TAM 9452002: redefining "control." (Technical Advice Memorandum)

In Letter Ruling (TAM) 9452002, the IRS has in one document summarized the entire body of law on voting stock and the affiliation requirement for consolidated return purposes. Anyone remotely familiar with the topic knows that voting stock is the right to elect directors and that the test is mechanical. Now the Service has retreated from a purely mechanical application of the test in situations in which restrictions on the ability of directors to carry out all of their management functions dilute the effectiveness of the directors' votes and also dilute the shareholder vote. This ruling has implications beyond Sec. 1504 and the ability to file consolidated returns; the TAM's message also extends to Sec. 351 transfers, liquidations under Sec. 332, "B" and "D" reorganizations, Sec. 269, and any other situation in which it is necessary to determine control of a corporation through ownership of voting stock.

In TAM 9452002, corporation W had two classes of stock outstanding (Class A and Class B), each entitled to elect five directors. Corporation V owned all the Class A stock, and thus had 50% of the voting stock of W. Because V was incurring substantial losses, while W was extremely profitable, a restructuring was devised to permit V to offset future losses against the anticipated profits of W by having V and W file a consolidated tax return. To that end, the stock of W was recapitalized, substituting a new class of stock (Class C) for V's Class A stock, and altering the voting rights. Following the restructuring, V's new Class C stock could elect four directors (each having two votes) and the other shareholders owning Class B stock could elect two directors (each with one vote). There were two nonvoting directors.

Had the restructuring ended there, consolidation between V and W would have been established, because V would have owned stock entitling it to vote for directors who would have 80% of the voting power of the corporation. Under existing precedents (see, e.g., Rev. Rul. 69-126), satisfaction of the mechanical 80% test was all that was required. (The situation addressed in the TAM arose prior to 1984, so the additional requirement of an 80% "value" test in Sec. 1504(a)(2)(B), added by the Deficit Reduction Act of 1984, was not an issue. Based on the ensuing discussion, it is unlikely that this additional test, had it applied, would have been met.)

The restructuring in the TAM did not, however, stop at a mere reassignment of voting rights. Amendments to W's charter and side agreements between the parties restricted the board's power in a number of areas. Specifically, an affirmative vote of a majority of each class of shareholders and directors was required (1) to acquire or dispose of "material assets" (those having a 5% or greater effect on book value), (2) to make capital appropriations or dispositions in excess of approximately 1.8% of the corporation's total assets, (3) to select or dismiss the corporation's chief executive officer, (4) to approve a merger involving the corporation or (5) to approve a loan from the corporation to one of its affiliates or a loan not in the ordinary course of business.

In addition to these five matters requiring approval by a majority of each class of directors, two other restrictions were placed on the board. First, for as long as the Class C stock was outstanding, the board was required to pay a dividend equal to 35% of the corporation's net income. Second, an intricate "call-or-convert" provision gave the Class B shareholders (i.e., those other than V) the right to purchase Class C stock at a bargain price on the occurrence of certain events that might jeopardize the Class B shareholders' investment. Complete implementation of this provision could cause the restructuring to be undone and the voting rights of the parties to revert to their previous 50/50 levels.

Because of the restrictions imposed on the board following the restructuring, the IRS concluded in the appeals process that V did not control W's management and that the two corporations were therefore not affiliated during the relevant period. In its Request for Technical Advice, the taxpayer contested this conclusion with two arguments. First, the taxpayer argued that the proper test was a mechanical 80% test and that, under that test, V had 80% of the board's voting power. Second, the taxpayer argued hat, even if the Service determine that it was appropriate beyond a purely mechanical test, the restrictions placed on the board were not material enough to result in a determination that V did not control W's management. Both of these arguments were rejected.

Although the strict mechanical test will continue to apply in the vast majority of situations, taxpayers are now on notice that the IRS will not follow that test blindly. Alterations in the charter or shareholder arrangements that limit the spectrum of class voting prerogatives may abrogate mechanical affiliation. Furthermore, any Code section that measures control via ownership of voting stock will be subject to this new, less mechanical, application of the control test.