Reincorporation and the Economic Substance Doctrine?

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Unwanted Assets. Normally, achieving this restructuring would require Sub to distribute the business assets to Parent, which could create deferred intercompany gain that would be triggered into income if either the business or Sub left the group. This is not different from the gain that Parent would recognize after the actual transaction if it sells the distributed business. However, if it sells Sub after this transaction treated as an upstream reorganization, it will not recognize its gain in the retained business, and that may be the plan. Indeed, the Chief Counsel delayed release of this ruling at the taxpayer’s request, so maybe that is just what taxpayer did. In other words, the transaction may be yet another solution to the unwanted asset problem in mergers and acquisitions.


Bausch & Lomb Repeal. The key to the tax result allowed by the ruling was the decision made by Treasury in 2000 to reverse the result in Bausch & Lomb Optical Co. v. CIR, 267 F.2d 75 (2d Cir. 1959) , cert. denied, 361 U.S. 835 (1959).  Regs. § 1.368-2(d)(4) in effect treats a parent’s historic ownership of a partial (or wholly owned) subsidiary as good continuity so that the subsidiary can reorganize into parent, rather than being treated as liquidating into parent. This change has been interpreted by the Chief Counsel to mean that in an overlap between such an upstream reorganization and a section 332 liquidation, the reorganization treatment trumps.


To make this work, the letter ruling deems Parent to have exchanged its voting stock for Sub’s assets (all of them), as if it were the acquirer in a reorganization of Sub, and then Sub distributed the hypothetical Parent stock back to Parent in its status as Sub’s shareholder. See Ruling 1 in LTR 201127004.


Reincorporation. The reason the reorganization treatment is useful is that it opens the door to using section 368(a)(2)(C), allowing assets received by an acquiring corporation in a reorganization to be transferred to another controlled corporation. Here and in earlier LTR 200952032, that other corporation is the temporarily disregarded entity that was Sub, and will become New Sub after it is converted to be a tax corporation again. This is permitted even though it is slightly different from what you would expect: some of the acquired assets being put into another subsidiary of acquirer while the acquired target’s remaining assets are held by the acquirer. Of course that is what happened, because New Sub is not Sub.


While there is not a wealth of letter ruling authority for these results and no revenue rulings, these results are pretty well understood. They allow “reincorporation,” which otherwise would void an attempted section 332 liquidation of a subsidiary, but in the context of an intragroup reorganization, which is usually just fine with the group because it gets all the results it would have received from the section 332 liquidation (attribute carryover, no recognition) and more (the ability to split up the Sub’s assets and keep some in corporate solution).


Discharge of Indebtedness Income. Perhaps the more novel aspects of the ruling are the treatment of debt from Parent to Sub and some preferred stock Parent holds in Sub.  The ruling states: “Parent will not realize income under §61(a)(12) or  §1.301-1(m) with respect to the extinguishment of the Intercompany Debt in the Conversion. See Rev. Rul. 74-54, 1974-1 C.B. 76. The reference to the regulation means that Parent is not receiving its own debt in its capacity as a shareholder of Sub in a nonliquidating distribution. Therefore, it must be receiving it in its capacity as a corporate acquirer in a reorganization. But the revenue ruling cited by the letter ruling applies section 332 to protect a debtor parent from income upon a liquidation of its subsidiary. This is inconsistent with the basic theory of the letter ruling that Sub did not liquidate into Parent, at least insofar as the transfer of Parent debt is concerned: it transferred the Parent debt as an asset to a corporate acquirer; therefore Rev. Rul. 75-54 should not apply.


Get a Ruling. It has been feared that a corporate acquirer could recognize discharge of indebtedness income in such a situation, under section 108(e). The ruling resolves the uncertainty, at least for taxpayers willing to go for rulings. The taxpayer represented that it would comply with Reg. 1.1503-13, which in subsection (g) includes rules that apply to the intercompany debt.


Stock Recapitalizaiton. Finally, the Parent revised the terms of the preferred stock in Sub between its liquidation and its reincorporation. Had this occurred while Sub was a member of the group a taxable event might have occurred, but as it occurred while Sub was disregarded, nothing occurred. Admittedly it would have been pretty difficult to make a stock recapitalization taxable, but it can occur with redeemable preferred.


The Economic Substance Doctrine. Finally, an economic substance doctrine safe harbor can be discerned in this ruling, at least in the mind of Chief Counsel (Corporate). The ruling blesses a transitory “liquidation.” Transitory corporate transactions have been the paradigm cases that the IRS has attacked over the decades. Now Chief Counsel is inviting taxpayers (at $14,000 a pop, cheap enough at 8X the price) to get its blessing for a transitory liquidation.


Does this say something about the economic substance doctrine? It may. It may say that Chief Counsel thinks a corporate group ought to be able to sell part of the assets of a subsidiary without recognizing the gain in all of the assets. That makes such a transaction with such results one to which the economic substance doctrine is not “relevant.” Therefore the Chief Counsel will ignore the transitory transaction because it finds the results consistent with…. with what? The intent of Congress? The way Chief Counsel thinks the Code should work? We don’t know for sure, but we know you too can get this result if you go in for a letter ruling.