The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 7, February 1999, Panel Publishers, New York, NY.
BEWARE TAX AVOIDANCE PURPOSE
By Robert W. Wood, San Francisco
It may almost seem an anachronism to talk about tax avoidance purpose in the context of acquisitions. Long gone are the days when tax attributes (such as net operating losses) could be easily "bought" and used by buyers without restriction. Section 382 was amended way back in 1986 to radically curtail the use of NOLs following acquisitions. Section 382 has since spawned a considerable volume of regulations, and incredible complexity.
There have also been other restrictions on the use of tax attributes, including Section 384. But what may be forgotten by many taxpayers and advisors is one of the briefer but more draconian Code sections applying to the merger field: Section 269. Section 269, it should be remembered, applies to knock out deductions, credits or other tax benefits that may have been realized in an acquisition if (but only if) the principal purpose of the acquisition was tax avoidance. A couple of phrases in Section 269 are really its key, and have been interpreted over the years in the case law. Perhaps the most important phrase in the provision is "the principal purpose" which suggests that the proscribed intent has to truly be the main reason for the acquisition, not merely one main reason. There is also a control requirement in Section 269, which is fairly straightforward (much more straightforward, in fact, than the one contained in Section 382).
Over the years, Section 269 has not been one of the Service's most effective weapons. Indeed, the IRS has lost most of the significant cases it has litigated under Section 269. Perhaps as additional evidence of the inefficacy of Section 269, the IRS had to lobby Congress for a special (but similar) provision, Section 269A, to go after tax avoidance in the personal service corporation context. Section 269 itself (at least the way the courts had interpreted it) was simply not sufficient for the IRS to use in this one particular area.
Today, it still seems unlikely that Section 269 will ever prove to be a terribly potent weapon in the hands of the IRS. Nonetheless, there has been at least one recently released piece of authority that tax advisors and M&A professionals ought to review. It is a 1993 Field Service Advice that was only recently made public (FSA 1998-416, Tax Analysts Doc. No. 98-25103). In this FSA, the IRS advised that Section 269 could be used to disallow the use of a merged corporation's NOL where substantially all of the merged corporation's assets were sold immediately after the merger. Does a mere sale of unwanted assets after a merger cause Section 269 tax avoidance principles to apply? Read on.
In the FSA, a privately held company operated a chain of supermarkets with substantial taxable income. A publicly held company (which happened to have a large NOL carryover) also operated supermarkets. The publicly held company emerged from a Chapter 11 bankruptcy with its NOL carryover intact. A merger plan was devised under which the private company would merge into the public company, the private company shareholders receiving public company shares in exchange. The public company was then to divest most of the private company's stock and devote its resources to the geographic areas where it operated.
In considering the applicability of Section 269 to this circumstance, the IRS reviews the fact that Section 269 applies where the principal purpose for an acquisition is the avoidance of federal income tax. Here, said the Service, the sale of the private company's historic business assets following the merger can create the impression that the purpose of the merger was to give the surviving company the use of the NOL carryover. The Service does note that determining a tax avoidance purpose is a purely factual question. Thus, the FSA suggests that Section 269 should be asserted only where there is a strong case.
Some factors that the Service thought helped indicate a non-tax avoidance purpose were:
the proxy statement indicated that the merger advanced the general
plan of the private company to gain control of a leading regional supermarket
the private company's board of directors found that the merger would provide its shareholders a significant return and greater liquidity.
When one reads authority such as the FSA described above, one cannot help but think that appropriate corporate documentation (corporate resolutions and the like) will go a long way toward alleviating any concern that Section 269 may apply. Section 269 has often been used by the Service almost as a throwaway argument in reviews of corporate transactions. The Service commonly asserts Section 269 in tandem with Section 382 restrictions.
Normally, defeating an IRS assertion under Section 269 is relatively easy. Still, it pays to be cautions. As a means of insuring that Section 269 remains a provision with considerably more bark than bite, it is appropriate for professionals to carefully document the non-tax reasons for an acquisition.
Beware Tax Avoidance Purpose, Vol. 7, No. 7, The M&A Tax Report (February 1999), p. 1.