Loss 'Importation' -- Opportunities and Limitations
There has been much concern recently on the part of the Treasury Department regarding a new breed of tax shelters for corporations and individuals. These concerns have led to legislative proposals to fix perceived "loopholes". The Clinton administration recently proposed legislation that would have granted the Treasury Department broad regulatory authority to attack tax planning techniques that involve so-called "imported losses" or losses created outside of the U.S. taxing jurisdiction that are used to reduce U.S. tax liability. Several related bills were introduced during the last Congress. See, e.g., H.R. 4852, 105th Cong., 2d Sess. (1998) (proposing amendments to section 357(c)). The Treasury Department has also undertaken to study the area of attribute importation. See Tax Notes Intl., December 21, 1998, at 1984 (quoting statements made by Treasury officials on December 10, 1998, at a George Washington University panel). The Treasury Department has also proposed new legislation in its 2000 Budget Plan to address loss importation and other corporate tax shelters.
The Clinton Administration has been very active in attempting to address these concerns in other ways as well. Various tax shelters have been the subject of recent IRS Notices, Proposed and Final Regulations, and legislative proposals. A great deal of public attention has been focused on the subject of tax shelters as a result of descriptions of various shelters appearing in the Wall Street Journal and other popular publications. See, e.g., Janet Novack and Laura Saunders, The Hustling of X Rated Shelters, Forbes, December 14, 1998.
This report begins by describing imported losses and then examines some of the techniques that have been developed to use imported losses and related attributes, such as deficits and credits.(1) The report then analyzes the extent to which existing law may limit these techniques and considers alternative methods which Congress or the Treasury Department could use to limit abuses under the current rules. The report also describes and comments on the proposals contained in the Administration's Year 2000 Budget Plan on these issues.
Although it may be difficult to precisely define imported losses, Treasury's concern seems to center on transactions shifting to U.S. taxpayers losses generated by mismatching deductions and income (accelerating income followed by a change in the "ownership" of the related deductions). The resulting mismatches may be manipulated so that only the deduction items have effect in determining U.S. tax liability. Thus, such transactions take advantage of inconsistencies between the timing and ownership of income and related deductions in a manner that results in the augmentation of U.S. losses. Examples include lease strips, section 357(c) bump-ups, and section 302 basis-shifting transactions. These, as well as certain other popular attribute-importation transactions, are discussed in greater detail below. Since these techniques most commonly involve splitting the beneficial ownership of the income items from the beneficial ownership of the tax loss items, few of these transactions involve substantial economic risks to the U.S. taxpayers apart from transaction costs. It would seem that any reasonably comprehensive approach to limiting attribute importation into the U.S. should limit the ability of taxpayers to import the "loss leg" following an income acceleration event that generated no significant U.S. income tax, particularly where there has been a substantial change in the beneficial owner of the income and the otherwise offsetting loss, and where the overall economic risk of loss is immaterial when compared to the anticipated tax benefits.
This report is concerned primarily with the technical aspects of loss importation and the creation of artificial losses. There is a somewhat different, but related, problem of deterring taxpayers from taking unreasonable positions on their returns. Deterrence is best addressed by stricter enforcement of the rules and routine imposition of penalties. Questions as to the extent to which such penalties are effective in deterring taxpayers from engaging in tax avoidance and the extent to which such penalties may be overly broad are beyond the scope of this report.
Treasury Proposal and Other Approaches
In its Year 1999 Budget Plan, the Treasury Department asked for broad authority from Congress to enable it to attack loss importation transactions. That proposal is briefly explained in the Treasury Department's description of the President's 1999 Budget Proposal. The proposal is described as follows:
The provision would require that the Secretary prescribe regulations to determine the basis of assets held directly or indirectly by a person other than a United States person and the amount of built-in deductions with respect to a person other than a U.S. person or an entity held directly or indirectly by such a non-U.S. person, as may be necessary or appropriate to prevent the avoidance of tax. No inference is intended as to the treatment under present law of transactions that purport to result in the use for U.S. tax purposes of losses arising outside the U.S. taxing jurisdiction. The proposal would be effective on the date of enactment. Tax Analysts' Highlights and Documents, February 3, 1998, p. 1569.
Commentators had begun to consider alternative approaches to limiting loss importation. See, e.g., Tax Notes International, March 23, 1998, at 884. In its Year 2000 Budget Plan, however, Treasury took a different approach, proposing that Congress enact specific mark-to-market and other rules to address attribute importation. Although the authority requested by the Treasury Department was not granted in 1998, it is quite possible that Congress may accede to Treasury's request this year.
Loss Importation Generally
Losses may be imported into U.S. taxing jurisdiction in at least two ways. One way is through a change in the status of the taxpayer owning an asset with a built-in-loss (a "BIL" asset) (i.e., an asset whose basis exceeds its fair market value). This could occur when a non-U.S. resident becomes a U.S. taxpayer, or in a transfer of a BIL asset to a U.S. resident individual or other U.S. taxpayer in a carryover basis transaction. A second way for losses to be imported is through a change in the status of a related asset from one that does not generate effectively connected income to one that generates such income.
Once a BIL asset has entered the U.S. taxing jurisdiction, the taxpayer may seek to utilize the loss by selling the asset, either immediately or after the lapse of time. Alternatively, the taxpayer may be able to use the asset in its trade or business and claim depreciation or amortization deductions. The latter approach has several advantages over the former. For example, by using the asset in its business, a taxpayer increases the likelihood of success should the IRS challenge its transaction.
Other Uses of Imported Losses
In addition to changing the U.S. tax status of a BIL asset, loss importation transactions often involve shifting the beneficial ownership of a loss, BIL asset, or deficit for purposes of the regular tax, the alternative minimum tax, the personal holding company tax, or the accumulated earnings tax. Loss importation may also be used to limit inclusions under Subpart F for U.S. shareholders of a controlled foreign corporation ("CFC"), a foreign personal holding company ("FPHC"), or a passive foreign investment company ("PFIC"). Loss importation may ultimately affect all measures of earnings and profits and may involve elimination, rather than merely deferral, of U.S. income tax. Loss importation can also be crafted to help convert ordinary income to capital gain, or to help eliminate certain restrictions of the consolidated return regulations and statutory provisions, such as those applicable to S corporations that convert from C corporation status while having earnings and profits.
Certain Loss Importation Transactions
The following discussion considers some of the ways in which losses may be imported into the U.S. As previously noted, one way is for the owner of the BIL asset to change its status so that it becomes subject to U.S. income tax on its worldwide income. In the case of an individual, the individual could become subject to U.S. tax by becoming a citizen, obtaining a green-card, or merely by increasing his presence in the U.S. so that he meets the substantial presence test in and thus becomes a U.S. "resident" for purposes of section 7701(b).(2) A nonresident alien who is married to a U.S. citizen or resident could make an election under section 6013(g) to be treated like a U.S. resident.
In the case of a corporation, it could domesticate through an "F" reorganization or, in the case of an insurance company, could make an election to be treated as a domestic corporation under section 953(d).
Another possibility is for the BIL asset to be transferred to another entity that is subject to U.S. tax in a tax-free transaction in which basis carries over to the transferee. For example, the foreign owner of a BIL asset could transfer the asset to a U.S. corporation in an exchange for shares under section 351. If the owner of the BIL asset has been a foreign corporate subsidiary of a U.S. corporation, the asset could be distributed to its U.S. corporate parent in a liquidation under section 332. Otherwise, the asset could also be transferred to a U.S. corporation in a tax-free reorganization, including a "C," "D," "F," or "G" reorganization.
If the BIL asset is owned by a partnership or similar flow through entity, equity interests in the entity could be transferred (e.g., in a partnership with no section 754 election in effect), or certain interests (e.g., up to 50% of the outstanding equity interests) in a C corporation with a BIL asset or a loss carryforward could be acquired.
As indicated above, the status of a BIL asset could also be changed without changing the status of the asset's owner. This could occur by transferring the asset to a U.S. branch of a foreign corporation or a nonresident alien individual in a manner that would cause a loss on the disposition (or amortization deduction) of the asset to be treated as connected to effectively connected income of a U.S. branch. See sections 873 and 882(c). If the owner of a BIL asset is in a country that has entered into an income tax treaty with the U.S., then this effect could be achieved by the owner's establishing a permanent establishment in the U.S. If an individual previously held a BIL asset for personal use, its basis must be marked down to fair market value when its use changes. See Treas. Reg. Search7RHSearch7RH1.165-7(a)(5), 1.165-9(b), 1.167(g)-1.
In the more potentially abusive transactions, of course, loss importation also involves the transfer of a BIL asset to a new beneficial owner who is a U.S. taxpayer. In some cases, the transfers are part of a larger series of transactions that are designed to create non-economic (or "artificial") losses through techniques that result in a mismatch of who recognizes the items of income and deduction.
Loss Trafficking.Loss importation transactions of one kind or another have been around for a long time and changes in tax status are bound to create tax issues with respect to built-in gain as well as built-in loss. Although some of techniques have become more sophisticated, what has apparently become so alarming to the IRS recently is the growing accessibility of non-economic tax losses to the average (high income) taxpayer ("going retail"). This may be largely the result of a perceived explosion in the marketing of tax shelters by aggressive tax shelter promoters, some of whom may push shelters having little economic substance apart from their transaction costs.(3) While it may seem elitist to suggest that such tax shelters should be of greater concern than shelters sought by more sophisticated taxpayers, in fact these shelters may be perceived as doing more harm to the integrity of the tax system, both in terms of the resulting loss in revenue and, perhaps even more importantly, in creating the impression that paying taxes is optional for those who can afford to hire a tax shelter promoter and its team of tax experts. Treasury may be legitimately concerned that, while an aggressive shelter may not pass the "smell test," it may actually be more difficult for a less sophisticated taxpayer to understand the real risks and thus to turn down what appear to be no-lose tax-savings plans.
Artificial Losses.There are a number of publicized methods that have been or are now being used to obtain non-economic tax losses or artificially create BILs, and tax shelter promoters are constantly inventing new ones. Several of these known methods are described briefly below.(4) A common pattern within these techniques is that they generally involve stripping away the economic value of an asset in a manner that results in an income acceleration to a person who is not generally subject to the U.S. income tax while preserving the asset's basis. Ironically, many of the Code provisions that make this possible are ones that were adopted to be and are ordinarily thought of as being anti-taxpayer in the sense that may decelerate deductions or prevent accelerated basis recovery.
Some rules result in the acceleration of income to a period prior to the one in which the related economic performance occurs. For example, prepayments of income are generally required to be included in income upon receipt. Schlude v. Comm'r, 371 U.S. 884 (1963); but cf. IRS Notice 95-53, 1995-2 C.B. 334 (predecessor to lease strip regulations, discussed below, illustrating how this rule may be abused by taxpayers).
Other rules require a loss to be deferred to a year after the year in which the loss is economically realized. For example, section 1091 requires that a loss from a "wash sale" be deferred until the replacement securities are sold, and section 1092 requires deferral of losses on a "straddle".
Such accounting-period rules make it possible for the economic value of an asset to be stripped away by an income-triggering transaction involving parties who are wholly or largely not subject to tax in the U.S., followed by movement of the corresponding BILs to a U.S. taxpayer.
Specific Methods.Following is a description of some of the transactions taxpayers have used to import losses or otherwise access imported tax attributes. Each of these transactions has been publicized in recent press accounts. Other methods exist that have not yet become public knowledge.
Section 302 Basis Shifts. One series of transactions receiving recent publicity was based on the regulations under section 302. Section 302 generally provides that if a corporation that has undistributed earnings and profits redeems shares held by one of its shareholders, then the redemption is treated as a distribution of earnings and profits (i.e., as a taxable dividend) rather than a sale or exchange of the shares, unless there is a meaningful reduction in the shareholder's ownership of the corporation. In order to prevent taxpayers from avoiding this rule through the use of related parties or similar arrangements, in determining whether there has been a meaningful reduction in the redeemed shareholder's ownership of the corporation, a shareholder is treated as continuing to own any stock owned by a person related to the corporation or which is subject to an option held by the shareholder. The constructive ownership rules of section 318 apply to determine stock ownership for this purpose.
If the corporation redeems only a portion of the shares owned by a shareholder and the redemption is treated like a dividend under section 302, then the basis of those shares shifts over to the shares retained by the shareholder. Treas. Reg. Search7RH1.302-2(c), Example 1. If all of a shareholder's shares are redeemed, but the redemption is treated like a dividend because shares owned by a different shareholder were attributed to the redeemed shareholder, then the regulations provide that the shareholder's basis shifts over to those shares. Treas. Reg. Search7RH1.302-2(c), Example 2. It is generally assumed that the rules of section 302 apply even in the case of a redemption by a foreign corporation of a foreign shareholder's stock insofar as the tax effect of that transaction ever becomes relevant for U.S. tax purposes.
Taxpayers have reportedly used this rule to create BIL assets in the following manner.(5) First, a foreign corporation that has earnings and profits is identified ("FSUB"). In many cases, FSUB will be a large foreign bank that has in place an active program for redeeming its shares from shareholders. A U.S. taxpayer ("A"), seeking to benefit from a loss to be created, buys shares of FSUB as well as options to buy additional FSUB shares. A second foreign corporation ("FPARENT") is formed by an unrelated foreign individual ("X") to buy a significant block of FSUB's stock, using borrowed funds and secured by the purchased stock. X also grants A an option to acquire a majority of the stock of FPARENT from X. FSUB redeems its shares held by FPARENT in exchange for cash, which is used to repay FPARENT's debt. Concurrently, A acquires shares of FSUB in an amount equivalent to the number of shares redeemed by FPARENT, using options.(6) Because section 302 treats A as a shareholder of FPARENT, as a result of the options held to acquire the FPARENT shares, FPARENT is treated as owning the shares of FSUB held by A. Thus, the number of shares of FSUB owned by FPARENT does not decrease and the redemption payment to FPARENT is treated as a dividend under section 302. See U.S. v. Davis, 397 U.S. 301 (1970) (section 302 requires a meaningful reduction in the shareholder's interest, after application of the construction ownership rules of section 318, in order to qualify for nondividend treatment). The dividend has no U.S. consequences to FPARENT or its individual shareholder, since FSUB is a foreign bank.(7) However, A, takes the position that the basis of the shares of FSUB that were held by FPARENT and that have been redeemed shifts over to the shares of FSUB held by the U.S. taxpayer under Treas. Reg. Search7RH1.302-2(c), Example 2. Thus, A ends up holding shares with a very large tax basis, which are eventually sold to generate a large capital loss.
As described, this technique could be structured so as to stand a good chance of withstanding an attack by the IRS. First, there would have to be a sufficient time period between the various steps so that the parties have a real possibility of earning a profit on fluctuations in the value of the stock. In addition, the exercise price of the U.S. taxpayer's call option on the FPARENT stock would have to be low enough that there would be a real chance that it would be exercised within a reasonable time period. In practice, however, taxpayers who engage in this type of transaction, and the foreign participants as well, often do not wish to run substantial economic risks. Where the risks (as well as the rewards) of fluctuations in FSUB's stock price are reduced (e.g., through derivative transactions or otherwise), the transaction may not survive the economic substance test of ACM Partnership v. Comm'r and other cases, which are considered further below.
This type of transaction conceptually is descended from a more primitive shelter based on the section 302 dividend recharacterization rules, which Congress shut down by first enacting, and then amending, section 1059. In that highly publicized transaction (involving Seagrams and DuPont), a U.S. corporation used options to structure a redemption of stock of a subsidiary in a manner that purportedly caused the redemption to be treated as a dividend under section 302, so that the parent could claim the dividends received deduction. The parent's basis in the shares redeemed would shift over to its remaining shares, resulting in the creation of a BIL asset. As originally enacted, section 1059 provided that the parent's basis in its shares was reduced (but not below zero) by the amount of the nontaxed portion of the dividends. The excess of the amount of the nontaxed portion of the dividend over the shareholder's basis resulted in the creation of a deferred gain that would be recognized only upon the sale of the remaining shares, which was anticipated to be far distant. Thus, a corporate shareholder who simply did not sell the remaining shares could defer its tax indefinitely. Congress subsequently amended section 1059(a), however, to provide for immediate gain recognition to the extent a nontaxable extraordinary dividend exceeds the shareholder's basis, and amended section 1059(e) to specifically bring option-based redemptions that are treated as dividends under section 302 within the scope of this expanded gain recognition rule.
Contingent Installment Sale Method.Another technique, which was apparently popularized during the 1980's by Merrill Lynch, involves the installment sales rules applicable to contingent installment notes. Such a transaction was addressed in ACM Partnership v. Comm'r, T.C. Memo 1997-115, affd. in part and reversed in part, 82 AFTR2d 98-6682 (3d Cir. October 13, 1998). The following description of the facts is somewhat simplified: the ACM Partnership was a partnership formed between a wholly owned subsidiary of Colgate-Palmolive Co. ("Colgate"), an affiliate of a large Netherlands bank ("ABN"), and an affiliate of Merrill Lynch ("MLCS"). The partners' initial percentage interests in ACM were 82.6%, 17.1%, and 0.3%, respectively. The partnership agreement provided, in part, that the partners would share most items of income, gain, loss, and deduction in proportion to their percentage interests in ACM. The agreement gave each of the partners the right to have its interest redeemed by the partnership upon request.
ACM was formed to accomplish a plan with two parts. The first part involved the acquisition by ACM of a large block of outstanding, long-term notes of Colgate, which Colgate believed would (and did in fact) result in the improvement of its credit rating and lower its cost of borrowing. In order to protect ABN from the interest rate risks posed by the partnership's holding a large block of fixed rate securities, ACM also invested a portion of its assets in a series of "LIBOR notes" that would provide for a stream of LIBOR-based payments on a notional principal amount. Merrill Lynch advised the partners that if ACM were to subsequently shift its investment portfolio into notes with a shorter term, or if ABN's interest in ACM were reduced, then there would be less need for the hedge provided by the LIBOR position, when the position could be sold by ACM.
The second part of the plan was a strategy that would generate a capital loss that Colgate could use to offset a capital gain that it had recognized before ACM was formed. In the brief period after ACM was funded (by capital contributions totaling over $200 million), and before the acquisition of the Colgate long-term notes, ACM invested $175 million of its assets in privately placed five-year notes of Citicorp, which were sold a month later. The sales price of the Citicorp notes was paid 80% in cash and 20% in 5-year LIBOR notes (the "5-year Notes") issued by unrelated purchasers, and which were to be retained by ACM to hedge the interest rate risk on the Colgate notes. Because the 5-year Notes did not have a stated principal amount, and the payments under them were uncertain, ACM accounted for the sale of the Citicorp notes under the contingent sales provisions of the installment sales rules. Temp. Reg. Search7RH15a.453-1(c). Pursuant to those regulations, ACM allocated its basis in the Citicorp notes ratably over the term of the notes, thereby recovering only $29 million of its basis in the year of the sale, and recognizing a capital gain of $111 million, 80% of which was allocated to ABN, which as a foreign corporation was not subject to any U.S. tax on the gain.(8) ACM then redeemed ABN's interest and, shortly thereafter, sold the 5-year Notes. Since most of the basis of the Citicorp notes had been allocated to the 5-year Notes, the sale of the 5-year Notes resulted in a capital loss of $85 million, which was allocated almost entirely to Colgate as the remaining majority partner. For reasons discussed further below, the capital loss claimed by Colgate was ultimately disallowed by the Tax Court, and that decision was largely sustained on appeal.
Lease Strips and Modified Lease Strips. Another transaction that taxpayers have used to create artificial imported losses involved lease stripping. Lease strips were the subject of IRS Notice 95-53, 1995-2 C.B. 334, and the later Prop. Reg. Search7RH1.7701(l)-2. In a typical lease strip, the foreign owner of a piece of equipment or other property used abroad would enter into a lease with respect to the property and then transfer the property to a U.S. taxpayer in a carryover basis transaction, subject to the lease, but with the transferor retaining the right to receive the rental payments (or having already received a large prepayment of rent). The intended effect of these transactions was that the property would be acquired by the transferee at a very low price, since its revenue had been stripped away, but with its original basis virtually intact. The transferee would claim full depreciation deductions with respect to the asset or sell it to generate a loss, while the transferor was indifferent to accelerating the income.
The examples in the proposed regulations illustrate several ways in which basis transfers had been achieved. One way was for the property to be owned by a partnership, which did not have a section 754 election in effect, and the partners of which were exempt entities or loss corporations. The partnership would receive a prepayment of rent, and interests in the partnership would later be acquired by a U.S. taxpayer.
The proposed regulations apply to any transfer of property (with certain narrow exceptions) in which one party assumes an obligation under a lease or similar contract without acquiring the right to receive the payments thereunder. The proposed regulations would require that any such transaction be treated as if all of the rental payments were being made to the assuming party, and as if the assuming party purchased the property at its full fair market value (unencumbered by the lease) in exchange for a note (a "section 7701(l) note") bearing interest at a rate equal to 110% of the applicable federal rate (the "AFR"). Under this recharacterization, in part, the assuming party would be required to include in its income each year the rent payable under the terms of the lease (or a notional amount determined under the section 467 rent-leveling rules), and would be allowed a deduction for the interest deemed paid on the self-amortizing section 7701(l) note. Ordinarily, the net effect of this recharacterization would be a large increase in the taxable income of the assuming party, since the deemed rental payments (which are each equal to an annual payment of principal and interest under the section 7701(l) note) will exceed the interest deduction on the section 7701(l) note.
Because the lease stripping rules are only triggered by a transaction that involves a transfer of the leased property (or a transfer of an interest in a pass-thru entity owning the leased property), taxpayers may be able to avoid these rules by transferring interests in a corporation holding the leased property instead.(9) This may result in the transaction being subject to section 382, however, which is considered further below. Section 382 will not always be effective to prevent use of the losses. For example, if the lease was initially entered into by a foreign corporation that is a subsidiary of a foreign parent, the foreign subsidiary may be able to distribute the rent prepayment, or the right to receive future rentals, to its parent. If the subsidiary were then sold to a U.S. person, or a CFC owned by a U.S. person, the acquired corporation would become a CFC. The new shareholders may be able to use the BIL asset from the stripped asset by causing other assets to be contributed to the subsidiary that produce sub-part F income. Section 382 is not particularly effective in the Subpart F area because it does not affect the determination of earnings and profits of a loss corporation. Section 269 could, of course, be invoked by the IRS, since it applies more broadly to specified transaction entered into with the principal purpose of "evasion or avoidance of federal income tax by securing the benefit of a deduction, credit, or other allowance which such person would not otherwise enjoy...."
Lease In, Lease Out. Another shelter recently receiving publicity is the so-called "lease in, lease out" ("LILO") arrangement.(10) In such transactions, a U.S. taxpayer seeking tax deferral leases property from a foreign entity, often a foreign-based local government, pursuant to a "master lease," and then subleases the property back to the foreign entity. The master lease provides for a single rental payment to be made at the commencement of the lease and for a second payment at the expiration of the lease. The U.S. taxpayer borrows the funds for the initial payment from an unrelated bank. The governmental entity is required to keep those funds on deposit with the lender and use interest earned on the deposit to pay the rent due under the sublease. The U.S. taxpayer amortizes the master lease payment and offsets its rental income with the deductions for interest due on its loan. Although in form the master lease term extends beyond the term of the sublease, the sublessee normally holds an option to acquire the sublessor's rights under the master lease upon the expiration of the sublease, and funds kept on deposit with the bank are expected to be used to pay the repurchase price under the option, and the repurchase price is expected to be used to repay the loan.
A LILO generally involves only deferral, not permanent tax shelter, since amortization deductions are effectively "recaptured" when the option is exercised. Nevertheless, Treasury is likely to find troublesome transactions such as this, which appear to have limited economic effects apart from the tax benefits, and which may be subject to attack by the IRS even under existing authority, such as Frank Lyon Co. v. U.S., 435 U.S. 561 (1978).(11)
Section 357(c) Step-Up. Another method involving imported losses uses section 357(c). Section 357(c) provides generally that where an asset, subject to a liability in excess of basis, is transferred in a section 351 transaction or in a "D" reorganization, the transferor recognizes gain to the extent of such excess. Certain courts supported the IRS when it asserted that section 357(c) applies to a liability even where the transferor remains liable for it, as long the property transferred secures the liability. See e.g., Owen v. Comm'r, 881 F.2d 832 (9th Cir. 1989) (finding section 357(c) gain even though the transferor remained personally liable for the debt and the debt was not includible in the transferor's amount realized under section 1001). Certain taxpayers have interpreted these decisions to mean that section 357(c) applies even where the liability is secured by another asset that remains in the hands of the transferor.
Thus, if a foreign corporation borrows funds and gives the lender security interests in two assets not used in the U.S., the lender can transfer each of the assets to a separate domestic corporation, and section 357(c) may require that the lender recognize gain on both transfers to the extent the liability exceeds the basis of each asset. Such gain would not be subject to tax in the U.S., and the domestic transferee could obtain a stepped-up basis in the asset.
Representative Archer introduced a bill in the 105th Congress, and he recently reintroduced that bill, as H.R. 18, in the 106th Congress. The bill would limit situations in which a step-up in basis can be obtained in a section 357(c) transaction. The bill would amend section 357 to apply only where the transferee "assumes" a liability, and would specify when a transfer of property "subject to" a liability is treated as an assumption of the liability. In the case of a transfer of property subject to a recourse liability, the transferee would be treated as having assumed the liability only to the extent the transferee agrees to satisfy the liability. In the case of a nonrecourse liability secured by multiple assets, some of which are not transferred to the transferee, the transferee would not be treated as having assumed the liability to the extent of the lesser of (1) the fair market value of the collateral not transferred to the transferee, or (2) the amount the owner of that collateral agrees to satisfy. A similar provision appears in the Administration's Budget Plan.
Straddle Techniques. Several techniques for the creation of artificial losses involve the use of straddles held by a foreign entity. See Tax Notes, April 13, 1998. In one method, the gain leg of the straddle is triggered by a foreign entity, and the remaining leg, with a BIL, is transferred to a U.S. taxpayer in a carryover basis transaction or by transfer of an interest in an entity. By using foreign currency positions in the straddle, taxpayers may also be able to have the loss treated as an ordinary loss under section 988.
Son-of-Mirror Technique. Long ago, the "son-of-mirror transaction," involving the investment adjustment rules of the consolidated return regulations, was devised. These rules, in Treas. Reg. Search7RH1.1502-32, which were designed to prevent double taxation of income earned by a subsidiary member of a consolidated group upon a sale of the subsidiary's stock following income earned by the subsidiary, were used to create a loss on the sale of a consolidated subsidiary to shelter income from related asset sales. This result was eliminated by the promulgation of Treas. Reg. Search7RH1.1502-20, which disallows any loss upon the sale of stock of a member of a consolidated group. See also IRS Notice 87-14, 1987-1 C.B. 445.
Tax Help From the Indian Nations. Some attribute shifting techniques do not involve the use of BILs, but rather creative use of limits on U.S. income taxation. One such class of transactions involves the use of entities not normally subject to U.S. income tax, such as native American tribes, to eliminate BIG in a subsidiary. This technique has been useful in cases where the sale of the stock of a subsidiary will be taxed more lightly than a sale of the subsidiary's assets, as a result of the subsidiary's stock having a higher basis that its assets, where a buyer insists on buying assets, and where the buyer is willing to pay more for the assets than it would for the stock. These transactions will generally be eliminated by Treas. Reg. Search7RH1.337(d)-4, effective January 29, 1999, since the new regulations provide that a corporation is required to recognize BIG when it becomes a tax exempt entity.
General Restrictions on Loss Importation
The IRS may seek to challenge a taxpayer's ability to deduct or to generate a deficit following its acquisition of an imported BIL asset on one or more of the following grounds under current law.
Assignment of Loss.Where the BIL asset is transferred to a U.S. transferee in a carryover basis transaction, and the asset is sold shortly thereafter, the IRS can argue that the transfer should be disregarded under the step transaction doctrine, based on Court Holding v. Comm'r, 324 U.S. 331 (1945), or based on assignment-of-loss theory.
Section 482.Where the transferor and transferee are related, a similar, but potentially more powerful, argument might be made by the IRS under the authority of section 482, which authorizes the IRS to reallocate items of income and deduction among taxpayers who are under common control if necessary in order to prevent the evasion of taxes or to more clearly reflect the income of the taxpayers. The IRS can act under the authority of section 482, even where the transaction between the related parties is nontaxable. In National Securities Corp. v. Comm'r, 137 F.2d 600 (3d Cir. 1943), a corporation contributed stock having a large built-in loss to its subsidiary and, approximately ten months later, the subsidiary sold the stock and claimed a deduction for the built-in loss. The Court upheld the Service's reallocation of the loss to the parent under the authority of the predecessor to section 482. This principle has been codified by the Service in Treas. Reg. Search7RH1.482-1A(d)(5).
Section 269.In some cases, the IRS may be able to prevent the taxpayer's use of the loss by invoking the authority of section 269. The provision applies if (1) any person acquires, directly or indirectly, control of another corporation or (2) any corporation acquires, directly or indirectly, property of another corporation, not controlled, directly or indirectly, immediately before such acquisition, by such acquiring corporation, in a carryover basis transaction, and if the principal purpose of the acquisition was tax avoidance;(12) the Secretary may disallow the deductions or other tax benefits resulting from the acquisition.
The application of this section can be avoided if the taxpayer can demonstrate that it did not acquire control in the transaction related to the transfer or sale of a BIL asset, or if the transaction was not undertaken with the principal purpose of tax avoidance. The regulations state that if a corporation acquires property having in its hands an aggregate carryover basis that is materially greater than its aggregate fair market value at the time of the acquisition (i.e., a BIL asset) and if the corporation uses the property to create tax reducing losses or deductions, then the acquisition is ordinarily viewed as having a principal purpose of tax avoidance in the absence of evidence to the contrary. A taxpayer can overcome this presumption by showing that the principal purpose of the transaction was avoidance of foreign income taxes, for example, or some other nontax purpose; it will not always be possible to structure a transfer of a BIL asset into the U.S. taxing jurisdiction from a foreign taxing jurisdiction in a manner that will have the effect of reducing the taxpayer's foreign tax.(13)
Sections 382, 383, and 384.The limitations in sections 382, 383, and 384 could be implicated if there has been a sufficient change in the beneficial ownership of a loss corporation over any three year period or acquisition of control of a gain corporation.
Section 382 essentially limits the deductibility of net operating losses ("NOLs") and BILs attributable to periods prior to a greater than 50% change in the beneficial ownership of the loss corporation. Furthermore, if the corporation that acquires a BIL or net operating loss does not continue the business enterprise of the old corporation, then no deduction is allowed for the NOLs or BILs of the loss corporation. One important limitation on the scope of section 382 as it applies to BILs, however, is that it only applies to losses that are recognized within five years of the date of the ownership change. Thus, the limitation can be avoided by waiting five years before selling the BIL asset. Effectively, this reduces the present value of the loss to approximately 68% of what it would otherwise be worth (assuming a discount rate of 8%).
The limitations of section 382 apply for purposes of determining the taxpayer's alternative minimum taxable income as well as the regular taxable income. Section 382(l)(7). See PLR 9401011 (granting taxpayer permission to determine alternative minimum taxable income under the closing of the books method, i.e., by closing the books of the loss corporation on the date of the ownership change). Section 382 also applies for purposes of using NOLs to reduce the tax imposed on C corporations that convert to S corporation status, under section 1374. Reg. Search7RH1.1374-5.
Section 383 extends the limitations of section 382 to the carryover of capital losses, foreign tax credits and certain other items of a loss corporation.
Another restriction that is brought into play in transactions involving a change of ownership is Code section 384. Section 384 states that if one corporation acquires control of another corporation, or acquires the assets of another corporation in a tax-free reorganization, and either of the two corporations' assets have a fair market value in the aggregate exceeding their basis (a "gain corporation"), built-in-losses of the other corporation that are recognized during the five-year period following the acquisition may not be used to offset built-in-gains of the gain corporation that predate the acquisition.(14) Items of income or loss that were realized before the acquisition but recognized subsequently (e.g., collection of accounts receivables by a cash-basis taxpayer) are treated like built-in-gains or losses for purposes of section 384. Again, section 384 is avoided if the acquiror is able to wait five years before triggering the BILs.
Note that sections 382, 383, and 384 generally apply only to changes in the beneficial ownership of stock and not to transfers of assets between corporations owned by the same beneficial owner. Thus, they are tailored to apply only to certain loss trafficking transactions. They apply only imperfectly to BIL assets; most obvious, taxpayers may avoid the application of sections 382, 383, and 384 to BILs by waiting five years before selling the BIL asset or otherwise triggering the loss.
Section 382 may also reduce the ability to traffic in certain BIL assets, and sections 383 and 384 provide related limitations, but none of these provisions limits the use of such losses to reduce the earnings and profits of an otherwise profitable corporation. Even if the deduction attributable to a loss recognized in a particular taxable year is deferred by reason of the limitation in section 382, the corresponding downward adjustment of the corporation's earnings and profits for such taxable year is not limited by the amount of the loss that is deductible immediately. See Reg. Search7RH1.312-7(b)(1). Therefore, a corporation may seek to acquire BIL assets in a transaction even though subject to section 382 in order to reduce its earnings and profits so that it can make a tax-free distribution to its shareholders. Similarly, a CFC may seek to acquire BIL assets in a transaction even though it is subject to section 382 in order to reduce the Subpart F income or section 1248 earnings includible by its shareholders, since one limit on inclusion is based on the current earnings and profits of the CFC.
Earnings and profits reduction may be useful in other contexts as well. For example, in the case of a shareholder in a PFIC that has a QEF election in effect, ordinary income inclusions under section 1293 are limited by the corporation's current earnings and profits. A reduction in earnings and profits may also useful in the case of a C corporation preparing to become an S corporation, to eliminate the potential application of section 1374, or in the case of a corporation subject to the accumulated earnings tax, which, under section 532(a), only applies if the corporation has excess accumulated earnings and profits.
SRLY Limitations and Other Consolidated Return Rules.If a BIL asset is transferred by one corporation to a second corporation, or to a new member of a consolidated group of corporations, the ability of the group to use deductions generated by the transferee corporation to offset income of other members of the group may be subject to the limitations in Treas. Reg. Search7RH1.1502-15T and 21T(c)(1)(ii) (the "SRLY" rules).(15) Similarly, the SRLY rules may apply to a BIL asset transferred to an existing member of a consolidated group in a section 351 exchange. See Treas. Reg. Search7RH1.1502-15T(c)(1)(ii). As is the case with BILs under section 382, however, the SRLY rules do not apply to BILs recognized after the five-year period beginning with the date the asset is acquired by the group.
The SRLY rules generally apply to a corporation with a BIL asset only if the corporation has a net unrealized built-in loss, i.e. its BILs exceed its built-in gains ("BIGs"). Treas. Reg. Search7RH1.1502-15T(b). The limitation could theoretically be avoided by also transferring BIG assets to the corporation. The regulations provide, however, that if assets are acquired by the corporation with a principal purpose of affecting its net unrealized built-in loss, those assets are disregarded for purposes of determining the amount of net unrealized built-in loss. Treas. Regs. Search7RHSearch7RH1.1502-15T(b)(2), -94T(c), and -92T(g)(3).
If the group sells stock of a corporation owning a BIL asset rather than the asset itself, then the loss may be disallowed under Treas. Reg. Search7RH1.1502-20, which disallows loss recognized on the sale of stock of a member of a consolidated group to the extent of any "duplicated loss," which includes a BIL. Furthermore, Treas. Reg. Search7RH1.1502-20(e) contains an anti-stuffing provision designed to inhibit avoidance of the loss disallowance rules by the contribution of BIG assets to the corporation, and by avoiding gain rather than triggering a loss. Under these anti-stuffing rules, a transfer of assets to a member of the group that is followed within two years by a disposition of the stock may generally not be taken into account in determining the basis of the member's stock.
Other Anti-Stuffing Rules.Even if the deduction of the BIL is not prevented by any of the foregoing grounds, the taxpayer will not find the loss useful unless it is able to use it to offset other U.S. income. The simplest way to achieve that goal is to transfer the asset directly to a U.S. corporation that has the requisite operating income or BIG assets. If, however, the BIG assets of the U.S. corporation consist of U.S. real property interests, then the transfer could be subject to the provisions of Treas. Reg. Search7RH1.897-6T(c). That regulation provides that if (1) a non-real estate asset with a built-in loss is transferred to a domestic corporation, (2) the transferred property will not be used in, or held by the domestic corporation for use in, the conduct of a trade or business, and (3) within two years of the transfer, the property is sold at a loss, then any loss recognized by the domestic corporation may not be used, either by direct offset or as part of a net operating loss or capital loss carryback or carryover, to offset any gain recognized on the sale of the corporation's U.S. real property interests. The loss will not be disallowed if the taxpayer can show by clear and convincing evidence that the property was not transferred to the domestic corporation for the purposes of avoiding taxation on the disposition. This and the other anti-stuffing rules described above can generally be avoided, for example, by simply waiting for more than two years before selling the BIL asset.
Current Law Restrictions on the Creation of Artificial Losses
Apart from the restrictions on loss trafficking, the IRS has some formidable weapons against transactions designed to create artificial losses.
Business Purpose.The IRS can be expected to attack the transfer of a BIL asset by attempting to disregard the transaction if the sole purpose of the transaction is tax avoidance. This is one view of the rule in ACM. The taxpayer could defeat such a claim by showing that the asset transferred to the U.S. corporation is retained and used by the corporation in its business.
Step Transaction Doctrine.In cases where the transaction depends upon payments or asset transfers flowing through an intermediary, the IRS can argue that the transfer should be disregarded under the step transaction doctrine. Such a transaction might be recharacterized as a sale of the BIL asset by the transferor rather than the transferee. See Court Holding v. Comm'r, 324 U.S. 331 (1945) (liquidation of corporation followed by buyer's sale of the assets received in the liquidation treated as sale of assets by the corporation). While Court Holding actually involved an assignment of income issue, there is no reason to believe the IRS could not use a similar theory to prevent an assignment of a loss.