ABA MEMBERS PROPOSE NEW SAFE HARBORS FROM 'NOMINAL OR TOKEN' DESIGNATION.

SUMMARY: Members of the Committee on Corporate Tax of the Section of Taxation, American Bar Association, have commented on the standards for determining whether stock is nominal or token under section 108. The ABA members' comments focus on the standards in the preamble to the proposed regulations under section 108(e)(8)(A), rather than on the regulations themselves. The commentators contend that the proposed standards deviate substantially from any prior interpretations of words such as "nominal" or "token" in the tax law and are unsupported by the legislative history or by any general understanding of the meaning of those or similar words.

The ABA members recommend that the three proposed standards set forth in the preamble not be implemented. Instead, they recommend that two substitute safe-harbor standards be promulgated. Under those safe harbors, stock could be considered not to be "nominal or token shares" under section 108(e)(8)(A) if either of two tests is satisfied: (1) the unsecured creditors of the debtor corporation receive at least 10 percent of the common stock equity of the debtor corporation in the reorganization or workout; or (2) at least 25 percent of the total consideration received by unsecured creditors of the debtor corporation for their creditor interests in the reorganization or workout consists of stock (other than "disqualified" stock) of the debtor corporation.

The commentators conclude that the interpretation of the phrase "nominal or token shares" must reflect a reasonable approach to its likely intended meaning, and must take into account its intended role in the context of all of the existing specific rules aimed at policing the use of net operating loss carryovers. The "nominal or token shares" rule under the stock-for-debt exception, the ABA members say, should not be expanded into a broad-based anti- trafficking rule.

The following comments are the individual views of members of the Section of Taxation who prepared them and do not represent the position of the American Bar Association or of the Section of Taxation.

The Comments were prepared by individual members of the Committee on Corporate Tax of the Section of Taxation. Principal responsibility was exercised by Sheldon M. Bonovitz, with participation by Herbert N. Beller, Robert A. Bergquist, Robert A. Jacobs, Kevin M. Keyes, Stuart J. Offer and Robert H. Wellen. The Comments were reviewed by Eric R. Fox of the Section's Committee on Government Submissions.

Contact Person: Sheldon M. Bonovitz (215) 979-1972

Date: February 22, 1991

These comments relate to the proposed standards for determining whether stock is "nominal or token" under section 108(e)(8)(A) of the Internal Revenue Code of 1986, as amended (the "Code"). The proposed standards are set forth in the preamble to the notice of proposed rulemaking (CO-76-90, 55 Fed. Reg. 50518 (December 7, 1990)) in which the regulations on this subject are proposed.

Our comments focus on the proposed standards in the preamble, rather than the proposed regulations set forth in the notice. The proposed standards reflect the concepts of Proposed Reg. section 1.108-1(b), which describes the facts and circumstances to be considered in determining whether shares are "nominal or token." Accordingly, we recommend that changes be made both to the proposed standards and to the proposed regulations.

SUMMARY OF RECOMMENDATIONS

The proposed standards should be reconsidered. They deviate substantially from any prior interpretations given to words such as "nominal" or "token" in the tax law and are unsupported by evidence of Congressional intent in the legislative history or by any general understanding of the meaning of those or similar words.

We recommend that the three proposed standards set forth in the preamble not be implemented. Instead, we recommend that two substitute "safe harbor" standards be promulgated. Under these safe harbors, stock could be considered not to be "nominal or token shares" under section 108(e)(8)(A) if either of the following two tests is satisfied:

1. The unsecured creditors of the debtor corporation receive at least 10 percent of the common stock equity of the debtor corporation in the reorganization or workout. ¹

2. At least 25 percent of the total consideration received by unsecured creditors of the debtor corporation for their creditor interests in the reorganization or workout consists of stock (other than "disqualified" stock) of the debtor corporation.

INTERPRETATION OF "NOMINAL OR TOKEN"

Under traditional interpretations of the tax law, the words "nominal" or "de minimis" usually have been interpreted to mean 5 percent or less or 10 percent or less, but not more than 15 percent of less (e.g., sections 142(b)(2)(B) and 144(a)(12)(C) (use of 5 percent or less of a tax-exempt financed facility for office space is de minimis and does not disqualify the issue -- see the General Explanation of the Tax Reform Act of 1984, p. 942); section 280G(b)(5)(B) and Reg. section 1.280G-1 Q&A 7:(a)(2)(b) (one percent or less in total stock value is de minimis); section 4943(c)(2)(C) (not more than 2 percent of stock in vote and value is de minimis); Reg. section 1.132-6(e)(1) (personal use of an employer's copying machine representing not more than 15 percent of its total use constitutes a "de minimis" fringe benefit). ² Ironically, on December 4, 1990, only a few days prior to the issuance of the proposed regulations for determining "nominal or token shares" under section 108(e)(8)(A), the Treasury issued proposed regulations under Code sections 6038A and 6038C in which it interpreted the term "de minimis value of related party transactions" to be satisfied only if both of the following two conditions are satisfied: (i) the value is not more than $2 million in terms of certain gross payments, and (ii) the value is less than 10 percent in terms of certain U.S. gross income. It is difficult to understand how the Service could adopt a position, as in proposed standard (3), that a threshold of 90 percent of all of a corporation's issued and outstanding stock could, under any circumstances, be appropriate to determine whether shares are "nominal or token."

It is not clear from the preamble whether the proposed standards are intended to constitute rules of law or safe harbors. As stated, the proposed standards are not appropriate to either function. If the proposed standards are intended to set forth rules that approximate reasonable standards for application of the "nominal or token shares" definition they deviate substantially from the meaning of those words in ordinary usage without any basis for such deviation in the legislative history. If they are intended to provide safe harbors for cases meeting the "nominal or token shares" standard, the safe harbors are so narrow that they are essentially of no value. Rather, the effect, albeit unintended, is an "in terrorem" effect on bankruptcy reorganization transactions which otherwise might have reasonable economic prospects for success but which clearly include as a material factor the preservation and future use of net operating loss carryovers of the debtor corporation.

LEGISLATIVE HISTORY

The legislative history concerning the intended meaning of "nominal or token" in section 108(e)(8)(A) provides little specific guidance regarding the adoption of objective standards. In the course of enacting the Bankruptcy Tax Act of 1980, the House Ways and Means Committee would have eliminated the judicial stock-for-debt exception for any debt that was not represented by a security. The Finance Committee, whose views prevailed in conference, rejected this rule to encourage reorganizations, rather than liquidations, of financially distressed companies with potential for economic survival. To prevent abuse, the Finance Committee concluded that discharge of debt income recognition should prevail if only a "de minimis" amount of stock was issued for the outstanding debt. The Finance Committee report states that the stock-for-debt exception should not apply, and that the "nominal or token shares" limitation would apply, if the reorganization resulted in a participating creditor having "no real equity interest" in the debtor corporation. S. Rep. No. 96-1035, 96th Cong., 2d Sess. 17 (November 25, 1980). This is the only guidance in the legislative history. If a creditor participating in a stock-for- debt exchange receives a real equity interest in the corporation in the exchange, then the shares received will not be considered to be "nominal or token shares".

Congress did not intend to employ the "nominal or token shares" rules as an additional policing or anti-trafficking rule to eliminate the use of net operating loss carryovers by corporate debtors in bankruptcy proceedings. There already exists a panoply of policing rules that apply to the use of loss carryovers after bankruptcy reorganization transactions, including the rules of section 269, the ownership change rules of section 382 (including the creditor reorganization rules of section 382(l)(5), the built-in gain rules of section 384 and the SRLY rules applicable to consolidated corporate groups.

Moreover, the Treasury Department's testimony in connection with enactment of the Bankruptcy Tax Act of 1980 acknowledges the need to reconcile fairly the interests of bankruptcy policy in rehabilitating debtors with the conflicting interests of tax policy in demanding recognition of gain in all possible cases. Statement of Daniel I. Halperin, Deputy Assistant Secretary of the Treasury for Tax Legislation, Hearing before the Subcommittee on Select Revenue Measures of the House Ways and Means Committee, 96th Cong., 1st Sess. (Sept. 27, 1979), and statement of David J. Shakow, Assistant Tax Legislative Counsel of the Treasury Department, Before the Committee on Finance, Subcommittee on Taxation and Debt Management, 96th Cong., 2d Sess. (May 30, 1980). It is submitted that the proposed standards, if adopted, would represent an abandonment of that announced policy position, which constituted a key ingredient of the decision made by Congress in enacting the Bankruptcy Tax Act.

THE PROPOSED STANDARDS CONTAIN NO VIABLE SAFE HARBOR RULE

The stock-for-debt exception has played a vital role in preserving net operating loss carryovers and thus making a great many chapter 11 reorganizations of corporate debtors viable. ³ A rational interpretation of the "nominal or token shares" rule with a reasonable, "bright-line" safe harbor is critical to these reorganizations so that debtors, creditors and new investors can make their plans based upon a predictable set of rules. Taxpayers attempting to gauge the impact of a rule having essentially all-or- nothing consequences on such a critical issue are entitled to more than a set of standards which, like the proposed standards, describe situations in which there is no reason to doubt the outcome.

DISCUSSION OF PROPOSED STANDARDS

For the reasons discussed below, we believe that proposed standard (3) should be abandoned, and that proposed standards (1) and (2) should be substantially revised.

PROPOSED STANDARD (3)

Under proposed standard (3) stock would be considered not nominal or token if (a) the ONLY consideration transferred in exchange for debt held by unsecured creditors is stock, and (b) the stock transferred to the unsecured creditors as a group is at least 90 percent of the outstanding stock of the corporation after the bankruptcy reorganization or insolvency workout. We believe both tests in proposed standard (3) are defective.

If the participating creditors receive 100 percent of the outstanding stock of the debtor corporation together with even a small cash payment, proposed standard (3) would not be satisfied. It is submitted that this result could not have been intended.

The requirement that stock be the only consideration received by the unsecured creditors in the exchange is totally unrealistic when, for example, one takes into account that unsecured creditors will ordinarily include trade creditors who normally (if not almost always) receive some cash under the plan. Moreover, ordinarily in bankruptcy proceedings, the bankrupt company owes taxes to various governmental units. In the case of many of these taxes (including the Federal income tax and various state and local excise taxes) the governmental unit is, as to such claims, an unsecured creditor. However, under the bankruptcy law, as a condition to completing the bankruptcy reorganization, the governmental unit must be paid the amount of these unsecured tax claims that are allowed, and the payment MUST be made in the form of CASH, unless the governmental unit agrees to take another form of consideration (see section 1129(a)(9)(C) of the Bankruptcy Code). It would appear to be highly unusual for a governmental unit (including the IRS) to agree to accept payment of taxes in the form of stock of the bankrupt company instead of cash. It is extremely unlikely that all of the unsecured creditors in any bankruptcy proceeding could be paid solely stock in satisfaction of their claims. For this reason alone, proposed standard (3) is meaningless.

It is further submitted that, even if the receipt of other consideration were permitted, the position that any percentage of the debtor's total outstanding stock less than 90 percent might constitute "nominal or token shares" could not have been envisioned by Congress. We see no reason why the issuance of stock to secured creditors, employees or new investors should have any effect on the determination of whether shares issued to unsecured creditors are "nominal or token shares." Even more fundamentally, we cannot conceive that shares constituting more than 10 percent of the debtor corporation's stock could be considered "nominal or token," especially if the creditors receive all or almost all stock for the debt they forgive. A "standard" or safe harbor at the 90 percent level is useless in planning transactions and would be viewed as an attempt by the Service to adopt a new substitute rule having no relation to the rule adopted by Congress.

PROPOSED STANDARD (2)

Under proposed standard (2), each qualifying creditor must receive at least 25 percent of its consideration received in the transaction in the form of stock (applying the "Stock to Total Consideration Ratio") and EACH qualifying creditor must also receive at least 25 percent of the debtor's total stock outstanding (applying the "Stock to Total Stock Ratio").

Application of the "Stock to Total Stock Ratio" on a per creditor basis, rather than on an aggregate basis (which is the intended basis for its application in the ordinary case under the proposed regulations), simply makes no sense. It is submitted that the number of creditors participating in the workout of a debtor is not a significant tax policy concern and was definitely not a concern expressed by Congress.

EXAMPLE (a): X, in a bankruptcy reorganization, issues 20 shares to each of five equal creditors, those shares constituting all of X's outstanding stock. The test of Proposed Standard (2) is not met because each creditor must receive at least 25 percent of the outstanding stock of X.

EXAMPLE (b): The facts are the same as in Example (a), except that each of four equal creditors receives 25 percent of the outstanding stock of X. The test of Proposed Standard (2) is met.

There is no justification for reaching a different result in Example (a) than the result reached in Example (b). If the 25 percent test (applying the "Stock to Total Stock Ratio") is satisfied on an essentially pro rata basis by the creditors participating in the workout (after application of the proportionality rule in section 108(e)(8)(B)), that should be just as satisfactory as a single creditor receiving 25 percent of the outstanding stock of the debtor corporation in the stock-for-debt exchange. Moreover, if the five creditors in Example (a) created a single entity pursuant to a plan, presumably there would be a need for additional rules governing permitted and disallowed aggregation of creditor interests to determine whether a stock-for-debt exchange would qualify under proposed standard (2). There is no indication that Congress intended to create yet another set or series of complex rules for determining whether shares are "nominal or token."

The application of a stock to total stock ratio to the unsecured creditors in the aggregate (subject to the existing statutory proportionality requirement) is a relevant inquiry that, as recommended below, should be made a separate safe harbor test.

Similarly, application of the other test established in Proposed Standard (2); namely, that the fair market value of the stock transferred in the stock-for-debt exchange must be at least 25 percent of the total fair market value of all consideration transferred in the exchange; is a relevant inquiry as applied to the unsecured creditors in the aggregate, which, if met, should satisfy the "nominal or token shares" test.

PROPOSED STANDARD (1)

Under proposed standard (1), the fair market value of the stock received by each qualifying creditor must be at least 10 percent of the face amount of the allocable debt forgiven (applying the "Stock to Debt Ratio"), and each creditor must receive at least 25 percent of its consideration received in the transaction in the form of stock (applying the "Stock to Total Consideration Ratio").

Application of any standard using the "Stock to Debt Ratio" established in the proposed regulations should be avoided. It is submitted that the total face amount of the debt outstanding has no bearing on whether creditors participating in a stock-for-debt exchange as part of a bankruptcy reorganization have obtained a "real equity interest" in the debtor as constituted after the reorganization. The only relevant inquiry is whether the creditors in the aggregate (and each participating creditor under the existing statutory proportionality requirement) have received a meaningful interest in the equity of the reconstituted debtor. As Congress has expressly recognized, debtor corporations reorganized in bankruptcy are unlikely to come out of bankruptcy with substantial equity values (see section 382(l)(6)). Correlation between the value of the equity received in a stock-for-debt exchange and the face amount of the debt forgiven simply cannot be determinative as a practical matter. The only reference made by Congress to share value in the context of bankruptcy is in connection with the application of the proportionality rule in section 108(e)(8)(B), which is a separate test from the "nominal or token" test in section 108(e)(8)(A).

It is difficult to understand what the "Stock to Debt Ratio" adds to the second component of the test in proposed standard (1) -- i.e., that stock make up at least 25 percent of total consideration paid to creditors. What is the relevance of the creditors receiving stock representing in value 2 percent, 5 percent or 8 percent of the face amount of the debt in lieu of 10 percent of the face amount of the debt? If the stock received constitutes a real, meaningful equity interest in the debtor, the test should be satisfied. Stock representing a substantial percentage (i.e., at least 25 percent) of the fair market value of the debt (which is another way of saying at least 25 percent of the total consideration received in the exchange) is a real equity interest. If creditors in the aggregate receive this amount of stock, that should suffice. This test is our proposed substitute to proposed standard (2).

Moreover, it would seem that any potential tax abuse that could flow from the fair market value of the stock being low is adequately foreclosed by the bankruptcy law requirement that the bankruptcy judge cannot approve a plan of bankruptcy unless he determines that the "reorganization is feasible", i.e., in practical terms, that the post-bankruptcy company will be viable economically. The bankrupt company would not be able to meet this standard if its equity were insufficient for its projected business needs.

PERCENTAGE OF OUTSTANDING COMMON EQUITY RECEIVED BY THE CREDITORS -- RECOMMENDED STANDARD (1)

If the unsecured creditors as a group receive at least 10 percent of the outstanding common equity of the debtor in the stock- for-debt exchange the shares received clearly should not be treated as "nominal or token." Ten percent, of the outstanding common stock of the debtor corporation is well beyond what should reasonably be construed as "nominal" or "token" and would provide a clear, bright- line safe harbor. For purposes of this safe harbor, there should be no need to compare the value of the stock to the value of the other consideration received by the creditors in the transaction. Nor should there be any need to require that each creditor receive any particular percentage of the stock exchanged. The proportionality rule in section 108(e)(8)(B) is expressly intended to deal with this issue. Thus, stock issued by a debtor could be stock that is not "nominal" or "token" within the meaning of section 108(e)(8)(A), but the stock-for-debt exception still might not apply to a specific unsecured creditor if the stock received by that creditor does not meet the proportionality requirement of section 108(e)(8)(B).

EXAMPLE: X corporation, a debtor in a chapter 11 bankruptcy proceeding, issues common stock to its unsecured creditors, which in the aggregate, represents 10 percent of its outstanding common stock. Creditor C, who receives one percent of X's outstanding stock in exchange for his X debt, does not meet the proportionality test of section 108(e)(8)(B). The exchange satisfies the "nominal or token" test of section 108(e)(8)(A); however, the one percentage point of X's stock issued to Creditor C does not qualify for the stock-for-debt exception because Creditor C failed to meet the proportionality requirements of section 108(e)(8)(B). Under the proposed safe harbor, although failing the proportionality test of section 108(e)(8)(B), the one percent issued to Creditor C nevertheless would be included in determining whether X stock issued to creditors in the aggregate satisfies the 10 percent "nominal" or "token" test of section 108(e)(8)(A).

A reasonable bright-line safe harbor would, in most cases, eliminate the necessity of obtaining appraisals of the fair market value of stock and would permit a taxpayer to come out of bankruptcy with the certainty that its net operating loss carryovers or other tax attributes are not at risk under the "nominal" or "token" requirement of section 108(e)(8)(A).

It is submitted that this recommended safe harbor standard based upon the percentage of common stock issued to all of the unsecured creditors (i.e., at least 10 percent) is more consistent with the statute and the legislative history than are the proposed standards and the proposed regulations. Ten percent is not "nominal" or "token" or "de minimis" under any reasonable standard and represents a meaningful, real equity interest in the debtor.

FAIR MARKET VALUE OF CONSIDERATION STANDARD -- RECOMMENDED STANDARD (2)

It is recommended that if the unsecured creditors in the aggregate receive stock of the debtor (i.e., common stock and preferred stock that is not disqualified stock) that represents 25 percent of the total consideration received in the aggregate by the unsecured creditors, ⁴ such stock should not be treated as nominal or token. Here, the premise is that so long as the creditors receive at least 25 percent of the total consideration paid to them in stock of the debtor, such stock interest is a meaningful, real equity interest and not "nominal" or "token." Under this test the amount of stock issued in the aggregate is not relevant if the recommended 25 percent threshold is met. Clearly 25 percent of the total consideration received by the creditors is meaningful and should not under any circumstances be considered "nominal" or "token." ⁵

One case in which this standard could apply is where parent stock is issued to creditors of a subsidiary. Here the percentage of outstanding stock of the parent issued to the creditors could be substantially less than 10 percent. It is recommended that the Service make clear in any reissued notice that parent stock issued to the creditors of a subsidiary may qualify for the stock-for-debt exception.

PROPOSED AMENDMENTS TO REGULATIONS SHOULD BE MODIFIED TO REFLECT THE ABOVE COMMENTS

The proposed regulations should be redrafted consistent with these comments, and the proposed standards should be replaced by the two recommended safe harbor rules described above. These safe harbor rules should be incorporated as examples in the new regulations or should be reflected in a revenue procedure published at the same time as the new regulations.

As we have suggested, the proposed interpretation of the phrase "nominal or token shares" must reflect a reasonable approach to its likely intended meaning, and must take into account its intended role in the context of all of the existing specific rules aimed at policing the use of net operating loss carryovers, including the rules of section 269, the ownership change rules of section 382 (including the creditor reorganization rules of section 382(l)(5)), the built-in gain rules of section 384 and the SRLY rules. The "nominal or token shares" rule under the stock-for-debt exception should not be expanded into a broad-based anti-trafficking rule. Congress did not intend that it occupy such a role, and there is no supportable basis for so expanding its application.

² There are several other provisions in the Code containing "de minimis" or "token" rules that provide no objective guidance identifying their limits, and there are two "de minimis" rules in the provisions relating to controlled foreign corporations (section 953(c)(3)(B) (de minimis exception applies if a foreign corporation's related person insurance income is less than 20 percent of its insurance income); and section 954(b)(3)(A) (de minimis rule applies if the sum of foreign base company income and gross insurance income is less than the lesser of 5 percent of gross income or $1,000,000)). It is believed that at the date of enactment of the Bankruptcy Tax Act of 1980 virtually no de minimis standard in the tax law required a percentage greater than 10 percent.

³ In most chapter 11 or insolvency reorganizations of corporations, the debtor has net operating loss carryovers. With the discharge of debt, the debtor does not recognize taxable income, by virtue of section 108(a)(1), but the debt discharged reduces the debtor's loss carryovers under section 108(b). If the stock-for-debt exception applies, there is no reduction of loss carryovers. (See section 108(e)(10)(B).) If, however, the shares issued in the reorganization are considered to be "nominal or token," the stock- for-debt exception does not apply, and reduction of loss carryovers occurs.

⁴ Secured creditors would be treated as unsecured to the extent their debt exceeds the fair market value of their security interest.

⁵ A third recommended standard which is a variant of recommended standard (2) could require that the creditors receive stock with an aggregate fair market value of at least $2 million. See, Proposed Regulations section 1.6038A-1(h)(1).