Tax Update
www.pepperlaw.com April 2009
IRS Issues Guidance On Build speakers’ corner
America Bonds • Lance Jacobs moderated a panel on “Implications
of New York’s ‘Amazon Law’” at the D.C. Bar
Taxation Section State and Local Tax Committee
In recently issued Notice 2009-26 (the Notice), the IRS
luncheon on April 21.
has provided important guidance on Build America Bonds
(BABs), a new category of tax-favored municipal bonds.
• Ellen McElroy will speak on “Tax Accounting
BABs may be issued only in 2009 and 2010, and the issuer
Issues for Companies in an Economic Downturn/
must elect BAB treatment.
NOL Position” and Todd B. Reinstein will
speak on “Tax Aspects of Alternative Energy
The interest on BABs is taxable under the Internal Revenue
Investments” at the ABA meeting on May 8-9 in
Code, but either the holder of a BAB or the issuer of the
Washington, DC.
BABs is entitled to a tax credit, depending on the type of
BAB. With a “Tax Credit” BAB, the holder is entitled to
• Todd Reinstein will provide a “Federal
a tax credit of 35 percent of the interest payable on each
Tax Update” to the Energy Association of
interest payment date. The amount of the credit is itself
Pennsylvania’s Financial Accounting Conference
taxable income. The credit is not “refundable,” and if the
in Camp Hill, Pa. on May 12.
holder cannot use the credit in a given tax year, it may be
carried forward to subsequent years. Tax Credit BABs are
• Lisa Petkun will speak on “Charitable Giving”
designed to provide the issuer with roughly a 26 percent
at the National Business Institute seminar in
“subsidy” – i.e., an investor generally would be willing
Philadelphia, Pa. on May 13.
to accept interest on a Tax Credit BAB at a rate that is
approximately 74 percent of the rate on a comparable fully
• Lance Jacobs and Bryan Keith will speak on
taxable, non-credit bond. With a “Direct Payment” BAB,
“State Conformity to Federal Tax Law Changes”
which type also must be elected by the issuer, the issuer
at the Institute for Professionals in Taxation on
itself gets a direct payment from the federal government
May 14 in McLean, Va.
of 35 percent of each interest payment. Because the issuer
is not taxed, a Direct Payment BAB is more efficient for
• Steven Bortnick will speak on “Structuring
the issuer, which in effect gets a 35 percent interest rate
Portfolio Company Debt Repurchases” at the
subsidy.
London School of Business on May 18.
Tax Credit BABs may be issued for any purpose for which
a tax-exempt governmental bond may be issued (which
excludes tax-exempt “private activity bonds”). Direct
in this issue
Payment BABs are further limited, in that they may be
issued only to finance new capital projects, plus costs of
issuance up to 2 percent of the bond proceeds and a reserve 1 IRS Issues Guidance On Build America Bonds
fund. Thus, for example, Direct Payment BABs may not 1 Speakers’ Corner
be issued to refinance, or “refund,” prior issues of bonds, 3 IRS Applies Economic Substance to Disallow the
or to finance working capital. Both types of BABs must Bankruptcy Exception under Section 382(l)(5)
comply with all requirements applicable to tax-exempt 5 IRS Issues Guidance to Small Businesses on Net Oper-
governmental bonds, including private use restrictions and ating Loss Carrybacks
arbitrage restrictions on the investment of bond proceeds. 6 Pepper Hamilton’s Tax Practice Group

Tax Update
Notice Provides Clarification
speakers’ corner continued
Before the Notice was issued, there was uncertainty about
a number of aspects of BABs, including how to make the
• Leonard Schneidman will speak on “Effectively
required elections to have the bonds be BABs (and further,
Connected Income for Foreign Investors” at
if applicable, Direct Payment BABs) and how the direct
Financial Research Associate’s 9th Annual Tax
subsidy for Direct Payment BABs would work.
Practices for Private Equity in New York City on
May 19.
Under the Notice, the BAB and Direct Payment BAB
elections need be made only on the issuer’s “books and
• Todd Reinstein will speak on “Tax Losses in
records” on or before the issuance date. For Direct Payment
Economic Crisis: Impaired Assets and Limits on
BABs, the federal government will make subsidy payments
Utilization of Losses by Insurance Companies;
beginning with interest payment dates on or after July 1,
Section 382 and Consolidated Return
2009. The issuer must file a new Form 8038-CP (Return
Regulations” at the FBA Tax Section’s 21st
for Credit Payments to Issuers of Qualified Bonds) for each
Annual Insurance Tax Seminar in Washington,
interest payment date. For fixed rate bonds, the form must
DC on May 28.
be filed no later than the 45th, and no earlier than the 90th,
day before the applicable interest payment date, and the
• Joan Arnold will moderate a panel on “Ask the
subsidy will be paid contemporaneously with the interest
Experts - India Version” at the Joint Meeting of
payment. For variable rate bonds, the form generally must
the USA and India Branches of the International
be filed quarterly, within 45 days following the quarter
Fiscal Association at The Fairmount Hotel in
to which it applies, and the subsidy will be paid on a
Washington, DC on May 28.
reimbursement basis for interest paid in that quarter.
The Notice contains additional helpful clarification about
the operation and effects of both types of BABs. For
example, it clarifies how the yield on BABs is calculated for
arbitrage purposes, and it explains how issuers are to report
the issuance of BABs on Form 8038-G. A detailed debt
service schedule must accompany that return.
Pepper Perspective
With this guidance, issuers are getting more comfortable
with BABs, and a number of large BAB issues (all of the
Direct Payment type) already have hit the street. However,
it remains important for participants to make sure the
compliance and reporting requirements are met. If the
RSS on www.pepperlaw.com
deadlines are not complied with, the special tax benefits of
these bonds could be lost.
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Tax Update
IRS Applies Economic Substance to Disallow the Bankruptcy
Exception under Section 382(l)(5)
In Chief Counsel Advice 200915033 (Dec. 24, 2008)
Taxpayers that seemingly meet all
the Internal Revenue Service (IRS) applied economic
substance and other judicial doctrines in determining that
statutory requirements but manipulate
the taxpayer could not utilize a target corporation’s net
either the economics or the timing of
operating losses under the Section 382(l)(5)1 bankruptcy
exception even though all statutory requirements appeared
a transaction to obtain favorable tax
to be satisfied. The IRS concluded that the transaction
at issue in CCA 200915033 was structured so that it consequences should be aware that the
appeared to satisfy Section 382(l)(5) but when it was recast
IRS may use various judicial doctrines
to reflect actual economic reality, the transaction could not
satisfy the underlying statutory requirements.
to deny the anticipated tax benefits.
Section 382, In General
Section 382 limits a loss corporation’s ability to utilize its least 50 percent of the vote and value of the reorganized
tax net operating losses following an ownership change. corporation after the ownership change.
A loss corporation that undergoes an ownership change
may only use pre-ownership change losses against post- Chief Counsel Advice 200915033, The Facts
ownership change taxable income to the extent of the
Section 382 limitation. In CCA 200915033, one corporation (Acquiring) acquired
all of the outstanding stock of another (Target) in a
Section 382(g) provides that an ownership change occurs if series of transactions. Initially, Target was owned by three
one or more 5-percent shareholders of the loss corporation 5-percent shareholders and a single public group. In the
increase their ownership, in the aggregate, by more than 50 first transaction of the series, Acquiring purchased from the
percentage points during a testing period. Section 382(k) public group shares in Target totaling less than 5 percent of
(1) defines a loss corporation as a corporation that (1) is Target’s outstanding common stock.
entitled to use a net operating loss carryfoward, (among
other tax attributes); (2) has a net operating loss for the Second, Acquiring entered into a stock purchase agreement
taxable year in which the ownership change occurs; or (3) with Target and Target’s principal creditor under which
has a net unrealized built-in loss. Section 382(b) provides Acquiring would purchase additional Target shares
that the Section 382 limitation is the value of the old loss and Target would solicit its shareholders to accept a
corporation multiplied by the long-term tax-exempt rate in prepackaged bankruptcy plan.
effect during the month of the ownership change.
Third, Target filed a disclosure and proxy statement with
The Section 382 Bankruptcy Exception the bankruptcy court formally requesting approval from
its shareholders for a prepackaged bankruptcy plan. The
Congress provided an exception to the general Section bankruptcy plan went into effect upon approval by the
382 limitation rules in Section 382(l)(5) (the Bankruptcy bankruptcy court. The following events occurred pursuant
Exception). The Bankruptcy Exception provides that a to the bankruptcy plan: (1) Target corporation redeemed
Section 382 limitation is not triggered upon an ownership substantially all of the Target stock held by the public
change when the loss corporation is (immediately before group and by one of the three 5-percent shareholders;
such ownership change) under the jurisdiction of the court (2) Acquiring purchased additional Target shares; and
in a Title 11 or similar case, and the loss corporation’s (3) Target’s creditors’ claims were paid by funds from
historic shareholders and creditors (determined Acquiring and/or Target in full, except that one principal
immediately before such ownership change) own at creditor’s claim was paid in part and cancelled in part.
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Tax Update
Importantly, Acquiring and the two original 5-percent have only held approximately 10 percent of Target if
shareholders that were not redeemed under the bankruptcy Acquiring had received the correct number of shares.
plan owned greater than 50 percent of Target’s common Consequently, the Bankruptcy Exception would not have
stock immediately before the bankruptcy plan went into been met and Target’s net operating losses should have
effect (and thus, before Acquiring purchased additional been subjected to limitation.
Target shares).
Next, the IRS inferred that the two original 5-percent
Fourth, within three weeks after the bankruptcy plan shareholders that were redeemed three weeks after Target
was implemented, Target redeemed the two remaining effected the prepackaged bankruptcy plan should be
original 5-percent shareholders so that Acquiring held 100 treated as if they were redeemed as part of the bankruptcy
percent of Target’s outstanding stock. Acquiring had caused and on the effective date of the bankruptcy. The IRS noted
Target to effectuate the redemption via a “short-form that the amount paid to the two shareholders three weeks
cash-out merger,” which was done without approval of after the bankruptcy suggested a side agreement since
other shareholders under Target’s articles of incorporation. the amount paid per share was the same amount paid to
Acquiring then caused Target to be converted into a single shareholders redeemed under the bankruptcy plan itself.
member limited liability company, which was treated as a The IRS pointed out that the economics suggest that a
disregarded entity for federal tax purposes. higher amount should have been paid considering the
substantial reduction in Target’s debt under the bankruptcy
This entire series of transactions was undertaken within a plan. Once again the IRS asserted economic substance
single calendar year. Acquiring then utilized substantially principles to recast this step to treat the redemptions as
all of Target’s federal tax net operating losses against taxable taking place at the time the prepackaged bankruptcy
income generated in subsequent tax years. plan was effected. In addition, the IRS noted that the
step-transaction doctrine3 could be used to collapse the
prepackaged bankruptcy plan and the later redemptions
Chief Counsel Advice 200915033, IRS Analysis
into a single step to reach the same result. Consequently,
the IRS found that the Bankruptcy Exception’s 50-percent
The IRS states in CCA 200915033 that Acquiring’s
threshold would not have been met had the two original
acquisition of Target “superficially” appears to satisfy
5-percent shareholders been properly treated as redeemed
the Bankruptcy Exception under Section 382(l)(5),
under the bankruptcy plan.
noting that Target’s post-emergence shareholders
owned greater than 50 percent of Target, pre-
Finally, the IRS noted that in a bankruptcy situation the
emergence. The IRS, however, then applied various creditors and not the shareholders effectively own the
judicial doctrines, including economic substance, debtor corporation. Acquiring not only contributed money
business purpose, substance-over-form, and the to Target in exchange for what eventually amounted to 100
step-transaction doctrine to argue that the structured percent of Target’s stock but also loaned four times more
transaction should not actually produce the claimed tax money to Target than what it contributed. Thus, the IRS
benefits. argues that as a single overall plan, Acquiring (i) infused
Target with sufficient capital to satisfy its creditors, (ii)
The IRS disputed the economic realities of several steps in eliminated Target’s unknown liabilities via bankruptcy, and
Acquiring’s acquisition of Target. First, the IRS noted that (iii) obtained 100 percent of Target’s stock.
Acquiring did not receive a sufficient number of shares
based on the amount Acquiring paid to Target under the The IRS noted that the business purpose doctrine4 also
bankruptcy plan. The IRS relied on the fact that Acquiring could be used to challenge Acquiring’s acquisition of Target
paid eight times more for newly issued shares than what and the application of the Bankruptcy Exception. The
Target paid to redeem shares from other shareholders IRS acknowledged Acquiring’s stated business purposes,
on the same date. The IRS asserted that this step lacked such as increasing transaction volume, expanding markets,
economic substance2 due to the price disparity. The IRS obtaining talented employees, and obtaining a new facility.
argued that because new money does not count towards The IRS asserted, however, that these stated business
satisfying the Bankruptcy Exception under Section 382(l) purposes should not shield the superfluous aspects of the
(5), in a recast transaction the historic shareholders would acquisition.
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Tax Update
IRS Issues Guidance to Small
Pepper Perspective
Taxpayers that seemingly meet all statutory requirements
Businesses on Net Operating
but manipulate either the economics or the timing of a
transaction to obtain favorable tax consequences should
Loss Carrybacks
be aware that the IRS may use various judicial doctrines to
deny the anticipated tax benefits. In CCA 200915033, the
IRS attacked a transaction using various judicial doctrines,
including the economic substance, business purpose, The Internal Revenue Service issued Revenue Procedure
substance over form, and step transaction doctrines. In 2009-26 (Rev. Proc.) on April 24, 2009. Rev. Proc.
addition, the IRS recommended that Section 6662(d) 2009-26 provides guidance to small businesses regarding
substantial underpayment penalties be assessed against the the application of certain net operating loss carryback
taxpayer. Taxpayers should carefully consider not just the provisions in the American Recovery and Reinvestment
statutory scheme when contemplating a transaction, but Act of 2009 (the Act). The Act provides that certain small
also the various judicial doctrines that could be asserted businesses may elect to carry net tax operating losses back
to either reorder the steps of an overall transaction, or for a period of three, four or five years to offset taxable
question the underlying economics of those steps. income in those preceding years. Before the enactment of
the Act, such taxpayers could only carry back net operating
Author: losses for two years. Rev. Proc. 2009-26 was issued in
response to the many net operating loss carryback claims
Bryan D. Keith submitted to the IRS that inadvertently failed to include
202.220.1220 a proper election and supersedes previous guidance on the
keithb@pepperlaw.com application of the Act under Rev. Proc. 2009-19.
Endnotes Specifically, Rev. Proc. 2009-26 provides that small
businesses may elect a three-, four- or five-year net
1 Unless otherwise stated, all references to “Section” are operating loss carryback by filing Form 1045 (Application
to the Internal Revenue Code of 1986, as amended, for Tentative Refund), Form 1139 (Corporation
and all references to “Treas. Reg. Section” are to the Application for Tentative Refund), or an amended tax
Treasury Regulations promulgated thereunder. return that carries back the net operating loss for three,
2 The IRS cited to Gregory v. Helvering, 293 U.S. 465 four or five years. These filings are typically due within
(1935), aff’g 69 F.2d 809 (2nd Cir. 1934); and ACM 12 months after the taxable year of the net operating
Partnership v. Comm’r, T.C. Memo. 1997-115, aff’d in loss. However, Rev. Proc. 2009-26 modifies the due date
part and rev’d in part by 157 F.3d 231 (3d Cir. 1998), and requires that the three-, four- or five-year carryback
in its analysis. elections be made within six months after the due date,
3 The IRS cited to Minnesota Tea Co. v. Helvering, excluding extensions, of the return for the taxable year of
302 U.S. 609 (1938); Penrod v. Comm’r, 88 T.C. the net operating loss. Taxpayers eligible for such elections
1415 (1987); King Enterprises, Inc. v. U.S., 418 F.2d must pay close attention to the timing and the form on
511 (Ct. Cl. 1969); Comm’r v. Gordon, 391 U.S. 83 which they make the election.
(1968); and McDonalds Restaurants of Ill. v. Comm’r,
688 F.2d 520 (7th Cir. 1982); and noted that the Author:
step-transaction doctrine can be viewed as a strand of
the substance-over-form doctrine and that the step- Bryan D. Keith
transaction doctrine can be applied using any one of 202.220.1220
three alternative tests, (i) the binding commitment keithb@pepperlaw.com
test, (ii) the end result test, or (iii) the mutual
interdependence test.
4 See Frank Lyon co. v. U.S., 435 U.S. 561 (1978).
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Tax Update
Pepper Hamilton’s Tax Practice Group
Federal and International Tax Issues
Annette M. Ahlers 202.220.1218 ahlersa@pepperlaw.com
Joan C. Arnold 215.981.4362 arnoldj@pepperlaw.com
James W. Barson 412.454.5077 barsonj@pepperlaw.com
Steven D. Bortnick 212.808.2715 bortnicks@pepperlaw.com
609.951.4117
Gordon R. Downing 215.981.4434 downingg@pepperlaw.com
W. Roderick Gagné 215.981.4695 gagner@pepperlaw.com
Howard S. Goldberg 215.981.4955 goldbergh@pepperlaw.com
Benjamin M. Hussa 215.981.4728 hussab@pepperlaw.com
Bryan D. Keith* 202.220.1220 keithb@pepperlaw.com
Timothy J. Leska 215.981.4008 leskat@pepperlaw.com
Ellen McElroy 202.220.1589 mcelroye@pepperlaw.com
Marc D. Nickel 202.220.1618 nickelm@pepperlaw.com
Michelle Parten 215.981.4894 partenm@pepperlaw.com
Lisa B. Petkun 215.981.4385 petkunl@pepperlaw.com
Todd B. Reinstein 202.220.1520 reinsteint@pepperlaw.com
Joan M. Roll 215.981.4515 rollj@pepperlaw.com
Leonard Schneidman 617.204.5104 schneidmanl@pepperlaw.com
James H. Stevralia 212.808.2724 stevraliaj@pepperlaw.com
Laura D. Warren 215.981.4593 warrenl@pepperlaw.com
State and Local Tax Issues
Philip E. Cook, Jr. 412.454.5075 cookp@pepperlaw.com
Lance S. Jacobs 202.220.1202 jacobsls@pepperlaw.com
Charles L. Potter, Jr. 412.454.5073 potterc@pepperlaw.com
Employee Benefits Issues
Jonathan A. Clark 215.981.4436 clarkja@pepperlaw.com
David M. Kaplan 215.981.4620 kapland@pepperlaw.com
Andrew J. Rudolph 215.981.4749 rudolpha@pepperlaw.com
*Admitted in the Commonwealth of Virginia only; supervision by principals of Pepper Hamilton llp who are members of the DC Bar.
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