1 M&A Tax Update Recent Developments Alan Barton February 27, 2004

2 Section 382 – Notice Section 108 – Treas. Reg. Sections T and T Section 338(h)(10) – Treas. Reg (h)(10)-1T Section 355 – Rev. Proc and Rev. Ruls , , & Recent Developments

Section 382 – Notice

4 Section 382(h) Section 382 Ownership Change Net Unrealized Built-in Gains (Losses) Recognized Built-in Gains (Losses) Built-in Income and Deduction Items No Regulations / Limited Guidance on Built-in Income and Deduction Items

5 Notice Identification of Built-in items for purposes of Section 382(h) Two Methods Section 1374 Approach Section 338 Approach Can use either approach for each ownership change Retroactive Application

6 Notice Section 1374 Approach Identifies built-in items by incorporating the rules of section NUBIG or NUBIL is the net amount of gain or loss that would be recognized in a hypothetical sale of the assets of the loss corporation immediately before the ownership change. This approach generally treats items of income and deduction as attributable to the pre-change period if such items accrue for tax purposes prior to the ownership change. This approach may be preferable for those taxpayers seeking to avoid characterization of deductions (including contingent liabilities) as recognized built-in losses.

7 Notice – Section 338 Approach NUBIG or NUBIL is calculated in the same manner as under the section 1374 approach – NUBIG or NUBIL is not redetermined for contingent consideration (including contingent liabilities). Identifies built-in items by comparing the loss corporation’s actual items of income, gain, deduction and loss with those that would have resulted if the loss corporation had been acquired in a section 338 election transaction on the ownership change date. Additional income resulting from forgone depreciation or amortization on a wasting asset can be treated as recognized built- in gain, and deductions for liabilities that were contingent on the change date can be treated as built-in losses, even though neither such item accrues for tax purposes prior to the ownership change. This approach may be preferable for those taxpayers seeking to treat income generated by wasting assets as recognized built-in gain.

8 Notice – Examples LossCo 1 NUBIL Position Contingent Tort Liability Ownership Change LossCo 2 NOL Carryforwards NUBIG Position High Value Low Basis Goodwill Ownership Change

Section 108

10 Section 108 Gross Income includes Cancellation of Debt Income Cancellation of Debt Income Excluded under Section 108(a) Bankruptcy Insolvency Attributes are Reduced under Section 108(b) Net operating losses, general business credits, minimum tax credits, capital losses Basis Passive activity losses and credits, foreign tax credits Timing of attribute reduction Net operating losses and other attributes Basis

11 Treas. Reg T Timing of Section 108(b) attribute reduction – NOL Carrybacks Basis reduction and Section 381 Transactions “G” Reorganizations FSA House Report of the Bankruptcy Tax Act of 1980 Effective for discharges occurring after July 17, 2003

12 Section 108 – Consolidated Return Groups Government’s initial position on attribute reduction: PLR Reduction of attributes under section 108(b) should be made on a separate company basis Government’s recent position on attribute reduction: FSA CCA Reduction of attributes under section 108(b) should be made on a consolidated basis

13 Treas. Reg T Determination of Insolvency – Separate Company Attribute Reduction – Ordering Rule Debtor Member’s Tax Attributes Look Through Rule Consolidated Tax Attributes Effective for discharges occurring after August 29, 2003

Section 338(h)(10)

15 Section 338 New Final and Temporary Regulations Address interplay between Section 338(h)(10) and step transaction doctrine Alleviates confusion caused by a series of IRS rulings Rev. Rul Rev. Rul

16 Revenue Ruling Merge S T T S/Hs 100% Cash P P T Former T S/Hs P S/Hs Merge Acquisition MergerUpstream Merger

17 Revenue Ruling Rev. Rul : First step QSP accorded independent significance from second step liquidation. Cites Congressional intent that a Section 338 election replace any non-statutory treatment of a stock purchase as an asset purchase under Kimbell Diamond doctrine.

18 Revenue Ruling Issues addressed in Rev. Rul The Issue: –After Rev. Rul , it was unclear what tax result prevailed when a first step taxable acquisition was followed by a second step merger (or other asset transfer) that could recast the transaction into a reorganization. –Practitioners argued that a first step QSP had independent significance from any future step.

19 Revenue Ruling X TY T s/h’s 1. Merger 70% X stock; 30% Cash X s/h’s X T T s/h’s 2. Merger Up X X s/h’sT s/h’s 3. Resulting Structure

20 Revenue Ruling Rev. Rul Situation 1: X owns all of Y, a newco. Pursuant to an integrated plan, X acquires all of T in a merger of T and Y, with T surviving. In the merger, shareholders of T receive 70% X stock and 30% cash. As part of the plan, X then merges T upstream. First step would not qualify as a “B” reorg. as solely rule is violated and does not qualify as an (a)(2)(E) because that section requires that at least 80% of the acquisition consideration be in the form of voting stock. Viewed as a merger into X, however, the more liberal COSI standard is met.

21 Revenue Ruling Issues addressed in Rev. Rul Conclusion: Policies underlying Section 338 not violated by treating Situation 1 as a single statutory merger that qualifies as a reorganization because X acquires the assets with a carryover basis under sec. 362, not cost basis under sec Thus, steps do not have independent significance. However, ruling was given only prospective application. Situation 2: Same as Situation 1 except that T shareholders receive solely X voting stock. Subsidiary merger would have qualified as an (a)(2)(E) by itself. Service holds that this difference should not change the result in Situation 1 – i.e., treated as a direct merger into parent.

22 Reg. Section 1.338(h)(10)-1T Issued in response to comments urging IRS and Treasury to allow Section 338(h)(10) elections in transactions identical to Situation 1 of Rev. Rul Regulations give effect to Section 338(h)(10) in multi-step transactions where a purchasing corporation’s initial acquisition of target’s stock viewed independently, constitutes a qualified stock purchase (QSP). Step transaction doctrine will not be applied in such transactions if a valid Section 338(h)(10) election is made. 4 new examples (11-14) were added to the Section 338(h)(10) regulations Allows for greater flexibility in structuring and planning – Elective Carryover or Section 338(h)(10) Treatment Effective July 9, 2003

23 Example 11 Stock Acquisition - Viewed Independently, constitutes a qualified stock purchase. No Section 338(h)(10) election made. P Y T S Merge 50% P Voting Stock 50% Cash Merge S/Hs S P T Upstream Merger - Viewed independently qualifies as a Section 332 liquidation.

24 Example 11 New regulation does not apply since no valid Section 338(h)(10) election was made. Treated as a tax-free reorganization under Section 368(a).

25 Example 12 Stock Acquisition - Viewed Independently, constitutes a qualified stock purchase. P and S make a valid joint Section 338(h)(10) election for T. P Y T S Merge 50% P Voting Stock 50% Cash P T S S/Hs Merge Upstream Merger - Viewed independently qualifies as a Section 332 liquidation.

26 Example 12 Application of the step transaction doctrine results in the 2 step transaction being treated as P’s acquisition of T’s assets in a tax-free reorganization Applying new regulations: Since a valid Section 338(h)(10) election was made, step transaction doctrine does not apply and P’s acquisition of T stock treated as a QSP and not a tax-free reorganization under Section 368(a).

27 Example 13 S Stock Acquisition - Viewed Independently, constitutes a qualified stock purchase. P and S make a valid joint Section 338(h)(10) election for T. P Y T Merge 50% P Voting Stock 50% Cash X T Merge X S/Hs S P Brother-Sister Merger - Viewed independently qualifies as a reorganization under Section 368(a).

28 Example 13 Application of the step transaction doctrine results in the 2 step transaction being treated as P’s acquisition of T’s assets in a tax-free reorganization Applying new regulations: Since a valid Section 338(h)(10) election was made, step transaction doctrine does not apply and P’s acquisition of T stock treated as a QSP and not a tax-free reorganization under Section 368(a).

29 Example 14 Same facts as Example 12, except S (T’s shareholder) receives only P voting stock as consideration for merger of Y into T. No Section 338(h)(10) election can be made since, viewed independently, Y’s merger into T does not constitute a QSP since S receives only P voting stock and transaction independently is a tax-free reorganization. New regulations do not apply. Step transaction doctrine applies. 2 step transaction treated as one tax-free reorganization under Section 368(a).

30 Change to Form 8023 October 2002 Form 8023 – Election Statement Form 8883 – Asset Allocation Statement

Section 355

32 Section 355 No gain or loss is recognized by the distributing corporation (D) or its shareholders on a distribution of a controlled subsidiary (C) Requirements D must Control C before the distribution Distribution must not be a Device for the distribution of E&P of D or C Must be a Continuity of Interest on the part of the D shareholders after the distribution Must be a Valid Business Purpose for the distribution D and C must each engage in the Active Conduct of a Five- Year Trade or Business immediately after the distribution Section 355(e) – D will recognize gain on the distribution if there is a 50% or greater change in the ownership of either D or C that is treated as part of a plan (or series of related transactions) that includes the distribution

33 Section 355 As a result of the significant tax exposure to D and its shareholders, taxpayers frequently seek private letter rulings from the IRS regarding the qualification of the distribution under section 355 Rev. Proc Contains the checklist questionnaire of information that must be included in a request for ruling under Section 355 Appendix A – Business purposes guidelines, e.g., “fit and focus” Rev. Proc IRS will not rule on issues that are primarily factual Active Trade or Business – Where FMV of active trade or business assets is less than 5% of total FMV of gross assets of corporation, IRS will ordinarily not rule that active business requirement of section 355 is met

34 Rev. Proc IRS will not rule on business purpose, device, or acquisition “pursuant to a plan” (section 355(e)) Taxpayers requesting rulings will have to make representations regarding the satisfaction of the business purpose, device and section 355(e) issues. IRS views these issues as “primarily factual”; best left for audit Deletes Appendix A of Rev. Proc , and Section 4.01(30) of Rev. Proc (the less than 5% FMV active trade or business assets no rule area) IRS will focus on increasing published guidance regarding business purpose and other section 355 legal questions One year pilot program

35 Recent Section 355 Rulings Revenue Ruling – Business Purpose – Increase in Aggregate Value of Stock of Distributing and Controlled Revenue Ruling – “Fit and Focus” – Management Problems Revenue Ruling – “Fit and Focus” – Capital Allocation Problems Revenue Ruling – “C” Reorg Following Spin

36 Rev. Rul – Increase in Stock Value Corporate Business Purpose satisfied even though the Distribution is expected to confer a benefit to existing shareholders Stock of Distributing and Controlled likely would, in the aggregate, have a higher trading price than the stock of Distributing if it continued to own Controlled The benefit of the increased aggregate value is a real and substantial benefit to Distributing, Controlled or both (enhanced equity based compensation or facilitates future acquisitions in a manner that preserves capital with less dilution of existing shareholders’ interests) Distributing’s directors do not effect the Distribution to facilitate any particular shareholder’s disposition of the stock of Distributing or Controlled

37 Rev. Rul “Fit & Focus” - Management Distributing engaged in high-growth software technology business Controlled engaged in slow-growth paper products business One 8% shareholder not involved in management Senior management wants to concentrate solely on software 2 shared directors – 1 with unlimited term – not officers

38 Rev. Rul “Fit & Focus” - Capital Distributing in pharmaceuticals and Controlled in cosmetics One 6% non-management shareholder Businesses compete for capital Controlled will have direct access to capital if spun off Continuing relationships – administrative, tax – for 2 years with limited extension

39 Rev. Rul – “C” Reorg Following Spin D conducts Businesses X and Y of equal value Unrelated A wants to acquire Business X but not Business Y D transfers Business X to newco C D spins off C to its shareholders A acquires C assets in exchange for A voting stock (not a merger) and C liquidates

40 Revenue Ruling A A A A C C Bus X D D C C D D Shldrs “C” reorg A voting stock Bus Y

41 Revenue Ruling Issue Addressed: Is the “substantially all of the properties requirement” of a “C” reorganization met on C’s transfer of Business X to A? Issue Assumed: D distributed “stock of a controlled corporation” – so a good spin-off Apparent violation of doctrine that transitory existence of a corporation formed solely to effect an acquisition should be disregarded