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This article summarizes selected recent developments in federal income taxation of corporations and shareholders. Congress was especially active in 2010, driven by a need to generate additional revenue. Consequently, it enacted a number of provisions affecting corporate taxpayers, including the codification of the economic substance doctrine, and various other corporate tax reform proposals are currently included in bills drafted by the House and the Senate.
At present, the enacted proposals affect U.S. domestic corporations primarily with respect to changes in the taxation of international operations—namely, how corporate taxpayers may utilize foreign tax credits generated by such operations. However, several proposals still under consideration in Congress would have much broader application to domestic corporations and their shareholders. In addition, the IRS and Treasury have provided additional guidance on certain subchapter C transactional issues in the form of new final and temporary regulations.
Legislative Update
In 2009, the White House and Treasury published a detailed explanation of the administration’s budget proposals for the 2010 fiscal year. 1 This Green Book detailed several new proposals, including one for the codification of the economic substance doctrine and another to repeal the “boot-within-gain” limitation of Sec. 356(a)(1) in certain cross-border reorganizations. As discussed below, in March President Barack Obama signed into law a new provision of the Code, Sec. 7701(o), which codifies the economic substance doctrine. In addition, Congress is considering a revised version of proposed changes to the boot-within-gain limitation that is broader in scope and impact than the proposal originally outlined in the Green Book. Finally, Congress has also proposed a change to the treatment of securities issued by a controlled corporation to its distributing corporation parent in connection with a divisive Sec. 355 distribution.
Codification of the Economic Substance Doctrine
Included in the Health Care and Education Reconciliation Act of 2010, 2 new Sec. 7701(o) codifies the common law economic substance doctrine, providing specific rules for applying it to any transaction for which the economic substance doctrine is determined to be relevant. As codified, Sec. 7701(o)(1) provides that in the case of any transaction to which the economic substance doctrine is relevant, that transaction will be treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position and (2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.
Based on this construction, the first question for taxpayers is deciding when the doctrine might be relevant to a particular transaction. If the economic substance doctrine is determined to be relevant to a transaction, taxpayers must satisfy a two-pronged conjunctive test in order to avoid the imposition of a strict liability penalty, the amount of which varies depending on whether the taxpayers have satisfied certain reporting requirements.
Determining Relevance
As the statute is drafted, Congress has provided taxpayers with almost no way to determine whether the economic substance doctrine is relevant to a transaction. The only guidance provided in the statute is in Sec. 7701(o)(5), which states, “The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection [Sec. 7701(o)] had never been enacted.” Consequently, taxpayers are left with practically no way to predict how the new statute is to be applied.
Despite requests from tax practitioners, the IRS and Treasury have steadfastly refused to issue an “angel list” of certain nonabusive transactions for which the economic substance doctrine is not relevant. 3 Although IRS officials have made public statements that certain transactions, such as sales of subsidiary stock in a Granite Trust transaction, 4 should not be subject to the economic substance doctrine, 5 taxpayers and their advisers remain uncertain about the economic substance doctrine’s scope.
Presumably Sec. 7701(o)(5) stands for the proposition that taxpayers must look to the common law developed by the courts in order to determine whether the economic substance doctrine is relevant to a transaction. However, although there are several cases that identify when the economic substance doctrine is relevant to a particular type of transaction, the converse is not true: There is little or no common law guidance that taxpayers may apply to affirmatively conclude that the economic substance doctrine is not relevant to a particular type of transaction. Therefore, in the absence of the publication of an angel list or similar guidance, it should be expected that taxpayers will be overly conservative in their economic substance doctrine analysis, at least until the courts have the opportunity to apply the new statute.
Conjunctive Test
Assuming that the economic substance doctrine is relevant to a transaction, the taxpayer must then determine whether it satisfies the economic substance requirements of Secs. 7701(o)(1)(A) and (B). Under the common law, courts have traditionally applied an analysis focused on two factors. First, did the transaction change the taxpayer’s economic position in a meaningful way (notwithstanding the federal income tax result)? Second, did the taxpayer have a business purpose for the transaction (apart from federal income tax planning)? Prior to the adoption of the statute, the courts were split as to whether the economic substance doctrine required taxpayers to satisfy a disjunctive or conjunctive test (i.e., some courts required only one of the two factors to be satisfied, while others required the satisfaction of both). Sec. 7701(o) resolves the conflict in favor of a conjunctive approach. Now, in order to satisfy the economic substance doctrine, Sec. 7701(o)(1) requires taxpayers to show that:
- The transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position; and
- The taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.
Obviously this two-pronged test is less favorable to taxpayers who might previously have fallen under the jurisdiction of a court that applied a disjunctive test.
With respect to the first prong, taxpayers are entitled to rely on factors other than the transaction’s profit potential, but to the extent the taxpayer asserts a profit potential motive, the profit potential of a transaction shall be taken into account only if the present value of the reasonably expected pretax 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. 6 For purposes of the second prong, the statute specifically provides that certain purposes do not satisfy the substantial purpose requirement. For example, generating a state and local tax effect does not satisfy the test if the effect is related to a federal income tax effect of the transaction. 7 In addition, creating financial accounting benefits does not serve as a good purpose where the origin of the financial accounting benefit is a reduction of federal income tax. 8
Penalty Provisions
The teeth of Sec. 7701(o) are found in the changes to penalty provisions of Sec. 6662(b) and new Sec. 6664(c)(2). These provisions combine to impose a 20% strict liability penalty for underpayments attributable to the disallowance of a tax benefit on the grounds that the transaction generating the benefit failed to satisfy the economic substance doctrine requirement of Sec. 7701(o) or failed to meet the requirements of any “similar rule of law.” The penalty is doubled to a 40% strict liability penalty if the taxpayer has not adequately disclosed the facts of the transaction on its original or amended return. 9
Because Sec. 6664(c)(2) denies taxpayers the ability to apply a good-faith exception to the penalty, the bad news for taxpayers is that they will not be able to avoid an imposition of the penalty by relying on an opinion of counsel. Moreover, the inclusion of the “similar rule of law” language in the penalty provision has raised the question of whether the IRS could apply the penalty in the case of transactions lacking a valid business purpose, such as is required in the case of corporate reorganizations.
Economic Substance Doctrine Guidance
To date, the only formal guidance from the IRS and Treasury on the application of Sec. 7701(o) is Notice 2010-62, which has been criticized as being one of the least helpful pieces of formal guidance in recent history. This notice recites some of the background for the codification of the economic substance doctrine and purports to offer two pieces of substantive guidance. First, the notice provides that the IRS will continue to rely on relevant case law under the common law economic substance doctrine:
- In applying the two-pronged conjunctive test in Sec. 7701(o)(1);
- To determine whether a transaction sufficiently affects the taxpayer’s economic position to satisfy the requirements of Sec. 7701(o)(1)(A); and
- To determine whether a transaction has a sufficient nontax purpose to satisfy the requirements of Sec. 7701(o)(1)(B).
As many in the tax practitioner community have noted, directing taxpayers to common law authorities does not offer the level of clarity that most taxpayers are seeking.
Second, the notice states 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 Sec. 7701(o). As such, if pre-codification authorities provided that the economic substance doctrine was not relevant to whether certain tax benefits are allowable, the IRS expects to continue to take the position that the economic substance doctrine is not relevant to whether those tax benefits are allowable. As stated above, there is little or no common law authority to support when the economic substance doctrine is not relevant to certain tax benefits. Therefore, taxpayers cannot receive much comfort from this notice as to when the IRS might consider the economic substance doctrine not to be relevant to a particular transaction. Absent further guidance, taxpayers are left to proceed with transactions at their own discretion.
Repeal of Boot-Within-Gain Limitation for Related-Party Reorgs.
As stated above, the Obama administration’s Green Book included a proposal to repeal the boot-within-gain limitation of Sec. 356(a)(1) in certain cross-border reorganizations. 10 As then proposed, the limitation would be turned off in the case of any reorganization in which the acquiring corporation is foreign and the exchange has the effect of distributing a dividend as determined under Sec. 356(a)(2). However, the latest iteration of boot-within-gain repeal is far broader than the Green Book proposal and includes changes that would apply specifically in the case of acquisitive D reorganizations effectively to treat such transactions the same as stock acquisitions described in Sec. 304.
The most recent version of this proposal provides that for any Sec. 356 exchange that has the effect of the distribution of a dividend, the amount of boot the shareholder receives will be treated as a dividend to the extent of the earnings and profits of the corporation, without limitation to the amount of gain in the shareholder’s stock. 11 The remainder, if any, of the gain recognized would then be treated as gain from the exchange of property. As written, this proposal is far broader than those considered in the Green Book and otherwise in 2009, which were limited in scope to cross-border reorganizations. The current proposal would apply to all acquisitive reorganizations, regardless of the identity of the parties to the reorganization or the form of acquisitive reorganization (i.e., the proposal is not limited to all-cash D reorganizations).
In determining the amount of a boot payment that should be characterized as a dividend, the statute retains the general language of current Sec. 356, which refers to earnings and profits of the corporation. Exactly which corporation’s earnings and profits should be available has been the subject of debate between taxpayers and the IRS, with authorities reaching different results in different cases. However, the proposed amendment would clarify that in the case of D reorganizations, a special earnings and profits source rule, similar to that of Sec. 304(b)(2), would apply. In other words, the amount of the payment characterized as a dividend would be determined first to the extent of the acquiring corporation’s earnings and profits, and then to the extent of the target corporation’s earnings and profits. With these changes, there would no longer be a difference in the treatment of all-cash D reorganizations and Sec. 304(a)(1) stock acquisitions in the internal context. Given that the different treatment under current law may be achieved solely by deciding to file a check-the-box election to disregard the target entity after the stock acquisition, or by converting the target into a single-member limited liability company, it is easy to understand why Congress feels that the tax treatment of these economically similar transactions should be consistent.
Treatment of Controlled Corporation Securities in Certain Sec. 355 Distributions
Where a Sec. 355 distribution of controlled corporation stock is preceded by a contribution of assets from the distributing corporation (a D/355 transaction), the distributing corporation can receive cash or other nonstock consideration from the controlled corporation without recognition of gain or loss, but only to the extent that the distributing corporation in turn distributes such consideration to its shareholders or uses such consideration to repay amounts owed to its creditors. 12 In the latter case, the distributing corporation is entitled to nonrecognition on receipt of the nonqualified property (i.e., property other than stock or securities of the controlled corporation) only to the extent that the amount of cash used to repay the distributing corporation’s creditors does not exceed the aggregate adjusted tax basis of the assets contributed by the distributing corporation prior to the Sec. 355 distribution. 13 However, this basis limitation applies only to distributions of nonqualified property by the controlled corporation. 14
Consequently, taxpayers have been able to push additional leverage into the controlled corporation on a tax-free basis by having the controlled corporation issue its own securities, rather than cash, to the distributing corporation in connection with the asset contribution, with the distributing corporation then using such securities to repay debt owed to the creditors of the existing corporation. 15 This provision has essentially allowed distributing corporations to achieve the same economic result of having the controlled corporation obtain new debt financing and distribute the proceeds to the distributing corporation, but without the same potential for current recognition of gain.
To reconcile these types of transactions, Congress has proposed an amendment to Sec. 361 that would treat controlled corporation securities the same as cash or other property, such that the distribution of controlled securities would also be subject to the basis limitation in a D/355 transaction. 16 The operative language of the most recent proposal would add new Sec. 361(d) to provide that in the case of a D/355 transaction:
- Sec. 361 would be applied by replacing the language “stock or securities” with “stock other than nonqualified preferred stock”; and
- The first sentence of subsection (b)(3) would apply only to the extent that the sum of the money and the fair market value (FMV) of the other property transferred to such creditors does not exceed the adjusted bases of such asset transactions (reduced by the amount of the liabilities assumed, within the meaning of Sec. 357(c)).
Under this proposal, securities of the controlled corporation would be treated as “other property” and would therefore be subject to the basis limitation otherwise attributable to cash distributions used to fund payments to the distributing corporation’s creditors.
Final and Temporary Regs.
Final All-Cash D Regs.
In 2006, the IRS and Treasury issued Temp. Regs. Sec. 1.368-2T(l) (the temporary regulations) 17 to address the uncertainty about whether certain acquisitive transactions could qualify as reorganizations described in Sec. 368(a)(1)(D), where no stock of the acquiring corporation was actually issued and distributed in the transaction—i.e., the consideration paid for the target corporation’s assets consisted entirely of cash or other nonstock property (commonly referred to as an all-cash D reorganization). In the context of a commonly controlled target and acquiring corporation, there is authority to support the view that the “meaningless gesture” doctrine should apply to reorganizations defined in Sec. 368(a)(1)(D). 18 However, these authorities did not address the concern posed by the fact that such all-cash D reorganizations technically did not satisfy the stock distribution requirement of Sec. 354(b)(1)(B).
To remedy this technical concern, the temporary regulations adopted the fiction that in addition to issuing nonstock consideration, the acquiring corporation in an all-cash D is deemed to issue a nominal share of its stock to the target corporation, and the share is then distributed to the target shareholder on liquidation. Thus, the issuance of the nominal share enables the target corporation to satisfy the stock distribution requirement in Sec. 354(b)(1)(B). However, the temporary regulations did not provide specific guidance as to how the nominal share should be treated for purposes of other tax provisions, such as the shareholder stock basis provisions of Sec. 358.
To provide additional clarity on the treatment of the nominal share, the IRS issued final all-cash D regulations in December 2009. 19 In final form, Regs. Sec. 1.368-2(l) provides guidance on all-cash D transactions, as well as exchanges involving the use of acquiring corporation stock in which there is not a value-for-value exchange. The final regulations also clarify the treatment of the nominal share and make other clarifications with respect to the application of the all-cash D rules.
The final regulations expand the meaningless gesture doctrine as it applies to D reorganizations. If the same person or persons own, directly or indirectly, all the stock of the transferor and transferee corporations in identical proportions, the regulations adopt two approaches for stockless D reorganizations:
- If the value of the consideration received is equal to the FMV of the transferor corporation’s assets, the transferee corporation will be deemed to issue a nominal share of its stock in addition to the actual consideration paid in the exchange; and
- If the consideration received in the transaction is less than the FMV of the transferor corporation’s assets (including no consideration), the transferee corporation will be treated as issuing stock with a value equal to the excess of the FMV of the transferor corporation’s assets over the value of the consideration actually received in the transaction.
Nominal share: The final regulations retain the nominal share approach adopted by the temporary regulations, clarifying that the nominal share provides a useful mechanism with respect to stock basis consequences to the exchanging shareholder. As stated in the preamble to the final regulations, the IRS believes that the nominal share should be treated as nonrecognition property under Sec. 358(a) and thus as substituted basis property. In addition, the nominal share preserves remaining basis, if any, that the target shareholder might otherwise lose in the transaction and facilitates future stock gain or loss recognition by the appropriate shareholder.
The final regulations further clarify the treatment of the nominal share, providing that the nominal share is deemed distributed by the transferor corporation to the shareholders of the transferor corporation as part of the Sec. 356 exchange. Where appropriate, the nominal share is further transferred through chains of ownership to the extent necessary to reflect the actual ownership of the transferor and transferee corporations. For example, assume the hypothetical situation illustrated in the exhibit. In this case, to reconcile actual legal ownership of A with the fictional issuance of the nominal share, the nominal share is deemed to be distributed by T to S1 when T liquidates, followed by a distribution from S1 to P and a subsequent contribution from P to S2. The regulations apply a similar treatment where the transferee corporation is treated as issuing stock with a value equal to the excess of the FMV of the transferor corporation’s assets over the value of the consideration actually received in the transaction.
Note, however, that when treating the nominal share as nonrecognition property for all purposes, taxpayers must be careful to avoid a couple of potential pitfalls associated with the nominal share fictions. For example, the deemed distribution of constructive shares of acquiring corporation stock can result in Sec. 311(b) gain. 20 In addition, if the nominal share retains basis under Sec. 358 following the reorganization, the deemed distribution of a nominal share other than in the liquidating distribution of the target corporation could result in loss of the basis without any tax benefit as a result of the application of Secs. 311(a) and 301(d). Furthermore, in the context of an intercompany reorganization between consolidated group members, the nominal share approach must be applied in conjunction with the treatment of boot mandated by Regs. Sec. 1.1502-13(f)(3), which treats nonqualifying property as received by the member shareholder in a separate transaction.
The interaction of these provisions can lead to the creation and subsequent triggering of a deferred intercompany gain as a result of a first deemed stock issuance under Regs. Sec. 1.1502-13(f), followed by a hypothetical redemption (leading to a potential excess loss account in the target corporation stock), which is then followed by the deemed distribution of the nominal share where necessary to rationalize actual legal ownership with the tax fiction. 21 Prudent taxpayers can avoid these collateral results by issuing a single share of acquiring corporation stock in the transaction; the share may then be retained by the target corporation shareholder, thus avoiding the consequences of the hypothetical share distribution.
Sec. 304 Anti-Abuse Regs.
As part of a broad set of anti-avoidance rules published on June 14, 1988, 22 the IRS promulgated Temp. Regs. Sec. 1.304-4T to address transactions that are subject to Sec. 304 but that are entered into with a principal purpose of avoiding the application of Sec. 304 to certain corporations. Specifically, for purposes of determining the amount of a property distribution constituting a dividend (and the source thereof) under Sec. 304(b)(2), the IRS director of field operations (formerly the district director) is permitted to consider a corporation (the deemed acquiring corporation) as having acquired for property the stock of the issuing corporation that is in fact acquired for property by the actual acquiring corporation, if the deemed acquiring corporation controls the acquiring corporation and if one of the principal purposes for creating, organizing, or funding the acquiring corporation (through capital contributions or debt) is to avoid the application of Sec. 304 to the deemed acquiring corporation.
Although effective in preventing the manipulation of a payment’s character through the use of artificial acquiring entities, these regulations did not (standing alone) prevent taxpayers from achieving similar results by using a shell entity as the issuing (or target) corporation. As the IRS learned of such transactions, it deemed it necessary to adopt an anti-avoidance rule similar to the prior rule of Temp. Regs. Sec. 1.304-4T.
Thus, the IRS issued revised regulations 23 that amend Temp. Regs. Sec. 1.304-4T to provide that for purposes of determining the amount of a property distribution that is a dividend (and the source thereof) under Sec. 304(b)(2), the acquiring corporation shall be treated as acquiring for property the stock of a corporation (the deemed issuing corporation) that is controlled by the issuing corporation if, in connection with the acquisition for property of the issuing corporation’s stock by the acquiring corporation, the issuing corporation acquired stock of the deemed issuing corporation with a principal purpose of avoiding the application of Sec. 304 to the deemed issuing corporation. 24 This amendment places the acquiring and issuing corporations on level ground with respect to the application of the anti-abuse rule.
Moreover, former Temp. Regs. Sec. 1.304-4T applies when “one of the principal purposes” for the transaction is to avoid the application of Sec. 304. The amended regulations now apply when “a principal purpose” of the transaction is to avoid the application of Sec. 304, although the IRS and Treasury do not view this modification as a substantive change. The new regulations also make the anti-avoidance rule of current Temp. Regs. Sec. 1.304-4T self-executing, such that consent of the director of field operations is no longer required. Finally, the regulations clarify that the anti-abuse rule may apply in cases where the funding for the Sec. 304 transaction is received from an unrelated party. For example, the regulations may apply when the deemed acquiring corporation facilitates the repayment of an obligation incurred by the acquiring corporation (even if that obligation is for a borrowing from an unrelated party) to acquire the stock of the issuing corporation.
Conclusion
The past year has seen an unusual amount of tax legislation affecting corporations. Given the federal government’s current need for revenue and the widespread interest in corporate tax reform, 2011 may well see even more legislative and regulatory action than 2010. Therefore, practitioners should monitor the proposed legislation discussed above—as well as new developments as they arise—to ensure their corporations or clients are ready for the changes that will inevitably come.
The views expressed herein are the author’s alone and do not necessarily reflect the views of Ernst & Young LLP.
Footnotes
1 See Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (May 2009) (the Green Book).
2 Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
3 See Notice 2010-62, 2010-40 I.R.B. 411.
4 Granite Trust Co., 238 F.2d 670 (1st Cir. 1956) (permitting a shareholder to sell stock of a subsidiary in order to avoid the application of Sec. 332 upon the subsidiary’s liquidation).
5 See Elliott, “IRS Not Targeting Granite Trust Transactions, Official Says,” 2010 TNT 94-8 (May 17, 2010) (statement of Marie Milnes-Vasquez, Branch 4 senior technical reviewer, IRS Office of Associate Chief Counsel (Corporate), that the IRS is not trying to close down intercompany Granite Trust transactions); and Elliott, “Practitioners Debate IRS’s Intercompany Accounting Method for Worthless Stock Loss,” 2010 TNT 206-2 (October 26, 2010) (statement of Lawrence Axelrod, special counsel, IRS Office of Associate Chief Counsel (Corporate): “There is no ‘angel list,’ but probably if there was one, Granite Trust would be at the top of it”).
6 Sec. 7701(o)(2).
7 Sec. 7701(o)(3).
8 Sec. 7701(o)(4).
9 Sec. 6662(i).
10 Under Sec. 356(a)(1), in an exchange of stock or securities or a distribution of stock of a controlled corporation where Sec. 354 or 355 would apply except for the fact that property received in the exchange consists not only of property permitted by those sections, but also other property or money (i.e., boot), then the gain recognized by the recipient will not exceed the value of the boot.
11 S. 3793 §412 (introduced 9/16/10).
12 Sec. 361(b).
13 Sec. 361(b)(3).
14 Sec. 361(c)(3).
15 See, e.g., IRS Letter Ruling 201032017 (8/13/10).
16 H.R. 4486 (introduced January 21, 2010, and referred to the House Ways and Means Committee) and S. 3380 (introduced May 17, 2010, and referred to the Senate Finance Committee).
17 T.D. 9303.
18 Under the meaningless gesture doctrine, the IRS and the courts have not required the actual issuance and distribution of stock and/or securities of the transferee corporation, despite the distribution requirement of Sec. 354(b)(1)(B), when the same person or persons owns all the stock of the transferor corporation and the transferee corporation, viewing the issuance of stock in such circumstances to be a “meaningless gesture” not mandated by Secs. 368(a)(1)(D) and 354(b). See, e.g., James Armour, Inc., 43 T.C. 295 (1964); Wilson, 46 T.C. 334 (1966); and Rev. Rul. 70-240, 1970-1 C.B. 81.
19 T.D. 9475.
20 See, e.g., IRS Letter Rulings 9336029 (6/14/93), 9102012 (10/10/90), and 9229026 (4/21/92).
21 See Regs. Sec. 1.1502-13(f)(7), Example (4).
22 T.D. 8209.
23 T.D. 9477.
24 Temp. Regs. Sec. 1.304-4T(b)(2).
EditorNotes
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 brandon.hayes@ey.com.
