Final Regs Provide Rules on Tax-Avoidance Aquisitions and Post-Bankruptcy Ownership Changes

 DEPARTMENT OF THE TREASURY

 ACTION: Final regulations.

 SUMMARY: This document contains final income tax regulations providing guidance relating to acquisitions made to evade or avoid income tax under section 269 of the Internal Revenue Code of 1986 (the "Code"). This document also contains final income tax regulations which provide guidance relating to the use of certain corporate tax attributes following an ownership change within the meaning of section 382(g)(1) to which section 382(l)(5) applies. Section 382 was amended in relevant part by the Tax Reform Act of 1986 (the "1986 Act") and the Revenue Act of 1987 (the "1987 Act").

 DATES: Effective Date: These regulations are effective January 6, 1992. Applicability Dates: These regulations apply generally to any ownership change, as defined under section 382 of the Code, occurring after December 31, 1986. The presumption under section 1.269-3(d) applies only to acquisitions of control or property effected pursuant to a plan of reorganization confirmed by a court in a title 11 or similar case (within the meaning of section 368(a)(3)(A)) after August 14, 1990.

 FOR FURTHER INFORMATION CONTACT: Victor L. Penico of the Office of Assistant Chief Counsel (Corporate), Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Ave., N.W., Washington, D.C. 20224 (Attention CC:CORP:T:R) or telephone 202-566-3618 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

A Notice of Proposed Rulemaking under sections 269, 382 and 383 of the Internal Revenue Code of 1986, relating to acquisitions made to evade or avoid income tax and to the use of pre-change corporate tax attributes following an ownership change with respect to which section 382(l)(5) applies, was published in the Federal Register on August 14, 1990 (55 FR 33137). Those regulations proposed to amend sections 1.269-3(a) and 1.269-6 of the Income Tax Regulations and to add new sections 1269-3(d), 1.269-3(e), 1.269-7, and 1.382-3.

 After issuance of the proposed regulations, the Internal Revenue Service received public comments on the proposed regulations and held a public hearing on December 3, 1990. After considering the comments and the statements made at the hearing, the Service adopts the proposed regulations as revised by this Treasury decision.

OWNERSHIP CHANGES TO WHICH SECTION 382(l)(5) APPLIES

 Section 1.269-7 of the proposed regulations clarifies that section 269 of the Code may be applied to disallow a deduction, credit or other allowance even though the acquisition of control or property of a corporation occurs in connection with an ownership change to which section 382 applies. Section 1.269-3(d) of the proposed regulations provides that, absent strong evidence to the contrary, a requisite acquisition of control or property in connection with an ownership change to which section 382(l)(5) applies is considered to be made for the principal purpose of tax evasion or avoidance unless the corporation carries on more than an insignificant amount of an active trade or business during and subsequent to the title 11 or similar case.

 Several commentators objected to the presumption provided in section 1.269-3(d) of the proposed regulations. These commentators asserted that the presumption should either be eliminated or replaced with a non-exclusive list of factors indicating that an acquisition should or should not be considered to be made principally for tax evasion or avoidance. Commentators also asserted that, although section 1.382-3(c) of the proposed regulations provides that the continuity of business enterprise test required by section 382(c) of the Code is inapplicable to section 382(l)(5) ownership changes, the presumption in section 1.269-3(d) indirectly applies the test to such ownership changes.

 As a result of these comments, the Service has made certain changes to clarify that the determination of whether a corporation carries on more than an insignificant amount of an active trade or business is made without regard to continuity of business enterprise under section 1.368-1(d) and that a corporation may satisfy this requirement even if all of the corporation's business activities temporarily cease for a period of time in order to address business exigencies.

 Several commentators argued that section 269 of the Code should play only a residual role, applying only to transactions to which the rules of sections 382 and 383 technically do not apply, but which violate the purposes of those sections. These commentators believe that the acquisition of control of a bankrupt corporation by its qualified creditors in a section 382(l)(5) ownership change does not violate the purposes of section 382 regardless of the corporation's level of business activity because the creditors have borne the economic losses reflected in the tax attributes.

 Relegating section 269 of the Code to a residual role is inconsistent with the intent of Congress, expressed in the Conference Report to the Tax Reform Act of 1986, that the amendment of sections 382 and 383 not alter the continuing application of section 269. See H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. 11-194 (1986), 1986-3 (Vol. 4) C.B. 194. The rules of section 269 and other provisions of the Code that prohibit or limit deductions, credits, or other allowances are not mutually exclusive. See section 1.269-2(b). The application of section 269 to loss corporations that do not carry on more than an insignificant amount of a trade or business is consistent with interpretations of existing law that prevent taxpayers from trafficking in tax attributes of corporations carrying on minimal business activities. See American Pipe and Steel Corporation v. Commissioner, 243 F.2d 125 (9th Cir. 1957) and U.S. Shelter Corporation v. United States, 13 Cl. Ct. 606 (1987). Creditors are allowed deductions under other provisions of the Code for losses they incur as a result of bad debts.

 Some commentators suggested that the presumption in section 1.269-3(d) ignores the requirement in section 269 of the Code that the acquiring persons or the corporation secure the benefit of a deduction, credit or other allowance which they would not otherwise enjoy. These commentators argue that section 269 does not apply to the acquisition of stock of a corporation unless there is a transfer of assets or other income-producing activity in order to use an otherwise unusable deduction, credit or other allowance. Section 269 has not been construed so narrowly. See Inductotherm Industries, Inc. v. Commissioner, T.C. Memo 1984-281 (taxpayer must demonstrate that the choice of a stock acquisition in preference to an asset acquisition was primarily motivated by genuine, nontax related, business reasons), aff'd without published opinion, 770 F.2d 1071 (3rd Cir. 1985); Urban Redevelopment Corporation v. Commissioner, 294 F.2d 328 (4th Cir. 1961) (purchaser's testimony inherently unbelievable because purchaser could have acquired assets rather than stock).

 One commentator requested that, when a corporation is a member of a consolidated group, the determination of whether the corporation carries on more than an insignificant amount of a trade or business be made by taking into account the business activities of other members of the consolidated group. The Service recognizes that taking into account business activities of other members of the consolidated group may be appropriate, but is deferring consideration of the issue until development of specific rules concerning reorganizations of consolidated groups under section 382(l)(5).

 Some commentators asserted that the presumption in section 1.269-3(d) unfairly penalized taxpayers who effected transactions in reliance upon prior law. These commentators believe that the presumption should not be applied retroactively. Because the presumption imposes an additional evidentiary burden by giving further weight to the presumption of correctness already arising from a determination by the Commissioner under section 269, the final regulations make the presumption effective only for acquisitions of control or property effected pursuant to a plan of reorganization confirmed by a court in a title 11 or similar case (within the meaning of section 368(a)(3)(A)) after August 14, 1990, the date the proposed regulations were published in the Federal Register. The general rules of section 269 continue to apply, however, to acquisitions of control or property occurring prior to such date.

TIME OF ACQUISITION OF CONTROL

 Section 1.269-5 of the proposed regulations provides that creditors acquire control of an insolvent or bankrupt corporation only when they acquire beneficial ownership of the requisite amount of stock. Under the proposed regulations, the creditors are treated as acquiring beneficial ownership of the stock no earlier than the time a bankruptcy court confirms a plan of reorganization.

 Some commentators argued that section 1.269-5, in conjunction with the presumption in section 1.269-3(d), inappropriately disregards the creditor's intent at the time the debt was incurred and that such intent should be a mitigating factor in the determination of whether the acquisition of control is made for the principal purpose of tax evasion or avoidance. Concern was also expressed that, in some cases, section 1.269-5 may create an inference that creditors acquire ownership of stock of the corporation before the effective date of the plan of reorganization for purposes of other Code sections.

 The final regulations clarify that section 1.269-5 is applicable solely for purposes of section 269 of the Code. The Service believes that the intention of creditors when they lend money to a corporation (or otherwise become creditors) is not relevant to the principal purpose for a bankruptcy reorganization. The claims of creditors initially were taken in a form distinct from equity interests in important ways for legal and tax purposes interest paid on the claims was deductible by the debtor). Subsequently, the financial condition of the debtor deteriorated, and the creditors' claims became, as a practical matter, subject to greater risks of not being fully repaid. In a title 11 or similar case, the creditors may vote to receive the value of their claims in cash or property (other than stock of the debtor) or in stock of the debtor. This decision is independent of the earlier transaction in which the creditors chose to be (or otherwise became) creditors of the corporation.

RELATIONSHIP OF SECTION 269 TO 11 U.S.C. 1129(d)

 Section 1.269-3(e) of the proposed regulations provides that the fact that a governmental unit did not seek a determination under 11 U.S.C. 1129(d) is not taken into account in determining under section 269 of the Code whether an acquisition was made for the principal purpose of evasion or avoidance of Federal income tax and any determination by a court under 11 U.S.C. 1129(d) that the principal purpose of the plan is not avoidance of taxes is not controlling.

 Although commentators criticized section 1.269-3(e) as incorrect and inappropriate for an income tax regulation, the final regulations adopt the rule of section 1.269-3(d) without substantive change. As stated in the Restatement of Judgments 2d section 28(4) (1982), issue preclusion does not apply where the burden of proof is changed in the subsequent proceeding. Moreover, it is appropriate as a matter of policy that determinations under 11 U.S.C. 1129(d) not preclude subsequent litigation of the issue in a tax proceeding because preclusion would deter the government from seeking determinations under 11 U.S.C. 1129(d). Finally, the interaction of a provision of the Code and another Federal statute is an appropriate issue for income tax regulations to address.

SPECIAL ANALYSES

 It has been determined that these regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking for the regulations was submitted to the Chief Counsel of Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Victor L. Penico, Office of the Assistant Chief Counsel (Corporate), Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations, in matters of both substance and style.

LIST OF SUBJECTS

26 CFR 1.261-1 through 1.280H-1T

Income taxes, Reporting and recordkeeping requirements. 26 CFR 1.381(a)-1 through 1.383-3

Income taxes, Reporting and recordkeeping requirements.

Treasury Decision 8388

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR, chapter I, part 1 is amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by adding the following citations:

Authority: Sec. 7805, 68A Stat. 917 (26 U.S.C. 7805) * * *

 Section 1.269-3(d) also issued under 26 U.S.C. 382(m).

Par. 3. Section 1.269-3 is amended as follows:

1. The last sentence of paragraph (a) concluding text is removed.

2. New paragraphs (d) and (e) are added to read as follows:

SECTION 1.269-3 INSTANCES IN WHICH SECTION 269(a) DISALLOWS A DEDUCTION. CREDIT, OR OTHER ALLOWANCE.

* * * * *

(d) OWNERSHIP CHANGES TO WHICH SECTION 382(l)(5) APPLIES: TRANSACTIONS INDICATIVE OF NURNOSE TO EVADE OR AVOID TAX -- (1) IN GENERAL. Absent strong evidence to the contrary, a requisite acquisition of control or property in connection with an ownership change to which section 382(l)(5) applies is considered to be made for the principal purpose of evasion or avoidance of Federal income tax unless the corporation carries on more than an insignificant amount of an active trade or business during and subsequent to the title 11 or similar case (as defined in section 382(l)(5)(G)). The determination of whether the corporation carries on more than an insignificant amount of an active trade or business is made without regard to the continuity of business enterprise requirement set forth in section 1.368-1(d). The determination is based on all the facts and circumstances, including, for example, the amount of business assets that continue to be used, or the number of employees in the work force who continue employment, in an active trade or business (although not necessarily the historic trade or business). Where the corporation continues to utilize a significant amount of its business assets or work force, the requirement of carrying on more than an insignificant amount of an active trade or business may be met even though all trade or business activities temporarily cease for a period of time in order to address business exigencies.

(2) EFFECTIVE DATE. The presumption under paragraph (d) of this section applies to acquisitions of control or property effected pursuant to a plan of reorganization confirmed by a court in a title 11 or similar case (within the meaning of section 368(a)(3)(A)) after August 14, 1990.

(e) RELATIONSHIP OF SECTION 269 TO 11 U.S.C. 1129(d). In determining for purposes of section 269 of the Internal Revenue Code whether an acquisition pursuant to a plan of reorganization in a case under title 11 of the United States Code was made for the principal purpose of evasion or avoidance of Federal income tax, the fact that a governmental unit did not seek a determination under 11 U.S.C. 1129(d) is not taken into account and any determination by a court under 11 U.S.C. 1129(d) that the principal purpose of the plan is not avoidance of taxes is not controlling.

Par. 4. Section 1.269-5 is revised to read as follows:

SECTION 1.269-5 TIME OF ACQUISITION OF CONTROL.

(a) IN GENERAL. For purposes of section 269, an acquisition of control occurs when one or more persons acquire beneficial ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or at least 50 percent of the total value of shares of all classes of stock of the corporation.

(b) APPLICATION OF GENERAL RULE TO CERTAIN CREDITOR ACQUISITIONS -- (1) For purposes of section 269, creditors of an insolvent or bankrupt corporation (by themselves or in conjunction with other persons) acquire control of the corporation when they acquire beneficial ownership of the requisite amount of stock. Although insolvency or bankruptcy may cause the interests of creditors to predominate as a practical matter, creditor interests do not constitute beneficial ownership of the corporation's stock. Solely for purposes of section 269, creditors of a bankrupt corporation are treated as acquiring beneficial ownership of stock of the corporation no earlier than the time a bankruptcy court confirms a plan of reorganization.

(2) The provisions of this section are illustrated by the following example.

EXAMPLE. Corporation L files a petition under chapter 11 of the Bankruptcy Code on January 5, 1987. A creditors' committee is formed. On February 22, 1987, and upon the request of the creditors, the bankruptcy court removes the debtor-in-possession from business management and operations and appoints a trustee. The trustee consults regularly with the creditors' committee in formulating both short-term and long-term management decisions. After three years, the creditors approve a plan of reorganization in which the outstanding stock of Corporation L is cancelled and its creditors receive shares of stock constituting all of the outstanding shares. The bankruptcy court confirms the plan of reorganization on March 23, 1990, and the plan is put into effect on May 25, 1990. For purposes of section 269, the creditors acquired control of Corporation L no earlier than March 23, 1990. Similarly, the determination of whether the creditors acquired control of Corporation L with the principal purpose of evasion or avoidance of Federal income tax is made by reference to the creditors' purposes as of no earlier than March 23, 1990.

Par. 5. The section heading for section 1.269-6 is revised to read as follows:

SECTION 1.269-6 RELATIONSHIP OF SECTION 269 TO SECTION 382 BEFORE THE TAX REFORM ACT OF 1986.

Par. 6. New section 1.269-7 is added to read as follows:

SECTION 1.269-7 RELATIONSHIP OF SECTION 269 TO SECTIONS 382 AND 383 AFTER THE TAX REFORM ACT OF 1986.

Section 269 and sections 1.269-1 through 1.269-5 may be applied to disallow a deduction, credit, or other allowance notwithstanding that the utilization or amount of a deduction, credit, or other allowance is limited or reduced under section 382 or 383 and the regulations thereunder. However, the fact that the amount of taxable income or tax that may be offset by a deduction, credit, or other allowance is limited under section 382(a) or 383 and the regulations thereunder is relevant to the determination of whether the principal purpose of an acquisition is the evasion or avoidance of Federal income tax.

Par. 7. New section 1.382-3 is added to read as follows:

SECTION 1.382-3 SPECIAL RULES UNDER SECTION 382 FOR CORPORATIONS UNDER THE JURISDICTION OF A COURT IN A TITLE 11 OR SIMILAR CASE.

(a) INTRODUCTION. Either section 382 (l)(5) or section 382(l)(6) may apply to an ownership change which occurs in a title 11 or similar case (as defined in section 368(a)(3)(A)) if the transaction resulting in the ownership change is ordered by the court or is pursuant to a plan approved by the court. Terms and nomenclature used in this section, and not otherwise defined herein, have the same respective meanings as in section 382 and the regulations thereunder.

(b) APPLICATION OF SECTION 382(l)(5). Section 382(a) does not apply to any ownership change if --

(1) The old loss corporation is (immediately before the ownership change) under the jurisdiction of the court in a title 11 or similar case; and

(2) The pre-change shareholders and qualified creditors of the old loss corporation (determined immediately before the ownership change) own (after the ownership change and as a result of being pre- change shareholders or qualified creditors immediately before the ownership change) stock of the new loss corporation (or stock of a controlling corporation if also in bankruptcy) that meets the requirements of section 1504(a)(2) (determined by substituting "50 percent" for "80 percent" each place it appears).

(c) [Reserved]

(d) [Reserved]

(e) [Reserved]

(f) [Reserved]

(g) [Reserved]

(h) [Reserved]

(i) [Reserved]

(j) [Reserved]

(k) [Reserved]

( ) [Reserved]

(m) CONTINUITY OF BUSINESS REQUIREMENT -- (1) Under section 382(l)(5). If section 382 (l)(5) applies to an ownership change of a loss corporation, section 382(c) and the regulations thereunder do not apply with respect to the ownership change.

(2) [Reserved]

(n) [Reserved]