Holding company may look through intercompany receipts for worthless-stock test

Plain-English summary

A corporate parent planned to claim an ordinary worthless-stock loss for a holding-company subsidiary after a restructuring. Section 165(g)(3) requires, among other things, that more than 90 percent of the subsidiary's gross receipts come from sources other than listed passive sources. The IRS ruled that the holding company would include receipts from consolidated-group intercompany transactions in that test. It also allowed a look-through approach, treating those receipts as passive only to the extent they were attributable to the counterparty's passive-source receipts. The ruling did not decide whether the stock was worthless or whether the taxpayer otherwise qualified for the loss.

Ruling snapshot

• Question: How should intercompany transaction receipts be treated under the section 165(g)(3)(B) gross-receipts test?
• Outcome: Approved use of a look-through approach for the intercompany receipts.
• Key authorities: IRC § 165(g)(3); Treas. Reg. §§ 1.1502-13, 1.1502-36, and 1.1502-80

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201610004                                              Third Party Communication: None
Release Date: 3/4/2016                                         Date of Communication: Not Applicable
Index Number: 165.06-00, 1502.13-00
                                                               Person To Contact:
--------------------                                           ---------------------------, ID No. ---------------
------------------------------------                           ----------------
-----------------------------                                  Telephone Number:
------------------------------------------------               --------------------
--------------------------------                               Refer Reply To:
                                                               CC:CORP:B02
                                                               PLR-119105-15
                                                               Date:
                                                               December 02, 2015




Parent                                       =         -----------------------------
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Holdco                                       =         ----------------------------------
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Sub 1                                        =         -----------------------------------------------
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Sub 2                                        =         ------------------------
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Sub 3                                        =         -----------------------------------
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Sub 4                                        =         ------------------------------------------------
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Sub 5                                        =         --------------------------------------------------------------
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Sub 6                                        =         --------------------------------------------------------------
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Sub 7 -------------------------------------------------------------------------------------------------
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Employees                                    =        ----------------------
PLR-119105-15                                                2

                                                      -------------------------

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State A                                      =        ------------

Year 1                                       =        ------

Date 1                                       =        --------------------------

Date 2                                       =        --------------------------

Date 3                                       =        -----------------------

Date 4                                       =        ------------------------

Date 5                                       =        -------------------

Date 6                                       =        -------------------

a                                            =        --------------

b                                            =        ------

c                                            =        ----

Intercompany Transaction                     =        ---------------------------------------------------------------
                                                      ---------------------------------------------


Dear -----------:

       This letter responds to your request, dated June 4 2015, submitted by your
authorized representatives on behalf of Parent, for a ruling on certain federal income tax
consequences of a restructuring transaction (the “Transaction”). The information
submitted in that request and in later correspondence is summarized below.

                                           SUMMARY OF FACTS
PLR-119105-15                                  3

         Parent is a State A corporation publicly traded and the common parent of an
affiliated group of includible corporations which join in the filing of a consolidated federal
income tax return (the Parent Consolidated Group).

         Holdco is a holding company organized on Date 1 under the laws of State A and
has been a member of the Parent Consolidated Group since inception. Holdco was
initially formed to acquire Sub 1. Since its inception, Holdco has had no separate
business operation or assets aside from its stock in subsidiary corporations.

       On Date 2, Holdco acquired Sub 1 (the Sub 1 Acquisition). Beginning of Date 2,
Sub 1 filed as part of the Parent Consolidated Group.

         On Date 3, Holdco acquired Sub 2 (the Sub 2 Acquisition). Sub 2 directly owned
100% of the issued and outstanding stock of Sub 3, which owned 100% of the issued
and outstanding stock of Sub 4 and 100% of the membership interest in Sub 5, a limited
liability company treated as a disregarded entity for federal income tax purposes. Sub 4
owned 100% of the issued and outstanding stock of Sub 6, which, in turn, owned 100%
of the issued and outstanding stock of Sub 7. Beginning on Date 3, Sub 2, Sub 3, Sub
4 and Sub 5 filed as part of the Parent’s Consolidated Group.

        Subsequent to the Sub 2 Acquisition, production and quality issues were
identified for both Sub 1 and Sub 2 resulting in lost customers and damage to the Sub 1
and Sub 2 brands. As a result, value declined significantly and projections were revised
downward.

      During all tax periods including and subsequent to Date 1, Holdco had no
separate business operations or assets (including cash) aside from its stock in Sub 1
and Sub 2 and served solely as a holding company for these subsidiaries, which were
engaged in certain businesses.

       Immediately prior to the Restructuring, defined below, Holdco had both voting
and non-voting common stock issued and outstanding. Additionally, Holdco had two
classes of convertible preferred stock issued and outstanding. Series A convertible
preferred stock and Series B convertible preferred stock. Immediately prior to the
restructuring, Parent owned, in the aggregate, b of the vote and value of Holdco. The
remaining c of the vote and value of Holdco was owned by Holdco’s management (the
Employees) who had rolled over interests as part of the Sub 1 and Sub 2 acquisitions.

       In addition, immediately prior to the Restructuring, Sub 1, Sub 2, and Sub 3, as
co-obligors, owed Parent a cumulative amount approximately equal to a with Holdco as
a guarantor (The Intercompany Loan Agreements).

      Because Holdco did not have separate cash account, certain expenses incurred
by Holdco were paid directly by Sub 1 and Sub 3. Included in these expenses were the
PLR-119105-15                                 4

amounts owed by Holdco to its managers/employees. The amounts owed by Holdco
and paid by Sub1 and Sub 3 were characterized and treated by Holdco as dividends
paid. In each of these instances, the expenses were incurred by Holdco, Sub 1 or Sub
3 disbursed the necessary funds to Holdco’s creditors in satisfaction of Holdco’s liability.

      Parent submitted financial information indicating that the businesses conducted
by Sub 1, Sub 3, Sub 4, and Sub 5, each has had gross receipts and operating
expenses representative of the active trade or business for each of the past five years.

       Parent provided the following description of the transaction (Restructuring):
       (i)   On Date 4, Holdco contributed the stock of Sub 1 to Sub 2 in exchange for
             no consideration.
       (ii)  On Date 5, Holdco converted to a limited liability company pursuant to
             state law.
       (iii) On Date 6, Parent converted a portion of the debt owed by Holdco and its
             subsidiaries in exchange for newly issued membership interest of Holdco.
             Holdco then capitalized the debt to Sub 1, Sub 2, and Sub 3.

                                      DISCUSSION

       Section 165(g)(3) provides taxpayers that are domestic corporations with an
ordinary loss on the worthlessness of stock in an affiliated subsidiary. Section 165(g)(3)
sets forth two requirements a subsidiary must satisfy in order to be considered affiliated
with the taxpayer. Paragraph (A) requires that stock meeting the requirements of
section 1504(a)(2) be owned directly by the taxpayer. Paragraph (B) requires that more
than 90 percent of the aggregate of the subsidiary’s gross receipts for all taxable years
be from sources other than the listed “passive sources” which are royalties, certain
rents, dividends, interest (except interest received on deferred purchase price of
operating assets sold), annuities, and gains from sales or exchanges of stocks and
securities.

        Rev. Rul. 88-65, 1988-2 C.B. 32, concludes that the rents received from short
term vehicle leases are not rents for purposes of section 165(g)(3)(B) due to the
significant services provided by the lessor. The ruling reasons that guidance
interpreting similar statutory language in section 1244, regarding “section 1244 stock,”
and section 1362, regarding the passive income limitation of S corporations with C
corporation earnings and profits, is relevant in construing section 165(g)(3)(B). Section
1.1362-2(c)(5)(ii)(A)(2) provides that royalties does not include royalties derived in the
ordinary course of a trade or business of franchising or licensing property. Royalties
received by a corporation are derived in the ordinary course of a trade or business of
franchising or licensing property only if, based on all the facts and circumstances, the
corporation -- (i) created the property; or (ii) performed significant services or incurred
substantial costs with respect to the development or marketing of the property.
PLR-119105-15                                5

                                  REPRESENTATIONS

(i)     Parent has owned more than 80% of the vote and value of Holdco within the
        meaning of section 1504(a)(2) since its formation on Date 1.
(ii)    Holdco’s adjusted basis in its Sub 1 shares transferred to Sub 2 pursuant to the
        Sub 1 contribution were greater than the fair market value of such property
(iii)   The Intercompany Loan Agreements are debt instruments for U.S. federal
        income tax purposes.
(iv)    Immediately before the Restructuring, Holdco’s stock was worthless within the
        meaning of section 165(g)(1) and Treas. Reg. §1.1502-80(c).
(v)     Sub 1 and Sub 3 have historically had greater than 90% of its gross receipts
        from active sources within the meaning of section 165(g)(3).
(vi)    Parent will claim a worthless stock loss with respect to the stock of Holdco only
        to the extent permitted by § 1.1502-36 relevant to the Sub 1 contributions and
        each loss transfer pursuant to the Holdco conversion.

                                   RULINGS

        Based solely on the information provided, we rule as follows:

           For purposes of the section 165(g)(3)(B) gross receipts test, Holdco will
           include in its aggregate gross receipts all amounts of gross receipts received
           in intercompany transactions that are described in Treas. Reg. § 1.1502-13
           (as effective/applicable on or after July 12, 1995) (“Intercompany
           Transactions”), and such amounts from Intercompany Transactions will be
           treated as “gross receipts from passive sources” only to the extent they are
           attributable to the Intercompany Transactions’ counterparty’s “gross receipts
           from passive sources” (“Look-Through Approach”). See Treas. Reg. 1.1502-
           13(a), (b), and (c) (as effective/applicable on or after July 12, 1995). For
           purposes of these rulings, “gross receipts from passive sources” is defined as
           royalties (other than the franchise fees described in ruling 5), certain rents,
           dividends(other than dividends received from affiliates), interest, annuities,
           and gains from sales of stock and securities as defined in section 165(g)(3)
           and the regulations thereunder.

                                        CAVEATS

      The rulings contained in this letter are based upon facts and representations
submitted by the taxpayer and accompanied by a penalties of perjury statement
executed by an appropriate party. This office has not verified any of the material
submitted in support of the request for rulings. Verification of the information,
representations, and other data may be required as part of the audit process.
PLR-119105-15                                  6

       Except at otherwise provided herein, no opinion is expressed or implied
regarding the appropriate adjustments to basis under section 1.1502-36(g) or the
application of section 382 to any transaction or item referenced in this letter.

       Except as expressly provided herein, no opinion is expressed or implied
concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, we express or imply no opinion whether the
taxpayer otherwise meets the requirements of section 165.

                              PROCEDURAL STATEMENTS

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representatives.

       A copy of this letter must be attached to any income tax return to which it is
relevant. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of the letter ruling.

                                       Sincerely,



                                       Isaac W. Zimbalist
                                       Senior Technician Reviewer, Branch 1
                                       Office of the Associate Chief Counsel
                                       (Corporate)




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