taxes it would owe but for the use of the parent's losses. Thus, earnings and profits are available in the subsidiary to support “dividend" treatment of distributions on the preferred stock. Possible Proposals 1. Deny the use of loss carryovers to offset income used to pay dividends on certain preferred stock-for example, stock that is issued to outside investors and that is not counted for purposes of determining whether there has been an ownership change or that is not counted for purposes of determining whether the corporations may file consolidated returns. 2. Require nonvoting preferred stock to be counted for purposes of determining whether more than 50 percent of the value of the company has been acquired if this would trigger the loss limitations of section 382 of the Code. 3. If a loss corporation is affiliated with another corporation that issues nonvoting preferred stock, do not permit consolidation of the losses unless the nonvoting preferred stock is counted for consolidation purposes (e.g., if the loss company is the parent, it must own 80 percent of the nonvoting preferred stock of the subsidiary). Alternatively, either require separate return treatment of the income used to pay dividends on the nonvoting preferred stock or reduce the earnings and profits of the profitable company by an amount equal to the taxes it would have owed without the affiliate's losses. Argument for the proposals Pros and Cons Corporations with loss carryovers should not be able to sell those losses without limitation to new investors through the use of nonvoting preferred stock. To the extent the net operating loss limitations are intended to prevent new owners from using prior corporate losses to offset a return on the new investor's new capital, the rules are not fully effective under the present law approach to nonvoting preferred stock. Furthermore, the tax system should not provide a double benefit to new investors by permitting both the use of a prior net operating loss and the dividends received deduction. Argument against the proposals The existing transferability of losses through the use of preferred stock assists loss corporations in raising capital. Loss companies should not be disadvantaged if they issue preferred stock rather than debt. h. Limitations on net operating loss carryforwards of corporation following worthless securities deduction by shareholders Present Law A deduction is allowed for any loss sustained during the taxable year as a result of securities held by the taxpayer becoming worthless. It has been held that, notwithstanding the fact that a worthless stock deduction has been claimed by parent corporation with respect to stock of a nonconsolidated subsidiary, the net operating loss carryforwards of the subsidiary survive and may be used to offset future income of the subsidiary. Textron, Inc. v. United States, 561 F.2d 1023 (1st Cir. 1977). In Textron, the parent provided a portion of the funds used by the subsidiary to acquire the business responsible for generating this income. Use of a subsidiary's losses following a worthless securities deduction has been denied to the parent corporation, however, where its nonconsolidated subsidiary was subsequently liquidated into the parent in a section 332 liquidation. Marwais Steel Co. v. Commissioner, 354 F.2d 997 (9th Cir. 1965), aff'g 38 T.C. 633 (1962). The court in Marwais Steel reasoned that to allow the parent to use the subsidiary's losses would permit it to claim two deductions for a single economic loss. Loss carryforwards of a corporation are limited if there is a more-than-50-percent change in the ownership of its stock during the relevant testing period. The amount of losses that may be used annually to offset post-change income of the corporation is equal to a prescribed rate of return on the net value of the corporation at the time of the change of ownership. Possible Proposals 1. Provide a rule that, if a worthless securities deduction is claimed by persons holding a specified percentage of a corporation's stock, its net operating loss carryforwards and other tax attributes are extinguished. This could be accomplished, for example, by treating the corporation's stock as having been sold to an unrelated party for purposes of the rules limiting the use of losses following an ownership change. Thus, if worthless stock deductions were claimed with respect to more than 50-percent of a corporation's stock during the testing period, net operating loss carryovers of the corporation arising prior to the change generally could not be used to offset the corporation's post-change income. 2. Alternatively, provide that a subsidiary's tax attributes are extinguished if a worthless securities deduction is claimed by an 80percent-or-more parent corporation (whether or not the subsidiary files a consolidated return with the parent). Pros and Cons Arguments for the proposals 1. The premise for the worthless securities deduction is that the shareholder's loss has been realized to the same extent as if there had been an actual disposition, even though the shareholder still technically owns the stock. Consistent with this premise, use of the attributes of the issuing corporation should be limited to the same extent as if an actual disposition had occurred. 2. Present law in effect allows the same economic loss to be deducted twice, since the net operating losses of a corporation are also reflected in the loss inherent in its stock. 3. Present law elevates form over substance to the extent it extinguishes the subsidiary's tax attributes if the subsidiary is liquidated into the parent following the worthless stock deduction, but not if the separate status of the subsidiary is formally preserved, even if the subsidiary's post-worthlessness income is generated by assets provided by the parent. These situations are economically identical, and the tax treatment should be the same. 4. Since no duplication of losses generally occurs in a consolidated return context, such duplication should not be allowed to occur in the case of similarly situated corporations not filing a consolidated return. Arguments against the proposals 1.To the extent there is a double deduction of what is essentially the same economic loss, this is merely a function of the two-tier system of taxing corporate operations, under which corporate-level gains as well as losses are duplicated at the shareholder level. 2. Application of the rules limiting loss carryforwards following a change of ownership is inappropriate in these circumstances. There has been no change in the beneficial ownership of the stock, and hence no transfer of the benefit of the corporation's losses. 3. The separate status of a subsidiary corporation should be respected for tax purposes, even where it is 80-percent or more controlled. 74-267 0 - 87 - 7 i. Deemed dividends to corporate shareholders Present Law If persons who directly or indirectly control each of two corporations sell the stock of one to the other, the transaction is not treated as a sale but can be recharacterized as a dividend. However, the results are not exactly the same as if there had been an actual dividend distribution. Instead, there are various "deemed" consequences. The dividend is deemed to come first from the earnings and profits of the purchasing corporation and then from the earnings and profits of the corporation whose stock is sold. The stock purchased, in the hands of the acquiring corporation, has a basis equal to its basis in the hands of the selling person and is deemed to have been received as a capital contribution. Specified attribution rules apply for purposes of determining whether a person directly or indirectly controls the two corporations. Under these rules as interpreted in IRS revenue rulings, two corporations that are under common control can be deemed to control one another in some circumstances, even though one may own no stock in the other. Although the special rules were enacted to prevent individual shareholders (who are not eligible for the dividends received deduction) from "bailing out" earnings from a controlled corporation at capital gains rates, rather than as ordinary dividend income, by using the form of a sale of stock, the rules apply not only to individual shareholders but also to corporate shareholders. Corporations may prefer dividend treatment to sale treatment because the dividends received deduction results in a maximum tax rate of 6.8 percent on dividends received from another corporation. Also, in many cases involving common control, there is no tax because the dividend is either eligible for the 100-percent dividends received deduction applicable within an affiliated group or is excluded from income under the consolidated return regulations. The special rules can provide significant tax planning opportunities to corporate shareholders. Not only can such shareholders receive dividend treatment if that is more preferential than sale treatment; the results may also be significantly more favorable than if an actual dividend had been paid, due to the "deemed" flows of earnings and profits. Under the consolidated return regulations, for example, an increase in the earnings and profits of a subsidiary can create a corresponding increase in the parent's basis in the stock of the subsidiary. Although a distribution of earnings and profits generally reduces the parent's basis in subsidiary stock, this does not occur if the distribution is not made to a corporation that actually owns stock in the distributing company. A "deemed" section 304 dividend from a brother to a sister company can thus have the effect of increasing the basis of the stock of the company that is treated as "receiving" the dividend, without reducing the basis of the stock of any other company. Although since 1984 the Code has taxed a distributing corporation on appreciation in stock it distributes to a controlling corporate shareholder unless the distribution qualifies under the special conditions of section 355, taxpayers have manipulated the rules to claim a tax-free distribution of nonqualifying stock. Also, taxpayers have claimed that the distributing corporation can then be sold without any reduction in its basis for any portion of the assets that were in effect withdrawn tax-free. Possible Proposals 1. Modify the rules with respect to corporate shareholders so that the results are not better than if the corporations had made actual distributions. For example, if stock is sold by a brother to a sister corporation, require the stock transfer to the treated as if the stock had actually been distributed to the common parent and recontributed to the recipient. 2. Modify the rules of section 304 so that corporate shareholders in control of two corporations who purport to "sell" the stock of one to the other must at least experience a basis reduction in the stock of any subsidiary from which amounts are directly or indirectly withdrawn. Also, require transfers or deemed transfers that are essentially "circular" to be disregarded where appropriate to prevent tax avoidance, including transfers of cash to a subsidiary that is then sold (or that transfers cash to an affiliate that is sold) for a price that repays the cash amount to the seller. Argument for the proposals Corporations should not be permitted to use a provision that was directed at "bail-outs" by individual shareholders to obtain better tax results than they could have obtained by either an actual sale or an actual distribution. Argument against the proposals The present-law rules with respect to intercorporate distributions of subsidiary stock are too harsh, and it is appropriate for taxpayers to be able to use section 304 to obtain more favorable results. |