Notice 2001-45 Attacks Basis-Increase Transactions as Tax Shelters

In July 26, 2001, Treasury and the IRS issued Notice 2001-45 to shut down what they perceived as a tax shelter designed to create an artificially high tax basis in stock, which is then sold at a loss or at less gain. The notice warned that the Service intends to challenge the asserted tax benefits. In addition, it informed corporate taxpayers of their obligation to disclose their participation in such transactions, and informed promoters of their obligation to register the transactions and keep a list of customers that engage in them.

Transactions Affected

Notice 2001-45 describes the following transaction: A U.S. taxpayer owns stock options to purchase 50% or more of the stock in a foreign corporation (first corporation). The U.S. taxpayer and the first corporation are considered related parties for tax purposes because of the stock attribution from the options. The U.S. taxpayer and the first corporation each own stock in a second corporation. The second corporation then redeems its stock held by the first corporation, and the first corporation treats the redemption as a dividend, because it is related to the U.S. taxpayer. The U.S. taxpayer claims that the first corporation's cost for the redeemed stock attaches to the U.S. taxpayer's stock in the second corporation, by relying on a regulation that provides for an increase in basis in a "similar" redemption. The U.S. taxpayer then sells its stock of the second corporation and claims a loss.

According to the notice, the purported basis increase relies on Example 2 of Regs. Sec. 1.302-2(c), which illustrates a proper adjustment when the entire amount received in redemption of the stock held by one spouse is treated as a dividend (because the redeemed spouse is treated as owning stock held by the other spouse). In that example, the basis of the nonredeemed-spouse's stock is properly increased by the basis of the redeemed-spouse's stock. According to Notice 2001-45, the example in the regulations is premised on the concept that an adjustment is appropriate when the redeemed spouse is required to include the full redemption proceeds as a dividend in gross income, subject to U.S. tax, and such spouse retains no stock to which the basis of the redeemed stock could attach. Therefore, the Service will disallow losses claimed (or increase gains) in the transactions described in the notice to the extent a taxpayer derives a tax benefit attributable to stock basis purportedly shifted from the redeemed shares.

The notice stated that the reasons the Service will give for the disallowance of such losses will depend on the facts of the particular case, and may include (but are not limited to):

1. The redemption does not result in a dividend (and consequently there is no basis shift) because, viewing the transaction as a whole, the redemption results in a reduction of interest in the redeeming corporation to which Sec. 302(b) applies;

2. The basis shift is not a "proper adjustment," as contemplated by Regs. Sec. 1.302-2(c); and

3. There is no attribution of stock ownership or basis shift, because the steps taken to achieve those results are transitory and serve no purpose other than tax avoidance.

Notice 2001-45 further states that variations on the transaction may include using the transaction to reduce income or gain (rather than to generate a loss) or transferring the stock with the increased basis to an entity in a carryover-basis exchange, followed by the sale of the interest in the entity or the sale of the entity's stock. An open question is whether variations on the transaction highlighted by the notice would include redemptions of stock held by domestic corporations to which the dividends-received deduction is available or intra-consolidated group redemptions.

Potential Sanctions

According to Notice 2001-45, the IRS and Treasury recognize that some taxpayers may have filed returns taking the position they were entitled to the purported tax benefits of the type of transaction described in the notice and advises them to promptly file amended returns. Transactions that are the same as (or substantially similar to) those described in the notice are considered "listed transactions" for purposes of the tax-shelter regulations under Secs. 6011, 6111 and 6112.

In addition, the Service may impose penalties on participants in these transactions, or, as applicable, on persons who participate in the promotion or reporting of these transactions, including the Sec. 6662 accuracy-related penalty, the Sec. 6694 return-preparer penalty, the Sec. 6700 promoter penalty and the Sec. 6701 aiding-and-abetting penalty.

From Jared H. Gordon, J.D., LL.M., and Bill Zimbalist, J.D., LL.M., CPA, Washington, DC