by Amy S. Elliott
In their never-ending attempt to find a way for a corporation to accelerate not just 79 percent but a full 100 percent of its losses in a subsidiary's stock through a Granite Trust fact pattern, practitioners are latching on to a recent private letter ruling that could provide such a result, provided Rev. Rul. 71-563, 1971-2 C.B. 175, applies to allow basis hopping. The letter ruling was discussed October 18 at a Practising Law Institute conference in New York on corporate tax strategies.
In July the IRS released LTR 201330004 on a related-party Granite Trust-type transaction. In a basic Granite Trust transaction, a domestic parent corporation (P) sells, for example, 30 percent of its domestic subsidiary loss corporation (S) to its foreign subsidiary (FS), which isn't a member of the P group, in exchange for nonqualified preferred stock, which avoids the application of section 304 and creates a capital loss.
Because P and FS are related, section 267(f) defers P's loss on the 30 percent S shares P sold to FS until FS leaves the P control group. S liquidates under section 331, and P takes a loss on the 70 percent S shares P retained. The transaction gets its name from Granite Trust Co. v. United States, 238 F.2d 670 (1st Cir. 1956), in which a sale of subsidiary stock to avoid section 332 treatment was allowed.
Section 267(f) Loss Deferral
Audrey Nacamuli Charling of General Electric Co. said that simple application of the section 267(f) regulations would result in continued deferral of the loss on the 30 percent S shares P sold. "What this means, as a practical matter, is that for most taxpayers, that loss is never going to be had," she said.
An audience member asked whether the result changes if there are multiple sales of S stock by P and the sales are to related parties. Lawrence Axelrod, special counsel, IRS Office of Associate Chief Counsel (Corporate), who signed LTR 201330004, said, "The standard fact pattern is that you're originally in the group and if you liquidated, you wouldn't get any loss at all. If you break it up by two or three or 27 sales to related parties, why should that suddenly make the loss immediately deductible?"
Axelrod continued: "If, by your own actions, you convert what would have been a loss on liquidation to a section 1001 loss, to which section 267 applies, then you walked into it. I mean, it may just be form, but that's what Granite Trust is all about -- form." If the corporation doesn't sell and liquidates, it doesn't get a loss, whereas if it sells off 30 percent, it gets some loss, he said. "It seems to me you want form over substance when you get the loss, but you don't want it when form causes the loss to continue to be deferred," he said.
"If you lay on Granite, you've got to sleep on Granite," he added.
A Better Answer?
But Charling suggested that taxpayers unhappy with the answer that section 267(f) defers the 30 percent loss may have an alternative that accelerates the loss by application of section 304 and the concept of "hopping" basis. She introduced the following scenario: P owns domestic subsidiary S1 and foreign subsidiary FS, which has a pool of earnings and profits and foreign tax credits. S1 owns domestic loss subsidiary S2.
Assume S1 sells 21 percent of S2 to FS in exchange for cash. One day later, S2 adopts a plan of liquidation and liquidates. Because S1 received property in its sale of S2 stock to FS, the sale is treated as a section 304 transaction and S1 is treated as contributing the 21 percent S2 stock to FS in exchange for FS stock that is deemed redeemed.
The redemption received by S1 could be treated either as a section 302(a) sale or exchange or as a section 302(d) dividend equivalent. Section 304 provides that the determination should be made by reference to S1's continuing interest in S2. However, because S2 liquidated in a transaction to which section 381 did not apply and because it doesn't have a section 381 successor, it doesn't exist anymore.
"Can S1 have a continuing interest in S2?" Charling asked, adding that LTR 201330004 may provide an answer to that question. In that letter ruling, the IRS concluded that section 302(d) applied, so in the above hypothetical, the proceeds that S1 received when it sold the S2 stock to FS would be treated as a section 301 deemed dividend. Applying section 302(d) to the redemption is "consistent with the policy of section 304," which has a bias of finding dividends, she said.
The key to possible loss acceleration lies in what happens to S1's basis in the S2 shares it sold to FS. Charling said that the obsolescence of Rev. Rul. 70-496, 1970-2 C.B. 74, suggests that S1's basis doesn't just disappear. She said that Rev. Rul. 71-563 indicates that the basis hops to S1's basis in its remaining shares of S2 (in this case, the 79 percent of S2 that S1 retained before S2 liquidated).
Charling said that if S1's basis in the sold S2 shares does in fact hop over to S1's remaining S2 shares, the loss that S1 would get upon liquidation of S2 would actually be "greater than the loss that it started with." She added that the control group paid for that extra loss.
Andrew J. Dubroff of EY said, "There are a dozen letter rulings now confirming Granite Trust results and applying section 267(f) extended deferral," under which the taxpayer intentionally planned out of section 304 for the preliminary stock sale. But he added that if Charling is correct and Rev. Rul. 71-563 applies, "all of those people did it wrong." Instead, they should have been planning into section 304 so that the basis of the sold shares would "snap back" into the retained target shares, Dubroff said, adding that the only place the loss stock basis is being recovered is under section 331, which is exempt from section 267.
Although section 304 was amended by the Taxpayer Relief Act of 1997 to change the construct from a capital contribution to a section 351 exchange, Charling said she has "a hard time seeing how the . . . amendments changed Rev. Rul. 71-563."
"You have a hard time, but this is a question that we continue to study," said William Alexander, IRS associate chief counsel (corporate). Axelrod added that Rev. Proc. 2013-3, 2013-1 IRB 113, provides that the IRS will no longer issue private letter rulings on some section 304 scenarios.
Hopping Basis Implications
Because the IRS doesn't rule on these sorts of basis questions, whether S1's basis in the S2 shares it sold to FS hopped to S1's remaining shares of S2 might be informed by congressional policy, Charling suggested. If it is determined that section 302(d) applies in these transactions, "is that undermining the section 267(f) regulation and some very important policy that formed the basis of that regulation?" she asked.
Alexander said that to apply the section 267(f) regulations, a taxpayer would have to make the case that it had a capital transaction. "The only technical way that one could make that case is [to show that the] corporation is going to disappear," he said.
Charling said that if that taxpayer had a firm and fixed plan to liquidate S2 in place when S1 sold a portion of S2 to FS, there would be no question "that S2 was going out of existence in a non-section-381 transaction."
"Part of the magic of Granite Trust is that it only works if we don't have a plan of liquidation," Alexander said. "You're going to go into court and tell the judge -- and I'm going to make you do this -- that 'I have a firm and fixed plan which I am going to effectuate through liquidation, but I do not have a plan of liquidation,' and you are welcome to tell the judge that."
Charling responded, "But what about the taxpayer in the PLR? They came and told you, 'We have a plan,' because it's one of the steps that's recited in the PLR, so no one is surprised that the subsidiary liquidated." She added that while the proposed transaction steps included an expectation that a plan to liquidate would be considered -- and if such a plan were adopted, S1 would in fact liquidate -- there was no formal liquidation plan adopted before the sale of stock. "The plan of liquidation was adopted after the sale of the stock," she said.
"This is a gray area and it's one that people in the office have been thinking about. I don't have any answers for you, but all of these are very legitimate questions," Axelrod said.
"This is a situation in which -- especially given the bias you noted towards finding dividends in these types of transactions -- you're not going to be able to have and eat the same piece of cake," Alexander said. "If you are, it's because a judge lets you."
Charling asked whether the basis implications of this type of transaction -- does basis hop, and if so, where? -- would be addressed by the basis recovery guidance project described in the 2013-2014 Treasury-IRS priority guidance plan as "regulations under sections 301, 302, and 358 regarding the recovery and allocation of basis in redemptions, organizations, and reorganizations." Treasury has yet to finalize the basis recovery regulations (REG-143686-07) it proposed in January 2009.
The scope of the guidance project "is the scope of what we proposed in that last round," Alexander said. "The types of questions that we're talking about today are within the scope of that project. . . . Granite Trust itself is not in the scope," he said.
Alexander said the project is going "slowly in fits and starts," adding, "Its being on our business plan is a commitment that we're going to do some work on it this year. It is such a large project that there is virtually no chance that we will finish it in the current cycle, but we at least are trying to get started, and we remain interested in people's view on it."