The following article is adapted from reprinted from the M&A Tax Report, Vol. 8, No. 2, September 1999, Panel Publishers, New York, NY.
SECTION 269 AND TAX AVOIDANCE: SHOULD THE IRS GIVE UP?
By Robert W. Wood, San Francisco
Over the years, both the IRS and Congress have devoted considerable attention to discouraging the practice of so-called "trafficking" in Net Operating Losses (NOLs). The very use of the term "trafficking" both by Congress and the Service is a little insulting. After all, in common parlance this word is almost exclusively relegated to drug dealers. "Trafficking" makes it sound as though the NOLs are coming into a company's coffers hidden in the wheelwell of an imported car. I would think even the IRS would have to admit that it is a bit over-dramatic to use the "trafficking" moniker when taking about net operating losses.
In any event, this so-called trafficking occurs in cases where the parties securing the benefit of the NOL (through offset against otherwise taxable income) are not the same parties who actually incurred the NOLs, or in some cases were not even in existence when the NOLs arose. This alteration (in parties) typically arises through an acquisition of the entity that originally generated the NOLs.
The first statutory weapon that had as its objective an IRS choke-hold on this practice is currently found in Section 269. This section gives the IRS the authority to disallow deductions, credits, or other allowances where, among other things, one or more persons acquire control of a corporation, and the principal purpose of the acquisition is tax avoidance by securing the benefit of a deduction, credit, or other allowance that the acquiring persons would not otherwise enjoy.
That's a pretty long sentence, but the meaning is abundantly clear. On its face, this paraphrase of the language of Section 269 seems to give the government a pretty big stick with which to whack people that are "trafficking"—or otherwise getting tax benefits through an acquisition—that the government thinks they shouldn't get.
It is a kind of "interrorem" provision, one to discourage or perhaps even terrorize people. The threat of not getting tax benefits based on a bad intent (and who hasn't had a bad intent about something once in a while?) is meant to be ever-present. Apart from the statute, the Regulations help out on this topic, too. Indeed, Section 1.269-3(b) of the Regulations expands on the statute, ascribing a bad purpose where a corporation with profits acquires control of a corporation with NOLs and the acquisition is followed by asset transfers from the acquirer to the target that are necessary to bring the deductions into conjunction with the income. Voila, say the Regs. Such a course of action ordinarily will indicate a principal purpose to avoid tax.
Professional Corporations and Other Failures
One special indication of just how effective (or ineffective) Section 269 has been for the Service over the years is demonstrated by a walk down memory lane and a look at the history of professional corporations. The Service attempted Section 269 in a whole pile of cases. In nearly every one—despite rather dramatic and obvious incidents of tax avoidance objectives—the Service failed dismally to achieve its desired goals. The Service then prevailed upon Congress to enact Section 269A specifically to target the professional corporation in a greater and more mechanized enforcement vehicle. That provision (which is not the subject of this article) similarly failed to deliver the goods.
Then, there are the NOL restrictions under Section 382. Section 382 (as we all know) went through its own set of drawn out and involved machinations. There were several different statutory versions, one that was actually repealed before it was ever implemented! Section 382 provides its own set of quite complicated rules governing the extent to which NOLs can be used by the acquirer after an acquisition. One would think that this specific NOL statute with its technical percentage tests and its interest rate calculations would be the single system of regulation for NOL acquisitions.
Nonetheless, early on, the IRS made clear that Section 269 could knock out NOLs, even where Section 382 would seem to permit them. But as a practical matter, this kind of thing hasn't happened very often. It does make one wonder why a provision still remains in the Code if it seems only to inhibit the conduct of unsophisticated taxpayers.
Plains Petroleum Case
The latest defeat suffered by the Service in this long line of its unsatisfactory results under Section 269 is Plains Petroleum Co. v. Commissioner, T.C. Memo 1999-241 (1999). In Plains Petroleum, the taxpayer corporation was a recent spinoff from KN Energy. Plains announced its acquisition plans in its first post-spinoff annual report. It indicated that it would vigorously pursue acquisitions in order to replace its reserves and diversify its operations. During 1986, it considered over 40 acquisition targets but was unsuccessful in acquiring them given its strict acquisition criteria. In addition, shortly after its organization, Plains' management began considering the adoption of a holding company structure. In due course, management concluded that such a structure would be best for its needs.
In October, 1986 Plains was offered the opportunity to acquire Tri-Power, an entity with characteristics that fit Plains' acquisition guidelines. Tri-Power also happened to possess NOLs totaling $84 million. In addition to verifying Tri-Power's reserves, Plains engaged Arthur Andersen to review Tri-Power's tax returns and to verify the existence of the substantial NOLs. Shortly thereafter, Arthur Andersen issued a favorable opinion. Management of Plains was fully aware that pending legislation (The Tax Reform Act of 1986) would limit its ability to exploit Tri-Power's NOLs if the acquisition was not consummated before 1987.
As a result, in the latter part of 1986, a stock purchase agreement was executed and Plains' acquisition of Tri-Power was consummated. On December 1,1986, Plains transferred all of its oil and gas properties to Tri-Power, then its wholly owned subsidiary. Over the ensuing years, the income from the transferred properties was offset by Tri-Power's NOLs. In fact, Plains was able to avoid paying any federal income taxes for its 1987 through 1993 tax years because of the substantial Tri-Power NOLs. The IRS, perhaps understandably, was a bit peeved.
Tax Avoidance or Just Business?
Plains Petroleum's acquisition of control of Tri-Power and the subsequent asset drop-down fell squarely within the "normal indication" of tax-avoidance described in Reg. Sec. 1.269-3(b). Nevertheless, the Tax Court concluded based on the record that business considerations, not tax avoidance, was the principal purpose for the acquisition. As a result, the court ruled that Section 269 did not operate to disallow the use of the NOLs.
It is unfair to suggest that Section 269 could never apply, or that the court in Plains Petroleum did less than a thorough job of reviewing the provision and its implicitly comparative approach. What was the principal reason for the acquisition? The court noted that Plains purchased Tri-Power pursuant to a pre-existing plan to replace its reserves and diversify its operations. This formally documented policy tended to establish a non-tax-avoidance motive for the acquisition. Moreover, the court was impressed with the fact that NOLs were not among Plains' pre-defined acquisition criteria.
The court also concluded that the asset drop-down (which in the language of the Regulations brought the NOLs into conjunction with the income) simply facilitated Plains' pre-existing plan to adopt a holding company structure. Both transactions (the acquisition as well as the asset drop-down) were undertaken pursuant to pre-existing plans to acquire replacement reserves, diversify operations, and adopt a holding company structure. The result, it followed quite logically, was that these transactions were not accomplished principally for tax-avoidance purposes.
Readers may well note that it is probably unlikely that the Service would pursue a case with as much vigor where the current law Section 382 restrictions would apply in any event. The current version of Section 382 functions as a far more effective roadblock to would-be traffickers than the pre-1987 version of Section 382 that was in effect when Plains Petroleum closed its deal for Tri-Power. Still, the courts focus on Plains' pre- established acquisition criteria and pre-existing restructuring/holding company plan may cause some companies to write-up such documents. Having good documentation in the file, among other things, can be so useful on a rainy day.
Other Arguments, Too
The court in Plains Petroleum also rejected the other arguments advanced by the Service to support its tax-avoidance thesis. The IRS had the temerity to suggest that the mere fact that Plains was aware of Tri-Power's NOL (duh!) was enough to import a tax avoidance purpose. Sensibly though, the court concluded that the fact that Plains was aware of Tri-Power's NOL during the period leading up to the acquisition did not mandate a finding that Plains harbored a principal purpose of tax avoidance.
The court also rejected the Service's finding that Plains' investigation of Tri-Power's reserves was minimal in relation to the efforts Plains expended in investigating the status, amount and viability of Tri-Power's NOLs. The court was similarly unimpressed with the Service's argument that Plains purchased Tri-Power's reserves at an excessive price, suggesting that the excess was actually paid to secure Tri-Power's favorable tax attributes.
In fact, based on industry data, the court found that the price per unit of energy, paid for Tri-Power's reserves was actually smaller than the industry average for the relevant period. There was no premium paid here for a company, which sometimes can suggest that the premium is allocable to tax benefits such as NOLs.
The Service also sought to invoke the spirit of the consolidated return rules, suggesting to the court that something had to be done to stop tax avoidance here. The Service actually pointed out to the court that the consolidated return Separate Return Limitation Year (SRLY) rules require a new member's NOLs to be used to offset only the portion of the consolidated taxable income that it contributes. Those rules would be rendered meaningless, argued the Service, if asset drop-downs of the type occurring here could be undertaken with impunity.
How could Sec. 269 apply to "prevent frustration" of the purpose of the SRLY rules? To answer that question we should note that the SRLY rules are scheduled to be repealed in instances where Section 382 also applies to the transaction. The repeal will be effective when the proposed regulations embodying their demise are eventually finalized. In any event, the court was not moved to use Section 269 here.
As Plains Petroleum indicates, Sec. 269 need not apply in such a case — because the course of action is only ordinarily indicative, but not necessarily determinative, of the requisite principal purpose. Where a fact pattern evoking visions of tax avoidance exists, and the Service still cannot successfully invoke Section 269, it seems relevant to question whether good old Section 269 has any continuing utility.
Interaction vs. Inaction
Indeed, despite the Service's view that Sections 269 and 382 operate independently, the practical result seems to leave Section 269 as a mere stepchild, and a poor one at that. Section 382 operates, with considerable precision, to inhibit NOL transfers. Section 382 is triggered by an ownership change with respect to the loss corporation. If such a change occurs, the amount of income the NOL can offset, in any year ending after the ownership change, is limited to the Section 382 limitation. This limitation equals the product of the value of the loss corporation's stock, immediately before the ownership change, and the long-term tax-exempt rate. At the moment, that rate is just over 5%.
The simple fact that Section 382 applies to an acquisition tends to suggest that the acquisition was not, within the meaning of Section 269, undertaken principally for tax-avoidance purposes.
It seems at least conceivable that Section 269 is breathing its last puffs of second hand smoke. After all, the court in Plains Petroleum concluded that Section 269 could only apply if it was found that the acquisition was undertaken, principally for tax-avoidance purposes. That, of course, is what the statute says, and the court just found too many facts suggesting there were bona fide business reasons for this acquisition. On the record, there was no way the court could find the predominant evil intent that kicks Section 269 into high gear.
As a result, the Service lost the case, one that arguably presented it with one of the more favorable fact patterns it could encounter. If anything, the argument for Section 269's viability simply has to be weaker under the post-1986 version of Section 382.
Perhaps it will be a while before the Service takes on another Section 269 case. Maybe it is even time for it to admit that Sec. 269 likely has little continuing utility as an enforcement weapon.
Section 269 and Tax Avoidance: Should the IRS Give Up?, Vol. 8, No. 2, The M&A Tax Report (September 1999), p. 4.