M&A tax recent guidance Other guidance p6

This Month in M&A / Issue 19 / October 2014
Did you know…? p2 / Court watch p3 / Private letter rulings p3 /
Other guidance p6
M&A tax recent guidance
This month features:

IRS to issue section 7874 regulations intended to address 'inversions' (Notice 2014-52)

Fifth Circuit affirms finding that certain partnerships were shams (Chemtech Royalty Associates)

Certain basis consequences arising from the conversion of a domestic partnership to a foreign
corporation (PLR 201437007)

No gain or loss recognized on receipt of "hook stock" (PLR 201436034)

A reverse Morris Trust transaction qualified under section 355 taking into account certain equity
compensation (PLR 201438009)

Service members of an investment management LLC held not 'limited partners' under section
1402(a)(13) (ILM 201436049)
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Did you know…?
Notice 2014-52, issued September 22, 2014, addresses certain cross-border business
combination transactions, termed ‘inversions’ in the Notice. The IRS views such
transactions as motivated in substantial part by the ability to undertake certain posttransaction steps designed to reduce US taxation that the IRS believes represent tax
avoidance transactions. The Notice announces the intention to issue regulations under
sections 304(b)(5)(B), 367, 956(e), 7701(l), and 7874. Notice 2014-52 states that the
regulations generally will apply only to business combination transaction completed on or
after September 22, 2014.
IRS approach
The Notice takes a two-pronged approach, addressing (1) aspects of the cross-border
business combination transactions themselves and (2) post-transaction steps that
taxpayers may undertake with respect to US-owned foreign subsidiaries. The section
7874 guidance involves the following:

Disregarding certain stock of a foreign acquiring corporation that holds a significant
amount of passive assets for purposes of the ownership-continuity test ratio, thereby
preventing companies from increasing the foreign side of such ratio.

Disregarding certain non-ordinary course distributions by the US company (so-called
'skinnying down' transactions), to prevent companies from decreasing the US side of
the ownership-continuity test ratio.

Changing the treatment of certain post-transaction transfers of the stock of the
foreign acquiring corporation – such as in a spin-off. The Notice addresses posttransaction steps under Sections 304(b)(5)(B), 956(e), and 7701(l).

The section 956(e) guidance would treat as 'US property' post-inversion acquisitions
by controlled foreign corporations (CFCs) of debt or equity interests in the new
foreign parent corporation or certain foreign affiliates, regardless of whether the
funds involved were made available to a US shareholder.

The section 7701(l) guidance would maintain CFC status for existing foreign
subsidiaries of the US company even when the new foreign parent or another foreign
affiliate makes an equity investment that gives it a majority interest. Specifically, the
new foreign parent or foreign affiliate would be treated as though it had made the
investment in the US parent company and not the CFC.

The section 304 guidance would limit the ability to bypass the former US parent
company by applying section 304(b)(5)(B) where the new foreign parent sells shares
of the former US parent company to a lower-tier CFC. Note: The section 304
provision is the only part of the Notice that is not limited to business combination
transactions completed on or after September 22, 2014. That provision applies to all
stock acquisitions completed on or after September 22, 2014 that meet section 304
criteria.
The Notice does not address the treatment of intercompany debt or transactions viewed
as reducing the US taxable income base. However, the Notice invites comments on those
issues and indicates that the IRS will issue additional guidance regarding cross-border
business combinations viewed as 'inversion' transactions, as well as the US federal
income tax consequences of post-transaction arrangements. The Notice states that such
further guidance 'will apply prospectively'; however, the IRS also states that it expects
that "to the extent that any tax avoidance guidance applies only to inverted groups, such
guidance will apply to groups that completed inversion transaction on or after September
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22, 2014." The Notice also signals that Treasury is reviewing its tax treaty policy
regarding 'inverted' groups.
For a more detailed discussion of Notice 2014-52, see PwC Tax Insight on Notice 2014-52
(October 1, 2014).
For additional information, please contact Mike DiFronzo, Carl Dubert, or Tim Lohnes.
Court watch
Chemtech Royalty Associates LP v. United States, Fifth Circuit No. 1330887 (September 10, 2014)
The Fifth Circuit held that, under the specific facts of the case, the district court did not
clearly err in finding that two Special Limited Investment Partnerships (SLIPs) operated
by Dow Chemical Company and foreign banks were shams due to the lack of intent to
share the profits and losses of the transactions with the foreign bank limited partners.
The Fifth Circuit vacated the district court’s holding that gross valuation misstatement
penalties did not apply and remanded the case for determination of penalties.
Observations
The Fifth Circuit’s opinion, similar to the district court's opinion, includes limited
technical analysis of the relevant provisions of the Code and regulations governing
partnerships. Rather, the Fifth Circuit appeared to follow the district court's resultsoriented approach based on what the court perceived to be tax abuse.
In reaching its conclusion, the Fifth Circuit focused on traditional partnership cases such
as Comm'r v. Tower, 327 U.S. 280 (1946), and Comm'r v. Culbertson, 337 U.S. 733
(1949), in determining whether the partners had the requisite intent to form a
partnership. Applying the factors established in Tower, the court focused heavily on
business purpose. This decision reinforces the importance of having a strong business
purpose to support entering a partnership, particularly when dealing with related parties
and certain financing transactions. For a further discussion of the district court’s
decision, see the March 2013 edition of This Month in M&A.
For additional information, please contact Susy Noles, Annie Jeong, or Vincent Cataldo.
Private letter rulings
PLR 201437007
In this PLR, the IRS addressed the conversion of a US partnership into a first-tier foreign
corporation.
Before:
After:
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Under simplified facts, a US partnership (US PRS) converted to a foreign corporation
(New Foreign Holdco) under the relevant migration statutes, and S2 contributed all the
stock of S3 to New Foreign Holdco in exchange for stock. The IRS ruled the conversion of
the partnership should be treated as a transfer of the US PRS assets to New Foreign
Holdco in exchange for common stock and voting and non-voting preferred equity
certificates (PECs), followed by the distribution of the New Foreign Holdco stock in
liquidation of US PRS, with neither US PRS nor New Foreign Holdco recognizing gain or
loss. This analysis appears generally consistent with the IRS’s position in Rev. Rul. 200459. The contribution by S2 was held to be a section 351(a) contribution.
In a key ruling, the PLR concludes that the aggregate basis of the New Foreign Holdco
stock deemed received by US PRS will be the same as the aggregate basis of the assets
deemed contributed in exchange therefor and will be allocated between the shares of New
Foreign Holdco common stock and voting and non-voting PECs received in the exchange
in proportion to the fair market values of each class, such that US PRS will have an
identical, averaged basis in each share.
Observations
The PLR expressly caveated any rulings regarding sections 367, 7874, and 732. The 'no
ruling' under sections 7874 and 367 may have been in anticipation of the release of Notice
2014-52. However, it appears likely that the conversion of US PRS would have qualified
for the statutory expanded affiliated group (EAG) rule of section 7874(c)(2)(A); because
the stock of New Foreign Holdco is held by members of the EAG, it would not be included
in the numerator or the denominator of the ownership fraction. Further, the rules
regarding subsequent transfers under sect. 2.03 of Notice 2014-52 likely would be
inapplicable under the foreign-parented group exception; i.e., since the stock of New
Foreign Holdco remains within the US parented group, it likely would still be treated as a
member of the EAG.
The PLR specifically excluded ruling on the basis consequences to the partners of US PRS
that were deemed to receive stock of New Foreign Holdco (other than as noted above)
upon liquidation of US PRS. It is unclear from the ruling whether the taxpayer sought
any specific findings on this issue. However, the potential basis consequences to the
partners might generate unexpected results. Section 732(f) and/or Treas. Reg. sec. 1.7043(a)(8) could be implicated in the transaction, causing adjustments to the inside basis of
the New Foreign Holdco assets and/or section 704(c) amounts being replicated in the
New Foreign Holdco stock received.
Note: The first ruling in this PLR applies Rev. Rul. 2004-59 and Reg. sec. 301.77013(g)(1)(i) treatment to the partnership conversion (the assets down approach). While
Rev. Rul. 2004-59 is limited under its facts to a US state law formless conversion, this
PLR appears to apply that ruling to cross-border conversions.
For additional information, please contact Karen Lohnes, Art Sewall, or Patrick
Phillips.
PLR 201436034
In what may be the last PLR to address 'hook stock,' the IRS ruled that stock of the
common parent of a consolidated group received in a reorganization was a successor
asset for purposes of the intercompany transaction regulations.
In the ruling, Parent wholly owned Subsidiary, who in turn, wholly owned Target. Both
Parent and Target were directly engaged in the same business. In order to combine
Parent and Target’s business activities, Parent formed a disregarded LLC and Target
merged with and into LLC, with LLC surviving. As part of the merger, Subsidiary received
Parent stock in exchange for its Target stock, resulting in a hook stock structure.
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The IRS ruled that the merger qualified as a reorganization under section 368(a)(1)(A).
In addition, the IRS ruled that the Parent stock received by Subsidiary (the hook stock)
was a successor asset to the stock of Target and that Parent became a successor to Target
under Reg. secs. 1.1502-13(j)(1) and (2), respectively.
Observations
The IRS previously stated in Rev. Proc. 2014-3 that it will not issue rulings addressing the
treatment or effects of hook stock. For a discussion of Rev. Proc. 2014-3 see the February
2014 edition of This Month in M&A. However, this PLR request was submitted prior to
the current 'no-rule' policy. In light of the IRS’s new policy, the PLR is instructive since it
acknowledges the issuance of hook stock and treats the hooks shares in the same manner
as non-hook stock.
One issue not addressed under the PLR facts is what the result might have been if there
had been an excess loss account (ELA) with respect to the stock of Target converted to
Parent stock in the merger. Could the ELA have been triggered, or could Subsidiary have
taken back a block of Parent hook stock with a negative tax basis? It appears this would
be a disposition of T stock within the meaning of Reg. sec. 1.1502-19(b)(1), and would
trigger recognition of any ELA. However, under Reg. sec. 1.1502-19(b)(2)(i) and the
intercompany transaction rules of Reg. sec. 1.1502-13, any gain from recognizing the ELA
likely would be deferred until the stock was sold to a nonmember.
For additional information, please contact David Friedel, Wade Sutton, or Rob
Calabrese.
PLR 201438009
In a recent PLR addressing a spin-off preceding a merger (a 'Reverse Morris Trust
transaction'), the IRS did not take into account certain equity-based compensation for
purposes of section 355(e).
Under simplified facts, all the stock of one corporation (Controlled 1) was distributed to
the parent of the consolidated group (Distributing 4) in a series of distributions that
qualified under section 355. Distributing 4 then contributed the stock of Controlled 1
along with other business assets to a newly formed corporation (Controlled 2), and
distributed all the stock of Controlled 2 to its shareholders (the External Spin-off
Transaction).
Subsequently, an unrelated corporation (Merger Partner) merged with and into
Controlled 2, with the shareholders of Merger Partner receiving Controlled 2 stock.
Although not expressly stated in the ruling, the shareholders of Merger Partner
presumably received less than 50% of the issued and outstanding stock of Controlled 2 in
order to prevent the transaction from violating the restriction under section 355(e), which
applies upon certain acquisitions of a 50%-or-greater interest in either a distributing or
controlled corporation.
The PLR states that if certain items are taken into account for purposes of section 355(e),
the spin-off may be taxable at the corporate level. Specifically, the ruling focuses on (1)
certain cash payments tied to the value of the Controlled 2 stock (received by Controlled
2's board of directors); (2) the receipt of stock-based compensation by employees; and (3)
Controlled 2 stock distributed to a section 401(k) plan, containing Distributing 4 stock,
but subsequently sold by the trustee because the Controlled 2 stock is not a permitted
item under the plan.
Observations
Although the PLR does not directly address whether section 355(e) applies, the IRS
appears to have concluded that the subsequent merger and equity compensation items
identified in the ruling did not result in a violation of section 355(e), in as much as it
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ruled that the External Spin-off Transaction was tax-free. Had the transaction violated
section 355(e), Distributing 4 would have recognized gain with respect to its distribution
of the stock of Controlled 2.
Reg. sec. 1.355-7(d)(8) provides a safe harbor under which stock-based compensation is
not treated as the acquisition of stock pursuant to a plan for purposes of section 355(e);
however, the safe harbor does not apply to a coordinating group (coordinating group
exception). Similarly, Reg. sec. 1.355-7(d)(9) provides a safe harbor for section 401(k)
plans; however, the safe harbor does not apply if the recipient, in the aggregate,
represents greater than 10 percent of the corporation's voting power (the aggregation
exception). The IRS concluded, in ruling the External Spin-off Transaction was tax-free,
that the equity transactions undertaken as part of the equity compensation plans and
Distributing's 401(k) plan were not acquisitions for purposes of section 355(e).
The regulations do not directly address whether board of directors compensation–
specifically if the compensation is tied to the value of the corporation's stock–may be
treated as an acquisition of stock for purposes of section 355(e). In the PLR, the IRS
concluded, by ruling that the External Spin-off Transaction was tax-free, that the
compensation was not an acquisition for purposes of section 355(e).
While the IRS has a general no-rule policy for section 355(e), this PLR illustrates that the
Service will issue rulings that address the mechanical application to a transaction and will
consider the potential application of section 355(e) when issuing a ruling.
For additional information, please contact Derek Cain, Art Sewall, or Viraj Patel.
Other guidance
ILM 201436049
In this ILM, the IRS concludes that active members of an investment management
limited liability company (LLC) are subject to self-employment taxes on their distributive
shares of the LLC’s income.
Management Company, an LLC treated as a partnership for US federal income tax
purposes, is the general partner of various investment partnerships (the Funds).
Management Company has full authority and responsibility to manage and control the
affairs of the Funds by providing all necessary investment management services; it
receives a quarterly management fee for its services. The members of Management
Company perform extensive services for the Funds in their capacity as partners. The
members are compensated for their services by Management Company via Form W-2
wages and health care and parking benefits paid on their behalf by the partnership as
guaranteed payments, all of which were subjected to self-employment taxes.
In the year under examination, Management Company’s distributable income was almost
entirely comprised of management fee income from the Funds for the management
services provided by the members. The Management Company represented that the
'wages' paid to the members represented reasonable compensation for each member and
that the members were 'limited partners' under section 1402(a)(13). That section
provides an exception to self-employment tax for limited partners, but does not define
that term, leaving open the question of whether a LLC member is a limited partner.
Applying section 1402(a)(13), the members excluded their distributive shares of this
management fee income from self-employment tax.
The IRS concluded that the members were not employees of the partnership, relying on
Rev. Rul. 69-184, and that the members do not meet the limited partner exception under
section 1402(a)(13). The IRS cited legislative history under section 1402(a)(13) for its
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position that Congress did not intend to allow service partners in a service partnership
acting in a partner capacity to avoid self-employment tax.
The IRS ruling is consistent with Renkemeyer, Campbell & Weaver, LLP v. Comm’r, 136
T.C. 137 (2011), where the Tax Court examined whether partners of a Kansas law firm
organized as a limited liability partnership were limited partners within the meaning of
section 1402(a)(3). In Renkemeyer, the partners made nominal capital contributions to
the partnership and all of the law firm’s revenue was derived from services provided by
the law firm partners. The Tax Court concluded that the partner’s distributive share did
not represent a return on the partner’s investment but rather arose from the services
provided; therefore, the partner’s distributive share was subject to self-employment taxes.
Observations
The law with respect to application of section 1402(a)(13) to LLC members remains
unclear. Proposed regulations (REG-209824-96) issued on January 13, 1997 under
section 1402 and case law analyzing the section 1402(a)(13) limited partner exception to
service partnerships provide some limited guidance. The IRS' position, consistent with
Renkemeyer, is that service-performing members of a LLC are not exempted from selfemployment tax under section 1402(a)(13) and, therefore, must include their distributive
share of service fee income in self-employment taxes.
Self-employment tax guidance for LLC members is on the IRS/Treasury’s 2014-15
Priority Guidance Plan.
For additional information, please contact Susy Noles, Annie Jeong, or Vincent Cataldo.
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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]
Mike DiFronzo, Washington, DC
Carl Dubert, Washington, DC
+1 (202) 312-7613
+1 (202) 414-1873
[email protected]
[email protected]
David Friedel, Washington, DC
Derek Cain, Washington, DC
+1 (202) 414-1606
+1 (202) 414-1016
[email protected]
[email protected]
Susy Noles, San Francisco, CA
Art Sewall, Washington, DC
+1 (415) 498-6185
+1 (202) 414-1366
[email protected]
[email protected]
Wade Sutton, Washington, DC
Dianna Miosi, Washington, DC
+1 (202) 346-5188
+1 (202) 414-4316
[email protected]
[email protected]
Annie Jeong, Phoenix, AZ
Vincent Cataldo, Washington, DC
+1 (415) 498-7866
+1 (202) 346-5185
[email protected]
[email protected]
Patrick Phillips, Washington, DC
Viraj Patel, Washington, DC
+1 (202) 346-5079
+1 (202) 312-7971
[email protected]
[email protected]
Andrew Gottlieb, Washington, DC
Robert Calabrese, Washington, DC
+1 (202) 414-1358
+1 (202) 346-5205
[email protected]
[email protected]
© 2014 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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