Twenty three years after it was enacted in 1989, the Treasury issued proposed regulations interpreting section 172(h), the corporate equity reduction transaction (CERT) loss carryback disallowance rule dating from the heyday of the leveraged buyouts. Most of us have tried to remember this rule as one aimed at preventing carrying back a loss generated by large interest deductions and obtaining a refund, when the loan causing the interest deductions was incurred to make a large equity purchase, hence a “corporate equity reduction.”
If that were all section 172(h) was aimed at it would be one of those provisions that you could examine at leisure, because you would be well aware of whether (1) your corporation is buying stock with cash, (2) the cash is borrowed, or at least the corporation carries substantial debt, and (3) a lot of interest will be involved so that a NOL may be produced and a refund from a carryback may be in the offing.
Trap for the Unwary. But section 172(h) also can be a trap for the unwary because it can treat as a CERT the tax free acquisition of stock in a reorganization and a section 355 distribution. At least the proposed regulations so state.
This was not expected. In the 23 years the IRS has never issued a revenue ruling or revenue procedure on section 172(h) and has declined to rule on section 172(h) issues in private letter rulings. The earliest and most expert commentator on the section observed that it should not apply to tax free distributions.
Although the CERT provisions are silent on this point, presumably if T makes a tax-free distribution to its shareholders of stock or securities of another corporation as part of a tax-free reorganization or tax-free Code section 355 transaction, the distributed stock or securities should not count in determining whether T made an excess distribution during the taxable year. This type of tax-free distribution by T does not reduce overall corporate equity, and the requisites for a tax-free reorganization or Code section 355 transaction in effect ensure that T cannot use a transaction of this type to circumvent the underlying intent of the excess-distribution CERT rules. Hopefully, regulations will clarify this point. Ginsburg, Levin and Welke, CERTS: The New Limitations on NOL Carrybacks, 46 Tax Notes 1315, 1318 (Mar. 12, 1990)).
Those commentators refined their view and admitted that literally a stock for stock reorganization could be within the definition of a CERT, but asserted that none of the corporation’s debt should be allocable to the acquisition and therefore section 172(h) would not effectively apply. Ginsburg, Levin and Rocap, Mergers, Acquisitions and Buyouts, Vol. 3, ¶1208.1.4 Ex. 27 (Aug. 2012). See also Dubroff, et al., Taxation of Corporations Filing Consolidated Returns § 41.04 n. 273 (questioning whether any equity reduction occurs as the result of a spin off without boot) (2012).
Now come the proposed regulations. They say there will be no “tracing” of debt to stock acquisition. They define a CERT cost as the value of the stock acquired, regardless of whether acquired for cash or in a tax free transaction. They purport to follow the statute and apply the “avoided cost” method adopted from another section, but they gut the “avoided cost” concept by treating the tax free acquisition as if it were paid for in cash. As a result, a portion of the corporation’s debt and interest expense will be allocated to the tax free reorganization or spinoff.
The notice of proposed rule making justifies this approach by stating: “the concerns targeted by Congress… can exist in the context of tax-free acquisitions.” What were those concerns?
The House Report on PL 101-239 does not indicate any concern that would support this aspect of the regulation. It states: “Until regulations are promulgated, however, a corporation's indebtedness is allocable to a CERT to the extent that the corporation's indebtedness could have been reduced if the CERT had not occurred, in the manner prescribed under section 263A(f)(2)(A)(ii) (without regard to clause (i) thereof).” Section 263A does not require treating stock as cash in tax free transactions.
Practical Application: Evidently five year loss carrybacks tend to attract the attention of revenue agents, particularly when the loss reflects substantial interest expense. In the absence of a CERT regulation, the revenue agents have been apt to assert the worst result for taxpayers. Perhaps the presence of a proposed regulation, no matter how complex, will serve to protect taxpayers. However, the “simplifying” approach of treating tax free stock as cash could be attacked as beyond the scope of the statute.