[Federal Register Volume 64, Number 153 (Tuesday, August 10, 1999)]
[Proposed Rules]
[Pages 43462-43503]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-19930]
[[Page 43461]]
_______________________________________________________________________
Part III
Department of the Treasury
_______________________________________________________________________
Internal Revenue Service
_______________________________________________________________________
26 CFR Parts 1 and 602
Purchase Price Allocations in Deemed Actual Asset Acquisitions;
Proposed Rule
Federal Register / Vol. 64, No. 153 / Tuesday, August 10, 1999 /
Proposed Rules
[[Page 43462]]
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[REG-107069-97]
RIN 1545-AZ58
Purchase Price Allocations in Deemed Actual Asset Acquisitions
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations relating to the
allocation of purchase price in deemed and actual asset acquisitions.
The proposed regulations determine the amount realized and the amount
of basis allocated to each asset transferred in a deemed or actual
asset acquisition and affect transactions reported on either Form 8023
or Form 8594.
DATES: Written comments must be received by September 20, 1999.
Requests to speak and outlines of topics to be discussed at the hearing
scheduled for 10 a.m., October 12, 1999, must be received by September
20, 1999.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG 107069 97), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday through
Friday between the hours of 8 a.m. and 5 p.m. to CC:DOM:CORP:R (REG
107069 97), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit
comments electronically via the Internet by selecting the ``Tax Regs''
option on the IRS Home Page, or by submitting comments directly to the
IRS Internet site at http://www.irs.ustreas.gov/tax__regs/
regslist.html. The public hearing will be held in the NYU Classroom,
Room 2615, Internal Revenue Building, 1111 Constitution Avenue, NW.,
Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Richard
Starke, (202) 622-7790 or Stephen R. Wegener, (202) 622-7530;
concerning submissions of comments, the hearing, and/or to be placed on
the building access list to attend the hearing, Guy R. Traynor (202)
622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)).
Comments on the collections of information should be sent to the
Office of Management and Budget, Attn: Desk Officer for the Department
of the Treasury, Office of Information and Regulatory Affairs,
Washington, DC 20503, with copies to the Internal Revenue Service,
Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224.
Comments on the collections of information should be received by
October 12, 1999.
Comments are specifically requested concerning:
Whether the proposed collections of information are necessary for
the proper performance of the functions of the IRS, including whether
the collections will have a practical utility;
The accuracy of the estimated burden associated with the proposed
collections of information (see below);
How the quality, utility, and clarity of the information to be
collected may be enhanced;
How the burden of complying with the proposed collections of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.
The collections of information in these proposed regulations are in
Secs. 1.338-2(d), 1.338-2(e)(4), 1.338-5(d)(3), 1.338-10(a)(4),
1.338(h)(10)-1(d)(2), and 1.1060-1(e)(ii)(A) and (B). The collections
of information are necessary to make an election to treat a sale of
stock as a sale of assets, to calculate and collect the appropriate
amount of tax in a deemed or actual asset acquisition, and to determine
the bases of assets acquired in a deemed or actual asset acquisition.
These collections of information are required to obtain a benefit.
The likely respondents and/or recordkeepers are small businesses or
organizations, businesses, or other for-profit institutions, and farms.
The regulation provides that a section 338 election is made by
filing Form 8023. The burden for this requirement is reflected in the
burden of Form 8023. The regulation also provides that both a seller
and a purchaser must each file an asset acquisition statement on Form
8594. The burden for this requirement is reflected in the burden of
Form 8594. The burden for the collection of information in Sec. 1.338-
2(e)(4) is as follows:
Estimated total annual reporting/recordkeeping burden: 25 hours.
Estimated average annual burden per respondent/recordkeeper: 0.56
hours.
Estimated number of respondents/recordkeepers: 45.
Estimated annual frequency of responses: On occasion.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
A. Evolution of Code and Regulations
Section 338 was added to the Internal Revenue Code of 1954 (Code)
by section 224(a) of the Tax Equity and Fiscal Responsibility Act of
1982, Public Law 97-248 (96 Stat. 324), and amended by section
306(a)(8) of the Technical Corrections Act of 1982, Public Law 97-448
(96 Stat. 2365), and further amended by section 712(k) of the Tax
Reform Act of 1984, Public Law 98-369 (98 Stat. 951). Section 338
replaces any nonstatutory treatment of a stock purchase as an asset
purchase by allowing certain acquiring corporations to elect to treat
qualifying stock purchases as asset acquisitions.
General rules for making elections under section 338 were first
issued in temporary regulations Secs. 5f.338-1, 5f.338-2, and 5f.338-3
published as TD 7942 in the Federal Register on February 8, 1984 (49 FR
4722) (1984-1 C.B. 93). Those rules were amended and redesignated as
Secs. 1.338-1T, 1.338-2T, and 1.338-3T by temporary regulations
published as TD 7975 in the Federal Register on September 6, 1984 (49
FR 35086) (1984-2 C.B. 81).
Treasury Decision 8021, published in the Federal Register on April
25, 1985 (50 FR 16402) (1985-1 C.B. 96), amended Secs. 1.338-1T and
1.338-2T and added Sec. 1.338-4T. These regulations provided guidance
in a question and answer format, most notably in the areas of asset and
stock consistency requirements.
Temporary regulations published as TD 8068 in the Federal Register
on January 8, 1986 (51 FR 741) (1986-1 C.B. 165) amended Secs. 1.338-1T
and
[[Page 43463]]
1.338-4T. The temporary regulations published on January 8, 1986 also
added Sec. 1.338(h)(10)-1T to implement section 338(h)(10), under which
a selling consolidated group can elect to treat certain stock sales as
asset sales.
Sections 1.338-1T and 1.338-4T were again amended by temporary
regulations published as TD 8072 in the Federal Register on January 29,
1986 (51 FR 3583) (1986-1 C.B. 111) (Due to typesetting errors, the
Federal Register republished TD 8072 in its entirety on March 28, 1986
(51 FR 10617)). The temporary regulations published on January 29, 1986
also amended Sec. 1.338(h)(10)-1T and added Secs. 1.338(b)-1T,
1.338(b)-22T, and 1.338(b)-3T. These regulations required the selling
price and basis allocated to each asset to be determined by using a
four class residual method.
On February 12, 1986, temporary regulations published as TD 8074 in
the Federal Register (51 FR 5163) (1986-1 C.B. 126) amended
Secs. 1.338-1T, 1.338-4T, and 1.338(h)(10)-1T and added Sec. 1.338-5T.
These regulations provided guidance on international aspects of section
338.
Sections 1.338-1T, 1.338-2T, 1.338-4T, 1.338-5T, and 1.338(h)(10)-
1T were amended by temporary regulations published as TD 8088 in the
Federal Register on May 16, 1986 (51 FR 17929) (1986-1 C.B. 103).
Sections 1.338-1T, 1.338-3T, 1.338-4T, 1.338-5T, and 1.338(h)(10)-1T
were amended by temporary regulations published as TD 8092 in the
Federal Register on July 1, 1986 (51 FR 23741) (1986-2 C.B. 49). The
temporary regulations published on July 1, 1986 also added
Sec. 1.338(b)-4T. These regulations made miscellaneous conforming
changes and transitional rules relating to making and filing section
338 elections.
Section 1060 was added by section 641 of the Tax Reform Act of
1986, Public Law 99-514 (100 Stat. 2282). Section 1060 requires both
the buyer and the seller of a trade or business to allocate their
consideration paid or received to the assets under the same residual
method prescribed by the section 338 regulations. Also as part of the
1986 act, miscellaneous changes were made to section 338 by section
631, 1275, 1804(e), and 1899A (100 Stat. 2269, 2598, 2800, 2958). The
changes to section 338 were made to conform section 338 with the repeal
of the General Utilities doctrine and to define a qualified stock
purchase by reference to section 1504.
General guidance under section 1060 was provided by Sec. 1.1060-1T,
added by temporary regulations published as TD 8215 on July 18, 1986
(53 FR 27035) (1988-2 C.B. 304). These regulations included direction
on the scope of section 1060 and reiterated the four class residual
method found in the section 338 regulations.
Section 1060 was amended by section 1006(h) of the Technical and
Miscellaneous Revenue Act of 1988, Public Law 100-647 (102 Stat. 3410).
This amendment requires the residual method to be used in the case of a
distribution of partnership property or a transfer of an interest in a
partnership, but only in determining the value of goodwill or going
concern value for purposes of applying section 755. Miscellaneous
changes were again made to section 338 by sections 1006(e)(20),
1012(bb)(5)(A), and 1018(d)(9) of the 1988 act (102 Stat. 3403, 3535,
3581).
Sections 338 and 1060 were amended by section 11323 of the Omnibus
Budget Reconciliation Act of 1990, Public Law 101-508 (104 Stat. 1388-
464). The amendments add certain reporting requirements under sections
338 and 1060. In addition, a provision was added to section 1060 under
which parties are bound by written agreements as to allocations or fair
market values. The legislative history indicates that the parties are
so bound unless the parties can refute the agreement under the
standards set forth in Commissioner v. Danielson, 378 F.2d 771 (3d
Cir.), cert. denied, 389 U.S. 858 (1967) (by presenting proof which in
an action between the parties would be admissible to alter that
construction or to show its unenforceability because of mistake, undue
influence, fraud, duress, etc.). See, H.R. Ways and Means Comm., 101st
Cong., 2d Sess. (Print No. 101-37, Oct. 15, 1990), at 79 .
Temporary regulations published as TD 8339 in the Federal Register
on March 15, 1991 (56 FR 11093) (1991-1 C.B. 52) added Sec. 1.338-6T.
The March 15, 1991, temporary regulations provided relief from
situations in which a corporation making an election under section 338
could be subjected to multiple taxation on the same gain as a result of
the 1986 repeal of the General Utilities doctrine.
On January 12, 1992, a notice of proposed rulemaking (C0-111-90)
under section 338 was published in the Federal Register (57 FR 1409)
(1992-1 C.B. 1000). The notice of proposed rulemaking contained
proposed regulations to replace the question and answer asset and stock
consistency rules of Sec. 1.338-4T and the rules relating to the
international aspects of section 338 found in Sec. 1.338-5T. In
addition, the proposed rules restated the remainder of the temporary
regulations under section 338, except that only minor conforming
changes were made to Secs. 1.338(b)-2T and 1.338(b)-3T.
Section 1060 was again amended by section 13261(e) of the Omnibus
Budget Reconciliation Act of 1993, Public Law 103-66 (107 Stat. 539).
This amendment made changes to section 1060 to conform the rules for
actual asset acquisitions to the amortization of intangibles under
section 197. In addition, the legislative history to section 197
suggested that the residual method should be altered to accommodate
section 197 intangibles (See H.R. Rep. 111, 103d Cong., 1st Sess. 760
(May 23, 1993) (1993-3 C.B. 336).
Sections 1.338-1T, 1.338-2T, 1.338-3T, 1.338-4T, 1.338-5T,
1.338(b)-1T, and 1.338(h)(10)-1T were revised and replaced by
Secs. 1.338-1, 1.338-2, 1.338-3, 1.338-4, 1.338-5, 1.338(b)-1, and
1.338(h)(10)-1, respectively, by final regulations published as TD 8515
in the Federal Register on January 20, 1994 (59 FR 2958) (1994-1 C.B.
89). The final regulations published on January 20, 1994 (TD 8515) also
removed Sec. 1.338-6T and added Sec. 1.338(i)-1. Also, a new
Sec. 1.338-4T was added by temporary regulations published as TD 8516
on January 20, 1994 in the Federal Register (59 FR 2956) (1994-1 C.B.
119). The temporary regulations provided consistency rules applicable
to certain cases involving controlled foreign corporations.
Treasury Decision 8626 amended Sec. 1.338-2 by final regulations
published in the Federal Register on October 27, 1995 (60 FR 54942)
(1995-2 C.B. 34), providing rules governing the treatment of an
intragroup merger following a qualified stock purchase of target stock
when a section 338 election is not made for the target.
Section 1.338-4 was amended and Sec. 1.338-4T was removed by final
regulations published as TD 8710 in the Federal Register on January 23,
1997 (62 FR 3458) (1997-1 C.B. 82).
Sections 1.338(b)-2T, 1.338(b)-3T, and 1.1060-1T were amended by
temporary regulations published as TD 8711 in the Federal Register on
January 16, 1997 (62 FR 2267) (1997-1 C.B. 85). The January 16, 1997,
changes to the regulations adapted the residual method to section 197
by adding a fifth class to the residual method prescribed for deemed
and actual asset acquisitions.
B. Current Regulations
Section 338 allows certain purchasers of stock to treat the
purchases instead as purchases of assets. A purchasing corporation can
elect to treat a stock acquisition as an asset acquisition if it
acquires 80 percent of the total voting
[[Page 43464]]
power and 80 percent of the total value of the stock of a target
corporation (not taking into account certain preferred stock) by
purchase within a 12-month period. If a purchasing corporation makes a
section 338 election, the target is treated as if it (as old target)
sold all of its assets at the close of the acquisition date at fair
market value in a single transaction and (as new target) purchased all
of the assets as of the beginning of day after the acquisition date.
If a purchasing corporation acquires the stock of a target
corporation in a qualified stock purchase and makes a section 338(g)
election (i.e., makes a general section 338 election, not a section
338(h)(10) election), old target's gain or loss from the deemed asset
sale is included in old target's final return unless old target is a
member of a consolidated group or is an S corporation. In the
consolidated and S corporation cases, old target files a special final
return including only the items from the deemed asset sale. Sec. 1.338
1(e). In the consolidated case, that return is consolidated with
neither the selling corporation's nor the purchasing corporation's
consolidated group. In the S corporation case, old target must file the
special final return as a C corporation. The section 338(g) election
(as opposed to a section 338(h)(10) election) generally does not change
the tax treatment of the selling shareholders--that is, they are still
taxed on their stock sale, notwithstanding the purchasing corporation's
section 338(g) election.
In certain cases, the selling shareholders may join with the
purchasing corporation in making a section 338(h)(10) election. Until
1994, a section 338(h)(10) election could be made only for target
corporations that were members of a consolidated group. The 1994
revisions to the section 338 regulations (effective retroactively to
1992 at taxpayers' election) expanded the eligibility for section
338(h)(10) elections to target corporations that are members of an
affiliated group and S corporations. The section 338(h)(10) election
changes the tax treatment of old target and the selling shareholders.
Old target is deemed to sell all its assets in a single transaction
while a member of the selling consolidated group (or while a non-
consolidated affiliate, or while an S corporation owned by the selling
shareholders) and is deemed immediately thereafter to distribute the
proceeds in complete liquidation to the members of the selling
consolidated group who sold the target stock (or to the selling
affiliate or to all the S corporation shareholders). Thus, under
section 338(h)(10), the selling shareholders are not treated as selling
stock but instead realize gain or loss, if any, on the stock in the
deemed liquidation. Sec. 1.338(h)(10)-1(d)(2). Usually, a selling
consolidated group or selling affiliate will recognize no stock gain or
loss on the deemed liquidation under section 332. S corporation
shareholders will include their share of items of income, gain, loss,
or deduction on the deemed asset sale passed through to them under
section 1366, increase or decrease their basis accordingly under
section 1367, and then recognize any remaining gain or loss in their
stock under section 331 (the overall effect of which is to recognize
net gain or loss equal to the amount of built-in gain or loss in their
S corporation stock immediately before the qualified stock purchase).
In the case of a section 338(g) election, old target's total amount
realized for the assets it is deemed to sell (aggregate deemed sale
price or ADSP) is the sum of (a) the purchasing corporation's grossed-
up basis in recently purchased target stock; (b) the liabilities of new
target; and (c) other relevant items. This is the amount to be
allocated among the assets sold for purposes of determining gain or
loss on the assets. Sec. 1.338-3(d)(1) and (2). The liabilities
referred to in (b) are those liabilities assumed by new target, but the
amount thereof taken into account in ADSP is determined as if old
target had sold its assets to an unrelated person for consideration
that included the liabilities. The liabilities include any tax
liability resulting from the deemed asset sale. Secs. 1.338-3(d)(3) and
1.338(b)-1(f). In the case of a section 338(h)(10) election, ADSP is
modified. While not stated explicitly, modified ADSP (MADSP) appears to
exclude any tax liabilities resulting from the deemed asset sale.
Sec. 1.338(h)(10)-1(f).
New target's adjusted grossed-up basis in the assets it is deemed
to purchase (AGUB) is the sum of (a) the purchasing corporation's
grossed-up basis in recently purchased target stock; (b) the purchasing
corporation's basis in nonrecently purchased target stock; (c) the
liabilities of new target; and (d) other relevant items. This is the
amount to be allocated among the assets sold for purposes of
determining the purchaser's basis in the assets. Sec. 1.338(b)-1(c)(1).
Section 1060(a) requires a purchaser and a seller to allocate basis
for any applicable asset acquisition in the same manner as amounts are
allocated to such assets under section 338(b)(5). Section 1060(c)
defines an applicable asset acquisition as any transfer of assets that
constitute a trade or business where the transferee's basis is
determined wholly by reference to the consideration paid for the
assets.
Section 338(b)(5) authorizes the Secretary to issue regulations
prescribing how the deemed purchase price is to be allocated among the
assets. Final and temporary regulations under sections 338(b) and 1060,
as amended, implement this authority. The regulations generally require
that the basis of the acquired (or deemed acquired) assets will be
determined using a five class residual method. Class I consists of cash
and cash equivalents; Class II consists of certificates of deposit,
U.S. Government securities, readily marketable stock or securities, and
foreign currency; Class III includes all assets not included in Class
I, Class II, Class IV, or Class V; Class IV consists of section 197
intangible assets except those in the nature of goodwill and going
concern value; and Class V consists of section 197 intangible assets in
the nature of goodwill and going concern value. The total allocable
basis is first decreased by the amount of Class I assets. Any remaining
amount is allocated proportionally to Class II assets to the extent of
their fair market value. Any remaining amount is then allocated first
to Class III assets and then to Class IV assets in the same manner as
to Class II assets. Finally, any remaining amount is allocated to the
Class V assets. See Secs. 1.338(b)-2T and 1.1060-1T.
Reasons for Change
A. In General
The regulations under section 338 have developed, in large part,
through a series of small changes and additions according to the
priorities of taxpayers' and the government's needs and in response to
statutory amendments to section 338 or other relevant Code sections.
Most of the regulations under section 338 (Secs. 1.338-1, 1.338-2,
1.338-3, 1.338-4, 1.338-5, 1.338(b)-1, 1.338(h)(10)-1, and 1.338(i)-1)
were made final as part of a single package as recently as 1994, but,
with the exception of the consistency rules, most of those regulations
were largely restatements of the existing temporary regulations that
had been developed to that point. The remaining temporary regulations
under section 338 and the temporary regulations under section 1060 have
been substantively changed only once since 1986 and 1988, respectively,
to accommodate the addition of section 197 to the Code. As a result of
the ad hoc manner in which the regulations under sections 338 and 1060
have been amended, the current regulations are
[[Page 43465]]
difficult to follow. Thus the IRS and Treasury determined that a review
of the regulations was appropriate.
In addition, the current regulations have proven problematic in
three major respects: first, in their statement of tax accounting rules
and their relationship to tax accounting rules for asset purchases
outside of section 338, second, in the effects of the allocation rules,
and, third, in their lack of a statement of a complete model for the
deemed asset sale (and, in the case of section 338(h)(10) elections,
the deemed liquidation) from which one can determine the tax
consequences not specifically set forth in the regulations.
B. Tax Accounting Rules Under Current Regulations
The current regulations include certain rules for accounting for
items in connection with the deemed asset sale. These tax accounting
rules apply for determining the original amounts of and subsequent
adjustments to ADSP and AGUB. For example, the regulations provide
rules governing the treatment of contingent liabilities deemed assumed
by new target. In some respects the tax accounting rules in the current
regulations differ considerably from the tax accounting rules
applicable to actual asset sales.
Link Between Old Target's and New Target's Tax Accounting
Under the current regulations, ADSP is defined as the sum of (a)
the grossed-up basis of the purchasing corporation's recently purchased
target stock, (b) the liabilities of new target, and (c) other relevant
items. Thus, the calculation of ADSP is linked to the tax accounting
treatment of new target or the purchaser of new target in item (a)
above. Such link does not exist, however, in the case of an actual
asset sale between two parties. In actual asset sales the timing and
amount of the seller's amount realized and the timing and amount of the
buyer's basis may differ. For example, with respect to the link under
(a), the current fair market value of promised future contingent
payments that constitute debt is taken into account in amount realized
under Sec. 1.1001-1(g) unless, in rare and extraordinary circumstances,
the fair market value is not reasonably ascertainable. Yet, under
Sec. 1.1012-1(g), the current fair market value of such future
contingent payments is not taken into account currently in the
purchaser's basis.
This link between old target's deemed sales price and the
purchasing corporation's basis in target stock existed in the original
version of section 338, adopted in 1982. In 1984, Congress removed that
link from the statute, providing instead that old target should be
deemed to sell its assets at fair market value. The regulations
originally allowed old target to choose between using the three-part
formula (items (a) through (c)) above to calculate ADSP and treating
the assets as being sold at their fair market value. In 1994, new
regulations eliminated the election, thereafter requiring use of the
three-part formula. Under the current regulations, any contingent
payments for target stock do not become part of AGUB and ADSP until
they become fixed and determinable. However, no rule prevents the
seller from using all its basis to offset the amount realized in the
year of the deemed sale. As a result of the link between old target's
deemed sales price and the purchasing corporation's purchase price, old
target receives open transaction treatment on terms broader than those
available in an actual asset sale. Compare Sec. 15A.453-1(d)(2)(iii)
(``Only in those rare and extraordinary cases involving sales for a
contingent payment obligation in which the fair market value of the
obligation * * * cannot reasonably be ascertained will the taxpayer be
entitled to assert that the transaction is `open.' '')
Liabilities Assumed
The current regulations specify new target's tax accounting
treatment for the assumption of liabilities. New target takes a
liability into account in AGUB only if it is a bona fide liability of
target as of that date that would be properly taken into account in
basis under principles of tax law if new target had acquired old
target's assets from an unrelated person and, as part of the
transaction, had assumed, or taken property subject to, the
liabilities, and the amount thereof is determined on the same basis.
Sec. 1.338(b)-1(f)(1) and (2).
Under Sec. 1.338(b)-3T(a)(1), AGUB is subsequently redetermined
only if an adjustment would be required, under general principles of
tax law, in connection with an actual asset purchase by new target from
an unrelated person. One of the subsequent events enumerated as an
example is the change in a contingent liability of target to one which
is fixed and determinable. Section 1.338(b)-3T(c)(1) provides that a
contingent amount (including contingent liabilities of old target
deemed assumed) is taken into account at the time at which such amount
becomes fixed and determinable. The statement of the latter rule
suggests to some that it overrides the rules based on general
principles of tax law stated in Secs. 1.338(b)-1(f)(2) and 1.338(b)-
3T(a)(1). However, interpreting the fixed and determinable rule in this
manner would be inconsistent with the economic performance rules of
section 461(h), that, in some circumstances, would operate to defer new
target's taking an assumed liability into account until some time after
the liability becomes fixed and determinable. See Secs. 1.461-4(a) and
1.446-1(c)(1)(ii)(B).
Installment Method
The current regulations provide no rules for old target to report
its deemed sale gain under the installment method. Because the parties
could have structured an actual asset sale to qualify for the
installment method, commentators have argued that making the
installment method available when a section 338(h)(10) election is made
would be consistent with the full asset sale model implied by those
rules. Making the installment method available when only a section
338(g) election is made would not be appropriate because the target
shareholders are still treated as selling stock and because target
would get a step-up in basis of assets before it had borne the tax
burden for such step-up.
C. Allocation Rules Under Current Regulations
Fast Pay Assets
The current regulations employ a residual method of allocation.
Under the residual method, the amount of basis to be allocated to
goodwill and going concern value is based entirely on the amount of
basis remaining to be allocated after all other assets have been
allocated basis to the extent of their fair market values. Because
assets other than goodwill and going concern value tend to be more
easily valued, the residual allocation method is intended to result in
less controversy over the value of goodwill and going concern value.
The legislative history of section 1060, adopted in the Tax Reform Act
of 1986, Public Law 99-514, (100 Stat. 2282), noted with approval the
use of the residual method under the section 338(b) regulations and
required that the same method be used in regulations to be prescribed
under section 1060. See S. Rep. No. 313, 99th Cong., 2d Sess., May 29,
1986, at 254. Accordingly, the current regulations place each acquired
asset into one of five asset classes. The total allocable basis is
allocated among the classes starting with the first class and
proceeding to the final, residual class. No asset in any class except
for the residual class can be allocated more than its fair market
value. If the aggregate basis allocable to a particular
[[Page 43466]]
class is less than the aggregate fair market value of the assets within
the class, each asset is allocated an amount in proportion to its fair
market value and nothing is allocated to any junior class.
The residual allocation method presents unique problems when the
cost of the assets, and hence the basis to be allocated thereto, is
less than the aggregate fair market value of the individual assets.
This situation may arise as a result of the use of contingent
consideration for target stock or the deemed assumption of liabilities
that are not yet taken into account. If this is the case, the basis of
the assets is said to be impaired. Under the residual method, the
impairment is borne equally by the assets in the first class in which
the cumulative fair market value exceeds the remaining aggregate basis
available for allocation. As no basis is allocated to assets in junior
classes, they are also impaired. If such an asset is sold, the taxpayer
will realize a gain on its disposition even if its value has not
increased since the acquisition date. Taxpayers may reverse the gain
recognized in later years if the purchasing corporation pays or incurs
additional amounts for target stock or additional target liabilities
deemed assumed are taken into account. For this reason, the gain
recognized is often referred to as phantom income.
The problem is most acute with assets that turn over quickly, such
as accounts receivable and inventory (fast pay assets). Comments
received on the temporary regulations suggested that fast pay assets
should be placed in a more senior class to make it more likely that
basis is allocated equal to the assets' fair market values in order to
alleviate concerns over phantom income.
Top-Down Allocation
Under the current regulations, stock in a subsidiary is generally a
Class III asset. In allocating basis among tiered corporations, an
allocation to the stock of a subsidiary becomes the starting point for
allocation to the assets inside the subsidiary if a section 338
election is also made for the subsidiary. See, e.g., Sec. 1.338-2(b)(4)
of the current regulations. One might refer to this as top-down
allocation. Under a top-down allocation, the basis of assets of a
particular class can be more impaired at one corporate level than at
another. For example, Class III assets in the parent target corporation
might be allocated some basis while Class II assets in its subsidiary
are allocated no basis because Class I assets in the subsidiary have
absorbed all the basis allocated to the stock in the subsidiary, a
Class III asset. The differences in impairment arising from the
differences in the location of assets and liabilities is inconsistent
with the residual method (e.g., liabilities secured by an asset support
basis of all assets in a single corporation) and can lead to the
misallocation of basis.
D. Statement of Complete Model
For purposes of effectuating the statutory purpose of permitting
taxpayers to elect to treat a stock acquisition as an asset
acquisition, section 338 and the current regulations deem certain
transactions to occur. The current regulations' express statement of
these deemed transactions provides the appropriate Federal income tax
consequences for most targets for which a section 338 election is made.
However, as with the tax accounting rules, some taxpayers interpret the
express statements in the current regulations as resulting in tax
consequences different from those had they actually engaged in the
transactions deemed under the regulations to have occurred or as
resulting in the tax consequences specifically stated and not any of
the collateral consequences.
Explanation of Provisions
A. Overview of Changes
The proposed regulations are intended to clarify the treatment of,
and provide consistent rules (where possible) for, both deemed and
actual asset acquisitions under sections 338 and 1060. In addition, the
proposed regulations propose changes to the current regulations to take
into account changes to the tax law made since the different portions
of the current regulations were published. The changes made by the
proposed regulations have four major components: organization of the
regulations; clarification and modification of the accounting rules
applicable to deemed and actual asset acquisitions; modifications to
the residual method mandated for allocating consideration and basis;
and miscellaneous revisions to the current regulations. These changes
are discussed in the order in which they arise in the proposed
regulations. The IRS and Treasury did not address any provisions of the
regulations relating to the consistency rules or the international
aspects of section 338.
B. Organization of Regulations
The proposed regulations change the organization of the regulations
in order to make the rules for all asset acquisitions more
administrable and provide consistent treatment, when appropriate, for
deemed and actual asset acquisitions. In order to make the regulations
more administrable, the proposed regulations redesignate certain of the
final regulations and reorganize and restate the remaining final and
temporary regulations in a manner that is more consistent with the
approach the IRS and Treasury has taken to drafting regulations in
other areas. The proposed regulations also attempt to provide similar
treatment, when appropriate, for deemed and actual asset acquisitions
by stating the relevant concepts once in the regulations under section
338 and cross-referencing those rules in Sec. 1.1060-1 of the proposed
regulations.
New Sec. 1.338-1 includes a scope statement. Section 1.338-1 also
addresses the question of to what extent the deemed asset sale and
other elements of the section 338 regime are considered as actually
having occurred for purposes of application of other Code sections,
such as those relating to retirement plan sponsors. Terminology and
definitions and provisions regarding the mechanics of the section 338
election of current Sec. 1.338-1 have been moved to new Sec. 1.338-2.
The return filing rules of current Sec. 1.338-1 have been moved to
their own section, Sec. 1.338-10. All of the current Sec. 1.338-2 rules
for qualification for making the section 338 election and rules
relating to the effect on continuity of proprietary interest have been
moved to new Sec. 1.338-3.
The rules defining ADSP, as well as various rules relating to
taxation of old target, currently in Sec. 1.338-3, are in Sec. 1.338-4
of the proposed regulations. The rules defining AGUB, currently in
Sec. 1.338(b)-1, are in Sec. 1.338-5. Current Sec. 1.338(b)-3T sets
forth the timing of increases or decreases in ADSP and AGUB; these
timing rules have been moved to new Sec. 1.338-4 (ADSP) and new
Sec. 1.338-5 (AGUB).
Current Secs. 1.338-4 and 1.338-5, dealing with consistency and
with international aspects of section 338, respectively, have been
renumbered Sec. 1.338-8 and 1.338-9, respectively. The substance of
these rules has not been addressed in connection with these proposed
regulations.
Section 1.338-6 of the proposed regulations addresses allocation of
ADSP and AGUB among assets, currently covered by Sec. 1.338(b)-2T. The
rules pertaining to subsequent adjustments to ADSP and AGUB, currently
in Sec. 1.338(b)-3T, are in Sec. 1.338-7 of the proposed regulations.
[[Page 43467]]
Section 1.338(h)(10)-1 has not been renumbered.
C. Section 1.338-1 General Principles; Status of Old Target and New
Target
Regulations' Scope Statement
The scope statement describes the general model of the deemed asset
sale and other aspects of the regulations used as the basis for the
rules in the proposed regulations. This statement of the model should
assist the reader generally in the correct interpretation and
application of the regulations. This section also provides that old
target and new target (as well as any other affected parties, for
example, when a section 338(h)(10) election is made) are to determine
the tax consequences as if they had actually engaged in the
transactions deemed under the section 338 regulations to have occurred.
Thus, the proposed regulations clarify that old target's deemed asset
sale may result in tax consequences for old target and new target (such
as income and deduction) in addition to old target's gain or loss
realized on its deemed sale of assets. For example, if target is an
insurance company for which a section 338 election is made, the deemed
asset sale would be characterized and taxed as an assumption-
reinsurance transaction under applicable Federal income tax law. See
Sec. 1.817-4(d).
The proposed regulations make minor amendments to the list of
sections in subtitle A for purposes of which old target and new target
are considered the same corporation, notwithstanding the deemed asset
sale between the two. Such changes generally are with respect to
retirement plan and similar provisions.
Anti-Abuse Rule
The proposed regulations incorporate an anti-abuse rule giving the
Commissioner, for purposes of calculating ADSP and AGUB and allocating
ADSP and AGUB among assets, the authority under certain circumstances
(a) to treat as not being part of target's assets those added to the
pool of target's assets before the deemed asset sale and (b) to treat
as being part of target's assets those removed from the pool of
target's assets before the deemed asset sale. The Commissioner's
authority to treat assets added to the pool as not being part of the
pool exists when the property is transferred to old target in
connection with the transactions resulting in the application of the
residual method if such property is, within 24 months after the deemed
asset sale, (a) not owned by new target but owned, directly or
indirectly, by a member of the affiliated group of which new target is
a member, or (b) owned by new target but held or used to more than an
insignificant extent in connection with an activity conducted, directly
or indirectly, by another member of the affiliated group of which new
target is a member in combination with other property acquired,
directly or indirectly, from the transferor of the property to old
target. The Commissioner's authority to treat assets removed from the
pool as being part of the pool exists where the property is removed in
connection with the transactions resulting in the application of the
residual method if the removed property, within 24 months after the
deemed asset sale, (a) is owned by new target, or (b) is owned,
directly or indirectly, by a member of the affiliated group of which
new target is a member and continues after the election to be held or
used to more than an insignificant extent in connection with one or
more of the activities of new target.
D. Section 1.338-2 Nomenclature and Definitions; Mechanics of the
Section 338 Election
Definitions
Four definitions of terms already used in the current regulations
have been added to the proposed regulations under section 338. These
terms are acquisition date asset, deemed asset sale, deemed sale gain,
and deemed sale return. The scope of some of these terms has been
expanded from their usage in the current regulations. For example,
deemed asset sale refers to the transaction deemed under the section
338 regulations to occur between old target and new target and deemed
sale gain, refers to, in the aggregate, the Federal income tax
consequences (generally, the income, gain, deduction, and loss) of the
deemed asset sale. Deemed sale gain can also refer to the Federal
income tax consequences of the transfer of a particular individual
asset in the deemed asset sale. The expanded definition of deemed sale
gain in conjunction with the rules in Sec. 1.338-7(c) of the proposed
regulations (Sec. 1.338(b)-3T(h) of the current regulations) provides a
mechanism for target (or, in the case of a section 338(h)(10) election,
the member of the selling consolidated group, the selling affiliate, or
the S corporation shareholders to which such income, loss, or other
amount is attributable) to report items that are properly taken into
account after the acquisition date. One such item would be the
deduction for an assumed liability of old target that it could not
deduct under its method of accounting on or before the acquisition
date.
The definition of purchasing corporation has been clarified to
include new target (new T) with respect to its deemed purchase of stock
in its own subsidiary.
The definition of selling group in Sec. 1.338-2 of the proposed
regulations and related provisions in Sec. 1.338(h)(10)-1 of the
proposed regulations provide that a section 338(h)(10) election may be
made for target notwithstanding that it was at some time during the
year in which the acquisition date occurs the common parent of its
affiliated or consolidated group, so long as it is not the common
parent on the acquisition date.
E. Section 1.338-3 Qualification for the Section 338 Election
More Than a Nominal Amount Paid for Purchase of Stock
The IRS and Treasury have received many informal comments in which
guidance was requested on whether a section 338 election may be made
for a target that is insolvent. In order to have a purchase of a share
of stock in target, the proposed regulations generally require that
more than a nominal amount of consideration be paid for the stock. With
respect to target affiliates, one cannot adequately determine whether
more than a nominal amount of consideration is paid for the stock
because the amount paid is not determined in an arm's length
transaction but instead under the allocation rules of the regulations.
Consequently, the proposed regulations provide that stock in a target
affiliate acquired by new target in the deemed asset sale of target's
own assets is considered purchased if, under general principles of tax
law, new target is considered to own stock of the target affiliate
meeting the requirements of section 1504(a)(2), notwithstanding that no
purchase price may be allocated to target's stock in the target
affiliate. For a discussion of the tax consequences when a qualified
stock purchase is made of an insolvent corporation and a section
338(h)(10) election is made, see the discussion of section 338(h)(10)
elections later in this preamble.
Time for Testing Relationship
A section 338 election may be made only with respect to a
transaction that qualifies as a purchase within the meaning of section
338(h)(3). Under section 338(h)(3)(iii), the parties to the transaction
must be unrelated in order for a transaction to qualify as a purchase.
The statute is unclear,
[[Page 43468]]
however, as to when the relationship between the parties is tested. The
proposed regulation provides that the relationship is tested
immediately after the transaction. This rule gives effect to the
statutory objective of preventing a transferor from obtaining the
benefits of a section 338 election while retaining a significant
interest, directly or indirectly, in the property transferred. This
rule also furthers the statutory objective of affording similar tax
treatment to section 338 deemed asset sales and actual asset sales. For
example, under this rule, if an actual sale of assets would qualify as
a reorganization under section 368(a)(1)(D) (with a carryover of basis
and other attributes), taxpayers are not able to reach a different
result by structuring the transaction as a stock sale and electing
under section 338.
F. Sections 1.338 4 and 1.338 5 Aggregate Deemed Sale Price; Various
Aspects of Taxation of the Deemed Asset Sale; Adjusted Grossed-up Basis
Breaking the Link Between ADSP and AGUB
Under the current regulations, the first element in the definition
of ADSP is the grossed-up basis of the purchasing corporation's
recently purchased target stock. The combination of the link between
the definitions of ADSP and AGUB with the rule in the current
regulations that contingent payments are taken into account in AGUB as
they become fixed and determinable effectively affords old target open-
transaction treatment, which treatment generally is inconsistent with
Secs. 15A.453-1(d)(2)(iii) and 1.1001 1(g)(2). The proposed regulations
remove the link in the current regulations between calculation of the
first element of ADSP and the purchaser's basis in recently purchased
target stock.
The new first element in the calculation of ADSP is the grossed-up
amount realized on the sale to the purchasing corporation of the
purchasing corporation's recently purchased target stock. Amount
realized is determined as if old target itself were the selling
shareholder. Also, notwithstanding that the sellers of the target
shares may use the installment method of section 453 to report their
gain on the stock, old target may not use the installment method in the
calculation of the first element of ADSP.
Time and Amount Combined
The proposed regulations provide that general principles of tax law
apply in determining the timing and amount of the elements of ADSP, and
that ADSP is redetermined at such time and in such amount as an
increase or decrease would be required, under general principles of tax
law, to the individual constituent elements of the definition of ADSP.
The proposed regulations also provide a parallel rule for AGUB.
Substantively, the two statements are designed to eliminate special
accounting rules included in the current section 338 regulations-such
as the current regulations' fixed and determinable rule for the timing
of taking into account contingent amounts-and to bring taxation of old
target's deemed asset sale closer to the taxation of an actual asset
sale. In contrast to the current regulations, the proposed regulations
state in one location all the rules for determining ADSP and AGUB.
Both the breaking of the link between the calculation of ADSP and
the purchaser's basis in recently purchased stock and the removal of
the fixed and determinable rule for contingent liabilities may often
result in increased disparities between ADSP and AGUB.
Liabilities
The current regulations appear to presume that any tax liability of
old target incurred on its deemed asset sale is a liability assumed by
new target if a section 338(h)(10) election is not made but is not a
liability assumed by new target if a section 338(h)(10) election is
made. These presumptions apparently required that the definition of
ADSP be modified in current Sec. 1.338(h)(10)-1. The proposed
regulations make clear that, whether or not a section 338(h)(10)
election is made, old target's tax liability is deemed not assumed by
new target only if the parties have agreed that (or the tax or non-tax
rules operate such that) the seller, and not target, will bear the
economic cost of that tax liability. This is because the legal burden
for the tax would otherwise remain with target. Thus, the proposed
regulations remove the term MADSP from Sec. 1.338(h)(10)-1, and extend
the use of the term ADSP to that regulation.
Under the proposed regulations, the amount of liabilities of old
target taken into account to calculate ADSP is determined as if old
target had sold its assets to an unrelated person for consideration
that included the unrelated person's assumption of, or taking subject
to, the liabilities. Similarly, they provide that, in order to be taken
into account in AGUB, a liability must be a liability of target that is
properly taken into account in basis under general principles of tax
law that would apply if new target had acquired its assets from an
unrelated person for consideration that included the assumption of, or
taking subject to, the liability. Regarding the timing of taking such
liabilities into account, the proposed regulations provide that general
principles of tax law apply in determining the timing and amount of the
elements of ADSP and AGUB. Thus, for example, under general principles
of tax law, a particular liability might not be taken into account in
basis when a purchaser buys an asset subject to such liability, but
might be taken into account at some later date; such timing controls
the timing of including the liability in AGUB. Accordingly, the current
rule in the regulations that liabilities are taken into account in
calculating AGUB, and apparently ADSP, only when such liabilities
become fixed and determinable is removed in the proposed regulations.
Costs
The treatment of selling costs for old target and acquisition costs
for new target is modified. For old target, it is made clear that when
grossing-up the selling shareholders' amount realized where not all the
target stock is recently purchased by the purchaser, the amount of
selling costs by which that grossed-up amount realized is reduced is
not itself grossed-up. For new target, the definition of AGUB is
changed such that when the purchaser's basis in recently purchased
stock is grossed-up, acquisition costs are no longer also grossed-up.
Grossing-up the selling shareholders' selling costs or the
purchasing corporation's acquisition costs would result in costs not
actually incurred reducing old target's amount realized for the assets
or increasing new target's cost basis in the assets. The IRS and
Treasury do not believe that these results are appropriate because
there is no evidence that the purchasing corporation's costs to acquire
an amount of target stock sufficient for there to be a qualified stock
purchase would increase proportionately if it acquired all of the
target stock and the deemed asset sale mechanism allows taxpayers to
avoid many of the costs that would be incurred in an actual asset sale.
Accordingly, the IRS and Treasury have exercised the authority under
section 338(b)(2) to prevent the grossing-up of selling costs and
acquisitions costs.
Other Relevant Items
The element other relevant items is removed from the definitions of
both ADSP and AGUB as it no longer serves any function. In the current
regulations, this element reduces ADSP for the purchasing corporation's
acquisition
[[Page 43469]]
costs that would otherwise be taken into account because the
purchaser's basis in recently purchased stock was an element in
calculation of both ADSP and AGUB. This element becomes unnecessary
with the removal of the link between ADSP and AGUB.
G. Section 1.338-6 Allocation of ADSP and AGUB Among Target Assets
Allocation of ADSP and AGUB Generally
Apart from a change in the number of classes, the proposed
regulations generally do not represent a substantive change in the
system of allocation of ADSP and AGUB. The proposed regulation states
the allocation rules that apply equally to ADSP and AGUB and then
states the modifications to those common allocation rules for AGUB.
Transaction Costs
Generally, the definition of fair market value is the price at
which a willing seller will transfer an asset to a willing buyer.
Therefore, the fair market value of a particular asset to a seller is
not different from the fair market value of the same asset to a buyer,
even though the economic value of the asset to each would reflect the
selling costs or acquisition costs. A seller may reduce its amount
realized on an asset and a buyer may increase its cost basis in an
asset for the transaction costs specifically allocable to the asset in
an actual asset sale. Because the underlying transaction in section 338
is actually a stock sale, the costs incurred are not specifically
allocable to any individual asset deemed transferred, but rather to the
stock. Therefore, in applying the residual method to a deemed asset
sale, transaction costs are accounted for only by decreasing the total
amount realized by the seller or increasing the total cost basis of the
buyer. In contrast, see the discussion of the treatment of transaction
costs in an actual asset acquisition below.
IRS Challenges to Asset Fair Market Value
Drawing from the existing rules under section 1060, the proposed
regulations provide that the IRS may challenge a taxpayer's
determination of the fair market value of any asset by any appropriate
method and take into account all factors, including any lack of adverse
tax interests between the parties.
Number and Content of Classes
The seven classes under the proposed regulations are as follows:
Class I, cash and cash equivalents; Class II, actively traded personal
property as defined in section 1092(d), certificates of deposit, and
foreign currency; Class III, accounts receivable, mortgages, and credit
card receivables which arise in the ordinary course of business; Class
IV, stock in trade of the taxpayer or other property of a kind which
would properly be included in the inventory of taxpayer if on hand at
the close of the taxable year, or property held by the taxpayer
primarily for sale to customers in the ordinary course of his trade or
business; Class V, all assets not in Class I, II, III, VI, or VII;
Class VI, all section 197 intangibles except goodwill or going concern
value; and Class VII, goodwill and going concern value.
AGUB Less Than the Amount of Class I Assets
The proposed regulations clarify that, if the total AGUB (or
consideration in an applicable asset acquisition under section 1060) to
be allocated is less than the amount of Class I assets (i.e., cash and
cash equivalents), then new target (or the purchaser in an applicable
asset acquisition under section 1060) immediately recognizes ordinary
income to that extent.
Marketable Securities
The current regulations include marketable stock and securities, as
defined in Sec. 1.351-1(c)(3), in Class II. Marketable stock and
securities are included in Class II because a value can be easily
assigned at any given time by looking at the value at which those
instruments were trading on a securities exchange. Since the time Class
II was first defined, financial markets have evolved and a greater
variety of financial instruments can be readily valued in the same
manner. The proposed regulations instead defines Class II with respect
to actively traded personal property as defined under section 1092(d)
because the regulations under that section have a more comprehensive
definition of public financial markets.
Fast Pay Assets
The IRS and Treasury are aware that many taxpayers engage in
transactions solely to avoid the impairment problems with fast-pay
assets. In addition, the IRS spends time evaluating whether such
transactions are subject to challenge under the section 338 regulations
or general principles of tax law. In order to address these concerns,
the proposed regulations create two new classes of assets between
current Classes II and III, one for accounts receivable, mortgages, and
credit card receivables which arise in the ordinary course of business
and another for stock in trade of the taxpayer or other property of a
kind which would properly be included in the inventory of taxpayer if
on hand at the close of the taxable year, or property held by the
taxpayer primarily for sale to customers in the ordinary course of its
trade or business.
Residual Class
In the current regulations, Class V, the residual class, is
comprised of section 197 intangibles in the nature of goodwill and
going concern value. Class IV is comprised of all section 197
intangibles except those in the nature of goodwill and going concern
value. Because many section 197 intangibles would have been
characterized by the IRS as assets in the nature of goodwill and going
concern value prior to the enactment of section 197, the current
regulations provide somewhat ambiguous guidance as to the line between
current Class IV and current Class V. Accordingly, the proposed
regulations remove the phrase ``in the nature of.'' Furthermore, in
rare circumstances, goodwill or going concern value is not a section
197 intangible. The residual class should include all goodwill and
going concern value to ensure that the residual method serves the
purpose of reducing valuation controversies. Therefore, the proposed
regulations define the residual class as goodwill and going concern
value without any reference to whether those assets would qualify as
section 197 assets.
In TD 8711, supra, the IRS amended the current regulations to adapt
the residual method to section 197 by creating a new Class IV for
section 197 intangibles other than goodwill or going concern value and
providing that goodwill and going concern value would remain in a true
residual class. The proposed regulations retain this distinction in
renumbered Class VI and Class VII. Allocating goodwill and going
concern value to Class VII avoids the need for determining the value of
goodwill and going concern value through a non-residual method.
Allocation of AGUB When Gain Recognition Election Available but Not
Made
When the purchaser of the target stock holds nonrecently purchased
target stock and no section 338(h)(10) election is made, the purchaser
has the option of making or not making the gain recognition election.
(If a section 338(h)(10) election is made, the making of the gain
recognition election is automatic rather than elective.) The proposed
regulations retain these rules. The current regulations have a special
allocation rule when the failure to make
[[Page 43470]]
the gain recognition election leaves AGUB less than ADSP (that is, when
the purchaser's nonrecently purchased stock was bought at a lower price
than the recently purchased stock). Under the special allocation rule,
AGUB, after reduction by the amount of Class I assets, is allocated
among all other assets, regardless of their class, in proportion to
their fair market values. (For this purpose, the fair market value of
assets in the residual class (current Class V) is deemed to be the
excess, if any, of the hypothetical purchase price over the sum of the
Class I assets and the fair market values of the Class II, III, and IV
assets. The hypothetical purchase price is the AGUB that would result
if a gain recognition election were made.)
If, looking at the hypothetical purchase price, full fair market
value was paid on the acquisition date for assets in each class above
the residual class, the current regulation's special allocation rule
spreads the impairment that arises because no gain recognition election
was made equally among all assets in classes below Class I. However,
if, looking at the hypothetical purchase price, full fair market value
was not paid on the acquisition date for assets in each class above the
residual class, this rule spreads the impairment that arises because no
gain recognition election was made as well as the impairment that
arises from the bargain purchase equally among all assets in classes
below Class I. In the latter case, the prioritization of classes under
the residual method becomes irrelevant by the failure to make a gain
recognition election. Prior to the enactment of section 197, the effect
of the current regulations generally would have been to shift basis
from depreciable or amortizable assets to nondepreciable,
nonamortizable assets.
The proposed regulations modify the special allocation rule to
minimize this effect. Generally, under the modified special allocation
rule, the portion of AGUB (after reduction by the amount of Class I
assets) to be allocated to each Class II, III, IV, V, VI, and VII asset
is determined by multiplying (a) the amount that would be allocated to
such asset under the general rules for allocation of AGUB were AGUB
increased to equal the hypothetical purchase price by (b) a fraction,
the numerator of which is actual AGUB (after reduction by the amount of
Class I assets) and the denominator of which is the hypothetical
purchase price (after reduction by the amount of Class I assets). The
reason for the modification is to spread only the impairment that
arises because no gain recognition election was made equally among all
assets in classes below Class I.
The IRS and Treasury request comments as to whether any special
allocation rule has continuing merit.
H. Section 1.338-7 Allocation of Redetermined ADSP and AGUB Among
Target Assets
In General
Section 1.338(b)-3T of the current regulations addresses subsequent
adjustments to ADSP and AGUB. In the proposed regulations, these rules,
contained in Sec. 1.338-7, have been streamlined and some of their
content has been moved to the sections defining ADSP and AGUB,
Secs. 1.338-4 and 1.338-5 respectively. The proposed regulations
eliminate the use of the term adjustment event used in certain
provisions of the current regulations. Instead, the proposed
regulations provide simply that when general principles of tax law
require a change in the amount of any of the various elements of ADSP
or AGUB (discussed earlier), the new ADSP or AGUB amount is reapplied
to produce new allocations to the assets. This generally is not
intended as a substantive change to the current rules for subsequent
adjustments provided in Sec. 1.338(b)-3T.
Item-Specific Adjustments
The current regulations at Sec. 1.338(b)-3T contain special rules
for changes to AGUB (and thus, indirectly, to ADSP) that relate to the
income produced by intangible assets. The special rules apply for
purposes of allocating an increase or decrease in AGUB or ADSP to the
extent (a) the contingency that results in the increase or decrease
directly relates to income produced by a particular intangible asset
(contingent income asset) and (b) the increase or decrease is related
to such contingent income asset and not to other target assets. The
special rules consist of two provisions that vary from the normal rules
of Sec. 1.338(b)-3T. Under the first provision, the fair market value
of the contingent income asset at the beginning of the day after the
acquisition date is redetermined at the time of the increase or
decrease in AGUB or ADSP (but only those circumstances that resulted in
the increase or decrease to AGUB or ADSP are taken into account in the
redetermination). Under the second, the increase or decrease in AGUB or
ADSP is allocated first to the contingent income asset, not to all
assets generally under the normal allocation rules. Any portion that
cannot be so allocated because of the fair market value limitation (as
redetermined) is allocated under the normal allocation rules.
The intent of this rule was to accommodate the uncertainties in the
valuation of contingent income assets. The rule produces an allocation
that would have resulted if the parties had known on the acquisition
date the fair market value of the contingent income asset (as
determined, with hindsight, on the date of the adjustment event) and
paid on the acquisition date the increased or decreased consideration.
The IRS and Treasury weighed the usefulness of this rule with its
complexity and decided that the proposed regulations should not include
any item-specific adjustment rule. Commentators, if they believe that
the item-specific adjustment rule continues to serve a useful function
that justifies its retention, should identify in their comments in what
circumstances the rule has proven useful or could prove useful.
Commentators should also identify what provisions would be necessary
for an effective item-specific adjustment rule.
I. Section 1.338(h)(10)-1 Deemed Asset Sale and Liquidation
Model
The proposed regulations explain the effects of the section
338(h)(10) election on the parties involved. The proposed regulations
discuss the effects of the section 338(h)(10) election on the
purchasing corporation, the effects on new target, the effects on old
target, and the effects on old target's shareholders (including non-
selling shareholders).
As with the rest of the proposed regulations, proposed
Sec. 1.338(h)(10)-1 describes the model on which taxation of the
section 338(h)(10) election is based. Under the proposed regulations,
old target is treated as transferring all of its assets by sale to an
unrelated person. Old target recognizes the deemed sale gain while a
member of the selling consolidated group, or owned by the selling
affiliate, or owned by the S corporation shareholders (both those who
actually sell their shares and any who do not). Old target is then
treated as transferring all of its assets to members of the selling
consolidated group, the selling affiliate, or S corporation
shareholders and ceasing to exist. If target is an S corporation, the
deemed asset sale and deemed liquidation are considered as occurring
while it is still an S corporation. The proposed regulations treat all
parties concerned as if the fictions the section 338(h)(10) regulations
deem to occur actually did occur, or as closely thereto as possible.
The structure of this model
[[Page 43471]]
should help taxpayers answer any questions not explicitly addressed by
the proposed regulations. Also, old target generally is barred by the
proposed regulations from obtaining any tax benefit from the section
338(h)(10) election that it would not obtain if it actually sold its
assets and liquidated.
The treatment of S corporation targets which own one or more
qualified subchapter S subsidiaries (as defined in section 1361(b)(3))
is also addressed, as is the treatment of tiered targets (i.e., the
order of their deemed asset sales and deemed liquidations).
Deemed Liquidation
The current regulations provide that, when a section 338(h)(10)
election is made, old target is deemed to sell all of its assets and
distribute the proceeds in complete liquidation. The term complete
liquidation is generally considered to be a term of art in tax law. The
proposed regulations instead provide that old target transferred all of
its assets to members of the selling consolidated group, the selling
affiliate, or S corporation shareholders and ceased to exist, making it
clear that the transaction following the deemed asset sale does not
automatically qualify as a distribution in complete liquidation under
either section 331 or 332. This is meant to clarify any inference one
might draw from previous regulations that section 332 treatment is
automatic under section 338(h)(10) in the case of an affiliated or
consolidated group. For example, if S owns all of the stock of T, T is
insolvent because of its indebtedness to S, P acquires T from S in a
qualified stock purchase, and, as a condition of the sale, S cancels
the debt owed it by T, and P and S make a section 338(h)(10) election
for target, T's deemed liquidation would not qualify under section 332
because S would not be considered to receive anything in return for its
stock in T. Rev. Rul. 68-602 (1968-2 C.B. 135).
Special S Corporation Issues
The current regulations provide that, notwithstanding the purchase
of 80 percent of the shares of an S corporation by a purchasing C
corporation, the S corporation continues to be considered an S
corporation for purposes of determining the tax effects of the section
338(h)(10) election to old target and its S corporation shareholders.
For example, old target reports to its shareholders under section 1366
the tax effects of its deemed asset sale, and the shareholders adjust
their stock basis pursuant to section 1367. The proposed regulations
clarify that when the target itself is an S corporation immediately
before the acquisition date, any direct and indirect subsidiaries of
target with respect to which qualified subchapter S subsidiary
elections are in effect are considered to remain qualified subchapter S
subsidiaries for purposes of target's and its S corporation
shareholders' reporting the effects of target's deemed sale of assets
and deemed liquidation. No similar rule applies when a qualified
subchapter S subsidiary, as opposed to the S corporation that is its
owner, is the target corporation. The IRS and Treasury request comments
as to whether it would be beneficial to make section 338(h)(10)
elections available for acquisitions of qualified subchapter S
subsidiaries and as to how the section 338(h)(10) regulations should be
modified to accommodate the unique taxation of these entities.
The proposed regulations clarify the effects of the section
338(h)(10) election on both selling and non-selling S corporation
shareholders. For example, the proposed regulations clarify that all S
corporation shareholders, selling or not, must consent to the making of
the section 338(h)(10) election, particularly because the non-selling
shareholders have to include their proportionate share of the deemed
sale gain under section 1366. Form 8023 will be corrected to reflect
this requirement.
Availability of the Section 453 Installment Method
When some or all of the target stock is purchased for an
installment obligation and a section 338(h)(10) election is made, the
proposed regulations make the section 453 installment method available
to old target in its deemed asset sale, as long as the deemed asset
sale would otherwise qualify for installment sale reporting. Solely for
purposes of the application of section 453 and related provisions to
the deemed asset sale and subsequent deemed corporate liquidation under
section 338(h)(10), old target generally is considered to receive from
new target in the deemed asset sale consideration consisting of the
installment obligation given to old target shareholders in exchange for
recently purchased stock, the assumption of, or taking subject to, old
target liabilities, and cash. Thus, regardless of its actual character,
any consideration conveyed by the purchaser to the selling shareholders
other than installment obligations is considered to have been in cash,
including for instance the purchaser's assumption of, or taking subject
to, liabilities of the selling shareholders. In addition, the amount of
any grossing-up under Sec. 1.338-4(d) of the proposed regulations is
deemed to be in the form of cash. For purposes of section 453, new
target is considered to be the obligor on the installment obligation
the purchasing corporation actually issued. The provisions of sections
453(h), 453B(d), and 453B(h) may then apply to old target and its
shareholders with respect to the deemed liquidation of old target
following the deemed asset sale. In the deemed liquidation, a selling
shareholder who actually received an installment obligation in the
stock sale is deemed to receive that installment obligation as part of
the liquidating distribution; the other shareholders are deemed to
receive none of the installment obligation.
The proposed regulations provide that old target generally is
barred from obtaining any tax benefit from the section 338(h)(10)
election that it would not obtain if it actually sold its assets and
liquidated. This bar extends to the application of section 453. In
other words, the results of application of section 453 to old target
should be as close as possible to those that would occur if old target
actually sold its assets for an installment obligation of the
purchaser. Thus, for example, the installment method of section 453
applies unless old target affirmatively elects out of the installment
method.
As another example, Sec. 15A.453-1(b)(2)(iv) provides that any
obligation created subsequent to the taxpayer's acquisition of the
property and incurred or assumed by the taxpayer or placed as an
encumbrance on the property in contemplation of disposition of the
property is not qualifying indebtedness if the arrangement results in
accelerating recovery of the taxpayer's basis in the installment sale.
Old target would be subject to this test with respect to its debts new
target is deemed to assume or take subject to.
Further, the rule of section 453A requiring payment of interest
will apply in the same manner as it would apply if target actually sold
all its assets in return for consideration that included an installment
obligation from the purchaser and then distributed in complete
liquidation all the consideration received.
Tiered Targets
The proposed regulations provide that, in the case of parent-
subsidiary chains of corporations making section 338(h)(10) elections,
the deemed asset sale at the parent level is considered to precede that
at the subsidiary level. The proposed regulations then provide,
however, that the deemed liquidation of
[[Page 43472]]
the subsidiary is considered to precede the deemed liquidation of the
parent.
Additional Information Required
The proposed regulations provide that the Commissioner may exercise
the authority granted in section 338(h)(10)(C)(iii) to require the
provision of any information deemed necessary to carry out the
provisions of section 338(h)(10) by requiring submission of information
on any tax reporting form. The IRS and Treasury are considering
requiring that the information about the amount and allocation of AGUB
and ADSP currently submitted on the election form (Form 8023) instead
be submitted by the purchaser and seller(s) separately on their income
tax returns, and is interested in comments on this approach.
J. Section 1.1060-1
Definition of Trade or Business
Section 1060 applies to the direct or indirect transfer of a trade
or business. Under the current regulations, a group of assets
constitutes a trade or business if the use of such assets would
constitute an active trade or business for purposes of section 355.
Further, even if a group of assets would not qualify as an active trade
or business for purposes of section 355, a group of assets will
constitute a trade or business for purposes of section 1060 if goodwill
or going concern value could attach under any circumstances. The
current regulations set out factors that will be considered in
determining whether goodwill or going concern could attach.
Although the current regulations set out factors, there are still
ambiguities regarding when goodwill or going concern value could
attach. For example, Sec. 1.1060-1T(b)(2) has been misinterpreted to
mean that a trade or business exists only when basis is allocated to
goodwill or going concern value under the residual method. Under the
misinterpretation, a taxpayer would be required to filter every bulk
asset purchase through the residual allocation method in order to
determine whether the transaction is subject to section 1060. The
proposed regulations clarify that a trade or business is present if
goodwill or going concern value could attach to the group of assets,
regardless of whether any value will eventually be allocated to the
residual class (Class VII).
In addition, the proposed regulations provide that the presence of
assets in the nature of section 197 assets is a factor to be considered
in determining whether goodwill or going concern value could attach.
This clarification recognizes that many section 197 assets would have
been considered part of goodwill or going concern value at the time
Congress enacted section 1060. However, the proposed regulations make
it clear that the transfer of an isolated section 197 asset will not be
subject to section 1060.
The proposed regulations clarify that an applicable asset
acquisition can occur even if the trade or business is transferred from
seller to purchaser in a series of related transactions and that the
residual method must be applied once to all of the assets transferred
in a series of related transactions. The proposed regulations also
incorporate the principles of the anti-abuse rule from Sec. 1.338-1(c)
of the proposed regulations to determine which assets must be included
for purposes of applying the residual method.
Asymmetrical Transfers of Assets
Section 1060 applies to the direct or indirect acquisition of a
trade or business when the purchaser's basis in the assets (other than
assets to which section 1031 applies) is determined wholly by reference
to the consideration paid by the purchaser. This rule clarifies that a
purchaser of assets in an applicable asset acquisition is subject to
the allocation rules set out in Secs. 1.338-6 and 1.338-7 even if the
transferor in the transaction is treated as transferring something
different from the assets the transferee is treated as receiving. For
example, Rev. Rul. 99-6 (1999-6 I.R.B. 6) concerns the purchase, by one
person, of all of the interests in a limited liability company which is
classified as a partnership under Sec. 301.7701-3. The revenue ruling
sets forth two situations and holds that each seller is treated as
having transferred its interests in the partnership, while each
purchaser is treated as having purchased the assets of the limited
liability company. The proposed regulations make it clear that each
purchaser described in Rev. Rul. 99-6 must use the residual method
prescribed under Secs. 1.338-6 and 1.338-7 to allocate the
consideration paid for the purchased assets (provided that the asset
transfer otherwise qualifies as an applicable asset acquisition).
Multiple Trades or Businesses Transferred in a Single Transaction
The current regulations are silent on the proper application of the
residual method to situations when a seller transfers a group of assets
that could be categorized as constituting more than one trade or
business. The proposed regulations clarify that, as long as any part of
the assets are a trade or business, all of the assets are to be treated
as a single trade or business for purposes of applying the residual
method. Therefore, the residual method should be applied once to all of
the assets transferred, rather than to blocks of the assets separately.
This rule is intended to reduce valuation conflicts regarding how much
consideration should be allocated to each separate group of assets. By
treating all of the assets as a single trade or business, all assets in
Classes I through VI can receive full fair market value allocation
before the goodwill of any trade or business is allocated basis. In
addition, this rule brings actual asset acquisitions into conformity
with deemed asset acquisitions by allocating consideration paid across
all assets acquired, without looking to the trade or business with
which they are associated.
Miscellaneous Changes
The proposed regulations incorporate two miscellaneous changes
addressing issues that have arisen under the current regulations.
First, the proposed regulations include any covenants entered into
between the seller and the purchaser in connection with an applicable
asset acquisition as an asset transferred as part of a trade or
business even though, to the seller, the covenant is a contract for
services. As a result, sellers must include any covenants in the asset
pool for purposes of applying the residual method, thus allowing for
greater symmetry to be achieved between the purchaser and seller.
Second, the like-kind exchange rule in the current regulation has
been expanded. Under this expanded rule, if an applicable asset
acquisition includes property that is transferred subject to any
provision of the Code or regulations that has the tax effect of section
1031, the tax treatment determined under such provision is given
effect. The residual method is then applied to the remaining assets and
consideration exchanged.
In addition, the proposed regulations no longer separately state
the residual allocation method. Instead, proposed Sec. 1.1060-1
incorporates the residual method by cross reference to proposed
regulations Secs. 1.338-6 and 1.338-7. Proposed regulation Sec. 1.1060-
1 only sets out rules in which the treatment of an actual asset
acquisition differs from the treatment of a deemed asset acquisition.
By cross-referencing the section 338 regulations rather than separately
stating the residual method, the proposed regulations ensure that
deemed and actual asset acquisitions will be treated similarly to the
extent possible.
[[Page 43473]]
Transaction Costs
Under the current regulations, consideration is allocated to each
asset to the extent of that asset's fair market value as long as there
is sufficient consideration to provide full allocation of basis to each
asset in the class. The fair market value limitation and the residual
allocation method of the current regulations do not permit costs
associated with specific assets to be allocated to those assets. For
example, if a purchaser incurred costs to acquire an asset and section
1060 did not apply to the acquisition, the basis of that asset would be
increased to reflect those costs. However, the fair market value
limitation under the current regulations would limit a purchaser's
basis in the asset to its fair market value. The proposed regulations
allow the buyer and seller to adjust their allocation of consideration
to particular assets for costs incurred which are specifically
identified with those assets. Thus, the total amount the seller
allocates to an asset for which it incurs specifically identifiable
costs would be less than its fair market value and, for the buyer,
greater than its fair market value. The parties are not allowed to
apportion costs associated generally with the overall transaction to
specific assets. A similar rule is not necessary, and therefore not
included, under section 338, because the underlying transaction is a
stock sale. Any costs associated with a deemed asset sale are of the
type generally associated with the overall sale of stock and,
therefore, the parties would not be allowed to apportion those costs to
specific assets under the rule.
Written Allocation Agreements
After the current regulations were adopted, Congress amended
section 1060 to provide that a written agreement allocating purchase
price is binding on both parties. See section 1060(a). The legislative
history indicates that parties must report consistent with their
agreed-upon allocations, unless the parties are able to refute the
agreement under the standards set forth in Commissioner v. Danielson,
378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967). The proposed
regulations incorporate the Danielson standard by reference.
Specific Requests for Comments and Matters Under Study
A. Examples in the Section 338 and Section 1060 Regulations
The proposed regulations, for the most part, retain the examples of
the current regulations. The retained examples are updated to reflect
the changes in the location, terminology, and substance of the
regulations which they illustrate. Some examples have been dropped as
it was thought that they were unnecessary. Comments are requested as to
whether any of the retained examples (or new examples) are superfluous
and whether other examples are necessary to illustrate the regulations.
B. Discharge of Indebtedness Income in the Case of Tiered Targets Under
Section 338 and the Current Regulations
Taxpayers may inadvertently experience adverse tax consequences
when there is intercompany indebtedness owing between tiered targets
acquired in the same qualified stock purchase. Such consequences might
include the realization of discharge of indebtedness income and changes
to the issue price of the indebtedness. The latter could affect the
total amount of AGUB to be allocated.
For example, assume that T owns 100 percent of the stock of T1, T
and T1 do not file a consolidated return, and T is indebted to T1.
Assume also that P acquires all the stock of T in a qualified stock
purchase and makes section 338 elections for both T and T1. Under
Sec. 1.338-2(b)(4), first old T is considered to sell its assets to new
T, and new T is deemed to assume the debt of old T to old T1. Next, old
T1 is deemed to sell its assets to new T1. New T1 thus may be
considered to acquire debt owed by new T (to old T1) at a time when new
T1 is related to new T.
Under section 108(e)(4), this may trigger discharge of indebtedness
income for new T if new T1's adjusted basis in the acquired debt is
less than the amount of the debt (see Sec. 1.108-2(f)(1)). That might
occur when the T stock is purchased partly for contingent consideration
not originally taken into account in AGUB. A variety of similar issues
may arise under Sec. 1.1502 13(g).
The IRS and Treasury solicit comments on whether the application of
section 108(e)(4) and Sec. 1.1502-13(g) is appropriate in these
circumstances and how one might best address these consequences.
C. Ideas for Revision of Application of the Residual Method of
Allocation Under Section 338 in the Case of Tiered Targets
In General
The IRS and Treasury are studying ways of addressing the allocation
of ADSP and AGUB in the case of tiered targets making section 338
elections. Set forth below is the framework for one potential method
that would equalize the amount of impairment for assets in a given
class without regard to which target corporation owns the assets. This
method uses a lookthrough approach. The method is incomplete, raises
difficult issues, and is more complicated than the current rules. For
these reasons, the proposed regulations do not adopt the method.
However, the IRS and Treasury request comments as to the value and
feasibility of the method; how best to resolve its issues; and what
alternative approaches might be better. For instance, would it be
better to have a complicated special method such as that described
below that operates in every case of tiered targets or, as the proposed
regulations do, retain the approach of the current regulations with the
addition of an anti-abuse rule, the goal of which is to restrict
movement of assets in advance of the qualified stock purchase
undertaken to benefit from the shortcomings of the current top-down
rules?
Essentially, the lookthrough approach referred to above would
revise the treatment of Classes I through V (referring to the class
numbering system of the proposed regulations). In allocating to these
senior classes, the tiered targets would be aggregated for purposes of
calculating the overall purchase price and allocating that amount among
the individual assets. This rule would apply to a target (referred to
as the parent target) and to those of its lower tier subsidiaries for
which a section 338 election is also made (referred to as subsidiary
targets). Stock in subsidiaries for which section 338 elections are not
or cannot be made would continue to be treated for all purposes as a
Class V asset (or Class II if publicly traded)--in other words, such
entities would not participate in the aggregation.
The method would thereafter switch back to the normal top-down
system for allocation to assets in Classes VI and VII, because the
process of dividing up the amount allocated to the aggregate goodwill
of all the targets under the residual method would be antithetical to
the notion that goodwill is best valued by looking at what value is
left over rather than being separately valued, and because both Class
VI and VII assets generally get the same 15 year amortization period
pursuant to section 197-hence determining which of those two classes or
assets within the classes receives a given dollar of basis is
relatively insignificant.
An issue in applying the method is how to treat liabilities owed by
one group member to another. The IRS and Treasury request comments as
to whether such liabilities should be
[[Page 43474]]
treated for all allocation purposes as not debt but as stock in the
debtor-member held by the creditor-member, and whether to do so even if
the creditor-member is a subsidiary of the debtor-member.
One possible method of implementing the method is set forth in
greater detail, below. Possible method of implementation of the
lookthrough approach
The first step under the method would be to calculate the total
amount to be allocated (ADSP and AGUB). Under the method, this would be
the sum of (a) the amount realized or basis, as appropriate, of the
parent target stock (grossed-up as appropriate to reflect stock not
recently purchased, etc.) and (b) liabilities.
In the second step, all Class I through Class V assets in the
parent target and subsidiary targets (other than stock of subsidiary
targets) would be combined into aggregate Classes I, II, III, IV, and
V. Then, the total basis would be allocated (as basis is under the
current system, except that the allocation would be across such joint
classes, not merely within individual members) first to Class I assets,
then, if there is any remainder, to Class II assets, then, if there is
any remainder, to Class III assets, then, if there is any remainder, to
Class IV assets, and then, if there is any remainder, to Class V
assets. The allocations thus made to individual Class I through V
assets would be the final, binding allocations to them.
In the third step, if there were no amount of the total basis
remaining to be allocated to Class VI and VII assets, one would proceed
to determine the basis in subsidiary target stock. If the aggregate
amount assigned to all the subsidiary's Class I through V assets
pursuant to the second step above exceeded the amount of the
subsidiary's liabilities, then the amount of the excess would become
its parent's basis in that subsidiary's stock.
If the aggregate amount were, however, less than the liabilities,
then the stock basis would be zero. A subissue is whether in such case
other action should also be taken: whether, in the case of a
consolidated group, an excess loss account should be created equal to
the amount of the shortfall; and whether, if the tiered entities do not
join in filing a consolidated return but other nonconsolidated
investment adjustment rules apply, future positive basis increases
should be denied to the extent of the excess loss account that would
have been created under the method had they been filing consolidated.
The rule could apply, for example, to increases in basis of controlled
foreign corporations for undistributed earnings taxed currently under
subpart F.
Under the method, if there were an amount of the total ADSP or AGUB
remaining to be allocated to Class VI and VII assets, then one would
proceed to allocate basis to Class VI and VII assets. At this point,
the aggregating of members' assets into joint classes would be
abandoned and the method would revert to a top-down system similar to
that of current rules. The process is top-down in that any basis not
already allocated to the parent target's Class I through V assets
(other than subsidiary target stock) would be allocated among its Class
VI and VII assets and subsidiary target stock, then the subsidiary
target would in turn make its own allocation of its own basis among its
own Class VI and VII assets and any stock it might own in other
subsidiary targets.
Certain adjustments, as yet undetermined, would have to be made to
this method for minority interests outstanding in subsidiaries.
Possible Disadvantages of the Method
The method has drawbacks:
(1) Complexity. The method is more complicated than the existing
rules. When, for example, there is a subsequent change in the amount of
a liability of a subsidiary target that changes the amount of AGUB or
ADSP, under the method one would recalculate the allocations to all the
assets of the parent target and all subsidiary targets, not just the
assets of the indebted subsidiary target and its own subsidiary
targets.
Also, questions arise regarding subsequent changes in AGUB and
ADSP, with respect to subsidiary targets already disposed of. What if,
for instance, at the time of a subsequent adjustment to AGUB or ADSP,
the group had already disposed of the stock of a particular subsidiary
target should one change the allocation to that former subsidiary's
assets? Separately, in determining whether AGUB or ADSP has changed,
should one take into account changes in the amount of liabilities of
former subsidiary targets? How would the group be made aware of such
changes?
(2) Lack of inside-outside basis conformity. The current system,
although it tolerates large disparities in the allocations to identical
assets based on location, assures conformity between stock basis and
net asset basis. The look-through approach does so only in a
consolidated setting (employing excess loss accounts to do so).
(3) The method would not eliminate all allocation disparities. The
method would not completely eliminate disparate allocations based on
location within the acquired group, because it applies only to tiered
targets. Similar disparities can exist in acquisitions of sister
corporations or in mixed stock and asset purchases. The method does not
include a mechanism for equalizing basis impairment in such cases.
Thus, the method would not fully solve the disparity problem. (Note,
however, that the new anti-abuse rule included in the proposed
regulations may operate in some cases.)
Proposed Effective Date
The regulations are proposed to be effective on the date that final
regulations are published in the Federal Register and apply to
qualified stock purchases or applicable asset acquisitions occurring on
or after the date that final regulations are published in the Federal
Register.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. An initial
regulatory flexibility analysis has been prepared pursuant to 5 U.S.C.
section 604 for the collections of information in this Treasury
Decision. The analysis is set forth below under the heading ``Initial
Regulatory Flexibility Analysis.'' Pursuant to section 7805(f) of the
Code, these regulations will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact
on small business.
Initial Regulatory Flexibility Analysis
This regulatory action is intended to simplify and clarify the
current rules relating to both deemed and actual asset acquisitions.
The current rules were developed over a long period of time and have
been repeatedly amended. The IRS and Treasury believe these proposed
regulations will significantly improve the clarity of the rules
relating to both deemed and actual asset acquisitions.
The major objective of the proposed regulations is to modify the
rules for allocating purchase price in both deemed and actual asset
acquisitions. In addition, the proposed regulations replace the general
rules for electing to treat a stock sale as an asset sale.
These collections of information may affect small businesses if the
stock of a corporation which is a small entity is acquired in a
qualified stock purchase or if a trade or business which is also a
small business is transferred in a
[[Page 43475]]
taxable transaction. Form 8023 (on which an election to treat a stock
sale as an asset sale is filed) has been submitted to and approved by
the Office of Management and Budget. With respect to Form 8023, the IRS
estimated that 201 forms would be filed each year and that each
taxpayer would require 12.98 hours to comply. Form 8594 (on which a
sale or acquisition of assets constituting a trade or business is
reported) has also been submitted to and approved by the Office of
Management and Budget. With respect to Form 8594, the IRS estimated
that 20,000 forms would be filed each year and that each taxpayer would
require 12.25 hours to comply. These estimates have been made available
for public comment and no public comments have been received. These
proposed regulations do not impose new requirements on small businesses
and, in fact, should lessen any difficulties associated with the
existing reporting requirements by clarifying the rules associated with
deemed and actual asset acquisitions.
The collections of information require taxpayers to file an
election in order to treat a stock sale as an asset sale. In addition,
taxpayers must file a statement regarding the amount of consideration
allocated to each class of assets under the residual method. The
professional skills that would be necessary to make the election or
allocate the consideration would be the same as those required to
prepare a return for the small business.
Consideration was given to limiting the reporting requirements
under section 1060 to trades or businesses meeting a threshold level of
business activity. However, any threshold derived without further
information would be arbitrary. Instead, the proposed regulations
authorize the Commissioner to exclude certain transactions from the
reporting requirements.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) that are timely submitted to the IRS. The IRS and
Treasury request comments on the clarity of the proposed rule and how
it may be made easier to understand. All comments will be available for
public inspection and copying.
A public hearing has been scheduled for October 12, 1999, beginning
at 10 a.m. in the NYU Classroom, Room 2615, Internal Revenue Service
Building, 1111 Constitution Avenue, NW., Washington, DC. Due to
building security procedures, visitors must enter at the 10th Street
entrance, located between Constitution and Pennsylvania Avenues, NW. In
addition, all visitors must present photo identification to enter the
building. Because of access restrictions, visitors will not be admitted
beyond the immediate entrance area more than 15 minutes before the
hearing starts. For information about having your name placed on the
building access list to attend the hearing, see the FOR FURTHER
INFORMATION CONTACT section of this preamble.
The IRS recognizes that persons outside the Washington, DC, area
may also wish to testify at the public hearing through
teleconferencing. Requests to include teleconferencing sites must be
received by September 20, 1999. If the IRS receives sufficient
indications of interest to warrant teleconferencing to a particular
city, and if the IRS has teleconferencing facilities available in that
city on the date the public hearing is to be scheduled, the IRS will
try to accommodate the requests. The IRS will publish the locations of
any teleconferencing sites in an announcement in the Federal Register.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must request to speak, and
submit written comments and an outline of the topics to be discussed
and the time to be devoted to each topic (a signed original and eight
(8) copies) by September 20, 1999. A period of ten minutes will be
allocated to each person for making comments. An agenda showing the
scheduling of the speakers will be prepared after the deadline for
receiving outlines has passed. Copies of the agenda will be available
free of charge at the hearing.
Drafting information. The principal authors of these proposed
regulations are Richard Starke and Stephen R. Wegener, Office of the
Assistant Chief Counsel (Corporate). However, other personnel from the
IRS and Treasury Department participated in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are proposed to be amended as
follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by
removing the entries for 1.338(b)-1, 1.338(b)-3T, and 1.1060 1T and by
adding entries in numerical order to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.338-6 also issued under 26 U.S.C. 337(d), 338, and
1502.
Section 1.338-7 also issued under 26 U.S.C. 337(d), 338, and
1502.
Section 1.338-8 also issued under 26 U.S.C. 337(d), 338, and
1502.
Section 1.338-9 also issued under 26 U.S.C. 337(d), 338, and
1502.
Section 1.338-10 also issued under 26 U.S.C. 337(d), 338, and
1502.* * *
Section 1.1060-1 also issued under 26 U.S.C. 1060.* * *
Par. 2. Sections 1.338-0 through 1.338-3 are revised to read as
follows:
Sec. 1.338-0 Outline of topics.
This section lists the captions contained in the regulations under
section 338 as follows:
Sec. 1.338-1 General principles; status of old target and new
target.
(a) In general.
(1) Deemed transaction.
(2) Application of other rules of law.
(3) Overview.
(b) Treatment of target under other provisions of the Internal
Revenue Code.
(1) General rule for subtitle A.
(2) Exceptions for subtitle A.
(3) General rule for other provisions of the Internal Revenue
Code.
(c) Anti-abuse rule.
(1) In general.
(2) Examples.
Sec. 1.338-2 Nomenclature and definitions; mechanics of the section
338 election.
(a) Scope.
(b) Nomenclature.
(c) Definitions.
(1) Acquisition date.
(2) Acquisition date assets.
(3) Affiliated group.
(4) Common parent.
(5) Consistency period.
(6) Deemed asset sale.
(7) Deemed sale gain.
(8) Deemed sale return.
(9) Domestic corporation.
(10) Old target's final return.
(11) Purchasing corporation.
(12) Qualified stock purchase.
(13) Related persons.
(14) Section 338 election.
(15) Section 338(h)(10) election.
(16) Selling group.
(17) Target; old target; new target.
(18) Target affiliate.
(19) 12-month acquisition period.
(d) Time and manner of making election.
(e) Special rules for foreign corporations or DISCs.
(1) Elections by certain foreign purchasing corporations.
(i) General rule.
[[Page 43476]]
(ii) Qualifying foreign purchasing corporation.
(iii) Qualifying foreign target.
(iv) Triggering event.
(v) Subject to United States tax.
(2) Acquisition period.
(3) Statement of section 338 may be filed by United States
shareholders in certain cases.
(4) Notice requirement for U.S. persons holding stock in foreign
market.
(i) General rule.
(ii) Limitation.
(iii) Form of notice.
(iv) Timing of notice.
(v) Consequence of failure to comply.
(vi) Good faith effort to comply.
Sec. 1.338-3 Qualification for the section 338 election.
(a) Scope.
(b) Rules relating to qualified stock purchases.
(1) Purchasing corporation requirement.
(2) Purchase.
(i) Definition.
(ii) Purchase of target.
(iii) Purchase of target affiliate.
(3) Acquisitions of stock from related corporations.
(i) In general.
(ii) Time for testing relationship.
(iii) Cases where section 338(h)(3)(C) applies--acquisitions
treated as purchases.
(iv) Examples.
(4) Acquisition date for tiered targets.
(i) Stock sold in deemed asset sale.
(ii) Examples.
(5) Effect of redemptions.
(i) General rule.
(ii) Redemptions from persons unrelated to the purchasing
corporation.
(iii) Redemptions from the purchasing corporation or related
persons during 12-month acquisition period.
(A) General rule.
(B) Exception for certain redemptions from related corporations.
(iv) Examples.
(c) Effect of post-acquisition events on eligibility for section
338 election.
(1) Post-acquisition elimination of target.
(2) Post-acquisition elimination of the purchasing corporation.
(3) Consequences of post-acquisition elimination of target.
(i) Scope.
(ii) Continuity of interest.
(iii) Control requirement.
(iv) Example.
Sec. 1.338-4 Aggregate deemed sale price; various aspects of
taxation of the deemed asset sale.
(a) Scope.
(b) Determination of ADSP.
(1) General rule.
(2) Time and amount of ADSP.
(i) Original determination.
(ii) Redetermination of ADSP.
(iii) Example.
(c) Grossed-up amount realized on the sale to the purchasing
corporation of the purchasing corporation's recently purchased
target stock.
(1) Determination of amount.
(2) Example.
(d) Liabilities of old target.
(1) In general.
(2) Time and amount of liabilities.
(3) Interaction with deemed sale gain.
(e) Calculation of deemed sale gain.
(f) Other rules apply in determining ADSP.
(g) Examples.
(h) Deemed sale of target affiliate stock.
(1) Scope.
(2) In general.
(3) Deemed sale of foreign target affiliate by a domestic
target.
(4) Deemed sale producing effectively connected income.
(5) Deemed sale of insurance company target affiliate electing
under section 953(d).
(6) Deemed sale of DISC target affiliate.
(7) Anti-stuffing rule.
(8) Examples.
Sec. 1.338-5 Adjusted grossed-up basis.
(a) Scope.
(b) Determination of AGUB.
(1) General rule.
(2) Time and amount of AGUB.
(i) Original determination.
(ii) Redetermination of AGUB.
(iii) Examples.
(c) Grossed-up basis of recently purchased stock.
(d) Basis of nonrecently purchased stock; gain recognition
election.
(1) No gain recognition election.
(2) Procedure for making gain recognition election.
(3) Effect of gain recognition election.
(i) In general.
(ii) Basis amount.
(iii) Losses not recognized.
(iv) Stock subject to election.
(e) Liabilities of new target.
(1) In general.
(2) Time and amount of liabilities.
(3) Interaction with deemed sale gain.
(f) Adjustments by the Internal Revenue Service.
(g) Examples.
Sec. 1.338-6 Allocation of ADSP and AGUB among target assets.
(a) Scope.
(1) In general.
(2) Fair market value.
(i) In general.
(ii) Transaction costs.
(iii) Internal Revenue Service authority.
(b) General rule for allocating ADSP and AGUB.
(1) Reduction in the amount of consideration for Class I assets.
(2) Other assets.
(i) In general.
(ii) Class II assets.
(iii) Class III assets.
(iv) Class IV assets.
(v) Class V assets.
(vi) Class VI assets.
(vii) Class VII assets.
(3) Other items designated by the Internal Revenue Service.
(c) Certain limitations and other rules for allocation to an
asset.
(1) Allocation not to exceed fair market value.
(2) Allocation subject to other rules.
(3) Special rule for allocating AGUB when purchasing corporation
has nonrecently purchased stock.
(i) Scope.
(ii) Determination of hypothetical purchase price.
(iii) Allocation of AGUB.
(4) Liabilities taken into account in determining amount
realized on subsequent disposition.
(d) Examples.
Sec. 1.338-7 Allocation of redetermined ADSP and AGUB among target
assets.
(a) Scope.
(b) Allocation of redetermined ADSP and AGUB.
(c) Special rules for ADSP.
(1) Increases or decreases in deemed sale gain taxable
notwithstanding old target ceases to exist.
(2) Procedure for transactions in which section 338(h)(10) is
not elected.
(i) Deemed sale gain included in new target's return.
(ii) Carryovers and carrybacks.
(A) Loss carryovers to new target taxable years.
(B) Loss carrybacks to taxable years of old target.
(C) Credit carryovers and carrybacks.
(3) Procedure for transactions in which section 338(h)(10) is
elected.
(d) Special rules for AGUB.
(1) Effect of disposition or depreciation of acquisition date
assets.
(2) Section 38 property.
(e) Examples.
Sec. 1.338-8 Asset and stock consistency.
(a) Introduction.
(1) Overview.
(2) General application.
(3) Extension of the general rules.
(4) Application where certain dividends are paid.
(5) Application to foreign target affiliates.
(6) Stock consistency.
(b) Consistency for direct acquisitions.
(1) General rule.
(2) Section 338(h)(10) elections.
(c) Gain from disposition reflected in basis of target stock.
(1) General rule.
(2) Gain not reflected if section 338 election made for target.
(3) Gain reflected by reason of distributions.
(4) Controlled foreign corporations.
(5) Gain recognized outside the consolidated group.
(d) Basis of acquired assets.
(1) Carryover basis rule.
(2) Exceptions to carryover basis rule for certain assets.
(3) Exception to carryover basis rule for de minimis assets.
(4) Mitigation rule.
(i) General rule.
(ii) Time for transfer.
(e) Examples.
(1) In general.
(2) Direct acquisitions.
(f) Extension of consistency to indirect acquisitions.
(1) Introduction.
(2) General rule.
(3) Basis of acquired assets.
(4) Examples.
(g) Extension of consistency if dividends qualifying for 100 percent
dividends received deduction are paid.
[[Page 43477]]
(1) General rule for direct acquisitions from target.
(2) Other direct acquisitions having same effect.
(3) Indirect acquisitions.
(4) Examples.
(h) Consistency for target affiliates that are controlled foreign
corporations.
(1) In general.
(2) Income or gain resulting from asset dispositions.
(i) General rule.
(ii) Basis of controlled foreign corporation stock.
(iii) Operating rule.
(iv) Increase in asset or stock basis.
(3) Stock issued by target affiliate that is a controlled foreign
corporation.
(4) Certain distributions.
(i) General rule.
(ii) Basis of controlled foreign corporation stock.
(iii) Increase in asset or stock basis.
(5) Examples.
(i) [Reserved]
(j) Anti-avoidance rules.
(1) Extension of consistency rules.
(2) Qualified stock purchase and 12-month acquisition period.
(3) Acquisitions by conduits.
(i) Asset ownership.
(A) General rule.
(B) Application of carryover basis rule.
(ii) Stock acquisitions.
(A) Purchase by conduit.
(B) Purchase of conduit by corporation.
(C) Purchase of conduit by conduit.
(4) Conduit.
(5) Existence of arrangement.
(6) Predecessor and successor.
(i) Persons.
(ii) Assets.
(7) Examples.
Sec. 1.338-9 International Aspects of Section 338.
(a) Scope.
(b) Application of section 338 to foreign targets.
(1) In general.
(2) Ownership of FT stock on the acquisition date.
(3) Carryover FT stock.
(i) Definition.
(ii) Carryover of earnings and profits.
(iii) Cap on carryover of earnings and profits.
(iv) Post-acquisition date distribution of old FT earnings and
profits.
(v) Old FT earnings and profits unaffected by post-acquisition date
deficits.
(vi) Character of FT stock as carryover FT stock eliminated upon
disposition.
(4) Passive foreign investment company stock.
(c) Dividend treatment under section 1248(e).
(d) Allocation of foreign taxes.
(e) Operation of section 338(h)(16). [Reserved]
(f) Examples.
Sec. 1.338-10 Filing of Returns.
(a) Returns including tax liability from deemed asset sale.
(1) In general.
(2) Old target's final taxable year otherwise included in
consolidated return of selling group.
(i) General rule.
(ii) Separate taxable year.
(iii) Carryover and carryback of tax attributes.
(iv) Old target is a component member of purchasing corporation's
controlled group.
(3) Old target is an S corporation.
(4) Combined deemed sale return.
(i) General rule.
(ii) Gain and loss offsets.
(iii) Procedure for filing a combined return.
(iv) Consequences of filing a combined return.
(5) Deemed sale excluded from purchasing corporation's consolidated
return.
(6) Due date for old target's final return.
(i) General rule.
(ii) Application of Sec. 1.1502 76(c).
(A) In general.
(B) Deemed extension.
(C) Erroneous filing of deemed sale return.
(D) Erroneous filing of return for regular tax year.
(E) Last date for payment of tax.
(7) Examples.
(b) Waiver.
(1) Certain additions to tax.
(2) Notification.
(3) Elections or other actions required to be specified on a timely
filed return.
(i) In general.
(ii) New target in purchasing corporation's consolidated return.
(4) Examples.
Sec. 1.338(h)(10)-1 Deemed Asset Sale and Liquidation.
(a) Scope.
(b) Definitions.
(1) Consolidated target.
(2) Selling consolidated group.
(3) Selling affiliate; affiliated target.
(4) S corporation target.
(5) S corporation shareholders.
(6) Liquidation.
(c) Section 338(h)(10) election.
(1) In general.
(2) Simultaneous joint election requirement.
(3) Irrevocability.
(4) Effect of invalid election.
(d) Certain consequences of section 338(h)(10) election.
(1) P.
(2) New T.
(3) Old T--deemed sale.
(i) In general.
(ii) Tiered targets.
(4) Old T and selling consolidated group, selling affiliate, or S
corporation shareholders--deemed liquidation; tax characterization.
(i) In general.
(ii) Tiered targets.
(5) Selling consolidated group, selling affiliate, or S corporation
shareholders.
(i) In general.
(ii) Basis and holding period of T stock not acquired.
(iii) T stock sale.
(6) Nonselling minority shareholders other than nonselling S
corporation shareholders.
(i) In general.
(ii) T stock sale.
(iii) T stock not acquired.
(7) Consolidated return of selling consolidated group.
(8) Availability of the section 453 installment method.
(i) In deemed asset sale.
(ii) In deemed liquidation.
(9) Treatment consistent with an actual asset sale.
(e) Examples.
(f) Inapplicability of provisions.
(g) Required information.
Sec. 1.338(i)-1 Effective dates.
Sec. 1.338-1 General principles; status of old target and new target.
(a) In general--(1) Deemed transaction. Elections are available
under section 338 when a purchasing corporation acquires the stock of
another corporation (the target) in a qualified stock purchase. One
type of election, under section 338(g), is available to the purchasing
corporation. Another type of election, under section 338(h)(10), is, in
more limited circumstances, available jointly to the purchasing
corporation and the sellers of the stock. (Rules concerning eligibility
for these elections are contained in Secs. 1.338-2, 1.338-3, and
1.338(h)(10)-1.) Although target is a single corporation under
corporate law, if a section 338 election is made, then two separate
corporations, old target and new target, generally are considered to
exist for purposes of subtitle A of the Internal Revenue Code. Old
target is treated as transferring all of its assets to an unrelated
person in exchange for consideration that includes the assumption of,
or taking subject to, liabilities, and new target is treated as
acquiring all of its assets from an unrelated person in exchange for
consideration that includes the assumption of or taking subject to
liabilities. (Such transaction is, without regard to its
characterization for Federal income tax purposes, referred to as the
deemed asset sale and the income tax consequences thereof as the deemed
sale gain.) If a section 338(h)(10) election is made, old target is
also deemed to liquidate following the deemed asset sale.
(2) Application of other rules of law. Other rules of law apply to
determine the tax consequences to the parties as if they had actually
engaged in the transactions deemed to occur under section 338 and the
regulations hereunder except to the extent otherwise provided in the
regulations hereunder. See also Sec. 1.338-6(c)(2). Other rules of law
may characterize the transaction as something other than or in addition
to a sale and purchase of assets; however, it must be a taxable
transaction. For example, if target is an insurance company for which a
section 338 election is made, the deemed asset
[[Page 43478]]
sale would be characterized and taxed as an assumption-reinsurance
transaction under applicable Federal income tax law. See Sec. 1.817-
4(d).
(3) Overview. Definitions and special nomenclature and rules for
making the section 338 election are provided in Sec. 1.338-2.
Qualification for the section 338 election is addressed in Sec. 1.338-
3. The amount for which old target is treated as selling all of its
assets (the aggregate deemed sale price, or ADSP) is addressed in
Sec. 1.338-4. The amount for which new target is deemed to have
purchased all its assets (the adjusted grossed-up basis, or AGUB) is
addressed in Sec. 1.338-5. Section 1.338-6 addresses allocation both of
ADSP among the assets old target is deemed to have sold and of AGUB
among the assets new target is deemed to have purchased. Section 1.338-
7 addresses allocation of ADSP or AGUB when those amounts change after
the close of new target's first taxable year. Asset and stock
consistency are addressed in Sec. 1.338-8. International aspects of
section 338 are covered in Sec. 1.338-9. Rules for the filing of
returns are provided in Sec. 1.338-10. Eligibility for and treatment of
section 338(h)(10) elections is addressed in Sec. 1.338(h)(10)-1.
(b) Treatment of target under other provisions of the Internal
Revenue Code--(1) General rule for subtitle A. Except as provided in
this section, new target is treated as a new corporation that is
unrelated to old target for purposes of subtitle A of the Internal
Revenue Code. Thus--
(i) New target is not considered related to old target for purposes
of section 168 and may make new elections under section 168 without
taking into account the elections made by old target; and
(ii) New target may adopt, without obtaining prior approval from
the Commissioner, any taxable year that meets the requirements of
section 441 and any method of accounting that meets the requirements of
section 446. Notwithstanding Sec. 1.441-1T(b)(2), a new target may
adopt a taxable year on or before the last day for making the election
under section 338 by filing its first return for the desired taxable
year on or before that date.
(2) Exceptions for subtitle A. New target and old target are
treated as the same corporation for purposes of--
(i) The rules applicable to employee benefit plans (including those
plans described in sections 79, 104, 105, 106, 125, 127, 129, 132, 137,
and 220), qualified pension, profit-sharing, stock bonus and annuity
plans (sections 401(a) and 403(a)), simplified employee pensions
(section 408(k)), tax qualified stock option plans (sections 422 and
423), welfare benefit funds (sections 419, 419A, 512(a)(3), and 4976),
voluntary employee benefit associations (section 501(c)(9) and the
regulations thereunder);
(ii) Sections 1311 through 1314 (relating to the mitigation of the
effect of limitations) if a section 338(h)(10) election is not made for
target;
(iii) Section 108(e)(5) (relating to the reduction of purchase
money debt);
(iv) Section 45A (relating to the Indian Employment Credit),
section 51 (relating to the Work Opportunity Credit), section 51A
(relating to the Welfare to Work Credit), and section 1396 (relating to
the Empowerment Zone Act);
(v) Sections 401(h) and 420 (relating to medical benefits for
retirees);
(vi) Section 414 (relating to definitions and special rules); and
(vii) Any other provision designated in the Internal Revenue
Bulletin by the Internal Revenue Service. See Sec. 601.601(d)(2)(ii) of
this chapter (relating to the Internal Revenue Bulletin). See
Sec. 1.1001-3(e)(4)(F) providing that an election under section 338
does not result in the substitution of a new obligor on target's debt.
(3) General rule for other provisions of the Internal Revenue Code.
Except as provided in the regulations under section 338 or in the
Internal Revenue Bulletin by the Internal Revenue Service (see
Sec. 601.601(d)(2)(ii) of this chapter), new target is treated as a
continuation of old target for purposes other than subtitle A of the
Internal Revenue Code. For example--
(i) New target is liable for old target's Federal income tax
liabilities, including the tax liability for the deemed sale gain and
those tax liabilities of the other members of any consolidated group
that included old target that are attributable to taxable years in
which those corporations and old target joined in the same consolidated
return (see Sec. 1.1502-6(a));
(ii) Wages earned by the employees of old target are considered
wages earned by such employees from new target for purposes of sections
3101 and 3111 (Federal Insurance Contributions Act) and section 3301
(Federal Unemployment Tax Act); and
(iii) Old target and new target must use the same employer
identification number.
(c) Anti-abuse rule--(1) In general. For purposes of applying the
residual method of Secs. 1.338-0 through 1.338-10, 1.338(h)(10)-1, and
1.338(i)-1, the Commissioner is authorized to treat any property
(including cash) transferred by old target in connection with the
transactions resulting in the application of the residual method as,
nonetheless, property of target at the close of the acquisition date if
the property so transferred, within 24 months after the deemed asset
sale, is owned by new target, or is owned, directly or indirectly, by a
member of the affiliated group of which new target is a member and
continues after the election to be held or used to more than an
insignificant extent in connection with one or more of the activities
of new target. The Commissioner is authorized to treat any property
(including cash) transferred to old target in connection with the
transactions resulting in the application of the residual method as,
nonetheless, not being property of target at the close of the
acquisition date if the property so transferred by the transferor is,
within 24 months after the deemed asset sale, not owned by new target
but owned, directly or indirectly, by a member of the affiliated group
of which new target is a member or owned by new target but held or used
to more than an insignificant extent in connection with an activity
conducted, directly or indirectly, by another member of the affiliated
group of which new target is a member in combination with other
property acquired, directly or indirectly, from the transferor of the
property (or a member of the same affiliated group) to old target. For
purposes of this paragraph (c)(1), an interest in an entity is
considered held or used in connection with an activity if property of
the entity is so held or used. The authority under this paragraph
(c)(1) includes the making of any necessary correlative adjustments.
(2) Examples. The following examples illustrate this paragraph (c):
Example 1. Prior to a qualified stock purchase under section
338, target transfers one of its assets to a related party. The
purchasing corporation then purchases the target stock and also
purchases the transferred asset from the related party. After its
purchase of target, the purchasing corporation and target are
members of the same affiliated group. A section 338 election is
made. Under an arrangement with the purchaser, target continues to
use the separately transferred asset to more than an insignificant
extent in connection with its own activities. Applying the anti-
abuse rule of this paragraph (c), the Commissioner may consider
target to own the transferred asset for purposes of applying section
338 and its allocation rules.
Example 2. Target (T) owns all the stock of T1. T1 leases
intellectual property to T, which T uses in connection with its own
activities. P, a purchasing corporation, wishes to buy the T-T1
chain of corporations. P, in connection with its planned purchase of
the T stock, contracts to consummate a purchase of all the stock of
T1
[[Page 43479]]
on March 1 and of all the stock of T on March 2. Section 338
elections are thereafter made for both T and T1. Immediately after
the purchases, P, T and T1 are members of the same affiliated group.
T continues to lease the intellectual property from T1 and to use
the property to more than an insignificant extent in connection with
its own activities. Thus, an asset of T, the T1 stock, was removed
from T's own assets prior to the qualified stock purchase of the T
stock, T1's own assets are used after the deemed asset sale in
connection with T's own activities, and the T1 stock is after the
deemed asset sale owned by P, a member of the same affiliated group
of which T is a member. Applying the anti-abuse rule of this
paragraph (c), the Commissioner may, for purposes of application of
section 338 both to T and to T1, consider P to have bought only the
stock of T, with T at the time of the qualified stock purchases of
both T and T1 (the qualified stock purchase of T1 being triggered by
the deemed sale under section 338 of T's assets) owning T1. The
Commissioner would accordingly apply section 338 first at the T
level and then at the T1 level.
Sec. 1.338-2 Nomenclature and definitions; mechanics of the section
338 election.
(a) Scope. This section prescribes rules relating to elections
under section 338.
(b) Nomenclature. For purposes of the regulations under section 338
(except as otherwise provided):
(1) T is a domestic target corporation that has only one class of
stock outstanding. Old T refers to T for periods ending on or before
the close of T's acquisition date; new T refers to T for subsequent
periods.
(2) P is the purchasing corporation.
(3) The P group is an affiliated group of which P is a member.
(4) P1, P2, etc., are domestic corporations that are members of the
P group.
(5) T1, T2, etc., are domestic corporations that are target
affiliates of T. These corporations (T1, T2, etc.) have only one class
of stock outstanding and may also be targets.
(6) S is a domestic corporation (unrelated to P and B) that owns T
prior to the purchase of T by P. (S is referred to in cases in which it
is appropriate to consider the effects of having all of the outstanding
stock of T owned by a domestic corporation.)
(7) A, a U.S. citizen or resident, is an individual (unrelated to P
and B) who owns T prior to the purchase of T by P. (A is referred to in
cases in which it is appropriate to consider the effects of having all
of the outstanding stock of T owned by an individual who is a U.S.
citizen or resident. Ownership of T by A and ownership of T by S are
mutually exclusive circumstances.)
(8) B, a U.S. citizen or resident, is an individual (unrelated to
T, S, and A) who owns the stock of P.
(9) F, used as a prefix with the other terms in this paragraph (b),
connotes foreign, rather than domestic, status. For example, FT is a
foreign corporation (as defined in section 7701(a)(5)) and FA is an
individual other than a U.S. citizen or resident.
(10) CFC, used as a prefix with the other terms in this paragraph
(b) referring to a corporation, connotes a controlled foreign
corporation (as defined in section 957, taking into account section
953(c)). A corporation identified with the prefix F may be a controlled
foreign corporation. The prefix CFC is used when the corporation's
status as a controlled foreign corporation is significant.
(c) Definitions. For purposes of the regulations under section 338
(except as otherwise provided):
(1) Acquisition date. The term acquisition date has the same
meaning as in section 338(h)(2).
(2) Acquisition date assets. Acquisition date assets are the assets
of the target held at the beginning of the day after the acquisition
date (other than assets that were not assets of old target).
(3) Affiliated group. The term affiliated group has the same
meaning as in section 338(h)(5). Corporations are affiliated on any day
they are members of the same affiliated group.
(4) Common parent. The term common parent has the same meaning as
in section 1504.
(5) Consistency period. The consistency period is the period
described in section 338(h)(4)(A) unless extended pursuant to
Sec. 1.338-8(j)(1).
(6) Deemed asset sale. The deemed asset sale is the transaction
described in Sec. 1.338-1(a)(1) that is deemed to occur for purposes of
subtitle A of the Internal Revenue Code if a section 338 election is
made.
(7) Deemed sale gain. Deemed sale gain refers to, in the aggregate,
the Federal income tax consequences (generally, the income, gain,
deduction, and loss) of the deemed asset sale. Deemed sale gain also
refers to the Federal income tax consequences of the transfer of a
particular asset in the deemed asset sale.
(8) Deemed sale return. The deemed sale return is the return on
which target's deemed sale gain is reported that does not include any
other items of target. Target files a deemed sale return when a section
338 election (but not a section 338(h)(10) election) is filed for
target and target is a member of a selling group (defined in paragraph
(c)(16) of this section) that files a consolidated return for the
period that includes the acquisition date or is an S corporation. See
Sec. 1.338-10.
(9) Domestic corporation. A domestic corporation is a corporation--
(i) That is domestic within the meaning of section 7701(a)(4) or
that is treated as domestic for purposes of subtitle A of the Internal
Revenue Code (e.g., to which an election under section 953(d) or
1504(d) applies); and
(ii) That is not a DISC, a corporation described in section
1248(e), or a corporation to which an election under section 936
applies.
(10) Old target's final return. Old target's final return is the
income tax return of old target for the taxable year ending at the
close of the acquisition date that includes the deemed sale gain. If
the disaffiliation rule of Sec. 1.338-10(a)(2)(i) applies or if target
is an S corporation, target's deemed sale return is considered old
target's final return.
(11) Purchasing corporation. The term purchasing corporation has
the same meaning as in section 338(d)(1). The purchasing corporation
may also be referred to as purchaser. Unless otherwise provided, any
reference to the purchasing corporation is a reference to all members
of the affiliated group of which the purchasing corporation is a
member. See sections 338(h)(5) and (8). Also, unless otherwise
provided, any reference to the purchasing corporation is, with respect
to a deemed purchase of stock under section 338(a)(2), a reference to
new target with respect to its own deemed purchase of stock in another
target.
(12) Qualified stock purchase. The term qualified stock purchase
has the same meaning as in section 338(d)(3).
(13) Related persons. Two persons are related if stock in a
corporation owned by one of the persons would be attributed under
section 318(a) (other than section 318(a)(4)) to the other.
(14) Section 338 election. A section 338 election is an election to
apply section 338(a) to target. A section 338 election is made by
filing a statement of section 338 election pursuant to Sec. 1.338-2(d).
The form on which this statement is filed is referred to in the
regulations under section 338 as the Form 8023 Elections Under Section
338 for Corporations Making Qualified Stock Purchases.
(15) Section 338(h)(10) election. A section 338(h)(10) election is
an election to apply section 338(h)(10) to target. A section 338(h)(10)
election is made by making a joint election for target under
Sec. 1.338(h)(10)-1.
(16) Selling group. The selling group is the affiliated group (as
defined in section 1504) eligible to file a
[[Page 43480]]
consolidated return that includes target for the taxable period in
which the acquisition date occurs. However, a selling group is not an
affiliated group of which target is the common parent on the
acquisition date.
(17) Target; old target; new target. Target is the target
corporation as defined in section 338(d)(2). Old target refers to
target for periods ending on or before the close of target's
acquisition date. New target refers to target for subsequent periods.
(18) Target affiliate. The term target affiliate has the same
meaning as in section 338(h)(6) (applied without section
338(h)(6)(B)(i)). Thus, a corporation described in section
338(h)(6)(B)(i) is considered a target affiliate for all purposes of
section 338. If a target affiliate is acquired in a qualified stock
purchase, it is also a target.
(19) 12-Month acquisition period. The 12-month acquisition period
is the period described in section 338(h)(1), unless extended pursuant
to Sec. 1.338-8(j)(2).
(d) Time and manner of making election. The purchasing corporation
makes a section 338 election for target by filing a statement of
section 338 election on Form 8023 in accordance with the instructions
to the form. The section 338 election must be made not later than the
15th day of the 9th month beginning after the month in which the
acquisition date occurs. A section 338 election is irrevocable. See
Sec. 1.338(h)(10)-1(c)(2) for section 338(h)(10) elections.
(e) Special rules for foreign corporations or DISCs--(1) Elections
by certain foreign purchasing corporations--(i) General rule. A
qualifying foreign purchasing corporation is not required to file a
statement of section 338 election for a qualifying foreign target
before the earlier of 3 years after the acquisition date and the 180th
day after the close of the purchasing corporation's taxable year within
which a triggering event occurs.
(ii) Qualifying foreign purchasing corporation. A purchasing
corporation is a qualifying foreign purchasing corporation only if,
during the acquisition period of a qualifying foreign target, all the
corporations in the purchasing corporation's affiliated group are
foreign corporations that are not subject to United States tax.
(iii) Qualifying foreign target. A target is a qualifying foreign
target only if target and its target affiliates are foreign
corporations that, during target's acquisition period, are not subject
to United States tax (and will not become subject to United States tax
during such period because of a section 338 election). A target
affiliate is taken into account for purposes of the preceding sentence
only if, during target's 12-month acquisition period, it is or becomes
a member of the affiliated group that includes the purchasing
corporation.
(iv) Triggering event. A triggering event occurs in the taxable
year of the qualifying foreign purchasing corporation in which either
that corporation or any corporation in its affiliated group becomes
subject to United States tax.
(v) Subject to United States tax. For purposes of this paragraph
(e)(1), a foreign corporation is considered subject to United States
tax--
(A) For the taxable year for which that corporation is required
under Sec. 1.6012 2(g)-(other than Sec. 1.6012-2(g)(2)(i)(B)(2)) to
file a United States income tax return; or
(B) For the period during which that corporation is a controlled
foreign corporation, a passive foreign investment company for which an
election under section 1295 is in effect, a foreign investment company,
or a foreign corporation the stock ownership of which is described in
section 552(a)(2).
(2) Acquisition period. For purposes of this paragraph (e), the
term acquisition period means the period beginning on the first day of
the 12-month acquisition period and ending on the acquisition date.
(3) Statement of section 338 election may be filed by United States
shareholders in certain cases. The United States shareholders (as
defined in section 951(b)) of a foreign purchasing corporation that is
a controlled foreign corporation (as defined in section 957 (taking
into account section 953(c))) may file a statement of section 338
election on behalf of the purchasing corporation if the purchasing
corporation is not required under Sec. 1.6012-2(g) (other than
Sec. 1.6012-2(g)(2)(i)(B)(2)) to file a United States income tax return
for its taxable year that includes the acquisition date. Form 8023 must
be filed as described in the form and its instructions and also must be
attached to the Form 5471 (information return with respect to a foreign
corporation) filed with respect to the purchasing corporation by each
United States shareholder for the purchasing corporation's taxable year
that includes the acquisition date (or, if paragraph (e)(1)(i) of this
section applies to the election, for the purchasing corporation's
taxable year within which it becomes a controlled foreign corporation).
The provisions of Sec. 1.964-1(c) (including Sec. 1.964-1(c)(7)) do not
apply to an election made by the United States shareholders.
(4) Notice requirement for U.S. persons holding stock in foreign
market--(i) General rule. If a target subject to a section 338 election
was a controlled foreign corporation, a passive foreign investment
company, or a foreign personal holding company at any time during the
portion of its taxable year that ends on its acquisition date, the
purchasing corporation must deliver written notice of the election (and
a copy of Form 8023, its attachments and instructions) to--
(A) Each U.S. person (other than a member of the affiliated group
of which the purchasing corporation is a member (the purchasing group
member)) that, on the acquisition date of the foreign target, holds
stock in the foreign target; and
(B) Each U.S. person (other than a purchasing group member) that
sells stock in the foreign target to a purchasing group member during
the foreign target's 12-month acquisition period.
(ii) Limitation. The notice requirement of this paragraph (e)(4)
applies only where the section 338 election for the foreign target
affects income, gain, loss, deduction, or credit of the U.S. person
described in paragraph (e)(4)(i) of this section under section 551,
951, 1248, or 1293.
(iii) Form of notice. The notice to U.S. persons must be identified
prominently as a notice of section 338 election and must--
(A) Contain the name, address, and employer identification number
(if any) of, and the country (and, if relevant, the lesser political
subdivision) under the laws of which is organized, the purchasing
corporation and the relevant target (i.e., target the stock of which
the particular U.S. person held or sold under the circumstances
described in paragraph (e)(4)(i) of this section);
(B) Identify those corporations as the purchasing corporation and
the foreign target, respectively; and
(C) Contain the following declaration (or a substantially similar
declaration): THIS DOCUMENT SERVES AS NOTICE
[[Page 43481]]
OF AN ELECTION UNDER SECTION 338 FOR THE ABOVE CITED FOREIGN TARGET THE
STOCK OF WHICH YOU EITHER HELD OR SOLD UNDER THE CIRCUMSTANCES
DESCRIBED IN TREASURY REGULATIONS SECTION 1.338-2(e)(4). FOR POSSIBLE
UNITED STATES FEDERAL INCOME TAX CONSEQUENCES UNDER SECTION 551, 951,
1248, OR 1293 OF THE INTERNAL REVENUE CODE OF 1986 THAT MAY APPLY TO
YOU, SEE TREASURY REGULATIONS SECTION 1.338-9(b). YOU MAY BE REQUIRED
TO ATTACH THE INFORMATION ATTACHED TO THIS NOTICE TO CERTAIN RETURNS.
(iv) Timing of notice. The notice required by this paragraph (e)(4)
must be delivered to the U.S. person on or before the later of the
120th day after the acquisition date of the particular target or the
day on which Form 8023 is filed. The notice is considered delivered on
the date it is mailed to the proper address (or an address similar
enough to complete delivery), unless the date it is mailed cannot be
reasonably determined. The date of mailing will be determined under the
rules of section 7502. For example, the date of mailing is the date of
U.S. postmark or the applicable date recorded or marked by a designated
delivery service.
(v) Consequence of failure to comply. A statement of section 338
election is not valid if timely notice is not given to one or more U.S.
persons described in this paragraph (e)(4). If the form of notice fails
to comply with all requirements of this paragraph (e)(4), the section
338 election is valid, but the waiver rule of Sec. 1.338-10(b)(1) does
not apply.
(vi) Good faith effort to comply. The purchasing corporation will
be considered to have complied with this paragraph (e)(4), even though
it failed to provide notice or provide timely notice to each person
described in this paragraph (e)(4), if the Commissioner determines that
the purchasing corporation made a good faith effort to identify and
provide timely notice to those U.S. persons.
Sec. 1.338-3 Qualification for the section 338 election.
(a) Scope. This section provides rules on whether certain
acquisitions of stock are qualified stock purchases and on other
miscellaneous issues under section 338.
(b) Rules relating to qualified stock purchases--(1) Purchasing
corporation requirement. An individual cannot make a qualified stock
purchase of target. Section 338(d)(3) requires, as a condition of a
qualified stock purchase, that a corporation purchase the stock of
target. If an individual forms a corporation (new P) to acquire target
stock, new P can make a qualified stock purchase of target if new P is
considered for tax purposes to purchase the target stock. Facts that
may indicate that new P does not purchase the target stock include new
P merging downstream into target, liquidating, or otherwise disposing
of the target stock following the purported qualified stock purchase.
(2) Purchase--(i) Definition. The term purchase has the same
meaning as in section 338(h)(3).
(ii) Purchase of target. A purchase of a share of target stock
occurs so long as more than a nominal amount is paid for such share.
(iii) Purchase of target affiliate. Stock in a target affiliate
acquired by new target in the deemed asset sale of target's assets is
considered purchased if, under general principles of tax law, new
target is considered to own stock of the target affiliate meeting the
requirements of section 1504(a)(2), notwithstanding that no amount may
be allocated to target's stock in the target affiliate.
(3) Acquisitions of stock from related corporations--(i) In
general. Stock acquired by a purchasing corporation from a related
corporation (R) is generally not considered acquired by purchase. See
section 338(h)(3)(A)(iii).
(ii) Time for testing relationship. For purposes of section
338(h)(3)(A)(iii), a purchasing corporation is treated as related to
another person if the relationship specified in section
338(h)(3)(A)(iii) exists--
(A) In the case of a single transaction, immediately after the
purchase of Target stock;
(B) In the case of a series of acquisitions otherwise constituting
a qualified stock purchase within the meaning of section 338(d)(3),
immediately after the last acquisition in such series; and
(C) In the case of a series of transactions effected pursuant to an
integrated plan to dispose of Target stock, immediately after the last
transaction in such series.
(iii) Cases where section 338(h)(3)(C) applies--acquisitions
treated as purchases. If section 338(h)(3)(C) applies and the
purchasing corporation is treated as acquiring stock by purchase from
R, solely for purposes of determining when the stock is considered
acquired, target stock acquired from R is considered to have been
acquired by the purchasing corporation on the day on which the
purchasing corporation is first considered to own that stock under
section 318(a) (other than section 318(a)(4)).
(iv) Examples. The following examples illustrate this paragraph
(b)(3):
Example 1. (i) S is the parent of a group of corporations that
are engaged in various businesses. Prior to January 1, Year 1, S
decided to discontinue its involvement in one line of business. To
accomplish this, S forms a new corporation, Newco, with a nominal
amount of cash. Shortly thereafter, on January 1, Year 1, S
transfers all the stock of the subsidiary conducting the unwanted
business (Target) to Newco in exchange for 100 shares of Newco
common stock. Prior to January 1, Year 1, S and Underwriter (U) had
entered into a binding agreement pursuant to which U would purchase
60 shares of Newco common stock from S and then sell those shares in
an Initial Public Offering (IPO). On January 6, Year 1, the IPO
closes.
(ii) Newco's acquisition of Target stock is one of a series of
transactions undertaken pursuant to one integrated plan. The series
of transactions ends with the closing of the IPO and the transfer of
all the shares of stock in accordance with the agreements.
Immediately after the last transaction effected pursuant to the
plan, S owns 40 percent of Newco, which does not give rise to a
relationship described in section 338(h)(3)(A)(iii). See paragraph
(b)(3)(ii)(C) of this section. Accordingly, S and Newco are not
related for purposes of section 338(h)(3)(A)(iii).
(iii) Further, because Newco's basis in the Target stock is not
determined by reference to S's basis in the Target stock and because
the transaction is not an exchange to which section 351, 354, 355,
or 356 applies, Newco's acquisition of the Target stock is a
purchase within the meaning of section 338(h)(3).
Example 2. (i) On January 1 of Year 1, P purchases 75 percent in
value of the R stock. On that date, R owns 4 of the 100 shares of T
stock. On June 1 of Year 1, R acquires an additional 16 shares of T
stock. On December 1 of Year 1, P purchases 70 shares of T stock
from an unrelated person and 12 of the 20 shares of T stock held by
R.
(ii) Of the 12 shares of T stock purchased by P from R on
December 1 of Year 1, 3 of those shares are deemed to have been
acquired by P on January 1 of Year 1, the date on which 3 of the 4
shares of T stock held by R on that date were first considered owned
by P under section 318(a)(2)(C) (i.e., 4 x .75). The remaining 9
shares of T stock purchased by P from R on December 1 of Year 1, are
deemed to have been acquired by P on June 1 of Year 1, the date on
which an additional 12 of the 20 shares of T stock owned by R on
that date were first considered owned by P under section
318(a)(2)(C) (i.e., (20 x .75) -3). Because stock acquisitions by P
sufficient for a qualified stock purchase of T occur within a 12-
month period (i.e., 3 shares constructively on January 1 of Year 1,
9 shares constructively on June 1 of Year 1, and 70 shares actually
on December 1 of Year 1), a qualified stock purchase is made on
December 1 of Year 1.
Example 3. (i) On February 1 of Year 1, P acquires 25 percent in
value of the R stock
[[Page 43482]]
from B (the sole shareholder of P). That R stock is not acquired by
purchase. See section 338(h)(3)(A)(iii). On that date, R owns 4 of
the 100 shares of T stock. On June 1 of Year 1, P purchases an
additional 25 percent in value of the R stock, and on January 1 of
Year 2, P purchases another 25 percent in value of the R stock. On
June 1 of Year 2, R acquires an additional 16 shares of the T stock.
On December 1 of Year 2, P purchases 68 shares of the T stock from
an unrelated person and 12 of the 20 shares of the T stock held by
R.
(ii) Of the 12 shares of the T stock purchased by P from R on
December 1 of Year 2, 2 of those shares are deemed to have been
acquired by P on June 1 of Year 1, the date on which 2 of the 4
shares of the T stock held by R on that date were first considered
owned by P under section 318(a)(2)(C) (i.e., 4 x .5). For purposes
of this attribution, the R stock need not be acquired by P by
purchase. See section 338(h)(1). (By contrast, the acquisition of
the T stock by P from R does not qualify as a purchase unless P has
acquired at least 50 percent in value of the R stock by purchase.
Section 338(h)(3)(C)(i).) Of the remaining 10 shares of the T stock
purchased by P from R on December 1 of Year 2, 1 of those shares is
deemed to have been acquired by P on January 1 of Year 2, the date
on which an additional 1 share of the 4 shares of the T stock held
by R on that date was first considered owned by P under section
318(a)(2)(C) (i.e., (4 x .75)--2). The remaining 9 shares of the T
stock purchased by P from R on December 1 of Year 2, are deemed to
have been acquired by P on June 1 of Year 2, the date on which an
additional 12 shares of the T stock held by R on that date were
first considered owned by P under section 318(a)(2)(C) (i.e.,
(20 x .75)--3). Because a qualified stock purchase of T by P is made
on December 1 of Year 2, only if all 12 shares of the T stock
purchased by P from R on that date are considered acquired during a
12-month period ending on that date (so that, in conjunction with
the 68 shares of the T stock P purchased on that date from the
unrelated person, 80 of T's 100 shares are acquired by P during a
12-month period) and because 2 of those 12 shares are considered to
have been acquired by P more than 12 months before December 1 of
Year 2 (i.e., on June 1 of Year 1), a qualified stock purchase is
not made. (Under Sec. 1.338-8(j)(2), for purposes of applying the
consistency rules, P is treated as making a qualified stock purchase
of T if, pursuant to an arrangement, P purchases T stock satisfying
the requirements of section 1504(a)(2) over a period of more than 12
months.)
Example 4. Assume the same facts as in Example 3, except that on
February 1 of Year 1, P acquires 25 percent in value of the R stock
by purchase. The result is the same as in Example 3.
(4) Acquisition date for tiered targets--(i) Stock sold in deemed
asset sale. If an election under section 338 is made for target, old
target is deemed to sell target's assets and new target is deemed to
acquire those assets. Under section 338(h)(3)(B), new target's deemed
purchase of stock of another corporation is a purchase for purposes of
section 338(d)(3) on the acquisition date of target. If new target's
deemed purchase causes a qualified stock purchase of the other
corporation and if a section 338 election is made for the other
corporation, the acquisition date for the other corporation is the same
as the acquisition date of target. However, the deemed sale and
purchase of the other corporation's assets is considered to take place
after the deemed sale and purchase of target's assets.
(ii) Examples. The following examples illustrate this paragraph
(b)(4):
Example 1. A owns all of the T stock. T owns 50 of the 100
shares of X stock. The other 50 shares of X stock are owned by
corporation Y, which is unrelated to A, T, or P. On January 1 of
Year 1, P makes a qualified stock purchase of T from A and makes a
section 338 election for T. On December 1 of Year 1, P purchases the
50 shares of X stock held by Y. A qualified stock purchase of X is
made on December 1 of Year 1, because the deemed purchase of 50
shares of X stock by new T because of the section 338 election for T
and the actual purchase of 50 shares of X stock by P are treated as
purchases made by one corporation. Section 338(h)(8). For purposes
of determining whether those purchases occur within a 12-month
acquisition period as required by section 338(d)(3), T is deemed to
purchase its X stock on T's acquisition date, i.e., January 1 of
Year 1.
Example 2. On January 1 of Year 1, P makes a qualified stock
purchase of T and makes a section 338 election for T. On that day, T
sells all of the stock of T1 to A. Although T held all of the T1
stock on T's acquisition date, T is not considered to have purchased
the T1 stock because of the section 338 election for T. In order for
T to be treated as purchasing the T1 stock, T must hold the T1 stock
when T's deemed asset sale occurs. The deemed asset sale is
considered the last transaction of old T at the close of T's
acquisition date. Accordingly, the T1 stock actually disposed of by
T on the acquisition date is not included in the deemed asset sale.
Thus, T does not make a qualified stock purchase of T1.
(5) Effect of redemptions--(i) General rule. Except as provided in
this paragraph (b)(5), a qualified stock purchase is made on the first
day on which the percentage ownership requirements of section 338(d)(3)
are satisfied by reference to target stock that is both--
(A) Held on that day by the purchasing corporation; and
(B) Purchased by the purchasing corporation during the 12-month
period ending on that day.
(ii) Redemptions from persons unrelated to the purchasing
corporation. Target stock redemptions from persons unrelated to the
purchasing corporation that occur during the 12-month acquisition
period are taken into account as reductions in target's outstanding
stock for purposes of determining whether target stock purchased by the
purchasing corporation in the 12-month acquisition period satisfies the
percentage ownership requirements of section 338(d)(3).
(iii) Redemptions from the purchasing corporation or related
persons during 12-month acquisition period--(A) General rule. For
purposes of the percentage ownership requirements of section 338(d)(3),
a redemption of target stock during the 12-month acquisition period
from the purchasing corporation or from any person related to the
purchasing corporation is not taken into account as a reduction in
target's outstanding stock.
(B) Exception for certain redemptions from related corporations. A
redemption of target stock during the 12-month acquisition period from
a corporation related to the purchasing corporation is taken into
account as a reduction in target's outstanding stock to the extent that
the redeemed stock would have been considered purchased by the
purchasing corporation (because of section 338(h)(3)(C)) during the 12-
month acquisition period if the redeemed stock had been acquired by the
purchasing corporation from the related corporation on the day of the
redemption. See paragraph (b)(3) of this section.
(iv) Examples. The following examples illustrate this paragraph
(b)(5):
Example 1. QSP on stock purchase date; redemption from unrelated
person during 12-month period. A owns all 100 shares of T stock. On
January 1 of Year 1, P purchases 40 shares of the T stock from A. On
July 1 of Year 1, T redeems 25 shares from A. On December 1 of Year
1, P purchases 20 shares of the T stock from A. P makes a qualified
stock purchase of T on December 1 of Year 1, because the 60 shares
of T stock purchased by P within the 12-month period ending on that
date satisfy the 80-percent ownership requirements of section
338(d)(3) (i.e., 60/75 shares), determined by taking into account
the redemption of 25 shares.
Example 2. QSP on stock redemption date; redemption from
unrelated person during 12-month period. The facts are the same as
in Example 1, except that P purchases 60 shares of T stock on
January 1 of Year 1 and none on December 1 of Year 1. P makes a
qualified stock purchase of T on July 1 of Year 1, because that is
the first day on which the T stock purchased by P within the
preceding 12-month period satisfies the 80-percent ownership
requirements of section 338(d)(3) (i.e., 60/75 shares), determined
by taking into account the redemption of 25 shares.
Example 3. Redemption from purchasing corporation not taken into
account. On December 15 of Year 1, T redeems 30 percent of its stock
from P. The redeemed stock was
[[Page 43483]]
held by P for several years and constituted P's total interest in T.
On December 1 of Year 2, P purchases the remaining T stock from A. P
does not make a qualified stock purchase of T on December 1 of Year
2. For purposes of the 80-percent ownership requirements of section
338(d)(3), the redemption of P's T stock on December 15 of Year 1 is
not taken into account as a reduction in T's outstanding stock.
Example 4. Redemption from related person taken into account. On
January 1 of Year 1, P purchases 60 of the 100 shares of X stock. On
that date, X owns 40 of the 100 shares of T stock. On April 1 of
Year 1, T redeems X's T stock and P purchases the remaining 60
shares of T stock from an unrelated person. For purposes of the 80-
percent ownership requirements of section 338(d)(3), the redemption
of the T stock from X (a person related to P) is taken into account
as a reduction in T's outstanding stock. If P had purchased the 40
redeemed shares from X on April 1 of Year 1, all 40 of the shares
would have been considered purchased (because of section
338(h)(3)(C)(i)) during the 12-month period ending on April 1 of
Year 1 (24 of the 40 shares would have been considered purchased by
P on January 1 of Year 1 and the remaining 16 shares would have been
considered purchased by P on April 1 of Year 1). See paragraph
(b)(3) of this section. Accordingly, P makes a qualified stock
purchase of T on April 1 of Year 1, because the 60 shares of T stock
purchased by P on that date satisfy the 80-percent ownership
requirements of section 338(d)(3) (i.e., 60/60 shares), determined
by taking into account the redemption of 40 shares.
(c) Effect of post-acquisition events on eligibility for section
338 election--(1) Post-acquisition elimination of target. (i) The
purchasing corporation may make an election under section 338 for
target even though target is liquidated on or after the acquisition
date. If target liquidates on the acquisition date, the liquidation is
considered to occur on the following day and immediately after new
target's deemed purchase of assets. The purchasing corporation may also
make an election under section 338 for target even though target is
merged into another corporation, or otherwise disposed of by the
purchasing corporation provided that, under the facts and
circumstances, the purchasing corporation is considered for tax
purposes as the purchaser of the target stock.
(ii) The following examples illustrate this paragraph (c)(1):
Example 1. On January 1 of Year 1, P purchases 100 percent of
the outstanding common stock of T. On June 1 of Year 1, P sells the
T stock to an unrelated person. Assuming that P is considered for
tax purposes as the purchaser of the T stock, P remains eligible,
after June 1 of Year 1, to make a section 338 election for T that
results in a deemed asset sale of T's assets on January 1 of Year 1.
Example 2. On January 1 of Year 1, P makes a qualified stock
purchase of T. On that date, T owns the stock of T1. On March 1 of
Year 1, T sells the T1 stock to an unrelated person. On April 1 of
Year 1, P makes a section 338 election for T. Notwithstanding that
the T1 stock was sold on March 1 of Year 1, the section 338 election
for T on April 1 of Year 1 results in a qualified stock purchase by
T of T1 on January 1 of Year 1. See paragraph (b)(4)(i) of this
section.
(2) Post-acquisition elimination of the purchasing corporation. An
election under section 338 may be made for target after the acquisition
of assets of the purchasing corporation by another corporation in a
transaction described in section 381(a), provided that the purchasing
corporation is considered for tax purposes as the purchaser of the
target stock. The acquiring corporation in the section 381(a)
transaction may make an election under section 338 for target.
(3) Consequences of post-acquisition elimination of target--(i)
Scope. The rules of this paragraph (c)(3) apply to the transfer of
target assets to the purchasing corporation (or another member of the
same affiliated group as the purchasing corporation) (the transferee)
following a qualified stock purchase of target stock, if the purchasing
corporation does not make a section 338 election for target.
Notwithstanding the rules of this paragraph (c)(3), section 354(a) (and
so much of section 356 as relates to section 354) cannot apply to any
person other than the purchasing corporation or another member of the
same affiliated group as the purchasing corporation unless the transfer
of target assets is pursuant to a reorganization as determined without
regard to this paragraph (c)(3).
(ii) Continuity of interest. By virtue of section 338, in
determining whether the continuity of interest requirement of
Sec. 1.368-1(b) is satisfied on the transfer of assets from target to
the transferee, the purchasing corporation's target stock acquired in
the qualified stock purchase represents an interest on the part of a
person who was an owner of the target's business enterprise prior to
the transfer that can be continued in a reorganization.
(iii) Control requirement. By virtue of section 338, the
acquisition of target stock in the qualified stock purchase will not
prevent the purchasing corporation from qualifying as a shareholder of
the target transferor for the purpose of determining whether,
immediately after the transfer of target assets, a shareholder of the
transferor is in control of the corporation to which the assets are
transferred within the meaning of section 368(a)(1)(D).
(iv) Example. The following example illustrates this paragraph
(c)(3):
Example. (i) Facts. P, T, and X are domestic corporations. T and
X each operate a trade or business. A and K, individuals unrelated
to P, own 85 and 15 percent, respectively, of the stock of T. P owns
all of the stock of X. The total adjusted basis of T's property
exceeds the sum of T's liabilities plus the amount of liabilities to
which T's property is subject. P purchases all of A's T stock for
cash in a qualified stock purchase. P does not make an election
under section 338(g) with respect to its acquisition of T stock.
Shortly after the acquisition date, and as part of the same plan, T
merges under applicable state law into X in a transaction that, but
for the question of continuity of interest, satisfies all the
requirements of section 368(a)(1)(A). In the merger, all of T's
assets are transferred to X. P and K receive X stock in exchange for
their T stock. P intends to retain the stock of X indefinitely.
(ii) Status of transfer as a reorganization. By virtue of
section 338, for the purpose of determining whether the continuity
of interest requirement of Sec. 1.368-1(b) is satisfied, P's T stock
acquired in the qualified stock purchase represents an interest on
the part of a person who was an owner of T's business enterprise
prior to the transfer that can be continued in a reorganization
through P's continuing ownership of X. Thus, the continuity of
interest requirement is satisfied and the merger of T into X is a
reorganization within the meaning of section 368(a)(1)(A). Moreover,
by virtue of section 338, the requirement of section 368(a)(1)(D)
that a target shareholder control the transferee immediately after
the transfer is satisfied because P controls X immediately after the
transfer. In addition, all of T's assets are transferred to X in the
merger and P and K receive the X stock exchanged therefor in
pursuance of the plan of reorganization. Thus, the merger of T into
X is also a reorganization within the meaning of section
368(a)(1)(D).
(iii) Treatment of T and X. Under section 361(a), T recognizes
no gain or loss in the merger. Under section 362(b), X's basis in
the assets received in the merger is the same as the basis of the
assets in T's hands. X succeeds to and takes into account the items
of T as provided in section 381.
(iv) Treatment of P. By virtue of section 338, the transfer of T
assets to X is a reorganization. Pursuant to that reorganization, P
exchanges its T stock solely for stock of X, a party to the
reorganization. Because P is the purchasing corporation, section 354
applies to P's exchange of T stock for X stock in the merger of T
into X. Thus, P recognizes no gain or loss on the exchange. Under
section 358, P's basis in the X stock received in the exchange is
the same as the basis of P's T stock exchanged therefor.
(v) Treatment of K. Because K is not the purchasing corporation
(or an affiliate thereof), section 354 cannot apply to K's exchange
of T stock for X stock in the merger of T into X unless the transfer
of T's assets is pursuant to a reorganization as determined
[[Page 43484]]
without regard to Sec. 1.338-3(c)(3). Under general principles of
tax law applicable to reorganizations, the continuity of interest
requirement is not satisfied because P's stock purchase and the
merger of T into X are pursuant to an integrated transaction in
which A, the owner of 85 percent of the stock of T, received solely
cash in exchange for A's T stock. See, e.g., Yoc Heating v.
Commissioner, 61 T.C. 168 (1973); Kass v. Commissioner, 60 T.C. 218
(1973), aff'd, 491 F.2d 749 (3d Cir. 1974). Thus, the requisite
continuity of interest under Sec. 1.368-1(b) is lacking and section
354 does not apply to K's exchange of T stock for X stock. K
recognizes gain or loss, if any, pursuant to section 1001(c) with
respect to its T stock.
Secs. 1.338-4 and 1.338-5 [Redesignated as Secs. 1.338-8 and 1.338-9]
Par. 3. Sections 1.338-4 and 1.338-5 are redesignated as
Secs. 1.338-8 and 1.338-9, respectively.
Par. 4. New Secs. 1.338-4 and 1.338-5 are added to read as follows:
Sec. 1.338-4 Aggregate deemed sale price; various aspects of taxation
of the deemed asset sale.
(a) Scope. This section provides rules under section 338(a)(1) to
determine the aggregate deemed sale price (ADSP) for target. ADSP is
the amount for which old target is deemed to have sold all of its
assets in the deemed asset sale. ADSP is allocated among target's
assets in accordance with Sec. 1.338-6 to determine the amount for
which each asset is deemed to have been sold. When an increase or
decrease with respect to an element of ADSP is required, under general
principles of tax law, after the close of new target's first taxable
year, redetermined ADSP is allocated among target's assets in
accordance with Sec. 1.338-7. This section also provides rules
regarding the recognition of gain or loss on the deemed sale of target
affiliate stock. Notwithstanding section 338(h)(6)(B)(ii), stock held
by a target affiliate in a foreign corporation or in a corporation that
is a DISC or that is described in section 1248(e) is not excluded from
the operation of section 338.
(b) Determination of ADSP--(1) General rule. ADSP is the sum of--
(i) The grossed-up amount realized on the sale to the purchasing
corporation of the purchasing corporation's recently purchased target
stock (as defined in section 338(b)(6)(A)); and
(ii) The liabilities of old target.
(2) Time and amount of ADSP--(i) Original determination. ADSP is
initially determined at the beginning of the day after the acquisition
date of target. General principles of tax law apply in determining the
timing and amount of the elements of ADSP.
(ii) Redetermination of ADSP. ADSP is redetermined at such time and
in such amount as an increase or decrease would be required, under
general principles of tax law, for the elements of ADSP. For example,
ADSP is redetermined because of an increase or decrease in the amount
realized for recently purchased stock or because liabilities not
originally taken into account in determining ADSP are subsequently
taken into account. An increase or decrease to one element of ADSP may
cause an increase or decrease to the other element of ADSP. For
example, if an increase in the amount realized for recently purchased
stock of target is taken into account after the acquisition date, any
increase in the tax liability of target for the deemed sale gain is
also taken into account when ADSP is redetermined. Increases or
decreases with respect to the elements of ADSP that are taken into
account before the close of new target's first taxable year are taken
into account for purposes of determining ADSP and the deemed sale gain
as if they had been taken into account at the beginning of the day
after the acquisition date. Increases or decreases with respect to the
elements of ADSP that are taken into account after the close of new
target's first taxable year result in the reallocation of ADSP among
target's assets under Sec. 1.338-7.
(iii) Example. The following example illustrates this paragraph
(b)(2):
Example. In Year 1, T, a manufacturer, purchases a customized
delivery truck from X with purchase money indebtedness having a
stated principal amount of $100,000. P acquires all of the stock of
T in Year 3 for $700,000 and makes a section 338 election for T.
Assume T has no liabilities other than its purchase money
indebtedness to X. In Year 4, when T is neither insolvent nor in a
title 11 case, T and X agree to reduce the amount of the purchase
money indebtedness to $80,000. Assume further that the reduction
would be a purchase price reduction under section 108(e)(5). T and
X's agreement to reduce the amount of the purchase money
indebtedness would not, under general principles of tax law that
would apply if the deemed asset sale had actually occurred, change
the amount of liabilities of old target taken into account in
determining its amount realized. Accordingly, ADSP is not
redetermined at the time of the reduction. See Sec. 1.338-
5(b)(2)(iii) Example 1 for the effect on AGUB.
(c) Grossed-up amount realized on the sale to the purchasing
corporation of the purchasing corporation's recently purchased target
stock--(1) Determination of amount. The grossed-up amount realized on
the sale to the purchasing corporation of the purchasing corporation's
recently purchased target stock is an amount equal to--
(i) The amount realized on the sale to the purchasing corporation
of the purchasing corporation's recently purchased target stock
determined as if old target were the selling shareholder and the
installment method were not available and determined without regard to
the selling costs taken into account in paragraph (c)(1)(iii) of this
section;
(ii) Divided by the percentage of target stock (by value,
determined on the acquisition date) attributable to that recently
purchased target stock;
(iii) Less the selling costs incurred by the selling shareholders
in connection with the sale to the purchasing corporation of the
purchasing corporation's recently purchased target stock that reduce
their amount realized on the sale of the stock (e.g., brokerage
commissions and any similar costs to sell the stock).
(2) Example. The following example illustrates this paragraph (c):
Example. T has two classes of stock outstanding, voting common
stock and preferred stock not taken into account for purposes of
section 1504(a)(2). On March 1 of Year 1, P purchases 40 percent of
the outstanding T stock from S1 for $500, 20 percent of the
outstanding T stock from S2 for $225, and 20 percent of the
outstanding T stock from S3 for $275. On that date, the fair market
value of all the T voting common stock is $1,250 and the preferred
stock $750. S1, S2, and S3 respectively incur $40, $35, and $25 of
selling costs. S1 continues to own the remaining 20 percent of the
outstanding T stock. The grossed-up amount realized on the sale to P
of P's recently purchased T stock is calculated as follows: The
total amount realized (without regard to selling costs) is $1,000
(500 + 225 + 275). The percentage of T stock by value on the
acquisition date attributable to the recently purchased T stock is
50% (1,000/(1,250 + 750)). The selling costs are $100 (40 + 35 +
25). The grossed-up amount realized is $1,900 (1,000/.5 -100).
(d) Liabilities of old target--(1) In general. The liabilities of
old target are the liabilities of target (and the liabilities to which
target's assets are subject) as of the beginning of the day after the
acquisition date (other than liabilities that were neither liabilities
of old target nor liabilities to which old target's assets were
subject). In order to be taken into account in ADSP, a liability must
be a liability of target that is properly taken into account in amount
realized under general principles of tax law that would apply if old
target had sold its assets to an unrelated person for consideration
that included that person's assumption of, or taking subject to, the
liability. Thus, ADSP takes into account both tax credit recapture
liability arising because of the
[[Page 43485]]
deemed asset sale and the tax liability for the deemed sale gain unless
the tax liability is borne by some person other than the target. For
example, ADSP would not take into account the tax liability for the
deemed sale gain when a section 338(h)(10) election is made for a
target S corporation because the S corporation shareholders bear that
liability. However, if a target S corporation is subject to a tax under
section 1374 or 1375, the liability for tax imposed by those sections
is a liability of target taken into account in ADSP (unless the S
corporation shareholders expressly assume that liability).
(2) Time and amount of liabilities. The time for taking into
account liabilities of old target in determining ADSP and the amount of
the liabilities taken into account is determined as if old target had
sold its assets to an unrelated person for consideration that included
the unrelated person's assumption of or taking subject to the
liabilities. For example, if no amount of a target liability is
properly taken into account in amount realized as of the beginning of
the day after the acquisition date, the liability is not initially
taken into account in determining ADSP (although it may be taken into
account at some later date). As a further example, an increase or
decrease in a liability that does not affect the amount of old target's
basis, deductions, or noncapital nondeductible items arising from the
incurrence of the liability is not taken into account in redetermining
ADSP.
(3) Interaction with deemed sale gain. Though deemed sale gain
increases or decreases ADSP by creating or reducing a tax liability,
the amount of the tax liability itself is a function of the size of the
deemed sale gain. Thus, the determination of ADSP may require trial and
error computations.
(e) Calculation of deemed sale gain. Deemed sale gain on each asset
is computed by reference to the ADSP allocated to that asset.
(f) Other rules apply in determining ADSP. ADSP may not be applied
in such a way as to contravene other applicable rules. For example, a
capital loss cannot be applied to reduce ordinary income in calculating
the tax liability on the deemed sale for purposes of determining ADSP.
(g) Examples. The following examples illustrate this section. For
purposes of the examples in this paragraph (g), unless otherwise
stated, T is a calendar year taxpayer that files separate returns and
that has no loss, tax credit, or other carryovers to Year 1.
Depreciation for Year 1 is not taken into account. T has no liabilities
other than the Federal income tax liability resulting from the deemed
asset sale, and the T shareholders have no selling costs. Assume that
T's tax rate for any ordinary income or net capital gain resulting from
the deemed sale of assets is 34 percent and that any capital loss is
offset by capital gain. On July 1 of Year 1, P purchases all of the
stock of T and makes a section 338 election for T. The examples are as
follows:
Example 1. One class. (i) On July 1 of Year 1, T's only asset is
an item of section 1245 property with an adjusted basis to T of
$50,400, a recomputed basis of $80,000, and a fair market value of
$100,000. P purchases all of the T stock for $75,000, which also
equals the amount realized for the stock determined as if old target
were the selling shareholder.
(ii) ADSP is determined as follows (In the following formula, G
is the grossed-up amount realized on the sale to P of P's recently
purchased T stock, L is T's liabilities other than T's tax liability
for the deemed sale gain, TR is the applicable tax rate,
and B is the adjusted basis of the asset deemed sold):
ADSP = G + L + TR x (ADSP - B)
ADSP = ($75,000/1) + $0 + .34 x (ADSP - $50,400)
ADSP = $75,000 + .34ADSP - $17,136
.66ADSP = $57,864
ADSP = $87,672.72
(iii) Because ADSP for T ($87,672.72) does not exceed the fair
market value of T's asset ($100,000), a Class V asset, T's entire
ADSP is allocated to that asset. Thus, T has deemed sale gain of
$37,272.72 (consisting of $29,600 of ordinary income and $7,672.72
of capital gain).
(iv) The facts are the same as in paragraph (i) of this Example
1, except that on July 1 of Year 1, P purchases only 80 of the 100
shares of T stock for $60,000. The grossed-up amount realized on the
sale to P of P's recently purchased T stock (G) is $75,000
($60,000/.8). Consequently, ADSP and deemed sale gain are the same
as in paragraphs (ii) and (iii) of this Example 1.
(v) The facts are the same as in paragraph (i) of this Example
1, except that T also has goodwill (a Class VII asset) with an
appraised value of $10,000. The results are the same as in
paragraphs (ii) and (iii) of this Example 1. Because ADSP does not
exceed the fair market value of the Class V asset, no amount is
allocated to the Class VII assets (goodwill and going concern
value).
Example 2. More than one class. (i) P purchases all of the T
stock for $140,000, which also equals the amount realized for the
stock determined as if old target were the selling shareholder. On
July 1 of Year 1, T has liabilities (not including the tax liability
for the deemed sale gain) of $50,000, cash (a Class I asset) of
$10,000, actively traded securities (a Class II asset) with a basis
of $4,000 and a fair market value of $10,000, goodwill (a Class VII
asset) with a basis of $3,000, and the following Class V assets:
------------------------------------------------------------------------
Ratio of
asset FMV
Asset Basis FMV to total
Class V
FMV
------------------------------------------------------------------------
Land................................... $5,000 $35,000 .14
Building............................... 10,000 50,000 .20
Equipment A (Recomputed basis $80,000). 5,000 90,000 .36
Equipment B (Recomputed basis $20,000). 10,000 75,000 .30
--------------------------------
Total.............................. 30,000 250,000 1.00
------------------------------------------------------------------------
(ii) ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to
the cash and $10,000 to the actively traded securities. The amount
allocated to an asset (other than a Class VII asset) cannot exceed
its fair market value (however, the fair market value of any
property subject to nonrecourse indebtedness is treated as being not
less than the amount of such indebtedness; see Sec. 1.338-6(a)(2)).
See Sec. 1.338-6(c)(1) (relating to fair market value limitation).
(iii) The portion of ADSP allocable to the Class V assets is
preliminarily determined as follows (in the formula, the amount
allocated to the Class I assets is referred to as I and the amount
allocated to the Class II assets as II):
ADSPV = (G - (I + II)) + L + TR x [(II -
BII) + (ADSPV - BV)]
ADSPV = ($140,000 - ($10,000 + $10,000)) + $50,000 + .34
x [($10,000 - $4,000) + (ADSPV - ($5,000 + $10,000 +
$5,000 + $10,000))]
ADSPV = $161,840 + .34 ADSPV
16.66 ADSPV = $161,840
ADSPV = $245,212.12
(iv) Because, under the preliminary calculations of ADSP, the
amount to be allocated to the Class I, II, III, IV, V, and VI
[[Page 43486]]
assets does not exceed their aggregate fair market value, no ADSP
amount is allocated to goodwill. Accordingly, the deemed sale of the
goodwill results in a capital loss of $3,000. The portion of ADSP
allocable to the Class V assets is finally determined by taking into
account this loss as follows:
ADSPV = (G - (I + II)) + L + TR x [(II -
BII) + (ADSPV - BV) +
(ADSPVII - BVII)]
ADSPV = ($140,000 - ($10,000 + $10,000)) + $50,000 + .34
x [($10,000 - $4,000) + (ADSPV - $30,000) + ($0 -
$3,000)]
ADSPV = $160,820 + .34 ADSPV
.66 ADSPV = $160,820
ADSPV = $243,666.67
(v) The allocation of ADSPV among the Class V assets
is in proportion to their fair market values, as follows:
------------------------------------------------------------------------
Asset ADSP Gain
------------------------------------------------------------------------
Land.................................... $34,113.33 $29,113.33
(capital gain)
Building................................ 48,733.34 38,733.34
(capital gain)
Equipment A............................. 87,720.00 82,720.00
(75,000
ordinary
income, 7,720
capital gain)
Equipment B............................. 73,100.00 63,100.00
(10,000
ordinary
income, 53,100
capital gain)
-------------------------------
Totals.............................. 243,666.67 213,666.67
------------------------------------------------------------------------
Example 3. More than one class. (i) The facts are the same as in
Example 2, except that P purchases the T stock for $150,000, rather
than $140,000. The amount realized for the stock determined as if
old target were the selling shareholder is also $150,000.
(ii) As in Example 2, ADSP exceeds $20,000. Thus, $10,000 of
ADSP is allocated to the cash and $10,000 to the actively traded
securities.
(iii) The portion of ADSP allocable to the Class V assets as
preliminarily determined under the formula set forth in paragraph
(iii) of Example 2 is $260,363.64. The amount allocated to the Class
V assets cannot exceed their aggregate fair market value ($250,000).
Thus, preliminarily, the ADSP amount allocated to Class V assets is
$250,000.
(iv) Based on the preliminary allocation, the ADSP is determined
as follows (in the formula, the amount allocated to the Class I
assets is referred to as I, the amount allocated to the Class II
assets as II, and the amount allocated to the Class V assets as V):
ADSP = G + L + TR [(II B II) + (V B
V) + (ADSP (I + II + V+ B VII))]
ADSP = $150,000 + $50,000 + .34 x [($10,000 - $4,000) + ($250,000
- $30,000) + (ADSP ($10,000 + $10,000 + $250,000 + $3,000))]
ADSP = $200,000 + .34ADSP $15,980
.66ADSP = $184,020
ADSP = $278,818.18
(v) Because ADSP as determined exceeds the aggregate fair market
value of the Class I, II, III, IV, V, and VI assets, the $250,000
amount preliminarily allocated to the Class V assets is appropriate.
Thus, the amount of ADSP allocated to Class V assets equals their
aggregate fair market value ($250,000), and the allocated ADSP
amount for each Class V asset is its fair market value. Further,
because there are no Class VI assets, the allocable ADSP amount for
the Class VII asset (goodwill) is $8,818.18 (the excess of ADSP over
the aggregate ADSP amounts for the Class I, II, III, IV, V and VI
assets).
Example 4. Amount allocated to T1 stock. (i) The facts are the
same as in Example 2, except that T owns all of the T1 stock
(instead of the building), and T1's only asset is the building. The
T1 stock and the building each have a fair market value of $50,000,
and the building has a basis of $10,000. A section 338 election is
made for T1 (as well as T), and T1 has no liabilities other than the
tax liability for the deemed sale gain. T is the common parent of a
consolidated group filing a final consolidated return described in
Sec. 1.338 10(a)(1).
(ii) ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to
the cash and $10,000 to the actively traded securities.
(iii) Because T does not recognize any gain on the deemed sale
of the T1 stock under paragraph (h)(2) of this section, appropriate
adjustments must be made to reflect accurately the fair market value
of the T and T1 assets in determining the allocation of ADSP among
T's Class V assets (including the T1 stock). In preliminarily
calculating ADSPV in this case, the T1 stock can be disregarded and,
because T owns all of the T1 stock, the T1 asset can be treated as a
T asset. Under this assumption, ADSPV is $243,666.67. See paragraph
(iv) of Example 2.
(iv) Because the portion of the preliminary ADSP allocable to
Class V assets ($243,666.67) does not exceed their fair market value
($250,000), no amount is allocated to Class VII assets for T.
Further, this amount ($243,666.67) is allocated among T's Class V
assets in proportion to their fair market values. See paragraph (v)
of Example 2. Tentatively, $48,733.34 of this amount is allocated to
the T1 stock.
(v) The amount tentatively allocated to the T1 stock, however,
reflects the tax incurred on the deemed sale of the T1 asset equal
to $13,169.34 (.34 x ($48,733.34 -$10,000)). Thus, the ADSP
allocable to the Class V assets of T, and the ADSP allocable to the
T1 stock, as preliminarily calculated, each must be reduced by
$13,169.34. Consequently, these amounts, respectively, are
$230,497.33 and $35,564.00. In determining ADSP for T1, the grossed-
up amount realized on the deemed sale to new T of new T's recently
purchased T1 stock is $35,564.00.
(vi) The facts are the same as in paragraph (i) of this Example
4, except that the T1 building has a $12,500 basis and a $62,500
value, all of the outstanding T1 stock has a $62,500 value, and T
owns 80 percent of the T1 stock. In preliminarily calculating
ADSPv, the T1 stock can be disregarded but, because T
owns only 80 percent of the T1 stock, only 80 percent of T1 asset
basis and value should be taken into account in calculating T's
ADSP. By taking into account 80 percent of these amounts, the
remaining calculations and results are the same as in paragraphs
(ii), (iii), (iv), and (v) of this Example 4, except that the
grossed-up amount realized on the sale of the recently purchased T1
stock is $44,455.00 ($35,564.00/0.8).
(h) Deemed sale of target affiliate stock--(1) Scope. This
paragraph (h) prescribes rules relating to the treatment of gain or
loss realized on the deemed sale of stock of a target affiliate when a
section 338 election (but not a section 338(h)(10) election) is made
for the target affiliate. For purposes of this paragraph (h), the
definition of domestic corporation in Sec. 1.338-2(c)(9) is applied
without the exclusion therein for DISCs, corporations described in
section 1248(e), and corporations to which an election under section
936 applies.
[[Page 43487]]
(2) In general. Except as otherwise provided in this paragraph (h),
if a section 338 election is made for target, target recognizes no gain
or loss on the deemed sale of stock of a target affiliate having the
same acquisition date and for which a section 338 election is made if--
(i) Target directly owns stock in the target affiliate satisfying
the requirements of section 1504(a)(2);
(ii) Target and the target affiliate are members of a consolidated
group filing a final consolidated return described in Sec. 1.338-
10(a)(1); or
(iii) Target and the target affiliate file a combined return under
Sec. 1.338-10(a)(4).
(3) Deemed sale of foreign target affiliate by a domestic target. A
domestic target recognizes gain or loss on the deemed sale of stock of
a foreign target affiliate. For the proper treatment of such gain or
loss, see, e.g., sections 1246, 1248, 1291 et seq., and 338(h)(16) and
Sec. 1.338-9.
(4) Deemed sale producing effectively connected income. A foreign
target recognizes gain or loss on the deemed sale of stock of a foreign
target affiliate to the extent that such gain or loss is effectively
connected (or treated as effectively connected) with the conduct of a
trade or business in the United States.
(5) Deemed sale of insurance company target affiliate electing
under section 953(d). A domestic target recognizes gain (but not loss)
on the deemed sale of stock of a target affiliate that has in effect an
election under section 953(d) in an amount equal to the lesser of the
gain realized or the earnings and profits described in section
953(d)(4)(B).
(6) Deemed sale of DISC target affiliate. A foreign or domestic
target recognizes gain (but not loss) on the deemed sale of stock of a
target affiliate that is a DISC or a former DISC (as defined in section
992(a)) in an amount equal to the lesser of the gain realized or the
amount of accumulated DISC income determined with respect to such stock
under section 995(c). Such gain is included in gross income as a
dividend as provided in sections 995(c)(2) and 996(g).
(7) Anti-stuffing rule. If an asset the adjusted basis of which
exceeds its fair market value is contributed or transferred to a target
affiliate as transferred basis property (within the meaning of section
7701(a)(43)) and a purpose of such transaction is to reduce the gain
(or increase the loss) recognized on the deemed sale of such target
affiliate's stock, the gain or loss recognized by target on the deemed
sale of stock of the target affiliate is determined as if such asset
had not been contributed or transferred.
(8) Examples. The following examples illustrate this paragraph (h):
Example 1. (i) P makes a qualified stock purchase of T and makes
a section 338 election for T. T's sole asset, all of the T1 stock,
has a basis of $50 and a fair market value of $150. T's deemed
purchase of the T1 stock results in a qualified stock purchase of T1
and a section 338 election is made for T1. T1's assets have a basis
of $50 and a fair market value of $150.
(ii) T realizes $100 of gain on the deemed sale of the T1 stock,
but the gain is not recognized because T directly owns stock in T1
satisfying the requirements of section 1504(a)(2) and a section 338
election is made for T1.
(iii) T1 recognizes gain of $100 on the deemed sale of its
assets.
Example 2. The facts are the same as in Example 1, except that P
does not make a section 338 election for T1. Because a section 338
election is not made for T1, the $100 gain realized by T on the
deemed sale of the T1 stock is recognized.
Example 3. (i) P makes a qualified stock purchase of T and makes
a section 338 election for T. T owns all of the stock of T1 and T2.
T's deemed purchase of the T1 and T2 stock results in a qualified
stock purchase of T1 and T2 and section 338 elections are made for
T1 and T2. T1 and T2 each own 50 percent of the vote and value of T3
stock. The deemed purchases by T1 and T2 of the T3 stock result in a
qualified stock purchase of T3 and a section 338 election is made
for T3. T is the common parent of a consolidated group and all of
the deemed asset sales are reported on the T group's final
consolidated return. See Sec. 1.338-10(a)(1).
(ii) Because T, T1, T2 and T3 are members of a consolidated
group filing a final consolidated return, no gain or loss is
recognized by T, T1 or T2 on their respective deemed sales of target
affiliate stock.
Example 4. (i) T's sole asset, all of the FT1 stock, has a basis
of $25 and a fair market value of $150. FT1's sole asset, all of the
FT2 stock, has a basis of $75 and a fair market value of $150. FT1
and FT2 each have $50 of accumulated earnings and profits for
purposes of section 1248(c) and (d). FT2's assets have a basis of
$125 and a fair market value of $150, and their sale would not
generate subpart F income under section 951. The sale of the FT2
stock or assets would not generate income effectively connected with
the conduct of a trade or business within the United States. FT1
does not have an election in effect under section 953(d) and neither
FT1 nor FT2 is a passive foreign investment company.
(ii) P makes a qualified stock purchase of T and makes a section
338 election for T. T's deemed purchase of the FT1 stock results in
a qualified stock purchase of FT1 and a section 338 election is made
for FT1. Similarly, FT1's deemed purchase of the FT2 stock results
in a qualified stock purchase of FT2 and a section 338 election is
made for FT2.
(iii) T recognizes $125 of gain on the deemed sale of the FT1
stock under paragraph (h)(3) of this section. FT1 does not recognize
$75 of gain on the deemed sale of the FT2 stock under paragraph
(h)(2) of this section. FT2 recognizes $25 of gain on the deemed
sale of its assets. The $125 gain T recognizes on the deemed sale of
the FT1 stock is included in T's income as a dividend under section
1248, because FT1 and FT2 have sufficient earnings and profits for
full recharacterization ($50 of accumulated earnings and profits in
FT1, $50 of accumulated earnings and profits in FT2, and $25 of
deemed sale earnings and profits in FT2). Sec. 1.338-9(b). For
purposes of sections 901 through 908, the source and foreign tax
credit limitation basket of $25 of the recharacterized gain on the
deemed sale of the FT1 stock is determined under section 338(h)(16).
Sec. 1.338 5 Adjusted grossed-up basis.
(a) Scope. This section provides rules under section 338(b) to
determine the adjusted grossed-up basis (AGUB) for target. AGUB is the
amount for which new target is deemed to have purchased all of its
assets in the deemed purchase under section 338(a)(2). AGUB is
allocated among target's assets in accordance with Sec. 1.338-6 to
determine the price at which the assets are deemed to have been
purchased. When an increase or decrease with respect to an element of
AGUB is required, under general principles of tax law, after the close
of new target's first taxable year, redetermined AGUB is allocated
among target's assets in accordance with Sec. 1.338-7.
(b) Determination of AGUB--(1) General rule. AGUB is the sum of--
(i) The grossed-up basis in the purchasing corporation's recently
purchased target stock;
(ii) The purchasing corporation's basis in nonrecently purchased
target stock; and
(iii) The liabilities of new target.
(2) Time and amount of AGUB--(i) Original determination. AGUB is
initially determined at the beginning of the day after the acquisition
date of target. General principles of tax law apply in determining the
timing and amount of the elements of AGUB.
(ii) Redetermination of AGUB. AGUB is redetermined at such time and
in such amount as an increase or decrease would be required, under
general principles of tax law, with respect to an element of AGUB. For
example, AGUB is redetermined because of an increase or decrease in the
amount paid or incurred for recently purchased stock or nonrecently
purchased stock or because liabilities not originally taken into
account in determining AGUB are subsequently taken into account. An
increase or decrease to an element of ADSP may cause an increase or
decrease to an element of AGUB. For example, if
[[Page 43488]]
an increase in the amount realized for recently purchased stock of
target is taken into account after the acquisition date, any increase
in tax liability of target for the deemed sale gain is also taken into
account when AGUB is redetermined. An increase or decrease to one
element of AGUB may also cause an increase or decrease to another
element of AGUB. For example, if there is an increase in the amount
paid or incurred for recently purchased stock after the acquisition
date, any increase in the basis of nonrecently purchased stock because
a gain recognition election was made is also taken into account when
AGUB is redetermined. Increases or decreases with respect to the
elements of AGUB that are taken into account before the close of new
target's first taxable year are taken into account for purposes of
determining AGUB and the basis of target's assets as if they had been
taken into account at the beginning of the day after the acquisition
date. Increases or decreases with respect to the elements of AGUB that
are taken into account after the close of new target's first taxable
year result in the reallocation of AGUB among target's assets under
Sec. 1.338-7.
(iii) Examples. The following examples illustrate this paragraph
(b)(2):
Example 1. In Year 1, T, a manufacturer, purchases a customized
delivery truck from X with purchase money indebtedness having a
stated principal amount of $100,000. P acquires all of the stock of
T in Year 3 for $700,000 and makes a section 338 election for T.
Assume T has no liabilities other than its purchase money
indebtedness to X. In Year 4, when T is neither insolvent nor in a
title 11 case, T and X agree to reduce the amount of the purchase
money indebtedness to $80,000. Assume that the reduction would be a
purchase price reduction under section 108(e)(5). T and X's
agreement to reduce the amount of the purchase money indebtedness
would, under general principles of tax law that would apply if the
deemed asset sale had actually occurred, change the amount of
liabilities of old target taken into account in determining its
basis. Accordingly, AGUB is redetermined at the time of the
reduction. See paragraph (e)(2) of this section. Thus the purchase
price reduction affects the basis of the truck only indirectly,
through the mechanism of Secs. 1.338-6 and 1.338-7. See Sec. 1.338-
4(b)(2)(iii) Example for the effect on ADSP.
Example 2. T, an accrual basis taxpayer, is a chemical
manufacturer. In Year 1, T is obligated to remediate environmental
contamination at the site of one of its plants. Assume that all the
events have occurred that establish the fact of the liability and
the amount of the liability can be determined with reasonable
accuracy but economic performance has not occurred with respect to
the liability within the meaning of section 461(h). P acquires all
of the stock of T in Year 1 and makes a section 338 election for T.
Assume that, if a corporation unrelated to T had actually purchased
T's assets and assumed T's obligation to remediate the
contamination, the corporation would not satisfy the economic
performance requirements until Year 5. Under section 461(h), the
assumed liability would not be treated as incurred and taken into
account in basis until that time. The incurrence of the liability in
Year 5 under the economic performance rules is an increase in the
amount of liabilities properly taken into account in basis and
results in the redetermination of AGUB. (Respecting ADSP, compare
Sec. 1.461-4(d)(5), which provides that economic performance occurs
for old T as the amount of the liability is properly taken into
account in amount realized on the deemed asset sale. Thus ADSP is
not redetermined when new T satisfies the economic performance
requirements.)
(c) Grossed-up basis of recently purchased stock. The purchasing
corporation's grossed-up basis of recently purchased target stock (as
defined in section 338(b)(6)(A)) is an amount equal to--
(1) The purchasing corporation's basis in recently purchased target
stock at the beginning of the day after the acquisition date determined
without regard to the acquisition costs taken into account in paragraph
(c)(3) of this section;
(2) Multiplied by a fraction, the numerator of which is 100 percent
minus the percentage of target stock (by value, determined on the
acquisition date) attributable to the purchasing corporation's
nonrecently purchased target stock, and the denominator of which is the
percentage of target stock (by value, determined on the acquisition
date) attributable to the purchasing corporation's recently purchased
target stock;
(3) Plus the acquisition costs the purchasing corporation incurred
in connection with its purchase of the recently purchased stock that
are capitalized in the basis of such stock (e.g., brokerage commissions
and any similar costs incurred by the purchasing corporation to acquire
the stock).
(d) Basis of nonrecently purchased stock; gain recognition
election--(1) No gain recognition election. In the absence of a gain
recognition election under section 338(b)(3) and this section, the
purchasing corporation retains its basis in the nonrecently purchased
stock.
(2) Procedure for making gain recognition election. A gain
recognition election may be made for nonrecently purchased stock of
target (or a target affiliate) only if a section 338 election is made
for target (or the target affiliate). The gain recognition election is
made by attaching a gain recognition statement to a timely filed Form
8023 for target. The gain recognition statement must contain the
information specified in the form and its instructions. The gain
recognition election is irrevocable. If a section 338(h)(10) election
is made for target, see Sec. 1.338(h)(10)-1(d)(1) (providing that the
purchasing corporation is automatically deemed to have made a gain
recognition election for its nonrecently purchased T stock).
(3) Effect of gain recognition election--(i) In general. If the
purchasing corporation makes a gain recognition election, then for all
purposes of the Internal Revenue Code--
(A) The purchasing corporation is treated as if it sold on the
acquisition date the nonrecently purchased target stock for the basis
amount determined under paragraph (d)(3)(ii) of this section; and
(B) The purchasing corporation's basis on the acquisition date in
nonrecently purchased target stock immediately following the deemed
sale in paragraph (d)(3)(i)(A) of this section is the basis amount.
(ii) Basis amount. The basis amount is equal to the amount in
paragraph (c)(1) of this section (the purchasing corporation's basis in
recently purchased target stock at the beginning of the day after the
acquisition date determined without regard to the acquisition costs
taken into account in paragraph (c)(3) of this section) multiplied by a
fraction the numerator of which is the percentage of target stock (by
value, determined on the acquisition date) attributable to the
purchasing corporation's nonrecently purchased target stock and the
denominator of which is 100 percent minus the numerator amount. Thus,
if target has a single class of outstanding stock, the purchasing
corporation's basis in each share of nonrecently purchased target stock
after the gain recognition election is equal to the average price per
share of the purchasing corporation's recently purchased target stock.
(iii) Losses not recognized. Only gains (unreduced by losses) on
the nonrecently purchased target stock are recognized.
(iv) Stock subject to election. The gain recognition election
applies to
(A) All nonrecently purchased target stock; and
(B) Any nonrecently purchased stock in a target affiliate having
the same acquisition date as target if such target affiliate stock is
held by the purchasing corporation on such date.
(e) Liabilities of new target--(1) In general. The liabilities of
new target are the liabilities of target (and the liabilities to which
target's assets are subject) as of the beginning of the day
[[Page 43489]]
after the acquisition date (other than liabilities that were neither
liabilities of old target nor liabilities to which old target's assets
were subject). In order to be taken into account in AGUB, a liability
must be a liability of target that is properly taken into account in
basis under general principles of tax law that would apply if new
target had acquired its assets from an unrelated person for
consideration that included the assumption of, or taking subject to,
the liability. See Sec. 1.338-4(d)(1) for examples of when tax
liabilities are considered liabilities assumed by new target.
(2) Time and amount of liabilities. The time for taking into
account liabilities of old target in determining AGUB and the amount of
the liabilities taken into account is determined as if new target had
acquired its assets from an unrelated person for consideration that
included the assumption of, or taking subject to, the liabilities. For
example, an increase or decrease in a liability that does not affect
the amount of new target's basis arising from the assumption of, or
taking subject to, the liability is not taken into account in
redetermining AGUB.
(3) Interaction with deemed sale gain. See Sec. 1.338-4(d)(3).
(f) Adjustments by the Internal Revenue Service. In connection with
the examination of a return, the District Director may increase (or
decrease) AGUB under the authority of section 338(b)(2) and allocate
such amounts to target's assets under the authority of section
338(b)(5) so that AGUB and the basis of target's assets properly
reflect the cost to the purchasing corporation of its interest in
target's assets. Such items may include distributions from target to
the purchasing corporation, capital contributions from the purchasing
corporation to target during the 12-month acquisition period, or
acquisitions of target stock by the purchasing corporation after the
acquisition date from minority shareholders.
(g) Examples. The following examples illustrate this section. For
purposes of the examples in this paragraph (g), T has no liabilities
other than the tax liability for the deemed sale gain, T shareholders
incur no costs in selling the T stock, and P incurs no costs in
acquiring the T stock. The examples are as follows:
Example 1. (i) Before July 1 of Year 1, P purchases 10 of the
100 shares of T stock for $5,000. On July 1 of Year 2, P purchases
80 shares of T stock for $60,000 and makes a section 338 election
for T. As of July 1 of Year 2, T's only asset is raw land with an
adjusted basis to T of $50,400 and a fair market value of $100,000.
T has no loss or tax credit carryovers to Year 2. T's marginal tax
rate for any ordinary income or net capital gain resulting from the
deemed asset sale is 34 percent. The 10 shares purchased before July
1 of Year 1 constitute nonrecently purchased T stock with respect to
P's qualified stock purchase of T stock on July 1 of Year 2.
(ii) The ADSP formula as applied to these facts is the same as
in Sec. 1.338-4(g) Example 1. Accordingly, the ADSP for T is
$87,672.72. The existence of nonrecently purchased T stock is
irrelevant for purposes of the ADSP formula, because that formula
treats P's nonrecently purchased T stock in the same manner as T
stock not held by P.
(iii) The total tax liability resulting from T's deemed asset
sale, as calculated under the ADSP formula, is $12,672.72.
(iv) If P does not make a gain recognition election, the AGUB of
new T's assets is $85,172.72, determined as follows (In the
following formula, GRP is the grossed-up basis in P's recently
purchased T stock, BNP is P's basis in nonrecently purchased T
stock, L is T's liabilities, and X is P's acquisition costs for the
recently purchased T stock):
AGUB = GRP + BNP + L + X
AGUB = $60,000 x [(1 - .1)/.8] + $5,000 + $12,672.72 + 0
AGUB = $85,172.72
(v) If P makes a gain recognition election, the AGUB of new T's
assets is $87,672.72, determined as follows:
AGUB = $60,000 x [(1 - .1)/.8] + $60,000 x [(1 - .1)/.8] x
[.1/(1 - .1)] + $12,672.72
AGUB = $87,672.72
(vi) The calculation of AGUB if P makes a gain recognition
election may be simplified as follows:
AGUB = $60,000/.8 + $12,672.72
AGUB = $87,672.72
(vii) As a result of the gain recognition election, P's basis in
its nonrecently purchased T stock is increased from $5,000 to $7,500
(i.e., $60,000 x [(1 - .1)/.8] x [.1/(1 - .1)]). Thus, P
recognizes a gain in Year 2 with respect to its nonrecently
purchased T stock of $2,500 (i.e., $7,500 - $5,000).
Example 2. On January 1 of Year 1, P purchases one-third of the
T stock. On March 1 of Year 1, T distributes a dividend to all of
its shareholders. On April 15 of Year 1, P purchases the remaining T
stock and makes a section 338 election for T. In appropriate
circumstances, the District Director may decrease the AGUB of T to
take into account the payment of the dividend and properly reflect
the fair market value of T's assets deemed purchased.
Example 3. (i) T's sole asset is a building worth $100,000. At
this time, T has 100 shares of stock outstanding. On August 1 of
Year 1, P purchases 10 of the 100 shares of T stock for $8,000. On
June 1 of Year 2, P purchases 50 shares of T stock for $50,000. On
June 15 of Year 2, P contributes a tract of land to the capital of T
and receives 10 additional shares of T stock as a result of the
contribution. Both the basis and fair market value of the land at
that time are $10,800. On June 30 of Year 2, P purchases the
remaining 40 shares of T stock for $40,000 and makes a section 338
election for T. The AGUB of T is $108,800.
(ii) To prevent the shifting of basis from the contributed
property to other assets of T, the District Director may allocate
$10,800 of the AGUB to the land, leaving $98,000 to be allocated to
the building. See paragraph (f) of this section. Otherwise, applying
the allocation rules of Sec. 1.338-6 would, on these facts, result
in an allocation to the recently contributed land of an amount less
than its value of $10,800, with the difference being allocated to
the building already held by T.
Par. 5. Sections 1.338-6 and 1.338-7 are added to read as follows:
Sec. 1.338-6 Allocation of ADSP and AGUB among target assets.
(a) Scope--(1) In general. This section prescribes rules for
allocating ADSP and AGUB among the acquisition date assets of a target
for which a section 338 election is made.
(2) Fair market value--(i) In general. Generally, the fair market
value of an asset is its gross fair market value (i.e., fair market
value determined without regard to mortgages, liens, pledges, or other
liabilities). However, for purposes of determining the amount of old
target's deemed sale gain, the fair market value of any property
subject to a nonrecourse indebtedness will be treated as being not less
than the amount of such indebtedness. (For purposes of the preceding
sentence, a liability that was incurred because of the acquisition of
the property is disregarded to the extent that such liability was not
taken into account in determining old target's basis in such property.)
(ii) Transaction costs. Transaction costs are not taken into
account in allocating ADSP or AGUB to assets in the deemed sale (except
indirectly through their effect on the total ADSP or AGUB to be
allocated).
(iii) Internal Revenue Service authority. In connection with the
examination of a return, the Internal Revenue Service may challenge the
taxpayer's determination of the fair market value of any asset by any
appropriate method and take into account all factors, including any
lack of adverse tax interests between the parties. For example, in
certain cases the Internal Revenue Service may make an independent
showing of the value of goodwill and going concern value as a means of
calling into question the validity of the taxpayer's valuation of other
assets.
(b) General rule for allocating ADSP and AGUB--(1) Reduction in the
amount of consideration for Class I assets. Both ADSP and AGUB, in the
respective allocation of each, are first reduced by the amount of Class
I acquisition date assets. Class I assets are cash and general deposit
accounts
[[Page 43490]]
(including savings and checking accounts) other than certificates of
deposit held in banks, savings and loan associations, and other
depository institutions. If the amount of Class I assets exceeds AGUB,
new target will immediately realize ordinary income in an amount equal
to such excess. The amount of ADSP or AGUB remaining after the
reduction is to be allocated to the remaining acquisition date assets.
(2) Other assets--(i) In general. Subject to the limitations and
other rules of paragraph (c) of this section, ADSP and AGUB (as reduced
by the amount of Class I assets) are allocated among Class II
acquisition date assets of target in proportion to the fair market
values of such Class II assets at such time, then among Class III
assets so held in such proportion, then among Class IV assets so held
in such proportion, then among Class V assets so held in such
proportion, then among Class VI assets so held in such proportion, and
finally to Class VII assets.
(ii) Class II assets. Class II assets are actively traded personal
property within the meaning of section 1092(d)(1) and Sec. 1.1092(d)-1
(determined without regard to section 1092(d)(3)). In addition, Class
II assets include certificates of deposit and foreign currency even if
they are not actively traded personal property. Examples of Class II
assets include U.S. government securities and publicly traded stock.
(iii) Class III assets. Class III assets are accounts receivable,
mortgages, and credit card receivables from customers which arise in
the ordinary course of business.
(iv) Class IV assets. Class IV assets are stock in trade of the
taxpayer or other property of a kind which would properly be included
in the inventory of taxpayer if on hand at the close of the taxable
year, or property held by the taxpayer primarily for sale to customers
in the ordinary course of its trade or business.
(v) Class V assets. Class V assets are all assets other than Class
I, II, III, IV, VI, and VII assets.
(vi) Class VI assets. Class VI assets are all section 197
intangibles, as defined in section 197, except goodwill and going
concern value.
(vii) Class VII assets. Class VII assets are goodwill and going
concern value (whether or not the goodwill or going concern value
qualifies as a section 197 intangible).
(3) Other items designated by the Internal Revenue Service. Similar
items may be added to any class described in this paragraph (b) by
designation in the Internal Revenue Bulletin by the Internal Revenue
Service.
(c) Certain limitations and other rules for allocation to an
asset--(1) Allocation not to exceed fair market value. The amount of
ADSP or AGUB allocated to an asset (other than Class VII assets) cannot
exceed the fair market value of that asset at the beginning of the day
after the acquisition date.
(2) Allocation subject to other rules. The amount of ADSP or AGUB
allocated to an asset is subject to other provisions of the Internal
Revenue Code or general principles of tax law in the same manner as if
such asset were transferred to or acquired from an unrelated person in
a sale or exchange. For example, if the deemed asset sale is a
transaction described in section 1056(a) (relating to basis limitation
for player contracts transferred in connection with the sale of a
franchise), the amount of AGUB allocated to a contract for the services
of an athlete cannot exceed the limitation imposed by that section. As
another example, the amount of AGUB allocated to an amortizable section
197 intangible resulting from an assumption-reinsurance transaction is
determined under section 197(f)(5).
(3) Special rule for allocating AGUB when purchasing corporation
has nonrecently purchased stock--(i) Scope. This paragraph (c)(3)
applies if at the beginning of the day after the acquisition date--
(A) The purchasing corporation holds nonrecently purchased stock
for which a gain recognition election under section 338(b)(3) and
Sec. 1.338-5(d) is not made; and
(B) The hypothetical purchase price determined under paragraph
(c)(3)(ii) of this section exceeds the AGUB determined under
Sec. 1.338-5(b).
(ii) Determination of hypothetical purchase price. Hypothetical
purchase price is the AGUB that would result if a gain recognition
election were made.
(iii) Allocation of AGUB. Subject to the limitations in paragraphs
(c)(1) and (2) of this section, the portion of AGUB (after reduction by
the amount of Class I assets) to be allocated to each Class II, III,
IV, V, VI, and VII asset of target held at the beginning of the day
after the acquisition date is determined by multiplying--
(A) The amount that would be allocated to such asset under the
general rules of this section were AGUB equal to the hypothetical
purchase price; by
(B) A fraction, the numerator of which is actual AGUB (after
reduction by the amount of Class I assets) and the denominator of which
is the hypothetical purchase price (after reduction by the amount of
Class I assets).
(4) Liabilities taken into account in determining amount realized
on subsequent disposition. In determining the amount realized on a
subsequent sale or other disposition of property deemed purchased by
new target, the entire amount of any liability taken into account in
AGUB is considered to be an amount taken into account in determining
new target's basis in property that secures the liability for purposes
of applying Sec. 1.1001-2(a). Thus, if a liability is taken into
account in AGUB, Sec. 1.1001-2(a)(3) does not prevent the amount of
such liability from being treated as discharged within the meaning of
Sec. 1.1001-2(a)(4) as a result of new target's sale or disposition of
the property which secures such liability.
(d) Examples. The following examples illustrate Secs. 1.338-4,
1.338-5, and this section:
Example 1. (i) T owns 90 percent of the outstanding T1 stock. P
purchases 100 percent of the outstanding T stock for $2,000. There
are no acquisition costs. P makes a section 338 election for T and,
as a result, T1 is considered acquired in a qualified stock
purchase. A section 338 election is made for T1. The grossed-up
basis of the T stock is $2,000 (i.e., $2,000 x 1/1).
(ii) The liabilities of T as of the beginning of the day after
the acquisition date (including the tax liability for the deemed
sale gain) that would, under general principles of tax law, be
properly taken into account before the close of new T's first
taxable year, are as follows:
Liabilities (nonrecourse mortgage plus unsecured liabilities).. $700
Taxes Payable.................................................. 300
--------
Total...................................................... 1,000
(iii) The AGUB of T is determined as follows:
Grossed-up basis............................................... $2,000
Total liabilities.............................................. 1,000
--------
AGUB....................................................... 3,000
(iv) Assume that ADSP is also $3,000.
(v) Assume that, at the beginning of the day after the
acquisition date, T's cash and the fair market values of T's Class
II, III, IV, and V assets are as follows:
------------------------------------------------------------------------
Fair
Asset Class Asset market
value
------------------------------------------------------------------------
I......................... Cash............................... *$200
II........................ Portfolio of actively traded 300
securities.
III....................... Accounts receivable................ 600
IV........................ Inventory.......................... 300
V......................... Building........................... 800
V......................... Land............................... 200
V......................... Investment in T1................... 450
--------
Total.......................... 2,850
------------------------------------------------------------------------
* Amount.
[[Page 43491]]
(vi) Under paragraph (b)(1) of this section, the amount of ADSP
and AGUB allocable to T's Class II, III, IV, and V assets is reduced
by the amount of cash to $2,800, i.e., $3,000-$200. $300 of ADSP and
of AGUB is then allocated to actively traded securities. $600 of
ADSP and of AGUB is then allocated to accounts receivable. $300 of
ADSP and of AGUB is then allocated to the inventory. Since the
remaining amount of ADSP and of AGUB is $1,600 (i.e., $3,000-($200 +
$300 + $600 + $300)), an amount which exceeds the sum of the fair
market values of T's Class V assets, the amount of ADSP and of AGUB
allocated to each Class V asset is its fair market value:
Building....................................................... 800
Land........................................................... 200
Investment in T1............................................... 450
--------
Total........................................................ $1,450
(vii) T has no Class VI assets. The amount of ADSP and of AGUB
allocated to T's Class VII assets (goodwill and going concern value)
is $150, i.e., $1,600-$1,450.
(viii) The grossed-up basis of the T1 stock is $500, i.e., $450
x 1/.9.
(ix) The liabilities of T as of the beginning of the day after
the acquisition date (including the tax liability for the deemed
sale gain) that would, under general principles of tax law, be
properly taken into account before the close of new T's first
taxable year, are as follows:
General Liabilities............................................ $100
Taxes Payable.................................................. 20
--------
Total...................................................... 120
(x) The AGUB of T1 is determined as follows:
Grossed-up basis of T1 Stock................................. $500
Liabilities.................................................. 120
----------
AGUB..................................................... 620
(xi) Assume that ADSP is also $620.
(xii) Assume that at the beginning of the day after the
acquisition date, T1's cash and the fair market values of its Class
IV and VI assets are as follows:
------------------------------------------------------------------------
Fair
Asset Class Asset Market
Value
------------------------------------------------------------------------
I......................... Cash............................... *$50
IV........................ Inventory.......................... 200
VI........................ Patent............................. 350
--------
Total.......................... 600
------------------------------------------------------------------------
*Amount.
(xiii) The amount of ADSP and of AGUB allocable to T1's Class IV
and VI assets is first reduced by the $50 of cash.
(xiv) Because the remaining amount of ADSP and of AGUB ($570) is
an amount which exceeds the fair market value of T1's only Class IV
asset, the inventory, the amount allocated to the inventory is its
fair market value ($200). After that, the remaining amount of ADSP
and of AGUB ($370) exceeds the fair market value of T1's only Class
VI asset, the patent. Thus, the amount of ADSP and of AGUB allocated
to the patent is its fair market value ($350).
(xv) The amount of ADSP and of AGUB allocated to T1's Class VII
assets (goodwill and going concern value) is $20, i.e., $570-$550.
Example 2. (i) Assume that the facts are the same as in Example
1 except that P has, for five years, owned 20 percent of T's stock,
which has a basis in P's hands at the beginning of the day after the
acquisition date of $100, and P purchases the remaining 80 percent
of T's stock for $1,600. P does not make a gain recognition election
under section 338(b)(3).
(ii) Under Sec. 1.338-5(c), the grossed-up basis of recently
purchased T stock is $1,600, i.e., $1,600 x (1-.2)/.8.
(iii) The AGUB of T is determined as follows:
Grossed-up basis of recently purchased stock as determined $1,600
under Sec. 1.338-5(c) ($1,600 x (1-.2)/.8).................
Basis of nonrecently purchased stock......................... 100
Liabilities.................................................. 1,000
----------
AGUB..................................................... 2,700
(iv) Since P holds nonrecently purchased stock, the hypothetical
purchase price of the T stock must be computed and is determined as
follows:
Grossed-up basis of recently purchased stock as determined $1,600
under Sec. 1.338-5(c) ($1,600 x (1-.2)/.8).................
Basis of nonrecently purchased stock as if the gain 400
recognition election under Sec. 1.338-5(d)(2) had been made
($1,600 x .2/(1-.2))........................................
Liabilities.................................................. 1,000
----------
Total.................................................... 3,000
(v) Since the hypothetical purchase price ($3,000) exceeds the
AGUB ($2,700) and no gain recognition election is made under section
338(b)(3), AGUB is allocated under paragraph (c)(3) of this section.
(vi) First, an AGUB amount equal to the hypothetical purchase
price ($3,000) is allocated among the assets under the general rules
of this section. The allocation is set forth in the column below
entitled Original Allocation. Next, the allocation to each asset in
Class II through Class VII is multiplied by a fraction having a
numerator equal to the actual AGUB reduced by the amount of Class I
assets ($2,700 -$200 = $2,500) and a denominator equal to the
hypothetical purchase price reduced by the amount of Class I assets
($3,000 -$200 = $2,800), or 2,500/2,800. This produces the Final
Allocation:
------------------------------------------------------------------------
Original Final
Class Asset allocation allocation
------------------------------------------------------------------------
I..................... Cash.................... $200 $200
II.................... Portfolio of actively 300 * 268
traded securities.
III................... Accounts receivable..... 600 536
IV.................... Inventory............... 300 268
V..................... Building................ 800 714
V..................... Land.................... 200 178
V..................... Investment in T1........ 450 402
VII................... Goodwill and going 150 134
concern value.
-----------------------
Total............... $3,000 $2,700
------------------------------------------------------------------------
* All numbers rounded for convenience.
Sec. 1.338-7 Allocation of redetermined ADSP and AGUB among target
assets.
(a) Scope. ADSP and AGUB are redetermined at such time and in such
amount as an increase or decrease would be required under general
principles of tax law for the elements of ADSP or AGUB. This section
provides rules for allocating redetermined ADSP or AGUB when increases
or decreases with respect to the elements of ADSP or AGUB are required
after the close of new target's first taxable year. For determining and
allocating ADSP or AGUB when increases or decreases are required with
respect to the elements of ADSP or AGUB before the close of new
target's first taxable year, see Secs. 1.338-4, 1.338-5, and 1.338-6.
(b) Allocation of redetermined ADSP and AGUB. When ADSP or AGUB is
redetermined, a new allocation of ADSP or AGUB is made by allocating
the redetermined ADSP or AGUB amount under the rules of Sec. 1.338-6.
If the allocation of the redetermined ADSP or AGUB amount under
Sec. 1.338-6 to a given asset is different from the original allocation
to it, the difference is added
[[Page 43492]]
to or subtracted from the original allocation to the asset, as
appropriate. Amounts allocable to an acquisition date asset (or with
respect to a disposed-of acquisition date asset) are subject to all the
asset allocation rules (for example, the fair market value limitation
in Sec. 1.338-6(c)(1)) as if the redetermined ADSP or AGUB were the
ADSP or AGUB on the acquisition date.
(c) Special rules for ADSP--(1) Increases or decreases in deemed
sale gain taxable notwithstanding old target ceases to exist. To the
extent general principles of tax law would require a seller in an
actual asset sale to account for events relating to the sale that occur
after the sale date, target must make such an accounting. Target is not
precluded from realizing additional deemed sale gain because the target
is treated as a new corporation after the acquisition date.
(2) Procedure for transactions in which section 338(h)(10) is not
elected--(i) Deemed sale gain included in new target's return. If an
election under section 338(h)(10) is not made, any additional deemed
sale gain of old target resulting from an increase or decrease in the
ADSP is included in new target's income tax return for new target's
taxable year in which the increase or decrease is taken into account.
For example, if after the acquisition date there is an increase in the
allocable ADSP of section 1245 property for which the recomputed basis
(but not the adjusted basis) exceeds the portion of the ADSP allocable
to that particular asset on the acquisition date, the additional gain
is treated as ordinary income to the extent it does not exceed such
excess amount. See paragraph (c)(2)(ii) of this section for the special
treatment of old target's carryovers and carrybacks. Although included
in new target's income tax return, the deemed sale gain is separately
accounted for as an item of old target and may not be offset by income,
gain, deduction, loss, credit, or other amount of new target. The
amount of tax on income of old target resulting from an increase or
decrease in the ADSP is determined as if such deemed sale gain had been
recognized in old target's taxable year ending at the close of the
acquisition date.
(ii) Carryovers and carrybacks--(A) Loss carryovers to new target
taxable years. A net operating loss or net capital loss of old target
may be carried forward to a taxable year of new target, under the
principles of section 172 or 1212, as applicable, but is allowed as a
deduction only to the extent of any recognized income of old target for
such taxable year, as described in paragraph (c)(2)(i) of this section.
For this purpose, however, taxable years of new target are not taken
into account in applying the limitations in section 172(b)(1) or
1212(a)(1)(B) (or other similar limitations). In applying sections
172(b) and 1212(a)(1), only income, gain, loss, deduction, credit, and
other amounts of old target are taken into account. Thus, if old target
has an unexpired net operating loss at the close of its taxable year in
which the deemed asset sale occurred that could be carried forward to a
subsequent taxable year, such loss may be carried forward until it is
absorbed by old target's income.
(B) Loss carrybacks to taxable years of old target. An ordinary
loss or capital loss accounted for as a separate item of old target
under paragraph (c)(2)(i) of this section may be carried back to a
taxable year of old target under the principles of section 172 or 1212,
as applicable. For this purpose, taxable years of new target are not
taken into account in applying the limitations in section 172(b) or
1212(a) (or other similar limitations).
(C) Credit carryovers and carrybacks. The principles described in
paragraphs (c)(2)(ii)(A) and (B) of this section apply to carryovers
and carrybacks of amounts for purposes of determining the amount of a
credit allowable under part IV, subchapter A, chapter 1 of the Internal
Revenue Code. Thus, for example, credit carryovers of old target may
offset only income tax attributable to items described in paragraph
(c)(2)(i) of this section.
(3) Procedure for transactions in which section 338(h)(10) is
elected. If an election under section 338(h)(10) is made, any
additional deemed sale gain resulting from an increase or decrease in
the ADSP is accounted for in determining the taxable income (or other
amount) of the member of the selling consolidated group, the selling
affiliate, or the S corporation shareholders to which such income,
loss, or other amount is attributable for the taxable year in which
such increase or decrease is taken into account.
(d) Special rules for AGUB--(1) Effect of disposition or
depreciation of acquisition date assets. If an acquisition date asset
has been disposed of, depreciated, amortized, or depleted by new target
before an amount is added to the original allocation to the asset, the
increased amount otherwise allocable to such asset is taken into
account under general principles of tax law that apply when part of the
cost of an asset not previously taken into account in basis is paid or
incurred after the asset has been disposed of, depreciated, amortized,
or depleted. A similar rule applies when an amount is subtracted from
the original allocation to the asset. For purposes of the preceding
sentence, an asset is considered to have been disposed of to the extent
that its allocable portion of the decrease in AGUB would reduce its
basis below zero.
(2) Section 38 property. Section 1.47-2(c) applies to a reduction
in basis of section 38 property under this section.
(e) Examples. The following examples illustrate this section. Any
amount described in the following examples is exclusive of interest.
For rules characterizing deferred contingent payments as principal or
interest, see Secs. 1.483-4, 1.1274-2(g), and 1.1275-4(c). The examples
are as follows:
Example 1. (i)(A) T's assets other than goodwill and going
concern value, and their fair market values at the beginning of the
day after the acquisition date, are as follows:
------------------------------------------------------------------------
Fair
Asset class Asset market
value
------------------------------------------------------------------------
V......................... Building........................... $100
V......................... Stock of X (not a target).......... 200
--------
Total........................ $300
------------------------------------------------------------------------
(B) T has no liabilities other than a contingent liability that
would not be taken into account under general principles of tax law
in an asset sale between unrelated parties when the buyer assumed
the liability or took property subject to it.
(ii)(A) On September 1, 2000, P purchases all of the outstanding
stock of T for $270 and makes a section 338 election for T. The
grossed-up basis of the T stock and T's AGUB are both $270. The AGUB
is ratably allocated among T's Class V assets in proportion to their
fair market values as follows:
------------------------------------------------------------------------
Asset Basis
------------------------------------------------------------------------
Building ($270 x 100/300)................................ $90
Stock ($270 x 200/300)................................... 180
------------
Total.................................................. $270
------------------------------------------------------------------------
(B) No amount is allocated to the Class VII assets. New T is a
calendar year taxpayer. Assume that the X stock is a capital asset
in the hands of new T.
(iii) On January 1, 2001, new T sells the X stock and uses the
proceeds to purchase inventory.
(iv) Pursuant to events on June 30, 2002, the contingent
liability of old T is at that time properly taken into account under
general principles of tax law. The amount of the liability is $60.
(v) T's AGUB increases by $60 from $270 to $330. This $60
increase in AGUB is first allocated among T's acquisition date
assets in accordance with the provisions of Sec. 1.338-6. Because
the redetermined AGUB for T ($330) exceeds the sum of the fair
market values at the beginning of the day after the acquisition date
of the Class V acquisition date assets
[[Page 43493]]
($300), AGUB allocated to those assets is limited to those fair
market values under Sec. 1.338-6(c)(1). As there are no Class VI
assets, the remaining AGUB of $30 is allocated to goodwill and going
concern value (Class VII assets). The amount of increase in AGUB
allocated to each acquisition date asset is determined as follows:
----------------------------------------------------------------------------------------------------------------
Redetermined
Asset Original AGUB AGUB Increase
----------------------------------------------------------------------------------------------------------------
Building $90 $100 $10
X Stock 180 200 20
Goodwill and going concern value 0 30 30
-----------------------------------------------------
Total................................................. $270 $330 $60
----------------------------------------------------------------------------------------------------------------
(vi) Since the X stock was disposed of before the contingent
liability was properly taken into account for tax purposes, no
amount of the increase in AGUB attributable to such stock may be
allocated to any T asset. Rather, such amount ($20) is allowed as a
capital loss to T for the taxable year 2002 under the principles of
Arrowsmith v. Commissioner, 344 U.S. 6 (1952). In addition, the $10
increase in AGUB allocated to the building and the $30 increase in
AGUB allocated to the goodwill and going concern value are treated
as basis redeterminations in 2002. See paragraph (d)(1) of this
section.
Example 2. (i) On January 1, 2002, P purchases all of the
outstanding stock of T and makes a section 338 election for T.
Assume that ADSP and AGUB of T are both $500 and are allocated among
T's acquisition date assets as follows:
------------------------------------------------------------------------
Asset class Asset Basis
------------------------------------------------------------------------
V....................... Machinery........................ $150
V....................... Land............................. 250
VII..................... Goodwill and going concern value. 100
------------
Total $500
------------------------------------------------------------------------
(ii) On September 30, 2004, P filed a claim against the selling
shareholders of T in a court of appropriate jurisdiction alleging
fraud in the sale of the T stock.
(iii) On January 1, 2007, the former shareholders refund $140 of
the purchase price to P in a settlement of the lawsuit. Assume that,
under general principles of tax law, both the seller and the buyer
properly take into account such refund when paid. Assume also that
the refund has no effect on the tax liability for the deemed sale
gain. This refund results in a decrease of T's ADSP and AGUB of
$140, from $500 to $360.
(iv) The redetermined ADSP and AGUB of $360 is allocated among
T's acquisition date assets. Because ADSP and AGUB do not exceed the
fair market value of the Class V assets, the ADSP and AGUB amounts
are allocated to the Class V assets in proportion to their fair
market values at the beginning of the day after the acquisition
date. Thus, $135 ($150 ($360/($150 + $250))) is allocated to the
machinery and $225 ($250 ($360/($150 + $250))) is allocated to the
land. Accordingly, the basis of the machinery is reduced by $15
($150 original allocation $135 redetermined allocation) and the
basis of the land is reduced by $25 ($250 original allocation -$225
redetermined allocation). No amount is allocated to the Class VII
assets. Accordingly, the basis of the goodwill and going concern
value is reduced by $100 ($100 original allocation -$0 redetermined
allocation).
(v) Assume that, as a result of deductions under section 168,
the adjusted basis of the machinery immediately before the decrease
in AGUB is zero. The machinery is treated as if it were disposed of
before the decrease is taken into account. In 2007, T recognizes
income of $15, the character of which is determined under the
principles of Arrowsmith v. Commissioner, 344 U.S. 6 (1952), and the
tax benefit rule. No adjustment to the basis of T's assets is made
for any tax paid on this amount. Assume also that, as a result of
amortization deductions, the adjusted basis of the goodwill and
going concern value immediately before the decrease in AGUB is $40.
A similar adjustment to income is made in 2007 with respect to the
$60 of previously amortized goodwill and going concern value.
(vi) In summary, the basis of T's acquisition date assets, as of
January 1, 2007, is as follows:
------------------------------------------------------------------------
Asset Basis
------------------------------------------------------------------------
Machinery.................................................. $0
Land....................................................... 225
Goodwill and going concern value........................... 0
------------------------------------------------------------------------
Example 3. (i) Assume that the facts are the same as Sec. 1.338-
6(d) Example 2 except that the recently purchased stock is acquired
for $1,600 plus additional payments that are contingent upon T's
future earnings. Assume that, under general principles of tax law,
such later payments are properly taken into account when paid. Thus,
T's AGUB, determined as of the beginning of the day after the
acquisition date (after reduction by T's cash of $200), is $2,500
and is allocated among T's acquisition date assets under Sec. 1.338-
6(c)(3)(iii) as follows:
------------------------------------------------------------------------
Final
Class Asset allocation
------------------------------------------------------------------------
I........................ Cash............................. $200
II....................... Portfolio of actively traded *268
securities.
III...................... Accounts receivable.............. 536
IV....................... Inventory........................ 268
V........................ Building......................... 714
V........................ Land............................. 178
V........................ Investment in T1................. 402
VII...................... Goodwill and going concern value. 134
-----------
Total........................ $2,700
------------------------------------------------------------------------
* All numbers rounded for convenience.
(ii) After the close of new target's first taxable year, P pays
an additional $200 for its recently purchased T stock. Assume that
the additional consideration paid would not increase T's tax
liability for the deemed sale gain.
(iii) T's AGUB increases by $200, from $2,700 to $2,900. This
$200 increase in AGUB is accounted for in accordance with the
provisions of Sec. 1.338-6(c)(3)(iii).
(iv) The hypothetical purchase price of the T stock is
redetermined as follows:
Grossed-up basis of recently purchased stock as determined $1,800
under Sec. 1.338-5(c) ($1,800 x (1 -.2)/.8)..............
Basis of nonrecently purchased stock as if the gain 450
recognition election under Sec. 1.338-5(d)(2) had been made
($1,800 x .2/(1-.2))......................................
Liabilities.................................................. 1,000
----------
Total.................................................... $3,250
(v) Since the redetermined hypothetical purchase price ($3,250)
exceeds the redetermined AGUB ($2,900) and no gain recognition
election was made under section 338(b)(3), the rules of Sec. 1.338-
6(c)(3)(iii) are reapplied using the redetermined hypothetical
purchase price and the redetermined AGUB.
(vi) First, an AGUB amount equal to the redetermined
hypothetical purchase price ($3,250) is allocated among the assets
under the general rules of Sec. 1.338 6. The allocation is set forth
in the column below entitled Hypothetical Allocation. Next, the
allocation to each asset in Class II through Class VII is multiplied
by a fraction with a numerator equal to the actual redetermined AGUB
reduced by the amount of Class I assets ($2,900-$200 = $2,700) and a
denominator equal to the redetermined hypothetical purchase price
reduced by the amount of Class I assets ($3,250-$200 = $3,050), or
2,700/3,050. This produces the Final Allocation:
[[Page 43494]]
------------------------------------------------------------------------
Hypothetical Final
Class Asset allocation allocation
------------------------------------------------------------------------
I................. Cash...................... $200 $200
II................ Portfolio of actively 300 * 266
traded securities.
III............... Accounts receivable....... 600 531
IV................ Inventory................. 300 266
V................. Building.................. 800 708
V................. Land...................... 200 177
V................. Investment in T1.......... 450 398
VII............... Goodwill and going concern 400 354
value.
-------------------------
Total................. $3,250 $2900
------------------------------------------------------------------------
*All numbers rounded for convenience.
(vii) As illustrated by this example, reapplying Sec. 1.338-
6(c)(3) results in a basis increase for some assets and a basis
decrease for other assets. The amount of redetermined AGUB allocated
to each acquisition date asset is determined as follows:
----------------------------------------------------------------------------------------------------------------
Original Redetermined
Asset (c)(3) (c)(3) Increase
allocation allocation (decrease)
----------------------------------------------------------------------------------------------------------------
Portfolio of actively traded securities......................... $268 $266 $(2)
Accounts receivable............................................. 536 531 (5)
Inventory....................................................... 268 266 (2)
Building........................................................ 714 708 (6)
Land............................................................ 178 177 (1)
Investment in T1................................................ 402 398 (4)
Goodwill and going concern value................................ 134 354 220
-----------------------------------------------
Total....................................................... $2,500 $2,700 $200
----------------------------------------------------------------------------------------------------------------
Example 4. (i) On January 1, 2001, P purchases all of the
outstanding T stock and makes a section 338 election for T. P pays
$700 of cash and promises also to pay a maximum $300 of contingent
consideration at various times in the future. Assume that, under
general principles of tax law, such later payments are properly
taken into account by P when paid. Assume also, however, that the
current fair market value of the contingent payments is reasonably
ascertainable. The fair market value of T's assets (other than
goodwill and going concern value) as of the beginning of the
following day is as follows:
------------------------------------------------------------------------
Fair
Asset class Assets market
value
------------------------------------------------------------------------
V........................ Equipment......................... $200
V........................ Non-actively traded securities.... 100
V........................ Building.......................... 500
----------
Total......................... $800
------------------------------------------------------------------------
(ii) T has no liabilities. The AGUB is $700. In calculating
ADSP, assume that, under Sec. 1.1001-1, the current amount realized
attributable to the contingent consideration is $200. ADSP is
therefore $900 ($700 cash plus $200).
(iii) (A) The AGUB of $700 is ratably allocated among T's Class
V acquisition date assets in proportion to their fair market values
as follows:
------------------------------------------------------------------------
Asset Basis
------------------------------------------------------------------------
Equipment ($700 x 200/800)................................. $175.00
Non-actively traded securities ($700 x 100/800)............ 87.50
Building ($700 x 500/800).................................. 437.50
----------
Total.................................................... $700.00
------------------------------------------------------------------------
(B) No amount is allocated to goodwill or going concern value.
(iv) (A) The ADSP of $900 is ratably allocated among T's Class V
acquisition date assets in proportion to their fair market values as
follows:
------------------------------------------------------------------------
Asset Basis
------------------------------------------------------------------------
Equipment.................................................... $200
Non-actively traded securities............................... 100
Building..................................................... 500
----------
Total.................................................... $800
------------------------------------------------------------------------
(B) The remaining ADSP, $100, is allocated to goodwill and going
concern value (Class VII).
(v) P and T file a consolidated return for 2001 and each
following year with P as the common parent of the affiliated group.
(vi) In 2004, a contingent amount of $120 is paid by P. Assume
that, under general principles of tax law, the payment is properly
taken into account by P at the time made. In 2004, there is an
increase in T's AGUB of $120. The amount of the increase allocated
to each acquisition date asset is determined as follows:
----------------------------------------------------------------------------------------------------------------
Redetermined
Asset Original AGUB AGUB Increase
----------------------------------------------------------------------------------------------------------------
Equipment....................................................... $175.00 $200.00 $25.00
Land............................................................ 87.50 100.00 12.50
Building........................................................ 437.50 500.00 62.50
Goodwill and going concern value................................ 0.00 20.00 20.00
-----------------------------------------------
Total....................................................... $700.00 $820.00 $120.00
----------------------------------------------------------------------------------------------------------------
[[Page 43495]]
Par. 6. Section 1.338 10 is added to read as follows:
Sec. 1.338-10 Filing of returns.
(a) Returns including tax liability from deemed asset sale--(1) In
general. Except as provided in paragraphs (a)(2) and (3) of this
section, any deemed sale gain is reported on the final return of old
target filed for old target's taxable year that ends at the close of
the acquisition date. If old target is the common parent of an
affiliated group, the final return may be a consolidated return (any
such consolidated return must also include any deemed sale gain of any
members of the consolidated group that are acquired by the purchasing
corporation on the same acquisition date as old target).
(2) Old target's final taxable year otherwise included in
consolidated return of selling group--(i) General rule. If the selling
group files a consolidated return for the period that includes the
acquisition date, old target is disaffiliated from that group
immediately before the deemed asset sale and must file a deemed sale
return separate from the group that includes only the deemed sale gain
and the carryover items specified in paragraph (a)(2)(iii) of this
section. The deemed asset sale occurs at the close of the acquisition
date and is the last transaction of old target. Any transactions of old
target occurring on the acquisition date other than the deemed asset
sale are included in the selling group's consolidated return. A deemed
sale return includes a combined deemed sale return as defined in
paragraph (a)(4) of this section.
(ii) Separate taxable year. The deemed asset sale included in the
deemed sale return under this paragraph (a)(2) occurs in a separate
taxable year, except that old target's taxable year of the sale and the
consolidated year of the selling group that includes the acquisition
date are treated as the same year for purposes of determining the
number of years in a carryover or carryback period.
(iii) Carryover and carryback of tax attributes. Target's
attributes may be carried over to, and carried back from, the deemed
sale return under the rules applicable to a corporation that ceases to
be a member of a consolidated group.
(iv) Old target is a component member of purchasing corporation's
controlled group. For purposes of its deemed sale return, target is a
component member of the controlled group of corporations including the
purchasing corporation unless target is treated as an excluded member
under section 1563(b)(2).
(3) Old target is an S corporation. If target is an S corporation
for the period that ends on the day before the acquisition date, old
target must file a deemed sale return as a C corporation. For this
purpose, the principles of paragraph (a)(2) of this section apply. This
paragraph (a)(3) does not apply if an election under section 338(h)(10)
is made for the S corporation.
(4) Combined deemed sale return--(i) General rule. Under section
338(h)(15), a combined deemed sale return (combined return) may be
filed for all targets from a single selling consolidated group (as
defined in Sec. 1.338(h)(10)-1(b)(3)) that are acquired by the
purchasing corporation on the same acquisition date and that otherwise
would be required to file separate deemed sale returns. The combined
return must include all such targets. For example, T and T1 may be
included in a combined return if--
(A) T and T1 are directly owned subsidiaries of S;
(B) S is the common parent of a consolidated group; and
(C) P makes qualified stock purchases of T and T1 on the same
acquisition date.
(ii) Gain and loss offsets. Gains and losses recognized on the
deemed asset sales by targets included in a combined return are treated
as the gains and losses of a single target. In addition, loss
carryovers of a target that were not subject to the separate return
limitation year restrictions (SRLY restrictions) of the consolidated
return regulations while that target was a member of the selling
consolidated group may be applied without limitation to the gains of
other targets included in the combined return. If, however, a target
has loss carryovers that were subject to the SRLY restrictions while
that target was a member of the selling consolidated group, the use of
those losses in the combined return continues to be subject to those
restrictions, applied in the same manner as if the combined return were
a consolidated return. A similar rule applies, when appropriate, to
other tax attributes.
(iii) Procedure for filing a combined return. A combined return is
made by filing a single corporation income tax return in lieu of
separate deemed sale returns for all targets required to be included in
the combined return. The combined return reflects the deemed asset
sales of all targets required to be included in the combined return. If
the targets included in the combined return constitute a single
affiliated group within the meaning of section 1504(a), the income tax
return is signed by an officer of the common parent of that group.
Otherwise, the return must be signed by an officer of each target
included in the combined return. Rules similar to the rules in
Sec. 1.1502-75(j) apply for purposes of preparing the combined return.
The combined return must include an attachment prominently identified
as an ELECTION TO FILE A COMBINED RETURN UNDER SECTION 338(h)(15). The
attachment must--
(A) Contain the name, address, and employer identification number
of each target required to be included in the combined return;
(B) Contain the following declaration (or a substantially similar
declaration): EACH TARGET IDENTIFIED IN THIS ELECTION TO FILE A
COMBINED RETURN CONSENTS TO THE FILING OF A COMBINED RETURN;
(C) For each target, be signed by a person who states under
penalties of perjury that he or she is authorized to act on behalf of
such target.
(iv) Consequences of filing a combined return. Each target included
in a combined return is severally liable for any tax associated with
the combined return. See Sec. 1.338-1(b)(3).
(5) Deemed sale excluded from purchasing corporation's consolidated
return. Old target may not be considered a member of any affiliated
group that includes the purchasing corporation with respect to its
deemed asset sale.
(6) Due date for old target's final return--(i) General rule. Old
target's final return is generally due on the 15th day of the third
calendar month following the month in which the acquisition date
occurs. See section 6072 (time for filing income tax returns).
(ii) Application of Sec. 1.1502-76(c)--(A) In general. Section
1.1502-76(c) applies to old target's final return if old target was a
member of a selling group that did not file consolidated returns for
the taxable year of the common parent that precedes the year that
includes old target's acquisition date. If the selling group has not
filed a consolidated return that includes old target's taxable period
that ends on the acquisition date, target may, on or before the final
return due date (including extensions), either--
(1) File a deemed sale return on the assumption that the selling
group will file the consolidated return; or
(2) File a return for so much of old target's taxable period as
ends at the close of the acquisition date on the assumption that the
consolidated return will not be filed.
(B) Deemed extension. For purposes of applying Sec. 1.1502-
76(c)(2), an extension of time to file old target's final return is
considered to be in effect until
[[Page 43496]]
the last date for making the election under section 338.
(C) Erroneous filing of deemed sale return. If, under this
paragraph (a)(6)(ii), target files a deemed sale return but the selling
group does not file a consolidated return, target must file a
substituted return for old target not later than the due date
(including extensions) for the return of the common parent with which
old target would have been included in the consolidated return. The
substituted return is for so much of old target's taxable year as ends
at the close of the acquisition date. Under Sec. 1.1502-76(c)(2), the
deemed sale return is not considered a return for purposes of section
6011 (relating to the general requirement of filing a return) if a
substituted return must be filed.
(D) Erroneous filing of return for regular tax year. If, under this
paragraph (a)(6)(ii), target files a return for so much of old target's
regular taxable year as ends at the close of the acquisition date but
the selling group files a consolidated return, target must file an
amended return for old target not later than the due date (including
extensions) for the selling group's consolidated return. (The amended
return is a deemed sale return.)
(E) Last date for payment of tax. If either a substituted or
amended final return of old target is filed under this paragraph
(a)(6)(ii), the last date prescribed for payment of tax is the final
return due date (as defined in paragraph (a)(6)(i) of this section).
(7) Examples. The following examples illustrate this paragraph (a):
Example 1. (i) S is the common parent of a consolidated group
that includes T. The S group files calendar year consolidated
returns. At the close of June 30 of Year 1, P makes a qualified
stock purchase of T from S. P makes a section 338 election for T,
and T's deemed asset sale occurs as of the close of T's acquisition
date (June 30).
(ii) T is considered disaffiliated for purposes of reporting the
deemed sale gain. Accordingly, T is included in the S group's
consolidated return through T's acquisition date except that the tax
liability for the deemed sale gain is reported in a separate deemed
sale return of T. Provided that T is not treated as an excluded
member under section 1563(b)(2), T is a component member of P's
controlled group for the taxable year of the deemed asset sale, and
the taxable income bracket amounts available in calculating tax on
the deemed sale return must be limited accordingly.
(iii) If P purchased the stock of T at 10 a.m. on June 30 of
Year 1, the results would be the same. See paragraph (a)(2)(i) of
this section.
Example 2. The facts are the same as in Example 1, except that
the S group does not file consolidated returns. T must file a
separate return for its taxable year ending on June 30 of Year 1,
which return includes the deemed asset sale.
(b) Waiver--(1) Certain additions to tax. An addition to tax or
additional amount (addition) under subchapter A of chapter 68 of the
Internal Revenue Code arising on or before the last day for making the
election under section 338 because of circumstances that would not
exist but for an election under section 338, is waived if--
(i) Under the particular statute the addition is excusable upon a
showing of reasonable cause; and
(ii) Corrective action is taken on or before the last day.
(2) Notification. The Internal Revenue Service should be notified
at the time of correction (e.g., by attaching a statement to a return
that constitutes corrective action) that the waiver rule of this
paragraph (b) is being asserted.
(3) Elections or other actions required to be specified on a timely
filed return--(i) In general. If paragraph (b)(1) of this section
applies or would apply if there were an underpayment, any election or
other action that must be specified on a timely filed return for the
taxable period covered by the late filed return described in paragraph
(b)(1) of this section is considered timely if specified on a late-
filed return filed on or before the last day for making the election
under section 338.
(ii) New target in purchasing corporation's consolidated return. If
new target is includible for its first taxable year in a consolidated
return filed by the affiliated group of which the purchasing
corporation is a member on or before the last day for making the
election under section 338, any election or other action that must be
specified in a timely filed return for new target's first taxable year
(but which is not specified in the consolidated return) is considered
timely if specified in an amended return filed on or before such last
day, at the place where the consolidated return was filed.
(4) Examples. The following examples illustrate this paragraph (b):
Example 1. T is an unaffiliated corporation with a tax year
ending March 31. At the close of September 20 of Year 1, P makes a
qualified stock purchase of T. P does not join in filing a
consolidated return. P makes a section 338 election for T on or
before June 15 of Year 2, which causes T's taxable year to end as of
the close of September 20 of Year 1. An income tax return for T's
taxable period ending on September 20 of Year 1 was due on December
15 of Year 1. Additions to tax for failure to file a return and to
pay tax shown on a return will not be imposed if T's return is filed
and the tax paid on or before June 15 of Year 2. (This waiver
applies even if the acquisition date coincides with the last day of
T's former taxable year, i.e., March 31 of Year 2.) Interest on any
underpayment of tax for old T's short taxable year ending September
20 of Year 1 runs from December 15 of Year 1. A statement indicating
that the waiver rule of this paragraph is being asserted should be
attached to T's return.
Example 2. Assume the same facts as in Example 1. Assume further
that new T adopts the calendar year by filing, on or before June 15
of Year 2, its first return (for the period beginning on September
21 of Year 1 and ending on December 31 of Year 1) indicating that a
calendar year is chosen. See Sec. 1.338-1(b)(1).Any additions to tax
or amounts described in this paragraph (b) that arise because of the
late filing of a return for the period ending on December 31 of Year
1 are waived, because they are based on circumstances that would not
exist but for the section 338 election. Notwithstanding this waiver,
however, the return is still considered due March 15 of Year 2, and
interest on any underpayment runs from that date.
Example 3. Assume the same facts as in Example 2, except that
T's former taxable year ends on October 31. Although prior to the
election old T had a return due on January 15 of Year 2 for its year
ending October 31 of Year 1, that return need not be filed because a
timely election under section 338 was made. Instead, old T must file
a final return for the period ending on September 20 of Year 1,
which is due on December 15 of Year 1.
Secs. 1.338(b)-1, 1.338(b)-2T, and 1.338(b)-3T [Removed]
Par. 7. Sections 1.338(b)-1, 1.338(b)-2T, and 1.338(b)-3T, are
removed.
Par. 8. Section 1.338(h)(10)-1 is revised to read as follows.
Sec. 1.338(h)(10)-1 Deemed asset sale and liquidation.
(a) Scope. This section prescribes rules for qualification for a
section 338(h)(10) election and for making a section 338(h)(10)
election. This section also prescribes the consequences of such
election. The rules of this section are in addition to the rules of
Secs. 1.338-0 through 1.338-10 and 1.338(i)-1 and, in appropriate
cases, apply instead of the rules of Secs. 1.338-0 through 1.338-10 and
1.338(i)-1.
(b) Definitions--(1) Consolidated target. A consolidated target is
a target that is a member of a consolidated group within the meaning of
Sec. 1.1502-1(h) on the acquisition date and is not the common parent
of the group on that date.
(2) Selling consolidated group. A selling consolidated group is the
consolidated group of which the consolidated target is a member on the
acquisition date.
(3) Selling affiliate; affiliated target. A selling affiliate is a
domestic corporation that owns on the acquisition date an amount of
stock in a domestic target, which amount of stock is
[[Page 43497]]
described in section 1504(a)(2), and does not join in filing a
consolidated return with the target. In such case, the target is an
affiliated target.
(4) S corporation target. An S corporation target is a target that
is an S corporation immediately before the acquisition date.
(5) S corporation shareholders. S corporation shareholders are the
S corporation target's shareholders. Unless otherwise indicated, a
reference to S corporation shareholders refers both to S corporation
shareholders who do and those who do not sell their target stock.
(6) Liquidation. Any reference in this section to a liquidation is
treated as a reference to the transfer described in paragraph (d)(4) of
this section notwithstanding its ultimate characterization for Federal
income tax purposes.
(c) Section 338(h)(10) election--(1) In general. A section
338(h)(10) election may be made for T if P acquires stock meeting the
requirements of section 1504(a)(2) from a selling consolidated group, a
selling affiliate, or the S corporation shareholders in a qualified
stock purchase.
(2) Simultaneous joint election requirement. A section 338(h)(10)
election is made jointly by P and the selling consolidated group (or
the selling affiliate or the S corporation shareholders) on Form 8023
in accordance with the instructions to the form. S corporation
shareholders who do not sell their stock must also consent to the
election. The section 338(h)(10) election must be made not later than
the 15th day of the 9th month beginning after the month in which the
acquisition date occurs.
(3) Irrevocability. A section 338(h)(10) election is irrevocable.
If a section 338(h)(10) election is made for T, a section 338 election
is deemed made for T.
(4) Effect of invalid election. If a section 338(h)(10) election
for T is not valid, the section 338 election for T is also not valid.
(d) Certain consequences of section 338(h)(10) election. For
purposes of subtitle A of the Internal Revenue Code (except as provided
in Sec. 1.338-1(b)(2)), the consequences to the parties of making a
section 338(h)(10) election for T are as follows:
(1) P. P is automatically deemed to have made a gain recognition
election for its nonrecently purchased T stock, if any. The effect of a
gain recognition election includes a taxable deemed sale by P on the
acquisition date of any nonrecently purchased target stock. See
Sec. 1.338-5(d).
(2) New T. The AGUB for new T's assets is determined under
Sec. 1.338-5 and is allocated among the acquisition date assets under
Secs. 1.338-6 and 1.338-7. Notwithstanding paragraph (d)(4) of this
section (deemed liquidation of old T), new T remains liable for the tax
liabilities of old T (including the tax liability for the deemed sale
gain). For example, new T remains liable for the tax liabilities of the
members of any consolidated group that are attributable to taxable
years in which those corporations and old T joined in the same
consolidated return. See Sec. 1.1502-6(a).
(3) Old T--deemed sale--(i) In general. Old T is treated as
transferring all of its assets to an unrelated person in exchange for
consideration that includes the assumption of or taking subject to
liabilities in a single transaction at the close of the acquisition
date (but before the deemed liquidation). See Sec. 1.338-1(a) regarding
the tax characterization of the deemed asset sale. ADSP for old T is
determined under Sec. 1.338-4 and allocated among the acquisition date
assets under Secs. 1.338-6 and 1.338-7. Old T realizes the deemed sale
gain from the deemed asset sale before the close of the acquisition
date while old T is a member of the selling consolidated group (or
owned by the selling affiliate or owned by the S corporation
shareholders). If T is an affiliated target, or an S corporation
target, the principles of Secs. 1.338-2(c)(10) and 1.338-10(a)(1), (5),
and (6)(i) apply to the return on which the deemed sale gain is
reported. When T is an S corporation target, T's S election continues
in effect through the close of the acquisition date (including the time
of the deemed asset sale and the deemed liquidation) notwithstanding
section 1362(d)(2)(B). Also, when T is an S corporation target, any
direct and indirect subsidiaries of T which T has elected to treat as
qualified subchapter S subsidiaries under section 1361(b)(3) remain
qualified subchapter S subsidiaries through the close of the
acquisition date. No similar rule applies when a qualified subchapter S
subsidiary, as opposed to the S corporation that is its owner, is the
target the stock of which is actually purchased.
(ii) Tiered targets. In the case of parent-subsidiary chains of
corporations making elections under section 338(h)(10), the deemed
asset sale of a parent corporation is considered to precede that of its
subsidiary. See Sec. 1.338-3(4)(i).
(4) Old T and selling consolidated group, selling affiliate, or S
corporation shareholders--deemed liquidation; tax characterization--(i)
In general. Old T is treated as if, before the close of the acquisition
date, after the deemed asset sale in paragraph (d)(3) of this section,
and while old T is a member of the selling consolidated group (or owned
by the selling affiliate or owned by the S corporation shareholders),
it transferred all of its assets to members of the selling consolidated
group, the selling affiliate, or S corporation shareholders and ceased
to exist. The transfer from old T is characterized for Federal income
tax purposes in the same manner as if the parties had actually engaged
in the transactions deemed to occur because of this section and taking
into account other transactions that actually occurred or are deemed to
occur. For example, the transfer may be treated as a distribution in
pursuance of a plan of reorganization, a distribution in complete
cancellation or redemption of all its stock, one of a series of
distributions in complete cancellation or redemption of all its stock
in accordance with a plan of liquidation, or part of a circular flow of
cash. In most cases, the transfer will be treated as a distribution in
complete liquidation to which section 336 or 337 applies.
(ii) Tiered targets. In the case of parent-subsidiary chains of
corporations making elections under section 338(h)(10), the deemed
liquidation of a subsidiary corporation is considered to precede the
deemed liquidation of its parent.
(5) Selling consolidated group, selling affiliate, or S corporation
shareholders--(i) In general. If T is an S corporation target, S
corporation shareholders (whether or not they sell their stock) take
their pro rata share of the deemed sale gain into account under section
1366 and increase or decrease their basis in T stock under section
1367. Members of the selling consolidated group, the selling affiliate,
or S corporation shareholders are treated as if, after the deemed asset
sale in paragraph (d)(3) of this section and before the close of the
acquisition date, they received the assets transferred by old T in the
transaction described in paragraph (d)(4)(i) of this section. In most
cases, the transfer will be treated as a distribution in complete
liquidation to which section 331 or 332 applies.
(ii) Basis and holding period of T stock not acquired. A member of
the selling consolidated group (or the selling affiliate or an S
corporation shareholder) retaining T stock is treated as acquiring the
stock so retained on the day after the acquisition date for its fair
market value. The holding period for the retained stock starts on the
day after the acquisition date. For purposes of this
[[Page 43498]]
paragraph, the fair market value of all of the T stock equals the
grossed-up amount realized on the sale to P of P's recently purchased
target stock. See Sec. 1.338-4(c).
(iii) T stock sale. Members of the selling consolidated group (or
the selling affiliate or S corporation shareholders) recognize no gain
or loss on the sale or exchange of T stock included in the qualified
stock purchase (although they may recognize gain or loss on the T stock
in the deemed liquidation).
(6) Nonselling minority shareholders other than nonselling S
corporation shareholders--(i) In general. This paragraph (d)(6)
describes the treatment of shareholders of old T other than the
following: members of the selling consolidated group, the selling
affiliate, S corporation shareholders (whether or not they sell their
stock), and P. For a description of the treatment of S corporation
shareholders, see paragraph (d)(5) of this section. A shareholder to
which this paragraph (d)(6) applies is called a minority shareholder.
(ii) T stock sale. A minority shareholder recognizes gain or loss
on the shareholder's sale or exchange of T stock included in the
qualified stock purchase.
(iii) T stock not acquired. A minority shareholder does not
recognize gain or loss under this section with respect to shares of T
stock retained by the shareholder. The shareholder's basis and holding
period for that T stock is not affected by the section 338(h)(10)
election.
(7) Consolidated return of selling consolidated group. If P
acquires T in a qualified stock purchase from a selling consolidated
group
(i) The selling consolidated group must file a consolidated return
for the taxable period that includes the acquisition date;
(ii) A consolidated return for the selling consolidated group for
that period may not be withdrawn on or after the day that a section
338(h)(10) election is made for T; and
(iii) Permission to discontinue filing consolidated returns cannot
be granted for, and cannot apply to, that period or any of the
immediately preceding taxable periods during which consolidated returns
continuously have been filed.
(8) Availability of the section 453 installment method. Solely for
purposes of applying sections 453, 453A, and 453B, and the regulations
thereunder (the installment method) to determine the consequences to
old T in the deemed asset sale and to old T (and its shareholders, if
relevant) in the deemed liquidation, the rules in paragraphs (d)(1)
through (7) of this section are modified as follows:
(i) In deemed asset sale. Old T is treated as receiving in the
deemed asset sale new T installment obligations, the terms of which are
identical (except as to the obligor) to P installment obligations
issued in exchange for recently purchased stock of T. Old T is treated
as receiving in cash all other consideration in the deemed asset sale
other than the assumption of, or taking subject to, old T liabilities.
For example, old T is treated as receiving in cash any amounts
attributable to the grossing-up of amount realized under Sec. 1.338-
4(c). The amount realized for recently purchased stock taken into
account in determining ADSP is adjusted (and, thus, ADSP is
redetermined) to reflect the amounts paid under an installment
obligation for the stock when the total payments under the installment
obligation are greater or less than the amount realized.
(ii) In deemed liquidation. Old T is treated as distributing in the
deemed liquidation the new T installment obligations that it is treated
as receiving in the deemed asset sale. The members of the selling
consolidated group, the selling affiliate, or the S corporation
shareholders are treated as receiving in the deemed liquidation the new
T installment obligations that correspond to the P installment
obligations they actually received individually in exchange for their
recently purchased stock. The new T installment obligations may be
recharacterized under other rules. See for example Sec. 1.453-11(a)(2)
which, in certain circumstances, treats the new T installment
obligations deemed distributed by old T as if they were issued by new T
in exchange for the members' of the selling consolidated group, the
selling affiliate's, or the S corporation shareholders' stock in old T.
The members of the selling consolidated group, the selling affiliate,
or the S corporation shareholders are treated as receiving all other
consideration in the deemed liquidation in cash.
(9) Treatment consistent with an actual asset sale. Old T may not
assert any provision in section 338(h)(10) or this section to obtain a
tax result that would not be obtained if the parties had actually
engaged in the transactions deemed to occur because of this section and
taking into account other transactions that actually occurred or are
deemed to occur.
(e) Examples. The following examples illustrate this section:
Example 1. (i) S1 owns all of the T stock and T owns all of the
stock of T1 and T2. S1 is the common parent of a consolidated group
that includes T, T1, and T2. P makes a qualified stock purchase of
all of the T stock from S1. S1 joins with P in making a section
338(h)(10) election for T and for the deemed purchase of T1. A
section 338 election is not made for T2.
(ii) S1 does not recognize gain or loss on the sale of the T
stock and T does not recognize gain or loss on the sale of the T1
stock because section 338(h)(10) elections are made for T and T1.
Thus, for example, gain or loss realized on the sale of the T or T1
stock is not taken into account in earnings and profits. However,
because a section 338 election is not made for T2, T must recognize
any gain or loss realized on the deemed sale of the T2 stock. See
Sec. 1.338-4(h).
(iii) The results would be the same if S1, T, T1, and T2 are not
members of any consolidated group, because S1 and T are selling
affiliates.
Example 2. (i) S and T are solvent corporations. S owns all of
the outstanding stock of T. S and P agree to undertake the following
transaction: T will distribute half its assets to S, and S will
assume half of T's liabilities. Then, P will purchase the stock of T
from S. S and P will jointly make a section 338(h)(10) election with
respect to the sale of T. The corporations then complete the
transaction as agreed.
(ii) Under section 338(a), the assets present in T at the close
of the acquisition date are deemed sold by old T to new T. Under
paragraph (d)(4) of this section, the transactions described in
paragraph (d) of this section are treated in the same manner as if
they had actually occurred. Because S and P had agreed that, after
T's actual distribution to S of part of its assets, S would sell T
to P pursuant to an election under section 338(h)(10), and because
paragraph (d)(4) of this section deems T subsequently to have
transferred all its assets to its shareholder, T is deemed to have
adopted a plan of complete liquidation under section 332. T's actual
transfer of assets to S is treated as a distribution pursuant to
that plan of complete liquidation.
Example 3. (i) S1 owns all of the outstanding stock of both T
and S2. All three are corporations. S1 and P agree to undertake the
following transaction. T will transfer substantially all of its
assets and liabilities to S2, with S2 issuing no stock in exchange
therefor, and retaining its other assets and liabilities. Then, P
will purchase the stock of T from S1. S1 and P will jointly make a
section 338(h)(10) election with respect to the sale of T. The
corporations then complete the transaction as agreed.
(ii) Under section 338(a), the assets present in T at the close
of the acquisition date are deemed sold by old T to new T. Under
paragraph (d)(4) of this section, the transactions described in this
section are treated in the same manner as if they had actually
occurred. Because old T transferred substantially all of its assets
to S2, and is deemed to have distributed all its remaining assets
and gone out of existence, the transfer of assets to S2, taking into
account the related transfers, deemed and actual, qualifies as a
[[Page 43499]]
reorganization under section 368(a)(1)(D). Section 361(c)(1) and not
section 332 applies to T's deemed liquidation.
Example 4. (i) T owns two assets: an actively traded security
(Class II) with a fair market value of $100 and an adjusted basis of
$100, and inventory (Class IV) with a fair market value of $100 and
an adjusted basis of $100. T has no liabilities. S is negotiating to
sell all the stock in T to P for $100 cash and contingent
consideration. Assume that under generally applicable tax accounting
rules, P's adjusted basis in the T stock immediately after the
purchase would be $100, because the contingent consideration is not
taken into account. Thus, under the rules of Sec. 1.338-5, AGUB
would be $100. Under the allocation rules of Sec. 1.338-6, the
entire $100 would be allocated to the Class II asset, the actively
traded security, and no amount would be allocated to the inventory.
P, however, plans immediately to cause T to sell the inventory, but
not the actively traded security, so it requests that, prior to the
stock sale, S cause T to create a new subsidiary, Newco, and
contribute the actively traded security to the capital of Newco.
Because the stock in Newco, which would not be actively traded, is a
Class V asset, under the rules of Sec. 1.338-6 $100 of AGUB would be
allocated to the inventory and no amount of AGUB would be allocated
to the Newco stock. Newco's own AGUB, $0 under the rules of
Sec. 1.338-5, would be allocated to the actively traded security.
When P subsequently causes T to sell the inventory, T would realize
no gain or loss instead of realizing gain of $100.
(ii) Assume that, if the T stock had not itself been sold but T
had instead sold both its inventory and the Newco stock to P, T
would for tax purposes be deemed instead to have sold both its
inventory and actively traded security directly to P, with P deemed
then to have created Newco and contributed the actively traded
security to the capital of Newco. Section 338, if elected, generally
recharacterizes a stock sale as a deemed sale of assets. The tax
results of the deemed sale of assets should, where possible, be like
those of an actual asset sale. Hence, the deemed sale of assets
under section 338(h)(10) should be treated as one of the inventory
and actively traded security themselves, not of the inventory and
Newco stock. That is the substance of the transaction. The anti-
abuse rule of Sec. 1.338-1(c) does not apply, because the substance
of the deemed sale of assets is a sale of the inventory and the
actively traded security themselves, not of the inventory and the
Newco stock. Otherwise, the anti-abuse rule might apply.
Example 5. (i) T, a member of a selling consolidated group, has
only one class of stock, all of which is owned by S1. On March 1 of
Year 2, S1 sells its T stock to P for $80,000, and joins with P in
making a section 338(h)(10) election for T. There are no selling
costs or acquisition costs. On March 1 of Year 2, T owns land with a
$50,000 basis and $75,000 fair market value and equipment with a
$30,000 adjusted basis, $70,000 recomputed basis, and $60,000 fair
market value. T also has a $40,000 liability. S1 pays old T's
allocable share of the selling group's consolidated tax liability
for Year 2 including the tax liability for the deemed sale gain (a
total of $13,600).
(ii) ADSP of $120,000 ($80,000 + $40,000 + 0) is allocated to
each asset as follows:
----------------------------------------------------------------------------------------------------------------
Assets Basis FMV Fraction Allocable ADSP
----------------------------------------------------------------------------------------------------------------
Land............................................ $50,000 $75,000 \5/9\ $66,667
Equipment....................................... 30,000 60,000 \4/9\ 53,333
---------------------------------------------------------------
Total....................................... $80,000 $135,000 1 $120,000
----------------------------------------------------------------------------------------------------------------
(iii) Under paragraph (d)(3) of this section, old T has gain on
the deemed sale of $40,000 (consisting of $16,667 of capital gain
and $23,333 of ordinary income).
(iv) Under paragraph (d)(5)(iii) of this section, S1 recognizes
no gain or loss upon its sale of the old T stock to P. S1 also
recognizes no gain or loss upon the deemed liquidation of T. See
paragraph (d)(4) of this section and section 332.
(v) P's basis in new T stock is P's cost for the stock, $80,000.
See section 1012.
(vi) Under Sec. 1.338-5, the AGUB for new T is $120,000, i.e.,
P's cost for the old T stock ($80,000) plus T's liability ($40,000).
This AGUB is allocated as basis among the new T assets under
Secs. 1.338-6 and 1.338-7.
Example 6. (i) The facts are the same as in Example 5, except
that S1 sells 80 percent of the old T stock to P for $64,000, rather
than 100 percent of the old T stock for $80,000.
(ii) The consequences to P, T, and S1 are the same as in Example
5, except that:
(A) P's basis for its 80-percent interest in the new T stock is
P's $64,000 cost for the stock. See section 1012.
(B) Under Sec. 1.338-5, the AGUB for new T is $120,000 (i.e.,
$64,000/.8 + $40,000 + $0).
(C) Under paragraph (d)(4) of this section, S1 recognizes no
gain or loss with respect to the retained stock in T. See section
332.
(D) Under paragraph (d)(5)(ii) of this section, the basis of the
T stock retained by S1 is $16,000 (i.e., $120,000 -$40,000 (the ADSP
amount for the old T assets over the sum of new T's liabilities
immediately after the acquisition date) x .20 (the proportion of T
stock retained by S1)).
Example 7. (i) The facts are the same as in Example 6, except
that K, a shareholder unrelated to T or P, owns the 20 percent of
the T stock that is not acquired by P in the qualified stock
purchase. K's basis in its T stock is $5,000.
(ii) The consequences to P, T, and S1 are the same as in Example
6.
(iii) Under paragraph (d)(6)(iii) of this section, K recognizes
no gain or loss, and K's basis in its T stock remains at $5,000.
Example 8. (i) The facts are the same as in Example 5, except
that the equipment is held by T1, a wholly-owned subsidiary of T,
and a section 338(h)(10) election is also made for T1. The T1 stock
has a fair market value of $60,000. T1 has no assets other than the
equipment and no liabilities. S1 pays old T's and old T1's allocable
shares of the selling group's consolidated tax liability for Year 2
including the tax liability for T and T1's deemed sale gain.
(ii) ADSP for T is $120,000, allocated $66,667 to the land and
$53,333 to the stock. Old T's deemed sale gain is $16,667 (the
capital gain on its deemed sale of the land). Under paragraph
(d)(5)(iii) of this section, old T does not recognize gain or loss
on its deemed sale of the T1 stock. See section 332.
(iii) ADSP for T1 is $53,333 (i.e., $53,333 + $0 + $0). On the
deemed sale of the equipment, T1 recognizes ordinary income of
$23,333.
(iv) Under paragraph (d)(5)(iii) of this section, S1 does not
recognize gain or loss upon its sale of the old T stock to P.
Example 9. (i) The facts are the same as in Example 8, except
that P already owns 20 percent of the T stock, which is nonrecently
purchased stock with a basis of $6,000, and that P purchases the
remaining 80 percent of the T stock from S1 for $64,000.
(ii) The results are the same as in Example 8, except that under
paragraph (d)(1) of this section and Sec. 1.338-5(d), P is deemed to
have made a gain recognition election for its nonrecently purchased
T stock. As a result, P recognizes gain of $10,000 and its basis in
the nonrecently purchased T stock is increased from $6,000 to
$16,000. P's basis in all the T stock is $80,000 (i.e., $64,000 +
$16,000). The computations are as follows:
(A) P's grossed-up basis for the recently purchased T stock is
$64,000 (i.e., $64,000 (the basis of the recently purchased T stock)
x (1 .2)/(.8) (the fraction in section 338(b)(4))).
(B) P's basis amount for the nonrecently purchased T stock is
$16,000 (i.e., $64,000 (the grossed-up basis in the recently
purchased T stock) x (.2)/(1.0-.2) (the fraction in section
338(b)(3)(B))).
(C) The gain recognized on the nonrecently purchased stock is
$10,000 (i.e., $16,000 -$6,000).
Example 10. (i) T is an S corporation whose sole class of stock
is owned 40 percent each by A and B and 20 percent by C. A and B
each has an adjusted basis of $10,000 in the stock. C has an
adjusted basis of $5,000 in the stock. A, B, and C hold no
installment obligations to which section 453A applies. On March 1 of
Year 1, A sells its stock to P for $40,000 in cash and B sells its
stock to P for a $25,000 note issued by P and real estate having a
fair market value of $15,000. The $25,000 note, due in full in Year
7, is not publicly traded and bears adequate stated interest. A and
B have no selling expenses.
[[Page 43500]]
T's sole asset is real estate, which has a value of $110,000 and an
adjusted basis of $35,000. Also, T's real estate is encumbered by
long-outstanding purchase-money indebtedness of $10,000. The real
estate does not have built-in gain subject to section 1374. A, B,
and C join with P in making a section 338(h)(10) election for T.
(ii) Solely for purposes of application of sections 453, 453A,
and 453B, old T is considered in its deemed asset sale to receive
back from new T the $25,000 note (considered issued by new T) and
$75,000 of cash (total consideration of $80,000 paid for all the
stock sold, which is then divided by .80 in the grossing-up, with
the resulting figure of $100,000 then reduced by the amount of the
installment note). Absent an election under section 453(d), gain is
reported by old T under the installment method.
(iii) In applying the installment method to old T's deemed asset
sale, the contract price for old T's assets deemed sold is $100,000,
the $110,000 selling price reduced by the indebtedness of $10,000 to
which the assets are subject. (The $110,000 selling price is itself
the sum of the $80,000 grossed-up in paragraph (ii) above to
$100,000 and the $10,000 liability.) Gross profit is $75,000
($110,000 selling price - old T's basis of $35,000). Old T's gross
profit ratio is 0.75 (gross profit of $75,000 $100,000
contract price). Thus, $56,250 (0.75 x the $75,000 cash old T is
deemed to receive in Year 1) is Year 1 gain attributable to the
sale, and $18,750 ($75,000 - $56,250) is recovery of basis.
(iv) In its liquidation, old T is deemed to distribute the
$25,000 note to B, since B actually sold the stock partly for that
consideration. To the extent of the remaining liquidating
distribution to B, it is deemed to receive, along with A and C, the
balance of old T's liquidating assets in the form of cash. Under
section 453(h), B, unless it makes an election under section 453(d),
is not required to treat the receipt of the note as a payment for
the T stock; P's payment of the $25,000 note in Year 7 to B is a
payment for the T stock. Because section 453(h) applies to B, old
T's deemed liquidating distribution of the note is, under section
453B(h), not treated as a taxable disposition by old T.
(v) Under section 1366, A reports 40 percent, or $22,500, of old
T's $56,250 gain recognized in Year 1. Under section 1367, this
increases A's $10,000 adjusted basis in the T stock to $32,500.
Next, in old T's deemed liquidation, A is considered to receive
$40,000 for its old T shares, causing it to recognize an additional
$7,500 gain in Year 1.
(vi) Under section 1366, B reports 40 percent, or $22,500, of
old T's $56,250 gain recognized in Year 1. Under section 1367, this
increases B's $10,000 adjusted basis in its T stock to $32,500.
Next, in old T's deemed liquidation, B is considered to receive the
$25,000 note and $15,000 of other consideration. Applying section
453, including section 453(h), to the deemed liquidation, B's
selling price and contract price are both $40,000. Gross profit is
$7,500 ($40,000 selling price - B's basis of $32,500). B's gross
profit ratio is 0.1875 (gross profit of $7,500 $40,000
contract price). Thus, $2,812.50 (0.1875 $15,000) is Year 1 gain
attributable to the deemed liquidation. In Year 7, when the $25,000
note is paid, B has $4,687.50 (0.1875 x $25,000) of additional
gain.
(vii) Under section 1366, C reports 20 percent, or $11,250, of
old T's $56,250 gain recognized in Year 1. Under section 1367, this
increases C's $5,000 adjusted basis in its T stock to $16,250. Next,
in old T's deemed liquidation, C is considered to receive $20,000
for its old T shares, causing it to recognize an additional $3,750
gain in Year 1. Finally, under paragraph (d)(5)(ii) of this section,
C is considered to acquire its stock in T on the day after the
acquisition date for $20,000 (fair market value=grossed-up amount
realized of $100,000 x 20%). C's holding period in the stock
deemed received in new T begins at that time.
(f) Inapplicability of provisions. The provisions of section 6043,
Sec. 1.331-1(d), and Sec. 1.332-6 (relating to information returns and
recordkeeping requirements for corporate liquidations) do not apply to
the deemed liquidation of old T under paragraph (d)(4) of this section.
(g) Required information. The Commissioner may exercise the
authority granted in section 338(h)(10)(C)(iii) to require provision of
any information deemed necessary to carry out the provisions of section
338(h)(10) by requiring submission of information on any tax reporting
form.
Par. 9. Section 1.338(i)-1 is revised to read as follows:
Sec. 1.338(i)-1 Effective dates.
The provisions of Secs. 1.338-0 through 1.338-10 and 1.338(h)(10)-1
apply to any qualified stock purchase occurring after the date that
final regulations are published in the Federal Register. For rules
applicable to qualified stock purchases before the date that final
regulations are published in the Federal Register, see Secs. 1.338-0
through 1.338-5, 1.338(b)-1, 1.338(b)-2T, 1.338(b)-3T, 1.338(h)(10)-1,
and 1.338(i)-1 as contained in 26 CFR part 1 revised April 1, 1999.
Par. 10. Section 1.1060-1 is added to read as follows:
Sec. 1.1060-1 Special allocation rules for certain asset acquisitions.
(a) Scope--(1) In general. This section prescribes rules relating
to the requirements of section 1060, which, in the case of an
applicable asset acquisition, requires the transferor (the seller) and
the transferee (the purchaser) each to allocate the consideration paid
or received in the transaction among the assets transferred in the same
manner as amounts are allocated under section 338(b)(5) (relating to
the allocation of adjusted grossed-up basis among the assets of the
target corporation when a section 338 election is made). In the case of
an applicable asset acquisition described in paragraph (b)(1) of this
section, sellers and purchasers must allocate the consideration under
the residual method as described in Secs. 1.338-6 and 1.338-7 in order
to determine, respectively, the amount realized from, and the basis in,
each of the transferred assets. For rules relating to distributions of
partnership property or transfers of partnership interests which are
subject to section 1060(d), see Sec. 1.755-2T.
(2) Effective date. The provisions of this section apply to any
asset acquisition occurring after the date that final regulations are
published in the Federal Register.
(3) Outline of topics. In order to facilitate the use of this
section, this paragraph (a)(3) lists the major paragraphs in this
section as follows:
(a) Scope.
(1) In general.
(2) Effective date.
(3) Outline of topics.
(b) Applicable asset acquisition.
(1) In general.
(2) Assets constituting a trade or business.
(i) In general.
(ii) Goodwill or going concern value.
(iii) Factors indicating goodwill or going concern value.
(3) Examples.
(4) Asymmetrical transfers of assets.
(5) Related transactions.
(6) More than a single trade or business.
(7) Covenant entered into by the seller.
(8) Partial non-recognition exchanges.
(c) Allocation of consideration among assets under the residual
method.
(1) Consideration.
(2) Allocation of consideration among assets.
(3) Certain costs.
(4) Effect of agreement between parties.
(d) Examples.
(e) Reporting requirements.
(1) Applicable asset acquisitions.
(i) In general.
(ii) Time and manner of reporting.
(A) In general.
(B) Additional reporting requirement.
(2) Transfers of interests in partnerships.
(b) Applicable asset acquisition--(1) In general. An applicable
asset acquisition is any transfer, whether direct or indirect, of a
group of assets if the assets transferred constitute a trade or
business in the hands of either the seller or the purchaser and, except
as provided in paragraph (b)(8) of this section, the purchaser's basis
in the transferred assets is determined wholly by reference to the
purchaser's consideration.
(2) Assets constituting a trade or business--(i) In general. For
purposes of this section, a group of assets constitutes a trade or
business if--
[[Page 43501]]
(A) The use of such assets would constitute an active trade or
business under section 355; or
(B) Its character is such that goodwill or going concern value
could under any circumstances attach to such group.
(ii) Goodwill or going concern value. Goodwill is the value of a
trade or business attributable to the expectancy of continued customer
patronage. This expectancy may be due to the name or reputation of a
trade or business or any other factor. Going concern value is the
additional value that attaches to property because of its existence as
an integral part of an ongoing business activity. Going concern value
includes the value attributable to the ability of a trade or business
(or a part of a trade or business) to continue functioning or
generating income without interruption notwithstanding a change in
ownership. It also includes the value that is attributable to the
immediate use or availability of an acquired trade or business, such
as, for example, the use of the revenues or net earnings that otherwise
would not be received during any period if the acquired trade or
business were not available or operational.
(iii) Factors indicating goodwill or going concern value. In making
the determination in paragraph (b)(2) of this section, all the facts
and circumstances surrounding the transaction are taken into account.
Whether sufficient consideration is available to allocate to goodwill
or going concern value after the residual method is applied is not
relevant in determining whether goodwill or going concern value could
attach to a group of assets. Factors to be considered include--
(A) The presence of any intangible assets (whether or not those
assets are section 197 intangibles), provided, however, that the
transfer of such an asset in the absence of other assets will not be a
trade or business for purposes of section 1060;
(B) The existence of an excess of the total consideration over the
aggregate book value of the tangible and intangible assets purchased
(other than goodwill and going concern value) as shown in the financial
accounting books and records of the purchaser; and
(C) Related transactions, including lease agreements, licenses, or
other similar agreements between the purchaser and seller (or managers,
directors, owners, or employees of the seller) in connection with the
transfer.
(3) Examples. The following examples illustrate paragraphs (b)(1)
and (2) of this section:
Example 1. S is a high grade machine shop that manufactures
microwave connectors in limited quantities. It is a successful
company with a reputation within the industry and among its
customers for manufacturing unique, high quality products. Its
tangible assets consist primarily of ordinary machinery for working
metal and plating. It has no secret formulas or patented drawings of
value. P is a company that designs, manufactures, and markets
electronic components. It wants to establish an immediate presence
in the microwave industry, an area in which it previously has not
been engaged. P is acquiring assets of a number of smaller companies
and hopes that these assets will collectively allow it to offer a
broad product mix. P acquires the assets of S in order to augment
its product mix and to promote its presence in the microwave
industry. P will not use the assets acquired from S to manufacture
microwave connectors. The assets transferred are assets that
constitute a trade or business in the hands of the seller. Thus, P's
purchase of S's assets is an applicable asset acquisition. The fact
that P will not use the assets acquired from S to continue the
business of S does not affect this conclusion.
Example 2. S, a sole proprietor who operates a car wash, both
leases the building housing the car wash and sells all of the car
wash equipment to P. S's use of the building and the car wash
equipment constitute a trade or business. P begins operating a car
wash in the building it leases from S. Because the assets
transferred together with the asset leased are assets which
constitute a trade or business, P's purchase of S's assets is an
applicable asset acquisition.
Example 3. S, a corporation, owns a retail store business in
State X and conducts activities in connection with that business
enterprise that meet the active trade or business requirement of
section 355. P is a minority shareholder of S. S distributes to P
all the assets of S used in S's retail business in State X in
complete redemption of P's stock in S held by P. The distribution of
S's assets in redemption of P's stock is treated as a sale or
exchange under sections 302(a) and 302(b)(3), and P's basis in the
assets distributed to it is determined wholly by reference to the
consideration paid, the S stock. Thus, S's distribution of assets
constituting a trade or business to P is an applicable asset
acquisition.
Example 4. S is a manufacturing company with an internal
financial bookkeeping department. P is in the business of providing
a financial bookkeeping service on a contract basis. As part of an
agreement for P to begin providing financial bookkeeping services to
S, P agrees to buy all of the assets associated with S's internal
bookkeeping operations and provide employment to any of S's
bookkeeping department employees who choose to accept a position
with P. In addition to selling P the assets associated with its
bookkeeping operation, S will enter into a long term contract with P
for bookkeeping services. Because assets transferred from S to P,
along with the related contract for bookkeeping services, are a
trade or business in the hands of P, the sale of the bookkeeping
assets from S to P is an applicable asset acquisition.
(4) Asymmetrical transfers of assets. If, under general principles
of tax law, a seller is not treated as transferring the same assets as
the purchaser is treated as acquiring, the assets acquired by the
purchaser constitute a trade or business, and, except as provided in
paragraph (b)(8) of this section, the purchaser's basis in the
transferred assets is determined wholly by reference to the purchaser's
consideration, then the purchaser is subject to section 1060.
(5) Related transactions. Whether the assets transferred constitute
a trade or business is determined by aggregating all transfers from the
seller to the purchaser in a series of related transactions. Except as
provided in paragraph (b)(8) of this section, all assets transferred
from the seller to the purchaser in a series of related transactions
are included in the group of assets among which the consideration paid
or received in such series is allocated under the residual method. The
principles of Sec. 1.338-1(c) are also applied in determining which
assets are included in the group of assets among which the
consideration paid or received is allocated under the residual method.
(6) More than a single trade or business. If the assets transferred
from a seller to a purchaser include more than one trade or business,
then, in applying this section, all of the assets transferred (whether
or not transferred in one transaction or a series of related
transactions and whether or not part of a trade or business) are
treated as a single trade or business.
(7) Covenant entered into by the seller. If, in connection with an
applicable asset acquisition, the seller enters into a covenant (e.g.,
a covenant not to compete) with the purchaser, that covenant is treated
as an asset transferred as part of a trade or business.
(8) Partial non-recognition exchanges. A transfer may constitute an
applicable asset acquisition notwithstanding the fact that no gain or
loss is recognized with respect to a portion of the group of assets
transferred. All of the assets transferred, including the non-
recognition assets, are taken into account in determining whether the
group of assets constitutes a trade or business. The allocation of
consideration under paragraph (c) of this section is done without
taking into account either the non-recognition assets or the amount of
money or other property that is treated as transferred in exchange for
the non-recognition assets (together, the non-recognition exchange
property). The basis in and gain or loss recognized with respect to the
non-recognition exchange property are
[[Page 43502]]
determined under such rules as would otherwise apply to an exchange of
such property. The amount of the money and other property treated as
exchanged for non-recognition assets is the amount by which the fair
market value of the non-recognition assets transferred by one party
exceeds the fair market value of the non-recognition assets transferred
by the other (to the extent of the money and the fair market value of
property transferred in the exchange). The money and other property
that are treated as transferred in exchange for the non-recognition
assets (and which are not included among the assets to which section
1060 applies) are considered to come from the following assets in the
following order: first from Class I assets, then from Class II assets,
then from Class III assets, then from Class IV assets, then from Class
V assets, then from Class VI assets, and then from Class VII assets.
For this purpose, liabilities assumed (or to which a non-recognition
exchange property is subject) are treated as Class I assets. See
Example 1 in paragraph (d) of this section for an example of the
application of section 1060 to a single transaction which is, in part,
a non-recognition exchange.
(c) Allocation of consideration among assets under the residual
method--(1) Consideration. The seller's consideration is the amount, in
the aggregate, realized from selling the assets in the applicable asset
acquisition under section 1001(b). The purchaser's consideration is the
amount, in the aggregate, of its cost of purchasing the assets in the
applicable asset acquisition that is properly taken into account in
basis.
(2) Allocation of consideration among assets. For purposes of
determining the seller's amount realized for each of the assets sold in
an applicable asset acquisition, the seller allocates consideration to
all the assets sold by using the residual method under Secs. 1.338-6
and 1.338-7, substituting consideration for ADSP. For purposes of
determining the purchaser's basis in each of the assets purchased in an
applicable asset acquisition, the purchaser allocates consideration to
all the assets purchased by using the residual method under
Secs. 1.338-6 and 1.338-7, substituting consideration for AGUB. In
allocating consideration, the rules set forth in paragraphs (c)(3) and
(4) of this section apply in addition to the rules in Secs. 1.338-6 and
1.338-7.
(3) Certain costs. The seller and purchaser each adjusts the amount
allocated to an individual asset to take into account the specific
identifiable costs incurred in transferring that asset in connection
with the applicable asset acquisition (e.g., real estate transfer costs
or security interest perfection costs). Costs so allocated increase, or
decrease, as appropriate, the total consideration that is allocated
under the residual method. No adjustment is made to the amount
allocated to an individual asset for general costs associated with the
applicable asset acquisition as a whole or with groups of assets
included therein (e.g., non-specific appraisal fees or accounting
fees). These latter amounts are taken into account only indirectly
through their effect on the total consideration to be allocated.
(4) Effect of agreement between parties. If, in connection with an
applicable asset acquisition, the seller and purchaser agree in writing
as to the allocation of any amount of consideration to, or as to the
fair market value of, any of the assets, such agreement is binding on
them to the extent provided in this paragraph (c)(4). Nothing in this
paragraph (c)(4) restricts the Commissioner's authority to challenge
the allocations or values arrived at in an allocation agreement. This
paragraph (c)(4) does not apply if the parties are able to refute the
allocation or valuation under the standards set forth in Commissioner
v. Danielson, 378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967)
(a party wishing to challenge the tax consequences of an agreement as
construed by the Commissioner must offer proof that, in an action
between the parties to the agreement, would be admissible to alter that
construction or show its unenforceability because of mistake, undue
influence, fraud, duress, etc.).
(d) Examples. The following examples illustrate this section:
Example 1. (i) On January 1, 2001, A transfers assets X, Y, and
Z to B in exchange for assets D, E, and F plus $1,000 cash.
(ii) Assume the exchange of assets constitutes an exchange of
like-kind property to which section 1031 applies. Assume also that
goodwill or going concern value could under any circumstances attach
to each of the DEF and XYZ groups of assets and, therefore, each
group constitutes a trade or business under section 1060.
(iii) Assume the fair market values of the assets and the amount
of money transferred are as follows:
----------------------------------------------------------------------------------------------------------------
By A By B
----------------------------------------------------------------------------------------------------------------
Fair market Fair market
Asset value Asset value
----------------------------------------------------------------------------------------------------------------
X............................................. $400 D.................................... $40
Y............................................. 400 E.................................... 30
Z............................................. 200 F.................................... 30
Cash (amount)........................ 1,000
-------------- ------------
Total..................................... $1,000 Total.......................... $1,100
----------------------------------------------------------------------------------------------------------------
(iv) Under paragraph (b)(8) of this section, for purposes of
allocating consideration under paragraph (c) of this section, the
like-kind assets exchanged and any money or other property that are
treated as transferred in exchange for the like-kind property are
excluded from the application of section 1060.
(v) Since assets X, Y, and Z are like-kind property, they are
excluded from the application of the section 1060 allocation rules.
(vi) Since assets D, E, and F are like-kind property, they are
excluded from the application of the section 1060 allocation rules.
In addition, $900 of the $1,000 cash B gave to A for A's like-kind
assets is treated as transferred in exchange for the like-kind
property in order to equalize the fair market values of the like-
kind assets. Therefore, $900 of the cash is excluded from the
application of the section 1060 allocation rules.
(vii) $100 of the cash is allocated under section 1060 and
paragraph (c) of this section.
(viii) A, as transferor of assets X, Y, and Z, received $100
that must be allocated under section 1060 and paragraph (c) of this
section. Since A transferred no Class I, II, III, IV, V, or VI
assets to which section 1060 applies, in determining its amount
realized for the part of the exchange to which section 1031 does not
apply, the $100 is allocated to Class VII assets (goodwill and going
concern value).
(ix) A, as transferee of assets D, E, and F, gave consideration
only for assets to which section 1031 applies. Therefore, the
allocation rules of section 1060 and paragraph (c) of this section
are not applied to determine the bases of the assets A received.
[[Page 43503]]
(x) B, as transferor of assets D, E, and F, received
consideration only for assets to which section 1031 applies.
Therefore, the allocation rules of section 1060 do not apply in
determining B's gain or loss.
(xi) B, as transferee of assets X, Y, and Z, gave A $100 that
must be allocated under section 1060 and paragraph (c) of this
section. Since B received from A no Class I, II, III, IV, V, or VI
assets to which section 1060 applies, the $100 consideration is
allocated by B to Class VII assets (goodwill and going concern
value).
Example 2. (i) On January 1, 2001, S, a sole proprietor, sells
to P, a corporation, a group of assets that constitutes a trade or
business under paragraph (b)(2) of this section. S, who plans to
retire immediately, also executes in P's favor a covenant not to
compete. P pays S $3,000 in cash and assumes $1,000 in liabilities.
Thus, the total consideration is $4,000.
(ii) On the purchase date, P and S also execute a separate
agreement that states that the fair market values of the Class II,
Class III, Class V, and Class VI assets S sold to P are as follows:
------------------------------------------------------------------------
Fair
Asset class Asset market
value
------------------------------------------------------------------------
II....................... Actively traded securities........ $500
----------
Total Class II................ 500
III...................... Accounts receivable............... 200
----------
Total Class III............... 200
V........................ Furniture and fixtures............ 800
Building.......................... 800
Land.............................. 200
Equipment......................... 400
----------
Total Class V................. 2,200
VI....................... Covenant not to compete........... 900
----------
Total Class VI................ 900
------------------------------------------------------------------------
(iii) P and S each allocate the consideration in the transaction
among the assets transferred under paragraph (c) of this section in
accordance with the agreed upon fair market values of the assets, so
that $500 is allocated to Class II assets, $200 is allocated to the
Class III asset, $2,200 is allocated to Class V assets, $900 is
allocated to Class VI assets, and $200 ($4,000 total consideration
less $3,800 allocated to assets in Classes II, III, V, and VI) is
allocated to the Class VII assets (goodwill and going concern
value).
(iv) In connection with the examination of P's return, the
District Director, in determining the fair market values of the
assets transferred, may disregard the parties' agreement. Assume
that the District Director correctly determines that the fair market
value of the covenant not to compete was $500. Since the allocation
of consideration among Class II, III, V, and VI assets results in
allocation up to the fair market value limitation, the $600 of
unallocated consideration resulting from the District Director's
redetermination of the value of the covenant not to compete is
allocated to Class VII assets (goodwill and going concern value).
(e) Reporting requirements--(1) Applicable asset acquisitions--(i)
In general. Unless otherwise excluded from this requirement by the
Commissioner, the seller and the purchaser in an applicable asset
acquisition each must report information concerning the amount of
consideration in the transaction and its allocation among the assets
transferred. They also must report information concerning subsequent
adjustments to consideration.
(ii) Time and manner of reporting--(A) In general. The seller and
the purchaser each must file asset acquisition statements on Form 8594
with their income tax returns or returns of income for the taxable year
that includes the first date assets are sold pursuant to an applicable
asset acquisition. This reporting requirement applies to all asset
acquisitions described in this section. For reporting requirements
relating to asset acquisitions occurring before the date final
regulations are published in the Federal Register, as described in
paragraph (a)(2) of this section, see the temporary regulations under
section 1060 in effect prior to the date final regulations are
published in the Federal Register (Sec. 1.1060-1T as contained in 26
CFR part 1 revised April 1, 1999).
(B) Additional reporting requirement. When an increase or decrease
in consideration is taken into account after the close of first taxable
year that includes the first date assets are sold in an applicable
asset acquisition, the seller and the purchaser each must file a
supplemental asset acquisition statement on Form 8594 with the income
tax return or return of income for the taxable year in which the
increase (or decrease) is properly taken into account.
(2) Transfers of interests in partnerships. For reporting
requirements relating to the transfer of the partnership interest, see
Sec. 1.755-2T(c).
Sec. 1.1060-1T [Removed]
Par. 11. Section 1.1060-1T is removed.
PART 602--OMB CONTROL NUMBERS UNDER PAPERWORK REDUCTION ACT
Par. 12. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Sec. 602.101 [Amended]
Par. 13. In Sec. 602.101, paragraph (b) is amended by removing the
entries for 1.338(b)-1 and 1.1060-1T from the table.
John M. Dalrymple,
Acting Deputy Commissioner of Internal Revenue.
[FR Doc. 99-19930 Filed 8-4-99; 9:14 am]
BILLING CODE 4830-01-U
