Comments on Notice Concerning Section 382(h) Built-in Gains and Losses. Sincerely, Kenneth W. Gideon Chair, Section of Taxation

Transcription

1 Defending Liberty Pursuing Justice CHAIR Kenneth W. Gideon Washington, DC CHAIR-ELECT Dennis B. Drapkin Dallas, TX VICE CHAIRS Administration Sylvan Siegler Kansas City, MO Committee Operations Charles H. Egerton Orlando, FL Communications Celia Roady Washington, DC Government Relations Stuart M. Lewis Washington, DC Professional Services Robert E. McKenzie Chicago, IL Publications Jerald D. August West Palm Beach, FL SECRETARY Evelyn Brody Chicago, IL ASSISTANT SECRETARY Christine L. Agnew New York, NY COUNCIL Section Delegates to the House of Delegates Stefan F. Tucker Washington, DC Paul J. Sax San Francisco, CA Immediate Past Chair Richard A. Shaw San Diego, CA MEMBERS Ellen P. Aprill Los Angeles, CA Samuel L. Braunstein Fairfield, CT Glenn R. Carrington Washington, DC Thomas A. Jorgensen Cleveland, OH Carolyn M. Osteen Boston, MA Lloyd Leva Plaine Washington, DC Charles A. Pulaski, Jr. Phoenix, AZ Rudolph R. Ramelli New Orleans, LA N. Susan Stone Houston, TX Fred T. Witt, Jr. Phoenix, AZ Mark Yecies Washington, DC Joel D. Zychick New York, NY LIAISON FROM ABA BOARD OF GOVERNORS Bruce M. Stargatt Wilmington, DE LIAISON FROM ABA YOUNG LAWYERS DIVISION Patrick T. Schmidt Louisville, KY LIAISON FROM LAW STUDENT DIVISION Lee Rankin Lincoln, NE DIRECTOR Christine A. Brunswick Washington, DC The Honorable Mark W. Everson Commissioner of Internal Revenue Internal Revenue Service Room Constitution Avenue, NW Washington, DC Re: Dear Commissioner Everson: Section of Taxation 10th Floor th Street N.W. Washington, DC (202) FAX: (202) Comments on Notice Concerning Section 382(h) Built-in Gains and Losses Enclosed are comments on Notice , regarding the treatment of built-in gains and losses for purposes of section 382(h), as prepared by members of the Committee on Corporate Tax. 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. Enclosure cc: Sincerely, Kenneth W. Gideon Chair, Section of Taxation The Honorable Donald L. Korb, Chief Counsel, Internal Revenue Service Mr. Eric Solomon, Acting Deputy Assistant Secretary, Department of the Treasury Ms. Helen M. Hubbard, Tax Legislative Counsel, Department of the Treasury Mr. William D. Alexander, Associate Chief Counsel (Corporate), Internal Revenue Service Mr. Wayne T. Murray, Acting Deputy Associate Chief Counsel (Corporate), Internal Revenue Service Mr. Mark S. Jennings, Chief, Branch 1, Office of Associate Chief Counsel (Corporate), Internal Revenue Service Ms. Audrey Nacamuli, Office of Tax Legislative Counsel, Department of the Treasury Ms. Stephanie Robinson, Office of Tax Legislative Counsel, Department of the Treasury Mr. Sean McKeever, Attorney-Advisor, Office of Associate Chief Counsel (Corporate), Branch 1, Internal Revenue Service

2 COMMENTS CONCERNING NOTICE UNDER SECTION 382 OF THE INTERNAL REVENUE CODE REGARDING THE TREATMENT OF RECOGNIZED BUILT-IN GAINS AND LOSSES The following comments are the individual views of the members of the Section of Taxation who prepared them and do not represent the position of the American Bar Association or the Section of Taxation. The comments were prepared by members of the Committee on Corporate Tax of the Section of Taxation. Principal responsibility was exercised by Kevin D. Anderson. Significant contributions were made by Robert J. Mason and Roger Ritt. Substantive comments were made by Jasper Cummings, Jr., Elliot Freier, Jared Gordon, Julie Hogan, and R. David Wheat. The Comments were reviewed by Robert A. Jacobs of the Section s Committee on Government Submissions and by Mark L. Yecies, Council Director for the Committee on Corporate Tax. 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 by these Comments, or have advised clients on the application of such principles, no such member (or the firm or organization to which such member belongs) 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 persons: Kevin D. Anderson (202) KAnderson@deloitte.com R. David Wheat (214) WheatD@tklaw.com Date:

3 I. EXECUTIVE SUMMARY In Notice , I.R.B. 747 (Built-in Gains and Losses under section 382(h)) (the Notice ), the Internal Revenue Service (the Service ) and Treasury provided interim guidance on the determination of built-in gains and losses for purposes of section 382(h) of the Internal Revenue Code of 1986, as amended (the Code ). 1 The issuance of interim guidance under section 382(h) is a welcome development, and we commend the Service and Treasury for taking steps to assist taxpayers in complying with an area of the law that had been fraught with uncertainty for 17 years. We agree that, regardless of the method used to identify built-in items, only one method should be used to determine the NUBIG or NUBIL of a loss corporation. 2 We also agree that the hypothetical sale model set forth in Treas. Reg (a), with slight modifications, is an appropriate method of determining NUBIG or NUBIL. We believe regulations should clarify that the recognition period begins at the beginning of the change date, notwithstanding that the change date is also the last day in the pre-change period for allocating taxable income or loss for the taxable year in which the change occurs. While certain potential anomalies may result from the inclusion of the change date in both the pre-change period and the recognition period, we believe that they are adequately addressed by existing provisions of the Code and regulations. The members of the Section who prepared these comments were unable to reach consensus favoring a Code section 338 Approach, a Code section 1374 Approach, or one similar to either. Instead, we offer comments showing the merits of one approach or the other, with slight modifications. Proponents of the 1374 Approach, sometimes referred to in the comments as an all events approach, cite among its advantages the objective nature of the approach and the relative ease of administration. Proponents also believe it is consistent with the legislative history and, thus, Congressional intent. Proponents of the 338 Approach, sometimes referred to in these comments as the economic accrual approach, believe it to be consistent with the larger policy objectives of section 382(h), to place a loss corporation in virtually the same position that it would have occupied had it sold its assets, or at least marked them to market, immediately prior to the ownership change. Regardless of the method used, we believe that a few questions should be resolved regarding cost recovery aspects of the section 382(h) provisions. We make several recommendations to provide greater clarity to the treatment of income from the 1 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended. 2 Unless otherwise indicated, capitalized terms used in the Executive Summary have the same meanings set forth in the text of the comments that follow.

4 cancellation of indebtedness. We believe that a method can be adopted to identify the amount of income that is considered to be built-in, and that, once identified, income should be included in NUBIG or NUBIL regardless of its ultimate disposition under sections 61, 108, and We also provide suggestions for identifying the appropriate time during the recognition period when the built-in COD income should be taken into account as RBIG, but we do not believe the section 382 limitation should be increased in every case where COD income excluded under section 108 is taken into account. Several miscellaneous questions, primarily relating to the 338 Approach, are posed in the event regulations would propose to adopt such an approach, or one similar to it. These questions, together with suggestions for resolving them, generally address the specific nature of the hypothetical section 338 election, the extent to which hypothetical tiered elections should be assumed, and the extent to which ADSP or AGUB in the hypothetical section 338 election should be used to determine the fair market value of the assets of the loss corporation. Finally, we suggest two other matters for consideration in drafting proposed regulations under section 382(h), although not directly related to the scope of the Notice. The first comment requests guidance under section 382(h)(9), and the second comment requests the Service and Treasury clarify the treatment under section 382(h)(3)(B) of accounts receivable acquired in the ordinary course of business. II. BACKGROUND A. General Comments Section 382 provides rules regarding a corporation s ability to offset its taxable income in years following an ownership change with losses attributable to periods before the change in ownership occurred. For this purpose, pre-change losses include (1) net operating loss carryforwards from taxable years ending prior to the year in which the ownership change occurred, (2) the portion of a net operating loss generated in the year of change allocable to the period preceding the date on which the ownership change occurred (the change date ), and (3) to the extent of the loss corporation s net unrealized built-in loss ( NUBIL ), the built-in losses recognized during the five-year period beginning with the change date. 3 Under section 382(a), post-change income for any taxable year may be offset with pre-change losses in an amount equal to the section 382 limitation. Under section 382(b), the section 382 limitation is an amount that is equal to the value of the loss corporation immediately prior to the ownership change multiplied by the applicable Federal long-term tax-exempt rate. If the section 382 limitation for any post-change year exceeds the taxable income for the year, the excess amount carries over to and increases the section 382 limitation for the succeeding year. 4 If the business of the corporation is discontinued within two years of the change date, the section 382 limitation is zero. 5 3 Section 382(d)(1) and (h)(1). 4 Section 382(b)(2). 5 Section 382(c)(1). -2-

5 B. Net Unrealized Built-In Gain or Loss A loss corporation has a net unrealized built-in gain ( NUBIG ) if the excess of the fair market value of its assets immediately before an ownership change over those assets aggregate adjusted basis exceeds the lesser of $10 million or 15 percent of the fair market value of the corporation s assets on the change date (the threshold ). 6 In such a case, the section 382 limitation is increased to the extent any such built-in gain is recognized during the five-year period beginning on the change date (the recognition period ). 7 Conversely, a loss corporation has a NUBIL if the excess of the aggregate adjusted basis of its assets over such assets fair market value exceeds the threshold, and any such built-in loss recognized during the recognition period is treated as pre-change loss that can offset post-change taxable income only to the extent of the available section 382 limitation. C. Income and Deduction Items that are Attributable to the Pre-Change Period Under Section 382(h)(6) Section 382(h)(6) and the last sentence of section 382(h)(2)(B) provide rules treating certain items of income or deduction as recognized built-in gain ( RBIG ) or recognized built-in loss ( RBIL ). Specifically, section 382(h)(6)(A) provides that any item of income properly taken into account during the recognition period is treated as RBIG if the item is attributable to periods before the change date. Section 382(h)(6)(B) provides that any item of deduction allowable as a deduction during the recognition period is treated as RBIL if the item is attributable to periods before the change date. In addition, the second sentence of section 382(h)(2)(B) provides that allowable depreciation, amortization, or depletion deductions are treated as RBIL except to the extent the loss corporation establishes that the amount of the deduction is not attributable to the asset s built-in loss on the change date. Under section 382(h)(6)(C), the amount of NUBIG or NUBIL is adjusted for items of income and deduction that would be treated as recognized built-in gains or losses under section 382(h)(6) if those amounts were taken into account (or allowed as deductions) during the recognition period. 8 III. NOTICE Section 382(h)(3)(B). 7 Section 382(h)(1)(A) and (h)(7). 8 Section 382(h)(6)(C) originally provided for an adjustment to the amount of NUBIG for items of built-in income treated as recognized built-in gains under section 382(h)(6)(A). This language was amended by a technical correction to provide that the amount of NUBIG includes items of income which would be treated as recognized built-in gain... if such amounts were properly taken into account... during the recognition period. Pub. L. No , section 7811(c)(5)(A)(i). The legislative history reveals that under this language, [i]tems of income... that would be treated as built-in gain... if recognized within the recognition period are included in the computation of net unrealized built-in gain... without regard to when or whether such items are actually recognized within the recognition period. H.R. Rep , 101 st Cong., 1 st Sess (1989). Thus, we believe that a loss corporation can have a NUBIG or NUBIL solely by reason of built-in income or deduction items. -3-

6 A. Generally On September 12, 2003, the Service and Treasury published Notice to provide interim guidance regarding the treatment of built-in gains and losses under section 382(h). In general, the Notice provides that a loss corporation may use either of two approaches, one based on section 338 (the 338 Approach ) and the other based on section 1374 (the 1374 Approach ), in determining the amount of its RBIG or RBIL for purposes of section 382(h). A taxpayer may not use elements of both approaches, however, for the same ownership change. These two methods are established as safe harbors, and thus are not the exclusive means of identifying built-in items for purposes of section 382(h). The use of alternative methods, however, will be subject to review by the Service on a case-by-case basis. The Notice provides that taxpayers may rely on the guidance provided therein until the Service and Treasury issue temporary or final regulations under section 382(h). B. Computation of NUBIG or NUBIL Under the Notice, the amount of NUBIG or NUBIL is calculated by first determining the amount that would be realized if immediately before the ownership change the loss corporation had sold all of its assets, including goodwill, at fair market value to a third party that assumed all of its liabilities. This gross amount realized is-- (i) (ii) (iii) Decreased by the sum of (x) the loss corporation s aggregate adjusted basis in its assets, and (y) the amount of any deductible liabilities that would be included in the amount realized on the hypothetical sale; Increased or decreased by the corporation s section 481 adjustments that would be taken into account on a hypothetical sale; and Increased by any recognized built-in loss that would not be allowed as a deduction under section 382, 383, or 384 on the hypothetical sale. 9 The Notice provides that NUBIG or NUBIL is calculated under this method for both the 338 Approach and the 1374 Approach. This method may be referred to from time to time in these comments as the hypothetical sale model. Although it is derived from section 1374 and the regulations thereunder, its use in the Notice is expressly applicable to both approaches. Our comments below explore the differences between the two approaches in the identification of the items to be treated as RBIG or RBIL It is sufficient at the outset to note that, under the hypothetical sale model, NUBIG or NUBIL, as the case may be, is not adjusted to take into account the differences in the treatment of items as RBIG or RBIL under the two approaches. 9 The Notice thus adopted the model of Treas. Reg (a) for the calculation of NUBIG or NUBIL. -4-

7 C. Determination of RBIG or RBIL 1. The 1374 Approach Section 1374 imposes a tax on the net recognized built-in gain of certain S corporations that either have converted from C corporation status or have acquired assets from a C corporation in a nonrecognition transaction. Although the purposes of sections 382 and 1374 are substantially different, the essential structure of the two provisions, consisting principally of a specified recognition period, an initial determination as to whether a corporation has a NUBIG or NUBIL on a specified date, and the identification of items of RBIGs and RBILs, is similar. Generally, the Notice provides that the 1374 Approach under section 382(h)(6) relies on an accrual method of accounting, patterned after Treas. Reg (b), to determine whether items of income and deduction constitute RBIG and RBIL. Under this approach, items of income or deduction properly included in income or allowed as a deduction during the recognition period are treated as being attributable to periods before the change date if an accrual-method taxpayer would have included the item in income or been allowed a deduction for the item before the change date. For the purposes of this determination, section 461(h)(2)(C) and Treas. Reg (g) (concerning certain liabilities for which payment constitutes economic performance) do not apply. As a result, under this approach an accrual-method taxpayer will not have recognized built-in income, and with the exception of payment liabilities (as described in section 461(h)(2)(C) and Treas. Reg (g)), certain types of expenses payable to related parties, nonqualified deferred compensation subject to section 404(a)(5), and the amortization of built-in loss assets, will not have built-in deduction items. Under the 1374 Approach, income derived from the use of an asset with an unrealized built-in gain during the recognition period is not treated as RBIG because the income does not accrue before the change. On the deduction side, however, by reason of section 382(h)(2), the 1374 Approach departs from the accrual method in its treatment of amounts allowable as depreciation, amortization, or depletion deductions during the recognition period. These amounts are treated as RBIL regardless of whether they accrued for tax purposes before the change date, except to the extent the loss corporation establishes that the amount is not attributable to the excess of basis over fair market value of the built-in loss asset at the time of the change. Under the Notice, a loss corporation may use any reasonable method to establish that an amortization deduction is not attributable to an asset s built-in loss on the change date. A recognized acceptable method is to calculate the difference between the actual deduction and the deduction that the taxpayer would have been allowed had it received a fair market value basis as a result of a hypothetical sale. For each year in the recognition period, under this method, the taxpayer determines the actual cost recovery deduction using the number of years remaining in the actual recovery period, but determines the hypothetical cost recovery deduction using a new recovery period beginning on the change date. The 1374 Approach treats cancellation of indebtedness ( COD ) income includible in income and bad debt expense deducted in the first 12 months of the recognition period as RBIG and -5-

8 RBIL, respectively, if the indebtedness was in existence at the beginning of the period. 10 corporation s status as solvent or insolvent on the change date is not relevant. A With respect to excluded COD income, the Notice provides that any basis reduction under sections 108(b)(5) and 1017(a) is treated as having occurred immediately before the ownership change for purposes of determining whether a recognized gain or loss is an RBIG or an RBIL, but not for purposes of determining a loss corporation s NUBIG or NUBIL. 11 The Notice does not provide for the treatment of excluded COD income as RBIG or RBIL (or for purposes of determining a loss corporation s NUBIG or NUBIL) to the extent the COD income is applied in any other way, i.e., by reducing attributes other than asset basis or by reducing no attributes. 2. The 338 Approach Under the 338 Approach, the taxpayer compares all post-change actual income, gain, deduction, and loss with the same items calculated as if the taxpayer made a section 338 election on the change date. The difference constitutes RBIG or RBIL, depending on whether the difference is positive or negative. The items resulting from the hypothetical section 338 election are determined by applying the loss corporation s actual accounting methods. The 338 Approach assumes that a built-in gain asset generates post-change date income in an amount equal to a hypothetical cost recovery deduction that would have resulted after the section 338 election. The amount of the hypothetical deduction in excess of the actual deduction is treated as RBIG. A deduction properly claimed during the recognition period for the payment of a contingent liability is treated as RBIL to the extent of its estimated amount on the change date. This approach attempts to determine the portion of the contingent liability that is built in as of that date, as well as the portion (if any) of such liability that is attributable to the corporation s continued conduct of its business for periods after the change date. Similar to the 1374 Approach, if a loss corporation recognizes taxable COD income attributable to pre-change items, all or a portion of the amount recognized constitutes RBIG. Unlike the 1374 Approach, the amount of recognized COD income treated as RBIG is limited to an amount equal to the excess of the adjusted issue price of the debt over the fair market value of the debt on the change date. In addition, unlike the 1374 Approach, the 338 Approach is not bound by the 12-month recognition limit. Thus, all COD income realized during the recognition period related to pre-change debt may be taken into account in calculating RBIG, except to the extent that the fair market value of the debt has declined further since the change date. Also, for excluded COD income, the basis reduction under sections 108(b)(5) and 1017(a) that occurs 10 Treas. Reg (f). 11 We understand that a drafting error limited the treatment described in the Notice to basis reductions under sections 108(b)(5) and 1017(a). Section 108(b)(5) merely provides that a taxpayer may elect to apply the required tax attribute reduction under section 108(b)(1) to first reduce the basis of any depreciable property. Whether or not this election is made, the basis of property may also be reduced under the normal order and priority set forth in section 108(b)(2)(E). We assume the Service and Treasury intended to provide for the treatment of excluded COD income as RBIG regardless of which basis reduction mechanism applies. -6-

9 during the recognition period is deemed to have occurred immediately before the ownership change. The basis reduction does not affect the loss corporation s NUBIG or NUBIL. 12 The Notice provides no specific rules for the treatment of bad debt expense. Under the principles implicit in the 338 Approach, a bad debt deduction during the recognition period on an account receivable in existence on the change date should be treated as an RBIL to the extent of the excess of the basis of the account on the change date over its fair market value on that date. In this regard, the treatment of such an account receivable is similar to that of any other asset held by a loss corporation at the beginning of the recognition period. IV. DETAILED COMMENTS A. Introductory We applaud the Service and Treasury for providing much-needed guidance under section 382(h). The statute had been in effect for approximately 17 years without any published guidance in this area. At least two economic downturns occurred during this period, and many corporations with net operating losses, other unused tax attributes, and/or built-in losses, both large and small, underwent ownership changes under section 382 and thus found it necessary to comply with the section 382(h) provisions. Our experience thus far has demonstrated that the Notice has successfully resolved disputes under section 382(h) arising in the examination of some taxpayers, and has permitted other taxpayers to determine the amount of their recognized built-in gains and losses with significantly more certainty that their positions will not be challenged by the Service. The Notice requested comments on a number of issues, including specifically whether one of the two approaches described in the Notice should be adopted and to what extent, if any, the approaches should be combined or modified to produce a set of rules that is both reflective of statutory intent and administrable. The members participating in the preparation of these comments were unable to reach a consensus favoring either approach, or an approach that resembles either approach. Accordingly, these comments explicate the respective merits of each such approach. Because the differences between the two approaches are reflected principally in the determination of items of built-in income and deduction under section 382(h)(6), that discussion will be confined to that section of the comments below. B. General Computation of Net Unrealized Built-In Gain or Loss We agree that, with modifications, the hypothetical sale model of the Notice can provide an appropriate methodology to identify the loss corporation s NUBIG or NUBIL. One modification we recommend is that, in determining the amount realized upon the deemed sale, the regulations should explicitly provide that the fair market value of the loss corporation s assets shall not be less than the adjusted issue price of the corporation s liabilities outstanding as of the beginning of the change date. This modification will confirm that built-in COD income for an insolvent 12 See fn. 11. The observation made there in connection with the 1374 Approach applies equally to the 338 Approach. -7-

10 corporation will be reflected in the NUBIG computation as an amount realized in the hypothetical sale. We also recommend that the regulations clarify application of the hypothetical sale model to situations in which an actual sale would bifurcate the treatment of the selling party. As one example, when a corporation has deferred income and is required to accelerate the recognition of that income on a deemed or actual sale of all of its assets, the Service has permitted the seller to increase the amount realized from the sale of the assets and claim a deduction for the amount paid to the purchaser to assume the liabilities associated with the deferred income. 13 Similar treatment may be warranted in other unusual cases. 14 We believe it appropriate that the regulations prescribe, as did the Notice, only one method for determining the NUBIG or NUBIL of a loss corporation. The hypothetical sale model of Treas. Reg (a), if modified in the manner described in these comments, is consistent with the structure of section 382(h)(6), which determines the aggregate tax consequences to the corporation, including income and deduction items, of a sale of all of the assets in a single transaction and the assumption or satisfaction of all of its liabilities. The hypothetical sale model prescribed by the regulations should, of course, be modified in circumstances where section 382(h)(8) applies. 15 With respect to the adjustment to the amount realized to reflect any deductible liabilities that are taken into account in the amount realized on the hypothetical sale (the deductible liability adjustment ), we acknowledge that the adjustment may reduce the amount of NUBIG or increase the amount of NUBIL for post-change deductions that, using the 1374 Approach, would not be treated as RBIL under section 382(h)(6)(B). On the other hand, the hypothetical sale model includes in the amount realized the value of built-in income items that, using the 1374 Approach, may not be treated as RBIG under section 382(h)(6)(A). Consequently, we believe the deductible liability adjustment is appropriate and should be retained. We recommend the regulations clarify that, for all purposes under section 382(h), contingent liabilities are taken into account based upon expectations on the change date, taking into account time value of money principles and all other relevant factors. 13 Rev. Rul , C.B. 62; Rev. Rul , C.B. 78; see also James M. Pierce Corp. v. Commissioner, 326 F.2d 67 (8 th Cir. 1964) (bifurcated treatment in the case of a corporation that had liquidated under pre-1982 version of section 334(b)(2) which had deferred prepaid subscription income). 14 For example, in the case of an insurance company, an actual sale of assets would be governed by section Under Prop. Reg (c)(5), the principles of Prop. Reg (a) through (d) would apply to the tax consequences of the hypothetical sale, and the selling insurance company may be treated as having paid a ceding commission to the purchasing company to assume the insurance liabilities. Presumably, the amount realized under the hypothetical sale model should include an amount equal to the fair market value of such ceding commission (thereby capturing any section 1001 gain or loss with respect to the assets dedicated to the ceding commission payment). 15 Section 382(h)(8) provides that, if 80 percent or more in value of the stock of a loss corporation is acquired in one transaction (or in a series of related transactions during any 12-month period), for purposes of determining the NUBIL, the fair market value of the assets of such corporation shall not exceed the grossed-up amount paid for such stock properly adjusted for indebtedness of the corporation and other relevant items. -8-

11 Finally, we recommend that the regulations do not adjust the amount realized by any loss that would not be allowed as a deduction in connection with the hypothetical sale because of a limitation under section 382, 383, or 384. We believe such an adjustment is inconsistent with the proposition that section 382 be applied independently with respect to each ownership change. 16 C. Time of Measurement As noted above, section 382(h)(1) provides that if a corporation has a NUBIG, the section 382 limitation for any recognition period taxable year is increased by the RBIG during such year, and that if a corporation has a NUBIL, the RBIL in any such year is subject to the applicable section 382 limitation as if such loss were a pre-change loss. A taxable year is a recognition period taxable year if any portion of such year is in the recognition period, defined as the 5- year period beginning on the change date. 17 [Emphasis added] Under section 382(h)(3), the existence and amount of NUBIG with respect to an ownership change is determined by reference to the excess of asset value over basis immediately before the change. 18 While an ownership change would seem to occur at the moment during the day that the greater-than-50 percentage point increase in stock ownership occurs, 19 the regulations mandate that computations of increases in percentage ownership are to be made as of the close of the testing date would support the conclusion that the ownership change occurs at day s end. 20 Thus, it is possible that the NUBIG or NUBIL determinations should be made immediately before the end of the change date. It may also be possible to interpret the phrase immediately before the ownership change by applying step-transaction principles. Under such an approach, if an asset is disposed of in connection with a transaction (or series of transactions) that results in an ownership change (or such transaction or transactions results in income or deduction items described in section 382(h)(6)), the computation of NUBIG or NUBIL would be made prior to the first planned transaction Cf Treas. Reg (d). 17 Section 382(h)(7)(A). 18 Section 382(h)(3)(A)(i). 19 Section 382(g)(1) (an ownership change occurs immediately after the 50-percentage-point threshold is exceeded). 20 Treas. Reg (a)(4)(i). 21 Cf. Berry Petroleum Co. v. Commissioner, 104 T.C. 584 (1995), involving the application of substantial nonbusiness asset test of section 382(l)(4) when the new owner of the loss corporation sold an historic loss corporation asset following the ownership change pursuant to a contract entered into before the stock acquisition took place. Under section 382(l)(4)(A), it was necessary to determine whether substantial nonbusiness assets were held immediately after the ownership change. In reaching its decision that the proceeds from the pre-arranged sale were taken into account in determining whether substantial nonbusiness assets were held, the court stated: -9-

12 In lieu of these approaches, we recommend the regulations specify that the computation of NUBIG or NUBIL be made by reference to the fair market value and adjusted tax basis of the loss corporation s assets, and includes its built-in items of income and deduction, as of the beginning of the change date (the beginning-of-the-day approach). By defining the recognition period as the five-year period beginning on the change date, we believe that changedate items were intended to be included in the NUBIG/NUBIL determinations without regard to the timing of the ownership change on the change date. 22 We believe that Congressional intent is further evidenced by the requirement that a loss corporation establish the tax basis and fair market value of an asset immediately before the change date as a condition to treating gain realized on that asset as RBIG (or to limit the amount of realized loss that should be treated as RBIL). 23 Because section 382(b)(2)(B) provides that the section 382 limitation does not apply to the portion of the loss corporation s taxable income that is allocable to the period on or before the change date, the change date is included in both the recognition period for purposes of the treatment of built-in gains and losses, and the pre-change period for purposes of determining the amount of income that can be offset without limitation by section 382. As a result of this overlap, income that is built-in as of the beginning of the change date but is realized on the change date will reduce (or eliminate) the amount of NUBIL potentially subject to the section 382 limitation resulting from such change even though such income can be offset by pre-change loss without limitation (e.g., by electing under Treas. Reg to allocate items of income, gain, deduction or loss under a closing-of-the-books methodology). 24 [w]e look to the definition of immediately after as that phrase is used in the regulations under section 351 as a situation where the rights of the parties have been previously defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure. [Treas. Reg (a)(1).] Momentary ownership of what might otherwise be a business asset is insufficient where the owner s rights and obligations with respect to that asset have been previously defined, and must be subsequently carried out, pursuant to a prearrangement, in this case, an agreement whose enforceability was triggered by the ownership change. [Citations omitted] See, also, Priv. Ltr. Rul (Mar. 31, 1992), which overcame the technical impediment that the section 382(h)(3) determination be made by reference to the basis and value immediately before the ownership change and held that a reduction in basis under section 1017 was taken into account in making the net unrealized built-in gain or loss computation under section 382(h) even though such reduction was not effective until the beginning of the year following the year of the ownership change. 22 Section 382(h)(2)(A)(i). 23 Section 382(h)(2). [Emphasis added] Moreover, we believe that Treas. Reg (d) adequately addresses situations in which pre-change-date activity is undertaken to inappropriately manipulate the application of section 382(h). But see PLR , which suggests an end-of-the-day approach. 24 Although NUBIL may be reduced or eliminated as indicated, the statute prevents either a double detriment or a double benefit for certain items of RBIG or RBIL. Specifically, regardless of the method used to determine prechange and post-change income or loss for the taxable year in which the ownership change occurs, the amount of income or loss to be allocated must be determined by not taking into account (a) RBIL that would be subject to a section 382 limitation or (b) RBIG that would increase a section 382 limitation. Section 382(h)(5)(A). -10-

13 These observations apply both to COD income realized on the change date and to gain or loss from the disposition of an asset on the change date. The realization of COD income in connection with, and on the same date as, an ownership change is relatively common. Accordingly, considerations applicable to the realization of COD income on the change date will be discussed in further detail below. Considerations applicable to the disposition of an asset on the change date will be discussed only as an adjunct to the COD discussion. D. Built-in Income and Deduction Items 1. Introductory and Historical Comments Prior to the Notice, the Service addressed the application of section 382(h)(6) to a broad range of income and deduction items, including: cancellation of indebtedness income not excluded under section 108 that arose in a transaction resulting in an ownership change (held attributable to the pre-change period); 28 deductions arising from the funding of retiree benefits 29 and from the exercise of stock options issued before the change date (same); 30 prepaid income items that had been deferred pursuant to Revenue Procedure (not attributable to the pre-change period); Section 382(h)(6), prior to amendment by section 1006(d)(22) of Pub. L. No See H.R. Rep. No , 99 th Cong., 2d Sess. II-191 (1986). See also Staff of Senate Finance Committee, The Subchapter C Revision Act of 1985, (1985 Green Book), S. Prt , 99 th Cong., 1 st Sess. 247 (1985) (a draft proposal upon which the 1986 Act amendments to section 382 was based described the corresponding provision as intended to apply to items that accrue and would be deductible prior to the change but for some provision in the law (e.g., section 267) ). (Emphasis supplied.) 27 See H.R. Rep. No , 100 th Cong., 2d Sess (1988). 28 Priv. Ltr. Rul (Mar. 10, 1989). Notably, the cancellation of indebtedness income was triggered after the ownership change had taken place. See also Priv. Ltr. Rul (May 16, 1989); Priv. Ltr. Rul (Dec. 19, 1992). 29 Priv. Ltr. Rul (Oct. 28, 1988). 30 Priv. Ltr. Rul (Aug. 5, 1994). 31 Tech. Adv. Mem (Oct. 22, 1999). Pursuant to Rev. Proc , C.B. 549, the taxpayer had elected to defer reporting of the prepaid income until the time of performance. Although the Service s rationale is not articulated, it may have believed the income was solely attributable to the post-change period because the services with respect to which the payments were received had been provided after the ownership change. As set forth above, section 382(h)(6) treats certain recognized built-in income and deduction items as items of RBIG and RBIL, respectively. Prior to the amendment by the Technical and Miscellaneous Revenue Act of 1988 (the 1988 Act ), section 382(h)(6) merely authorized regulations to treat amounts which accrue on or before the change date but which are allowable as a deduction after such date as recognized built-in losses. 25 The legislative history of the pre Act version of section 382(h)(6) cited deductions deferred by sections 267 or 465 as examples of accrued deductions. 26 The legislative history to the 1988 Act does not address the significance of the change in terms from accrue to attributable to in section 382(h)(6)

14 and income derived from the licensing of software (where the corporation s loss carryovers were attributable to expenditures incurred in the software s development) Use of a 1374 Approach As indicated above, the 1374 Approach generally adopts the accrual-method rule of Treas. Reg (b). Thus, except for certain liabilities subject to the economic performance requirements of section 461(h), or to certain other special timing provisions, an item of income or deduction is built in for purposes of section 382(h)(6) only if it would have been taken into account by an accrual-method taxpayer before the beginning of the recognition period. The principal advantages of the 1374 Approach to built-in income and deduction items include the objective nature of the approach and relative ease of administration. Proponents of the 1374 Approach are sympathetic to the Government s desire to avoid the factsand-circumstances inquiries associated with administering an approach to section 382(h)(6) that identifies the recognition of built-in income and deductions through tracing. In addition, they argue that a narrower interpretation is suggested by the limited examples of built-in items in the legislative history to section 382(h)(6). 33 Thus, proponents believe that classification of built-in income and deduction items under an all events approach promotes certainty with respect to both the determination of NUBIG or NUBIL and the identification of recognized built-in income and deduction items, and avoids both valuation uncertainties and realization presumptions. For these reasons, proponents believe regulations issued under section 382(h)(6) could reasonably adopt an all events approach to identifying items of built-in income and deduction items. Unlike the 1374 Approach, however, it is believed that an item of deduction should constitute a built-in loss if it would have been taken as a deduction in the pre-change period by an accrual basis taxpayer but for the failure of economic performance or the application of another Code or tax regulatory limitation on deductions (e.g., sections 163(j), 465, 469, 470, etc.). The list of exceptions should be short and should be united by a common purpose to move this test closer to a pure all events test. The four cited Code sections all defer the deduction of net losses or expenses that otherwise meet the fixed and determinable components of the all events test. Similarly, as in the regulations under section 1374, the regulations under section 382(h)(6) may need to specify additional built-in income and deduction items that are not otherwise identified under an all events model (e.g., income from the cancellation of indebtedness) Field Service Advice (July 8, 1993), reprinted in 98 TNT (LEXIS, FEDTAX Library, TNT File). 33 The sole items of built-in deduction identified in the legislative history are losses deferred by section 267 or section 465, while the only identified items of built-in income are: (a) accounts receivable of a cash-basis taxpayer that arose before the change date and are collected after that date, (b) gain on completion of a long-term contract performed by a taxpayer using the completed contract method of accounting that is attributable to periods before the change date, and (c) the recognition of income attributable to periods before the change date pursuant to an adjustment under section 481. H.R. Rep. No , 99 th Cong., 2d Sess. II-191 (1986) (relating to the grant of authority to the Treasury to issue regulations to treat certain deductions as built-in losses); S. Rep. No , 100 th Cong., 2d Sess. 48 (1988) (relating to the treatment of certain income items as built-in gains). 34 We have not considered the additional items that such regulations might identify as attributable to the pre-change -12-

15 3. Use of a 338 Approach The 338 Approach takes into account the following items as recognized built-in income or deduction items that would not be considered under the 1374 Approach: (i) (ii) (iii) (iv) (v) Rights to income that do not satisfy the all events test, but would be valued in a hypothetical purchase of all of the assets of the corporation; Deductions for liabilities that do not satisfy the all events test, but would be included in amount realized in a hypothetical sale under general principles of Federal tax law; Deductions for bad debts properly taken into account more than 12 months after the ownership change, to the extent that the adjusted basis of the debt exceeded its fair market value as of the change date; COD income properly taken into account more than 12 months after the ownership change, to the extent that the adjusted issue price of the debt exceeded its fair market value as of the change date; 35 and Hypothetical or foregone depreciation and amortization of assets with an unrealized built-in gain as of the date of the ownership change. Proponents believe that the 338 Approach can also be viewed as consonant with the purposes of section 382(h), citing the following explanation of the reasons for section 382(h) by the Staff of the Joint Committee on Taxation: Built-in losses should be subject to special limitations because they are economically equivalent to pre-acquisition NOL carryforwards. If built-in losses were not subject to limitations, taxpayers could reduce or eliminate the impact of the general rules by causing a loss corporation (following an ownership change) to recognize its built-in losses free of the special limitations (and then invest the proceeds in assets similar to the assets sold). The Act also provides relief for loss corporations with built-in gain assets. Built-in gains period, or whether the extent to which built-in items for sections 382 and 384 might appropriately differ. For example, the legislative history to section 384 indicates an expectation that built-in gain-- will also include any income recognized after an acquisition in which the fair market value of the property acquired is less than the present value of the taxes that would be due on the income associated with the property (for example, in the case of a burnt-out leasing subsidiary with built-in income transferred to a loss corporation). H.R. Rep. No (Parts 1 and 2), 100 th Cong., 1 st Sess. (1987). 35 Because of issues that are unique to this area, the treatment of COD income under section 382(h)(6) is set forth in a separate section of these comments. -13-

16 are often the product of special tax provisions that accelerate deductions or defer income (e.g., accelerated depreciation or installment sales reporting). Absent a special rule, the use of NOL carryforwards to offset built-in gains recognized after an acquisition would be limited, even though the carryforwards would have been fully available to offset such gains had the gains been recognized before the change in ownership occurred.... Although the special treatment of built-in gains and losses may require valuations of a loss corporation s assets, the Act limits the circumstances in which valuations will be required by providing a generous de minimis rule. Staff of Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 288, 298 (Comm. Print 1987). This explanation arguably evidences an intent to place a loss corporation in virtually the same position, vis-à-vis its unrealized built-in gains and losses, that it would have occupied had it sold all of its assets in a fully taxable transaction immediately prior to the ownership change and adjusted its net operating loss and other attribute carryforwards to account for the recognized gains and losses. Proponents also argue that, like the 1374 Approach, the 338 Approach is consistent with the structure of the statute. Thus, section 382(h)(6)(C) provides that the amount of NUBIG or NUBIL is properly adjusted for amounts which would be treated as RBIG or RBIG under section 382(h)(6) if such amounts were properly taken into account during the recognition period. If the hypothetical sale model for determining NUBIG or NUBIL is to be consistent with section 382(h)(6)(C), it is argued, the items of income or deduction taken into account in NUBIG or NUBIL must be capable of being described in section 382(h)(6)(A) or (B), as the case may be, during the recognition period. The 338 Approach satisfies this statutory requirement. More specifically, proponents note the difference in the 338 Approach as compared to the 1374 Approach as follows. Rights to Income. Under the hypothetical sale model, an asset of a loss corporation (including a receivable) is taken into account in its NUBIG or NUBIL based upon the fair market value of the asset. A hypothetical buyer of all of the assets of a loss corporation is likely to be willing to pay some amount for the receivable, even though that amount may not meet the all events test as of the change date because, for example, the receivable is being disputed by the obligor. 36 This amount would not be built in under the 1374 Approach. Deductions for Contingent Liabilities. Similarly, it is not uncommon for a liability of a target corporation to be contingent as of the date of purchase, but to become fixed and determinable at some later time. 37 In an actual sale transaction, liabilities may be treated by the seller as part of 36 Rev. Rul , C.B In Pacific Transport Co. v. Commissioner, 483 F.2d 209 (9 th Cir. 1973), a parent corporation made payments in discharge of a contested tort liability that was first asserted against a subsidiary corporation and assumed by the parent corporation upon liquidation of the subsidiary. The events giving rise to the liability took place before the parent had purchased the subsidiary s stock. The parent was aware of the contingent liability at the time of the -14-