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Significant Recent Developments This article summarizes some of the more significant recent subchapter C and consolidated return developments, including the American Jobs Creation Act, proposed regulations on reorganization continuity requirements, guidance on subsidiary stock losses and various other significant rulings. Mark
A. Schneider, J.D., LL.M. John
Nemeth, J.D., MBA Yidan
Chui, CPA, M.Sc. Editor’s note: Mr. Schneider is the immediate past chair of the AICPA Tax Division’s Corporations & Shareholders Taxation Technical Resource Panel. Executive Summary
This article summarizes some recent, significant subchapter C and consolidated return developments. It addresses, among other things, (1) the American Jobs Creation Act of 2004 (AJCA); (2) proposed regulations on the continuity of interest (COI) and continuity of business enterprise (COBE) requirements in tax-free reorganizations; (3) guidance on how to determine allowable loss on subsidiary stock in a consolidated group setting; and (4) revenue rulings on the business purpose for spinoffs and on the tax effects of a state law conversion of a partnership to a corporation. Legislation The AJCA was signed into law by President Bush on Oct. 22, 2004. It contains several corporate tax provisions. First, AJCA Section 898(b) narrows the scope of Sec. 357(c) to apply only to Sec. 351 transfers and divisive D reorganizations (i.e., D reorganizations undertaken to affect a corporate spinoff). Under Sec. 357(c), the transferor corporation recognizes gain to the extent that liabilities assumed by the transferee exceed the aggregate adjusted basis of the assets received by the transferee. The AJCA makes clear that the provision no longer applies to acquisitive D reorganizations. This is a welcome change. AJCA Section 899(a) clarifies the definition of nonqualified preferred stock, by providing under Sec. 351(g)(3) that stock shall not be treated as participating in corporate growth to any significant extent, unless there is a real and meaningful likelihood of the shareholder actually participating in corporate earnings and growth. In addition, AJCA Section 836 narrows the ability to transfer a built-in loss (BIL) in a Sec. 351 transaction. Finally, AJCA Section 839 provides that a qualified stock purchase for which an election is made under Sec. 338(h)(10) is subject to estimated taxes. The estimated tax is determined based on a stock sale, unless and until there is an agreement to make a Sec. 338(h)(10) election.1 Regulations COI and COBE To qualify as a Sec. 368(a) tax-free reorganization, a transaction generally must satisfy the COI and COBE requirements. For example, target corporation (T) merges into acquiring corporation (A), with A surviving the merger. Under the COI requirement in Regs. Sec. 1.368-1(e), the consideration issued to the T shareholders must consist of a certain amount of A stock. In addition, under the Regs. Sec. 1.368-1(d) COBE requirement, A must continue T’s historic business or use a significant portion of the historic T assets in a business. E and F reorganizations: Proposed regulations2 would excuse two types of reorganizations—E and F reorganizations—from the continuity requirements. An E reorganization is a recapitalization, or a “reshuffling of the corporate deck.”3 A typical recapitalization involves the conversion of a corporation’s debt into its stock. An F reorganization is a mere change in one corporation’s identity, form or place of organization. For recapitalizations, the IRS has long held that the COI and COBE requirements do not apply to transactions involving only a single corporation.4 F reorganizations, according to the preamble to the proposed regulations, effectively involve only one corporation, even though two corporations technically might be involved (e.g., a reincorporation in another state). Testing date for COI requirement: In certain types of reorganizations, for example, when a target corporation merges into an acquiring corporation under Sec. 368(a)(1)(A), the acquirer may issue money or other property to the target’s shareholders, in addition to the acquirer’s stock. The amount of money or other property is limited, however, by the COI requirement under Regs. Sec. 1.368-1(e), which is designed to prevent transactions that resemble sales from qualifying as tax free. To satisfy the COI requirement, the acquirer must issue an amount of its stock to the target’s shareholders that preserves a proprietary interest in the target. A transaction will meet the IRS’s safe harbor if the value of such stock is at least 50% of the value of the total consideration issued.5 This is a key factor. In light of potential shifts in the value of the acquirer’s stock—such as a decrease during the interim period (between execution of the reorganization agreement and the transaction closing date)—the testing date for determining whether COI is met is critical. Against this backdrop, Prop. Regs. Sec. 1.368-1(e)(2)6 would provide that, in determining whether the COI requirement is satisfied, the consideration to be exchanged for the target’s stock is valued as of the end of the last business day before the first date there is a binding contract to effect the transaction. The consideration must be fixed in the contract and include only stock and money. The value of any stock or money placed in escrow to secure the customary target representations and warranties would be fixed consideration, under the proposed regulations. Push-Up Distributions Under Sec. 368(a)(2)(C), an acquiring corporation in certain enumerated tax-free reorganizations may transfer all or a portion of the acquired assets or stock to a controlled corporation. However, this provision does not specifically sanction a distribution of assets (a push-up). Proposed regulations issued in March 20047 amplify Sec. 368(a)(2)(C) to permit the acquirer to push up a portion of the acquired assets or stock to its corporate shareholder. Prop. Regs. Sec. 1.368-2(k) would provide that a transaction otherwise qualifying as a tax-free reorganization will not be disqualified because of a subsequent distribution of the acquired assets or stock, provided that (1) no distributee receives substantially all of the acquired assets; (2) the distributee is a member of the “qualified group,” as defined in the COBE regulations;8 and (3) the COBE regulations are met. Thus, in a forward-subsidiary merger under Sec. 368(a)(2)(D), the proposed regulations would permit the acquirer to distribute an amount of the acquired assets to its parent that is less than substantially all. However, the proposed regulations do not further elaborate on the “substantially all” requirement; thus, practitioners must rely on the IRS safe-harbor rules or case law.9 The proposed regulations also would expand Sec. 368(a)(2)(C)’s scope to permit an acquirer to transfer assets (1) following a reorganization described in Sec. 368(a)(1)(D) (relating to transfers between controlled corporations) and (2) to a partnership (subject to the COBE requirements). Stock Basis-Tracing Approach When all of a shareholder’s stock in a target is exchanged for stock of an acquirer in a tax-free reorganization, the basis of the acquirer’s stock received is generally equal, under Sec. 358, to the basis of the target stock surrendered. While this rule would seem relatively painless to apply, it becomes complex when a shareholder has different bases in various shares of the target stock—because, for example, the shareholder purchased different lots at different prices. The Sec. 358 regulations do not address this situation. Case law on this point is mixed: some cases permit shareholders to trace the basis of the acquirer shares back to particular shares of target stock,10 while others require averaging.11 Taking the more flexible approach, recent proposed regulations12 under Sec. 358 would permit tracing. Under Prop. Regs. Sec. 1.358-2(a)(2)(iii), a shareholder would designate which share of acquirer stock it received for a particular share of target stock. The designation must be consistent with the terms of the overall reorganization agreement and generally must be made by the first date on which the designation becomes relevant, such as a sale of acquirer shares. Failure to make a designation would result in the shareholder being treated as selling acquirer shares in respect of the earliest target shares purchased. Disconformity Method for Subsidiary Stock Losses Generally, Temp. Regs. Sec. 1.337(d)-2T disallows a deduction for losses realized on subsidiary stock within a consolidated group, to the extent that stock basis is attributable to recognized built-in gain (BIG). To provide taxpayers with an acceptable method for determining BIG, the IRS issued Notice 2004-58.13 In principal part, the notice sets forth the basis-disconformity method, described below. In addition, temporary regulations were amended14 so that taxpayers could elect to apply the method to stock losses occurring before the pre-amendment effective date of the regulations (March 7, 2002).15 Any such election must be made with, or as part of, an amended return filed before the date the original return for the tax year that includes Aug. 26, 2004, is due (including extensions). Under the basis-disconformity method, subsidiary stock basis is reduced (but not below zero) by the least of the (1) gain amount, (2) disconformity amount and (3) positive investment adjustment amount. The gain amount is the sum of all gains (net of directly related expenses) recognized on asset dispositions that are allocable to the share while the subsidiary is a group member. The disconformity amount is the excess (if any) of a subsidiary share’s basis over the share’s proportionate interest in the subsidiary’s net asset basis.16 The positive investment adjustment amount is the excess (if any) of the sum of the positive adjustments made to the subsidiary share over the sum of the negative adjustments made to the share under Regs. Sec. 1.1502-32, excluding adjustments for distributions made by the subsidiary.17 Sec. 108(b) Attribute Reduction and Circular Basis Adjustments Temp. Regs. Sec. 1.1502-28T18 requires a reduction of tax attributes of consolidated group members when cancellation of debt (COD) income is excluded under Sec. 108(a), beginning with a member’s share of the consolidated net operating loss (CNOL). Proposed regulations19 address the possibility that a reduction in CNOL might result in a circular basis adjustment. The problem of circular basis adjustments (outside of the Sec. 108 context) is addressed in Prop. Regs. Sec. 1.1502-11(b). According to these regulations, if one group member (P) sells the stock of another member (S) during the year, the group will be limited in its ability to offset gain on the sale with S’s losses (if any) generated during such year. The limit is intended to benefit taxpayers, by preventing P’s gain on the sale from increasing the absorption of S’s loss; such increased absorption would reduce P’s basis in S’s stock under Regs. Sec. 1.1502-32 and, in turn, increase P’s income or gain. The proposed regulations would provide a somewhat complex, nine-step calculation designed to prevent a potential circular-basis quagmire when reducing a member’s share of the CNOL on a sale of its stock outside the group in the year of attribute reduction.20 Taxpayers may rely on these proposed regulations before they are adopted as temporary or final. Revenue Rulings Disregarded-Entity Election Worthless stock deduction: Rev. Rul. 2003-12521 provided that a parent may claim a worthless stock deduction on an insolvent subsidiary’s election to be treated as a disregarded entity. In the ruling, P was a domestic corporation that owned all of the stock of FS, a foreign corporation. FS elected under the check-the-box regulations to be treated as a disregarded entity. As a result, under Regs. Sec. 301.7701-3(g)(1)(iii), FS was deemed to distribute all of its assets and liabilities to its single owner in liquidation. Immediately before the effective date of the election, the fair market value (FMV) of FS’s assets, including intangible assets such as goodwill and going-concern value, was less than the sum of its liabilities. In the first instance, the ruling held that the liquidation of FS was not tax free under Sec. 332, because FS was insolvent at the time of the liquidation. Citing Regs. Sec. 1.332-2(b), the ruling noted that a tax-free liquidation would entail P receiving payment for its stock in FS. The regulation cross-references Sec. 165 (relating to a worthless stock deduction) for transactions failing to meet the Sec. 332 solvency requirement. The ruling then provided its central holding: the deemed liquidation was an identifiable event that entitled P to claim a worthless stock deduction for the FS stock. This holding was significant because it had not been clear that a deemed liquidation (as opposed to an actual one) would be viewed as an event signaling worthlessness. Transfers: Rev. Rul. 2004-8522 provided guidance on transfers involving disregarded entities. This ruling set forth three situations. In the first, X was an S corporation that owned 100% of the stock of Sub1, which X elected to treat as a qualified subchapter S subsidiary (QSub) under Sec. 1361(b)(3)(B).23 The X shareholders formed U Corp.; X then merged into U in an F reorganization. The X shareholders owned 100% of the U stock as a result of the merger, and U was eligible to be an S corporation. The second situation was the same as the first, except that X transferred—by either sale or tax-free reorganization other than an F reorganization—all of its assets, including the Sub1 stock, to M, another S corporation. In the third situation, X owned all of the membership interests in limited liability company LLC, an eligible entity that elected under Regs. Sec. 301.7701-3 to be treated as a corporation, despite its default classification as a disregarded entity. X transferred, by sale or tax-free reorganization, all of the membership interests in LLC to N, an unrelated person. Citing Rev. Rul. 64-250,24 the ruling held that because the merger of X into U constituted an F reorganization, U was treated as a continuation of X. It concluded that U was thus treated as an S corporation immediately after the merger, and the reorganization did not terminate X’s election to treat Sub1 as a QSub. In the second situation, the ruling found that, because X’s transfer of its assets (including the Sub1 stock) to M did not qualify as an F reorganization, M was not treated as a continuation of X. As a result, X’s QSub election for Sub1 terminated, unless M made such an election. In contrast, in the third situation, X’s transfer of all of the membership interests in LLC did not undo the entity’s election to be treated as a corporation (presumably because the entity, rather than X, made the election). Spinoffs Rev. Rul. 2004-23:25 Under Rev. Rul. 2004-23, a spinoff undertaken to increase shareholder value is permissible if there is a “corporate” business purpose. In the ruling, D, a publicly held corporation, indirectly conducted businesses B1 and B2 through its subsidiaries. The two businesses attracted different investors, some of whom were averse to investing in D, because of the presence of the other business. D was advised that if each business were conducted in a separate corporation, the stock of the two corporations (D and newly formed C) would likely trade publicly for a higher price, in the aggregate, than the D stock in its current form. With the intent and expectation of increasing the aggregate trading price of the common stock representing B1 and B2, D transferred all of the subsidiaries engaged in B2 to C, and distributed all of the C stock pro rata to its shareholders in a transaction that qualified for tax-free treatment under Sec. 355. This ruling was interesting in that it considered what the IRS has long regarded as a shareholder business purpose: a spinoff that increases stock value. The Sec. 355 regulations are relatively clear that only a corporate business purpose may justify a spinoff.26 In this regard, the ruling acknowledged that D’s directors anticipated that “increasing the aggregate trading price of the D and C common stock is expected to confer a benefit to existing shareholders.” However, D’s directors also expected the increase in stock value to result in future corporate benefits—such as making the stock a more attractive currency for subsequent corporate acquisitions, as well as for rewarding employees. The addition of these corporate purposes in the ruling made it relatively clear that, from an IRS perspective, increasing stock value is not, in and of itself, a valid business purpose for a tax-free spinoff. Rev. Rul. 2003-110:27 This ruling reconfirmed the “competition” business purpose. In the ruling, parent (D) was a publicly traded corporation in the pesticide business. D owned all the stock of subsidiary C, which was in the baby foods business. A significant number of C’s potential customers refused to buy from C, due to its affiliation with D. D’s management consultant advised D that separating C from D’s business would remedy this problem. Based on that advice, D distributed all of the C stock to its shareholders on a pro-rata basis. According to the ruling, although the distribution of C’s stock resulted in the nonrecognition of gain that would otherwise be recognized under Sec. 311(b) if Sec. 355 did not apply, it did not constitute tax avoidance, because it was motivated by a bona fide business purpose within the meaning of Regs. Sec. 1.355-2(b). The ruling was interesting not so much for its central holding, but rather because it reconfirmed the viability of the competition business purpose, described in Rev. Proc. 96-30.28 Appendix A of that revenue procedure set forth a nonexclusive list of business purposes for which the IRS was comfortable issuing advance rulings. As the Service no longer issues letter rulings on the business-purpose requirement, Rev. Rul. 2003-10’s description of the competition business purpose—and its implicit validation of such purpose—is helpful. Debt Instruments Change in obligor: Under Rev. Rul. 2004-78,29 debt instruments qualifying as securities do not lose their status because of a change in obligor that occurs in a tax-free reorganization. In the ruling, a target (T) merged into an acquirer (A) in a transaction that qualified as a tax-free reorganization under Sec. 368(a). Pursuant to the merger, in addition to the common stock exchanges, the T debt holders exchanged their debt for A debt with terms identical to the T debt, except that the interest rate was changed to reflect differences in the creditworthiness of the two corporations. On issuance, the T debt, which had a 12-year term, constituted securities within the meaning of Sec. 354. The securities were two years from maturity at the time of the merger. Under case law, an instrument with a term of less than five years is not generally deemed to be a security in applying Sec. 354.30 Although the new debt had a term of only two years, the ruling concluded that the A debt instruments were securities under Sec. 354. Essentially, it reasoned that in the case of a tax-free reorganization in which the debt instruments bear the same terms (other than interest rate), the A debt instruments were a continuation of the security holder’s investment in T in substantially the same form. This step-in-the-shoes treatment is a reasonable approach and should be helpful for concerns in this area. Subsidiary’s distribution of parent’s debt: Rev. Rul. 2004-7931 provided that a subsidiary’s distribution of parent debt back to the parent might result in COD income. A parent (P) issued debt to an unrelated party. S was P’s wholly owned subsidiary. S purchased all of the P debt for $9.5 million when the adjusted issue price, as defined in Sec. 1273, was $10 million. Because S was related to P, P realized COD income on S’s acquisition under Sec. 108(e)(4) and the regulations equal to the excess of the debt’s adjusted issue price over its acquisition price, or $500,000.32 Under the Sec. 108(e)(4) regulations, P was treated as if it reissued the debt to S for the $9.5 million acquisition price. After the acquisition, S distributed the P debt to P, presumably extinguishing the debt under local law. At that time, the debt’s adjusted issue price was roughly $9.65 million; its FMV was $9.25 million. S’s earnings and profits (E&P) were $20 million in the distribution year. The ruling held that S’s distribution of the P debt was a distribution under Sec. 301, with the debt’s FMV ($9.25 million) being treated as a dividend (because S’s E&P exceeded the distribution’s value). Significantly, the ruling also held that, because the distribution extinguished the debt, P was treated as having repurchased its debt for its FMV. Thus, P realized $400,000 in COD income (the excess of the debt’s adjusted issue price ($9.65 million) over its FMV ($9.25 million)). In reaching this holding, the ruling relied on Rev. Rul. 93-7,33 which held that when a partnership distributes partner debt to the issuing partner, the partner is treated as having satisfied its debt at the debt’s FMV.34 Sec. 304 Rev. Rul. 2004-8335 held that Sec. 304 does not apply to prevent tax-free reorganization treatment under the step-transaction doctrine. Under Sec. 304, cash received on the sale of a brother corporation to a sister corporation is generally treated as having been received in redemption of the latter’s stock. In Rev. Rul. 2004-83, a parent (P) and its two wholly owned subsidiaries (S and T) were members of a consolidated group. Via an integrated plan, P sold the T stock to S for cash, then T liquidated into S. The ruling held that because P, S and T were consolidated group members, S’s purchase of the T stock from P was not subject to Sec. 304.36 Accordingly, consistent with prior published guidance, the ruling collapsed the stock sale and liquidation of T and treated the overall transaction as a transfer of the T assets to S, qualifying as a tax-free reorganization under Sec. 368(a)(1)(D).37 The ruling also held that the result would be the same and Sec. 304 would not apply, even if the corporations did not file a consolidated return. Citing the legislative history to Sec. 304, it reasoned that there is no policy that required applying Sec. 304 when the tax-free reorganization rules would otherwise apply. Partnership Conversion to Corporation Rev. Rul. 2004-5938 provided tax-free treatment for a state law conversion of a partnership to a corporation. In the ruling, A was an unincorporated entity under state law, and classified as a partnership for Federal tax purposes. Pursuant to a formless conversion statute, A elected to convert into a state law corporation. As a result, A was classified as a corporation for Federal tax purposes. After a recitation of comparable authority, the ruling concluded that the incorporation of A fell within the tax-free rules of Sec. 351. Specifically, the ruling treated the partnership (1) as having contributed all its assets and liabilities to the corporation in exchange for stock in the corporation and (2) immediately thereafter, as having liquidated, distributing the stock to its partners. The ruling noted that this treatment is identical to the check-the-box regime under Regs. Sec. 301.7701-3(g)(1)(i), relating to a partnership that elects to be classified as a corporation.39 |
