In June 2005, the Internal Revenue Service (IRS) issued a package of proposed regulations providing that certain corporate liquidations, formations and reorganizations would not qualify for nonrecognition treatment if the shares distributed or exchanged did not have positive “net value” (2005 Proposed Regulations). Certain of the proposed regulations, addressing the extent to which a corporation’s creditors will be treated as proprietors in determining whether the continuity of interest requirement is satisfied, were finalized in 2008. On July 12, 2017, more than 12 years after their release, the remaining proposed regulations, and with them the proposed net value requirement, were formally withdrawn.
Generally, the 2005 Proposed Regulations would have required that, for a transaction to qualify for nonrecognition under subchapter C, the property exchanged for, or distributed with respect to, the stock of a corporation have a positive net value. The underlying rationale was that a transaction that fails to meet this standard resembles a sale, not a change in form where there is a continuing investment.
In issuing the 2005 Proposed Regulations, the IRS noted that the authorities were not consistent in requiring an exchange of net value in the reorganization context. While a series of authorities have required a distribution of net value in the section 332 context, the law was less certain in the section 351 and section 368 contexts. In Rev. Rul. 59-296, the IRS indicated that the net value principles relevant to section 332 also applied to reorganizations. However, in Norman Scott, Inc. v. Comm’r, 48 T.C. 598 (1967), the Tax Court held that a transaction involving an insolvent target corporation qualified as a reorganization under section 368(a)(1)(A). The 2005 Proposed Regulations were an attempt to resolve this uncertainty and impose a general net value requirement for nonrecognition under subchapter C.
The 2005 Proposed Regulations would have applied to corporate liquidations intended to qualify for nonrecognition under section 332 and corporate formations intended to qualify for nonrecognition under section 351. The proposed regulations also would have applied to tax-free corporate reorganizations described in section 368 other than reorganizations described in sections 368(a)(1)(E) and 368(a)(1)(F) and certain reorganizations described in section 368(a)(1)(D).
The 2005 Proposed Regulations were never finalized in part because of the difficulty of dealing with certain fundamental issues. For example, the proposed regulations provided no definition of “liabilities” and left unaddressed the manner for determining whether there was “net value.”
In withdrawing the 2005 Proposed Regulations, the IRS stated that current law requires a distribution of net value in order for a liquidation to qualify for nonrecognition under section 332. The IRS posited that current law is sufficient to ensure that sections 368 and 351 are used to accomplish readjustments of continuing interests in property held in modified corporate form. However, the uncertainty on whether there is a net value requirement for purposes of sections 368 and 351 remains unresolved. The IRS thus appears to have abandoned its goal to create an explicit uniform requirement of an exchange or distribution of net value for transactions to qualify for nonrecognition under subchapter C.
As indicated above, on July 7, 2017, Treasury identified eight significant regulations issued after January 1, 2016, including regulations under sections 385 (treatment of certain debt as equity), 752 (partnership liabilities), 367 (outbound transfers of property) and 987 (currency gains and losses), for potential modification or repeal. See our prior legal alert. It remains to be seen whether the withdrawal of the 2005 Proposed Regulations is a one-off initiative or, like Treasury’s identification of regulations for potential modification or repeal, it is part of a broader campaign to reduce the backlog of regulations and guidance that have not been finalized.