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Consolidated Returns Issues and Developments

Consolidated Returns Issues and Developments. American Bar Association Winter Meeting– February 17, 2012. Panelists:. Marie Milnes-Vasquez Mark Schneider IRS Office of Chief Counsel Deloitte Tax LLP Washington, DC Washington , DC Matt Gareau Dianna Muth

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Consolidated Returns Issues and Developments

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  1. Consolidated Returns Issues and Developments American Bar Association Winter Meeting– February 17, 2012

  2. Panelists: Marie Milnes-Vasquez Mark Schneider IRS Office of Chief Counsel Deloitte Tax LLP Washington, DC Washington, DC Matt Gareau Dianna Muth Deloitte Tax LLP Steptoe & Johnson LLP Washington, DC Washington, DC

  3. Agenda • ILM 201148006 – Affiliation of Medical Practice • PLR 201148002 – Affiliation of Insurance Companies • PLR 201149015 – §165 and Intercompany Transactions • PLR 201143012 – ELAs • Magma Power • Reverse Acquisition Issues • CERT Issues

  4. Affiliation of Medical Practice ILM 201148006

  5. Affiliated Groups – §1504(a) Requirements • For an includable corporation to be affiliated with a group, one or more other group members must directly own stock: • possessing at least 80 percent of the total voting power of the corporation’s stock (vote requirement), and • at least 80 percent of the total value of the corporation’s stock (value requirement). • The value requirement is generally met by analyzing two factors: • right to dividends, and • right to liquidation proceeds.

  6. ILM 201148006 P Hospital • Facts: Hospital (“P”) is the sole holder of all ownership interests in incorporated Medical Practice (“Sub”). P completely controls the board of trustees of Sub and the bylaws grant P the ability to unseat any trustee of Sub at any time, without cause. In addition, P had the power to amend both the Bylaws and the Articles at any time. State law prohibits Sub from making dividend distributions, and Sub is insolvent or may have been at certain relevant times. The board of trustees of Sub had the right to determine who received liquidating distributions. As stated, P controlled the board of trustees, so P effectively had distribution rights by virtue of such control. • Conclusion: Sub is includible in the P consolidated group. Sub Medical Practice

  7. ILM 201148006 • Analysis: • The Field Memo concluded the vote requirement for affiliation was satisfied, so the vote requirement was not in question. • The ILM focused on the value requirement for affiliation, looking to the right to dividends and the right to liquidation proceeds. • The Field Memo argued that because state law prohibited Sub from making dividend distributions, P did not possess the right to dividends to meet the value requirement. • The ILM did not find such prohibition to be fatal because state law prohibited Sub from paying dividends to any party, not just P. • The Field Memo argued that the right to liquidation proceeds was arguably not present because Sub was insolvent. • The IRS National Office disagreed, citing Rev. Rul. 63-104 (which provides that a subsidiary's bankruptcy filing does not cause a deconsolidation).

  8. ILM 201148006 • Analysis (continued): • The Field Memo and the ILM agreed that, by virtue of its control of Sub’s board of trustees, P had rights to the distribution of Sub’s assets upon liquidation. • The Field Memo also argued that the right to liquidation proceeds arguably was not present because a transfer of assets to P would not further the enumerated purposes listed in the Articles of Sub, and that such a transfer would arguably be precluded by Bylaws and Articles. • The IRS National Office disagreed, stating that P’s ability to remove trustees without cause and the ability to amend the Articles and Bylaws at any time effectively granted P the ability to determine who would receive liquidating distributions. Also, the ILM stated that one of Sub’s corporate purposes was to “deliver health care to the public,” and P’s business activities involve providing health care to the public. As such, the Field Memo’s argument was not supportable. • The IRS National Office noted, however, that its conclusion regarding the value requirement was not free from doubt due to possible differences in interpretation of the organizational documents under state law. • Compare PLR 201024001.

  9. PLR 201024001 P Sub 2 Sub 1 PRS Sub 3 Facts: Parent (“P”) indirectly owns Sub 1 and Sub 2. Sub 1 is a member of P’s consolidated group (the “Group”). Sub 2 is not a member of the Group. Sub 1 and Sub 2 own all interests in PRS. Sub 3 employs physicians and operates a medical services business. Regulations preclude Sub 1 from having control over decisions relating to the professional practice of medicine (e.g., termination or retention of physicians). The board of directors of Sub 3 must be comprised of physicians. The PLR’s Ruling: Sub 1’s ownership of Sub 3 satisfies the affiliation requirements, and Sub 3 is included in the Group.

  10. PLR 201024001(continued) Representations: • Sub 1 is the only person with a legal or beneficial interest in the equity of Sub 3; • Sub1 has sole voting power to elect Sub 3’s directors, to remove Sub 3’s directors, to determine Sub 3’s operating budget, to appoint Sub 3’s officers, and to control Sub 3’s decision to completely liquidate; • The only voting matter Sub 1 does not control is Sub 3’s decision relating to the professional practice of medicine, which Sub 3’s board has exclusive control over; • Sub 1 has sole entitlement to liquidation proceeds of Sub 3; and • Sub 3 is precluded under state law from paying any dividends, and Sub 3 is governed by Code Y, which precludes Sub 1 from having control over decisions relating to the professional practice of medicine (e.g., termination or retention of physicians, credentialing, quality assurance, utilization review, peer review, and the practice of medicine). Query: • Generally, when a law or regulatory body inhibits a corporation's ability to take certain actions, what is the impact on the affiliation requirements? • Because the regulatory body disallows certain decisions, such as the ability to fire key personnel, how does this interference impact the vote or value requirements? • Compare “Friendly Doctor Ruling” – PLR 9605015, revoked by PLR 9752025.

  11. Affiliation of Insurance Companies PLR 201148002

  12. PLR 201148002 Result Transaction • Facts: Parent (“P”) owns Sub 1. Sub 1 owns Sub 2. P, Sub 1, and Sub 2 constitute a consolidated group (the “Parent Group”). A regulator (“Dept.”) issued an order requiring Sub 1 to pay and satisfy each valid claim under an insurance policy issued by Sub 1. The claims were to be satisfied in part with cash and in part by allocating to the insured holding such claim an undivided special preferential interest in Sub 1’s surplus (the “USPIs”). Policy holders P P Policy holders Sub 1 Sub 1 undivided special preferential interests Sub 2 Sub 2

  13. PLR 201148002 (continued) • Description of the USPIs (What are they?): • The USPIs are not evidenced by formal notes or other instruments of indebtedness nor is there a fixed term or maturity date; • Sub 1 recorded the USPIs in its financial statements; • The USPIs accrue interest, and the interest payable account is kept separate from the USPI balance (no interest is charged on the interest payable account); • Payment of the USPIs and associated interest is subject to the future financial performance of Sub 1 and Sub 2 and requires approval from Dept.; • Payment of the USPIs are senior to any distributions, and have equal priority to payment of all other claims made by policyholders in a liquidation proceeding; • The financial projections prepared for Sub 1 and Sub 2 indicate that Sub 1 will not be able to satisfy 100 percent of the USPIs; • The USPIs are generally neither transferable nor convertible into any class of stock of any member of the Parent Group;

  14. PLR 201148002 (continued) • Description of the USPIs (continued): • Sub 1 treats the USPIs as debt for US federal income tax purposes and equity for financial statement purposes applicable to insurance companies; • The USPIs do not provide any of the following to the holders of the USPIs: control over Sub 1 or Sub 2, influence over the management of Sub 1 or Sub 2, the right to participate in the election of corporate directors, the right to receive dividends, the right to receive liquidation proceeds in excess of the USPI balance, nor the right to participate in the management of Sub 1; and • Under no circumstances could an insured allocated an USPI in Sub 1’s surplus ever acquire rights to participate in the management of Sub 1 by reason of its ownership of the USPI. • The Ruling: • The USPIs do not cause Sub 1 to cease to be a member of the Parent Group.

  15. §165 and intercompany transactions PLR 201149015

  16. PLR 201149015Background on §165(g)(3): • A domestic Taxpayer may claim an ordinary loss with respect to the stock of Loss Co under section 165(g)(3) if: • Worthlessness is established for Loss Co’s stock (i.e., the same test as under section 165(g)(1)); • Loss Co is “affiliated” with Taxpayer (i.e., Taxpayer must directly own Loss Co stock that has at least 80% of the total voting power and at least 80% of the total value of Loss Co); AND • more than 90% of Loss Co’s aggregate “gross receipts” for all taxable years are from sources other than royalties, rents, dividends, interest, annuities, and gains from the disposition of stocks or securities (i.e., passive income). • Note that the amount of the worthless stock loss of a consolidated group member is subject to the unified loss rule under Treas. Reg. § 1.1502-36.

  17. PLR 201149015Facts: Parent3 • In Year 2, HoldCo2 (the “worthless entity”) filed a consolidated return as the common parent with its subsidiaries Sub1, Sub2, and Sub3. • In Year 4, the HoldCo2 group became members of the Parent1 Group as a result of a reverse subsidiary cash merger. • In Year 7, the Parent2 Group became part of the Parent3 Group. HoldCo1 TP HoldCo2 Sub2 Sub1 Sub3

  18. PLR 201149015Facts: • Intercompany Transactions: • Beginning in Year 3: Sub1 and Sub2 distributed cash dividends to HoldCo2. • Years 8 and 9: Some or all of Sub1’s distributions to HoldCo2 were in excess of Sub1’s current and accumulated E&P. • Years 3 – 6: HoldCo2 provided management services for a fee to Sub1, Sub2, and Sub3. • Year 3: Sub1 sold furniture and fixtures to HoldCo2. HoldCo2 $, property, fees Services Sub2 Sub1 Sub3

  19. PLR 201149015Facts: TP • In Year 9: All of the stock of HoldCo1 was contributed to TP and the stock of TP was distributed out of the Parent3 Group. • In Year 10: TP Group elected to file a consolidated return. • In Year 11: Sub1’s last significant asset was rendered worthless. • Sub1 liquidated • HoldCo2 liquidated • Stock of HoldCo2 and Sub1 was worthless • HoldCo2 shares owned by HoldCo1 were cancelled for no consideration HoldCo1 HoldCo2 Sub2 Sub1 Sub3

  20. PLR 201149015Rulings: • HoldCo1 may claim a worthless stock deduction under 165(g)(3) upon the dissolution of HoldCo2. • For the “gross receipts” test, HoldCo2 will include in its aggregate gross receipts all amounts of gross receipts received in intercompany transactions. • Intercompany Transactions: “Look- Through Approach” • HoldCo 2 will source gross receipts from intercompany transactions by “looking through” to the character of the gross receipts from the counterparty. • Intercompany Dividends: Amounts will be attributed pro-rata to the gross receipts that gave rise to the E&P from which the dividend was distributed. • Intercompany Transactions other than §301(c)(1) distributions: Amounts will be attributed pro rata to the gross receipts of the taxable year during which the intercompany transaction occurred.

  21. Allocating Basis in ELAs PLR 201143012

  22. PLR 201143012Facts: • Date 1: • P owns 100% of Sub stock • Date 2: • Sub issues 2nd class of stock • Date 3: • Public offering of Class A stock • Parent retains 100% of Class B stock • Date 4: P Public and EEs P: Class A = b% Class B = 100% Public/EEs: Class A = c% Sub

  23. PLR 201143012Facts: • Class A vs. Class B stock • Sub’s Class A and Class B stock are identical with respect to liquidation rights, dividend rights and consideration for any consolidation or merger. • Class A stock is entitled to 1 vote/share and Class B stock is entitled to 10 votes/share. • Reassessing Ownership • Parent reassess ownership every time an employee exercises stock options or vests in its RSUs. • Parent has the ability to purchase additional Sub shares to retain at least 80% in the vote and value of Sub.

  24. PLR 201143012Facts: • Temporary ELA in Sub stock owned by P • Because the stock price rose dramatically, a large volume of EEs exercised their options. • Sub takes a deduction for the compensatory stock issued to its EEs pursuant to its Equity and Incentive Plan resulting in a net negative basis adjustment. • Now P has an ELA in the Class A and Class B stock that it owned before the new purchases. • In order for P to retain 80% ownership: • P purchases e shares of Class A stock on the market, and • Sub repurchases shares of Class A stock on the market.

  25. PLR 201143012Law: • Treas. Reg. § 1.502-19(d)(1) • If a member has an excess loss accountin shares of a class of S’s stock at the time of a basis adjustment or determination under the Internal Revenue Code with respect to shares of the same class of S’s stock owned by the member, the adjustment or determination is allocated first to equalize and eliminate that member’s excess loss account. • When is the time of basis adjustment? • Investment adjustments are made as of the close of each consolidated return year and at any time when necessary to determine a tax liability of any person. See Treas. Reg. § 1.1502-32(b). • Same class of stock restriction? • Because the Class A and B common stock are identical in all respects except voting rights, Treas. Reg. § 1.1502-32(c)(2)(ii) has the effect of treating them as one class. • Note caveat in Ruling

  26. PLR 201143012Holding: • P can utilize the positive basis in the newly purchased Class A shares to offset the ELA in the previously held Class A and B shares. • Note that the allocation to the previously owned shares is only to extent of the ELA. • This ruling supports the underlying purpose of -19(d) by utilizing P’s positive investment in Sub to eliminate its ELA to the greatest extent possible.

  27. 108 AFTR 2d (10/28/11) Magma Power Co. v. U.S.

  28. Magma PowerFacts: IRS refunds MidAmerican overpayment Magma incurs deficiency Magma acquired by Cal Energy Magma satisfies delinquency = interest accruing on Magma deficiency = interest accruing on MidAmerican overpayment = overlapping period of interest

  29. Magma PowerFacts: • Interest Netting: • Under § 6621(d)(1), the net rate of interest on overlapping periods of tax overpayments and underpayments is zero if three conditions are met: • The offsetting sums have to be equivalent; • They have to overlap during the designated tax years; and • They have to be incurred by the same taxpayer. • Issue: • Is Magma Power considered the “same taxpayer” with respect to its underpayment for 1993 and with respect to the MidAmerican consolidated group’s overpayments for 1995-1998?

  30. Magma PowerHolding: • Magna Power was considered the same taxpayer with respect to their 1993 underpayment and the 1995-1998 MidAmerican overpayment to the extent the overpayment could be traced to Magma. • “Same taxpayer status is intended to be applied to underpayments and overpayments attributable to a corporate entity with the same EIN, irrespective of intervening merger activity.” • The consolidated group itself is not a “taxpayer.” See FSA 20027026, 2000 FSA LEXIS 57 (Apr. 10, 2000).

  31. Reverse Acquisition ISSUEs

  32. Exception for “Reverse Acquisitions” (§1.1502-75(d)(3)) • The reverse acquisition exception addresses transactions in which “the minnow swallows the whale.” • The reverse acquisition exception applies if: • (i) a corporation (the “1st corporation”) acquires stock of another corporation (the “2nd corporation”) in exchange (in whole or in part) for stock of the 1st corporation, and as a result the 2nd corporation would otherwise become a member of a group of which the 1st corporation is the common parent, and • (ii) the stockholders of the 2nd corporation, as a result of owning stock of the 2nd corporation, own (immediately after the acquisition) more than 50% of the FMV of the stock of the 1st corporation. • If the reverse acquisition exception applies, the 1st corporation’s group ceases to exist and the group of which the 2nd corporation was the common parent remains in existence, with the 1st corporation as the common parent. • The reverse acquisition exception similarly applies if the 1st corporation acquires substantially all of the assets of the 2nd corporation. • “[Any] acquisitions or redemptions of the stock of either corporation which are pursuant to a plan of acquisition” are taken into account for purposes of determining if a reverse acquisition occurred.

  33. Exception for “Reverse Acquisitions”Example 1 P1 Shs. P2 Shs. Transaction P1 Shs. P2 Shs. Result • Facts: P1 (value=$40) is the parent of a consolidated group that includes S1. P2 (value=$60) is the parent of a separate consolidated group that includes S2. P1 acquires all of the stock of P2 in exchange for 60% of P1’s stock. • Analysis: The transaction is a “reverse acquisition” because: • P1 acquires P2 stock in exchange for P1 stock. • But for the reverse acquisition exception, P2 would become a member of the P1 group. • The P2 shareholders, by reason of owning P2 stock, own more than 50% of the FMV of the stock of P1. • Result: • The P2 group continues, with P1 as the common parent. • The P1 group terminates. 60% P1 stock 40% 60% P2 stock P1 P1 (V=$40) P2 (V=$60) S1 P2 S1 S2 S2

  34. Exception for “Reverse Acquisitions”Example 2 3 Transaction Result Ptrs. Ptrs. NC Stock • Transaction: (1) PS forms NC with minimum capital. (2) PS contributes P stock to NC in exchange for NC stock. (3) PS dissolves and distributes NC stock to its partners. • Is this a reverse acquisition when partnership dissolves and distributes the NC stock to its partners? • See Situation 1 of Rev. Rul. 84-111 and Treas. Reg. § 301.7701-3(g)(1)(i). • See and compare PLR 200744006 and Situation 3 of Rev. Rul. 84-111. • See also Situation 2 of Rev. Rul. 84-111. NC PS NC Stock P P NC 1 2 Sub Sub P Stock

  35. Exception for “Reverse Acquisitions”Example 3 Transaction Result Shrs. Shrs. • Transaction: (1) Foreign Parent (“FP”) forms NC, a US corporation. (2) FP merges with and into NC with NC surviving. The transaction is treated as an "inbound" reorganization under section 368(a)(1)(F) (an "F" reorganization). • Is this a reverse acquisition? • Does the distribution of NC shares to the shareholders pursuant to the F reorganization result in the shareholder of P owning stock of NC immediately after the acquisition representing more than 50% of the FMV of the stock of NC? 1 FP NC NC 2 P P Sub Sub

  36. PLR 201015004 (simplified) Transaction Result • Facts: • FH, a Country A entity classified as a partnership, owns all of the equity interests of F1, a foreign “disregarded entity.” F1 owns all of the equity interests of F2, a foreign disregarded entity. F2 owns all of the equity interests of F3, a foreign corporation. F3 owns all of the equity interests of F4, a foreign corporation, and X, a US corporation. USP is the parent of a consolidated group that includes US Subs (the “U.S. Group”). At the time of the transactions, the only assets of F1, F2, and F3 were investments in subsidiaries. • Transactions: • F1, F2, and F3 each domesticated becoming U.S. corporations (the “Domestications”). F4 elected to be classified as a disregarded entity for U.S. Federal income tax purposes.The PLR’s Consolidated Return Rulings: • The U.S. Group remains in existence, with US1 becoming the new common parent (citing Rev. Rul. 82-152). • Every corporation that was a member of the U.S. Group on the day preceding “Date 1” must continue to be included in the consolidated return (citing Treas. Reg. § 1.1502-75(d)(1)). FH FH F1 (f) US1 (US) Domestication F2 (f) F2 (f) US2 (US) Domestication F3 (f) US3 (US) Domestication X (US) F4 (f) X (US) F4 (f) F4 (f) CTB Election USP (US) USP (US) USS (US) USS (US)

  37. PLR 201015004 (simplified) (continued) • Analysis of the Group Continuation Ruling: • Is the transaction described in -75(d)(2)(ii) (as expanded by Rev. Rul. 82-152)? • USP does not cease to exist (as required by -75(d)(2)(ii)). • US1, the new common parent, is not a member of the U.S. Group before the transactions (as apparently required by -75(d)(2)(ii) and as described in Rev. Rul. 82-152). • The Domestications are downstream transactions (similar to -75(d)(2)(ii) and Rev. Rul. 82-152). • Is the transaction “indistinguishable in substance” from a -75(d)(2)(ii) transaction? • Is the transaction described in -75(d)(3) (reverse acquisitions)? • US1 does not acquire USP in exchange for US1 stock (as required by -75(d)(3)). • The ruling represents that more than 50% of the value of the equity of US1 was attributable to the value of the USP stock. • The ruling further represents that the FMV of USP stock immediately before the transaction exceeded the sum of (i) the FMV of all of F4’s other assets, plus (ii) the FMV of the stock of F3.

  38. CERT ISSUES

  39. CERTs Generally Issue • If a C corporation engages in certain acquisitive or redemptive transactions, its ability to carry back an NOL may be limited by the CERT rules of § 172(b)(1)(E). • These are complicated rules with little authoritative guidance: • Presently no Treasury Regulations directly applicable to CERTs. • Indirect application of the Avoided Cost Method under Treas. Reg. § 1.263A-9. • Guidance consists solely of a small number of CCAs and TAMs. • The purpose of these rules is to limit the ability of corporations to fund certain debt-financed transactions by carrying back NOLs that are created by interest deductions allocable to a CERT event.

  40. CERT Applicability • Generally, a CERT limitation will arise only if all of the following conditions are present: • The corporation has generated an NOL and has the ability to carry it back under § 172(b); • The corporation has experienced a CERT in the year of the NOL or within the previous two taxable years (including short taxable years); • A special rule applies in cases where extended NOL carryback is elected. • A portion of such NOL is attributable to interest deductions incurred as a result, directly or indirectly, of the CERT (Corporate Equity Reduction Interest Loss or “CERIL”); and • The corporation is an “applicable corporation."

  41. What is a CERT? • See §§ 172(b)(1)(E), 172(b)(1)(H), and 172(h). • A CERT is defined as either a major stock acquisition or an excess distribution. • A major stock acquisition CERT occurs if a corporation acquires 50% or more of the stock (by vote or value) of another corporation pursuant to a single plan and no election under § 338 is made. • All acquisitions within a 24-month period are treated as pursuant to a plan. • An excess distribution CERT occurs if the aggregate distributions, including redemptions, made during a taxable year by a corporation with respect to its stock exceed the greater of: • 150% of the average of such distributions during the 3 preceding years; or • 10% of the fair market value of the corporation’s stock as of the beginning of the taxable year. • QUERY: What about tax-free transactions?

  42. General Limitation • The calculation of a CERT limitation generally includes two components: • Allocable interest deductions computed under the Avoided Cost Method of Treas. Reg. § 1.263A-9, or • Increase in interest deductions over the average interest deductions in the 3 preceding taxable years. • The lesser of the two amounts represents the CERIL. • The CERIL cannot be carried back to a year prior to the year of the CERT; however, it can be carried back to the year of the CERT. • The amount of disallowed NOL carryback is allowed as an NOL carryforward under the general rules of IRC § 172(b).

  43. Special Rules Favorable • De Minimis rule – no CERT limitation if the amount of allocable interest deductions is less than $1,000,000. • Relief for certain unforeseeable events. Unfavorable • No tracing of debt is permitted (i.e., the CERT rules may apply even if no acquisition debt is incurred). • Under the Avoided Cost Method, interest is allocated to a CERT to the extent that the taxpayer’s interest costs could have been reduced if the CERT had not occurred; this method assumes that the corporate indebtedness would have been paid down had the CERT not occurred. Other • All members of an affiliated group filing a consolidated tax return are treated as one taxpayer. • Interest refers to all amounts that are characterized as interest expense under any provision of the Code (Treas. Reg. § 1.263A-9(a)(3)).

  44. CERT Example 1 – Apportionment of CERT Limitation P • Common questions: • There is only one CERT limitation for the P Group; how is it apportioned for carryback purposes? • T never incurred any debt; should any CERT limitation attach to the CNOL apportioned to T? Bank S Debt T • On 1/1 Year 5, S borrows money for the purchase of T. • T becomes a member of the P Group. • In Year 5, the P Group reports a CNOL of $30 • Member’s separate taxable income: • P: NOL of $40 • S: Income of $20 • T: NOL of $10 • The P Group incurred $5 of interest expense, all attributable to S. • Neither T nor the P Group had interest expense in prior years. • Both T and the P Group have carryback potential to separate taxable years.

  45. CERT Example 1 – Apportionment of CERT Limitation (cont.) • On 1/1 Year 5, S borrows money for the purchase of T. • T becomes a member of the P Group. • In Year 5, the P Group reports a CNOL of $30 • Member’s separate taxable income: • P: NOL of $40 • S: Income of $20 • T: NOL of $10 • The P Group incurred $5 of interest expense, all attributable to S. • Neither T nor the P Group had interest expense in prior years. • Both T and the P Group have carryback potential to separate taxable years. P • Regardless of whether T is liable for the debt, it is a member of the P Group; under the CERT rules, the P Group represents one taxpayer. • The CNOL is subject to the apportionment rules of Treas. Reg. § 1.1502-21(b)(2). • The Service has held that the CERT limitation should then be apportioned to each loss member based upon the ratio calculated under Treas. Reg. § 1.1502-21(b)(2). • CCA 200305019 explains the reasoning behind the mechanics in more detail. • In this case, any of P’s remaining NOL and T’s remaining NOL above and beyond the CERT limitation are available for carryback to separate taxable years. Bank S $100 Debt T

  46. CERT Example 2 – Non-leveraged Acquisition P • Issue: • The acquisition was solely funded by equity and there was no increase of indebtedness due to the CERT event. • The application of the Avoided Cost Method specifically rejects tracing of the debt. • The Avoided Cost Method provides a rather harsh result – all interest expense on S’s loan would be allocated to the CERT because had P not purchased T’s stock, the $100 used to purchase T could have been used to pay off S’s $100 loan (query whether this result is altered by any covenants restricting S's ability to prepay principal on its debt?). • The CERT-tainted CNOL of $10 cannot be carried back to taxable years prior to Year 5. Bank S T $100 Debt Plant • P is the parent of a consolidated group. • In Year 5, P purchases all of the stock of T, a widely held corporation , for $100 of unborrowed cash. • Neither P nor T has outstanding debt. • S has outstanding debt incurred to purchase a plant in December, Year 4. • The P Group generated positive taxable income in all years prior to Year 5. • The P Group generated nominal interest expense in all years prior to Year 5. • In Year 5, the P Group generates a CNOL of $15, including $10 of interest expense. • The stock purchase of T constitutes a major stock acquisition CERT.

  47. CERT Example 3 – Acquisition or Redemption? 1 $20 Shareholders P Bank P $80 Debt Facts In Year 4, P purchased 20% of the outstanding stock of T. Immediately after, P formed a transitory subsidiary MS, caused MS to borrow $80, and then merged MS with and into T. P and T have no other debt. P has made only nominal interest payments and no distributions in Years 1-3. Issue T will likely be treated as redeeming $80 of its stock (see e.g., Rev. Rul. 78-250 and Rev. Rul. 79-273) Accordingly, no corporation technically purchased 50% or more of the stock of another corporation. Is this properly viewed as an excess distribution CERT by T? Or will the two steps be collapsed into a major stock acquisition CERT by P? Could there be two CERT transactions (i.e., an excess distribution by T, and an acquisition by P of 100% of the stock of T remaining after the redemption)? Facts In Year 4, P borrows $80 and uses $20 of its own cash to acquire 100% of the stock of T. P and T have no other debt. P has made only nominal interest payments and no distributions in Years 1-3. T’s average distributions in Years 1-3 were $8. Issue This transaction is clearly a major stock acquisition CERT. Interest expense allocable to the $80 debt will be tested under the CERT limitations. Bank MS merge T T $80 Debt FMV = $100 2 FMV = $100

  48. CERT Example 4 – Timing Considerations Shareholders Shareholders 1 2 Facts The FMV of T’s stock is $100. T made no distributions in Years 1-4. T had no interest expense in Years 1-4. On 1/1 Year 5, T makes a dividend distribution of $18. In Year 5, T generates an NOL of $10, including $9 of interest expense. Issue This transaction would constitute an excess distribution CERT in Year 5 to the extent of $8 (i.e., the excess of $18 over the greater of (i) 10% of $100, or (ii) 150% of $0) Facts The FMV of T’s stock is $100 at the beginning of Year 4. T made no distributions in Years 1-4. T had no interest expense in Years 1-4. On 12/31 Year 4, T makes a dividend distribution of $9. On 1/1 Year 5, T makes a dividend distribution of $9. Issue It appears there would be no excess distribution CERT in Year 4 (i.e., $9 does not exceed the greater of (i) 10% of $100, or (ii) 150% of $0) Further, there would be no excess distribution in Year 5 (i.e., $9 does not exceed the greater of (i) 10% of $91, or (ii) 150% of $3) Distribute $9 on 1/1 Year 5 Distribute $9 on 12/31 Year 4 Distribute $18 on 1/1 Year 5 T T FMV = $100 FMV = $91 FMV = $100

  49. CERT Example 5 – § 368 Transaction with Boot Shareholders Shareholders $50 P-Stock / $50 Boot P T merge FMV = $100 • Facts • T merges into P in a tax-free "A" reorganization, in which T shareholders receive $50 of P-stock and $50 cash boot. • Issue • Will the form of the transaction be viewed as if T transferred all of its assets and liabilities to P in exchange for $50 of P-stock and $50 of cash, and then distributed such property to T shareholders in liquidation (see e.g., Rev. Rul. 69-6, 1969-1 C.B. 104)? • If so, will T be viewed as having made an excess distribution of the $50 cash boot (ignoring the 10% FMV floor) to its shareholders? What happens if T has subsidiaries? Will P be viewed as having made a major stock acquisition of those subsidiaries?

  50. Forthcoming CERT Regulations What can we expect the CERT Regulations to resolve? • Consequences to a member departing the consolidated group? • Is the departing member still subject to CERT? • What happens to the interest and dividend history? • Consequences to a consolidated group when a member joins? • What happens in a reverse acquisition?

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