IRS Proposes Safe Harbors For Determining Basis In 'B' Reorganization Stock Acquisitions.

Part III -- Administrative, Procedural, and Miscellaneous

I. Purpose

The Internal Revenue Service (IRS) is studying various issues that have arisen in connection with the determination of basis in stock that is acquired in reorganizations described in section 368(a)(1)(B) of the Internal Revenue Code and other transferred basis transactions. The IRS intends to issue further guidance on the determination of such basis. This Notice sets forth the substance of the guidance that the IRS currently contemplates issuing and requests comments on the administrability, accuracy, and appropriateness of such guidance.

II. Background

Section 368(a)(1)(B) of the Code provides that the term reorganization includes the acquisition by one corporation (Acquiring) of stock of another corporation (Target) solely in exchange for part or all of the voting stock of either Acquiring or its parent, provided that Acquiring has control of Target immediately after the acquisition (a B reorganization). Under section 362(b), Acquiring's basis in each share of Target stock acquired in the reorganization is determined with reference to the basis of the share in the hands of the transferor shareholder immediately before the reorganization. Section 362(a) provides similar treatment for Target stock received in a section 351 exchange.

Section 1.368-3 of the Income Tax Regulations requires each significant holder and each corporate party to a reorganization to provide certain essential information regarding the reorganization, including the basis of the transferred property, in a statement on or with its return for the year of the reorganization. In general, a significant holder is any shareholder that owns five percent (by vote or value) of a publicly traded corporation or one percent (by vote or value) of a non-publicly traded corporation. Section 1.351-3 of the regulations imposes similar reporting requirements on significant transferors and transferee corporations in section 351 exchanges. In general, a significant transferor is any transferor that owns five percent (by vote or value) of a publicly traded corporation or one percent (by vote or value) of a non-publicly traded corporation immediately after the section 351 exchange.

By 1981, the IRS had identified two significant problems encountered by taxpayers in attempting to establish basis in Target stock acquired in a B reorganization. One was that the acquisition of basis information from shareholders surrendering stock of widely held corporations was time consuming, burdensome, and costly. The other was that not all surrendering shareholders were responding to requests for basis information. To facilitate the determination of basis in these cases, the IRS published Rev. Proc. 81-70, 1981-2 C.B. 729, which set forth general guidelines for surveying surrendering shareholders to determine the basis of Target stock acquired in B reorganizations and provided sampling and estimation procedures to address administrative burdens and shareholder nonresponsiveness.

At the time that Rev. Proc. 81-70 was published, most stock was registered stock, that is, the name of the beneficial owner of the stock was recorded by the issuing corporation's stock transfer agent on its books. However, market practices have changed substantially since the publication of Rev. Proc. 81-70. Today, stock of public companies is primarily held in street name, that is, the stock is held by a nominee (typically a clearinghouse or other financial institution holding stock on behalf of their members or customers) and the transfer agent's books list the nominee as the owner of the stock. Often there are several tiers of nominee owners, each subject to confidentiality and other constraints that could bar the release of information. As a result, the identification of the beneficial owners of large portions of public companies, and thus their bases in those interests, is often difficult or impossible to discover. To address this problem, many taxpayers have developed complicated modeling techniques intended to establish Acquiring's allowable basis in shares acquired in a B reorganization.

There is an additional concern that the information necessary to identify the nominee holders dissipates fairly quickly. In particular, the securities positions reports of depositories and clearinghouses, the most reliable means for identifying such holdings, are generally only maintained by the depository or clearinghouse for five to seven years. Thus, unless such information is secured within that time, the identification of nominee holders will be difficult if not impossible if a basis study subsequently becomes necessary. Accordingly, any model adopted to determine basis in nominee held shares must take that concern into account.

The IRS has been studying the issues raised by nominee stock holdings. As part of that study, the IRS issued Notice 2004-44, 2004-2 C.B. 32, requesting comments on both the difficulties encountered in applying, and the need for modification of, the guidelines set forth in Rev. Proc. 81-70. Written and oral comments were received from a number of sources, including taxpayers, practitioners, and IRS examination teams. Based on these comments, the IRS has concluded that the guidelines of Rev. Proc. 81-70 must be expanded to address the issues presented by nominee stock holdings. In addition, the IRS has concluded that basis determinations should be facilitated for small stock holdings and intends to adopt rules that simplify basis determination in such cases.

The IRS recognizes that the difficulties in establishing basis in Target stock acquired in B reorganizations can be presented whenever a corporation acquires Target stock in a transaction in which the acquiring corporation's basis in the acquired stock is determined with reference to the transferring shareholder's basis (transferred basis transaction). In addition to B reorganizations, transferred basis transactions include section 351 exchanges (see section 362(a), which provides that the transferee corporation's basis in property received is determined with reference to the transferor's basis in the property). Transferred basis transactions also include reverse triangular mergers that qualify as either a section 351 exchange or a B reorganization if Acquiring elects to determine basis in acquired property under the provisions of section 362(b) (as permitted by § 1.368-6(c)(2)(ii). Certain triangular reorganizations involving foreign corporations may also be transferred basis transactions. See § 1.367(b)-13. Accordingly, the IRS has concluded that any further guidance in this area will apply not only to B reorganizations, but to all transferred basis transactions in which Target stock is acquired.

III. The Proposed Guidance: an Expansion of Rev. Proc. 81-70

As noted above, the concerns expressed regarding the determination of basis following a B reorganization are present, at least to some extent, in any transferred basis transaction. Therefore, the provisions of Expanded Rev. Proc. 81-70 will apply to all transferred basis transactions.

To address those concerns, and to simplify the determination of basis for small stock holdings, Expanded Rev. Proc. 81-70 will include several "safe harbor" provisions. Each safe harbor will apply to a specified group of surrendering shareholders and will prescribe a methodology that can be used to determine those shareholders' bases in surrendered stock. An acquiring corporation may use one or more of the safe harbors; Expanded Rev. Proc. 81-70 will not require the use of all the safe harbors.

The principal provisions of Expanded Rev. Proc. 81-70 are described in more detail in the following sections, beginning with generally applicable provisions in Section III.B of this Notice.

The safe harbor provisions are described in Section III.C (describing a survey method applicable to shares acquired from "reporting shareholders"), Section III.D (describing a certificate method applicable to shares acquired from "registered, non-reporting shareholders"), and Section III.E (describing a basis modeling method applicable to shares acquired from "nominee, non-reporting shareholders").

Section III.F modifies the reporting requirements under §§ 1.351-3 and 1.368-3 to take into account the time needed to complete a basis determination following a transferred basis transaction subject to Expanded Rev. Proc. 81-70.

Section III.G provides a safe harbor for taxpayers using a methodology prescribed in Expanded Rev. Proc. 81-70 and states that the IRS will not assert a different basis determination methodology if a taxpayer complies with the provisions of Expanded Rev. Proc. 81-70.

Section III.H expands the issues that may be the subject of a pre-filing agreement to include basis studies completed in accordance with the terms of Expanded Rev. Proc. 81-70.

Finally, Section III.I provides that Rev. Proc. 81-70 will be obsoleted, subject to a transition rule, when Expanded Rev. Proc. 81-70 is issued.

For purposes of Expanded Rev. Proc. 81-70, a determination of basis will be considered timely if it is completed within two years of the later of the date of the transferred basis transaction and the date that Expanded Rev. Proc. 81-70 becomes effective. In addition, a previously completed basis determination will be considered timely if made compliant with the provisions of Expanded Rev. Proc. 81-70 within two years of the date that Expanded Rev. Proc. 81-70 becomes effective.

For purposes of Expanded Rev. Proc. 81-70, an estimate of basis will be considered to have been done diligently if Acquiring made every reasonable effort to obtain best evidence and, to the extent it was unable to obtain such evidence, can demonstrate that the evidence or basis information could not have been reasonably obtained. The fact that the IRS could, or does, obtain basis information using methods not available to Acquiring does not prevent a determination that Acquiring was diligent in its estimate of basis. Further, Acquiring must have made every reasonable effort to identify and adjust for surrendered shares with low bases (relative to Target's average historical trading price) and for surrendered shares with bases lower than the bases of shares bought and sold under normal market conditions. Circumstances in which this can occur include those in which shares are (1) held by investors with a transferred basis, (2) exchanged for convertible stock or debt, or (3) exchanged for debt or other property, as in bankruptcy reorganizations.

The provisions of each safe harbor specify the evidence that should be used for the safe harbor. However, all basis determinations are to be based on best evidence and the determination of the source that is the best evidence is made as of the date of the transferred basis transaction. If a basis determination is not made timely and basis information is lost, missing, or disposed of (e.g., pursuant to the Target's, clearinghouse's or financial institution's record retention policy), and such information could have been obtained if Acquiring had sought it on or shortly after the date of the transaction, Acquiring will not satisfy the best evidence requirement.

In any case in which best evidence is not used, the IRS, in its discretion, may nevertheless accept such evidence, subject to appropriate adjustments to reflect the diminished credibility of the evidence used.

Notwithstanding any safe harbor prescribed in Expanded Rev. Proc. 81-70, if Acquiring has or acquires actual knowledge of a surrendering shareholder's actual basis in a share of surrendered Target stock, Acquiring's allowable basis in the share is equal to that surrendering shareholder's basis. Further, if the examining team has or obtains knowledge of a surrendering shareholder's actual basis in surrendered Target stock, Acquiring's allowable basis in that share is the basis identified by the examining team, even if the basis determined by Acquiring differs from that identified by the examining team. Where the basis of a share is known, any estimated or modeled basis amount must be adjusted to eliminate any basis amount attributable to such share.

To identify reporting shareholders, Target's books and records, the Master Securityholder Files maintained by the stock transfer agent, and Securities Exchange Commission (SEC) filings, including Schedule 13 series data, may be used.

In general, a survey must be done in accordance with the guidelines set forth in Rev. Proc. 81-70. Thus:

However, under this safe harbor, if Acquiring does not survey a reporting shareholder, estimation may not be used and the basis of the shares acquired from such shareholder will be deemed to be zero.

To determine basis under this certificate method, Acquiring must obtain or access Target's books and records and, using those books and records, identify all outstanding certificated shares that were surrendered by or on behalf of non-reporting shareholders and the dates that all such shares were issued. Using both public and private stock exchange trading data, Acquiring must then determine the average trading price of the Target shares on the date each certificate was issued. Subject to the limitations described below, Acquiring may treat the basis of each such share as equal to the average trading price on its issuance date.

Notwithstanding the general rule of this safe harbor, if there has been an extraordinary issuance or event, appropriate adjustment must be made to the basis otherwise determined under this safe harbor. For this purpose, an extraordinary issuance or event is any issuance or event that could have caused the basis of a share to be materially different from the average trading price on its issuance date, including but not limited to the following --

Modeled basis is determined separately for each series of shares and is done in accordance with the following:

For purposes of this rule, Target's pre-SPR Public Offering aggregate basis is the excess of Target's "public offering basis" over Target's "redeemed share basis." Target's "public offering basis" is equal to the number of shares offered in the IPO multiplied by the lesser of the offering price and the fair market value of shares issued in the offering, plus the amount so computed for each subsequent public offering before the first SPR date (specifically, the number of shares issued in an offering multiplied by the lesser of the offering price and the fair market value of the shares issued in the offering). Target's redeemed share basis is the sum of the bases of all shares redeemed by Target prior to the first SPR date, treating each redeemed share as having been issued in the public offering immediately preceding the redemption of the share.

A share's allocable portion of Target's pre-SPR Public Offering aggregate basis is determined by allocating Target's pre-SPR Public Offering aggregate basis equally among all shares outstanding as of the first SPR date, other than shares that were privately placed.

Nominee holdings are then compared to nominee holdings at each next successive measuring date to determine the extent to which there are previously unidentified nominee holdings and changes in previously identified nominee holdings. New and increased holdings are treated as purchases, and decreased holdings are treated as sales, of Target stock. Sales are treated as being made either on the first-in, first-out ("FIFO"), the last-in, first-out ("LIFO"), or the average cost ("ACO") method. Acquiring must identify and adopt the single method that best predicts estimated basis across all investors, which will generally be LIFO, FIFO or ACO basis whichever is lower. As of the end of each measuring date, each nominee's holdings are deemed to have a basis equal to its basis on the immediately preceding measuring date, increased to reflect the deemed cost basis of any purchased stock, or decreased to reflect a deemed sale of any stock, as appropriate.

IV. Interim Use of Safe Harbor Methodologies

Prior to the issuance of Expanded Rev. Proc. 81-70, whether in the form described in this Notice or otherwise, taxpayers may use the methodologies of any safe harbor described in this Notice (taking into account those provisions generally applicable to all of the safe harbors) to determine the basis of Target stock acquired in any transferred basis transaction that occurs prior to the publication of Expanded Rev. Proc. 81-70. In such cases, the timeliness requirement will be deemed satisfied if the study is completed within two years of the later of the date of the transferred basis transaction and January 12, 2009. The IRS will not assert an alternative methodology against a taxpayer that determines basis in accordance with these proposed guidelines.

V. Request for Comments

The IRS requests comments regarding whether the approaches described in this Notice should be adopted and to what extent, if any, the approaches should be further combined or modified to produce a set of rules that is both administrable and reflective of statutory intent. The IRS is particularly interested in comments regarding whether a simpler methodology, such as one that would determine the basis of all surrendered shares by using a weighted average trading price, would be helpful to taxpayers and appropriate for the tax system. The IRS also specifically requests comments regarding the determination of basis in atypical transferred basis transactions, such as acquisitions in bankruptcy reorganizations, acquisitions involving foreign transfer agents, and acquisitions involving foreign corporations that may be subject to the rules of § 1.367(b)-13.

Comments should refer to Notice 2009-4 and should be submitted to:

All comments will be available for public inspection and copying.

VIII. DRAFTING INFORMATION

The principal authors of this Notice are George Johnson of the Office of Associate Chief Counsel (Corporate) and Ed Cohen of LMSB. For further information regarding this Notice generally, contact Mr. Johnson at (202) 622-7930 (not a toll-free number). For further information about estimation techniques described in this Notice, contact Edward Cohen at (212) 719-6693 (not a toll-free number).