IRS Notice
99-59
 
Cumulative Bulletin Notice 99-59, , I.R.B. 1999-52, 761,
December 9, 1999.
The
Internal Revenue Service and Treasury Department
have become aware of certain types of transactions,
as described below, that are being marketed to
taxpayers for the purpose of generating tax losses.
This notice is being issued to alert taxpayers and
their representatives that the purported losses
arising from such transactions are not properly
allowable for federal income tax purposes.
The
transactions are cast in a variety of forms. In one
typical arrangement, taxpayers act through a
partnership to contribute cash to a foreign
corporation, which has been formed for the purpose
of carrying out the transaction, in exchange for the
common stock of that corporation. Another party
contributes additional capital to the corporation in
exchange for the preferred stock of that
corporation. The foreign corporation then acquires
additional capital by borrowing from a bank and
grants the bank a security interest in securities
acquired by the foreign corporation that have a
value equal to the amount of the borrowing.
Thereafter, the foreign corporation makes a
distribution of the encumbered securities to the
partnership that holds its common stock. The effect
of the distribution, combined with fees and other
transaction costs incurred at the corporate level,
is to reduce the remaining value of the foreign
corporation's common stock to zero or a minimal
amount. Although the distributed securities are
encumbered by the bank debt (and the taxpayers or
their partnership may be secondarily liable for the
debt as guarantors), the foreign corporation has
sufficient other assets to repay the debt, and it is
the understanding of all parties that the foreign
corporation will repay the debt with such other
assets.
For
example, if the taxpayers' partnership had
contributed $100x for the common stock of the
foreign corporation, the partnership might receive a
distribution of securities with a fair market value
of approximately $100x, and that distribution would
have the economic effect of reducing the remaining
value of the foreign corporation's common stock to
zero. Nonetheless, because the distribution to the
partnership is subject to the bank debt, the parties
take the position, pursuant to §301(b)(2) of the
Internal Revenue Code , that the amount of the
distribution is zero for purposes of §301 . On that
theory, no part of the distribution is treated
either as a dividend or as a reduction of stock
basis under §301(c) .
The
partnership is treated as having subsequently
disposed of the stock of the foreign corporation,
giving rise to a tax loss equal to the excess of the
partnership's original basis in the stock ($100x in
the example) over the fair market value of the
common stock after the distribution of securities
(zero). The deemed disposition of the stock may be
based upon an election under §301.7701-3(c) of the
regulations to change the federal income tax
classification of the foreign corporation from a
corporation to a partnership, giving rise to a
deemed liquidation of the foreign corporation, or by
treating the partnership as a trader in securities
which elects under §475(f) to treat the securities
that it holds, including the stock of the foreign
corporation, as having been sold for their fair
market value on the last business day of the taxable
year.
Thereafter,
typically in a later taxable year, the bank debt is
repaid out of other assets held by the foreign
corporation. Although the parties previously treated
the debt as reducing the amount of the earlier
distribution from the foreign corporation, promoters
advise taxpayers to take the position that the
foreign corporation's repayment of the debt is not
treated as a distribution on its common stock.
A
loss is allowable as a deduction for federal income
tax purposes only if it is bona fide and reflects
actual economic consequences. An artificial loss
lacking economic substance is not allowable. See ACM
Partnership v. Commissioner, 157 F.3d 231, 252
(3d Cir. 1998), cert. denied, 119 S. Ct. 1251
(1999) ("Tax losses such as these . . . which
do not correspond to any actual economic losses, do
not constitute the type of 'bona fide' losses that
are deductible under the Internal Revenue Code and
regulations."); Scully v. United States,
840 F.2d 478, 486 (7th Cir. 1988) (to be deductible,
a loss must be a "genuine economic loss");
Shoenberg v. Commissioner, 77 F.2d 446, 448
(8th Cir. 1935) (to be deductible, a loss must be
"actual and real"); §1.165-1(b)
("Only a bona fide loss is allowable. Substance
and not mere form shall govern in determining a
deductible loss.").
In
the view of the Service and the Treasury Department,
the arrangement described above (or any similar
arrangement) does not produce an allowable loss.
Through a series of contrived steps, taxpayers claim
tax losses for capital outlays that they have in
fact recovered. Such artificial losses are not
allowable for federal income tax purposes.
The
purported tax benefits from these transactions may
also be subject to challenge under other provisions
of the Code and regulations, including but not
limited to §§269 , 301 , 331 , 446 , 475 , 482 ,
752 , and 1001 of the Code.
Additionally,
the Service may impose penalties on participants in
these transactions or, as applicable, on persons who
participate in the promotion or reporting of these
transactions, including the accuracy-related penalty
under §6662 , the return preparer penalty under §6694
, the promoter penalty under §6700 , and the aiding
and abetting penalty under §6701 .
The
principal author of this notice is Ken Cohen of the
Office of Assistant Chief Counsel (Corporate). For
further information regarding this notice, contact
Mr. Cohen at
(202)
622-7790
(not a toll-free call).
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