Procedure & Administration
If the tax result of a business transaction creates an undesirable outcome, the rules of federal income taxation might allow an opportunity for the taxpayer effectively to erase the transaction. The IRS has demonstrated flexibility in its application of the rescission doctrine to unwind transactions. Letter Ruling 201021002 is one in a series of rulings in which the IRS has applied the rescission doctrine more liberally than many tax advisers thought possible. However, tax advisers should be aware that the IRS has placed the rescission doctrine on its Priority Guidance Plan, so other guidance may be forthcoming soon.
Rev. Rul. 80-58
Rev. Rul. 80-58 sets forth the IRS’s public position on rescission. In that ruling, A sells land to B. Under the sales contract, A is obligated to take back the land at B’s option if the land cannot be rezoned. When rezoning is not possible, the parties rescind the sale—B transfers the land back to A during the same tax year as the sale and receives the purchase price in return. The ruling concludes that the rescission is respected for tax purposes; therefore, A does not recognize gain on the initial sale, and B does not recognize gain on the rescinding transfer.
The tax doctrine of rescission stems from the contractual right of rescission and is based in part on Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940), a claim of right case that allowed taxpayers to reverse a transaction without recognizing any tax consequences from the initial transaction or its nullification. Based on Rev. Rul. 80-58, the IRS generally requires four elements for a valid rescission: (1) the transaction must occur under an agreement or contract that (2) during the same tax year is (3) rescinded in a formally proper manner (such as by agreement of the parties) so that (4) the parties are returned to the same position as if that transaction had never occurred.
Letter Ruling 201021002
The facts of Letter Ruling 201021002 are complicated, so a simplified description follows. Prior to implementing a restructuring plan, a parent company owned interests in several disregarded entities. Because these subsidiaries were disregarded, debt issued by certain of them to the parent was also disregarded for federal tax purposes. The parent engaged in a series of steps through which it contributed the disregarded entities to a regarded corporate subsidiary. Although the parent intended to contribute its creditor positions for the receivables along with the interests in the disregarded entities, it failed to do so and, in the case of one subsidiary, neglected to contribute all its ownership interests. Therefore, for tax purposes, the debt became regarded (presumably with the undesirable result that this “springing debt” became taxable boot in the contribution), and one of the disregarded entities became a regarded partnership.
When the undesirable tax results were discovered, the parent endeavored to undo the portions of the restructuring that caused those results. Under a rescission agreement, some steps of the transaction were unwound. However, because the parent still wanted to restructure, any part of the transaction that did not trigger unintended tax consequences was left alone. Further, the parent notified the IRS that it intended to re-execute the rescinded steps after the effective date of the rescission in a manner that would achieve its initial objectives but avoid the springing debt and the creation of a regarded partnership.
The IRS ruled that the parties validly rescinded the transaction for tax purposes and that the initial transactions were therefore disregarded. Accordingly, the parent was treated as owning the disregarded entities at all times from the effective date of the initial transaction through the effective date of the rescission. In addition, the disregarded entities’ debt was treated as disregarded at all times from the effective date of the initial transaction through the effective date of the rescission. Finally, the unintended partnership was treated as a disregarded entity at all times from the effective date of the initial transaction through the effective date of the rescission.
Analysis
A tax adviser presented with the facts of Letter Ruling 201021002 might have been reluctant to opine that the parties validly rescinded the transaction for tax purposes. Although Rev. Rul. 80-58 does not mention these issues, the taxpayer’s adviser may have been concerned about, among other things, whether a transaction could be rescinded if the rescission was solely tax motivated or influenced by hindsight (rather than a result of some contractual right, like the rezoning clause in Rev. Rul. 80-58, or an execution error). Concerns may also have arisen because the rescinding transactions did not completely unwind all steps of the original transaction, and the parties consequently did not return to the same position in all respects as if the transaction had never occurred.
The taxpayer’s adviser may also have believed that there was an issue regarding the validity of the rescission because the taxpayer intended to redo the rescinded transaction in a different form to change the transaction’s tax consequences (in other contexts, the IRS has applied the substance over form and step-transaction doctrines to disregard tax-motivated transaction restructuring). Although the facts of Letter Ruling 201021002 would appear to implicate each of these issues, the IRS ruled that neither the original restructuring transactions nor the rescinding transactions had any tax effect.
If presented with these types of issues, tax advisers might consider this private letter ruling, and other similarly broad rescission-related private letter rulings, when advising a client as to the potential tax effects of a rescinded transaction or counseling a client on whether to seek a private letter ruling. Although private letter rulings cannot be used or cited as precedent under Sec. 6110(k)(3), they can provide a helpful indication of the IRS’s position on the issues addressed therein. Letter Ruling 201021002 and other rescission-related letter rulings might be a cause for some level of optimism. Nevertheless, because of the prohibition on reliance, tax advisers should remain cautious when advising clients with facts that might be seen as deviating from and even similar to Letter Ruling 201021002 or the spirit of Rev. Rul. 80-58 and consider counseling clients to seek rulings when the stakes are high.
A Warning
On December 7, 2010, Treasury issued the Office of Tax Policy and IRS Priority Guidance Plan for 2010–2011, which includes projects that the department has made it a priority to address through guidance published by July 2011. For the first time, this plan includes “guidance regarding the scope and application of the rescission doctrine.” Government representatives have given no indication about the possible form of this guidance, nor have they stated whether it will follow the generally permissive approach of certain IRS letter rulings. Informally at public events, however, government representatives have suggested that the letter rulings already issued were based on an interpretation of Rev. Rul. 80-58 as requiring only the four elements described above for rescission, whereas new guidance may revisit the basic question of what elements should be required for a valid rescission. In light of this potential shift in the government’s position and certain concerns about whether recent letter rulings may have been liberal in their interpretation of the rescission doctrine, tax advisers might encourage clients with facts implicating issues of concern or potentially inconsistent with the contractual right of rescission to seek rescission rulings sooner rather than later.
EditorNotes
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or mvanleuven@kpmg.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
