| ||Triple Taxation|
Deborah L. Paul*
*Partner, Wachtell, Lipton, Rosen & Katz, New York, New York; Harvard University, A.B., 1986; Harvard Law School, J.D. 1989; New York University School of Law, LL.M. 1994. This article was originally presented to the Tax Club on December 18, 2002. The author would like to thank her colleague, Joshua Blank, for his valuable research assistance.
U.S. corporations increasingly find themselves in a difficult situation as the owners of large but noncontrolling ownership interests in other corporations. Traditionally, U.S. corporations did not make such investments. But, the dynamics of the telecommunications and dotcom sectors changed that and invited large corporations to invest in start-ups without taking a controlling stake. Thus, the corporate landscape now includes numerous situations in which one corporation owns an investment in another. Inevitably, the situation is not stable. The parties eventually want to combine or separate. As businesses mature or change their focus, there is inevitable pressure to change the legal structure.
U.S. tax law creates serious impediments to a combination or a separation of the corporations. Those impediments stem from the fact that the classical double taxation system of U.S. tax law is in some ways a system of triple taxation. While the intent of the system has been to tax corporate earnings twice, Congress has never attempted rigorously to eradicate the possibility that corporate earnings would be taxed more than twice. Under our system of double taxation, if a corporation earns income, the income is taxed at the corporate level and then, again, to shareholders in the event that the corporation distributes the income as a dividend or at such time as a shareholder sells the stock of the corporation at a gain. Thus, "double taxation" refers to the idea that income earned by a corporation is taxed once at the corporate level and once at the shareholder level. Triple taxation is a possibility when one corporation (the "Parent") owns stock in a second corporation (the "Subsidiary"). In such circumstances, income of the Subsidiary is potentially taxed a total of three times. Specifically, the earnings of the Subsidiary are taxed to the Subsidiary when they are earned; the Parent is taxed when the Parent sells its stock in the Subsidiary at a gain or receives a dividend from the Subsidiary; and then the same income is taxed a third time at the ultimate shareholder level when the Parent's shareholders receive a dividend from the Parent or sell their shares in the Parent.
Double taxation has long been a fact of life in the U.S. tax system. But, a system aimed at achieving double taxation need not impose triple taxation. Corporations that are shareholders should not necessarily be taxed the same way that individuals who are shareholders should be taxed. Indeed, the Code does ameliorate triple taxation in at least two ways. First, the corporate dividends received deduction of section 243 provides that there is no tax on a "qualifying dividend" (generally those received from 80% owned subsidiaries) and there is reduced tax on other dividends received by a corporation. Second, under section 1501, affiliated groups are entitled to file consolidated returns. Under the investment basis adjustment rules that apply to consolidated groups, subsidiary earnings increase the parent's basis in subsidiary stock thus avoiding a second corporate level tax on subsidiary earnings in the event that the parent sells the subsidiary's stock after the subsidiary has earned income. The dividends received deduction and the opportunity to file consolidated returns are well-entrenched aspects of the U.S. tax system. But, they leave a gap. They do not address the potential for triple taxation in the case of a disposition by one corporation of the stock in another corporation where the two corporations do not file consolidated returns.
The Bush Administration recently proposed a bold redirection of the corporate tax system. The Administration proposed to eradicate the "double taxation" inherent in the Code by eliminating tax on corporate dividends and by providing shareholders with a basis increase in their shares for a corporation's retained earnings. The basis increase contemplated by the Bush proposal would ameliorate some of the problems discussed in this Article, because the basis increase would reduce the tax that the Parent would pay on a subsequent sale of the stock of the Subsidiary. Even if the Bush proposal is enacted, many of the issues discussed in the Article would remain, however, as the proposal integrates the corporate and shareholder tax on recent earnings only (2001 and subsequent years), while historic ownership structures in many cases reflect appreciation from prior years. Further, the Bush proposal itself contains anomalies. At the time of publication, it is unclear whether the proposal will pass.
Indeed, in recent years, the rules have changed to make it more difficult for a corporation to dispose of stock it owns in another corporation. With the repeal of General Utilities, the enactment of sections 355(d) and (e) and the enactment of amendments to sections 337 and 1059, it has become increasingly difficult for a corporation to dispose of subsidiary stock without triggering gain. Why has gain on stock sales come under ever increasing strictures while the dividends received deduction and the consolidated return regulations, both designed to ameliorate triple taxation, remain well-entrenched? The reason likely relates to administrative concerns and upheaval rather than a belief that corporate level income should be subject to potentially three levels of tax. A regime that attempted to relieve shareholder-corporations from tax on stock sales would potentially go too far and lead to no tax on corporate earnings at the corporate level, rather than one tax on corporate earnings at the corporate level.
The current rules thus encourage taxpayers to engage in self-help. Parts II through VI of this Article examine the approaches that a corporation may take when it owns a significant stake in a subsidiary and wants either to combine or separate from the subsidiary. The structures chosen to mitigate the potential for triple taxation depend on whether the business goal is to combine all of Parent with all of Subsidiary or instead to separate some or all of Parent or Subsidiary from the rest of Parent and Subsidiary. If the business goal is to conduct all the businesses of Parent and all the businesses of Subsidiary under a single ultimate corporate parent, then either Parent will acquire Subsidiary or Subsidiary will acquire Parent. Such upstream and downstream combinations are candidates for qualifying as reorganizations, despite their similarity in some cases to a liquidation of Parent. If Subsidiary owns certain businesses and assets that Parent wants and other businesses and assets that Parent does not want, then structures involving splitoffs or tracking stock are sometimes used. Splitoffs also may be used if, instead, the parties desire to combine some (but not all) of Parent's assets or businesses with all of Subsidiary. If the parties desire to separate Parent and Subsidiary completely, tax deferral could be obtained using a financial products monetization. Another way that shareholders attempt to mitigate the potential tax on a stock sale is by taking advantage of the favorable treatment afforded dividends by having the subsidiary pay a dividend when a stock sale is on the horizon. Thus, whether the goal is combination or separation, there exist structures to facilitate the business objective.
Ironically, in light of the numerous ways that parties attempt to mitigate tax on a sale of stock of another corporation, it is questionable whether requiring corporations to pay tax on stock sales raises significant revenue. Instead, it may simply deter transactions from taking place or limit dispositions to those that can be structured in ways not subject to tax. As such, the rule may add needless complication. Indeed, recently, taxpayers have sought to turn the duplicative aspect of subchapter C on its head by duplicating losses, rather than gains, as discussed in Part VII.
Legislative developments in the mid-1980s show that Congress does intend to tax sales by one corporation of stock in another. The legislative history accompanying the repeal of General Utilities in the Tax Reform Act of 1986 and the elimination of the mirror subsidiary structure in the Revenue Act of 1987 make clear that Congress generally wanted to treat sales of stock like sales of other types of assets. The potential for eventually taxing gain or earnings at the subsidiary level was viewed by Congress as an inadequate substitute for taxing gain recognized by a corporate parent on a sale of subsidiary stock. But, Congress was aware that taxing dispositions by a corporation of stock in another corporation meant that corporate earnings could be taxed twice at the corporate level. As discussed in Part VIII below, Congress never came to grips with the problem. The legislative history gives incomplete answers, such as pointing to the existence of section 338(h)(10), which addresses the problem only within certain boundaries. Congress did not endorse the notion of triple taxation, but instead seemed to be at a loss as to what to do about it, given the Congressional concern over deferring tax until the subsidiary earns income.
As discussed in Part IX below, Germany and the United Kingdom recently adopted "participation exemption" regimes which exempt from tax certain sales by one corporation of stock in another corporation. Those developments show that such a rule can be enacted in a major industrial country. In light of congressional concern over deferring taxation until the subsidiary earns income, another alternative that may be more palatable in the United States would be a basis step up for the subsidiary reflecting the gain recognized by the parent on the stock sale.
The ensuing discussion illustrates the situations in which triple taxation can occur, and the techniques taxpayers use to address the problem.