Proposed section 1504(a) regulations relating to the treatment of certain options as exercised.

On November 3, 1992, Tax Executives Institute submitted the following comments to the Internal Revenue Service on proposed regulations under section 1504(a) of the Internal Revenue Code on the circumstances in which certain options with respect to a subsidiary's stock will be treated as exercised for purposes of determining whether the 80-percent voting power and value tests for affiliation under section 1504(a) are satisfied. The comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is David F. Nitschke of Amerada Hess Corporation. Contributing materially to the development of the Institute's position were William V. Meltzer and George Papazicos of the New York Chapter.

On February 28, 1992, the Internal Revenue Service issued proposed regulations under section 1504(a) of the Internal Revenue Code, concerning the circumstances in which certain options with respect to a subsidiary's stock will be treated as exercised for purposes of determining whether the 80-percent voting power and value tests for affiliation under section 1504(a) are satisfied. The proposed regulations treat an option as exercised (and the underlying stock as issued or transferred, as the case may be) if (1) the issuance or transfer of the option rather than the stock would result (but for the regulations) in the elimination of a substantial amount of federal income tax liability, and (2) a reasonable certainty exists on a measurement date (generally the issuance, notification, or transfer date of the option) that the option will be exercised.

The proposed regulations (CO-152-84) were published in the Federal Register on March 2, 1992 (57 Fed. Reg. 7340), and in the March 23, 1992, issue of the Internal Revenue Bulletin (1992-12 I.R.B. 37).(1) A public hearing on the proposed regulations that had been scheduled for April 14, 1992, was subsequently canceled. Tax Executives Institute is pleased to submit the following comments on the proposed regulations.

Effective Date

Prop. Reg. [section] 1.1504-4(i) provides that the regulations apply "to options with a measurement date on or after February 28, 1992." The preamble states that "[n]o inference is intended that options with no measurement date on or after February 28, 1992, are to be disregarded for purposes of determining affiliation." (1992-12 I.R.B. at 40.)

TEI believes that, for purposes of determining affiliation, the regulations should expressly permit taxpayers to disregard options issued prior to February 28, 1992 (regardless of whether there has been a measurement date after that date) to the extent such options do not have an abuse potential. Thus, taxpayers that, prior to the effective date of these regulations, have entered into arrangements involving, for example, publicly traded options, stock purchase agreements, employee stock options, security agreements, and options issued pursuant to a bonafide loan agreement should be permitted to apply the regulations (and their safe harbors) retroactively to prevent disaffiliation. Similarly, taxpayers should be allowed to apply the regulations retroactively to prevent disaffiliation where an option would have satisfied one of the safe harbors of the regulations or where it otherwise could be shown under Prop. Reg. [section] 1.1504-4(g) that there was no reasonable certainty of exercise of such option.

Non-Abusive Options

Prop. Reg. [section] 1.1504-4(d)(2) identifies number of instruments that, provided they are not used as "device[s] to avoid the application of section 1504 and this section," will not be treated as options. TEI submits that the overlay of the "device" test threatens to undermine the certainty and predictability otherwise offered by the regulations. The subjective and sweeping nature of the test is apparently intended to produce an in terrorem effect on taxpayers. The absence of any guidance on the scope of the term, however, may effectively sweep numerous non-abusive options within its reach. More fundamentally, we question whether even an objectively based device test is needed in light of the manner in which the safe harbors themselves are crafted. For example, Prop. Reg. [section] 1.1504-4(d)(2)(v) states that stock appreciation rights, warrants, stock options, and similar arrangements provided to employees, directors, and independent contractors as compensation will not be treated as options so long as such compensation "is not excessive by reference to services performed. . . ." The reference to "excessive" compensation itself precludes abuse. Thus, TEI recommends that the device test be eliminated from the final regulations; if safeguards are needed to prevent the safe harbors from being abused, those limitations should be narrowly and specifically included in the safe harbor definitions themselves rather than embodied in an overreaching general rule.

As previously noted, Prop. Reg. [section] 1.1504-4(d)(2)(v) provides that certain compensation arrangements -- such as employee stock options -- will not be treated as options for purposes of the regulations. TEI does not believe that this rule should be limited by the requirements that the instruments be "nontransferable" and "not have a readily ascertainable fair market value." Thus, if the grant of rights permitting participation in the future appreciation of the issuer does not constitute excessive compensation, then it should not matter that such rights may be cash equivalents.

Finally, TEI submits that Prop. Reg. [subsection] 1.1504-4(d)(1)(ii) and 1.1504-4(d)(2)(v) overreach in treating all stock appreciation rights, phantom stock, and cash settlement options as options, even where the holder has no right under the instrument to obtain an ownership interest in the company. The IRS's authority under section 1504(a)(5) relates to options, warrants, obligations convertible into stock, and "other similar interests." Where the holder of an instrument cannot convert that instrument into an ownership interest in the company, then that instrument should not be treated as within the scope of the statutory provision. Consequently, TEI recommends that the final regulations provide that an instrument will be treated as an option only if it grants the holder the right on exercise to receive stock.

Convertible Obligations

Under Prop. Reg. [section] 1.1504-4(d)(1)(i), a convertible obligation is an instrument that is considered to be an option and may be treated as exercised for purposes of determining whether a corporation is a member of an affiliated group. The preamble to the regulations invites comments on the desirability of establishing a safe harbor for convertible obligations. 1992-12 I.R.B. at 40. TEI supports the development of a safe harbor in respect of convertible obligations. For example, the regulations could provide that, for purposes of determining the relative percentages of the value of stock owned by the holder of a convertible obligation (which is treated as exercised under Prop. Reg. [section] 1. 1504-4(b)(2)(i)) and other parties as described in Prop. Reg. [section] 1.1504-4(b)(2)(ii)(A), the value of stock owned by the holder that is attributable to the convertible obligation will be treated as not exceeding the value of the consideration given in exchange for the obligation.

Valuation

Prop. Reg. [section] 1.1504-4(b)(2)(iii) provides that, for purposes of the 80-percent of value test generally (as well as in the case of options treated as exercised), all shares of stock within a single class are considered to have the same value and, hence, control premiums and minority and blockage discounts within a single class are not to be taken into account.

Although TEI appreciates the desire to craft a rule that is comparatively easy to administer, we question whether the wholesale disregard of control premiums and minority and blockage discounts is supported by sections 1504(a)(2)(B) and 1504(a)(5)(B). Moreover, if the valuation provision is retained, we believe that it should apply for all purposes of section 1504(a)(2)(B), without regard to whether options are involved.

Elimination of Tax Liability

Under Prop. Reg. [section] 1.1504-4(b)(2)(i)(A), an option will be treated as exercised only if the failure to so treat the option "will result in the elimination of a substantial amount of federal income tax liability." TEI opposes this results-oriented, one-sided rule and urges the IRS to reconsider the rule.

Under the standards set forth in Prop. Reg. [subsection] 1.1504-4(e) and (f), taxpayers will never be able to prove to the satisfaction of an examining agent that the issuance or transfer of an option in lieu of the underlying stock will not result in the elimination of a substantial amount of federal income tax liability. Example 2 of Prop. Reg. [section] 1.1504-4(h) -- which involves an option with respect to a loss subsidiary given by the common parent of a consolidated group with tax income to another similar group's common parent -- illustrates that there is no elimination of tax liability because S's losses would be used to offset the income of either group.

The fact pattern of Example 2, however, is extremely narrow and is not at all illustrative of most commercial transactions involving options on subsidiary stock. More important, the regulations permit the parties to ignore only the deferral of pin with respect to the stock subject to the option in determining whether there is an elimination of federal income tax liability. An examining agent would apparently be permitted to consider such items as the trigger of deferred inter-company gains and the loss of the 100-percent dividends-received deduction, both of which would be present in the regulations' simple example, as well as the potential application of section 382 or the loss disallowance rules.

TEI recommends that the regulations narrow the circumstances in which the "elimination of a substantial amount of federal income tax liability" requirement will be invoked. Prop. Reg. [section] 1.1504-4(f), which is captioned "Substantial amount of federal income tax liability," does not define the term; rather, it states that the provision's applicability is to be --

based on all the facts and circumstances,

including the absolute

amount of the elimination,

the amount of the elimination

relative to overall tax

liability, and the timing of

items of income and deductions,

taking into account

present value concepts.

TEI believes that taxpayers deserve more guidance on the scope of "substantial amount of federal income tax liability." Additional examples should be developed, with the regulations specifying which other tax rules should or should not be taken into account. In addition, the final regulations should provide an additional safe harbor under which the term "substantial amount of federal income tax liability" will in no event be less than a percentage of tax liability for the year or a specified minimum amount (say, 100,000).

Safe Harbors

TEI believes that the safe harbors provided by Prop. Reg. [section] 1.1504-4(g)(2) are too restrictive. Although the proposed regulations seem on their face to trigger the treatment of options as exercised in only special circumstances, the limited number of safe harbors -- coupled with the ambiguity surrounding whether exercise of an option is reasonably certain -- mandate that greater regulatory guidance be provided. For example, the two-year period set forth in subsections (g)(2)(i)(A) and (g)(2)(ii)(A) is not at all indicative of typical commercial practice with respect to instruments of this type. Five years is more common, and TEI recommends that the regulations be revised to hue more closely to commercial reality.

The clear aim of the regulations should be to expand the number of safe harbors and to treat options as exercised only in abusive situations. Specifically, we believe no legitimate policy goal is furthered by treating an option as exercised where the fair market value of an option is equal to its exercise price at the time of grant.

In addition, the safe harbor in Prop. Reg. [section 1.1504-4(g)(2)(iii) -- which permits the grant of an option exercisable at a formula fair market value -- should be given wider application. TEI recommends that an example of the provision's application should be included in the final regulations. Finally, we suggest that more guidance be provided on how a taxpayer that fails to meet a safe harbor can utilize the factors described in Prop. Reg. [section] 1.1504-4(g)(1) to prove to an examining agent that there is a "reasonable certainty of exercise" of an option.

Measurement Dates

Under Prop. Reg. [section] 1.1504-4(c)(4)(ii)(B), the transfer of an option to or from a party related to the issuing corporation causes a measurement date. The attribution rules set forth in the regulations would treat a corporate holder of an option on 10 percent or more of the stock as related to

the issuer. Thus, any transfer of such an option by the corporate holder has the effect of requiring a retesting for "reasonable certainty of exercise." TEI recommends that the list of permitted modifications (before retesting is required) be expanded.

Reconsolidation 

Where an option is deemed to be "reasonably certain of exercise" under Prop. Reg. [section] 1.1504-4(g), the consequence may be the deconsolidation of the issuing subsidiary. If the option subsequently lapses without being exercised in fact (or where the holder of the option forfeits his right to acquire the stock), TEI believes that the subsidiary should once again be considered an affiliate. In other words, the proposed regulations should not operate to the subsidiary's detriment where the option, in fact, has no effect on the ownership of the issuing corporation. Quite simply, we believe the ancillary effects of deconsolidation are too severe not to reverse, or at least to temper, in circumstances where the option lapses. Thus, we believe that the rule in section 1504(aX3) requiring the passage of five years before reconsolidation should be automatically waived where the options lapse. This rule would be consistent with Temp. Reg. [section] 1.382-2T(h)(4)(viii), which provides that upon lapse or forfeiture an option should be treated as having never been issued. Indeed, if this latter approach were taken, the taxpayer would be permitted to file amended returns for prior open years that include the subsidiary in the affiliated group.

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the proposed regulations relating to the treatment of certain options as exercised for purposes of section 1504(a) of the Code. If you have any questions concerning these comments, please do not hesitate to call David F. Nitschke, chair of TEI's Federal Tax Committee, at [phone] or Timothy J. McCormally of the Institute's professional tax staff at [phone]. (1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.