August/September 2004

Tax Cases Alan Barton Taxation Section Editor KPMG LLP Houston, TX abarton@kpmg.com .

Internal Revenue Service
Background – Section 382
IRC section 382 provides that, following an ownership change, the amount of a loss corporation’s taxable income for any post-change year that may be offset by pre-change losses may not exceed the section 382 limitation for that year. A loss corporation includes any corporation that has a net operating loss (“NOL”), an NOL carryforward, or a net unrealized built-in loss for the taxable year in which the ownership change occurs. For these purposes, an ownership change generally occurs when the aggregate stock ownership (by value) of so-called 5% shareholders of the loss corporation has increased by more than 50 percentage points over such shareholders’ lowest ownership percentages during the testing period, which is generally three years. The IRC section 382 limitation generally equals the fair market value of the equity of the loss corporation immediately before the ownership change, subject to certain adjustments, multiplied by the long-term tax-exempt rate.

How is a shareholder’s ownership percentage determined when the loss corporation has multiple classes of stock outstanding?

IRC section 382(k)(6)(C) provides that determinations of the percentage of stock of any corporation held by any person shall be made on the basis of value. IRC section 382(l)(3)(C) provides that, except as provided in regulations, any change in proportionate ownership which is attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into account.

No regulations have been issued under IRC section 382(l)(3)(C). Until recently, the Internal Revenue Service (“Service” or “IRS”) had not issued any guidance on how taxpayers should interpret or apply IRC section 382(l)(3)(C). As a result, in certain situations it could be difficult to determine a shareholder’s ownership percentage, when the loss corporation had multiple classes of stock outstanding.

The Service recently issued a private letter ruling to a taxpayer, addressing IRC section 382(l)(3)(C). The facts of the ruling are as follows:

Prior to Date 1, Taxpayer, a loss corporation, had one class of common stock outstanding. On Date 1, Taxpayer issued shares of Class 1 preferred stock pursuant to a preferred stock purchase agreement with Shareholder A. In addition, on Date 1, Shareholder A acquired common stock in the open market. Shareholder A’s stock purchases, coupled with other equity changes occurring during the testing period, resulted in Taxpayer experiencing a section 382 ownership change on Date 1.

Subsequent to Date 1, Taxpayer experienced owner shifts caused by open market purchases of Taxpayer stock by Shareholder A, the exercise of options for common stock, and the sale of common stock by existing 5% shareholders on six occasions.

On Date 2, Taxpayer issued shares of Class 2 preferred stock pursuant to a second preferred stock purchase agreement with an unrelated party who was not previously a 5% shareholder of Taxpayer. On the same date, Taxpayer issued shares of Class 3 preferred stock to Shareholder A pursuant to a third preferred stock purchase agreement.

The Taxpayer was contemplating a proposed transaction whereby it would issue additional stock on or before Date 6. Such issuance may include the issuance of additional shares to Shareholder A, other existing shareholders, new shareholders, or a combination thereof. The proposed transaction was intended to raise additional capital for the acquisition of business assets.

Subsequent to Date 1 and Date 2, the Taxpayer’s common stock declined in value relative to the values of the Class 1 preferred stock, the Class 2 preferred stock and the Class 3 preferred stock. As a result, the preferred stock shareholders’ percentage of the outstanding equity value had increased, although their actual preferred stock ownership had not changed. In light of the previous stock activity and the overall decline in the value of Taxpayer’s common stock relative to its preferred stock, Taxpayer requested a ruling from the Service on the application of Section 382(l)(3)(C) to the contemplated stock issuance.

The Service ruled that the Taxpayer may apply the following principle on the testing date caused by the proposed transaction and on any subsequent testing date:

On any testing date, in determining the ownership percentage of any 5% shareholder, the value of such shareholder’s stock, relative to the value of all other stock of the corporation, shall be considered to remain constant since the date that shareholder acquired the stock; and the value of such shareholder’s stock relative to the value of all other stock of the corporation issued subsequent to such acquisition date shall also be considered to remain constant since that subsequent date.

Private Letter Ruling 200411012 (March 12, 2004).

Whether the acquisition of Target stock, the funding of the acquisition of Target stock, the implementation of cash sweep accounts or royalty payments from Target to Acquiring constitute a redemption or other corporate contraction within the meaning of IRC section 382(e)(2)?

IRC section 382(k)(2) defines an old loss corporation as any loss corporation that experiences an ownership change. IRC section 382(e)(1) generally provides that the fair market value of the old loss corporation is the value of its stock immediately before an ownership change. IRC section 382(e)(2) requires a reduction in the fair market value of the old loss corporation where a redemption or other corporate contraction occurs in connection with an ownership change.

The committee reports to the Technical and Miscellaneous Revenue Act of 1988, which modified IRC section 382(e)(2) to include the reference to other corporate contractions, and indicates that it was Congress’ intent that IRC section 382(e)(2) could apply to leveraged buyout trans-actions and other debt financed acquisitions of a loss corporation. For example, the committee report indicates that a corporate contraction may include cases in which debt used to pay the old shareholders remains an obligation of an acquisition corporation or an affiliate, where the acquired loss corporation is directly or indirectly the source of funds for repayment of the obligation.

The Service recently ruled on the application of IRC section 382(e)(2) where the acquisition of a loss corporation was financed by borrowings. In the ruling, Acquiring is the publicly traded common parent of an affiliated group that files a consolidated federal income tax return. Acquiring indirectly owns stock in various subsidiaries primarily engaged in the same type of business as Target. Target is the publicly traded common parent of an affiliated group that files a consolidated federal income tax return. Target Group is a loss group within the meaning of Treasury Regulation section 1.1502-91(c)(1) with a consolidated net operating loss carry forward for federal income tax purposes.

On the acquisition date, Acquiring purchased in excess of 90 percent of Target’s outstanding stock for cash pursuant to a public tender offer. As a result, the former members of Target Group joined Acquiring Group and became the Target Subgroup. On the following day, Acquiring acquired the remaining Target shares through the cash merger of a wholly-owned subsidiary with and into Target.

Acquiring obtained the necessary funds for the acquisition by drawing on its revolving line of credit. The line of credit was due to expire and had no requirement pursuant to which Acquiring would be required to refinance if funds were used to effect an acquisition. In accordance with pre-existing indentures and credit agreements, Target Subgroup members became guarantors of certain debt of Acquiring, including the line of credit. Subsequently, Acquiring completed a series of capital markets transactions refinancing its debt, including the line of credit.

Following the acquisition, Acquiring applied its preexisting treasury management program to the members of Target Subgroup. Under this program, Acquiring maintains a central disbursement account from which all of its operating subsidiaries may draw cash for disbursements, as well as a group-wide cash sweep function to consolidate each subsidiary’s excess cash on a routine basis. In addition, Acquiring is the owner of all Acquiring-related intellectual property and charges all of its subsidiaries royalties for the use of such intellectual property, such royalties having been set at a percentage of sales in accordance with an IRC section 482 transfer pricing study. Consistent with this practice, Target Subgroup members are using the intellectual property in their operations and anticipate making royalty payments to Acquiring during the regular course of business.

In the ruling, Acquiring made the following representations:

(a) Even absent the cash swept from the historic operations of the Target Subgroup pursuant to the consolidated treasury management and cash sweep program and the payment of royalties by Target Subgroup members, Acquiring believes it will have sufficient funds to make all required payments on the debt incurred to fund the acquisition of Target.

(b) There is no expectation that the inter-company receivables owing to any member of the Target Subgroup (or to any other member of the Acquiring Group that acquired assets from a member of the Target Subgroup) created pursuant to the consolidated treasury management and cash sweep program will be forgiven.

(c) Acquiring has not caused, and has no plan or intention to cause, the Target Subgroup to engage in any dividend or loan not arising pursuant to the consolidated treasury management and cash sweep program that will result in the net asset value of the Target Subgroup at any time to be below the net asset value of the Target Subgroup on the change date determined, in the case of change date net asset value, prior to the reduction of Target Subgroup debt on the change date funded by Acquiring.

Based on the facts and the representations made by Acquiring, the Service ruled that neither the acquisition of Target stock (including the subsequent “squeeze-out” cash merger), the funding of the acquisition of Target stock with lines of credit subsequently guaranteed by Target Subgroup members, the treasury management and cash sweep programs or the royalty payments to Acquiring by Target Subgroup members constitutes a redemption or other corporate contraction occurring in connection with the acquisition of Target within the meaning of IRC section 382(e)(2). Private Letter Ruling 200406027 (February 6, 2004).

United States District Court

Whether the Debtor’s failure to properly serve the IRS with copies of her dischargeability motion and the hearing on the dischargeability motion is grounds for vacating a tax discharge in Bankruptcy?

On July 26, 1993, Debtor filed for voluntary bankruptcy under Chapter 13. The IRS filed a proof of claim for unpaid income taxes for the years 1987, 1990, and 1991. On May 23, 1994, the Bankruptcy Court adopted Debtor’s amended Chapter 13 Plan, allowing a priority tax claim of $1,674 and a general unsecured tax claim for $40,701.

On August 8, 1994, Debtor filed a motion requesting discharge of her tax liabilities. Debtor mailed her motion for discharge to the IRS at an incorrect mailing address in Phoenix, Arizona, and to the IRS District Counsel in Phoenix, but served neither the U.S. Attorney General in Washington, D.C., nor the U.S. Attorney in Phoenix. Debtor sent her notice of hearing on the motion for discharge to the correct address for the IRS in Phoenix, as well as the IRS in Ogden, Utah, but again failed to provide notice to the U.S. Attorney General or the U.S. Attorney in Phoenix.

Because the United States failed to appear at the hearing, the Bankruptcy Court vacated the hearing on Debtor’s motion for discharge and granted the motion, discharging her federal income taxes for the years 1987, 1990, and 1991 on October 14, 1994. The Bankruptcy Court’s discharge order was mailed to the IRS at an incorrect address in Phoenix, but not to the U.S. Attorney General or the U.S. Attorney in Phoenix. Debtor’s Chapter 13 bankruptcy case was dismissed on December 18, 1995, and closed on July 12, 1996.

On December 4, 2001, the IRS received a letter from Debtor’s counsel advising it of the discharge. On June 17, 2002, on behalf of the IRS, the United States moved to reopen Debtor’s bankruptcy case and set aside the discharge order as void due to improper service. Debtor acknowledged that the IRS was not properly served with process pursuant to Bankruptcy Rules 7004(b)(5) and 9014. On November 13, 2002, after additional briefs and a hearing, the Bankruptcy Court vacated its discharge order of October 14, 1994, as void pursuant to Federal Rule 60(b), and relieved the IRS from its impact. On May 16, 2003, Debtor filed an appeal, challenging the Bankruptcy Court’s determination on the IRS’ Rule 60 motion.

Debtor argued that the Bankruptcy Court’s decision to vacate and set aside its October 14, 1994, discharge order should be reversed because the IRS was served with notice of the original hearing “in some fashion” and because the Rule 60 motion was not timely made. Debtor asserted that although “all of the noticing was not complied with as to the original Motion to Discharge the above tax years, . . . some noticing did occur” at IRS addresses in Phoenix and Ogden.

Federal Rule 60(b), made applicable to final bankruptcy orders by Bankruptcy Rule 9024, provides, in part, that a court may relieve a party from a final judgment, order or proceeding where such judgment is void. The District Court, citing United States v. Berke, 170 F.3d 882, 883 (9th Cir. 1999) and In re Center Wholesale, 759 F.2d 1440, 1448 (9th Cir. 1985), noted that a final judgment is void for purposes of Rule 60(b)(4) where the court that considered it lacked jurisdiction over the parties to be bound, or acted in a manner inconsistent with due process of law. The

District Court found that due process of law is violated, if the court does not require sufficient notice and opportunity to be heard on a matter.

Bankruptcy Rule 7004(b)(5) specifies that proper service on an agency of the United States is provided when copies of pleadings are served on (i) the U.S. agency, (ii) the office of the U.S. attorney for the district in which the action is brought, and (iii) the U.S. Attorney General in Washington, D.C. Bankruptcy Rules 7001(6) and 9014 require this method of service in contested bankruptcy matters, including determinations of discharge-ability. The District Court held that the Bankruptcy Court appropriately concluded that Debtor failed to properly serve the IRS with her motion for discharge and notice of hearing, rendering void the Bankruptcy Court’s granting of that motion.

Debtor’s final argument on appeal was that the IRS failed to file its motion to vacate the Bankruptcy Court’s discharge order within a reasonable time, thereby waiving its right to relief. The District Court found the basis for such argument unclear, citing Debtor’s failure to provide any factual or legal support for it. On the contrary, the District Court, again citing Center Wholesale as well as Meadows v. Dominican Republic, 817 F.2d 517, 521 (9th Cir. 1987), and Bookout v. Beck, 354 F.2d. 823, 825 (9th Cir. 1965), found that there is no time limit on a Rule 60(b)(4) motion to set aside a judgment as void. The District Court held that the Bankruptcy Court’s finding that the IRS filed its motion within a reasonable time was not clearly erroneous. The District Court affirmed the Bankruptcy Court’s order. Judy A. Walker v. IRS (In re Walker), 92 A.F.T.R.2d (RIA) 6494 (September 29, 2003).