Federal Taxation Developments Blog : Federal Taxation Lawyer & Attorney : Fox Rothschild Law Firm : Federal Income Taxation & Tax Litigation

Section 304 provides provides generally that, for purposes of §§302 and 303, if one or more persons are in control of each of two corporations and one such corporation (the “acquiring corporation”) acquires in exchange for property stock of the other corporation (the “issuing corporation”) from the person (or persons) so in control, then, unless §304(a)(2) applies, the property is treated as received in redemption of the stock of the acquiring corporation. 

Section 304(a)(2) provides generally that, for purposes of §§302 and 303, if in exchange for property the acquiring corporation acquires stock of the issuing corporation from a shareholder of the issuing corporation and the issuing corporation controls the acquiring corporation, then the shareholder shall be treated as receiving the property in redemption of the stock of the issuing corporation.

“Control” for purposes of §304 means the ownership of stock possessing at least 50% of the total combined voting power of all classes of voting stock or at least 50% of the total value of shares of all classes of stock. With certain modifications, the constructive ownership rules of §318 are applied.

Under section 304(b)(2), the determination of the amount of the property distribution that is a dividend (and the source thereof) is made as if the property were distributed by the acquiring corporation to the extent of its earnings and profits, and then by the issuing corporation to the extent of its earnings and profits. If the acquiring corporation is foreign, §304(b)(5) limits the amount of earnings and profits of the acquiring corporation that are taken into account for this purpose.  

Where  and to the extent that the dividend is sourced from the E&P of the acquiring corporation, the transferor is considered to receive the dividend directly from the acquiring corporation;this outcome has been referred to by tax practitioners as “hopscotching” because the dividend bypasses any intermediary shareholders.

Special rules apply if the acquiring corporation is foreign under §304(b)(5). For purposes of determining the amount of the dividend to the transferor, the foreign acquiring corporation's E&P  that is required to be taken into account is limited to the portion of such E&P that: (i) is attributable to stock of the foreign acquiring corporation held by a corporation or individual who is the transferor (or a person related thereto) of the target corporation and who is a U.S. shareholder per §951(b) of the foreign acquiring corporation and (ii) was accumulated while such stock was owned by the transferor (or a person related thereto) and while the foreign acquiring corporation was a controlled foreign corporation (“CFC”).

Where the redemption treated as a dividend is made with respect to stock held by a non-U.S. person, 30% withholding under §1441 is generally required on the dividend unless and to the extent that a treaty is applicable and provides for a lower rate of withholding.

Revision to Section 304.

Under the recent revision to §304 made in the Medicaid Assistance bill, an additional limitation on the E&P of a foreign acquiring corporation is taken into account in determining the amount (and source) of the distribution that is treated as a dividend. In particular, where more than 50% of the dividends arising from acquisition would (without taking into account the provision) not be: (i) subject to U.S. tax in the year in which the dividend arises, or (ii) includible in the E&P of a CFC per §957 (but without taking into account §953(c)),  the E&P of the foreign acquiring corporation is not taken into account for this purpose. The new special rule generally applies if more than 50%  of the target corporation is acquired from a foreign corporation which is not a controlled foreign corporation.

Where the special rule applies, none of the foreign acquiring corporation's E&P is taken into account. In such case, the only E&P that is taken into account to determine the amount constituting a dividend is the target corporation's E&P. The provision is aimed to prevent the foreign acquiring corporation's E&P from permanently escaping U.S. taxation by being deemed to be distributed directly to a foreign person (i.e., the transferor) without “hopschotching” over” an intermediate distribution to a domestic corporation in the chain of ownership between the acquiring corporation and the transferor corporation. Generally, if the transferor is a foreign corporation (and not a CFC) and the acquiring corporation is a CFC, it is not relevant whether the target corporation is a domestic or a foreign corporation. However, if the target is a U.S. corporation, the 30-percent gross basis withholding tax applies to the amount constituting a dividend from the target, unless reduced or eliminated by treaty. See §1442. Regulations are to provide rules to prevent circumvention of the provision through the use of partnerships, options, or other arrangements to cause a foreign corporation to be treated as a CFC.

The revision applies to redemptions occurring after the date of enactment (8/10/2010).

Temporary Regulations setting forth anti-abuse rules to §304 were issued last year. See Treas. Reg. §1.304-4T.

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In Field Service Advisory 2011110F, issued by Chief Counsel’s Office on March 18, 2011, the Service stated that  §197(f)(1) prohibits a worthless amortization deduction for a §197 intangible, in this case an automobile franchise contract, that was terminated by the manufacturer. Section 197(f)(1) prohibits a deductions for worthless §197 intangibles, including goodwill, where other amortizable §197 intangibles purchase as part of the same transaction remain in place. The amount of such worthless amortizable §197 intangible is included in the basis of the remaining §197 intangibles.

Under the facts of the FSA, a automobile dealership was granted a sales and services franchise under a franchise agreement. Then the dealership purchased certain assets of another auto dealer including the amount of $39x for goodwill related to such franchise rights (sales and servicing) for a particular make of automobile. The automobile dealer alleged that $4x of the amount was allocated to goodwill for the franchise agreement but such allocation was not contained in the agreement. Later, the automobile dealer was notified that the manufacturer was terminating its franchise to sell certain products and the sales franchise as well. The automobile dealer was paid 1.8% of $39x in consideration for the terminations as well as for certain releases, waivers and transfer to manufacturer of the dealership’s customer lists and service records. Thus, the automobile dealer claimed that the goodwill associated with the franchise rights became worthless.  

Section 197(a), which was enacted into the Code in 1993, permits a taxpayer to amortize an amortizable §197 intangible asset, generally acquired by purchase after August 11, 1993, ratably over a 15 year period regardless of the assets’ MACRS period or useful life. See Frontier Chevrolet Co. v. Comm’r, 329 F.3d 1131, 1135 (9^th Cir. 2003). In general, a §197 intangible includes goodwill and any franchise, trademark or trade name. See also §1253(b). Certain self-created intangibles are excluded from the definition of “an amortizable § 197 intangible”.

Under §1253(b)(1), a franchise includes an agreement that gives one of the parties the right to distribute, sell, or provide goods, services, or facilities within a specified area. Where there is a disposition of any §197 intangible or any such intangible becomes worthless, §197(f)(1) provides that in such instance were any one or more amortizable §197 assets acquired in such transaction or series of related transactions are retained: (i) no loss may be recognized, and (ii) appropriate basis adjustments must be made to the retained intangibles. See Treas. Reg. § 1.197-2(g)(1). The abandonment of an amortizable §197 intangible, or any other event rendering an amortizable §197 intangible worthless, is treated as a disposition of the intangible per §197(f)(1) and Treas. Reg. § 1.197-2(g)(1). See Treas. Reg. § 1.197-2(g)(1)(i)(B).

The taxpayer-automobile dealer contended that it was entitled to deduct the claimed amount of worthless goodwill based on two arguments. First that the asset purchase agreement separately stated a goodwill value for one of the franchises purchased and which one later became worthless. The Service felt that the evidence did not support this argument and that even if goodwill was separately stated for each franchise,  §197(f)(1) still applies, as all of the goodwill was acquired in a single transaction or series of related transactions.

The automobile dealer further argued that §197(f)(1) does not apply to its special situation and that the “spirit” of  §197(f)(1)(A)(i) did not contemplate automobile franchises.The Service found no indication in either the Code or the legislative history to §197 to support this thought or notion that automobile franchises were exempt from application of §197(f)(1).

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In PLR 201109003 (3/04/2011) the Service ruled, under the facts set forth in the request,  that the proposed issuance of two classes of stock by a corporation which intended to meet the requirements of a real estate investment trust (REIT) would not cause distributions to stockholders to be treated as “preferential dividends” under Section 562(c) or otherwise jeopardize the corporation’s qualification as a REIT.

A REIT and its shareholders are taxed in accordance with Sections 856-859 provided certain requirements are met. A REIT, generally organized as a corporation, trust or association,  generally results in federal income taxes being imposed on a current basis to its members through the form of dividend distributions. 

The general requirements of a REIT per Section 856(a) are: (i) the organization must be managed by one or more trustees or directors; (ii) beneficial ownership in the organization must be represented by transferable shares or certificates; (iii) the organization generally must be taxable as a domestic corporation ; (iv) the organization must be neither a financial institution per Section 582(c)(5) nor an insurance company subject to the provisions of Subchapter L; (v) the organization must be beneficially owned by at least 100 persons during a minimum of 335 days in a taxable year of twelve months (or during a proportionate part of a taxable year of less than twelve months); and (vi) the organization must not be closely held per Section 542(a)(2). Substantial amendments were made to the REIT provisions in 2004 which expanded the types of securities which will constitute “straight debt” for purposes of apply the 10% single issuer limitation in Section 856(m) as well as adding safe harbor rules for determining whether rents from a taxable REIT subsidiary are comparable to unrelated party rents. See Section 856(d)(8)(A).

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Back to the ruling. Under Section 857(a)(1) , a REIT's dividends-paid deduction must equal or exceed 90% of its REIT taxable income. For purposes of Section 561(a) , the deduction for dividends paid includes dividends paid during the tax year. A distribution is not qualified dividend if it is “preferential” in nature. Thus, under Section 562(c), a dividend for REIT deductibility purposes can not: (i) prefer any shares of stock in a class over other shares of stock within the same class; or (ii) prefer one class of stock over another (except to the extent that such a class is entitled to a preference).

In Rev Proc 99-40, 1999-2 CB 565 , the Service rule that in certain instances distributions made by a  regulated investment company (RIC) to its shareholders in varying amounts may still be deductible as dividends under Section 562. Where the varying distributions to different groups of shareholders differ on account of expense allocations relating to shareholder services, the distribution of shares, allocation of the benefit of a waiver or reimbursement of a fee, or variations resulting from the allocation of performance-based advisory fees,  will not be treated as nondeductible preferential dividends so long as such expenses are allocated to the group of shares for which the expenses were incurred and certain other requirements are met.

Under the facts of PLR 201109003 the taxpayer-corporation (intending to qualify as a REIT) . intends, through its operating partnership, to invest primarily in a diversified portfolio of commercial real estate properties located in major metropolitan markets and other real estate-related assets. Taxpayer's shares of common stock will not be publicly traded but liquidity for shares would be realized under a redemption plan. The plan would generally allow stockholders to request on a daily basis that Taxpayer redeem their shares at the net asset value (“NAV”) per share. Taxpayer's shares will be distributed a broker-dealer that will form a syndicate of participating broker-dealers to offer and sell the shares to the public.

Ttraditional non-listed REITs have been criticized for up front costs which will be avoided in this case through a reduced commission at closing but will pay dealer manager fees based on net asset value and a distribution fee.  In preliminary discussions with potential broker-dealers, Taxpayer was informed that its shares will not be attractive to investors with wrap accounts or registered investment advisors (RIAs) where investors pay their financial advisors an asset-based fee as an alternative to paying additional transaction fees. Specifically, although Taxpayer's selling commission could be waived for such investors, they would still bear a second level of distribution charges if Taxpayer charges a distribution fee with respect to such investors. So, to attract investors the Taxpayer proposed to issue: (i) one class of common stock that will be subject to the selling commission and annual distribution fee; and (ii) for investors with wrap accounts or RIAs, a class of common stock that will not be subject to any selling commission or allocation of the distribution fee. After shares are purchased, Taxpayer will pay certain quarterly and annual fees which are accrued on a daily basis for purposes of NAV calculation.

Taxpayer filed its registration statement on Form S-11 to register its shares of common stock to be offered to the public. Taxpayer now intends to amend its registration statement before its public offering to provide for two classes of common stock. The various fees Taxpayer proposes to charge for each class are as follows: (i) an advisory fee payable by Taxpayer to advisor for implementing Taxpayer's investment strategy and managing its day-to-day operations which will be charged at the same rate for each class of stock; (ii) a dealer manager fee, charged at the same rate for each class, paid in consideration of the distribution, marketing and stockholder services the Dealer Manager provides to Taxpayer in connection with the continuous offerings; (iii) a distribution fee, charged only to one class of stockholders, that will be entirely reallowed to participating broker-dealers selling such shares. This fee compensates those broker-dealers for their distribution services related to the shares.

Conclusion.

The PLR concluded that under the facts involved the  issuance of the two classes of shares won't: (i) cause the dividends paid by Taxpayer with respect to those shares to be preferential dividends under Section 562(c) ; or (ii) cause Taxpayer to fail to qualify as a REIT.

The Service  determined that, although Taxpayer didn't technically fall within the scope of Rev Proc 99-40 , sufficient common ground exists between REITs and RICs warranting similar treatment. Thus, the dual class structure the Service found was consistent with RIC requirements under Rev. Proc. 99-40 and therefore qualified for favorable treatment. The Service found significant the provision that the Taxpayer is subject to a continuous “merit review” process intended to ensure that the stockholders are treated fairly, in addition to many SEC, state, and other restrictions and regulations with respect to its stock offerings, its operations, and the rights of its stockholders.

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Now we can add Program Manager’s Technical Advice or “PMTA” to the list of administrative projects on tax matters that are open to FOIA and review by the tax practitioner community. One area that needs some help are investors in tenancy-in-common programs. On May 15, 2010, the Service issue PMTA 2010-05 which provides an legal analysis from Chief Counsel’s office directed to IRS program managers in the field. In addressing a bankruptcy in which TIC investors were involved, the PMTA concluded : (i) the short-term pooling of funds by TIC owners with a payment agent does not result in a partnership even if provided in a non-pro rata format; and (ii) the appointment of a communications agent by TIC owners to facilitate communication between the TIC owners and their counsel does not result in a partnership.

The  PMTA addressed a TIC offering in which A, the hypothetical TIC sponsor, or an affiliate of A, purchased rental property and then sold TIC interests in the property to TIC individual investors to complete section 1031 exchanges. The purchase price paid was (i) the amount of cash funded by a prior section 1031 exchange and (ii) the assumption of debt encumbering the property. The total number of investors (including the A affiliate) did not exceed 35 in any single property.

At the same time as the purchase of the TIC interests, the TIC owners leased the Property to a master tenant (an affiliate of A) under a master law. The TIC owners further entered into a TIC Agreement which contained the requirements for an (favorable) advance ruling under Rev. Proc. 2002-22. The Agreement required the TIC owners to share all revenues and fund all expenses related to the Property pro rata in proportion to their relative percentage TIC interests.

Under the facts, A and several of its affiliates owning the Property filed petitions for bankruptcy and as a direct result, the TIC owners undertook the following actions to protect their respective interests in the Property: (i) the TIC owners raised funds (initially on a non-pro rata basis) to pay legal fees and costs of the bankruptcy and make debt service payments on the Property; (ii) intended to file for reimbursements of such funds, costs and debt service payments in relation to their percentage TIC interests; (iii) one TIC owner was designated as a payment agent to collect funds and make required disbursements; and (iv) designated a point person for working with the various parties involved in the bankruptcy. The PMTA stated  indicates that in most cases, the TIC owners equalized the non-pro-rata pooling of funds in an amount of time in a “reasonable amount of time.”

The issue was whether the temporary pooling of funds on a non-pro rata basis and the appointment of the payment agent and communications agent, caused by the bankruptcy converted the TIC owners to become partners in a de facto partnership for federal income tax purposes. The PMTA concluded that the actions taken did not cause the TIC owners to become partners for federal income tax purposes.

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