Service Recently Issues Favorable Continuity of Business Interest Private Letter Ruling on R&D Activities
One of the various requirements to qualify an acquisitive transaction as a tax-free reorganization is the continuity of business enterprise requirement. A tax-free reorganization requires a “continuity of business under modified corporation forms”. (citation omitted). The courts have entered into this area from time to time dealing with such issues as post reorganization asset drop-downs (Standard Realization Co. v. Comm’r, 10 TC 708 (1948) (acq.)) or asset sales (Pridemark, Inc. v. Comm’r, 345 F2d 35 (4th Cir. 1965) . .(reorganization treatment denied under preconceived sale of assets where business operations had been suspended during the interim period). The reported cases in this area may be viewed as having turned on the specific facts in each case.
The COBE rule requires that there be a continuity of business activity of the historic business of the acquired entity. The regulations provide that in order to meet the COBE requirement, in general, the acquiring corporation must: (i) continue the target corporation’s historic business; or (ii)) continue the use of a “significant portion” of the target corporation’s historic business assets in a business. Logically the regulations state that the fact that the acquiring corporation is engaged in the same line of business as the target corporation should result in a finding that COBE is present. Where the target had been engaged in more than one business, COBE requires that the target only continue a significant line of its business. Another rule provides that the acquiring corporation may continue the “historic business” of the target which is the business most recently conducted.
While the COBE requirements applies to the various species of tax-free reorganizations, for insolvency (Type G) reorganizations, the COBE requirement may present a greater obstacle particularly where the historic business operations of the debtor-reorganized corporation have been substantially reduced in size of operation. Examples are contained in the regulations applying these principles.
Regulations adopted in 1998, liberalized the COBE requirements by permitting post-reorganization asset drop-downs to controlled subsidiaries or even partnership if certain conditions are met. Numerous examples are contained in the regulations. Additional changes to the COBE regulations were promulgated in 2007.
Another COBE rule is contained in section 382(c) pertaining to the portability of net operating losses in particular ownership change and equity structure shift events.
Against this backdrop in PLR 201015024 (4/16/2010) the National Office of the IRS ruled that using historic business assets to conduct research and development activities in order to perfect and protect patent rights satisfied the continuity of business enterprise (COBE) test.
The taxpayer-corporation seeking the ruling was had engaged in research and development activities in years one to three for one aspect of “Business A”. It applied for and/or received patents for this new technology; created a product based on this new technology; and brought this product to the commercial market. In year two an “ownership change” occurred per §382(g). The §382(c) 2 year testing period for COBE or the “COBE Period) began on Date A and ended on Date B. In year 3 Competitor A (as it was referred to in the ruling), an established company in the same line of business as Taxpayer), engaged in vigorous action to compete with the taxpayer’s commercial marketing of its product. Within the 2 year COBE Period, on Date C, as a result of the competition of Competitor A, taxpayer sold part of its business relating to the commercial marketing of its product to Acquiring-1. The taxpayer, however, retained all or part of its R&D department, its patents and patent applications and law suits or potential lawsuits against Competitor A for patent infringement and antitrust violations. In year 4, after the end of the COBE Period. Pm Date D. the taxpayer sold its R&D activities to Acquiring 2 for potential future payments. In year 5 the taxpayer received a payment from Competitor A in settlement of the patent infringement and antitrust lawsuits and for the right to the future use of Taxpayer's patents. The amount of the settlement payment was substantially more than the funds previously received by taxpayer for the part of its business it sold in year 2.
In addition to certain other representations made by the taxpayer as set forth in the ruling request and recited in the ruling, the Service ruled:
1. Taxpayer’s activities after the asset sale in developing and perfecting new technology; in applying for and/or perfecting patents; and negotiating with and litigating against Competitor A with regard to its business and patents and with regard to the patent infringement and antitrust lawsuits constitute the use of “historic business assets” by Taxpayer. See Treas. Reg. §1.368-1(d)(3)(ii).
2. The “historic business assets” with regard to which Taxpayer received the large settlement payment constitutes a “significant portion” of Taxpayer's pre–asset sale historic business assets.
3. Taxpayer's use of its “historic business assets” from DateC until the DateB end of the 2–year COBE Period constitutes a continued business use by Taxpayer of a significant portion of its historic business assets sufficient to meet the continuity of business enterprise requirement in Treas. Reg. § 1.368-1(d) and, accordingly, the DateC asset sale does not bring into effect the § 382(c) carryforward limitation (2 year COBE period).
As various corporate tax jocks would say, “what a ruling” this one is (and favorable at that). Note §6110(k)(3)’s warning: “Unless the Secretary otherwise establishes by regulations, a written determination [e.g., private letter ruling] may not be used or cited as precedent. The preceding sentence shall not apply to change the precedential status (if any) of written determinations with regard to taxes imposed by subtitle D of this title.”
