The general rule under section 165(g) provides that a loss from worthless securities is treated as a loss from the sale or exchange of a capital asset (i.e., a capital loss). An exception to this general rule in section 165(g)(3), however, provides a more taxpayer-favorable result – the loss is treated as ordinary
instead of capital if:
(1) A domestic corporate taxpayer owns domestic or foreign subsidiary stock representing at least 80% of the voting power and at least 80% of the value of the subsidiary (“ownership test”); and
(2) More than 90% of the corporation’s historic gross receipts for all taxable years are derived from sources other than certain passive income (“gross receipts test”).
Passive income for purposes of the gross receipts test includes royalties; rent (except certain rent received from employees); dividends; interest (except interest from the sale of operating assets); annuities; and gain from the sale/exchange of stock/securities.
The Internal Revenue Service (IRS) recently concluded in a Private Letter Ruling that, for purposes of computing the gross receipts test, a foreign-based holding company owned by a US affiliate in a consolidated group takes into account the historic gross receipts of a foreign subsidiary that was liquidated into the holding company while the foreign subsidiary was solvent.
In PLR 202140002, the common parent of an affiliated group of corporations that filed a consolidated US federal income tax return (“US Parent”) wholly and directly owned a domestic corporation (“US Subsidiary”). In year one, US Subsidiary formed a foreign subsidiary (“Foreign Subsidiary 1”) to focus on developing a product (“Product”). In year two, US Subsidiary formed a second foreign subsidiary (“Foreign Subsidiary 2”) as its European operating corporation meant to facilitate the development and ultimate commercialization of Product. In year three, US Subsidiary formed a foreign holding company (“Foreign Holding Company”) to centralize foreign operations. US Subsidiary contributed all of the shares of Foreign Subsidiary 1 and Foreign Subsidiary 2, respectively, to Foreign Holding Company in exchange for additional voting stock of Foreign Holding Company. After the transaction, US Subsidiary directly owned 100% of the total vote and value of Foreign Holding Company. US Subsidiary subsequently concluded that Product was not effective as intended but continued to explore the possibility of monetizing the intellectual property (IP) associated with Product in other ways.
In the first half of year four, it became clear that the desired monetization was impossible, and, as a result, US Subsidiary began to wind down its operations related to Product, along with the foreign entities established solely for the development and commercialization of Product. As part of this process, US Subsidiary’s management eliminated Foreign Subsidiary 2’s workforce and disposed of substantially all of Foreign Subsidiary 2’s assets such that Foreign Subsidiary 2 was insolvent by date B.
On date C, Foreign Holding Company filed a check-the-box election to treat Foreign Subsidiary 2 as a disregarded entity for US federal income tax purposes effective as of date A. A third-party appraiser determined that, as of date D, US Subsidiary’s equity interest in Foreign Holding Company was worthless and, in turn, that Foreign Holding Company’s interests in Foreign Subsidiary 1 and Foreign Subsidiary 2 were worthless. On date F, US Subsidiary filed a check-the-box election to treat Foreign Holding Company as a disregarded entity for US federal income tax purposes effective as of date E. Foreign Holding Company remained insolvent as of dates E and F and had no gross receipts since its incorporation.
The taxpayer made four key representations. First, Foreign Subsidiary 2 was solvent on date A and its election to be treated as a disregarded entity would qualify as a liquidation under section 332. Second, Foreign Subsidiary 1 had no gross receipts since its incorporation. Third, Foreign Holding Company had no other subsidiaries other than Foreign Subsidiary 1 and Foreign Subsidiary 2. Finally, Foreign Subsidiary 1 and Foreign Subsidiary 2 had no subsidiaries.
Business activities of a regarded subsidiary are not considered to be the business activities of its parent. When Foreign Subsidiary 2 liquidated while solvent, however, the liquidation was subject to section 332. A liquidation under section 332 triggers section 381(a)(1), which requires the liquidating subsidiary’s owner to inherit the subsidiary’s tax attributes, including its earnings and profits. Although gross receipts are not on the enumerated list of inheritable tax attributes provided in section 381, such list is not exclusive, and the IRS concluded that, for purposes of evaluating whether the gross receipts test was satisfied, Foreign Holding Company takes into account Foreign Subsidiary 2’s historic gross receipts (in other words, gross receipts are an inheritable tax attribute under section 381). This essentially allows the conversion of a holding company into an operating company and allows a taxpayer to choose whether to take a capital loss or ordinary loss with proper planning. For purposes of this planning, it is essential that the operating company be liquidated into the holding company effective as of a date when the operating company is solvent.
Taxpayers are increasingly looking at worthless stock deductions as a result of uncertain economic conditions associated with the COVID-19 pandemic. There are several common traps taxpayers historically have encountered during an IRS audit of such deductions, including (1) establishing that the worthlessness occurred in the year claimed (and not in a prior year), (2) basis calculations, and (3) the gross receipts test. With this recent administrative guidance, the IRS has helpfully confirmed certain nuances regarding at least one such trap – the gross receipts test – and further suggests an opportunity to plan into the desired character of the claimed loss.
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