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May 1993

Proposed regulations simplify IRC Sec. 338 rules. (Federal Taxation)

by Jacobini, Susan

    Abstract- The IRS has proposed regulations that would simplify and limit the reach of consistency rules under IRC Sec. 338(e) by terminating the theoretical groundwork of the existing directives on consistency. The asset consistency regulation being tendered is aimed at preventing the structuring of acquisitions that allows exploitation of the Reg. Sec. 1.1502-32, or the consolidated return investment adjustment rules. Under the proferred statute, the consistency rules would only apply if the company being acquired is a part of a consolidated return of the group selling it. It also requires carryover basis in an acquired asset if the asset is transferred within the target consistency timeframe, the basis of the target stock is indicative of gain from the disposition of the asset and the asset is held by a company that buys the target stock in the qualified stock purchase. Anti-avoidance provisions to avert circumvention of the consistency rules are also included.

Existing IRC Sec. 338 Rules

When a corporation purchases a target corporation in a qualified stock purchase, the purchasing corporation may elect to treat the purchase as an asset acquisition under IRC Sec. 338(g). The target is treated as if it sold its assets in a single transaction, and then repurchased those assets as a new corporation. This results in the taxation of any built- in gain on the assets. Unless the target has significant net operating losses available to shelter the deemed-sale gain, it is generally not desirable to affirmatively elect asset sale treatment under IRC Sec. 338(g) since there are two levels of gain--gain to the seller on the actual sale of the stock and gain to the buyer on the deemed sale.

However, there are several circumstances where an IRC Sec. 338(g) election coupled with an IRC Sec. 338(h)(10) election still renders favorable tax consequences. If the latter election is made, the deemed sale by old target occurs while target is still a member of the seller's consolidated return followed by a tax-free liquidation of old target into its parent under IRC Sec. 332. The purchasing corporation is treated as having purchased target with a stepped-up basis in its assets. If the selling consolidated group has NOLs or other tax attributes to shelter the deemed-sale gain, the assets of target are stepped-up without a tax cost. Even if there were no tax attributes available to shelter the gain, only one level of tax is paid in the transaction. Under this scenario, the cost of the step-up would be weighed against the present value of the future depreciation and amortization deductions attributable to the step-up. The sales price of the stock would theoretically be adjusted to reflect any increased tax cost to the seller as a result of the deemed sale. If the outside basis of the target stock were lower than the inside basis of the target assets, the deemed asset sale would yield a lower tax gain to the seller. This should also be considered in the analysis.

IRC Sec. 338(e) provides consistency rules to prevent the purchasing corporation from selectively acquiring certain assets from a target or target affiliate in a direct purchase, for the purpose of obtaining a stepped-up cost basis in these assets, while acquiring other assets and tax attributes through a stock acquisition, not involving an IRC Sec. 338 election, and obtaining a carryover basis in those assets. The consistency period is the 12-month period preceding the date on which the stock is purchased and the 12-month period after the stock purchase date. The consistency rules have their genesis in pre-TEFRA law. Under old IRC Sec. 334(b)(2), a purchasing corporation could purchase Target 1 and Target 2 and obtain a step-up basis in Target 1 by liquidating Target 1 while retaining historical basis in the assets of Target 2 by not liquidating. The Treasury viewed this type of selectivity as abusive. Stock consistency rules were incorporated into the IRC Sec. 338 to address this concern.

A similar abusive result was thought to occur when there was the purchase of an asset contemporaneous with a qualified stock purchase, and this was reflected in the drafting of the temporary relations. These type of transactions became known as "tainted asset acquisitions." Certain asset acquisitions made in the ordinary course of business or assets acquired by a purchaser that would not result in a stepped-up basis in the hands of the purchaser are excepted from the consistency rules and will not result in a tainted asset acquisition.

Three Choices

In any asset acquisition (and the concurrent purchase of the stock of a target corporation), the taxpayer has three choices. It can 1) do nothing, 2) make a "protective carryover basis election", or, 3) make an IRC Sec. 338 election for target.

If no action is taken, alternative 1, all assets acquired from the seller take a carryover basis, and the target stock retains historic attributes and basis. Under alternative 1, the district director may on audit impose a deemed IRC Sec. 338 election. This would result in the stock acquisition being treated as an asset acquisition, with all the gain on the assets recognized. But assets acquired in the tainted asset acquisition would have a stepped-up basis. This IRS discretion will probably never be exercised in favor of the taxpayer. Alternative 2 precludes an IRC Sec. 338 election (and the resulting recognition of all gain to target). The trade-off is that the purchaser receives a carryover basis in the tainted assets acquired. Alternative 2 is appropriate when the detriment of carryover basis on the tainted assets is small compared to the benefit obtained by avoiding the recognition of substantial gains on an IRC Sec. 338 election. Alternative 3 is appropriate when the need for a cost basis on the tainted asset acquisition is substantial compared to the small detriment to the taxpayer making an IRC Sec. 338 election and recognizing gain on the target assets.

Applying consistency rules became a complex matter for many taxpayers and practitioners alike, especially when consolidated return regulations impact certain post-acquisition asset goals. This complexity is especially perplexing since after the General Utilities repeal, the consistency rules no longer serve their intended purpose which was to prevent taxpayers from engaging in transactions designed selectively to obtain tax benefits then available without the associated tax cost.

Proposed Changes

The IRS has issued proposed regulations under IRC Sec. 338 which are not effective until finalized. Until the regulations are issued in final form, the rules under the existing temporary regulations remain in force with all the attendant consequences discussed above. The proposed regulations, when effective, would simplify and narrow the scope of consistency rules under IRC Sec. 338(e) by abandoning the theoretical underpinning of the old consistency rules. The sole purpose of the new asset consistency rules is to prevent acquisitions from being structured to take advantage of the consolidated return investment adjustment rules (Reg. Sec. 1.1502-32).

Under the proposed regulations, the consistency rules generally apply only if the target is a member of a consolidated return of the selling group. The District Director and Commissioner's discretion in applying the consistency rules and the affirmative action carryover, protective carryover, offset prohibition, and regular exclusion elections are eliminated.

Generally, the new consistency rules operate to require carryover basis in an acquired asset if--

* The asset is disposed of during the target consistency period;

* The basis of the target stock reflects gain from the disposition of the asset; and

* The asset is owned, immediately after its acquisition and on the target acquisition date, by a corporation that acquires stock of target in the qualified stock purchase (or by an affiliate of an acquiring corporation).

The carryover-basis rules generally apply to direct acquisitions of assets from target, a subsidiary in a consolidated group, by the purchaser (or an affiliate), during the consistency period. The rules also apply to assets acquired from lower-tier target affiliates or certain conduits if gain from the sale is reflected in the basis of the target stock. Thus, if the seller receives a step-up in the basis of T stock, an automatic carryover basis rule applies to the asset purchase unless P makes an IRC Sec. 338 election. This ensures that someone pays the tax on the step-up. A de minimis exception applies to prevent the automatic carryover-basis rule from applying in the case of a tainted- asset acquisition of less than $250,000.

Apparently, the carryover basis rule only applies in situations where the consolidated investment adjustment rules afford a benefit to the seller. If the purchaser acquires target and causes target to sell the asset to a member of the purchasing group, the purchasing member obtained a cost basis in the assets. Presumably it has been conceded that "anti-mirror" rules which were added to the consolidated return regulations after TRA 86 has solved the abuses perceived under the former set of consistency rules. The new regulations also adopt anti- avoidance rules to prevent circumvention of the consistency rules.

Of special significance is the repeal of the stock consistency rules. The new regulations allow the purchasing corporation to make an election under IRC Sec. 338 for target without being deemed to have made the election for any target affiliate. However, the stock consistency rules would still apply to prevent asset inconsistency under the new regime.

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