Discussion Topics. Primer on Unsuccessful Subsidiaries in Consolidated Returns. PLI Tax Attributes and Consolidation February 21, 2018

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1 LI Tax Attributes and Consolidation February 21, 2018 Gerald (Jerry) B. Fleming IR, enior Technician Reviewer (Corporate Branch 2) William D. Alexander kadden, Arps, late, Meagher & Flom LL tuart J. Goldring Weil, Gotshal & Manges LL Mark R. Hoffenberg KMG LL Bernita L. Thigpen KMG LL Discussion Topics Worthless tock Losses in Consolidation: Background Determining Ordinary Loss Character Worthless tock Loss lanning remaining in the group leaving the group Other Considerations Tax Reform Impacts on Tax Attributes 2 rimer on Unsuccessful ubsidiaries in Consolidated Returns 3

2 ubsidiaries are not always successful. 4 Losses in member subsidiaries flow through to the consolidated return. 5 Basis Adjustments A shareholder member s basis in the stock of a loss generating member is adjusted downward as the loss is used by the group. 6

3 tock Losses Built in losses inside the subsidiary may be duplicated in the stock of the subsidiary held by members. Or a shareholder member may have a greater outside loss, for example, if the loss subsidiary s stock was a acquired at a premium over net asset basis. 7 tock Losses Consolidation has special rules for stock losses that are duplicative of inside losses. Reg The default treatment is to allow the stock loss and sacrifice duplicative inside attributes. There are elections to sacrifice some or all of the stock loss to preserve inside attributes. 8 Character Inside losses are what they are, often ordinary. tock losses generally are capital, except to the extent worthless stock losses are ordinary under ection 165(g)(3). 9

4 Consolidated Return Rules The consolidated return regulations have a number of rules that inhibit the harvesting of losses: Many losses on intercompany transactions are deferred. ection 267(f) extends the deferral regime to unconsolidated related parties. Reg aggregates group members to meet ection 332 s ownership requirement. 10 Worthless tock Deduction Deferred Reg (c) defers worthless stock deductions on subsidiary member stock until the subsidiary is devoid of assets, experiences certain types of cancellation of debt (COD) in insolvency situations, or ceases to be a member of the group. 11 Harvesting Losses Losses may be claimed through sales of assets or stock to unrelated parties. There are also techniques for harvesting losses through related party transactions. One technique for harvesting stock losses on subsidiaries that are not worthless is the Granite Trust structure, in which an interest in the subsidiary is sold and the subsidiary is then liquidated under ection

5 Loss tock and Worthless tock Deductions: A Closer Look 13 Granite Trust Transaction (Built-In Loss tock) 100% Unrelated arty 70% 30% sells 30% of stock (at a loss) to Unrelated arty. recognizes and takes into account the loss on the sold stock. liquidates under 331. recognizes and takes into account the loss on its remaining 70% of stock. ee Granite Trust Co. v. U.., 238 F.2d 670 (1st Cir. 1956); Commissioner v. Day & Zimmerman, Inc., 151 F.2d 517 (3d Cir. 1945). 14 ection 267(f) Background ection 267(a)(1) disallows losses on sales between related persons (as defined in ection 267(b)). It does not apply, however, to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation. ection 267(f)(2) defers losses from sales between members of the same controlled group to which ection 267(a)(1) would otherwise apply, until the property is transferred outside the controlled group and there would be recognition of the loss under consolidated return principles or until such other time prescribed by regulations. ection 1563 definition of controlled group applies, except that a greater than 50% (rather than at least 80%) relationship between corporations is required. 15

6 ection 267(f) Background (cont d) Losses under ection 267(f) are generally deferred until they are taken into account under the timing principles of the matching and acceleration rules of -13(c) and (d). Reg (f)-1(c)(1). The attribute redetermination rules in -13(c) generally do not apply; therefore, the attributes of the losses subject to ection 267(f) are not affected. Reg (f)- 1(c)(2). The attribute redetermination rules generally redetermine separate entity items of and B to the extent necessary to produce the effect of a transaction between divisions of a single corporation. -13(c) and (d). Redetermined items may be treated as excluded from gross income or as noncapital, nondeductible amounts. -13(c)(6). However, to the extent s (the selling member s) loss subject to ection 267(f) would be redetermined to be a noncapital, nondeductible amount under the principles of -13, the loss remains deferred and is not taken into account until and B (the buying member) are no longer in a controlled group relationship. Reg (f)-1(c)(1)(iv). 16 Basic Granite Trust Transaction NQ arent 1 NQ of REIT 1 1 1) 1 sells, at fair market value, (at least) 25 percent of the common stock of 2 to REIT1 in exchange for non-qualified preferred stock of REIT 1.* Following the sale, 1 and REIT1 are the owners of 75 percent and 25 percent, respectively, of the outstanding stock of 2. REIT1 25 percent of the common stock of 2 3 liquidating distribution of 25% of 2 s assets 100% 75% 3 liquidating distribution of 75% of 2 s assets 2) At least one day after the tep 1, the Board of Directors of 2 adopts a formal plan of liquidation, which contemplates the liquidation of 2. 25% 2 3) 2 liquidates, distributing its assets pro rata: 25 percent to REIT1 and 75 percent to 1. = Member of U.. Consolidated Group *Note that while we use REITs in this example, the same concepts apply with any entity that is not a member of the U.. Consolidated Group. 17 Tax Treatment If various requirements are met, it is intended that: 1 should account for a loss, if any, on the sale of 2 shares to REIT1 (the hares ale ) under the rules of ection 267(f), after taking into account Reg Under Reg (f)-1(c)(1)(iv), any such loss should remain deferred until 1 and REIT1 (including any successors) are no longer in a controlled group relationship. The liquidation of 2 (the 2 Liquidation ) should be governed by ection 331 and not by ection 332 or ection 368. Each 2 shareholder should recognize gain or loss in its 2 shares in an amount equal to the difference between the fair market value of the property distributed to such shareholder in the 2 Liquidation and such shareholder s adjusted basis (determined inter alia after applying Reg ) in its 2 shares. The adjusted basis of any property treated as received by each 2 shareholder in connection with the 2 Liquidation should equal the fair market value of such property on the date of such distribution. 18

7 Determining Ordinary Loss Character of Worthless tock Deduction 19 ection 165(g) Worthless ecurities (1) General rule. If any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall, for purposes of this subtitle, be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset. (2) ecurity defined. For purposes of this subsection, the term security means (A) a share of stock in a corporation;... (3) ecurities in affiliated corporation. For purposes of paragraph (1), any security in a corporation affiliated with a taxpayer which is a domestic corporation shall not be treated as a capital asset. For purposes of the preceding sentence, a corporation shall be treated as affiliated with the taxpayer only if (A) the taxpayer owns directly stock in such corporation meeting the requirements of ection 1504(a)(2), and (B) more than 90 percent of the aggregate of its gross receipts for all taxable years has been from sources other than royalties, rents (except rents derived from rental of properties to employees of the corporation in the ordinary course of its operating business), dividends, interest (except interest received on deferred purchase price of operating assets sold), annuities, and gains from sales or exchanges of stocks and securities. In computing gross receipts for purposes of the preceding sentence, gross receipts from sales or exchanges of stocks and securities shall be taken into account only to the extent of gains therefrom. 20 Redetermination Rules Under Reg (c), the separate entity attributes of s intercompany items and B s corresponding items are redetermined to the extent necessary to produce the same effect on consolidated taxable income (and consolidated tax liability) as if and B were divisions of a single corporation, and the intercompany transaction was a transaction between divisions. Under Reg (a)(2), timing, character, source and other attributes (excluding amount and location) are initially determined on a separate entity basis, but are redetermined to produce the effect of transactions between divisions of a single corporation. 21

8 ection 165(g)(3) Ordinary Loss Determination (worthless) Dividend Distribution OpCo Facts:,, and OpCo are members of a consolidated group. OpCo had made dividend distributions to. becomes worthless. Result: The IR has issued numerous LRs allowing members of a consolidated group to use a look through approach for purpose of the 90% gross receipts test. To the extent a member receives a dividend from a subsidiary, the dividend will be allocated pro rata as active or passive gross receipts based upon the activities of the distributing subsidiary out of which the E& was distributed. ee, e.g., Ltr. Rul , , ection 165(g)(3) Ordinary Loss Determination (worthless) interest OpCo Loan Facts:,, and OpCo are members of a consolidated group. loans funds to OpCo and OpCo pays interest on the loan to. becomes worthless. Result: The IR has issued LRs allowing a look through approach for all intercompany transactions under the current regulations. ee, e.g., Ltr. Rul However, on October 13, 2017, the IR released a statement providing that, with respect to ection 165(g)(3)(B), it will no longer rule on whether the character of gross receipts received by a consolidated group member in an intercompany transaction may be redetermined by reference to the character of the source funds possessed by the counter party to the intercompany transaction. The statement indicated that the IR is studying this issue and new guidance may be issued. The issue was added to the 2018 norule revenue procedure. ee ection 3.01(31) of Rev. roc , IRB ection 165(g)(3) Ordinary Loss Determination (worthless) Active- Co assive- Co Facts:,, and OpCo are members of a consolidated group. is worthless. Active Co has active gross receipts and assive Co has passive gross receipts. Result: Under the look through approach of the letter rulings, whether has an ordinary or capital loss on its stock may depend on whether Active Co or assive Co paid a dividend to. Consider whether this result is consistent with the purpose of the intercompany transaction rules as expressed in Reg (a): The purpose of this section is to provide rules to clearly reflect the taxable income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or consolidated tax liability). 24

9 Claiming a Worthless tock Loss for a Continuing ubsidiary 25 Timing of Loss Outside consolidation, a worthless stock deduction must be claimed (if at all) in the taxable year of worthlessness. In consolidation, Reg (c) delays the deductions until the earlier of the time: All of s assets are treated as disposed of, abandoned, or destroyed.* Other than for consideration (other than relief from debt). A debt of is discharged and has excluded black hole cancellation ofdebt income.* has an intercompany payable for which the member creditor claims a bad debt deduction and does not have a matching amount of income.* for any reason ceases to be a member of the group. Current focus is the first and last event. * ee Reg (c)(1)(iii) 26 elf Help Triggering of Loss Conversion of to LLC Common tock I/C Debt Third arty Debt Rev. Rul (ituation 2). ee also H.G. Hill tores, 44 B.T.A (1941); Rev. Rul ; Ltr. Rul (Oct. 28, 2009) is insolvent. converts into a limited liability company (disregarded entity). Ruled: When an election is made to change the classification of an insolvent entity from a corporation to a disregarded entity, the shareholder of such entity is allowed a worthless stock loss. is treated as transferring its assets in satisfaction of any intercompany debt owed to, and subject to any debt owed to others. In effect, an intercompany sale of the assets (in which the gain or loss is recognized upon the liquidation of ). 27

10 Amount of Loss The loss is determined after taking into account all applicable investment adjustment (and the anti circularity rules of Reg ), and after applying the unified loss rules of Reg : ubsection (b) which generally evens out share basis should not be applicable, since all the stock held by all members of the group is being treated as disposed of by reason of the worthless stock loss ubsection (c) which generally disallows any non economic stock loss is a key provision: Reduces stock basis by the lesser of the stock s net positive adjustments and the stock s disconformity amount. ubsection (d) which generally reduces the internal tax attributes of a subsidiary and any lower tier subsidiaries to avoid loss duplication is not particularly relevant where the insolvent subsidiary s assets are treated as transferred in a taxable transfer to the parent member, but can still have relevance where the insolvent subsidiary itself has consolidated subsidiaries that remain in the group. 28 Effect of Worthlessness on Lower Tier Members Reduction of inside tax attributes? If the stock of the lower tier member is transferred intercompany at a loss, 36 would apply at such time since no longer exists and there is no tax successor. ee Reg (e)(3). Thus, any lower tier member may be required to write down its duplicated loss amounts (including possibly tax basis) under 36(d). This may require a balancing of the amount of worthless stock loss desired and the amount of inside tax attributes. Under 36(d)(6), the common parent can elect to forgo all or a portion of the stock loss so as to preserve the inside tax attributes. ection 382 ownership change? Under ection 382(g)(4)(D), a worthless stock deduction by a 50% shareholder can create an ownership change of the corporation if the stock is still held at year end. Query, whether this could create an ownership change of a lower tier member? resumably not, since the general focus of Reg et. seq governing the application of ection 382 to a consolidated group is on changes in the ownership of parent stock, and 96(b) only provides two narrow exceptions for an ownership change of a continuing lower tier member. 29 otential Tax Free Reorganization Common tock referred tock I/C Debt Third arty Debt ee ection 332(b)(2); paulding Bakeries, 27 T.C. 684 (1957), aff d, 252 F.2d 693 (2d Cir. 1958); H.K. orter, 87 T.C. 689 (1986). Contrast Rev. Rul , with former rop. Reg (e), Ex. 2 (allows). Also consider Rev. Rul is solvent relative to its debt, but has insufficient assets to cover its preferred stock. merges into a limited liability company (disregarded entity). The deemed is liquidation is not a good ection 332 liquidation since there was not a distribution of property in respect of each class of stock. However, the merger should qualify as a good A reorganization, due to the value of the preferred stock. Although reasonably should generally be allowed a worthless stock loss with respect to its common stock (for which no consideration was received), query whether the loss continues to be delayed since is a ection 381 successor to? 30

11 Continued Deferral After Tax Free Reorganization? Reg (c) does not have its own successor rule, and as required by Reg (c), the insolvent subsidiary is itself no longer a member. Cf. Reg (f); Reg (f). However, Reg (d)(7) provides for the extinguishment of inside NOL carryforwards, etc., where a worthless stock loss is recognized and the worthless subsidiary continues to be a member. An example to the 36 regulation views 80(c) as subject to a ection 381 successor rule. Reg (d)(7)(iii) Ex. (iii). ee TAM ( examples incorporated into Treasury Regulations are generally considered illustrative only and are not considered as dispositive ). Alternatively, can Reg be applied to effectively delay or disallow the worthless stock loss, based on single entity principles or broader successor rules (which apply as the context may require )? ee 13(j). 31 Comparative Implications If worthless stock loss is deferred: Any impact under Reg would await such time as the loss is allowed. Because merged into, this would be at such time as is no longer a member of the group. If in fact is the common parent, this may be a very long time. resumably, some form of tracing of s assets would be required to properly apply 36 at such later time. If worthless stock loss is not deferred: Would the attribute redetermination rule under Reg (c)(6)(i) apply to render the loss nondeductible? resumably not, since to do so would distort (rather than clearly reflect) the income and loss of the group. But consider 13(f)(7)(i) Ex. 5(d) (loss on intercompany transfer of parent hook stock rendered nondeductible under attribute redetermination rule). Reg would apply currently. Accordingly, in the event of a duplicated loss under 36(d), may be required to reduce its inside tax attributes immediately prior to the merger, absent an election by the common parent to forgo all or a portion of the stock loss so as to preserve the inside tax attributes. 32 Other tock Loss Considerations Tax haring Agreement? If there is a worthless stock deduction that offsets income within the group, does the parent who claims the deduction receive any compensation? Does it matter whether the parent company is a pure holding company, such that the parent could not have benefited from the loss on its own? rudential Lines and its progeny: Is in bankruptcy? Decided prior to Reg (c), and prior to 36 and its predecessor 20, the rudential Lines case involves a common parent s intent to claim a worthless stock deduction with respect to a consolidated subsidiary in bankruptcy. In re rudential Lines, Inc., 928 F.2d 565 (2d Cir. 1991), cert. denied. econd Circuit held that such action would violate the automatic stay in bankruptcy, as an action to assert control over property of the subsidiary in bankruptcy (i.e., its NOLs, since the worthless stock loss would cause a ection 382 ownership change of the subsidiary), and enjoined any worthless stock loss from being claimed for any taxable year ending prior to the effective date of a chapter 11 plan of the subsidiary. Under such line of authority, generally would be precluded from taking any voluntary action to accelerate a worthless stock loss that is otherwise deferred under 80(c) if doing so could adversely affect the tax attributes of. ee also In re Triad Guaranty, Inc., 2016 U.. Dist. LEXI (D. Del. 2016). 33

12 lanning for External Worthless tock Loss (assets leave the group) 34 External lanning Base Case C $0b value $1b basis C $1b 3 B $2b (worthless) 2 (worthless) $1b 1 $1b value $0b basis Facts: and are members of a consolidated group. has a $1b basis in the stock of. No investment basis adjustments are reflected in s basis in. owes $2b to a creditor. sells all of its assets ($1b value / $0b basis) to unrelated B for $1b in cash. transfers the proceeds to its creditor, C. dissolves for corporate legal purposes. receives zero distributions from in liquidation of. Result: seeks to offset the gain on the sale of s assets with a worthless stock deduction with respect to the stock of. recognizes $1b of gain on the transfer of its assets to B. increases its basis in the stock by $1b. recognizes an ordinary worthless stock deduction with respect to the stock of upon the liquidation of. ee Rev. Rul ; (c). s basis in is reduced by $1b under Reg (c) prior to the liquidation. s worthless stock deduction is $1b. has $1b of COD income that may be excluded under ection 108. B obtains a fair market value basis in the without an incremental tax cost to as a result of s 35 worthless stock deduction. External lanning Complex Example C Holdco 1 C Holdco ub LLC B C Holdco B $6b B= $2b Newco ub LLC $4b 4 Newco 5 Merge 6 Merger ub $2b ub LLC Newco 2 V = $4b B = $0b ub LLC V = $1b B = $0b ub LLC $4b Target 3 A ub Other A ub Target Other Target Other Target Facts: Holdco wants to dispose of Target. B will not assume liabilities. Holdco cannot assume liabilities due to the terms of ub LLC s debt. Holdco forms Newco, contributes the membership interests of ub LLC, and elects to change ub LLC s entity classification from a corporation to a disregarded entity. ub LLC transfers the Target to A ub in exchange for $4b cash, and transfers the proceeds to its creditor, C. Newco transfers the membership interests of ub LLC to Holdco. Merger ub merges into Newco with Newco surviving. In the merger, Holdco s shares of Newco are cancelled for no consideration and B s Merger ub shares convert to shares of Newco. Result: The intent is that B acquired newly issued Newco stock from Newco for $4b cash, Newco made a $4b payment to C, and Holdco acquired Newco s remaining assets in exchange for the assumption of Newco s remaining liability. The deemed cancellation of the old Newco stock would give rise to a worthless stock deduction, which would offset $2b of gain recognized on the transfer of the Other to Holdco. 36

13 Certain Tax Reform Highlights 37 NOL Carryovers For losses arising in taxable years beginning after December 31, 2017, limit NOL deduction to 80% of taxable income. For NOLs arising in taxable years ending after December 31, 2017 Eliminate carryback Generally provide indefinite carryover rior NOLs still subject to 20 year carryforward period but may be used to offset 100% of taxable income. 38 Business Interest Limitation ection 382 amended to treat carryover of disallowed interest under amended ection 163(j) as a triggering event for loss corporation status and as a pre change loss. More companies will now care about ection 382 (and ection 163(j)). Amendments to ection 382 and 163(j) apply for tax years beginning after December 31,

14 Business Interest Limitation Considerations resumably, old ection 163(j) suspended interest deductions can still be carried forward. Are such amounts similarly treated as a re Change Loss? If so, a corporation may retroactively be considered a loss corporation as a result of disallowed interest under old ection 163(j)(2) carried forward into Is it possible that prior disallowed interest becomes limited with respect to an ownership change that occurred before 1/1/2018? Interest carryover is not an attribute subject to reduction under ection 108(b) with respect to excluded COD income. What about ordering for purposes of ection 382, or allocation of the disallowed interest among consolidated group members? 40 Disclaimer This presentation [and related panel discussion] contains general information only and the respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation. 41