December 2004/ January 2005

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

Taxes

The American Jobs Creation Act of 2004
On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004 (Public Law No. 108-357) (the “Act”). The Act has been described as the most significant piece of tax legislation affecting businesses enacted since the Tax Reform Act of 1986.

The Act contains significant changes to a number of inter-national tax provisions, including: the general repeal of the extra-territorial income (“ETI”) export related tax benefit regime; changes to the foreign tax credit provisions (summarized, in part, below); new provisions to encourage repatriation of foreign earnings; and changes to Subpart F and other anti-deferral provisions contained in Subchapter N of the Internal Revenue Code (“IRC”), generally pertaining to taxation of income from sources outside of the United States (“U.S.”).

Another significant provision of the Act is the enactment of new IRC Section 199, which provides for a new deduction for taxpayers engaged in certain U.S. production activities.

In addition to these significant changes, the Act contains several other provisions affecting businesses involved in a restructuring, or businesses that have certain tax attributes. Following is a brief summary of certain of these other provisions.

Recognition of Cancellation of Debt Income Realized on Satisfaction of Debt with a Partnership Interest
Under prior-law IRC Section 108(e)(8), a corporation that transfers shares of its stock in satisfaction of its debt must recognize cancellation of debt (“COD”) income in the amount that would be realized if the debt were satisfied with money equal to the fair market value of the stock. Before the enactment of this provision in 1993, case law provided that a corporation did not recognize COD income when it transferred stock to a creditor in satisfaction of debt.

IRC Section 108(e)(8) previously did not apply to partnerships. Therefore, it was unclear whether a partnership is required to recognize COD income if it transfers a capital or profits interest to a creditor in satisfaction of debt.

The Act amends IRC Section 108(e)(8) to apply to both corporate stock and partnership interests. Thus, if a partnership transfers a capital or profits interest to a creditor to satisfy partnership debt, the partnership recognizes COD income in the amount that would be recognized if the debt were satisfied with money equal to the fair market value of the partnership interest. The same rule applies regardless of whether the cancelled debt is recourse or nonrecourse.

The Act also provides that any COD income recognized under this rule is required to be allocated solely among the partners who held partnership interests immediately prior to the satisfaction of the debt.

Effective Date: Cancellations of debt occurring on or after October 22, 2004.

S Corporation Reform and Simplification
Under prior law, a small business corporation may elect to be an S corporation with the consent of all its shareholders, and may terminate its election with the consent of shareholders holding more than 50% of the stock. An eligible small business corporation is defined as a domestic corporation, which is not an ineligible corporation, and has:

• No more than 75 shareholders, all of whom are individuals (and certain trusts, estates, charities, and qualified retirement plans) who are citizens or residents of the United States; and

• Only one class of stock.

For purposes of the 75-shareholder limitation, a husband and wife are treated as one shareholder.

Members of Family Treated as One Shareholder

The Act permits S corporations to elect to treat family members as one shareholder for purposes of determining the number of shareholders in the corporation.

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For these purposes, a family is defined as the lineal descendants (and their spouses) of a common ancestor. The common ancestor cannot be more than six generations removed from the youngest generation of shareholder at the time the S election is made (or the effective date of this provision, if later).

Except as provided by Treasury regulations, the election may be made by any family member and the election remains in effect until terminated.

Effective Date: Tax years beginning after 2004.

Increase in Number of Eligible Shareholders to 100

The Act increases the maximum number of eligible shareholders in an S corporation from 75 to 100.

Effective Date: Tax years beginning after 2004.

Transfers of Suspended Losses Incident to Divorce

Under prior law, a loss or deduction was not allowed to a share-holder of an S corporation if the loss exceeds the shareholder’s basis in stock and debt of the S corporation (a suspended loss). The suspended loss was treated as incurred by the S corporation with respect to that shareholder in the subsequent tax year. A suspended loss is generally not transferred upon a transfer of the S corporation stock by the shareholder.

The Act provides that if a shareholder’s stock in an S corporation is transferred to a spouse (or to a former spouse) incident to a divorce, any suspended loss or deduction relating to that stock is treated as incurred by the S corporation with respect to the transferee in the subsequent tax year.
Thus, when stock is transferred to a spouse (or former spouse) incident to divorce, the transferee steps into the shoes of the transferor, and can claim suspended losses in subsequent tax years, including if:

• The S corporation has taxable income; or

• The transferee obtains basis in the stock or debt by making capital contributions and/or making additional loans.

Effective Date: Transfers after 2004.

Affirmation of Consolidated Return Regulation Authority
An affiliated group of corporations may elect to file a consolidated return in lieu of separate returns. IRC Section 1502 gives the Treasury Secretary the authority to prescribe regulations necessary to ensure that the tax liability of any affiliated group of corporations making a consolidated return (and of each corporation in the group, both during and after the period of affiliation) be returned, determined, computed, assessed, collected, and adjusted, so as to clearly reflect income tax liabilities.

In Rite Aid Corp. v. United States, 255 F.3d 1357 (Fed. Cir. 2001), the Federal Circuit invalidated the so-called “duplicated loss factor” of the consolidated return loss disallowance regulations. This factor would have denied a loss on the sale of stock of a subsidiary by a parent corporation that had filed a consolidated return with the subsidiary, to the extent the subsidiary corporation had assets that had a built-in loss, or had losses, that could be recognized or used later. The court’s opinion contained language discussing the fact that the regulations produced a result different from the result that would have been obtained if the corporations had filed separate returns rather than consolidated returns.

The legislative history indicates a concern that Treasury Department resources might be unnecessarily devoted to defending challenges to consolidated return regulations on the mere assertion by a taxpayer that the result under the consolidated return regulations is different from the result for separate taxpayers.

Accordingly, the Act amends IRC Section 1502 by adding language explicitly authorizing the Secretary to prescribe rules that are different for affiliated corporations filing a consolidated return from the rules that apply to corporations that file separate returns. The new provision does not overturn the result of Rite Aid, with respect to the type of factual situations presented in that case.

Effective Date: For all years, whether beginning before, on, or after October 22, 2004.

Limitation on Transfer or Importation of Built-in Loss
Pursuant to IRC Sections 362 and 334(b), the basis of property received by a corporation (whether from domestic or foreign transferors) in a tax-free IRC Section 351 exchange, a tax-free reorganization, or a tax-free liquidation of a subsidiary corporation is the same as the adjusted basis of that property in the hands of the transferor, adjusted for gain or loss recognized by the transferor.

The legislative history provides generally that in certain transactions involving transfers of built-in loss property, the basis of the property in the hands of the transferee should not be transferred basis, but rather should be the fair market value of the transferred property immediately after the transfer.

The Act generally fixes a corporation’s basis in property acquired in an IRC Section 362 transfer at fair market value in certain situations. The limitation applies in three situations:

1. Importations of net built-in loss properties into the U.S. tax system subject to IRC Section 362 (that is, IRC Section 351 exchanges and reorganizations). Property is imported into the U.S. tax system if gain or loss with respect to the property is not subject to U.S. income tax in the hands of the transferor immediately before the transfer, and gain or loss with respect to the property is subject to U.S. income tax in the hands of the transferee immediately after the transfer. If the transferee’s total basis in all such properties transferred otherwise exceeds the total fair market value of the properties at the time of the transfer, the properties have a net built-in loss. Under the Act, all such properties have a fair market value basis in the hands of the transferee immediately after the transfer. (There is no provision affecting the transferor’s basis in the stock of the transferee received in exchange for the properties.)

2. Transfers of net built-in loss property into the U.S. tax system subject to IRC Section 334(b) (that is, IRC Section 332 subsidiary liquidations). The changes to IRC Section 334(b)(1) refer to the amendments to IRC Section 362. The amendment applies if all properties imported into the U.S. tax system in a liquidation to a domestic corporate distributee have a total basis that otherwise exceeds their total fair market value. If the change applies, IRC Section 334(b)(1) fixes the basis of all property received in the liquidation at fair market value.

3. Transfers of net built-in loss properties in IRC Section 351 transactions. A transferee’s total basis in properties received from a transferor in an IRC Section 351 transaction that is not subject to the importation rule described above cannot exceed the total fair market value of the properties immediately after the transfer. A special rule allocates the total reduction of basis among the properties received in proportion to their respective built-in loss immediately before the transaction. A transferor and transferee will be permitted to elect jointly to not have this amendment apply (thus permitting the transferee to receive a transferred basis in the properties) at a cost of having the transferor’s total basis in the transferee stock received capped at the fair market value of the properties.

Effective Date: For transactions after October 22, 2004.

Reporting of Taxable Mergers and Acquisitions
In the case of an acquisition of stock or assets in which gain or loss is recognized, in whole or in part, by the shareholders of the target corporation, the acquiring corporation (or the target corporation, if so prescribed by the Treasury Secretary) is subject to new reporting obligations.
Effective Date: For acquisitions after October 22, 2004.

Foreign Tax Credit Provisions
Foreign Tax Credit Carryforward and Carryback

Under prior law, the amount of creditable taxes paid or accrued (or deemed paid) in any tax year that exceeds the foreign tax credit limitation could be:

• carried back to the two immediately preceding tax years (to the earliest year first); and
• carried forward five tax years (in chronological order)

and credited to the extent that the taxpayer otherwise has an excess foreign tax credit limitation for those years.

The Act extends the carryforward period from five years to 10 years and reduces the carryback period from two years to one year.

Effective Date: With respect to the carryforward period, for excess foreign taxes that may be carried to any tax year ending after October 22, 2004. Concerning the carryback period, for excess foreign taxes arising in tax years beginning after October 22, 2004.

Reduction in Number of Foreign Tax Credit Baskets and “Base Differences”

Under prior law, the foreign tax credit limitation was applied separately to the following nine categories (or baskets) of income:

• Passive income
• High withholding tax interest
• Financial services income
• Shipping income
• Certain dividends received from noncontrolled IRC Section 902 foreign corporations (10/50 companies)
• Certain dividends from a domestic international sales corporation (“DISC”) or a former DISC
• Taxable income attributable to certain foreign trade income
• Certain distributions from a foreign sales corporation (“FSC”) or a former FSC
• Any other income not described above (the “general basket” income)

Under this regime, foreign taxes were allocated and apportioned to the same foreign tax credit limitation categories as the income to which they related. When foreign law imposes tax on an item of income that does not constitute income under U.S. tax principles (a “base difference” item), the tax was treated as imposed on income in the general basket.

Foreign Tax Credit Baskets

The Act reduces the number of foreign tax credit limitation baskets from nine to two:

• Passive category income
• General category income

Income from the eliminated baskets will be assigned to the two remaining categories.
Passive category income means passive income and specified passive category income. Specified passive category income includes certain dividends from a DISC or former DISC, taxable income attributable to foreign trade income, and certain distributions from a FSC or former FSC. General category income means all income other than passive category income.

Income in the financial services income basket generally will be treated as general category income if earned by a member of a financial services group or any other person that is predominantly engaged in the active conduct of a banking, insurance, financing, or similar business.

Base Difference Items

For tax years beginning after 2006, creditable foreign taxes imposed on amounts that do not constitute income under U.S. tax principles will be treated as general category income.

Such taxes that are paid or accrued in tax years beginning after 2004, but before 2007 (when the number of baskets is reduced to two), will be treated as imposed on either general limitation income or financial services income, at the taxpayer’s election. Once made, this election will apply to all such taxes for the tax years described above and will be revocable only with the Treasury Secretary’s consent.

Effective Date: Tax years beginning after 2006. Taxes paid or accrued in tax years beginning before 2007, and carried forward to any subsequent tax year will be assigned to one of the two baskets, as appropriate (as if this provision were in effect on the date the taxes were paid or accrued). The Treasury Secretary is authorized to issue regulations to address the allocation of income concerning taxes carried back to pre-effective date years.

The rules dealing with base difference items will be effective for taxes arising in tax years beginning after 2004.

Foreign Tax Credits Under Alternative Minimum Tax

Taxpayers are subject to an alternative minimum tax (“AMT”) to the extent their tentative minimum tax (“TMT”), reduced by the AMT foreign tax credit, is greater than their regular income tax, reduced by the regular tax foreign tax credit. TMT is based on alternative minimum taxable income (“AMTI”), a recomputation of regular taxable income with certain adjustments and increased for certain tax preferences.

The AMT foreign tax credit is determined under principles similar to those for the regular tax foreign tax credit, but taking into account the adjustment and preferences required to compute AMTI. However, under prior law, the AMT foreign tax credit for any tax year was limited to 90% of the taxpayer’s TMT computed without any AMT net operating loss deduction.

The Act repeals the 90% limitation on the use of the AMT foreign tax credit.

Effective Date: Tax years beginning after 2004.

(The summary of the provisions above is adapted from a description of the Act prepared by the Washington National Tax practice of KPMG LLP).