A recent IRS Letter Ruling, 200701019, applied the rarely seen principles of the rescission doctrine. While the doctrine is most often applied to a sale of property, the ruling involved its application to a corporate merger. The Service allowed application even though the taxpayer was seeking to reduce its Federal income tax.
What Is the Rescission Doctrine?
“Rescission” is defined as the cancelling or voiding of a contract and the return of the parties to the positions they would have been in had the contract not been made. The principles of rescission can be found in case law dating back to the 1920s; see, e.g., A.W. Shaw, 13 BTA 716 (1928). The requirements for a successful application of the doctrine are more clearly described in Rev. Rul. 80-58.
To have a valid rescission, two conditions must be met: the (1) parties to the transaction must be restored to the exact same position they would have been in had no contract been made and (2) rescission must occur in the same tax year the original transaction took place (application of Sec. 451). Subsequent events cannot be considered.
If an effective rescission occurs, the original transaction is disregarded and the taxpayer recognizes no gain or loss. While prior law held that a valid rescission could not occur unless the original contract raised the possibility that a rescission later might become desirable (Branum v. Campbell, 211 F2d 147 (5th Cir. 1954)), modern law does not appear to follow this requirement.
The rescission doctrine has been applied to a variety of transactions, including sales of property (both real and personal), cancellations of income tax elections (e.g., Sec. 83(b) elections, terminations of S corporation status and choice-of-entity elections), sales of company stock and cancellations of common stock subscriptions or other ownership changes. It has also been applied to transactions in which the principal motivations were both tax and nontax.
In Letter Ruling 200701019, the IRS applied the rescission doctrine to a corporate merger. Parent (P) acquired all the outstanding common stock of Sub 1 for cash. Sub 1’s sole asset was all the outstanding common stock of Sub 2. Neither Sub 1 nor Sub 2 had any other equity interests outstanding. As part of the acquisition, P also retired $A of Sub 2’s debt in exchange for a note from Sub 2 in the same amount.
To maximize operational efficiencies and reduce state franchise tax exposure, immediately after P acquired all of Sub 1’s outstanding stock, it caused Sub 1 to merge into P with P surviving (the merger constituted a liquidation of Sub 1). After the merger (and before the rescission), P loaned $B to Sub 2 for use in Sub 2’s ongoing business.
Shortly after the merger, P experienced an unexpected downturn in its business and realized it would need to dispose of one or more business lines to raise capital. It also realized that its decision to liquidate Sub 1 rather than preserve its adjusted tax basis in Sub 1’s stock had not been prudent. Accordingly, on date C, P formed new Sub 1 under the laws of the same state in which old Sub 1 had been incorporated. P contributed all the outstanding stock of Sub 2 to the capital of new Sub 1 in exchange for all the common stock of new Sub 1.
P also made the following representations: (1) all the assets and liabilities of old Sub 1 are the same as those of new Sub 1; (2) new Sub 1’s articles of incorporation and bylaws are identical to those of old Sub 1 in effect at the time of the merger; (3) even if old Sub 1 had not merged out of existence, P still would have (i) retired $A of Sub 2’s debt in exchange for a note from Sub 2 in the same amount and (ii) loaned $B to Sub 2 for use in its business; (4) other than P’s receipt of Sub 2’s note for $A and P’s $B loan to Sub 2, there were no actual or constructive transfers of money or property between any member of the affiliated group of which P is a member and Sub 2 between the time of the merger and P’s incorporation of new Sub 1 and contribution of Sub 2’s stock to the capital of new Sub 1; (5) no material changes in the legal or financial arrangements occurred between any member of the affiliated group of which P is a member and Sub 2 between the time of the merger and P’s incorporation of new Sub 1 and contribution of Sub 2’s stock to new Sub 1’s capital; (6) on the completion of P’s incorporation of new Sub 1, the legal and financial arrangements among P, new Sub 1 and Sub 2 are identical in all material respects to the legal and financial arrangements among P, old Sub 1 and Sub 2 before the merger of old Sub 1 into P; and (7) the merger of old Sub 1 into P, P’s incorporation of new Sub 1 and P’s contribution of Sub 2’s stock to the capital of new Sub 1 all occurred within the same tax year of P, old Sub 1, new Sub 1 and Sub 2.
Based on the above facts and representations, the IRS ruled that Sub 1 will not be treated as having merged into P and that Sub 1 and P will be treated as two separate corporations at all times during the tax year. In addition, P will be treated as having been the shareholder of Sub 1 at all times during the tax year, and the merger of Sub 1 into P will not be treated as a liquidation of Sub 1 for purposes of determining P’s or Sub 1’s taxable income. As a result of this rescission, P was able to take advantage of the higher tax basis in Sub 1’s stock that otherwise would have disappeared in the upstream merger, thereby reducing its gain on the disposition of Sub 1’s stock.
ConclusionTo apply the rescission doctrine successfully, taxpayers must demonstrate that the (1) parties to the transaction were restored to the exact same position that they would have been in had nothing occurred and (2) rescission occurred in the same tax year as the original transaction. The rescission doctrine may be available with respect to both tax- and nontax-motivated transactions. In addition, the possibility of rescission need not be contemplated in the original contract or transaction to apply its principles subsequently. For taxpayers that encounter an unexpected turn of events, the rescission doctrine may be available as a useful tool for unwinding a prior transaction.
Annette B. Smith, CPA, Washington National Tax Services PricewaterhouseCoopers LLP, Washington, DC.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers, LLP.
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