Editor: Greg A. Fairbanks, J.D., LL.M.
Corporations & Shareholders
In Letter Ruling 201220020 the IRS integrated an internal stock sale followed by a spinoff and ruled that the internal stock sale was eligible for a Sec. 338(h)(10) election.
Sec. 338(h)(10) in General
Sec. 338(h)(10) provides that when a target corporation is sold in a “qualified stock purchase” by its parent corporation to a purchasing corporation, the seller and purchaser may make a joint election to treat the stock sale as a deemed asset sale for federal income tax purposes. Under the tax fiction imposed under Sec. 338(h)(10) and its corresponding regulations, the stock sale is disregarded and instead the “old” target corporation is deemed to sell its assets to the “new” target corporation. The “old” target corporation is then deemed to liquidate into the selling corporation. Gain or loss on the deemed asset sale is reported by the “old” target corporation as of the end of the day of the transaction while the target is still a member of the selling group. The “new” target, owned by the purchasing corporation, obtains a cost basis in the acquired assets.
An election under Sec. 338(h)(10) is available only when the target corporation’s stock is acquired in a qualified stock purchase. A qualified stock purchase under Sec. 338(d)(3) is any transaction or series of transactions in which the stock of one corporation (meeting the 80% vote and value requirements of Sec. 1504(a)(2)) is acquired by another corporation by purchase during a 12-month acquisition period. A purchase is defined by Sec. 338(h)(3)(A) as any acquisition of stock, but only if (1) the stock’s basis does not carry over from the transferors; (2) the stock is not received in a capital contribution or reorganization (exchanges described in Sec. 351, 354, 355, or 356); and (3) the acquired stock was not acquired from a person the ownership of whose stock would be attributed to the purchaser under Sec. 318(a) (other than Sec. 318(a)(4), regarding options).
The Facts in Letter Ruling 201220020
In Letter Ruling 201220020, a publicly traded foreign corporation (Acquirer) owned, indirectly through a chain of other foreign corporations, all of the outstanding stock of a U.S. corporation (Target Parent). Target Parent was the common parent of an affiliated group that elected to file a U.S. consolidated income tax return (the Target Parent Group). Target Parent directly and wholly owned all of the outstanding stock of another U.S. corporation (Target), which was a member of the Target Parent Group.
Acquirer and its various foreign and U.S. affiliates operated two different businesses. Acquirer, certain of its foreign subsidiaries, and Target were engaged in the first business (Business A ). Certain other foreign subsidiaries, including Acquirer’s fourth-tier foreign subsidiary (Foreign Sub 4), and Target Parent were engaged in the second business (Business B ). Acquirer proposed a transaction to separate its two businesses. The transaction was undertaken in three steps, as follows:
- Step 1: Acquirer purchased all of the outstanding stock of Target from Target Parent (the “target sale”).
- Step 2: Acquirer caused all of the outstanding stock of Foreign Sub 4, which in turn indirectly owned all Target Parent’s stock, to be transferred directly to Acquirer.
- Step 3: Acquirer distributed all of the stock in Foreign Sub 4 to Acquirer’s shareholders (taken together with Step 2, the “share distribution”).
Thus, the transaction effectively separated Business A and Business B into two separate chains of corporations, and each chain was owned by approximately the same shareholders. The first chain operated Business A and included Acquirer, several foreign subsidiaries, and Target. The second chain operated Business B and included Foreign Sub 4, several foreign subsidiaries, and Target Parent.
The IRS ruled that Acquirer’s purchase of Target from Target Parent in the target sale was a “qualified stock purchase” within the meaning of Sec. 338(d)(3). In addition, the IRS ruled that Target Parent and Acquirer were eligible to make a joint election under Sec. 338(h)(10) with respect to Acquirer’s purchase of Target from Target Parent.
Sec. 338 Related-Party Rule
As discussed above, a qualified stock purchase must satisfy the related-party rule under Sec. 338(h)(3)(A)(iii), which provides that the acquired stock must not be acquired from a person the ownership of whose stock would be attributed to the purchaser under Sec. 318(a) (other than Sec. 318(a)(4) with respect to options). Sec. 338 does not indicate when relatedness must be tested, but Treasury regulations finalized in 2001 address this timing issue. For purposes of the related-party rule, Regs. Sec. 1.338-3(b)(3)(ii)(A) provides that relatedness is tested immediately after the purchase of target stock. Importantly, however, Regs. Sec. 1.338-3(b)(3)(ii)(C) modifies this rule and provides that in the case of a series of transactions effected under an integrated plan to dispose of target stock, relatedness is tested immediately after the last transaction in the series.
Letter Ruling 201220020 is the most recent in a series of rulings where the IRS considered whether a taxpayer engaged in a qualified stock purchase as part of a transaction involving a series of integrated steps (see also, e.g., Letter Rulings 201126003 and 201145007). In each instance, the IRS appears to have tested for relatedness after the last transaction in a series of transactions, as contemplated by Regs. Sec. 1.338-3(b)(3)(ii)(C). In Letter Ruling 201220020 the related-party rule for a qualified stock purchase would not have been met if the relationship between Acquirer and Target Parent had been tested immediately after the target sale but before the share distribution. At that point, 100% of Target Parent would have been attributed to Acquirer under the Sec. 318 attribution rules. Thus, the IRS apparently treated the target sale and the share distribution as a series of transactions effected pursuant to an integrated plan as contemplated under Regs. Sec. 1.338-3(b)(3)(ii)(C). Following the share distribution, Target Parent and Acquirer were not related under the Sec. 318 attribution rules, even though the ultimate shareholder group of each separate chain of corporations was approximately the same.
Sec. 304 Redemption by Related Corporation
The IRS did not specifically determine in the letter ruling whether Sec. 304 applied to any aspect of the transaction. In general, if Sec. 304 applies to a sale of stock between two affiliated corporations, the sale is instead treated for tax purposes as a redemption. In a typical Sec. 304 transaction, the stock sale is recast as a deemed Sec. 351 contribution for newly issued stock and a redemption of the deemed newly issued stock. Thus, a stock purchase that falls within the scope of Sec. 304 generally cannot qualify for a Sec. 338(h)(10) election because Sec. 338(h)(3)(A)(i) excludes carryover basis transactions and Sec. 338(h)(3)(A)(ii) excludes Sec. 351 transactions from the definition of a qualified stock purchase. Although the IRS did not rule on Sec. 304 in the letter ruling, the taxpayer made a representation that immediately after the target sale and at all times during the transaction, Target Parent did not control Acquirer within the meaning of Sec. 304(c). The taxpayer apparently relied on Rev. Rul. 74-605, where the IRS ruled that Sec. 304 did not apply to an upstream sale of the target corporation.
Sec. 197 Anti-Churning
The IRS did not address whether the anti-churning rules under Sec. 197(f)(9) might apply to any intangibles stepped up as a result of the Sec. 338(h)(10) election on the target sale in Letter Ruling 201220020. The anti-churning rules under Sec. 197(f)(9) and Regs. Sec. 1.197-2(h) generally prevent taxpayers from converting nonamortizable goodwill, going-concern value, or other intangibles held prior to the enactment of Sec. 197 on July 25, 1991, into amortizable Sec. 197 intangibles unless those intangibles are transferred after the enactment of Sec. 197 in a transaction giving rise to a significant change in ownership or use. Thus, the anti-churning rules generally prevent the application of Sec. 197 on transfers of intangibles between related parties.
Regs. Sec. 1.197-2(h)(6)(i) provides that relatedness for purposes of the anti-churning rules is determined under Secs. 267(b) and 707(b)(1), with certain modifications. Unlike the related-party rule for Sec. 338 qualified stock purchases discussed above, the relatedness rule for anti-churning purposes tests relationships at two different points in time. Regs. Sec. 1.197-2(h)(6)(ii) provides that a person is treated as related to another person for purposes of applying the anti-churning rules if a related-party relationship exists immediately “before” or immediately “after” the transaction in which the intangible is acquired. In the case of a series of related transactions, Regs. Sec. 1.197-2(h)(6)(ii)(B) provides that relatedness is tested immediately before the earliest transaction and immediately after the last transaction.
As a practical matter, however, relatedness for anti-churning purposes is tested only once, when a Sec. 338(h)(10) election is made. In the context of a Sec. 338(h)(10) election, Regs. Sec. 1.197-2(k), Example 24, applies the anti-churning related-party relationship test to a multistep transaction. In Example 24, old target and new target were not related immediately “before” the earliest transaction because new target, created as a function of the Sec. 338(h)(10) election, did not exist immediately before the earliest transaction. Turning then to the immediately “after” prong of the relatedness test, Example 24 indicates that new target and old target were not related immediately after the series of transactions because the requisite common ownership threshold of 20% by reference to Sec. 267 was not met.
Similar to Regs. Sec. 1.197-2(k), Example 24, the old target and new target in Letter Ruling 201220020 were not related immediately before the stock purchase because new target did not exist. In addition, an argument can be made that the same theory applied by the IRS in testing relatedness for purposes of Sec. 338 at the end of a series of integrated transactions in the letter ruling should be applied for purposes of testing relatedness under the Sec. 197 anti-churning rules. If so, then old target and new target in Letter Ruling 201220020 were unrelated immediately after the share distribution under Sec. 267, as modified by Sec. 197(f)(9). Thus, under this view the Sec. 197 anti-churning rules would not apply, and Target would be permitted to amortize its goodwill and other intangibles that were stepped up under Sec. 338(h)(10) on the target sale.
In summary, Letter Ruling 201220020 continues the recent IRS practice of issuing favorable Sec. 338 rulings to taxpayers when the selling corporation is ultimately separated in a series of transactions from the purchasing corporation and target corporation through a sale or other disposition, such as the spinoff in the letter ruling. The IRS appears willing to test relatedness for Sec. 338 purposes at the end of a series of related transactions.
EditorNotes
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.
