Overview

On July 13" 2017, Treasury and the IRS withdrew parts of proposed regulations (REG-163314-03; see Tax Alert 2005-242) issued on March 10, 2005 (Proposed Net Value Regulations) that would require an exchange of net value for transactions intended to qualify under Sections 351 and 368 and a distribution of net value for transactions intended to qualify under Section 332.

Withdrawal notice

The Government withdrew the proposed:

— Revisions to Reg. Section 1.332-2(b) and (e)
— Addition of Example 2 to Reg. Section 1.332-2(e)
— Additions of Reg. Section 1.351-1(a)(1)(iii) and (a)(1)(iv)
— Addition of Example 4 to Reg. Section 1.351-1(a)(2)
— Amendments to Reg. Section 1.368-1(a) and (b)
— Addition of Reg. Section 1.368-1(f)
— Revision to Reg. Section 1.368-2(d)(1) in the Proposed Net Value Regulations

These portions of the Proposed Net Value Regulations were previously adopted as final regulations: (1) provisions regarding creditor continuity of interest, and (2) provisions reflecting statutory changes to Sections 332 and 351. (See TD 9434; Tax Alert 2008-1858.)

In discussing the withdrawal of Prop. Reg. Section 1.332-2, the Government stated that "the holdings of H.K. Porter Co. v. Commissioner, 87 T.C. 689 (1986), Spaulding Bakeries Inc. v. Commissioner, 27 T.C. 684 (1957), aff'd, 252 F.2d 293 (2d Cir., 1958), H.G. Hill Stores, Inc. v. Commissioner, 44 B.T.A. 1182 (1941), Revenue Ruling 2003-125, 2003-2 C.B. 1243, Revenue Ruling 68-602, 1968-2 C.B. 135, Revenue Ruling 68-359, 1968-2 C.B. 161, and Revenue Ruling 59-296, 1959-2 C.B. 87, continue to reflect the position of the Treasury Department and the IRS." The preamble to the Proposed Net Value Regulations cited some of the same authorities in noting that "[t]he authorities interpreting [S]ection 332 have consistently concluded that the language of the statute referring to a distribution in complete cancellation or redemption of stock requires a distribution of net value."

In discussing the withdrawal of Prop. Reg. Sections 1.351-1, 1.368-1, and 1.368-2, the Government simply stated that "current law is sufficient to ensure that the reorganization provisions and Section 351 are used to accomplish readjustments of continuing interests in property held in modified corporate form." This statement is made against the backdrop of the preamble to the Proposed Net Value Regulations, which cited Revenue Ruling 59-296 and Norman Scott, Inc. v. Commissioner, 48 T.C. 598 (1967) (holding that a transaction involving an insolvent target corporation qualified as a reorganization under Section 368(a)(1)(A)) in stating that the authorities are "not consistent."

Observations

Rather than withdrawing the Proposed Net Value Regulations without comment or with a vague explanation, the Government chose to explain its thinking. The manner in which the Government did so is interesting. Specifically, the Government provided the aforementioned list of technical citations to show that courts and the IRS view Section 332 as not applying to liquidations of insolvent corporations. But, rather than provide a similar list of citations with respect to the impact of insolvency on Section 351 and 368 transactions, the Government stated that "current law is sufficient" — despite having expressly stated in the preamble to the Proposed Net Value Regulations that inconsistent authority existed. Seemingly, the law has retained enough ambiguity to justify leaving the proposed regulations outstanding for the past 12 years. It is not clear what has changed — why now, in 2017, the Government believes that "current law is sufficient."

On a more technical basis, the Government stated that, "[w]ith respect to Section 332, the holdings of Revenue Ruling 59-296 … continue to reflect the position of the Treasury Department and the IRS." Interestingly, Revenue Ruling 59-296 also contained a ruling that there was no reorganization involving the insolvent target corporation, but the Government limited its affirmative statement of support to Section 332. One could interpret this asymmetrical treatment as supporting the proposition that an insolvent target corporation may engage in a reorganization with its corporate shareholder.

The withdrawal notice also withdrew a helpful example — proposed Example 2 of Reg. Section 1.332-2(e). In the example, P Corporation owned all of the preferred and common stock of Q Corporation. The fair market value of Q Corporation's assets exceeded the amount of its liabilities, but did not exceed the liquidation preference on the Q Corporation preferred stock. Q Corporation liquidated and distributed all of its assets to P Corporation, and P Corporation received partial payment for its Q Corporation preferred stock but received nothing for its Q Corporation common stock. The example concluded that P Corporation did not receive Q Corporation's assets in a transaction qualifying under Section 332, but that P Corporation was entitled to a worthless security deduction for its Q Corporation common stock under Section 165(g). In addition, the example stated that the transaction may qualify as a reorganization under Section 368(a)(1)(C). In the reorganization context, this example allays the concern that Revenue Ruling 74-515 could be read to preclude the worthless stock loss under Section 356(c). In Revenue Ruling 74-515, pursuant to a statutory merger, common stock was exchanged for common stock and preferred stock was exchanged for cash. The Service ruled that the shareholders who owned both common and preferred stock made an exchange under Section 356 because they received both common stock and cash. The ruling provided that gain under Section 356(a)(1) is recognized on the transfer of preferred stock for cash, but no loss is recognized as provided in Section 356(c).

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