On July 13, 2017, Treasury and the IRS withdrew parts of proposed regulations (REG-163314-03) issued on March 10, 2005 (proposed net value regulations), that would require an exchange of net value for transactions intended to qualify under Secs. 351 and 368 and a distribution of net value for transactions intended to qualify under Sec. 332.
The government withdrew the proposed:
- Revisions to Regs. Secs. 1.332-2(b) and (e);
- Addition of Example 2 to Regs. Sec. 1.332-2(e);
- Additions of Regs. Secs. 1.351-1(a)(1)(iii) and (a)(1)(iv);
- Addition of Example 4 to Regs. Sec. 1.351-1(a)(2);
- Amendments to Regs. Secs. 1.368-1(a) and (b);
- Addition of Regs. Sec. 1.368-1(f); and
- Revision to Regs. Sec. 1.368-2(d)(1) in the proposed net value regulations.
These portions of the proposed net value regulations previously were adopted as final regulations: (1) provisions regarding creditor continuity of interest; and (2) provisions reflecting statutory changes to Secs. 332 and 351 (see T.D. 9434).
In discussing the withdrawal of Prop. Regs. Sec. 1.332-2, Treasury stated that:
the holdings of H.K. Porter Co. v. Commissioner, 87 T.C. 689 (1986), Spaulding Bakeries Inc. v. Commissioner, 27 T.C. 684 (1957), aff'd, 252 F.2d 293 (2d Cir. 1958), H.G. Hill Stores, Inc. v. Commissioner, 44 B.T.A. 1182 (1941), Rev. Rul. 2003-125, . . . Rev. Rul. 68-602, . . . Rev. Rul. 68-359, . . . and Rev. Rul. 59-296 . . . continue to reflect the position of the Treasury Department and the IRS. [preamble, REG-139633-08]
The preamble to the proposed net value regulations cited some of the same authorities in noting that "[t]he authorities interpreting [Sec.] 332 have consistently concluded that the language of the statute referring to a distribution in complete cancellation or redemption of stock requires a distribution of net value."
In discussing the withdrawal of Prop. Regs. Secs. 1.351-1, 1.368-1, and 1.368-2, Treasury simply stated that "current law is sufficient to ensure that the reorganization provisions and [Sec.] 351 are used to accomplish readjustments of continuing interests in property held in modified corporate form." This statement is made against the backdrop of the preamble to the proposed net value regulations, which cited Rev. Rul. 59-296 and Norman Scott, Inc., 48 T.C. 598 (1967) (holding that a transaction involving an insolvent target corporation qualified as a reorganization under Sec. 368(a)(1)(A)) in stating that the authorities are "not consistent."
Rather than withdraw the proposed net value regulations without comment or with a vague explanation, Treasury chose to explain its thinking. The manner in which it did so is interesting. Specifically, Treasury provided the aforementioned list of technical citations to show that courts and the IRS view Sec. 332 as not applying to liquidations of insolvent corporations. But, rather than provide a similar list of citations on the impact of insolvency on Sec. 351 and Sec. 368 transactions, Treasury stated that "current law is sufficient" — despite having expressly stated in the preamble to the proposed net value regulations that inconsistent authority existed. Seemingly, the law has retained enough ambiguity to justify leaving the proposed regulations outstanding for the past 12 years. It is not clear what has changed — why now, in 2017, Treasury believes that "current law is sufficient."
On a more technical basis, Treasury stated that, "[w]ith respect to [Sec.] 332, the holdings of . . . Rev. Rul. 59-296 . . . continue to reflect the position of the Treasury Department and the IRS." Interestingly, Rev. Rul. 59-296 also contained a ruling that there was no reorganization involving the insolvent target corporation, but Treasury limited its affirmative statement of support to Sec. 332. One could interpret this asymmetrical treatment as supporting the proposition that an insolvent target corporation may engage in a reorganization with its corporate shareholder.
The withdrawal notice also withdrew a helpful example — proposed Example 2 of Regs. Sec. 1.332-2(e). In the example, P Corporation owned all of the preferred and common stock of Q Corporation. The fair market value of Q Corporation's assets exceeded the amount of its liabilities but did not exceed the liquidation preference on the Q Corporation preferred stock. Q Corporation liquidated and distributed all of its assets to P Corporation, and P Corporation received partial payment for its Q Corporation preferred stock but received nothing for its Q Corporation common stock.
The example concluded that P Corporation did not receive Q Corporation's assets in a transaction qualifying under Sec. 332, but that P Corporation was entitled to a worthless security deduction for its Q Corporation common stock under Sec. 165(g). In addition, the example stated that the transaction may qualify as a reorganization under Sec. 368(a)(1)(C). In the reorganization context, this example allays the concern that Rev. Rul. 74-515 could be read to preclude the worthless stock loss under Sec. 356(c). In Rev. Rul. 74-515, pursuant to a statutory merger, common stock was exchanged for common stock and preferred stock was exchanged for cash. The IRS ruled that the shareholders who owned both common and preferred stock made an exchange under Sec. 356 because they received both common stock and cash. The ruling provided that gain under Sec. 356(a)(1) is recognized on the transfer of preferred stock for cash, but no loss is recognized as provided in Sec. 356(c).
Michael Dell is a partner at Ernst & Young LLP in Washington.
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