- The IRS issued regulations under Sec. 1502 adopting a unified rule for determining the amount of loss that may be recognized on a transfer of stock of a member corporation.
- Temporary regulations provide guidance with respect to the “Killer B” and “Killer C” transactions described in Notice 2006-85 and Notice 2007-48.
- Long-awaited proposed regulations were issued under Secs. 367(a)(5) and 1248(f) providing certain exceptions to the gain recognition rules thereof.
- Proposed regulations were issued under Sec. 336(e) to permit inside basis adjustments on certain taxable stock dispositions.
- Notice 2008-111 established four required components for a transaction to be considered an intermediate transaction tax shelter within the scope of Notice 2001-16.
This article summarizes selected U.S. federal income tax developments during 2008 affecting corporations, including those filing consolidated returns. Since the last update, there has not been any significant legislation specifically directed at corporations or consolidated taxpayers. However, Congress did enact several items of legislation, including the Housing and Economic Recovery Act of 2008 (the Housing Act) 1 and the Emergency Economic Stabilization Act of 2008 (EESA). 2 Treasury and the IRS have issued a number of notices providing short-term guidance about how certain provisions of EESA and the Housing Act may affect taxpayers. In addition, the Service and Treasury have issued several packages of final, temporary, and proposed regulations covering a broad spectrum of corporate and consolidated issues.
Final and Temporary Regs.
The Unified Loss Rule
The Service finalized regulations 3 under Sec. 1502 that establish an integrated set of rules, commonly referred to as the unified loss rule (ULR), for determining the amount of loss, if any, that a consolidated group recognizes on the transfer of the stock of a member corporation. The ULR replaces the pre–Rite Aid 4 loss disallowance rules of Regs. Secs. 1.337(d)-1, 1.337(d)-2, and 1.1502-20. The ULR’s principal purposes are:
- To prevent the consolidated return rules from reducing a group’s consolidated taxable income (CTI) through the creation and recognition of noneconomic losses; and
- To prevent group members from duplicating the tax benefit of a single economic loss. 5
The ULR generally applies whenever a member (M) transfers a share of the stock of a subsidiary corporation (S) and the share is a loss share. For this purpose, the concept of a transfer is broader than a sale or disposition of the share. The regulations define a transfer as any event in which:
- M ceases to own the S share in a taxable transaction;
- M and S cease to be members of the same consolidated group;
- A nonmember acquires the S share from M; or
- The S share becomes worthless (taking into account the provisions of Regs. Sec. 1.1502-80(c)). 6
Certain nonrecognition transactions are excepted from this definition, and the regulations incorporate a special rule for intercompany transfers.
If M transfers a loss share of S, then immediately before the transfer taxpayers must sequentially apply three rules to redetermine basis or attributes of S.
- Under Regs. Sec. 1.1502-36(b), each member’s basis in S shares is subject to redetermination (the redetermination rule).
- If any member’s basis in a transferred S share is still greater than that share’s value, that basis is subject to reduction under Regs. Sec. 1.1502-36(c) (the basis reduction rule).
- If any member’s basis in a transferred S share exceeds that share’s value after application of the prior rules, S’s attributes are subject to reduction under Regs. Sec. 1.1502-36(d) (the attribute reduction rule).
Under the redetermination rule, if M transfers a loss share of S stock, its basis in all shares of its S stock is redetermined first by reducing basis in the transferred loss common shares (but not below fair market value) by the amount of positive investment adjustments previously applied to the shares and reallocating such adjustments to other shares. If there is still loss in a transferred S share (either common or preferred), basis is reduced in such shares by reallocating negative basis adjustments from common shares that are not transferred loss shares. 7 The regulations provide specific rules as to how these allocations are to be made. However, the redetermination rule is not applied if the group disposes of all the S shares in a taxable transaction or the members have no gain or loss on S preferred stock and no disparity in their common stock bases. 8
In general, the basis reduction rule requires M to reduce its basis in the transferred share, but not below fair market value, by the lesser of (1) the share’s net positive adjustment or (2) the share’s “disconformity amount.” 9 The regulations provide purely mechanical formulas for calculating a share’s net positive adjustment and its disconformity amount—no tracing is permitted. 10 As a result, this rule reaches appropriate results in true “son of mirror” situations but may improperly allow or deny certain true economic losses. 11
Finally, if after the basis reductions described above the transferred S share is still a loss share, S’s attributes are reduced (with certain exceptions) by S’s attribute reduction amount as defined in Regs. Sec. 1.1502-36(d)(3). The reduction is applied to four separate categories of S’s attributes in the following order: (1) capital loss carryovers; (2) net operating loss carryovers; (3) deferred deductions; and (4) basis of assets other than Class I assets as defined in Regs. Sec. 1.338-6(b)(1) (e.g., cash). 12
The regulations also establish rules for allocating the reduction among the fourth category of assets. Regs. Sec. 1.1502- 36(d)(6) allows the common parent to make an election to avoid or limit attribute reduction by electing to otherwise reduce members’ bases in the transferred S loss shares, to reattribute S’s attributes to the common parent (if S is leaving the group), or some combination thereof. A taxpayer may make this election protectively if it is uncertain whether any transferred S share is a loss share. Informed purchasers may require a protective election to be filed by the common parent of a selling group in order to preclude an unintended reduction in the tax attributes of a target corporation acquired from a consolidated group.
The regulations also include certain exceptions to the application of these rules as well as an anti-avoidance provision. Under the anti-avoidance provision, appropriate adjustments will be made to effect the purposes of the regulations if a taxpayer acts with a view to avoid the purposes of Regs. Sec. 1.1502-36 or to apply the regulations to avoid the purposes of any other rule of law. 13
These regulations have been criticized as overly complex, particularly with respect to the application of the rules to lower-tier subsidiaries. In addition, much of the information required to perform the calculations, such as asset and stock basis, will not be readily available and must be separately determined. The regulations are generally effective as of September 17, 2008. 14
“Killer B” and “Killer C” Transactions
On May 23, 2008, the Service issued temporary regulations 15 implementing the rules published in Notices 2006-85 16 and 2007-48. 17 Temp. Regs. Sec. 1.367(b)-14T applies to triangular reorganizations (as described in Regs. Sec. 1.358-6(b)(2) or Secs. 368(a)(1)(G) and (a)(1)(D)) where either the parent (P) or the subsidiary (S) or both are foreign corporations, and S acquires, in exchange for property, all or a portion of the P stock that is used to acquire the stock or assets of the target corporation (T). Generally, if the regulation applies, adjustments will be made to have the effect of a deemed distribution of property from S to P under Sec. 301. The amount of the deemed distribution is equal to the amount of money plus the value of the other property transferred by S in exchange for the P stock used in the reorganization. This distribution is deemed to occur in an unrelated transaction immediately before the triangular reorganization. 18
Moreover, if S acquires the P stock from a person other than P, immediately following the deemed distribution P is treated as contributing to S the property deemed to be distributed by S to P. If at the time of the purchase P owns S stock satisfying the requirements of Sec. 368(c), the deemed distribution and contribution are treated as separate transactions occurring immediately before the purchase. If P does not have Sec. 368(c) control of S at the time of purchase, the deemed distribution and contribution are treated as occurring in separate transactions immediately after P acquires control of S. The regulations provide that the deemed distribution is treated as a distribution of property for all purposes of the Code and that the deemed contribution, if any, is treated as a contribution of property for all purposes of the Code. 19
The regulations also contain an antiabuse rule under which appropriate adjustments shall be made if, in connection with a triangular reorganization, a transaction is undertaken with a view to avoiding the purpose of the regulations. 20The temporary regulations are generally effective May 27, 2008, but have retroactive application to four enumerated types of transactions. Furthermore, each effective date is subject to a limited “binding commitment” exception. 21
Complete Liquidations into Multiple Members
Sec. 332(a) generally provides that a corporation shall not recognize any gain or loss in connection with the receipt of property distributed in complete liquidation of another corporation. As a general rule, Sec. 332(b) provides that in order to qualify under Sec. 332(a), the recipient corporation must own stock of the liquidating corporation satisfying the Sec. 1504(a)(2) requirements (i.e., stock ownership representing at least 80% of the outstanding voting power and value of the corporation).
In the separate-return context, this 80% ownership requirement must be satisfied by a single corporation, but for members of a consolidated group, Regs. Sec. 1.1502-34 provides that in determining the stock ownership of a group member in another corporation, the stock owned by all group members is aggregated. Therefore, if members of a consolidated group collectively satisfy the 80% ownership requirement, each member may qualify for nonrecognition under Sec. 332(a) on the receipt of property distributed in a complete liquidation.
As a general rule, a complete liquidation of a subsidiary under Sec. 332 is a transaction to which Sec. 381 applies, 22such that the acquiring corporation succeeds to and takes into account the items of the liquidating corporation, including items described in Sec. 381(c), subject to certain limitations.
While the Sec. 381 provisions are easily applied in the separate-return context, in which there can be only one “acquiring” corporation, the Code does not provide clear guidance on how to apply Sec. 381 in the context of a corporation’s liquidation into multiple members. The Service issued proposed regulations in 2005, 23 providing a set of rules for the application of Sec. 381 to these transactions, and recently finalized the proposed regulations, 24 with some modifications, effective for transactions occurring after April 14, 2008.
As finalized, Regs. Sec. 1.1502-80(g) provides a system of rules for determining how the multiple distributee members succeed to items of the liquidating subsidiary. Note, however, that these rules do not apply to intercompany items described in Regs. Sec. 1.1502-13. The allocation of items among the distributee members varies based on the item category. For example, for income offset items (such as net operating losses and capital loss carryforwards) and deferred deductions, each distributee generally succeeds to such items to the extent they would be reflected in an investment adjustment under Regs. Sec. 1.1502-32(c) to the stock of the liquidating corporation owned by such distributee. However, for deferred deductions, as well as deferred income items, a distributee succeeds to the full amount of the item if it is attributable to specific property or business operations acquired by the distributee, provided the item is not taken into account in the determination of the liquidating corporation’s income or loss under general tax law principles.
The liquidating corporation’s earnings and profits are similarly allocated under the principles of Regs. Sec. 1.1502-32(c)— that is, based on hypothetical investment adjustments to the stock of the liquidating corporation owned by the distributee. However, each distributee member succeeds to and takes into account the liquidating corporation’s tax credits based on the percentage value of the stock owned by the distributee member and based on the total value of the liquidating corporation’s stock owned by all members at the time of the liquidation. Stock of the liquidating corporation owned by a nonmember is excluded in this determination.
Finally, the regulations include a special rule for the allocation of “other items” not otherwise described. Generally, if one of the distributee members directly satisfies the 80% ownership requirement, it will succeed to all “other items” in accordance with Sec. 381 and other applicable principles. If no distributee member directly satisfies the 80% ownership requirement, each distributee succeeds to the other items to the extent that it would have succeeded to those items if it had purchased, in a taxable transaction, the property it received in the liquidation and had assumed the liabilities it actually assumed in the liquidation.
Matching Rule for Certain Intercompany Gains on Member Stock
Final and temporary regulations (T.D. 9383) were issued to provide for the redetermination of an intercompany gain from the sale of member stock as excluded from gross income.
Generally, Regs. Sec. 1.1502-13 provides a system of rules that determine the timing and characterization of items of income, gain, loss, or deduction arising from transactions between a seller (S) and a buyer (B) that are members of the same consolidated group. Regs. Sec. 1.1502- 13(c)(6)(i) provides that, in certain cases, S’s intercompany item may be redetermined to be excluded from gross income or treated as a noncapital, nondeductible amount. However, these cases were previously limited to three situations specifically enumerated in the regulations. 25 Of these, Regs. Sec. 1.1502-13(c)(6)(ii)(C) provided that S’s intercompany item may be redetermined to be excluded from gross income to the extent the IRS determines such exclusion is consistent with the purposes of Regs. Sec. 1.1502-13 and other provisions of the Code and regulations. The preamble to the final and temporary regulations refers to this as the “commissioner’s discretionary rule” (CDR).
As stated in the preamble to the regulations, the Service has received ruling requests for the application of the CDR to determine that S’s gain with respect to a member’s stock should be excluded from gross income. In considering these requests, the IRS concluded that the principles guiding the CDR’s application were not clear enough to justify the redetermination of such gain as excludible. However, the Service did identify at least one additional situation involving intercompany gain on member stock for which it is appropriate to permit exclusion of such gain, and the new temporary regulations were issued to add this new exception. The new regulations redesignate the CDR as Regs. Sec. 1.1502-13(c)(6)(ii)(D) and add the new exception as Temp. Regs. Sec. 1.1502-13T(c)(6)(ii)(C).
Temp. Regs. Sec. 1.1502-13T(c)(6)(ii)(C) provides that intercompany gain with respect to member stock is redetermined to be excluded from gross income to the extent that:
- The gain is the intercompany item of the group’s common parent (P);
- Immediately before the intercompany gain is taken into account, P owns the member stock for which the intercompany gain was realized;
- P’s basis in such stock is eliminated without the recognition of gain or loss (and such eliminated basis is not further reflected in the basis of any successor asset);
- The group has not and will not derive any U.S. federal income tax benefit from the intercompany transaction that gave rise to the intercompany gain or the redetermination of such gain (including basis adjustments under Regs. Sec. 1.1502-32); and
- The effects of the intercompany transaction have not previously been reflected, directly or indirectly, on the group’s consolidated return.
While favorable to taxpayers, this new exception is narrowly tailored and does not provide relief for situations that do not fall squarely within the criteria set forth above. For example, a deferred gain from the sale of stock of a wholly owned foreign subsidiary does not satisfy the new exception because the foreign corporation is not a member.
Furthermore, based on language in the preamble and informal discussions with the Service, the author believes that with the addition of this limited exception, the IRS is unlikely to respond to ruling requests for the application of the CDR to situations not specifically covered by this exception.
Outbound Asset Transfers Under Secs. 367 and 1248
On August 19, 2008, the Service issued proposed regulations under Secs. 367, 1248, and 6038B 26 regarding certain outbound transfers of property under Sec. 361. The proposed regulations also clarify certain conditions for the application of the coordination rule exception in Regs. Sec. 1.367(a)-3(d)(2)(vi)(B).
Sec. 367(a)(5): In general, Sec. 367(a)(5) provides that Sec. 361 exchanges remain subject to Sec. 367(a)(1) and that the nonrecognition exceptions in Secs. 367(a)(2) and (a)(3) do not apply. As a result, under the general rule of Sec. 367(a)(5), a U.S. transferor is required to recognize gain on the transfer of appreciated property to the foreign acquiring corporation in a Sec. 361 exchange. However, Sec. 367(a)(5) also provides that, subject to basis adjustments and such other conditions as provided in the regulations, this general rule does not apply if the U.S. transferor is controlled (within the meaning of Sec. 368(c)) by five or fewer domestic corporations.
Before the issuance of these proposed regulations, neither Treasury nor the Service had issued any guidance on the application of the basis adjustment exception in Sec. 367(a)(5). Prop. Regs. Sec. 1.367(a)-7 sets forth an elective exception to the general rule of Sec. 367(a)(5) under which a U.S. transferor may avoid the recognition of gain in an outbound Sec. 361 exchange if the transfer satisfies four conditions and requirements, discussed below. Generally, the proposed regulations apply to all property transferred in a Sec. 361 exchange other than property to which the provisions of Sec. 367(d) apply.
First, the U.S. transferor must be directly controlled (within the meaning of Sec. 368(c)) by five or fewer domestic corporations, excluding regulated investment companies, real estate investment trusts, and subchapter S corporations (the control group). 27 Indirect ownership by a domestic corporation through a partnership or other entity is not taken into account.
Second, the U.S. transferor must recognize gain equal to the aggregate amount of the inside asset gain allocable to noncontrol group members. 28 This gain is allocated among the control group members based on the respective ownership interests in the U.S. transferor, measured by value, at the time of the exchange. In addition, the U.S. transferor must recognize gain to the extent that any member of the control group is unable to preserve its share of the “inside gain” in the basis of the stock it receives in the exchange. The regulations provide formulas for determining the inside gain, the amount of inside gain that cannot be preserved, and the amount of stock allocable to Sec. 367(a) property (the Sec. 367(a) percentage). 29
Third, Prop. Regs. Sec. 1.367(a)-7(c)(3) requires each control group member to reduce its basis in the stock it received in the Sec. 361 exchange to the extent necessary to preserve its share of the inside gain. The proposed regulations, as initially issued, provided that the appropriate basis reduction was equal to the amount by which the member’s share of inside gain exceeded the built-in gain in such stock (i.e., the outside gain). However, a subsequent technical correction to the proposed regulations clarifies that the basis reduction is equal to the amount by which the inside gain exceeds the outside gain or loss in such stock. 30 If a control group member holds separate blocks of stock, the basis in each block must be reduced pro rata according to the relative basis of each block of stock. 31 Finally, the U.S. transferor must file a statement with its income tax return for the year of the exchange certifying that if the foreign acquirer disposes of a “significant” amount of the assets it acquired in the Sec. 361 exchange in one or more transactions entered into with a principal purpose of avoiding the U.S. tax on the inside gain, then the U.S. transferor must file a tax return (or amended return) for the year of the exchange reporting the gain realized, but not recognized, on such exchange. 32
In addition, the U.S. transferor and each control group member must enter into a written agreement to make an election to apply the regulatory exception. The agreement must include certain information specified in the proposed regulations. 33
Secs. 367(b) and 1248(f ): Under Sec. 1248(f), except as provided in regulations, a domestic corporation that transfers the stock of a foreign corporation of which it is a Sec. 1248 shareholder in certain distributions, including under Secs. 355(c) or 361(c), is required to include the Sec. 1248 amount for the stock in income as a dividend.
Under the current regulations, in certain circumstances the Sec. 1248 shareholders may avoid a current income inclusion if the Sec. 1248 amount attributable to the foreign stock may be preserved. However, current regulations also provide that if a Sec. 1248 shareholder of a foreign acquired corporation transfers the stock of such corporation to a foreign acquiring corporation in a Sec. 361 exchange, that shareholder must include in income the attributable Sec. 1248 amount, even if the foreign acquiring and foreign acquired corporations are controlled foreign corporations (CFCs) for which the transferor continues to be a Sec. 1248 shareholder immediately after the exchange. 34
The proposed regulations alter the latter result. Generally, they would require the U.S. transferor to include in income the Sec. 1248 amount only if, immediately following the Sec. 361 exchange, either the foreign acquiring or the foreign acquired corporation is not a CFC with respect to which the U.S. transferor is a Sec. 1248 shareholder. The proposed regulations modify Regs. Sec. 1.367(b)-4(b)(1)(iii), Example (4), accordingly. The proposed regulations also provide for certain adjustments to the basis of the foreign acquiring stock received in the transaction, as well as the earnings and profits attributable to such stock, in order to fully preserve the application of Sec. 1248. In addition, the proposed regulations make similar changes to the current regulations with respect to a transfer of foreign acquired corporation stock to a foreign acquiring corporation in a Sec. 361 exchange that is part of a triangular asset reorganization.
The proposed regulations under Sec. 1248(f) provide a general rule that if a domestic corporation distributes the stock of a foreign corporation for which it is a Sec. 1248 shareholder either under Sec. 337 or in a nondivisive Sec. 355 distribution, the domestic corporation is required to include in its income the Sec. 1248(f) amount from the distributed foreign stock. The regulations also set forth exceptions to this general recognition rule, including an irrevocable elective exception for certain Sec. 355 distributions that may require adjustments to the basis and holding period of the distributed stock in the hands of the Sec. 1248 distributee.
Elections for Qualified Stock Dispositions
Sec. 336(e) was enacted by the Tax Reform Act of 1986 35 as part of the repeal of the General Utilities doctrine 36 and is intended to provide taxpayers with a means of avoiding potential multiple taxation of the same economic gain. To that end, Sec. 336(e) provides that, under regulations prescribed by the IRS, if a corporation (the seller) owns stock in a subsidiary corporation (the target) satisfying the ownership requirements of Sec. 1504(a)(2) and sells, exchanges, or distributes all the stock, the seller may elect to treat such sale, exchange, or distribution as a sale of the target’s assets.
Based on the statutory language, the Service does not consider Sec. 336(e) to be self-executing. To provide taxpayers with the requirements and methodology for making a Sec. 336(e) election, Treasury issued proposed regulations authorizing Sec. 336(e) elections for certain transactions. 37 Generally, these proposed regulations provide an election to treat certain stock dispositions that are not otherwise eligible for a Sec. 338 election as deemed asset sales. However, the election is not available for dispositions of stock to related parties or for dispositions in which either the seller or the target corporation is foreign.
The proposed regulations adopt mechanics for a Sec. 336(e) election analogous to those that apply in the case of an election under Sec. 338(h)(10), but the Sec. 336(e) election applies to dispositions to both corporate and noncorporate shareholders. Under Prop. Regs. Sec. 1.336-2(a), a seller may make a Sec. 336(e) election if it disposes of a target’s stock in a qualified stock disposition (QSD). For this purpose, a QSD is generally any transaction or series of related transactions under which the target’s stock meeting the requirements of Sec. 1504(a)(2) is sold, exchanged, or distributed within a 12-month period. A QSD also includes a distribution qualifying under Sec. 355 but for which the distributing corporation is required to recognize gain under Secs. 355(d)(2) or (e)(2). 38
Under the general rule, if an election is made, the old target is treated as selling its assets to an unrelated person in exchange for the aggregate deemed asset disposition price (ADADP) determined under Prop. Regs. Sec. 1.336-3. 39 The old target realizes the tax consequences of this deemed disposition while still owned by the seller. The old target is then deemed to transfer all of its assets to the seller before the close of the disposition date. 40 This transfer will generally be treated as a distribution in complete liquidation of the seller.
Similarly, the new target is deemed to have acquired the old target’s assets in a single transaction from an unrelated seller in exchange for an amount equal to the adjusted grossed-up basis (AGUB) determined under Prop. Regs. Sec. 1.336-4. 41 Both the ADADP and the AGUB are allocated among the assets under the principles of Sec. 338. The new target also remains liable for the old target’s tax liabilities. In the case of elections for multiple tiers of subsidiaries, the proposed regulations provide that the deemed asset sales and the deemed asset purchases occur in a “top-down” and “bottom-up” sequence, respectively, as in the case of a Sec. 338 election for tiered entities.
In the case of a stock distribution, the seller is then deemed to have purchased from the new target on the disposition date the amount of stock distributed in the QSD and to have then distributed such stock to its shareholders in a transaction in which the seller recognizes no gain or loss. If the seller retains any target stock, it is deemed to have been purchased on the day after the disposition date for an amount equal to its fair market value. 42
The Sec. 336(e) election is a unilateral election available only to the seller. The proposed regulations establish the manner for making the election. Moreover, the proposed regulations clearly provide that sellers may make protective Sec. 336(e) elections that will have no effect if the transaction does not constitute a QSD but that are otherwise binding and irrevocable. 43 The availability of a protective election is particularly useful for a Sec. 355 distribution that is subject to Secs. 355(d) or (e), where the event that gives rise to the application of Secs. 355(d) or (e) (thus resulting in a QSD) may not occur until several months after the disposition date.
Rulings and Publications
Intermediate Transaction Tax Shelters
In Notice 2001-16, 44 the Service identified a category of listed transaction known as an intermediary transaction tax shelter (ITTS), commonly referred to as a “midco” transaction. The notice describes the typical ITTS transaction as involving four parties: a seller (X) that wants to sell stock of a corporation (T), an intermediary (midco) corporation (M), and a buyer (Y) that desires to purchase the assets (and not the stock) of T. Under an integrated plan, X sells the T stock to M, and T then sells some or all of its assets to Y. Y claims a basis in the T assets equal to Y’s purchase price, but either M or T offsets or is not required to report the gain (or tax) resulting from T’s sale of assets. Thus, X is subjected to only a single level of tax on the sale of T, but Y obtains a stepped-up basis in the T assets with no tax cost to X, M, or T. The notice states that transactions the same or substantially similar to such a transaction are also listed transactions but provides no additional guidance. 45
Notice 2008-111 46 modifies Notice 2001-16 by providing that a transaction will be treated as an ITTS with respect to a particular person only if the transaction includes four objective components, the person participates in the transaction as part of a plan, and none of the three safe-harbor exceptions in the notice applies to the person. The four objective components are:
- T (the target corporation) directly or indirectly (e.g., through a passthrough entity) owns assets, the sale of which would result in taxable gain. As of the time of the stock disposition described in component 2, T (or its consolidated group) has insufficient tax benefits to eliminate or offset such taxable gain, or the tax, in whole (the built-in tax). 47
- At least 80% of the T stock (by vote or value) is disposed of by T’s shareholder(s) (X), other than in liquidation of T, in one or more related transactions within a 12-month period.
- Either within 12 months before, simultaneously, or within 12 months after the date on which X has disposed of at least 80% of the T stock (by vote or value), at least 65% (by value) of T’s assets are disposed of (sold T assets) to one or more buyers (Y) in one or more transactions in which gain is recognized with respect to the sold T assets. Transactions in which T disposes of all or part of its assets to either another member of the controlled group of corporations of which T is a member or a partnership in which members of such controlled group satisfy the requirements of Regs. Sec. 1.368- 1(d)(4)(iii)(B) will be disregarded provided there is no plan to dispose of at least 65% (by value) of the sold T assets to one or more persons that are not members of such controlled group or such partnerships.
- At least half of T’s built-in tax described in component 1 that would otherwise result from the disposition of the sold T assets described in component 3 is purportedly offset, avoided, or not paid.
A person engages in the transaction pursuant to a plan if the person knows or has reason to know the transaction is structured to effectuate the plan. Additionally, any X that is at least a 5% shareholder of T (by vote or value), or any X that is an officer or director of T, engages in the transaction pursuant to a plan if certain officers or directors of T or advisers engaged by T or X know or have reason to know the transaction is structured to effectuate a plan. The scope of the term “plan” is not well defined, but the notice does provide three safe harbors for transactions that are not an ITTS with respect to certain of the participants.
Thus, a transaction may be an ITTS with respect to X but not Y, with respect to Y but not X, or with respect to some but not all Xs and/or some but not all Ys, depending on whether they engage in the transaction pursuant to the plan. A transaction will not be an ITTS with respect to any person that does not engage in the transaction pursuant to a plan regardless of the amounts reported on any return.
The new rules in Notice 2008-111 represent a significant improvement over Notice 2008-20, which did not include a plan requirement and merely focused on whether a transaction included the four objective components. Because the previous notice did not include a plan requirement, it was possible that a person could inadvertently participate in a transaction considered to be an ITTS if the transaction met the four objective requirements. The inclusion of the plan requirement in Notice 2008-111 significantly limits the scope of Notice 2001-16, but does not completely preclude the possibility that certain nonabusive transactions might be treated as an ITTS.
Reverse Subsidiary Merger Followed by Liquidation of Target Fails to Qualify as a Reorg.
On May 8, 2008, the Service issued Rev. Rul. 2008-25, 48 addressing the income tax consequences of a transaction in which, under an integrated plan, a parent corporation (P) acquires all the stock of a target corporation (T) in a reverse subsidiary merger and then completely liquidates T into P in a nonmerger liquidation.
The step-transaction doctrine is not applied to integrate a taxable stock purchase followed by a liquidation of the target as an acquisition of the target’s assets 49 because Congress has explicitly provided that an election under Sec. 338 is the only means by which a taxable stock purchase may be treated as an asset acquisition for federal income tax purposes. However, the Service has also ruled that the policy underlying the exclusivity of Sec. 338 is not violated by integrating a stock acquisition and subsequent liquidation of the target to treat the transaction as an acquisition of the target’s assets if the integrated transaction qualifies as a nontaxable reorganization. 50
In Rev. Rul. 2008-25, an individual (A) owns all the stock of a corporation (T) having assets worth $150x and $50x of liabilities. P, a corporation unrelated to A and T, with net assets of $410x, wishes to acquire the T stock. P forms corporation X, a wholly owned subsidiary, for the sole purpose of acquiring the T stock by causing X to merge with and into T in a statutory merger, with T surviving. In the merger, A exchanges the T stock for $10x in cash and P voting stock worth $90x. Following the merger and under an integrated plan that includes the merger, T completely liquidates into P, transferring all its assets and liabilities to P. The liquidation of T is not accomplished through a statutory merger. After the liquidation, P continues to conduct the business previously conducted by T.
The Service notes that, treated separately, the merger should qualify as a reorganization under Sec. 368(a)(1)(A) by reason of Sec. 368(a)(2)(E), and the liquidation should qualify as tax free under Sec. 332. However, Regs. Sec. 1.368- 1(a) provides that a transaction must be evaluated under relevant provisions of law, including the step-transaction doctrine, in order to determine whether it qualifies as a Sec. 368 reorganization. In the present case, because T completely liquidates, the safe harbor of Regs. Sec. 1.368-2(k) (precluding application of the step-transaction doctrine) does not apply. As such, the merger and liquidation cannot be analyzed separately and the transaction fails to qualify as a reorganization under Sec. 368(a)(1)(A) by reason of Sec.368(a)(2)(E) because T does not hold substantially all of its properties and the properties of S after the transaction.
Moreover, P’s acquisition of T’s assets does not qualify as a reorganization under any other provision of the Code. Unlike the transaction described in Rev. Rul. 67- 274, in this transaction the consideration provided in exchange for T’s assets does not consist solely of P voting stock, and the “boot relaxation rule” of Sec. 368(a)(2)(B) is not satisfied. 51 Furthermore, because the liquidation of T is not completed via a statutory merger, the recast transaction does not qualify as a reorganization within the scope of Sec. 368(a)(1)(A). In addition, P’s acquisition of the T stock in the merger is not a Sec. 351 transaction because A does not have Sec. 368(c) control of P immediately after the exchange.
Because the integrated transaction does not constitute a Sec. 368 reorganization, Rev. Rul. 90-95 and Regs. Sec. 1.338-3(d) reject the application of the step-transaction doctrine and treat P’s acquisition of T as a qualified stock purchase within the scope of Sec. 338, with the subsequent liquidation of T constituting a complete liquidation of a controlled subsidiary under Sec. 332.
Guidance Under EESA and the Housing Act
The Service has issued several notices regarding the application of the loss limitation provisions of Sec. 382 to certain of the transactions arising out of the passage of the Housing Act and EESA.
The Housing Act granted Treasury the authority to purchase securities to be issued by Freddie Mac and Fannie Mae. In Notice 2008-76, 52 the IRS and Treasury announced their intention to issue new regulations under Sec. 382(m) under which the definition of “testing date” will be modified to exclude any date on or after which the U.S. government (or any agency thereof) acquires certain stock or options in Freddie Mac or Fannie Mae under the Housing Act. The regulations will be effective for transactions occurring on or after September 7, 2008. This modification will preclude potential ownership changes of Freddie Mac or Fannie Mae as a result of these investments because there cannot be an ownership change without a testing date. Absent this provision, an ownership change could severely limit the loss carryforwards or net unrealized built-in losses of Freddie Mac or Fannie Mae.
In Notice 2008-84, 53 the Service announced that regulations will be issued to address the application of Sec. 382 to certain acquisitions not described in Notice 2008-76, namely, any acquisition by the U.S. government (or any agency thereof), directly or indirectly, of a more-than- 50% interest in any loss corporation. For this purpose, a more-than-50% interest is stock possessing (1) more than 50% of the total value of the corporation (excluding stock described in Sec. 1504(a)(4)) or (2) more than 50% of the total combined voting power of all classes of voting stock. The definition also includes an option to acquire such a stock interest.
The regulations to be issued will operate in similar fashion to those described in Notice 2008-76, by amending the definition of “testing date” to exclude any date as of the close of which the United States directly or indirectly owns a more-than-50% interest in a loss corporation. Note, however, that any owner shifts occurring during this period may be relevant for testing during the periods after which the United States no longer owns a more-than-50% interest.
Notice 2008-83 54 provides that for purposes of Sec. 382(h), solely with respect to a loss corporation that is also a bank (as defined in Sec. 581), any deduction properly allowed after a Sec. 382 ownership change with respect to losses on loans or bad debts shall not be treated as a pre-change builtin loss or deduction. Thus, these items will not be subject to the Sec. 382 limitation that would otherwise apply to pre-change losses. Banks are entitled to rely on the provision of this notice unless and until additional guidance is issued. This notice is strictly limited to deductions attributable to banks and does not include any deductions of nonbank affiliate entities.
In Notice 2008-78, 55 the Service announced that it will issue regulations regarding the application of Sec. 382(l) to loss corporations. Generally, these regulations will provide that notwithstanding Sec. 382(l)(1)(B), a capital contribution to a loss corporation during the two-year period ending on the date of an ownership change shall not be presumed to be part of a plan having a principal purpose of avoiding or increasing a Sec. 382 limitation.
Instead, the determination of whether such a contribution is part of a plan will be made on the basis of all relevant facts and circumstances, applying principles similar to those set forth in Regs. Sec. 1.355-7. In addition, the notice establishes four safe harbors for certain types of contributions. It provides that taxpayers may rely on the rules described therein for any ownership change that occurs in a tax year ending on or after September 26, 2008, unless and until there is additional guidance.
These notices are likely to be followed by additional published guidance covering other bailout-related issues, particularly as additional legislative action is taken.
Brandon Hayes is a senior manager, National Tax M&A/ Transaction Advisory Services, at Ernst & Young LLP in Washington, DC. For more information about this article, contact Mr. Hayes at firstname.lastname@example.org.
The views expressed herein are the author’s alone and do not necessarily reflect the views of Ernst & Young LLP.
1 Housing and Economic Recovery Act of 2008, P.L. 110-289.
2 Emergency Economic Stabilization Act of 2008, P.L. 110-343.
3 Regs. Sec. 1.1502-36, T.D. 9424.
4 See Rite Aid Corp., 255 F.3d 1357 (Fed. Cir. 2001) (finding that the loss duplication factor in Regs. Sec. 1.1502-20 distorted the tax liability of consolidated groups contrary to the directive of Sec. 1502 and was therefore an invalid exercise of regulatory authority).
5 Regs. Sec. 1.1502-36(a)(2).
6 Regs. Sec. 1.1502-36(f)(10).
7 Regs. Sec. 1.1502-36(b)(2).
8 Regs. Sec. 1.1502-36(b)(1).
9 Regs. Sec. 1.1502-36(c)(2).
10 Regs. Secs. 1.1502-36(c)(3), (4).
11 A “son of mirror” transaction occurs
where loss on the sale of a consolidated
subsidiary’s stock can be attributed to recognition of built-in gain on the
disposition of an asset (i.e., the gain is already reflected in the stock’s basis
before the asset’s disposition).
12 Regs. Sec. 1.1502-36(d)(4).
13 Regs. Sec. 1.1502-36(g).
14 For more on the ULR, see Huck, “Final Unified Loss Rule Published,” Tax Clinic, p. 8.
15 T.D. 9400.
16 Notice 2006-85, 2006-41 I.R.B. 677.
17 Notice 2007-48, 2007-25 I.R.B. 1428.
18 Temp. Regs. Secs. 1.367(b)-14T(b)(1), (2).
19 Temp. Regs. Sec. 1.367(b)-14T(b)(3).
20 Temp. Regs. Sec. 1.367(b)-14T(d).
21 Temp. Regs. Sec. 1.367(b)-14T(e).
22 Sec. 381(a)(1).
24 T.D. 9376.25 Regs. Secs. 1.1502-13(c)(6)(ii)(A)–(C).
27 Prop. Regs. Sec. 1.367(a)-7(c)(1).
28 Prop. Regs. Sec. 1.367(a)-7(c)(2)(i).
29 See Prop. Regs. Secs. 1.367(a)-7(f), 1.367(a)-7(c)(2)(ii), and 1.367(a)-7(g), Example (2).
30 73 Fed. Reg. 56535 (9/9/08).
31 Prop. Regs. Sec. 1.367(a)-7(c)(3)(ii)(B).
32 Prop. Regs. Sec. 1.367(a)-7(c)(4).
33 See Prop. Regs. Sec. 1.367(a)-7(c)(5) for the applicable election and reporting requirements.
34 See Regs. Sec. 1.367(b)-4(b)(1)(iii), Example (4).
35 Tax Reform Act of 1986, P.L. 99-514.
36 The General Utilities doctrine allowed a C corporation to make a tax-free liquidating distribution to its shareholders prior to a sale of the company (General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935)).
38 Prop. Regs. Sec. 1.336-1(b)(5).
39 Prop. Regs. Sec. 1.336-2(b)(1)(i)(A).
40 Prop. Regs. Sec. 1.336-2(b)(1)(iii).
41 Prop. Regs. Sec. 1.336-2(b)(1)(ii).
42 Prop. Regs. Secs. 1.336-2(b)(1)(iv), (v).
43 Prop. Regs. Sec. 1.336-2(j).
44 Notice 2001-16, 2001-1 C.B. 730.
45 See Enbridge Energy Co., 553 F. Supp. 2d 716 (S.D. Tex. 2008), for a recent case in which the Service successfully challenged a midco transaction.
46 Notice 2008-111, 2008-51 I.R.B. _. This notice supercedes Notice 2008-20, 2008-6 I.R.B. 406.
47 In determining whether T’s (or the consolidated group’s) tax benefits are insufficient for these purposes, these tax benefits are excluded: (1) any tax benefits attributable to a listed transaction under Regs. Sec. 1.6011-4(b)(2), and (2) any tax benefits attributable to built-in loss property acquired within 12 months before the stock disposition described in component 2, to the extent such built-in losses exceed built-in gains in property acquired in the same transaction(s).
48 Rev. Rul. 2008-25, 2008-21 I.R.B. 986.
49 See Rev. Rul. 90-95, 1990-2 C.B. 67.
50 Rev. Rul. 2001-46, 2001-2 C.B. 321. See also Rev. Rul. 67-274, 1967-2 C.B. 141, and Rev. Rul. 72-405, 1972-2 C.B. 217.
51 The total consideration provided in the merger consists of $10x in cash, $90x in P voting stock, and $50x of assumed liabilities that must be treated as boot due to the issuance of $10x in cash. Thus, only 60% of T’s assets ($90x ÷ $150x) are acquired in exchange for P voting stock.
52 Notice 2008-76, 2008-39 I.R.B. 768.
53 Notice 2008-84, 2008-41 I.R.B. 855.
54 Notice 2008-83, 2008-42 I.R.B. 905.
55 Notice 2008-78, 2008-41 I.R.B. 851.