The IRS announced in July that it has withdrawn proposed regulations (the net value regulations) that provided guidance regarding corporate formations, reorganizations and liquidations of insolvent corporations. Those regulations, which were proposed in 2005, required the exchange (or, in the case of the liquidation of a subsidiary into its parent, the distribution) of “net value” in order for the transaction to qualify for nonrecognition treatment under the Internal Revenue Code (the Code).
The Net Value Regulations
Net Value in 332 Liquidations
When it issued the net value regulations, the IRS stated that the authorities interpreting the requirements of a tax-free liquidation of a subsidiary into its parent (a 332 liquidation) have consistently concluded that a distribution of “net value” is required, and that the parent corporation must receive payment in its capacity as a stockholder of the liquidating subsidiary corporation, and not solely in its capacity as a creditor.
Regulations in effect prior to the issuance of the net value regulations implemented the net value requirement for potential 332 liquidations by requiring that the parent corporation receive at least partial payment for the stock it owns in the liquidating subsidiary corporation. Such payment could not occur unless there were a distribution of net value. The only change the net value regulations made to this rule was to require that the parent corporation receive at least partial payment for each class of stock that it owns, if it owns shares of multiple classes of stock in the liquidating subsidiary corporation. The IRS adopted this approach — which it viewed as a “clarification” of existing requirements — because it believed it appropriate for a taxpayer to recognize a loss when it fails to receive a distribution on a class of stock in a 332 liquidation.
Net Value in 351 Transactions and Reorganizations
The IRS takes the position that the net value principles applicable to 332 liquidations also apply to potential tax-free “351 transactions” and reorganizations. However, the IRS’ position that an exchange of net value is required is inconsistent with certain existing authorities. The IRS recognized the uncertainties that exist in this area, and sought to resolve them by adopting a net value requirement for the transactions within the scope of the net value regulations.
A 351 transaction — that is, a transfer of property to a corporation in exchange for stock of the corporation — is a nonrecognition transaction under Section 351 of the Code if certain conditions are met. The net value regulations required that there be a transfer of net value to the corporation and a receipt of net value from the corporation. The net value regulations added a similar requirement of an exchange of net value for certain potential tax-free reorganizations. The net value requirement did not apply to reorganizations that were recapitalizations or mere changes in identity, form or place of incorporation, or certain acquisitive “D” reorganizations.
The IRS stated that it believed the net value requirement was the appropriate unifying standard for nonrecognition treatment because transactions that fail that requirement — that is, transfers of property in exchange for the assumption of liabilities or in satisfaction of liabilities — resemble sales and should not receive nonrecognition treatment.
The Withdrawal Notice
The IRS withdrew the portions of the net value regulations that required, as a condition to nonrecognition, that (i) net value be transferred to a corporation in a 351 transaction, (ii) the corporation receiving the transfer of property in a 351 transaction be solvent, (iii) there be an exchange of net value in applicable reorganizations and (iv) in a 332 liquidation, the parent receive at least partial payment for each class of a stock that it owns in the liquidating subsidiary corporation.
In announcing the withdrawal, the IRS stated that it is of the view that, with respect to 332 liquidations, existing case law and published IRS rulings reflect the position of the IRS.
The IRS also stated that it is of the view that current law is sufficient to ensure that the reorganization provisions and Section 351 of the Code are used to accomplish readjustments of continuing interests in property held in modified corporate form; such “readjustments” are the touchstone of tax-free transactions, as distinguished from taxable sale transactions.
However, the withdrawal of the net value regulations leaves in place the uncertainty that previously existed in this area with respect to 351 transactions and reorganizations involving insolvent corporations. Although the withdrawal may be viewed as allowing taxpayers the ability to rely on existing authorities that are inconsistent with the IRS’ position, that position has not changed, and the IRS may challenge a transaction that does not satisfy the net value requirement.
Creditor Continuity of Interest
The net value regulations also provided guidance on determining when (and the extent to which) creditors of a corporation are treated as “proprietors” of the corporation in determining whether continuity of interest is preserved in a potential reorganization. Absent the preservation of the requisite continuity of interest, a reorganization will not qualify for nonrecognition treatment. The portion of the net value regulations addressing creditor continuity of interest was finalized in 2008, and is not affected by the withdrawal of the remainder of the net value regulations.