Rev. Rul. 83-73: Relation-back doctrine and contingent liabilities

Citations: Rev. Rul. 83-73; 1983-1 C.B. 84

Rev. Rul. 83-73

‍ISSUES

(1) Is an acquiring corporation that pays to settle a liability of the acquired corporation allowed a deduction under section 162 of the Internal Revenue Code, through the application of section 381(c)?

(2) If the deduction is allowed, is a reimbursement for such payment includible in the gross income of the acquiring corporation?

FACTS

The taxpayer, X corporation, employing the calendar year as its accounting period, merged with Z corporation on December 1, 1979, in a reorganization qualifying under section 368(a)(1)(A) of the Code. Under the terms of the merger agreement and applicable state law, X obtained all the assets and assumed all the liabilities of Z, including a contingent claim discussed below.

As a condition of the merger, A and B, the shareholders of Z, agreed with X to reimburse X for any after-tax expenses that X might incur as the result of a specific contingent claim that C, an employee of Z, had against Z. X transferred stock to Z equal to the fair market value of Z's assets less Z's liabilities. Contingent liabilities of Z, including the contingent liability to C did not enter into this computation.

On January 15, 1981, X settled C's claim for 700x dollars. A and B reimbursed X 500x dollars during 1981, which was X's after-tax cost of the settlement with C based upon the assumption that X could deduct the payment to C and would not have to report the reimbursement as income.

X and Z used the accrual method of accounting prior to December 1, 1979, and X continued to use that method after the merger.

LAW AND ANALYSIS

Section 381(a)(2) of the Code provides that in a transfer to which section 361 applies, the acquiring corporation shall succeed to and take into account the items of the transferor corporation described in section 381(c). Section 361 provides for the nonrecognition of gain or loss in a statutory merger under section 368(a)(1)(A).

Section 381(c)(16) of the Code describes obligations of the transferor corporation as one of those items, but provides that section 381(c)(16) does not apply if the obligation is reflected in the amount of stock, securities, or property transferred by the acquiring corporation to the transferor corporation for the property of the transferor corporation.

Section 1.381(c)(16)-1(a)(5) of the Income Tax Regulations provides that the determination whether an obligation was reflected in the amount of consideration transferred by the acquiring corporation to the transferor corporation or its shareholders in exchange for the property of the transferor corporation is made on the basis of all the facts of each particular transfer. If on the date of transfer the parties were aware of the existence of a specific obligation and reduced the amount of consideration to be transferred by the acquiring corporation by a specific amount because of the existence of such obligation, then such obligation is considered to have been reflected in the amount of consideration transferred. In the absence of such facts, it is presumed that the obligation was not reflected in the amount of consideration transferred.

Section 1.381(c)(16)-1(a)(2)(iv) of the regulations provides that if the obligation gives rise to a liability after the date of a transfer, and the obligation was reflected in the amount of consideration transferred by the acquiring corporation to the transferor corporation or its shareholders in exchange for the property of the transferor corporation, then see section 381(c)(4) of the Code and the regulations thereunder.

Section 381(c)(4) of the Code, relating to the carryover of a method of accounting, provides that if prior to a merger the transferor and acquiring corporation used the same method of accounting, the acquiring corporation will carry over that method.

Section 1.381(c)(4)-1(a)(1) of the regulations provides that the acquiring corporation will take into its accounts the dollar balances of the transferor's accounts representing items of deduction that could not be deducted by the transferor prior to the transfer date because of its method of accounting; items of deduction will have the same character in the hands of the acquiring corporation as they would have had in the hands of the transferor if the transfer had not occurred. This regulation refers to section 381(c)(16) of the Code by stating that in the case of an obligation of the transferor corporation that is assumed by the acquiring corporation and that gives rise to a liability after the date of transfer, the deductibility of such an item is determined under that section if it is not deductible under section 381(c)(16) and the regulations thereunder.

Although X did not take into consideration the contingent liability to C when it computed the amount of consideration (stock) to be transferred to Z at the time of the merger, it did require the shareholders of Z to agree to indemnify it for any after-tax expenses attributable to this contingent liability. In VCA Corp v. United States, 566 F.2d 1192 (Ct. Cl. 1977), the court accepted the findings and conclusion of a trial judge who had ruled that, for purposes of section 381(c)(16) of the Code, the amount of consideration transferred by an acquiring corporation is reduced when shareholders of the transferor indemnify the acquiring corporation for its payment of a contingent obligation received in a merger.

Rev. Rul. 58-374, 1958-2 C.B. 396, examined how a transferor should treat reimbursements made in relation to the sale of property of a subsidiary, which was tax-free under section 371(d) and (f) of the Internal Revenue Code of 1939 (section 1081(d) and (f) of the Internal Revenue Code of 1954). The ruling considered whether the seller could claim an interest deduction with respect to an amount paid to reimburse the acquiring corporation for its payment of interest on a tax liability of the acquired corporation and whether the seller would have to recognize income because the acquiring corporation also paid it amounts received by the acquiring corporation as refunds of tax overpayments by the acquired corporation. The ruling held that no gain or loss was recognized with respect to either payment because they were both adjustments to the purchase price of the stock and related back to the original tax-free exchange.

Because the indemnity payments relate back to the initial exchange, the contingent obligation to C was reflected in the consideration transferred and section 381(c)(16) of the Code does not apply. However, under section 1.381(c)(4)-1(a)(1) of the regulations, the deduction is allowable under section 381(c)(4) even though it is not allowable under section 381(c)(16).

Under the principal of relation-back to the time of the initial exchange, the indemnity payments should be treated as if they had been contributions to the capital of the transferor corporation, made by its shareholders immediately before the merger. See Arrowsmith v. Commissioner, 344 U.S. 6 (1952), 1952-2 C.B. 136. Under section 118(a) of the Code, these payments result in no recognition of income. Furthermore, since the indemnity payments are seen as contributions to capital of the transferor, the acquiring corporation is not treated as receiving additional income when these payments are made; all that it has given up in the initial reorganization and subsequent adjustment are the shares of the acquiring corporation. Under section 1032(a) of the Code, there is no recognition of income.

Additionally, under section 1.118-1 of the regulations, the indemnity payments are seen as having increased the shareholders' bases in their stock of the transferor immediately before the merger. Under sections 354(a) and 358(a)(1) of the Code this increase in the bases of stock of the transferor is reflected by increasing these shareholders' bases in the stock of the acquiring corporation that they received in the merger.

HOLDINGS

(1) X, the acquiring corporation, is allowed a deduction in 1981 under sections 162 and 381(c)(4) for 700x dollars, the amount it expended to settle Z's obligation to C.

(2) X does not have to report as income the 500x dollars reimbursement that it received from A and B.

(3) A and B must increase their basis in the stock of X for the 500x dollars reimbursement they paid to X. A and B are not allowed a deduction for this reimbursement.

EFFECT ON OTHER REVENUE RULINGS

The facts in Rev. Rul. 58-374 state that the acquiring corporation reported as income the reimbursement it received from the seller for interest paid by the seller on a tax deficiency of the acquired corporation, while the seller claimed this amount as an interest deduction. Although the ruling concludes that it was improper for the seller to deduct its payment of the reimbursement because it was an adjustment to the sale price of the stock, it does not specifically state whether the acquiring corporation was correct in reporting this payment as income.

Rev. Rul. 58-374 is clarified to hold specifically that the acquiring corporation does not realize income when it is reimbursed by the seller.

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