PRACTICAL U.S. / DOMESTIC TAX STRATEGIES

... as appeared in... WTE PRACTICAL U.S. / DOMESTIC TAX STRATEGIES WorldTrade Executive, Inc. www.wtexec.com/tax.html The International Business Information Source TM How US Business Manages its Tax Liability February 2009 Volume 9, Number 2 Significant Business-Related Tax Law Under the American Recovery and Reinvestment Act of 2009 By Samuel R. Weiner, David O. Kahn, Ana G. O Brien, Ofer Lion, Jiyeon Lee-Lim and Cheryl M. Coe (Latham & Watkins) The American Recovery and Reinvestment Act of 2009 (the 2009 Act), signed into law by President Obama on February 17, 2009, includes certain notable changes to current United States federal tax law. This Alert provides a brief summary of the following changes: Deferral of cancellation of indebtedness income; Temporary suspension of the rules governing applicable high-yield discount obligations; Five-year carryback of net operating losses for eligible small businesses; Temporary reduction of S corporation built-in gains holding period from 10 years to seven years; Samuel Weiner (sam.weiner@lw.com), David Kahn (david. kahn@lw.com), Ana O Brien (ana.obrien@lw.com), Jiyeon Lee-Lim (jiyeon.lee-lim@lw.com) and Cheryl Coe (cheryl. coe@lw.com) are Partners, and Ofer Lion (ofer.lion@lw.com) is an Associate, with Latham & Watkins. Mr. Weiner s practice is focused on federal and state taxation of corporations and partnerships in a variety of U.S. and international contexts, including mergers and acquisitions, financings, and financial products and services. He is co-chair of the firm s Transactional Tax Practice Group. Mr. Kahn concentrates his practice on federal taxation of corporations, partnerships and real estate investment trusts. Ms. O Brien s practice is focused on federal taxation of corporations, partnerships and REITs, including mergers and acquisitions, financings and restructurings. Mr. Lion specializes in mergers and acquisitions, international structuring, financial products, securities, REITs and tax-exempt organizations. Ms. Lee- Lim s practice is focused on corporate and international tax matters, including taxation of financial instruments and transactions and inbound and outbound investments. Cheryl Coe s practice is focused on corporate and partnership taxation, and particularly mergers, recapitalizations, domestic and international acquisitions, and tax-free reorganizations. Ms. O Brien and Messrs. Weiner, Kahn, and Lion are in the Los Angeles office. Ms. Lee-Lim is in the New York office, and Ms. Coe is in the Washington, D.C. office. Prospective repeal of Treasury Notice 2008-83; Treatment of certain ownership changes for purposes of limitations on net operating loss carryforwards and certain built-in losses; and Rate reduction for gain from the sale of qualified small business stock. In general, a reduction in a partner s allocable share of partnership liabilities is treated as a distribution of money to the partner. Companies should consider carefully whether the 2009 Act provides enhanced tax benefits or new business opportunities. Deferral of Cancellation of Indebtedness Income (Section 1231 of the 2009 Act) Currently, a repurchase by a debtor (or a person related to the debtor within the meaning of Section 108(e)(4) of the United States Internal Revenue Code of 1986, as amended (the IRC)) of such debtor s outstanding obligations at a discount will result in cancellation of indebtedness income (COD Income) to the debtor. This is generally the case regardless of whether the obligation is repurchased for cash, equity or a new obligation. In addition, certain modifications of a debt obligation may cause a deemed debt-for-debt exchange, and if the issue price of the deemed new debt is lower than the adjusted issue price of the old debt, the deemed exchange will also result in COD Income to the debtor. Under IRC Section 108(a), COD Income is excluded from gross income if the debtor is in a Title 11 bankruptcy case or insolvent, or the cancelled debt is certain student loan indebtedness, certain farm indebtedness, certain real

property business indebtedness or certain qualified principal residence indebtedness. The 2009 Act permits taxpayers to elect to defer COD Income arising from a reacquisition of an applicable debt instrument after December 31, 2008 and before January 1, 2011. Once the election is made, the applicable COD Income is deferred until the fifth taxable year (if the reacquisition occurs in 2009) or the fourth taxable year (if the reacquisition occurs in 2010) following the acquisition, and is includible in gross income ratably over a five-taxable- year period starting after the deferral period. For example, if a calendar year taxpayer reacquires an applicable debt instrument in 2009 at a discount, the taxpayer can elect to include any COD Income recognized in connection with such reacquisition in income ratably over the five-year period that starts in 2014 and ends in 2018. The 2009 Act includes a rule coordinating the deferral of the COD Income and the deduction of the related original issue discount (OID) in the event the reacquisition takes the form of a debt-for-debt exchange. Under this rule, if an applicable debt instrument is exchanged (or deemed exchanged) for a new debt instrument, and if there is OID with respect to the new debt instrument, no deduction is allowed with respect to the portion of the OID which accrues on the new debt instrument before the first taxable year in which COD Income is includible (but only to the extent such OID does not exceed the COD Income). The disallowed OID deduction is allowed as a deduction ratably over the five-taxable-year period during which the COD Income is included. In this regard, a debt-for-debt exchange includes an indirect exchange where a debt instrument is issued by an issuer and all or any of the proceeds of such debt are used directly or indirectly to reacquire an applicable debt instrument of the issuer (to the extent the proceeds are so used). Definitions The term applicable debt instrument includes any bond, debenture, note, certificate, or any other instrument or contractual arrangement constituting indebtedness for United States federal income tax purposes, issued by a C corporation or any other person in connection with the conduct of a trade or business by such person. The term reacquisition means any acquisition of an applicable debt instrument by the debtor which issued (or is otherwise the obligor under) the debt instrument or a person related to the debtor (within the meaning of IRC Section 108(e)(4)). The term acquisition includes (1) an acquisition for cash, (2) the exchange of the debt instrument for another debt instrument (including a deemed exchange resulting from a modification), (3) the exchange of the debt instrument for corporate stock or a partnership interest, (4) the contribution of the debt instrument to capital, and (5) the complete forgiveness of the indebtedness by the holder of the debt instrument. Election A taxpayer must elect to apply the above rule by including a statement identifying the debt instrument and containing certain other information with the tax return for the taxable year in which the reacquisition of the debt instrument occurs. In the case of a partnership, S corporation or other pass-through entity, the election is made by the partnership, S corporation or other entity, as applicable. The Secretary of the Treasury (the Secretary) is authorized to require reporting of the election in subsequent taxable years. The election is made on an instrument-by-instrument basis and, once made, is irrevocable. Coordination with Other Exclusions If a taxpayer makes the election to defer the COD Income with respect to a debt instrument, other exclusions (such as the bankruptcy or the insolvency exception) do not apply to the COD Income with respect to such instrument for the taxable year of the election or any subsequent year. Acceleration of Deferred Items If an electing taxpayer dies, is liquidated, sells substantially all of its assets or ceases to conduct business, any deferred income or OID deduction is taken into account in the taxable year in which such event occurs. For a passthrough entity, a sale, exchange or redemption of an interest in such entity by a partner, shareholder or other owner is also an acceleration event. The Secretary is authorized to issue regulations extending the acceleration provisions to other situations. Special Rules for Partnerships and Other Pass-Through Entities In the case of a partnership, any income or OID deduction deferred pursuant to these provisions is allocated to the partners in the partnership immediately before the discharge in the same manner as such amounts would have been allocated to them if such income or OID deduction were recognized at that time. In general, a reduction in a partner s allocable share of partnership liabilities is treated as a distribution of money to the partner. To the extent that a deemed distribution exceeds a partner s basis in its partnership interest, the partner will recognize gain. Under the 2009 Act, any decrease in a partner s share of partnership liabilities as a result of a discharge to which these provisions apply will not be taken into account to the extent it would cause the partner to recognize gain. Any decrease in partnership liabilities deferred under the preceding sentence WorldTrade Executive, Inc. 2009 February, 2009

will be taken into account by a partner at the same time, and to the same extent, as deferred COD Income is recognized. The Secretary is authorized to issue regulations applying the deferral of COD Income to partnerships, S corporations and other pass-through entities. Temporary Suspension of AHYDO Rules (Section 1232 of the 2009 Act) In general, an issuer of a debt instrument issued with OID may deduct OID as it accrues over time. However, under IRC Section 163(e)(5), if a debt instrument is an applicable high yield discount obligation (AHYDO) issued by a corporation, no deduction is allowed for the disqualified portion of the OID on such debt instrument, and the remainder of the OID is not deductible until paid. A debt instrument generally is treated as an AHYDO if it has a term of more than five years, has significant OID and has a yield to maturity that equals or exceeds the applicable federal rate (AFR) for the month of issuance plus five percent. Certain modifications of a debt instrument may be treated as a deemed exchange of the debt instrument for a new debt instrument. Even if the old debt was issued without OID, depending on the issue price or terms of the modified debt, the modified debt instrument may be treated as an AHYDO. The AHYDO rules do not apply to certain obligations issued during the period beginning on September 1, 2008 and ending on December 31, 2009, even if the obligation meets the statutory definition of an AHYDO. This temporary suspension applies only if (1) the obligation is issued in exchange for an obligation that is not an AHYDO, and (2) the issuer (obligor) of the old and the new obligations are the same. In this regard, the debt instrument with respect to which the rules are suspended is not treated as an AHYDO for purposes of subsequent application of the rule. The temporary suspension does not apply to contingent interest debt described in IRC Section 871(h)(4)(without regard to (D) thereof)(generally, an obligation the interest on which is determined by reference to receipts, sales, cash flow, income or profits of the obligor or a related person or changes in the value of any property of the obligor or a related person) or to any obligation issued to a person related to the obligor (within the meaning of IRC Section 108(e)(4)). The 2009 Act permits the Secretary to extend the suspension rule beyond 2009 if appropriate. It also permits the Secretary to issue regulations to allow, for obligations issued after December 31, 2009, a rate higher than the AFR to be used in determining the status as an AHYDO if the Secretary determines that such rate is appropriate in light of distressed conditions in the debt capital markets. Five-Year Carryback of Net Operating Losses (Section 1211 of the 2009 Act) A net operating loss (NOL) generally means the amount by which a taxpayer s business deductions exceed its gross income. Under present law, an NOL generally may be carried back two years and carried forward 20 years to offset taxable income in such years. The 2009 Act permits eligible small businesses (whose gross receipts generally do not exceed $15 million) to elect to carry back 2008 NOLs for up to five years instead of the two years currently permitted. NOLs subject to the new rule include any NOLs for any taxable year ending in 2008, or if elected by the taxpayer, NOLs for any taxable year beginning in 2008. Temporary Reduction in Recognition Period for Builtin Gains Tax (Section 1251 of the 2009 Act) When a C corporation converts to an S corporation, any built-in gain in its assets at the date of conversion is subject to a 35 percent corporate level built-in gains tax if those assets are disposed of in a taxable transaction by the S corporation during the recognition period (generally the first 10 taxable years that the S election is in effect). A similar rule applies with respect to the disposition of built-in gain assets acquired by an S corporation from a C corporation in a carryover basis transaction. Gains recognized during the recognition period are not built-in gains for purposes of this rule to the extent they are shown to have arisen after the S election was in effect or are offset by recognized built-in losses. Treasury regulations under IRC Section 337 generally extend these rules to the conversion of a C corporation into a Regulated Investment Company (RIC) or Real Estate Investment Trust (REIT), and to the acquisition of C corporation assets by such companies in a carryover basis transaction, unless an election is made to recognize the taxable gains upon such conversion or acquisition. The amount of the built-in gains tax is treated as a loss taken into account by the S corporation shareholders in computing their individual income tax or, in the case of RIC or REIT, in computing its taxable income. In the case of any taxable year beginning in 2009 and 2010, no corporate level built-in gains tax is imposed on the net recognized built-in gain of an S corporation if the seventh taxable year in the recognition period preceded such taxable year, effectively shortening the recognition period from 10 to seven taxable years. Likewise, in the case of built-in gain attributable to an asset received by an S corporation from a C Practical US/International Tax Strategies WorldTrade Executive, Inc. 2009

corporation in a carryover basis transaction, no built-in gains tax will be imposed if such gain is recognized after the date that is seven years following the date on which the asset was acquired. While the statutory change contained in the 2009 Act refers only to S corporations, as discussed previously, Treasury regulations under IRC Section 337 generally extend those rules to RICs and REITs. As a result, while not free from doubt, this temporary shortening of the recognition period may also be applicable to RICs and REITs. Repeal of Treasury Notice 2008-83 (Section 1261 of the 2009 Act) IRC Section 382 provides that the taxable income of a loss corporation for a year following an ownership change may be offset by pre-change net operating losses and certain built-in losses only to the extent of the Section 382 limitation for such year. The Section 382 limitation is generally equal to the fair market value of the stock of the loss corporation immediately before the ownership change multiplied by the applicable long-term tax-exempt rate (published monthly by the Internal Revenue Service). An ownership change occurs with respect to a corporation if it is a loss corporation on a testing date and, immediately after the close of the testing date, the percentage of stock of the corporation owned by one or more five-percent shareholders has increased by more than 50 percentage points over the lowest percentage of stock of such corporation owned by such shareholders at any time during the testing period (generally, the three-year period ending on the testing date). A loss corporation is defined as a corporation entitled to use a net operating loss carryover or having a net operating loss carryover for the taxable year in which the ownership change occurs. The Secretary issued Internal Revenue Service Notice 2008-83 (the Notice) on October 1, 2008. The Notice provided that any deduction properly allowed after an ownership change to certain banks with respect to losses on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts) would not be treated as a builtin loss or a deduction that is attributable to periods before the change date. Thus, no Section 382 limitation would be applied to limit the use of such losses after an ownership change. The rule change was limited to loss corporations consisting of certain United States incorporated banks and trust companies both immediately before and after the change date. The Notice provided that such entities could rely on the treatment set forth unless and until there was additional guidance. The 2009 Act indicates that the delegation of authority to the Secretary under IRC Section 382 to issue regulations does not authorize the Secretary to provide exemptions or special rules restricted to particular industries or classes of taxpayers. The Notice is described as inconsistent with congressional intent, and the legal authority to prescribe the Notice is called into question. However, as taxpayers should generally be able to rely on guidance issued by the Secretary, the Notice is deemed to have the force of law only with respect to ownership changes occurring on or before January 16, 2009, or with respect to ownership changes occurring after January 16, 2009 if such changes are pursuant to: (1) a written binding contract entered into on or before such date, or (2) a written agreement entered into on or before such date and such agreement was described on or before such date in a public announcement or in a filing with the Securities and Exchange Commission required by reason of such ownership change. Treatment of Certain Ownership for Purposes of Limitations on Net Operating Loss Carryforwards and Certain Built-in Losses (Section 1262 of the 2009 Act) As described previously, IRC Section 382 generally imposes a Section 382 limitation on the amount of taxable income that may be offset by a loss corporation after an ownership change with pre-ownership change NOLs. The Section 382 limitation shall not apply in the case of an ownership change which is pursuant to a restructuring plan of a taxpayer which (1) is required under a loan agreement or a commitment for a line of credit entered into with the Department of the Treasury under the Emergency Economic Stabilization Act of 2008, and (2) is intended to result in a rationalization of the costs, capitalization and capacity with respect to the manufacturing workforce of, and suppliers to, the taxpayer and its subsidiaries. This exception does not apply in the case of any ownership change if, immediately after the change, any person (other than a voluntary employees beneficiary association under IRC Section 501(c)(9)) owns stock of the new loss corporation possessing 50 percent or more of the total combined voting power of all classes of stock entitled to vote, or of the total value of the stock of such corporation. For these purposes, related persons are treated as a single person. Special rules are provided to determine whether a relationship exists, and a relationship is treated as existing where members of a group of persons act in concert. Special Rules Applicable to Qualified Small Business Stock for 2009 and 2010 (Section 1241 of the 2009 Act) Under current law, non-corporate taxpayers that acquire qualified small business stock (QSBS) are, in some circumstances, eligible for a reduced rate of federal income taxation if such QSBS is disposed of at a gain after having WorldTrade Executive, Inc. 2009 February, 2009

been held for more than five years. To qualify as QSBS, the stock, issuing company and holder must meet a variety of conditions, including generally: (1) the stock must have been issued by an eligible domestic C corporation for money, other property or services after August 10, 1993; (2) at issuance and during all prior periods, the issuing corporation must have had adjusted gross assets of $50 million or less; (3) during substantially all of the period the stock was held (and subject to certain exceptions), at least 80 percent of the value of the issuer s assets must have been used in the active conduct of a qualified trade or business, and the total value of real estate or non-subsidiary securities not used in such trade or business cannot, in each case, have exceeded 10 percent of the issuing corporation s net assets; and (4) during specified periods surrounding the issuance of the QSBS, the issuing corporation must have refrained from undertaking certain prohibited redemptions of its stock. Presently, if QSBS held as a capital asset for more than five years is disposed of in a taxable transaction at a gain, it is subject to federal tax at the rate of 14 percent. In addition, non-corporate taxpayers that dispose of QSBS held for more than six months in a taxable transaction may, under certain circumstances, be eligible to defer the federal income tax on such gain by purchasing other QSBS within 60 days of such disposition (effectively rolling over the taxable gain). With respect to QSBS acquired after February 17, 2009, and before January 1, 2011, and later disposed of at a gain after having been held for more than five years, the 2009 Act reduces the federal tax rate imposed on that gain from 14 percent to seven percent. As under current law, however, a portion of this tax benefit is treated as a preference item for purposes of the federal alternative minimum tax. The 2009 Act does not change the 60-day rollover rule applicable to QSBS held for more than six months. 2009 Latham & Watkins q Reprinted from the February, 2009 issue of Practical U.S./ Domestic Tax Strategies 2009 WorldTrade Executive, Inc www.wtexecutive.com Practical US/International Tax Strategies WorldTrade Executive, Inc. 2009