In Notice 2009-4, the IRS has proposed to amplify the methods available to an acquiring corporation (Acquiring) to estimate basis in the stock of a target corporation (Target) received in tax-free reorganizations under Sec. 368(a)(1)(B) (a B reorganization), as well as to expand the use of such methods to certain other tax-free transactions. Those methods currently are set forth in Rev. Proc. 81-70. In the interim period, the notice provides safe harbors upon which taxpayers may currently rely.
In a typical B reorganization, all the stock of Target is acquired from the Target shareholders solely in exchange for shares of Acquiring’s voting stock (or for the voting stock of a corporation that controls Acquiring). Under Sec. 362(b), Acquiring’s basis in the acquired Target stock is equal to the former Target shareholders’ bases in such stock. While a determination of former Target shareholder basis would seem readily available where Target was closely held, this is not the case where the Target stock was publicly traded and widely held. In those instances, to avoid a zero basis in the acquired Target stock, Acquiring must inquire of the former Target shareholders regarding their bases in the Target shares. In order to provide taxpayers with some relief from this burdensome process, as well as in recognition of the reality of nonresponsive former Target shareholders, the IRS issued Rev. Proc. 81-70, which permits taxpayers to rely on certain statistical methodologies under which aggregate Target stock basis is extrapolated from a sampling of the former Target shareholders.
Since the issuance of Rev. Proc. 81-70, however, the trend in the public markets has shifted sharply toward the holding of stock in “street name”—i.e., by brokers who hold the stock as nominee on behalf of their clients, who are the true economic owners of such stock. In light of this market development, the IRS issued Notice 2004- 44, in which it identified potential concerns with the impact of subsequent market developments on the application of Rev. Proc. 81-70. The IRS requested comments regarding how it might modify or amplify Rev. Proc. 81-70 to accommodate this market trend. Based upon the comments received, the IRS determined that Rev. Proc. 81-70 must be expanded to address issues raised by nominee stock holdings.
Notice 2009-4 reaffirms the general approaches of Rev. Proc. 81-70 but indicates that future guidance will expand the revenue procedure to adjust for current market realities (this future guidance is referred to in the notice as Expanded Rev. Proc. 81-70). The notice states that surveying the surrendering Target shareholders and using sampling and estimation techniques is a proper method for Acquiring to determine its basis in Target stock following a B reorganization but that a modeling methodology may be appropriate in the case of stock held in street name. Thus, the notice envisions that Expanded Rev. Proc. 81-70 will preserve certain provisions of Rev. Proc. 81-70 without material modification but will include certain safeharbor provisions.
In the interim, Notice 2009-4 sets forth three separate safe harbors, each of which is described in more detail below. These safe harbors are tailored specifically to different types of shareholders (i.e., one for reporting shareholders, one for registered but nonreporting shareholders, and one for shares held in street name). Subject to certain conditions, including actual knowledge of the former Target shareholders’ bases, taxpayers may currently rely on these safe harbors until additional guidance is issued.
Safe Harbor 1: Reporting shareholders
Under Safe Harbor 1, Acquiring’s basis in Target stock surrendered by “reporting shareholders” must be determined under the survey guidelines prescribed in Rev. Proc. 81-70. Thus, Acquiring’s basis in shares acquired from the surveyed shareholders is the basis reported by such shareholders. If Acquiring does not receive a response from a surveyed shareholder, Acquiring may use estimation techniques to determine the basis of Target shares surrendered by the nonresponding shareholder. If Acquiring does not survey a reporting shareholder, estimation may not be used, and the basis of the shares acquired from that shareholder is deemed to be zero.
For purposes of Expanded Rev. Proc. 81-70, a reporting shareholder is any surrendering Target shareholder that was a “significant transferor,” a “significant holder,” an officer or director of Target, or a plan that acquired Target stock for or on behalf of Target employees, such as an employee stock option or pension plan, immediately before the date of the transaction. The term “significant transferor” has the same meaning as in Regs. Sec. 1.351-3, and the term “significant holder” has the same meaning as in Regs. Sec. 1.368-3 (i.e., in both cases, a person owning 5% of the voting power or value of a publicly traded Target or 1% of the voting power or value of a nonpublic Target). To identify reporting shareholders, Target’s books and records, the master security holder files maintained by the stock transfer agent, and SEC filings, including Schedule 13 series data, may be used.
Safe Harbor 2: Registered Nonreporting Shareholders
Under Safe Harbor 2, Acquiring’s basis in Target stock surrendered by registered, nonreporting shareholders must be determined by the certificate method, which requires that Acquiring examine Target’s books and records to determine the date each stock certificate was issued. Using both public and private stock exchange trading data, Acquiring must then determine the average trading price of the Target shares on the date each certificate was issued. Subject to adjustments for extraordinary issuances and events, Acquiring may treat the basis of each such share as equal to the average trading price on its issuance date.
For purposes of Expanded Rev. Proc. 81-70, a registered, nonreporting shareholder is a shareholder that held Target stock in certificated form but that is not a reporting or nominee shareholder.
Safe Harbor 3: Nominees for Nonreporting Shareholders
Under Safe Harbor 3, Acquiring’s basis in Target stock surrendered by nominees on behalf of nonreporting shareholders must be determined under a four-step basis modeling method:
- First, Acquiring must establish measuring dates for purposes of the model. Generally, the dates selected should be representative of Target stock trading activity, including dates surrounding periods of significant volatility in share price or trading activity of Target stock.
- Second, Acquiring must determine each nominee’s starting basis in Target stock using the guidelines set forth in the notice.
- Third, Acquiring must compare nominee holdings between measuring dates. Any increase or decrease in the holdings of a previously identified nominee is treated as a purchase or sale of that number of shares on each subsequent measuring date. Deemed purchases are treated as made at the volumeweighted average of the trading prices for the period between the measuring dates. Deemed sales are treated as being made on the first-in, first-out (FIFO) method; the last-in, first-out (LIFO) method; or the average cost (ACO) method. Acquiring must identify and adopt the single method that best predicts estimated basis across all investors, which will generally be the lowest of the LIFO, FIFO, and ACO basis.
- Finally, Acquiring’s basis in Target shares acquired from nominees on behalf of nonreporting shareholders is deemed to be the basis allocated to such shares under the safe-harbor model, determined as of the date of the transferred basis transaction.
Safe-Harbor Reliance Conditioned upon Timely and Diligent Completion
In order to rely on any of the safe harbors, the notice requires that Acquiring timely and diligently complete a basis determination. A timely determination generally is one that is completed within two years after the date of the transaction or the date that Expanded Rev. Proc. 81-70 becomes effective, whichever is later. In order to complete the basis determination diligently,
- Acquiring must make every reasonable effort to obtain best evidence; or
- To the extent it was unable to obtain such evidence, Acquiring must demonstrate that it could not have reasonably obtained the evidence or basis information.
In addition, Acquirer must make every reasonable effort to identify surrendered Target shares having low bases (relative to Target’s average historical trading price) and surrendered shares with bases lower than the bases of shares bought and sold under normal market conditions. The notice also provides taxpayers with a two-year extension of time for reporting Target stock basis under Regs. Secs. 1.351-3 and 1.368-3, provided that they include a statement in the relevant tax returns that a basis study with respect to acquired Target stock is pending.
New Guidance Expanded to Certain Other Transferred Basis Transactions
Finally, the notice expands the scope of transactions currently covered by Rev. Proc. 81-70, recognizing that the difficulties in establishing basis in Target stock may be present in certain transferred basis transactions other than B reorganizations. Such transactions may include Sec. 351 exchanges, certain reverse triangular mergers, and certain triangular reorganizations involving foreign corporations. Thus, any further guidance in this area may apply not only to B reorganizations but also to all transferred basis transactions in which Target stock is so acquired.
For the interim period, the IRS continues to invite comments on whether it should adopt the approaches described in the notice and to what extent, if any, it should combine or modify the approaches to produce a set of administrable rules.
Jeff Kummer is director of tax policy at Deloitte Tax LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.
For additional information about these items, contact Mr. Kummer at (202) 220-2148 or firstname.lastname@example.org.