Administration's Proposal Elicits 'Ho-Hum' Response From ABA Members

[1] I am enclosing comments on the above noted proposed change as prepared by members of the Committee on Corporate Tax. Principal responsibility was exercised by Jasper L. Cummings, Jr., Alston & Bird LLP, Raleigh, NC. Substantive contributions were made by Julie A. Divola, Pillsbury, Madison & Sutro, San Francisco, CA; Mark J. Silverman, Steptoe & Johnson, Washington, DC; Robert H. Wellen, Ivins, Phillips & Barker, Washington, DC; and David Wheat, Thompson & Knight PC, Dallas, TV. These comments were reviewed by members of our Committee on Government Submissions.

[2] These comments represent the individual views of those members who prepared them and do not represent the position of the American Bar Association or of the Section of Taxation.

Sincerely,

[3] These 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.

[4] Primary responsibility was exercised by Jasper L. Cummings, Jr. Substantive contributions to these comments were made by Julie A. Divola, Mark J. Silverman, Robert H. Wellen and David Wheat, members of the Corporate Tax Committee. These comments were reviewed by William J. Wilkins for the Committee on Government Submissions and by Council Director Terrill Hyde.

[5] Although the members of the Section of Taxation who participated in preparing these comments may have clients who would be affected by the federal income tax principles addressed, or have advised clients on the application of these principles, no such member (or firm) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these comments.

Contact Person: Jasper L. Cummings, Jr.

o We neither endorse nor oppose the proposal as stated. If a

[7] The Administration proposes to conform the control test that is used in connection with tax-free incorporations, distributions and reorganizations, with the affiliation test for determining whether corporations can file consolidated returns. Thus, "control" would be defined as the ownership of at least 80 percent of the total voting power and at least 80 percent of the total value of the corporation's stock. For this purpose, stock would not include certain preferred stock that meets the requirements of section 1504(a)(4) (nonvoting, nonparticipating stock). The proposal would be effective for transactions on or after the date of enactment.

[8] The General Explanation of the Administration proposals describes current law as follows:

For tax-free incorporations, distributions, and reorganizations,

The control test for tax-free incorporations, distributions, and

[11] Transaction in which the control definition's flexibility facilitates a reorganization in which the Target shareholder does not participate in future growth of the Target. This transaction relies on the section 368(c) control definition to allow an Acquiror (which is effectively the "parent" of the Parent of a subsidiary used in a merger with Target that is intended to be a tax free reverse subsidiary merger) to obtain 80 percent voting control of the Target and ownership of its equity upside, while giving the Target shareholder a cash-like equity stake in the Target's Parent. The transaction has many similarities to an acquisition for voting preferred stock (that is not nonqualified preferred stock), but allows the Acquiror and the Target shareholder to enter into a mixing bowl type of arrangement that would be unavailable using preferred stock. The section 368(c) control definition facilitates this transaction by allowing the Acquiror to have direct ownership of the Target voting common stock, and thus of its upside potential, while allowing the former Target shareholder to own the common of the acquiring Parent and thereby benefit from its other asset (aside from Target), a pot of cash equal to the value of Target, contributed by Acquiror. Put another way, this transaction could not occur, at least as a reverse subsidiary merger under section 368(a)(2)(E), but for the ability of the acquiring Parent to own less than 80 percent of the value of the stock of the Target into which its subsidiary merges. In this transaction, the focus of concern should be on the effective shift of the target shareholders' interests from a continuing stake in Target and Parent to a stake in the earnings from the invested cash.

[12] Transactions in which cash is obtained through an IPO by a subsidiary, of which Parent does not lose control because stock sold is low vote common; cash is paid up to Parent and subsidiary is thereafter distributed under section 355, which is facilitated by the section 368(c) definition of control. This transaction involves a sale of more than 20 percent of the equity of a subsidiary followed by a split off that could not qualify under section 355 if the distributing corporation was required to own 80 percent of both the vote and value of the split off subsidiary. The cash may be used to pay back debt to the Parent or as a distribution. If the two classes of stock remain outstanding, then the creation of the second class should not be attacked as lacking a business purpose, and the focus of concern, if any, would seem to rest on the movement of cash.

[13] Transactions in which stock ownership change following a section 355 distribution does not upset tax-free section 355 treatment due to use of low vote stock to avoid change of section 368(c) control. In this type of transaction a corporation spins off a subsidiary, after which the subsidiary merges with an unrelated Acquiror. When it was important (under Rev. Proc. 96-39) that the 80 percent control of the spunoff corporation not be lost as part of the spinoff, the acquisition would be arranged so that the subsidiary's shareholders retained 80 percent of the voting power, but the Acquiror got the bulk of the value of the subsidiary. This transaction now would be impacted by section 355(e).

II. DISCUSSION OF PROPOSAL

A. RELATIONSHIP BETWEEN THE SECTION 1504 AND SECTION 368 DEFINITIONS OF CONTROL.

[14] Currently, the definitions of control found in section 368(c) and 1504 perform significantly different roles. This fact mitigates against a one-size-fits-all approach to the control definition.

[15] It seems clear that consolidation requires a high percentage of value ownership and not just of the vote of the affiliate, because economic linkage should be the key to treating separate corporations in effect as divisions through the mechanism of consolidated returns. Pure preferred stock has long been excluded from the calculation of value linkage for affiliation. Indeed, it is curious that it took so long for the current definition in section 1504 requiring 80 percent value ownership to come about, although the lack of need for the change was perhaps due to the novelty of low vote common and to the exclusions of pure preferred from the calculation. Furthermore, the section 1504 definition is frequently employed by reference in other sections to identify a grouping of corporations that should be treated as one.

[16] In contrast, the roles played by the section 368(c) control definition are distinguishable from the role of section 1504: they are generally to identify two corporations that should be treated as essentially one and the same (not necessarily just in an economic sense), in order to reach a particular end: either for purposes of providing taxpayer-favorable results or taxpayer- unfavorable results (thus preventing the avoidance of certain rules by the use of separate but affiliated entities in transactions). That the section 368(c) definition applies most prominently in taxpayer favorable situations (triangular mergers facilitated by use of controlled subsidiaries, corporate formation, spinoff of controlled subsidiaries) perhaps explains its vote and nonvoting stock standard (i.e., access to the benefits is made harder), as contrasted with an anti-abuse control definition in the code in section 1563, which utilizes a vote or value standard to snare a larger group of affiliates in order to prevent certain corporate taxpayer abuses.

[17] Within sub-chapter C, the fundamental interplay between the section 368(c) definition of control and that in section 1504 comes in sections 332 and 338, which rely on section 1504, as contrasted with sections 351, 355 and 368, which rely on section 368(c). The section 1504 definition of control governs when the assets of a controlled corporation can be removed in bulk from the corporation while remaining in corporate solution controlled by the same parent. Sec. 332 (and section 337) allow a controlled subsidiary to be liquidated into its parent corporation without income or loss recognition. Sec. 338 allows the purchase of control of a corporation to be followed by an election to treat the corporation as selling all of its assets to itself as a new corporation; more importantly, it allows certain shareholders of a corporation to treat the sale of the corporate stock as the corporation's sale of its assets, thus eliminating the gain on the stock sale, based on the analogy of the section 332 liquidation.

[18] In contrast, the incorporation of assets tax free under section 351, the tax free division under section 355, and the tax free change in control of assets by reorganization under section 368 are limited by the control definition of section 368(c). The discontinuity with section 1504 is brought most acutely into focus in connection with sections 351 and 332: while a parent corporation can incorporate a subsidiary tax free under the section 368(c) definition, it must comply with the stricter section 1504 definition of control to unincorporate it tax free by liquidation.

[19] The principal uses of the section 368(c) definition in sections 351, 355 and 368 should appropriately require some "substantial" proportion of value (as section 368(c) does). This view is suggested by the principal authority interpreting that section, Rev. Rul. 59- 259, 1959-2 CB 115. It determined that nonvoting classes cannot be aggregated for purposes of the 80 percent test, but rather that 80 percent of each nonvoting class must be owned. It stated:

Moreover, percentage ownership of the number of non-voting

B. THE USE OF SECTION 368(c) IN SECTION 355.

[21] The ABA suggested in 1988 (see Background section, below) that the control definition used in section 355 should not be tightened. This is an issue that is now even more difficult. Since 1988, section 355 has taken on an even higher level of importance, both to taxpayers and the government, as evidenced most recently by the several amendments to section 355(d) and (e) imposing various "anti- abuse" rules. Taxpayers are even more loath now to propose yet another stricture on section 355, which is so hedged about with limitations. Nevertheless, if the control definition is to be reformed for purposes of sections 351 and 368, a different treatment for section 355 would require a major reanalysis of section 355, which we assume no one is prepared to do at this juncture.

C. DOES SECTION 368(c) FACILITATE "SALE-LIKE" TRANSACTIONS?

[22] While section 368(c) may be said to facilitate certain sale-like transactions without gain recognition (see section I, above), the definition is not alone in this role, and the proposed change will impact a far wider class of transactions. When a subsidiary issues low vote/high value stock for cash prior to a section 355 division, the control definition may facilitate a "sale- like" characterization only if the cash is moved out of the subsidiary to the distributing corporation. But similar results can be had by leveraging up the subsidiary, provided no excess loss account is created.

[23] Most other transactions in the mainstream of acquisitions, reorganizations and divisions that will be impacted by the proposed change have no "sale-like" features at all. The proposed change simply will force a higher percentage of value to be owned in some cases to achieve tax free results, with no cash moving to any party in the transaction.

D. THE WISDOM OF THE PROPOSAL AND SCOPE OF ANY CHANGE: THE COMPETING FACTORS

[24] The lack of requirement for a clearly defined level of aggregate equity ownership for section 368(c) control stands out as an anomaly in subchapter C, making it hard to oppose a proposal for some such requirement. Some such level of value ownership pertains to all other definitions of control commonly used in subchapter C: section 1504, section 1563 and section 304(c) (where control may be established by either vote or value). However, it is not obvious that 80 percent is the right level; it may be 50 percent.

[25] Professors Bittker and Eustice observed 33 years ago with respect to section 368(c): "There is no good reason why the statute should require control of such stock to be ascertained by total number, a test that has no relevance to the policy underlying section 351, rather than by market value (except perhaps to avoid the necessity of an appraisal.)." Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, sec. 3.07 (Federal Tax Press 1966). Rev. Rul. 59-259 in effect reaches the market value result, but with two serious shortcomings: first, it limits the ability to prove 80 percent of market value by any method other than 80 percent of each class; second, and more importantly, it cannot be a true proxy for an 80 percent fair market value requirement because it ignores the value of voting classes.

[26] On the other hand, it is our view that the reasons given by the Administration do not justify the proposal. The Administration cites transactions involving the section 368(c) control definition that resemble "sales," but proposes a remedy that will affect many transactions with no sale-like qualities. Further, the Administration cites the 1984 changes to the section 1504 control definition as addressing "similar concerns." The analogy is not appropriate, however, because the policies underlying the control requirement in a consolidated return context call for a stricter definition of control than do the policies for the control requirement in section 368. In order to allow two corporations to offset their gains and losses in consolidation, the two corporations should have a substantial economic relationship (i.e., the value of the subsidiary stock held by the parent should be very high). It is much less clear that the reorganization rules should require such a high degree of economic linkage.

[27] There are several competing considerations relevant to the proposal and to any change.

1. EXCLUSION OF PURE PREFERRED STOCK.

[28] Competing considerations relate to the proposed exclusion of pure preferred stock, although it is clearly desirable from a practice standpoint because it adds flexibility:

o The current section 368(c) control definition does not exclude

Other matters are implicated by the proposed change, including the following:

o The definition of qualified group in Reg. section 1.368-

Any change in the section 368(c) definition of control should be prospective only and should contain generous transition relief. We do not view the use of this control definition in the ways described in the background material above as abusive. Tax professionals have relied on long standing straightforward statutory rules to obtain flexibility in planning. For example, where control now exists through the existence of relatively high vote/low value stock, transactions requiring control should be permitted to occur for some period after enactment of a change in the control definition.

III. BACKGROUND

A. THE SECTION 368(c) DEFINITION OF CONTROL AND ITS USES IN THE CODE

[29] Section 368(c) states: "For purposes of part I (other than section 304), part II, this part, and part V, the term "control" means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation." This sentence has been importantly construed by a revenue ruling so that the second 80 percent requirement relates separately to each class of nonvoting stock. Rev. Rul. 59-259, 1959-2 CB 115. One, perhaps unintended, pro- taxpayer feature of this construction has been to provide electivity to taxpayers, who can choose not to have section 351, for example, apply to an exchange by creating another class of nonvoting stock that is not 80 percent owned.

[30] Most provisions in the four parts of subchapter C where the definition can apply do not employ definitions of control in any way, and when they do, they frequently employ the section 1504 definition: sections 332(b)(1), 336(e), 337(c), 338(d)(3), and 384(c)(5). At several points "groups" are identified in those parts of subchapter C by reference to section 1504: sections 355(b)(2), 358(g), 382(l)(5). In one subsection control under section 368(c) is employed as well as a reference to affiliates under section 1504: section 367(a)(5). In certain cases the section 1563 definition of controlled group is employed, such as in section 384(b)(2). In three cases within subchapter C control is defined in a way different from either section 368(c) or section 1504: sections 304(c) (and section 368(a)(2)(H) incorporating that subsection), 367(c)(2), and 382 (where value is employed without reference to section 1504(a)(4) pure preferred stock).

[31] Indeed, it appears that rather than providing the common definition of control in subchapter C, section 368(c) provides a special definition used most prominently in section 368, of which it is a part, and also in sections 351 and 355. Section 368 employs the definition to define a stock-for-stock reorganization, wherein control must exist after the stock acquisition: section 368(a)(1)(B); to define when the stock of a controlling corporation can be exchanged for the stock or assets of a target corporation: section 368(a)(1)(B) and (C), section 368(a)(2)(D) and (E); and to define how acquired assets or stock can be redeployed to controlled corporations: section 368(a)(2)(C). Section 351 employs the definition of control to define the persons or persons having control after they have exchanged property for corporate stock, in order to enjoy gain/loss nonrecognition on the exchange. Section 355 employs the definition in various ways, but principally to identify the subsidiary corporation the stock of which can be distributed to shareholders in a nonrecognition transaction.

[32] Other code sections outside of subchapter C incorporate the section 368(c) definition of control. These usages display no common theme. In some cases narrowing that control definition would be taxpayer favorable, in other cases it would be taxpayer unfavorable. In the favorable category would be: section 108(e) (related party's stock in discharge of indebtedness); section 249(b) (related party purchase and bond premium); section 279(c) (convertibility and interest deduction). In the taxpayer unfavorable category would be section 367(a)(5); section 453(h) (reduced availability of deferral); section 1202(h) (reduced availability of small business stock rules).

B. HISTORY OF CHANGES IN CORPORATE CONTROL DEFINITIONS

[33] Summary: The control definitions in section 368(c), section 1504 and section 332 were the same up to 1984 except for the exclusion of pure preferred stock in the latter two sections. In 1984 the requirement for affiliation was tightened to require ownership of 80 percent of both the vote and the value of the subsidiary stock (excluding "pure preferred"); a 1986 technical amendment conformed section 332 with section 1504. Evidently certain congressional leaders intended to conform the section 368(c) definition in 1985, but that change perhaps was not needed for the reasons originally concerning Congress due to the amendment of the section 332 definition of control in 1986; in any event no change was made in section 368(c). Aside from a desire to retain flexibility in section 355, there has previously been no defense offered for the discontinuity of the control definitions (but defenses appear herein).

[34] Affiliation control definition: The consolidated return control definition existing in 1984 dated back to 1924 when ownership of "95 percentum of the voting stock" was required. Revenue Laws of 1924, sec. 240(c). This changed in the 1926 Revenue Act to provide an alternate route to affiliation: 95 percent of the stock, excluding pure preferred stock. Sec. 240(c) and (d). In 1928 the definition changed back to 95 percent of the stock, excluding pure preferred. Revenue Act of 1928, sec. 142. In 1939 the definition was changed to 95 percent of each class of nonvoting stock (excluding pure preferred) and 95 percent of the voting power of all classes of stock. Internal Revenue Code of 1939, sec. 141(d). The percentage ownership requirement was decreased to 80 percent in 1954, where it has remained. The statute was amended to incorporate the current value requirement in 1984.

[35] Section 368(c) control definition: The 1939 change in the affiliation control definition adopted the control definition (to which it added the exclusion of pure preferred) that had been used for reorganizations and incorporations since at least 1924. Sec. 204(i) of the Revenue Act of 1924 defined control essentially as it is today in section 368(c). This definition was used not only for the reorganization rules within that section but also for the precursor of section 351 and of section 332 (added as section 112(b)(6) in 1935), which were all in section 112 by 1936.

[36] Section 332 control definition: In the 1936 Revenue Act, however, the control definition for subsidiary liquidations was modified to except "nonvoting stock which is limited and preferred as to dividends." This definition, which was essentially the same as the control definition for affiliation, remained until amended by the Technical Corrections provisions of the Tax Reform Act of 1986.

[37] 1984 amendments: Thus, for most years up to 1984, the definition of control in section 1504 (and section 332) was essentially the same as that in section 368(c), in that it measured voting control in the aggregate and permitted voting control to exist without ownership of 80 percent of each class of voting stock and without 80 percent of the value of all stock (but excluded pure preferred). The Deficit Reduction Act of 1984 (P.L. 98-369) changed section 1504 to require ownership of 80 percent of vote and 80 percent of value of stock (excluding "pure preferred"). The Committee Reports did not discuss extending the change to section 368(c). H. Conf. Rep. No. 98-861, 98th Cong. 2d Sess. 831-832, 1984-3 CB Vol. 2, p. 85.

[38] The 1984 House Report identified the following as an example of abuse to be corrected: loss corporation supplies 80 percent of the equity to a new corporation for common stock having 20 percent of the vote, while profitable corporation supplies 20 percent of the equity for voting stock having 80 percent of the vote. The profitable parent includes the new corporation in its consolidated return; the new corporation produces losses. A conversion feature allows the loss corporation parent to acquire control in the future. H. Rep. No. 98- 432, Part II, 98th Cong. 2d Sess. 872-873 (1984). This Report indicates that Congress was concerned both with an indirect transfer of tax benefits from the loss parent to the profitable parent corporation and also with the fact that consolidation should require owning a significant percentage of the value of the affiliate. In other words, the includibility of members in an affiliated group was thought to be too elective. See J.S. Eustice, The Tax Reform Act of 1984 3.04[1] (Warren Gorham & Lamont 1984).

[39] At or immediately after the enactment of the changes to section 1504(a)(2) in 1984, it was anticipated that the control definition in section 368(c) would be conformed. See Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 172 n. 25 (Dec. 31, 1984) ("A technical amendment will be made recommending conforming section 332, and perhaps other sections, to new section 1504."). The Subchapter C Revision Bill of 1985 would have conformed the definition of control in section 368(c) (which would have become section 366(c)) to that in section 1504(a)(2), as part of a major change in the reorganization rules providing for elective treatment of "qualified acquisition." The Senate thought it inappropriate that the section 368(c) definition did not involve the element of value. Report of Senate Finance Committee Staff on Subchapter C Revision Bill of 1985, 99th Cong. 1st Sess. p. 47, S. Prt. (May 1985). Interestingly, the reasons for change cited were not the ease of satisfying section 368(c) but rather the possibility of being affiliated under section 1504 and thereby obtaining a double tax benefit (that would be unavailable today): a "subsidiary" corporation sells its assets, followed by a liquidation that was "taxable" because the affiliation required for section 332 to apply did not exist; under General Utilities law the asset sale would not be taxed, on the theory that the tax on the liquidation was enough, but the report worried that the liquidating distribution might not be taxed due to the consolidation.

[40] The Tax Reform Act of 1986 noted discontinuities produced between section 1504 affiliation and section 332 liquidation by the 1984 changes to section 1504, and consequently amended section 332 to coordinate the control definition with that of section 1504. The 1986 amendment to section 332 was not concerned with General Utilities repeal, but rather was made effective in 1985 and was concerned with pre-GU repeal law discussed above, under which an affiliated subsidiary could sell its assets tax free and liquidate within 12 months, supposedly without income recognition by the parent under the consolidated return rules.

[41] Section 355 control definition: Section 368(c) has applied to the control requirements of section 355 throughout its history. A 1988 ABA Report on section 355 discouraged changing the definition of control from that of section 368(c) to that of section 1504 due to the added flexibility provided by section 368(c). American Bar Association Report on Section 355, 88 TNT 164-41 (July 21, 1988). This view stemmed from a desire to allow spinoffs of corporations having more substantial minority interests. The Report noted that under the section 368(c) definition a corporation could spin off a subsidiary of which it owned 2/3 of the equity but 80 percent of the vote.

IV. CONCLUSION

[42] Against the background of 20 years of massive changes to subchapter C with little to show for it in terms of clarification and ease of use, we cannot support another such "abuse-targeted" change. But if a change is to be made, we agree with the adoption of some value requirement and we urge the broader rationalization of section 368, particularly by recognizing 368(c) control for all affiliated group members.