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Applying the Rescission Doctrine A recent IRS Letter Ruling,
200701019, applied the rarely seen principles of the rescission doctrine. While
the doctrine is most often applied to a sale of property, the ruling involved
its application
to a corporate merger. The Service allowed application even though the taxpayer
was seeking to reduce its Federal income tax.
What Is the Rescission Doctrine? “Rescission”
is defined as the cancelling or voiding of a contract
and the return of the parties to the positions they would have been in had the
contract not been made. The principles of rescission can be found in case law
dating back to the 1920s; see, e.g., A.W.
Shaw, 13 BTA 716 (1928). The requirements for a successful application of
the doctrine are more clearly described in Rev. Rul.
80-58. To
have a valid rescission, two conditions must be met: the (1) parties to the
transaction must be restored to the exact same position they would have been in
had no contract been made and (2) rescission must occur in the same tax year
the original transaction took place (application of Sec. 451). Subsequent
events cannot be considered. If
an effective rescission occurs, the original transaction is disregarded and the
taxpayer recognizes no gain or loss. While prior law held that a valid
rescission could not occur unless the original contract raised the possibility
that a rescission later might become desirable (Branum v. Campbell, 211 F2d 147 (5th Cir. 1954)), modern law does not
appear to follow this requirement.
Application The
rescission doctrine has been applied to a variety of transactions, including
sales of property (both real and personal), cancellations of income tax elections
(e.g., Sec. 83(b) elections, terminations of S corporation status and
choice-of-entity elections), sales of company stock and cancellations of common
stock subscriptions or other ownership changes. It has also been applied to
transactions in which the principal motivations were both tax and nontax.
Ruling’s Facts In
Letter Ruling 200701019, the IRS applied the rescission doctrine to a corporate
merger. Parent (P) acquired all the outstanding common stock of Sub 1 for cash.
Sub 1’s sole asset was all the outstanding common stock of Sub 2. Neither Sub 1
nor Sub 2 had any other equity interests outstanding. As part of the
acquisition, P also retired $A of Sub 2’s debt in exchange for a note from Sub
2 in the same amount. To
maximize operational efficiencies and reduce state franchise tax exposure,
immediately after P acquired all of Sub 1’s outstanding stock, it caused Sub 1
to merge into P with P surviving (the merger constituted a liquidation of Sub
1). After the merger (and before the rescission), P loaned $B to Sub 2 for use
in Sub 2’s ongoing business. Shortly
after the merger, P experienced an unexpected downturn in its business and
realized it would need to dispose of one or more business lines to raise
capital. It also realized that its decision to liquidate Sub 1 rather than
preserve its adjusted tax basis in Sub 1’s stock had not been prudent.
Accordingly, on date C, P formed new Sub 1 under the laws of the same state in
which old Sub 1 had been incorporated. P contributed all the outstanding stock
of Sub 2 to the capital of new Sub 1 in exchange for all the common stock of
new Sub 1. P
also made the following representations: (1) all the assets and liabilities of
old Sub 1 are the same as those of new Sub 1; (2) new Sub 1’s articles of
incorporation and bylaws are identical to those of old Sub 1 in effect at the
time of the merger; (3) even if old Sub 1 had not merged out of existence, P
still would have (i) retired $A of Sub 2’s debt in
exchange for a note from Sub 2 in the same amount and (ii) loaned $B to Sub 2
for use in its business; (4) other than P’s receipt of Sub 2’s note for $A and
P’s $B loan to Sub 2, there were no actual or constructive transfers of money
or property between any member of the affiliated group of which P is a member and
Sub 2 between the time of the merger and P’s incorporation of new Sub 1 and
contribution of Sub 2’s stock to the capital of new Sub 1; (5) no material
changes in the legal or financial arrangements occurred between any member of
the affiliated group of which P is a member and Sub 2 between the time of the
merger and P’s incorporation of new Sub 1 and contribution of Sub 2’s stock to
new Sub 1’s capital; (6) on the completion of P’s incorporation of new Sub 1,
the legal and financial arrangements among P, new Sub 1 and Sub 2 are identical
in all material respects to the legal and financial arrangements among P, old
Sub 1 and Sub 2 before the merger of old Sub 1 into P; and (7) the merger of
old Sub 1 into P, P’s incorporation of new Sub 1 and P’s contribution of Sub
2’s stock to the capital of new Sub 1 all occurred within the same tax year of
P, old Sub 1, new Sub 1 and Sub 2.
Holding Based
on the above facts and representations, the IRS ruled that Sub 1 will not be
treated as having merged into P and that Sub 1 and P will be treated as two
separate corporations at all times during the tax year. In addition, P will be
treated as having been the shareholder of Sub 1 at all times during the tax
year, and the merger of Sub 1 into P will not be treated as a liquidation of
Sub 1 for purposes of determining P’s or Sub 1’s taxable income. As a result of
this rescission, P was able to take advantage of the higher tax basis in Sub
1’s stock that otherwise would have disappeared in the upstream merger, thereby
reducing its gain on the disposition of Sub 1’s stock.
Conclusion To
apply the rescission doctrine successfully, taxpayers must demonstrate that the
(1) parties to the transaction were restored to the exact same position that
they would have been in had nothing occurred and (2) rescission occurred in the
same tax year as the original transaction. The rescission doctrine may be
available with respect to both tax- and nontax-motivated
transactions. In addition, the possibility of rescission need not be
contemplated in the original contract or transaction to apply its principles
subsequently. For taxpayers that encounter an unexpected turn of events, the
rescission doctrine may be available as a useful tool for unwinding a prior
transaction.
From Jennifer Ulbricht, CPA, MST, |
