Release Date: APRIL 07, 1999 April 7, 1999 the Honorable Charles O. Rossotti Commissioner

Release Date: APRIL 07, 1999
April 7, 1999
The Honorable Charles O. Rossotti
Commissioner
Internal Revenue Service
Room 3000
1111 Constitution Avenue, NW1
Washington, DC 20224
Re: Comments on Proposed Change to Section 368(c) Definition of
Corporate Control
Dear Commissioner Rossotti:
[1] I am enclosing comments on the above noted proposed change as prepared by members of the Committee on Corporate Tax. Principal responsibility was exercised by Jasper L. Cummings, Jr., Alston & Bird LLP, Raleigh, NC. Substantive contributions were made by Julie A. Divola, Pillsbury, Madison & Sutro, San Francisco, CA; Mark J. Silverman, Steptoe & Johnson, Washington, DC; Robert H. Wellen, Ivins, Phillips & Barker, Washington, DC; and David Wheat, Thompson & Knight PC, Dallas, TV. These comments were reviewed by members of our Committee on Government Submissions.
[2] These comments represent the individual views of those members who prepared them and do not represent the position of the American Bar Association or of the Section of Taxation.
Sincerely,
Stefan F. Tucker
Chair, Section of Taxation
Enclosure
cc: The Honorable Donald C. Lubick, Assistant Secretary Tax Policy,
Department of Treasury
The Honorable Stuart L. Brown, Chief Counsel, Internal Revenue
Service
Jonathan Talisman, Deputy Assistant Secretary, Tax Policy,
Department of Treasury
Joseph Mikrut, Tax, Legislative Counsel, Department of Treasury
ABA TAX SECTION COMMENTS ON PROPOSED CHANGE TO SECTION 368(c) DEFINITION OF CORPORATE CONTROL
[3] These comments are the individual views of members of the Section of Taxation who prepared them and do not represent the position of the American Bar Association.
[4] Primary responsibility was exercised by Jasper L. Cummings, Jr. Substantive contributions to these comments were made by Julie A. Divola, Mark J. Silverman, Robert H. Wellen and David Wheat, members of the Corporate Tax Committee. These comments were reviewed by William J. Wilkins for the Committee on Government Submissions and by Council Director Terrill Hyde.
[5] Although the members of the Section of Taxation who participated in preparing these comments may have clients who would be affected by the federal income tax principles addressed, or have advised clients on the application of these principles, no such member (or firm) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these comments.
Contact Person: Jasper L. Cummings, Jr.
(919) 420-2208
Date: March 26, 1999
ABA TAX SECTION COMMENTS ON ADMINISTRATION PROPOSAL
TO CHANGE SECTION 368(c)DEFINITION OF CORPORATE CONTROL
EXECUTIVE SUMMARY
[6] The Administration's Fiscal 2000 Budget Proposals include a proposal to conform the definition of "control" of a corporation found in section 368(c) to one like that in section 1504, which requires ownership of stock having 80 percent of the other corporation's vote and value, excluding consideration of pure preferred stock (nonvoting, nonparticipating). Section 368(c) now requires ownership of 80 percent of each class of nonvoting stock (including pure preferred stock) and 80 percent of the combined vote. Highlights of our comments include the following:
o We neither endorse nor oppose the proposal as stated. If a
change is to be made, we endorse the elimination of a class-
by-class ownership standard for nonvoting stock and we endorse
the imposition of some minimum level of value ownership, but
not necessarily 80 percent. We do not agree that the reasons
stated by the Administration justify the proposal.
o The definition of control in section 368(c) is illogical in
that it requires overly strict class-by-class control of
nonvoting stock, without aggregation, but then ignores the
value component of voting classes entirely, requiring only
aggregated voting control.
o But the inconsistent looseness/strictness of the section
368(c) definition has existed for 75 years while numerous
subchapter C rules have grown up around it, and have employed
it, and practitioners have to rely on it to soften some of
those rules. Presumably, the flexibility afforded by the
current definition was intended by Congress and generally does
not involve "disguised sales," at which the proposal is said
to be aimed. For an example of the flexibility, the
requirement to hold 80 percent of each nonvoting class makes
the control definition effectively elective.
o Perhaps certain types of transactions that depend in part on
the section 368(c) definition may be "sale-like," as the
Administration proposal suggests, but they probably can be
dealt with in other ways, possibly administratively. While the
existence of such alternative remedies may not be an adequate
reason to oppose the legislation, it calls into question the
wisdom of this type of fundamental change, with major
radiations, to deal with targeted "abuses."
o Most of the radiations of the proposed change involve the
multiple and irreconcilable ways that a tax free
reorganization can be structured. That is, the discontinuity
of section 368(c) is only one of many in section 368, and in
subchapter C generally. Even if legislative realities dictate
that amendment of section 368(c) not necessarily await
overhaul of section 368 generally, that project should not be
abandoned in favor of a continuing stream of piecemeal fixes.
o Specifically in this regard, if the definition of control is
to be changed to that of section 1504, then this change should
be used as an opportunity to rationalize section 368 by
applying the control definition to indirect subsidiaries, thus
permitting, for example, triangular reorganizations for
grandparent stock. Such a positive change would be a natural
extension of the proposal, which by itself is at best a
neutral development aimed at certain isolated transactions.
o Eliminating pure preferred stock from the section 368(c)
control definition seems to be a matter separate and apart
from measuring both vote and value on an aggregated basis, and
so should be given careful attention. Elimination would
provide desirable flexibility.
o Transition rules should respect control that now exists under
current law, where there has been some objective movement
toward a reorganization or division depending on that control.
TABLE OF CONTENTS
EXECUTIVE SUMMARY
I. THE ADMINISTRATION'S FISCAL 2000 BUDGET PROPOSALS
II. DISCUSSION OF PROPOSAL
A. RELATIONSHIP BETWEEN THE SECTION 1504 AND SECTION 368
DEFINITIONS OF CONTROL
B. THE USE OF SECTION 368(c) IN SECTION 355
C. DOES SECTION 368(c) FACILITATE "SALE-LIKE" TRANSACTIONS?
D. THE WISDOM OF THE PROPOSAL AND SCOPE OF ANY CHANGE: THE
COMPETING FACTORS
1. Exclusion of pure preferred stock
2. Is the section 368(c) definition justifiable?
3. Need for flexibility in reorganizations and spinoffs
E. OTHER IMPLICATED ISSUES
F. EFFECTIVE DATE/TRANSITION RELIEF
III. BACKGROUND
A. THE SECTION 368(c) DEFINITION OF CONTROL AND ITS USES IN THE
CODE
B. HISTORY OF CHANGES IN CORPORATE CONTROL DEFINITIONS
IV. CONCLUSION
I. THE ADMINISTRATION'S FISCAL 2000 BUDGET PROPOSALS: "CONFORM CONTROL TEST FOR TAX-FREE INCORPORATIONS, DISTRIBUTIONS, AND REORGANIZATIONS"
[7] The Administration proposes to conform the control test that is used in connection with tax-free incorporations, distributions and reorganizations, with the affiliation test for determining whether corporations can file consolidated returns. Thus, "control" would be defined as the ownership of at least 80 percent of the total voting power and at least 80 percent of the total value of the corporation's stock. For this purpose, stock would not include certain preferred stock that meets the requirements of section 1504(a)(4) (nonvoting, nonparticipating stock). The proposal would be effective for transactions on or after the date of enactment.
[8] The General Explanation of the Administration proposals describes current law as follows:
For tax-free incorporations, distributions, and reorganizations,
"control" is defined as the ownership of 80 percent of the
voting stock and 80 percent of the number of shares of all other
classes of stock of the corporation. In contrast, the necessary
"ownership" for affiliation to insure that two corporations are
permitted to file consolidated returns, tax-free liquidations,
and qualified stock purchases is at least 80 percent of the
total voting power of the corporation's stock and at least 80
percent of the total value of the corporation's stock. Prior to
1984, the test for affiliation was based on 80 percent of the
voting stock and 80 percent of the number of shares of all other
classes of stock of the corporation. In response to concerns
that corporations were filing consolidated returns under
circumstances in which a parent corporation's interest in the
issuing corporation accounted for less than 80 percent of the
real equity value of such corporation, Congress amended the
test. In 1986, the control test for tax-free liquidations and
qualified stock purchases was harmonized with the test for
affiliation.
[9] The General Explanation explains the reasons for change as follows:
The control test for tax-free incorporations, distributions, and
reorganizations is easily manipulated by allocating voting power
among the shares of a corporation. The absence of a value
component allows corporations to retain control of a corporation
but to "sell" a significant amount of the value of the
corporation. While the ability to manipulate control has been
present since the provision was enacted, there has been a
proliferation of transactions that qualify under tax-free
provisions but resemble sales because the value of the company
has been stripped away from the voting power. Congress amended
the test for affiliation to address similar concerns about
manipulating the equity value of controlled corporations.
[10] While the Explanation did not identify those proliferating transactions, certain generic types of transactions have been reported in the tax press.
[11] Transaction in which the control definition's flexibility facilitates a reorganization in which the Target shareholder does not participate in future growth of the Target. This transaction relies on the section 368(c) control definition to allow an Acquiror (which is effectively the "parent" of the Parent of a subsidiary used in a merger with Target that is intended to be a tax free reverse subsidiary merger) to obtain 80 percent voting control of the Target and ownership of its equity upside, while giving the Target shareholder a cash-like equity stake in the Target's Parent. The transaction has many similarities to an acquisition for voting preferred stock (that is not nonqualified preferred stock), but allows the Acquiror and the Target shareholder to enter into a mixing bowl type of arrangement that would be unavailable using preferred stock. The section 368(c) control definition facilitates this transaction by allowing the Acquiror to have direct ownership of the Target voting common stock, and thus of its upside potential, while allowing the former Target shareholder to own the common of the acquiring Parent and thereby benefit from its other asset (aside from Target), a pot of cash equal to the value of Target, contributed by Acquiror. Put another way, this transaction could not occur, at least as a reverse subsidiary merger under section 368(a)(2)(E), but for the ability of the acquiring Parent to own less than 80 percent of the value of the stock of the Target into which its subsidiary merges. In this transaction, the focus of concern should be on the effective shift of the target shareholders' interests from a continuing stake in Target and Parent to a stake in the earnings from the invested cash.
[12] Transactions in which cash is obtained through an IPO by a subsidiary, of which Parent does not lose control because stock sold is low vote common; cash is paid up to Parent and subsidiary is thereafter distributed under section 355, which is facilitated by the section 368(c) definition of control. This transaction involves a sale of more than 20 percent of the equity of a subsidiary followed by a split off that could not qualify under section 355 if the distributing corporation was required to own 80 percent of both the vote and value of the split off subsidiary. The cash may be used to pay back debt to the Parent or as a distribution. If the two classes of stock remain outstanding, then the creation of the second class should not be attacked as lacking a business purpose, and the focus of concern, if any, would seem to rest on the movement of cash.
[13] Transactions in which stock ownership change following a section 355 distribution does not upset tax-free section 355 treatment due to use of low vote stock to avoid change of section 368(c) control. In this type of transaction a corporation spins off a subsidiary, after which the subsidiary merges with an unrelated Acquiror. When it was important (under Rev. Proc. 96-39) that the 80 percent control of the spunoff corporation not be lost as part of the spinoff, the acquisition would be arranged so that the subsidiary's shareholders retained 80 percent of the voting power, but the Acquiror got the bulk of the value of the subsidiary. This transaction now would be impacted by section 355(e).
II. DISCUSSION OF PROPOSAL
A. RELATIONSHIP BETWEEN THE SECTION 1504 AND SECTION 368 DEFINITIONS OF CONTROL.
[14] Currently, the definitions of control found in section 368(c) and 1504 perform significantly different roles. This fact mitigates against a one-size-fits-all approach to the control definition.
[15] It seems clear that consolidation requires a high percentage of value ownership and not just of the vote of the affiliate, because economic linkage should be the key to treating separate corporations in effect as divisions through the mechanism of consolidated returns. Pure preferred stock has long been excluded from the calculation of value linkage for affiliation. Indeed, it is curious that it took so long for the current definition in section 1504 requiring 80 percent value ownership to come about, although the lack of need for the change was perhaps due to the novelty of low vote common and to the exclusions of pure preferred from the calculation. Furthermore, the section 1504 definition is frequently employed by reference in other sections to identify a grouping of corporations that should be treated as one.
[16] In contrast, the roles played by the section 368(c) control definition are distinguishable from the role of section 1504: they are generally to identify two corporations that should be treated as essentially one and the same (not necessarily just in an economic sense), in order to reach a particular end: either for purposes of providing taxpayer-favorable results or taxpayer- unfavorable results (thus preventing the avoidance of certain rules by the use of separate but affiliated entities in transactions). That the section 368(c) definition applies most prominently in taxpayer favorable situations (triangular mergers facilitated by use of controlled subsidiaries, corporate formation, spinoff of controlled subsidiaries) perhaps explains its vote and nonvoting stock standard (i.e., access to the benefits is made harder), as contrasted with an anti-abuse control definition in the code in section 1563, which utilizes a vote or value standard to snare a larger group of affiliates in order to prevent certain corporate taxpayer abuses.
[17] Within sub-chapter C, the fundamental interplay between the section 368(c) definition of control and that in section 1504 comes in sections 332 and 338, which rely on section 1504, as contrasted with sections 351, 355 and 368, which rely on section 368(c). The section 1504 definition of control governs when the assets of a controlled corporation can be removed in bulk from the corporation while remaining in corporate solution controlled by the same parent. Sec. 332 (and section 337) allow a controlled subsidiary to be liquidated into its parent corporation without income or loss recognition. Sec. 338 allows the purchase of control of a corporation to be followed by an election to treat the corporation as selling all of its assets to itself as a new corporation; more importantly, it allows certain shareholders of a corporation to treat the sale of the corporate stock as the corporation's sale of its assets, thus eliminating the gain on the stock sale, based on the analogy of the section 332 liquidation.
[18] In contrast, the incorporation of assets tax free under section 351, the tax free division under section 355, and the tax free change in control of assets by reorganization under section 368 are limited by the control definition of section 368(c). The discontinuity with section 1504 is brought most acutely into focus in connection with sections 351 and 332: while a parent corporation can incorporate a subsidiary tax free under the section 368(c) definition, it must comply with the stricter section 1504 definition of control to unincorporate it tax free by liquidation.
[19] The principal uses of the section 368(c) definition in sections 351, 355 and 368 should appropriately require some "substantial" proportion of value (as section 368(c) does). This view is suggested by the principal authority interpreting that section, Rev. Rul. 59- 259, 1959-2 CB 115. It determined that nonvoting classes cannot be aggregated for purposes of the 80 percent test, but rather that 80 percent of each nonvoting class must be owned. It stated:
Moreover, percentage ownership of the number of non-voting
shares outstanding, as contrasted to percentage ownership of
each class of non-voting shares, is ordinarily of no
significance and can lead to results which are inconsistent with
the statutory scheme and clear congressional purpose. Ownership
of large numbers of non-voting shares in a multi-class stock
structure would not necessarily assure, in itself, the
continuation of substantial proprietary interests in modified
corporate forms as contemplated by the statute. See section
1.368-1 of the Income Tax Regulations.
[20] Two points about this ruling illustrate its focus on value. First, it identifies the reorganization as the transaction that should inform the definition of control in section 368(c). This is appropriate, given the placement of the definition in that section: its principal purpose is to define reorganizations (for purposes of Type B stock-for-stock acquisitions, Type D reorganizations and triangular mergers). In 1959 the only form of reorganization in which control related directly to the continuation of a substantial proprietary interest by Target shareholders was the Type D reorganization. However, the same control definition was (and is) used in section 368(a)(1)(B) to require that an Acquiror have control of Target immediately after a Type B reorganization. This represents an indirect application of the continuity of proprietary interest requirement. Second, the ruling observes the illogic of lumping all types of nonvoting stock. Similarly, it is illogical not to apply to voting classes the class by class approach that the ruling applied to nonvoting classes, in order to fully effectuate a requirement of substantial continuity of interest in value.
B. THE USE OF SECTION 368(c) IN SECTION 355.
[21] The ABA suggested in 1988 (see Background section, below) that the control definition used in section 355 should not be tightened. This is an issue that is now even more difficult. Since 1988, section 355 has taken on an even higher level of importance, both to taxpayers and the government, as evidenced most recently by the several amendments to section 355(d) and (e) imposing various "anti- abuse" rules. Taxpayers are even more loath now to propose yet another stricture on section 355, which is so hedged about with limitations. Nevertheless, if the control definition is to be reformed for purposes of sections 351 and 368, a different treatment for section 355 would require a major reanalysis of section 355, which we assume no one is prepared to do at this juncture.