Proposed section 338 consistency regulations.
On January 13, 1992, the Internal Revenue Service issued proposed regulations relating to the stock and asset consistency rules under section 338 of the Internal Revenue Code. The regulations were published in the Federal Register on February 13, 1992 (57 Fed. Reg. 1409), and in the February 10, 1992, issue of the Internal Revenue Bulletin (1992-6 I.R.B. 12). A public hearing was held on the proposed regulations on March 26, 1992.
The proposed regulations would replace sections 1.338-4T and 1.338-5T of the current temporary regulations and revise the rules regarding the international aspects of section 338 that are set forth primarily in Temp. Reg. [section] 1.338-5T. The proposed regulations generally restate the remainder of the temporary regulations with only minor conforming changes. For simplicity's sake, the extant temporary regulations are referred to collectively as the "temporary regulations" or the "current regulations"; the proposed regulations are referred to as the "proposed regulations." Specific provisions are cited as "Temp. Reg. [section]" and "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin. In addition, the comments adopt the terminology used in the proposed regulations: "T" or "target" refers to the corporation that is to be purchased; "S" or "seller" refers to the selling corporation; and "P" or "purchaser" refers to the purchasing corporation.
Tax Executives Institute is the principal association of corporate tax executives in North America. Our 4,700 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.
Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations relating to the stock and asset consistency rules under section 338 of the Code.
Section 338 of the Internal Revenue Code was enacted as a reform and simplification measure as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). As originally enacted, section 338 generally provided that a corporation purchasing 80 percent or more of the stock of a target corporation could elect to have the target treated as if it had sold all of its assets to a new corporation in a transaction to which former section 337 applied. The target was treated conceptually as two separate corporations: one that sold all of its assets in a former section 337 transaction ("Old T") and another that purchased those assets in a taxable transaction ("New T"). Old T incurred tax liabilities for depreciation recapture and similar items, as would the seller of assets in a section 337 transaction. New T was treated as a new corporation with a new tax history and attributes and had a basis in its assets reflecting the buyer's purchase price for the target's stock. S. Rep. No. 97-530, 97th Cong., 2d Sess. 535-36 (1982) (hereinafter referred to as the "1982 Conference Report").
The statute included a set of rules intended to impose consistent treatment on purchases of different parts of the same enterprise. Under the stock consistency rules of section 338(f), a corporation that purchased 80 percent or more of the stock of each of two related corporations within a designated acquisition period was required to treat those corporations in the same manner for purposes of section 338, with the treatment of the first corporation acquired controlling the treatment of the second. If a section 338 election were made for the first corporation, then the second corporation would also be treated as if a section 338 election had been made. If a section 338 election were not made for the first corporation, the buyer was not allowed to make an election for the second. The rules applied to all purchases made by members of the same affiliated group of corporations. The asset consistency rules of section 338(e) provided that, with certain exceptions, a purchase of assets from the target or a related corporation by the buyer of the target's stock was treated as subject to a constructive section 338 election with respect to the target. 1982 Conference Report at 536-37.
The original intent of section 338 was threefold. First, section 338 was an attempt to simplify the tax laws by allowing an acquiring corporation to step-up the basis in a target corporation merely by filing an election. Second, section 338 was intended to eliminate many of the differences between (1) asset purchases and (2) stock purchases that were treated as asset purchases. Finally, section 338 was intended to curb practices in corporate acquisitions that were considered abusive, especially devices used to step-up the basis in certain target assets while maintaining a carryover basis in other target assets. 1982 Conference Report at 535-36. The consistency rules arise out of the anti-selectivity purpose.
The temporary regulations implementing section 338(e) were a principal source of complexity in the consistency rules. The most complex provisions were those implementing section 338(E)(2)(D), which addressed exceptions to the application of various elections, including the carryover basis and affirmative action carryover elections described in Temp. Reg. [section] 1.338-4T(f)(6). These rules were rendered largely irrelevant with the repeal of the General Utilities doctrine in the Tax Reform Act of 1986.(1)
The 1986 Act provided that gain loss generally is recognized by a corporation on liquidating distributions of its property as if the property had been sold at fair market value to the distributee. See Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 339 (1987). The 1986 Act thus radically altered the effect of section 338 by imposing two taxes -- one at the shareholder level for the sale of the target's shares and a second on the target corporation on the deemed sale of its assets. In addition, with the repeal of the General Utilities doctrine, the consistency rules of sections 338(e) and (f) no longer served their original purpose of targeting transactions designed to selectively step up the basis of certain assets while preserving the tax attributes of other corporations. Given their complexity, the administrative burden of enforcing them, and the compliance burden imposed upon taxpayers, no meaningful tax policy objective continues to be served by the consistency rules in the temporary regulations. This philosophy is reflected in the proposed regulations.
TEI commends the IRS on its effort to simplify and narrow the scope of the temporary regulations under section 338. The elimination of the protective carryover, offset prohibition, affirmative action carryover, and regular exclusion elections with the "carryover basis rule" substantially simplifies the asset consistency rules. TEI further supports the proposed elimination of the District Director's discretion in applying the various consistency rules. This change will alleviate any doubt about the tax consequences of a section 338 transaction.
Although the proposed regulations represent a significant simplification of the current rules, we suggest that the loss disallowance rule under Treas. Reg. [section] 1.1502-20 already provides more than ample safeguards against possible abuses in this area. Moreover, we believe there is room for improvement in the regulations, especially with respect to their retroactive application. Our specific comments on the proposed regulations follow.
Prop. Reg. [section] 1.338(i)-1: Effective Date
Prop. Reg. [section] 1.338(i)-1 provides that the proposed regulations are generally effective for target corporations with acquisition dates on or after the date final regulations are published in the Federal Register. TEI recommends that the final regulations accord taxpayers an election to apply the regulations retroactively in respect of acquisitions made on or after August 1, 1986.
Congress enacted the consistency provisions of section 338 in response to certain anti-selectivity concerns. The temporary regulations implementing these consistency rules were not issued until three years after the enactment of section 338. As a result, taxpayers were left without guidance on the stock-asset consistency requirements for an extraordinarily long period of time.
Shortly after the issuance of the temporary regulations, the Tax Reform Act of 1986 interred the General Utilities doctrine, severely restricting the utility of section 338 for qualified stock purchases made on or after August 1, 1986. Notwithstanding this repeal, the restrictions set forth in the temporary regulations continue to impose undue hardship and administrative burdens on both the taxpayers and, we suggest, the IRS. Furthermore, the ancillary elections previously contained in the temporary regulations have created a trap for even sophisticated taxpayers.
The proposed regulations simplify many of these complexities and substantially narrow the scope of the asset and stock consistency rules contained in the temporary regulations. By eliminating most, if not all, of the complications, the IRS has acknowledged that such complexity serves no continuing purpose. Nevertheless, taxpayers who make qualified stock purchases prior to the effective date of the new rules will continue to be adversely affected by the temporary regulations. In addition, tying the effective date to the issuance of final regulations will create uncertainty during the interim period.
Elective retroactive application of the proposed section 338 regulations would reduce the inequity and complexity inherent in the temporary regulations without undermining any legitimate tax policy. TEI therefore recommends that the final regulations permit taxpayers to elect to apply the new rules retroactively to acquisitions made on or after August 1, 1986.
Prop. Reg. [section] 1.338-4(d): Effect of the Loss Disallowance Rules
The preamble to the proposed regulations states that the consistency rules will be applied to consolidated groups to "prevent acquisitions from being structured to take advantage of the investment adjustment rules." 1992-6 I.R.B. at 14. The preamble contains the following example of the typical transaction to which the consistency rules should apply:
S and T file a consolidated
return. S has a $100x basis
in the T stock, which has a
fair market value of $200x.
On January 1, 1993, T sells
an asset to P and recognizes
$100x of pin. Under [section] 1502-32,
S's basis in the T stock is
increased from $100x to
$200x. On March 1, 1993, S
sells the T stock to P for $200x
and recognizes no gain or loss.
The preamble states that the consistency rules apply to the transaction because T's gain on the asset age is reflected under Treas. Reg. [section] 1.1502-32 in S's basis in the T stock. Under Prop. Reg. [section] 1.338-4(d), P therefore takes a carryover basis in any asset acquired from T. 1992-6 I.R.B. at 14.
The preamble, however, ignores the effect of the loss disallowance rule under Treas. Reg. [section] 1.1502-20. This rule imposes its own penalty where T's assets have built-in gain, i.e., the general disallowance of the loss deduction on the sale of the stock of a member of the consolidated group. The carryover basis rules may thus impose a duplicate tax cost on the transaction -- once on the purchaser under the consistency rules and once on the seller under the loss disallowance rule.
Moreover, the proposed regulations conflict with the loss disallowance rule, which is intended to permit the use of the consolidated return rules to offset post-acquisition appreciation in the stock of an acquired subsidiary.(2) When the loss disallowance rule was first proposed, then-IRS Commissioner (and now Assistant Treasury Secretary) Fred T. Goldberg, Jr. deflected criticism of the proposed disallowance rule by pointing out that "when the economy is on the upswing, the loss disallowance rule will work to a taxpayer's benefit in that post-acquisition appreciation would escape taxation." Minutes of TEI-IRS Liaison Meeting (April 27, 1990) (reprinted in 42 Tax Executive 225, 226 (1990)). The proposed regulations now seek to deny this result -- without even referencing the policy evinced by the loss disallowance rule. Such a result fuels taxpayers' concerns that "rough justice" too frequently works only in favor of the IRS. This regulation represents one more reason why the loss disallowance rule should be re-examined, especially as it relates to the consistency rules.
Prop. Reg. [section] 1.338-1(g): Special Rules for Foreign Corporations
1. Time for Filing Election. Under Temp. Reg. [section] 1.338-1T(k)(2), a qualifying foreign purchasing corporation is not required to file a statement of section 338 election before the 180th day after the close of the purchasing corporation's taxable year within which a "triggering event" occurs. This triggering event occurs when the foreign corporation, or any corporation in the affiliated group, becomes subject to U.S. tax. Prop. Reg. [section] 1.338-1(g) revises that rule by providing that a qualifying foreign purchasing corporation is not required to make a section 338 election before the earlier of (1) three years after the acquisition date or (2) the 180th day after the close of the taxable year within which a triggering event occurs. Accordingly, regardless whether a triggering event occurs, the election must be filed no later than three years after the date of acquisition.
By definition, a qualifying foreign purchasing corporation is a member of an affiliated group of foreign corporations -- none of which is subject to U.S. tax -- which acquired a foreign corporation target that (along with its target affiliates) is not subject to U.S. tax during the acquisition period. Since many years could pass between the date of the acquisition and the date a triggering event occurs, the three-year requirement provided in the proposed regulations seems reasonable. Accordingly, TEI does not object to the three-year period in the proposed regulations.
2. Notice of Election. Under Temp. Reg. [section] 1.338-1T(k)(7), notice must be given to U.S. persons holding stock in a foreign target on or before the day on which the statement of section 338 election is filed. Failure to comply with the notice requirements will render the election invalid. Prop. Reg. [section] 1.338-1(g)(4)(v) relaxes these requirements by providing for a good faith exception. The purchasing corporation will be considered to have complied with the notice requirement if the Commissioner determines that the purchasing corporation made a "good faith effort" to identify and provide timely notice to those U.S. persons.
TEI supports the inclusion of a good faith exception in the notice requirements. We suggest, however, that an example be added to the regulations to show what constitutes good faith. Specifically, we recommend the regulations confirm that a purchasing corporation will be deemed to show good faith when (1) it mails the notice to those persons identified as holders or former holders of stock in the foreign target and the purchasing group members on the records of those corporations or (2) the notice is given in a stock purchase agreement to which the shareholders are a party and the agreement specifies that the purchaser will make a section 338 election.
Prop. Reg. [section] 1.338-2(b)(1): Purchasing Corporation Requirement
Section 338 does not apply to an individual or other non-corporate purchaser of stock. Rather, these excluded parties are required to liquidate the target in order to attain a step-up in basis. Alternatively, a non-corporate stock purchaser may create a new corporation, infuse it with cash, and cause the new corporation to purchase the target stock and effect a section 338 election. To avoid the existence of a useless holding company, the purchaser may merge the new corporation downstream into the target (T) after the qualified stock purchase.
Temp. Reg. [section] 1.338-4T(d), Question 5, appeared to approve of this technique. Unfortunately, Answer 5 stated that a qualified purchase of T stock had only been made "provided that, under the facts and circumstances, P is considered for tax purposes as the purchaser of the T stock." The proviso seemed to elevate form over substance. P would be disregarded if it was merely a facade for the individual shareholder ("B") who negotiated the acquisition of the T stock; conversely, P would be treated as the purchaser if B observed the formality of having P negotiate to acquire the stock in its own right. If this was the intended meaning, Q&A 5 created a trap for the unwary.(3)
Prop. Reg. [section] 1.338-2(b)(1) provides that if an individual forms a corporation to acquire target stock, that corporation may make a qualified stock purchase of target if the new corporation is "considered for tax purposes to purchase the target stock." The new corporation is not considered to be the purchaser of the target stock if the new corporation merges downstream into target, liquidates, or otherwise disposes of the target stock following the stock purchase. In that event, the individual stockholder is considered the purchaser and a section 338 election is not available. The proposed regulations thus seek to clarify the circumstances under which a corporation will be considered transitory for purposes of section 338.
The effect of a transitory corporation is similarly demonstrated in Prop. Reg. [section] 1.338-2(b)(2)(ii), Example 2, whereby P exchanges cash for the stock of N, a new corporation formed for the sole purpose of acquiring all of the T stock by means of a reverse subsidiary cash merger. Pursuant to the plan, N merges into T and the T shareholders receive cash for their stock. The existence of N is disregarded and P is considered the purchaser of the T stock directly from the T shareholders for cash.
TEI recommends that the final regulations clarify how long P must be maintained as a holding company before it is no longer considered transitory. Moreover, we see no policy justification for imposing carryover basis with respect to the disposition of T shares by the holding company where a significant portion of T's assets have been transferred to the holding company and the holding company remains in existence for a period of time, eg., at least two years. We recommend that the final regulations confirm that the rationale used in the rulings is still valid.
Prop. Reg. [section] 1.338-2(b)(5): Effect of Redemptions
Under Temp. Reg. [section] 1.338-4T(c)(4)(i), a qualified stock purchase may be achieved through a combination of P's acquisition of T stock and T's redemption of stock from persons unrelated to P. To meet the 80-percent requirement under section 338(d)(3) and the applicable temporary regulations, P's purchase must be made "during the 12-month acquisition period ending on that day" when the 80-percent requirement is first satisfied. T's redemptions must occur before the close of the same "12-month acquisition period."
The use of the term "12-month acquisition period" in the temporary regulations is unfortunate because the same term appears in section 338(h)(1) where it has a different meaning. That statutory provision states that the "12-month acquisition period" is generally "the 12-month period beginning with the date of the first acquisition by purchase of stock included in a qualified stock purchase . . ." The use of the same terminology to describe two different periods under section 338 has long confused taxpayers.
Prop. Reg. [section] 1.338-2(b)(5) retains the use of the term "acquisition" in describing the 12-month period in which the percentage ownership requirements of section 338(d)(3) can be satisfied. To avoid confusion, TEI recommends that the word "acquisition" be eliminated in the final regulations.
Prop. Reg. [section] 1.338-4. Asset and Stock Consistency
1. In General. Section 338(f) of the Code sets forth the consistency rule for stock acquisitions from the same affiliated group. If a purchasing corporation makes qualified stock purchases with respect to T and one or more T affiliates during any consistency period, a section 338 election for the first purchase shall also apply to the other purchases and no election may be made with respect to the second or subsequent purchases if an election was not made for the first. Temp. Reg. [section] 1.338-4T(e) retained the statutory "all or nothing" approach.
In the proposed regulations, the stock consistency rules are greatly simplified and are applied only where necessary to prevent avoidance of the asset consistency rules. Specifically, Prop. Reg. [section] 1.338-4 imposes carryover basis treatment with respect to an asset sale that occurs during the consistency period, but only if the basis of the target stock, as of the target acquisition date, reflects (through the operation of the investment adjustment provisions of the consolidated return regulations) gain from the disposition of the assets.
TEI supports this significant simplification of the consistency rules. We note, however, that the proposed rule operates on an asset-by-asset basis and makes no offsetting allowance for assets sold at a loss during the consistency period. It therefore improperly penalizes taxpayers where the basis of the target stock, as of the acquisition date, has had no net basis step-up from the sale of assets during the consistency period.
Operation of this rule is shown in Prop. Reg. [section] 1.338-4(e)(2), Example 4. Subparagraph (e) of that example states that the consistency (carryover basis) rule applies to the sale of the gain assets even though the target incurred an "unrelated" loss in an amount equal to the gain.(4) The example does not state whether the unrelated loss was on the sale of assets to the purchaser or an affiliate.
TEI believes that purchasers and affiliates should be permitted to net the gains and losses on asset sales in determining whether the basis of the target stock, as of the acquisition date, reflects gain from the disposition of assets. Moreover, where a net pin exists, the asset consistency rule should be applied only to the extent necessary to reduce basis in the pin assets by the amount of such net gain.
2. De Minimis Rule. The temporary regulations provide that the consistency rules do not apply to certain de minimis acquisitions whose aggregate fair market value does not exceed the lesser of (1) the sum of the "five-percent amounts" for T and all affected T affiliates, or (2) $50,000. Temp. Reg. [section] 1.338-4T(f)(7)(Q&A 2). The proposed regulations eliminate the five-percent requirement, but interject a factual consideration into the dollar threshold. Prop. Reg. [section] 1.338-4(d)(3) provides that the carryover basis rules do not apply to an asset if (1) the asset is not disposed of as part of the same "arrangement" as the acquisition of the target and (2) the aggregate amount realized for all assets otherwise subject to the carryover basis rules does not exceed $250,000.
TEI supports the inclusion of a de minimis rule in the proposed regulations. We believe, however, that a bright-line rule would be simpler to administer and have broader application, especially in light of the reduced need for the consistency rules. Thus, the rule should apply whether or not the asset and target acquisitions are part of an "arrangement."
As proposed, the de minimis exception seemingly contemplates only the case where a qualified stock purchase is preceded by a small asset purchase. The proposed regulations do not provide a de minimis rule for the reverse situation, i.e., where a qualified stock purchase comprises a small part of a large asset purchase. Inadvertent consistency violations can readily occur in such circumstances. The IRS previously recognized the equity of providing relief from the carryover basis treatment of the assets for such inadvertent stock purchases in Rev. Proc. 89-40, 1989-2 C.B. 453, which permits the District Director to grant taxpayer's request to impose a deemed section 338 election for an asset acquisition that includes a qualified stock purchase. The preamble to the proposed regulations does not state whether the revenue procedure remains valid. TEI recommends that the IRS clarify that relief continues to be available in such circumstances.
3. Nonconsolidated Subsidiaries. Prop. Reg. [section] 1.338-4(g) applies the consistency rules to asset acquisitions from nonconsolidated subsidiaries that are part of an affiliated group. Specifically, the proposed regulations apply the consistency rule to a nonconsolidated target that (1) sells an asset at a gain to a purchaser or an affiliate (during the portion of the consistency period that ends on the target acquisition date), and (2) pays dividends to which section 243(aX3) applies. If these requirements are met, the purchaser obtains a carryover basis in the gain assets, regardless of the relationship of the amount of the pin to the amount of the dividend.
TEI believes this rule should be modified to apply the consistency rule only to the extent necessary to reduce basis in the gain assets by the lesser of (1) the total net gain,(5) and (2) the amount of the section 243(a)(3) dividends paid by the target during the period described in Prop. Reg. [section] 1.338-4(g)(1)(iii). The tax benefit to the nonconsolidated selling group will not be greater than the lesser of these two amounts.
4. Controlled Foreign Corporations. Prop. Reg. [section] 1.338-4(h)(2) provides for application of the consistency (carryover basis) rules to assets sold by a controlled foreign corporation (CFC) of a domestic target corporation to a purchaser where the gain on the sale gives rise to Subpart F income under section 951(a)(1)(A) -- effectively increasing the stock basis of the target. Incongruously, Prop. Reg. [section] 1.338-4(h)(2)(ii) disallows the basis increase in the stock of the CFC that would normally occur under section 961(a).(6) The proposed regulations thus impose a double tax penalty: the U.S. target shareholder of the CFC receives a reduced basis in the CFC stock and the purchaser receives a carryover basis in the asset purchased.
This treatment is inconsistent with the application of the proposed regulations to a wholly domestic situation, where the domestic corporation is permitted a positive investment adjustment to the stock basis under Treas. Reg. [section] 1.1502-32. Although there may be a policy justification for such a rule where P is a foreign corporation not subject to U.S. tax, there is no valid rationale for the rule with respect to CFCs of domestic corporations. If the rule is not withdrawn, it should at least be restricted to situations where the purchaser is a foreign corporation with no effectively connected U.S. income.
Prop. Reg. [section] 1.338(h)(10)-1(e)(3): Elective Recognition of Gain or Loss
Prop. Reg. [section] 1.338(h)(10)-1(e)(3) provides that, notwithstanding the deemed sale of assets under section 338(h)(10), New T remains severally liable under Treas. Reg. [section] 1.1502-6(a) for those tax liabilities (including tax liabilities resulting from the deemed sale of its assets) of the other members of the S group that are attributable to taxable years in which those corporations and Old T joined in the filing of a consolidated return.
TEI believes that treating a transferee of assets as being liable for taxes attributable to the selling group is unwarranted and inequitable. If the same transaction were to take the form of an asset sale followed by a section 332 liquidation, it is clear that the tax liability would not be inherited by the purchaser. Since the section 338(h)(10) transaction is treated as an asset sale for virtually all other purposes, it seems implausible that New T would be burdened with this tax liability as if it had actually acquired the stock of Old T. This is especially true where there is a joint election and the selling group has expressly agreed to assume the tax liability arising on the deemed asset sale. Maintaining several liability on the target is an unnecessary and inappropriate impediment to the use of section 338(h)(10). Sound tax policy dictates that several liability should not apply where a section 338(h)(10) election has been made.
Tax Executive Institute appreciates this opportunity to present its views on pending issues relating to the proposed regulations under section 338. If you should have any questions about these comments, please do not hesitate to call either David F. Nitschke, Chair of the Institute's Federal Tax Committee, at (908) 750-6782 or Mary L. Fahey of the Institute's professional staff at (202) 638-5601. (1) General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), permitted non-recognition of gain by corporations on certain distributions of appreciated property to their shareholders and on certain liquidating sales of property. The case was codified in section 337 of the Internal Revenue Code of 1954, which was repealed by the 1986 Act. See Pub. L. No. 99-514, [subsection] 631, 632, and 633. (2) Preamble to T.D. 8294, 1990-1 C.B. 66, 70-71. For an analysis of how these rules work, see Neil Z. Auerbach, New Proposed Regulations Under Section 338: A Study In Consistency, 58 Tax Notes 233, 243-50 (1992). (3) The sentence could also be interpreted to provide that P could be diaregarded as the real purchaser whenever its existence was transitory, resulting in the unavailability of section 338 treatment. (4) The rule does not apply to sales of assets at a loss. Thus, the purchaser's basis in the loss assets is stepped down. (5) In this context, the term "total net gain" means net gains on assets sold to the purchaser or an affiliate during the portion of the target consistency period that ends on the target acquisition date. See our comments at pages 14-16, recommending the netting of gains and losses. (6) Similar rules apply to a passive foreign investment company that is a qualified elective fund under section 1293. Prop. Reg. [section] 1.338-4(h)(2)(i) and (ii).
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|Date:||Nov 1, 1992|
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