Inside This Issue. Important Modifications to Rules Governing Cancellation of Debt in a Consolidated Group

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1 GCD Gardner Carton & Douglas Tax Update March 2004 Issue Executive Overview Insights and Frequently Overlooked Items Arising From Purchase Price Allocations in an Asset Purchase Many more acquisitions of businesses occur in the form of asset purchases, as opposed to stock purchases. This structure presents many opportunities and pitfalls when it comes time to allocate the purchase price for the assets over the various types of assets acquired in the acquisition. This article focuses on some of the often overlooked allocation opportunities and the hidden tax liabilities that are important to understand when a deal is being negotiated and priced. Many times, if these issues are not addressed prior to closing, the opportunities are lost. To receive future editions, please complete and return the form on the back page. Insights and Frequently Overlooked Items Arising From Purchase Price Allocations in an Asset Purchase by Annette M. Ahlers and Todd Reinstein Many corporate buyers prefer purchasing the assets (as opposed to stock) of a corporation for several reasons, including the sense that the buyer may have more control over which of the target s assets it acquires directly and the ability to exclude pre-acquisition liabilities that may attach to the corporate entity. Another important reason for engaging in an asset purchase is for the income tax benefits that may arise from obtaining a cost basis and the associated increased depreciation and amortization for years going forward. Unlike buyers, corporate sellers may generally prefer stock sales so that they can be relieved of certain liabilities associated with the unwanted line of business (including those not readily identifiable or valued at the time of the transaction) and incur only one level of tax at the shareholder level. Section 338 of the Code provides some relief to reconcile these divergent motivations by allowing taxpayers that enter into a stock sale to file an election to treat a stock sale transaction as an asset sale for tax purposes. Section 338 provides several choices for buyers and sellers in determining how they want to be taxed in a purchase situation. For example, a basic Section 338(a) election is made by the buyer only and results in stock sale treatment to the seller. The buyer will be responsible for any income tax due as a result of the deemed sale of all of old target s assets to new target. The buyer will then receive a step-up in the tax basis of the target company s assets. For domestic purchases, continues on page 2 Inside This Issue Important Modifications to Rules Governing Cancellation of Debt in a Consolidated Group The IRS and Treasury recently published regulations intending to clarify the timing and overall impact of the recognition of excluded COD in a consolidated return setting. These rules generally require an approach that is somewhat of a hybrid between separate company treatment and group treatment. For those companies acquiring assets or stock out of a bankrupt group, or for those that are themselves undergoing a restructuring, these changes have an immediate impact.

2 2 Gardner Carton & Douglas LLP Insights and Frequently Overlooked Items continued from page 1 this is not a favored approach because of the tax cost on the transaction date. A more typical use of Section 338, is the Section 338(h)(10) election. This election is made jointly by both the buyer and the seller and can only be applied to a target corporation that is either an S corporation for federal income tax purposes, or a target corporation whose stock is held by a controlling (80%) shareholder. If a Section 338(h)(10) election is made, the target corporation is treated as having sold all of its assets at the close of the acquisition date at fair market value in a single transaction, and a new target corporation is deemed to purchase all the assets on the day after the acquisition date. Once the buyer and seller agree to file the election, the seller will recognize the gain or loss on target s assets on its consolidated income tax return with no recognition of the gain or loss on the sale of the target stock. If the target is a member of a consolidated group of corporations which has net operating losses, tax credits, and other tax benefits available for use, the gain on the deemed asset sale may be partially or totally offset by these available tax attributes because the deemed sale is treated as occurring while the target corporation is still owned by the selling parent corporation. To qualify for the election, the corporate acquirer must purchase at least 80% (based on vote and value) of the target stock within a 12 month acquisition period. The buyer and seller must both sign Form 8023 agreeing to the election and the allocation of the purchase price. The form must be filed no later that the fifteenth day of the ninth month, beginning after the month in which the acquisition date occurs. This is very important because these election deadlines do not normally coincide with a normal tax return due date, and as a result can be easily overlooked. The mechanics involved in treating a stock sale as a deemed asset acquisition or just an outright purchase of the desired assets, are generally identical. The buyer s basis in the assets acquired is equal to its aggregate cost of purchasing such assets including any liabilities assumed as part of the transaction. The allocation of purchase price among the acquired assets for purposes of determining the assets new tax basis in the hands of the buyer is accomplished by allocating the aggregate purchase price in proportion to their relative fair market values. This allocation is made in accordance with the seven-class residual allocation method. For Section 338(h)(10) elections, the buyer and the seller must each report the allocation on Form 8883 (or Form 8594 in the case of an actual asset sale) which is filed with the federal income tax return in the year that the purchase is taken into account. Although the mechanics of the election seem pretty straightforward, many nuisances are frequently overlooked and if planned for, could create tax benefits or minimize tax surprises. While many of these positions are highly factual and require a thorough analysis, we have provided a short list of some of the more interesting items: Non-Traditional Assets; Contingent Liabilities (including Employee Benefits); Treatment of Deferred Revenue, Possible Termination of a Partnership; Opportunities to Elect New Accounting Methods, and Potential Estimated Tax Payment Relief. Non-Traditional Assets Intercompany obligations that are not extinguished When a business is sold through an asset purchase it is possible for intercompany items to still exist among the members of the group of purchased companies. A portion of the purchase price may need to be allocated to these types of Class V assets. In the context of a bargain sale (one where the value of the tangible assets are greater than the purchase price), this could create low tax basis receivables that could result in gain being recognized when and if, these receivables are repaid. Allocation to an overfunded defined benefit plan after the purchase If one of the assets acquired as part of the purchase of a business is a defined benefit plan, and that plan is overfunded, a portion of the purchase price might be properly allocable to the overfunded portion of the plan as a Class V asset. A buyer may be able to recover the basis of this asset equal to the amount by which the overfunded portion of the pension plan has been reduced by the amount of the annual pension expense accrued. Contingent Liabilities Current deduction for certain contingent claims instead of capitalizing them as part of the purchase price - Certain contingent liabilities that are included in the purchase price for financial accounting purposes may not actually be considered assumed liabilities under the tax laws, but are rather liabilities that arise out of the transaction and could lead to current deductions or allocations to the underlying assets.

3 Tax Update For tax purposes, a liability is arguably assumed by the buyer when the events most crucial to the creation of the obligation occur prior to the acquisition. If the events most crucial to the creation of the obligation occur after the transaction closes, the liability might not be included in the purchase price but might be more properly taken into account by the buying group. For example, there is a position that severance costs triggered by the acquisition but paid after the transaction closing date should not be part of the purchase price but are deductible by the buyer (now the employer of these employees) in the year the severance is paid. Deferred revenue related to the assumption of pre-existing contracts - Assumption of a seller s deferred revenue that arises from pre-existing contracts can have tax implications to the seller and to the buyer. Sellers will generally have to recognize additional gain and receive an offsetting deduction since the buyer assumed the liability. The theory behind this result is that the seller, by transferring the obligation to the purchaser, forgoes receipt of consideration for the assumption of the liability. Because this gain may be characterized as capital and the deduction as ordinary, the corporate seller is tax neutral unless it has any unused capital loss carryfowards that can be utilized. With respect to the buyer s tax impact, a buyer will generally recognize revenue and deduct expenses to perform the services as required, under the terms of the assumed pre-paid contracts, without receiving any cash. Buyers negotiating the purchase price of a business with a significant amount of pre-paid items should consider any significant future tax liability that will arise once goods or services are delivered following the acquisition and these pre-paid amounts are converted into revenue. Vacation pay accrual - The Internal Revenue Code permits a corporate deduction for deferred compensation (such as vacation pay) in the year it is actually paid, unless it is paid within two and half months from the close of the relevant tax year. An issue arises when a vacation pay accrual is assumed by a buyer as part of an asset purchase and paid by the buyer at closing. Generally, a buyer is not entitled to a deduction for the cost of paying the seller s vacation pay obligation that is assumed in an asset acquisition because the liability assumed is added to the basis of the acquired assets (it is considered to be a cost of acquiring the assets). Since the rule requires the vacation accrual to be paid in order to receive a deduction, the seller may want to consider establishing some type of escrow arrangement in lieu of a cash payment at closing that will allow the buyer to pay the expense in future years, thus potentially preserving the deduction. Real estate transfer and other asset specific costs - In the context of an asset acquisition, certain liabilities must be taken into account directly with respect to a particular asset rather than being allocated over the entire transaction. For example, real estate transfer costs or security interest perfection costs should be taken into account directly. Thus, if the seller is required to pay a transfer tax on the conveyance of real estate, and the buyer pays this tax, the seller must determine its gain or loss on the sale of this real estate by taking into account the transfer tax. Correspondingly, if the buyer pays the tax, it increases the buyer s tax basis in the real estate asset. Accounting Methods/Procedural Issues Termination of partnership status - If a corporation owns fifty percent or more of a partnership and a Section 338(h)(10) election is made in connection with the purchase of that corporation, the IRS has previously taken the position that the partnership is terminated. If the termination occurs, the newly formed partnership would retain its employer identification number and might be able to make new elections regarding its accounting methods and other matters without the consent of the IRS. Ability to adopt new methods for the purchased business - A corporate buyer that makes a Section 338(h)(10) election can often adopt a new taxable year and methods of accounting without obtaining IRS approval. However, new target keeps the same employer identification number and, thus, may not have to start the wage base over for FICA and FUTA purposes. Certain relief from estimated tax payments - For estimated tax purposes, a corporation is required to make quarterly estimated income tax installment payments. Unless certain elections are made, a corporation generally must make an installment payment equal to 25% of the required annual payment. Section 6655 imposes a penalty on corporations that do not satisfy this requirement. Section 338(h)(13) saves the day by stating that Section 6655 will not be taken into account for sales in which a Section 338 election is made. Thus, sellers may have a position that the gain from a deemed asset 3

4 4 Gardner Carton & Douglas LLP sale should not be taken into account for estimated tax purposes but can pay the tax, if any, on the due date for their tax return. In preparing this article, we have highlighted certain positions that have been taken by other taxpayers facing these issues. These determinations are highly fact driven and therefore, no assurance can be made that a similar result will apply under a particular taxpayer s facts. For your reference we have listed some of the more significant authorities that we drew from to prepare this article: IRC 404(a)(11) & 1012, Treas. Reg (b)(1)(ii); (b)(2)(iii)(A); (c)(3); & T(c)(1), 1998 FSA Lexis 372 (1998); TAM (1997); & TAM (1997), and James M. Pierce Corp. v. Comm, (326 F2d 67 (1964). GCD s Perspective Some of the finer details involved with an asset purchase or deemed asset purchase can have a major tax impact on both buyers and sellers with regard to the timing and amount of tax liability that will arise out of the transaction. As a result, both parties should consider these opportunities prior to the close of the transaction. Important Modifications to Rules Governing Cancellation of Debt in a Consolidated Group by Annette M. Ahlers and Kristin B. Jones Background Until recently, it was unclear whether a member of a consolidated group that realized cancellation of indebtedness ( COD ) income that is excluded from gross income (either because the member is in a Title 11 proceeding ( the bankruptcy exception ) or is insolvent ( the insolvency exception ) would be required to reduce its separate tax attributes by the excluded COD income, including reduction of the tax basis of lower tier subsidiaries, or whether the attributes of the entire consolidated group would be reduced by such income. For this purpose, tax attributes include, net operating losses, capital losses, tax credits, etc. 1 On August 29, 2003 Treasury issued Treas. Reg T to clarify that the ordering of attribute reduction after an excluded COD event should be as follows: (1) The tax attributes of the separate debtor member; (2) The tax attributes of the subsidiaries of the separate debtor member; and finally (3) The tax attributes of all other members of the consolidated group on a pro-rata basis. On March 12, 2004 Treasury issued temporary and final regulations that amend Treas. Reg T, Treas. Reg (g)(3)(ii)(B), and Prop. Treas. Reg (c). These regulations were issued largely in response to three specific problems that the existing regulations did not address (1) Section 1245 recapture, (2) matching of intercompany obligations, and (3) stock basis adjustments with respect to the timing of triggering an excess loss account ( ELA ). Disposition of Subsidiary Stock After Basis Reduction The problem arose once the debtor member reduced its stock basis in a subsidiary because of attribute reduction after a COD event. After this, the consolidated group could potentially be taxed more than once on Section 1245 recapture income when the stock or assets of the subsidiary are subsequently disposed of by the parent. Thus, in this context, the debtor member would be required to recapture ordinary income on the sale of subsidiary stock and even if the stock or assets of the subsidiary are not sold or disposed of, this lookthrough rule also required the subsidiary to reduce its tax attributes by the amount of COD income deemed realized when its parent, the debtor member, reduced its stock basis after attribute reduction for excluded COD. See Treas. Reg Thus, if in a subsequent year, the subsidiary distributed its assets to its parent in a Section 332 liquidation or in another disposition event, Section 1245 could apply a second time with regard to the value of the assets. The new regulations were intended to change this result. While the look-through rule remains in the amended regulation, the application of Section 1245 appears to be narrower. Now, Section 1245 recapture only comes into play to the extent the debtor member s stock basis reduction exceeds the total amount of the tax attributes attributable to the subsidiary. Thus, Treas. Reg T(b)(4), (b)(5), and (b)(6) (e.g., the

5 Tax Update three amended provisions) now apply to exclude COD income that is cancelled after August 29, 2003, provided the cancellation occurs during a taxable year for which the return is due after March 12, However, taxpayers may apply the regulation to COD cancelled after August 29, 2003 and during a taxable year for which the return is due on or before March 12, Full Repayment of Intercompany Obligations After Attribute Reduction The new regulations also address matching rules with respect to intercompany obligations. In general, the redetermination rule of Treas. Reg (c)(6)(i), requires a matching of corresponding intercompany items of income and loss, such that if an item is excluded from gross income of one particular member, it is therefore nondeductible for the other participating member. Thus, an issue was presented as to whether the redetermination rule also applied where the debtor member reduced its basis in an intercompany obligation, and later received payment in excess of its basis in the intercompany obligation. Specifically, would the member s income be redetermined to be excluded from gross income? Apparently, not. Treas. Reg T(g)(3)(ii)(B) provides that the basis reduction in an intercompany obligation is not a realization event for purposes of the redetermination rule. Therefore, the member s income cannot be excluded from gross income upon payment of the receivable. This result stems from the desire to not create a double benefit from both the exclusion of COD from gross income that is taken into account through attribute reduction, and then excluding the income from repayment over and above the redetermined tax basis in the somewhat unusual circumstance where the debtor member actually fully repays the intercompany obligation. Treas. Reg T(g)(3)(ii)(B) applies to transactions that occur during a taxable year for which the tax return is due after March 12, Timing of Inclusion of Taxable Income in Year Parent Disposes of Subsidiary Stock in Which it has Negative Basis Where a parent disposes of stock of a subsidiary in which it has an ELA (negative tax basis) and in the same year the subsidiary realizes excluded COD income, when must parent take the ELA into income? This particular question arose because under the existing regulations, the timing of parent s inclusion of the ELA in income and the reduction of the stock basis due to the subsidiary s excluded COD income are not compatible. The parent would take the ELA into income in the same year that its subsidiary realized the excluded COD income, i.e., the year of disposition. However, the reduction of the subsidiary s tax attributes would not occur until the year after such income is realized. The rule persisted for several years despite concerns that this result could cause certain circular adjustments - the parent could end up including more ELA in income because income that would otherwise be offset by losses subject to attribute reduction is not offset until the subsequent year. To resolve this issue, the final regulations now require the inclusion of an ELA in the year of the COD event. Treas. Reg T(b)(6) applies to transactions that occur during a taxable year for which the tax return is due after March 12, For rules detailing the calculation of stock basis in these situations and others, Treasury has issued Prop. Treas. Reg , which is discussed below. Proposed Calculation Procedures for Stock Basis Adjustments Where Excluded COD Income is Realized in Same Year That a Member s Stock is Disposed The proposed regulations set forth a nine-step methodology which applies in two situations: (1) where a departing subsidiary member realizes excluded COD income, and (2) where a member other than the departing subsidiary realizes excluded COD income. 3 The purpose of the methodology is to avoid certain circular adjustments that occurred when a parent corporation disposed of a subsidiary in which it had a negative basis, and the corresponding attribute reduction did not occur until the year after the excluded COD income was realized and parent included the ELA in gross income. In summary, the proposed regulations first require a series of tentative calculations with regard to stock basis and consolidated taxable income without regard to attribute reduction, followed by a final calculation which imposes limitations on tax attribute reduction in computing the final stock basis adjustment and consolidated taxable income. The effective date of Prop. Treas. Reg (c) is the date such regulations are published as final or temporary regulations. GCD s Perspective Any consolidated group that recently completed a debt workout or bankruptcy restructuring, or expects to do so in the near future, should consider the potential implications of these regulations. Some consolidated groups may possess significant tax attributes at the 5

6 6 Gardner Carton & Douglas LLP lower-tier subsidiary levels, and debt at the highertier parent level, and will therefore, need to know how these rules apply. For example, many of the issues addressed by these regulations require detailed documentation of subsidiary tax basis, built-in gains or built-in losses, and location and treatment of both intercompany and third-party indebtedness. As a result, the full impact of the amendments to these regulations cannot be determined until such calculations are prepared and factual histories are analyzed. We suggest working with a tax advisor early in the restructuring process. 1 See IRC Section 108(b)(2) for listing of tax attributes and the ordering of tax attributes that are subject to reduction where excluded COD income is realized. In general, the survival of tax attributes after a debt restructuring can be an important factor in the viability of the reorganized entity going forward. The ability to offset income with these surviving losses can often give the reorganized enterprise the jump start that it needs to be successful on a goingforward basis. 2 See also Treas. Reg T(b)(5) cross reference to Treas. Reg T(g)(3)(ii)(B)(3) with respect to rules regarding reduction of basis for intercompany obligations. 3 See Prop. Treas. Reg (c). With regard to the latter scenario, the concern appears to be that to the extent the reduction in tax attributes caused a decrease in the basis of the stock of the departing subsidiary, parent s gain on the stock sale would increase. As a consequence, there would be fewer tax attributes available for reduction if most are absorbed by parent. To avoid this problem, the proposed regulations limit the reduction of tax attributes in this context. To learn how Gardner Carton & Douglas Corporate Tax Group can assist you, please contact Homeira Ghorbani, Director of Tax Service Business Development, at or send to hghorbani@dc.gcd.com. If you have any questions about the implications of these topics, please contact any member of our Corporate Tax Department. Please Return This Form by , Facsimile or Mail to: Gardner Carton & Douglas LLP 1301 K Street, N.W., Suite 900, East Tower Washington, D.C (202) Telephone (202) Facsimile hghorbani@dc.gcd.com Attn: Homeira Ghorbani Name Title Company Address Phone Fax Corporate Tax Attorneys Annette M. Ahlers aahlers@gcd.com Dennis J. Carlin dcarlin@gcd.com Glenn E. Ferencz gferencz@gcd.com Jeffrey M. Friedman jfriedman@gcd.com Kristin B. Jones kjones@gcd.com Karen Brown McAfee kmcafee@gcd.com Francisca N. Mordi fmordi@gcd.com Kathleen M. Nilles knilles@gcd.com Todd B. Reinstein treinstein@gcd.com T.J. Sullivan tsullivan@gcd.com To Receive Future Issues To add a name to our mailing list, or to correct or update information, please complete and return the form below. Gardner Carton & Douglas is a Limited Liability Partnership This client memorandum is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here. 191 N. Wacker Drive Suite 3700 Chicago, IL K Street, N.W. Suite 900, E. Tower Washington, D.C