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Significant recent developments.


The TIPRA made significant changes to the Sec. 355 spinoff rules.

* Several regulations were issued and amended on a range of issues.

* The IRS obtained a victory in Coltec Industries, Inc., applying the economic-substance doctrine to disallow a large capital loss.


This article summarizes selected income tax developments during the past year affecting corporations, including those that file consolidated returns. Since the last update (1) (approximately one year ago), the most significant tax legislation enacted was the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), signed into law on May 17, 2006. For corporate taxpayers, the most significant TIPRA changes are the amendments to the Sec. 355 spinoff rules. Those changes--as well as other selected administrative and case law developments--discussed below.

TIPRA Changes to Sec. 355

Under Sec 355, if a corporation (the distributing corporation) distributes to a shareholder with respect to its stock, or to a security holder in exchange for its securities, solely stock or securities of a corporation (the controlled corporation) that it controls immediately before the distribution, no gain or loss is recognized to such shareholder or security holder. The distribution may also qualify for nonrecognition at the corporate level, under Sec. 355(c) or 361(c). This statutory provision--popularly thought of as enabling tax-flee spinoffs--contains a number of requirements that must be satisfied, and the TIPRA enlarged the list.

Under the TIPRA, new Sec. 355(b)(3) amends the active-trade-or-business requirement, while new Sec. 355(g) provides an exclusion from Sec. 355 for distributions involving qualified investment companies.

Modification of Active-Business Definition

To qualify for nonrecognition treatment, both the distributing corporation and the controlled corporation must, immediately after the distribution, be engaged in the active conduct of a trade or business, among other requirements. Under Sec. 355(b)(2)(A), a corporation is treated as engaged in the active conduct of a trade or business only if it is directly engaged in the active conduct of a trade or business, or "substantially all" (2) of its assets consist of stock and securities of a corporation controlled by it that is so engaged.

Following the TIPRA amendment, for distributions made after May 17, 2006 and before 2011, all members of a corporation's separate affiliated group are treated as one corporation for purposes of the active-conduct test. For this purpose, a corporation's separate affiliated group is the affiliated group, determined under Sec. 1504(a) as if such corporation (e.g., the distributing or controlled corporation) were the common parent and Sec. 1504(b) did not apply. Transition rules are provided for certain corporations seeking to rely on the old standard of direct satisfaction or meeting the holding--company requirement. (3)

New Sec. 355(b)(3) is intended to liberalize the active-wade-or-business requirement. By permitting a corporation to rely on the business of a lower-tier affiliate for purposes of the requirement, Sec. 355(b)(3) effectively introduces a lookthrough rule. Thus, for distributions occurring before 2011, corporations not directly engaged in business operations will not be subject to the "substantially all" requirement. Rather, the active-business requirement will be satisfied if at least one corporate affiliate (whether domestic or foreign) is engaged in a five-year active wade or business.


The TIPRA also added new Sec. 355(g), providing that Sec. 355 (and the portion of Sec. 356 that relates to Sec. 355) does not apply to any distribution that is a part of a transaction, if (1) either the distributing or the controlled corporation is a disqualified investment corporation immediately after the transaction and (2) any person that did not hold a 50%-or-greater interest (by vote or value, determined using the Sec. 318 attribution rules) immediately before the transaction, holds such an interest immediately after the transaction in a disqualified investment corporation.

A disqualified investment corporation is any distributing or controlled corporation if the aggregate fair market value (FMV) of the corporation's investment assets is: (1) 2/3 or more of the FMV of all assets of the corporation, for distributions after the end of the one-year period beginning on May 17, 2006; and (2) for distributions during such one-year period, 3/4 or more of the FMV.

Investment assets include (1) cash; (2) stock or securities; (3) interest in a partnership; (4) any debt instrument or other evidence of debt; (5) any option, forward or futures contract, notional principal contract or derivative; (6) foreign currency; or (7) any similar asset. Exceptions exist for assets used in the active conduct of certain lending or finance, banking and insurance businesses. An exception also exists for securities marked-to-market.

Investment assets do not include stock, securities, debt instruments, options, forward or futures contracts, notional principal contracts or derivatives issued by a 20%-controlled entity. This is a corporation whose stock is at least 20% owned (by vote and value), directly or indirectly, by the distributing or controlled corporation. Under a lookthrough rule, a distributing or controlled corporation is treated as owning its ratable share of the assets of any 20%-controlled entity.

In addition, partnership interests and debt instruments issued by a partnership are not investment assets if one or more of the partnership's wades or businesses are taken into account by the distributing or controlled corporation for purposes of the Sec. 355(b) active-wade-or-business requirement. Under a lookthrough rule, the distributing or controlled corporation is treated as owning its ratable share of the partnership's assets.

The amendments are generally effective after May 17, 2006, but a transition rule excludes distributions pursuant to a transaction (1) made under an agreement binding on that date, and at all times thereafter; (2) described in a ruling request submitted to the Service on or before that date; or (3) described on or before that date, in a public announcement or in a filing with the Securities and Exchange Commission.

New Sec. 355(g) addresses "cash-rich" spinoff or split-off transactions. The provision might be viewed as a supplement to the historic "device" requirement of Sec. 355(a)(1)(B), placing limits on the amount of investment assets of either the distributing or the controlled corporation, when compared to the respective corporation's qualifying trade or business assets.

Final Regs.

Sec. 338(h)(10) Election For qualified stock purchases, Sec. 338 allows a purchasing corporation to elect to treat the target as having sold all of its assets at the close of the acquisition date at FMV, then treats the target as a new corporation that purchased all of its assets as of the beginning of the next day.

Final regulations (4) allow a Sec. 338 (h)(10) election to be made for a target (T) when the acquiring parent's (P's) acquisition of T stock, viewed independently, constitutes a qualified stock purchase, even though T merges or liquidates into P after the acquisition (and restless of whether the stock purchase and subsequent merger/liquidation, taken together, qualify as a Sec. 368(a) reorganization under relevant law (including the step-transaction doctrine)).

The final regulations adopted proposed regulations issued in 20035 without modification. They made permanent the Service's reversal of its earlier position in Rev. Rul. 2001-46, (6) in which the IRS concluded that it treat the merger of a newly created subsidiary into T, followed by the merger of T into P, as a single statutory merger of T into P that qualifies as a tax-free reorganization under Sec. 368(a)(1)(A) and, thus, not eligible for a Sec. 338 election (because the initial stock acquisition is disregarded under step-transaction principles). The final regulations thus preserve a taxpayer's ability to effectively "turn off" the step-transaction doctrine for Sec. 338(h)(10) transactions; however, the regulations do not apply to "regular" or unilateral, Sec. 338(g) elections (which are often made when T is foreign).

Anti-Loss Duplication

The Service also issued Regs. Sec. 1.1502-35, (7) which is intended to prevent a consolidated group from duplicating deductions or losses within a consolidated return. The final regulations adopted the rules of Temp. Regs. Sec. 1.1502-35T (8) as in effect on Feb. 1, 2006, without substantive changes, but modified certain examples to reflect the enactment of Sec. 362(e)(2). The amendments do not change the regulations' operation or address the application of Sec. 362(e)(2) to transactions between consolidated group members.

In addition, the final regulations also adopted related provisions in Temp. Regs. Secs. 1.1502-21T and -32T as final, without substantive changes. The related temporary stock loss disallowance rule (Temp. Regs. Sec. 1.337(d)-2T) was similarly adopted as a final regulation on March 3, 2005, without substantive change. (9) In the preamble to the final regulations, the IRS stated an intent to publish a single set of proposed regulations on the circumvention of General Utilities (10) repeal through (1) inappropriate stock losses and (2) loss duplication.

Basis Determinations in Certain Reorganizations

Sec. 358(a)(1), in general, provides that the basis of stock or securities received in a nonrecognition exchange to which Sec. 351,354, 355,356 or 361 applies, is the same as that of the property exchanged, decreased by the (1) FMV of any other property (except money) received by the taxpayer, (2) any money received by the taxpayer and (3) loss to the taxpayer recognized on such exchange, and increased by the (1) amount treated as a dividend and (2) gain the taxpayer recognized on such exchange (not including any portion treated as a dividend).

The Service issued final regulations (11) under Sec. 358 addressing the determination of the basis of stock or securities received in exchange for, or with respect to, stock or securities in certain Sec. 368 reorganizations. Also amended were Sec. 356 regulations addressing the computation of gain on the receipt of boot in a reorganization. Temporary and proposed regulations (12) under Sec. 1502 that govern basis determinations and adjustments of subsidiary stock in certain transactions involving consolidated group members, were also included. The final and temporary regulations were effective on Jan. 23, 2006. The final regulations retained the tracing method of other prior proposed regulations, (13) but made the modifications discussed below in response to the comments received.

Allocation of Consideration Received

The final regulations provide that, for an exchange subject to Sec. 354, 355 or 356, when a shareholder or security holder receives stock or securities of more than one class, or other property or money in addition to shares, to the extent the exchange's terms specify which shares of stock, securities, other property or money are received in exchange for a particular share of stock or security (or a particular class of stock or securities), the terms Hill control, provided they are economically reasonable, for purposes of applying both Sec. 356 (treatment of boot) and Sec. 358 (basis in stock or securities received).To the extent the terms do not provide a specific allocation of the consideration received, it (including boot) is allocated pro rata to the surrendered stock and securities, in accordance with their relative FMVs. The regulations also include similar rules that apply to Sec. 355 distributions. The Service and Treasury will continue to study situations in which the stock (or security) surrendered is subject to a loss. The regulations also provide special rules for stockless reorganizations. (14)

Finally, the regulations do not apply to "pure" Sec. 351 exchanges (i.e., they will apply to an "overlap" transaction if it is a Sec. 351 exchange, but will not apply if the shareholder or security holder exchanges property for stock or securities in an exchange to which neither Sec. 354 nor 356 applies, or if shareholder or security holder liabilities are assumed).


Regs. Sec. 1.1502-19(d) generally provides that if a consolidated group member has an excess loss account (ELA) (i.e., negative basis) in shares of a class of another member's stock at the time of a basis adjustment or determination as to other shares of the same class owned by the member, the adjustment or determination is allocated first to equalize and eliminate that member's ELA. This rule reflects a policy of encouraging ELA elimination.

The IRS is expanding the situations to which this policy will apply, through temporary regulations. The additional rule added to Regs. Sec. 1.1502-19 provides that, if a member would otherwise determine shares of a class of stock (a new share) to have an ELA and such member owns one or more other shares of the same class, the basis of such other shares is allocated to eliminate and equalize any ELA that would otherwise exist in the new shares.

Expansion of Merger Reorganizations

Sec. 368 provides for general non-recognition treatment for certain reorganizations. Under Sec. 368(a)(1)(A), a reorganization includes a statutory merger or consolidation. The Service issued final regulations (15) revising the definition of "statutory merger or consolidation" for Sec. 368(a)(1)(A) purposes. They essentially adopted proposed regulations issued in 2005 as final, with certain technical changes. (16) The primary significance is that a statutory merger or consolidation is no longer limited to a transaction effected under the laws of the U.S., a state or the District of Columbia. Now, a transaction can qualify if it is effected under any statute(s), whether or not domestic. Thus, a merger transaction pursuant to foreign law may qualify as a reorganization within the meaning of Sec. 368(a)(1)(A), and foreign corporations may qualify as parties to a reorganization. (17) The regulations were effective Jan. 23, 2006.

The final regulations essentially adopted the 2005 proposed regulations, with certain technical changes and clarifications. They clarify that a stock acquisition, followed by a conversion of the target to an entity disregarded as separate from its corporate owner (under either a state conversion statute or an entity-classification election under Regs. Sec. 301.7701-3 (i.e., a check-the-box election)) will not qualify as a statutory merger or consolidation, because the target does not cease its separate legal existence for all purposes. In the preamble, the Service stated that it will continue to consider whether a stock acquisition followed by a conversion of the target to a disregarded entity should qualify as a statutory merger or consolidation.

The final regulations also clarified that the existence and composition of the "transferee unit" is tested immediately before the transaction, not after. The IRS is considering certain mergers involving corporations and partnerships that may raise additional tax consequences to the parties to the transaction, including the extent to which the principles of Rev. Rul. 99-6 (18) apply and the resulting consequences.

To qualify as a statutory merger or consolidation, Kegs. Sec. 1.368-2(b) (1)(ii)(B) requires that all of the assets and Labilities of the target combining unit (consisting of the target and all of its disregarded entities) must become the assets and liabilities of the acquiring combining unit (consisting of the acquiring corporation and all of its disregarded entities) (the transferee unit). A commentator questioned whether the following could qualify as a statutory merger or consolidation: A and T, both corporations, together own all of the membership interests in P, a limited liability company treated as a partnership for Federal income tax purposes. T merges into P; the T shareholders exchange their T stock for A stock. As a result of the merger, P becomes an entity disregarded as separate from A. There was concern that P, the entity acquiring the target's assets, may not be considered a member of the acquiring combining unit, because it was not wholly owned by that unit prior to the merger.

In response, Kegs. Sec. 1.368-2(b) (1)(iii), Example 11, clarifies that the composition of the acquiring combining unit is determined immediately after the transaction. Hence, because immediately after the merger, P is wholly owned by A and, thus, is disregarded as separate from A, Kegs. Sec. 1.368-2(b)(1)(ii)(B) is satisfied. The Service is considering the implications of the above transaction from a partnership perspective and invites comments, including the extent to which Rev. Rul. 99-6 applies and the ramifications.

The IRS indicated that consolidating or amalgamating entities continuing in a resulting corporation do not prevent a consolidation or an amalgamation from qualifying as a statutory merger or consolidation, although it intends to study further the appropriate characterization of such transactions in the context of Sec. 368(a) (1) (F).

Application of Sec. 367(a) and (b) to Outbound Sec. 304(a)(1) Transactions

Sec. 304(a)(1) generally provides that, for purposes of Secs. 302 and 303, if one or more persons are in control of each of two corporations and, in return for property, one corporation (the acquiring corporation) acquires stock in the other (the issuing corporation) from the person(s) in control, such property shall be treated as a distribution in redemption of the acquiring corporation's stock. To the extent the distribution is treated as one to which Sec. 301 applies, the transferor and the acquiring corporation are treated as if the (1) former transferred the issuing corporation's stock to the latter in exchange for its stock in a transaction to which Sec. 351 (a) applies and (2) acquiring corporation then redeemed the stock it is treated as having issued.

Sec. 367(a)(1) provides that if, in connection with certain nonrecognition transactions (including Sec. 351), a U.S. person transfers property to a foreign corporation, such corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered a corporation. In addition, certain Sec. 351 exchanges can cause the exchanging shareholder to include in income a deemed dividend under Sec. 367(b).

On Feb. 17, 2006, Treasury issued final regulations under Sec. 367(a) and (b) on the interaction of Secs. 304 and 367. (19) They adopted, with modest amendments, the proposed regulations issued on May 25, 2005. (20) Specifically, they provide that Sec. 367(a) and (b) do not apply to deemed outbound Sec. 351 exchanges that arise solely by reason of a transaction described in Sec. 304(a) (1). The final regulations apply to Sec. 304(a)(1) transactions occurring after Feb. 20, 2006; however, taxpayers may elect to apply them to all Sec. 304(a)(1) transactions that occurred in open tax years. In these cases, any gain-recognition agreements filed with respect to such transactions under Regs. Sec. 1.367(a)-8 shall terminate and have no further effect.

Temp. Regs. Reduce Corporate Reporting Burdens

The Service issued temporary regulations amending regulations under Secs. 302, 331,332, 338, 351,355, 368, 381,382, 1081, 1221, 1502, 1563 and 6012. (21) They also generally address and revise various reporting requirements. In addition to eliminating reporting requirements that pose impediments to electronic filing (e-filing), they streamline various reporting requirements, by eliminating certain provisions that the IRS no longer deems necessary. In conjunction with the temporary regulations, the Service also issued a notice of proposed rulemaking. The temporary regulations were generally effective on May 30, 2006, and sunset on May 26, 2009.

The IRS also issued Rev. Proc. 2006-21, (22) which eliminates certain impediments to e-filing found in Rev. Procs. 89-56, (23) 90-39 (24) and 2002-32. (25)

Prop. Regs.

Basis Shifting to Create Artificial Losses

In Ann. 2006-30, (26) the Service announced the withdrawal of proposed regulations (27) providing guidance on the treatment of the basis of redeemed stock when a redemption is treated as a dividend under Sec. 301. The withdrawal was effective on April 19, 2006.

The proposed regulations had set forth a general rule that, in any case in which the amount received in a redemption was treated as a dividend, the basis for the redeemed stock would not shift to other shares owned by the redeemed shareholder, or to shares owned by another person whose stock ownership would be attributed to the redeemed shareholder. Rather, the proposed regulations would have allowed, and suspended, a loss equal to the basis of the redeemed stock.

In response to comments that the proposed regulations' approach was an unwarranted departure from current law and would create the potential for two levels of tax in certain transactions, the government decided to withdraw the proposed regulations. It is continuing to study their approach and seeks comments on whether a difference should be drawn between a redemption in which the redeemed shareholder continues to have direct ownership of the stock in the redeemed corporation (whether the same class of stock as that redeemed or a different class) and a redemption in which the redeemed shareholder only constructively owns stock in the redeemed corporation. The Service is also interested in comments on whether a different approach is warranted for (1) corporations filing consolidated returns and (2) Sec. 304(a)(1) transactions.

In addition, it is also studying whether, under Sec. 301(c)(2), basis reduction should be limited to the basis of the redeemed shares or whether it is appropriate to reduce the basis of both the retained and redeemed shares before applying Sec. 301(c)(3).The IRS stated that it is considering approaches other than the one recently articulated in TD 9250, (28) that only the basis of the shares redeemed may be recovered under Sec. 301(c)(2). It seeks comments on this issue.

"Killer B" Transactions

Notice 2006-85 (29) announced the Service's intention to issue regulations under Sec. 367(b) to address a repatriation transaction it has deemed abusive. The prototypical transaction--popularly known as a "Killer B" transaction--involves the acquisition by a first-tier foreign subsidiary of a domestic parent; the former acquires a foreign target from another corporate chain in a triangular reorganization under Sec. 368(a)(1)(B), using domestic parent voting stock acquired for cash or notes. As described by the IRS, the parent would claim no income or gain on the proceeds it receives from the foreign acquiring corporation, citing Sec. 1032. In the notice, the Service announced that it intends to issue regulations that would generally apply to transactions occurring after Sept. 21, 2006 to require, among other things, that the parent treat the proceeds received for its stock as a Sec. 301 distribution from the foreign acquiring corporation.

Case Law

One of the most significant recent cases interpreting the "economic substance doctrine" represents another installment in the ongoing saga and tension between form and substance; this time, the Service obtained a victory by convincing the Federal Circuit to apply the economic-substance doctrine in disallowing a large capital loss.

In Coltec, (30) the taxpayer, a consolidated group, revived a dormant subsidiary with the intent of making it an asbestos claims manager. One of the group members transferred its creditor position in a $375 million intercompany note (i.e., an asset) to the revived subsidiary, in exchange for stock representing approximately 7% of the transferee's outstanding stock and the transferee's assumption of all asbestos-related claims against the transferor (estimated at approximately $375 million). The transferor subsequently sold its 7% interest outside the affiliated group for $500,000, claiming a significant capital loss because, it asserted, there was no downward stock-basis adjustment for the assumption of contingent liabilities such as its asbestos-related claims under Sec. 358 (prior to the 2000 enactment of Sec. 358(h)). Tax planning was involved; the taxpayer had realized a significant capital gain within the same tax year, and sought capital losses with which to offset its gains.

Although the court drew a significant conclusion that the contingent asbestos liabilities constituted a "liability" within the meaning of Sec. 358(d)--which appeared to give the taxpayers the stock basis result desired--it ultimately decided that the transaction's liability-assumption leg lacked economic substance and, thus, should be disregarded. The court primarily focused on a lack of objective business purpose (although it suggested the taxpayer would lose simply based on lack of subjective intent of performing any function other than tax avoidance).

Causing some consternation among tax professionals is the court's apparent focus, not on the business purpose of the overall transaction, but instead on a specific step or one part of a specific step (i.e., the assumption of asbestos liabilities in exchange for the creditor position of a note), suggesting that a more micro-level economic-substance analysis must be applied to a multistep transaction. That is, even though there may be economic substance in establishing a separate subsidiary to manage asbestos liabilities, the court found no economic substance for the transfer of such liabilities in exchange for the note. It stated that such a transaction could only affect relations among the affiliated group, and had absolutely no effect on third-party asbestos claimants. Thus, it concluded, the transaction had to be disregarded for tax purposes.

For more information about this article, contact Mr. Bakke at

Author's note: The authors gratefully acknowledge the thoughtful comments and assistance of Robert P. Hansen and Laura Berson. The views expressed herein are the author's alone, and not necessarily those of Ernst & Young LLP.

(1) See Bakke and Zaitzeff, "Corporations & Shareholders: Significant Current Developments," 37 The Tax Adviser 100 (February 2006).

(2) The IRS has defined "substantially all" as 90% of the fair market value (FMV) of the gross assets; see Rev. Procs. 77-37, 1977-2 CB 568, Section 3.04, and 96-30, 19961 CB 696, Section 4.03(5).

(3) Notice 2006-81, IRB 2006-40, 595, provides guidance on Sec. 355(b)(3), addressing the continuing applicability of Sec. 355(b)(2)(A), as well as the transition rule.

(4) TD 9271 (7/10/06).

(5) TD 9071 and REG-143679-02 (both dated 7/9/03).

(6) Rev. Rul. 2001-46, 2001-2 CB 321.

(7) TD 9254 (3/13/06).

(8) TD 9048 (3/14/03).

(9) TD 9187 (3/22/05). For a summary, see Bakke and Zaitzeff, note 1 supra, at pp. 102-103.

(10) See General Utilities & Operating Co., 296 US 200 (1935). Under the General Utilities doctrine, a corporation could distribute appreciated property to its shareholders without recognizing gain. The Tax Reform Act of 1986 repealed this holding to require corporate-level gain recognition on the corporation's sale or distribution of appreciated property.

(11) TD 9244 (1/26/06).

(12) REG-138879-05 (1/26/06).

(13) REG-116564-03 (5/03/04).

(14) See Regs. Sec. 1.358-2(a)(2)(iii).

(15) TD 9242 (1/26/06).

(16) REG-117969-00 (1/5/05). For a summary; see Bakke and Zaitzeff note 1 supra, at p. 104.

(17) See Sec. 368(b).

(18) Rev. Rul. 99-6, IRB 1996-1, 6.

(19) TD 9250 (2/17/06).

(20) REG-127740-04 (5/25/05).

(21) TD 9264 and REG-134317-05 (both dated 5/30/06).

(22) Rev. Proc. 2006-21, IRB 2006-24, 1050.

(23) Rev. Proc. 89-56, 1989-2 CB 643.

(24) Rev. Proc. 90-39, 1990-2 CB 365.

(23) Rev. Proc. 2002-32, 2002-1 CB 959.

(26) Ann. 2006-30, IRB 2006-19, 879.

(27) REG-150313-01 (10/18/02).

(28) See note 19, supra.

(29) Notice 2006-85, IRB 2006-19, 879.

(30) Coltec Industries, Inc., 454 F3d 1340 (Fed. Cir. 2006).

Don W. Bakke, J.D., LL.M.

Senior Manager

Transaction Advisory Services

Ernst & Young LLP

New York, NY

Elizabeth Zaitzeff, J.D., LL.M.


National Tax M&A/Transaction Advisory Services

Ernst & Young LLP

Washington, DC
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Title Annotation:Corporations & Shareholders
Author:Zaitzeff, Elizabeth
Publication:The Tax Adviser
Date:Jan 1, 2007
Previous Article:Tax section survey results.
Next Article:Interaction of the AMT and S Corporation basis rules (part I).

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