M&A tax recent guidance Publications p6

This Month in M&A / Issue 1 / January 2016
Did you know…? p2 / Other Guidance p4 / Legislative update p5 / PwC M&A
Publications p6
M&A tax recent guidance
This month features:

Recent PLRs (201551005, 201551009) apply favorable provisions in proposed active trade or
business regulations to acquisitions during five year pre-distribution period

Ordinary loss deduction disallowed to S corporation for worthlessness of recently incorporated
insolvent subsidiary (CCA 201552026)

REIT spins and subsequent REIT elections limited by year-end ‘extenders’ legislation
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Did You Know…?
In two recent Private Letter Rulings (201551005, 201551009), the IRS ruled favorably on
the impact of certain acquisitions on the qualification of the active trade or business
requirement (ATOB) applicable to tax-free spin-off transactions. Each acquisition occurred
within the five year period preceding the spin-off (the “pre-distribution period”). In
general, acquisitions of entities or businesses within the pre-distribution period can result
in a violation of the ATOB rules if such acquisition is not wholly tax-free.
Both recent rulings are consistent with the approach of proposed ATOB regulations issued
in June 2007. These rulings demonstrate the IRS’ willingness to rule favorably on issues in
the proposed ATOB regulations in advance of the regulations being finalized, and also
indicate the type of issues the IRS may be willing to consider under its significant issue
ruling practice. (See the June 2007 edition of This Month in M&A for a detailed discussion
of proposed regulations relating to the ATOB requirements and see the July 2013 edition
of This Month in M&A on the revised ruling procedures set forth in Rev. Proc. 2013-32.)
PLR 201551005
In PLR 20151005, the IRS ruled favorably on the distribution by a distributing corporation
that was acquired upon the acquisition of its corporate owner in a tax-free reorganization
with boot. Since the acquisition of the corporate owner was partially for boot, the
acquisition of the distributing corporation was in a transaction that was not entirely taxfree.
More specifically, a domestic target corporation (Target) merged with and into a
disregarded entity (DRE1) of an unrelated publicly traded consolidated parent (Parent),
with DRE1 surviving, in a transaction that qualified as a reorganization under Section
368(a)(1)(A) (the Acquisition). Target’s assets included all the stock of Distributing. In the
Acquisition, Target shareholders received a mix of Parent stock and cash and recognized
gain to the extent of the cash received under Section 356. Within five years of the
Acquisition, Distributing sought to distribute controlled corporations to Parent in
transactions intended to qualify under section 355 (the Distributions). The taxpayer
represented that the Distributee’s basis in the stock of Distributing was equal to Target’s
basis in such assets immediately before the Acquisition pursuant to Section 362(b).
The IRS ruled that Parent’s use of cash in the acquisition will not prevent Parent from
satisfying the requirement that control of a corporation conducting an active trade or
business was not acquired during the five-year period preceding the Distributions in a
transaction in which gain or loss was recognized.
Observations
In the case of spin-offs, Section 355 requires that both the distributing and controlled
corporations engage in an ATOB immediately after distribution. Generally, a corporation
cannot satisfy the ATOB requirement if (1) the trade or business sought to be relied upon
was acquired in the five-year pre-distribution period in a transaction in which gain or loss
is recognized in whole or in part (ATOB Violation 1), or (2) control of the corporation
conducting such trade or business was acquired directly or indirectly by either the
distributee or distributing corporation within such period by reason of transactions in
which gain or loss was recognized in whole or in part (ATOB Violation 2).
Based solely on the statutory language of Section 355, the recognition of boot gain by Target
shareholders in the Acquisition could be viewed as triggering ATOB Violation 2 with
respect to the business conducted by Distributing at the time of the Acquisition. Under such
a view, the Distributions could not occur within five years of the Acquisition (as proposed
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in the PLR) notwithstanding the taxpayer’s representations that Target recognized no gain
or loss in the Acquisition and that Parent took carryover basis in the Distributing stock
received as a Target asset under Section 362(b).
In the PLR, however, the IRS took a taxpayer-favorable approach in ruling that the
presence of boot in the Acquisition would not by itself give rise to ATOB Violation 2. The
most direct support for this approach appears to be located in the proposed ATOB
regulations that would apply to disregard the recognition of gain or loss in transactions of
the type described in the Acquisition for purposes of evaluating ATOB Violation 2. (See
Prop. Reg. secs. 1.355-3(b)(4)(iii)(C), -3(d)(2), Ex. 40.)
The taxpayer’s representation that Parent had no plan or intention to further distribute the
stock of Distributing or the controlled corporations reflects the limited applicability of the
proposed ATOB regulations to a distribution by the acquired distributing corporation (i.e.,
Distributing) and not to any subsequent distribution by the Distributee (i.e., Parent). Thus,
the PLR illustrates that the IRS may allow a favorable result in the context of a taxpayer
seeking to undertake a post-acquisition internal restructuring notwithstanding the general
treatment of a taxable stock acquisition as a taxable asset acquisition under the Section
355(b)(3) separate affiliated group (SAG) rule. However, the PLR also reflects that Section
355(b)(2)(D) limitations continue to apply to the extent the acquired businesses are sought
to be relied on in subsequent Section 355 transactions.
PLR 201551009
In another application of the ATOB rules, in PLR 201551009, the IRS ruled favorably that
gain recognized under section 751 upon the distribution of Controlled stock to Distributing
would not prevent Controlled from satisfying the ATOB requirement.
In the ruling, Distributing and a subsidiary owned LP, an entity treated as a partnership,
which operated multiple businesses including Business A, which the taxpayers represented
to meet the ATOB requirement for the five-year period before the below transactions. In a
series of transactions, LP formed Controlled and contributed the Business A assets and
liabilities (among other assets) to Controlled in exchange for all the stock of Controlled,
which the taxpayer represented may result in an income inclusion due to a change in
accounting method. Then, LP distributed the stock of Controlled to Distributing in partial
redemption of Distributing’s LP interest, which the taxpayer represented may result in gain
recognition under Section 751. Distributing then distributed all the stock of Controlled pro
rata to its shareholders.
The IRS ruled that gain or loss recognized under Section 751 and any inclusion due to the
accounting method change would not prevent Controlled from satisfying the ATOB
requirement.
Observation
The income inclusion on LP’s contribution of Business A to Controlled and the potential
Section 751 gain recognized on LP’s distribution of Controlled to Distributing could be read
as resulting in both ATOB Violation 1 and ATOB Violation 2, since the change in accounting
method gain could be treated as gain recognized in the acquisition of assets and the Section
751 gain could be treated as gain recognized in Distributing’s acquisition of Controlled
stock. However, as in PLR 201551005, the IRS issued a taxpayer-favorable ruling.
As a general matter, a corporate partner may be treated as directly engaging in the
partnership’s business depending on the size of the partner’s interest and the activities
conducted by the partner and the partnership (see Rev. Rul. 2007-42 and Prop. Reg. sec.
1.355-3(b)(2)(v)). If a corporate partner’s interest in a partnership fails to meet the
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requirements to attribute the partnership’s business to the corporation, the proposed
ATOB regulations indicate that a non-pro rata distribution of a trade or business to that
corporate partner will be treated as a taxable acquisition of the trade or business.
However, in the instant case, the ruling is consistent with an example in the proposed
ATOB regulations that illustrates that a non-pro rata redemption of a corporate partner
should not ‘taint’ the distributed business when the redeemed partner previously was
attributed the partnership’s ATOB. (See Prop. Reg. secs. 1.355-3(b)(4)(ii)(B), (b)(3)(iii),
-3(d)(2), Ex. 35). The PLR goes beyond the example in the proposed regulations as the
example contemplates a non-pro rata distribution where no gain or loss is recognized,
while the ruling addresses a transaction with the potential for gain on the asset acquisition
and the distribution of shares of the controlled corporation.
The new PLRs indicate the types of items that the IRS views as significant for purposes of
applying the revised ruling procedures set forth in Rev. Proc. 2013-32. Generally, proposed
regulations have no reliance value for taxpayers, and a PLR has no reliance value other than
for the particular taxpayer receiving the ruling. At the same time, these rulings may suggest
receptiveness on the part of the IRS to consider issues covered under proposed regulations
(to the extent not otherwise contradicted by statute, final or temporary regulations, and
binding guidance) on a taxpayer-by-taxpayer basis.
For additional information, please contact, please contact Rich McManus, Bruce Decker,
Jon Lewbel, or Andrew Gottlieb.
Other Guidance
CCA 201552026
In this CCA, the IRS disallowed an ordinary loss deduction to an S corporation for
worthlessness of its subsidiary, where the subsidiary had been deemed incorporated as an
insolvent entity.
S corporation owned a qualified Subchapter S subsidiary (QSub), which was treated as a
disregarded entity (DE) for US federal tax purposes. QSub was insolvent and about to be
placed in receivership, which would have effectively resulted in S corporation losing the
ability to recognize losses realized by QSub (and thus pass them through to S Corporation
shareholders). Seeking to generate an ordinary loss deduction, the S Corporation
terminated its S status, which also terminated the qualified subsidiary status of QSub.
Under Reg. sec. 1.1361-5(b)(1)(j), a terminated QSub is treated as a newly formed
corporation acquiring all the assets and liabilities of the QSub from the S Corporation
immediately before termination in exchange for its stock. The IRS rejected the taxpayer’s
position that S corporation was entitled to an ordinary deduction under Section 165(g)(3)
with respect to the stock of the newly formed corporation on the grounds that (1) the
incorporation transaction was a taxable exchange rather than a Section 351 transfer, (2)
the Section 165 regulations prohibit a stock acquisition solely for purposes of converting a
loss from capital to ordinary, and (3) an S corporation may not claim an ordinary worthless
stock loss.
Observation
An ordinary loss deduction cannot be achieved if the incorporation of an insolvent DE is
treated as a Section 1001 exchange because the basis of the stock of the newly formed
corporation received would be equal to its cost (i.e., $0), rather than equal to the historical
basis in the transferred assets under Section 358 (as is generally the case under Section
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351). Moreover, in a taxable incorporation, gains generally are recognized immediately,
while losses may be subject to disallowance or deferral under Sections 267(a)(1) and 267(f).
For additional information, please contact Horacio Sobol, Jon Lewbel, or Lilia Doibani.
Legislative update
On December 18, 2015, President Barack Obama signed into law the Protecting Americans
from Tax Hikes Act of 2015 (PATH Act). The $680 billion law includes numerous
taxpayer-favorable provisions, such as permanency or multi-year extensions of many
traditional ‘extenders’ tax provisions that had expired at the end of 2014.
The final legislation also includes provisions generally disallowing tax-free distributions
under Section 355 in situations where the distributing corporation or controlled
corporation is a real estate investment trust (REIT) immediately after the distribution.
Exceptions apply for spinoffs of a REIT by another REIT as well as spinoffs of certain
taxable REIT subsidiaries. Although an earlier version of the REIT provisions introduced
on December 7 provided an immediate effective date, the enacted legislation provides a
transition rule for any taxpayer that submitted a ruling request with regard to a covered
transaction on or before December 7. Additionally, the legislation prevents a distributing
corporation or a controlled corporation from making a REIT election for 10-years following
the completion a tax-free spinoff.
The REIT-related provisions in the PATH Act are expected to raise $4.3 billion in revenue
over a 10-year window. A number of taxpayer-favorable ancillary provisions related to
REITS also are included in the legislation.
The business tax provisions renewed in the PATH Act include the following:

Research tax credit: The Act provides a permanent extension of the research credit
and includes changes to allow certain small businesses to use the credits against
AMT and payroll tax liabilities.

CFC look-through treatment: The Act provides a five-year extension through 2019,
generally allowing deferral for certain payments between CFCs.

Exceptions under Subpart F for active financing income: The Act provides a
permanent extension of deferral of tax on the US parent of a foreign subsidiary
engaged in a banking, financing, or similar business if the subsidiary is
predominantly engaged in such business and conducts substantial activity with
respect to such business.

Reduction in S corporation recognition period for built-in-gains tax: The Act
provides a permanent extension allowing a reduced period, from ten years to five
years, during which the built-in-gains of S corporations are subject to tax.
Observations
Although inclusion of the REIT revenue-raising provisions in the legislation shortly before
its enactment may not have been expected, provisions limiting a REIT’s ability to undertake
tax-free distributions under Section 355 were included in the Tax Reform Act of 2014 (H.R.
1), introduced February 26, 2014 by then House Ways and Means Committee Chairman
Dave Camp (R-MI). Utilizing select provisions of the 2014 reform draft as “pay fors” for
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other tax legislation could continue if Congress acts on other tax legislation prior to the
enactment of more comprehensive tax reform.
For additional information, please contact, please contact Bruce Decker, Jon Lewbel, or
Lindsay Freeman.
PwC M&A publications
PwC recently filed a comment letter with the Department of Treasury and the IRS in
response to proposed Section 367 regulations published on September 16, 2015. (The letter
was published in Tax Notes on December 15, 2015.) PwC recommends that Treasury and
the IRS address outlined concerns by (1) harmonizing the regulations with Congressional
intent, (2) tailoring the regulations to Treasury’s stated concerns, and (3) providing a
prospective effective date. Please refer to the October 2015 edition of This Month in M&A
for a detailed discussion of this subject.
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Let’s talk
For a deeper discussion of how this issue might affect your business, please contact:
Tim Lohnes, Washington, DC
Karen Lohnes, Washington, DC
+1 (202) 414-1686
+1 (202) 414-1759
[email protected]
[email protected]
Horacio Sobol, Washington, DC
Elizabeth Amoni, Washington, DC
+1 (202) 312-7656
+1 (202) 346-5296
[email protected]
[email protected]
Derek Cain, Washington, DC
David Friedel, Washington, DC
+1 (202) 414-1016
+1 (202) 414-1606
[email protected]
[email protected]
Wade Sutton, Washington, DC
Carl Dubert, Washington, DC
+1 (202) 346-5188
+1 (202) 414-1873
[email protected]
[email protected]
Rich McManus, Washington, DC
Jeff Rosenberg, Washington, DC
+1 (202) 414-1447
+1 (202) 414-1765
[email protected]
[email protected]
John Schmalz, Washington, DC
Bruce Decker, Washington, DC
+1 (202) 414-1465
+1 (202) 414-1306
[email protected]
[email protected]
Art Sewall, Washington, DC
Jonathan Lewbel, Washington, DC
+1 (202) 414-1366
+1 (202) 312-7980
[email protected]
[email protected]
Andrew Gottlieb, Washington, DC
Lilia Doibani, Washington, DC
+1 (202) 346-5079
+1 (202) 312-7546
[email protected]
[email protected]
Lindsay Freeman, Washington, DC
+1 (202) 312-7925
[email protected]
This document is for general information purposes only, and should not be used as a
substitute for consultation with professional advisors.
SOLICITATION
© 2016 PricewaterhouseCoopers LLP. All rights reserved. In this document, 'PwC' refers
to PricewaterhouseCoopers (a Delaware limited liability partnership), which is a member
firm of PricewaterhouseCoopers International Limited, each member firm of which is a
separate legal entity.
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