Assessing the value of the proposed "no net value" regulations

Tax Executive, The, May-June, 2005 by Mark J. Silverman, Lisa M. Zarlenga, Gregory N. Kidder

1. Overview

On March 10, 2005, the Internal Revenue Service and the U.S. Department of the Treasury issued proposed regulations governing the treatment of nonrecognition transactions involving insolvent companies--perhaps the most significant guidance in the area in a quarter century. The proposed regulations do two things: (1) establish a uniform "net value" requirement for nonrecognition treatment of section 351 (1) contributions, section 332 liquidations, and section 368 reorganizations (the "no net value" regulations); and (2) clarify the circumstances in which creditors will be treated as holding proprietary interests in target corporations for purposes of satisfying the continuity of interest (COI) requirement for reorganizations under section 368 (the "creditor continuity" regulations).

First, the proposed regulations establish that a transaction must involve an exchange (or distribution) of "net value" in order to qualify for nonrecognition treatment as a section 351 contribution, a section 332 liquidation, or a section 368 reorganization. For nonrecognition treatment under section 332, current law is clear that shareholders must receive at least some value in their capacity as shareholders. The proposed regulations codify existing authority and clarify that in order to qualify as a section 332 liquidation, the shareholder must receive some payment with respect to each class of stock in the liquidating subsidiary. Current law is less clear with respect to other nonrecognition transactions involving insolvent corporations. The proposed regulations extend the net value requirement applicable to section 332 liquidations to section 351 incorporations and section 368 reorganizations.

Second, with respect to reorganizations under section 368, the proposed regulations clarify when a creditor may be treated as holding a proprietary interest for purposes of determining whether the COI requirement is satisfied. The regulations generally adopt the approach taken by current law, but relax the rules to enable creditors more easily to be treated as holding proprietary interests and transactions to more easily satisfy COI.

This article reviews the authority that currently governs nonrecognition transactions involving insolvent corporations and the new rules under the proposed regulations. In general, the proposed regulations clarify the requirements for certain transactions to qualify for nonrecognition treatment. Unfortunately, in doing so, the proposed regulations reject certain principles of Norman Scott, Inc. v. Commissioner (2) and also deny a parent corporation the ability to convert its creditor position to equity in order to qualify as a liquidation under section 332. The regulations also leave many questions unanswered. The preamble specifically states that the IRS and Treasury are still considering the best approach to valuing liabilities and are continuing to study whether the net value requirement should be applied to acquisitive D reorganizations. The preamble also leaves open questions of how nonrecourse liabilities will be treated for purposes of the net value requirement and whether a similar net value requirement should be established with respect to contributions to a partnership (the proposed regulations only apply to contributions to a corporation).

One thing that is certain about the proposed regulations is that they continue the tendency of recent guidance to place an increased emphasis on valuations. The proposed regulations rely on comparisons of the fair market value of assets to outstanding liabilities and therefore necessarily depend on valuations of those assets and liabilities. In this way, the proposed regulations create further challenges for taxpayers.

II. The Proposed "No Net Value" Regulations

A. In General

The proposed regulations adopt a uniform "net value" requirement applicable to section 351 contributions, section 332 liquidations, and reorganizations under section 368. (3) In general, the proposed regulations establish that property with a net value must be exchanged in these transactions (or distributed in the case of a section 332 liquidation). The preamble states that the IRS and Treasury believe a uniform standard is proper because transfers of property in exchange for the assumption of liabilities or in satisfaction of liabilities are akin to taxable sales and should not be treated as nonrecognition transactions. (4) The IRS and Treasury also point to specific provisions providing for nonrecognition treatment, which all use the word "exchange," in support of the net value requirement: (5)

* Section 351(a) states "[n]o gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control of the corporation."

* Section 354(a) states "[n]o gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of a plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization."