Consolidated Return Issues for Buyers and Sellers in M&A Transactions Michael L. Schler In this outline, P represents the parent in the target consolidated group; S is the subsidiary in the target consolidated group; Buyer is an unrelated buyer of P or S filing a consolidated return. All regulation section references are to Treas. Reg. 1.1502 unless otherwise indicated. No section 338 or section 338(h)(10) election is made unless otherwise indicated. E&P refers to earnings and profits; NOL, to net operating loss; NUBIL, to net unrealized built-in loss; OFL, to overall foreign loss; and SRLY, to separate return limitation year. A. Issues for P Selling Stock of S 1. Determining basis in S. It may be difficult for P to determine the basis in its S stock, to determine gain or loss on the sale. Consolidated return basis adjustments must be made for the entire period of P s ownership of the S stock in the consolidated group. -32. The rules of the existing regulations must generally be applied, even for periods before those regulations became effective. -32(h). Although annual basis adjustments are supposed to be recorded, -32(g), this is often not done in practice. 2. Excess loss account in S. P may have an excess loss account (negative basis) in the S stock. -19(a)(2). This will be triggered on the sale. -19(b)(1). As a result, taxable gain could exceed the entire sales price. Michael L. Schler is a partner in the New York office of Cravath, Swaine & Moore. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA. Call 1-800-CLE-NEWS and ask for Customer Service. Have the order number of the materials CH024 handy. 15
16 ALI-ABA Business Law Course Materials Journal February 2003 3. Post-closing audit adjustments for pre-closing period. Post-closing audit adjustments for the pre-closing period of S can retroactively increase or decrease P s basis in S. For example, such adjustments might affect S s pre-closing taxable income, as well as S s pre-closing accruals of federal or state tax liability. 4. Post-closing indemnity payments between P and Buyer. Indemnity payments between P and Buyer can also affect P s gain or loss on the sale. Payments by P to Buyer would probably be viewed as a reduction in P s sale price of S. If P has indemnified S against certain liabilities, payments to S might equivalently be viewed as a contribution by P to the capital of S, thereby increasing P s basis in S. a. See FSA 199942025. P indemnifies S and Buyer for S s environmental liabilities. S later incurs costs and P reimburses S. Held, S is entitled to deduct its expenses, and P is treated as making a capital contribution to S. b. Likewise, see FSA 200147013. When P indemnifies S against certain claims, P s expenses in administering the claims (as well as the indemnity payments themselves) are capital expenses. 5. P gain can be offset by losses of other subsidiaries. If P has a gain on the sale of the stock, losses of P or other group members (other than S) can be used to offset the gain, subject to the usual limitations if the losses are SRLY. If losses of a subsidiary (call it L) are used to offset P gain, P s basis in L is reduced accordingly. -32(b)(3)(i). As a result, P has a corresponding increase in gain on a subsequent sale of the L stock. L s losses are wasted in this situation if P promptly sells the L stock. Losses of S itself are discussed separately below. 6. P loss on the stock sale. All or part of P s loss on the stock sale may be disallowed if (1) P had previously purchased the stock of S, and (2) S had subsequently sold assets at a gain that included built-in gain from the time P acquired S. In that case, the built-in gain is already reflected in P s stock basis in S, but S s taxable gain on the asset sale increases P s stock basis by the amount of the gain. P s loss on the stock sale is disallowed to the extent of this doubling up of basis. Temp. Treas. Reg. 1.337(d)-2T. a. This rule is designed to prevent son of mirror transactions. Without this rule, if S had low-basis assets, P could buy the stock of S, then S would sell the assets at a taxable gain, and then P would sell the S stock at a corresponding loss. The loss on the stock would exactly offset the gain on the assets. The assets would receive a stepped-up basis with no net taxable
Consolidated Return Issues 17 gain in the P/S group. The regulation is designed to prevent this result. For prior rules disallowing losses to P, see A(15) below. 7. Triggering deferred gains. In the past, S may have bought an asset from another group member, sold an asset to another group member, or distributed an appreciated asset to P. These transactions (among others) could have created deferred gain within the group. -13(c). The sale of the S stock would trigger this deferred gain. -13(d). If S had been the buyer of assets, the gain would be in another group member and would be an additional tax cost of the sale of S. If S had been the seller of assets, the gain would be in S. Gain triggered in S would increase P s basis in the S stock under -32. This would reduce P s gain on the sale, or create a loss on the sale, and thus might have no net tax cost. However, if the gain on the asset creates a loss on the stock sale, (1) a capital loss on the stock sale might not be usable if the gain on the asset is ordinary, and (2) the loss on the stock sale might not be allowed as discussed in A(6) if P had previously purchased the stock of S and the gain on the asset was builtin gain at that time. a. Although much less common, dual consolidated losses of S under section 1503 may also be recaptured by the P group. Treas. Reg. 1.1503-2(g)(2)(iii); FSA 199949030. 8. Removing assets from S before selling S. If P desires to take some assets out of S before selling the S stock, the dividend of those assets will create deferred gain under -13(c) that will be triggered on the sale of the S stock. P s basis in S is increased by the gain triggered, but reduced by the amount of the dividend. -32. As a result, all appreciation in the S stock, including that attributable to the distributed assets, will be recognized by P, some directly on the sale of the S stock and the remainder on the triggering of the asset gain. Moreover, if the gain to S on the distributed assets exceeds the overall appreciation in the S stock, the considerations in A(7) would apply. 9. Post-closing transactions on sale date. S remains a member of the P group until the end of the day of the sale. -76(b)(1)(ii)(A). Under this rule, actions by Buyer after the purchase of S, but on the day of the purchase, could be attributed to the P group. a. For example, Buyer could have S sell assets to third parties, and the resulting gain could be on the P group. This result is generally avoided by -76(b)(1)(ii)(B). This provision treats post-closing transactions on the closing day as occurring on the next day if properly allocable to the post-
18 ALI-ABA Business Law Course Materials Journal February 2003 closing portion of the closing day. Thus, actions of Buyer after the actual closing, but on the closing date, will not affect the P return. b. If Buyer unilaterally makes a section 338 election for S, there is a deemed sale of S s assets to New S at the close of the sale date. The resulting gain does not appear on the P consolidated return, but rather is on a separate return of S and thus becomes the responsibility of Buyer. Treas. Reg. 1.338-10(a)(2)(i). On the other hand, the general rule under the latter regulation is that the entire sale date before the deemed sale, including the portion after the actual closing, is included in the P consolidated return. However, if a post-closing transaction occurs on the sale date outside the ordinary course of business, it is automatically deemed to occur on the next day, outside P s return. Treas. Reg. 1.338-1(d). As a result, actions of Buyer outside the ordinary course of business after the actual stock sale and before the deemed sale of assets will not affect the P return. 10. Allocating income between short periods. Because the taxable year of S ends at the end of the closing day for the purchase, income and deduction must be allocated between the pre-closing and post-closing periods. The general rule would be a closing of the books, as at the end of any other taxable year. However, Buyer and P can jointly elect to have all nonextraordinary items of S allocated between the two taxable periods under a ratable allocation method. -76(b)(2)(ii). This election is only available if Buyer and P have the same taxable year. This election is not commonly made in practice, generally because Buyer and P do not want their own tax items affected by activities of the other party. See TAM 199950005, holding that a retail store s high fourthquarter sales are not an extraordinary item, and so the election would apply to such sales, even though the result was to shift some of those post-acquisition sales into the pre-closing taxable year. 11. Carrybacks of post-closing losses. If S has ordinary losses in its first two post-sale tax years that cannot be used currently by the Buyer group, the losses are carried back by S to S s taxable years while it was in the P group. -21(b)(2)(i). The losses so carried back can only be used to the extent of S s own income while it was in the P group. These carrybacks may exceed S s own income during the carryback period. -21(c)(1)(i), (c)(1)(iii) Example 3, (h)(2), (h)(3). The same rules would apply to capital losses recognized by S during the first three postsale tax periods. -22(b)(3), (c). These carrybacks would require P to file amended returns and are generally undesirable to P.
Consolidated Return Issues 19 a. P can request Buyer to agree to elect not to carry back ordinary losses of S into the P group, -21(b)(3). Unlike former -21T(b)(3), the current regulation permits Buyer to limit the waiver of carrybacks only to losses of S (and any other subsidiaries Buyer acquired from the P group), rather than requiring the waiver to apply to losses of all members of the Buyer group. In any event, no such election applies to capital losses. b. The Job Creation and Worker Assistance Act of 2002 amended Internal Revenue Code section 172 to allow an elective five-year (rather than twoyear) carryback of operating losses arising in taxable years ending in 2001 and 2002. Under -21T, adopted May 2002, if Buyer had not previously elected to give up the carryback of S losses, and S has losses in 2001 and/or 2002, Buyer can make a new election: i. Not to carry back any such S losses into the P group; or ii. Not to carry back such losses for more than two taxable years to the extent the earlier carryback years are in the P group. 12. Intercompany debt between P and S. Normally any intercompany debt between P and S would be canceled before P sells S. If any such debt remains outstanding following the stock sale, immediately before the sale it will be treated as being redeemed for cash equal to its fair market value, with a matching of the character of any resulting taxable income or loss. Any gain or loss in S would affect P s basis in the S stock and thus P s gain or loss on the sale. Immediately after the stock purchase, the debt would then be treated as reissued for the same amount, -13(g)(3)(iii), which could create premium or original issue discount to P on the debt that continues to be issued or held by it. -13(g)(3), -13(g)(5) Ex. 2(d),(e), proposed -13(g)(3). 13. Loss carryovers in S. Any loss carryovers of the P group allocable to S will follow S out of the P group and will no longer be available to offset future income of the P group. -21(b)(2)(i), -22(b)(3). Certain exceptions to this rule are discussed below. 14. S losses can t offset P gain but can offset other P group income for year of sale. Current or carryover losses of S cannot be used to offset P s gain on the S stock. -11(b). This is actually a pro-taxpayer rule, because such use of S losses would reduce P s basis in S by a corresponding amount, increasing the gain on the S stock by the same amount and wasting the losses. Because of this rule, S gets to keep its losses on a carryforward basis.