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M&A Tax Update Recent Developments

M&A Tax Update Recent Developments. Alan Barton February 27, 2004. Recent Developments. Section 382 – Notice 2003-65 Section 108 – Treas. Reg. Sections 1.108-7T and 1.1502-28T Section 338(h)(10) – Treas. Reg. 1.338(h)(10)-1T

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M&A Tax Update Recent Developments

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  1. M&A Tax UpdateRecent Developments Alan BartonFebruary 27, 2004

  2. Recent Developments • Section 382 – Notice 2003-65 • Section 108 – Treas. Reg. Sections 1.108-7T and 1.1502-28T • Section 338(h)(10) – Treas. Reg. 1.338(h)(10)-1T • Section 355 – Rev. Proc. 2003-48 and Rev. Ruls. 2004-23, 2003-74, 2003-75 & 2003-79

  3. Section 382 – Notice 2003-65

  4. Section 382(h) • Section 382 Ownership Change • Net Unrealized Built-in Gains (Losses) • Recognized Built-in Gains (Losses) • Built-in Income and Deduction Items • No Regulations / Limited Guidance on Built-in Income and Deduction Items

  5. Notice 2003-65 • Identification of Built-in items for purposes of Section 382(h) • Two Methods • Section 1374 Approach • Section 338 Approach • Can use either approach for each ownership change • Retroactive Application

  6. Notice 2003-65 - Section 1374 Approach • Identifies built-in items by incorporating the rules of section 1374. • NUBIG or NUBIL is the net amount of gain or loss that would be recognized in a hypothetical sale of the assets of the loss corporation immediately before the ownership change. • This approach generally treats items of income and deduction as attributable to the pre-change period if such items accrue for tax purposes prior to the ownership change. • This approach may be preferable for those taxpayers seeking to avoid characterization of deductions (including contingent liabilities) as recognized built-in losses.

  7. Notice 2003-65 – Section 338 Approach • NUBIG or NUBIL is calculated in the same manner as under the section 1374 approach – NUBIG or NUBIL is not redetermined for contingent consideration (including contingent liabilities). • Identifies built-in items by comparing the loss corporation’s actual items of income, gain, deduction and loss with those that would have resulted if the loss corporation had been acquired in a section 338 election transaction on the ownership change date. • Additional income resulting from forgone depreciation or amortization on a wasting asset can be treated as recognized built-in gain, and deductions for liabilities that were contingent on the change date can be treated as built-in losses, even though neither such item accrues for tax purposes prior to the ownership change. • This approach may be preferable for those taxpayers seeking to treat income generated by wasting assets as recognized built-in gain.

  8. Notice 2003-65 – Examples Ownership Change LossCo 1 NUBIL Position Contingent Tort Liability Ownership Change NOL Carryforwards NUBIG Position High Value Low Basis Goodwill LossCo 2

  9. Section 108

  10. Section 108 • Gross Income includes Cancellation of Debt Income • Cancellation of Debt Income Excluded under Section 108(a) • Bankruptcy • Insolvency • Attributes are Reduced under Section 108(b) • Net operating losses, general business credits, minimum tax credits, capital losses • Basis • Passive activity losses and credits, foreign tax credits • Timing of attribute reduction • Net operating losses and other attributes • Basis

  11. Treas. Reg. 1.108-7T • Timing of Section 108(b) attribute reduction – NOL Carrybacks • Basis reduction and Section 381 Transactions • “G” Reorganizations • FSA 200145009 • House Report of the Bankruptcy Tax Act of 1980 • Effective for discharges occurring after July 17, 2003

  12. Section 108 – Consolidated Return Groups • Government’s initial position on attribute reduction: • PLR 9121017 • Reduction of attributes under section 108(b) should be made on a separate company basis • Government’s recent position on attribute reduction: • FSA 199912007 • CCA 200149008 • Reduction of attributes under section 108(b) should be made on a consolidated basis

  13. Treas. Reg. 1.1502-28T • Determination of Insolvency – Separate Company • Attribute Reduction – Ordering Rule • Debtor Member’s Tax Attributes • Look Through Rule • Consolidated Tax Attributes • Effective for discharges occurring after August 29, 2003

  14. Section 338(h)(10)

  15. Section 338 • New Final and Temporary Regulations • Address interplay between Section 338(h)(10) and step transaction doctrine • Alleviates confusion caused by a series of IRS rulings • Rev. Rul. 90-95 • Rev. Rul. 2001-46

  16. Revenue Ruling 90-95 P S/Hs Former T S/Hs P T S/Hs 100% Cash P Merge S T Merge T Acquisition Merger Upstream Merger

  17. Revenue Ruling 90-95 • Rev. Rul. 90-95: • First step QSP accorded independent significance from second step liquidation. Cites Congressional intent that a Section 338 election replace any non-statutory treatment of a stock purchase as an asset purchase under Kimbell Diamond doctrine.

  18. Revenue Ruling 2001-46 • Issues addressed in Rev. Rul. 2001-46 • The Issue: • After Rev. Rul. 90-95, it was unclear what tax result prevailed when a first step taxable acquisition was followed by a second step merger (or other asset transfer) that could recast the transaction into a reorganization. • Practitioners argued that a first step QSP had independent significance from any future step.

  19. Revenue Ruling 2001-46 X s/h’s T s/h’s X s/h’s T s/h’s X 70% X stock; 30% Cash X 2. Merger Up 1. Merger Y T T X s/h’s T s/h’s X 3. Resulting Structure

  20. Revenue Ruling 2001-46 • Rev. Rul. 2001-46 • Situation 1: X owns all of Y, a newco. Pursuant to an integrated plan, X acquires all of T in a merger of T and Y, with T surviving. In the merger, shareholders of T receive 70% X stock and 30% cash. As part of the plan, X then merges T upstream. • First step would not qualify as a “B” reorg. as solely rule is violated and does not qualify as an (a)(2)(E) because that section requires that at least 80% of the acquisition consideration be in the form of voting stock. • Viewed as a merger into X, however, the more liberal COSI standard is met.

  21. Revenue Ruling 2001-46 • Issues addressed in Rev. Rul. 2001-46 • Conclusion: Policies underlying Section 338 not violated by treating Situation 1 as a single statutory merger that qualifies as a reorganization because X acquires the assets with a carryover basis under sec. 362, not cost basis under sec. 1012. Thus, steps do not have independent significance. • However, ruling was given only prospective application. • Situation 2: Same as Situation 1 except that T shareholders receive solely X voting stock. • Subsidiary merger would have qualified as an (a)(2)(E) by itself. Service holds that this difference should not change the result in Situation 1 – i.e., treated as a direct merger into parent.

  22. Reg. Section 1.338(h)(10)-1T • Issued in response to comments urging IRS and Treasury to allow Section 338(h)(10) elections in transactions identical to Situation 1 of Rev. Rul. 2001-46. • Regulations give effect to Section 338(h)(10) in multi-step transactions where a purchasing corporation’s initial acquisition of target’s stock viewed independently, constitutes a qualified stock purchase (QSP). • Step transaction doctrine will not be applied in such transactions if a valid Section 338(h)(10) election is made. • 4 new examples (11-14) were added to the Section 338(h)(10) regulations • Allows for greater flexibility in structuring and planning – Elective Carryover or Section 338(h)(10) Treatment • Effective July 9, 2003

  23. Example 11 S/Hs S P S P 50% P Voting Stock 50% Cash Merge Y T T Merge Stock Acquisition - Viewed Independently, constitutes a qualified stock purchase. No Section 338(h)(10) election made. Upstream Merger - Viewed independently qualifies as a Section 332 liquidation.

  24. Example 11 • New regulation does not apply since no valid Section 338(h)(10) election was made. • Treated as a tax-free reorganization under Section 368(a).

  25. Example 12 S/Hs S S P P 50% P Voting Stock 50% Cash Merge T Y T Merge Stock Acquisition - Viewed Independently, constitutes a qualified stock purchase. P and S make a valid joint Section 338(h)(10) election for T. Upstream Merger - Viewed independently qualifies as a Section 332 liquidation.

  26. Example 12 • Application of the step transaction doctrine results in the 2 step transaction being treated as P’s acquisition of T’s assets in a tax-free reorganization • Applying new regulations: • Since a valid Section 338(h)(10) election was made, step transaction doctrine does not apply and P’s acquisition of T stock treated as a QSP and not a tax-free reorganization under Section 368(a).

  27. Example 13 S S/Hs S P 50% P Voting Stock 50% Cash P X Y T Merge X T Merge Stock Acquisition - Viewed Independently, constitutes a qualified stock purchase. P and S make a valid joint Section 338(h)(10) election for T. Brother-Sister Merger - Viewed independently qualifies as a reorganization under Section 368(a).

  28. Example 13 • Application of the step transaction doctrine results in the 2 step transaction being treated as P’s acquisition of T’s assets in a tax-free reorganization • Applying new regulations: • Since a valid Section 338(h)(10) election was made, step transaction doctrine does not apply and P’s acquisition of T stock treated as a QSP and not a tax-free reorganization under Section 368(a).

  29. Example 14 • Same facts as Example 12, except S (T’s shareholder) receives only P voting stock as consideration for merger of Y into T. • No Section 338(h)(10) election can be made since, viewed independently, Y’s merger into T does not constitute a QSP since S receives only P voting stock and transaction independently is a tax-free reorganization. • New regulations do not apply. • Step transaction doctrine applies. • 2 step transaction treated as one tax-free reorganization under Section 368(a).

  30. Change to Form 8023 • October 2002 • Form 8023 – Election Statement • Form 8883 – Asset Allocation Statement

  31. Section 355

  32. Section 355 • No gain or loss is recognized by the distributing corporation (D) or its shareholders on a distribution of a controlled subsidiary (C) • Requirements • D must Control C before the distribution • Distribution must not be a Device for the distribution of E&P of D or C • Must be a Continuity of Interest on the part of the D shareholders after the distribution • Must be a Valid Business Purpose for the distribution • D and C must each engage in the Active Conduct of a Five-Year Trade or Business immediately after the distribution • Section 355(e) – D will recognize gain on the distribution if there is a 50% or greater change in the ownership of either D or C that is treated as part of a plan (or series of related transactions) that includes the distribution

  33. Section 355 • As a result of the significant tax exposure to D and its shareholders, taxpayers frequently seek private letter rulings from the IRS regarding the qualification of the distribution under section 355 • Rev. Proc. 96-30 • Contains the checklist questionnaire of information that must be included in a request for ruling under Section 355 • Appendix A – Business purposes guidelines, e.g., “fit and focus” • Rev. Proc. 2003-3 • IRS will not rule on issues that are primarily factual • Active Trade or Business – Where FMV of active trade or business assets is less than 5% of total FMV of gross assets of corporation, IRS will ordinarily not rule that active business requirement of section 355 is met

  34. Rev. Proc. 2003-48 • IRS will not rule on business purpose, device, or acquisition “pursuant to a plan” (section 355(e)) • Taxpayers requesting rulings will have to make representations regarding the satisfaction of the business purpose, device and section 355(e) issues. • IRS views these issues as “primarily factual”; best left for audit • Deletes Appendix A of Rev. Proc. 96-30, and Section 4.01(30) of Rev. Proc. 2003-3 (the less than 5% FMV active trade or business assets no rule area) • IRS will focus on increasing published guidance regarding business purpose and other section 355 legal questions • One year pilot program

  35. Recent Section 355 Rulings • Revenue Ruling 2004-23 – Business Purpose – Increase in Aggregate Value of Stock of Distributing and Controlled • Revenue Ruling 2003-74 – “Fit and Focus” – Management Problems • Revenue Ruling 2003-75 – “Fit and Focus” – Capital Allocation Problems • Revenue Ruling 2003-79 – “C” Reorg Following Spin

  36. Rev. Rul. 2004-23 – Increase in Stock Value • Corporate Business Purpose satisfied even though the Distribution is expected to confer a benefit to existing shareholders • Stock of Distributing and Controlled likely would, in the aggregate, have a higher trading price than the stock of Distributing if it continued to own Controlled • The benefit of the increased aggregate value is a real and substantial benefit to Distributing, Controlled or both (enhanced equity based compensation or facilitates future acquisitions in a manner that preserves capital with less dilution of existing shareholders’ interests) • Distributing’s directors do not effect the Distribution to facilitate any particular shareholder’s disposition of the stock of Distributing or Controlled

  37. Rev. Rul. 2003-74 - “Fit & Focus” - Management • Distributing engaged in high-growth software technology business • Controlled engaged in slow-growth paper products business • One 8% shareholder not involved in management • Senior management wants to concentrate solely on software • 2 shared directors – 1 with unlimited term – not officers

  38. Rev. Rul. 2003-75 - “Fit & Focus” - Capital • Distributing in pharmaceuticals and Controlled in cosmetics • One 6% non-management shareholder • Businesses compete for capital • Controlled will have direct access to capital if spun off • Continuing relationships – administrative, tax – for 2 years with limited extension

  39. Rev. Rul. 2003-79 – “C” Reorg Following Spin • D conducts Businesses X and Y of equal value • Unrelated A wants to acquire Business X but not Business Y • D transfers Business X to newco C • D spins off C to its shareholders • A acquires C assets in exchange for A voting stock (not a merger) and C liquidates

  40. Revenue Ruling 2003-79 Shldrs Shldrs A voting stock D A D C A Bus Y Bus X “C” reorg C Bus X

  41. Revenue Ruling 2003-79 • Issue Addressed: Is the “substantially all of the properties requirement” of a “C” reorganization met on C’s transfer of Business X to A? • Issue Assumed: D distributed “stock of a controlled corporation” – so a good spin-off • Apparent violation of doctrine that transitory existence of a corporation formed solely to effect an acquisition should be disregarded

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