1. ALGIERS AUSTIN DALLAS FORT WORTH HOUSTON MACAÉ MONTERREY PARIS RIO DE JANEIRO VITÓRIA Tax Issues for Loss Corporations October 19, 2004 Presented Presented by R. David Wheat 1700 Pacific Avenue, Suite 3300 Dallas, Texas 75201 214.969.1468 david.wheat@tklaw.com 1700 Pacific Avenue, Suite 3300 Dallas, Texas 75201 214.969.1468 david.wheat@tklaw.com

2. 2 Overview Section 382 Section 382 SRLY Rules SRLY Rules Insolvent Liquidations Insolvent Liquidations Loss Disallowance Rules Loss Disallowance Rules American Jobs Creation Act of 2004 American Jobs Creation Act of 2004

3. 3 Section 382

4. 4 Section 382 General Rules Section 382 of the Code limits the ability of a corporation to use its net operating losses following an “ownership change.” Section 382 of the Code limits the ability of a corporation to use its net operating losses following an “ownership change.” Section 383 of the Code extends the limitation to a corporation’s other tax attributes, such as tax credits and net capital loss carryovers. Section 383 of the Code extends the limitation to a corporation’s other tax attributes, such as tax credits and net capital loss carryovers.

5. 5 Section 382 Base Case P $100 L Stock L $50 NOL Facts: P buys 100% of L Stock from L’s shareholders for $100. Conclusion:The P - L group’s use of L’s $50 NOL is limited by Section 382. Shareholders

6. 6 Section 382 Definition of “Ownership Change” An “ownership change” occurs if the percentage of stock of the loss corporation owned by one or more “5 percent shareholders” has increased by more than 50 percentage points over the lowest percentage of stock of the corporation owned by such shareholders at any time during the testing period (generally 3 years or since the last ownership change, if shorter). An “ownership change” occurs if the percentage of stock of the loss corporation owned by one or more “5 percent shareholders” has increased by more than 50 percentage points over the lowest percentage of stock of the corporation owned by such shareholders at any time during the testing period (generally 3 years or since the last ownership change, if shorter).

7. 7 Section 382 Definition of “Ownership Change” In applying the test, the methodology is: In applying the test, the methodology is: Identify each 5 percent shareholder whose stock ownership has increased compared with such shareholder’s lowest stock ownership percentage during the testing period. Identify each 5 percent shareholder whose stock ownership has increased compared with such shareholder’s lowest stock ownership percentage during the testing period. Add up the increases of each such 5 percent shareholder and see whether the sum amounts to more than 50 percent. Add up the increases of each such 5 percent shareholder and see whether the sum amounts to more than 50 percent.

8. 8 Section 382 Ownership Change – Example A 20 L Facts:C buys 40 shares from B. D buys 20 shares from A. Conclusion: C’s ownership has increased from 25% to 65% (40%) and D’s ownership has increased from 15% to 35% (20%). The total increase by 5% shareholders is greater than 50% (60%) and, therefore, an ownership change has occurred. BCD 402515

9. 9 Section 382 Definition of “Ownership Change” A “5 percent shareholder” is generally an individual or “public group” that, directly or indirectly through intermediate entities, owns 5 percent or more of the stock of the corporation being tested for an ownership change. A “5 percent shareholder” is generally an individual or “public group” that, directly or indirectly through intermediate entities, owns 5 percent or more of the stock of the corporation being tested for an ownership change. A “public group” is a group of individuals, entities or other persons each of whom owns less than 5 percent of the corporation. There can be (and there often are) more than one public group. A “public group” is a group of individuals, entities or other persons each of whom owns less than 5 percent of the corporation. There can be (and there often are) more than one public group. Special rules: Special rules: “Plain vanilla” preferred stock is ignored (generally, non-voting, non- convertible stock with a fixed coupon). “Plain vanilla” preferred stock is ignored (generally, non-voting, non- convertible stock with a fixed coupon). Options and warrants may be treated as stock in certain situations. Options and warrants may be treated as stock in certain situations. All stock percentage calculations are based on value, not vote. All stock percentage calculations are based on value, not vote.

10. 10 Section 382 Stock Ownership Percentage Based on Value A stockholder’s stock ownership is measured by the percentage of the fair market value of the stock owned by the shareholder compared to the fair market value of the outstanding stock of the company. A stockholder’s stock ownership is measured by the percentage of the fair market value of the stock owned by the shareholder compared to the fair market value of the outstanding stock of the company. Each share with the same terms is treated as having the same value (i.e., no control premium or blockage discount). Each share with the same terms is treated as having the same value (i.e., no control premium or blockage discount). Any change in the proportionate ownership that is attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into account. Thus, increases or decreases in the value of the company generally should not cause an ownership change, but the rule is not entirely clear. Any change in the proportionate ownership that is attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into account. Thus, increases or decreases in the value of the company generally should not cause an ownership change, but the rule is not entirely clear.

11. 11 Section 382 Fluctuation in Value – Example L is a loss corporation with common and preferred stock outstanding. At the time L incurs its losses, the preferred stock is worth $100 (its face amount) and the common stock is worth $900. Thus, the common shareholders own 90% of the corporation by value. Two years later, the value of L drops dramatically to $150. The preferred stock continues to be worth $100, but the common stock declines in value to $50. Thus, based on value, the preferred stockholder has increased its ownership in L from 10% to 66%. L is a loss corporation with common and preferred stock outstanding. At the time L incurs its losses, the preferred stock is worth $100 (its face amount) and the common stock is worth $900. Thus, the common shareholders own 90% of the corporation by value. Two years later, the value of L drops dramatically to $150. The preferred stock continues to be worth $100, but the common stock declines in value to $50. Thus, based on value, the preferred stockholder has increased its ownership in L from 10% to 66%. Has an ownership change ocurred? Probably not, because the change is due solely to fluctuations in value. Has an ownership change ocurred? Probably not, because the change is due solely to fluctuations in value.

12. 12 Section 382 Certain Options and Warrants Deemed Exercised An option is treated as exercised for ownership change purposes only if the option is issued or transferred “with a principal purpose of avoiding or ameliorating an ownership change” and it satisfies one of the following three tests: An option is treated as exercised for ownership change purposes only if the option is issued or transferred “with a principal purpose of avoiding or ameliorating an ownership change” and it satisfies one of the following three tests: Ownership Test. Was the option issued to avoid or ameliorate the impact of an ownership change by providing the holder of the option, prior to its exercise, with a substantial portion of the attributes of ownership of the underlying stock? Ownership Test. Was the option issued to avoid or ameliorate the impact of an ownership change by providing the holder of the option, prior to its exercise, with a substantial portion of the attributes of ownership of the underlying stock? Control Test. Did the holder and any related persons directly or indirectly own more than the 50% of the company counting the options as exercised? Control Test. Did the holder and any related persons directly or indirectly own more than the 50% of the company counting the options as exercised? Income Test. Does the issuance of an option facilitate the creation of income (including accelerating income or deferring deductions) or value (including unrealized built-in gains) prior to the exercise or transfer of the option? Income Test. Does the issuance of an option facilitate the creation of income (including accelerating income or deferring deductions) or value (including unrealized built-in gains) prior to the exercise or transfer of the option?

13. 13 Section 382 Option – Example P Option L Facts:P buys 49% of L with an option to buy the remaining 51%. P’s 49% stock (by value) has 60% of vote. A 51% 49%

14. 14 Section 382 Certain Options and Warrants Deemed Exercised (cont’d.) Employee stock options generally are not deemed exercised. Employee stock options generally are not deemed exercised. No warrants or options that have a nominal exercise price (e.g., one penny) are generally deemed exercised. No warrants or options that have a nominal exercise price (e.g., one penny) are generally deemed exercised. Preferred stock generally is not deemed converted into common. Preferred stock generally is not deemed converted into common.

15. 15 Section 382 Calculation of Limitation If there has been an ownership change, the amount of taxable income of the loss corporation in any post-change year that can be offset by pre-change losses may not exceed the “Section 382 limitation.” If there has been an ownership change, the amount of taxable income of the loss corporation in any post-change year that can be offset by pre-change losses may not exceed the “Section 382 limitation.” The Section 382 limitation for any post-change year is, in general, an amount equal to: The Section 382 limitation for any post-change year is, in general, an amount equal to: The value of the loss corporation determined as of the time immediately before the ownership change, multiplied by The value of the loss corporation determined as of the time immediately before the ownership change, multiplied by The long-term tax exempt rate published by the IRS. The long-term tax exempt rate published by the IRS.

16. 16 Section 382 Allocation of Income for Change Year The Section 382 limitation does not apply to income incurred in the change year if it is allocated to the days of the year up to and including the change date (the pre-change period). This rule requires an allocation of change year income where a corporation's taxable year does not end on the same date as the ownership change date. The Section 382 limitation does not apply to income incurred in the change year if it is allocated to the days of the year up to and including the change date (the pre-change period). This rule requires an allocation of change year income where a corporation's taxable year does not end on the same date as the ownership change date. There are two ways to allocate income: a daily ratable allocation method and the closing-of-the-books method. The taxpayer must elect to apply the closing-of-the-books method. Treas. Reg. § 1.382-6; Notice 87-79. There are two ways to allocate income: a daily ratable allocation method and the closing-of-the-books method. The taxpayer must elect to apply the closing-of-the-books method. Treas. Reg. § 1.382-6; Notice 87-79. Importantly, the IRS has ruled that discharge of indebtedness income generated by an ownership change may all be allocated to the pre-change period by applying the closing-of-the-books method. See, e.g., PLR 9427033 (April 13, 1994). Importantly, the IRS has ruled that discharge of indebtedness income generated by an ownership change may all be allocated to the pre-change period by applying the closing-of-the-books method. See, e.g., PLR 9427033 (April 13, 1994).

17. 17 Section 382 Continuity of Business Enterprise Continuity of business requirement – If the corporation does not continue the business enterprise that it conducted prior to the ownership change at all times during the 2 year period beginning on the change date, the Section 382 limitation is zero. Continuity of business requirement – If the corporation does not continue the business enterprise that it conducted prior to the ownership change at all times during the 2 year period beginning on the change date, the Section 382 limitation is zero.

18. 18 Section 382 Recognized Built-in Gains and Losses Special rules apply to “built-in” gains and losses recognized within 5 taxable years of the ownership change. In general: Special rules apply to “built-in” gains and losses recognized within 5 taxable years of the ownership change. In general: The Section 382 limitation is increased for any recognized built-in gains (“RBIGs”) in the year those gains are recognized. The Section 382 limitation is increased for any recognized built-in gains (“RBIGs”) in the year those gains are recognized. Deductions for recognized built-in losses (“RBILs”) are subject to the Section 382 limitation along with pre-change losses. Deductions for recognized built-in losses (“RBILs”) are subject to the Section 382 limitation along with pre-change losses. Important: foregoing rules only apply if the loss corporation has a net unrealized built-in gain (“NUBIG”) or a net unrealized built-in loss (“NUBIL”) which exceeds de minimis amount (lesser of $10 million or 15% of FMV of assets). Important: foregoing rules only apply if the loss corporation has a net unrealized built-in gain (“NUBIG”) or a net unrealized built-in loss (“NUBIL”) which exceeds de minimis amount (lesser of $10 million or 15% of FMV of assets).

19. 19 Section 382 NUBIL Example P acquires 100% of stock of L from unrelated shareholders. P acquires 100% of stock of L from unrelated shareholders. L has two assets: Asset A (FMV $100/Basis $0) and Asset B (FMV $0/Basis $100). L also has a $100 NOL. L has two assets: Asset A (FMV $100/Basis $0) and Asset B (FMV $0/Basis $100). L also has a $100 NOL. One year after P acquires L, L sells Asset B for a $100 loss. One year after P acquires L, L sells Asset B for a $100 loss. L did not have a NUBIL and, therefore, Section 382 does not limit L’s use of the $100 loss. L did not have a NUBIL and, therefore, Section 382 does not limit L’s use of the $100 loss.

20. 20 Section 382 Built-In Income and Deduction As noted above, RBIGs increase the Section 382 limitation and RBILs are subject to the Section 382 limitation. As noted above, RBIGs increase the Section 382 limitation and RBILs are subject to the Section 382 limitation. Section 382(h)(6)(A) provides that any item of income “properly taken into account during the recognition period” is treated as RBIG if the item is “attributable to periods before the change date.” A similar rule is provided for built-in deductions. Section 382(h)(6)(A) provides that any item of income “properly taken into account during the recognition period” is treated as RBIG if the item is “attributable to periods before the change date.” A similar rule is provided for built-in deductions. The theory is that items economically accruing before the change date should be subject to Section 382 in the same manner as if they had actually been recognized before the change date. Example – COD income triggered after the change date. The theory is that items economically accruing before the change date should be subject to Section 382 in the same manner as if they had actually been recognized before the change date. Example – COD income triggered after the change date.

21. 21 Section 382 Built-In Income and Deduction Notice 2003-65 allows taxpayers two approaches for applying Section 382(h)(6) to built-in items: Notice 2003-65 allows taxpayers two approaches for applying Section 382(h)(6) to built-in items: Section 1374 Approach Section 1374 Approach Section 338 Approach Section 338 Approach

22. 22 Section 1374 Approach Overview – Under the 1374 approach, NUBIG or NUBIL is the amount of gain or loss that would be recognized in a hypothetical sale of the assets of the loss corporation immediately before the ownership change. Overview – Under the 1374 approach, NUBIG or NUBIL is the amount of gain or loss that would be recognized in a hypothetical sale of the assets of the loss corporation immediately before the ownership change. Gains and Losses from Sale or Exchange of Assets – The amount of gain or loss recognized during the recognition period on the sale or exchange of an asset is RBIG or RBIL. The sum of the RBIG or RBIL attributable to an asset cannot exceed the unrealized built-in gain or loss in that asset on the change date. Gains and Losses from Sale or Exchange of Assets – The amount of gain or loss recognized during the recognition period on the sale or exchange of an asset is RBIG or RBIL. The sum of the RBIG or RBIL attributable to an asset cannot exceed the unrealized built-in gain or loss in that asset on the change date.

23. 23 Section 1374 Approach (cont’d.) Items of Income and Deduction – In cases other than sales and exchanges, the 1374 approach generally relies on the accrual method of accounting to identify income or deduction items as RBIG or RBIL, respectively. Items of income or deduction during the recognition period are treated as RBIG or RBIL, respectively, if an accrual method taxpayer would have included the item in income or been allowed a deduction for the item before the change date. Items of Income and Deduction – In cases other than sales and exchanges, the 1374 approach generally relies on the accrual method of accounting to identify income or deduction items as RBIG or RBIL, respectively. Items of income or deduction during the recognition period are treated as RBIG or RBIL, respectively, if an accrual method taxpayer would have included the item in income or been allowed a deduction for the item before the change date. Example: Immediately before an ownership change, LossCo, which uses the cash method of accounting, has a $50 account receivable with a fair market value of $40 and a basis of zero. In Year 2 of the recognition period, LossCo sells the account receivable for $40 before collecting any part of it. LossCo has $40 of RBIG in Year 2. Example: Immediately before an ownership change, LossCo, which uses the cash method of accounting, has a $50 account receivable with a fair market value of $40 and a basis of zero. In Year 2 of the recognition period, LossCo sells the account receivable for $40 before collecting any part of it. LossCo has $40 of RBIG in Year 2.

24. 24 Section 1374 Approach (cont’d.) Income Generated by Built-In Gain Assets – In general, the 1374 approach does not treat income from a built-in gain asset during the recognition period as RBIG because such income did not accrue before the change date. Income Generated by Built-In Gain Assets – In general, the 1374 approach does not treat income from a built-in gain asset during the recognition period as RBIG because such income did not accrue before the change date. Example: LossCo has a NUBIG of $300,000 that is attributable to several non-amortizable assets with an aggregate fair market value of $650,000 and an aggregate adjusted basis of $500,000, and a patent with a fair market value of $170,000 and an adjusted basis of $20,000. This patent is an “amortizable Section 197 intangible” as defined in Section 197(c). In Year 1 of the recognition period, LossCo has gross income of $75,000, $20,000 of which is attributable to royalties collected in connection with the license of the patent. No part of the $20,000 attributable to the royalties is RBIG in Year 1 because the income would not have been properly taken into account before the change date by an accrual method taxpayer. Accordingly, LossCo’s Section 382 limitation for Year 1 is not increased by any part of that amount. Example: LossCo has a NUBIG of $300,000 that is attributable to several non-amortizable assets with an aggregate fair market value of $650,000 and an aggregate adjusted basis of $500,000, and a patent with a fair market value of $170,000 and an adjusted basis of $20,000. This patent is an “amortizable Section 197 intangible” as defined in Section 197(c). In Year 1 of the recognition period, LossCo has gross income of $75,000, $20,000 of which is attributable to royalties collected in connection with the license of the patent. No part of the $20,000 attributable to the royalties is RBIG in Year 1 because the income would not have been properly taken into account before the change date by an accrual method taxpayer. Accordingly, LossCo’s Section 382 limitation for Year 1 is not increased by any part of that amount.

25. 25 Section 338 Approach Overview – The 338 approach identifies items of RBIG and RBIL generally by comparing the loss corporation’s actual items of income, gain, deduction, and loss with those that would have resulted if a Section 338 election had been made with respect to a hypothetical purchase of all the outstanding stock of the loss corporation on the change date (the “hypothetical purchase”). As a result, unlike under the 1374 approach, under the 338 approach, built-in gain assets may be treated as generating RBIG even if they are not disposed of at a gain during the recognition period, and deductions for liabilities, in particular contingent liabilities, that exist on the change date may be treated as RBIL. Overview – The 338 approach identifies items of RBIG and RBIL generally by comparing the loss corporation’s actual items of income, gain, deduction, and loss with those that would have resulted if a Section 338 election had been made with respect to a hypothetical purchase of all the outstanding stock of the loss corporation on the change date (the “hypothetical purchase”). As a result, unlike under the 1374 approach, under the 338 approach, built-in gain assets may be treated as generating RBIG even if they are not disposed of at a gain during the recognition period, and deductions for liabilities, in particular contingent liabilities, that exist on the change date may be treated as RBIL. Calculation of NUBIG and NUBIL – Under the 338 approach, NUBIG or NUBILs are calculated in the same manner as under the 1374 approach. Calculation of NUBIG and NUBIL – Under the 338 approach, NUBIG or NUBILs are calculated in the same manner as under the 1374 approach. Calculation of RBIG and RBIL – The 338 approach identifies RBIG or RBIL by comparing the loss corporation’s actual items of income, gain, deduction, and loss with the items of income, gain, deduction and loss that would result if a Section 338 election had been made for the hypothetical purchase. Calculation of RBIG and RBIL – The 338 approach identifies RBIG or RBIL by comparing the loss corporation’s actual items of income, gain, deduction, and loss with the items of income, gain, deduction and loss that would result if a Section 338 election had been made for the hypothetical purchase.

26. 26 Section 338 Approach – Wasting or Consumption of Built-In Gain Assets Wasting Assets – As described above, for loss corporations with a NUBIG, a 338 approach treats certain built-in gain assets of the loss corporation as generating RBIG even if such assets are not disposed of during the recognition period. The 338 approach assumes that, for any taxable year, an asset that had built-in gain on the change date generates income equal to the cost recovery deduction that would have been allowed for such asset under the applicable Code section if an election under Section 338 had been made with respect to the hypothetical purchase. Therefore, with respect to an asset that had a built-in gain on the change date, the 338 approach treats as RBIG an amount equal to the excess of the cost recovery deduction that would have been allowable with respect to such asset had an election under Section 338 been made for the hypothetical purchase over the loss corporation’s actual allowable cost recovery deduction. Wasting Assets – As described above, for loss corporations with a NUBIG, a 338 approach treats certain built-in gain assets of the loss corporation as generating RBIG even if such assets are not disposed of during the recognition period. The 338 approach assumes that, for any taxable year, an asset that had built-in gain on the change date generates income equal to the cost recovery deduction that would have been allowed for such asset under the applicable Code section if an election under Section 338 had been made with respect to the hypothetical purchase. Therefore, with respect to an asset that had a built-in gain on the change date, the 338 approach treats as RBIG an amount equal to the excess of the cost recovery deduction that would have been allowable with respect to such asset had an election under Section 338 been made for the hypothetical purchase over the loss corporation’s actual allowable cost recovery deduction.

27. 27 Section 338 Approach – Wasting or Consumption of Built-In Gain Assets Example: Example: LossCo has a NUBIG of $300,000 that is attributable to various non- amortizable assets with an aggregate fair market value of $710,000 and an aggregate adjusted basis of $500,000, and a patent with a fair market value of $120,000 and an adjusted basis of $30,000. The patent is an “amortizable Section 197 intangible” as defined in Section 197(c) for which ten years of tax depreciation remain. In Year 1 of the recognition period, LossCo has gross income of $75,000. In Year 1, $5,000 is RBIG attributable to the patent (the excess of the $8,000 amortization deduction that would have been allowed had a Section 338 election been made with respect to a hypothetical purchase of all of the stock of LossCo ($120,000 fair market value divided by 15, the amortization period) over $3,000 (the actual allowable amortization deduction). This $5,000 of RBIG increases LossCo’s Section 382 limitation for Year 1.

28. 28 Section 382 Bankruptcy Rules Two special rules exist for ownership changes occurring in a bankruptcy case: Two special rules exist for ownership changes occurring in a bankruptcy case: Section 382(l)(5) – Provides a one-time “free pass” from the Section 382 rules for ownership changes in a limited class of bankruptcy cases. Section 382(l)(5) – Provides a one-time “free pass” from the Section 382 rules for ownership changes in a limited class of bankruptcy cases. Section 382(l)(6) – Provides for a higher Section 382 limitation than would otherwise apply in cases not falling under Section 382(l)(5). Section 382(l)(6) – Provides for a higher Section 382 limitation than would otherwise apply in cases not falling under Section 382(l)(5).

29. 29 Section 382 Bankruptcy Rules Under Section 382(l)(5), no Section 382 limitation will apply if: Under Section 382(l)(5), no Section 382 limitation will apply if: The corporation is, immediately before the ownership change, under the jurisdiction of a court in a title 11 or similar case; The corporation is, immediately before the ownership change, under the jurisdiction of a court in a title 11 or similar case; The transaction resulting in the ownership change is ordered by the court or pursuant to a plan approved by the court; and The transaction resulting in the ownership change is ordered by the court or pursuant to a plan approved by the court; and The shareholders and “old and cold” creditors of the corporation as of the time immediately before the ownership change own at least 50 percent of the corporation’s stock following the ownership change. The shareholders and “old and cold” creditors of the corporation as of the time immediately before the ownership change own at least 50 percent of the corporation’s stock following the ownership change.

30. 30 Section 382 Bankruptcy Rules Old and cold creditors include: Old and cold creditors include: Creditors who held their debt for at least 18 months prior to the filing of the title 11 case (bonds owned by “vultures” may not qualify); and Creditors who held their debt for at least 18 months prior to the filing of the title 11 case (bonds owned by “vultures” may not qualify); and Creditors who have continuously held debt of the corporation that arose in the ordinary course of the corporation’s business. Creditors who have continuously held debt of the corporation that arose in the ordinary course of the corporation’s business. E.g., trade debt, liabilities arising from employment relationships, tort claims, etc. E.g., trade debt, liabilities arising from employment relationships, tort claims, etc. A claim that arises upon the rejection of a burdensome contract or lease also qualifies as ordinary course indebtedness. A claim that arises upon the rejection of a burdensome contract or lease also qualifies as ordinary course indebtedness.

31. 31 Section 382 Bankruptcy Rules Drawbacks of the Section 382(l)(5) exception: Drawbacks of the Section 382(l)(5) exception: The Section 382 limitation will be zero if there is another ownership change within 2 years. The Section 382 limitation will be zero if there is another ownership change within 2 years. Pre-change NOLs are reduced by the amount of any interest paid or accrued by the corporation during the three years prior to the date of the ownership change on debt that was converted into equity. Pre-change NOLs are reduced by the amount of any interest paid or accrued by the corporation during the three years prior to the date of the ownership change on debt that was converted into equity. Because of the drawbacks, a corporation may elect not to have Section 382(l)(5) apply. Because of the drawbacks, a corporation may elect not to have Section 382(l)(5) apply.

32. 32 Section 382 Bankruptcy Rules Section 382(l)(6) provides that if Section 382(l)(5) does not apply, the value of the corporation for purposes of determining the Section 382 limitation shall reflect the increase in value resulting from any surrender or cancellation of creditors’ claims in the transaction. Section 382(l)(6) provides that if Section 382(l)(5) does not apply, the value of the corporation for purposes of determining the Section 382 limitation shall reflect the increase in value resulting from any surrender or cancellation of creditors’ claims in the transaction. Under this provision, the Section 382 limitation will be based on the lesser of: Under this provision, the Section 382 limitation will be based on the lesser of: The value of the stock of the corporation immediately after the ownership change; or The value of the stock of the corporation immediately after the ownership change; or The value of the corporation’s assets immediately before the ownership change. The value of the corporation’s assets immediately before the ownership change.

33. 33 Section 382 Bankruptcy Rules Section 382(l)(6) Example: Section 382(l)(6) Example: L has assets with a fair market value of $250 million and debt of $300 million. Y does an in-bankruptcy restructuring in which its creditors exchange the $300 million of debt for $200 million in new debt plus all of the common stock in Y. The existing equity holders receive nothing. L has assets with a fair market value of $250 million and debt of $300 million. Y does an in-bankruptcy restructuring in which its creditors exchange the $300 million of debt for $200 million in new debt plus all of the common stock in Y. The existing equity holders receive nothing. Without Section 382(l)(6), and assuming Section 382(1)(5) does not apply, the Section 382 limitation would be zero because the company’s stock had no value immediately before the ownership change. Without Section 382(l)(6), and assuming Section 382(1)(5) does not apply, the Section 382 limitation would be zero because the company’s stock had no value immediately before the ownership change. With Section 382(l)(6), the Section 382 limitation is $50 million (i.e., the value of Y’s stock immediately following the ownership change) multiplied by the tax-exempt rate. With Section 382(l)(6), the Section 382 limitation is $50 million (i.e., the value of Y’s stock immediately following the ownership change) multiplied by the tax-exempt rate.

34. 34 Section 382 Application to Consolidated Groups Overview: Single Entity Theory Overview: Single Entity Theory Determine the following on a group basis (v. entity by entity): Determine the following on a group basis (v. entity by entity): Ownership Change Ownership Change Amount of Section 382 Limitation Amount of Section 382 Limitation NUBIG/NUBIL NUBIG/NUBIL COBE COBE

35. 35 Section 382 Consolidated Ownership Change Parent Change Method. The general rule is that if the common parent of the loss group experiences an ownership change, all of the loss group’s pre-change consolidated Section 382 attributes become subject to the consolidated Section 382 limitation. Although an individual subsidiary may not experience an ownership change on a separate company basis, its share of the consolidated NOL will be subject to the Section 382 limitation. Parent Change Method. The general rule is that if the common parent of the loss group experiences an ownership change, all of the loss group’s pre-change consolidated Section 382 attributes become subject to the consolidated Section 382 limitation. Although an individual subsidiary may not experience an ownership change on a separate company basis, its share of the consolidated NOL will be subject to the Section 382 limitation. Supplemental Method. The supplemental method is an anti- abuse rule. The supplemental method aggregates increases in percentage ownership by a 5% shareholder of the common parent in both the subsidiary and the common parent during a three-year period or such increases are pursuant to a “plan or arrangement.” Supplemental Method. The supplemental method is an anti- abuse rule. The supplemental method aggregates increases in percentage ownership by a 5% shareholder of the common parent in both the subsidiary and the common parent during a three-year period or such increases are pursuant to a “plan or arrangement.”

36. 36 Section 382 Consolidated Ownership Change - Example Facts:Individual A owns all the stock of L, which files a consolidated return with its 80% owned subsidiary, L1. Individual B owns the other 20% of L1. During 2003, the L group incurred a 100 consolidated NOL, attributable entirely to L1. On August 1, 2004, A sold 60% of its L stock to C, an unrelated individual. Conclusion: The stock sale causes an ownership change with respect to the L-L1 group. Note that L1 did not experience an ownership change on a separate company basis (i.e., L1 has experienced only a 48% ownership shift). L 20% A C L1 B $ 60% 80%

37. 37 Section 382 Consolidated NUBIG/NUBIL Determination – Example Facts:L has Asset A (FMV $100 / Basis $0). L1 has Asset B (FMV $0 / Basis $100) and a $100 NOL. Conclusion: On a separate company basis, L has a NUBIG and L-1 has a NUBIL. But L-L1 group has no NUBIL or NUBIG. L A L1

38. 38 Section 382 Sale of a Member of a Consolidated Group Apportionment of Section 382 limitation to Departing Member. Generally, when a subsidiary ceases to be a member of a loss group after such group has had an ownership change, the issue arises of how the Section 382 limitation should be allocated between the remaining group members and the departing member. The general rule provides that the Section 382 limitation of the departing member becomes zero unless the common parent of a loss group elects to apportion all or a part of the consolidated Section 382 limitation to the departing member. Apportionment of Section 382 limitation to Departing Member. Generally, when a subsidiary ceases to be a member of a loss group after such group has had an ownership change, the issue arises of how the Section 382 limitation should be allocated between the remaining group members and the departing member. The general rule provides that the Section 382 limitation of the departing member becomes zero unless the common parent of a loss group elects to apportion all or a part of the consolidated Section 382 limitation to the departing member. Apportionment of NUBIG to Departing Member. As with apportionment of the Section 382 limitation, the NUBIG allocable to a departing member would be zero unless the common parent elects to apportion all or a part of the NUBIG to the departing member. Apportionment of NUBIG to Departing Member. As with apportionment of the Section 382 limitation, the NUBIG allocable to a departing member would be zero unless the common parent elects to apportion all or a part of the NUBIG to the departing member.

39. 39 Section 382 Apportionment of Section 382 Limitation and NUBIG – Example Facts:P group has a $200 per year Section 382 limitation and a $100 NUBIG from a prior ownership change. L1 and L2 each have $100 of NOL subject to the Section 382 limitation. A buys L2 for $50. L1 P L2 A $50 L2 Stock

40. 40 SRLY Rules

41. 41 SRLY Rules Overview General Rule. When a loss corporation joins a consolidated group, the SRLY regulations allow the group to utilize the loss corporation’s NOLs only against the loss corporation’s share of consolidated net income. Treas. Reg. § 1.1502-21(c). General Rule. When a loss corporation joins a consolidated group, the SRLY regulations allow the group to utilize the loss corporation’s NOLs only against the loss corporation’s share of consolidated net income. Treas. Reg. § 1.1502-21(c). Built-in Losses. Like Section 382, the SRLY rules apply to built-in losses as well as NOLs. Built-in Losses. Like Section 382, the SRLY rules apply to built-in losses as well as NOLs. Creeping Acquisitions. The SRLY rules apply to a new member of an affiliated group without regard to the degree of ownership change that occurs when the new member joins the group. Creeping Acquisitions. The SRLY rules apply to a new member of an affiliated group without regard to the degree of ownership change that occurs when the new member joins the group.

42. 42 SRLY Rules Creeping Acquisition – Example Facts: P has owned 75% of L for several years. During that period, L has incurred significant NOLs. Now P acquires another 5% of L’s subsidiary stock and includes L in its consolidated group. Facts: P has owned 75% of L for several years. During that period, L has incurred significant NOLs. Now P acquires another 5% of L’s subsidiary stock and includes L in its consolidated group. Conclusion: L’s NOLs are subject to the SRLY limitation. Conclusion: L’s NOLs are subject to the SRLY limitation.

43. 43 SRLY Rules Non-Applicability in Section 382 Overlap General Rule. When a corporation becomes a member of a consolidated group (a “SRLY event”) within six months of the change date of an ownership change that gives rise to a Section 382 limitation with respect to NOL carryover (a “Section 382 event”), the SRLY rules will not apply to such corporation’s NOL carryover. General Rule. When a corporation becomes a member of a consolidated group (a “SRLY event”) within six months of the change date of an ownership change that gives rise to a Section 382 limitation with respect to NOL carryover (a “Section 382 event”), the SRLY rules will not apply to such corporation’s NOL carryover. Coextensive Subgroups. The overlap rule only applies if the SRLY loss subgroup is coextensive with (i.e., identical to) the Section 382 loss subgroup. Coextensive Subgroups. The overlap rule only applies if the SRLY loss subgroup is coextensive with (i.e., identical to) the Section 382 loss subgroup.

44. 44 SRLY Rules Section 382/SRLY Overlap – Example Facts:P buys 80% of L stock from A, an unrelated individual. L has both a SRLY event and a Section 382 event. L-L1 group constitutes both a 382 subgroup and a SRLY subgroup. L A L1 $ 80% P

45. 45 SRLY Rules Loss Subgroup Election Under Treas. Reg. § 1.1502-91(d)(4) L, L1 and L2 are all members of the same SRLY subgroup but they do not comprise a Section 382 subgroup. Absent the -91(d)(4) election, the SRLY restrictions would apply to the losses of L, L1 and L2. L L1 P T $ L + L1 stock L2

46. 46 SRLY Rules Planning Opportunities Merger. Merge SRLY member with a profitable member. Merger. Merge SRLY member with a profitable member. Conversion to LLC. Convert SRLY member into a single-member LLC which is disregarded so that parent’s income will count when computing SRLY limitation. Conversion to LLC. Convert SRLY member into a single-member LLC which is disregarded so that parent’s income will count when computing SRLY limitation. Stuffing. Parent contributes income generating assets to SRLY member. Stuffing. Parent contributes income generating assets to SRLY member.

47. 47 SRLY Rules Stuffing - Conduit Transactions Facts: Shareholder P contributes Asset A with built-in gain to S. S promptly sells Asset A to third party and shelters gain on Asset A with S’s SRLY NOLs. Business Purpose: Stewart v. Comm’r, T.C. Memo 1982-209, aff’d., 714 F.2d 977 (9th Cir. 1983); Kluener v. Comm’r, T.C. Memo 1996-579, aff’d., 154 F.3d 630 (6th Cir. 1998); Hallowell v. Comm’r, 56 T.C. 600 (1971); W.& K. Holding Corp. v. Comm’r, 38 B.T.A. 830 (1938). Substance Over Form: Comm’r v. Court Holdings, 324 U.S. 331 (1943). Section 482: National Securities Corp. v. Comm’r, 137 F.2d 600 (3d Cir. 1943); Ruddick v. United States, 643 F.2d 747 (Ct. Cl. 1981). S3P Asset A $ P

48. 48 SRLY Rules Investment Basis Adjustments The amount of a stock basis adjustment is the net of S’s: The amount of a stock basis adjustment is the net of S’s: + Contributions + Contributions - Distributions - Distributions + Taxable income + Taxable income - Taxable loss - Taxable loss + Tax-exempt income + Tax-exempt income - Noncapital, nondeductible expenses (including expiring loss carryovers) - Noncapital, nondeductible expenses (including expiring loss carryovers)

49. 49 SRLY Rules Loss Waiver Election P T T1 T2 X T T1 T2 T Stock $200 Asset A FMV:$200 Basis:$10 $50 Basis $60 Basis $100 NOL Analysis:Without a loss waiver election, T2’s $100 expiring NOL reduces T1’s stock basis, creating a $40 ELA in T1’s T2 stock. This basis adjustment tiers up to T, creating a $50 ELA in T’s T1 stock. See Treas. Reg. § 1.1502-32(b)(4).

50. 50 Insolvent Liquidations

51. 51 Insolvent Subsidiary – Liquidation Typically, when P liquidates an 80% or greater owned subsidiary, the transaction qualifies for nonrecognition treatment under Section 332. Typically, when P liquidates an 80% or greater owned subsidiary, the transaction qualifies for nonrecognition treatment under Section 332. Where S is insolvent, however, there is no distribution with respect to its common stock, and, therefore, Section 332 is inapplicable. Treas. Reg. § 1.332-2(b); Spaulding Bakeries, Inc. v. Comm’r, 27 T.C. 684 (1957), aff’d, 252 F2d 693 (2nd Cir. 1958). Where S is insolvent, however, there is no distribution with respect to its common stock, and, therefore, Section 332 is inapplicable. Treas. Reg. § 1.332-2(b); Spaulding Bakeries, Inc. v. Comm’r, 27 T.C. 684 (1957), aff’d, 252 F2d 693 (2nd Cir. 1958).

52. 52 Tax Consequences of Insolvent Liquidation S recognizes gain or loss on the transfer of its property in satisfaction of its liabilities. I.R.C. § 1001. S recognizes gain or loss on the transfer of its property in satisfaction of its liabilities. I.R.C. § 1001. S recognizes cancellation of indebtedness income on the discharge of any remaining indebtedness. I.R.C. § 61(a)(12). S recognizes cancellation of indebtedness income on the discharge of any remaining indebtedness. I.R.C. § 61(a)(12). S’s tax attributes do not carry over to the shareholder (i.e., attributes vanish). S’s tax attributes do not carry over to the shareholder (i.e., attributes vanish). The creditor takes a fair market value basis in the assets received in satisfaction of any indebtedness and a loss with respect to the indebtedness. I.R.C. §§ 165(g), 166. The creditor takes a fair market value basis in the assets received in satisfaction of any indebtedness and a loss with respect to the indebtedness. I.R.C. §§ 165(g), 166. The shareholders take a loss on the subsidiary’s stock (after adjustment for any income or loss if the subsidiary is a member of an affiliated group filing a consolidated return). I.R.C. § 165(g). The shareholders take a loss on the subsidiary’s stock (after adjustment for any income or loss if the subsidiary is a member of an affiliated group filing a consolidated return). I.R.C. § 165(g).

53. 53 Liquidating an Insolvent Subsidiary – Example 1 P S 100% Facts:Year 1 – P capitalized S with $50 of equity and $150 of debt. Year 2 – S incurred operating losses of $180. End of Year 2 – S becomes insolvent and adopts a plan of liquidation, distributing its only assets ($20) to P in satisfaction liquidation, distributing its only assets ($20) to P in satisfaction of its outstanding debt to P. of its outstanding debt to P. $50 Equity $150 Debt $20 Assets $180 NOL

54. 54 Liquidating an Insolvent Subsidiary – Example 2 P S 100% Facts:Same as Example 1, except that at the end of Year 2 P contributes the $150 debt to capital immediately before liquidating S such that S is solvent at the time of the liquidation. Conclusion: IRS would assert that the liquidation does not qualify under Section 332 per Rev. Rul. 68-602. $50 Equity $150 Debt $20 Assets $180 NOL

55. 55 Check the Box Stock Worthlessness Rev. Rul. 2003-125 P (U.S.) Facts: The fair market value of S-1’s assets (including goodwill and going concern value) exceeded the sum of its liabilities. The fair market value of S-2’s assets (including goodwill and going concern value) did not exceed the sum of its liabilities.P checked the box on S-1 and S-2 to cause them to be treated for U.S. tax purposes as liquidating. S-1 and S-2 continue to be treated as corporations under the foreign country laws and continue to operate as they had before the election. Facts: The fair market value of S-1’s assets (including goodwill and going concern value) exceeded the sum of its liabilities. The fair market value of S-2’s assets (including goodwill and going concern value) did not exceed the sum of its liabilities. P checked the box on S-1 and S-2 to cause them to be treated for U.S. tax purposes as liquidating. S-1 and S-2 continue to be treated as corporations under the foreign country laws and continue to operate as they had before the election. Analysis: In considering whether P was entitled to a loss under Section 165(g) with respect the stock of S-1 and S-2, the IRS concluded that the deemed liquidation occasioned by the change in classification election was an identifiable event permitting the loss under Section 165(g). P was allowed a worthless stock deduction for S-2, but not S-1. S-1 (Foreign) S-2 (Foreign)

56. 56 Tax-Free Reorganizations of Insolvent Corporations The IRS is currently studying whether a merger of an insolvent target corporation into another corporation may qualify as a tax-free reorganization under Section 368. The IRS is currently studying whether a merger of an insolvent target corporation into another corporation may qualify as a tax-free reorganization under Section 368. Existing law is unclear, although at least one case indicates that an insolvent target corporation may engage in a tax-free reorganization. Norman Scott, Inc. v. Comm’r, 48 T.C. 598 (1967). Existing law is unclear, although at least one case indicates that an insolvent target corporation may engage in a tax-free reorganization. Norman Scott, Inc. v. Comm’r, 48 T.C. 598 (1967).

57. 57 Insolvent Reorganizations Tax Consequences if Section 368 Does Not Apply Gain or loss is recognized by the target corporation on the transfer of its assets. Gain or loss is recognized by the target corporation on the transfer of its assets. Transferor corporation recognizes cancellation of indebtedness income on the full or partial satisfaction of its indebtedness for an amount less than the “adjusted issue price” of the outstanding indebtedness. Transferor corporation recognizes cancellation of indebtedness income on the full or partial satisfaction of its indebtedness for an amount less than the “adjusted issue price” of the outstanding indebtedness. Transferee corporation takes a fair market value basis in the assets acquired from the transferor. I.R.C. § 1012. Transferee corporation takes a fair market value basis in the assets acquired from the transferor. I.R.C. § 1012. Tax attributes of transferor vanish. Tax attributes of transferor vanish. Transferor, shareholders and security holders recognize gain or loss equal to the amount realized less the tax basis in the stock or securities surrendered. Transferor, shareholders and security holders recognize gain or loss equal to the amount realized less the tax basis in the stock or securities surrendered.

58. 58 Loss Disallowance Rules

59. 59 Loss Disallowance Rules Son of Mirror Example PB T Asset A T Stock $250 Asset B Basis = $100 FMV = $250 Basis = $150 FMV = $250 Facts:P purchases T stock for $500. Later, T distributes Asset B to P and then P sells T stock to B for $250. Analysis:T recognizes $100 of gain on the distribution of Asset B, which increases P’s stock basis in T. The dividend of Asset B reduces P’s stock basis in T by $250, causing a net negative adjustment of $150. Thus, P’s basis in T stock is $350 and P has a $100 loss on the sale of the T stock to B. P, therefore, has no net gain on the transaction but obtained a stepped-up basis in Asset B.

60. 60 Computation of Allowed Loss Under Former Treas. Reg. § 1.1502-20 P’s capital loss is deductible to the extent it exceeds: P’s capital loss is deductible to the extent it exceeds: Extraordinary Gain Extraordinary Gain Positive Investment Adjustments Positive Investment Adjustments Duplicated Loss Duplicated Loss

61. 61 Rite Aid Decision Fed. Circuit held LDR and duplicated loss factor invalid – Taxpayer’s loss is deductible despite LDR. Fed. Circuit held LDR and duplicated loss factor invalid – Taxpayer’s loss is deductible despite LDR. Reasoning: “In the absence of a problem created from the filing of consolidated returns, the secretary is without authority to change the application of other tax code provisions to a group of affiliated corporations filing consolidated returns.” Reasoning: “In the absence of a problem created from the filing of consolidated returns, the secretary is without authority to change the application of other tax code provisions to a group of affiliated corporations filing consolidated returns.” Thus, LDR could not override Section 165, which allowed the taxpayer to deduct the loss. Thus, LDR could not override Section 165, which allowed the taxpayer to deduct the loss.

62. 62 Summary of Current LDR Treas. Reg. § 1.337(d)-2T General Rule: Loss recognized by a consolidated group member with respect to the disposition of consolidated sub stock is disallowed. General Rule: Loss recognized by a consolidated group member with respect to the disposition of consolidated sub stock is disallowed. Exception: Loss is allowed if not attributable to built-in gain recognized on the disposition of an asset that is reflected in the basis of the stock of the disposed subsidiary when it was created or acquired. Exception: Loss is allowed if not attributable to built-in gain recognized on the disposition of an asset that is reflected in the basis of the stock of the disposed subsidiary when it was created or acquired.

63. 63 LDR – Base Case (Son of Mirror) T Shareholders P T STEP 1 STEP 1$100 T Stock X STEP 2 Asset A $100 Asset A Asset A FMV:$100 Basis:$ 0 Facts:P purchases 100% of stock of T for $100. T has one asset, Asset A, with a $100 built-in gain. P causes T to sell Asset A to X. T’s $100 gain increases P’s basis in T to $200. Analysis:If P sells the T stock to a third party for $100, P’s $100 capital loss will be disallowed. Treas. Reg. § 1.337(d)-2T. Y STEP 3 $100 T Stock

64. 64 LDR – No Loss Case T Shareholders P T STEP 1 STEP 1$100 T Stock X STEP 2 Asset A $100 Asset A Asset A FMV:$100 Basis:$ 0 Facts:Same facts as the previous example (Base Case), except that T invests the $100 sales proceeds in Asset B that appreciates to $200. P sells the T stock for $200 and recognizes no loss. Analysis:Since P has not recognized a loss, Treas. Reg. § 1.337(d)-2T does not apply even though P increased its basis in T stock by $100 (step 2) that was already reflected in P’s basis when T’s stock was acquired. Y T Stock $200 STEP 3

65. 65 LDR – Offsetting Built-in Gains and Losses T Shareholders P T STEP 1 $100 T Stock X STEP 2 Assets A & B $100 Asset A Asset A FMV:$100 Basis:$ 0 Asset B Asset B FMV:$ 0 Basis:$100 Facts:P purchases 100% of the stock of T for $100. T has two assets, Asset A, with $100 built-in gain and Asset B with $100 built-in loss. P causes T to sell Assets A and B to X. P has no net increase in its stock basis in T and thus, P’s T stock basis remains $100. T invests the $100 unwisely and the value of its assets declines to zero. Analysis:If P sells the T stock to a third party for $0, P’s $100 capital loss will be allowed. Treas. Reg. § 1.337(d)-2T(c)(4), Example. Y STEP 3 $0 T Stock

66. 66 Difficulties in the Application of Treas. Reg. § 1.337(d)-2T Difficulty in determining whether P’s basis increase in T was attributable to built-in gain in an asset of T. This is particularly true where there are multiple subsidiaries and many adjustments to P’s stock basis in T. Difficulty in determining whether P’s basis increase in T was attributable to built-in gain in an asset of T. This is particularly true where there are multiple subsidiaries and many adjustments to P’s stock basis in T. Determining the built-in gain in T’s assets on the date P acquires the T stock is often difficult due to the passage of time. Also, T may have its own subsidiaries acquired at earlier dates. Determining the built-in gain in T’s assets on the date P acquires the T stock is often difficult due to the passage of time. Also, T may have its own subsidiaries acquired at earlier dates. The regulation applies only to built-in gain and not built-in income. The regulation applies only to built-in gain and not built-in income.

67. 67 LDR – Built-in Income T Shareholders P T STEP 1 STEP 1$100 T Stock X STEP 2 Natural Gas $100 Asset A Asset A FMV:$100 Basis:$ 0 Facts:When P acquires T, T’s only asset is an oil and gas property worth $100. T produces the oil and gas property and receives $100 from the sale of natural gas. The $100 of income increases P’s basis in the T stock to $200. P then sells the T stock for $100 and claims a $100 capital loss. Analysis:Since T did not “dispose” of an asset with built-in gain that had been reflected in P’s stock basis in T, Treas. Reg. § 1.337(d)-2T does not apply. Y STEP 3 T Stock $100

68. 68 Notice 2004-58 The IRS will accept various methods under –2T(c), including “tracing,” “basis disconformity,” and other methods. The IRS will accept various methods under –2T(c), including “tracing,” “basis disconformity,” and other methods. No consistency required between different dispositions. No consistency required between different dispositions. What are “other” acceptable methods? What are “other” acceptable methods? Basis disconformity adopts a single entity approach. Basis disconformity adopts a single entity approach. S’s asset gain is not treated as already reflected in S stock basis if S’s inside asset basis at least equals S’s outside stock basis (i.e., basis conformity). S’s asset gain is not treated as already reflected in S stock basis if S’s inside asset basis at least equals S’s outside stock basis (i.e., basis conformity). S’s asset gain is treated as reflected in S stock basis to the extent of any excess of S’s outside stock basis over S’s inside asset basis (i.e., basis disconformity). S’s asset gain is treated as reflected in S stock basis to the extent of any excess of S’s outside stock basis over S’s inside asset basis (i.e., basis disconformity).

69. 69 Basis Disconformity Calculation Loss on subsidiary stock is disallowed to the extent of the least of three factors: Loss on subsidiary stock is disallowed to the extent of the least of three factors: Gain amount. The sum of all gains, net of directly related expenses, from asset dispositions. Gain amount. The sum of all gains, net of directly related expenses, from asset dispositions. Not necessary to the theory, but required by the language of – 2T(c). Not necessary to the theory, but required by the language of – 2T(c). No netting of asset gains with asset losses. No netting of asset gains with asset losses. Disconformity amount. Any excess of stock basis over “net asset basis.” Net asset basis equals any excess of (a) the asset basis (other than subsidiary stock), loss carryforwards available under – 21(b) in SRYs, and deferred deductions, over (b) tax liabilities. Disconformity amount. Any excess of stock basis over “net asset basis.” Net asset basis equals any excess of (a) the asset basis (other than subsidiary stock), loss carryforwards available under – 21(b) in SRYs, and deferred deductions, over (b) tax liabilities. Positive investment adjustment amount (“PIA”). Any excess of the sum of the positive – 32 adjustments over the sum of the negative – 32 adjustments, excluding adjustments for distributions. Positive investment adjustment amount (“PIA”). Any excess of the sum of the positive – 32 adjustments over the sum of the negative – 32 adjustments, excluding adjustments for distributions. Nets operating profits and losses, as well as asset gains and losses. Nets operating profits and losses, as well as asset gains and losses.

70. 70 Tracing v. Basis Disconformity In some cases, tracing disallows losses that basis disconformity would allow In some cases, tracing disallows losses that basis disconformity would allow In others, basis disconformity disallows losses that tracing would allow. In others, basis disconformity disallows losses that tracing would allow.

71. 71 LDR – Offsetting Built-in Gains and Losses T Shareholders P T STEP 1 $100 T Stock X STEP 2 Asset A $100 Asset A Asset A FMV:$100 Basis:$ 0 Asset B Asset B FMV:$ 0 Basis:$100 Facts:P purchases 100% of the stock of T for $100. T has two assets, Asset A, with $100 built-in gain and Asset B with $100 built-in loss. P causes T to sell Assets A to X. P has $100 increase in its stock basis in T and thus, P’s T stock basis is $200. Analysis:If P sells the T stock to a third party for $100, P’s $100 capital loss will be disallowed under the tracing rules but not under basis conformity. There is basis conformity because P’s stock basis in T is $200 and T’s inside basis is $200. Y STEP 3 $0 T Stock

72. 72 Tracing v. Basis Disconformity Requires knowledge of how P (or its predecessor) valued each T asset Requires knowledge of how P (or its predecessor) valued each T asset Requires asset valuations Requires asset valuations Might take into account FMV fluctuations Might take into account FMV fluctuations Does not require knowledge of how P (or its predecessor) valued each T asset Does not require knowledge of how P (or its predecessor) valued each T asset Does not require asset valuations Does not require asset valuations Does not take into account FMV fluctuations Does not take into account FMV fluctuations Basis Disconformity method is significantly more administrable. TRACING BASIS DISCONFORMITY

73. 73 Overview of Treas. Reg. § 1.1502-35T The goal is to prevent a consolidated group from recognizing more than one tax loss on a particular economic loss. Charles Ilfeld Co. v. Comm’r, 292 U.S. 62 (1934). The goal is to prevent a consolidated group from recognizing more than one tax loss on a particular economic loss. Charles Ilfeld Co. v. Comm’r, 292 U.S. 62 (1934). The -35T rule applies only if P sells less than all of its T stock within a single taxable year. Conversely, the rule does not apply if P sells all of its T stock in a single taxable year. Treas. Reg. §1.1502-35T(b)(3). The -35T rule applies only if P sells less than all of its T stock within a single taxable year. Conversely, the rule does not apply if P sells all of its T stock in a single taxable year. Treas. Reg. §1.1502-35T(b)(3). The -35T regulation contains two main rules: a loss disallowance rule and a basis spreading rule. The -35T regulation contains two main rules: a loss disallowance rule and a basis spreading rule. The -35T rules address two main scenarios: where T is deconsolidated immediately after P’s sale of T stock and where T remains consolidated immediately after the sale of T stock. The -35T rules address two main scenarios: where T is deconsolidated immediately after P’s sale of T stock and where T remains consolidated immediately after the sale of T stock.

74. 74 -35T – Basic Deconsolidation Case (Assets First) P T N STEP 3 Asset Y $100 Facts:P contributes $100 cash to T for Share A. At a later date, P contributes Asset Y to T for Share B. Asset Y has a basis of $200 and a fair market value of $100 and, therefore, has a $100 built-in loss. T later sells Asset Y for $100 and recognizes a $100 Section 1231 loss. The loss reduces P’s basis in both Share A and Share B by $50 each. P then sells Share B to N for $100 and recognizes a $50 capital loss. Thus, the P-T group has realized $50 of the $100 built-in loss twice. Analysis: The -35T regulation would prevent P from recognizing the $50 loss via the basis spreading rule. Immediately before P’s deconsolidating sale of the T stock, P’s aggregate $200 basis in all of its T stock would be spread equally among all of the shares. Thus, P’s basis in its B share would be reduced from $150 to $100, resulting in no loss on P’s sale of such share to N. X STEP 4 Share B $100 STEP 1 $100 Cash for Share A STEP 2 Asset Y with $100 BIL for Share B

75. 75 Basis Reallocation Rule This rule applies when: This rule applies when: T is deconsolidated from P, and T is deconsolidated from P, and Immediately before the deconsolidation, any of the P stock in T is worth less than its tax basis. Immediately before the deconsolidation, any of the P stock in T is worth less than its tax basis. If this rule applies, then the basis of all the T stock is reallocated in a manner so as to equalize to the extent possible the ratio of value to basis of each share. If P owns any preferred stock of T with a built-in gain, the reallocable basis is first reallocated to such preferred stock in a manner so as to increase the basis to the value to the extent possible. The remainder of the reallocable basis is then allocated to the common stock in a manner so that, to the extent possible, the ratio of basis to the value of each share is the same. If this rule applies, then the basis of all the T stock is reallocated in a manner so as to equalize to the extent possible the ratio of value to basis of each share. If P owns any preferred stock of T with a built-in gain, the reallocable basis is first reallocated to such preferred stock in a manner so as to increase the basis to the value to the extent possible. The remainder of the reallocable basis is then allocated to the common stock in a manner so that, to the extent possible, the ratio of basis to the value of each share is the same.

76. 76 -35T Loss Disallowance Rule This loss disallowance rule applies when: This loss disallowance rule applies when: P transfers any stock of T, P transfers any stock of T, Such T stock is worth less than its tax basis, Such T stock is worth less than its tax basis, Immediately after the transfer, T remains a member of the P group. Immediately after the transfer, T remains a member of the P group. In that case, the regulation requires the following: In that case, the regulation requires the following: The basis of all of the T stock held by members of the P group immediately before the transfer is aggregated. The basis of all of the T stock held by members of the P group immediately before the transfer is aggregated. The aggregate basis is allocated to any preferred stock up to the value of such stock. Any remaining basis is allocated proportionately to the common stock. The aggregate basis is allocated to any preferred stock up to the value of such stock. Any remaining basis is allocated proportionately to the common stock. Any loss remaining in the stock after the foregoing reallocation of basis is suspended to the extent of the “duplicated loss” allocated to such stock. The total duplicated loss generally equals the net inside asset basis of the subsidiary less the value of the subsidiary stock. Any loss remaining in the stock after the foregoing reallocation of basis is suspended to the extent of the “duplicated loss” allocated to such stock. The total duplicated loss generally equals the net inside asset basis of the subsidiary less the value of the subsidiary stock. The foregoing suspended loss is permanently reduced to the extent that T recognizes any loss or deduction after the stock sale while it remains a member of the P group, unless either (i) P establishes that T’s loss or deduction was not reflected in the computation of duplicated loss on P’s stock sale date, or (ii) T’s loss reduces the basis of T shares then held by P. The foregoing suspended loss is permanently reduced to the extent that T recognizes any loss or deduction after the stock sale while it remains a member of the P group, unless either (i) P establishes that T’s loss or deduction was not reflected in the computation of duplicated loss on P’s stock sale date, or (ii) T’s loss reduces the basis of T shares then held by P. P’s remaining suspended loss is allowed in the taxable year that T leaves the P group. P’s remaining suspended loss is allowed in the taxable year that T leaves the P group.

77. 77 -35T - Basic Consolidation Case (Assets First) Facts:In Step 1, P contributes $40 of cash to T in exchange for four shares of T common stock. In Step 2, P contributes Asset A with a $50 built-in loss (tax basis of $60 and value of $10) in exchange for one new share of common stock. T sells Asset A to M for $10 and recognizes a $50 Section 1231 loss. Later, P sells the one new share to N for $10 and recognizes a $40 loss. Thus, $40 of the $50 built-in loss in Asset A is duplicated within the P-T consolidated group. Analysis:Prior to the stock sale, the basis reallocation rule will eliminate the built-in loss in the one new share. Thus, P will recognize no loss when it sells the new share for $10. The basis reallocation rule will allocate P’s aggregate $50 basis in the shares evenly among the five shares ($10 to each share). P T N STEP 3 Asset A $10 M STEP 4 1 new share $10 STEP 1 $40 for 4 shares STEP 2 Asset A for 1 new share ($60 basis / $10 value)

78. 78 -35T - Basic Consolidation Case (Stock First) Facts:The facts are the same as the previous example, except that P sells the new share for $10 before T sells Asset A to M. After the stock sale, T remains a member of the P group. P would have a $50 loss on the sale of the new stock and a $50 loss on the sale of Asset M. Analysis:First, P’s basis in the new share will be decreased under the basis reallocation rule. In particular, P’s aggregate basis of $100 will be allocated pro rata among each of the five shares ($20 per share). Further, P’s $10 loss on the sale of the one new share to N will be suspended. T’s loss on the sale of Asset A to M will eliminate the suspended loss. P T N STEP 4 Asset A $10 M STEP 3 1 new share $10 STEP 1 $40 for 4 shares STEP 2 Asset A for 1 new share ($60 basis / $10 value)

79. 79 American Jobs Creation Act of 2004

80. 80 American Jobs Creation Act of 2004 Importation of Built-in Losses The Act adds new Section 362(e)(1) that applies to a transaction described in Sections 351 or 368(a)(1) where there is “an importation of a net built-in loss.” Such “importation” occurs where: The Act adds new Section 362(e)(1) that applies to a transaction described in Sections 351 or 368(a)(1) where there is “an importation of a net built-in loss.” Such “importation” occurs where: The transferor of property is not subject to U.S. income tax on gain or loss at the time of the transfer, but the transferee is; and The transferor of property is not subject to U.S. income tax on gain or loss at the time of the transfer, but the transferee is; and The aggregate adjusted basis of the property transferred exceeds its fair market value immediately after the transaction. The aggregate adjusted basis of the property transferred exceeds its fair market value immediately after the transaction. In such a case, Section 362(e)(1) provides that the basis of each property transferred is “stepped down” to its fair market value immediately after the transaction. In such a case, Section 362(e)(1) provides that the basis of each property transferred is “stepped down” to its fair market value immediately after the transaction.

81. 81 American Jobs Creation Act of 2004 Importation of Built-in Losses – Example Facts: F, a foreign corporation, transfers an asset with a basis of $200 and a value of $50 to its wholly-owned domestic subsidiary, S, in a Section 351 transaction. Facts: F, a foreign corporation, transfers an asset with a basis of $200 and a value of $50 to its wholly-owned domestic subsidiary, S, in a Section 351 transaction. Conclusion: S’s basis in the asset is stepped down to $50. Conclusion: S’s basis in the asset is stepped down to $50.

82. 82 American Jobs Creation Act of 2004 Elimination of Loss Duplication in Section 351 Transactions Generally New Section 362(e)(2) applies when: New Section 362(e)(2) applies when: there is no “importation” of the net built-in loss (and thus, Section 362(e)(1) does not apply), and there is no “importation” of the net built-in loss (and thus, Section 362(e)(1) does not apply), and the aggregate adjusted basis of the transferred property exceeds its fair market value. the aggregate adjusted basis of the transferred property exceeds its fair market value. In such a case, new Section 362(e)(2) generally limits the transferee’s aggregate adjusted basis of the property transferred to the fair market value of such property. In such a case, new Section 362(e)(2) generally limits the transferee’s aggregate adjusted basis of the property transferred to the fair market value of such property. The aggregate reduction in basis is allocated among the assets transferred in proportion to their respective built-in losses. The aggregate reduction in basis is allocated among the assets transferred in proportion to their respective built-in losses. Alternatively, the transferor and the transferee can jointly elect to reduce the transferor’s basis of the stock received in the transaction to its fair market value. Alternatively, the transferor and the transferee can jointly elect to reduce the transferor’s basis of the stock received in the transaction to its fair market value.

83. 83 American Jobs Creation Act of 2004 Elimination of Loss Duplication in Section 351 Transactions Generally – Example Facts: P transfers two assets to S in a Section 351 transaction. Asset A has a fair market value of zero and a basis of $100 and Asset B has a fair market value of $100 and a basis of zero. Facts: P transfers two assets to S in a Section 351 transaction. Asset A has a fair market value of zero and a basis of $100 and Asset B has a fair market value of $100 and a basis of zero. Conclusion: Section 362(e)(2) does not apply because the assets transferred do not have a net built-in loss. Conclusion: Section 362(e)(2) does not apply because the assets transferred do not have a net built-in loss.

84. 84 American Jobs Creation Act of 2004 Elimination of Loss Duplication in Section 351 Transactions Generally – Example Facts: P transfers two assets to S in a Section 351 transaction. Asset A has a fair market value of $100 and a basis of zero and Asset B has a fair market value of zero and a basis of $150. Thus, the assets transferred have a net built-in loss of $50. Facts: P transfers two assets to S in a Section 351 transaction. Asset A has a fair market value of $100 and a basis of zero and Asset B has a fair market value of zero and a basis of $150. Thus, the assets transferred have a net built-in loss of $50. Conclusion: Section 362(e)(2) applies. The basis of Asset B is reduced to $100. Conclusion: Section 362(e)(2) applies. The basis of Asset B is reduced to $100.