M&A tax recent guidance

This Month in M&A / Issue 18 / September 2014
Did you know…? p2 / Private letter rulings p5 / PwC’s M&A publications p10
M&A tax recent guidance
This month features:

IRS Business Plan lists forthcoming guidance that will affect corporate and partnership
transactions.

Section 7874 applied to foreign-to-foreign ‘F’ reorganization. (PLR 201432002)

Contingent payment debt obligations tested for significance under Reg. sec. 1.1001-3(e)(1). (PLR
201431003)

Section 382(l)(5) applied to consolidated groups. (PLR 201435003)
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Did You Know…?
The IRS recently released its 2014-2015 Priority Guidance Plan (the Plan), listing 317
guidance projects anticipated for the year ending June 2015. Businesses may want to
consider accelerating or deferring planned transactions that would be affected by items
on the Plan, depending on the potential impact of the anticipated guidance and its
expected effective date.
The Plan includes 25 projects related to consolidated returns, corporations and
shareholders, and S corporations, plus 18 projects related to partnerships. The following
summarizes certain of the new items in the corporate and partnership sections of the Plan
as well as selected items carried over from the 2013-2014 Priority Guidance Plan. The
Plan is not an exclusive list of guidance that may be published before next June, and
guidance is not expected on every listed project.
Consolidated returns
New items
Circular stock basis adjustments. Reg. sec. 1.1502-11(b) sets forth some of the most
complicated rules in the tax arena. In general, the current rules provide for computing
taxable income and reducing attributes to avoid circular basis adjustments to the stock of
a subsidiary where there is excluded cancellation of indebtedness income. New
regulations, which are expected to be issued soon, should provide some clarity in this
complex area. For an analysis of some of the uncertainty in this area, see "The Race for
Last: Interaction between consolidated COD, loss disallowance, and circular adjustment
rules," published in the Journal of Corporate Taxation, November/December 2013 issue,
by PwC author Rob Melnick.
Rules when a member joins or leaves a consolidated group. When a consolidated group
acquires or disposes of a member, the member's items for the year may have to be
allocated between the pre- and post-acquisition periods. Relatively little guidance exists
for determining how to apply the so-called ‘end-of-day’ and ‘next-day’ rules, contained in
Reg. secs. 1.1502-76(b)(1)(ii)(A) and (B), respectively, with respect to items of the
member. See the February 2013 edition of This Month in M&A for a detailed discussion
of Reg. sec. 1.1502-76 as it was applied in a generic legal advice memorandum released by
the IRS (AM 2012-010). New regulations are expected to be released relatively soon.
Retained items
Application of section 172(h) (corporate equity reduction transaction (CERT)) to a
consolidated group. See the "Did You Know…?" section in the October 2012 edition of
This Month in M&A for a detailed discussion of the proposed CERT regulations published
September 17, 2012. In general, the CERT rules limit a corporation's ability to carry back
a net operating loss (NOL) to the extent the NOL is attributable to interest deductions
allocable to certain leveraged buyout transactions. The CERT rules are intended to
prevent taxpayers from obtaining income tax refunds from NOL carrybacks created by
interest deductions from leveraged financing. Final CERT regulations, which are
expected to be released soon, should provide welcome guidance on the CERT rules.
Status as agent of a consolidated group. See the June 2012 edition of This Month in
M&A for a detailed discussion of proposed regulations published on May 30, 2012.
Generally, the consolidated return regulations require an agent to act on behalf of a
consolidated group. Under the current regulations, Reg. sec. 1.1502-77, a common parent
that is the agent for the group and that goes out of existence may designate its successor,
another member of the group, or a group member's successor entity as the substitute
agent for the group. The proposed regulations would limit the common parent's ability to
designate a substitute agent to circumstances where the terminating common parent does
not have a successor. By designating a default successor, the proposed regulations, if
issued as final regulations, will provide greater certainty as to which entity will be the
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substitute agent for the group when the common parent of the group goes out of
existence.
Determination of consolidated net unrealized built-in gain and loss (NUBIG/NUBIL).
See the November 2011 edition of This Month in M&A for a detailed discussion of the
proposed regulations that were published on October 24, 2011. Reg. sec. 1.1502-91(g)
provides rules for determining whether a loss group has a consolidated NUBIG, a
consolidated NUBIL, or both at the time of a section 382 ownership change. The
proposed regulations address certain situations where the current regulations result in an
understatement of the amount of gain or loss that the group may take into account
following an ownership change.
Corporations and shareholders
New items
Treatment of certain stock dispositions as asset sales. See the "Did You Know…?" section
in the June 2013 edition of This Month in M&A for a detailed discussion of the final
section 336(e) regulations issued on May 10, 2013. Presumably, the IRS intends to clarify
certain issues that have been raised with respect to the final regulations.
Investment company issues. Section 351(e) provides an exception to the general
nonrecognition rule of section 351 where property is transferred to an ‘investment
company.’ Similarly, section 368(a)(2)(F) disallows tax-free reorganization treatment in
certain situations where ‘investment companies’ are involved. Forthcoming regulations
should provide further guidance as to the definition of investment company as well as the
application of sections 351(e) and 368(a)(2)(F).
Definition of acquiring corporation under section 381. Proposed regulations published
May 7, 2014, would modify the definition of an ‘acquiring corporation’ for purposes of
section 381. This change, if finalized, would limit the ability of taxpayers to choose the
location of tax attributes inherited from a target corporation in an asset reorganization.
See the June 2014 edition of This Month in M&A for a detailed discussion of the proposed
regulations.
Retained items
Recovery and allocation of basis in redemptions, organizations, and reorganizations.
Given conflicting authorities, taxpayers face difficulties in determining the proper
approach to recovering basis in the stock of the distributing corporation as a result of a
section 301 distribution, or when recovering basis in constructive section 301
distributions under sections 302, 304, and 356. Proposed regulations adopting the
approach taken in Johnson v. United States, 435 F.2d 1257 (4th Cir. 1971), were
published on January 21, 2009. See "This Month in M&A," February 2009, for a detailed
discussion of the proposed regulations in the "Did You Know…?" section. The proposed
regulations also address the allocation of basis under section 358.
Allocation of earnings and profits (E&P) in connection with a reorganization. Proposed
section 312 regulations were published on April 16, 2012. See the May 2012 edition of
This Month in M&A for a detailed discussion of these proposed regulations in the "Did
You Know…?" section. The proposed regulations would modify Reg. sec. 1.312-11(a) and
clarify that in a transfer described in section 381(a), the acquiring corporation, as defined
in Reg. sec. 1.381(a)-1(b)(2), and only that corporation, succeeds to the E&P of the target
corporation. Thus, the E&P account would not be divided if the acquiring corporation
subsequently transfers the target's assets to one or more controlled subsidiaries in a taxfree transfer.
North-south transactions. The IRS continues to work on guidance regarding when a
transfer by a person to a corporation and a transfer by that corporation to that person,
ostensibly in two separate transactions, should be respected as two separate transactions
for Federal income tax purposes. In Rev. Proc. 2013-3, the IRS announced that rulings
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no longer would be issued in this area until the issue is resolved through publication of
additional guidance.
Recapitalizations into control in anticipation of section 355 distributions. This area also
was added to the no-rule list by Rev. Proc. 2013-3.
The IRS has respected
recapitalizations into control prior to a section 355 distribution in published guidance on
numerous occasions, including Rev. Rul. 69-407. The scope of Rev. Rul. 69-407 has
continued to expand in private letter rulings issued by the IRS. However, in light of the
no-rule position currently taken by the IRS on this issue, taxpayers no longer can achieve
the same level of comfort with transactions that are not exactly in line with the facts of
Rev. Rul. 69-407.
Leveraged spin-off transactions. The IRS continues to work on guidance regarding the
application of sections 355 and 361 to a distributing corporation's use of its controlled
corporation's stock or debt to retire debt issued in anticipation of the distribution. These
leveraged spin-off transactions also were added to the no-rule list by Rev. Proc. 2013-3,
making the need for guidance in this area even more pressing.
Active trade or business (ATOB) requirements. Proposed regulations under section
355(b) were published on May 7, 2007. See the June 2007 edition of This Month in M&A
for a discussion of the proposed regulations. The highly anticipated ATOB regulations
are expected to be issued shortly and should provide significant guidance regarding the
separate affiliated group rules.
S corporations
New items
Worthless stock deductions under section 165(g) for S corporations. Section 165(g)(3)
provides that a security in a corporation affiliated with a taxpayer is not treated as a
capital asset. As a result, a parent corporation's loss on the stock of a wholly owned
subsidiary is treated as an ordinary loss. There is no guidance as to whether an S
corporation disposing of subsidiary stock also should treat such a loss as ordinary.
Future guidance is expected to provide taxpayers with some clarity on this issue.
Basis ordering rules of certain suspended losses. Section 1367 contains rules for
adjusting the basis of S corporation stock. Forthcoming guidance is expected to provide
taxpayers with rules regarding whether distributions should be taken into account before
suspended losses when calculating a shareholder's basis in stock of an S corporation
under section 1367.
Partnerships
New items
‘Qualified income’ of PTPs. Publicly traded partnerships (PTPs) generally are taxed as
corporations unless 90% or more of their gross income is ‘qualifying income,’ including
certain income derived in the oil and gas and other natural resource industries. Earlier
this year, the IRS temporarily stopped issuing qualifying income rulings as it evaluated its
position in light of industry developments. Guidance under section 7704(d)(1)(E) is
listed on the Plan.
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Self-employment earnings of LLC members. Under section 1402, net earnings from selfemployment generally are subject to self-employment taxes. ‘Limited partners,’ however,
are not subject to self-employment tax except to the extent of guaranteed payments
received from the partnership for services (section 1402(a)(13)). On two occasions, the
IRS proposed regulations with respect to application of self-employment tax to LLCs.
The most recent regulations, proposed in 1997, were subject to a Congressional
moratorium and never finalized. In Renkemeyer v. Comm’r, 136 T.C. 137 (2011), the Tax
Court examined whether the partners of a Kansas law firm organized as a LLP could
exclude income allocated to them by the partnership from self-employment tax pursuant
to the section 1402(a)(13) exception for limited partners. The LLP at issue was
predominantly a service provider, with the result that the exception did not apply. The
law is this area remains unclear. It is uncertain whether any self-employment tax
guidance will be welcome relief or cause for further controversy.
For additional information, please contact Tim Lohnes, Todd McArthur, or Bruce
Decker
Private letter rulings
PLR 201432002
In this ruling, the IRS concluded that a foreign corporation (FA) was not a surrogate
foreign corporation ―i.e., there was no inversion― when it acquired a US corporation
(USCo) from another foreign corporation (FS 1) in an ‘F’ reorganization followed by an
IPO and private placement of FA stock. This is the first ruling of its kind since temporary
regulations under section 7874 were released earlier this year. See the February 2014
edition of This Month in M&A for a discussion of the temporary regulations.
Transactions
FS 1, a foreign corporation organized in Country D and owned by a foreign parent, owned
FS 2, a Country C corporation, and FDE 3, a Country E corporation which was a
disregarded entity for US tax purposes. FS 2 wholly owned USCo, which needed
additional cash to fund the expansion of its business. To raise the funds, FS 1 intended to
conduct stock offerings of USCo stock, but was advised and concluded that the stock
offerings would be more beneficial if they were to occur in Country G.
FS 1 contributed the stock of FS 2 to FDE 3, which contributed the FS 2 stock to FA, a
newly formed Country G corporation. As part of the same transaction, FS 2 filed a checkthe-box election to be treated as a disregarded entity for US tax purposes (the
Reorganization, collectively). The taxpayer represented that the Reorganization qualified
under Section 368(a)(1)(F).
Following the Reorganization, FA initiated stock offerings through (i) a private placement
of no more than 20% of its stock to private investors (the FA Private Placement) and (ii)
an IPO of its sole outstanding class of stock on a Country G stock exchange (the FA IPO).
Following the FA IPO, the private investors and the public, combined, held no more than
49% of the outstanding stock of FA.
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In the Reorganization, under the rules of section 368(a)(1)(F) and Reg. sec. 1.367(b)-2(f),
there was deemed to exist:

a transfer by FS 2 of the USCo shares to FA in exchange for FA stock,

a distribution by FS 2 to FS 1 of the FA stock; and

an exchange by FS 1 of its FS2 stock for new FA stock.
Background
The rules for determining whether an entity has inverted are set forth in section 7874.
Specifically, section 7874(a)(2)(B)(ii) outlines the components of the ownership fraction
used to determine the ownership percentage of the former shareholders of the acquired
corporation in the foreign acquiror for purposes of determining if the acquiring
corporation is a surrogate foreign corporation.
Under these rules, where former shareholders of an acquired domestic corporation hold
at least 80% of the stock of the foreign acquiror, the foreign acquiror is considered a US
corporation for US tax purposes. If the former shareholders hold at least 60% but less
than 80% of the stock of the foreign acquiror, the foreign acquiror is considered a
surrogate foreign corporation, subject to certain other requirements. If the former
shareholders hold less than 60% of the foreign acquiror, it is not considered a surrogate
foreign corporation.
In determining the ownership fraction, stock of the acquiring corporation that is
transferred in exchange for nonqualified property (e.g., cash) in a transaction related to
the acquisition is generally excluded from the denominator under Reg. sec. 1.7874-4T.
Stock received by the former shareholders of the acquired domestic corporation that
subsequently is transferred continues to be described in section 7874(a)(2)(B)(ii), even if
the subsequent transfer was related to the acquisition described in section
7874(a)(2)(B)(i), under Reg. sec. 1.7874-5T. In addition, section 7874(c)(2)(A) provides
that stock held by members of the expanded affiliated group that includes the foreign
corporation is not taken into account in determining ownership under section
7874(a)(2)(B)(ii).
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IRS conclusion
On these facts, the IRS concluded that:

FA shares treated as received by FS 2 in the Reorganization were described in
section 7874(a)(2)(B)(ii) and did not cease to be described as a result of FS 2’s
distribution of the FA shares.

Shares issued in the FA Private Placement and the FA IPO were not includible in
the denominator of the ownership fraction.

FA shares treated as issued in exchange for the USCo shares in the
Reorganization were excluded from both the numerator and the denominator in
the ownership fraction.

As a result, the ownership fraction was zero over zero, and therefore FA was not a
surrogate foreign corporation.
Observations
The IRS’ conclusion in the PLR that the ownership fraction should be zero over zero
confirms the interpretation of the temporary regulations released earlier this year, despite
the mathematically strange result. Notably, in reaching this conclusion, the IRS appears
to apply a logical extension of Rev. Rul. 96-29 in the context of section 7874 by respecting
the F reorganization prior to the IPO and private placement of stock for purposes of
calculating the ownership fraction.
For additional information, please contact Bart Stratton or Nils Cousin.
PLR 201431003
The IRS held that a one-time consent payment to certain holders of contingent payment
debt obligations should be tested for significance under Reg. sec. 1.1001-3(e)(1) using a
change of yield method similar to that used for debt instruments providing for fixed
payments.
Transactions
Taxpayer planned to contribute certain assets of its wholly owned, disregarded subsidiary
(Subsidiary) to a new corporation (SpinCo), then distribute the SpinCo stock in a
transaction intended to qualify as tax-free under sections 355 and 368(a)(1)(D) (the
Proposed Transaction).
Subsidiary, however, had publicly traded exchangeable debentures outstanding (the
Notes) which contained a so-called ‘Successor Provision’ prohibiting Taxpayer from
transferring substantially all of Subsidiary’s assets, subject to certain conditions.
Taxpayer anticipated that the holders of the Notes (Noteholders) would claim that the
Proposed Transaction was a violation of the Successor Provision and sought to modify it
to permit the Proposed Transaction to proceed without the threat of litigation. As part of
the modification, Taxpayer also would provide a one-time cash payment to consenting
Noteholders (the Consent Payment). The issue in the PLR was how the modification and
consent payment should be tested for significance for purposes of section 1001.
Background
Section 1001 and the regulations thereunder provide the rules for calculating gain or loss
from a sale or disposition of property. Reg. sec. 1.1001-1(a) provides that gain or loss
generally is realized upon an exchange of property that differs materially either in kind or
extent. Under Reg. sec. 1.1001-3(b), a significant modification of a debt instrument
results in an exchange of the original debt for modified debt that differs materially in
either kind or extent for purposes of Reg. sec. 1.1001-1(a).
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The rules for determining whether a modification is significant are set forth in Reg. sec.
1.1001-3(e). Under the general rule of Reg. sec. 1.1001-3(e)(1), a modification is tested for
significance by examining whether, based on all the facts and circumstances, legal rights
or obligations are modified in an ‘economically significant’ manner. Importantly, all
modifications falling under Reg. sec. 1.001-1(e)(1) should be considered collectively to
determine significance.
IRS conclusion
The IRS found that because the Noteholders would receive money to which they had not
been entitled under the terms of the Notes, the one-time payment would result in a
modification required to be tested for significance under Reg. sec. 1.1001-3.
Moreover, the IRS concluded that the one-time Consent Payment would result in a
change in the yield of the Notes. Generally, a change in the yield of a debt instrument is
tested under Reg. sec. 1.1001-3(e)(2), which provides a safe harbor if the change in yield
is less than the greater of 25 basis points or 5% of the annual yield of the instrument.
This general rule, however, is not applicable to contingent debt obligations. A change in
yield of a contingent debt obligation must be tested under the general ‘economic
significance’ test of Reg. sec. 1.1001-3(e)(1).
The Notes at issue were treated as a contingent payment debt instrument as defined by
Reg. sec. 1.1275-4 and subject to the noncontingent bond method of Reg. sec. 1.1274-4(b).
When determining the proper method under Reg. sec. 1.1001-3(e)(1), the IRS reasoned
that because the Consent Payment otherwise would not alter the amounts that the
Noteholders would receive and because the noncontingent bond method of accounting
provided the Notes with interest that accrued by reference to the comparable yield and
projected payment schedule, using a test for significance similar to the method used for
fixed payment obligations was appropriate.
The PLR instructed Taxpayer to compare the “go-forward yield” of the Notes with the
‘original yield’ and then apply the 25 basis point or 5% threshold discussed above. The
original yield of the Notes is the comparable yield calculated under Reg. sec. 1.12754(b)(4) as of the issue date. Although the go-forward yield is computed in a similar
manner, the yield is calculated on a hypothetical debt instrument having (i) an issue date
on the date of modification, (ii) an issue price equal to the adjusted issue price of the
Notes as of that date, reduced by the amount of the Consent Payment, and (iii) a
projected payment schedule consisting of the remaining payment on the Notes under the
original projected payment schedule.
Observations
In holding that the change of yield method could be used under the general economic
significance test of Reg. sec. 1.1001-3(e)(1), the IRS indicated its position on how to
analyze the economic significance of modifications to contingent payment debt
obligations.
Although it is unclear whether the IRS intended to create a bright line threshold under
the general facts and circumstances test of Reg. sec. 1.1001-3(e)(1), this ruling
demonstrates the IRS’s willingness to rule on the appropriate method for determining
significance and suggests an acceptable method for contingent payment debt obligations.
It should be noted that by applying the change in yield method based on the comparable
yield of a contingent payment debt obligation, the threshold for significance has the
potential to be significantly different than that of a fixed payment obligation with a
similar yield.
For additional information, please contact Jeff Maddrey or Horacio Sobol.
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PLR 201435003
The IRS held that the applicability of section 382(l)(5) to an ownership change following
a chapter 11 bankruptcy depends on whether the shareholders and qualified creditors of
the entire taxpayer consolidated group, rather than any single debtor member, receive the
requisite amount of stock of the reorganized parent.
Transactions
Parent, the parent of a US consolidated group (the Parent Group), and substantially all its
domestic subsidiaries commenced voluntary chapter 11 bankruptcy proceedings.
Pursuant to the same plan, a newly formed, wholly owned first-tier subsidiary of Parent
entered into a reverse triangular merger with Target, with Target surviving as a wholly
owned subsidiary of Parent. Immediately thereafter, the stock of reorganized Parent was
divided between (i) the historic Parent shareholders, (ii) the former holders of Target
stock, and (iii) unsecured creditors of Parent and other members of the Parent Group.
Background
Section 382 generally limits a loss company's ability to use NOLs arising prior to an
ownership change. Under an exception in section 382(l)(5), a loss corporation that is
under the jurisdiction of the court in a title 11 or similar case can avoid a section 382
limitation if its shareholders and qualified creditors― determined immediately before
such ownership change― own― after such ownership change and as a result of being
shareholders or creditors immediately before such change― stock of the new loss
corporation (or stock of a controlling corporation if also in bankruptcy) that meets the
requirements of section 1504(a)(2), determined by substituting ‘50 percent’ for ‘80
percent’ each place it appears.
IRS Conclusion
The IRS ruled that whether section 382(l)(5) applied did not depend on whether the
shareholders and qualified creditors of Parent itself received sufficient stock to satisfy the
ownership test, but on whether the shareholders and qualified creditors of the entire
Parent Group received the requisite amount of stock.
Observations
As noted above, the IRS permitted Parent to apply the section 382(l)(5) ownership test on
a consolidated basis. This presumably means that the shareholders and qualified
creditors of Parent did not own enough stock of reorganized Parent after the ownership
change to satisfy the section 382(l)(5) ownership test. The PLR implies, however, that the
shareholders and qualified creditors of Parent and each member of its consolidated group
in the aggregate owned enough stock of reorganized Parent to satisfy the ownership test.
The ability to distribute stock of the reorganized parent to shareholders and qualified
creditors of its subsidiaries could give increased flexibility to taxpayers looking to take
advantage of section 382(l)(5) and avoid a section 382 limitation.
This PLR is consistent with the position taken by the IRS in previous rulings that section
382(l)(5) may be applied on a consolidated basis (see PLRs 200618022, 201306003, and
201328027). Under appropriate circumstances, section 382(l)(5) has the potential to
permit taxpayers commencing bankruptcy proceedings to avoid an onerous section 382
limitation.
For additional information, please contact Julie Allen or Rich McManus.
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PwC’s M&A publications
In an article titled Goodwill Games: Determining the Existence And Ownership of
Goodwill In a Closely Held Business, published in the BNA Tax Management
Memorandum (September 22, 2014), PwC authors Anna Turkenich, Michael Kliegman,
and Vanessa Rutman examine the treatment of goodwill and certain other intangibles in
either a liquidation or a disposition of a closely held corporation generally owned by one
or two individuals.
Let's talk
For a deeper discussion of how this issue might affect your business, please contact:
Tim Lohnes, Washington, DC
Todd McArthur, Washington, DC
+1 (202) 414-1686
+1 (202) 312-7559
[email protected]
[email protected]
Julie Allen, Washington, DC
Rich McManus, Washington, DC
+1 (202) 414-1393
+1 (202) 414-1447
[email protected]
[email protected]
Bart Stratton, Los Angeles, CA
Horacio Sobol, Washington, DC
+1 (213) 830-8208
+1 (202) 312-7656
[email protected]
[email protected]
Michael Kliegman, New York, NY
Jeff Maddrey, Washington, DC
+1 (646) 471-8213
+1 (202) 414-4350
[email protected]
[email protected]
Anna Turkenich, New York, NY
Wade Sutton, Washington, DC
+1 (646) 258-6798
+1 (202) 346-5188
[email protected]
[email protected]
Michael Hauswirth, Washington, DC
Bruce Decker, Washington, DC
+1 (202) 346-5164
+1 (202) 414-1306
[email protected]
[email protected]
Jamal Razavian, Washington, DC
Vanessa Rutman, New York, NY
+1 (202) 414-4559
+1 (646) 471-8391
[email protected]
[email protected]
Nils Cousin, Washington, DC
Brian Corrigan, Washington, DC
+1 (202) 414-1874
+1 (202) 414-1717
[email protected]
[email protected]
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Matthew Cotter, Washington, DC
Ryan Tichenor, Washington, DC
+1 (202) 312-7558
+1 (202) 312-7528
[email protected]
[email protected]
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