On August 12, 2010, the IRS released temporary regulations dealing with the special election afforded taxpayers in 2009 and 2010 to defer the inclusion of income recognized upon the reacquisition of their own distressed debt instruments. The election provision, IRC Section 108(i), was enacted by the American Recovery and Reinvestment Tax Act of 2009. (Click here to read our September 10, 2009, legal alert IRS Provides Guidance on Stimulus Act Workout Provision.) The newly released regulations indicate that, notwithstanding the sunset of the provision at the end of this year, elections made to defer 2009 and 2010 income will have to be taken into account in planning corporate M&A transactions over the next decade.

Section 108(i) provides that any income deferred by reason of an election made with respect to corporate debt reacquired in 2009 or 2010 must be taken into account ratably over a five-year period beginning in 2014. However, the Code section further provides that a liquidation or sale of substantial assets of the electing corporation, cessation of its business, or "similar circumstances" occurring before the five-year period expires will accelerate the recognition of the entire amount of deferred income. Furthermore, the Code gives the IRS authority to expand this acceleration rule "to other circumstances where appropriate." In issuing the new regulations, the IRS has exercised its authority to develop a new rule to trigger the acceleration of income for certain corporate "impairment transactions."

Under the new regulations, "impairment transactions" are defined to include distributions (including tax-free liquidations), redemptions, below-market sales, charitable contributions, and the incurrence of debt without an increase in corporate asset value. Distributions that do not exceed the average annual amount of dividends paid by a corporation over three preceding taxable years and charitable contributions that are consistent with the corporation's historic giving practices are not considered impairment transactions. In addition, value-for-value exchanges, "mere declines" in the market value of corporate assets, and expenditures pursuant to a corporation’s good faith business judgment are not considered to be impairment transactions.

Although the events cited as impairment transactions would not necessarily occur in an M&A context, a special section of the regulations makes the events relevant to situations where an electing corporation is acquired from a consolidated return group. Specifically, the regulations delay the triggering effect of impairment transactions that involve intercompany transactions between members of a consolidated return group, such as the payment of intercompany dividends or intercompany liquidations, until an acquisition of the electing corporation occurs. If a member of a consolidated return group has engaged at any time in an intercompany impairment transaction, the regulations will deem the member to have engaged in the impairment transaction as of the date the member ceases (whether through its sale or other means) to be a member of the consolidated return group in which the intercompany transaction occurred.

The departing member will be subject to the "net value floor" (NVF) test imposed by the regulations. In brief, to avoid acceleration of its deferred income, the gross asset value of a departing member must be equal to or greater than 110 percent of the sum of its total liabilities and the tax on its net deferred income immediately after it leaves the group (the NVF). If the departing member fails the NVF test, the selling consolidated return group will be required to take all of the member’s deferred Section 108(i) income into account immediately before the sale.

However, if the departing member with an impairment transaction history is acquired by a second consolidated return group, the NVF test will be applied with respect to the assets, liabilities, and deferred items of the members of the acquiring group immediately after the acquisition. It should be particularly noted that in applying this test to the acquiring group not only the deferred items relevant to the corporation joining the group but also the deferred items of the existing members of the acquiring group are taken into account. Failure of the acquiring group to satisfy the NVF test would still result in the acceleration of the departing member's deferred income within the selling consolidated return group, even though the test has been failed by the acquiring group.

It is possible to avoid either of these acceleration events by restoring net value to the acquired corporation before the due date of the consolidated return of the selling group for the year in which it ceases to be a member. The amount of value that must be restored is the lesser of: the amount of value previously removed in impairment transactions and the amount by which the acquired corporation's NVF exceeds its gross asset value. Note that this remedial action to restore net value by the selling group would have to be taken after the sale closes, when the corporation is no longer owned by the seller. For that reason, it would require an adjustment of the original purchase price.

If the sale of the departing members stock produces a tax gain, the selling group may be indifferent to whether an acceleration event occurs because the stock basis adjustment resulting from the inclusion of the Section 108(i) income will reduce the amount of gain that would otherwise be taxable. For that reason, the selling group may be agreeable to making a special election that is permitted under the temporary regulations to accelerate all of its remaining Section 108(i) income. Even if no impairment transaction has occurred before the date of an acquisition, an acquiring corporation must be wary of inadvertently tripping one of the acceleration rules whenever it acquires a target corporation with a Section 108(i) election history and so may want to make the selling group's agreement to this special election a condition to its purchase of the departing member’s stock.

Planners of corporate acquisitions during the next decade will want to inquire about the Section 108(i) election history of potential acquisition targets and obtain appropriate representations and covenants. Corporations that become owners of corporations that have made Section 108(i) elections will want to monitor intercompany transactions to determine whether any would constitute impairment transactions in the event of a subsequent disposition of the electing member. Finally, corporate consolidated returns groups selling corporations that have made Section 108(i) elections to other consolidated groups will want to obtain representations that the purchasing group possesses sufficient assets to satisfy the NVF test. Failure to take such measures could produce unexpected, if not catastrophic, tax results for sellers and buyers in M&A transactions.