TaxUpdate. in this issue... Application of Interest Netting Rules to Consolidated Groups. Follow Us on Twitter

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1 Vol. 2012, Issue 1 Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington Follow Us on Twitter We wish you a happy New Year! Speakers Corner Todd Reinstein presented Proposed Section 382 Regulations on the Application of the Segregation Rules at the Bloomberg Tax Advisory Board meeting in New York on January 17. On February 9, Todd Reinstein will participate in a webinar, Fundamentals of Section 382, for Lorman Education Services. Todd Reinstein will moderate a panel, Hot Tax Topics for Utilities, at the American Bar Association Tax Section Midyear Meeting on February 17 in San Diego, CA. On March 2, Todd Reinstein will be a panelist for Rehabilitating Troubled Corporations at the Federal Bar Association Tax Section 36th Annual Tax Law Conference in Washington, D.C. The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please send address corrections to phinfo@pepperlaw.com Pepper Hamilton LLP. All Rights Reserved. Application of Interest Netting Rules to Consolidated Groups To d d B. Re i n s t e i n r e i n s t e i n t@pepperlaw.com Nicholas Metcalf As is widely known, taxpayers must pay interest on tax deficiencies and the IRS must pay interest on overpayments. 1 The interest rates charged by the IRS for deficiencies is not surprisingly higher than the interest rate paid on overpayments. In situations in which a taxpayer is assessed tax for deficiencies and has refunds, Section 6621(d) provides relief for this mismatch and allows for interest netting on underpayments and overpayments by the same taxpayer. Interest can be netted if the following three criteria are met: (1) the underpayment and overpayment must be the same amount; (2) the time period must overlap; and (3) the underpayment and overpayment must have been incurred by the same taxpayer. Consolidated Groups The application of the interest netting rules to consolidated groups has been relatively unsettled as there are no current Treasury Regulations laying out rules when consolidated members come and go. The interplay between consolidated group rules and Section 6621(d) creates an issue as to the same taxpayer requirement. Recently, the U.S. Court of Federal Claims tackled the same taxpayer application to consolidated groups in Magma Power Co. v. U.S. 2 The taxpayer, Magma Power Company (Magma) and its parent corporation, MidAmerican Energy Holdings Company (MidAmerican), sought a refund of interest assessed against Magma for underpayment in In 1995, Magma was acquired * Nicholas Metcalf is a law clerk, resident in Pepper Hamilton s Washington, D.C. office. He is not admitted to practice law. This publication may contain attorney advertising. 1 Application of Interest Netting Rules to Consolidated Groups in this issue... 3 IRS Proposes Taxpayer-Friendly Changes to Section 382 Segregation Rules 6 Pepper Hamilton s Tax Practice Group

2 Speakers Corner continued Todd Reinstein, Ellen McElroy and Howard Goldberg will present Life Cycle of a Business Transaction: From Cocktail Napkin to Financial Statement at the Tax Executives Institute s 62nd Mid Year Conference on March 26 in Washington, D.C. Quotable Todd B. Reinstein was quoted in BNA s Daily Tax Report and Tax Notes Today on the new proposed Section 382 regulations on November 23 and in CCH s Federal Tax Weekly on December 1. His comments on the proposed regulations from a District of Columbia Bar panel on the proposed regulations were reported in BNA s Daily Tax Report and Tax Notes Today and in CCH s Tax Day on December 7, and his comments from a panel on the proposed regulations from a BNA Washington Items Tax Luncheon were reported in BNA s Daily Tax Report and Tax Notes Today and CCH s Tax Day on December 13. Kevin M. Johnson was quoted in the December 5 issue of Tax Notes by Marie Sapirie in the article, The IRS Wants Your Metadata Now What?. He also presented this topic to the ABA Tax Section Admin Practice Committee on December 21. Lance S. Jacobs s comments from a panel from the District of Columbia Bar Taxation Section s State and Local Tax Committee luncheon were quoted in Tax Analysts State Tax Today on January 11. Published Timothy J. Leska co-authored an article, Conversion of Insolvent Corporation into a Tax Partnership: IRS Reaches Favorable Conclusions, but Questions Remain, published in the November 30, 2012 issue of Practical International Tax Strategies, published by WorldTrade Executive, a part of Thomson Reuters. by its parent company, CalEnergy (MidAmerican is CalEnergy s successor in interest), and by 2002 Magma had paid a 1993 deficiency plus interest. Post-acquisition, Magma was included in CalEnergy s consolidated return along with other subsidiaries. The IRS determined, following an examination from , that the consolidated group was entitled to overpayment refunds. Magma filed a refund claim for the 1993 year utilizing the overpayment determined in the IRS exam and by doing so sought the interest paid for the 1993 deficiency in applying the interest netting rules. The IRS conceded that a portion of the overpayment was attributable to Magma; however, it denied MidAmerican s ability to apply the interest netting rules to offset the interest paid on the 1993 deficiency with the overpayments determined in the later years. The IRS claimed that Section 6621(d) did not allow for the netting of interest between an overpayment of a consolidated group s income tax for one taxable year and an underpayment of a member s income tax for a prior taxable year because the consolidated group and the member were not the same taxpayer for purposes of both overpayment and underpayment. The Court of Federal Claims first looked to the plain meaning of same taxpayer. The IRS argued that the overpayment could only be applied to the consolidated group as a whole and not to the individual taxpayers that made up the group. The court rejected the IRS s argument because at all times Magma maintained its own EIN; portions of the overpayment were directly attributable to Magma; and it was well established that the individual corporations in a consolidated group were the taxpayers, not the consolidated group itself. After distinguishing a previous case, the court looked to non-precedential IRS guidance in making its determination. In FSA , the IRS found that in the consolidated group framework, interest-netting could apply, but such a determination would be based on the facts and circumstances of the particular case. 3 Next, the court looked at CCA in which Corporation C underpaid its tax liability in year one, and later filed as part of a consolidated group in years eight and nine. The IRS concluded that Corporation C would have met the same taxpayer test and would have been allowed to net the year-one underpayment against year-eight and year-nine overpayments, to the extent Corporation C could have shown it was entitled to the consolidated group overpayments. The court finally noted that in the bankruptcy arena, an individual member of a consolidated group is entitled to a refund resulting from an overpayment that is directly attributable to the member. 2

3 The court dismissed the IRS s remaining arguments regarding pass-through entities and administrative burdens and noted that the IRS s interpretation of same taxpayer would have completely undermine[d] Congress s direction to the IRS to implement the most comprehensive interest netting procedures. The court concluded that the plain meaning of the term same taxpayer focused on corporate identity and that filing as a member of a consolidated group did not destroy that identity. Accordingly, the court held that Magma Power was the same taxpayer when it filed as a member of the consolidated group and was therefore entitled to interest netting to the extent that overpayments could be attributed to it. En d n o t e s 1 Unless otherwise stated, all references to Section are to the Internal Revenue Code of 1986 (the Code) AFTR 2d , 2001 U.S. Claims LEXIS 2099 (Fed. Cl. Ct., 2011). 3 FSA at *10. IRS Proposes Taxpayer-Friendly Changes to Section 382 Segregation Rules An n e t t e M. Ah l e r s a h l e r s a@p e p p e r l a w.c o m Todd B. Reinstein reinsteint@pepperlaw.com Section 382 of the Internal Revenue Code generally requires a corporation to limit the amount of its income in future years that can be offset by historic losses (NOLs) once that corporation has undergone an ownership change. 1 An important factor in determining whether or not an ownership change has occurred, and therefore whether or not a limitation is required, is determining the changes in the equity holdings of a corporation s 5-percent shareholders. A 5-percent shareholder, for purposes of Section 382, includes individuals, entities, and public groups. A public group is generally a 5-percent holder that is comprised of equity owners of the loss corporation that are not themselves 5-percent shareholders and have not acquired their shares of a loss corporation in a coordinated acquisition. 2 Section 382 generally requires that any equity event between the corporation and its equity holders, including public groups, is tracked and accounted for in determining whether or not an ownership change occurs. The segregation rules of Section 382 and the accompanying Treasury regulations generally treat certain transactions as if a new public group separate from any pre-existing public groups acquired the stock. In effect, the Section 382 rules presume that persons representing a completely new set of investors purchase such shares. 3 Thus, this set of investors will generally constitute a public group and is treated as a 5-percent shareholder sepa- rate from other 5-percent shareholders or previously identified public groups treated as 5-percent shareholders. For testing dates occurring during tax years beginning after November 4, 1992, the regulations provide two key exceptions to the full segregation presumption. These special rules significantly modify the segregation rules and provide certain assumptive rules when the equity of the loss corporation was issued in a small issuance, or a cash issuance. Notice and Proposed Regulations In order to address concerns expressed over the years that small and cash issuance exceptions did not do enough to reduce the administrative burden on taxpayers performing Section 382 analyses, the IRS invited practitioners to provide comments on how to further modify the segregation rules in Notice ( June 11, 2010). The thought was that because so many of the segregation events constituted transactions that involved less-than-5- percent shareholders, further modifications could be undertaken to ignore certain changes in equity of the loss corporation while preserving the policy goals of tracking ownershifts for purposes of calculating whether or not an ownership change occurred on any given equity event. After receiving detailed comments on how to modify the rules, the IRS and Treasury issued Prop. Reg. Section (i) on November. 22, These proposed regu- 3

4 lations generally adopted the Purposive Approach described in Notice and provided for a Secondary Transfer exception to segregation rules for sales by 5-percent shareholders to the public. The proposed regulations also included a Small Redemption exception to segregation rules (similar to the current small-issuance exception), and provided a small holder with first-tier and higher-tier-entity exception from segregation rules, which generally modifies the segregation rules applicable to transactions involving tiered entities. In addition to the three new proposed rules Prop. Reg. Section (i), interestingly, clarifies Treas. Reg. Section T (j)(3)(i) rules regarding sales of interests in higher-tier entities and provides that the segregation rules generally apply when a 5-percent shareholder or first-tier entity sells a direct interest in the loss corporation. Current Treas. Reg. Section T(j) (3)(i) provides that the principles of this paragraph (j)(3)(i) also apply to transactions in which an ownership interest in a highertier entity that owns 5 percent or more of the loss corporation or a first-tier entity is transferred to a public owner or 5-percent owner who is not a 5-percent shareholder, but a question has always existed as to whether it applied to a 5-percent shareholder of the intermediary or the loss corporation. There was concern in the practitioner community as to the interpretation of the vaguely written regulation, which relies on the principles for determining how to apply the rule. The Prop. Reg. Section (i) clarifies that the segregation rules only apply when an equity holder (transferor) of a first-tier (or higher) entity sells an interest in the entity (not the loss corporation) if the transferor of the entity indirectly owns at least 5 percent of the loss corporation. Secondary Transfer Exception Prop. Reg. Section (j)(13) also provides an exception to Section T(j)(3)(i) for the transfer of loss corporation stock by individuals or first-tier entities that directly own 5 percent or more in loss corporation to the public does by not creating a new public group if certain requirements are met. Existing public groups are deemed to acquire proportionate shares instead of a new segregated public group acquiring the shares. A similar rule applies when an interest in a tiered entity that owns 5 percent (directly or indirectly) in the loss corporation is sold by a 5-percent owner that is either: (i) a 5-percent shareholder of the loss corporation, or (ii) a higher-tier entity owning 5 percent or more of the loss corporation. Under this rule, each public group of the entity existing at the time of the transfer is treated as acquiring its proportionate share of the transferred ownership interest. Once effective, this rule should have a favorable impact on Section 382 studies as no new public groups will be created upon the disposition of shares by current 5-percent shareholders. Redemption Exception Under Treas. Reg. Section T(j)(2)(iii)(C), a redemption by a loss corporation of its stock from small shareholders results in the segregation of each public group into two groups. Prop. Reg. Section (j)(14) provides a similar rule to the small-issuance exception, and states that the segregation rules do not apply to small redemptions. Under this rule, a smallredemption limitation is limited to 10 percent of the beginning of the year stock value (value measurement) or 10 percent of the number of shares of the class of stock being tested (class-by-class measurement). The limitation method is selected at the taxpayer s option each year and there is no consistency requirement with the small issuance limitation. The small redemption is generally defined as a redemption from public shareholders, to the extent the amount (on an aggregate year-to-date basis) of stock redeemed does not exceed the small-redemption limitation. If a single redemption from public shareholders exceeds the limitation, no part of the redemption qualifies. As is the case with the small-issuance exception in general, a loss corporation must treat as a single redemption those that are made close in time pursuant to the same plan or arrangement or redemptions deliberately separated to minimize or avoid an owner shift. If the smallredemption exception applies, the shares subject to the smallredemption limitation are allocated to pre-existing direct public groups proportionately. Actual knowledge, however, may permit greater allocation to existing public groups. Higher-Tier Entities Exception As noted, Section 382 generally tracks changes in ownership by individuals, whether they invest directly or through intermediaries. One of the principles behind the segregation rules is that a loss corporation has the ability to track ownership of all of its stock even if the loss corporation cannot identify small shareholders. However, tracking the ownership of higher-tier entities, which the loss corporation has no relationship to, may prove difficult if not impossible. Many financial buyers, such as hedge funds, may be first-tier entities with more than a 5-percent ownership in loss corporations. Hedge funds are reluctant, if not prohibited, from disclosing their ownership to others, including loss corporations in which they own stock. Recognizing this, the 4

5 IRS issued new Prop. Reg. Section (j)(15) that provides that the segregation rules do not apply to a shift in ownership of a higher-tier entity if: (i) the first-tier entity owns 10 percent or less by value of all outstanding stock of the loss corporation, and (ii) the first-tier entity s direct or indirect investment does not exceed 25 percent of the gross assets (excluding cash and cash items 382(h)(3)(B)(ii)). For this purpose, a first-tier entity s ownership is established by actual knowledge or presumptions. If this exception applies, the continuing public group must combine its increase and lowest percentage with that of the former public group s proportionate share. Several issues exist, however, with this exception. For example, how do you determine the ownership interest of a 5-percent shareholder on a given date when the higher-tier entities experience ownershifts in the first-tier entity? Current rules provide that you can rely on the existence or absence of SEC Schedule 13 filings if they are required to file such forms to identify 5-percent shareholders, but the rules are silent as to relying on their percentage of ownership. Thus, it is not clear if you can rely on the same rule for the determination as to whether the 5-percent shareholder owns less than 10 percent of the loss corporation on the measurement date for relying on this proposed exception. Another open issue for this exception: if certain first-tier entities are reluctant to provide ownership information, it is likely equally difficult to provide information on what percentage of the first-tier entity s portfolio the loss corporation is, because it is not required to be disclosed on the current SEC Schedule En d n o t e s 1 Unless otherwise stated, all references to Section are to the Internal Revenue Code of 1986, as amended, and all references to the Regulations or to Treas. Reg. are to the Treasury Regulations promulgated thereunder. 2 See Treas. Reg. Section (a)(1), which provides that an entity is any corporation, estate, trust, association, company, partnership or similar organization. An entity also includes a group of persons who have a formal or informal understanding among themselves to make a coordinated acquisition of stock. 3 See Treas. Reg. Section T(j)(2)(iii)(B)-(C). 4 It should be noted that the ownership test generally ignores Section T(h)(2), but includes attribution under Section 318(a) (but see the exception for options not treated as exercised). Eff e c t i v e Da t e The rules will generally apply to testing dates occurring on or after the date these regulations are published as final regulations. Thus, although these rules do not apply to current calculations of ownershifts under Section 382, they are an indication of the directional thoughts of the IRS and Treasury on how the segregation rules should be applied, and may be useful in planning transactions that may ultimately be impacted by these or similar rules that become finalized. As discussed above, there was also a clarification to existing regulations included in the proposed regulation package. The effective date of the clarification is somewhat of an issue in that the IRS is using the guidance to clarify its current position and so the effective date of that position may not be dependent on the finalization of these rules. RSS on Subscribe to the latest Pepper articles via RSS feeds. Visit today and click on the RSS button on the publications page to subscribe to our latest articles in your news reader. 5

6 Pepper Hamilton s Tax Practice Group Federal and International Tax Issues Annette M. Ahlers ahlersa@pepperlaw.com Timothy B. Anderson andersontb@pepperlaw.com Joan C. Arnold arnoldj@pepperlaw.com Anthony J. Balden baldena@pepperlaw.com James W. Barson barsonj@pepperlaw.com Steven D. Bortnick bortnicks@pepperlaw.com Gordon R. Downing downingg@pepperlaw.com W. Roderick Gagné gagner@pepperlaw.com Howard S. Goldberg goldbergh@pepperlaw.com Kevin M. Johnson johnsonkm@pepperlaw.com Timothy J. Leska leskat@pepperlaw.com Ellen McElroy mcelroye@pepperlaw.com Michelle Moersfelder moersfelderm@pepperlaw.com Paul D. Pellegrini pellegrinip@pepperlaw.com Lisa B. Petkun petkunl@pepperlaw.com Todd B. Reinstein reinsteint@pepperlaw.com Joan M. Roll rollj@pepperlaw.com State and Local Tax Issues Lance S. Jacobs jacobsls@pepperlaw.com Employee Benefits Issues Jonathan A. Clark clarkja@pepperlaw.com David M. Kaplan kapland@pepperlaw.com Andrew J. Rudolph rudolpha@pepperlaw.com Sign-Up to Receive Your Tax Update Sooner We are encouraging our readers to switch to delivery. delivery means faster delivery of updates to you, reduced printing and postage costs for us, and reduced environmental impact for everyone. Please subscribe online at or send your request, name, company and address to phinfo@pepperlaw.com. Please be assured that we will respect your privacy please see our privacy policy at 6