The IRS reviews revenue procedure 81-70: the stakes for taxpayers are high.
An acquiring corporation can acquire the shares of stock of a target corporation through a tax-free stock-for-stock exchange in two common ways. The first way is through a direct exchange with the target corporation's shareholders, commonly known as a "B" reorganization. The acquiring corporation has a total tax basis in the stock received equal to the total tax basis that the transferor shareholders had in the shares surrendered. (This is also known as carryover basis or outside basis.) The acquiring company has the burden of collecting the data regarding the tax basis of the shares surrendered.
The second way to acquire the shares of stock of a target corporation is through a reverse stock merger, commonly referred to as an (a)(2)(E) reorganization. In general, reverse stock mergers dwarf "B" reorganizations in number and dollar value. The acquiring corporation may elect from two methods how it determines its total tax basis in the stock received. The first method allows the use of the "B" reorganization rules and hence carryover basis. The second method has the total tax basis in the shares received equal to the total basis that the target corporation has in its assets, net of liabilities. In many cases, the total basis using the first method (outside basis) has been found to be upward of four times greater than the total basis using the second method (inside basis).
Consider this scenario: There is a multi-billion dollar stock-for-stock merger, where the outside basis of the acquired target's stock is $1 billion, and the inside basis is only $250 million. A few years and a corporate reorganization later, the stock is sold for $300 million. Using the inside basis results in a $50-million gain. If the outside basis had been identified, there would be a $700-million loss, a seemingly more palatable position for the company. In other words, a $50 million gain can become a $700 million loss with tax planning.
In Revenue Procedure 81-70, the IRS acknowledges that, in the event the acquired target company is widely held, it would be "time consuming, costly, and burdensome" to collect tax basis data from the target shareholders involved in a "B" reorganization. The revenue procedure hence permits the computation of the acquiring corporation's tax basis in the shares received in the exchange using "standard statistical sampling procedures." To ensure that the statistical estimate of shareholder basis is accurate and precise, Rev. Proc. 81-70 requires that the sampling process meets certain criteria. For example, the study must identify the shareholder population and the sample must be representative of that population. Further, the sampling estimate of shareholder basis must meet the statistical precision criteria established by the revenue procedure.
Arriving at a proper sample for a Rev. Proc. 81-70 study often requires the cooperation of one or more layers of nominees and custodians interposed between the corporation's transfer agent and the tax beneficial owner of a share of stock. These nominees and custodians often have varying degrees of information relevant to tax basis that must be collected and analyzed. Sometimes, the information is fresh and reliable; other times, information is unavailable or sources are not responsive.
In recent months, the Internal Revenue Service has manifested some concerns about the continuing vitality of Rev. Proc. 81-70 and whether sampling procedures used by taxpayers have in all events been proper. While some taxpayers have resorted to abbreviated methodologies, circumventing the procedures in Rev. Proc. 81-70, studies adhering to those procedures can, and have been done, successfully. (If the IRS is not satisfied with the sampling, it potentially has the authority to set the taxpayer's basis in the stock at zero.)
Some pressing issues pertaining to Rev. Proc. 81-70 are the age of the revenue procedure and the transformation of the economic landscape. In the last 20 years, considerable changes have occurred to obscure shareholder ownership, but this does not pose an insurmountable hurdle. Previously, public-company share ownership was fairly identifiable through a transfer agent's registered holder list. Now, a taxpayer may find a significant majority of its outstanding shares held through one nominee. In addition, the securities industry has adopted several initiatives to immobilize physical securities and eliminate certificate holding. These programs have resulted in a significant majority of U.S. securities being held with a central repository, the Depository Trust & Clearing Corporation. Further, a consolidation among nominees has enabled the creation of a central clearing and settlement operation, known as National Security Clearing Corp. The NSC enables substantial cost efficiencies while dealing with the explosive trading volume the stock market has seen over the last decade.
Other less obvious issues exist that may present obstacles to the unsophisticated taxpayer. Understanding the multiple layers of share ownership is the first step an acquirer of a publicly traded target may want to take in conducting a Rev. Proc. 81-70 study in order to assay and comprehend the demographics of its owners and their respective stock bases. Cooperation by nominees and bank and broker custodians can be paramount to the success of a Rev. Proc. 81-70 study. Record retention is another important issue for basis gathering. It is not enough for the taxpayer to have a copy of the target company's registered holder list as of transaction close. A taxpayer conducting a Rev. Proc. 81-70 study should be concerned whether the custodian has the appropriate records on the beneficial owners of the acquired target company. Further, shareholder responsiveness can decrease with transaction age. Certainly, it behooves the taxpayer to take advantage of the availability of shareholder records, through the custodians or from the shareholder itself, by conducting a Rev. Proc. 81-70 study contemporaneous with the transaction close.
Changes in the shareholder ownership dynamics coupled with the uncertain availability of shareholder records have seemingly opened opportunities for "diverse" procedure interpretation. Apparently, some taxpayers and their advisers have debated the feasibility of conducting a study that follows the revenue procedure. In addition, vagaries with respect to the identification of the shareholder population and the statistical sampling flame within the revenue procedure may have led to a preponderance of basis estimations. These estimations in lieu of a well-defined study based on actual shareholder tax basis data appear to have fueled the IRS's concern over compliance with Rev. Proc. 81-70. In the event the IRS questions the propriety of alternative interpretations, taxpayers may be at risk for multi-million-dollar adjustments.
Concern about over-aggressive interpretations of Rev. Proc. 81-70 has prompted a review of the area. As the IRS plans its course of action, taxpayers should scrutinize how best to pursue basis studies with a focus on complying with the revenue procedure. They may want to consider the following issues:
* Did we ascertain the tax basis of that stock we acquired in the "B" reorganization we conducted X number of years ago?
* If we did not, when do we plan on conducting a basis study--keeping in mind the record retention issue and the added risks for delay?
* If a study was conducted, how well did it adhere to the revenue procedure?
* In the study, how much latitude was given in interpretation?
* What attempt, if any, was made to contact the shareholders to retrieve their actual basis data?
The IRS will continue its own fact finding. First, the IRS is likely to query field agents on the prevalence of Rev. Proc. 81-70 basis studies. In the current climate of reorganizations, restructurings, and bankruptcies, one can assume that the number of basis studies to be conducted and reviewed will continue to grow.
If actions are warranted, the IRS's next step may be to issue a director's memorandum establishing guidelines for the field agents, essentially providing them a heads-up on what to look for. For taxpayers, the issuance of such guidance should be a red alert for internal compliance. Whether authoritative guidance (such as another revenue procedure) will be issued depends on the IRS's assessment of Rev. Proc. 81-70's continued viability. If the revenue procedure is deemed sound though in need of clarification, a new revenue procedure may not be inevitable. At the same time, the issue will likely not go away any time soon. The economic landscape, with its corporate reorganizations, has highlighted the importance of the basis study to the taxpayer. With the amount of money at risk for adjustment, the IRS may be less likely to tolerate more creative interpretations of the revenue procedure.
JULIANE LAURA KEPPLER is Managing Director of Shareholder Services, a division of KPMG's Mergers & Acquisitions practice, where she conducts stock basis studies to assist clients in complying with IRS reporting requirements. She received her M.B.A. degree in 1991 and has been specializing in shareholder demographics for more than 15 years.
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|Title Annotation:||determining the tax basis of stock acquired in tax-free corporate acquisitions|
|Author:||Keppler, Juliane Laura|
|Date:||Mar 1, 2003|
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