News Briefings - Federal Tax

The following article is from the 5/8/08 issue of Federal Taxes Weekly Alert.

5/8/08 -- Insolvent sub's liquidation in deemed asset purchase didn't qualify under Code Sec. 332 despite its debt being forgiven

Chief Counsel Advice 200818005

IN Chief Counsel Advice (CCA), IRS has concluded that in a Code Sec. 338 transaction (stock purchase treated as asset acquisition), the deemed liquidation of an insolvent subsidiary didn't qualify as a nontaxable Code Sec. 332(a) liquidation. IRS came to this conclusion because the parent, which had forgiven debt owed by its subsidiary's wholly owned subsidiary, didn't receive any property with respect to its stock interest in the subsidiary. Any property the parent received was attributable to its creditor interest in its subsidiary's wholly owned subsidiary.

Facts. S1, a wholly owned subsidiary of Corporation, sold all its stock in its subsidiary S2 to unrelated Purchaser. S1 owned at least 80% of the stock of S2, with the remaining shares publicly held. S2 owned all the stock of S3, which had borrowed funds from S1. As a condition of the sale, Purchaser required S1 to forgive a part of S3's debt. Prior to the debt forgiveness, S3's liabilities exceeded its assets' fair market value, and S2's liabilities exceeded the fair market value of its assets. Immediately after the debt forgiveness, the net value of S3's assets exceeded its liabilities, and the net value of S2's assets (including S3 stock) exceeded S2's liabilities.

Purchaser and Corporation made a joint Code Sec. 338(h)(10) election for the sale of the S2 stock and the deemed sale of the S3 stock.

Background. Generally, Code Sec. 338(a) allows certain stock purchases to be treated as asset acquisitions if the purchasing corporation makes or is treated as having made a Code Sec. 338 or Code Sec. 338(h)(10) election and the acquisition is a "qualified stock purchase." Code Sec. 338(h)(10) allows the purchasing and selling corporations to elect jointly to treat the target corporation as having sold all of its assets and distributed the proceeds in complete liquidation. Reg § 1.338-1(a)(2) provides that in a Code Sec. 338 transaction, the tax consequences to the parties is determined under Code sections other than Code Sec. 338, as if the parties had actually engaged in the transactions deemed to occur under Code Sec. 338 and its regs, except to the extent otherwise provided.

When a parent corporation completely liquidates its 80%-owned sub, the parent (as shareholder) doesn't recognize gain or loss on the liquidating distributions (Code Sec. 332(a)) Reg § 1.332-2(b) provides that Code Sec. 332 only applies where the recipient corporation receives at least partial payment for the stock that it owns in the liquidating corporation. Where the value of the subsidiary's property transferred to the parent was less than the amount of the subsidiary's debt to the parent, IRS ruled that no part of the transfer of the subsidiary's assets to the parent in complete liquidation was attributable to the parent's stock ownership, and the Reg § 1.332-2(b) requirement wasn't satisfied. (Rev Rul 59-296, 1959-2 CB 87) IRS also held that debt cancellation between a parent and its wholly owned insolvent subsidiary immediately before the subsidiary's liquidation was to be disregarded with the result that the liquidation didn't qualify under Code Sec. 332(a). (Rev Rul 68-602, 1968-2 CB 135)

On the other hand, IRS ruled that a pre-transfer cancellation of debt owed by a transferor to a related party reduced the amount of a transferor's liabilities assumed on the transfer where the cancellation had an independent economic significance. Where a parent corporation planned to have one subsidiary transfer all its assets and liabilities to another subsidiary, but the liabilities exceeded basis, the parent's cancellation of the excess liabilities by contributing the transferor subsidiary's indebtedness to that subsidiary's capital was respected by IRS. (Rev Rul 78-330, 1978-2 CB 147)

RIA observation: Where a liquidation doesn't qualify as a nontaxable liquidation under Code Sec. 332, the parent recognizes any gain or loss. For example, it can deduct a loss on worthless stock under Code Sec. 165(g). However, if Code Sec. 332 does apply, there is a carryover of the subsidiary's net operating losses to the parent on liquidation under Code Sec. 381.

Not a nontaxable liquidation. The CCA concluded that the deemed liquidation didn't qualify as a nontaxable liquidation under Code Sec. 332. While recognizing that the debt cancellation in this situation generally has economic significance--it's reasonable for a purchaser not to want its newly purchased subsidiary to be indebted to a member of the seller's affiliated group after the purchase--the CCA reasoned that the debt cancellation shouldn't be taken into account in determining whether S1 should be deemed to have received anything in exchange for its S2 stock interest.

If not for S1's cancellation of a portion of the debt owed to it by S3 before S1's sale of its S2 stock, the CCA determined that the deemed distribution of S2's assets under the Code Sec. 338(h)(10) election wouldn't qualify as a liquidation under Code Sec. 332(a) because none of the distribution to S1 would be attributable to S1's stock interest in S2. Rather, any property S1 received would be attributable to its creditor interest in S3.

The CCA stressed that the tax consequences of a Code Sec. 338(h)(10) election is generally the same as if the parties to the transaction had actually engaged in the transactions deemed to occur under Code Sec. 338 and its regs. The CCA reasoned that the transaction was substantially similar to that in Rev Rul 68-602, except that the debt was between a parent and its second tier subsidiary rather than its direct subsidiary. Rev Rul 68-602 dictates that the debt cancellation of an insolvent subsidiary immediately before its liquidation is to be disregarded in determining the liquidation's tax consequences. Absent the debt cancellation, neither S2 nor S1 would receive any property with respect to its stock interest. Any property received by S1 would be received in its capacity as a creditor, not as a shareholder of S2, while S3, having no net assets, could not distribute anything to S2 with respect to S2's stock interest in S3.

IRS distinguished the contrary conclusion in Rev Rul 78-330 based on the fact that S1 didn't liquidate in the transaction.

References: For the payment requirement for a liquidating subsidiary to qualify for nontaxable treatment, see FTC 2d/FIN ¶ F-13218; United States Tax Reporter Income ¶ 3324.01; Tax Desk ¶ 245,725; Tax Guide ¶ 5465.

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