Basis in Acquired Assets Does Not Include Guarantee Payment

[5] Our primary position is that * * * is entitled to basis in the assets of target in the year of sale in the amount of the purchase price-for target with no subsequent adjustment. Our secondary fallback position is that, * * * is entitled to basis in the assets of target in the year of sale in the amount of the value of the * * * ecurities (independent of the guarantee), and additional basis in the subsequent year in the amount of the difference between the purchase price and such value of the * * * securities in the year of sale.

[7] Briefly, on * * *, * * * ("* * *") purchased all of the stock of * * * * * * ("* * *") from * * * (the "seller") and the * * * ("* * *") consolidated group (the "selling consolidated group"). The seller owns all of the stock of * * *.

[8] * * * and the selling consolidated group made the election under I.R.C. section 338(h)(10) to treat the stock sale as if * * * (while a subsidiary of the selling consolidated group, i.e., "Old * * *") sold its assets to a newly-formed subsidiary of * * * i.e., "New * * *". Old * * * was then deemed to have liquidated tax- free into the selling consolidated group under I.R.C. section 332. See Treas. Reg. section 1.338(h)(10)-1T(a).

[9] The purchase price for the * * * stock was $* * *, payable as follows: $ * * * in cash and the balance in securities of * * * with an aggregate value of $ * * *. In fact, the fair market value of these securities at that time was $ * * *.

[10] The sales agreement between * * * and the seller provided that * * * would guarantee that, during the period beginning on the date of the sale and ending * * * months after the effective date of the registration of such securities with the SEC (but in no event more than * * * months after the date of sale) (the "guarantee period"), the securities transferred to the selling consolidated group would be worth the remaining balance of $* * *. If the securities were not worth that amount, * * * would make up the difference in cash or additional securities. In addition, * * * agreed to pay interest on the remaining balance of $* * * at an annual rate of * * *% from the date of the sale until the end of the guarantee period or the * * * securities were sold, whichever was earlier.

[11] On * * *, * * * filed the registration statement with the SEC, thus starting the * * *-month guarantee period.

[12] On * * *, * * * agreed to satisfy its guarantee obligation. On that date the fair market value of the * * * securities that * * * had transferred to the selling consolidated group at the time of the sale, was $ * * *. To satisfy its guarantee obligation, * * * redeemed these securities for that amount and also transferred $* * * ($* * * - $* * *). Thus, the total amount paid by * * * on * * *, was the stated purchase price of $* * *. In addition, * * * paid interest on that amount of $* * *.

[13] * * * argues that its basis in the * * * assets, to be allocated among them in proportion to their relative fair market values, is $* * * $ * * *, the fair market value of the * * * securities transferred to the selling consolidated group at the time of the sale, + $* * *, the "guarantee amount"). Thus, * * * proposes to allocate the entire amount of $* * * among the * * * assets. Since * * * had already allocated the initial amount of $* * * in the * * * year, the consequence of its position was that it was now allocating the additional amount of $* * * in the * * * year, the consequence of its position was that it was not allocating the additional amount of $* * * in the * * * year.

[14] In other words, * * * is treating the guarantee payment as a "contingent amount," within the meaning of Treas. Reg. section 1.338(b)-3T(b)(2)(iii). If * * * were correct, it would be entitled to increase its basis in the * * * assets by such amount. Treas. Reg. section 1.338(b)-3T(a)(1).

[15] However, your position is that * * * is limited to an aggregate basis in the * * * assets in the amount of the original purchase price of $* * *. Essentially, you argue that the guarantee amount was not an additional payment, i.e., a "contingent amount," for the * * * stock, but rather a means of satisfying * * *'s obligation to pay the selling consolidated group that amount in securities or cash. Thus, since * * * claimed a basis in * * *'s assets in the * * * year of $* * *, it would be limited to an increase in the basis of such assets of $* * * ($* * * - $* * *) in the * * * year.

[16] In addition, * * * relies on the case of Estate of McGlothlin v. Commissioner, 370 F.2d 729 (5th Cir. 1967), aff'g 44 T.C. 611 (1965). In McGlothlin, the taxpayer, a majority shareholder of the corporation acquired in a merger, guaranteed that certain of the acquired corporation's properties could be sold within three years at a certain price. When the properties could not be sold for this amount, the taxpayer-transferred $* * * to the acquiring corporation in satisfaction of the guaranty.

[17] The Fifth Circuit ruled that the taxpayer could not deduct the payment as a loss under I.R.C. section 165. Rather, because these payments were considered to be part of the "purchase price" of the acquiring corporation stock that he received in the merger, the taxpayer had to add this amount to his basis in the acquiring corporation stock. Similarly, * * * argues that the additional amount it was required to pay, the guarantee amount of $ * * *, should also be considered as part of the purchase price for the stock of target and added to its basis in such stock.

[18] However, you believe that the case is distinguishable. one important distinction is that the issue in McGlothlin involved determining the correct value of the target corporation. That value was not completely established at the time of the merger because the value of some of the target's assets was not established at that time. Once these assets were sold, and their value established, the correct value of the target corporation could be determined. At that point, the consideration for target could be adjusted to take into account this revised value of target.

[19] In this case, by contrast, there is no question as to the value, i.e., purchase price, of the target,* * *. Rather, the question is whether the consideration, i.e., the * * * securities, would equal the total amount of the agreed upon consideration for target at the end of the guarantee period. However, the total amount of consideration to be paid was unchanged and once the value of the * * * securities could be determined at the appropriate time, the property mix * * * intended to use to satisfy its obligation could be adjusted so as to satisfy the total amount of the agreed upon consideration for the * * * stock.

[20] You also argue that the consideration can be recharacterized as debt rather than equity. In other words, * * * can be treated as having issued cash in the amount of $* * * and a note with an issue price of $* * * with a due date no longer than * * * months. The note had an interest rate of * * *%. In support of this argument, you note that the * * * securities were initially unregistered and thus could not have been sold by the seller when issued. Thus, such securities could essentially be considered as a guarantee that * * * would pay the agreed price of $* * * at least by the end of the * * * - month period.

[21] Finally, you make two fallback arguments. Under the first fallback argument, * * * would not be treated as having paid consideration for the * * * stock until the * * * year. The argument is that the value of the * * * securities was uncertain at the time of issuance and thus could not be treated as amount realized by the seller in that year. However, it is the position of the Service that securities issued by a corporation can generally be valued, even if unregistered. See Rev. Rul. 77-287, 1977-2 C.B. 319. In that case, the seller would be required to treat the value of such securities as amount realized in the * * * year. Treas. Reg. section 1.1001-1(a). Thus, we do not recommend making this argument.

[22] Under the second fallback argument, the Service should argue that * * * paid $* * * in the * * * year and a net amount of $* * * in the * * * year. The net amount of $* * * is based on netting the guarantee amount, on which the seller recognized gain of $* * *, and the amount paid to redeem the * * * securities, on which the seller recognized a loss of $* * * ($* * * - $* * *) for a net additional gain of $* * * ($* * * - $* * *).

[23] Under Treas. Reg. section 1.338(b)-3T(a)(1), * * *'s adjusted grossed-up basis ("AGUB"), i.e., the amount deemed paid for the target stock, is increased by contingent amounts and decreased by reduction amounts. Under Treas. Reg. section 1.338(b)- 3T(b)(2)(iii), a contingent amount is additional consideration paid for target stock after the close of target's first tax year. * * * argues that the guarantee payment is a contingent amount that increases its AGUB in * * *'s assets.

[24] For the purpose of addressing this argument, the Service would agree with * * *. However, we would note that under Treas. Reg. section 1.338(b)-3T(b)(2)(iv), a "reduction amount" is a reduction in the consideration paid for the target stock. Thus, consistent with * * *'s argument, we would argue that the reduction in the value of the * * * stock (which was redeemed by the seller for a loss) is a reduction in the consideration for the * * * stock. This reduction in the purchase price must be netted against the increase in purchase price claimed by * * *. Under this analysis, * * * would only increase its basis in the * * * assets by the net increase of $* * *.

Sec. 338. Certain stock purchases treated as asset acquisitions

[26] Treas. Reg. section 1.338(b)-2T(a)(1) prescribes rules under section 338(b)(5) for allocating adjusted grossed-up basis ("AGUB") [i.e., the amount deemed paid for the target's stock] among the assets of a target for which a section 338 election is made.

[27] Treas. Reg. section 1.338(b)-2T(b) provides that AGUB is allocated among the assets of target, according to a formula provided therein. Generally target's assets are divided into Class I, Class II, Class III, Class IV and Class V assets. Class I assets include cash and Class II assets include readily marketable stock or securities. Class IV assets are all section 197 intangibles, as defined in section 197, except those in the nature of goodwill and going concern value. Class V assets are section 197 intangibles in the nature of goodwill and going concern value. Class III assets are all other assets of target.

[28] Treas. Reg. section 1-338(h)(10)-1T(e)(6)(ii) provides, in the case of an election made under section 338(h)(10), that the purchaser's AGUB for the target stock shall be allocated as basis among the target assets in accordance with section 338(b)(5). In other words, section 338 has the same basis allocation rules for a section 338 election as for a section 338(h)(10) election.

[29] Treas. Reg. section 1.338(b)-2T(c)(1) provides that the amount of the AGUB allocated to an asset (other than Class V assets) shall not exceed the fair market value of that asset at the beginning of the day after the acquisition date.

[30] Treas. Reg. section 1.338(b)-3T(a)(1) provides rules for redetermining AGUB to account for adjustment events that occur after the close of new target's first taxable year. These adjustments must be made upon the payment of contingent amounts for recently or nonrecently purchased stock, the change in a contingent liability of old target to one which is fixed and determinable, reductions in the amounts paid for recently or nonrecently purchased stock, and reductions in liabilities of target (and the liabilities to which its assets are subject) that were taken into account in determining AGUB. AGUB is redetermined under this section only if such an adjustment would be required, under general principles of tax law, in connection with an actual asset purchase by new target from an unrelated person. This section also provides rules for the allocation of such adjustments subsequent to the close of new target's first taxable year.

[31] Treas. Reg. section 1.338(b)-3T(b)(2)(i) provides that the definitions in section 338 and sections 1.338-1T, 1.338-4T, 1.338(b)- 1T, and 1.338(b)-2T also apply to this section.

[32] Treas. Reg. section 1.338(b)-1T(b)(2)(ii) provides that "adjustment events" are increases (or decreases) in the consideration paid for target stock, reductions in target's liabilities included in AGUB as of the beginning of the day after the acquisition date and old target liabilities that become fixed and determinable.

[33] Treas. Reg. section 1.338(b)-3T(b)(2)(iii) provides that the term "contingent amount" means the amount of the consideration to be paid for stock of target that is not fixed and determinable by the close of new target's first taxable year.

[34] Treas. Reg. section 1.338(b)-3T(b)(2)(iv) provides that the term "reduction amount" means a reduction after the close of new target's first taxable year in either (A) the consideration paid for target stock or (B) a liability of target (or a liability to which one more of its assets are subject) that has been taken into account in determining AGUB.

[36] However, as also noted above, your position is that * * * is limited to an aggregate basis in the assets in the amount of the original purchase price of $* * *. Essentially, you argue that the guarantee amount was not an additional payment for the * * * stock, but rather a means of satisfying * * *'s obligation to pay the selling consolidated group that fixed amount of consideration by issuing securities, paying cash or some combination thereof. Thus, since * * * claimed a basis in * * *'s assets in the * * * year of $* * *, it would under your view be limited to an increase in the basis of such assets of $* * * ($* * * - $* * *) in the * * * year.

[37] Our position is that * * * paid or promised to pay a purchase amount of $* * * on the date of sale and that that amount was fixed. There are several different ways of arriving at this result. First, * * * can be viewed as having paid for the stock of target with securities having a fair market value of $* * *. Initially, we note that the value of a similar number of * * * securities traded on the stock market would be $* * *. However, * * * can be viewed as having provided the selling consolidated group with securities with a special feature, i.e., a guarantee that these securities, at the end of the guarantee period, will be worth $* * *. In effect, * * * was guaranteeing that the * * * securities it issued to the selling consolidated group had a redemption price of $* * *. In other words, * * * can be viewed as having guaranteed that the total amount it would have to pay the selling consolidated group was $* * *. Thus, the guarantee feature of the securities was worth $* * * ($* * * - $* * *).

[38] As a consequence, * * * can allocate the full purchase price of $* * * among the * * * assets in the * * * year. In other words, since * * * initially allocated only $* * * in the * * * year, it may now allocate an additional $* * * in the * * * year. Of course, under this position, * * * may not allocate any additional amount to the basis of the * * * assets in any subsequent years. In addition, to be consistent, the payment of interest at the end of the guarantee period should be characterized as a dividend.

[39] Second, * * * can be viewed as having promised in the * * * year to pay a purchase price of $* * * (which the selling consolidated group can be treated as having received). In other words, * * * would be treated as having issued an obligation to the selling consolidated group, in exchange for the * * * stock, in the amount of $* * *. Thus, the obligation would be deemed to have an issue price of $* * *. The * * * securities that * * * issued to the selling consolidated group would be treated as a deposit of an open amount, rather than as partial payment for the * * * stock. Consequently, the value of the * * * securities at that time would not be controlling.

[40] In support of this argument, we note that interest was based on the entire purchase price of $* * * and not on the balance due of $* * * ($* * * - $* * *). Thus, the selling consolidated group would only include in income the interest in the amount of $* * *. In addition, when * * * actually paid $* * * to the selling consolidated group in the * * * year, the selling consolidated group would not recognize such amount again (because it recognized such amount in the * * * year). Consequently, * * * would not be entitled to any additional basis adjustments as a result of making the guarantee payment.

[41] Another explanation of the second characterization of the transaction is that, on the closing date, * * * acquired the * * * stock by giving the selling consolidated group $* * * cash and incurring a fixed obligation to pay the selling consolidated group $* * * with a maturity date of up to * * * months and a fixed rate of interest of * * *%.

[42] This obligation, although for a fixed amount, had a provision that left open how it would be satisfied, i.e., the combination of * * * securities and cash. The fact that the obligation leaves up in the air the mode of satisfaction does not alter the fact that the target stock was sold for a fixed and definite amount in the * * * tax year. Uncertainties as to the mode of payment should not make an obligation to pay a fixed amount "contingent" within the meaning of Treas. Reg. section 1.338(b)- 3T(b)(2)(iii).

[43] Treas. Reg. section 1.338(b)-3T(b)(2)(iii) provides that a "contingent amount" means that the amount of the consideration is not fixed and determinable (by the close of target's first taxable year). As noted above, here the amount of the consideration is fixed at $* * *. Thus, Treas. Reg. section 1.338(b)-3T(b)(2)(iii) does not apply where, as here, the method of payment, but not the amount, is not fixed.

[44] Third, the * * * securities, with the guarantee feature and the payment of interest, can be viewed as a debt instrument. In support of this argument, we note that * * * agreed to pay the selling consolidated group a fixed amount of consideration. The method it chose to pay the consideration was to issue an appropriate number of units of securities. * * * anticipated that the aggregate value of these securities would equal (or exceed) the total amount of the agreed upon consideration by the end of the guarantee period. However, if this was not the case, * * * agreed to issue additional units or pay cash to make up the difference. Thus, the amount of the consideration was fixed, not the number of units of * * * securities to be issued. This theory differs from the one above in that it views the * * * security as itself representing the obligation. An obligation embedded in the * * * security on the part of * * * to pay the selling consolidated group a fixed amount of consideration is consistent with debt treatment.

[45] By contrast, if the total amount of the agreed upon consideration was not fixed, * * * could not he viewed as having a debt arrangement with the selling consolidated group. This would be the case if * * * had agreed: (1) to issue to the selling consolidated group a fixed number of units of securities (and the parties had agreed that the value of such securities would represent the consideration for the sale) and (2) subsequently to issue additional units (to satisfy a contingent element of the consideration). Under these circumstances, there is no question the securities issued by * * * would be respected as equity.

[46] In addition, we note that the parties agreed that * * * would pay the selling consolidated group interest on the remaining balance of $* * *. Of course, corporations do not pay interest with, respect to equity. They pay dividends which are not guaranteed and which can only be paid if there are sufficient earnings. ² By contrast, a debtor pays interest on an obligation. Further, the payment of such interest does not require the existence of earnings. An obligation on the part of * * * to pay the selling consolidated group a stated amount of interest is consistent with debt treatment.

[47] Further, although not stated, we believe that * * *'s obligation to the selling consolidated group was on a par with other indebtedness of * * *. Thus, the selling consolidated group would receive its payment of $* * * plus interest by the end of the guarantee period the same as any other creditors of * * * and ahead of any dividends or redemption proceeds paid to shareholders of * * *. This treatment of the obligation is consistent with debt treatment. Thus, the securities should be treated as an obligation of * * *.

[48] Finally, the only element supporting equity characterization of the * * * securities is the fact that such securities could have appreciated and ultimately been worth more than the total amount of the agreed upon consideration. In that case, of course, the selling consolidated group would have received more as than the total amount of the consideration, which is inconsistent with treating the securities as an obligation. However, this is the only element favoring equity characterization and does not outweigh the elements described above that favor debt characterization.

[49] As a result, we agree with you that * * *'s argument is not correct. The purchase price for the * * * assets cannot be bifurcated between the * * * securities and the guarantee payment because, as noted above, there was no contingent consideration. Rather, there were contingent modes of how the fixed amount of consideration was to be paid. In other words, * * * knew upfront what the total amount of consideration would be, whether it is viewed as conveyed entirely in the * * * tax year or part in the * * * tax year and part in the * * * tax year.

[50] As a fallback response to * * *'s argument, however, we note that even if * * * is correct in its determination of the amount of the basis of the * * * assets as being $* * *, it does not follow that * * * can allocate that additional amount among all those assets in the * * * year.

[51] * * * can only allocate purchase price among * * *'s Class III assets (i.e., all assets other than cash and cash equivalent (Classes I and II) and other than section 197 assets, including those in the nature of goodwill and going concern value (Class IV and Class V)) up to the fair market value of those assets on the date of the sale. Treas. Reg. sections 1-338(h)(10)-1T(e)(6)(ii) and 1.338(b)- 2T(c)(1).

[52] Thus, even if * * * is correct in its determination of basis, it still cannot allocate the additional amount among * * *'s Class III assets in the * * * year in the manner it has asserted. Instead, such additional amount must all be allocated to * * *'s Class V assets, i.e., section 197 assets in the nature of goodwill and going concern value.

[53] As an alternative fallback argument, the Service should argue that * * * paid $* * * in the * * * year and a net additional amount of $* * * in the * * * year. The net amount of $* * * is based on netting the guarantee amount, on which the seller recognized gain of $* * *, and the amount paid to redeem the * * * securities, on which the seller recognized a loss of $* * * ($* * * - $* * *) for a net additional gain of $* * * ($* * * - $* * *).

[54] Under Treas. Reg. section 1.338(b)-3T(a)(1),* * *'s adjusted grossed-up basis ("AGUB"), i.e., the amount deemed paid for the target stock, is increased by contingent amounts and decreased by reduction amounts. Under Treas. Reg. section 1.338(b)-3T(b)(2)(iii), a contingent amount is additional consideration pal id for target stock after the close of target's first tax year. * * * argues that the guarantee payment is a contingent amount that increases its AGUB in * * *'s assets.

[55] For the purpose of addressing this argument, the Service would agree with * * *. However, we would note that under Treas. Reg. section 1.338(b)-3T(b)(2)(iv), a "reduction amount" is a reduction in the consideration paid for the target stock. Thus, consistent with * * *'s argument, we would argue that the reduction in the value of the * * * stock (which was redeemed by the seller) represents a reduction in the consideration for the * * * stock. This reduction in the purchase price must be netted against the increase in purchase price claimed by * * *. Under this analysis, * * * would only increase its basis in the * * * assets by the net increase of $* * *.

[56] Thus, to the extent that * * * is able to convince a court that the guarantee amount of $* * * is an additional amount of purchase price paid for the * * * stock, then we should be able to argue that there has likewise been a reduction of the purchase price attributable to the decline in value of the * * * securities. This is a good tactical argument because even if a court gets confused about the $* * * representing additional purchase price by confusing the guarantee amount as representing a contingent amount, we should still prevail by getting a corresponding reduction of basis.

[57] If you have any questions regarding this matter, please contact Grid Glyer at 202-622-7930.

² Thus, dividends can generally only be paid if a corporation has a surplus after having paid its expenses, including any interest obligation.