Significant Recent Corporate Developments

EXECUTIVE SUMMARY

• The IRS finalized regulations under Sec. 1502 that cover basis determinations for subsidiary stock in certain transactions involving consolidated group members and when subsidiary stock becomes worthless.
• Temporary regulations provide guidance on the distribution requirement in all-cash D reorganizations, the continuity of interest requirement for Sec. 368 reorganizations, and the treatment of prepaid income under the built-in gain provisions of Sec. 382(h).
• Proposed regulations provide guidance on limitations on transfers of built-in losses in certain nonrecognition transactions under Sec. 362(e) and on the active trade or business requirement as it relates to new Sec. 355(b)(3).
• The Court of Federal Claims held that a purported stock redemption transaction between a corporation and its subsidiary lacked economic substance and would not be treated as a redemption for federal tax purposes.

This article summarizes selected income tax developments during the past year affecting corporations, including those that file consolidated returns. Since the last update one year ago, there has not been significant legislation that would affect corporate taxpayers. There have, however, been a number of developments affecting corporations and their shareholders, discussed below.

Given the many fiscal issues with which Congress is grappling, one should not interpret the lack of new tax legislation during the past year as an indication that taxes and tax policy are not on legislators’ minds. There has been no shortage of debate and hearings regarding how to pay for alternative minimum tax reform, with the taxation of so-called carried interests in private equity partnership structures receiving particularly sharp scrutiny. In addition, variations of “economic substance” codification have made their way into introduced bills. As of this writing, there appears to be renewed congressional momentum in enacting this provision.

Final and Temporary Regs.

Basis Determinations and Adjustments of Subsidiary Stock

The Service issued final regulations¹ under Sec. 1502 that govern basis determinations and adjustments of subsidiary stock in certain transactions involving members of a consolidated group as well as the determination of when subsidiary stock is treated as worthless under Sec. 165. The regulations are effective July 18, 2007, and adopt without modification the proposed regulations (REG-138879-05) issued on January 26, 2006, and the proposed regulations (REG-157711-02) issued on January 23, 2007. The temporary regulations (TD 9244) issued on January 26, 2006, have been removed.

The final regulations add a rule to Regs. Sec. 1.1502-19 providing that if a member would otherwise determine shares of a class of stock (a new share) to have an excess loss account and the member owns one or more other shares of the same class of stock, the basis of the other shares is allocated to eliminate and equalize any excess loss account that would otherwise be in the new shares.

The final regulations also provide that subsidiary stock is not treated as worthless before the earlier of the time that the subsidiary ceases to be a member of the group or the time that the subsidiary’s stock is worthless within the meaning of Regs. Sec. 1.1502-19(c)(1)(iii). Regs. Sec.1.1502-19(c)(1)(iii) identifies three separate events that cause a share of subsidiary stock to be treated as worthless and therefore disposed of for purposes of taking into account an excess loss account in the share. Regs. Sec. 1.1502-19(c)(1)(iii)(A) applies when the subsidiary disposes of substantially all of its assets. In that case, the members of the consolidated group would be treated as a single entity, and the worthless stock deduction would be deferred until the subsidiary has no assets left.

All-Cash D Reorgs.

The Service issued temporary and proposed regulations² providing guidance on the distribution requirement and, in particular, the scope of the “meaningless gesture” doctrine as it applies to acquisitive Sec. 368(a)(1)(D) reorganizations (D reorganizations). Significantly, the temporary regulations confirm that groups can engage in “down-the-chain” all-cash D reorganizations. The regulations apply to transactions occurring on or after March 19, 2007, except that they do not apply to any transaction occurring under a written agreement that is binding before December 19, 2006, and at all times thereafter.

One of the requirements for an acquisitive D reorganization is that the transferor corporation must distribute stock received in the transferee corporation under Sec. 354(b)(1)(B) (the distribution requirement). Notwith-standing the distribution requirement, the Service and the courts have not required the actual issuance and distribution of stock and/or securities of the transferee corporation when the same person or persons owns all the stock of the transferor corporation and the transferee corporation. In those circumstances, the Service and the courts have viewed issuance of stock to be a “meaningless gesture” not mandated by Secs. 368(a)(1)(D) and 354(b).

Thus, under the temporary regulations, the distribution requirement will be satisfied even though no stock is actually issued in the transaction if the same persons own, directly or indirectly, all of the stock of the transferor and transferee corporations in identical proportions. In such cases, the transferee will be deemed to issue a nominal share of stock to the transferor in addition to the actual consideration exchanged for the transferor’s assets. The nominal share is then deemed distributed by the transferor to its shareholders and, when appropriate, further transferred through chains of ownership to the extent necessary to reflect the actual ownership of the transferor and transferee corporations. This construct thus enables Sec. 368 reorganization treatment for a transaction that, for all practical and economic purposes, is a sale: e.g., the transfer, for cash, of all of a lower-tier corporation’s assets in one chain to a lower-tier corporate purchaser in another chain, followed by the liquidation of the selling corporation. In such a case, where the lower-tier corporations have identical ultimate ownership, the transaction should generally qualify as a D reorganization, assuming the satisfaction of other reorganization requirements (e.g., business purpose).

After issuing the temporary regulations, the Service and Treasury became aware that the temporary regulations may have unintended consequences for related-party triangular asset acquisitions otherwise qualifying under Sec. 368. In an additional set of temporary and proposed regulations,³ the Service and Treasury clarified that the recent all-cash D regulations will not apply to cause certain related-party asset acquisitions that otherwise qualify as tax-free triangular reorganizations to be treated as reorganizations described in Sec. 368(a)(1)(D) with boot.

Prepaid Income Is Not Treated as Sec. 382(h) RBIG

The IRS has issued temporary and proposed regulations⁴ providing that prepaid income is not treated as recognized built-in gain (RBIG) for purposes of Sec. 382(h). The temporary regulations are effective for ownership changes on or after June 14, 2007. As a consequence, loss corporations that have deferred prepaid income as of the date of an ownership change may not, as the income is earned during the five-year period following the ownership change, increase the amount of post-change income that may be offset by pre-change losses. The Service also expressed concern that in some cases, taking income and deduction items into account separately under the Sec. 338 approach of Notice 2003-65⁵ may result in income being inappropriately treated as RBIG.

Temporary Regs. on Closing Date Continuity of Interest

In September 2005, the Service released final regulations⁶ on the continuity of interest (COI) requirement, applicable to Sec. 368 reorganizations. Among other things, the 2005 COI regulations addressed how the COI requirement could be met during the interim period between the date a binding contract was signed and the transaction closing. Prior to the issuance of such regulations, there was uncertainty about whether a transaction would qualify as a reorganization if, for example, the value of publicly traded acquiring corporation stock provided to target corporation shareholders in a merger transaction dropped from 50% on the signing date to 30% of the total consideration value at closing. The 2005 COI regulations provide that in determining whether a proprietary interest in the target corporation is preserved, the consideration to be exchanged for the proprietary interest in the target corporation under a contract to effect the potential reorganization is valued on the last business day before the first date such contract is a binding contract (the signing date) if the contract provides for fixed consideration (the signing date rule).

On March 20, 2007, the IRS replaced the 2005 COI regulations with temporary and proposed COI regulations⁷ that retain the general rules of the 2005 COI regulations but expand the scope of the regulations. The 2007 temporary regulations modify the definition of “fixed consideration” and clarify that consideration is fixed, for purposes of the signing date rule, only if the contract specifies the number of the issuing corporation’s shares to be exchanged for all or each proprietary interest in the target corporation. Moreover, the temporary regulations retain the general presumption that a modification of the sales contract results in a new signing date, but they expand the exception to provide that an issuance of additional shares or a decrease in the money or other property delivered to the target’s shareholders will not trigger a new signing date. In addition, the 2007 temporary regulations expand the instances in which contingent consideration may qualify for the contract signing date rule. Prior regulations allowed contingent consideration for this purpose if stock of the issuing corporation was the only contingent consideration that could be received. The temporary regulations broaden this provision, allowing taxpayers to receive non-stock contingent consideration as long as the target shareholder remains subject to the economic benefits and burdens of owning the issuing corporation as of the signing date.

Proposed Regs.

Second “Killer B” Notice

In September 2006, the IRS issued Notice 2006-85,⁸ addressing a transaction sometimes referred to as “Killer B.”⁹ The notice addressed triangular Sec. 368 reorganizations involving a foreign corporation (e.g., the acquisition by a first-tier foreign subsidiary of a domestic parent corporation in which the foreign subsidiary acquires a foreign target corporation from another corporate chain in a triangular reorganization under Sec. 368(a)(1)(B), using voting stock of the domestic parent corporation that was acquired for cash or notes). Under forthcoming Sec. 367(b) regulations, property used to acquire parent stock used in a triangular reorganization will be treated instead as distributed to the parent corporation, under Sec. 301(c). In Notice 2006-85, however, the Service requested comments on whether the scope of forthcoming regulations should be expanded to cover situations in which either the controlled subsidiary or its parent corporation is foreign and the subsidiary purchases parent stock from an unrelated person (e.g., from the public on the open market).

The Service decided to expand the scope of transactions that will be subject to forthcoming Sec. 367(b) regulations. In Notice 2007-48,¹⁰ it announced that forthcoming regulations will apply to situations in which the parent or subsidiary (or both) is a foreign corporation and, under the reorganization, the subsidiary acquires from one or more parent shareholders, in exchange for property, all or a portion of the parent stock that is used to acquire the stock or assets of a target corporation.

The IRS anticipates regulations that require adjustments with respect to the parent and the subsidiary that will have the effect of a property distribution from the subsidiary to the parent, under Sec. 301(c). The amount of the distribution will equal the amount of money plus the fair market value (FMV) of other property transferred from the subsidiary to the parent’s shareholders in exchange for the parent stock used to acquire the stock or assets of the target corporation. Therefore, the regulations will require, as appropriate, an inclusion in the parent’s gross income as a dividend, a reduction in the parent’s basis in its subsidiary’s stock (or, as appropriate, the target’s stock), and the recognition of the parent’s gain from the sale or exchange of property. The adjustments also will provide, as appropriate, that the amount of property deemed distributed to the parent corporation is then considered to be contributed by the parent to the subsidiary immediately thereafter, thus increasing the parent’s basis in subsidiary stock.¹¹

The regulations described in Notice 2007-48 will apply to transactions occurring on or after May 31, 2007.

Limitations on Transfers of Built-In Losses

The Service has issued proposed regulations¹² under Sec. 362(e)(2) that would provide guidance on determining the bases of assets and stock transferred in certain nonrecognition transactions. The regulations are proposed to be effective for transactions occurring after the date the final regulations are published in the Federal Register.

Sec. 362(e), enacted as part of the American Jobs Creation Act of 2004, P.L. 108-357 (AJCA), generally limits taxpayers’ ability to duplicate net losses in certain nonrecognition transactions. Sec. 362(e)(2) in particular provides that in the case of property that is transferred in a Sec. 351 transfer and that is not described in Sec. 362(e)(1), if the transferee’s aggregate basis in such property would (but for Sec. 362(e)(2)) exceed the FMV of such property, then the transferee’s aggregate basis in such transferred property shall not exceed the FMV. More specifically, Sec. 362(e)(2) applies to Sec. 351 transactions or capital contributions involving (1) a domestic transferor and domestic transferee; (2) transfers by a domestic corporation to a controlled foreign corporation; (3) transfers by a controlled foreign corporation to a domestic corporation; and (4) a foreign transferor and foreign transferee. The aggregate basis reduction required under Sec. 362(e)(2) is allocated among the transferred built-in loss property in proportion to the respective built-in losses. Alternatively, a transferor and transferee may jointly and irrevocably make an election under which the transferor’s basis in the stock received shall not exceed its FMV immediately after the transfer.

The proposed regulations would, in general, apply to transfers of net built-in loss property within the U.S. tax system in a transaction described in Sec. 362(a), where the net built-in asset loss would be duplicated in the stock of the transferee. The proposed regulations would not apply to a transfer in which the duplicated loss is imported into the U.S. tax system and the transfer is subject to Sec. 362(e)(1). While Sec. 362(e)(2) technically applies to transfers that are wholly outside the U.S. tax system (i.e., a transfer by one foreign corporation to another foreign corporation), the proposed regulations would offer relief for such transactions entered into with no plan or intention of entering the U.S. tax system.

Sec. 355(b) Active Trade or Business Requirement

In the area of Sec. 355 spinoffs, the Service issued proposed regulations¹³ intended to reconcile the “active trade or business” requirement of Sec. 355(b)(2) with Sec. 355(b)(3), which was enacted in 2006.¹⁴ Newly enacted Sec. 355(b)(3) allows a distributing or controlled corporation to rely on the business operations of lower-tier affiliates—i.e., its separate affiliated group (SAG)—for purposes of the active trade or business requirement.

The proposed regulations apply only to distributions that occur after the date in which the final regulations are published in the Federal Register. But since the statutory provision is relatively new, the proposed regulations offer the first window into the government’s interpretation of new Sec. 355(b)(3).

Consistent with the statute, the proposed regulations treat all SAG members as one corporation; thus, the separate existence of “subsidiary SAG members” is disregarded, and all assets (and activities) owned (or performed) by SAG members are treated as owned (and performed) by the distributing or controlled corporation, as the case may be, for purposes of the active trade or business requirement. While the proposed regulations are not currently effective, they do represent the Service’s current interpretation of Sec. 355(b)(3), which may sometimes produce surprising results. For example, the Service is interpreting the 2006 statutory change as effectively rewriting Secs. 355(b)(2)(C) and (D);¹⁵ thus, stock acquisitions in which a new subsidiary joins the group (even if the acquired subsidiary is otherwise affiliated under Sec. 1504 but is not part of the relevant SAG) are treated as asset acquisitions for purposes of Sec. 355(b)(2)(C). On the other hand, the IRS has confirmed a position in the regulations attributing a partnership’s active trade or business to the owner of a significant interest (e.g., one-third) in such partnership, a position reinforced by revenue ruling.¹⁶

Case Law

Substance over form is a recurring theme in tax litigation, as is the degree of permissible tax planning surrounding a transaction. A recent case reaffirmed the principle that strict adherence to the technical provisions of the Code may not suffice to produce the tax results anticipated by a taxpayer.¹⁷ The H. J. Heinz case involved actions taken by an indirect subsidiary of the publicly traded H. J. Heinz Company (Heinz) with respect to Heinz stock. The subsidiary, H. J. Heinz Credit Company (HCC), purchased Heinz stock on the open market in the fall of 1994 for approximately $129 million. In January 1995, 95% of the purchased shares were transferred to Heinz in exchange for a convertible note issued by Heinz. HCC and the Heinz group claimed that under Sec. 302(d), the redemption was treated as a Sec. 301 dividend distribution (presumably because HCC’s convertible note was treated as an option to purchase Heinz stock; thus, under Sec. 318(a)(4), HCC had not sufficiently reduced its ownership in Heinz, the issuing corporation, to qualify for “exchange” treatment under Sec. 302(a)). Therefore, income from the redemption of HCC’s stock was treated as excluded from HCC’s income under the consolidated return regulations. Moreover, applying an example in the Sec. 302 regulations, HCC claimed that its basis in the 95% block “leaped” onto its basis in the retained 5% block.¹⁸ Thus, when HCC sold the 5% block to a third party in May 1995, it claimed a net capital loss of over $124 million. The Heinz group filed refund claims for earlier tax years, arising from a carryback of the $124 million net capital loss.

The government contended that the redemption was not within the meaning of Sec. 317(b). A “redemption,” within the meaning of Sec. 317(b), occurs when a corporation acquires its stock from a shareholder in exchange for property. Sec. 317(b) presupposes that the person receiving property in fact owns and possesses the stock being redeemed, so the government first argued that HCC’s ownership of Heinz stock was transitory and that it was never the owner. The court disagreed, finding that HCC possessed the benefits and burdens of ownership: It had borrowed money on its own accord, received dividends, and was subject to risk of loss during the period it held the stock (although the stock in fact had appreciated).

However, the court did agree with the government that HCC’s acquisition of Heinz stock lacked economic substance, noting that when a taxpayer claims a deduction, it is the taxpayer that bears the burden of proving that the transaction had economic substance. According to the court, HCC did not meet this burden because its asserted purpose for acquiring the shares—as an investment—was not supported by the evidence. While corporate minutes and other documents recited the investment purpose, this claim was belied by the plan to redeem the Heinz stock, which was in place before HCC ever acquired the Heinz stock. Moreover, the court noted that while Heinz had an ongoing stock repurchase program, the main purpose of that program—to reacquire common shares to be held in the Heinz treasury for use in stock option issuances and preferred stock conversions, among other things—could not be accomplished as long as HCC held the stock. Finally, the court did not give credence to an alternative contention put forth by the taxpayers that an investment by HCC in Heinz stock would bolster HCC’s substance as a Delaware holding company with state income tax authorities. The transaction had one purpose, the court concluded: producing capital losses that could be carried back to offset prior gains.

The court could have stopped its analysis there. But it also held that the Heinz group’s claim would be disallowed under a step-transaction analysis as well. While the step-transaction doctrine has various formulations (e.g., binding commitment, end result, mutual interdependence), the ultimate question is whether the taxpayer intended a series of transactions to be part of a single, integrated transaction. The court found a single, integrated transaction applying either the end result test or the mutual interdependence test. Under either formulation, the court concluded that HCC’s ownership of the Heinz stock must be ignored and that Heinz must be viewed as having acquired the stock on the market.

Regardless of the theory used, the court found that the purchase by Heinz of its stock from HCC did not qualify as a redemption under Sec. 317(b). In turn, then, there was no reattribution of basis, so the subsequent sale by HCC of its retained 5% block of Heinz stock did not produce a capital loss that could be carried back to prior taxable years.

Rulings

Sec. 357(c) Application to Overlap Transactions

On February 12, 2007, the Service issued Rev. Rul. 2007-8,¹⁹ addressing the application of Sec. 357(c) to a transaction that qualified as an exchange described in both Sec. 351 and Sec. 368(a)(1)(D). Sec. 357(c) requires that a transferor in a Sec. 351 exchange recognize gain to the extent that the amount of liabilities assumed by the transferee corporation exceeds the aggregate basis of assets transferred. Prior to the enactment of the AJCA, Sec. 357(c) applied to both Sec. 351 exchanges and Sec. 361 exchanges that were under a reorganization described in Sec. 368(a)(1)(D). The AJCA modified the application of Sec. 357(c) to D reorganizations so that Sec. 357(c) applies only to “divisive” D reorganizations (i.e., those in which transferee stock or securities are distributed in a transaction that qualifies under Sec. 355).

Rev. Rul. 2007-8 addresses a transaction in which a common shareholder owns all of the stock of an acquiring corporation and a target corporation. The target corporation transfers all of its assets to the acquiring corporation in exchange for acquiring corporation stock and the assumption of target corporation liabilities; the acquiring corporation stock is distributed in liquidation of the target corporation. The amount of assumed liabilities exceeded the basis of assets transferred, and the amount of acquiring corporation stock issued in the exchange represented Sec. 368(c) “control” (i.e., at least 80% of all acquiring corporation voting stock and 80% of any other classes of acquiring corporation stock). The Service noted that the acquisitive D reorganization transfer to the acquiring corporation also constituted an exchange described in Sec. 351. However, the IRS concluded that Sec. 357(c) does not apply to this overlap transaction. Since the transferor ceases to exist, the Service reasoned that it “cannot be enriched as a result of the assumption of its liabilities,” citing legislative history. The Service stated that the intent of the AJCA was to exclude reorganizations (other than divisive D reorganizations) from the application of Sec. 357(c)(1), regardless of whether such reorganizations are also exchanges to which Sec. 351 applies. Thus, in this case, the transferor corporation would not recognize gain under Sec. 357(c).

Rescission Rulings

One of the thornier issues that a tax adviser may confront is whether and when it is possible to “unwind” the tax effects of a particular transaction. While advisers need to be careful in this area,²⁰ recent private rulings affirm that it is possible to unwind the tax effects of a transaction under the right circumstances. In one ruling, an acquiring corporation purchased the stock of a target corporation in a taxable transaction and did not make a Sec. 338 election for the target. The target corporation was subsequently liquidated via an upstream merger, and the acquiring corporation succeeded to the target corporation’s subsidiary, its only asset. On experiencing “unexpected and significant weakness in two core businesses,” the acquiring corporation realized it might have to dispose of the target (and presumably realized that it had lost its stock basis in the target as a consequence of the liquidation). Thus, the acquiring corporation transferred the target’s subsidiary to a newly formed corporation. The taxpayer represented that both transactions (the target’s liquidation and its “reincorporation”) occurred within the same tax year. The Service ruled that the upstream merger would be treated as not having occurred, and the parent would be treated as the target corporation’s shareholder “at all times during the taxable year.”²¹ In another ruling, the IRS ignored the conversion of a limited liability company to a corporation that had been undertaken in expectation of an initial public offering. Given changed market conditions, the Service concluded that the entity would be treated as a limited liability company, taxable as a partnership, for the entire tax year.²²

Two principles emerge from the rulings: (1) if the transaction is to be unwound for tax purposes, the unwind/rescission needs to occur within the same tax year; and (2) the unwind/rescission generally needs to put the relevant parties back into the positions they would have occupied if the original transaction had not occurred.²³

EditorNotes

Don W. Bakke, J.D., LL.M. Senior Manager National Tax M&A/Transaction Advisory Services Ernst & Young LLP Washington, DC Elizabeth Zaitzeff, J.D., LL.M. Manager Transaction Advisory Services Ernst & Young LLP New York, NY

For information about this article, contact Mr. Bakke at don.bakke@ey.com

Notes

¹ TD 9341 (7/18/07).

² TD 9303 (12/19/06) and REG-125632-06 (12/19/06).

³ TD 9313 (3/1/07) and REG-157834-06 (3/1/07).

⁴ TD 9330 (6/14/07) and REG-144540-06 (6/14/07).

⁵ Notice 2003-65, 2003-2 CB 747.

⁶ TD 9225 (9/16/05).

⁷ TD 9316 (3/20/07) and REG-146247-06 (3/20/07).

⁸ Notice 2006-85, 2006-41 IRB 677.

⁹ For further discussion of this notice, see Bakke and Zaitzeff, “Significant Recent Developments,” 38 The Tax Adviser (January 2007): 26.

¹⁰ Notice 2007-48, 2007-25 IRB 1428.

¹¹ See, e.g., Regs. Sec. 1.367(b)-2(e)(3)(ii).

¹² REG-110405-05 (10/23/06).

¹³ REG-123365-03 (4/8/07).

¹⁴ For more background regarding Sec. 355(b)(3), see Bakke and Zaitzeff, “Significant Recent Developments,” 38 The Tax Adviser (January 2007): 26.

¹⁵ See Notice 2007-60 (8/6/07).

¹⁶ See Rev. Rul. 2007-42 (7/9/07).

¹⁷ H. J. Heinz Co., 76 Fed. Cl. 570 (2007).

¹⁸ Regs. Sec. 1.302-2(c), Example (1) (basis of one-half of an individual’s shares, redeemed in a dividend-equivalent redemption, added to retained shares).

¹⁹ Rev. Rul. 2007-8, 2007-7 IRB 469.

²⁰ The title of one of the seminal articles on this topic says it all: Banoff, “Unwinding or Rescinding a Transaction: Good Tax Planning or Tax Fraud?,” 62 Taxes (1984): 942.

²¹ IRS Letter Ruling 200701019 (10/5/06).

²² IRS Letter Ruling 200613027 (10/16/05). See also IRS Letter Ruling 200716024 (10/22/05) (redemption transaction preceding spinoff unwound).

²³ See Rev. Rul. 80-58, 1980-1 CB 181.