Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Underwater Assets and Insolvent Corporations: Reflections on
Treasury’s Recently Proposed Regulations and Related Matters
By Jerred G. Blanchard, Jr., Kenneth L. Hooker, and Gary R. Vogel
The authors are members of the Transaction Advisory Services practice of Ernst & Young LLP practicing in the mergers and acquisitions field. Mr. Blanchard holds degrees from New York University (LL.M), Vanderbilt University School of Law (J.D.), and Yale University (B.A.); Mr. Hooker holds degrees from University of Texas School of Law (J.D. 1983) and University of Texas at Arlington (B.A. 1980); and Mr. Vogel holds degrees from New York University Law School (LL.M 1995), George Washington University School of Law (J.D. 1992), and Gettysburg College (B.A. 1989). All views expressed in this paper are solely those of the authors and do not reflect any official views of Ernst & Young LLP.
INTRODUCTION and Overview of Proposed Net Value Regulations
Over the last few years there has been a significant interest on the part of the tax bar in resolving longstanding uncertainties regarding the tax consequences of transactions involving transfers to corporations of underwater assets and acquisitions and liquidations of insolvent corporations. As a result of this interest and concerns over the appropriate characterization of these transactions the Treasury Department issued Proposed Regulations (the “Proposed Net Value Regulations”) designed to provide guidance regarding formations, reorganizations and liquidations of potentially insolvent corporations. While the Proposed Net Value Regulations are clearly a positive step in the right direction, they make policy calls that may be somewhat problematic.
This Article describes the Proposed Net Value Regulations, including the comments made in the preamble to the Proposed Regulations. It then attempts to make constructive comments with respect to the policy calls made in both the Proposed Regulations and the preamble. It also discusses related issues involved in transfers of underwater assets, reorganizations and liquidations involving insolvent corporations. Finally, this paper briefly addresses the question of whether the proposed requirements for transfers of net value in the context of sections 351 and 368, issued some 80 years after the relevant statutory provisions were enacted and positing an interpretation of those provisions that could be viewed as conflicting with prior judicial interpretations, are subject to challenge on invalidity grounds.
The Proposed Net Value Regulations substantially alter the rules set forth in sections 351 and 368 with respect to asset incorporations and corporate reorganizations, and clarify the law as it applies to complete liquidations of corporations. Those regulations address four general subchapter C areas described briefly below.
A. Section 332 Liquidations
In the context of section 332, the Proposed Net Value Regulations continue the requirement of current law that at least a partial payment must be made to the parent corporation with respect to each class of subsidiary stock held by the parent in order for a complete liquidation of a subsidiary to qualify for nonrecognition treatment under that provision. 4 However, the Proposed Net Value Regulations also clarify that (1) if the parent does not receive at least a partial payment in exchange for a class of subsidiary stock, the parent generally is entitled to a worthless securities deduction equal to its basis in that class of stock under section 165(g), regardless of whether the transaction also qualifies as an upstream reorganization; and (2) if the parent receives at least a partial payment in exchange for one or more other classes of subsidiary stock ( e.g., preferred stock), the transaction may qualify as an upstream reorganization of the subsidiary into the parent within the meaning of section 368(a) or, failing such qualification, the parent will recognize capital gain or loss with respect to such partial payment under section 331. 5
B. Section 351 Exchanges
In the context of section 351 exchanges, the Proposed Net Value Regulations require a transferor to surrender net value to the transferee corporation and also receive net value from the transferee corporation in the form of stock in order for a transfer of property to a controlled corporation to qualify for nonrecognition treatment under that provision. 6
C. Section 368 Reorganizations
In the context of section 368, the Proposed Net Value Regulations add a new requirement for exchange of net value and clarify the continuity of proprietary interest requirement in the context of insolvent targets. 7 In doing so, the Proposed Net Value Regulations would overrule limited caselaw by imposing the net value exchange requirement and would generally preserve caselaw regarding treatment of creditors of insolvent targets as shareholders for continuity of interest purposes.