Complexities in the consolidated return reverse acquisition rules.

The determination of whether a transaction is a reverse acquisition under the consolidated return regulations has a large impact on a number of consolidated return issues, such as the application of the separate return limitation year rules under Temp. Regs. Sec. 1.1502-21T, stock basis adjustments under Regs. Sec. 1.1502-31, earnings and profits adjustments under Regs. Sec. 1.1502-33(f) and certain consolidated return filings (such as short-period returns or consolidated return elections). The reverse acquisition rule of Regs. Sec. 1.150275(d)(3), while mechanical in its approach, has been rather broadly applied in IRS rulings. Examples of the Service's broad interpretation of the reverse acquisition rule can be found in GCM 39528 and Letter Ruling 8834013. The IRS's broad interpretation makes the application of the reverse acquisition rule to complex transactions even more difficult.

Substance-Over-Form Approach

Generally under Regs. Sec. 1.150275(d)(3), a reverse acquisition occurs when:

1. A corporation acquires the stock or substantially all of the assets of a second corporation;

2. The second corporation becomes a member of the first corporation's group; and

3. The shareholders of the second corporation end up owning more than 50% of the first corporation's outstanding stock.

If an acquisition is treated as a reverse acquisition, the second corporation's group continues in existence, with the first corporation as the parent. Provided that consolidated returns are filed after the acquisition, the tax year of the first corporation and any consolidated subsidiaries ends on the acquisition date.

The reverse acquisition rule is intended to prevent taxpayers from altering the consolidated tax return consequences of a transaction merely by changing its form. Therefore, the reverse acquisition rule looks to the transaction's substance rather than its form. For example, a consolidated group could be terminated at the taxpayer's choosing by altering the structure of the transaction, by which the common parent of one consolidated group is merged into the common parent of another consolidated group. Barring the application of the reverse acquisition rule, either consolidated group could be terminated, depending on which common parent the taxpayers choose to survive the merger.

Regardless of the form of the acquisition, the reverse acquisition rule requires the consolidated group whose former shareholders own more than 50% of the new parent corporation's stock to be the continuing consolidated group. Relying on the mechanical approach of Regs. Sec. 1.1502-75(d)(3) would be contrary to the overall purpose of the reverse acquisition rule. Therefore, even though a transaction may not meet all the tests under Regs. Sec. 1.1502-75(d)(3), the substance of the transaction should be examined to determine whether the reverse acquisition rule should apply. The Service, however, currently does not rule on reverse acquisition treatment unless the taxpayer meets all the requirements under Regs. Sec. 1.1502-75(d)(3).

Application in a Sec. 304 Transaction

The following example illustrates the difficulties in applying reverse acquisition principles to a transaction that meets the Sec. 304 requirements.

Example: FP is a foreign parent of FH, a foreign holding company. FH owns all of the stock of P, the parent of a consolidated group. FP also owns all of DS, a U.S. corporation that has a fair market value of $75. In the transaction, DS purchases all of P's stock from FH/hr $100.

Sec. 304 will apply. Therefore, DS treats FH's sale of P as a redemption of DS's stock. The redemption does not qualify for exchange treatment; thus, the IRS treats the redemption as a distribution under Sec. 301. Further, changes made by the Taxpayer Relief Act of 1997 (TRA '97) clarify that FH is deemed to contribute P stock to DS for DS stock in a Sec. 351 transaction prior to the redemption. Then, FH's DS stock is redeemed for $100. Prior to the amendment by the TRA '97, FH was never deemed to own directly DS stock for stock basis purposes (see Rev. Rul. 70-496), but was deemed to own DS stock for foreign tax credit purposes (see Rev. Rul. 91-5).

In the example, DS acquires P's stock and P becomes a member of DS's consolidated group; however, FH (the P shareholder) will not own more than 50% of DS. Therefore, under the literal requirements of a reverse acquisition, the transaction does not qualify. How ever, FP still owns (indirectly) all of P. Therefore, in looking to the substance of the transaction, reverse acquisition treatment may apply.

In Regs. Sec. 1.1502-75(d)(3), for purposes of determining whether the former stockholders of the second corporation (FH) own more than 50% of the outstanding stock of the first corporation, the Service will take into account any acquisitions or redemptions of the stock of either corporation that are pursuant to the overall acquisition plan. The deemed redemption of FH pursuant to Sec. 304 (as amended by the TRA '97) is pursuant to the overall plan and should be taken into account. This would seem to suggest that reverse acquisition treatment should not apply. This change to Sec. 304 may have clarified the application of the reverse acquisition principle to this transaction; however, unless the Service is willing to rule on these types of transactions, or provide additional guidance on the application of the reverse acquisition rules, the uncertainty will continue.