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. §1.482-1A(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. §1.1374-5.
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. §1.312-7(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. §1.1502-15T 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. §1.1502-15T(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. §1.1502-15T(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. §§1.1502-15T(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. §1.1502-20, 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. §1.1502-20(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. §1.897-6T(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.
Substance over Form.
Substance over Form.The application of traditional substance over form principles may come into play in transactions structured to shift the tax benefits of ownership with no economic consequences. For example, authority exists for recharacterizing leases where either the lessee or a third party other than the lessor, such as a lender, actually owns the economic value of the leased property. See e.g., Frank Lyon Co. v. U.S., 435 U.S. 561 (1978). See also Prop. Reg. § 1.7701(l)-2; Prop. Reg. § 1.7701(l)-3 (discussed below).
Section 467.In the case of transactions involving leases, the IRS may be able to use section 467 and the proposed lease strip regulations, discussed above. Section 467 contains rules that recharacterize deferred rental payments as loans from the landlord to the tenant and require current inclusion of interest income. Proposed regulations under section 467 would extend the application of section 467 to prepaid rent as well. Prop. Reg. § 1.467-1(c).
Section 446(b).Where a transaction creates distortions by mismatching the timing of income and deductions, the IRS may be able to invoke its authority under section 446(b) (method of accounting must clearly reflect income), to require the taxpayer to use a method of accounting that clearly reflects income. See, e.g., Prabel v. Comm'r, 91 T.C. 1105 (1988), affd., 882 F.2d 820 (3rd Cir. 1989) (upholding IRS's determination that real estate tax shelter's use of Rule of 78s method of accounting for interest did not clearly reflect income). It seems noteworthy that the Tax Court, in ACM, commented that the IRS had not raised the issue of section 446(b), suggesting that it should have.
Partnership Anti-Abuse Provision.Where a transaction involves use of a partnership to achieve basis shifting, the IRS may be able to disregard the partnership, or otherwise challenge the transaction.16 Recently adopted Reg. §1.701-2 includes a general anti-abuse rule and states that if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K, the IRS may recharacterize the transaction as appropriate to achieve tax results that are consistent with the intent of subchapter K. This rule may be invoked even if a transaction fits within the literal words of a particular provision of the Code or regulations.
Practitioners and commentators alike have complained about the uncertainty resulting from the partnership anti-abuse regulations. See e.g., NYS Bar Association Tax Section Report on the Proposed Partnership Anti-Abuse Rule, No. 797, July 1, 1998 (supporting promulgation of partnership anti-abuse rule, but urging Treasury to add additional examples to clarify the scope of the new rules). As a result of such comments, Reg. §1.701-2 contains numerous examples of specific transactions that do, or do not, come within the scope of the anti-abuse rule. Taxpayers are forced to treat the examples of transactions that will not invoke the anti-abuse rules as narrow safe harbors, out of concern that even a small deviation from the facts in an example will create a problem.
Economic Substance.The lack of economic substance may be invoked by the IRS not only to prevent the shifting of a BIL asset, but also to the prevent the initial creation of the BIL. This was the approach adopted recently by the Tax Court in ACM Partnership v. Comm'r, supra, the facts of which are summarized above. The Court in ACM found that all the transactions between the parties were conducted at arms length and that all the parties derived some economic benefit from the transactions, viewed as a whole, apart from the tax benefits attained by Colgate. Nevertheless, the IRS successfully argued that the capital loss claimed upon the sale of the LIBOR notes should be disallowed. In agreeing with the IRS, the Tax Court focused specifically on the role of the sale of the Citicorp notes and the acquisition of the LIBOR notes in the overall plan. The Court found that, given the substantial transaction costs incurred by Colgate in structuring the transaction (in the range of $5 million), there was no realistic possibility that Colgate could earn a net profit on its investment. The Court also determined that the LIBOR notes were not necessary to hedge ABN's interest rate risk since ABN had entered into hedging transactions outside the partnership for that purpose. The Court stated that since the acquisition and sale of the LIBOR notes lacked a business purpose, and was entered into purely for tax reasons, the transaction was a sham without economic substance, and could be ignored for tax purposes.
The principal holding in ACM was affirmed on appeal to the Third Circuit, though that court disagreed with the Tax Court's related decision to disallow a deduction for the economic loss from the transaction. 82 AFTR 2d 98-6682 (Oct. 13, 1998). One statement made by the Third Circuit goes to the heart of the artificial loss issue. The Court stated, "[i]n order to be deductible, a loss must reflect economic consequences sustained in an economically substantive transaction and cannot result solely from the application of a tax accounting rule to bifurcate a loss component of a transaction from its offsetting gain component to generate an artificial loss which . . . is not inherent in the transaction."
Addressing Solutions -- Macro v. Micro Approaches
A review of the history of the approaches taken by Congress and the Treasury toward tax shelters in the past suggests that certain generalizations may be made about the different approaches to addressing loss importation. One useful way of looking at the different approaches is to classify them based on how broad each one is. Thus, the issues may be approached on more of a "macro" level (e.g., with one or more sweeping anti-abuse provisions), or on more of a "micro" level by narrow changes to the existing rules to tackle specific instances of abuse as they come to the attention of the IRS, Treasury or Congress).
Many transactions in which losses are imported into the U.S. are undertaken in the ordinary course of business for perfectly legitimate non-tax reasons independent of the tax consequences. In other cases, similar transactions may result in the effective import of BIG assets into the U.S. While it is probably true that taxpayers will try to structure transactions in a manner that will result in more losses than gains being imported into the U.S., the same could be said about virtually any of the rules in the Code) (i.e., taxpayers attempt to use them or avoid them so as to minimize taxes). Therefore, it is difficult to see why ordinary planning in the area of loss importation should be viewed as more offensive than other tax planning. In fact, the importation of a BIL loss asset by the same beneficial owner who bore the economic loss seems no different from the rules allowing taxpayers to offset the income from profitable activities with the losses from other activities,17 nor does it seem different from the rules allowing affiliated corporations to file a consolidated return on which the income of one member may be netted against the losses of another in the absence of a SRLY or section 382 ownership change.
Under current law, an asset that enters U.S. taxing jurisdiction either by a change in the status of the asset's owner or by a change in the status of the asset (i.e., from generating noneffectively connected income to generating effectively connected income) is not subject to an automatic basis adjustment to reflect appreciation that occurred prior to the change. As a result, the owner of the asset may well be subject to tax in the U.S. on any prior appreciation, or entitled to a loss on any prior depreciation, upon a subsequent disposal of the asset.
It might be argued that any comprehensive revision of the rules for BILs should, as a matter of fairness, be accompanied by analogous rules to prevent imported gains from being subject to U.S. tax. One counterargument, however, is that taxpayers have always been free to engage in transactions to step up the basis of assets before transferring the assets into the United States. But the current system does create traps for the unwary.
To the extent Congress is concerned about inconsistencies resulting from mismatches between the rules of the Code and the tax systems of other countries, one possible approach might be to adopt an across the board mark-to-market rule for all property that enters the United States taxing jurisdiction.
The current system is probably superior to such a mark-to-market rule, however, which would add an additional layer of complexity and expense for quotidian transactions that are not tax motivated at all. In addition, a mark-to-market rule for imported property would be inconsistent with the section 367 regime and similar rules that may trigger gain but not loss where property is exported from the U.S. taxing jurisdiction, and where gain recognition can often be deferred.
From a policy perspective, the "export" of appreciated or depreciated assets is closely related to the "import" of such assets. Existing law contains a number of provisions designed to prevent taxpayers from escaping tax on appreciated assets by "exporting" the gains. Section 367 is but one example. Section 684 also serves to prevent exportation of gains through foreign trusts, and section 877 impedes exportation of gains by an individual through expatriation. Current law also tends to permit the preservation of exported losses. For example, a U.S. taxpayer who transfers a BIL asset to a foreign corporation in a section 351 exchange obtains a high carryover basis in the stock it receives in the exchange. Thus, the loss could ultimately be recognized when the stock is sold. The BIL asset will have been exported with a BIL, which may reduce future Subpart F inclusions of a CFC, for example, or otherwise offset foreign earnings and profits subject to possible attack by IRS on the grounds noted above.
Mark-to-Market Method.If Congress were to become convinced that loss importation is per se a bad thing, then it would only seem fair to allow a basis step-up for the importation of BIG assets. Under existing law, mark-to-market treatment applies in limited situations. See, e.g., IRC section 475 (mandating mark-to-market treatment for securities held by dealers as inventory). Mark-to-market treatment is also available for BIG assets entering the United States in several special situations.
Code section 877(e), which subjects expatriating individuals who are long-term residents to a separate tax regime, states that BIG assets that were owned by the individual at the time the individual became a U.S. resident are treated as having a stepped-up basis unless the individual elects otherwise.
A shareholder of a PFIC may elect mark-to-market treatment of the stock in the PFIC, under section 1296, in which any BIG or BIL is recognized as of the end of each taxable year. If, however, a nonresident becomes a U.S. resident while owning an interest in a PFIC, then the adjusted basis of the stock in the PFIC is stepped up to fair market value as of the date the shareholder becomes a U.S. resident, for purposes of determining gain or loss under those mark-to-market rules.
Anti-Abuse Rule.Another "macro" approach would be to adopt a broad anti-abuse rule aimed at loss importation generally. Such a macro rule could be similar to the partnership anti-abuse rule in Reg. §1.701-2, which was described above. Such a rule could provide, for example, that any loss importation transaction undertaken with a principal tax avoidance purpose will result in the taxpayer receiving a stepped-down basis in the imported property.
An even more extreme possibility would be for the United States to adopt a general anti-avoidance rule ("GAAR"), such as the one used in other countries, like Canada and, more recently, the U.K. A GAAR, like Reg. §1.701-2, adds substantial uncertainty to legitimate tax planning. Informal discussions with tax practitioners in Canada suggest, for example, that legal opinions now must effectively carve out any action that may be taken by Revenue Canada under GAAR.
Micro Solutions.Alternatively, the IRS Treasury, and Congress could proceed with a more focused (or "micro") approach, using more narrowly tailored rules to stop specific abuses. For example, the modified lease-strip (through transfers of interests in corporate lessors) could be attacked by an amendment to the regulations under section 269 (e.g., stating that such transactions are presumed to be for a principal purpose of tax avoidance). The modified lease strip could also be addressed by amendments to the proposed regulations. Similarly, Congress could authorize selective extension of the five-year recognition period under section 382, 383 and 384 in extreme cases, and/or for the IRS could do the same under the SRLY regulations.
The Temporary Regulations issued on January 11, 1999, under section 865, provide an excellent illustration of another micro approach that Treasury could take toward attribute importation transactions, and may in fact apply to prevent some of the loss importation transactions considered above. The Regulations provide that if one of the principal purposes of a transaction is to change the allocation of a BIL with respect to stock or other property by transferring the property to another person, qualified business unit (within the meaning of section 989(a)), office or other fixed place of business, or branch that subsequently recognizes the loss, the loss is allocated by the transferee as if it were recognized by the transferor immediately prior to the transaction. Treas. Reg. §1.865-1T(c)(6) & -2T(b)(4). The Regulations also apply to a change in residence if a principal purpose of the change in residence is to change the allocation of a BIL. The Regulations specifically include transactions designed to take advantage of provisions such as sections 332, 351 and 721. Furthermore, the Regulations state that where a taxpayer enters into offsetting positions with respect to a straddle, the loss is allocated to offset the gain under the straddle. Treas. Reg. §1.865-1T(b)(6)(ii) & -2T(b)(4)(ii).
The Regulations appear to apply even with respect to transactions involving no change in the ultimate beneficial ownership of a BIL. This approach seems to be appropriate for artificial losses, such as the ones involving straddles, but may be overly broad in including transfers made for legitimate business objectives (apart from an awareness of the favorable tax consequences) among entities or branches having a single economic owner.
While these rules appear to be limited to loss importation transactions where the source of the loss is important, e.g., where the taxpayer is foreign or is seeking to improve its foreign tax credit position, similar rules could be drafted to apply to other attribute importation transactions.
LILO transactions could be eliminated by clarifications made to the section 467 regulations.
The section 302-redemption tax shelters could be eliminated by expanding the rules of section 1059 (e.g., to require a basis reduction for any extraordinary dividend paid to a tax exempt entity or to a foreign entity subject to U.S. taxation of an extraordinary dividend at a rate of less than 30%) (e.g., as in section 163(j)). Alternatively, the option attribution rule in section 318(a)(4) could be narrowed to take into account the likelihood of exercise.
Another, more complex, approach would be to adopt an approach like the one under section 382 for BIL assets. Such an approach would limit a BIL if the beneficial owner of the transferee of the asset is materially different than that of the transferor. The application of this rule could be limited to significant BIL assets. A similar approach would be to apply purpose-based tests, analogous to the one in section 269, on an asset by asset basis for all imported BIL assets.
Additional regulations to address other abusive transactions involving multi-party financings, such as those recently proposed for step-down preferred stock, could also be issued under the authority of section 7701(l).
Comparison of the Two Approaches.Each alternative has advantages and disadvantages. A macro-based approach would be very difficult to administer and would create significant uncertainty among taxpayers as to the consequences of numerous transactions that are not really abusive, but would have some in terrorem effect. The experience of living under the shadow of Reg. §1.701-2 should provide a lesson of the difficulties with this approach, however. In addition, such a rule may actually create unexpected conduct among taxpayers considering abusive transactions, since their advisers may adopt the view that nobody really knows what the general rule means. This logic supports further toughening of penalties. Along these lines, note that guidance is expected soon under section 6111(d) (as amended by the Taxpayer Relief Act of 1997).
On the other hand, a micro approach is not perfect either. As the rules become more complex, taxpayers are likely to discover more wrinkles in the rules that can be manipulated to their advantage. Historically, Congress, Treasury and the IRS lag behind taxpayers in finding and exploiting opportunities for tax avoidance. While many abuses could be curbed by Treasury Regulation, or IRS Notice, the process of drafting amendments to regulations or issuing new regulations often takes a long time. Thus, taxpayers who can afford to hire the best legal talent are likely to stay one step ahead of the regulations, in many cases using the rules to create new and ever more sophisticated shelters.
The IRS appears to be streamlining and improving its ability to respond rapidly to and address new shelters too. The IRS has used its Notices, targeted specifically at new shelters, as a temporary fix until Regulations can be issued. A Notice, stating that Regulations will be issued that will be retroactive to the date of the Notice, has provided a powerful weapon. The IRS has used the Notice mechanism several times in recent years.
A recent example of this is the issuance of Notice 97-21, 1997-21 I.R.B. 9, to target arrangements involving "fast-pay" or "step-down" preferred stock. These are arrangements in which a sponsor uses a conduit entity such as a RIC, a REIT, or a foreign corporation (the "company") to shelter or defer income. The company typically issues two classes of stock, one ordinary common stock and the other the fast-pay preferred. The preferred stockholder, which is generally a tax-exempt entity or a non-U.S. taxpayer, is entitled to a relatively large dividend (not subject to U.S. tax) for a number of years and then to a much smaller annual dividend after that. The preferred stockholder may or may not be redeemed out once the fast-pay period expires, at a price reflecting the reduced value of the stock. Economically, the holder of the fast-pay stock effectively recovers virtually all of its investment through the large dividends in the earlier years and as the value of the preferred stock decreases, the value of the common stock increases. The common stock holder may then sell its shares and recognize capital gain (and if the issuer is foreign, section 1248 is avoided because the company has distributed all of its e&p to the preferred stock holder); if the sponsor is a corporation, the sponsor may be able to liquidate the company tax free under section 332 and acquire appreciated assets with a stepped-up basis. In addition, the holder of the preferred stock could recognize a capital loss on the redemption of the preferred, or transfer the preferred stock to a U.S. taxpayer, thereby importing a BIL asset.
Notice 97-21 indicated that the IRS would issue Regulations recharacterizing such arrangements as investments directly in the underlying assets owned by the company, and indicated that the Regulations would be retroactive to the date of the Notice. The IRS waited until January 5, 1999 to issue Proposed Regulations implementing Notice 97-21, using a slightly different approach than the one set forth in the Notice, but with an effective date consistent with it. By using the Notice mechanism, the IRS was presumably able to deter taxpayers from entering into such transactions until it was ready to issue Proposed Regulations.
To prevent taxpayers from affirmatively using the rules of the proposed regulations to recharacterize transactions for their own benefit, the proposed regulations state, "[a] taxpayer may not use [rules of Prop. Reg. §1.7701(l)-3] if a principal purpose for using such rules is the avoidance of any tax imposed by the Code. Thus, with respect to such taxpayer, the Commissioner may depart from the rules of this section and recharacterize (for all purposes of the Code) the fast-pay arrangement in accordance with its form or economic substance." Prop. Reg. §1.7701-3(d). This refinement, prevent taxpayers from using anti-abuse recharacterization rules affirmatively, should provide the sort of in terrorem mechanic some practitioners and taxpayers need to dissuade them from pursuing strategies that are too aggressive.
Year 2000 Budget Plan Proposal.Just recently, the Clinton Administration released its Budget Plan for the Year 2000. The Budget Plan includes a number of provisions targeting corporate tax shelters including many of those discussed in this report. The Budget Plan also includes proposals for significant changes to the existing penalty regime for a broad category of corporate tax avoidance transactions and the imposition of "excise taxes" on certain arrangements entered into in connection with such tax shelters. As noted above, this report considers only the technical rules under which loss importation transactions and transactions that create artificial losses can arise. Following is a summary of the Budget Plan proposals to change those rules, as described in the Treasury Department's explanation of the Budget Plan.
Expansion of Section 269.One of the broader proposals would expand the scope of section 269 to authorize the IRS to disallow a deduction, credit, exclusion or other allowance obtained in any "tax avoidance transaction." The term "tax avoidance transaction" would be defined as any transaction in which the reasonably expected pre-tax profit (determined on a present value basis, after taking into account foreign taxes as expenses and transaction costs) of the transaction is insignificant relative to the reasonably expected net tax benefits (i.e., tax benefits in excess of the tax liability arising from the transaction, determined on a present value basis) of the transaction.18 The Treasury Department explanation states that "certain transactions involving the improper elimination or significant reduction of tax on economic income" would also be covered by the definition. It is not clear how broad this provision would be. The Treasury Department's explanation does not specifically state that it will be limited to transactions involving corporations. Furthermore, it is not clear whether the transactions referred to in the language quoted above would also cover transactions that carry significant potential economic benefits to their participants. Absent specific statutory language it is difficult to imagine whether such transactions will be described individually or described generally by yet further sets of definitional rules. Finally, such a provision will put pressure on the definition of "significance" in measuring relative economic benefit -- will that be left in the hands of taxpayers and the IRS to struggle with on a case by case basis?
This proposal seems somewhat similar to the general anti-avoidance rules that are used by some other countries. As noted above, such a generic rule would inject an entirely new level of complexity and uncertainty in virtually every transaction undertaken by taxpayers with a view to the tax impact of the transaction. Congress should carefully weigh whether it is desirable to inject such a large measure of uncertainty in ordinary business transactions where the economic and/or tax benefits are not easily ascertainable and may be assessed differently by the parties as well as experts, judges, and juries. Taxpayers can imagine being challenged by the IRS in cases where the business decision does not result in the profits initially projected. We thought such second guessing was left to the rarified practice of transfer pricing.
Impose Tax on Tax Shelter Income Earned by Tax-Exempt Taxpayers.As discussed above, a common feature of transactions designed to create artificial losses is the involvement of a "tax indifferent party" who absorbs an accelerated item of income and leaves to the U.S. taxpayer the benefit of the associated deductions or losses. Under the Budget Plan, any income allocable to a tax indifferent party with respect to a corporate tax shelter may be taxed to such party, without regard to any statutory, regulatory, or treaty exclusion or exception. The other, non-indifferent parties, would be held jointly and severally liable for such tax. If the tax indifferent party is protected from tax under a treaty or is a Native American tribal organization, then the tax would only be collected from the other participants in the shelter. A corporate tax shelter would be defined as any entity, plan, or arrangement in which a direct or indirect corporate participant attempts to obtain a tax benefit in tax avoidance transaction. A tax avoidance transaction would be defined in the same manner as for the proposed section 269 anti abuse rule described above. Thus, this proposal suffers from the same uncertainties inherent in the section 269 proposal, as discussed above. It seems especially unfair to compound the uncertainty with liability for another participant's tax liability. The authors note that other circumstances creating joint and/or several liability normally involve closer relationships, such as filing a consolidated or joint return.
Loss Importation.Another proposal would target loss importation. The proposal would provide for a "fresh start" when an entity or asset first becomes relevant for federal tax purposes by marking to market the assets and by eliminating tax attributes (including built-in gain or loss items). An entity would become relevant for U.S. tax purposes when (i) a tax-exempt entity (including a nonresident alien individual or a foreign corporation) becomes a taxable U.S. entity, or (ii) a foreign corporation that is not a CFC becomes a CFC or a U.S. person. For this purpose, a corporation that is part of a qualified group under section 902(b)(2), i.e., a 10% owned foreign corporation, is also treated as a taxable U.S. entity. The proposal would provide analogous rules for the transfer of assets and liabilities from entities considered tax exempt to entities considered taxable and from a non-CFC to a CFC. Special rules would also be provided to preserve the attributes of an entity that changes its status, where a some of its assets were ECI or UBTI related, as the case may be, or where the entity had U.S. shareholders before the change in status -- cases involving prior partial U.S. tax "relevance."
Expand Section 1059 to Include Section 302 Basis Shifting Transactions.Another budget proposal would eliminate the ability of taxpayers to use the section 302 basis shifting rules to shift basis from a foreign shareholder to a U.S. taxpayer (see description above). The proposal would treat the portion of a dividend that is not subject to current U.S. tax as a nontaxable dividend resulting in a basis reduction to the shares under section 1059. Where the rate of tax on a dividend is reduced under a treaty, then a portion of the dividend would be treated as nontaxable.
Restricting LILO Transactions.The Budget Plan would limit the benefit of a LILO by subjecting all leases involving tax-exempt use property to a loss deferral regime similar to the regime applicable to passive activities under section 469. A lessor of tax-exempt use property would not be able to recognize a net loss from such leasing transactions (and any related financing arrangements) during the lease term. The net loss would be available to offset gain upon termination of the lease held.
Elimination of Section 357(c) Step-Up Transactions.The Budget Plan includes a proposal similar to the one in the bill sponsored by Representative Archer, described above, that would change the rules applicable to property transferred subject to a liability in a section 351 exchange.
As the foregoing discussion suggests, neither a "macro" approach nor a "micro" approach can be expected to eliminate entirely the existence of loss trafficking transactions and other tax shelters involving loss importation. On balance, however, the micro approach appears to be superior. Although some advisers will always be able to devise new tax avoidance structures, the IRS should be able to close down new shelters as or before they become widespread by monitoring publications that are eager to be first to "break" with a story of a new, creative, and allegedly abusive transaction. See, e.g., Tax Notes, September 22, 1997, at p. 1524 (discussing a recent Times Mirror transaction).
Inclusion in the Budget Proposals of a much expanded section 269, expansion of U.S. taxing jurisdictions to foreign participants in tax shelters, and imposition of joint and several liability for additional taxes on U.S. participants would chill legitimate tax planning and should be opposed by tax practitioners and their clients.
Any approach taken in the United States to the loss importation issue may also become a model for how other nations should address the same or similar concerns. Accordingly, one question to ask of any proposal is whether Treasury and Congress would be comfortable with the possibility of the U.S. model (like a general anti-avoidance rule or a routine for moving from IRS Notice to Regulations) being adopted worldwide.
12. See section 269(b) (deductions or losses arising from the liquidation of a subsidiary pursuant to a plan adopted within two years of the date the subsidiary was acquired may be disallowed).
13. In fact, assuming the application of similar tax accounting concepts in the two jurisdictions, a taxpayer may be increasing its foreign income tax by removing the BIL asset from the foreign jurisdiction, which could otherwise have been used in that foreign jurisdiction.
14. Unlike section 382, section 384 applies even where a loss corporation acquires a gain corporation.
15. The Service recently indicated that it was considering an amendment to the SRLY rules that would conform the SRLY rules to methodology of section 382. Notice 98-38, 1998-34 I.R.B. 7.
16. In a recent memorandum decision, the Tax Court disallowed a capital loss claimed on a contingent installment note transaction very similar to the one at issue in ACM, reasoning that the alleged partnership between the taxpayer and the investment bank that set up the structure should not be respected for tax purposes. ASA Investerings Partnership v. Comm'r, T.C. Memo. 1998-305.
17. The use of losses to offset income from a different activity is restricted somewhat by sections 465 (at-risk rules) and 469 (passive activity rules).
18. "Tax avoidance transactions," as so defined, are a centerpiece of several of the proposals in the Budget Plan. They are the defining element of the proposed modified substantial understatement penalty for corporate tax shelters and of the proposed tax on tax shelter income earned by tax-exempt taxpayers, discussed below.
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