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Legislative Developments. Administration’s Fiscal Year 2014 Revenue Proposals – Repeal of Section 197 Anti-Churning Rules. Repeal of Section 197 Anti-Churning Rules.

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Legislative Developments

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Legislative developments

Legislative Developments


Legislative developments

  • Administration’s Fiscal Year 2014 Revenue Proposals –

  • Repeal of Section 197 Anti-Churning Rules


Repeal of section 197 anti churning rules

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.


Codification of economic substance

Codification of Economic Substance


Economic substance codification

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.


Economic substance codification1

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; seealso 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).


Economic substance codification2

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).


Economic substance codification3

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).


Legislative developments

Economic Substance –

Section 7701(o)


New section 7701 o

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.


New section 7701 o1

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.


Legislative developments

Notice 2010-62


Notice 2010 62

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.


Notice 2010 621

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.


When does the doctrine apply in general

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


When does the doctrine apply in general1

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).


When does the doctrine apply congressional plan or purpose

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.


When does the doctrine apply congressional plan or purpose1

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).


When does the doctrine apply congressional plan or purpose2

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?


When does the doctrine apply certain credits

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?


When does the doctrine apply safe harbors

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) pass the two prong test in the codified ES statute.


When does the doctrine apply safe harbors1

When Does the Doctrine Apply – “Safe Harbors”

1.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?

    2.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.


When does the doctrine apply safe harbors2

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 anti-abuse 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 anti-abuse rule applies to partnership formation.

  • What about Treas. Reg. § 1.1002-1 strict construction for nonrecognition rules?


When does the doctrine apply safe harbors3

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)?


When does the doctrine apply disaggregation

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; butsee 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)?

      • SeeSala 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).


If the es doctrine is determined to be relevant the two prong test the objective component

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?

    • SeeSala 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).


The two prong test the objective component

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?


The two prong test the objective component1

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.


The two prong test the objective component2

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. Butsee 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.

      • ContraCompaq 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.


The two prong test the subjective component

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? SeeColtec 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?


The two prong test the subjective component1

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?

    • CompareConsolidated 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.


  • Es doctrine individual exception

    ES DoctrineIndividual 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


    Legislative developments

    Economic Substance –

    Strict Liability Penalty


    Es codification penalties

    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.


    Es codification penalties1

    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.


    Es codification penalties2

    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.

      • SeeJCX-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.”


    Es codification penalties3

    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).


    Es codification penalties4

    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?


    Es codification penalties5

    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?


    Legislative developments

    Economic Substance –

    LMSB Directive on Imposition of Penalty


    Lmsb directive

    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.”


    Legislative developments

    Economic Substance –

    LB&I Directive


    Lb i directive

    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.


    Lb i directive1

    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.


    Chief counsel notice economic substance

    Chief Counsel Notice – Economic Substance


    Chief counsel notice economic substance1

    Chief Counsel Notice – Economic Substance

    On April 3, 2012, the IRS Office of Chief Counsel issued a notice (CC-2012-008) 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.


    Chief counsel notice economic substance2

    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. 2012-1).

    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.


    Chief counsel notice economic substance3

    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).


    Legislative developments

    Economic Substance –

    Practice and Procedure


    When does the doctrine apply practice and procedure

    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 40-percent penalty (even though a 20-percent penalty may be applied for a substantial understatement apart from a non-ES transaction).


    When does the doctrine apply practice and procedure1

    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.


    When does the doctrine apply practice and procedure2

    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?


    When does the doctrine apply practice and procedure3

    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?


    When does the doctrine apply practice and procedure4

    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 absent litigation?


    When does the doctrine apply practice and procedure5

    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. SeeSala 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. SeeShore v. United States, 9 F.3d 1524 (Fed. Cir. 1993).

        • What grounds are there to challenge the penalty?


    When does the doctrine apply practice and procedure6

    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.


    Legislative developments

    Economic Substance Doctrine – Summary


    Es doctrine summary

    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?


    Recent economic substance cases

    Recent Economic Substance Cases


    Coltec transaction

    Coltec Transaction

    Coltec

    C/S

    Class A Stock

    $14 million

    (1)

    (3)

    (2)

    7% C/S

    7% Garrison C/S

    Assumption of Liabilities

    Garlock

    Garrison

    Unrelated

    Banks

    $50,000

    $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).


    Coltec decision court of federal claims

    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. SeeColtec 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.


    Coltec decision court of federal claims1

    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.”


    Coltec on appeal federal circuit

    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. SeeColtec 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.


    Coltec on appeal federal circuit1

    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.


    Coltec on appeal federal circuit2

    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.


    Coltec certiorari petition

    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.


    Heinz transaction

    Heinz Transaction

    PUBLIC

    PUBLIC

    PUBLIC

    $130M

    Heinz

    Heinz

    Heinz

    3.325M

    Heinz

    shares

    3.5M

    Heinz

    shares

    ~ $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.


    Heinz court of federal claims

    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.


    Heinz court of federal claims1

    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.


    Heinz court of federal claims2

    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.


    Jade trading son of boss transaction

    Jade Trading – Son-of-Boss Transaction

    AIG

    Spread Options (w/ premium of ~ $15m)

    Net $150,000 Payment

    LLC 1

    LLC 2

    LLC 3

    (1)

    LLC 1

    LLC 2

    LLC 3

    Euros & stock (worth $125k)

    Spread Options &

    $75,000 cash

    (2)

    Jade

    Interests

    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.


    Jade trading taxpayer s position

    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.


    Jade trading court of federal claims

    Jade Trading – Court of Federal Claims

    • The Court of Federal Claims held that the transaction creating the basis increase lacked economic substance. SeeJade 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 –

        • 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.

        • The taxpayer had the burden of proving that the transaction had economic substance.

        • The objective reality of the transaction was the relevant criterion rather than any subjective intent of the taxpayer.

        • 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.

        • 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.


    Jade trading court of appeals for the federal circuit

    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. SeeJade 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.


    Sala v united states

    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.


    Sala v united states1

    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. SeeHelmer 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.


    Sala v united states district court decision

    Sala v. United States – District Court Decision

    The District Court made the following rulings with respect to the Deerhurst Program:

    • 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.

      • CompareKlamath 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)


    Sala v united states district court decision1

    Sala v. United States – District Court Decision

    2.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.

      3.Treasury exceeded its authority when issuing Treas. Reg. § 1.752-6(b)(2) and when making the regulations retroactive. CompareKlamath Strategic Inv. Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006) withCemco 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.


  • Sala v united states tenth circuit decision

    Sala v. United States – Tenth Circuit Decision

    • On appeal, the Tenth Circuit Court of Appeals reversed the district court’s decision. SeeSala 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.


    Countryside facts of transaction

    Countryside – Facts of Transaction

    C

    Other partners

    W

    6

    Countryside

    Distribution of 99% interest in CLPP in complete termination of W and C’s interest

    1

    $8.5 million

    Note

    Sale of real property for Cash

    7

    Loan Repayment

    99%

    2

    CLPP

    8

    5

    $8.5 million

    $8.5 million

    $11.9 million

    3

    MP

    4

    99%

    AIG Notes

    $3.4 million

    Note

    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 third-party 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.


    Countryside tax issues

    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. SeeCountryside Limited Partners v. Commissioner, T.C. Memo. 2008-3.


    Countryside economic substance

    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


    Countryside effect of continued litigation

    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.


    Countryside and valero section 7525

    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).


    Shell petroleum facts of transaction

    Shell Petroleum – Facts of Transaction

    ShellEnergyResources

    Unrelated Investors

    • 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 auction-rate 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)

    ShellOffshore

    ShellWestern

    ShellRoyalties

    ShellFrontier


    Shell petroleum facts of transaction1

    Shell Petroleum – Facts of Transaction

    ShellEnergyResources

    • 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.

    540 shares of Shell Frontier stock

    ShellOffshore

    ShellWestern

    cash

    UnrelatedInvestors

    ShellRoyalties

    >20%

    ShellFrontier


    Shell petroleum irs challenge

    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.


    Shell petroleum district court decision

    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. SeeShell 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.”


    Klamath strategic investment fund v united states facts

    Klamath Strategic Investment Fund v. United States – Facts

    Patterson

    $1.5M

    St. Croix

    LLC

    Presidio

    Resources

    LLC

    Presidio

    Growth

    LLC

    NatWest

    Loan of $41.7M plus a loan premium of $25M (total of $66.7M)

    90%

    9%

    1%

    Investment of $66.7M plus $1.5M

    Klamath

    LLC

    This example shows the facts for Patterson, St. Croix and Klamath; the facts are the same for Nix, Rogue, and Kinabalu.

    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.


    Klamath strategic investment fund v united states district court decision

    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.


    Klamath strategic investment fund v united states fifth circuit decision

    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.


    Schering plough corp v united states

    Schering-Plough Corp. v. United States

    (1)

    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 Schering-Plough 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.

    ABN

    SP

    interest rate swaps

    (US)

    $690.4 million

    (2)

    SC

    Assignment of

    “receipt leg” of swaps

    (US)

    SPI

    (US)

    SPL

    (Swiss)

    SL

    (Swiss)


    Schering plough corp v united states1

    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.


    Schering plough corp v united states2

    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. SeeSchering-Plough Corp. v. United States, 651 F. Supp. 2d 219 (D.C. N.J. 2009).

      • 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.


    Schering plough corp v united states3

    Schering-Plough Corp. v. United States

    • Court Decision (cont’d)

      • 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.


    Schering plough corp v united states4

    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).

      • 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. SeeMerck & 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.


    Coned v united states

    ConEd v. United States

    ConEd

    HBU

    $

    Periodic

    Rent (debt portion)

    CEL

    Note

    Upfront and deferred rent

    Headlease

    CEL Trust

    EZH

    Sublease

    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.


    Coned v united states court of federal claims

    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. SeeConsolidated 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.


    Coned v united states court of federal claims1

    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.


    Coned v united states court of federal claims2

    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.”


    Coned v united states court of federal claims3

    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.


    Wells fargo v united states court of federal claims

    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.


    Southgate master fund v united states

    Southgate Master Fund v. United States

    CCB

    $

    Cinda

    NPLs

    MCA

    Cinda

    MCA

    Beal

    NPLs

    $100k & note

    1%

    1%

    $19.6m

    Martel

    Eastgate

    Eastgate

    89.1% interest in Southgate

    99%

    99%

    Southgate

    NPLs

    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.


    Southgate master fund v united states1

    Southgate Master Fund v. United States

    Other

    partners

    Beal

    89.1% Southgate

    interest

    Beal

    (1)

    Other

    partners

    $162m

    GNMAs

    (FMV = $180.5m)

    Martel

    (1)

    (2)

    (3)

    (2)

    GNMA Repo

    Martel

    Martel

    Southgate

    UBS

    89.1%

    $162m

    89.1%

    GNMAs

    Southgate

    Southgate

    Martel

    NPLs

    NPLs

    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.


    Southgate master fund v united states2

    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-to-market 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.


    Southgate master fund v united states3

    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. SeeSouthgate 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.


    Southgate master fund v united states4

    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.


    Southgate master fund v united states fifth circuit decision

    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 KlamathStrategic 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.


    Country pine finance llc v commissioner

    Country Pine Finance, LLC v. Commissioner

    J&S liability on

    €16.6 million note

    U.K. Residents

    €1.9 note

    €1.0

    Members

    1

    3

    €16.6 million

    4

    Fairlop

    Country

    Pine

    Zurich

    Bank

    €1.9 note

    €1.0

    note

    €16.6 million

    €13.6 note

    €1.9 note

    €1.0

    2

    5

    Currency rate swap

    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).


    Country pine finance llc v commissioner1

    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.


    Country pine finance llc v commissioner2

    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.


    Fidelity int l v united states

    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. SeeFidelity 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.


    Fidelity int l v united states district court decision

    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.


    Fidelity int l v united states district court decision1

    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


    Canal corp v commissioner

    Canal Corp. v. Commissioner

    C

    Indemnity Agreement

    GP

    Guaranty of LLC Loan

    W

    Assets

    BOA

    Assets

    5% Interest + Cash Distribution Financed by LLC Loan

    LLC

    95% Interest

    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 substantial understatement penalty under section 6662(a).


    Canal corp v commissioner1

    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. SeeCanal 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 debt-financed 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.


    Canal corp v commissioner2

    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.


    Flextronics america llc v commissioner

    Flextronics America, LLC v. Commissioner

    C-MAC Industries

    C-MAC Holdings Stock

    Bank

    Cash

    (1)

    Pledge of Inventory

    as Security for

    $51.6 million liability

    (2)

    C-MAC Interconnect

    C-MAC Holdings

    Inventory (subject to $51.6 million liability)

    Cash

    Nortel

    C-MAC Holdings

    Stock + Note

    Inventory

    Facts: C-MAC Industries, a Canadian corporation and the parent company of all C-MAC entities (the “C-MAC group”), owned C-MAC 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, C-MAC 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.


    Flextronics america llc v commissioner1

    Flextronics America, LLC v. Commissioner

    C-MAC Industries

    Nortel

    (2)

    C-MAC Holdings

    (1)

    C-MAC

    Network

    Systems

    Stock +

    Note

    Cash

    Inventory (subject to

    $51.6 million liability) +

    Cash

    C-MAC Network Systems

    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.


    Flextronics america llc v commissioner2

    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.


    Flextronics america llc v commissioner3

    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 C-MAC 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.


    Sundrup v commissioner

    Sundrup v. Commissioner

    Sundrups

    Payments for

    Residence

    Residence

    Transfer

    Leasing

    Consulting

    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.


    Sundrup v commissioner1

    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.


    Historic boardwalk hall llc v commissioner

    Historic Boardwalk Hall, LLC v. Commissioner

    NJSEA

    (.01% ownership interest)

    PB

    (99.9% ownership interest)

    Boardwalk

    Section 47

    Credits

    Section 47

    Credits

    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.


    Historic boardwalk hall llc v commissioner1

    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.


    Historic boardwalk hall llc v commissioner2

    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 whether PB was a bona fide partner.


    Historic boardwalk hall llc v commissioner third circuit decision

    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.


    Superior trading llc v commissioner

    Superior Trading, LLC v. Commissioner

    Arapua

    U.S. Investors

    Holding Company Membership Interests

    Membership Interests

    (2)

    Warwick

    Receivables

    Trading Company Membership Interests

    Cash / assets

    (1)

    (3)

    Holding Companies

    Membership Interests

    Receivables

    Trading Companies

    Holding Company Membership Interests

    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.


    Superior trading llc v commissioner1

    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.


    Wfc holdings corp v united states

    WFC Holdings Corp. v. United States

    (2)

    Cash

    Lehman Brothers

    WFC

    Charter

    Preferred

    Stock

    Charter

    Preferred

    Stock

    (3)

    Cash

    (1)

    Banks

    Charter

    Securities + Leasehold Interests

    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.


    Wfc holdings corp v united states1

    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.


    Wfc holdings corp v united states2

    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.


    Pritired 1 llc v united states

    Pritired 1, LLC v. United States

    Pritired

    Citibank

    Principal

    Other Owners

    SAS

    Pritired

    $300

    million

    Foreign Tax Credits

    SAS

    SAS

    B Shares + Perpetual Certificates

    • 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.


    Pritired 1 llc v united states1

    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.


    Pritired 1 llc v united states2

    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.


    K2 trading ventures llc v united states court of federal claims decision

    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

    Gerdau MacSteel, Inc. v. Commissioner

    (1)

    Cash

    Q

    (2)

    $38 million +

    Medical Plan Liabilities

    QHMC

    Class B Stock

    CS

    Former Q Group Employee

    (4)

    QS

    Stock

    Cash

    QHMC

    Class C Stock

    (3)

    Cash

    QHMC

    QS

    QHMC

    Class C Stock

    QHMC

    Class C Stock

    $38 million +

    Medical Plan Liabilities

    • 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.


    Gerdau macsteel inc v commissioner1

    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 savingsrather 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 commissioner2

    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).


    Legislative developments

    Economic Substance –

    Transaction Planning


    Sale to recognize loss

    Sale to Recognize Loss

    • 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.

    P

    ThirdParty

    Sale of S stock

    S

    P has built-in loss in S stock


    Accelerating a built in gain

    Accelerating a Built-In Gain

    P

    100%

    100%

    S1

    S2

    asset

    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?


    Busting consolidation example 1

    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.


    Busting consolidation example 2

    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.


    Avoiding loss disallowance rules

    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.


    Section 331 liquidation

    Section 331 Liquidation

    P

    P

    25% S stock

    Liquidation

    cash

    100%

    75%

    S

    FS

    S

    FS

    25%

    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.


    Section 332 liquidation

    Section 332 Liquidation

    P

    P

    25% S stock

    Liquidation

    cash

    75%

    100%

    S

    FS

    S

    FS

    25%

    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?


    Check and sell transaction

    Check-and-Sell Transaction

    P

    Bus. 2

    CFC1

    X

    Deemed Liquidation

    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?


    Check the box election to claim worthless security deduction

    X

    Worthless

    Security

    Deduction

    Check-the-box Election to Claim 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?


    Checking and unchecking

    Checking and Unchecking

    USCO

    • 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

    CFC

    HOLDCO

    Cash

    Newco


    Use of a blocker to avoid ubti

    Use of a blocker to avoid UBTI

    X and Investor Form Partnership

    • 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

      • Income produced by the X business would be UBTI to TE

    • 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

    TE

    P’ship interest

    Cash

    2

    1

    X

    Blocker

    1

    P’ship

    business

    Operating

    business


    Purchase and liquidation

    Purchase and Liquidation

    • 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?

    P

    P

    T stock

    A

    $

    Liquidation

    T

    T


    Liquidation and sale

    Liquidation and Sale

    • 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?

    P

    ThirdParty

    Sale of S assets

    Liquidation

    S


    Busted section 351 transaction to make section 338 h 10 election

    Busted Section 351 Transaction to Make Section 338(h)(10) Election

    (3) N stock

    P

    PUBLIC

    • 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?

    (2) X & Y Stock

    Z

    N

    (1) Newco formed

    X

    Y


    Section 351 transaction with built in loss asset

    Section 351 Transaction with Built-in Loss Asset

    P

    • 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? SeeShell 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).

    S stock

    Built-in loss asset

    S


    C reorganization

    “C” Reorganization

    T S/H’s

    T S/H’s

    P S/H’s

    P S/H’s

    • 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?

    T S/H’s

    P S/H’s

    T

    P Stock

    Liquidates

    P

    T

    P

    P

    T Assets

    T Assets

    T Assets

    T Assets


    D reorganizations cash rev rul 70 240

    “D” Reorganizations – Cash – Rev. Rul. 70-240

    Step One

    Step Two

    P

    P

    Liquidation

    X

    Y

    X

    Assets

    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.


    All cash d reorganizations consolidation

    All-Cash “D” Reorganizations – Consolidation

    P

    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?

    X

    Y

    (1)

    X Assets

    (2)

    Liquidation

    Cash

    T


    All cash d reorganizations foreign to foreign

    All-Cash “D” Reorganizations – Foreign-to-Foreign

    P

    (2)

    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); butseeSchering-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).

    Liquidation

    CFC1 Assets

    CFC1

    CFC2

    (1)

    Cash


    Section 304 cross border transaction

    Section 304 Cross-Border Transaction

    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?

    P

    cash

    F1

    stock

    F1

    F2


    Roll up transaction

    Roll-up Transaction

    P

    • 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”?

    A

    Ownership interests in LLC1, LLC, and LLC3

    LLC1

    B

    LLC2

    C

    Newco

    LLC3


    Administrative developments and caselaw

    Administrative Developments and Caselaw


    Section 338 overview

    Section 338 Overview


    Section 338

    Section 338

    P

    T Stock

    SH

    $

    T

    P

    SH

    Old

    T

    New

    T

    Asset

    Sale


    Section 338 h 10

    Section 338(h)(10)

    T Stock

    S

    P

    T

    S

    P

    332

    Liquidation

    Asset

    Sale

    Old

    T

    New

    T


    Section 338 regulations organization

    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)


    Section 338 regulations accounting rules

    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.


    Section 338 regulations allocation rules

    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) andTreas. 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).


    Treas reg 1 338 3 qualification for the section 338 election

    Treas. Reg. § 1.338-3Qualification 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 beconsidered purchased if, under general principles of tax law, the purchasing corporation isconsidered to own the stock of the target (or the target affiliate) meeting the requirementsof 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).


    Treas reg 1 338 h 10 1 deemed asset sale and liquidation

    Treas. Reg. § 1.338(h)(10)-1Deemed 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).


    Reporting requirements

    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.


    Purchase

    Purchase


    Section 338 regulations

    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. SeeTreas. 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.”


    Section 338 purchase has a corporation made the purchase

    Section 338 – PurchaseHas a Corporation Made the Purchase?

    P

    S

    $

    T Stock

    Newco

    T

    1. Newco buys T stock from S.


    Section 338 purchase has a corporation made the purchase cont d

    Section 338 – PurchaseHas a Corporation Made the Purchase? (cont’d)

    P

    332

    Liquidation

    Newco

    T

    2. Newco is liquidated into P.


    Section 338 purchase has a corporation made the purchase cont d1

    Section 338 – PurchaseHas 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.


    Section 338 purchase has a corporation made the purchase cont d2

    Section 338 – PurchaseHas a Corporation Made the Purchase? (cont’d)

    P

    X

    GP

    Liquidate T

    T


    Section 338 purchase has a corporation made the purchase cont d3

    Section 338 – PurchaseHas a Corporation Made the Purchase? (cont’d)

    X

    A

    T Shareholders

    P

    $

    T

    T1 Stock

    N

    T stock

    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).


    Section 338 purchase contemporaneous sale of affiliate stock

    Section 338 – PurchaseContemporaneous Sale of Affiliate Stock

    T shareholders

    $

    P

    T

    T stock

    T1 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).


    Section 338 purchase common ownership of s and p

    Section 338 – PurchaseCommon Ownership of S and P

    C

    C

    B

    B

    A

    D

    A

    D

    25%

    25%

    25%

    25%

    25%

    25%

    25%

    25%

    S

    P

    T Stock

    $

    T

    Has P purchased the T stock?


    Section 338 purchase cash investment

    Section 338 – PurchaseCash Investment

    P

    A

    90% of T Stock

    $

    T

    1. A owns all T stock.

    2. P transfers cash to T for 90 percent of T stock.

    3. Has P purchased the T stock?

    4. What if T also has non-voting preferred stockthat is not bought?


    Section 338 purchase cash investment followed by redemption

    Section 338 – PurchaseCash Investment Followed by Redemption

    P

    A

    1 Share of T Stock

    T Stock

    $

    $

    T

    1. A owns all T stock.

    2. P transfers cash to T for 1 share of T stock.

    3. A is redeemed by T (using funds other than those provided by P).

    4. Has P purchased the T stock?


    Legislative developments

    Section 338 – Purchase

    A

    S

    45%

    55%

    T

    • T redeems S’s T stock and then S purchases A’s T stock

    • Recap S’s T stock to § 1504(a)(4) preferred stock and then S purchases A’s T Stock

    • S sells T stock to P and then S buys T stock from A and P

    Are any of these transactions Qualified Stock Purchases?


    Qualified stock purchase effect of section 351

    Qualified Stock Purchase – Effect of Section 351

    I

    S

    (1)

    $

    (2) T stock

    (3) $ & 5% P stock

    P

    T

    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.


    Qualified stock purchase effect of section 351 cont d

    Qualified Stock Purchase – Effect of Section 351 (cont’d)

    I

    S

    95%

    5%

    P

    T

    • Variations

      • S is several individuals, some shareholders sell Pstock, while others do not.

      • The transaction is leveraged.


    Qualified stock purchase section 351 cont d

    Qualified Stock Purchase – Section 351 (cont’d)

    Investor

    Shareholder

    20% T Stock

    $

    N Stock

    N Stock

    T

    N

    80% T

    Stock

    $

    loan

    N1

    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?


    Legislative developments

    Participation by T Management – Section 351

    5%

    M

    95%

    SH

    X

    cash

    $15

    T Stock

    $95

    T

    P

    T Stock

    $15

    merger

    S

    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 management’s stock and that cash is used to purchase T stock.


    Legislative developments

    Sale by T Management to P – Newly Formed P

    $5

    X

    cash

    $15

    95%

    SH

    5%

    M

    P

    T

    S

    Bank

    $80

    • 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).

    • The result is the same as the prior example – Section 338 is not available.


    Special issues use of p stock

    Special Issues – Use of P Stock

    S

    P

    99% P stock

    1% cash

    T

    1. Can P and S make a Section 338(h)(10) election and with what consequences?

    2. What if T liquidates/merges into P?


    Special issues use of p stock1

    Special Issues – Use of P Stock

    P

    T Stock

    Public

    P Stock

    P Stock

    T

    S

    T Stock

    • 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.


    Qualified stock purchase

    Qualified Stock Purchase


    Section 338 purchase has a corporation made the purchase1

    Section 338 – PurchaseHas 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.”


    Legislative developments

    Section 338 – Qualified Stock Purchase

    Target Stock Owned by Subsidiary

    P

    T Stock

    PUBLIC

    $

    60%

    T

    1. The public owns 60 percent of

    T stock. X owns the

    remaining 40 percent of T stock.

    2. P purchases the T stock

    held by the public.

    3. Has P made a QSP of T?

    See PLR 8425120.

    40%

    100%

    X


    Acquisition of partnership interests

    Acquisition of Partnership Interests

    100% of GP

    Partners

    P

    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).


    Deemed purchase rule

    Deemed Purchase Rule


    Deemed purchase

    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).


    Section 338 election rules chain of corporations

    Section 338 Election RulesChain of Corporations

    $

    S

    P

    T stock

    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?


    Section 338 h 101

    Section 338(h)(10)


    Section 338 h 10 and busted 351 transaction

    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.


    Section 338 h 10 and busted 351 transaction cont d

    Section 338(h)(10) and “Busted 351” Transaction (cont’d)

    PUBLIC

    (3) N stock

    P

    (1) Newco formed

    (2)

    X & Y

    Stock

    Z

    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.


    Section 338 h 10 and busted 351 transaction cont d1

    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. Seesections 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 anti-churning rules of section 197(f)(9).

    • Prior to the effective date of Treas. Reg. § 1.197-2 it was possible that the anti-churning rules could have applied even if P sold all of the N stock because of the momentary relationship between P and N. SeeOld Prop. Treas. Reg. § 1.197-2(h)(6)(ii).


    Section 338 h 10 and busted 351 transaction variation

    Section 338(h)(10) and “Busted 351” Transaction Variation

    PUBLIC

    (3) N stock

    P

    • 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?

    (3) N stock

    (1) Newco formed

    (2)

    X & Y

    Stock

    Z

    N

    X

    Y


    Plr 200427011

    PLR 200427011

    (1) (immediately)

    21% NewcoCommon Stock

    Newco Stock, Convertible Instruments & Non-Cash Consideration

    Public

    P

    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

    • 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

    • 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.

    (2) (within 2 years)

    Stock of Purchased Subs

    30% NewcoCommon Stock

    Public

    PurchasedSubs

    Newco


    Situation 1

    Situation 1

    Form of Transaction

    Recharacterized Transaction

    Subsequent Sale

    Public

    Public

    • 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.

    30% Newco stock

    Public

    21% Newco stock

    21% Newco stock

    P

    P

    P

    21%

    T stock

    Newco

    Newco

    T liquidates

    T

    Newco

    T

    New T

    New T

    T assets

    P and Newco make a section 338(h)(10) election


    Situation 2

    Situation 2

    Public

    30% Newco stock

    • 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.

    P

    21% Newco stock

    P

    Public

    21%

    T

    Newco

    Newco

    T liquidates

    T assets


    Situation 3

    Situation 3

    Public

    30% Newco stock

    P

    • 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.

    Public

    21% Newco stock

    Public

    P

    P

    21%

    T stock

    Newco

    21%

    Newco

    T

    Newco

    Merger

    T


    Situation 4

    Situation 4

    Public

    21% Newco stock

    30% Newco stock

    P

    • 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.

    Public

    P

    P

    Public

    T liquidates

    T1 stock

    21%

    21%

    Newco

    T

    T1

    Newco

    Newco

    Merger

    T1

    T assets


    Plr 201228011

    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.


    Plr 2012280111

    PLR 201228011

    Parent

    Public

    20% NewCoStock

    > 30% NewCo Stock

    > 30% NewCo Stock

    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.


    Plr 2012280112

    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.”


    Plr 201216026

    PLR 201216026

    Public

    Parent Group

    Foreign Target

    > 80 %

    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.


    Plr 2012160261

    PLR 201216026

    Public

    Parent Group

    Sale of some T Stock

    Target

    > 80 %

    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).”


    Intragroup section 338 h 10 election example recent plrs

    Intragroup Section 338(h)(10) ElectionExample – Recent PLRs

    (4)

    P Stock

    Buyer

    Shareholders

    Newco

    Common Stock

    Cash

    (5)

    (3)

    Newco

    Preferred Stock

    P

    Third-Party

    Cash

    (1)

    T Stock

    (2)

    Business B

    T

    Newco Stock – Common and Preferred

    Newco

    Business A

    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 Newcoand 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; seealso PLRs 201203004 and 201145007.


    Legislative developments

    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

    Business B

    NewCo 1

    NewCo 1

    (3)

    Target

    (4)

    NewCo 1 common and preferred interests

    Business B

    Business

    A

    Business A

    NewCo 2

    NewCo 2

    NewCo 1 common and preferred interests

    Target Sub

    Target Sub

    Target stock

    NewCo 3

    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.


    Legislative developments

    PLR 201126003

    Final Structure

    Current

    Shareholders

    (5)

    Current

    Shareholders

    Public

    NewCo 1 common interests

    Less than 10%

    $

    (6)

    Parent

    Parent

    Stock

    REIT

    NewCo 1

    NewCo 1

    Business B

    REIT

    NewCo 2

    Parent

    Parent

    NewCo 2

    NewCo 3

    Business B

    Target

    Business B

    NewCo 3

    Business A

    Target

    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.


    Plr 201145007

    PLR 201145007

    NewCo

    Preferred

    Stock

    (2)

    P

    Investors

    Sub 2 –

    Sub 5

    LLC1

    Sub 2 – Sub 5

    NewCo

    Sub 1

    Sub 7 –

    Sub 12

    (1)

    NewCo Sub

    Sub 6

    Sub 7

    Sub 8

    Sub 9 –Sub 12

    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).


    Plr 2011450071

    PLR 201145007

    Acquiring

    P

    Acquiring

    NewCo

    P

    LLC1

    Sub 1

    NewCo

    Merger Sub

    NewCo Sub

    LLC1

    Sub 1

    Sub 6

    NewCo Sub

    Sub 2 – Sub 5

    Sub 7 –Sub 12

    Sub 6

    Sub 2 – Sub 5

    Sub 7 –Sub 12

    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.


    Plr 2011450072

    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.


    Plr 201203004

    PLR 201203004

    (4)

    Public

    C Stock

    (3)

    (1)

    Newco

    Preferred Stock

    D

    Investors

    Newco Common/

    Preferred Stock

    Cash

    C Stock

    T Stock

    (2)

    Newco

    Common Stock

    Newco

    S

    T

    C

    Business B

    (Built-in Losses)

    Business A

    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.

      • D distributes all of the C stock to its shareholders(pro rata).


    Plr 2012030041

    PLR 201203004

    Public

    D

    C

    Investors

    Newco

    Common

    Stock

    Newco Preferred Stock

    S

    Newco

    Business A

    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).


    Plr 2012030042

    PLR 201203004

    Public

    D

    C

    Investors

    Newco

    Common

    Stock

    Newco Preferred Stock

    S

    Newco

    Business A

    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.


    Plr 201213013

    PLR 201213013

    Buyer Investors

    Seller Parent Group

    Partnership

    (3) Target Stock

    Buyer Parent Group

    Target

    (1) Buyer Parent Stock

    Buyer

    (2) Assets

    FSub

    (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.


    Final section 336 e regulations

    Final Section 336(e) Regulations


    Final section 336 e regulations background

    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 self-executing, 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 disposition date is on or after May 15, 2013.


    Legislative developments

    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).


    Legislative developments

    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


    Final section 336 e regulations s corporations

    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.

      • The regulations provide additional and special rules to allow section 336(e) elections 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.

      • 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.


    Final section 336 e regulations disallowed loss rule

    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.


    Legislative developments

    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).


    Legislative developments

    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. § 1.336-1(b)(12).


    Final regulations under section 336 e related party rule

    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.


    Legislative developments

    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.


    Final section 336 e regulations time and manner for making section 336 e election

    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.


    Final section 336 e regulations time and manner for making section 336 e election1

    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.


    Legislative developments

    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 12-month disposition period.


    Legislative developments

    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.


    Legislative developments

    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.


    Legislative developments

    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 12-month 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.


    Legislative developments

    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).


    Requirements for section 336 e election

    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).


    Section 338 h 10 vs section 336 e

    Section 338(h)(10) vs. Section 336(e)


    Section 338 h 10 vs section 336 e modifications to terms in treas reg 1 338 5

    Section 338(h)(10) vs. Section 336(e)Modifications to Terms in Treas. Reg. § 1.338-5


    Sales

    Sales

    At close of Day 1, Old T deemed to sell all assets to unrelated party for FMV and liquidate

    Old T has gain/loss on deemed sale

    2

    Seller

    Buyer

    Seller

    Target Stock

    Cash

    Liquidates

    On Day 1, B purchases stock of T from S for Cash

    S and T make 336(e) election

    Old Target

    Unrelated Party

    Target

    1

    All Assets

    FMV

    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)

    3

    Buyer

    Buyer

    Seller

    Tax Attributes of Old Target if a 332

    New Target

    New Target

    Unrelated Party

    All Assets

    FMV

    Stepped Up Basis in Assets No Tax Attributes


    Qualified stock purchase1

    Qualified Stock Purchase

    T stock

    P

    A

    • P sells all the T stock to A for cash.

    $

    T

    S

    • 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).


    Qualified stock disposition sale general

    Qualified Stock Disposition – Sale – General

    80% of T stock

    Public

    P

    • 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. § 1.336-1(b)(6)(ii)(B).

    $

    T1

    T

    S


    Stock sale with section 336 e election

    Stock Sale with Section 336(e) Election

    T stock

    (2)

    S

    A

    Deemed liquidation

    Cash

    Deemed assets

    Old T

    NewT

    (1)

    ADADP

    • 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.


    Qualified stock disposition sale timing

    Qualified Stock Disposition – Sale – Timing

    Date 1

    80% T stock

    Public

    P

    $

    • 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.

      Treas. Reg. § 1.336-2(b)(2)(iv).

    Date 2

    20% T stock

    $

    T

    S


    Qualified stock disposition sale asset basis

    Qualified Stock Disposition – Sale – Asset Basis

    Date 1

    Date 2

    85 sh T stock

    15 sh T stock

    17 Individuals

    P

    3 Individuals

    • 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.

    100 sh

    $1,700

    $150

    ($20/sh)

    T

    ($10/sh)

    S


    Consolidation issues

    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).


    Consolidation issues example

    Consolidation Issues – Example

    July 1, Year 1

    June 30, Year 2

    20% T stock

    A

    P

    60% T stock

    A

    P

    B

    • 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. SeeTreas. 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?

    $

    $

    20%

    20%

    80%

    80%

    T

    T


    Consolidation issues example cont d

    Consolidation Issues – Example (cont’d)

    July 1, Year 1

    June 30, Year 2

    20% T stock

    A

    P

    60% T stock

    A

    P

    B

    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?

    $

    $

    20%

    20%

    80%

    80%

    T

    T


    Non section 355 distributions

    Shareholder

    Shareholder

    Old Target

    Non-Section 355 Distributions

    Old T deemed to sell all assets to unrelated party for FMV

    Old T has gain/loss on deemed sale

    D distributes stock of T to S/H

    D and T make a 336(e) election

    2

    1

    Distributor

    Target

    Stock

    Distributor

    Old Target

    Unrelated Party

    All Assets

    Target

    FMV

    D deemed to purchase New T stock from unrelated party and distribute such stock to S/H

    Tax consequences to S/H are generally the same as when 336(e) election not made

    New T deemed to buy all assets from unrelated party for FMV

    Old T deemed to liquidate

    5

    3

    Distributor

    4

    New T

    Stock

    Liquidates

    Distributor

    FMV

    All Assets

    Unrelated Party

    Tax Attributes of Old T

    New Target

    Unrelated Party

    New T

    Stock

    New T: Stepped Up Basis in Assets; No Tax Attributes or E&P

    FMV


    Qualified stock disposition non section 355 intra group and non pro rata external distributions

    Qualified Stock Disposition – Non-Section 355 Intra Group and Non Pro Rata External Distributions

    B

    60 sh

    A

    40 sh

    (2)

    T stock

    • 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.

    D

    25 sh D stock

    (1)

    T stock

    S

    T

    No 5-Year ATB


    Section 355 distributions

    Shareholder

    Shareholder

    Shareholder

    Section 355 Distributions

    Old T deemed to sell all assets to unrelated party for FMV

    Old T has gain/loss on deemed sale

    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)

    D and T make a 336(e) election

    2

    1

    Distributor

    Target

    Stock

    Distributor

    Old Target

    Unrelated Party

    All Assets

    Target

    FMV

    Old T deemed to repurchase all assets for FMV

    D distributes Old T stock to S/H

    3

    4

    Old T

    Stock

    Distributor

    Old Target

    Distributor

    Stepped Up Basis in Assets Retains Tax Attributes

    and E&P

    Old Target

    Unrelated Party

    FMV

    All Assets


    Section 355 d or e stock distribution with section 336 e election

    Section 355(d) or (e) Stock Distributionwith Section 336(e) Election

    SH’s

    25% A stock

    T stock

    S

    A

    Merge

    Deemed asset sale

    Unrelated Person

    Old T

    Deemed asset acquisition

    • 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.


    Deemed treatment as result of section 336 e election

    Deemed Treatment as Result of Section 336(e) Election

    Section 355(d) and (e) Spins

    Sales and Exchanges

    Section 301 / 311 Distributions

    Deemed Asset Sale by Target

    Yes

    Yes

    Yes

    Losses Recognized

    Yes

    Limited

    Limited

    Deemed Liquidation of Target

    Yes

    Yes

    No


    Disallowed loss example facts

    Disallowed Loss Example — Facts

    Shareholders

    Target

    Stock

    • 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.

    Seller

    Section 336 (e)Realized Gain or Loss

    (30)

    80

    FMV 100Basis 50Realized Gain 50

    Basis

    40

    10

    FMV

    10

    90

    Asset 1

    Asset 2

    Target


    Disallowed loss example results

    Disallowed Loss Example — Results

    Shareholders

    Target

    Stock

    • 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.

    Seller

    Section 336 (e)Realized Gain or Loss

    (30)

    80

    FMV 100Basis 50Realized Gain 50

    Basis

    40

    10

    FMV

    10

    90

    Asset 1

    Asset 2

    Target


    Section 351 transactions

    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. § 1.336-1(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.


    Legislative developments

    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 non-taxable 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.


    Section 351 transactions example

    Section 351 Transactions – Example

    Investors

    Seller

    Target

    Stock

    • 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.

    Acquiror

    Stock

    Cash

    Acquiror

    Stock and Cash

    Target

    Acquiror


    Intercompany sale or spin followed by external sale or spin

    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.


    Legislative developments

    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. § 1.1502-13(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.


  • Section 336 e election foreign corporations

    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-the-box election is unavailable?


    Contingent liabilities

    Contingent Liabilities


    Contingent liabilities in taxable asset acquisitions

    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.


    Contingent liabilities in taxable asset acquisitions1

    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.


    Contingent liabilities assumed obligation

    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


    Contingent liabilities assumed obligation1

    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.


    Contingent liabilities assumed obligation2

    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.


    Contingent liabilities assumed obligation3

    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.

      • Butsee 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.


    Contingent liabilities assumed obligation4

    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.


    Contingent liabilities assumed obligation5

    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.


    Legislative developments

    • 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


    Consequences of an assumed liability to the seller

    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.


    Consequences of an assumed liability to the seller1

    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.


    Consequences of an assumed liability to the seller2

    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. SeeTreas. 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.


    Consequences of an assumed liability to the seller3

    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).


    Consequences of an assumed liability to the buyer

    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

        • SeeWebb 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.

        • Seealso Holdcroft, Pacific Transport, M. Buten & Sons.

      • Uncertain whether buyer can treat a portion of the payments as interest.


    Consequences of an assumed liability to the buyer1

    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.

      • ABA and NYSBA support the deductibility approach.


    Consequences of an assumed liability to the buyer2

    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.


    Contingent liabilities section 338 h 10

    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.


    Legislative developments

    IRS Ruling Policy


    Irs ruling policy for corporate transactions rev proc 2013 32

    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.


    Irs specific no rule areas

    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 ‘north-south’ 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.”


    Transfers to creditors in divisive reorganizations

    Transfers to Creditors in Divisive Reorganizations


    Treatment of transfers to creditors in divisive reorganizations

    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.


    Treatment of transfers to creditors in divisive reorganizations example

    Treatment of Transfers to Creditors in Divisive Reorganizations – Example

    D Shareholders

    (3)

    (2)

    C Stock

    $300 Cash

    D

    D Creditors

    Business A Assets

    Aggregate FMV = $500

    Aggregate Basis = $250

    $200 C Stock

    $300 Cash

    (1)

    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.


    Treatment of transfers to creditors in divisive reorganizations irs rulings

    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.


    Plr 201138021

    PLR 201138021

    Cash

    Unrelated

    Third

    Parties

    Investment

    Banks

    Public

    (2)

    C Securities

    D Debt

    C Stock

    (4)

    D

    C Securities

    (3)

    (1)

    C Stock,

    C Securities,

    Liability Assumption

    BusinessA

    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 gainor loss with respect to the C securities under section 361(c).

    • SeealsoPLRs 200808006, 200802009.


    Treatment of transfers to creditors in divisive reorganizations irs rulings1

    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.


    Legislative developments

    Repayment of Distributing Debt in 355 Spin-off – PLR 201029007

    Debt holders

    (1)

    D issues Debt to unrelated investors

    D

    (2)

    (3)

    D distributes C stock to D’s shareholders and exchanges C Debt for D Debt

    D contributes assets to C in exchange for C stock and C 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.


    Legislative developments

    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.

      • ComparePLR 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.


    Plr 201232014

    PLR 201232014

    Third-Party

    Investors

    Public

    (3)

    Facts: D is a publicly-traded corporation that operates Businesses Aand 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.

    Cash

    (2)

    C Stock

    D Securities

    D

    (1)

    C stock,

    Cash,

    C Securities,

    Liability Assumption

    BusinessA

    C


    Plr 2012320141

    PLR 201232014

    Third-Party

    Investors /

    D Creditors

    Public

    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 gainor 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.

    (4)

    D Securities /

    Debt

    (5)

    C

    Securities

    D Creditors

    C

    D

    C Cash


    Plr 2012320142

    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.


    Control requirement

    Control Requirement


    Legislative developments

    Recap into Control for 355 Spin-off, followed by Unwind of Recap – PLR 201007050

    D2

    (4)

    D1 distributes Class B stock of C to D2 (“Internal Spin-off”)

    (2)

    shares of Class A stock are issued to D2 for assets

    D1

    Public

    (3)

    (1)

    C is recapped to create Class A & B stock; D1 is issued Class B stock

    shares of Class A stock are issued to the public in an IPO

    C

    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.


    Legislative developments

    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. SeePLRs 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.


    Spin off of born to die controlled

    Spin-Off of “Born-To-Die” Controlled

    D wants to separate Business B from Business A. X wants to acquire D’s Business B.

    D forms C and transfers Business B to C.

    D distributes the C stock to Public.

    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).

    .

    (3)

    >50% X Stock

    X

    Public

    (2)

    C Stock

    D

    (1)

    Bus. B

    (3)

    Merger

    Bus. A

    Bus. B

    C


    Plr 201032017 born to die controlled

    PLR 201032017 –Born-to-Die Controlled

    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).

    SeeGregory 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.

    D5

    C1 merges into a DE owned by D5

    Section 355 distribution of C1 to D5

    (4)

    (3)

    D4

    D1

    Section 355 distribution of C1 to D4

    (2)

    D1 contributes ATB to C1

    (1)

    C1

    (Newco)


    Rev rul 63 260 d shareholder contribution of c stock to d before spin of c not respected

    Rev. Rul. 63-260 – D Shareholder Contributionof C Stock to D Before Spin of C Not Respected

    • 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”).

    • 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.

    Shareholder

    (2)

    80% of

    C Stock

    (1)

    10% of

    C Stock

    D

    30%

    70%

    C


    Rev rul 71 593 divisive d reorganization to exchange stock ownership between shareholders

    Rev. Rul. 71-593 – Divisive “D” Reorganization to Exchange Stock Ownership Between Shareholders

    A

    B

    • X transfers Asset to Y in exchange for 900 shares (90 percent) of Y stock.

    • 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.

    (2)

    900 sh

    Y Stock

    (2)

    25 sh

    X Stock

    50 sh

    50 sh

    X

    75 sh

    25 sh

    (1)

    900 sh

    Y Stock

    (1)

    Asset

    Y


    Plr 201132009 simplified acquisition of control from shareholder before spin

    PLR 201132009 Simplified –Acquisition of “Control” from Shareholder Before Spin

    D2 wants to separate Business Y from Business X.

    • 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).

    • D1 transfers Asset Y to C1 in exchange for all the Class A C1 stock.

    • D1 distributes the Class A C1 stock to D2.

    Public

    (3)

    Class A

    C1 Stock

    D2

    (2)

    Class A C1 Stock

    D1

    C2

    [new]

    Asset Y

    Bus. X

    C1

    Asset

    Y

    Bus. Y


    Plr 201132009 simplified acquisition of control from shareholder before spin cont d

    PLR 201132009 Simplified –Acquisition of “Control” from Shareholder Before Spin (cont’d)

    • D2 transfers the C1 stock (Class A and Class B) to C2.

    • 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.

    Public

    (5)

    C2

    Stock

    D2

    (4)

    C1 Class A & B Stock

    C2

    [new]

    D1

    Class B

    Bus. X

    Class A

    C1

    Bus. Y

    Asset Y


    Legislative developments

    North-South Transactions


    North south transactions

    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.


    North south issues spin off transactions transactions between shareholder and distributing

    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.


    North south issues spin off transactions transactions between shareholder and distributing1

    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 non-exchange 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”).


    Plr 201033007 north south transactions between shareholder and distributing

    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; seealso 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”).


    Plr 201136009 north south transactions between distributing and controlled

    PLR 201136009 – North-South Transactions Between Distributing and Controlled

    Shareholder

    (3)

    D distributes C stock to Shareholder

    • 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?

    D

    (2)

    D contributes assets to C

    (1)

    C distributes cash to D

    C


    Tax free acquisitions

    Tax-Free Acquisitions


    What is this transaction

    What Is This Transaction?

    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?

    Where do S’s attributes end up?

    P

    (2)

    Merger

    (1)

    S

    Sub all of S assets

    Newco


    Treas reg 1 368 2 k 1

    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.”


    Step transaction issues

    Step Transaction Issues


    King enterprises transaction

    King Enterprises Transaction

    Step 1

    Step 2

    Public

    Public

    50% P voting stock and 50% cash

    P

    Merge

    100% T stock

    P

    T

    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.


    Rev rul 2001 46 situation 1

    Rev. Rul. 2001-46 – Situation 1

    Step 1

    Step 2

    100% T stock

    T Shareholders

    P

    P

    70% P voting stock and

    30% cash

    100%

    Merge

    Merge

    T

    T

    S

    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. SeeRev. 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.


    Final treas reg 1 338 h 10 1 c 2 e

    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). Seeid. 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.


    Rev rul 2001 46 situation 2

    Rev. Rul. 2001-46 – Situation 2

    Step 1

    Step 2

    100% T stock

    T Shareholders

    P

    P

    100% P voting stock

    100%

    Merge

    Merge

    T

    T

    S

    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.


    King enterprises transaction variation

    King Enterprises Transaction – Variation

    Step 1

    Step 2

    Step 3

    Public

    Public

    P

    50% P stock &

    50% cash

    T assets

    P

    X

    Merge

    Cash

    100%

    T stock

    P

    T

    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.


    Legislative developments

    King Enterprises Transaction – Variation

    Step 1:

    Step 3:

    Step 2:

    S/H’s

    S/H’s

    S/H’s

    S/H’s

    P

    Voting

    Stock

    T

    Businesses

    1 + 2

    S/H’s

    C

    Stock

    P

    C

    Business 2

    P

    100% T Stock

    Business 2

    assets

    T

    Liquidates

    C

    Business 2

    T

    Business 1

    C

    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? SeeRev. Rul. 2001-46; Treas. Reg. § 1.338-3(c)(1)(i), (2); Treas. Reg. § 1.338(h)(10)-1(c)(2), (e).


    Legislative developments

    Rev. Rul. 2008-25

    Step One

    Step Two

    (2)

    Old P Sh.

    A

    P

    $90 P Voting Stock

    $10 Cash

    A

    P

    T Stock

    Liquidation

    (1)

    T

    (2)

    P forms X

    Merger

    T

    X

    Assets = $150

    Liabilities = $50

    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. 90-95 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.


    Merrill lynch v commissioner

    Merrill Lynch v. Commissioner

    GATX/BCE

    MLC

    STEP 4

    $

    STEP 2

    MLCR Stock

    MLCR Stock

    MLCMH

    Stock

    MLCMH

    1987

    Transaction

    STEP 3

    STEP 1

    $

    Dividend

    $

    MLCR

    MLC

    Subsidiaries

    MLCR

    Subsidiaries

    Stock

    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.

    MLC entered into a similar transaction using subsidiaries of MLCR in 1986


    Merrill lynch v commissioner1

    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. SeeZenz 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.


    Merrill lynch v commissioner2

    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.


    Merrill lynch v commissioner3

    Merrill Lynch v. Commissioner

    Position of Merrill Lynch on Remand:Relying onsection 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).


    Plr 2004270111

    PLR 200427011

    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.

    Newco Stock, Convertible Instruments & Non-Cash Consideration

    30% Newco Common Stock

    P

    S1, S2, and S3 Stock

    Public

    Newco

    S1

    S2

    S3


    Heinz transaction1

    Heinz Transaction

    PUBLIC

    PUBLIC

    PUBLIC

    $130M

    Heinz

    Heinz

    Heinz

    3.325M

    Heinz

    shares

    3.5M

    Heinz

    shares

    ~ $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.


    Heinz court of federal claims3

    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.


    Heinz court of federal claims4

    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.


    Heinz court of federal claims5

    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.


    Schering plough corp v united states5

    Schering-Plough Corp. v. United States

    (1)

    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 Schering-Plough 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.

    ABN

    SP

    interest rate swaps

    (US)

    $690.4 million

    (2)

    SC

    Assignment of

    “receipt leg” of swaps

    (US)

    SPI

    (US)

    SPL

    (Swiss)

    SL

    (Swiss)


    Schering plough corp v united states6

    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.


    Schering plough corp v united states7

    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. SeeSchering-Plough Corp. v. United States, F. Supp. 2d 219 (D.C. N.J. 2009).

      • 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.


    Schering plough corp v united states8

    Schering-Plough Corp. v. United States

    • Court Decision (cont’d)

      • 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.


    Schering plough corp v united states9

    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).

      • 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. SeeMerck & 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.


    Barnes group inc subs v commissioner

    Barnes Group, Inc. & Subs. v. Commissioner

    BGF Bermuda CS + Foreign Currency

    Barnes Group, Inc.

    Barnes Group, Inc.

    (3)

    BGF

    Delaware CS

    Loan

    (2)

    CS

    ASA (Singapore)

    BGF Delaware

    ASA (Singapore)

    BGF

    Bermuda

    CS

    (1)

    BGF Delaware

    Foreign Currency

    BGF

    Delaware

    PS

    BGF

    Bermuda

    CS

    CS

    CS

    BGF Bermuda

    BGF Delaware PS

    Foreign Currency (i.e., excess / borrowed cash)

    BGF Bermuda

    BGF Bermuda CS + Foreign Currency

    • 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.


    Barnes group inc subs v commissioner1

    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. SeeBarnes 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.


    Barnes group inc subs v commissioner2

    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.


    Liquidation reincorporation

    Liquidation / Reincorporation


    Legislative developments

    Rev. Rul. 69-617

    P

    Step 1: Merge

    Step 2: All 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 all of the assets received from S to X.


    Legislative developments

    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.


    Legislative developments

    Rev. Rul. 69-617 & The Bausch & Lomb Regulations

    P

    1. Liquidate

    2. Some of S’s Assets

    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?


    Legislative developments

    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

    S

    X

    Y

    Z

    LLC

    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).


    Legislative developments

    Rev. Rul. 58-93

    Individual Minority Shareholders

    X

    (2)

    Merger

    Y

    (1)

    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 newly-formed 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. 188.


    Legislative developments

    PLRs 200733002 and 201026010

    P

    (2)

    Merger

    T

    (1)

    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.


    Legislative developments

    PLR 200733002 –Variation – Double Drop and Liquidation

    P

    (2)

    Liquidation

    T

    50% T Assets

    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 transaction? What if substantially all of T’s assets were transferred in one drop?


    Plr 200952032 liquidation reincorporation

    PLR 200952032Liquidation-Reincorporation

    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

    (1)

    H

    S1-Corp1 converts to S1-LLC

    (2)

    S1-Corp1

    (State X & State Y)

    S2

    TIC assets

    (3)

    S1 converts

    to S1-Corp2

    Other Assets

    TIC assets

    Other Assets


    Legislative developments

    PLR 200952032

    Liquidation-Reincorporation (cont’d)

    After Transactions:

    H

    S1-Corp2

    (State X)

    S2

    Other

    Assets

    TIC

    Assets

    Other

    Assets


    Legislative developments

    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”); ButseeTASCO 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).

    PLR 200952032

    Liquidation-Reincorporation (cont’d)


    Movement of attributes

    Movement of Attributes


    Movement of attributes following an asset reorganization

    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 percentof the T assets?

    • What if Acquirer transfers the T assets for $?


    Movement of attributes1

    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 adjustmentand allocationof 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).


    Legislative developments

    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).


    Proposed regulations under section 312

    Proposed Regulations Under Section 312


    Existing law section 381

    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.


    Existing law section 312

    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).


    Prop treas reg 1 312 11

    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.


    Prop treas reg 1 312 111

    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.


    D reorganizations

    “D” Reorganizations


    D reorganizations stock

    “D” Reorganizations – Stock

    Step One

    Step Two

    P

    P

    Liquidation

    X

    Y

    X

    Assets

    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).


    D reorganizations cash rev rul 70 2401

    “D” Reorganizations – Cash – Rev. Rul. 70-240

    P

    Liquidation

    (2)

    (1)

    X Assets

    X

    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). 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; seealso Rev. Rul. 2004-83.


    D reorganizations temporary regulations

    “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.


    D reorganizations final regulations

    “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.


    D reorganizations final regulations1

    “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. § 1.358-6(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.


    D reorganizations final regulations2

    “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.


    D reorganizations final regulations3

    “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. § 1.1502-13.


    D reorganizations direct ownership

    “D” Reorganizations – Direct Ownership

    P

    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. § 1.368-2(l)(2); Cf. Treas. Reg. § 1.368-2(l)(3), ex. 1.

    Liquidation

    (2)

    (1)

    X Assets

    X

    Y

    Cash


    D reorganizations indirect ownership

    “D” Reorganizations – Indirect Ownership

    P

    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?

    S

    S1

    (2)

    Liquidation

    (1)

    XAssets

    X

    Y

    Cash


    D reorganizations constructive ownership

    “D” Reorganizations – Constructive Ownership

    A

    B

    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; Seealso PLR 9111055.

    S

    (1)

    Liquidation

    (2)

    X Assets

    X

    Y

    Cash


    D reorganizations plr 200551018

    “D” Reorganizations – PLR 200551018

    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.

    A

    B

    C

    Liquidation

    50%

    50%

    90%

    10%

    (2)

    (1)

    X Assets

    X

    Newco

    Two Notes


    D reorganizations plr 200551018 variation

    “D” Reorganizations – PLR 200551018 Variation

    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.

    A

    B

    C

    Liquidation

    50%

    50%

    90%

    10%

    (2)

    (1)

    X Assets

    X

    Newco

    Cash + Share of Newco Stock


    Final regulations deemed stock

    Final Regulations – Deemed Stock

    P

    Liquidation

    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.

    X assets

    X

    Y


    Final regulations triangular reorganizations

    Final Regulations – Triangular Reorganizations

    P

    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).

    P stock

    T assets

    S

    T

    P stock


    D reorganizations stock sale deemed liquidation

    “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.


    Check and sell transaction1

    Check-and-Sell Transaction

    P

    Deemed Liquidation

    Cash

    (1)

    (2)

    T’s LLC Interests

    T

    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? SeeDover Corp. v. Commissioner, 122 T.C. 324 (2004).


    Check and sell transaction variation

    Check-and-Sell Transaction – Variation

    P

    X

    Y

    (2)

    (1)

    Cash

    Deemed Liquidation

    T

    Z

    T’s LLC Interests

    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? SeeDover Corp. v. Commissioner, 122 T.C. 324 (2004). What result if X sells only part of its LLC interests in T?


    Cross chain section 351 exchange

    P

    S1

    S2

    Assets

    Cross-Chain Section 351 Exchange

    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? SeeGLAM 2012-006 (analysis of Situation 4).


    Boot within gain limitation effect on e p

    Boot-Within-Gain Limitation – Effect on E&P

    P

    (2)

    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.

    Liquidation

    Assets

    CFC1

    CFC2

    (1)

    Cash


    Temporary regulations allocation of basis in all cash d reorganizations

    Temporary Regulations – Allocation of Basis in All Cash “D” Reorganizations


    Legislative developments

    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.


    Legislative developments

    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.


    Legislative developments

    Temporary Regulations on Allocation of Basis in All Cash “D” Reorganizations – Acquisition of Lower-Tier Subsidiary by Upper-Tier Subsidiary

    P

    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.

    Nominal

    Y Share

    (Deemed)

    X

    Y

    Liquidation

    T

    Assets

    $100 +

    Nominal Y Share


    Legislative developments

    Temporary Regulations on Allocation of Basis in All Cash “D” Reorganizations – Acquisition of Upper-Tier Subsidiary by Lower-Tier Subsidiary

    P

    Nominal

    Y Share

    (Deemed)

    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.

    Liquidation

    T

    X

    Assets

    $100 +

    Nominal

    Y Share

    Y


    Continuity of interest final and proposed regulations

    Continuity of Interest –Final and Proposed Regulations


    Continuity of interest in general

    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).


    Measuring continuity of interest signing date rule background

    Measuring Continuity of InterestSigning 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.


    Measuring continuity of interest signing date rule contract modifications

    Measuring Continuity of InterestSigning 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. § 1.368-1(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.


    Measuring continuity of interest signing date rule fixed consideration

    Measuring Continuity of InterestSigning 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.


    Measuring continuity of interest signing date rule contingent consideration

    Measuring Continuity of InterestSigning 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. § 1.368-1(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.


    Measuring coi example 1 signing date rule

    Measuring COI – Example 1: Signing Date Rule

    T shs

    T shs

    40 P Shares ($40)

    $60

    40 P Shares ($10)

    $60

    P

    T

    P

    T

    Merger

    Merger

    January 2 Signing Date

    (P share = $1)

    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.


    Measuring coi example 2 contract modification

    Measuring COI – Example 2: Contract Modification

    T shs

    T shs

    40 P Shares ($40)

    $60

    50 P Shares ($25)

    $75

    P

    T

    P

    T

    Merger

    Merger

    January 2 Signing Date

    (P share = $1)

    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. § 1.368-1(e)(2)(v), ex. 4 and 5.


    Measuring coi example 3 contingent consideration

    Measuring COI – Example 3: Contingent Consideration

    T shs

    T shs

    40 P Shares ($40)

    $60

    64 P Shares ($25.60)

    $75

    P

    T

    P

    T

    Merger

    Merger

    Contract (without Contingent Consideration)

    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. § 1.368-1(e)(2), ex. 10.


    Measuring coi example 4 contingent consideration

    Measuring COI – Example 4: Contingent Consideration

    T shs

    T shs

    40 P Shares ($40)

    $60

    28 P Shares ($21)

    $42

    P

    T

    P

    T

    Merger

    Merger

    Contract (without Contingent Consideration)

    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 consideration, and the COI requirement is satisfied. See Treas. Reg. § 1.368-1(e)(2), ex. 12.


    Final regulations effective date

    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.


    Measuring continuity of interest proposed regulations average value

    Measuring Continuity of InterestProposed 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.


    Measuring continuity of interest proposed regulations floor and ceiling rules

    Measuring Continuity of InterestProposed 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 orabove 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 orbelow 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


    Measuring coi floor and ceiling rules example collar

    Measuring COI – Floor and Ceiling RulesExample: 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

    • If P stock price had increased to above Ceiling Price, Ceiling rule would have applied


    Final regulations under section 267 f

    Final Regulations Under Section 267(f)


    Legislative developments

    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.


    Legislative developments

    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.


    Legislative developments

    Example – Sale of Stock by Consolidated Group Member to Controlled Group Member

    P1

    P1

    75%

    75%

    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 losscontinues 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.

    P

    L stock

    P

    Cash

    25%

    M

    S

    M

    S

    Liquidation

    of L

    25%

    50%

    50%

    50%

    L

    L


    Legislative developments

    Example – Issuance of Stock to Controlled Group Member

    FP

    FP

    (2)

    T Stock

    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.

    • See Treas. Reg. § 1.267(f)-1(j), ex. 10.

    Cash

    P

    FS

    FS

    P

    60%

    (3)

    Cash

    T

    (1)

    T

    40%

    Deemed Liquidation of T

    T Stock


    Final regulations on methods of accounting in section 381 a asset acquisitions

    Final Regulations on Methods of Accounting in Section 381(a) Asset Acquisitions


    Legislative developments

    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.


    Legislative developments

    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.


    Legislative developments

    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.


    Section 382 guidance

    Section 382 Guidance


    Notice 2010 49 small shareholders

    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 5-percent shareholders has increased by more than 50 percentage points.

      • Under section 382(g)(4)(A), Small Shareholders are aggregated and treated as one 5-percent 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.


    Notice 2010 49 small shareholders1

    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 income-producing 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.


    Proposed regulations application of segregation rules

    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.


    Proposed regulations application of segregation rules1

    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 5-percent 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.


    Section 382 l 3 c fluctuations in value

    Section 382(l)(3)(C):Fluctuations in Value


    Section 382 l 3 c fluctuations in value1

    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. SeeTemp. Reg. § 1.382-2T(l).


    Section 382 l 3 c fluctuations in value2

    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.


    Fluctuation in value example 1

    Fluctuation in Value – Example 1

    Year 1

    Year 2

    A

    B

    A

    B

    $80 C/S

    $20 P/S

    $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.


    Fluctuation in value example 2

    Fluctuation in Value – Example 2

    Year 1

    Year 2

    $5

    A

    B

    C

    A

    B

    C/S

    $80 C/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, 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?


    Fluctuation in value example 3

    Fluctuation in Value – Example 3

    Year 1

    Year 2

    $20

    A

    B

    A

    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.


    Fluctuation in value example 4

    Fluctuation in Value – Example 4

    Year 1

    $20

    Year 2

    $5

    D

    A

    B

    A

    C

    C

    P/S

    C/S

    C/S = $80

    P/S = $20

    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?


    Fluctuation in value example 5

    Fluctuation in Value – Example 5

    Year 1

    Year 2

    Year 3

    $

    A

    A

    A

    B

    B

    $10 C/S

    $10 C/S

    IPO

    $85 C/S

    $100 C/S

    $90 C/S

    $90 C/S

    L Corp

    L Corp

    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.


    Notice 2010 50 fluctuations in stock value

    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.


    Notice 2010 50 fluctuations in stock value1

    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.


    Proposed basis allocation regulations

    Proposed Basis Allocation Regulations


    Proposed basis allocation regulations1

    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.


    Distributions under section 301

    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. SeeJohnson 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.


    Dividend equivalent redemptions

    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).


    Dividend equivalent redemptions1

    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).


    Dividend equivalent reorganizations

    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.


    Dividend equivalent reorganizations1

    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. SeeJohnson 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 securities, provided the designation is economically reasonable.


    Dividend equivalent reorganizations2

    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.


    Dividend equivalent reorganizations3

    Dividend Equivalent Reorganizations

    Block 1 = $50 basis / $150 value

    Block 2 = $150 basis / $50 value

    P

    Sub 1

    $200

    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 share-by-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.


    Non dividend equivalent reorganizations

    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.


    Other issues related to redemptions

    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.


    Section 351 exchanges

    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.


    Capital contributions and certain section 351 exchanges

    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.


    Example 1 section 351 exchange

    Example 1 – Section 351 Exchange

    “D” Reorganization

    Section 304 Transaction

    (1)

    (1)

    P

    P

    (2)

    Cash

    Cash

    Sub 1 Stock

    Stock

    Stock

    Cash

    (2)

    Sub 1

    Sub 1

    Sub 2

    Sub 2

    Liquidation

    Cash

    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).


    Example 2 capital contribution

    Example 2 – Capital Contribution

    “D” Reorganization

    Section 304 Transaction

    (1)

    (1)

    P

    P

    (2)

    Cash

    Cash

    Sub 1 Stock

    Cash

    (2)

    Sub 1

    Sub 1

    Sub 2

    Sub 2

    Liquidation

    Cash

    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.


    Legislative developments

    Insolvency and Liability Issues


    Legislative developments

    Liquidations and Upstream Mergers


    Legislative developments

    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.


    Legislative developments

    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. Butsee 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)).


  • Legislative developments

    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). Butsee 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?


    Legislative developments

    Liquidation with No Payment on Common Stock

    P

    Liquidation

    Preferred

    Stock

    Common

    Stock

    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.


    Legislative developments

    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.; seealso Rev. Rul. 70-489, 1970-2 C.B. 53, amplifying Rev. Rul. 59-296, 1959-2 C.B. 87.


    Legislative developments

    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.


    Legislative developments

    Revenue Ruling 78-330

    P

    (1) S1 Debt

    S1

    S2

    (2) Merger

    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.


    Legislative developments

    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. 68-602, 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.


    Cca 200818005

    CCA 200818005

    P

    P

    Stock of S2

    S1

    S1

    X

    • 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 issue in that ruling.

    Public

    Public

    <20%

    >80%

    <20%

    >80%

    S2

    S2

    Note

    S3

    S3


    Legislative developments

    Rev. Rul. 2003-125


    Rev rul 2003 125

    Rev. Rul. 2003-125

    Situation 1

    Situation 2

    P

    P

    P checks the box for FS

    P checks the box for FS

    Tangibles - $800K

    Intangibles - $150K

    Liabilities - $1,000K

    Tangibles - $800K

    Intangibles - $250K

    Liabilities - $1,000K

    FS

    FS

    Situation 1: CorporationP 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.


    Rev rul 2003 125 cont d

    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.


    Rev rul 2003 125 cont d1

    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.


    Rev rul 2003 125 cont d2

    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. 59-296, 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).


    Legislative developments

    GLAM 2011-003


    Glam 2011 003

    GLAM 2011-003

    X

    U

    $110 Liability (Situation 1)

    Y

    80%

    $110 Liability (Situation 2)

    Z

    20%

    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.


    Glam 2011 0031

    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.


    Glam 2011 0032

    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.


  • Glam 2011 0033

    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 . . . .”).


    Glam 2011 0034

    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).


    Legislative developments

    GLAM 2012-006


    Glam 2012 006 base facts

    GLAM 2012-006: Base Facts

    Asset 1

    AB: $10

    FMV: $10

    S1 Stock

    AB: $5

    FMV: $5

    (1)

    (2)

    $10

    Unrelated

    Party

    Unrelated

    Party

    P

    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).

    P

    S Stock

    $5

    $5

    Unwanted

    Asset

    $10 Debt

    to P

    S1

    S

    S1

    S

    Unwanted Asset

    AB: $5

    FMV: $5

    Wanted Intangible

    AB: $0

    FMV: $15


    Glam 2012 006 situation 1

    GLAM 2012-006: Situation 1

    P

    Deemed

    Liquidation

    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.

    • P’s basis in its S stock is eliminated, and P may not claim a worthless stock deduction.

    $10 Debt

    to P

    S

    S1

    Wanted Intangible

    AB: $0

    FMV: $15


    Glam 2012 006 situation 2

    GLAM 2012-006: Situation 2

    P

    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).

    • The later election by S to be treated as a disregarded entity has no federal income tax consequences.

    Wanted

    Intangible

    $10 Debt

    to P

    S1

    S

    Wanted Intangible

    AB: $0

    FMV: $15


    Glam 2012 006 situation 3

    GLAM 2012-006: Situation 3

    P

    Cancellation

    of $10 Debt

    owed by S

    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.

      • P’s $5 basis in its S stock is increased by $10 to $15 as a result of the contribution to S.

    Wanted

    Intangible

    S1

    S

    Wanted Intangible

    AB: $0

    FMV: $15


    Glam 2012 006 situation 3 cont d

    GLAM 2012-006: Situation 3 (cont’d)

    P

    Cancellation

    of $10 Debt

    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.

    Wanted

    Intangible

    S1

    S

    Wanted Intangible

    AB: $0

    FMV: $15


    Glam 2012 006 situation 4

    GLAM 2012-006: Situation 4

    (3)

    Unrelated

    Party

    $15

    (1)

    P

    P

    S Stock

    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 deemed distributed to P).

    Asset 1

    (2)

    Wanted

    Intangible

    S1

    S

    S

    S1


    Glam 2012 006 situation 4 cont d

    GLAM 2012-006: Situation 4 (cont’d)

    (3)

    Unrelated

    Party

    $15

    (1)

    P

    P

    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 15-year 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.

    Asset 1

    S Stock

    (2)

    Wanted

    Intangible

    S1

    S

    S

    S1


    Glam 2012 006 situation 4 cont d1

    GLAM 2012-006: Situation 4 (cont’d)

    (3)

    Unrelated

    Party

    $15

    (1)

    P

    P

    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. SeeBarenholtz 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.

    Asset 1

    S Stock

    (2)

    Wanted

    Intangible

    S1

    S

    S

    S1


    Legislative developments

    Final Hot Stock Regulations


    Section 355 a 3 b hot stock

    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.


    Hot stock example prior law

    “Hot Stock” Example – Prior Law

    100% C stock

    D

    Sh.

    ATB 1

    Cash

    C

    C

    ATB 2

    ATB 2

    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?


    Hot stock example prior law1

    “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.”


    Final regulations section 355 a 3 b hot stock

    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)).


    Hot stock example 1

    “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. § 1.355-2(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; seealso 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?


    Hot stock example 2

    “Hot Stock” – Example 2

    Year 8

    Year 6

    D

    C Stock

    S

    Unrelated Shareholders

    368(c)

    stock

    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.


    Hot stock example 3

    “Hot Stock” – Example 3

    Year 6

    P

    C Stock

    X

    Year 8

    10%

    90%

    D

    Y

    368(c) stock

    C

    Facts:For more than 5 years,P has owned90 percentof D stock and a portion of C stock. X has owned the remaining 10 percentof 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.


    Legislative developments

    Proposed Regulations – Corporate Equity Reduction Transactions


    Proposed regulations corporate equity reduction transactions background

    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 taxable year. Section 172(h)(3)(C).


    Proposed regulations corporate equity reduction transactions background1

    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).


    Proposed regulations corporate equity reduction transactions general rules

    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.


    Proposed regulations corporate equity reduction transactions consolidated groups

    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.


    Proposed regulations corporate equity reduction transactions consolidated groups1

    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.


    Proposed regulations corporate equity reduction transactions consolidated groups2

    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.


  • Proposed regulations corporate equity reduction transactions general

    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.


    Legislative developments

    Schedule UTP


    Schedule utp

    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.


    Schedule utp1

    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.


    Schedule utp2

    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.


    Schedule utp3

    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.


    Schedule utp4

    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.


    Schedule utp5

    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.


    Schedule utp6

    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.


    Schedule utp7

    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.


    Schedule utp8

    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.


    Schedule utp9

    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.


    Schedule utp10

    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.


    Schedule utp11

    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.


    Schedule utp12

    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.


    Schedule utp13

    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.


    Schedule utp14

    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.


    Schedule utp15

    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 Schedule UTP.


    United states v textron

    United States v. Textron


    United states v textron1

    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.


    United states v textron2

    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.


    United states v textron3

    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.


    United states v deloitte

    United States v. Deloitte


    United states v deloitte district court

    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 work-product protection for the three documents.

    • The government appealed the district court’s ruling, and Dow Chemical intervened to assert work-product protection.


    United states v deloitte court of appeals

    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.”


    United states v deloitte court of appeals1

    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.


    Mayo found for med educ and research v united states

    Mayo Found. for Med. Educ. and Research v. United States


    Mayo found for med educ and research v united states supreme court decision

    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.


    Mayo found for med educ and research v united states supreme court decision1

    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.


    Mayo found for med educ and research v united states supreme court decision2

    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?”


    Mayo found for med educ and research v united states supreme court decision3

    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?


    Mayo found for med educ and research v united states supreme court decision4

    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.


    Deference to regulations after mayo

    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


    Home concrete and supply llc v united states

    Home Concrete and Supply, LLC v. United States


    Overstated basis and the six year statute of limitations

    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. Seealso 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. SeeBurks 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). SeealsoBakersfield 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. SeeIntermountain 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). SeealsoBeard 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).


    Home concrete and supply llc v united states supreme court decision

    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.


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