199905008
Tax Avoidance Purpose v. No Avoidance Purpose
DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224
CC:DOM:FS:CORP
October 29, 1998
T-N-4117-98
Number: 199905008
Release Date: 2/5/1999
UILC: 357.01-00
INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE
MEMORANDUM FOR JAMES E. GRAY
SENIOR ATTORNEY CC:SER:NCS:GBO
FROM:
DEBORAH A. BUTLER
ASSISTANT CHIEF COUNSEL CC:DOM:FS
SUBJECT:
This Field Service Advice responds to your memorandum dated July 24, 1998.
Field Service Advice is not binding on Examination or Appeals and is not a final
case determination. This document is not to be cited as precedent.
LEGEND:
P
=
S1
=
X
=
S2
=
S3
=
S4
=
Date 1
=
Date 2
=
Date 3
=
Date 4
=
Month 1
=
Month 2
=
2
Year 1
=
Year 2
=
$a
=
$b
=
$c
=
$d
=
$e
=
$f
=
$g
=
$h
=
$i
=
$j
=
$k
=
$l
=
A
=
B
=
C
=
D
=
E
=
F
=
G
=
H
=
I
=
ISSUE(S):
Whether S1 properly calculated its basis in the S2 stock it received from S2, in
exchange for the S4 note, the S3 stock and the assumption by S2 of the contingent
liabilities, for purposes of determining the amount of its loss on the subsequent sale
of its S2 stock to an unrelated party. More specifically, whether the Service can
apply I.R.C. § 357(b) to reduce S1's basis in the S2 stock it received in the initial
exchange.
CONCLUSION:
We do not recommend that the Service argue that I.R.C. § 357(b) applies to the
exchange because, even if it does, such section would not have any effect on S1's
basis in its S2 stock.
3
However, for the reasons noted below, we recommend that the Service argue that
the transfer, followed by S1's sale of its S2 stock, did not meet the business
purpose requirement of I.R.C. § 351(a). In that case, S1 would realize a loss on the
sale of its property to S2, which would not be taken into account until either the
property or S2 left the group. S1's sale of its S2 stock did not cause S2 to leave
the group. Moreover, the property also stayed within the group.
As a result of the sale, S1 would take a basis in the S2 stock it received in the
exchange equal to the value of such stock. We do not know what value S1 might
assign to such stock. Because S1 and S2 are affiliated, any value assigned to the
S2 stock by the parties can not be presumed to reflect the fair market value of that
stock. However, several months after this exchange, S1 sold the S2 stock for $i. If
there was no substantial change in the circumstances of S2 during this period, then
the Service has a reasonable argument that $i also represents the fair market value
of the S2 stock at the time it was issued to S1 in the exchange. In that case, when
S1 sold its S2 stock, S1 would not recognize any gain or loss.
FACTS:
P is the common parent of an affiliated group of corporations filing a consolidated
Federal income tax return. P owns all of the stock of S1.
As of Date 1, there were tort claims against S1. S1's estimated exposure was $a
before considering insurance coverage and $b million after taking into account
insurance coverage. Through Year 1 all paid-out claims were paid from insurance.
X had been a wholly owned subsidiary of P for more than A years, but had been
dormant for a number of years prior to Date 2. On Date 2, X changed its name to
S2.
On Date 3, S2 amended its charter, increasing its authorized capital stock to B
shares of common stock and C shares of voting preferred stock. According to the
taxpayer, this charter amendment was done to facilitate the operation of S2 as a
litigation management company with equity participation by third-party investors,
including independent lawyers who defend S1 and S3 in tort liability actions.
On Date 4, P contributed to S2:
(1) $c in cash in exchange for D shares of S2 common stock. P already owned E
shares of S2 common stock, bringing its total to F shares.; and
(2) $d in cash in exchange for G shares of voting preferred stock.
4
Also on Date 4, S1 contributed to S2:
(A) a note in the amount of $e due to S1 from a related corporation, S4;
(B) all of the outstanding shares of S3, valued at $f; and
(C) the beneficial rights to all future insurance recoveries with respect to S1’s tort
obligations and certain other assets relating to the defense of S1’s tort obligations,
which were valued at H.
In exchange for the assets contributed to S2 pursuant to steps (A) - (C), S1
received F shares of S2 common stock and S2’s assumption of S1’s liability for the
defense and payment of S1’s tort obligations, including S3’s tort obligations.
In Month 2 of Year 2, S1 sold I shares of its S2 stock to one unrelated party and the
remaining I shares to another unrelated party. After these sales, S2 continued to
be a member of the P group (because of P’s ownership of S2's voting preferred
stock). In the case of each sale, the consideration was $g. S1 reported a total
capital loss of $h, determined as follows: S1 received consideration for the S2 stock
in the amount of $i and its basis in the S2 stock was $j, its exchanged basis
determined under I.R.C. § 358 by reference to the $e basis in the note and the $k
basis in the S3 stock.
In Month 1 of Year 2, P sold all of the stock of three subsidiaries to an unrelated
party and recognized capital gain of approximately $l. This gain was fully offset by
P’s capital loss upon the subsequent sale by S1 of some of its S2 stock. In fact,
you believe that the transfer of assets by P and S1 to S2, followed by S1’s sale of
its S2 stock appear to have been structured to generate a substantial tax benefit to
the taxpayer with no apparent bona fide business purpose.
You have asked whether S1 properly ignored the contingent tort liabilities in
computing its basis in its S2 stock. In considering this issue, you note that Rev.
Rul. 95-74, 1995-2 C.B. 36, concludes that certain contingent liabilities assumed by
a transferee in an I.R.C. § 351 exchange are not liabilities for purposes of I.R.C.
§ 357(c)(1) and 358(d). You also note that the holding of Rev. Rul. 95-74 is limited
to transactions that do not have a tax avoidance motive within the meaning of I.R.C.
§ 357(b). As noted above, you believe that the P group undertook the transfer of
assets followed by the sale for tax avoidance motives. Thus, you have also asked
whether, under these circumstances, Rev. Rul. 95-74 applies to the facts of this
case.
5
LAW AND ANALYSIS
I.R.C. § 351
Law and Other Authorities
I.R.C. § 351(a) provides that no gain or loss shall be recognized if property is
transferred to a corporation by a person solely in exchange for stock in such
corporation and immediately after the exchange such person is in control of the
corporation.
I.R.C. § 351(b) provides that if I.R.C. § 351(a) would apply to an exchange but for
the fact that there is received, in addition to the stock permitted to be received
under I.R.C. § 351(a), other property or money, then, gain (if any) to such recipient
shall be recognized, but not in excess of the amount of money received, plus the
fair market value of such other property received, and no loss to such recipient
shall be recognized.
I.R.C. § 357(a) provides that, except as provided in I.R.C. § 357(b), if the taxpayer
receives property which would be permitted to be received under I.R.C. § 351
without the recognition of gain if it were the sole consideration and, as part of the
consideration, another party to the exchange assumes a liability of the taxpayer,
then such assumption shall not be treated as money or other property and shall not
prevent the exchange from being within the provisions of I.R.C. § 351.
I.R.C. § 357(b) provides that if, taking into consideration the nature of the liability
and the circumstances in the light of which the arrangement for the assumption was
made, it appears that the principal purpose of the taxpayer with respect to the
assumption described in I.R.C. § 357(a) was a purpose to avoid Federal income tax
on the exchange, or if not such a purpose, was not a bona fide business purpose,
then such assumption shall, for purposes of I.R.C. § 351, be considered as money
received by the taxpayer on the exchange.
I.R.C. § 357(c)(1) provides that in the case of an exchange (A) to which I.R.C.
§ 351 applies, or (B) to which I.R.C. § 361 applies by reason of a plan of
reorganization within the meaning of I.R.C. § 368(a)(1)(D), if the sum of the amount
of the liabilities assumed, plus the amount of the liabilities to which the property is
subject, exceeds the total of the adjusted basis of the property transferred pursuant
to such exchange, then such excess shall be considered as a gain from the sale or
exchange of a capital asset or of property which is not a capital asset, as the case
may be.
6
I.R.C. § 357(c)(2) provides that I.R.C. § 357(c)(1) shall not apply to any exchange
(A) to which I.R.C. § 357(b)(1) applies, or (B) which is pursuant to a plan of
reorganization within the meaning of I.R.C. § 368(a)(1)(G) where no former
shareholder of the transferor corporation receives any consideration for his stock.
I.R.C. § 357(c)(3)(A) provides that if a taxpayer transfers, in an exchange to which
I.R.C. § 351 applies, a liability the payment of which either (i) would give rise to a
deduction, or (ii) would be described in I.R.C. § 736(a), then, for purposes of I.R.C.
§ 357(c)(1), the amount of such liability shall be excluded in determining the
amount of liabilities assumed or to which the property transferred is subject.
I.R.C. § 357(c)(3)(B) provides that I.R.C. § 357(c)(3)(A) shall not apply to any
liability to the extent that the incurrence of the liability resulted in the creation of, or
increase in, the basis of any property.
I.R.C. § 358(a)(1) provides that, in the case of an exchange to which I.R.C. § 351,
354, 355, 356, or 361 applies, the basis of property permitted to be received under
such section without the recognition of gain or loss (i.e., the stock of the transferee
corporation) shall be the same as that of the property exchanged, decreased by the
amount of money received by the taxpayer, and increased by the amount of gain to
the taxpayer which was recognized on such exchange.
I.R.C. § 358(d)(1) provides that where, as part of the consideration to the taxpayer,
another party to the exchange assumed a liability of the taxpayer or acquired from
the taxpayer property subject to a liability, such assumption or acquisition (in the
amount of the liability) shall, for purposes of I.R.C. § 358, be treated as money
received by the taxpayer on the exchange.
I.R.C. § 358(d)(2) provides that I.R.C. § 358(d)(1) shall not apply to the amount of
any liability excluded under I.R.C. § 357(c)(3).
I.R.C. § 368(c) provided that, for purposes of I.R.C. § 351, the term "control" means
the ownership of stock possessing at least 80% of the total combined voting power
of all classes of stock entitled to vote and at least 80% of the total number of shares
of all other classes of stock of the corporation.
Treas. Reg. § 1.1502-34 provides that, for purposes of Treas. Reg. §§ 1.1502-1
through 1.1502-80, in determining the stock ownership of a member of the group in
another corporation (the “issuing corporation”) for purposes of determining the
application of, e.g., I.R.C. § 351(a) in a consolidated return year, there shall be
included stock owned by all other members of the group in the issuing corporation.
7
1 Of course, if such liability is not taken into account currently, then there is no
argument that it can reduce basis currently.
Rev. Rul. 95-74, 1995-2 C.B. 36
The relevant facts of Rev. Rul. 95-74 are that a transferor owns a manufacturing
business, including the land upon which the business sits. Since that corporation
acquired the land, it has become polluted as a result of the manufacturing business.
For valid business reasons, the corporation transfers the manufacturing business,
including the land, to a newly-formed subsidiary in exchange for all of the stock of
that subsidiary and the assumption by the subsidiary of the liabilities associated
with the transferred assets, including the environmental liabilities. The transferor
has no plan or intention to dispose of (or have the subsidiary issue) any subsidiary
stock.
Rev. Rul. 95-74 noted that the contingent environmental liabilities had not been
taken into account, within the meaning of I.R.C. § 357(c)(3), by the transferor prior
to the transfer. Consequently, Rev. Rul. 95-74 held that these liabilities are not
included in determining whether the amount of liabilities assumed by the subsidiary
exceeds the adjusted basis of the property transferred by the transferor, within the
meaning of I.R.C. § 357(c)(1).
In addition, Rev. Rul. 95-74 noted that any liabilities that are not included in the
determination under I.R.C. § 357(c)(1) are also not included in the I.R.C. § 358
determination of the transferor’s basis in the stock received in the I.R.C. § 351
exchange. Therefore, Rev. Rul. 95-74 held that the transferor does not reduce its
basis in its subsidiary stock by the amount of such liabilities.
Analysis
As a threshold matter, we note that this case potentially raises the issue of whether
a contingent liability is the type of liability that is to be taken into account currently
under I.R.C. §§ 357 and 358. However, because of the specific language of I.R.C.
§§ 357(c)(3) and 358(d)(2), as interpreted by Rev. Rul. 95-74, 1995-2 C. B. 36, we
do not believe it is necessary to address this broader issue. That is, we will
assume for purposes of the following discussion that such contingent liability is the
type of liability to be taken into account currently under I.R.C. §§ 357 and 358.1
Section 351(a) provides that no gain or loss shall be recognized if property (i.e., the
cash from P, and the S4 note and the S3 stock from S1 ) is transferred to a
corporation (i.e., S2) by members of a consolidated group (i.e., P and S1) solely in
exchange for voting stock in S2 and immediately after the exchange P and S1 are
8
2 Of course, S1 subsequently sold all of its S2 stock to an unrelated party.
However, even if the facts were to indicate that that sale should be taken into account
in determining whether the I.R.C. § 368(c) control requirement for the I.R.C. § 351
exchange was satisfied, P’s continuing ownership of its S2 common and voting
preferred stock appears to have assured that that requirement was satisfied.
in control of S2 (as defined in I.R.C. § 368(c) and Treas. Reg. § 1.1502-34). For
purposes of I.R.C. § 351(a), I.R.C. § 368(c) defines control as the ownership of at
least 80% of the outstanding voting stock of the transferee corporation (i.e., S2).
For purposes of these two sections, Treas. Reg. § 1.1502-34 provides that any
stock of S2 owned by the members of the P group are included. In other words, it is
not necessary for any one member of the P group to meet the control requirement
of I.R.C. § 368(c). In this case, of course, P and S1 initially own all of the stock of
S2 immediately after the exchange. Therefore, the P group satisfies the control
requirement of I.R.C. §§ 351(a) and 368(c).2
However, P and S1 did not transfer property to S2 solely in exchange for the S2
stock because S2 also assumed the contingent tort liability. Therefore, the transfer
does not fit the literal terms of I.R.C. § 351(a). However, I.R.C. § 357(a) provides
that, except as provided in I.R.C. § 357(b) and (c), if the taxpayer (i.e., S1) receives
property (i.e., the S2 stock) which it would be permitted to receive under I.R.C.
§ 351 without the recognition of gain if such property were the sole consideration
and, as part of the consideration, another party to the transfer (i.e., S2) assumes a
liability of S1 (i.e., the contingent tort liability), then such assumption shall not be
treated as money or other property and shall not prevent the transfer from being
within the provisions of I.R.C. § 351. Thus, except as provided in I.R.C. § 357(b)
and (c), S1 would not recognize gain or loss on the transfer as a result of the
assumption of the contingent tort liability by S2 if I.R.C. §§ 351(a) and 357(a)
applied.
S1's basis in the S2 stock would be determined under I.R.C. § 358. Section
358(a)(1) provides that a transferor’s basis in the stock received from the transferee
in an exchange to which I.R.C. § 351 applies is the same as the basis of the
property surrendered, reduced by the amount of any money received. Section
358(d)(1) provides that, for purposes of I.R.C. § 358, an assumption of liability shall
be treated as money received by the transferor. Thus, a transferor reduces its
basis in the stock received from the transferee by the amount of any liability
assumed.
In Rev. Rul. 95-74, the Service held that certain contingent liabilities had not been
taken into account, within the meaning of I.R.C. § 357(c)(3), by the transferor prior
to the transfer. Thus, such liabilities were excluded in determining whether the
9
amount of the liabilities assumed exceeded, within the meaning of I.R.C.
§ 357(c)(1), the transferor’s basis in the transferred assets. In addition, such
liabilities did not reduce the transferor’s basis. Section 358(d)(2). Thus, in this
case, if the rationale of Rev. Rul. 95-74 applies, S1 would not reduce the basis of
its S2 stock by the amount of the contingent liabilities assumed by S2. This would
be the case whether or not the contingent liabilities would, absent I.R.C. § 357(c)(3)
and I.R.C. § 358(d)(2), otherwise be considered liabilities for purposes of I.R.C.
§§ 357 and 358.
However, you note that Rev. Rul. 95-74 does not apply if the transfer has no
business purpose. As one line of attack, you have suggested that the Service
apply I.R.C. § 357(b).
Section 357(b) provides that if, taking into consideration the nature of the liability
and the circumstances in the light of which the arrangement for the assumption was
made, it appears that the principal purpose of the taxpayer with respect to the
assumption described in I.R.C. § 357(a) was a purpose to avoid Federal income tax
on the exchange, or if not such a purpose, was not a bona fide business purpose,
then such assumption shall, for purposes of I.R.C. § 351, be considered as money
received by the taxpayer on the exchange.
In this case, whether either I.R.C. § 357(a) or I.R.C. § 357(b) applies is not
determinative of whether a liability assumed will reduce the transferor’s basis in the
stock of the transferee under I.R.C. § 358(d)(2). Under I.R.C. § 358(d)(2), a
transferor does not reduce its basis in the stock it receives by the amount of any
liability excluded under I.R.C. § 357(c)(3). Based on the policy reasons discussed
later in this memo, we interpret this provision as applying to a liability that could be
excluded under I.R.C. § 357(c)(3).
Moreover, I.R.C. § 357(c)(3), unlike I.R.C. § 357(a) and I.R.C. § 357(c)(1) (by virtue
of I.R.C. § 357(c)(2)(A)), does not contain an exception for I.R.C. § 357(b). Thus,
even if I.R.C. § 357(b) applied, S1 would not be required to reduce the basis of its
S2 stock by the amount of the contingent liabilities assumed. Consequently, we do
not believe that the application of I.R.C. § 357(b) will cause S1 to reduce the basis
of its S2 stock by any liabilities assumed.
In addition, you have asked whether Rev. Rul. 95-74 is distinguishable because it
relied on an analysis of I.R.C. § 357 in reaching its conclusion that such liabilities
also do not reduce basis under I.R.C. § 358(d). As noted above, applying I.R.C.
§ 357 in the instant case does not cause S1 to recognize any portion of such
amount. Therefore, you have asked whether I.R.C. § 358(d) provides an
independent rationale for reducing S1's basis in the S2 stock. It is the position of
10
3 For a further discussion of this issue, please read the legal memorandum
written in support of Rev. Rul. 95-74, which we have attached to this memorandum.
the Service, as stated in Rev. Rul. 95-74, that I.R.C. §§ 357(a) and 358(d) operate
on similar principles. See also Focht v. Commissioner, 68 T.C. 223 (1977); S. Rep.
No. 1263, 95th Cong., 2d Sess. 183-85 (1978), 1978-3 C.B. 481-83, adding I.R.C.
§ 357(c)(3) to the Code. Therefore, it is not determinative that in this case I.R.C.
§ 357 is not applicable.3
In 1978, in adding I.R.C. § 357(c)(3) to I.R.C. § 357(c), Congress, in the legislative
history cited above, expressly approved of Focht. Focht had held that an obligation
should not be treated as a liability under I.R.C. §§ 357 and 358 to the extent its
payment would have been deductible if made by the transferor. The Tax Court
further held that, under I.R.C. § 358, deductible liabilities are excluded in
determining the transferor's basis in stock received as part of the exchange. More
generally, the legislative history of I.R.C. § 351 indicates that Congress viewed
incorporation exchanges as merely changes in form and intended to enact I.R.C.
§ 351 to eliminate impediments to business readjustments by making incorporations
tax free. S. Rep. No. 398, 68th Cong., 1st Sess. 17 (1924); H.R. Rep. No. 350,
67th Cong., 1st Sess. 9 (1921). Sections 357(c)(3) and 358(d)(2) now provide that
a corporation's assumption of a liability that, if paid, would give rise to a deduction
shall neither be taken into account under I.R.C. § 357(c)(1) nor diminish the
shareholder's basis under I.R.C. § 358.
The first holding in Rev. Rul. 95-74 applied the logic of I.R.C. §§ 357(c)(3) and
358(d)(2) to any liability which had not yet given rise to a deduction or to basis--a
larger sphere than the liabilities covered by I.R.C. § 357(c)(3). Nothing in Focht, or
in the legislative history, or in logic suggests that the holding of the revenue ruling
as regards I.R.C. § 358(d) is not fully applicable in a case where I.R.C. § 357(c)
happens not to apply because assumed liabilities do not exceed basis. Nothing in
logic suggests that a shareholder gets a lower basis in his stock just because
liabilities do not exceed basis; especially when, if he had realized gain, it would be
insulated anyway from tax by Rev. Rul. 95-74.
Also, the result dictated by the logic of Rev. Rul. 95-74 makes technical sense.
Suppose individual A owns a building with a basis and value of $100, but burdened
by a contingent environmental liability reasonably valued at $100. In other words,
A will very likely lose his entire investment. If he waited for the liability to become
non-contingent, he could take a $100 deduction. Instead, he contributes the
building to his controlled corporation, which also assumes the contingent liability.
Thereafter, the liability becomes non-contingent. Section 357(c) did not apply,
because liabilities did not exceed basis. The corporation's paying the liability wipes
11
out his equity; thus he should get a $100 tax benefit. Had he continued to owe the
liability personally, that benefit would have come in the form of a deduction. He
ultimately gets the appropriate $100 tax benefit because, pursuant to Rev. Rul. 95-
74, I.R.C. § 358 does not operate to reduce his $100 stock basis. Instead, he
ultimately gets a $100 stock loss. Were his stock basis reduced by the contingent
liability to $0, he would never get the $100 tax benefit to which he is entitled. The
taxpayer in the FSA has abused the rules, but I.R.C. § 358, a section that does not
inquire into taxpayer intent, is not the means of correcting that. The legislative
history and Rev. Rul. 95-74 preclude that.
Alternatively, we recommend that you consider arguing that the transfer of property
by P and S1 to S2 followed by S1's sale of the S2 stock does not satisfy the
business purpose requirement of I.R.C. § 351(a).
Courts have hinted at the concept of a business purpose requirement in I.R.C.
§ 351 repeatedly. Opinions discussing other I.R.C. § 351 issues often indicate that
the taxpayer had a valid business purpose for the transaction in question. See
Hempt Bros., Inc. v. United States, 490 F.2d 1172, 1178 (3d Cir. 1974), cert.
denied, 419 U.S. 826 (1974); Stewart v. Commissioner, 714 F.2d 977, 992 (9th Cir.
1983). Perhaps the most thorough judicial exploration of the business purpose
doctrine in I.R.C. § 351 is in Caruth v. United States, 688 F. Supp. 1129, 1138-41
(N.D. Tex. 1987), aff'd, 865 F.2d 644 (5th Cir. 1989). In Caruth, the court explains
that I.R.C. § 351 is tied very closely to the reorganization provisions and reasons
that the doctrines applicable there are equally valid for capital contributions. Under
Caruth, the business purpose requirement for I.R.C. § 351 transactions appears to
be the same as the business purpose requirement for acquisitive reorganizations.
Generally, I.R.C. § 351 will apply to a transaction if the taxpayer has a valid
business purpose for the transaction other than tax savings. See Stewart v.
Commissioner, 714 F.2d 977, 991 (9th Cir. 1983); Rev. Rul. 60-331, 1960-2 C.B.
189, 191.
In this case, P and S1 will probably argue that the business purpose for the transfer
of the cash, S3 stock and S4 note in exchange for S2 stock and the assumption of
the contingent tort liabilities was to isolate such liabilities in a separate corporation.
However, S1 sold the S2 stock several months after this transfer. The loss that S1
recognized offset a capital gain P recognized several months prior to the transfer.
In that case, S1 may not be able to articulate a reason for selling such stock other
than to recognize a capital loss to offset that gain. In other words, the Service may
be able to argue that S1's sale of its S2 stock is inconsistent with the stated
business purpose for the transfer to S2.
12
4 The field believes that, even if the contingent liabilities S2 assumed were
included in the amount realized under I.R.C. § 1001 (because I.R.C. § 351 did not
apply), S1 would have realized a loss on its exchange with S2. We assume that is the
case, but note that (i) the numbers in the case do not self-evidently support that
conclusion and (ii) the appeals officer has informally indicated that the taxpayer
contends that if the assumed contingent liabilities were included in the amount realized,
then it would have had a gain if I.R.C. § 1001 applied. However, even if the taxpayer
realized a nominal amount of gain, and even if the Service were able to invoke I.R.C.
§ 357(b), that section would trigger recognition of gain only to the extent of that nominal
amount.
If the transfer does not qualify under I.R.C. § 351, then it would be treated as a
taxable exchange under I.R.C. § 1001. In that case, but for the application of
certain provisions of Treas. Reg. § 1.1502-13, S1 might be entitled to recognize its
loss arising from the transfer.4 In the next section of this letter, we explain under
what circumstances S1 may deduct the loss.
Consolidated Return Regulations
Law:
Treas. Reg. § 1.1502-13:
(a) In general--(1) Purpose. This section provides rules for taking into account
items of income, gain, deduction, and loss of members from intercompany
transactions. The purpose of this section is to provide rules to clearly reflect the
taxable income (and tax liability) of the group as a whole by preventing
intercompany transactions from creating, accelerating, avoiding, or deferring
consolidated taxable income (or consolidated tax liability).
(b) Definitions. For purposes of this section–
(1) Intercompany transactions--(i) In general. An intercompany transaction is a
transaction between corporations that are members of the same consolidated group
immediately after the transaction. S is the member transferring property or
providing services, and B is the member receiving the property or services.
Intercompany transactions include: (A) S's sale of property (or other transfer, such
as an exchange or contribution) to B, whether or not gain or loss is recognized.
(2) Intercompany items--(i) In general. S's income, gain, deduction, and loss from
an intercompany transaction are its intercompany items. For example, S's gain
13
from the sale of property to B is intercompany gain. An item is an intercompany
item whether it is directly or indirectly from an intercompany transaction.
(3) Corresponding items--(i) In general. B's income, gain, deduction, and loss from
an intercompany transaction, or from property acquired in an intercompany
transaction, are its corresponding items. For example, if B pays rent to S, B's
deduction for the rent is a corresponding deduction. If B buys property from S and
sells it to a nonmember, B's gain or loss from the sale to the nonmember is a
corresponding gain or loss (emphasis supplied); alternatively, if B recovers the
cost of the property through depreciation, B's depreciation deductions are
corresponding deductions. An item is a corresponding item whether it is directly or
indirectly from an intercompany transaction (or from property acquired in an
intercompany transaction).
(4) Recomputed corresponding items. The recomputed corresponding item is the
corresponding item that B would take into account if S and B were divisions of a
single corporation and the intercompany transaction were between those divisions.
For example, if S sells property with a $70 basis to B for $100, and B later sells the
property to a nonmember for $90, B's corresponding item is its $10 loss, and the
recomputed corresponding item is $20 of gain (determined by comparing the $90
sales price with the $70 basis the property would have if S and B were divisions of
a single corporation). Although neither S nor B actually takes the recomputed
corresponding item into account, it is computed as if B did take it into account
(based on reasonable and consistently applied assumptions, including any
provision of the Internal Revenue Code or regulations that would affect its timing or
attributes).
(c) Matching rule. For each consolidated return year, B's corresponding items and
S's intercompany items are taken into account under the following rules:
(2) Timing–
(ii) S's items. S takes its intercompany item into account to reflect the difference
for the year between B's corresponding item taken into account and the recomputed
corresponding item.
(d) Acceleration rule. S's intercompany items and B's corresponding items are
taken into account under this paragraph (d) to the extent they cannot be taken into
account to produce the effect of treating S and B as divisions of a single
corporation. For this purpose, the following rules apply:
14
(1) S's items--(i) Timing. S takes its intercompany items into account to the extent
they cannot be taken into account to produce the effect of treating S and B as
divisions of a single corporation. The items are taken into account immediately
before it first becomes impossible to achieve this effect. For this purpose, the
effect cannot be achieved–
(A) To the extent an intercompany item or corresponding item will not be taken into
account in determining the group's consolidated taxable income (or consolidated
tax liability) under the matching rule (for example, if S or B becomes a nonmember,
or if S's intercompany item is no longer reflected in the difference between B's
basis (or an amount equivalent to basis) in property and the basis (or equivalent
amount) the property would have if S and B were divisions of a single corporation);
or
(B) To the extent a nonmember reflects, directly or indirectly, any aspect of the
intercompany transaction (e.g., if B's cost basis in property purchased from S is
reflected by a nonmember under section 362 following a section 351 transaction).
Analysis:
If I.R.C. § 351 does not apply, then S1 would recognize gain or loss under I.R.C.
§ 1001 upon the sale of the S3 stock and S4 note to S2 (the first sale). S1 would
determine the amount of its gain or loss from the first sale by subtracting its basis in
the property sold, $j, from the value of the consideration it received, the S2 stock.
We do not know what value S1 and S2 might assign to such stock. Because S1
and S2 are affiliated, any value they assign to the S2 stock can not be presumed to
reflect the fair market value of that stock. However, several months after the first
sale, S1 sold the S2 stock to unrelated parties for $i (the second sale). If there was
no substantial change in the circumstances of S2 during this period, then the
Service has a reasonable argument that $i also represents the fair market value of
the S2 stock at the time of the first sale. In that case, $i also represents S1's basis
in the S2 stock for purposes of the first sale. Treas. Reg. § 1.1001-1(a).
Consequently, S1 would recognize a loss on the first sale.
The first sale would be an intercompany transaction. Treas. Reg. § 1.1502-
13(b)(1)(i). S1's loss would be an intercompany item. Treas. Reg. § 1.1502-
13(b)(2)(i). However, as long as the property sold by S1 to S2 remains in S2 and
S2 remains a member of the group, there is no provision in Treas. Reg. § 1.1502-13
which would allow S to claim the loss upon the sale of such property. Treas. Reg.
15
5 Assuming the value of the S2 stock is $i, then substantially all of that amount
also represents S2's basis in the S4 note (because a small portion of that amount
would be allocated to the S3 stock). Any payments on the note that constitute
repayment of principal (as opposed to payment of interest) in excess of $i would result
in income to S2 (as a corresponding item under Treas. Reg. § 1.1502-13(b)(3)) and an
equal offsetting amount of loss to S1. However, see also Treas. Reg. § 1.1502-13(g),
relating to the treatment of intercompany obligations.
§ 1.1502-13(d)(1)(i)(A). Thus, the second sale would not allow S1 to take into
account currently any portion of its intercompany item attributable to the loss.5
With respect to the second sale, as noted above, S1 has a basis in the S2 stock of
$i, which is equal to the amount that the unrelated buyers paid for such stock.
Consequently, S1 would not recognize any gain or loss as a result of this sale.
CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:
ACM Partnership v. Commissioner, #97-7484 (3d Cir., 10/13/98) suggests two other
possible routes of attack on the group’s claimed loss on S1's sale of its S2 stock to
the unrelated parties. First, the Third Circuit noted the Supreme Court case
Knetsch v. United States, 364 U.S. 361 (1960). In Knetsch, the taxpayer had
purchased annuity savings bonds from an insurance company, borrowed virtually
their entire value against them, made payments back to the insurance company,
and characterized those payments as deductible interest. Because the borrowing
against the bonds had reduced their value to a mere “pittance,” leaving the
taxpayer with nothing of value apart from tax deductions, the Supreme Court
concluded that the net effect of the transfers between the taxpayer and the
insurance company amounted only to a payment of a “fee for providing the facade
of ‘loans’ whereby the [taxpayers] sought to reduce” their taxes and therefore could
not be characterized as payment of interest on a debt. Knetsch, at 366.
We recommend
16
.
The second route of attack suggested by ACM is an alternative argument that the
Service made at the trial level (see footnote 42 of the Third Circuit ACM opinion).
The Service argued that the “tax consequences of the transaction must be
disregarded because ACM’s partnership structure artificially ‘bifurcat[ed] the tax
consequences of the transaction’ by allocating taxable gains to a foreign partner
and offsetting tax losses to a taxpayer in a manner which the relevant statue and
regulations did not intend.”
In this case, the abuse is that by means of the I.R.C. § 351 exchange and S1's
subsequent sale of its S2 stock, the taxpayer has attempted to turn a liability not
currently deductible, because it is contingent, into a currently deductible loss.
Those steps also abuse a second rule, the I.R.C. § 461(h) economic performance
requirement, under which a deduction generally is not allowed until the liability in
question is actually paid. The tort liabilities here had not been paid when S1
claimed the loss. In connection with this argument, you may want to request Field
Service Advice from CC:DOM:FS:IT&A.
If you have any further questions, please call (202) 622-7930.
DEBORAH A. Butler
Assistant Chief Counsel
By:
Steven J. Hankin
STEVEN J. HANKIN
Chief, Corporate Branch
cc: