provided in regulations, any change in proportionate ownership
of the stock of a loss corporation attributable solely to fluctuations in the relative fair market values of different
classes of stock shall not be taken into account.
– The current regulations under section 382 do not provide any specific guidance on section 382(l)(3)(C).
– The Notice states that Treasury and the IRS are aware that taxpayers employ a number of differing
methodologies to interpret and apply section 382(l)(3)(C), including the Full Value Methodology and the
Hold Constant Principle
Full Value Methodology
– Under the Full Value Methodology, the determination of the percentage of stock owned by any person
is made on the basis of the basis of the relative fair market value of the stock owned by such person
compared to the total fair market value of the outstanding stock of the corporation.
– Thus, changes in percentage ownership as a result of fluctuations in value are taken into account if a
testing date occurs, regardless of whether a particular shareholder actively participates or is otherwise
party to the transaction that causes the testing date to occur; essentially all shares are “marked to
market” on each testing date.
Hold Constant Principle
– Under the Hold Constant Principle, the value of a share, relative to the value of all other stock of the
corporation, is established on the date that share is acquired by a particular shareholder.
– On subsequent testing dates, the percentage interest represented by that share (the “tested share”) is
then determined by factoring out fluctuations in the relative values of the loss corporation’s share
classes that have occurred since the acquisition date of the tested share.
– There are generally two alternative methodologies for implementing the Hold Constant Principle.
• Under the first methodology, the hold constant percentage represented by a tested share is
recalculated to factor out changes in its relative value since the share’s acquisition date.
• Under the second methodology, the percentage interest represented by a tested share is tracked
from the date of acquisition forward, adjusting for subsequent dispositions and for the subsequent
issuance or redemption of other stock.
421
Notice 2010-50: Fluctuations in Stock Value
•
•
•
The Notice states that, because of the complexity of the issues involved in measuring
owner shifts of loss corporation stock where fluctuations in value are present,
Treasury and the IRS have determined that it is appropriate to accept taxpayers’
reasonable attempts to measure increases in ownership where fluctuations in value
are present.
– The Notice thus states that the IRS will generally not challenge any reasonable
application of either the Full Value Methodology or the Hold Constant Principle,
provided that a single methodology is applied consistently.
– The Notice also states that either of the two alternative methodologies for
implementing the Hold Constant Principle are reasonable applications of that
principle.
The Notice states that taxpayers may rely on the guidance in the Notice until
Treasury and the IRS issue additional guidance regarding fluctuation in value under
section 382(l)(3)(C).
In addition, the Notice requests comments on what it describes as the “threshold”
question of whether interpreting the fluctuation in value rule in section 382(l)(3)(C)
broadly to require rules for factoring out fluctuations in value, such as may be done
through the methodologies that employ the Hold Constant Principle, is appropriate in
light of the purposes of section 382.
422
Proposed Basis Allocation
Regulations
423
Proposed Basis Allocation Regulations
•
•
•
On January 16, 2009, Treasury and the IRS issued proposed regulations
that provide a single model for stock basis recovery by a shareholder that
receives a constructive or actual distribution to which section 301 applies
and a single model for sale and exchange transactions to which section
302(a) applies (the “Proposed Regulations”).
– The Proposed Regulations apply the single model regardless of
whether section 301 or section 302(a) applies directly or by reason of
section 302(d), section 304, or section 356.
The Proposed Regulations also provide a methodology for determining
gain realized under section 356 and stock basis determined under section
358.
The Proposed Regulations generally will apply to transactions that occur
after the regulations are published as final regulations.
424
Distributions Under Section 301
•
•
•
•
Section 301(c)(2) provides that “that portion of the distribution which is not
a dividend shall be applied against and reduce the adjusted basis of the
stock.” [emphasis added.]
The Proposed Regulations treat a section 301 distribution as received on
a pro rata, share-by-share basis with respect to the class of stock upon
which the distribution is made.
The Preamble provides that the share-by-share approach is consistent
with the fundamental notion that a share of stock is the basic unit of
property that can be disposed of.
– The approach in the Proposed Regulations follows the generally
accepted treatment of section 301 distributions. See Johnson v.
United States, 435 F.2d 1257 (4th Cir. 1971).
Under the share-by-share approach, a distribution that is not a dividend
can result in gain with respect to some shares within a class of stock while
other shares have unrecovered basis.
425
Dividend Equivalent Redemptions
•
•
•
•
The Proposed Regulations apply the basis recovery rules applicable to section
301 distributions to dividend equivalent redemptions and certain section 304
transactions.
– Current law does not provide clear guidance on what share’s basis will be
recovered in a dividend equivalent redemption.
The Proposed Regulations provide that a dividend equivalent redemption results
in a pro rata, share-by-share distribution to all shares of the “redeemed class”
held by the redeemed shareholder immediately before the redemption.
This approach can result in gain with respect to some shares within a class even
though other shares may have unrecovered basis.
Less Than All Shares in a Class Redeemed
– If less than all of the shares of a class of stock are redeemed, there is a
hypothetical recapitalization in which the redeemed shareholder is deemed
to exchange all of its shares in the class, including the redeemed shares, for
the actual number of shares held after the redemption.
– The Proposed Regulations clarify that the tracing rules in existing regulations
under section 358 apply to this deemed recapitalization (e.g., basis
remaining on the redeemed shares, if any, will shift to a portion of the
remaining shares).
426
Dividend Equivalent Redemptions
•
•
All Shares in a Class Redeemed
– The Proposed Regulations preclude the shifting of basis if all shares of
single class of stock held by a shareholder are redeemed in a dividend
equivalent redemption.
– Currently, Treas. Reg. § 1.302-2(c) permits the basis of the redeemed
shares to shift in certain circumstances.
– The Proposed Regulations preserve the tax consequences of
unrecovered basis by treating the amount of unrecovered basis as a
deferred loss that can be recognized when the conditions of sections
302(b)(1), (2), or (3) are satisfied or when all shares of the issuing
corporation become worthless.
If a redemption is treated as a sale or exchange, the Proposed Regulations
clarify that a shareholder that owns stock with different bases can decide
which shares to surrender.
– This is consistent with current law. See Treas. Reg. § 1.1012-1(c).
427
Dividend Equivalent Reorganizations
•
•
•
The Proposed Regulations provide for a different treatment for boot
received in a reorganization depending on whether the reorganization
exchange is the equivalent to a dividend.
The overall reorganization exchange must be taken into account in
determining whether a particular exchange is dividend equivalent. See,
e.g., Commissioner v. Clark, 489 U.S. 726 (1989).
The Proposed Regulations provide that a reorganization exchange
involving an exchange of one class of stock for stock and the exchange
of another class of stock for non-qualifying property must be considered
as an overall exchange rather than as two separate exchanges.
428
Dividend Equivalent Reorganizations
•
Dividend equivalent transactions. Dividend equivalent transactions will be treated similar to
dividend equivalent redemptions under the Proposed Regulations.
– The Proposed Regulations provide that shareholders cannot specify that boot is received with
respect to particular shares within a class of stock.
• Solely Boot
– The Proposed Regulations provide that section 302(d) applies (rather than section
356(a)(2)) to the extent a dividend equivalent transaction involves the exchange of
a class of stock solely for boot. Compare Rev. Rul. 74-515, where a transfer of
preferred stock of a target for cash is treated as an exchange under section 356.
» Note that the “boot within gain” limitation in section 356(a)(2) will not apply to
a dividend equivalent reorganization to the extent section 302(d) applies.
– A shareholder’s receipt solely of boot with respect to a class of stock in a
reorganization exchange is treated as received pro rata, on a share-by-share
basis, with respect to each share in the class. See Johnson v. United States, 435
F.2d 1257 (4th Cir. 1971).
– As a result of this rule, an exchange can result in gain recognition with respect to
some shares while other shares in the class have unrecovered basis.
• Boot and qualifying property
– If a shareholder receives both qualifying and nonqualifying property with respect to
shares within a particular class, the nonqualifying property must be allocated
proportionally among all of the surrendered shares within the class.
– Current regulations under section 358 permit designations of qualifying and
nonqualifying property to shares within the class.
– A taxpayer may specify the terms of the exchange between the classes of stock surrendered
if the shareholder receives more than one class of stock or surrenders one class of stock and
429
securities, provided the designation is economically reasonable.
Dividend Equivalent Reorganizations
•
Dividend equivalent transactions (cont’d)
– Treasury and the IRS declined to reverse Johnson and allow gain to be
determined in the aggregate with respect to a single class of stock.
– The Preamble to the Proposed Regulations states that Treasury and the
IRS believe such an aggregate approach would contradict the
fundamental principle that a share is a discrete unit of property and also
would compromise the principle that a reorganization is not an event that
justifies stock basis averaging.
430
Dividend Equivalent Reorganizations
Block 1 = $50 basis / $150 value
Block 2 = $150 basis / $50 value
P
$200
Sub 1
Sub 2
merger
Facts: P owns all of the stock of Sub 1 and Sub 2. P has 2 different blocks of stock in Sub 1: Block 1 with
a basis of $50 and a value of $150 and Block 2 with a basis of $150 and a value of $50. Neither Sub 1 nor
Sub 2 has any E&P. Sub 1 transfers all of its assets to Sub 2 in exchange for $200, which Sub 1
distributes to P in a transaction that qualifies as a “D” reorganization.
Result: The transaction will be treated as a dividend equivalent reorganization under section 356(a)(2).
Because there is no E&P, P recognizes gain on the exchange of Block 1 and Block 2 in an amount not to
exceed $200. The Proposed Regulations reject an aggregate approach to determining the amount of “gain”
that may be recognized under section 356(a)(2). The Proposed Regulations determine “gain” on a shareby-share basis. Therefore, P must recognize $100 on the exchange even though P has zero gain in all
shares of Sub 1.
Note that section 302(d) should not apply to the dividend equivalent reorganization under the Proposed
Regulations because Sub 2 is treated as issuing a nominal share to Sub 1, which Sub 1 transfers to P in
exchange for P’s Sub 1 stock.
431
Non-Dividend Equivalent Reorganizations
•
Non-dividend equivalent reorganizations.
– The Proposed Regulations provide that section 302(a) applies to the extent
shares are exchanged solely for boot.
• Under current law, section 356(a)(1) applies so that gain but not loss
may be recognized in the exchange. See Rev. Rul. 74-515.
• Under section 302(a), gain and loss may be recognized in the
exchange.
– A shareholder that owns stock with different bases can decide which shares
to exchange solely for boot (provided that the terms of the exchange are
economically reasonable).
– Note that section 356(a)(1) will still apply if shares are received for other
shares.
432
Other Issues Related to Redemptions
•
•
•
•
The Proposed Regulations do not affect the basis reduction rules of section 1059,
such that a redeeming shareholder must first reduce basis under section
1059(e)(1)(A) and then the Proposed Regulations would apply to the shareholder.
The Proposed Regulations clarify that the transferor in a section 304 transaction
will receive common stock of the acquirer in a deemed redemption under section
304.
The Proposed Regulations reserve with respect to issues relating to redeemed
shareholders that are flow-through entities pending further study and comment.
The Preamble to the Proposed Regulations provides that Treasury and the IRS
continue to study issues raised when a redeemed shareholder with a deferred
loss files a consolidated return.
433
Section 351 Exchanges
•
•
Current Regulations
– Current regulations under section 358 require tracing to determine basis in stock
received in a section 351 exchange only if (i) such exchange also qualifies as a
reorganization (e.g., there is a transfer of only stock) and (ii) no liabilities are
assumed in the exchange.
– For other section 351 exchanges, an aggregate approach applies to allocate
basis in transferred assets to shares received in the exchange.
Proposed Regulations
– The Proposed Regulations retain the aggregate approach if only property is
transferred in a section 351 exchange or if liabilities are assumed in the
exchange.
– The Proposed Regulations expand the scope of the tracing rules to section 351
exchanges involving a transfer of stock not otherwise qualifying as a
reorganization.
• An aggregate approach applies to other property transferred in the
exchange.
434
Capital Contributions and Certain Section 351 Exchanges
•
•
Current Regulations
– Current regulations require a deemed issuance and recapitalization for section
351 exchanges that qualify as a reorganization where value of property received
by the transferor was less than the value of the property transferred.
– For other capital contributions and section 351 exchanges, the basis of
transferred property appeared to be added to the basis of the existing stock held
by the shareholder (i.e., the basis in the transferred property was not preserved).
Proposed Regulations
– The Proposed Regulations apply the deemed issuance and recapitalization
approach to section 351 exchanges to preserve basis if insufficient shares, or no
shares at all, are actually issued in the exchange.
– The Proposed Regulations apply to capital contributions to which section 118
applies.
– The Proposed Regulations treat a capital contribution in effect as a section 351
exchange in which stock is deemed received followed by a deemed
recapitalization.
435
Example 1 – Section 351 Exchange
“D” Reorganization
(1)
Section 304 Transaction
(1)
P
Cash
Cash
Stock
(2)
P
Stock
Cash
Sub 1
Stock
(2)
Liquidation
Sub 1
Cash
Sub 2
Sub 1
Sub 2
Assets
Facts: P owns all of the stock of Sub 1 and Sub 2. P contributes cash to Sub 1 in exchange for Sub 1 stock. The parties
engage in one of two alternative transactions: (i) Sub 1 transfers all of its assets to Sub 2 in exchange for cash, which Sub 1
distributes to P in a transaction that qualifies as a “D” reorganization, or (ii) Sub 2 acquires Sub 1 stock from P in exchange
for cash in a transaction governed by section 304 (i.e., the transaction is treated as if P contributed the Sub 1 stock to Sub 2
in exchange for Sub 2 stock in a section 351 transaction, and Sub 2 redeemed that stock in exchange for the consideration
used in the transaction).
Result—Current Regulations: In the “D” reorganization under alternative 1, tracing is required to determine P’s basis in each
separate block of its Sub 1 stock. In the section 304 transaction under alternative 2, the tracing rules do not apply, and the
bases of P’s multiple blocks of Sub 1 stock appear to be blended and transferred to the stock issued by Sub 2. See Rev. Rul.
85-164, 1985-2 C.B. 117.
Change in Result—Proposed Regulations: Under alternative 2, the tracing rules would apply because such rules are
expanded to apply to section 351 exchanges involving a transfer of stock not otherwise qualifying as a reorganization
(assuming no liabilities are assumed in the exchange).
436
Example 2 – Capital Contribution
“D” Reorganization
(1)
Section 304 Transaction
(1)
P
Cash
(2)
P
Cash
Cash
Sub 1
Stock
(2)
Liquidation
Sub 1
Cash
Sub 2
Sub 1
Sub 2
Assets
Facts: P owns all of the stock of Sub 1 and Sub 2. P contributes cash to Sub 1, but receives no stock or other
property in exchange. The parties engage in one of two alternative transactions: (i) Sub 1 transfers all of its assets
to Sub 2 in exchange for cash, which Sub 1 distributes to P in a transaction that qualifies as a “D” reorganization,
or (ii) Sub 2 acquires stock in Sub 1 from P in exchange for cash in a transaction governed by section 304 (i.e., the
transaction is treated as if P contributed the Sub 1 stock to Sub 2 in exchange for Sub 2 stock in a section 351
transaction, and Sub 2 redeemed that stock in exchange for the consideration used in the transaction).
Result—Current Regulations: Under both alternatives, the cash is added to the basis of the existing Sub 1 stock
held by P.
Change in Result—Proposed Regulations: In both alternatives, there would be a deemed issuance of Sub 1 stock
and recapitalization of Sub 1, as the proposed regulations effectively treat P’s capital contribution as a section 351
exchange in which Sub 1 stock is deemed received followed by a deemed recapitalization. As in Example 1 above,
the tracing rules would apply to both the subsequent “D” reorganization and section 304 transaction in alternatives
1 and 2, respectively.
437
Insolvency and Liability Issues
438
Liquidations and Upstream Mergers
439
In General
•
•
•
Section 332
• A liquidation is not taxable to a corporate shareholder if the corporate shareholder owns at
least 80 percent (by vote and value) of the stock of the liquidating subsidiary. Under
section 337, the liquidating corporation does not recognize gain or loss.
• If the requirements of section 332 are not satisfied, a liquidation is generally taxable to the
liquidating corporation and its shareholders under sections 331 and 336.
Treas. Reg. §1.332-2(b)
• Section 332 applies only where the parent receives at least partial payment for its stock.
• This requirement has been held to apply to section 331 liquidations as well. See Braddock
Land Co. v. Commissioner, 75 T.C. 324 (1980); Jordan v. Commissioner, 11 T.C. 914 (1948).
• Section 332 requires a distribution in cancellation or redemption of all of the stock of the
liquidating company. Thus, a distribution that is sufficient to redeem only the company’s
preferred stock is not a liquidation. See Commissioner v. Spaulding Bakeries, Inc., 252
F.2d 693 (2d Cir. 1958); H.K. Porter Co. v. Commissioner, 87 T.C. 689 (1986).
Section 332 does not apply when a parent liquidates an insolvent subsidiary, and the parent
can recognize loss on its subsidiary stock under section 165(g). Iron Fireman Mfg. Co. v.
Commissioner, 5 T.C. 452 (1945); H.G. Hill Stores, Inc. v. Commissioner, 44 B.T.A. 1182 (1941);
Rev. Rul. 70-489, 1970-2 C.B. 53, amplifying Rev. Rul. 59-296, 1959-2 C.B. 87.
440
In General
•
•
Proposed No Net Value Regulations
• The proposed regulations retain the partial payment rule of the current
regulations and provide new rules with respect to liquidations involving
multiple classes of stock. Prop. Treas. Reg. §1.332-2(b).
• If partial payment is not received for every class of stock but is received for at
least one class, the proposed regulations look separately to each class of
stock to determine the tax consequences.
• With respect to those classes of stock for which no payment is received, the
proposed regulations refer to section 165(g) worthless stock deductions.
• With respect to those classes of stock for which payment is received, the
proposed regulations refer to section 368(a)(1) regarding a potential
reorganization or to section 331 if the distribution does not qualify as a
reorganization.
The IRS also takes the position that an upstream merger cannot qualify as a tax-free
“A” reorganization. Rev. Rul. 70-489. But see Norman Scott, Inc. v. Commissioner, 48
T.C. 598 (1967) (noting that unlike the requirement for a liquidation that there be a
payment in cancellation or redemption of stock, there is no such requirement for a
statutory merger to qualify under section 368(a)(1)(A)).
441
Liquidations vs. Upstream Merger
P
$160 Debt
Liquidation
S
Facts: P owns all of the stock of S. S has assets worth $100 and is indebted to P in the
amount of $150. S adopts a plan of liquidation, and distributes all of its assets to P.
Result: The transaction does not qualify as a section 332 liquidation under either current law
or the proposed regulations. Instead, S should be treated as transferring its $100 of assets
in satisfaction of its $150 debt to P, and P should be entitled to a worthless stock deduction
of $100 and a bad debt deduction of $50.
What if S merged upstream into P? See Norman Scott, Inc. v. Commissioner, 48 T.C. 598
(1967). But see Rev. Rul. 70-489, 1970-2 C.B. 53, amplifying Rev. Rul. 59-296, 1959-2 C.B.
87. Could the liquidation be treated as an upstream “C” reorganization?
442
Liquidation with No Payment on Common Stock
P
Preferred
Stock
Common
Stock
Liquidation
S
Facts: P owns all of the common and preferred stock of S. The preferred stock has a liquidation
preference of $200. S has assets worth $100 and no liabilities. S adopts a plan of liquidation, and
distributes all of its assets to P.
Result: The transaction does not qualify as a section 332 liquidation under either current law or the
proposed regulations, because P did not receive any payment on its common stock. See
Commissioner v. Spaulding Bakeries, Inc., 252 F.2d 693 (2d Cir. 1958); H.K. Porter Co. v.
Commissioner, 87 T.C. 689 (1986); Prop. Treas. Reg. §1.332-2(b), (e), ex. 2. Thus, P is entitled to a
worthless stock deduction for its common stock under section 165(g). Under the proposed
regulations, the transaction may qualify as a reorganization with respect to P’s preferred stock,
since it received partial payment on that. If the transaction does not qualify as a reorganization,
then P would recognize gain or loss on the preferred stock under section 331.
443
Deemed Liquidation
P
$160
Debt
S
Convert to LLC
Facts: P owns all of the stock of S. S has assets worth $100 and is indebted to P in the
amount of $160. S converts into a single-member LLC pursuant to state law.
Result: The conversion into a single-member LLC results in a deemed liquidation under Treas.
Reg. §301.7701-3(g)(1)(iii). However, because S is insolvent, the deemed liquidation does not
qualify as a section 332 liquidation under either current law or the proposed regulations. The
deemed liquidation is considered an identifiable event that fixes the loss with respect to the
stock for purposes of a worthless stock deduction under section 165(g). Rev. Rul. 2003-125,
2003-52 I.R.B. 1 (reversing the result in F.S.A. 200226004 (Mar. 7, 2002)). Thus, P should be
entitled to worthless stock and bad debt deductions, even though P continues the business
formerly conducted by S. Id.; see also Rev. Rul. 70-489, 1970-2 C.B. 53, amplifying Rev. Rul.
444
59-296, 1959-2 C.B. 87.
Revenue Ruling 68-602
P
$160 Debt
(1)
$160
Debt
(2)
Liquidation
S
Facts: P owns all of the stock of S. S has assets worth $100 and is indebted to P in the
amount of $160. P cancels the $160 debt by contributing it to S’s capital. S then adopts a
plan of liquidation, and distributes all of its assets to P.
Result: In Rev. Rul. 68-602, 1968-2 C.B. 135, the IRS ruled that the debt cancellation was an
integral part of the liquidation and had no independent significance other than to secure the
tax benefits of S’s net operating loss carryover. Therefore, the IRS considered the
cancellation transitory and disregarded it. As a result, the liquidation did not qualify as a
section 332 liquidation.
445
Revenue Ruling 78-330
(1) S1 Debt
P
(2) Merger
S1
S2
Liabilities > Asset Basis
Facts: P owns all of the stock of S1 and S2. P gratuitously cancels the debt owed by
S1 to P so that the basis of S1’s assets exceed its liabilities. S1 merges with and into
S2.
Result: In Rev. Rul. 78-330, 1978-2 C.B. 147, the IRS found that P’s cancellation of
S1’s debt had independent economic significance because it resulted in a genuine
alteration of a previous bona fide business relationship. Consequently, P’s cancellation
of S1’s debt was respected.
446
Revenue Ruling 68-602 – Variation
P
$200
Debt
(1)
$200
Debt
(2)
Liquidation
S
Bank
$100 Debt
Facts: P owns all of the stock of S. S has assets worth $150 and is indebted to P in the
amount of $200 and to the bank in the amount of $100. P cancels the $200 debt by
contributing it to S’s capital. S then adopts a plan of liquidation, repaying the bank debt in full
and distributing the remaining assets (i.e., $50) to P.
Result: Absent the debt cancellation, 1/3 of S’s assets (i.e., $50) would have gone to the
bank, and 2/3 (i.e., $100) would have gone to P. Arguably, in these circumstances, the debt
cancellation has independent economic significance and Rev. Rul. 78-330, not Rev. Rul. 68602, should apply. Query whether the cancellation has independent economic significance
only to the extent of $150, the value of S’s assets available to repay its outstanding debt.
447
CCA 200818005
P
P
Stock of S2
Public
<20%
>80%
S2
S3
•
•
•
Public
S1
<20%
Note
S1
X
>80%
S2
S3
P is the common parent of a consolidated group. P owns all of the stock of S1. S1 owns x percent (at least 80 percent)
of the stock of S2. The public owns the remaining shares of S2. S2 owns all the stock of S3. S1 was the lender on an
intercompany indebtedness with S3. Prior to the transaction, S3’s liabilities exceed the fair market value of its assets and
S2’s liabilities exceed the fair market value of its assets.
On Date 1, as a condition to a pending sale, S1 forgave a portion of the indebtedness it had with S3. Immediately after
this cancellation, the net value of S3’s assets exceeded its liabilities and the net value of S2’s assets (including the stock
of S3) exceed S2’s liabilities. On Date 2, S1 sold all of its stock in S2 to purchaser X, an unrelated third party. On Date
3, P and X make a section 338(h)(10) election with respect to the sale of the stock of S2 and the deemed sale of the
stock of S3.
The National Office determined that the deemed liquidation of S2 pursuant to the section 338(h)(10) election would not
qualify under section 332. The National Office determined that the cancellation of the indebtedness between S1 and S3
would be disregarded as in Rev. Rul. 68-602. Because the cancellation of indebtedness would be disregarded, S1 would
not be treated as receiving any net value for its stock interest in S2 and therefore the liquidation would not qualify under
section 332. The CCA stated that the fact that there may be economic significance in the cancellation of indebtedness
does not alter the result. The CCA distinguished Rev. Rul. 78-330 because there was no liquidation in the transaction at 448
issue in that ruling.
Rev. Rul. 2003-125
449
Rev. Rul. 2003-125
Situation 1
Situation 2
P
P checks
the box
for FS
P
Tangibles - $800K
Intangibles - $250K
Liabilities - $1,000K
FS
P checks
the box
for FS
Tangibles - $800K
Intangibles - $150K
Liabilities - $1,000K
FS
Situation 1: Corporation P owns 100 percent of the stock of FS, an entity organized under the laws of Country X that operates
a manufacturing business. FS is an “eligible entity” under Treas. Reg. § 301.7701-3(a) and, prior to July 1, 2003, FS is treated
as a corporation for federal tax purposes (under section 7701(a)(3)). On December 31, 2002, the stock of FS was not
worthless. On July 1, 2003, P files a check-the-box election for FS, changing the classification of FS from a corporation to a
disregarded entity for federal tax purposes effective as of that date. At the close of the day immediately before the effective
date of the election, the fair market value of FS's assets, including intangible assets such as goodwill and going concern value,
exceeds the sum of its liabilities. However, at that time, the fair market value of FS's assets, excluding intangible assets such
as goodwill and going concern value, does not exceed the sum of its liabilities. After the change in entity classification election
is effective, FS continues its manufacturing operations.
Situation 2: Same facts as in Situation 1, except that at the close of the day immediately before the effective date of the
election, the fair market value of FS's assets, including intangible assets such as goodwill and going concern value, does not
exceed the sum of its liabilities.
450
Rev. Rul. 2003-125 (cont’d)
Holding: When an election is made to change the classification of an entity from a corporation to a
disregarded entity, the shareholder of such entity is allowed a worthless security deduction under section
165(g) if the fair market value of the assets of the entity, including intangible assets such as goodwill and
going concern value, does not exceed the entity's liabilities such that on the deemed liquidation of the
entity the shareholder receives no payment on its stock.
Situation 1: Because the aggregate value of FS’s tangible and intangible assets ($1,050,000) exceeds
FS’s liabilities ($1,000,000) immediately before the effective date of the P’s check-the-box election for FS,
the stock of FS is not worthless on that date. Accordingly, because P receives at least partial payment on
its FS stock in the deemed liquidation of FS. As a result, section 332 applies to the deemed liquidation
and no loss is allowable to P.
Situation 2: Because the aggregate value of FS’s tangible and intangible assets ($950,000) does not
exceed FS’s liabilities ($1,000,000) immediately before the effective date of the P’s check-the-box
election for FS, the stock of FS is worthless. Accordingly, section 332 does not apply because P does not
receive any payment on its FS stock in the deemed liquidation of FS. The deemed liquidation is an
identifiable event that fixes P's loss with respect to the FS stock and, therefore, P is allowed a worthless
security deduction under section 165(g) for its 2003 tax year. Also, depending on the facts, FS's
creditors, including P, may be entitled to a deduction for a partially or wholly worthless debt under
sections 165 or 166.
451
Rev. Rul. 2003-125 (cont’d)
Rev. Rul. 2003-125 clarifies that:
• Where a worthless stock deduction is claimed upon the liquidation of a
corporation and the stock did not become worthless in a prior tax year, the
standard for determining worthlessness is whether the shareholders receive
payment for their stock. See H.K. Porter Co. v. Commissioner, 87 T.C. 689 (1986).
• A shareholder receives no payment for its stock in a liquidation if, at the time of
the liquidation, the fair market value of the corporation's assets is less than the
corporation's liabilities.
• The value of intangible assets, including goodwill and going concern, is included
in determining the fair market value of the entity’s assets immediately before the
deemed liquidation.
• Certain facts, such as (i) the continuation of the corporation's business after a
liquidation without a substantial infusion of capital, and (ii) the revenues of that
business following the liquidation exceed the amount required to service debt that
existed immediately prior to the liquidation, may suggest that at the time of
liquidation the fair market value of the liquidating entity's assets, including
goodwill and going concern value, exceeded the sum of its liabilities.
452
Rev. Rul. 2003-125 (cont’d)
Rev. Rul. 2003-125 clarifies that (cont’d):
• Nevertheless, depending on the facts, the parent could claim a bad debt
deduction and a worthless stock deduction where its wholly owned subsidiary
owes a bona fide indebtedness to its parent corporation that exceeds the fair
market value of its assets and the subsidiary transfers all of its assets to the
parent in partial satisfaction of its indebtedness. This may be true even
where the parent continues the business formerly conducted by the
subsidiary. See Rev. Rul. 70-489, 1970-2 C.B. 53, amplifying Rev. Rul. 59296, 1959-2 C.B. 87.
• If a shareholder receives no payment for its stock in a liquidation of the
corporation, neither section 331 nor section 332 applies to the liquidation.
• The fact that a shareholder receives no payment for its stock in a liquidation
of the corporation demonstrates that such shareholder's stock is worthless.
• The liquidation is an identifiable event that fixes the loss with respect to the
stock for purposes of a worthless stock deduction under section 165(g).
453
GLAM 2011-003
454
GLAM 2011-003
X
$110 Liability
(Situation 1)
U
80%
Y
$110 Liability
(Situation 2)
20%
Z
Assets: $100
Liabilities: $110
AB of Assets: $120
Situation 1: X, a U.S. Corporation, owns 100 percent of Y, a foreign corporation. X also owns 80 percent of Z, a foreign
corporation. Y owns the remaining 20-percent interest in Z. X’s ownership of Z satisfies the 80-percent vote and value test
of section 1504(a)(2).
The fair market value of Z’s assets is $100, and Z has an adjusted basis in its assets of $120. Z has $110 of liabilities, all of
which are owed to X. The liabilities are not securities within the meaning of section 165(g)(2), and, at the time they were
incurred, constituted genuine indebtedness that Z expected to repay in full. X’s adjusted basis in its Z stock is $100, and Y’s
adjusted basis in its Z stock is $30.
Z is an eligible entity for purposes of the entity classification rules of Treas. Reg. § 301.7701-3. Z properly elects to change
its classification from a corporation to a partnership under Treas. Reg. § 301.7701-3(c)(1)(i).
Situation 2: The facts are the same as in Situation 1, except that all of Z’s liabilities are owed to U, an unrelated foreign
corporation.
455
GLAM 2011-003
Issue 1 – Is a shareholder of an insolvent corporation that elects to be treated as a
partnership allowed a worthless security deduction under section 165(g)?
• Under Treas. Reg. § 301.7701-3(g)(1)(ii), Z is deemed to distribute its assets and
liabilities to X and Y in liquidation of Z.
– Because the FMV of Z’s assets ($100) is less than its liabilities ($110), Z’s
shareholders do not receive payment for their stock.
– Under section 165(g), in Situations 1 and 2, X and Y are entitled to worthless
security deductions of $100 and $30, respectively (their basis in the Z stock),
assuming they satisfy the other requirements under section 165(g).
• The GLAM cited Rev. Rul. 2003-125, which reached the same conclusion in the
context of an insolvent foreign corporation that elected to be treated as a disregarded
entity.
456
GLAM 2011-003
Issue 2 – How are liabilities treated for federal tax purposes in transactions that are deemed to occur under
Treas. Reg. § 301.7701-3(g)(1)(ii)?
•
The distribution of Z’s liabilities followed by the contribution of the liabilities to the new partnership is not a
significant modification of the liabilities for section 1001 purposes.
– In Situations 1 and 2, the partnership acquires substantially all of Z's assets and liabilities – Z is
deemed to distribute its assets and liabilities to X and Y, who contribute them to the partnership.
– The change in entity classification from a corporation to a partnership is not likely to result in a
change in payment expectations.
– No significant alteration occurs as a result of the deemed liquidation in Situations 1 and 2 – the
election by Z does not affect the liabilities of Z with respect to its creditors under local law.
•
The tax consequences of Z’s debt with respect to its partnership election are the same as if Z actually
liquidates, shareholders of Z immediately form a new partnership, and Z's debt survives the liquidation
and becomes an obligation of the partnership.
•
The liabilities are not treated under section 1001 as exchanged for new debt of the partnership as a
result of Z’s election.
Issue 3 – Is a creditor of the insolvent corporation entitled to a bad debt deduction under section 166?
•
Because the liabilities are treated as surviving Z’s deemed liquidation and as being contributed to the
newly formed partnership, Z’s creditors in Situations 1 (X) and 2 (U) are not entitled to a bad debt
deduction under section 166.
•
Cf. Rev. Rul. 2003-125, which indicated that the foreign subsidiary’s creditors, including its parent
corporation, may be entitled to a section 166 bad debt deduction.
457
GLAM 2011-003
Issues 4 and 5 – What is the newly-formed partnership’s basis in the assets deemed contributed to it, and what is
the basis of each partner’s interest in the new partnership?
•
Z is deemed to distribute its assets and liabilities to X and Y in liquidation. Because Z is insolvent, sections
331 or 332 are inapplicable, and the basis of the assets is determined under section 1012 (i.e., the cost of
the assets).
– In Situations 1 and 2, because X is deemed to assume liabilities of $88 in the deemed liquidation of Z
(80 percent of $110), X is deemed to receive assets with a basis of $88, and because Y is deemed to
assume liabilities of $22 (20 percent of $110), Y is deemed to receive assets with a basis of $22.
•
In Situations 1 and 2, X and Y are treated as contributing assets and liabilities, pro rata, to the newly formed
partnership.
– Under section 752(c), the amount of the liabilities treated as assumed by the partnership is limited to
the FMV of the assets at the time of the deemed contribution ($100).
• Accordingly, X is deemed to contribute assets with a basis to X of $88 and liabilities of $80, and Y
is deemed to contribute assets with a basis to Y of $22 and liabilities of $20.
– Under section 721, no gain or loss is recognized to the partnership or X and Y on the deemed
contribution.
– Under section 723, the partnership's basis in the assets deemed contributed is $110 (the AB of the
assets to X and Y).
– Cf. Prop. Treas. Reg. § 1.351-1(a)(1)(iii)(A) and (B), which would require a surrender and receipt of net
value, respectively, in a section 351 transaction.
• The GLAM takes the position that section 721 applies regardless of whether net value is
transferred, contrary to the principles in the proposed no net value regulations.
• See Preamble to Proposed No Net Value Regulations (“The IRS and the Treasury Department
recognize that the principles in the proposed rules under section 351 may be applied by analogy
to other Code sections that are somewhat parallel in scope and effect, such as section 721 . . . .”).
458
GLAM 2011-003
Issues 4 and 5 (cont’d)
•
In Situation 1, X’s basis in its partnership interest is $108 and Y’s basis in its partnership interest
is $2.
– The partnership is deemed to assume $100 of the liabilities contributed by X and Y ($80 and
$20, respectively), but because X bears the economic risk of loss for the liability, X's share of
the liability is increased by $100.
– X's basis in its partnership interest is $108 (adjusted basis in assets deemed contributed
($88) under section 722 increased by the deemed contribution of money ($20) under section
752(a)), and Y's basis in its partnership interest is $2 (adjusted basis in assets deemed
contributed ($22) under section 722 decreased by a deemed distribution of $20 under
section 752(b)).
•
In Situation 2, X’s basis in its partnership interest is $88 and Y’s basis in its partnership interest is
$22.
– Because no partner bears the economic risk of loss with respect to the liabilities contributed
to the partnership, the liability contributed is nonrecourse.
– There is no net change in the partners' share of liabilities and, thus, no deemed contributions
or distributions under section 752(a) and (b) (partnership assumes $100 of liabilities deemed
contributed by X and Y ($80 and $20, respectively), and X and Y's share of the liability
increases by $80 and $20, respectively).
– X's basis in its partnership interest is $88 (adjusted basis in assets deemed contributed ($88)
under section 722) and Y's basis in its partnership interest is $22 (adjusted basis in assets
deemed contributed ($22) under section 722).
459
GLAM 2012-006
460
GLAM 2012-006: Base Facts
Asset 1
AB: $10
FMV: $10
S1 Stock
AB: $5
FMV: $5
(1)
$10
P
(2)
Unrelated
Party
Unrelated
Party
P
S Stock
$5
Unwanted
Asset
$10 Debt
to P
S1
S
Wanted Intangible
AB: $0
FMV: $15
$5
S1
S
Unwanted Asset
AB: $5
FMV: $5
Facts: P is the common parent of a consolidated group that owns Asset 1 (AB: $10; FMV: $10) and all of the stock of S1
(AB: $5; FMV: $5). On January 1 of Year 1, P purchases all of the stock of S, a domestic corporation, for $10 from an
unrelated party. At the time of the purchase, S has two assets, Wanted Intangible (amortizable under section 197) (AB: $0;
FMV: $15) and Unwanted Asset (AB: $5; FMV: $5). S also has outstanding debt of $10 owed to P. On February 1 of Year
1, S sells Unwanted Asset to an unrelated person for $5 and distributes the proceeds to P.
Analysis:
•
P’s purchase of S stock creates an initial basis of $10 in the S stock.
•
S recognizes no gain or loss on the sale of Unwanted Asset. S’s distribution of the $5 proceeds to P is a distribution
under section 301 that is treated as an intercompany distribution. Thus, the $5 is not included in P’s income under Treas.
Reg. § 1.1502-13(f)(2)(ii) , but results in a $5 reduction to P’s basis in its S stock under Treas. Reg. § 1.1502-32(b)(2)(iv).
461
GLAM 2012-006: Situation 1
P
Deemed
Liquidation
$10 Debt
to P
S1
S
Wanted Intangible
AB: $0
FMV: $15
Facts: On December 31 of Year 1, when the FMV of Wanted Intangible is $15, S elects to be treated as a
disregarded entity. On the consolidated return for Year 1, P claims a worthless stock deduction with respect
to its equity ownership in S.
Analysis:
•
The election by S to be a disregarded entity is treated as a distribution of all its assets (the Wanted
Intangible) and liabilities to P in liquidation of S.
•
At the time of the election, the FMV of Wanted Intangible, $15, exceeds the amount of S’s liabilities,
$10. Accordingly, under Rev. Rul. 2003-125 and section 332, no gain or loss is recognized by P on the
receipt of S’s property in cancellation of its S stock.
462
•
P’s basis in its S stock is eliminated, and P may not claim a worthless stock deduction.
GLAM 2012-006: Situation 2
P
Wanted
Intangible
S1
$10 Debt
to P
S
Wanted Intangible
AB: $0
FMV: $15
Facts: On May 14 of Year 1, when the FMV of Wanted Intangible is $15, S distributes Wanted Intangible to P. On
December 31 of Year 1, S elects to be treated as a disregarded entity. On the consolidated return for Year 1, P
claims a worthless stock deduction with respect to its equity ownership in S.
Analysis:
•
Under Rev. Rul. 61-191, 1961-2 C.B. 251, S is treated at the time of the distribution of Wanted Intangible to P
as having distributed such asset in complete liquidation.
•
The distribution of Wanted Intangible is deemed to fully satisfy the $10 liability owed to P and to be in
cancellation of S’s stock. Under section 332, no gain or loss is recognized to P on the receipt of S’s property in
cancellation of its S stock. Under Treas. Reg. § 1.332-7, S recognizes no gain or loss on the transfer. P’s
basis in S’s stock is eliminated and S is treated as ceasing to exist. See Treas. Reg. § 1.6012-2(a)(2).
463
•
The later election by S to be treated as a disregarded entity has no federal income tax consequences.
GLAM 2012-006: Situation 3
P
S1
Cancellation
of $10 Debt
owed by S
Wanted
Intangible
S
Wanted Intangible
AB: $0
FMV: $15
Facts: On May 14 of Year 2, when the FMV of Wanted Intangible is $15, S transfers Wanted Intangible to S1 in
exchange for no consideration. P also cancels S’s liability. The transfer by S is not disclosed on the group’s
consolidated return. On December 31 of Year 2, S elects to be treated as a disregarded entity. On the
consolidated return for Year 2, P claims a worthless stock deduction with respect to its equity ownership in S.
Analysis:
•
S’s transfer of Wanted Intangible is treated as a reorganization under section 368(a)(1)(D).
•
The $10 liability S owed to P is treated as if it were cancelled before the reorganization, with the amount of the
extinguished liability, $10, treated as contributed by P to S. See Rev. Rul. 78-330, 1978-2 C.B. 47.
– The cancellation of S’s $10 debt is treated by S as if it satisfied the indebtedness for $10 under section
108(e)(6), and does not result in the recognition of income.
464
– P’s $5 basis in its S stock is increased by $10 to $15 as a result of the contribution to S.
GLAM 2012-006: Situation 3 (cont’d)
P
Cancellation
of $10 Debt
S1
Wanted
Intangible
S
Wanted Intangible
AB: $0
FMV: $15
Analysis (cont’d):
•
Under Treas. Reg. § 1.368-2(l)(2), S is treated as transferring Wanted Intangible to S1 in exchange for $15 of deemed S1
stock and distributing the deemed S1 stock to P in exchange for its S stock.
– P’s basis in the S1 stock deemed received is $15, the same basis of the S stock exchanged in the reorganization.
See section 358(a)(1); Treas. Reg. § 1.358-2(a)(2)(i).
– Under Treas. Reg. § 1.358-2T(a)(2)(iii), P is then treated as surrendering all of its shares in S1, including the S1
shares it held immediately before the transaction and the S1 shares it is deemed to receive, in a reorganization
under section 368(a)(1)(E), in exchange for the S1 shares P actually holds immediately after the transaction.
– Under section 354, P does not recognize gain or loss on the deemed exchange of its S stock for S1 stock, and the
S stock is treated as having been cancelled.
•
After the completion of the transactions, S ceases to exist for federal income tax purposes. See Rev. Rul. 61-191; Treas.
Reg. § 1.6012-2(a)(2). The subsequent election by S to be treated as a disregarded entity has no federal income tax
consequences.
465
GLAM 2012-006: Situation 4
(3)
$15
(1)
P
P
Asset 1
Unrelated
Party
S Stock
(2)
S1
Wanted
Intangible
S
S1
S
Facts: On May 1 of Year 1, P contributes Asset 1 to S. On January 1 of Year 2, S transfers Wanted Intangible to S1 in exchange
for no consideration. The transfer is not disclosed on the group’s consolidated return. On January 1 of Year 7, P sells S to an
unrelated party for $15. The group’s consolidated returns do not include any amortization deduction for S1 with respect to Wanted
Intangible or any income for S with respect to the transfer of Wanted Intangible.
Analysis:
•
P’s contribution of Asset 1 to S results in a contribution to the capital of S. P’s basis in S is increased by $10 to $15.
•
S’s transfer of Wanted Intangible to S1 is not considered an arm’s length transaction. Under Rev. Rul. 69-630, 1969-2 C.B.
112, and section 482, Wanted Intangible is treated as distributed by S to P and then contributed by P to S1.
– The deemed distribution by S to P requires S to recognize $15 of gain under section 311(b), which is not taken into
account at the time of the distribution under Treas. Reg. § 1.1502-13(b)(1). Under Treas. Reg. § 1.1502-32(b)(3)(i), S’s
intercompany gain does not result in an increase to P’s basis in its S stock prior to the time the gain is taken into
account.
– The $15 distribution received by P is not included in P’s gross income under Treas. Reg. § 1.1502-13(f)(2)(ii), but
results in a $15 decrease in P’s basis in its S stock under Treas. Reg. § 1.1502-32(b)(2)(iv).
– P ends up with a zero basis in its S stock ($10 AB reduced by the $5 distribution to P following the sale of Unwanted
Asset, increased by $10 due to P's contribution of Asset 1 to S, and reduced by $15, the FMV of Wanted Intangible
466
deemed distributed to P).
GLAM 2012-006: Situation 4 (cont’d)
(3)
$15
(1)
P
P
Asset 1
Unrelated
Party
S Stock
(2)
S1
Wanted
Intangible
S
S1
S
Analysis (cont’d):
•
Under section 301(d), P takes a $15 basis (FMV) in Wanted Intangible.
•
Under section 362(a), S1 takes a $15 basis in Wanted Intangible on P's deemed contribution. P's $5
basis in its S1 stock is increased by $15 to $20.
•
Under Treas. Reg. § 1.1502-13 and section 197, when S1 receives Wanted Intangible with a FMV basis
of $15 from P in the deemed contribution, S1 can amortize its basis in Wanted Intangible over its 15year amortizable life.
– As S1 claims a deduction, S includes in income a corresponding amount of its $15 intercompany
item resulting from its section 311(b) gain.
467
GLAM 2012-006: Situation 4 (cont’d)
(3)
$15
(1)
P
P
Asset 1
Unrelated
Party
S Stock
(2)
S1
Wanted
Intangible
S
S1
S
Analysis (cont’d):
•
When S ceases to be a member of the P group in Year 7, the portion of S's intercompany item resulting from its section 311(b) gain
that has not been taken into account is accelerated under Treas. Reg. § 1.1502-13(d).
•
Because adjustments to basis are necessary in determining either the correct basis of a member or gain or loss on a transaction in
an open year, S's unreported intercompany items for Years 2 through 7 relating to its section 311(b) gain should be taken into
account in determining P's basis in its S stock and consequently P's gain or loss on the sale of S in Year 7. See Barenholtz v.
United States, 784 F.2d 375 (Fed. Cir. 1986); Rev. Rul. 81-88, 1981-1 C.B. 585. Also, S1's unclaimed depreciation deductions for
Years 2 through 7 should be taken into account in determining P's basis in its S1 stock in Year 7.
•
S1 is treated as if it deducted $1 each year between Years 2 and 7 and S is treated as if it included in income $1 of its intercompany
item resulting from its section 311(b) gain each year between Years 2 and 6, and the remainder of its intercompany item in Year 7.
– Consequently – (i) S1’s $15 basis in Wanted Intangible on January 1 of Year 7 is reduced by S1’s unclaimed amortization for
Years 2 through 7 ($5) to $10; (ii) P’s $20 basis in its S1 stock on January 1 of Year 7 is reduced by S1’s unclaimed
amortization for Years 2 through 7 ($5) resulting in a basis of $15; and (iii) under Treas. Reg. § 1.1502-32(b)(2)(i), P’s basis in
its S stock is increased by $1 each year for Years 2 through 7 ($5), resulting in a total basis in S in Year 7 of $5.
– Upon P’s sale of its S stock, S will cease to be a member of the consolidated group and must take into account the $10 of
gain under section 311(b) that remains after taking into account the amounts that should have been included in prior years.
468
Final Hot Stock
Regulations
469
Section 355(a)(3)(B) “Hot Stock”
•
•
•
Section 355(a)(3)(B) provides that stock of Controlled acquired by Distributing in a
transaction during the 5-year pre-distribution period in which gain or loss is
recognized (“hot stock”) is treated as boot.
– Prior regulations provided that stock of Controlled acquired in a taxable
transaction within the 5-year pre-distribution period shall not be treated as
stock of Controlled for purposes of section 355(a)(1)(A).
On December 12, 2008, Treasury and the IRS issued temporary regulations
modifying the application of the hot stock rule to be consistent with the ATB rules
of section 355(b)(3).
On October 19, 2011, Treasury and the IRS finalized the temporary regulations
without substantive change.
• The final regulations apply to distributions occurring after October 20, 2011.
• In issuing the final regulations, Treasury and the IRS noted that they continue
to study the interrelationship between section 355(a)(3)(B) and section
355(b).
• Treasury and the IRS also stated that no inference regarding the content of
future section 355(b) guidance should be drawn from the final regulations,
and that further guidance may be issued under section 355(a)(3)(B) in
connection with future section 355(b) guidance if it is necessary to harmonize
the two provisions.
470
“Hot Stock” Example – Prior Law
100% C stock
D
ATB 1
ATB 2
Sh.
Cash
C
ATB 2
C
Facts: D acquires all of the stock of C in Year 1 in a taxable acquisition. In Year 4, D distributes the
stock of C to its shareholders.
Result: The acquisition in Year 1 would be treated as an asset acquisition because C becomes a
member of the DSAG. The transaction would violate section 355(b)(2)(C). The “hot stock” rule is
not relevant because the distribution is a taxable distribution rather than a tax-free distribution under
section 355.
Alternative 1: D has engaged in ATB 1 and ATB 2 for more than five years and the acquisition of C
stock is treated as a business expansion of ATB 2. D drops its ATB 2 business into C before the
spin-off. The transaction would not violate section 355(b)(2)(C). Does the hot stock rule apply?
Alternative 2: C is a member of the DSAG at the time D acquires the remaining C stock in Year 1.
The transaction would not violate section 355(b)(2)(D). Does the hot stock rule apply?
471
“Hot Stock” Example – Prior Law
Year 8
Year 6
Additional C Stock
D
X
368(c)
stock
C
Facts: For more than 5 years, D has owned stock in C constituting control for section 368(c)
purposes (“section 368(c) stock”) but not control for section 1504(a)(2) purposes (“section
1504(a)(2) stock”). In Year 6, D purchases additional C stock, although not enough to
constitute section 1504(a)(2) stock in the aggregate. In Year 8, D distributes the stock of C to
its shareholders.
Result: The additional C stock purchased in Year 6 would be “hot stock.” See prior Treas.
Reg. § 1.355-2(g)(2).
Alternative 1: What if D acquired section 1504(a)(2) stock in C (and, as a result, C became a
member of the DSAG) in connection with the acquisition in Year 6? The additional C stock
purchased would still be “hot stock.”
472
Final Regulations – Section 355(a)(3)(B) “Hot Stock”
•
•
•
•
•
The final regulations retain the hot stock rule of section 355(a)(3)(B), but expand the
scope of the exceptions to the rule set forth in the prior “hot stock” regulations of
Treas. Reg. § 1.355-2(g)(2).
The “hot stock” rule in the final regulations applies for purposes of section
355(a)(1)(A), section 355(c), and as much of section 356 as relates to section 355.
– Section 355(c) provides that Distributing recognizes gain on distributions of
appreciated property other than stock or securities of Controlled.
– Section 355(a)(1)(A) and section 356 provide that the shareholders recognize
gain on distributions of property other than stock or securities of Controlled as if
section 301 applied to the distribution.
Controlled is member of DSAG -- The final regulations provide that the hot stock rule
is inapplicable where Controlled is a member of Distributing’s SAG at any time after
the acquisition (but prior to the distribution).
Transfers between DSAG members -- The final regulations disregard transfers of
Controlled stock between members of a DSAG for purposes of the hot stock rule.
Transfers between affiliates -- The final regulations retain the affiliate exception set
forth in the prior regulations, which generally provides that the hot stock rule does not
apply to Distributing’s acquisition of Controlled stock from a member of Distributing’s
affiliated group (as defined in Treas. Reg. § 1.355-3(b)(4)(iv)).
473
“Hot Stock” – Example 1
Year 8
Year 6
Additional C Stock
D
X
368(c)
stock
C
Facts: For more than 5 years, D has owned stock in C constituting control for section 368(c)
purposes (“section 368(c) stock”) but not control for section 1504(a)(2) purposes (“section
1504(a)(2) stock”). In Year 6, D purchases additional C stock, although not enough to constitute
section 1504(a)(2) stock in the aggregate. In Year 8, D distributes the stock of C to its
shareholders.
Result: The additional C stock purchased in Year 6 would be “hot stock.” See Treas. Reg. § 1.3552(g)(5), ex. 1.
Alternative 1: What if D acquired section 1504(a)(2) stock in C as a result of the acquisition in Year
6? See Treas. Reg. § 1.355-2(g)(5), ex. 2; see also Notice 2007-60.
Alternative 2: What if D owned no C stock prior to the acquisition in Year 6 and acquired section
1504(a)(2) stock in C as a result of the acquisition?
474
“Hot Stock” – Example 2
Year 8
Year 6
D
C
Stock
S
368(c)
stock
Unrelated
Shareholders
C
Facts: For more than 5 years, D has owned all of the stock of S, and D and S, in the
aggregate, own section 368(c) stock but not section 1504(a)(2) stock in C. In Year 6, D
purchases S’s C stock. In Year 8, D distributes the stock of C to its shareholders.
Result: The C stock purchased in Year 6 would not be “hot stock” because transfers of
C stock between DSAG members are disregarded. See Treas. Reg. § 1.355-2(g)(5),
ex. 3.
475
“Hot Stock” – Example 3
Year 6
C Stock
X
Year 8
10%
P
90%
D
Y
368(c) stock
C
Facts: For more than 5 years, P has owned 90 percent of D stock and a portion of C stock. X has
owned the remaining 10 percent of D stock. D has owned section 368(c) stock in C. In Year 6, D
purchases P’s C stock, although not in an amount resulting in section 1504(a)(2) control. In Year 8,
D distributes its C stock to X in exchange for X’s D stock.
Result: The C stock purchased in Year 6 would not be “hot stock” because the C stock was
purchased from a member (P) of the affiliated group of which D is a member, and P did not
purchase that C stock within the pre-distribution period. See Treas. Reg. § 1.355-2(g)(5), ex. 4.
476
Proposed Regulations –
Corporate Equity
Reduction Transactions
477
Proposed Regulations – Corporate Equity
Reduction Transactions: Background
•
•
•
•
On September 13, 2012, Treasury and the IRS issued proposed regulations under sections 172(h)
and 1502 that provide guidance on the treatment of a corporate equity reduction transaction
(“CERT”). The proposed regulations affect C corporations and corporations filing consolidated
returns.
In 1989, Congress enacted the CERT rules of section 172(b)(1)(E) and (h) in response to the use of
NOL carrybacks to finance leveraged buyout transactions.
– The rules were intended to limit a corporation’s ability to obtain tax refunds resulting from the
carryback of NOLs attributable to interest deductions allocable to such transactions.
– No regulations had ever been issued with respect to these provisions.
The CERT rules generally provide that the portion of an NOL for any loss limitation year that is
attributable to the interest deductions allocable to a CERT may not be carried back to any year prior
to the year in which the CERT occurred.
Under section 172(h)(3)(A), a CERT is defined as (i) a major stock transaction (“MSA”) or (ii) an
excess distribution (“ED”).
– An MSA is an acquisition by a corporation, pursuant to a plan of such corporation, of stock in
another corporation representing 50 percent or more (by vote or value) of the stock in such
other corporation. Section 172(h)(3)(B)(i).
• An MSA does not include a qualified stock purchase to which an election under section
338 applies. Section 172(h)(3)(B)(ii).
– An ED is the excess (if any) of the aggregate distributions (including redemptions) made during
a taxable year by a corporation with respect to its stock over the greater of (i) 150 percent of the
average of such distributions during the three taxable years immediately preceding such taxable
year, or (ii) 10 percent of the FMV of the stock of the corporation at the beginning of such
478
taxable year. Section 172(h)(3)(C).
Proposed Regulations – Corporate Equity
Reduction Transactions: Background
•
If an MSA or ED occurs, section 172(b)(1)(E) and (h) limit the carryback of the portion of an NOL
that constitutes a corporate equity reduction interest loss (“CERIL”) of an applicable corporation in
any loss limitation year.
– A CERIL is the excess (if any) of (i) the total NOL for a loss limitation year, over (ii) the NOL
for the loss limitation year computed without regard to the allocable interest deductions that
are otherwise taken into account in computing the NOL. Section 172(h)(1).
• Allocable interest deductions are deductions allowed on the portion of any indebtedness
allocable to a CERT. Section 172(h)(2)(A).
• Section 172(h)(2)(B) indicates that, except as provided in regulations and section
172(h)(2)(E), the indebtedness allocable to a CERT is determined under the avoided
cost methodology of section 263A(f)(2)(A), with certain adjustments.
• The allocable interest deductions are limited to the increase in interest deductions (the
amount allowable as a deduction for interest paid or accrued during the loss limitation
year) over a historical, three-year baseline (the average of deductions allowed for
interest paid or accrued for the three taxable years preceding the taxable year in which
the CERT occurred). Section 172(h)(2)(C).
– An applicable corporation is (i) a C corporation that acquires stock, or the stock of which is
acquired, in an MSA; (ii) a C corporation making distributions with respect to, or redeeming,
its stock in connection with an ED; or (iii) a C corporation that is a successor to one of the
other types of applicable corporations. Section 172(b)(1)(E)(iii).
– A loss limitation year is the taxable year in which a CERT occurs and each of the two
succeeding taxable years. Section 172(b)(1)(E)(ii).
479
Proposed Regulations – Corporate Equity
Reduction Transactions: General Rules
•
•
•
The proposed regulations provide general rules addressing whether an MSA or ED has occurred.
– The proposed regulations provide that a tax-free transaction that meets the definition of an MSA or
ED must be tested as a CERT under section 172(b)(1)(E) and (h).
– The proposed regulations require taxpayers to test a multiple-step, integrated plan of stock
acquisition as a single potential MSA.
– The proposed regulations state that, to the extent that a distribution is part of an integrated plan that
is treated as an MSA, the distribution is excluded from the computation of the taxpayer’s three-year
distribution average that is relevant to any other potential ED.
In connection with the computation of a CERIL, the proposed regulations provide MSA and ED specific
rules for computing costs associated with a CERT. The proposed regulations also identify additional
CERT costs by looking to the capitalization rules under section 263(a).
– With regard to an MSA, CERT costs include (i) the FMV of the stock acquired (whether acquired in
exchange for cash, stock or other property), (ii) the FMV of any distribution part of an integrated
transaction constituting the MSA, and (iii) amounts paid or incurred to facilitate any step of the MSA
(to the extent required to be capitalized or if disallowed under section 162(k)).
– CERT costs associated with an ED generally include (i) the FMV of distributions to shareholders
determined to be EDs during the year the CERT occurs, and (ii) a portion of amounts paid or
incurred to facilitate the distributions (to the extent required to be capitalized or if disallowed under
section 162(k)).
– Once CERT costs are identified, the interest allocable to those costs is computed under the
principles of section 263A(f)(2)(A) and the regulations thereunder, which effectively allocate interest
to a CERT to the extent that the taxpayer’s interest costs could have been reduced if the taxpayer
had not engaged in the CERT.
The proposed regulations define a successor as a transferee or distributee in a transaction to which
section 381(a) applies.
480
Proposed Regulations – Corporate Equity
Reduction Transactions: Consolidated Groups
•
•
•
•
The proposed regulations also address issues specific to the application of section 172(b)(1)(E) and (h)
to consolidated groups.
The proposed regulations confirm that a consolidated group is treated as a single taxpayer (thus,
avoiding the need to track separately transactions and expenditures of individual members).
– Intercompany transactions are generally disregarded under the proposed regulations, unless a
party to the transaction becomes a non-member as part of the same plan or arrangement.
Under the proposed regulations, if an applicable corporation with regard to a CERT occurring in a
separate return year joins a consolidated group, the group is treated as a single applicable corporation
with regard to that CERT in the consolidated year of the acquisition and any relevant succeeding year.
– Also, both the debt of a new member acquired in a CERT and the corresponding interest expenses
are included in the group’s CERIL computation.
The proposed regulations provide that, if a member deconsolidates from a group on or after (i) the date
on which the group engages in a CERT, or (ii) the date on which the group acquires a pre-existing CERT
member, then, following the deconsolidation, both the deconsolidating member and the group generally
will be treated as applicable corporations with regard to the CERT.
– The deconsolidating member will be apportioned a pro rata share of the group’s CERT costs
incurred through the date of the deconsolidation, based on the relative FMVs of the deconsolidating
corporation and the entire group. This rule applies regardless of whether any particular corporation
would have constituted an applicable corporation with regard to the CERT without the application of
the single entity treatment.
– The deconsolidating member may elect out of the general rule of apportionment, in which case the
deconsolidating member will not be treated as an applicable corporation with regard to the CERT
and it will not be allocated any CERT costs. Applicable corporation status and CERT costs will
remain with the former group, even if the deconsolidating member directly engaged in the CERT.
481
Proposed Regulations – Corporate Equity
Reduction Transactions: Consolidated Groups
•
•
The proposed regulations provide special rules for determining loss limitation years of
consolidated groups and former members of consolidated groups.
– The taxable year in which a CERT actually occurs is a loss limitation year. Any
other taxable year of any applicable corporation will constitute a loss limitation
year with regard to the CERT only if, under the carryover rules of sections
172(b)(1)(A)(ii) and 381(c)(1), the potential loss limitation year would constitute
the first or second taxable year following the taxable year of the corporation or
consolidated group that actually engaged in the CERT.
– The separate return years of a corporation that deconsolidates from a
consolidated group may be loss limitation years with regard to a CERT of the
former group, if the consolidated return year of the deconsolidation is a first or
second loss limitation year with regard to that CERT.
With respect to the limitation on allocable interest deductions in section 172(h)(2)(C),
the proposed regulations provide rules applicable to consolidated groups regarding
the computation of the three-year average of paid or accrued interest.
– Under the proposed regulations, when a corporation joins a group, the interest
history of that corporation is combined with that of the acquiring group.
– In the deconsolidation of a group member, a portion of the group’s entire interest
history is generally apportioned to the deconsolidating member, based on the
relative FMVs of the deconsolidating member and the entire group.
482
Proposed Regulations – Corporate Equity
Reduction Transactions: Consolidated Groups
•
•
The proposed regulations provide rules for consolidated groups relating to the
computation of an ED.
– In computing the limitation based on 150 percent of a taxpayer’s average of
distributions made in the three preceding tax years, the only distributions taken
into account are those made to non-member shareholders.
– In computing the three-year distribution average of a consolidated group that
includes a member for less than the entire consolidated year of a potential ED,
the group takes into account only a pro rata portion of the actual distribution
history of that member.
– A corporation that deconsolidates from a group takes into account its actual
history of non-intercompany distributions for purposes of applying the CERT
rules in future separate return years, as the corporation is not apportioned a pro
rata share of the total distribution history of the group.
The proposed regulations provide rules relating to the apportionment of consolidated
NOLs that contain a component portion of special status loss (such as a CERIL).
– The proposed regulations also amend and expand the “split-waiver” election in
Treas. Reg. § 1.1502-21(b)(3)(ii)(B) by making the election available to any
group that acquires a corporation, regardless of whether such corporation was
acquired from another group.
483
Proposed Regulations – Corporate Equity
Reduction Transactions: General
• Treasury and the IRS declined to provide rules addressing the
application of section 172(h) to related parties, pass-through entities,
or intermediaries, but said that the circumstances under which those
persons should be subject to section 172(b)(1)(E) and (h) is under
study.
• Treasury and the IRS also said that, although they considered
including an anti-avoidance rule that would prevent taxpayers from
engaging in section 381 transactions to shorten loss limitation years,
they decided that the detrimental effects of shortening tax years
meant taxpayers would be unlikely to undertake those transactions
as a planning technique.
484
Schedule UTP
485
Schedule UTP
Background
• In Announcement 2010-9 (issued January 16, 2010), the IRS introduced a proposed
reporting requirement on certain business taxpayers to provide information about uncertain
tax positions affecting their federal income tax liability.
– In Announcement 2010-17 (issued March 5, 2010), the IRS extended the comment
period for the proposal and stated that it planned to require the filing of the new
schedule for returns relating to calendar year 2010 and for fiscal years that begin in
2010.
– In Announcement 2010-30 (issued April 19, 2010), the IRS announced the release of
the draft schedule (“Schedule UTP”) and instructions, comments on which were due
by June 1, 2010.
• On September 9, 2010, Treasury and the IRS issued proposed regulations authorizing the
IRS to require certain corporations (as set out in forms, publications or instructions, or other
guidance) to provide information concerning uncertain tax positions concurrent with the
filing of a return.
– The proposed regulations appear to have been in response to criticisms that Treasury
and the IRS lack the authority to require taxpayers to file Schedule UTP.
– On December 15, 2010, final regulations were published without any substantive
changes.
• On September 24, 2010, the IRS released the final Schedule UTP and its instructions.
– Changes from the draft Schedule UTP and instructions are detailed in the
contemporaneously issued Announcement 2010-75.
– The IRS also released a directive to the field to provide guidance on the
implementation of Schedule UTP, as well as a separate announcement
(Announcement 2010-76) regarding modifications to the policy of restraint.
486
Schedule UTP
Final Schedule UTP – Significant Changes from Draft Schedule
• Five-year phase-in of the reporting requirement based on a
corporation’s asset size.
• No reporting of the rationale and nature of uncertainty in the concise
description of the position.
• No reporting of a maximum tax adjustment.
• No reporting of tax positions for which no reserve was created due
to a widely-understood administrative practice.
487
Schedule UTP
Schedule UTP Filing Requirement
• In general, Schedule UTP requires a corporation with assets equal to or exceeding $100
million to report its U.S. federal income tax positions for which the corporation or a related
party has (i) recorded a reserve in an audited financial statement or (ii) not recorded a
reserve because the corporation expects to litigate the position.
– Corporations are required to file a 2010 Schedule UTP with income tax returns for the
calendar year 2010 and fiscal years that begin in 2010 and end in 2011. A corporation
is not required to file a Schedule UTP for a short tax year that ends in 2010.
– Corporations are not required to report a tax position taken in a tax year beginning
before January 1, 2010, even if a reserve is recorded with respect to that tax position
in audited financial statements issued in 2010 or later.
• The final Schedule UTP and instructions require only corporations filing a Form 1120, Form
1120-F, Form 1120-L, or Form 1120-PC to file a 2010 Schedule UTP. The IRS will
consider whether to extend all or a portion of Schedule UTP reporting to other taxpayers
for later tax years, such as pass-through entities and tax exempt entities.
• The IRS has implemented a five-year phase-in of Schedule UTP for corporations with
assets under $100 million.
– The total asset threshold will be reduced to $50 million starting with 2012 tax years
and to $10 million starting with 2014 tax years.
• The final instructions do not exclude taxpayers in the Compliance Assurance Program
(CAP) from the Schedule UTP filing requirement.
– The IRS indicated that it will be expanding CAP and making it permanent, and that it
will address Schedule UTP compliance in upcoming CAP permanence guidance.
488
Schedule UTP
Reporting of Uncertain Tax Positions on Schedule UTP
•
A corporation or a related party records a reserve for a U.S. federal income tax position when a reserve for income
tax, interest, or penalties with respect to that position is recorded in audited financial statements of the corporation
or a related party.
– A tax position is taken in a tax return if it would result in an adjustment to a line item on that tax return (or
would be included in a section 481(a) adjustment) if the position is not sustained.
– Audited financial statements mean financial statements on which an independent auditor has expressed an
opinion under GAAP, IFRS, or another country-specific accounting standard, including a modified version of
any of the above. Compiled or reviewed financial statements are not audited financial statements.
– The initial recording of a reserve triggers reporting of a tax position taken on a return. Subsequent reserve
increases or decreases, however, do not.
•
A corporation must report on Schedule UTP a tax position for which no reserve was recorded based on an
expectation to litigate.
– This occurs if the corporation or a related party determines the probability of settling with the IRS to be less
than 50% and, under applicable accounting standards, no reserve was recorded because the corporation
intends to litigate the position and has determined that it is more likely than not to prevail on the merits in the
litigation.
•
Schedule UTP and its instructions define a related party broadly to include any entity that is related to the
corporation under sections 267(b), 318(a), or 707(b), or any entity that is included in a consolidated audited
financial statement in which the corporation is also included.
– The final schedule contains a box that must be checked if the corporation is unable to obtain information
from related parties sufficient to determine whether a tax position must be disclosed.
•
Schedule UTP generally requires the reporting of current year and prior year uncertain tax positions.
– The portion of Schedule UTP relating to prior year uncertain tax positions will be used in tax years after 2010
to report tax positions taken by the corporation in a prior tax year that have not been reported on a prior
year’s tax return.
– A corporation is generally not required to report a tax position it has taken in a prior year if the corporation
reported that tax position on a Schedule UTP filed with a prior year tax return. However, an exception
applies if there is a transaction that results in tax positions taken in more than one tax return.
489
Schedule UTP
Information Required in Schedule UTP
•
A corporation must provide a concise description of each uncertain tax position, including a description of the
relevant facts affecting the tax treatment of the position and information that reasonably can be expected to
apprise the IRS of the identity of the tax position and the nature of the issue. According to the IRS, this description
should, in most cases, not exceed a few sentences.
– The final Schedule UTP instructions expressly provide that a concise description should not include an
assessment of the hazards of a tax position or an analysis of the support for or against the tax position.
– The instructions contain several examples of what constitutes an acceptable concise description.
•
A corporation must rank by size each uncertain tax position (including transfer pricing and other valuation
positions) reported on Schedule UTP.
– The size of each tax position is determined on an annual basis and is the amount of U.S. federal income tax
reserve recorded for that position. The size of a tax position, however, is not required to be reported on
Schedule UTP.
• If a reserve is recorded for multiple tax positions, then a reasonable allocation of that reserve among
the tax positions to which it relates must be made in determining the size of each tax position.
• For an affiliated group filing a consolidated return, the determination of the size of a tax position taken
on such return is determined at the affiliated group level for all members of the affiliated group.
• In ranking its uncertain tax positions, a corporation must specify whether a tax position is a transfer
pricing position.
– A corporation must also indicate on the Schedule UTP if an uncertain tax position is a “major tax position.”
• An uncertain tax position is a major tax position if the reserve exceeds 10% of the aggregate amount
of the reserves for all of the tax positions reported on the Schedule UTP.
– The final instructions provide that no size needs to be determined for uncertain tax positions based on an
expectation to litigate, which can be assigned any rank. Further, such positions are disregarded for
purposes of the major tax position calculation.
•
Other information that must be provided on the Schedule UTP with respect to an uncertain tax position includes:
(i) the primary IRC sections relating to the tax position, (ii) whether a tax position creates temporary or permanent
(or both) differences, and (iii) if the tax position relates to a position of a pass-through entity, such entity’s EIN.
490
Schedule UTP
Coordination with Other Reporting Requirements
• The final Schedule UTP instructions state that the IRS will treat a complete and
accurate disclosure of a tax position on a Schedule UTP as if the corporation filed a
Form 8275, Disclosure Statement (or Form 8275-R, Regulation Disclosure
Statement), with respect to the tax position.
• Consistent with Notice 2010-62, in the case of a transaction that is not a reportable
transaction, the IRS will treat a complete and accurate disclosure on Schedule UTP
as satisfying the disclosure requirements of section 6662(i) (relating to the strict
liability penalty under the codified economic substance doctrine).
• The IRS is continuing to study other ways to reduce duplicate reporting, and is
considering whether complete and accurate disclosure on Schedule UTP would also,
in appropriate circumstances, provide the information necessary to satisfy the
reportable transaction disclosure requirements.
Penalties
• The final Schedule UTP instructions do not provide specific guidance regarding
penalties.
• According to the IRS, it intends to review compliance on how Schedule UTP is
completed by corporations and to take appropriate enforcement action, including the
possibility of opening an examination or making another type of taxpayer contact, in
those instances in which there appears to be a failure to complete Schedule UTP or a
failure to report whether the corporation is required to complete the schedule.
491
Schedule UTP
LB&I Directive on Implementation of Schedule UTP
• Concurrent with the release of the final Schedule UTP, the IRS issued a
directive for all Large Business and International Division (LB&I) personnel
setting forth the planned treatment of Schedule UTP.
• The directive outlines the various uses for the information reported on
Schedule UTP and indicates that initial processing of Schedule UTP
information will be centralized to ensure appropriate review to identify trends
and areas requiring further guidance to address uncertainty in the law.
• The directive also stresses that “[a]lthough the Schedule UTP is intended to
expedite the return selection and issue identification process, it does not
serve as a substitute for other examination tools or for the independent
judgment of the examiner, and it should not be used to shortcut other parts
of the audit process or the careful and considered examination of issues
and an objective application of the law to the facts.”
• The IRS plans to institute training specific to the handling of Schedule UTP.
492
Schedule UTP
Announcement 2010-76 – Modification to IRS Policy of Restraint
• In connection with the release of the final Schedule UTP, the IRS announced that it is
expanding its policy of restraint, and that it will forgo seeking particular documents
that relate to uncertain tax positions and the workpapers that document the
completion of Schedule UTP.
– According to the IRS, these changes are designed to reassure taxpayers that the
IRS is only seeking issue identification, and not legal analysis or risk
assessments, in order to further IRS objectives for increased efficiency, certainty,
and consistency.
• Significant changes in the modified policy of restraint include:
– Disclosing issues on Schedule UTP does not otherwise affect the protections
afforded under the policy of restraint.
– Drafts of issue descriptions and information regarding qualification or ranking of
issues are protected under the policy.
– The IRS generally will not seek documents that would otherwise be privileged,
even though the taxpayer has disclosed the documents to a financial auditor as
part of an audit of the taxpayer’s financial statements.
493
Schedule UTP
Frequently Asked Questions
•
On March 23, 2011 and July 19, 2011, the IRS released FAQs that provide guidance on issues raised by taxpayers about
Schedule UTP.
•
The FAQs clarify the following with respect to reporting on Schedule UTP:
– For a corporation subject to FIN 48, if the position is “highly certain” within the meaning of FIN 48, a tax position is
considered “sufficiently certain so that no reserve was required,” and therefore does not need to be reported on
Schedule UTP.
– If the corporation reconsiders whether a reserve is required for a tax position and eliminates the reserve in an interim
audited financial statement issued before the tax position is taken in a return, the corporation does not need to report
the tax position to which the reserve relates on Schedule UTP.
– The use of an NOL or credit carryover in a post-2009 return is a tax position that should not be reported if the portion
of the NOL or the credit carryforward that is used includes a tax position taken in a pre-2010 return for which a reserve
has been recorded.
• This does not affect the requirement to report a tax position claimed on a post-2009 return for which a reserve
has been recorded that is included in an NOL or credit carryover for potential use in a later year.
• The FAQs indicate that additional guidance will be provided regarding reporting requirements for the use of
NOLs and credit carryovers.
– The size of a tax position is the amount of the reserve recorded for that position. If an amount of interest or penalties
relating to a tax position is not separately identified in the books and records as associated with that position, then that
amount of interest and penalties is not included in the size of a tax position used to rank that position or compute
whether the position is a major tax position.
– If, under the Schedule UTP Instructions, a taxpayer has no tax positions that must be reported on the current year
Schedule UTP, the taxpayer should not file a blank Schedule UTP for that year.
– A reserve is recorded when an uncertain tax position or a FIN 48 liability is stated anywhere in a corporation’s or
related party’s financial statements, including footnotes and any other disclosures, and may be indicated by any of
several types of accounting journal entries.
• The FAQs indicate that some of the types of entries that, entered alone or in tandem, indicate the recording of a
reserve are: (i) an increase in a current or non-current liability for income taxes, interest or penalties payable, or
a reduction of a current or non-current receivable for income taxes and/or interest with respect to the tax
position, or (ii) a reduction in a deferred tax asset or an increase in a deferred tax liability with respect to the tax
position.
– A corporation is not required to report accruals of interest on a tax reserve recorded with respect to a tax position
taken on a pre-2010 tax return.
494
Schedule UTP
Frequently Asked Questions (cont’d)
•
The FAQs describe several hypothetical situations that provide further guidance regarding Schedule
UTP:
– A corporation claims a deduction in 2011 and determines under applicable accounting standards
that it can recognize the full benefit of the position. In 2013 the IRS begins an examination of the
2011 tax return and decides to examine whether the deduction is proper. The corporation
subsequently reevaluates the tax position and records a reserve for that position in 2013.
• The corporation must report the tax position on Schedule UTP filed with its 2013 tax return
even though the IRS is aware of the tax position.
– A corporation takes a tax position on its 2011 tax return for which no reserve is recorded because
the corporation determines the tax position is correct. Circumstances change, and in 2013 the
corporation determines that the tax position is uncertain, but does not record a reserve because of
its expectation to litigate the position and the determination that it is more likely than not to prevail.
• The corporation must report the tax position on the Schedule UTP filed with its 2013 tax
return. The corporation must report the position if it records a reserve or if it does not record a
reserve because it expects to litigate, even if that decision to record or not record occurs
because of a change in circumstances in a later year.
– Corporation A merges into Corporation B in 2011, and Corporation B survives. Corporation B
records a reserve with respect to a tax position taken on the final return of Corporation A.
• Whether the tax position must be reported on the Schedule UTP filed with Corporation A’s
final 2011 tax return depends on when Corporation B records its reserve. If Corporation B
records a reserve with respect to Corporation A’s tax position before the final return is filed,
the tax position should be reported on the Schedule UTP filed with Corporation A’s final tax
return even though the return was filed by Corporation B and the reserve was recorded by
Corporation B. Corporation B should not report the tax position on the Schedule UTP filed
with its 2011 tax return because Corporation A’s final return is a prior year tax return on which
the tax position was reported. If Corporation B records the reserve for the tax position after
filing Corporation A’s final tax return, Corporation B must report the tax position on the
Schedule UTP filed with its 2011 tax return.
495
Schedule UTP
Frequently Asked Questions (cont’d)
•
Additional hypotheticals:
– A corporation claims an item of deduction, loss, or credit on its 2010 tax return and that tax
return contains an NOL or a credit. The NOL or credit cannot be used in 2010 and is carried
forward. The corporation records a reserve with respect to the tax position that is reflected
on an audited financial statement in 2010. The NOL carryforward or credit carryforward is
used to reduce the tax liability reported on the corporation’s 2012 tax return. The corporation
records a reserve with respect to the tax position that is reflected on an audited financial
statement in 2012.
• Because the corporation recorded a reserve for the tax position in 2010, the corporation
must report that tax position on the Schedule UTP filed with its 2010 tax return. This
reporting in 2010 is the only reporting required. Even though the future use of the NOL
or credit carryforward is a tax position for which the corporation recorded a reserve, the
IRS will not require reporting with respect to the future use of NOLs or credit
carryforwards. The corporation should not report the use of the NOL or credit
carryforward on the Schedule UTP filed with its 2012 tax return.
– A corporation records a reserve for a tax position that would result in an adjustment to a line
item on a schedule or form attached to the corporation's 2010 Form 1120 (for example, the
tax position would result in an adjustment to a balance sheet item on the corporation's
Schedule L that is filed with the corporation's 2010 Form 1120), if that position was not
sustained.
• The tax position must be reported on Schedule UTP filed with the corporation's 2010
return. Assuming all other requirements in the Schedule UTP Instructions are satisfied,
a corporation must report a tax position for which it has recorded a reserve or did not
record a reserve because it expected to litigate the position that would result in an
adjustment to a line item on any schedule or form attached to the corporation's filed
Form 1120.
496
Schedule UTP
Frequently Asked Questions (cont’d)
• With respect to the policy of restraint, the FAQs provide:
– The changes to the policy of restraint in Announcement 2010-76 apply to
documents requested by Appeals.
– In general, in document requests by IRS counsel after the filing of a Tax Court
petition, IRS counsel will not issue discovery requests for documents or
information that the IRS would not seek under its policy of restraint.
– The changes announced in Announcement 2010-76 apply to any request for
documents outstanding on or made after September 24, 2010, in any open
examination.
497
Schedule UTP
LB&I Guidance for Compliance Assurance Process (CAP) Program
•
On August 31, 2011, LB&I issued guidance covering the use of Schedule UTP as part of the CAP Program.
– The guidance provides CAP teams with requirements and procedures to be followed when reviewing and
using Schedule UTP in conjunction with CAP.
– The guidance applies to CAP returns filed for the 2010 tax year by CAP taxpayers that were in CAP in 2010.
•
The guidance notes the following with respect to the use of Schedule UTP in connection with the CAP Program:
– Tax returns for the 2010 tax year filed by taxpayers that were in CAP in 2010 that include a Schedule UTP
will be released to CAP teams shortly after filing.
– During the post-file period, a CAP team should follow existing CAP guidance in reviewing the return, and the
issues listed on the Schedule UTP should be considered and compared to the list of taxpayer disclosures
made during the CAP year.
– The guidance outlines procedures for a CAP team to follow in the following alternative scenarios—
• The tax return includes a Schedule UTP but no issues are disclosed.
• The Schedule UTP describes an issue that was disclosed to the team, was reviewed during the CAP
year, and is either unagreed or being examined in the post-file period.
• The Schedule UTP describes an issue that was disclosed to the team, and the team decided not to
pursue it.
• The Schedule UTP describes an issue that the team believes was not disclosed during the CAP year.
• The taxpayer disclosed an issue or transaction to the team and the team anticipated the taxpayer
would record a reserve for that issue or transaction, but the taxpayer did not file a Schedule UTP.
• The taxpayer filed a Schedule UTP but the team anticipated that additional items would be disclosed
on the Schedule UTP in light of the reserves reflected on the taxpayer’s financial statements.
• The taxpayer’s financial statements reflect an increase in reserves but the filed return did not include a
Schedule UTP.
498
Schedule UTP
LB&I Examination Guidance
•
On November 1, 2011, LB&I released guidance for examination teams regarding the requirements and
procedures to be followed when reviewing and using Schedule UTP in conjunction with an examination.
•
The guidance states that, prior to the release of returns that contain a Schedule UTP to the field, a
Centralized Review Team will review and evaluate the Schedule UTP to assess compliance.
– If the requirements of the Schedule UTP instructions are not satisfied, the Centralized Review
Team will contact the taxpayer – thus, when returns with a Schedule UTP are assigned to the field,
examiners should not need to evaluate compliance with the Schedule UTP instructions.
•
The guidance notes the following with respect to the use of Schedule UTP in the audit process:
– The examination of a return with a Schedule UTP is not mandatory. The presence of the Schedule
UTP should not, in and of itself, be the sole factor used to determine whether or not to proceed with
an examination.
– Examiners should apply regular procedures to a return containing a Schedule UTP when
determining whether to examine an issue or the return and/or whether to decide to survey a return
after assignment.
– All territory managers must be involved in team discussions during the pre-exam analysis when
there is a Schedule UTP. The territory manager’s subsequent level of involvement will vary
depending on the case.
– For issues that are disclosed on the Schedule UTP, the examination team may ask the taxpayer for
information about the relevant facts affecting the tax treatment of the position and information about
the identity of the tax issue.
• However, the examination team cannot ask the taxpayer to explain their rationale for
determining that the issue was uncertain, or for information about the hazards of the position
or an analysis of support for or against the tax position.
499
Schedule UTP
LB&I Examination Guidance (cont’d)
•
The guidance also notes the following with respect to the use of Schedule UTP in the audit
process:
– The examination team cannot ask the taxpayer why a Schedule UTP issue is uncertain, nor
can the team ask the taxpayer for copies of workpapers used to prepare Schedule UTP, any
Tax Accrual Workpapers, or any documents privileged under the IRS’s modified policy of
restraint.
– The fact that an issue disclosed on the Schedule UTP was present on a prior year audit is
not sufficient to automatically roll over an issue from one year to the next.
– The fact that an issue disclosed on a 2010 Schedule UTP is selected for examination is not
sufficient to automatically raise the issue in a prior year whether or not that prior year is
already under examination.
• However, if an examination team thinks that an issue disclosed on the Schedule UTP
should be addressed in a prior year that is under examination, the approval of the team
manager is required before the issue is included in the audit plan or a discussion occurs
with the taxpayer.
• If the examination team thinks that an issue disclosed on the Schedule UTP should be
addressed in a prior year not under examination, the approval of the team manager is
required to order a prior year return.
– If the taxpayer’s financial statements reflect an increase in reserves, but the filed return did
not include a Schedule UTP—
• The examination team cannot ask the taxpayer about the makeup of the reserves.
• The examination team may only ask the taxpayer to confirm that there are no issues to
be disclosed according to the Schedule UTP reporting requirements.
500
Schedule UTP
Guidance for Preparing Schedule UTP Concise Descriptions
•
On May 11, 2012, the IRS released guidance regarding the concise description of uncertain tax
positions required on Schedule UTP.
– According to the IRS, during the centralized review of the concise descriptions disclosed on
Schedules UTP filed in 2010, the IRS identified problems with the quality of the content of
some disclosures.
•
In the guidance, the IRS stated that concise descriptions that do not clearly identify the taxpayer’s
tax position and/or do not provide sufficient relevant facts to apprise the IRS about the nature of
the issue do not meet the requirements of the Schedule UTP instructions.
•
The IRS provided the following examples of concise descriptions that do not meet these
requirements :
– This issue is under audit for a prior year.
– This issue is one for which we have recorded a reserve because it was unresolved in prior
years and is currently in Appeals.
– This is an issue for which we have recorded a reserve because the appropriate tax treatment
of this position is unsettled and we are awaiting published guidance and we are awaiting the
outcome of pending litigation.
– This is an issue that we know is subject to IRS scrutiny.
– This issue relates to how we have characterized certain expenditures and related
deductions.
•
As part of the guidance, the IRS provided examples of hypothetical concise descriptions that
identify a tax issue, but do not provide relevant facts affecting the tax treatment of the item and
insufficiently describe the nature of the issue. Concurrently, the IRS provided examples of
concise descriptions for the same issues that meet all the requirements of the instructions for
501
Schedule UTP.
United States v. Textron
502
United States v. Textron
District Court
• The IRS requested Textron’s tax accrual workpapers.
– Attorneys prepared the workpapers, which were kept confidential, although content
had been shared with accounting firm (E&Y).
– Content of tax accrual workpapers:
• List of issues (uncertain tax positions)
• List of “hazards of litigation” conclusions, expressed as percentage chance of
losing each issue in court
• List of monetary value of each issue and reserve
• The District Court denied the IRS’ petition to enforce the summons, reaching the following
conclusions:
– Privilege:
• Tax accrual workpapers were initially protected by attorney-client privilege and
section 7525 tax practitioner-client privilege.
• However, the privileges were waived when the workpapers were disclosed to
Textron’s independent auditors.
– Work Product
• Tax accrual workpapers were protected by work product because they would not
have been prepared “but for” the fact that Textron anticipated the possibility of
litigation with the IRS.
• Work product protection was not waived because disclosure to independent
auditors did not substantially increase the opportunity for potential adversaries
(i.e., the IRS) to obtain the information.
503
United States v. Textron
Initial Appeals Court Decision
• The First Circuit initially upheld the decision of the District Court.
• In the initial hearing, the First Circuit considered three issues: (1) whether the work-product
doctrine protects Textron's workpapers; (2) whether any such work-product protection was
waived through disclosure to E&Y; and (3) whether the District Court erred in not
considering the IRS's request for E&Y's workpapers.
• The First Circuit concluded that the "ordinary course of business" exception to the work
product doctrine could not be applied to require disclosure of all documents prepared with
some business purpose in mind. Accordingly, the First Circuit found that dual purpose
documents prepared by Textron may be protected under the work product doctrine.
• Although affirming the holding of the District Court regarding work product protection, the
First Circuit remanded the case to the District Court to resolve factual issues relating to the
discoverability of certain workpapers prepared by Textron's attest auditors. This group of
workpapers was distinct from the workpapers prepared by Textron’s inhouse attorneys.
– The workpapers at issue were prepared and retained by the attest auditors. The First
Circuit observed that Arthur Young “suggests such documents are not protected and
Textron has not argued otherwise.”
– As described by the First Circuit, the issue with respect to discoverability was whether
Textron was considered to have possession, custody, or control of these documents,
even though the documents were retained by the attest auditors. This was the issue
because the summons in question was issued to Textron, not the attest auditors. The
First Circuit stated that Textron may be considered to have possession, custody, or
control if it has a right to access or obtain the documents from the attest auditors. The
First Circuit remanded the case to the District Court to resolve this question.
504
United States v. Textron
Appeals Court Rehearing En Banc
• The First Circuit vacated its initial decision and reheard the appeal en banc.
• The en banc court, divided 3-2, held that the workpapers were not protected by the
work product doctrine because they were not prepared “in anticipation of litigation.”
– According to the majority, “the work product privilege is aimed at protecting work
done for litigation, not in preparing financial statements. Textron’s workpapers
were prepared to support financial filings and gain auditor approval; the
compulsion of the securities laws and auditing requirements assure that they will
be carefully prepared, in their present form, even though not protected; and IRS
access serves the legitimate, and important, function of detecting and disallowing
abusive tax shelters.”
• The dissent criticized the majority for abandoning, but not overruling, the First
Circuit’s adoption of the “because of” test in Maine v. United States.
• According to the dissent, “the majority purports to follow Maine, but really conducts a
new analysis of the history of the work-product doctrine and concludes that
documents must be ‘prepared for any litigation or trial.’” The dissent argued that the
“prepared for” rule was contrary to the broader “because of” rule and inconsistent with
the policy of the work product doctrine.
Petition for Certiorari Denied:
• On May 24, 2010, the U.S. Supreme Court denied a petition for certiorari to
reconsider the First Circuit's ruling.
505
United States v. Deloitte
506
United States v. Deloitte – District Court
District Court Decision
•
The IRS requested three documents from Deloitte, the independent auditor for Dow Chemical,
who was involved in ongoing litigation concerning the tax treatment of two partnerships owned by
it and two of its wholly owned subsidiaries.
– The first document was a draft memorandum prepared by Deloitte summarizing a meeting
between Dow Chemical’s employees, Dow Chemical’s outside counsel, and Deloitte about
the possibility of litigation over one of the partnerships, and the necessity of accounting for
this possibility in an ongoing audit. The meeting took place after Dow Chemical informed
Deloitte about the likelihood of litigation regarding the partnership transaction.
– The second document was a memorandum and flow chart prepared by two Dow Chemical
employees (an accountant and in-house attorney).
– The third document was a tax opinion prepared by Dow Chemical’s outside counsel.
•
The District Court denied the government’s motion to compel. United States v. Deloitte & Touche
USA LLP, 623 F. Supp. 2d 39 (D.D.C. 2009).
– The court concluded that the Deloitte memorandum was work product because it was
“prepared because of the prospect of litigation with the IRS over the tax treatment of [the
partnership].”
• The court further concluded that, although the document was created by Deloitte, it was
Dow Chemical’s work product because its contents recorded the thoughts of Dow
Chemical’s counsel regarding the prospect of litigation.
– The court also rejected the government’s contention that Dow Chemical had waived workproduct protection for the three documents.
•
The government appealed the district court’s ruling, and Dow Chemical intervened to assert workproduct protection.
507
United States v. Deloitte – Court of Appeals
•
On appeal, the U.S. Court of Appeals for the District of Columbia Circuit vacated the District Court’s
holding in part and remanded for further proceedings. United States v. Deloitte, LLP, 610 F.3d 129 (D.C.
Cir. 2010).
Deloitte Memorandum
•
The government contended that the Deloitte memorandum was not attorney work product because (i) it
was created by Deloitte, not Dow Chemical or its representative, and (ii) it was generated as part of the
routine audit process, not in anticipation of litigation.
•
The court found that Deloitte’s preparation of the memorandum did not exclude the possibility that it
contained Dow Chemical’s work product.
– According to the court, the question was not who created the document or how they were related to
the party asserting work-product protection, but whether the document itself contained work product
(i.e., the thoughts and opinions of counsel developed in anticipation of litigation).
•
In addressing the government’s second argument, the court noted that it applied the “because of” test for
determining whether a document was prepared “in anticipation of litigation.”
– The court rejected the government’s argument that the document’s function should be examined
separately from its contents in determining its status as work product.
– The court also rejected the government’s argument that when a document is created as part of an
independent audit, its sole function is to facilitate that audit, which means it is not prepared in
anticipation of litigation.
• The court disregarded the government’s reliance on United States v. El Paso Co., 682 F.2d
530 (5th Cir. 1982), finding that El Paso was decided under the more demanding “primary
motivating purpose test,” and that under the more lenient “because of” test, material
generated in anticipation of litigation may also be used for ordinary business purposes without
losing its protected status.
• As part of its argument, the government relied on the First Circuit’s holding in Textron. The
court, however, found Textron to be distinguishable because it turned on the First Circuit’s
examination of the particular documents at issue and, while it determined those documents
were not work product, it did not exclude the possibility that other documents prepared during
the audit process might warrant work-product protection. The court also noted that the dissent
in Textron made a strong argument that the First Circuit in that case applied a more exacting
standard by examining whether the documents were “prepared for use in possible litigation.”
508
United States v. Deloitte – Court of Appeals
Deloitte Memorandum (cont’d)
•
Ultimately, the court concluded that, although the Deloitte memorandum may have been protected
work product, the district court did not have a sufficient evidentiary foundation for its holding that
the memorandum was purely work product.
– The court thus remanded this question to the district court to assess whether the document
was entirely work product or whether a partial or redacted version of the document could
have been disclosed.
Dow Chemical Documents
•
With respect to the two documents prepared by Dow Chemical and its outside counsel, the
government acknowledged that the documents were work product, but argued that Dow Chemical
waived work-product protection by disclosing them to Deloitte, who, according to the government,
was a potential adversary and a conduit to other adversaries.
•
The court rejected both government arguments and concluded that Dow Chemical had not waived
work-product protection.
– The court found that Deloitte could not be considered a potential adversary with respect to
the Dow Chemical documents. According to the court, Deloitte could not be Dow Chemical’s
adversary in the sort of litigation the Dow Chemical documents addressed, as such
documents were prepared in anticipation of a dispute with the IRS and would not likely be
relevant in any dispute Dow Chemical might have with Deloitte.
– The court also concluded that Deloitte was not a conduit to Dow Chemical’s adversaries.
Because Deloitte was not an adversary, the court found that Dow Chemical’s disclosure was
not a selective disclosure. Dow Chemical also had a reasonable expectation of
confidentiality because Deloitte, as an independent auditor, had an obligation to refrain from
disclosing confidential client information.
509
Mayo Found. for Med. Educ. and
Research v. United States
510
Mayo Found. for Med. Educ. and Research v. United
States – Supreme Court Decision
• In Mayo Found. for Med. Educ. and Research v. United States, 131
S. Ct. 704 (2011), the Supreme Court examined whether medical
school graduates in residency programs were “students,” and,
therefore, whether their income qualified for an exemption from
FICA taxes.
• The Treasury Department had applied the student exception to
exempt from taxation students who work for their schools “as an
incident to and for the purpose of pursuing a course of study” there.
– Until 2005, Treasury determined whether an individual's work
was “incident to” his studies by performing a case-by-case
analysis. The primary considerations in that analysis were the
number of hours worked and the course load taken.
– The Social Security Administration (SSA) also articulated in its
regulations a case-by-case approach to the corresponding
student exception in the Social Security Act.
• In 1998, the Court of Appeals for the Eighth Circuit held that the
SSA could not categorically exclude residents from student status,
given that its regulations provided for a case-by-case approach.
511
Mayo Found. for Med. Educ. and Research v. United
States – Supreme Court Decision
• Treasury regulations adopted in 2004 stated that the services
of a full-time employee normally scheduled to work 40 or
more hours a week are not incident to or for the purpose of
pursuing a course of study, thus making residents, who
typically spend between 50 and 80 hours a week caring for
patients, ineligible for the student exemption.
• Taxpayer sued for a refund of FICA taxes it had paid on
residents’ stipends in 2005, arguing that the full-time
employee rule was invalid because it addressed something
that was clearly spelled out in the statute.
512
Mayo Found. for Med. Educ. and Research v. United
States – Supreme Court Decision
• The key issue before the Court was what level of deference
should be afforded to the Treasury regulations. There was
conflicting precedent– Chevron’s two-step analysis:
• Has Congress directly addressed the question at issue
- is the statute clear and unambiguous?
• If the statute is ambiguous, is the agency rule “arbitrary
or capricious in substance, or manifestly contrary to the
statute?”
513
Mayo Found. for Med. Educ. and Research v. United
States – Supreme Court Decision
– The multi-factor analysis of National Muffler Dealers
Association, Inc. v. U.S., 440 U.S. 472 (1979)
• What is the history of the promulgation of the
regulation?
– Is the regulation a substantially contemporaneous
construction of the statute by those presumed to
have been aware of congressional intent?
– If not, how did the regulation evolve?
• How long has the regulation been in effect? What
reliance has been placed on the regulation?
• Has the Commissioner interpreted the regulation
consistently?
• What degree of scrutiny has Congress devoted to the
regulation during subsequent reenactments of the
statute?
514
Mayo Found. for Med. Educ. and Research v. United
States – Supreme Court Decision
• The Court chose to apply Chevron and upheld the
regulation, finding that the statute did not define the term
“student” and “does not otherwise attend to the precise
question whether medical residents are subject to FICA.”
– The Court found there was no justification for applying
a less deferential standard than Chevron.
515
Deference to Regulations After Mayo
•
•
•
•
Augurs a period of great deference to Treasury and
the IRS
Regulations in response to litigation are not suspect
Irrelevant whether a regulation is promulgated
pursuant to a general or specific grant of authority
Should not lead to increased deference to litigating
positions generally, but will in practice, when they are
promulgated as regulations
516
Home Concrete and Supply, LLC v.
United States
517
Overstated Basis and the
Six-Year Statute of Limitations
•
•
Section 6501(e)(1) generally provides that, if a taxpayer omits more than 25% of gross income, the
SOL for assessment and collection is extended from three to six years. See also section 6229(c)(2)
(relating to partnerships).
–
In Colony, Inc. v. Commissioner, 357 U.S. 28 (1958), the Supreme Court held that an
overstatement of basis was not an omission of gross income and that a three-year SOL
applied rather than a five-year SOL (decided under a prior version of the Code).
–
In September 2009, Treasury and the IRS issued temporary regulations that generally
provided that overstatements of basis were omissions from gross income and therefore
potentially subject to a six-year SOL. In December 2010, Treasury and the IRS issued final
regulations. See Treas. Reg. § 301.6501(e)-1(e); Treas. Reg. § 301.6229(c)(2)-1.
The circuit courts of appeals were split as to whether an overstatement of basis is an omission from
gross income that can trigger a six-year SOL.
–
The Fourth and Fifth Circuits had held that an overstatement of basis does not constitute an
omission from gross income, and had found that the regulations issued by Treasury and the
IRS should not be entitled to Chevron deference. See Burks v. United States, 633 F.3d 347
(5th Cir. 2011); Home Concrete and Supply, LLC v. United States, 634 F.3d 249 (4th Cir.
2011). See also Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir.
2009) (in decision prior to issuance of regulations, holding that Colony controls).
–
The D.C., Tenth, and Federal Circuits had held that an overstatement of basis is an omission
of gross income and had granted Chevron deference to the regulations issued by Treasury and
the IRS, relying on Mayo. See Intermountain Ins. Serv. of Vail, LLC v. Commissioner, 650
F.3d 691 (D.C. Cir. 2011); Salman Ranch, Ltd. v. Commissioner, 647 F.3d 929 (10th Cir.
2011); Grapevine Imports, Ltd. v. United States, 636 F.3d 1368 (Fed. Cir. 2011). See also
Beard v. Commissioner, 633 F.3d 616 (7th Cir. 2011) (in decision pre-dating Mayo, holding
that Colony does not control, and indicating in dicta that Treas. Reg. § 301.6501(e)-1(e), then
in temporary form, would be entitled to Chevron deference).
518
Home Concrete and Supply, LLC v. United States
– Supreme Court Decision
•
•
•
In Home Concrete and Supply, LLC v. United States, 132 S. Ct. 1836 (2012), the
Supreme Court affirmed the decision of the Fourth Circuit, concluding that an
overstatement of basis does not constitute an omission from gross income that triggers
the extended six-year limitations period.
The Court held that the decision in Colony, Inc. v. Commissioner, 357 U.S. 28 (1958),
determined the outcome in the case.
–
According to the Court, the operative language of the 1939 provision at issue in
Colony and the provision currently at issue (which stems from the 1954 Code)
were identical, and it would be difficult to interpret the language differently without
effectively overruling Colony, which the Court was hesitant to do under principles
of stare decisis.
–
The Court rejected the government’s position that differences in other parts of the
1954 Code supported a different interpretation than the one adopted in Colony.
The Court also rejected the government’s argument that its recently promulgated
regulations should be granted deference under Chevron.
–
Because Colony had already interpreted the statute, the Court stated that there
was no longer any different construction consistent with Colony and available for
adoption by the administrative agency.
–
Finding that the Court in Colony concluded that the statute did not leave an
interpretive gap for the agency to fill, the Court held that the regulations could not
change Colony’s interpretation of the statute.
519