n-99-59.pdf

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# Part III - Administrative, Procedural, and Miscellaneous Tax Avoidance Using Distributions of Encumbered Property

Notice 99-59

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

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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.

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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

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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
on (202) 622-7790 (not a toll-free call).