Mergers and Acquisitions: Hot Topics & Current … Rel.61.pdf · Mergers and Acquisitions: Hot Topics & Current ... The former loss disallowance regulations under Treasury ... subsidiary’s

CHAPTER 6

Mergers and Acquisitions:Hot Topics & Current Transactions1

KAREN GILBREATH, ESQ.

Ernst & Young LLP

DIANA WOLLMAN, ESQ.

Sullivan & Cromwell

JOHN J. CLAIR, ESQ.

Latham & Watkins

JOSEPH M. DOLOBOFF, ESQ.

Ernst & Young National Office West

STACEY WARNIX, ESQ.

Ernst & Young LLP

DAVID KAHN, ESQ.

Latham & Watkins

1 The authors would like to thank Jennifer V. Stroffe of the Los Angeles officeof Latham & Watkins for her assistance in the preparation of these materials.

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SYNOPSIS

§ 6.01 Loss Disallowance Rules

[1] Introduction

[2] Former Loss Disallowance Rules

[a] General Loss Disallowance Rule

[b] General Deconsolidation Rule

[c] Overlap Between the Former Loss Disallowance andDeconsolidation Rules

[d] Reattribution of Subsidiary Losses to Parent

[e] Anti-stuffing Rules

[f] Extraordinary Gain Dispositions Factor

[g] Positive Investment Adjustments Factor

[h] Duplicated Losses Factor

[3] Rite Aid Invalidates the Loss Duplication Factor Under theFormer Rules

[a] Rite Aid Decision

[i] Background

[ii] Appellate Decision

[iii] Scope of Decision

[b] Notice 2002-18

[4] New Loss Disallowance Regulations

[a] Dispositions on or After March 7, 2002

[i] Reattribution of Subsidiary’s Losses and Anti-stuffing Rules

[ii] Netting

[b] Dispositions Prior to March 7, 2002

[i] Recalculation of Reattributed Losses

[ii] Apportionment of Applicable Limitations

[iii] Notification by Common Parent

[iv] Investment Adjustment for Losses Restored UponRetroactive Application of New Regulations

[5] Observations and Anticipated Developments

[a] Comprehensive LDR Regime

[b] Loss Duplication Regulations

[c] Refund Opportunity

[d] Pending Legislation

§ 6.02 Mergers with Disregarded Entities

[1] Former Proposed Regulations

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[a] No “A” Reorganization Treatment

[b] Rationale

[2] New Regulations

[a] “A” Reorganization Treatment for Certain Mergers

[b] New Terminology

[c] Requirements for Nontaxable Treatment as an “A”Reorganization

[d] Cross-Border and Foreign-to-Foreign Mergers

[e] Mergers Pursuant to Non-corporate Statutes

[3] Example — Merger of Target Corporation into DisregardedEntity in Exchange for Stock of Owner


[a] Private Letter Rulings

[b] Cross-Border and Foreign-to-Foreign Mergers

§ 6.03 Divisive Transactions

[1] Introduction

[2] Scope of Section 355(e)

[a] Former Proposed and Temporary Regulations

[b] New Proposed and Temporary Regulations

[i] Factors

[ii] Super Safe Harbor for Certain Post-distributionAcquisitions

[iii] Safe Harbors

[iv] Special Rules for Public Offerings and Auctions

[v] Similar Acquisitions

[vi] Options

[vii] Recent Private Letter Rulings

[3] Active Trade or Business Requirement

[a] Real Estate Investment Trusts (REITs)

[i] Revenue Ruling 2001-29

[ii] Recent Public Transaction

[b] Limited Liability Corporations (LLCs)

[i] Management of LLC Satisfies Active Trade inBusiness Requirement

[ii] Deemed Taxable Acquisition Fails Active Trade inBusiness Requirement

[4] Control Requirement

[a] Introduction

[b] Recapitalization to Acquire Control

[c] Post-spin Unwinding of Pre-spin Recapitalization

MERGERS & ACQUISITIONS — HOT TOPICS6–3



[5] Business Purpose Requirement

[a] Key Employee Business Purpose

[6] Tracking Stock Dispositions

[a] Introduction

[b] Recent Private Letter Rulings

[c] Section 355(e) Consequences

[d] Other Section 355(e) Considerations

[7] Corporate Tax Consequences Associated with Post-distributionIssuances of Compensatory Stock

[a] Introduction

[b] Previous Guidance on Allocation of Post-distributionCompensation Deductions

[c] Current Service Position

[8] Anticipated Developments

§ 6.04 Step Transaction Doctrine in Triangular Reorganizations

[1] Revenue Ruling 2001-46

[a] Introduction

[b] Step Transaction Doctrine Applied to Integrate UpstreamMerger with Initial Reverse Subsidiary Acquisition

[c] Modified Acquisition Structure

[i] Qualification Under Section 368(a)(2)(D)

[ii] Step Transaction Doctrine Applied to IntegrateSideways Merger with Initial Reverse SubsidiaryAcquisition

[2] Benefits of Multi-step Acquisition Structures


[a] Application of Step Transaction Doctrine Only in Nontax-able Contexts

[b] No Application of Step Transaction Doctrine Where InitialAcquisition is Reverse Subsidiary Merger

[c] Regulatory Guidance Under Section 338

§ 6.05 Circular 230

[1] Introduction

[2] Status of Tax Shelter Opinion Provisions of Circular 230

[3] Highlights of the July 2002 Final Regulations

[a] Sections 10.3 through 10.7 — Who May Represent aTaxpayer or Prepare a Tax Return

[b] Section 10.20(a) — Obligation to Furnish Information tothe Service Upon Request

[i] What is a “Matter Before the IRS”?

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[ii] What Records or Information Must be Submittedto the Service?

[iii] Section 10.20(b) — Obligation to Furnish Informa-tion Regarding an Alleged Violation of Circular 230to the Director of Practice

[c] Section 10.21 — Knowledge of a Client’s Omission

[i] Compromise Language Regarding Advice on“Consequences”

[d] Section 10.22 — Diligence as to Accuracy

[i] Presumption of Due Diligence for Papers Preparedby Persons Other Than the Practitioner

[e] Section 10.23 — Prompt Disposition of Matters PendingBefore the Service

[f] Section 10.24 — Assistance from or To Disbarred orSuspended Persons and Former Service Employees

[g] Section 10.26 — Notaries

[h] Section 10.27 — Fees

[i] Section 10.28 — Return of a Client’s Records

[i] Scope

[ii] Fee Disputes

[iii] Definition of “Records of the Client”

[j] Section 10.29 — Conflicting Interests

[i] Scope

[ii] Exception Where There is Informed WrittenConsent

[k] Section 10.34 — Standards for Advising with Respect toTax Return Positions and for Preparing or SigningReturns

[i] Good Faith Reliance Upon Information Provided Bya Client

[l] Sections 10.50 Through 10.82 — Sanctions for Violationsof Circular 230

§ 6.06 Proposed Tax Shelter Legislation

[1] Principle Features of the Proposed Legislation

[a] Coordination of Key Terms

[b] Definition of “Reportable Transactions”

[c] Definition of Listed Transactions

[d] Proposed Legislation to Prevent Expatriation Transac-tions and Earnings Stripping

[e] Proposed Legislation on Deferred Compensation

§ 6.07 Tax Implications of the Sarbanes-Oxley Act

[1] Limitation on Provision of Non-audit Services by Auditors

MERGERS & ACQUISITIONS — HOT TOPICS6–5



[a] Effective Date

[2] Pre-approval of Non-audit Services by the Audit Committee

[a] Specificity of the Approval

[b] Delegation of Pre-approval Authority

[c] Advance Approvals

[d] De Minimis Exception

[3] Current Restrictions on Non-audit Services as Compared to theAct’s Limitations on the Provision of Non-audit Services

[4] Effect of the Act’s Non-audit Services Restrictions on Non-Registered Accounting Firms and Companies that Are Not SECRegistrants

[5] Under the Act, the CEO and CFO Must Personally Attest tothe Accuracy of the Company’s Financial Statements andPeriodic Reports with the SEC

[6] Companies May Not Avoid the Act by Expatriating

[7] Changes in Financial Statement Disclosures of Off-balanceSheet Transactions and the Use of Special Purpose Entities

[8] Fraudulently Influencing Accountants in Relation to the AuditReport

[9] Transfer of Employees from Accounting Firm to the PublicCompany

[10] Application of the Act to Non-U.S. Accounting Firms

[11] Will Corporate Tax Returns Have to be Signed by the CEO?

§ 6.01 LOSS DISALLOWANCE RULES

[1] Introduction

In March of 2002, the Internal Revenue Service (the “Service”)and Treasury Department (the “Treasury”) replaced the former lossdisallowance regulations2 with proposed and temporary regula-tions3 for transactions occurring on or after March 7, 2002.4 TheseRegulations were issued following the Federal Circuit’s decisionin Rite Aid Corporation and Subsidiary Corporations v. UnitedStates,5 which invalidated the duplicated loss factor of the priorregulations and threatened the continued viability of the remaining

2 See Treas. Reg. § 1.1502-20. 3 See Temp. Treas. Reg. § 1.1502-20T; Temp. Treas. Reg. § 1.337-2T. 4 Treas. Reg. § 1.1502-20T(i)(1). 5 255 F.3d 1357 (Fed. Cir. 2001).

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factors.6 The following discussion summarizes the significantprovisions in the prior regulations and the anticipated changes tothe loss disallowance rules.

[2] Former Loss Disallowance Rules

The former loss disallowance regulations under Treasury Regula-tions Section 1.1502-20 limited the ability of a consolidated groupmember to recognize a loss on its disposition of stock or deconsoli-dation of a subsidiary member through loss disallowances7 orforced basis reductions.8 As stated in the preambles, the formerregulations were designed to reflect a balancing of concerns.9 Mostsignificantly, the former regulations did not prevent the reductionof gains, but instead, only operated to disallow loss.10 Accordingto the Service, these rules were intended to prevent the circumven-tion of the 1986 repeal of the General Utilities11 doctrine in theconsolidated return context.12

[a] General Loss Disallowance Rule

According to the former regulations, a corporation was generallynot permitted to take a deduction for any loss recognized upon adisposition on or after February 1, 1991 of stock in a subsidiarywhich, prior to such disposition, was a member of the corporation’sconsolidated group.13 Under the regulations, a disposition wasdefined as “any event in which gain or loss was recognized, inwhole or in part.”14 However, Treasury Regulations Section1.1502-20(c) limited the reach of the general disallowance byclarifying that the amount disallowed would be limited to the sumof three factors: (i) extraordinary gain dispositions, (ii) positive

6 Id. at 1360. 7 Treas. Reg. § 1.1502-20(a)(1). 8 Treas. Reg. § 1.1502-20(b)(1). 9 T.D. 8984, 2002-13 I.R.B. 668 (March 8, 2002). 10 Id. 11 General Utilities & Operating Co. v. Helvering, 295 U.S. 200 (1935); re-

pealed by Tax Reform Act 1986. 12 CO-93-90, 1990-2 C.B 696. 13 Treas. Reg. § 1.1502-20(h)(1). 14 Treas. Reg. § 1.1502-20(a)(2).

§ 6.01[2]MERGERS & ACQUISITIONS — HOT TOPICS6–7



investment adjustments, and (iii) duplicated losses.15 As discussedin more detail below, the Service intended these factors to limitthe recognition of loss to only the “true economic loss” in asubsidiary’s stock.16 To benefit from this limitation, a corporationwas required to attach a statement meeting the requirements ofTreasury Regulations Section 1.1502-20(c)(3) to the consolidatedreturn for the year that encompassed the disposition.17

[b] General Deconsolidation Rule

Under the former regulations, if an event caused a subsidiary tobecome deconsolidated at a time when the consolidated member’sbasis in the share of such subsidiary exceeded the value of thesubsidiary’s stock, the basis in the subsidiary’s stock was requiredto be reduced to fair market value immediately before the deconsoli-dation, so that the loss would not be triggered.18 This rule wasintended to prevent a corporation from intentionally avoiding theloss disallowance rules by simply disaffiliating a subsidiary priorto the disposition of the subsidiary’s stock.19

Similar to the limitation upon a disposition of a subsidiarymember’s stock, Treasury Regulations Section 1.1502-20(c) cappedthe amount of the basis reduction upon a deconsolidation at anamount equal to the sum of the three factors. 20 In addition, in orderto benefit from this limitation, a corporation was required to filea statement meeting the requirements of Treasury RegulationsSection 1.1502-20(c)(3) with its consolidated return for the yearthat included the deconsolidation.21

[c] Overlap Between the Former Loss Disallowance and Decon-solidation Rules

Under the regulations, if an event gave rise to both a dispositionand a deconsolidation of the subsidiary’s stock, the disallowance

15 Treas. Reg. § 1.1502-20(c)(1)(i–iii). 16 Preamble to T.D. 8984, 2002-13 I.R.B. 668 (March 8, 2002). 17 Treas. Reg. § 1.1502-20(c)(3). 18 Treas. Reg. § 1.1502-20(b)(1). 19 Preamble to T.D. 8984, 2002-13 I.R.B. 668 (March 8, 2002). 20 See Treas. Reg. § 1.1502-20(c)(1)(i–iii). 21 Treas. Reg. § 1.1502-20(c)(3).




rules were to be applied first.22 Thereafter, to the extent necessaryto eliminate any remaining permissible loss, the basis in thesubsidiary’s stock would be reduced to fair market value.23

[d] Reattribution of Subsidiary Losses to Parent

The draconian effect of the disallowance under the formerregulations was somewhat mitigated by the ability of the consoli-dated group parent to reattribute to itself some, or all, of any netoperating loss or capital loss carryovers attributable to the subsid-iary or its lower tier subsidiaries for the parent’s future use uponthe disposition or deconsolidation of the subsidiary.24 However, inorder to be effective, this reattribution had to be made jointly byan irrevocable election by both the parent and the subsidiary.25

[e] Anti-stuffing Rules

The former regulations also contained an anti-stuffing rule thatrequired a basis reduction if an asset transfer was (i) made within2 years of a disposition or deconsolidation (or the making of anagreement, option, or other arrangement with respect thereto), and(ii) made with a view to avoid, directly or indirectly, the lossdisallowance or basis reduction rules upon the disposition ordeconsolidation or the recognition of unrealized gain.26 Adjust-ments to the amount of the reduction were made as necessary toremedy the perceived avoidance.27

[f] Extraordinary Gain Dispositions Factor

As noted above, under the former regulations, if a dispositionoccurred on or after November 19, 1990, the loss that resulted fromthe sale of stock in a member subsidiary was disallowed (or thebasis in the stock was reduced) by an amount equal to the incomeor gain from extraordinary gain dispositions, net of directly relatedexpenses (e.g. commissions, legal fees, and state income taxes).28

22 Treas. Reg. § 1.1502-20(b)(1). 23 Id. 24 Treas. Reg. § 1.1502-20(g)(1). 25 Treas. Reg. § 1.1502-20(g)(4)(i). 26 Treas. Reg. § 1.1502-20(e)(2)(i). 27 Treas. Reg. § 1.1502-20(e)(1). 28 Treas. Reg. § 1.1502-20(c).




If less than 100% of the shares were disposed of, the extraordinarygain amount was adjusted proportionately.29 However, extraordi-nary losses could not be offset against extraordinary gains to reducethe amount of the disallowance or basis adjustment.30

Extraordinary gain dispositions were actual or deemed disposi-tions of the following assets for a gain:

(1) capital assets;31

(2) depreciable property and real property used in a trade orbusiness;32

(3) inventory, if substantially all of the inventory was disposedof in one transaction or a series of related transactions;33

(4) certain categories of noncapital assets if substantially allsuch assets in a given category were disposed of in onetransaction or a series of related transactions;34

(5) assets sold in an applicable asset acquisition under Section1060(c);35 and

(6) certain other items arising from the disposition of an asset,such as cancellation of indebtedness or accounting methodchanges that gave rise to positive adjustments under Section481.36

[g] Positive Investment Adjustments Factor

As noted above, in calculating the amount of the disallowed lossor basis adjustment, the regulations also considered positive invest-ment adjustments.37 Positive investment adjustments were definedas any adjustments required to increase a member’s basis in its stockin a subsidiary under Treasury Regulations Section 1.1502-32.38

29 Treas. Reg. § 1.1502-20(c)(iii). 30 Treas. Reg. § 1.1502-20(c). 31 Treas. Reg. § 1.1502-20(c)(2)(i)(A)(1). 32 Treas. Reg. § 1.1502-20(c)(2)(i)(A)(2). 33 Treas. Reg. § 1.1502-20(c)(2)(i)(A)(3). 34 Id. 35 Treas. Reg. § 1.1502-20(c)(2)(i)(A)(4). 36 Treas. Reg. § 1.1502-20(c)(2)(i)(B–D). 37 See Treas. Reg. § 1.1502-20(c)(2)(ii). 38 Treas. Reg. § 1.1502-20(c)(1)(ii).




The adjustments were considered to the extent they were reflecteddirectly or indirectly (from partnerships and other conduits) in thebasis of the share, immediately prior to the disposition or deconsoli-dation of the subsidiary.39 In an attempt to reflect what the Serviceperceived as the true economic loss in the stock, any amountsincluded in a loss carryover were taken into account in the yearthey arose, rather than in the year they were absorbed.40

Under a positive investment adjustment, limited netting wasallowed. Positive adjustments were generally allowed to offsetnegative adjustments (other than negative adjustments to reflectcorporate distributions) within the same tax year.41 Thus, theamount of the annual adjustment (if any) would equal the amountof positive earnings and profits before distributions for the year.However, net negative adjustments were not permitted to offset netpositive investment adjustments from prior years, unless the adjust-ments were for tax years ending on or before September 13, 1991.42

To the extent a loss was attributable to an extraordinary gain thatresulted in a positive investment adjustment, the amount wasdisallowed only once and was treated as an extraordinary gaindisposition.43 In other words, adjustments that related to extraordi-nary gain dispositions were eliminated from the total positiveinvestment adjustments.

[h] Duplicated Losses Factor

As noted above, the amount of the loss disallowance or basisadjustment was also based upon the amount of duplicated losses.The duplicated loss amount generally measured the net unrealizedloss inherent in the assets of the subsidiary, plus its loss carryoversimmediately following the disposition or deconsolidation.44 Morespecifically, it represented the sum of the total adjusted basis ofthe subsidiary’s assets, net operating or capital loss carryovers, plusdeferred deductions, less the value of the subsidiary’s stock and

39 Treas. Reg. § 1.1502-20(c)(1)(iii). 40 Id. 41 Id. 42 Treas. Reg. § 1.1502-20(c)(2)(v). 43 Treas. Reg. § 1.1502-20(c)(1)(ii). 44 Treas. Reg. § 1.1502-20(c)(2)(vi).




liabilities.45 The duplicated loss amount for a subsidiary includedits allocable portion of corresponding amounts for each of its lower-tiered subsidiaries.46

[3] Rite Aid Invalidates the Loss Duplication Factor Underthe Former Rules

[a] Rite Aid Decision

On July 6, 2001, the Court of Appeals for the Federal Circuitreversed the Court of Federal Claims in Rite Aid Corp., et al. v.United States, and held that the consolidated return loss disallow-ance rules were invalid as applied in that decision.47

[i] Background

In 1995, the Rite Aid Corporation claimed a loss on the sale ofstock in a subsidiary acquired in a multi-step stock purchase inwhich Rite Aid had made a Section 338 election.48 The Servicedisallowed the loss under the loss disallowance rules of TreasuryRegulations Section 1.1502-20.49 Rite Aid sued for a refund ongrounds that the loss disallowance rules were invalid, arguing thatthe issuance of regulations was beyond the Secretary’s regulatoryauthority.50 Rite Aid argued that the duplicated loss factor arbitrar-ily imposed a tax that wouldn’t otherwise be imposed on corpora-tions filing consolidated returns by denying a loss allowed underSection 165.51 Rite Aid also argued that the regulations did notfurther the stated purposes of Section 1502 — to clearly reflect theincome of the consolidated group and prevent tax avoidance.52

The trial court granted the government’s motion for summaryjudgment, finding that Treasury Regulations Section 1,1502-20 wasnot “arbitrary, capricious, or manifestly contrary to the statute.”53

45 Id. 46 Id. 47 255 F.3d 1357, 1360 (Fed. Cir. 2001). 48 Id. at 1358. 49 Id. 50 Id. 51 Id.at 1360. 52 Id. at 1359. 53 Id. at 1358.




Thus, because the subsidiary’s duplicated loss factor exceeded RiteAid’s loss on the stock, the court disallowed Rite Aid’s entireclaimed loss.54

[ii] Appellate Decision

Like the lower court, the Circuit Court also applied the “arbitrary,capricious, or manifestly contrary to law” standard, noting that aregulation would be contrary to a statute if it were outside the scopeof delegated authority.55 The Circuit Court, however, reached adifferent conclusion than the trial court.56 After examining thelegislative history of Section 1502, the court concluded that thepurpose for the statute was to give the Secretary authority to identifyand correct instances of tax avoidance that were created by the filingof consolidated returns and that, in the absence of such avoidance,the Secretary was without authority to alter the application of othertax code provisions to consolidated groups.57 The court stated thata loss realized on the sale of a former subsidiary’s assets after theconsolidated group sells the subsidiary’s stock is not a problem thatresults from the filing of a consolidated income tax return.58 Thecourt determined that Rite Aid’s loss did not stem from the filingof a consolidated return and that the duplicated loss factor of theloss disallowance regulations, in particular, was manifestly contraryto the statute since it addressed situations that arise from the saleof stock regardless of whether a corporation files a separate orconsolidated return.59

Although the Service requested a rehearing by the FederalCircuit, the request was denied,60 and the Service ultimatelydecided not to file an appeal to the Supreme Court.

[iii] Scope of Decision

On January 31, 2002, the Service released Notice 2002-11, inwhich it indicated that it would no longer litigate the duplicated

54 Id. 55 Id. at 1359. 56 Id. at 1360. 57 Id. 58 Id. at 1360. 59 Id. 60 255 F.3d 1357, 1360 (Fed. Cir. 2001), rehearing denied, Oct. 3, 2001.




loss factor of the loss disallowance rules.61 The Service stated that,despite its continued position that the Federal Circuit’s decision inRite Aid was incorrect, the interests of sound tax administrationwould not be served by continuing to litigate the validity of theduplicated loss factor.62 The Service also announced that becauseof the interrelationships of the three loss disallowance factors, ithad decided to implement entirely new regulations.63 The Servicerevealed that the existing regulations would be replaced with interimregulations that require consolidated groups to determine theallowable loss on a sale or disposition of a subsidiary member’sstock under an amended version of Treasury Regulation Section1.337(d)-2.64 The Service also announced that it was undertakinga broader study of the regulations necessary to reflect the singleentity principles of the consolidated return rules.65

[b] Notice 2002-18

On March 7, 2002, in conjunction with its release of the newLDR regulations discussed below, the Service issued Notice2002-18. In the Notice, the Service announced the issuance of newproposed and temporary regulations under Sections 337 and 1502that set forth new rules governing a consolidated group’s allowableloss or basis reduction upon the disposition or deconsolidation ofa subsidiary’s stock.66 The Service pointed out that the new rulesdo not disallow stock losses that reflect net operating or built-inlosses.67

In the Notice, the Service nonetheless stated that the Service andTreasury intend to issue regulations to prevent a consolidated groupfrom duplicating tax benefits with respect to a single economic loss(i.e., where a deduction related to an asset would reflect the sameeconomic loss that gives rise to a stock loss).68 Interestingly, the

61 I.R.S. Notice 2002-11, 2002-7 I.R.B. 526. 62 Id. 63 Id. 64 Id. 65 Id. 66 I.R.S. Notice 2002-18, 2002-12 I.R.B. 644. 67 Id. 68 Id.




Service and Treasury have not indicated that they will issueregulations allowing the reduction of gain, which could result inthe multiple taxation of a single economic gain.

The Notice was apparently issued in response to a transactionby Bank of America wherein it duplicated unrealized losses insecurities by transferring them to a subsidiary.69 At the May 10,2002, meeting of the Affiliated and Related Corporations Commit-tee of the ABA Section of Taxation (the “May ABA Tax Meeting”),a Treasury representative defended Notice 2002-18, indicating thatthe administration characterized the sweeping statements in Rite Aidas dicta.70 The representative also distinguished the Bank ofAmerica transaction at issue in the notice as involving duplicationof loss within a single affiliated group, whereas Rite Aid involvedthe disallowance of a single economic loss.71 Interestingly, therepresentative indicated that the Service would continue to pursuenot only duplicated losses within a single affiliated group, but alsoduplicated losses generated in a separate return context or insituations involving intermediaries such as partnerships or realestate investment trusts.72 It is not clear what authority exists tosupport the issuance of regulations beyond the consolidated groupcontext.

[4] New Loss Disallowance Regulations

On March 7, 2002, the Service and Treasury issued new proposedand temporary regulations under Sections 337(d) and 1502 of theCode.73 These complex regulations are intended to provide interimguidance while the IRS considers a revised permanent regulatoryregime for loss disallowance and basis allocations made upon aparent’s disposition or deconsolidation of a subsidiary.74 In addi-tion, on October 23, 2002, the IRS published proposed regulationsintended to address the concerns raised by the Service in Notice2002-18. As discussed below, however, considerable uncertainty

69 Id. 70 ABA Tax Meeting: Consolidated Return Issues and Rite Aid Discussed. Tax

Notes Today (May 10, 2002). 71 Id 72 Id 73 See I.R.S. Notice 2002-18, 2002-12 I.R.B. 644. 74 Id.




remains even after the promulgation of these proposed and tempo-rary regulations.

[a] Dispositions on or After March 7, 2002

All dispositions or deconsolidations arising on or after March 7,2002 are governed by the new regulations at Treasury RegulationsSection 1.337(d)-2T rather than the former regulations at Section1.1502-20.75 Under these new temporary regulations, a loss uponthe disposition or deconsolidation of a subsidiary member is onlypermitted if the group is able to establish that the stock loss is notattributable to the recognition of built-in gain on dispositions of thesubsidiary’s assets.76 Thus, the new regulations incorporate tracingprinciples in order to identify the extent to which a stock loss isattributable to the subsidiary’s recognition of excess asset value thatwas inherent in the parent’s stock basis.77 Unfortunately, however,the regulations do not provide a precise definition of recognizedbuilt-in gain and provide little guidance as to how a taxpayer shouldimplement the tracing regime. In fact, this tracing approach waspreviously considered and explicitly rejected by the Service in thiscontext because of administrative concerns.78 In addition, the newregulations eliminate the requirement under the prior Section 337regulations that a consolidated group must dispose of its entireequity interest in a subsidiary to unrelated persons in order torecognize a loss on the stock.79

[i] Reattribution of Subsidiary’s Losses and Anti-stuffingRules

Unlike Treasury Regulations Section 1.1502-20, the new regula-tions do not allow any of the subsidiary’s losses to be reattributedto the parent.80 The new regulations do, however, incorporate thesame anti-stuffing rules that were contained in the prior regula-tions.81

75 Temp. Treas. Reg. § 1.337(d)-2T(g). 76 Temp. Treas. Reg. § 1.337(d)-2T(c)(2). 77 Id.; Temp. Treas. Reg. § 1.337(d)-2T(b)(1). 78 Notice of Prop. Rule Making, 67 Fed. Reg. 11070 (Mar. 12, 2002). 79 Temp. Treas. Reg. § 1.337(d)-2T(c)(2). 80 Temp. Treas. Reg. § 1.337(d)-2T(a)(1). 81 Temp. Treas. Reg. § 1.337(d)-2T(e).




[ii] Netting

The new regulations initially did not allow any form of netting.82

However, on May 30, 2002, the Service issued several clarificationsand amendments to the new regulations, including the adoption ofa netting rule comparable to the netting provisions in the priorregulations.83 The new netting provisions permit a loss recognizedby one member of a group to be offset against gain recognized bythe same or different member of its group, provided that the lossand gain are each recognized with respect to dispositions of stockof the same subsidiary, having the same material terms, that aredisposed of as part of the same plan or arrangement.84 Prior to thischange, a corporation could potentially have been required torecognize a stock gain, while at the same time, having its stockloss disallowed under the loss disallowance regulations.

[b] Dispositions Prior to March 7, 2002

For dispositions or deconsolidations occurring either prior toMarch 7, 2002, or pursuant to a binding contract in effect as ofMarch 7, 2002, a consolidated group is permitted to determine theamount of the allowable loss or basis reduction by applying theold rules at Section 1.1502-20 either in their entirety or by electingone of two alternatives: (i) application of the old regulations withoutregard to the duplicated loss factor (i.e., based upon the Rite-Aiddecision),85 or (ii) application of the new temporary regulations.86

[i] Recalculation of Reattributed Losses

The new regulations provide only limited guidance regardinghow to re-determine the allowable loss or basis reduction for priortax periods, or how to compute any reattribution elections and losscarryforwards if one of the alternative methods is elected. Althoughlimited reattribution is allowed, the recalculated amount will neverexceed the amount that would have been allowed under the priorLDR regime. If a corporation elects to apply the former loss

82 T.D. 8984, 2002-13 I.R.B. 668 (Mar. 7, 2002). 83 Temp. Treas. Reg. § 1.337(d)-2T(a)(4). 84 Id. 85 Temp. Treas. Reg. § 1.1502-20T(i)(2)(i). 86 Temp. Treas. Reg. § 1.1502-20T(i)(2)(ii).




disallowance rules without the duplicated loss factor and it timelyfiles an election to reattribute some or all of the subsidiary’s losses,the parent can preserve any reattributed losses that were absorbedin closed tax years. However, with respect to open tax years,reattribution will be permitted only to the extent that the loss isdisallowed under the extraordinary gain dispositions and positiveinvestment adjustments factors. On the other hand, if the taxpayerelects to apply the new regulations and a timely election is madeto reattribute some or all of the subsidiaries losses, although theparent may retain any reattributed losses that it absorbed in a closedyear, it will not be able to reattribute any losses that were absorbedin years that remain open. If the group elects to use one of thealternative methods listed, and such use reduces the amount oflosses subject to reattribution, the subsidiary or its consolidatedgroup is entitled to utilize these excess losses, subject to otherapplicable limitations on their use.

[ii] Apportionment of Applicable Limitations

Reattributed losses that are reduced and shifted back for use bythe subsidiary or a group of which it is a member, retain allapplicable limitations (e.g., Section 382 and SRLY).87 The newregulations allow the parent to make certain adjustments to thelimitations that must be apportioned between the parent and thesubsidiary or subsidiary group.88 The new regulations protect theacquirer by not requiring that a negative investment adjustmentreflect the expiration in closed tax years of any loss carryovers madeavailable to the subsidiary upon the retroactive application of oneof the alternative loss disallowance regimes.89 In addition, theregulations also authorize the acquiring group to elect to treat anyunexpired loss carryovers as having expired immediately before thesubsidiary became a member of the group, thereby enabling thegroup to avoid a negative basis adjustment upon the expiration ofsuch loss carryovers.90 However, in order to qualify, this electionmust be filed with the group’s tax return for the taxable year in

87 Temp. Treas. Reg. § 1.1502-20T(i)(3)(iii). 88 See Temp. Treas. Reg. § 1.1502-20T(i)(3)(iii)(C). 89 See Temp. Treas. Reg. § 1.1502-20T(i)(3)(iii). 90 Id.




which the subsidiary receives notification of the recomputed lossallocations.91

[iii] Notification by Common Parent

The new regulations impose an obligation upon the parent tonotify the subsidiary and the common parent of the acquiring group,if any, of any recomputed reattribution amount and any adjustmentsto the apportionment of limitations to which the losses are subject.92

The practical implications of this obligation, however, remainsomewhat unclear.

[iv] Investment Adjustment for Losses Restored UponRetroactive Application of New Regulations

On May 30, 2002, the Service amended the new regulations toallow a positive investment adjustment for the amount of lossrestored as a result of an election to retroactively apply the newregulations to a closed tax year if the loss would either have beenabsorbed or expired in a closed year.93 This modification isintended to neutralize the negative investment adjustment thatwould have been required under Treasury Regulations Section1.1502-32.94


[a] Comprehensive LDR Regime

The Service and Treasury have indicated that the current regula-tions are simply a temporary measure until a comprehensive systemcan be identified, and that in finalizing the regulations, they willbe looking at all related issues.95 The preamble to the proposedand temporary regulations indicated that one approach beingconsidered was the denial of positive investment adjustments forgain recognized and income attributable to the disposition orconsumption of built-in gain assets held by a subsidiary prior to

91 Id. 92 Temp. Treas. Reg. § 1.1502-20T(i)(3)(iv). 93 T.D. 8998, 2002-26 I.R.B. 1 (May 30, 2002). 94 Id. 95 Id.




joining a consolidated group.96 The Service scheduled a publichearing on the new regulations for mid-July; however, because noone requested to speak, the hearing was cancelled.

[b] Loss Duplication Regulations

On October 23, 2002, the Service issued proposed loss duplica-tion regulations to implement Notice 2002-18.97 Under theseproposed regulations, a consolidated group would be preventedfrom duplicating losses by two rules: (i) a basis redeterminationrule and (ii) a loss suspension rule.98 The basis redetermination rulewould essentially require that the group’s basis in the stock of asubsidiary be redetermined prior to certain deconsolidations and/ordispositions if the group’s basis in such stock exceeds its value.Under the loss suspension rule, if, after application of the basisredetermination rule, a member of a consolidated group were torecognize loss on the disposition of the stock of another memberof the group that remains a member of the group, such loss wouldbe “suspended” to the extent of any “duplicated loss.” The proposedregulations define “duplicated loss” for this purpose as the excessof (1) the sum of the aggregate basis of the subsidiary member’sassets (excluding stock in other group subsidiaries), the subsidiary’slosses that are carried forward to its first taxable year after thedisposition, and the subsidiary’s deductions that have been recog-nized but otherwise deferred, over (2) the sum of the value of thestock of the subsidiary and it’s liabilities that have been taken intoaccount for tax purposes.99 The proposed regulations also includea basis reduction rule (intended to cover certain situations not withinthe scope of the loss suspension rule and anti-avoidance rules andcertain anti-abuse rules.)100 The loss duplication rules are effectivefor disposition of member stock on or after March 7, 2002. In orderto hold this effective date, however, the Service and Treasury mustissue temporary or final regulations by March 15, 2003.

96 Id. 97 67 F.R. 65060 98 Id. 99 Id. 100 Id.




[c] Refund Opportunity

Because the new regulations do not incorporate the duplicatedloss or positive adjustment factors, the ability to elect to apply thenew regulations to prior dispositions and deconsolidations presentsa refund opportunity for many taxpayers. In order to elect into oneof the new regimes, a taxpayer must either file an amended returnprior to the due date for the consolidated tax return that encom-passes March 7, 2002, or attach an irrevocable election to itsoriginal return for such year.101 Additionally, in light of the RiteAid decision, it might even be argued that no LDR regime existsfor years prior to March 7, 2002.102 The fact that the Service hasdelineated a limited set of choices does not necessarily preventtaxpayers from taking the position that the prior LDR regime wascompletely invalidated by Rite Aid.

[d] Pending Legislation

Currently, both houses of Congress are considering bills thatwould undermine the Federal Circuit’s statements in Rite Aid thatthe ability of a formerly consolidated subsidiary to deduct a lossrealized on the sale of its assets after it has deconsolidated is nota problem that results from the filing of a consolidated income taxreturn.103 The proposed legislation would provide that the Service’sauthority to issue regulations under Section 1502 should be con-strued without regard to the interpretation of that authority in RiteAid and would confirm that the Treasury is authorized to issueconsolidated return regulations utilizing either a single or separateentity approach, or a combination thereof, to clearly reflect the taxliability of consolidated groups.104 In effect, if this legislation ispassed, it will limit the potential effect of Rite Aid on otherconsolidated return regulations and on the other factors of the priorLDR regulations.

101 Temp. Treas. Reg. § 1.1502-20T(i)(2). 102 See generally, Rite Aid, 255 F.3d 1357 (Fed. Cir. 2001). 103 See Affirmation of Consolidated Return Regulation Authority, H.R. 5095,

107th Cong. § 123 (2002); Affirmation of Consolidated Return RegulationAuthority, H.R. 7, 107th Cong. § 631 (2002).

104 Id.




§ 6.02 MERGERS WITH DISREGARDED ENTITIES

The Service has withdrawn earlier issued proposed regulationsthat would have precluded mergers between corporations anddisregarded entities from qualifying for tax-free treatment underIRS Code Section 368(a)(1)(A) (“A” reorganization).105 In theirplace, the Service has issued new proposed regulations which wouldpermit certain mergers including disregarded entities, to qualify asa tax-free “A” reorganization.106

[1] Former Proposed Regulations

[a] No “A” Reorganization Treatment

On November 14, 2001, the Service withdrew the proposedregulations at Treasury Regulations Section 1.368-2(b)(1) that wereissued on May 16, 2000.107 The prior regulations provided that eventhough it could potentially qualify under Sections 368(a)(1)(C), (D),or (F) or Section 351 if all other applicable requirements were met,neither a merger of a disregarded entity into a corporation nor amerger of a corporation into a disregarded entity would qualify asa tax-free statutory merger or consolidation under Section368(a)(1)(A).108 The Service indicated that compliance with acorporate law merger statute was not sufficient to qualify as an Areorganization.

[b] Rationale

Under the former proposed regulations, to qualify as a statutorymerger, a transaction was required to have, by operation of therelevant merger statute, involved both (i) an acquisition by theacquiring corporation of the assets of the merging corporation109

and (ii) the termination of the merging corporation’s existence.110

Thus, the Service took the position that a merger of a disregardedentity into a corporation, which under Federal tax law, is treated

105 See Notice of Prop. Rule Making, 65 Fed. Reg. 31115 (May 16, 2000).106 See Prop. Treas. Reg. § 1.368-2 (as amended in Nov. 14, 2001). 107 See Announcement 2001-121, 2001-2 CB 584. 108 See Notice of Prop. Rule Making, 65 Fed. Reg. 31115 (May 16, 2000).109 Id. 110 Id.

6–2261ST N.Y.U. INSTITUTE§ 6.02



as if the owner of the disregarded entity had transferred the assetsheld in the disregarded entity to the acquiring corporation, wouldnot qualify under Section 368(a)(1)(A) because (i) not all of theowner’s assets would be transferred to the acquiring corporationand (ii) the owner would not cease to exist. The Service labeledthis type of transaction as a divisive transaction, and stated thatSection 355 was intended to be the sole means under which divisivetransactions may be afforded tax-free treatment.111 The Service hasretained this view in the new proposed regulations.

Furthermore, the Service determined that a merger of a corpora-tion into a disregarded entity, which under Federal tax law wouldbe treated as if the owner of the disregarded entity acquired all ofthe assets of the target corporation, did not conform closely enoughto a merger of the target corporation into the owner.112 Morespecifically, the Service objected on the grounds that (i) the ownerwould not be a party to the transaction and (ii) the combinationof the target corporation and owner’s assets and liabilities wouldnot be pursuant to a direct combination under state or Federalmerger law, but instead, merely a tax fiction.113

[2] New Regulations

[a] “A” Reorganization Treatment for Certain Mergers

Simultaneous to its withdrawal of the prior proposed regulations,the Service issued new proposed regulations on November 14, 2001,partially reversing its earlier position.114 The new regulations willbe effective when issued in final form.115 These regulationsreaffirm the Service’s earlier position that a merger of a disregardedentity into a corporation, is effectively a divisive transaction inwhich the owner of the disregarded entity continues to exist afterthe merger and retains its assets not held in the disregardedentity.116 However, under the new proposed regulations, some

111 Id. 112 Id. 113 Id. 114 See Announcement 2001-121, 2001-2 CB 584. 115 Prop. Treas. Reg. § 1.368-2(b)(1)(v) (as amended in Nov. 14, 2001). 116 Prop. Treas. Reg. § 1.368-2(b)(1)(ii) (as amended in Nov. 14, 2001).




mergers of corporations into disregarded entities will qualify fortax-free treatment under Section 368(a)(1)(A).117 To so qualify, thenew regulations require that the assets and liabilities of the targetbe transferred to a corporation and/or one or more disregardedentities whose assets are treated as owned by such corporation forFederal tax purposes.118 This modification eliminates the concernunder the prior proposed regulations that the target corporationwould not be directly combining its assets and liabilities with theassets and liabilities of the owner of the acquiring disregardedentity.

[b] New Terminology

The new proposed regulations introduced several key termswhich govern the determination of whether or not a merger orconsolidation will qualify as a statutory merger under Section368(a)(1)(A). A “combining entity” is a business entity that is acorporation and not disregarded for federal income tax purposes.119

A “disregarded entity” is a business entity that is disregarded asan entity separate from its owner for federal income tax purposes;it includes domestic single-member limited liability companies,qualified REIT subsidiaries, and qualified subchapter S subsidia-ries.120 A “combining unit” collectively refers to a single combiningentity and any disregarded entities of that combining entity.121

Every merger will involve at least two combining units, one knownas the “transferor unit” and the other as the “transferee unit.”122

[c] Requirements for Nontaxable Treatment as an “A”Reorganization

The new proposed regulations provide that a transaction canconstitute a tax-free statutory merger under Section 368(a)(1)(A)if two requisite events occur at the effective time. First, eachmember of one or more transferor units must transfer substantially

117 See Notice of Prop. Rule Making, 66 Fed. Reg. 57400 (as amended in Nov.15, 2000).

118 Id. 119 Prop. Treas. Reg. § 1.368-2(b)(1)(i)(B) (as amended, in Nov. 14, 2001).120 Prop. Treas. Reg. § 1.368-2(b)(1)(i)(A) (as amended in Nov. 14, 2001). 121 Prop. Treas. Reg. § 1.368-2(b)(1)(i)(C) (as amended in Nov. 14, 2001). 122 Prop. Treas. Reg. § 1.368-2(b)(1)(ii)(A) (as amended in Nov. 14, 2001).




all of its assets and liabilities to one or more members of thetransferee unit, except to the extent that assets are distributed orliabilities are satisfied or discharged in the transaction.123 TheService explained in the preamble to the proposed regulations thatit did not intend that this requirement be interpreted in the samemanner as the “substantially all” requirement applicable to C, D,or triangular reorganizations.124 The Service did reiterate itsintention, however, that divisive transactions would not qualify asstatutory mergers under Section 368(a)(1)(A).125 Second, thecombining entity of each transferor unit must cease its separate legalexistence for all purposes.126

[d] Cross-Border and Foreign-to-Foreign Mergers

The new proposed regulations do not apply if either combiningentity (transferee or transferor), any disregarded entity of thetransferee group that acquires the assets or liabilities of the trans-feror combining entity, or any business entity through which thecombining entity of the transferee unit holds its interests in adisregarded entity, is foreign.127 Note that a transferor disregardedentity can be foreign, presumably because its owner must be adomestic corporation under these regulations.

[e] Mergers Pursuant to Non-corporate Statutes

As a final note, the new proposed regulations, consistent witha change made by the earlier proposed regulations, remove the word“corporation” from the requirement that a merger or consolidationmust be effected pursuant to the corporation laws of the relevantjurisdiction in order to qualify under Section 368(a)(1)(A).128 Thenew language conforms the regulation to the Service’s long-standing position that a merger or consolidation can qualify as an“A” reorganization even though it is undertaken under other lawsof a jurisdiction (e.g., pursuant to the National Banking Act).129

123 Prop. Treas. Reg. § 1.368-2(b)(1)(ii)(A) (as amended in Nov. 14, 2001).124 See Notice of Prop. Rule Making, 66 Fed. Reg. 57400. 125 Id. 126 Prop. Treas. Reg. § 1.368-2(b)(1)(ii)(B) (as amended in Nov. 14, 2001).127 Prop. Treas. Reg. § 1.368-2(b)(1)(iii)(as amended in Nov. 14, 2001). 128 See Notice of Prop. Rule Making, 66 Fed. Reg. 57400. 129 Id.




[3] Example — Merger of Target Corporation intoDisregarded Entity in Exchange for Stock of Owner

As noted above, the new proposed regulations enable a mergerof a target into a disregarded entity to qualify as a statutory mergerunder Section 368(a)(1)(A). Example twos at Treasury RegulationsSection 1.368-2(B)(1)(iv) provides the following example:

Y and Z are domestic corporations. X is a limited liability companythat is wholly owned by Y and is disregarded as an entity separatefrom its owner for federal income tax purposes. Under State W law,Z merges into X, pursuant to which all of Z’s assets and liabilitiesare transferred to X and Z ceases its separate legal existence forall purposes. In the merger, the Z shareholders exchange all of theirZ stock for Y stock. Prior to the transaction, Z was not treated asowning any assets of an entity that is disregarded as separate fromits owner for federal tax purposes.

This transaction qualifies as a statutory merger or consolidationunder Section 368(a)(1)(A) by reason of Section 368(a)(2)(D)because each of the following requirements were satisfied:

u The transaction is effected pursuant to the laws of theUnited States, a state, or the District of Columbia.

u At the effective time of the merger, substantially all of theassets and liabilities of each member of each transferor unit




(in this case, Z) are transferred to one or more membersof the transferee unit (in this case, X) (except to the extentthat assets are distributed or liabilities are satisfied ordischarged in the transaction).

u At the effective time of the merger, the combining entityof each transferor unit (in this case, Z) must cease itsseparate legal existence for all purposes.

u The combining entity of the transferee unit and eachtransferor unit, each disregarded entity of the transfereeunit, and each business entity through which the combiningentity owns such disregarded entities (in this case, X, Y,and Z) are domestic.

Note once again that if the direction of this transaction were to bereversed (i.e., Z rather than X survives the merger), the transactionfalls outside of the proposed regulations.


[a] Private Letter Rulings

Since the new regulations will not be effective until publishedas final, it is difficult to determine whether a tax opinion can beissued on whether a transaction involving one or more disregardedentities qualifies under Section 368(a)(1)(A). This uncertainty hasgenerated questions as to whether the Service will entertain rulingson the issue. At the December 12, 2001 Corporate Tax Committeeluncheon of the Taxation Section of the D.C. Bar Association, anIRS representative stated that there was a strong possibility that theService would entertain private letter rulings on situations similarto the examples in the new proposed regulations. The merger ofa corporation into a disregarded entity likely presents a significantissue under Section 3.01 of Revenue Procedure 2001-3 sufficientfor the Service to rule on all aspects of the transaction relating toits qualification under Section 368(a)(1)(A). To date, the Servicehas issued one such private ruling, PLR 200236005.130 Interest-ingly, the Office of the Chief Counsel has issued a notice to theChief Counsel attorneys reminding them of the requirements tofollow legal positions established by published guidance or pro-posed regulations. This notice should give taxpayers comfort in

130 Priv. Ltr. Rul. 200236005 (May 23, 2002).




issuing opinions on disregarded entity mergers that are accom-plished consistent the proposed regulations.131

[b] Cross-Border and Foreign-to-Foreign Mergers

The Treasury’s current business plan contains an item calling forguidance on cross-border and foreign-to-foreign mergers for thethird consecutive year.

§ 6.03 DIVISIVE TRANSACTIONS

[1] Introduction

Over the past 18 months, the Service and Treasury have issuedextensive authority related to divisive transactions under Section355. These items have included regulatory guidance under Section355(e) regarding the meaning of a “plan or series of relatedtransactions”132 and several rulings on the various prerequisitesrequired for tax-free treatment, such as the active trade or business,control, and business purpose requirements.133 Further, the publicmarketplace has seen a growing reliance on Section 355 distribu-tions for the tax-free unwinding of tracking stock structures. Thesedevelopments, along with other anticipated developments, arediscussed in this section.

[2] Scope of Section 355(e)

Section 355(e) imposes restrictions on events occurring pursuantto a plan (or series of related transactions) that affect the sharehold-ers’ interests in the distributing or controlled corporations or anysuccessors thereto.134 In particular, Section 355(e) provides that thedistributing corporation will recognize gain on the distribution ofthe stock of the controlled corporation if the distribution is part ofa plan (or series of related transactions) pursuant to which one ormore persons acquire, directly or indirectly, stock representing a50% or greater interest in either the distributing corporation or

131 CC-2002-043. 132 See I.R.C. § 355(e). 133 See e.g., Rev. Rul. 2001-29, 2001-1 CB 1348; Rev. Rul. 2002-49, 2002-32

I.R.B. 288. 134 I.R.C. § 355(e)(3).




controlled corporation.135 In addition, Section 355(e)(2)(B) estab-lishes a rebuttable presumption that acquisitions of stock within twoyears of a distribution are part of the distribution plan.136

[a] Former Proposed and Temporary Regulations

Since late 1999, the regulations under Section 355(e), regardingwhether a distribution and a stock acquisition would be treated aspart of a plan or series of related transactions, have been in aconstant state of flux. On August 24, 1999, proposed regulationswere issued, but they were subsequently withdrawn on December29, 2000.137 New proposed regulations were then issued on January2, 2001.138 On August 3, 2001, these regulations were adopted astemporary regulations in substantially identical form as the pro-posed regulations, except that the temporary regulations reservedon two of the proposed provisions.139 Specifically, the regulationsreserved upon the proposed suspension of the two-year presumptionperiod for any period in which there is a “substantial diminutionof risk of loss” within the meaning of Section 355(d)(6)(B) andon an example that illustrated application of the regulations regard-ing “similar acquisitions” in situations involving multiple acquisi-tions.140 In the preamble to the temporary regulations, the Serviceand Treasury stated that they would continue to analyze commentsreceived on the proposed regulations and that they would likelypromulgate additional guidance on their interpretation of a plan orseries of related transactions.141

[b] New Proposed and Temporary Regulations

On April 26, 2002, the Service and Treasury withdrew theexisting temporary regulations and issued a significantly revised setof temporary and proposed regulations concerning the scope ofSection 355(e).142 Generally, in comparison to the previous

135 See I.R.C. § 355(e)(2)(A)(ii). 136 I.R.C. § 355(e)(2)(B). 137 See Prop. Treas. Reg. 1.355-7 (Aug. 24, 1999). 138 See Prop. Treas. Reg. 1.355-7 (as amended in Jan. 2, 2001). 139 See Temp. Treas. Reg. § 1.355-7T (2001). 140 T.D. 8960, 2001-34 I.R.B. 176 (Aug. 3, 2001). 141 T.D. 8988, 2002-20 I.R.B. 929 (Apr. 29, 2002). 142 See Temp. Treas. Reg. § 1.355-7T (as amended in 2002).




regulations, the new regulations reduce the likelihood that a distri-bution and a stock acquisition will be treated as part of the sameplan or series of related transactions for purposes of Section355(e).143 The revised regulations are effective for distributionsafter April 26, 2002.144 However, taxpayers may apply the revisedregulations to distributions occurring after April 16, 1997, providedthe regulations are applied in their entirety.145

[i] Factors

Consistent with the approach taken in the prior temporaryregulations, the newly revised regulations adopt a facts and circum-stances-based approach and provide certain safe harbors.146 How-ever, whereas under the prior regulations, if an acquisition anddistribution arose within six months of one another, the existenceof a plan was rebuttably presumed, the new regulations eliminatethis presumption and provide a revised list of factors tending toshow whether a distribution and acquisition are part of the sameplan.147 These revisions reduce the likelihood that a post-distribution acquisition will be considered as part of a plan, althoughpublic offerings and pre-distribution acquisitions are subject tohigher scrutiny. As an example, in the case of a post-distributionacquisition that does not involve a public offering, the priorregulations treated discussions regarding the acquisition as tendingto show the existence of a common plan.148 The new regulations,on the other hand, focus only on whether there was an agreement,understanding, arrangement, or substantial negotiations within thetwo year period following the distribution.149 However, in the caseof acquisitions preceding a distribution and public offerings (regard-less of whether they occur before or after a distribution), the factthat the distributing or controlled corporation had discussionsregarding the latter transaction (or a similar acquisition) with anacquirer or investment banker within two years of the earlier

143 Id. 144 Temp. Treas. Reg. § 1.355-7T(k) (as amended in 2002). 145 Id. 146 See Temp. Treas. Reg. § 1.355-7T (as amended in 2002). 147 Temp. Treas. Reg. § 1.355-7T(b)(3) (as amended in 2002). 148 See Temp. Treas. Reg. § 1.355-7T(d)(2)(2001). 149 Temp. Treas. Reg. § 1.355-7T(b)(2) (as amended in 2002).




transaction will tend to show that the distribution and acquisitionwere part of the same plan.150 Consistent with the earlier regula-tions, the revised regulations also consider the corporate businesspurpose(s) for the distribution, unexpected changes in market orbusiness conditions, a lack of discussions during the two-year periodregarding the latter transaction, and whether the distribution wouldhave occurred regardless of the acquisition or similar acquisition.151

The regulations generally do not specify the weight to be accordedeach factor.

[ii] Super Safe Harbor for Certain Post-distributionAcquisitions

The most significant change in the new temporary regulationsis that they contain a “super safe harbor.” Except in the case ofa stock acquisition that involves a public offering, under the newregulations, a distribution and a subsequent acquisition will not betreated as part of a plan unless there is an agreement, understanding,arrangement, or substantial negotiations regarding the acquisitionor a similar acquisition during the 2-year period that ends on thedate of the distribution.152 Only if there is an agreement, under-standing, etc., is it necessary to conduct a deeper factual inquiryinto whether or not a plan existed. 153 Because most taxpayers willlikely be interested in taking advantage of this super safe harbor,it is necessary to resolve such issues as what constitutes substantialnegotiations, similar acquisitions, and when pre-distribution negoti-ations or discussions have been terminated.

[iii] Safe Harbors

The regulations provide seven other safe harbors that treat certainacquisitions as not part of a plan or series of related transactionsfor purposes of Section 355(e).154 Safe Harbor I is applicable ifan acquisition occurs more than 6 months after a distribution and(i) the business purpose for the distribution was one other than to

150 Temp. Treas. Reg. § 1.355-7T(b)(3)(iii), (iv) (as amended in 2002). 151 Temp. Treas. Reg. § 1.355-7T(b)(3)(v) (as amended in 2002); Temp. Treas.

Reg. § 1.355-7T(b)(4) (as amended in 2002). 152 Temp. Treas. Reg. § 1.355-7T(b)(2) (as amended in 2002). 153 Id. 154 See Temp. Treas. Reg. § 1.355-7T(d)(as amended in 2002).




facilitate an acquisition of the acquired corporation,155 and (ii) therewas no agreement, understanding, arrangement, or substantialnegotiations regarding the acquisition during the 18-month periodbeginning one year before the distribution.156 Safe Harbor II appliesif an acquisition occurs more than 6 months after a distribution andduring the 18-month period beginning one year before the distribu-tion, (i) the business purpose for the distribution was one other thanto facilitate the acquisition of the acquired corporation or similaracquiring,157 (ii) there was no agreement, understanding, arrange-ment, or substantial negotiations regarding the acquisition or similaracquisition,158 and (iii) no more than 25% of the corporation’s stockwas acquired or subject to an agreement, understanding, arrange-ment, or substantial negotiations.159

Safe Harbors III and IV generally limit the length of time duringwhich an agreement, understanding, arrangement, or substantialnegotiations may be considered in determining whether an acquisi-tion and distribution are part of the same plan.160 For example, SafeHarbor III applies to acquisitions of the corporation’s stock occur-ring more than one year after a distribution, provided there was noagreement, understanding, or arrangement at the time of the distri-bution and no agreement, understanding, arrangement, or substantialnegotiations during the year following the acquisition.161 For stockacquisitions that occur more than two years prior to the distribution,Safe Harbor IV applies to the acquisition as long as there were noagreements, understanding, arrangements, or substantial negotia-tions concerning the distribution at the time of the acquisition orwithin 6 months thereafter.162

Other safe harbors relate to stock traded among public sharehold-ers, other than (i) 5% shareholders who actively participate inmanagement, 10% shareholders, underwriters, or affiliated members

155 Temp. Treas. Reg. § 1.355-7T(d)(1)(i)(as amended in 2002). 156 Temp. Treas. Reg. § 1.355-7T(d)(1)(ii)(as amended in 2002). 157 Temp. Treas. Reg. § 1.355-7T(d)(2)(i)(A)(as amended in 2002). 158 Temp. Treas. Reg. § 1.355-7T(d)(2)(i)(B)(as amended in 2002). 159 Temp. Treas. Reg. § 1.355-7T(d)(2)(i)(C)(as amended in 2002). 160 See Temp. Treas. Reg. § 1.355-7T(d)(3–4)(as amended in 2002). 161 Temp. Treas. Reg. § 1.355-7T(d)(3)(as amended in 2002). 162 Temp. Treas. Reg. § 1.355-7T(d)(4)(as amended in 2002).




of the distributing or controlled corporation (Safe Harbor V),163

(ii) stock acquired pursuant to the exercise of options issued inexchange for services (Safe Harbor VI),164 and (iii) stock acquiredby qualified retirement plans (Safe Harbor VII).165 However, if thevoting power of publicly traded stock is decreased or otherwiseshifted upon or after a public acquisition, the public tradingexception will not apply to exempt the voting power associated withsuch stock upon its transfer.

[iv] Special Rules for Public Offerings and Auctions

The prior regulations tested public offerings and auctions underdifferent rules than generally applied to other acquisitions ofstock.166 While the new regulations continue to maintain specialrules for public offerings,167 the new regulations subject acquisi-tions involving a public auction to the same rules and presumptionsas apply to any acquisition other than a public offering.168

[v] Similar Acquisitions

The new regulations further reduce the likelihood that an acquisi-tion will be treated as part of the same plan as a distribution bylimiting the scope of the term “similar acquisition.”169 Under theprior regulations, even though the identity of the acquirer, the timingof the acquisition, or the terms of the acquisition differed betweenthe acquisitions, an acquisition may have been treated as identicalto an intended acquisition.170 The new regulations, however,generally treat an actual acquisition as similar to another acquisitiononly if the “actual acquisition effects a direct or indirect combina-tion of all or a significant portion of the same business operationsas the combination that would have been effected by such otherpotential acquisition.”171 An acquisition will not be treated as

163 Temp. Treas. Reg. § 1.355-7T(d)(5)(as amended in 2002). 164 Temp. Treas. Reg. § 1.355-7T(d)(6)(as amended in 2002). 165 Temp. Treas. Reg. § 1.355-7T(d)(7)(as amended in 2002). 166 See Temp. Treas. Reg. § 1.355-7T(d)(2)(2001). 167 See Temp. Treas. Reg. § 1.355-7T(b)(3)(ii)(as amended in 2002). 168 See Temp. Treas. Reg. § 1.355-7T(a)(as amended in 2002). 169 See Temp. Treas. Reg. § 1.355-7T(h)(8)(as amended in 2002). 170 See Temp. Treas. Reg. § 1.355-7T(b)(2)(2001). 171 Temp. Treas. Reg. § 1.355-7T(h)(8)(as amended in 2002).




substantially similar to another acquisition if the ultimate ownersof the acquired businesses operations are substantially differentfrom those of the other business.172

[vi] Options

As in the prior regulations, if an option is more likely than notto be exercised, it will be treated as an agreement, understanding,or arrangement to acquire stock on the earliest date that it waswritten, transferred, or modified to materially increase the likeli-hood of its exercise, provided that it was more likely than not tobe exercised on such date.173

[vii] Recent Private Letter Rulings

The Service ruled that a distributing corporation could divestitself of one of its two businesses which it had determined not longerfit with its strategic objectives, in a tax-free spin-off distributionunder Sections 355 and 368(a)(1)(D).174 Thereafter, immediatelyfollowing the distribution, the spun-off business (“Controlled”)would then be merged with and into an unrelated, publicly tradedacquiring company (“Acquiring”) in a transaction that would resultin Controlled shareholders receiving more than 50% of the outstand-ing Acquiring stock.175 The Private Letter Ruling contained thefollowing noteworthy rulings under Section 355(e).

Public Trading

Although Acquiring was publicly traded, as noted above, thepublic trading safe harbor will not apply if the voting powerassociated with the publicly traded stock is decreased or otherwiseshifted in connection with a public acquisition.176 As a result, thevoting power associated with such shifts is, for purposes of Section355(e), potentially counted when the underlying stock is ac-quired.177 In this case, Acquiring’s only class of common stock

172 Id. 173 Temp. Treas. Reg. § 1.355-7T(e) (as amended in 2002). 174 Priv. Ltr. Rul. 200234044 (Aug. 23, 2002). 175 Id. 176 Id. 177 Id.




had been subject to a time-phased voting structure, wherein thevoting rights associated with each share were decreased upon atransfer or change in beneficial ownership and were restored to theoriginal amount only after ownership of the share was not changedfor a specified length of time.178 Because of the time-phased votingfeatures inherent in the Acquiring stock, Acquiring intended tomodify the voting structure of its stock in connection with theproposed merger to provide that each share would have equal andconstant voting rights for purposes of electing directors and all othermatters with the exception of certain specific matters delineated inAcquiring’s articles of incorporation.179 As a result, the time-phased voting feature of the stock remained in effect only withrespect to the specific matters granted in the articles of incorpora-tion, which included voting on plans related to:

(1) the dissolution or liquidation of Acquiring;

(2) the merger, share acquisition, or business combination ora significant lease, sale, or other disposition of assets ofAcquiring or its subsidiaries;

(3) amendments to the articles of incorporation or bylaws;

(4) matters related to a pre-existing “poison pill” plan and anystock option, compensation, and similar benefit plans,certain merger and share acquisition plans; and

(5) certain other matters generally reserved to shareholdersunder applicable laws.180

Significantly, the Service noted that Acquiring’s board of directorswould retain the types of powers traditionally reserved to a boardof directors in managing the company as they deemed fit.181

Accordingly, the Service ruled that shifts in voting power broughtabout by the time-phased voting features of the stock would notbe taken into account for purposes of Section 355(e).182 In soholding, the Service apparently reasoned, consistent with longstand-ing tax principles under Section 368, that the controlling factor inassessing the voting power of stock is the right to elect board

178 Id. 179 Id. 180 Id. 181 Id. 182 Id.




directors, as long as no material restrictions limit the ability of thedirectors to exercise the types of powers traditionally reserved tocorporate boards.183

Compensatory Issuances

Consistent with Safe Harbor VI of the revised regulationsdiscussed above, the Service ruled that post-distribution issuancesof Acquiring shares in connection with the performance of servicesby employees and directors of Acquiring in transactions underSection 83 would not be taken into account for purposes of Section355(e).184 The Service specifically indicated that this ruling wouldalso apply to acquisitions of Acquiring stock with respect to stockoptions granted to employees or directors before the distribution.185

Cash Issued for Fractional Shares

In connection with the proposed merger, Acquiring intended toaggregate for sale on the open market all fractional shares thatwould otherwise have been issuable to the Controlled shareholdersand to deliver the proceeds to the shareholders according to whowould have been entitled to the underlying shares.186 The Serviceruled that it viewed the fractional shares as having been transferredto the Controlled shareholders in the merger and then disposed ofby the shareholders in transactions that would not be counted forpurposes of Section 355(e).187

[3] Active Trade or Business Requirement

Sections 355(a)(1)(C) and 355(b) require that, immediately afterthe distribution, the distributing and controlled corporations musteach be engaged in the active conduct of a trade or business.188

Section 355(b)(2) provides, with certain limitations, that thisrequirement is satisfied only if the trade or business was activelyconducted throughout the five-year period ending on the date of

183 Id. 184 Id. 185 Id. 186 Id. 187 Id. 188 I.R.C. § 355(a)(1)(C); I.R.C. § 355(b).




distribution.189 Recent Revenue Rulings have provided guidanceon how this requirement applies to certain entities such as real estateinvestment trusts and limited liability companies, that have a specialstatus for Federal tax purposes.190

[a] Real Estate Investment Trusts (REITs)

[i] Revenue Ruling 2001-29

In Revenue Ruling 2001-29, the Service obsoleted its earlierruling in Revenue Ruling 73-236.191 Revenue Ruling 73-236 statedthat a REIT could not satisfy the active trade or business require-ment since REITs were permitted to manage or operate propertyonly indirectly through an independent contractor from whom theREIT did not derive any income.192 In 1986, this restriction waseliminated, permitting REITs to render customary services relatedto the rental of property so long as its services are not renderedprimarily for the convenience of its tenant.193 Revenue Ruling2001-29 formally recognizes this change and acknowledges that aREIT may now be able to satisfy the active trade or businessrequirement through such rental-related services.194

[ii] Recent Public Transaction

The combined ability for a corporation to separate its real estateoperations from its mainstream operating businesses via a tax-freetransaction and to direct them into a tax-favorable REIT structure,which would be exempt from corporate taxation, may cause somecorporations with significant investments in real estate to considersuch distributions. The potential tax savings were exemplified by— and have been widely publicized in the wake of — the GeorgiaPacific/Plum Creek reverse Morris Trust transaction, the firstSection 355 distribution to involve a REIT conversion. On October5, 2001, Georgia Pacific Corporation split-off its timber and

189 I.R.C. § 355(b)(2). 190 See e.g., Rev. Rul. 2001-29, 2001-1 CB 1348; Rev. Rul. 2002-49, 2002-32

I.R.B. 288. 191 See Rev. Rul. 2001-29, 2001-1 CB 1348. 192 Rev. Rul. 73-236, 1973-1 CB 183. 193 See Rev. Rul. 89-27, 1989-1 CB 106. 194 See Rev. Rul. 2001-29, 2001-1 CB 1348.




timberlands business (the “Timber Company”) to the holders of theGeorgia Pacific tracking stock that tracked the separate performanceof the Timber Company. One day after the distribution, the TimberCompany was merged with and into Plum Creek Timber Company,Inc., which was a REIT. Although Georgia Pacific unsuccessfullysought a private letter ruling from the Service, it ultimately consum-mated the distribution on an opinion from its tax counsel shortlyafter the issuance of Revenue Ruling 2001-29. In fact, it is widelythought that the Georgia Pacific transaction prompted the ruling.In light of these developments, it may now be possible for acorporation to effectively remove its real estate operations fromcorporate taxation by transferring them into a REIT via a tax-freedistribution meeting all of the applicable requirements of Section355.195

[b] Limited Liability Corporations (LLCs)

[i] Management of LLC Satisfies Active Trade in BusinessRequirement

In Situation 1 of Revenue Ruling 2002-49, the Service issueda formal ruling that a corporation may be able to satisfy the activetrade or business requirement through its ownership of an LLC thatis treated as a partnership for Federal tax purposes if it conductsactive and substantial management functions with respect to theLLC.196 The Service determined that the purchase of all of theremaining membership interests by a managing member who, priorto the purchase owned only 20% of the interests, would not resultin the acquisition of a new or different business in violation ofSections 355(b)(2)(B) and (C), even though gain or loss would berecognized upon the transaction.197 The ruling formalized theService’s view that the limited liability nature of the interest is notrelevant.198 The ruling also acknowledges that the active trade orbusiness requirement may be satisfied even though a corporationjointly engages in management of an LLC with another member.199

195 Id. 196 Rev. Rul. 2002-49, 2002-32 I.R.B. 288. 197 Id. 198 Id. 199 Id.




In other words, the fact that the management duties are carried outby more than one manager will not preclude either of the managingmembers from being treated as actively conducted in the businessof the LLC. In so holding, the Service appears to view eachmanaging member (i.e., partner) as actively conducting the entireunderlying business.

[ii] Deemed Taxable Acquisition Fails Active Trade inBusiness Requirement

In Situation 2 of Revenue Ruling 2002-49, the Service ruled thata corporation will not satisfy the active trade or business require-ment of Section 355 if it contributed appreciated securities or cashto an LLC that is taxed as a partnership within the 5-year periodpreceding the date of the distribution, irrespective of whether thecontribution qualified for tax-free treatment under Section 721.200

The Service reasoned that if the corporation had acquired the tradeor business that its membership interest in the LLC represented indirect exchange for the appreciated securities or cash, the exchangewould have constituted a transaction in which gain or loss wasrecognized.201 Therefore, the corporation was treated as havingacquired the trade or business in a taxable transaction, and becausethe transaction occurred within the 5-year period preceding thedistribution, the business could not be relied upon to satisfy theactive trade or business requirement.202

Some practitioners are concerned that the rationale of this rulingcould be extended to deny tax-free treatment under Section 355 insituations where one or more members (partners) contribute busi-ness assets that include cash. It is unclear, however, exactly whatauthority there is for this position. Further, it is unclear whetherthe same analysis would be applied, if instead of cash, a five-yearbusiness were contributed to the LLC. Certainly, such a businessshould continue to satisfy the requirements of Section 355(b).

200 Id. 201 Id. 202 Id.




[4] Control Requirement

[a] Introduction

Section 355(a)(1)(A) requires that, immediately before the distri-bution, the distributing corporation must control the subsidiarywhose stock is being distributed.203 In addition, Section355(a)(1)(C), by application of Section 355(b)(2)(D), requires that,immediately after the distribution, the distributing corporation andthe controlled subsidiary must each be engaged in the active conductof a trade or business, the control of which was not acquired ina taxable transaction during the five year period preceding thedistribution.204 Finally, Section 368(a)(1)(D) requires that thedistributing corporation distribute an amount of subsidiary stockthat constitutes control of such subsidiary.205 Under Section 355,the term “control” is defined by reference to Section 368(c) as stockpossessing at least 80% of the total combined voting power andat least 80% of the total number of shares of each class of non-voting classes of stock.206 Several recent rulings have shed lighton these control requirements.207

[b] Recapitalization to Acquire Control

In Private Letter Ruling 200135039, the Service determined thata recapitalization to acquire control of a subsidiary in preparationfor a spin-off of the subsidiary did not violate Section 355 becausethe recapitalization qualified as a tax-free reorganization underSection 368(a)(1)(E).208 Prior to the recapitalization, the distribut-ing corporation owned less than 80% of the stock of a subsidiary,with the remaining shares held by the public.209 In the recapitaliza-tion, the stock held by the distributing corporation was replacedwith a new class of stock that included the right to elect at least

203 I.R.C. § 355(a)(1)(A). 204 See I.R.C. § 355(a)(1)(C). 205 I.R.C. § 368(a)(1)(D). 206 I.R.C. § 355(a)(1)(D)(ii). 207 See e.g., Priv. Ltr. Rul. 200135039 (Sept. 4, 2001); Priv. Ltr. Rul. 200139001

(Oct. 1, 2001). 208 Priv. Ltr. Rul. 200135039 (Sept. 4, 2001). 209 Id.




80% of the subsidiary’s board of directors.210 The shares of thesubsidiary’s stock held by the public were not changed.211 In thespin-off, the distributing corporation distributed the new class ofsubsidiary stock pro rata to its shareholders.212 Because the distrib-uting corporation represented that there was no plan or intentionto recapitalize or to convert or change the voting rights, corporatedocuments, or board of directors of the controlled subsidiary, therecapitalization effected a permanent realignment of voting controlof the subsidiary, as required by Revenue Ruling 69-407.213 Sincethe recapitalization qualified for nonrecognition treatment underSection 368(a)(1)(E), the distributing corporation did not acquirecontrol of the subsidiary in a taxable transaction, as required underSections 355(a)(1)(C) and 355(b)(2)(D).214 This ruling is consistentwith prior rulings issued by the Service permitting the use of tax-free recapitalizations to adjust the voting rights in a subsidiary’sstock and thereby gain Section 368(c) control of the subsidiary.215

[c] Post-spin Unwinding of Pre-spin Recapitalization

In Private Letter Ruling 200139001, a distributing corporationrequested a ruling from the Service that a post-spin merger had notadversely affected the Service’s earlier determination that a spin-offwas tax-free.216 Prior to the spin-off, the controlled corporation wastaken public, and to ensure that it did not lose the requisite controlof the subsidiary, the distributing corporation recapitalized thesubsidiary to create a dual-class stock structure.217 After the spin-off, an unexpected and significant price differential developedbetween the classes of stock, and as a result, the controlledcorporation decided to eliminate the two-class structure through amerger.218 The Service held that the transaction, which had not

210 Id. 211 Id. 212 Id. 213 See Rev. Rul. 69-407, 1969-2 CB 50. 214 Priv. Ltr. Rul. 200135039 (Sept. 4, 2001). 215 See e.g., Priv. Ltr. Rul. 199909029 (Mar. 8, 1999); Priv. Ltr. Rul. 9836019

(Sept. 4, 1998). 216 Priv. Ltr. Rul. 200139001 (Oct. 1, 2001). 217 Id. 218 Id.




been contemplated by the distributing corporation at the time ofthe spin-off, did not affect the tax-free nature of the spin-off.219

This ruling is consistent with the Service’s position stated inRevenue Ruling 98-27 that even though a post-distribution acquisi-tion or restructuring is undertaken (whether prearranged or not),the step transaction doctrine will not be applied to test whether thedistributing corporation had sufficient control of the distributedcorporation at the time of the distribution.220

[5] Business Purpose Requirement

In addition to the statutory requirements under Section 355, theregulations impose certain additional nonstatutory requirements thatmust be satisfied. Among these additional requirements is therequirement imposed by Treasury Regulations Section 1.355-2(b)that the distribution be motivated, in whole or in part, by one ormore corporate business purposes.

[a] Key Employee Business Purpose

Appendix A of Revenue Procedure 96-30 delineates the require-ments for several common examples of appropriate corporatebusiness purposes, including what is known as the “key employee”business purpose for distributions that are intended to providecurrent or prospective employees with an equity interest in thedistributing or controlled corporation.221 In Private Letter Ruling200214014, the Service ruled that the key employee businesspurpose was satisfied through the issuance of options to keyemployees.222 The Service had previously stated in RevenueProcedure 96-30 that it would closely scrutinize transactions inwhich stock issued to key employees is subject to an option or otherrestriction.223 In the ruling, the controlled corporation proposed thedistribution to establish a market for the controlled corporation’sstock and to initiate an incentive equity participation program tiedto the performance of the stock and designed to motivate its keyemployees.224

219 Id. 220 See Rev. Rul. 98-27, 1998-1 C.B. 1159. 221 Rev. Proc. 96-30, 1996-1 CB 696. 222 Priv. Ltr. Rul. 200214014 (Apr. 5, 2002). 223 Rev. Proc. 96-30, 1996-1 CB 696. 224 Priv. Ltr. Rul. 200214014 (Apr. 5, 2002).




[6] Tracking Stock Dispositions

[a] Introduction

Tracking stock is a class or series of corporate stock that tracksthe performance of specific corporate assets, but remains subjectto the overall risks of the entire corporation. Corporations com-monly utilize tracking stock structures to separate the economicownership of a business without losing control of the business orto fund incentive compensation programs for employees. Lately,many corporations have come to question whether tracking stockstructures are properly valued by the capital markets, since someinvestors may find it difficult to identify the appropriate growthprospects and risks. Over the past couple of years, there appearsto have been a growing trend among corporations to use spin-offand split-off distributions to unwind their tracking stock structures.Publicly-disclosed examples include AT&T,225 Georgia Pacific’ssplit-off and merger of its timber operations into Plum Creek, andQuantum Corporation’s split-off and merger of its hard disk driveoperations into Maxtor Corporation.

[b] Recent Private Letter Rulings

In Private Letter Ruling 200138004, a distributing corporation,which operated two distinct business lines, determined that it neededa significant amount of additional capital to commercialize newtechnology being developed by one of the businesses (“BusinessA”).226 Its financial advisor determined that the distributing corpo-ration could raise substantially more capital if it completely sepa-rated Business A from the other business (“Business B”).227

Accordingly, the distributing corporation proposed to (i) contributeBusiness B to a controlled subsidiary which was tracked by its ClassB common stock and then (ii) split-off the controlled subsidiaryby distributing its stock in the subsidiary to the holders of the ClassB common stock in exchange for their shares of the Class Bcommon stock.228 In the ruling, the Service held that the transfer

225 See Priv. Ltr. Rul. 200131003 (Aug. 6, 2001); Priv. Ltr. Rul. 200137011(Sept. 17, 2001); Priv. Ltr. Rul. 200139009 (Oct. 1, 2001).

226 Priv. Ltr. Rul. 200138004 (Sept. 24, 2001). 227 Id. 228 Id.




of the business to the subsidiary, followed by the distribution ofthe subsidiary stock in redemption of the distributing corporation’stracking stock qualified as a tax-free distribution under Sections 355and 368(a)(1)(D).229

[c] Section 355(e) Consequences

Section 355(e)(3)(A)(iv) provides that an acquisition of stock willbe disregarded to the extent that existing shareholders’ ownershippercentages do not decrease.230 In the typical tracking stockrecapitalization, each share of a corporation’s common stock isexchanged for one share of each class of tracking stock, and theresulting shares will, in the aggregate, have the same voting powerthat a single share of the former common stock had before therecapitalization. Because such a recapitalization would not haveaffected any shareholder’s proportionate interest in the corporation,whether measured by vote or value, in light of Section355(e)(3)(A)(iv), it should not be treated as an acquisition forpurposes of Section 355(e).

[d] Other Section 355(e) Considerations

As noted earlier, Section 355(e)(2)(B) establishes a rebuttablepresumption that acquisitions of stock within two years before orafter a distribution are part of the distribution plan.231 Under theliteral terms of Section 355(e), a recapitalization in issuance oftracking stock could be counted against a corporation’s 50% changein ownership, especially if the recapitalization arose within 2 yearsof the distribution.232 Under the newly revised regulations underSection 355(e), Safe Harbor IV exempts acquisitions of a corpora-tion’s stock that occur more than two years prior to the distributionas long as there were no agreements, understanding, arrangements,or substantial negotiations concerning the distribution at the timeof the acquisition or within 6 months thereafter.233 While there isno specific safe harbor that would potentially apply if the recapital-ization arose within 2 years of the distribution, the distributing

229 Id. 230 I.R.C. § 355(e)(3)(A)(iv). 231 See I.R.C. § 355(e)(2)(B). 232 See I.R.C. § 355(e). 233 Temp. Treas. Reg. § 1.355-7T(d)(4).




corporation would want to develop similar facts. Accordingly, thedistributing corporation should provide adequate evidence of itsbusiness purpose for the tracking stock issuance (e.g., to enableinvestors to invest separately in each of lines of business or toenable the corporation to provide equity-based compensation pack-ages that would allow employees to participate in the success ofboth businesses.) and should establish facts tending to show thatthe corporation did not envision the distribution at the time thetracking stock was issued.

[7] Corporate Tax Consequences Associated with Post-distribution Issuances of Compensatory Stock

[a] Introduction

In Revenue Ruling 2002-1, the Service ruled that, following aspin-off, (i) neither the distributing corporation nor the controlledcorporation will recognize any gain or loss upon the lapse ofrestrictions on stock or the exercise of options issued to theiremployees and (ii) that each corporation was entitled to take adeduction for the amount includible in its employees’ income uponsuch lapse or exercise in the year in which the employees reportthe amounts as income.234 The ruling used a “relation back” theoryto insure that no gain or loss is recognized by Distributing whentheir employees exercise options in Controlled and, similarly, nogain or loss is recognized by Controlled when their employeesexercise options in Distributing.235 However, the ruling failed toprovide new insight regarding the extent to which each party isentitled to claim the resulting compensation deductions.236

[b] Previous Guidance on Allocation of Post-distribution Com-pensation Deductions

As a general rule, compensation deductions under Section 83(h)are available to the “service recipient” — that is, the company forwhich the employee was employed when the employee’s rights tothe property vested.237 However, in the context of divisive

234 Rev. Rul. 2002-1, 2002-2 IRB 268. 235 Id. 236 Id. 237 I.R.C. § 83(h).




transactions where an employee may have rendered services to morethan one employer, the Service has issued several private letterrulings addressing which employer is entitled to the compensationdeduction.238 Several rulings, including Private Letter Ruling200025001, Private Letter Ruling 199927004, and Private LetterRuling 9738009, have concluded, without explanation, that thedeductions are allowed to the entity that issues its shares insatisfaction of the options upon exercise, even where the spun-offentity is a newly-formed corporation.239 However, in Private LetterRuling 200031028, the Service acknowledged a lack of statutoryguidance in situations where an employer is divided after it hasissued options and then concluded that, following such a division,the post-division corporations should apportion the correspondingSection 83(h) deductions under a system that clearly reflectsincome.240 In the ruling, the Service added that “the determinationof how the Section 83(h) deduction should be claimed by the post-division entities is a question of fact,” upon which the Service willnot ordinarily rule.241

[c] Current Service Position

It is widely thought that the Service has been formulating aposition on this issue but has been unable to reach consensus.Significantly, the ruling involved the spin-off of a preexistingcontrolled subsidiary that maintained its own separate work force,such that no employees had to be transferred in connection withthe spin-off.242 Because the ruling did not involve a Section368(a)(1)(D) reorganization in which employees were transferredto Controlled, the compensation deduction issue was easy. Giventhe explicit limitation of the ruling to its facts, in factually distinctsituations, it is probably in a taxpayer’s best interest to follow theService’s previously-stated policy of allocating the available deduc-tions in a manner that clearly reflects income. The government has

238 See e.g., Priv. Ltr. Rul. 200025001 9 (Jun. 2, 2000); Priv. Ltr. Rul. 200031028(Aug. 7, 2000); Priv. Ltr. Rul. 199927004 (Jul. 12, 1999); Priv. Ltr. Rul. 9738009(Sept. 19, 1997).

239 See Priv. Ltr. Rul. 200025001 9 (Jun. 2, 2000); Priv. Ltr. Rul. 199927004(Jul. 12, 1999); Priv. Ltr. Rul. 9738009 (Sept. 19, 1997).

240 Priv. Ltr. Rul. 200031028 (Aug. 7, 2000). 241 Id. 242 See Rev. Rul. 2002-1, 2002-2 IRB 268.




indicated informally that it is unlikely to issue any guidance as toproper allocation of the deduction in situations where employeeshave transferred employment because such issues are too factualin nature.

[8] Anticipated Developments

The Treasury’s current business plan includes a proposal for anupdate to Revenue Procedure 96-30 for the second consecutive year.It is expected that the update will include additional guidance onthe active trade or business requirement, particularly as it appliesin partnership and business expansion contexts, and under Sections355(d) and (e). Future Section 355(e) guidance may include clarifi-cation on what constitutes an acquisition and on the predecessorand successor rules.

§ 6.04 STEP TRANSACTION DOCTRINE INTRIANGULAR REORGANIZATIONS

[1] Revenue Ruling 2001-46

[a] Introduction

On October 15, 2001, the Service issued Revenue Ruling2001-46, in which it analyzed two factual scenarios involving a two-step acquisition of a target corporation.243 In both situations,pursuant to an integrated plan, a parent corporation (“Parent”)formed a wholly owned acquisition subsidiary (“New Sub”), whichit merged in a statutory merger into a target corporation (“Target”),with the Target surviving (the “Acquisition Merger”).244 In Situa-tion 1, the Target shareholders exchanged 100% of their Targetstock for 30% cash and 70% voting stock of Parent, whereas inSituation 2, the Target shareholders exchanged 100% of their stocksolely for voting stock of Parent.245 In both scenarios, the Targetwas then merged upstream in a statutory merger into Parent as partof the same plan as the Acquisition Merger (the “Upstream Merg-er”).246

243 See Rev. Rul. 2001-46, 2001-2 C.B. 321. 244 Id. 245 Id. 246 Id.




[b] Step Transaction Doctrine Applied to Integrate UpstreamMerger with Initial Reverse Subsidiary Acquisition

If the transactions were respected as separate, the AcquisitionMerger in Situation 1 would have been treated as a taxable stockacquisition that was a qualified stock purchase under Section 338followed by a liquidation under Section 332.247 Similarly, inSituation 2, the Acquisition Merger would have qualified as areorganization under Section 368(a)(1)(A) by reason of Section368(a)(2)(E), followed by a liquidation under Section 332.248

Because application of the step transaction doctrine produced anontaxable result, the Service applied the step transaction doctrinein both situations, treating the overall transaction as single statutorymerger of the target directly into the controlling corporation thatqualifies under Section 368(a)(1)(A).249 Thus, Revenue Ruling2001-46 indicates that the step transaction doctrine will be appliedin situations where a target is acquired in a reverse subsidiarymerger if, pursuant to an integrated plan, the target is then mergedinto the controlling corporation.250 In addition, the two steps will

247 Id. 248 Id. 249 Id. 250 Id.




be treated as a single tax-free asset acquisition in which thecontrolling corporation directly acquires the assets of the target.251

[c] Modified Acquisition Structure

Based on the analysis in Revenue Ruling 2001-46, it is likelythat a slight variation of the multi-step acquisition involved in thatruling can also produce similar benefits. Rather than merging thetarget upstream into the controlling corporation, the target couldbe merged sideways into another wholly-owned subsidiary of thecontrolling corporation (the “Sideways Merger”). Assuming that thestep transaction doctrine properly applies, the two steps (i.e., theAcquisition Merger and the Sideways Merger”) would be treatedas a single asset acquisition in which the brother-sister subsidiarydirectly acquired the assets of the target.252

The question then is whether such a stepped-together acquisitionwould also qualify for tax-free treatment.

[i] Qualification Under Section 368(a)(2)(D)

Section 368(a)(2)(D) provides that an acquisition by a subsidiarycorporation of substantially all of the properties of a target corpora-tion pursuant to an exchange in which the target shareholders

251 Id. 252 Id.




receive stock of a corporation that controls the subsidiary will notprevent the acquisition from qualifying as a reorganization underSection 368(a)(1)(A), provided that two requirements are satis-fied.253 First, no stock of the subsidiary corporation may be issuedin the transaction.254 Second, the transaction would have qualifiedunder Section 368(a)(1)(A) if the target had merged directly intothe controlling corporation in a single transaction.255

[ii] Step Transaction Doctrine Applied to Integrate SidewaysMerger with Initial Reverse Subsidiary Acquisition

Because the integrated transaction would qualify as a statutorymerger under Section 368(a)(1)(A) by application of Section368(a)(2)(D), it appears consistent with Revenue Ruling 2001-46that in situations where the Acquisition Merger is followed by aSideways Merger, pursuant to an integrated plan, the overalltransaction would be treated as a direct merger of the target intothe subsidiary of the controlling corporation that issues its stockin the transaction.256 This conclusion, of course, assumes that infact, substantially all of the assets of the target were acquired inthe transaction, only stock of the controlling corporation was issued,the step-transaction doctrine properly applies, and that other prereq-uisites for tax-free reorganization treatment are satisfied (e.g., validbusiness purpose, continuity of proprietary interest and businessenterprise).

[2] Benefits of Multi-step Acquisition Structures

Interestingly, the utilization of a multi-step structure affordsadditional flexibility to the parties by combining the benefits of aforward merger (e.g., less stringent boot limitations) with thebenefits of a reverse subsidiary merger (e.g., no corporate-level taxexposure and expedited closing). Relevant considerations include:

253 I.R.C. § 368(a)(2)(D). 254 I.R.C. § 368(a)(2)(D)(i). 255 I.R.C. § 368(a)(2)(D)(ii). 256 See Rev. Rul. 2001-46, 2001-2 CB 321.




Single-Step (a)(2)(E) Multi-Step (a)(1)(A) or (a)(2)(D)

● No risk as to whether step ● Early involvement requiredtransaction doctrine will apply to ensure integrated

structure based on sufficientbinding legal commitments,interrelationships, and/orfocus towards particularend results — obligation inmerger agreement tocomplete second mergershould be sufficient

● Can achieve time efficient ● Can achieve time efficientclosing — no need for closing for acquisitionshareholder or contractual merger — can time secondconsents merger as convenient, but

generally should closewithin one year

● No incremental transaction ● Incremental costs tocosts associated with a second structure and satisfymerger transaction applicable statutory filing

requirements are minimal● Approval required by target ● Approval required by target

shareholders, but generally shareholders, but generallynot by acquiring shareholders not by acquiring

shareholders● No need to transfer assets or ● All assets must be capable

assign contracts of transfer by merger andconsents for assignment ofcontracts may need to beobtained, but secondtransaction need not beimmediate

● Must hold “sub all” of assets ● No “sub all” requirementof the target and merged (if followed by Upstreamentity (can drop down, but Merger)must retain within controlledgroup).

● Must acquire “sub all” ofthe target’s assets (iffollowed by SidewaysMerger)




Single-Step (a)(2)(E) Multi-Step (a)(1)(A) or (a)(2)(D)

● No ability to pick and choose ● Some, but limited, abilityassets to pick and choose assets

in nontaxable transactions● Parent can assume liabilities ● Liabilities are transferred as

of target, but they will be matter of law — nottreated as capital contributions treated as boot for purposesto target of gain recognition

● If followed by SidewaysMerger, either of acquiringsubsidiary or controllingparent can assume liabilitiesof target (e.g., the parentmay assume/substitutebenefit plans)

● Only shareholder-level tax ● Corporate-level tax liabilityexposure exposure if transaction

found taxable, but may beprotected by earlier368(a)(2)(E)

● Must issue solely voting ● No minimum issuance ofstock for at least 80% of voting stock required (buttarget stock may want to meet 80% test

of 368(a)(2)(E) if there isdoubt as to the tax-freenature of overall transactionin order to avoidcorporate-level tax)

● Nonvoting stock, cash, and ● Nonvoting stock, cash, andother boot consideration other boot considerationcannot exceed 20% of total can exceed 20% of totalconsideration consideration (but still not

more than 50–55%)● Subsidiary stock could be ● If followed by Sideways

issued in addition to stock of Merger, no stock ofthe controlling parent subsidiary may be issued

● Recovery of transaction costs ● Accelerated recovery fordelayed until certain transaction costsdisposition/termination ofsubsidiary




In light of these benefits, it is anticipated that multi-step acquisitionstructures will become more commonplace, especially given thewidespread popularity of reverse subsidiary mergers to date.


[a] Application of Step Transaction Doctrine Only in NontaxableContexts

Generally, under Revenue Ruling 2001-46, if application of thestep transaction doctrine results in a nontaxable integrated transac-tion, then the step transaction doctrine will be applied since theresult would not violate the principle that a Section 338(g) or (h)(10)election should be the sole means for obtaining an asset step-upfollowing a stock acquisition.257 The ruling clearly indicates thatthe step transaction doctrine may not be used to obtain a step upin the basis of the acquired assets.258

[b] No Application of Step Transaction Doctrine Where InitialAcquisition is Reverse Subsidiary Merger

One should note that the Service would not apply the steptransaction doctrine to treat an initial acquisition under Section368(a)(2)(D) that is followed by an upstream merger as a statutorymerger under Section 368(a)(1)(A) since the merger parties differin each transaction.259

[c] Regulatory Guidance Under Section 338

In Revenue Ruling 2001-46, the Service indicated that it isconsidering whether to issue regulations that reflect the generalprinciples of the ruling but in addition, also allow a Section338(h)(10) election to be made for a single step in a multiple steptransaction if that step independently qualifies as a qualified stockpurchase and was effected pursuant to a written agreement thatrequires or permits the making of such an election.260 In otherwords, the Service is considering regulations that would allow

257 Id. 258 Id. 259 Id. 260 Id.




taxpayers to elect taxable treatment pursuant to a Section 338(h)(10)election for transactions, that under the step transaction doctrine,would qualify as a tax-free reorganization.

§ 6.05 CIRCULAR 230

[1] Introduction

Circular 230 governs the practice of taxpayers’ representativesbefore the Treasury Department. Final regulations were issued July26, 2002 (the “July 2002 Final Regulations”).261 The July 2002Final Regulations cover provisions of Circular 230 other than thosegoverning tax shelter opinions.262

[2] Status of Tax Shelter Opinion Provisions of Circular230

The current provisions (principally, Section 10.33) governing taxshelter opinions were issued in 1984,263 and proposed regulationswere issued in January 2001.264 Although the Service and Treasuryintend to issue a second set of proposed regulations on tax shelteropinions in the near future, at this time the 1984 provisions are stillapplicable.265 The Service and Treasury also intend to issue a setof proposed regulations governing other matters under Circular 230,but it is not clear what matters will be covered.

[3] Highlights of the July 2002 Final Regulations

[a] Sections 10.3 through 10.7 — Who May Represent a Taxpayeror Prepare a Tax Return

Section 10.3 through Section 10.7 cover who may “practicebefore the IRS,” such as attorneys, certified public accountants, andpersons enrolled to practice before the IRS as “agents” or “actuar-ies.”266 These sections also provide rules for enrollment, including

261 T.D. 9011, 2002-33 I.R.B. 356 (July 25, 2002). 262 Id. 263 49 F.R. 6719 (Feb 23 1984). 264 66 F.R. 3276 (Jan 12, 2001). 265 See 49 F.R. 6719 (Feb 23 1984). 266 Reg. 10.3–10.7 (Circular 230) (2002).




continuing education requirements, and identify persons who mayrepresent a taxpayer before the Service or prepare tax returns fora taxpayer.267 No noteworthy changes were made to theseprovisions.

[b] Section 10.20(a) — Obligation to Furnish Information to theService Upon Request

A practitioner who receives a “proper and lawful” request fromthe Service relating to “any matter before the Service” must submitrecords or information unless the practitioner “believes in good faithand on reasonable grounds” that the records or information areprivileged.268

[i] What is a “Matter Before the IRS”?

There is no definition as to what constitutes a “matter before theIRS,” but it presumably means any matter which is under investiga-tion by the Service.

[ii] What Records or Information Must be Submitted to theService?

Practitioners must submit any records or information which thepractitioner or the client has in its possession or over which theyhave control.269 If neither the practitioner nor the client has therecords or information, the practitioner must provide to the Serviceany information the practitioner has regarding the identity of anyperson who the practitioner believes may have possession or controlof the requested records or information and must “make reasonableinquiry” of the client regarding the identity of any person who mayhave possession or control of the requested records or informa-tion.270 The practitioner is not required to make inquiry of any otherperson or independently verify any information provided by theclient regarding the identity of such persons.271

267 Id. 268 Reg. § 10.20(a)(1) (Circular 230) (2002). 269 Reg. § 10.20(a)(2) (Circular 230) (2002). 270 Id. 271 Id.




[iii] Section 10.20(b) — Obligation to Furnish InformationRegarding an Alleged Violation of Circular 230 to theDirector of Practice

If a practitioner receives a “proper and lawful” request from theDirector of Practice concerning an inquiry by the Director ofPractice into an alleged violation of Circular 230, the practitionermust provide any information the practitioner has and must testifyregarding this information in any proceeding under Circular 230,unless the practitioner believes “in good faith and on reasonablegrounds” that the information is privileged.272

[c] Section 10.21 — Knowledge of a Client’s Omission

If a practitioner who has been retained by a client with respectto any matter “administered by the Service” knows that the clienthas not complied with the United States tax laws or has made anerror in or omission from any return, document, affidavit, or otherpaper which the client has submitted or executed under UnitedStates tax laws (whether or not related to the matter for which thepractitioner was retained), the practitioner must (i) advise the clientpromptly of the fact of such noncompliance, error or omission and(ii) advise the client “of the consequences as provided under theCode and the regulations of such noncompliance, error or omis-sion.”273 Note that this obligation applies if the practitioner isadvising on any matter relating to United States Federal taxes.274

In other words, neither the matter for which the practitioner wasretained nor the matter where the error occurred needs to be a matter“before the Service” for this obligation to apply. The obligationapplies whether the error/omission relates to the matter for whichretained or to any other current or prior matter.275

[i] Compromise Language Regarding Advice on“Consequences”

The language requiring a practitioner to advise a client of the“consequences under the Code and the regulations” reflects a

272 Reg. § 10.20(b) (Circular 230) (2002). 273 Reg. § 10.21 (Circular 230) (2002). 274 Id. 275 Id.




compromise by the Treasury, which had initially proposed that thepractitioner advise the client as to the consequences of not takingcorrective action. However, some commentators on the proposedregulations complained that this would require some practitionersto advise on matters beyond their competence.276 The compromiselanguage simply requires the practitioner to tell the client what thesanctions (e.g., penalties and interest) under the Code and regula-tions would be if the error is ultimately discovered.277

[d] Section 10.22 — Diligence as to Accuracy

A practitioner must exercise due diligence in the rendering ofseveral specified services.278 These include services in (i) preparingor assisting in the preparation of, approving, and filing tax returns,documents, affidavits, and other papers relating to Service mat-ters,279 (ii) determining the correctness or written representationsmade by the practitioner to the Treasury,280 and (iii) determiningthe correctness of oral or written representations made by thepractitioner to clients with reference to any matter administered bythe Service.281

[i] Presumption of Due Diligence for Papers Prepared byPersons Other than the Practitioner

Except as provided in Sections 10.33 and 10.34, a practitionerwill be presumed to have exercised due diligence if the practitionerrelies on the work product of another person and the practitionerused reasonable care in engaging, supervising, training, and evaluat-ing the person, taking into account the nature of the relationshipbetween the practitioner and the person.282

276 See T.D. 9011, 2002-33 I.R.B. 356 (July 25, 2002). 277 Reg. § 10.21 (Circular 230)(2002). 278 See Reg. § 10.22 (Circular 230)(2002). 279 Reg. § 10.22(a)(1) (Circular 230)(2002). 280 Reg. § 10.22(a)(2) (Circular 230)(2002). 281 Reg. § 10.22(a)(3) (Circular 230)(2002). 282 Reg. § 10.22(b) (Circular 230)(2002).




[e] Section 10.23 — Prompt Disposition of Matters PendingBefore the Service

A practitioner may not unreasonably delay the prompt dispositionof any matter before the Service.283

[f] Section 10.24 — Assistance from or to Disbarred or SuspendedPersons and Former Service Employees

A practitioner may not knowingly, directly or indirectly, acceptassistance from or assist any person who has been disbarred orsuspended from practice before the Service if the assistance relatesto matters constituting “practice before the IRS.”284

“Practice before the IRS” is defined as including “all mattersconnected with a presentation to the [Service] relating to a taxpay-er’s rights, privileges, or liabilities under [the United States taxlaws],” including “preparing and filing documents, correspondingand communicating with the [Service], and representing a clientat conferences, hearings and meetings.”285

[g] Section 10.26 — Notaries

A practitioner may not act as a notary public with respect to anymatter administered by the Service (i.e, any United States taxmatter) and for which he or she is employed as counsel or in anyway interested.286

[h] Section 10.27 — Fees

In a matter before the Service, a practitioner may not charge anunconscionable fee.287 In addition, a practitioner may not chargea contingent fee for preparing an original tax return or for advicerendered in connection with a position taken or to be taken on anoriginal tax return.288 In this context, a contingent fee is any feethat is based, in whole or in part, on whether or not a position taken

283 Reg. § 10.23 (Circular 230)(2002). 284 Reg. § 10.24(a) (Circular 230)(2002). 285 Reg. § 10.2(d)(Circular 230)(2002). 286 See Reg. § 10.26 (Circular 230)(2002). 287 Reg. § 10.27(a) (Circular 230)(2002). 288 Reg. § 10.27(b)(2) (Circular 230)(2002).




on a tax return or other filing avoids challenge by the Service oris sustained (either by the Service or in litigation).289 Such feesinclude any arrangement in which the practitioner will reimbursethe client for all or a portion of the fee in the event that a positionon a tax return or other filing is challenged by the Service or isnot sustained, whether pursuant to an indemnity agreement, aguarantee, rescission rights, or any other arrangement with a similareffect.290 According to Section 10.27, a contingent fee may becharged for preparation of or advice in connection with an amendedtax return or a claim for refund (other than a refund claim madeon an original tax return), but only if the practitioner reasonablyanticipates at the time the fee arrangement is entered into that theamended tax return or refund claim will receive substantive reviewby the Service.291

[i] Section 10.28 — Return of a Client’s Records

[i] Scope

Upon a client’s request, a practitioner must return any and allrecords necessary for the client to comply with his or her Federaltax obligations.292

[ii] Fee Disputes

If there is a fee dispute and applicable state law allow or permitsa practitioner to retain client records in the event of a fee dispute,a practitioner is required to return only those records that must beattached to the taxpayer’s return and must provide the client accessto review and copy any additional “records of the client” retainedby the practitioner that are necessary for the client to comply withhis or her Federal tax obligations.293

[iii] Definition of “Records of the Client”

“Records of the client” includes:

289 Reg. § 10.27(b)(1) (Circular 230)(2002). 290 Id. 291 Reg. § 10.27(b)(3) (Circular 230)(2002). 292 Reg. § 10.28(a) (Circular 230)(2002). 293 Id.




(1) any documents provided to the practitioner or obtained bythe practitioner in the course of the representation thatexisted prior to their retention by the practitioner;

(2) all documents prepared by the client or a third party at anytime; and

(3) any document prepared by the practitioner that was pres-ented to the client with respect to a prior representation.294

[j] Section 10.29 — Conflicting Interests

This section applies only if the practitioner’s services constitute“practice before the IRS,” as defined above under discussion ofSection 10.24. A practitioner may not represent a client in “practicebefore the IRS” if the representation involves a conflict of inter-est.295

[i] Scope

A “conflict of interest” exists if (i) the representation of one clientwill be directly adverse to the another client,296 or (ii) there is asignificant risk that the representation of one or more clients willbe materially limited by the practitioner’s responsibilities to anotherclient, a former client, or a third person or by a personal interestof the practitioner.297

[ii] Exception Where There is Informed Written Consent

A practitioner may represent a client where there is a conflictof interest if (i) the practitioner reasonably believes that thepractitioner will be able to provide competent and diligent represen-tation to each affected client,298 (ii) the representation is notprohibited by law,299 and (iii) each client gives informed writtenconsent.300

294 Reg. § 10.28(b) (Circular 230)(2002). 295 Reg. § 10.29(a) (Circular 230)(2002). 296 Reg. § 10.29(a)(1) (Circular 230)(2002). 297 Reg. § 10.29(a)(2) (Circular 230)(2002). 298 Reg. § 10.29(b)(1) (Circular 230)(2002). 299 Reg. § 10.29(b)(2) (Circular 230)(2002). 300 Reg. § 10.29(b)(3) (Circular 230)(2002).




[k] Section 10.34 — Standards for Advising with Respect to TaxReturn Positions and for Preparing or Signing Returns

Generally, if practitioner prepares or signs a return as a “taxreturn preparer,” or advises a client to take a position on a tax return,the practitioner must inform the client of the penalties “reasonablylikely to apply” with respect to the position, of any opportunity toavoid such penalty by disclosure, and of the requirements foradequate disclosure.301 This rule is modified somewhat if a practi-tioner believes that a position being taken on a return does not have“realistic possibility of being sustained on the merits” (i.e., theposition has a less than 1-in-3 chance of being sustained on itsmerits).302 In such case, if the practitioner is signing the return asa “tax return preparer,” the position must not be frivolous (i.e.,“patently improper”) and must be adequately disclosed.303 How-ever, if the practitioner is advising the client to take the positionon a tax return or is preparing a portion of the tax return of whichthe position is taken, the position must not be frivolous and thepractitioner must advise the client of any opportunity to avoid aSection 6662 accuracy-related penalty by disclosing the positionand advising as to what constitutes adequate disclosure.304

[i] Good Faith Reliance Upon Information Provided by aClient

In advising a client with respect to a position that may be takenon a tax return or in preparing or signing a return as a preparer,a practitioner may generally rely in good faith without verificationupon information furnished by the client.305 However, a practitionermay not ignore the implications of information furnished to oractually known by the practitioner and must make reasonableinquiries if the information furnished appears to be incorrect,inconsistent with an important fact or another factual assumption,or incomplete.306

301 Reg. § 10.34(b) (Circular 230)(2002). 302 See Reg. § 10.34(a) (Circular 230)(2002). 303 Id. 304 Reg. § 10.34(a)(1–2) (Circular 230)(2002). 305 Reg. § 10.34(c) (Circular 230)(2002). 306 Id.




[l] Sections 10.50 Through 10.82 — Sanctions for Violations ofCircular 230

Sanctions for violations under Circular 230 range from censureor suspension to disbarment “from practice before the IRS.”307 Apractitioner may be subject to such sanctions if he or she (i) isshown to be incompetent or disreputable, (ii) willfully and know-ingly misleads a client or prospective client with intent to defraud,(iii) willfully violates any provision of Circular 230, or (iv)recklessly or with gross incompetence violates Sections 10.33 or10.34 of Circular 230, regarding tax opinions and advice on taxreturn preparation, respectively.308

§ 6.06 PROPOSED TAX SHELTER LEGISLATION

Both houses of Congress are currently considering bills relatingto tax shelters. The proposal in the House of Representatives is titledthe “American Competitiveness and Corporate Accountability Actof 2002”309 and was introduced by Representative Thomas, theHouse Ways and Means Committee Chair, on July 12, 2002. Thebill in the Senate is known as the “CARE Act”310 and was reportedout by the Senate Finance Committee on July 19, 2002.

[1] Principle Features of the Proposed Legislation

There are several principal features common to both bills. First,both bills would create monetary penalties for taxpayers who failto disclose “reportable transactions” as required under Section6011.311 Second, both bills would increase penalties for understate-ments, tightening exceptions to understatement penalties and impos-ing higher penalties in the case of reportable and listed transactionsthat were not adequately disclosed by the taxpayer.312 Finally, bothbills require those who act as material advisors with respect to a

307 See Reg. § 10.50(a) (Circular 230)(2002). 308 Id. 309 American Competitiveness and Corporate and Accountability Act of 2002,

H.R. 5095, 107th Cong. (2002). 310 CARE Act of 2002, H.R. 7, 107th Cong. Title VI, Part II (2002). 311 Id.; American Competitiveness and Corporate and Accountability Act of 2002,

H.R. 5095, 107th Cong. (2002). 312 Id.




reportable or listed transaction to file returns with the Servicedisclosing the transactions (and imposing substantial penalties inthe case of noncompliance) and to maintain lists of advisees.313

The proposals contain no exception for attorneys or for informationthat would be protected by the attorney-client privilege, the work-product privilege, or attorney’s ethical obligations to maintain clientconfidences.314

[a] Coordination of Key Terms

Both bills would coordinate the various rules governing requireddisclosures by taxpayers and “material advisors,” the maintenanceby advisors of advisee lists, and the imposition of understatementpenalties by providing a single definition for “reportable transac-tion” and a single definition for “listed transaction.”315 All ruleswould then refer to these definitions.

[b] Definition of “Reportable Transactions”

“Reportable transactions” would be defined in treasury regula-tions to be issued under Section 6011. The current Section 6011regulations use a five-factor test, under which a reportable transac-tion is found to exist when two of the five factors are present.316

The Senate Committee on Finance report stated that the newregulations would likely follow the suggestions made in the Trea-sury’s report on abusive tax avoidance transactions.317 Thus,reportable transactions would include any transaction that involves:

(1) a significant loss;

(2) a brief holding period;

(3) marketing under conditions of confidentiality;

(4) indemnification for failure to realize the expected taxbenefits; or

(5) a book tax difference in excess of a specified threshold.318

313 Id. 314 Id. 315 Id. 316 See Temp. Treas. Reg. § 1.6011-4T(b)(3)(i). 317 CARE Act of 2002, H.R. 7, 107th Cong. Title VI, Part II (2002). 318 Id.




[c] Definition of Listed Transactions

Listed transactions would be any transaction that is the same orsimilar to any of the transactions identified by the Secretary as“listed transactions.”319

[d] Proposed Legislation to Prevent Expatriation Transactionsand Earnings Stripping

The House Bill also contains proposed legislation that wouldattack expatriation transactions by generally treating expatriatedcompanies as U.S. corporations and would change the currentearnings stripping rules in Section 163(j).320 The revisions toSection 163(j) would apply, however, to all U.S. corporations andall non-U.S. corporations with U.S. operations.321

[e] Proposed Legislation on Deferred Compensation

The House Bill also included proposed legislation that wouldalter the treatment of certain deferred compensation arrange-ments.322

§ 6.07 TAX IMPLICATIONS OF THE SARBANES-OXLEYACT

The Sarbanes-Oxley Act of 2002 (the “Act”),323 was signed intolaw on July 30, 2002. The Act has broad reaching implications forU.S. and foreign companies that are registered with the U.S.Securities and Exchange Commission and for accounting firms thataudit the financial statements of those issuers. Aspects of the Actthat have direct impact on tax departments are highlighted below.

[1] Limitation on Provision of Non-audit Services byAuditors

Under the “auditor independence rules” contained in Sections 201through 209 of the Act, a public corporation may not retain the

319 Temp. Treas. Reg. § 1.6011-4T(b)(2). 320 American Competitiveness and Corporate and Accountability Act of 2002,

H.R. 5095, 107th Cong. § 202 (2002). 321 Id. 322 Id. at § 403; 409(a). 323 Sarbanes-Oxley Act of 2002, H.R. 3763 107th Cong. (Jul. 30, 2002).




accounting firm that audits its financial statements (or any associ-ated person of that firm) to provide certain non-audit servicescontemporaneously with the audit.324 A public company is anycompany with securities registered under section 12 of the Securi-ties and Exchange Act of 1934 or that is obligated to file reportsunder section 15(d) or that has filed a registration statement withthe SEC that has not yet become effective. A person is “associatedwith” a public accounting firm if the person (i) shares in the profitsof, or receives compensation in any form from, that firm;325 or (ii)participates as an agent or otherwise on behalf of the accountingfirm in any activity of that firm.326 Thus, for example, a foreignaffiliate of a U.S. accounting firm or an associated foreign lawwould be subject to these prohibitions.

Non-audit services governed by this limitation include:

(1) bookkeeping or other services related to the accountingrecords or financial statements of the audit client;327

(2) financial information systems design and implementa-tion;328

(3) appraisal or valuation services, fairness opinions, or contri-bution-in-kind reports;329

(4) actuarial services;330

(5) internal audit outsourcing services;331

(6) management functions or human resources;332

(7) broker or dealer, investment adviser or investment bankingservices;333

(8) legal services and expert services unrelated to the audit;334

and

324 Id. at § 201(g). 325 Id. at § 2(a)(9)(i). 326 Id. at § 2(a)(9)(ii). 327 Id. at § 201(g)(1). 328 Id. at § 201(g)(2). 329 Id. at § 201(g)(3). 330 Id. at § 201(g)(4). 331 Id. at § 201(g)(5). 332 Id. at § 201(g)(6). 333 Id. at § 201(g)(7). 334 Id. at § 201(g)(8).




(9) any other service identified by the new Public CompanyAccounting Oversight Board (created by the Act).335

The accounting firm (and its associated persons) may provide anyother non-audit services (i.e., anything not specifically listedabove), including tax services, but only if the audit committee ofthe corporation’s board of directors pre-approves the activity.336

Section 201(a) of the Act specifically states that “tax services” areamong the permissible non-audit services.337 However, accountingfirms may not provide any appraisal or valuation services (even ifneeded for tax purposes) or any tax-related legal advice or ser-vices.338 For example, an accounting firm could not assist a publiccorporation in the development or documentation of a transferpricing plan or prepare a request for an advanced pricing agreement(“APA”) from the Service.

[a] Effective Date

These prohibitions will become effective sometime in 2003following commencement of operations of the Oversight Board andregistration of accounting firms.339 The prohibitions apply only toa “registered public accounting firm,” which is defined as any publicaccounting firm that has registered with the Oversight Board asrequired by the Act.340 An accounting firm may not audit a publiccorporation’s financials unless it has registered with the OversightBoard.341 Until the Oversight Board is operational, however, noaccounting firm is a “registered public accounting firm,” andtherefore the prohibition is not applicable. The Oversight Boardmust be established within 3 months of enactment of the Act andmust become operational within 6 months after it is established.342

All accounting firms must be registered within 6 months thereaf-ter.343

335 Id. at § 201(g)(9). 336 Id. at § 201(h). 337 Id. at § 201(a). 338 Id. at § 201(g). 339 Id. 340 Id. at § 2(a)(12). 341 Id. at § 102(a). 342 Id. 343 Id.




Although the prohibitions described here are not dependent onSEC rulemaking, because they are very general, the SEC is expectedto issue clarifying rules. Thus, it is important to keep in mind thatthe observations in this article are preliminary.

[2] Pre-approval of Non-audit Services by the AuditCommittee

Each non-audit service must be approved in advance of theservices commencing.344 In addition, the approval must be dis-closed to investors in the public company’s periodic reports filedwith the SEC.345 These limits apply only to the provision of non-audit services by a public accounting firm to a public companywhich it audits. These limits do not apply where an accounting firmprovides non-audit services to a non-public company or to a publiccompany that it does not audit. Under Section 301 of the Sarbanes-Oxely Act, all public companies must have established (by April26, 2003) an “audit committee” of the board of directors composedentirely of independent directors.346 The SEC is also required todirect public companies to disclose in periodic reports whether theaudit committee includes at least one “financial expert,” and if itdoes not, then it is required to explain its reasons for not doingso.347

[a] Specificity of the Approval

The legislation leaves the issue as to how specific a pre-approvalmust be to the discretion of Oversight Board.348 However, thelegislative history indicates that each non-audit service must be“specifically identified” and that the audit committee may notsimply give a blanket pre-approval for any permitted non-auditservice of for any non-audit service that management determinesappropriate.349

344 Id. at § 201(h). 345 Id. at § 202(i)(2). 346 Id. at § 301(m)(3). 347 Id. at § 407(a). 348 Id. at § 202(i)(4). 349 See S. Rep. No. 107-20 at 20 (2001).




[b] Delegation of Pre-approval Authority

The audit committee is permitted to delegate pre-approval author-ity to a sub-committee of one or more members.350 This delegationis intended to facilitate obtaining the requisite approval in a timelymanner.351

[c] Advance Approvals

Can a pre-approval become “stale”? It is not clear how far inadvance an audit committee may properly give its approval.

The Act does not specify and leaves this issue to the discretion ofthe Oversight Board.352 However, legislative history suggests aone-year advance approval might be an acceptable limit.

[d] De Minimis Exception

The legislation provides a narrow de minimis exception from pre-approval for non-auditing services.353 Specifically, the requirementthat non-audit services be pre-approved will be waived if:

(1) the issuer did not recognize the services to be provided asnon-audit services at the time of the engagement;354

(2) the aggregate amount of all non-audit services provided tothe issuer represents nor more than 5 percent of the totalamount of revenues paid by the issuer to its auditor duringthe fiscal year in which the non-audit services are provid-ed;355 and

(3) the audit committee approves the provision of such servicesbefore the audit is completed.356

350 Id. at § 202(i)(3). 351 Id. 352 Id. at § 202. 353 Id. at § 202(i)(1)(B). 354 Id. at § 202(i)(1)(B)(ii). 355 Id. at § 202(i)(1)(B)(i). 356 Id. at § 202(i)(1)(B)(iii).




[3] Current Restrictions on Non-audit Services asCompared to the Act’s Limitations on the Provision ofNon-audit Services

The current rules regarding restrictions on non-audit services arein 17 C.F.R. Reg. section 210.2-01.357 These rules remain in effectuntil superceded by the Act, when its provisions become effective(i.e., after the Oversight Board becomes operational and the ac-counting firm has registered). Similar to the Act, under Section210.2-01(c)(4), a public company’s independent accountant is alsogenerally prohibited from providing the “non-audit services” listedabove.358 However, there are several important exceptions:

(1) Bookkeeping or other services related to the accountingrecords or financial statements of the company may beprovided to foreign divisions or subsidiaries of the auditclient in certain situations.359

(2) Appraisal or valuation services may be provided if per-formed in the context of the planning and implementationof a tax-planning strategy or for tax compliance servicesor for non-financial purposes.360

(3) Legal services may be provided so long as the personproviding the service does not need to be admitted topractice in the U.S. — in other words, any non-U.S. legalservices may be provided.361

(4) Internal audit services may be provided if they representless than 40% of the client’s annual internal audit activi-ties.362

Under the current rules, a violation will only result in the auditorno longer being considered “independent” and the audit report notsatisfying the SEC requirements for audit reports. A violation ofthe Act, on the other hand, is a violation of law.

357 17 C.F.R. § 210.2-01(Feb. 5, 2001). 358 See 17 C.F.R. § 210.2-01(c)(4) (Feb. 5, 2001). 359 17 C.F.R. § 210.2-01(c)(4)(i)(B)(2)(Feb. 5, 2001). 360 17 C.F.R. § 210.2-01(c)(4)(iii)(B)(3)(Feb. 5, 2001). 361 17 C.F.R. § 210.2-01(c)(4)(ix)(Feb. 5, 2001). 362 17 C.F.R. § 210.2-01(c)(4)(v)(A)(Feb. 5, 2001).




[4] Effect of the Act’s Non-audit Services Restrictions onNon-registered Accounting Firms and Companies thatAre Not SEC Registrants

Section 109 of the Act calls on State regulatory authorities toindependently determine what standards should apply to nonregis-tered public accounting firms that are supervised by State regulatoryauthorities.363

[5] Under the Act, the CEO and CFO Must PersonallyAttest to the Accuracy of the Company’s FinancialStatements and Periodic Reports with the SEC

Section 302 of Act directs the SEC by rule, to require a publiccompany’s CEO and CFO to personally attest in each annual andquarterly report filed with the SEC that:

(1) the signing officer has reviewed the report;364

(2) based upon the officer’s knowledge, the report does notcontain any untrue statement of material fact or omit to statea material fact necessary in order to make the statementsmade not misleading;365

(3) based upon such officer’s knowledge, the financial state-ments fairly present in all material respects the financialcondition and results of operations of the issuer;366 and

(4) the officer is responsible for establishing and maintaininginternal controls,367 that those internal controls are de-signed to ensure that material information relating to theissuer is made known to the officers,368 that the signingofficers have evaluated the effectiveness of the internalcontrols in the prior 90 days369 and presented in their reporttheir conclusions and any changes in the internal controlssubsequent to the evaluation,370 and have disclosed to the

363 Sarbanes-Oxley Act of 2002, H.R. 3763 107th Cong. § 209 (Jul. 30, 2002).364 Id. at § 302(a)(1) 365 Id. at § 302(a)(2). 366 Id. at § 302(a)(3). 367 Id. at § 302(a)(4)(A). 368 Id. at § 302(a)(4)(B). 369 Id. at § 302(a)(4)(C). 370 Id. at § 302(a)(4)(D).




auditors any deficiencies371 and any fraud (whether or notmaterial) that involves employees who have a significantrole in the internal controls.372

In response to this, some CEO’s and CFO’s have already insistedthat other employees who have a significant role in the internal rolesand in the preparation of the books and records and financialstatements provide similar certifications to the CEO and CFO, toback up the certifications given by the CEO and CFO. Similarly,public companies also must maintain disclosure controls. In additionto internal accounting controls, the company’s tax directors maybe given specific responsibility in that connection as well. CEOsand CFOs also must certify that they have evaluated these controls.

Section 906 of the Act contains a separate provision requiringthe CEO and CFO to certify, in each “periodic report containingfinancial statements” filed with the SEC that the periodic report“fully complies” (without a materiality qualifier) with the require-ments of Section 13(a) or 15(d) of the Securities and Exchange Actof 1934 and that “information contained in the periodic report fairlypresents, in all material respects, the financial condition and resultsof operations” of the company.373 This certification is not limitedto the financial statements (as the certification under Section 302is).374 Violation of this provision results in criminal penalties: ifa party certifies a report knowing that the certification is inaccurate,a fine of up to $1 million and a term of imprisonment for up to10 years may be imposed;375 if the improper certification is made“willfully” by a party, the penalties can reach a fine up to $5 millionand a term of imprisonment up to 20 years.376 A violation ofSection 302, on the other hand, is a civil violation. Both of thesecertification requirements are different from the one-time SEC orderthat required Fortune 1000 certifications generally by August 14,2002.

371 Id. at § 302(a)(5)(A). 372 Id. at § 302(a)(5)(B). 373 Id. at § 906(b). 374 Id. 375 Id. at § 906(c)(1). 376 Id. at § 906(c)(2).




[6] Companies May Not Avoid the Act by Expatriating

Section 302(b) specifically states that a reincorporation or anyother transaction that results in the transfer of the corporate domicileor offices of the issuer to outside of the U.S. will not lessen thelegal force of these certifications.377

[7] Changes in Financial Statement Disclosures of Off-balance Sheet Transactions and the Use of SpecialPurpose Entities

Section 401 of the Act requires the SEC to issue rules (by January26, 2003) requiring that annual and quarterly reports filed with theSEC disclose all material off-balance sheet transactions, arrange-ments, obligations (including contingent obligations) and otherrelationships of the issuer with unconsolidated entities or otherpersons that may have a material current or future effect on financialcondition, changes in financial condition, results of operations,liquidity, capital expenditures, capital resources or significantcomponents of revenues or expenses.378

The SEC is also required, under Section 401(c) of the Act toconduct a study of the effectiveness of the new off-balance sheetdisclosure rules to determine (i) the extent of off-balance sheettransactions, including assets, liabilities, leases, losses and the useof special purposes entities;379 and (ii) whether generally acceptedaccounting rules result in financial statements reflecting the eco-nomics of off-balance sheet transactions to investors in a transparentfashion.380

[8] Fraudulently Influencing Accountants in Relation to theAudit Report

Section 303 of Act makes it unlawful for any officer or directorof the issuer (or any person acting under their direction) to takeany action to fraudulently influence, coerce, manipulate, or misleadany accountant engaged in preparing an audit for the purpose ofrendering the audit report misleading.381

377 Id. at § 302(b). 378 Id. at § 401(a)(j). 379 Id. at § 401(c)(1)(A). 380 Id. at § 401(c)(1)(B). 381 Id. at § 303(a).




[9] Transfer of Employees from Accounting Firm to thePublic Company

Any employee of accounting firm who worked on the issuer’saudit must wait one year before becoming employed by the issuerin a “senior management capacity.”382 Presumably, this wouldapply to a tax director, but not to someone who is employed undera tax director.

[10] Application of the Act to Non-U.S. Accounting Firms

The Sarbanes-Oxely Act applies to any foreign public accountingfirm that audits a public company that is subject to U.S. securitieslaws.383 The Board is also authorized to determine that the Actapplies to any other foreign public accounting firm (or class of suchfirms) that does not issue the audit report of the public companybut plays “a substantial role in the preparation and furnishing of”the audit report.384

[11] Will Corporate Tax Returns Have to be Signed by theCEO?

Section 1001 of Act provides “[i]t is the sense of the Senate thatthe Federal income tax returns of a corporation should be signedby the chief executive officer.” Under proposed Senate Bill 1971(National Employee Savings and Trust Equity Guarantee bill,pension reform legislation) Section 6062 of the Code would beamended to require the CEO to sign the corporate tax return.385

However, this proposal is not included in the draft tax shelterlegislation proposed by the House or the Senate prior to their August2002 recess.386 If this legislation is passed and the CEO is requiredto sign the return, the tax department and/or the tax return preparerswill most likely need to provide the CEO with a detailed explanationof the return and the tax treatment of the companies operations.387

382 Id at § 206(l). 383 Id. at § 106(a)(1). 384 Id. at § 106(a)(2). 385 Section 511 of S. 1971. 386 See American Competitiveness and Corporate and Accountability Act of 2002,

H.R. 5095, 107th Cong. (2002); CARE Act of 2002, 107th Cong. (2002). 387 A point argued in the letter the Tax Executive’s Institute made in a letter

to Senators Baucus and Grassley urging them not to pass such legislation. (August22, 2002).





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