Purchase Price Allocations in Deemed Actual Asset Acquisitions

SUMMARY: This document contains proposed regulations relating to the

allocation of purchase price in deemed and actual asset acquisitions.

The proposed regulations determine the amount realized and the amount

of basis allocated to each asset transferred in a deemed or actual

asset acquisition and affect transactions reported on either Form 8023

or Form 8594.

DATES: Written comments must be received by September 20, 1999.

Requests to speak and outlines of topics to be discussed at the hearing

scheduled for 10 a.m., October 12, 1999, must be received by September

20, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG 107069 97), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to CC:DOM:CORP:R (REG

107069 97), Courier's Desk, Internal Revenue Service, 1111 Constitution

Avenue, NW., Washington, DC. Alternatively, taxpayers may submit

comments electronically via the Internet by selecting the ``Tax Regs''

option on the IRS Home Page, or by submitting comments directly to the

IRS Internet site at http://www.irs.ustreas.gov/tax__regs/

regslist.html. The public hearing will be held in the NYU Classroom,

Room 2615, Internal Revenue Building, 1111 Constitution Avenue, NW.,

Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Richard

Starke, (202) 622-7790 or Stephen R. Wegener, (202) 622-7530;

concerning submissions of comments, the hearing, and/or to be placed on

the building access list to attend the hearing, Guy R. Traynor (202)

622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in this notice of proposed

rulemaking have been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507(d)).

Comments on the collections of information should be sent to the

Office of Management and Budget, Attn: Desk Officer for the Department

of the Treasury, Office of Information and Regulatory Affairs,

Washington, DC 20503, with copies to the Internal Revenue Service,

Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224.

Comments on the collections of information should be received by

October 12, 1999.

Comments are specifically requested concerning:

Whether the proposed collections of information are necessary for

the proper performance of the functions of the IRS, including whether

the collections will have a practical utility;

The accuracy of the estimated burden associated with the proposed

collections of information (see below);

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the proposed collections of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of services to provide information.

The collections of information in these proposed regulations are in

Secs. 1.338-2(d), 1.338-2(e)(4), 1.338-5(d)(3), 1.338-10(a)(4),

1.338(h)(10)-1(d)(2), and 1.1060-1(e)(ii)(A) and (B). The collections

of information are necessary to make an election to treat a sale of

stock as a sale of assets, to calculate and collect the appropriate

amount of tax in a deemed or actual asset acquisition, and to determine

the bases of assets acquired in a deemed or actual asset acquisition.

These collections of information are required to obtain a benefit.

The likely respondents and/or recordkeepers are small businesses or

organizations, businesses, or other for-profit institutions, and farms.

The regulation provides that a section 338 election is made by

filing Form 8023. The burden for this requirement is reflected in the

burden of Form 8023. The regulation also provides that both a seller

and a purchaser must each file an asset acquisition statement on Form

8594. The burden for this requirement is reflected in the burden of

Form 8594. The burden for the collection of information in Sec. 1.338-

2(e)(4) is as follows:

Estimated total annual reporting/recordkeeping burden: 25 hours.

Estimated average annual burden per respondent/recordkeeper: 0.56

hours.

Estimated number of respondents/recordkeepers: 45.

Estimated annual frequency of responses: On occasion.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless it displays a valid

control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

A. Evolution of Code and Regulations

Section 338 was added to the Internal Revenue Code of 1954 (Code)

by section 224(a) of the Tax Equity and Fiscal Responsibility Act of

1982, Public Law 97-248 (96 Stat. 324), and amended by section

306(a)(8) of the Technical Corrections Act of 1982, Public Law 97-448

(96 Stat. 2365), and further amended by section 712(k) of the Tax

Reform Act of 1984, Public Law 98-369 (98 Stat. 951). Section 338

replaces any nonstatutory treatment of a stock purchase as an asset

purchase by allowing certain acquiring corporations to elect to treat

qualifying stock purchases as asset acquisitions.

General rules for making elections under section 338 were first

issued in temporary regulations Secs. 5f.338-1, 5f.338-2, and 5f.338-3

published as TD 7942 in the Federal Register on February 8, 1984 (49 FR

4722) (1984-1 C.B. 93). Those rules were amended and redesignated as

Secs. 1.338-1T, 1.338-2T, and 1.338-3T by temporary regulations

published as TD 7975 in the Federal Register on September 6, 1984 (49

FR 35086) (1984-2 C.B. 81).

Treasury Decision 8021, published in the Federal Register on April

25, 1985 (50 FR 16402) (1985-1 C.B. 96), amended Secs. 1.338-1T and

1.338-2T and added Sec. 1.338-4T. These regulations provided guidance

in a question and answer format, most notably in the areas of asset and

stock consistency requirements.

Temporary regulations published as TD 8068 in the Federal Register

on January 8, 1986 (51 FR 741) (1986-1 C.B. 165) amended Secs. 1.338-1T

and

[[Page 43463]]

1.338-4T. The temporary regulations published on January 8, 1986 also

added Sec. 1.338(h)(10)-1T to implement section 338(h)(10), under which

a selling consolidated group can elect to treat certain stock sales as

asset sales.

Sections 1.338-1T and 1.338-4T were again amended by temporary

regulations published as TD 8072 in the Federal Register on January 29,

1986 (51 FR 3583) (1986-1 C.B. 111) (Due to typesetting errors, the

Federal Register republished TD 8072 in its entirety on March 28, 1986

(51 FR 10617)). The temporary regulations published on January 29, 1986

also amended Sec. 1.338(h)(10)-1T and added Secs. 1.338(b)-1T,

1.338(b)-22T, and 1.338(b)-3T. These regulations required the selling

price and basis allocated to each asset to be determined by using a

four class residual method.

On February 12, 1986, temporary regulations published as TD 8074 in

the Federal Register (51 FR 5163) (1986-1 C.B. 126) amended

Secs. 1.338-1T, 1.338-4T, and 1.338(h)(10)-1T and added Sec. 1.338-5T.

These regulations provided guidance on international aspects of section

338.

Sections 1.338-1T, 1.338-2T, 1.338-4T, 1.338-5T, and 1.338(h)(10)-

1T were amended by temporary regulations published as TD 8088 in the

Federal Register on May 16, 1986 (51 FR 17929) (1986-1 C.B. 103).

Sections 1.338-1T, 1.338-3T, 1.338-4T, 1.338-5T, and 1.338(h)(10)-1T

were amended by temporary regulations published as TD 8092 in the

Federal Register on July 1, 1986 (51 FR 23741) (1986-2 C.B. 49). The

temporary regulations published on July 1, 1986 also added

Sec. 1.338(b)-4T. These regulations made miscellaneous conforming

changes and transitional rules relating to making and filing section

338 elections.

Section 1060 was added by section 641 of the Tax Reform Act of

1986, Public Law 99-514 (100 Stat. 2282). Section 1060 requires both

the buyer and the seller of a trade or business to allocate their

consideration paid or received to the assets under the same residual

method prescribed by the section 338 regulations. Also as part of the

1986 act, miscellaneous changes were made to section 338 by section

631, 1275, 1804(e), and 1899A (100 Stat. 2269, 2598, 2800, 2958). The

changes to section 338 were made to conform section 338 with the repeal

of the General Utilities doctrine and to define a qualified stock

purchase by reference to section 1504.

General guidance under section 1060 was provided by Sec. 1.1060-1T,

added by temporary regulations published as TD 8215 on July 18, 1986

(53 FR 27035) (1988-2 C.B. 304). These regulations included direction

on the scope of section 1060 and reiterated the four class residual

method found in the section 338 regulations.

Section 1060 was amended by section 1006(h) of the Technical and

Miscellaneous Revenue Act of 1988, Public Law 100-647 (102 Stat. 3410).

This amendment requires the residual method to be used in the case of a

distribution of partnership property or a transfer of an interest in a

partnership, but only in determining the value of goodwill or going

concern value for purposes of applying section 755. Miscellaneous

changes were again made to section 338 by sections 1006(e)(20),

1012(bb)(5)(A), and 1018(d)(9) of the 1988 act (102 Stat. 3403, 3535,

3581).

Sections 338 and 1060 were amended by section 11323 of the Omnibus

Budget Reconciliation Act of 1990, Public Law 101-508 (104 Stat. 1388-

464). The amendments add certain reporting requirements under sections

338 and 1060. In addition, a provision was added to section 1060 under

which parties are bound by written agreements as to allocations or fair

market values. The legislative history indicates that the parties are

so bound unless the parties can refute the agreement under the

standards set forth in Commissioner v. Danielson, 378 F.2d 771 (3d

Cir.), cert. denied, 389 U.S. 858 (1967) (by presenting proof which in

an action between the parties would be admissible to alter that

construction or to show its unenforceability because of mistake, undue

influence, fraud, duress, etc.). See, H.R. Ways and Means Comm., 101st

Cong., 2d Sess. (Print No. 101-37, Oct. 15, 1990), at 79 .

Temporary regulations published as TD 8339 in the Federal Register

on March 15, 1991 (56 FR 11093) (1991-1 C.B. 52) added Sec. 1.338-6T.

The March 15, 1991, temporary regulations provided relief from

situations in which a corporation making an election under section 338

could be subjected to multiple taxation on the same gain as a result of

the 1986 repeal of the General Utilities doctrine.

On January 12, 1992, a notice of proposed rulemaking (C0-111-90)

under section 338 was published in the Federal Register (57 FR 1409)

(1992-1 C.B. 1000). The notice of proposed rulemaking contained

proposed regulations to replace the question and answer asset and stock

consistency rules of Sec. 1.338-4T and the rules relating to the

international aspects of section 338 found in Sec. 1.338-5T. In

addition, the proposed rules restated the remainder of the temporary

regulations under section 338, except that only minor conforming

changes were made to Secs. 1.338(b)-2T and 1.338(b)-3T.

Section 1060 was again amended by section 13261(e) of the Omnibus

Budget Reconciliation Act of 1993, Public Law 103-66 (107 Stat. 539).

This amendment made changes to section 1060 to conform the rules for

actual asset acquisitions to the amortization of intangibles under

section 197. In addition, the legislative history to section 197

suggested that the residual method should be altered to accommodate

section 197 intangibles (See H.R. Rep. 111, 103d Cong., 1st Sess. 760

(May 23, 1993) (1993-3 C.B. 336).

Sections 1.338-1T, 1.338-2T, 1.338-3T, 1.338-4T, 1.338-5T,

1.338(b)-1T, and 1.338(h)(10)-1T were revised and replaced by

Secs. 1.338-1, 1.338-2, 1.338-3, 1.338-4, 1.338-5, 1.338(b)-1, and

1.338(h)(10)-1, respectively, by final regulations published as TD 8515

in the Federal Register on January 20, 1994 (59 FR 2958) (1994-1 C.B.

89). The final regulations published on January 20, 1994 (TD 8515) also

removed Sec. 1.338-6T and added Sec. 1.338(i)-1. Also, a new

Sec. 1.338-4T was added by temporary regulations published as TD 8516

on January 20, 1994 in the Federal Register (59 FR 2956) (1994-1 C.B.

119). The temporary regulations provided consistency rules applicable

to certain cases involving controlled foreign corporations.

Treasury Decision 8626 amended Sec. 1.338-2 by final regulations

published in the Federal Register on October 27, 1995 (60 FR 54942)

(1995-2 C.B. 34), providing rules governing the treatment of an

intragroup merger following a qualified stock purchase of target stock

when a section 338 election is not made for the target.

Section 1.338-4 was amended and Sec. 1.338-4T was removed by final

regulations published as TD 8710 in the Federal Register on January 23,

1997 (62 FR 3458) (1997-1 C.B. 82).

Sections 1.338(b)-2T, 1.338(b)-3T, and 1.1060-1T were amended by

temporary regulations published as TD 8711 in the Federal Register on

January 16, 1997 (62 FR 2267) (1997-1 C.B. 85). The January 16, 1997,

changes to the regulations adapted the residual method to section 197

by adding a fifth class to the residual method prescribed for deemed

and actual asset acquisitions.

B. Current Regulations

Section 338 allows certain purchasers of stock to treat the

purchases instead as purchases of assets. A purchasing corporation can

elect to treat a stock acquisition as an asset acquisition if it

acquires 80 percent of the total voting

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power and 80 percent of the total value of the stock of a target

corporation (not taking into account certain preferred stock) by

purchase within a 12-month period. If a purchasing corporation makes a

section 338 election, the target is treated as if it (as old target)

sold all of its assets at the close of the acquisition date at fair

market value in a single transaction and (as new target) purchased all

of the assets as of the beginning of day after the acquisition date.

If a purchasing corporation acquires the stock of a target

corporation in a qualified stock purchase and makes a section 338(g)

election (i.e., makes a general section 338 election, not a section

338(h)(10) election), old target's gain or loss from the deemed asset

sale is included in old target's final return unless old target is a

member of a consolidated group or is an S corporation. In the

consolidated and S corporation cases, old target files a special final

return including only the items from the deemed asset sale. Sec. 1.338

1(e). In the consolidated case, that return is consolidated with

neither the selling corporation's nor the purchasing corporation's

consolidated group. In the S corporation case, old target must file the

special final return as a C corporation. The section 338(g) election

(as opposed to a section 338(h)(10) election) generally does not change

the tax treatment of the selling shareholders--that is, they are still

taxed on their stock sale, notwithstanding the purchasing corporation's

section 338(g) election.

In certain cases, the selling shareholders may join with the

purchasing corporation in making a section 338(h)(10) election. Until

1994, a section 338(h)(10) election could be made only for target

corporations that were members of a consolidated group. The 1994

revisions to the section 338 regulations (effective retroactively to

1992 at taxpayers' election) expanded the eligibility for section

338(h)(10) elections to target corporations that are members of an

affiliated group and S corporations. The section 338(h)(10) election

changes the tax treatment of old target and the selling shareholders.

Old target is deemed to sell all its assets in a single transaction

while a member of the selling consolidated group (or while a non-

consolidated affiliate, or while an S corporation owned by the selling

shareholders) and is deemed immediately thereafter to distribute the

proceeds in complete liquidation to the members of the selling

consolidated group who sold the target stock (or to the selling

affiliate or to all the S corporation shareholders). Thus, under

section 338(h)(10), the selling shareholders are not treated as selling

stock but instead realize gain or loss, if any, on the stock in the

deemed liquidation. Sec. 1.338(h)(10)-1(d)(2). Usually, a selling

consolidated group or selling affiliate will recognize no stock gain or

loss on the deemed liquidation under section 332. S corporation

shareholders will include their share of items of income, gain, loss,

or deduction on the deemed asset sale passed through to them under

section 1366, increase or decrease their basis accordingly under

section 1367, and then recognize any remaining gain or loss in their

stock under section 331 (the overall effect of which is to recognize

net gain or loss equal to the amount of built-in gain or loss in their

S corporation stock immediately before the qualified stock purchase).

In the case of a section 338(g) election, old target's total amount

realized for the assets it is deemed to sell (aggregate deemed sale

price or ADSP) is the sum of (a) the purchasing corporation's grossed-

up basis in recently purchased target stock; (b) the liabilities of new

target; and (c) other relevant items. This is the amount to be

allocated among the assets sold for purposes of determining gain or

loss on the assets. Sec. 1.338-3(d)(1) and (2). The liabilities

referred to in (b) are those liabilities assumed by new target, but the

amount thereof taken into account in ADSP is determined as if old

target had sold its assets to an unrelated person for consideration

that included the liabilities. The liabilities include any tax

liability resulting from the deemed asset sale. Secs. 1.338-3(d)(3) and

1.338(b)-1(f). In the case of a section 338(h)(10) election, ADSP is

modified. While not stated explicitly, modified ADSP (MADSP) appears to

exclude any tax liabilities resulting from the deemed asset sale.

Sec. 1.338(h)(10)-1(f).

New target's adjusted grossed-up basis in the assets it is deemed

to purchase (AGUB) is the sum of (a) the purchasing corporation's

grossed-up basis in recently purchased target stock; (b) the purchasing

corporation's basis in nonrecently purchased target stock; (c) the

liabilities of new target; and (d) other relevant items. This is the

amount to be allocated among the assets sold for purposes of

determining the purchaser's basis in the assets. Sec. 1.338(b)-1(c)(1).

Section 1060(a) requires a purchaser and a seller to allocate basis

for any applicable asset acquisition in the same manner as amounts are

allocated to such assets under section 338(b)(5). Section 1060(c)

defines an applicable asset acquisition as any transfer of assets that

constitute a trade or business where the transferee's basis is

determined wholly by reference to the consideration paid for the

assets.

Section 338(b)(5) authorizes the Secretary to issue regulations

prescribing how the deemed purchase price is to be allocated among the

assets. Final and temporary regulations under sections 338(b) and 1060,

as amended, implement this authority. The regulations generally require

that the basis of the acquired (or deemed acquired) assets will be

determined using a five class residual method. Class I consists of cash

and cash equivalents; Class II consists of certificates of deposit,

U.S. Government securities, readily marketable stock or securities, and

foreign currency; Class III includes all assets not included in Class

I, Class II, Class IV, or Class V; Class IV consists of section 197

intangible assets except those in the nature of goodwill and going

concern value; and Class V consists of section 197 intangible assets in

the nature of goodwill and going concern value. The total allocable

basis is first decreased by the amount of Class I assets. Any remaining

amount is allocated proportionally to Class II assets to the extent of

their fair market value. Any remaining amount is then allocated first

to Class III assets and then to Class IV assets in the same manner as

to Class II assets. Finally, any remaining amount is allocated to the

Class V assets. See Secs. 1.338(b)-2T and 1.1060-1T.

Reasons for Change

A. In General

The regulations under section 338 have developed, in large part,

through a series of small changes and additions according to the

priorities of taxpayers' and the government's needs and in response to

statutory amendments to section 338 or other relevant Code sections.

Most of the regulations under section 338 (Secs. 1.338-1, 1.338-2,

1.338-3, 1.338-4, 1.338-5, 1.338(b)-1, 1.338(h)(10)-1, and 1.338(i)-1)

were made final as part of a single package as recently as 1994, but,

with the exception of the consistency rules, most of those regulations

were largely restatements of the existing temporary regulations that

had been developed to that point. The remaining temporary regulations

under section 338 and the temporary regulations under section 1060 have

been substantively changed only once since 1986 and 1988, respectively,

to accommodate the addition of section 197 to the Code. As a result of

the ad hoc manner in which the regulations under sections 338 and 1060

have been amended, the current regulations are

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difficult to follow. Thus the IRS and Treasury determined that a review

of the regulations was appropriate.

In addition, the current regulations have proven problematic in

three major respects: first, in their statement of tax accounting rules

and their relationship to tax accounting rules for asset purchases

outside of section 338, second, in the effects of the allocation rules,

and, third, in their lack of a statement of a complete model for the

deemed asset sale (and, in the case of section 338(h)(10) elections,

the deemed liquidation) from which one can determine the tax

consequences not specifically set forth in the regulations.

B. Tax Accounting Rules Under Current Regulations

The current regulations include certain rules for accounting for

items in connection with the deemed asset sale. These tax accounting

rules apply for determining the original amounts of and subsequent

adjustments to ADSP and AGUB. For example, the regulations provide

rules governing the treatment of contingent liabilities deemed assumed

by new target. In some respects the tax accounting rules in the current

regulations differ considerably from the tax accounting rules

applicable to actual asset sales.

Link Between Old Target's and New Target's Tax Accounting

Under the current regulations, ADSP is defined as the sum of (a)

the grossed-up basis of the purchasing corporation's recently purchased

target stock, (b) the liabilities of new target, and (c) other relevant

items. Thus, the calculation of ADSP is linked to the tax accounting

treatment of new target or the purchaser of new target in item (a)

above. Such link does not exist, however, in the case of an actual

asset sale between two parties. In actual asset sales the timing and

amount of the seller's amount realized and the timing and amount of the

buyer's basis may differ. For example, with respect to the link under

(a), the current fair market value of promised future contingent

payments that constitute debt is taken into account in amount realized

under Sec. 1.1001-1(g) unless, in rare and extraordinary circumstances,

the fair market value is not reasonably ascertainable. Yet, under

Sec. 1.1012-1(g), the current fair market value of such future

contingent payments is not taken into account currently in the

purchaser's basis.

This link between old target's deemed sales price and the

purchasing corporation's basis in target stock existed in the original

version of section 338, adopted in 1982. In 1984, Congress removed that

link from the statute, providing instead that old target should be

deemed to sell its assets at fair market value. The regulations

originally allowed old target to choose between using the three-part

formula (items (a) through (c)) above to calculate ADSP and treating

the assets as being sold at their fair market value. In 1994, new

regulations eliminated the election, thereafter requiring use of the

three-part formula. Under the current regulations, any contingent

payments for target stock do not become part of AGUB and ADSP until

they become fixed and determinable. However, no rule prevents the

seller from using all its basis to offset the amount realized in the

year of the deemed sale. As a result of the link between old target's

deemed sales price and the purchasing corporation's purchase price, old

target receives open transaction treatment on terms broader than those

available in an actual asset sale. Compare Sec. 15A.453-1(d)(2)(iii)

(``Only in those rare and extraordinary cases involving sales for a

contingent payment obligation in which the fair market value of the

obligation * * * cannot reasonably be ascertained will the taxpayer be

entitled to assert that the transaction is `open.' '')

Liabilities Assumed

The current regulations specify new target's tax accounting

treatment for the assumption of liabilities. New target takes a

liability into account in AGUB only if it is a bona fide liability of

target as of that date that would be properly taken into account in

basis under principles of tax law if new target had acquired old

target's assets from an unrelated person and, as part of the

transaction, had assumed, or taken property subject to, the

liabilities, and the amount thereof is determined on the same basis.

Sec. 1.338(b)-1(f)(1) and (2).

Under Sec. 1.338(b)-3T(a)(1), AGUB is subsequently redetermined

only if an adjustment would be required, under general principles of

tax law, in connection with an actual asset purchase by new target from

an unrelated person. One of the subsequent events enumerated as an

example is the change in a contingent liability of target to one which

is fixed and determinable. Section 1.338(b)-3T(c)(1) provides that a

contingent amount (including contingent liabilities of old target

deemed assumed) is taken into account at the time at which such amount

becomes fixed and determinable. The statement of the latter rule

suggests to some that it overrides the rules based on general

principles of tax law stated in Secs. 1.338(b)-1(f)(2) and 1.338(b)-

3T(a)(1). However, interpreting the fixed and determinable rule in this

manner would be inconsistent with the economic performance rules of

section 461(h), that, in some circumstances, would operate to defer new

target's taking an assumed liability into account until some time after

the liability becomes fixed and determinable. See Secs. 1.461-4(a) and

1.446-1(c)(1)(ii)(B).

Installment Method

The current regulations provide no rules for old target to report

its deemed sale gain under the installment method. Because the parties

could have structured an actual asset sale to qualify for the

installment method, commentators have argued that making the

installment method available when a section 338(h)(10) election is made

would be consistent with the full asset sale model implied by those

rules. Making the installment method available when only a section

338(g) election is made would not be appropriate because the target

shareholders are still treated as selling stock and because target

would get a step-up in basis of assets before it had borne the tax

burden for such step-up.

C. Allocation Rules Under Current Regulations

Fast Pay Assets

The current regulations employ a residual method of allocation.

Under the residual method, the amount of basis to be allocated to

goodwill and going concern value is based entirely on the amount of

basis remaining to be allocated after all other assets have been

allocated basis to the extent of their fair market values. Because

assets other than goodwill and going concern value tend to be more

easily valued, the residual allocation method is intended to result in

less controversy over the value of goodwill and going concern value.

The legislative history of section 1060, adopted in the Tax Reform Act

of 1986, Public Law 99-514, (100 Stat. 2282), noted with approval the

use of the residual method under the section 338(b) regulations and

required that the same method be used in regulations to be prescribed

under section 1060. See S. Rep. No. 313, 99th Cong., 2d Sess., May 29,

1986, at 254. Accordingly, the current regulations place each acquired

asset into one of five asset classes. The total allocable basis is

allocated among the classes starting with the first class and

proceeding to the final, residual class. No asset in any class except

for the residual class can be allocated more than its fair market

value. If the aggregate basis allocable to a particular

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class is less than the aggregate fair market value of the assets within

the class, each asset is allocated an amount in proportion to its fair

market value and nothing is allocated to any junior class.

The residual allocation method presents unique problems when the

cost of the assets, and hence the basis to be allocated thereto, is

less than the aggregate fair market value of the individual assets.

This situation may arise as a result of the use of contingent

consideration for target stock or the deemed assumption of liabilities

that are not yet taken into account. If this is the case, the basis of

the assets is said to be impaired. Under the residual method, the

impairment is borne equally by the assets in the first class in which

the cumulative fair market value exceeds the remaining aggregate basis

available for allocation. As no basis is allocated to assets in junior

classes, they are also impaired. If such an asset is sold, the taxpayer

will realize a gain on its disposition even if its value has not

increased since the acquisition date. Taxpayers may reverse the gain

recognized in later years if the purchasing corporation pays or incurs

additional amounts for target stock or additional target liabilities

deemed assumed are taken into account. For this reason, the gain

recognized is often referred to as phantom income.

The problem is most acute with assets that turn over quickly, such

as accounts receivable and inventory (fast pay assets). Comments

received on the temporary regulations suggested that fast pay assets

should be placed in a more senior class to make it more likely that

basis is allocated equal to the assets' fair market values in order to

alleviate concerns over phantom income.

Top-Down Allocation

Under the current regulations, stock in a subsidiary is generally a

Class III asset. In allocating basis among tiered corporations, an

allocation to the stock of a subsidiary becomes the starting point for

allocation to the assets inside the subsidiary if a section 338

election is also made for the subsidiary. See, e.g., Sec. 1.338-2(b)(4)

of the current regulations. One might refer to this as top-down

allocation. Under a top-down allocation, the basis of assets of a

particular class can be more impaired at one corporate level than at

another. For example, Class III assets in the parent target corporation

might be allocated some basis while Class II assets in its subsidiary

are allocated no basis because Class I assets in the subsidiary have

absorbed all the basis allocated to the stock in the subsidiary, a

Class III asset. The differences in impairment arising from the

differences in the location of assets and liabilities is inconsistent

with the residual method (e.g., liabilities secured by an asset support

basis of all assets in a single corporation) and can lead to the

misallocation of basis.

D. Statement of Complete Model

For purposes of effectuating the statutory purpose of permitting

taxpayers to elect to treat a stock acquisition as an asset

acquisition, section 338 and the current regulations deem certain

transactions to occur. The current regulations' express statement of

these deemed transactions provides the appropriate Federal income tax

consequences for most targets for which a section 338 election is made.

However, as with the tax accounting rules, some taxpayers interpret the

express statements in the current regulations as resulting in tax

consequences different from those had they actually engaged in the

transactions deemed under the regulations to have occurred or as

resulting in the tax consequences specifically stated and not any of

the collateral consequences.

Explanation of Provisions

A. Overview of Changes

The proposed regulations are intended to clarify the treatment of,

and provide consistent rules (where possible) for, both deemed and

actual asset acquisitions under sections 338 and 1060. In addition, the

proposed regulations propose changes to the current regulations to take

into account changes to the tax law made since the different portions

of the current regulations were published. The changes made by the

proposed regulations have four major components: organization of the

regulations; clarification and modification of the accounting rules

applicable to deemed and actual asset acquisitions; modifications to

the residual method mandated for allocating consideration and basis;

and miscellaneous revisions to the current regulations. These changes

are discussed in the order in which they arise in the proposed

regulations. The IRS and Treasury did not address any provisions of the

regulations relating to the consistency rules or the international

aspects of section 338.

B. Organization of Regulations

The proposed regulations change the organization of the regulations

in order to make the rules for all asset acquisitions more

administrable and provide consistent treatment, when appropriate, for

deemed and actual asset acquisitions. In order to make the regulations

more administrable, the proposed regulations redesignate certain of the

final regulations and reorganize and restate the remaining final and

temporary regulations in a manner that is more consistent with the

approach the IRS and Treasury has taken to drafting regulations in

other areas. The proposed regulations also attempt to provide similar

treatment, when appropriate, for deemed and actual asset acquisitions

by stating the relevant concepts once in the regulations under section

338 and cross-referencing those rules in Sec. 1.1060-1 of the proposed

regulations.

New Sec. 1.338-1 includes a scope statement. Section 1.338-1 also

addresses the question of to what extent the deemed asset sale and

other elements of the section 338 regime are considered as actually

having occurred for purposes of application of other Code sections,

such as those relating to retirement plan sponsors. Terminology and

definitions and provisions regarding the mechanics of the section 338

election of current Sec. 1.338-1 have been moved to new Sec. 1.338-2.

The return filing rules of current Sec. 1.338-1 have been moved to

their own section, Sec. 1.338-10. All of the current Sec. 1.338-2 rules

for qualification for making the section 338 election and rules

relating to the effect on continuity of proprietary interest have been

moved to new Sec. 1.338-3.

The rules defining ADSP, as well as various rules relating to

taxation of old target, currently in Sec. 1.338-3, are in Sec. 1.338-4

of the proposed regulations. The rules defining AGUB, currently in

Sec. 1.338(b)-1, are in Sec. 1.338-5. Current Sec. 1.338(b)-3T sets

forth the timing of increases or decreases in ADSP and AGUB; these

timing rules have been moved to new Sec. 1.338-4 (ADSP) and new

Sec. 1.338-5 (AGUB).

Current Secs. 1.338-4 and 1.338-5, dealing with consistency and

with international aspects of section 338, respectively, have been

renumbered Sec. 1.338-8 and 1.338-9, respectively. The substance of

these rules has not been addressed in connection with these proposed

regulations.

Section 1.338-6 of the proposed regulations addresses allocation of

ADSP and AGUB among assets, currently covered by Sec. 1.338(b)-2T. The

rules pertaining to subsequent adjustments to ADSP and AGUB, currently

in Sec. 1.338(b)-3T, are in Sec. 1.338-7 of the proposed regulations.

[[Page 43467]]

Section 1.338(h)(10)-1 has not been renumbered.

C. Section 1.338-1 General Principles; Status of Old Target and New

Target

Regulations' Scope Statement

The scope statement describes the general model of the deemed asset

sale and other aspects of the regulations used as the basis for the

rules in the proposed regulations. This statement of the model should

assist the reader generally in the correct interpretation and

application of the regulations. This section also provides that old

target and new target (as well as any other affected parties, for

example, when a section 338(h)(10) election is made) are to determine

the tax consequences as if they had actually engaged in the

transactions deemed under the section 338 regulations to have occurred.

Thus, the proposed regulations clarify that old target's deemed asset

sale may result in tax consequences for old target and new target (such

as income and deduction) in addition to old target's gain or loss

realized on its deemed sale of assets. For example, if target is an

insurance company for which a section 338 election is made, the deemed

asset sale would be characterized and taxed as an assumption-

reinsurance transaction under applicable Federal income tax law. See

Sec. 1.817-4(d).

The proposed regulations make minor amendments to the list of

sections in subtitle A for purposes of which old target and new target

are considered the same corporation, notwithstanding the deemed asset

sale between the two. Such changes generally are with respect to

retirement plan and similar provisions.

Anti-Abuse Rule

The proposed regulations incorporate an anti-abuse rule giving the

Commissioner, for purposes of calculating ADSP and AGUB and allocating

ADSP and AGUB among assets, the authority under certain circumstances

(a) to treat as not being part of target's assets those added to the

pool of target's assets before the deemed asset sale and (b) to treat

as being part of target's assets those removed from the pool of

target's assets before the deemed asset sale. The Commissioner's

authority to treat assets added to the pool as not being part of the

pool exists when the property is transferred to old target in

connection with the transactions resulting in the application of the

residual method if such property is, within 24 months after the deemed

asset sale, (a) not owned by new target but owned, directly or

indirectly, by a member of the affiliated group of which new target is

a member, or (b) owned by new target but held or used to more than an

insignificant extent in connection with an activity conducted, directly

or indirectly, by another member of the affiliated group of which new

target is a member in combination with other property acquired,

directly or indirectly, from the transferor of the property to old

target. The Commissioner's authority to treat assets removed from the

pool as being part of the pool exists where the property is removed in

connection with the transactions resulting in the application of the

residual method if the removed property, within 24 months after the

deemed asset sale, (a) is owned by new target, or (b) is owned,

directly or indirectly, by a member of the affiliated group of which

new target is a member and continues after the election to be held or

used to more than an insignificant extent in connection with one or

more of the activities of new target.

D. Section 1.338-2 Nomenclature and Definitions; Mechanics of the

Section 338 Election

Definitions

Four definitions of terms already used in the current regulations

have been added to the proposed regulations under section 338. These

terms are acquisition date asset, deemed asset sale, deemed sale gain,

and deemed sale return. The scope of some of these terms has been

expanded from their usage in the current regulations. For example,

deemed asset sale refers to the transaction deemed under the section

338 regulations to occur between old target and new target and deemed

sale gain, refers to, in the aggregate, the Federal income tax

consequences (generally, the income, gain, deduction, and loss) of the

deemed asset sale. Deemed sale gain can also refer to the Federal

income tax consequences of the transfer of a particular individual

asset in the deemed asset sale. The expanded definition of deemed sale

gain in conjunction with the rules in Sec. 1.338-7(c) of the proposed

regulations (Sec. 1.338(b)-3T(h) of the current regulations) provides a

mechanism for target (or, in the case of a section 338(h)(10) election,

the member of the selling consolidated group, the selling affiliate, or

the S corporation shareholders to which such income, loss, or other

amount is attributable) to report items that are properly taken into

account after the acquisition date. One such item would be the

deduction for an assumed liability of old target that it could not

deduct under its method of accounting on or before the acquisition

date.

The definition of purchasing corporation has been clarified to

include new target (new T) with respect to its deemed purchase of stock

in its own subsidiary.

The definition of selling group in Sec. 1.338-2 of the proposed

regulations and related provisions in Sec. 1.338(h)(10)-1 of the

proposed regulations provide that a section 338(h)(10) election may be

made for target notwithstanding that it was at some time during the

year in which the acquisition date occurs the common parent of its

affiliated or consolidated group, so long as it is not the common

parent on the acquisition date.

E. Section 1.338-3 Qualification for the Section 338 Election

More Than a Nominal Amount Paid for Purchase of Stock

The IRS and Treasury have received many informal comments in which

guidance was requested on whether a section 338 election may be made

for a target that is insolvent. In order to have a purchase of a share

of stock in target, the proposed regulations generally require that

more than a nominal amount of consideration be paid for the stock. With

respect to target affiliates, one cannot adequately determine whether

more than a nominal amount of consideration is paid for the stock

because the amount paid is not determined in an arm's length

transaction but instead under the allocation rules of the regulations.

Consequently, the proposed regulations provide that stock in a target

affiliate acquired by new target in the deemed asset sale of target's

own assets is considered purchased if, under general principles of tax

law, new target is considered to own stock of the target affiliate

meeting the requirements of section 1504(a)(2), notwithstanding that no

purchase price may be allocated to target's stock in the target

affiliate. For a discussion of the tax consequences when a qualified

stock purchase is made of an insolvent corporation and a section

338(h)(10) election is made, see the discussion of section 338(h)(10)

elections later in this preamble.

Time for Testing Relationship

A section 338 election may be made only with respect to a

transaction that qualifies as a purchase within the meaning of section

338(h)(3). Under section 338(h)(3)(iii), the parties to the transaction

must be unrelated in order for a transaction to qualify as a purchase.

The statute is unclear,

[[Page 43468]]

however, as to when the relationship between the parties is tested. The

proposed regulation provides that the relationship is tested

immediately after the transaction. This rule gives effect to the

statutory objective of preventing a transferor from obtaining the

benefits of a section 338 election while retaining a significant

interest, directly or indirectly, in the property transferred. This

rule also furthers the statutory objective of affording similar tax

treatment to section 338 deemed asset sales and actual asset sales. For

example, under this rule, if an actual sale of assets would qualify as

a reorganization under section 368(a)(1)(D) (with a carryover of basis

and other attributes), taxpayers are not able to reach a different

result by structuring the transaction as a stock sale and electing

under section 338.

F. Sections 1.338 4 and 1.338 5 Aggregate Deemed Sale Price; Various

Aspects of Taxation of the Deemed Asset Sale; Adjusted Grossed-up Basis

Breaking the Link Between ADSP and AGUB

Under the current regulations, the first element in the definition

of ADSP is the grossed-up basis of the purchasing corporation's

recently purchased target stock. The combination of the link between

the definitions of ADSP and AGUB with the rule in the current

regulations that contingent payments are taken into account in AGUB as

they become fixed and determinable effectively affords old target open-

transaction treatment, which treatment generally is inconsistent with

Secs. 15A.453-1(d)(2)(iii) and 1.1001 1(g)(2). The proposed regulations

remove the link in the current regulations between calculation of the

first element of ADSP and the purchaser's basis in recently purchased

target stock.

The new first element in the calculation of ADSP is the grossed-up

amount realized on the sale to the purchasing corporation of the

purchasing corporation's recently purchased target stock. Amount

realized is determined as if old target itself were the selling

shareholder. Also, notwithstanding that the sellers of the target

shares may use the installment method of section 453 to report their

gain on the stock, old target may not use the installment method in the

calculation of the first element of ADSP.

Time and Amount Combined

The proposed regulations provide that general principles of tax law

apply in determining the timing and amount of the elements of ADSP, and

that ADSP is redetermined at such time and in such amount as an

increase or decrease would be required, under general principles of tax

law, to the individual constituent elements of the definition of ADSP.

The proposed regulations also provide a parallel rule for AGUB.

Substantively, the two statements are designed to eliminate special

accounting rules included in the current section 338 regulations-such

as the current regulations' fixed and determinable rule for the timing

of taking into account contingent amounts-and to bring taxation of old

target's deemed asset sale closer to the taxation of an actual asset

sale. In contrast to the current regulations, the proposed regulations

state in one location all the rules for determining ADSP and AGUB.

Both the breaking of the link between the calculation of ADSP and

the purchaser's basis in recently purchased stock and the removal of

the fixed and determinable rule for contingent liabilities may often

result in increased disparities between ADSP and AGUB.

Liabilities

The current regulations appear to presume that any tax liability of

old target incurred on its deemed asset sale is a liability assumed by

new target if a section 338(h)(10) election is not made but is not a

liability assumed by new target if a section 338(h)(10) election is

made. These presumptions apparently required that the definition of

ADSP be modified in current Sec. 1.338(h)(10)-1. The proposed

regulations make clear that, whether or not a section 338(h)(10)

election is made, old target's tax liability is deemed not assumed by

new target only if the parties have agreed that (or the tax or non-tax

rules operate such that) the seller, and not target, will bear the

economic cost of that tax liability. This is because the legal burden

for the tax would otherwise remain with target. Thus, the proposed

regulations remove the term MADSP from Sec. 1.338(h)(10)-1, and extend

the use of the term ADSP to that regulation.

Under the proposed regulations, the amount of liabilities of old

target taken into account to calculate ADSP is determined as if old

target had sold its assets to an unrelated person for consideration

that included the unrelated person's assumption of, or taking subject

to, the liabilities. Similarly, they provide that, in order to be taken

into account in AGUB, a liability must be a liability of target that is

properly taken into account in basis under general principles of tax

law that would apply if new target had acquired its assets from an

unrelated person for consideration that included the assumption of, or

taking subject to, the liability. Regarding the timing of taking such

liabilities into account, the proposed regulations provide that general

principles of tax law apply in determining the timing and amount of the

elements of ADSP and AGUB. Thus, for example, under general principles

of tax law, a particular liability might not be taken into account in

basis when a purchaser buys an asset subject to such liability, but

might be taken into account at some later date; such timing controls

the timing of including the liability in AGUB. Accordingly, the current

rule in the regulations that liabilities are taken into account in

calculating AGUB, and apparently ADSP, only when such liabilities

become fixed and determinable is removed in the proposed regulations.

Costs

The treatment of selling costs for old target and acquisition costs

for new target is modified. For old target, it is made clear that when

grossing-up the selling shareholders' amount realized where not all the

target stock is recently purchased by the purchaser, the amount of

selling costs by which that grossed-up amount realized is reduced is

not itself grossed-up. For new target, the definition of AGUB is

changed such that when the purchaser's basis in recently purchased

stock is grossed-up, acquisition costs are no longer also grossed-up.

Grossing-up the selling shareholders' selling costs or the

purchasing corporation's acquisition costs would result in costs not

actually incurred reducing old target's amount realized for the assets

or increasing new target's cost basis in the assets. The IRS and

Treasury do not believe that these results are appropriate because

there is no evidence that the purchasing corporation's costs to acquire

an amount of target stock sufficient for there to be a qualified stock

purchase would increase proportionately if it acquired all of the

target stock and the deemed asset sale mechanism allows taxpayers to

avoid many of the costs that would be incurred in an actual asset sale.

Accordingly, the IRS and Treasury have exercised the authority under

section 338(b)(2) to prevent the grossing-up of selling costs and

acquisitions costs.

Other Relevant Items

The element other relevant items is removed from the definitions of

both ADSP and AGUB as it no longer serves any function. In the current

regulations, this element reduces ADSP for the purchasing corporation's

acquisition

[[Page 43469]]

costs that would otherwise be taken into account because the

purchaser's basis in recently purchased stock was an element in

calculation of both ADSP and AGUB. This element becomes unnecessary

with the removal of the link between ADSP and AGUB.

G. Section 1.338-6 Allocation of ADSP and AGUB Among Target Assets

Allocation of ADSP and AGUB Generally

Apart from a change in the number of classes, the proposed

regulations generally do not represent a substantive change in the

system of allocation of ADSP and AGUB. The proposed regulation states

the allocation rules that apply equally to ADSP and AGUB and then

states the modifications to those common allocation rules for AGUB.

Transaction Costs

Generally, the definition of fair market value is the price at

which a willing seller will transfer an asset to a willing buyer.

Therefore, the fair market value of a particular asset to a seller is

not different from the fair market value of the same asset to a buyer,

even though the economic value of the asset to each would reflect the

selling costs or acquisition costs. A seller may reduce its amount

realized on an asset and a buyer may increase its cost basis in an

asset for the transaction costs specifically allocable to the asset in

an actual asset sale. Because the underlying transaction in section 338

is actually a stock sale, the costs incurred are not specifically

allocable to any individual asset deemed transferred, but rather to the

stock. Therefore, in applying the residual method to a deemed asset

sale, transaction costs are accounted for only by decreasing the total

amount realized by the seller or increasing the total cost basis of the

buyer. In contrast, see the discussion of the treatment of transaction

costs in an actual asset acquisition below.

IRS Challenges to Asset Fair Market Value

Drawing from the existing rules under section 1060, the proposed

regulations provide that the IRS may challenge a taxpayer's

determination of the fair market value of any asset by any appropriate

method and take into account all factors, including any lack of adverse

tax interests between the parties.

Number and Content of Classes

The seven classes under the proposed regulations are as follows:

Class I, cash and cash equivalents; Class II, actively traded personal

property as defined in section 1092(d), certificates of deposit, and

foreign currency; Class III, accounts receivable, mortgages, and credit

card receivables which arise in the ordinary course of business; Class

IV, stock in trade of the taxpayer or other property of a kind which

would properly be included in the inventory of taxpayer if on hand at

the close of the taxable year, or property held by the taxpayer

primarily for sale to customers in the ordinary course of his trade or

business; Class V, all assets not in Class I, II, III, VI, or VII;

Class VI, all section 197 intangibles except goodwill or going concern

value; and Class VII, goodwill and going concern value.

AGUB Less Than the Amount of Class I Assets

The proposed regulations clarify that, if the total AGUB (or

consideration in an applicable asset acquisition under section 1060) to

be allocated is less than the amount of Class I assets (i.e., cash and

cash equivalents), then new target (or the purchaser in an applicable

asset acquisition under section 1060) immediately recognizes ordinary

income to that extent.

Marketable Securities

The current regulations include marketable stock and securities, as

defined in Sec. 1.351-1(c)(3), in Class II. Marketable stock and

securities are included in Class II because a value can be easily

assigned at any given time by looking at the value at which those

instruments were trading on a securities exchange. Since the time Class

II was first defined, financial markets have evolved and a greater

variety of financial instruments can be readily valued in the same

manner. The proposed regulations instead defines Class II with respect

to actively traded personal property as defined under section 1092(d)

because the regulations under that section have a more comprehensive

definition of public financial markets.

Fast Pay Assets

The IRS and Treasury are aware that many taxpayers engage in

transactions solely to avoid the impairment problems with fast-pay

assets. In addition, the IRS spends time evaluating whether such

transactions are subject to challenge under the section 338 regulations

or general principles of tax law. In order to address these concerns,

the proposed regulations create two new classes of assets between

current Classes II and III, one for accounts receivable, mortgages, and

credit card receivables which arise in the ordinary course of business

and another for stock in trade of the taxpayer or other property of a

kind which would properly be included in the inventory of taxpayer if

on hand at the close of the taxable year, or property held by the

taxpayer primarily for sale to customers in the ordinary course of its

trade or business.

Residual Class

In the current regulations, Class V, the residual class, is

comprised of section 197 intangibles in the nature of goodwill and

going concern value. Class IV is comprised of all section 197

intangibles except those in the nature of goodwill and going concern

value. Because many section 197 intangibles would have been

characterized by the IRS as assets in the nature of goodwill and going

concern value prior to the enactment of section 197, the current

regulations provide somewhat ambiguous guidance as to the line between

current Class IV and current Class V. Accordingly, the proposed

regulations remove the phrase ``in the nature of.'' Furthermore, in

rare circumstances, goodwill or going concern value is not a section

197 intangible. The residual class should include all goodwill and

going concern value to ensure that the residual method serves the

purpose of reducing valuation controversies. Therefore, the proposed

regulations define the residual class as goodwill and going concern

value without any reference to whether those assets would qualify as

section 197 assets.

In TD 8711, supra, the IRS amended the current regulations to adapt

the residual method to section 197 by creating a new Class IV for

section 197 intangibles other than goodwill or going concern value and

providing that goodwill and going concern value would remain in a true

residual class. The proposed regulations retain this distinction in

renumbered Class VI and Class VII. Allocating goodwill and going

concern value to Class VII avoids the need for determining the value of

goodwill and going concern value through a non-residual method.

Allocation of AGUB When Gain Recognition Election Available but Not

Made

When the purchaser of the target stock holds nonrecently purchased

target stock and no section 338(h)(10) election is made, the purchaser

has the option of making or not making the gain recognition election.

(If a section 338(h)(10) election is made, the making of the gain

recognition election is automatic rather than elective.) The proposed

regulations retain these rules. The current regulations have a special

allocation rule when the failure to make

[[Page 43470]]

the gain recognition election leaves AGUB less than ADSP (that is, when

the purchaser's nonrecently purchased stock was bought at a lower price

than the recently purchased stock). Under the special allocation rule,

AGUB, after reduction by the amount of Class I assets, is allocated

among all other assets, regardless of their class, in proportion to

their fair market values. (For this purpose, the fair market value of

assets in the residual class (current Class V) is deemed to be the

excess, if any, of the hypothetical purchase price over the sum of the

Class I assets and the fair market values of the Class II, III, and IV

assets. The hypothetical purchase price is the AGUB that would result

if a gain recognition election were made.)

If, looking at the hypothetical purchase price, full fair market

value was paid on the acquisition date for assets in each class above

the residual class, the current regulation's special allocation rule

spreads the impairment that arises because no gain recognition election

was made equally among all assets in classes below Class I. However,

if, looking at the hypothetical purchase price, full fair market value

was not paid on the acquisition date for assets in each class above the

residual class, this rule spreads the impairment that arises because no

gain recognition election was made as well as the impairment that

arises from the bargain purchase equally among all assets in classes

below Class I. In the latter case, the prioritization of classes under

the residual method becomes irrelevant by the failure to make a gain

recognition election. Prior to the enactment of section 197, the effect

of the current regulations generally would have been to shift basis

from depreciable or amortizable assets to nondepreciable,

nonamortizable assets.

The proposed regulations modify the special allocation rule to

minimize this effect. Generally, under the modified special allocation

rule, the portion of AGUB (after reduction by the amount of Class I

assets) to be allocated to each Class II, III, IV, V, VI, and VII asset

is determined by multiplying (a) the amount that would be allocated to

such asset under the general rules for allocation of AGUB were AGUB

increased to equal the hypothetical purchase price by (b) a fraction,

the numerator of which is actual AGUB (after reduction by the amount of

Class I assets) and the denominator of which is the hypothetical

purchase price (after reduction by the amount of Class I assets). The

reason for the modification is to spread only the impairment that

arises because no gain recognition election was made equally among all

assets in classes below Class I.

The IRS and Treasury request comments as to whether any special

allocation rule has continuing merit.

H. Section 1.338-7 Allocation of Redetermined ADSP and AGUB Among

Target Assets

In General

Section 1.338(b)-3T of the current regulations addresses subsequent

adjustments to ADSP and AGUB. In the proposed regulations, these rules,

contained in Sec. 1.338-7, have been streamlined and some of their

content has been moved to the sections defining ADSP and AGUB,

Secs. 1.338-4 and 1.338-5 respectively. The proposed regulations

eliminate the use of the term adjustment event used in certain

provisions of the current regulations. Instead, the proposed

regulations provide simply that when general principles of tax law

require a change in the amount of any of the various elements of ADSP

or AGUB (discussed earlier), the new ADSP or AGUB amount is reapplied

to produce new allocations to the assets. This generally is not

intended as a substantive change to the current rules for subsequent

adjustments provided in Sec. 1.338(b)-3T.

Item-Specific Adjustments

The current regulations at Sec. 1.338(b)-3T contain special rules

for changes to AGUB (and thus, indirectly, to ADSP) that relate to the

income produced by intangible assets. The special rules apply for

purposes of allocating an increase or decrease in AGUB or ADSP to the

extent (a) the contingency that results in the increase or decrease

directly relates to income produced by a particular intangible asset

(contingent income asset) and (b) the increase or decrease is related

to such contingent income asset and not to other target assets. The

special rules consist of two provisions that vary from the normal rules

of Sec. 1.338(b)-3T. Under the first provision, the fair market value

of the contingent income asset at the beginning of the day after the

acquisition date is redetermined at the time of the increase or

decrease in AGUB or ADSP (but only those circumstances that resulted in

the increase or decrease to AGUB or ADSP are taken into account in the

redetermination). Under the second, the increase or decrease in AGUB or

ADSP is allocated first to the contingent income asset, not to all

assets generally under the normal allocation rules. Any portion that

cannot be so allocated because of the fair market value limitation (as

redetermined) is allocated under the normal allocation rules.

The intent of this rule was to accommodate the uncertainties in the

valuation of contingent income assets. The rule produces an allocation

that would have resulted if the parties had known on the acquisition

date the fair market value of the contingent income asset (as

determined, with hindsight, on the date of the adjustment event) and

paid on the acquisition date the increased or decreased consideration.

The IRS and Treasury weighed the usefulness of this rule with its

complexity and decided that the proposed regulations should not include

any item-specific adjustment rule. Commentators, if they believe that

the item-specific adjustment rule continues to serve a useful function

that justifies its retention, should identify in their comments in what

circumstances the rule has proven useful or could prove useful.

Commentators should also identify what provisions would be necessary

for an effective item-specific adjustment rule.

I. Section 1.338(h)(10)-1 Deemed Asset Sale and Liquidation

Model

The proposed regulations explain the effects of the section

338(h)(10) election on the parties involved. The proposed regulations

discuss the effects of the section 338(h)(10) election on the

purchasing corporation, the effects on new target, the effects on old

target, and the effects on old target's shareholders (including non-

selling shareholders).

As with the rest of the proposed regulations, proposed

Sec. 1.338(h)(10)-1 describes the model on which taxation of the

section 338(h)(10) election is based. Under the proposed regulations,

old target is treated as transferring all of its assets by sale to an

unrelated person. Old target recognizes the deemed sale gain while a

member of the selling consolidated group, or owned by the selling

affiliate, or owned by the S corporation shareholders (both those who

actually sell their shares and any who do not). Old target is then

treated as transferring all of its assets to members of the selling

consolidated group, the selling affiliate, or S corporation

shareholders and ceasing to exist. If target is an S corporation, the

deemed asset sale and deemed liquidation are considered as occurring

while it is still an S corporation. The proposed regulations treat all

parties concerned as if the fictions the section 338(h)(10) regulations

deem to occur actually did occur, or as closely thereto as possible.

The structure of this model

[[Page 43471]]

should help taxpayers answer any questions not explicitly addressed by

the proposed regulations. Also, old target generally is barred by the

proposed regulations from obtaining any tax benefit from the section

338(h)(10) election that it would not obtain if it actually sold its

assets and liquidated.

The treatment of S corporation targets which own one or more

qualified subchapter S subsidiaries (as defined in section 1361(b)(3))

is also addressed, as is the treatment of tiered targets (i.e., the

order of their deemed asset sales and deemed liquidations).

Deemed Liquidation

The current regulations provide that, when a section 338(h)(10)

election is made, old target is deemed to sell all of its assets and

distribute the proceeds in complete liquidation. The term complete

liquidation is generally considered to be a term of art in tax law. The

proposed regulations instead provide that old target transferred all of

its assets to members of the selling consolidated group, the selling

affiliate, or S corporation shareholders and ceased to exist, making it

clear that the transaction following the deemed asset sale does not

automatically qualify as a distribution in complete liquidation under

either section 331 or 332. This is meant to clarify any inference one

might draw from previous regulations that section 332 treatment is

automatic under section 338(h)(10) in the case of an affiliated or

consolidated group. For example, if S owns all of the stock of T, T is

insolvent because of its indebtedness to S, P acquires T from S in a

qualified stock purchase, and, as a condition of the sale, S cancels

the debt owed it by T, and P and S make a section 338(h)(10) election

for target, T's deemed liquidation would not qualify under section 332

because S would not be considered to receive anything in return for its

stock in T. Rev. Rul. 68-602 (1968-2 C.B. 135).

Special S Corporation Issues

The current regulations provide that, notwithstanding the purchase

of 80 percent of the shares of an S corporation by a purchasing C

corporation, the S corporation continues to be considered an S

corporation for purposes of determining the tax effects of the section

338(h)(10) election to old target and its S corporation shareholders.

For example, old target reports to its shareholders under section 1366

the tax effects of its deemed asset sale, and the shareholders adjust

their stock basis pursuant to section 1367. The proposed regulations

clarify that when the target itself is an S corporation immediately

before the acquisition date, any direct and indirect subsidiaries of

target with respect to which qualified subchapter S subsidiary

elections are in effect are considered to remain qualified subchapter S

subsidiaries for purposes of target's and its S corporation

shareholders' reporting the effects of target's deemed sale of assets

and deemed liquidation. No similar rule applies when a qualified

subchapter S subsidiary, as opposed to the S corporation that is its

owner, is the target corporation. The IRS and Treasury request comments

as to whether it would be beneficial to make section 338(h)(10)

elections available for acquisitions of qualified subchapter S

subsidiaries and as to how the section 338(h)(10) regulations should be

modified to accommodate the unique taxation of these entities.

The proposed regulations clarify the effects of the section

338(h)(10) election on both selling and non-selling S corporation

shareholders. For example, the proposed regulations clarify that all S

corporation shareholders, selling or not, must consent to the making of

the section 338(h)(10) election, particularly because the non-selling

shareholders have to include their proportionate share of the deemed

sale gain under section 1366. Form 8023 will be corrected to reflect

this requirement.

Availability of the Section 453 Installment Method

When some or all of the target stock is purchased for an

installment obligation and a section 338(h)(10) election is made, the

proposed regulations make the section 453 installment method available

to old target in its deemed asset sale, as long as the deemed asset

sale would otherwise qualify for installment sale reporting. Solely for

purposes of the application of section 453 and related provisions to

the deemed asset sale and subsequent deemed corporate liquidation under

section 338(h)(10), old target generally is considered to receive from

new target in the deemed asset sale consideration consisting of the

installment obligation given to old target shareholders in exchange for

recently purchased stock, the assumption of, or taking subject to, old

target liabilities, and cash. Thus, regardless of its actual character,

any consideration conveyed by the purchaser to the selling shareholders

other than installment obligations is considered to have been in cash,

including for instance the purchaser's assumption of, or taking subject

to, liabilities of the selling shareholders. In addition, the amount of

any grossing-up under Sec. 1.338-4(d) of the proposed regulations is

deemed to be in the form of cash. For purposes of section 453, new

target is considered to be the obligor on the installment obligation

the purchasing corporation actually issued. The provisions of sections

453(h), 453B(d), and 453B(h) may then apply to old target and its

shareholders with respect to the deemed liquidation of old target

following the deemed asset sale. In the deemed liquidation, a selling

shareholder who actually received an installment obligation in the

stock sale is deemed to receive that installment obligation as part of

the liquidating distribution; the other shareholders are deemed to

receive none of the installment obligation.

The proposed regulations provide that old target generally is

barred from obtaining any tax benefit from the section 338(h)(10)

election that it would not obtain if it actually sold its assets and

liquidated. This bar extends to the application of section 453. In

other words, the results of application of section 453 to old target

should be as close as possible to those that would occur if old target

actually sold its assets for an installment obligation of the

purchaser. Thus, for example, the installment method of section 453

applies unless old target affirmatively elects out of the installment

method.

As another example, Sec. 15A.453-1(b)(2)(iv) provides that any

obligation created subsequent to the taxpayer's acquisition of the

property and incurred or assumed by the taxpayer or placed as an

encumbrance on the property in contemplation of disposition of the

property is not qualifying indebtedness if the arrangement results in

accelerating recovery of the taxpayer's basis in the installment sale.

Old target would be subject to this test with respect to its debts new

target is deemed to assume or take subject to.

Further, the rule of section 453A requiring payment of interest

will apply in the same manner as it would apply if target actually sold

all its assets in return for consideration that included an installment

obligation from the purchaser and then distributed in complete

liquidation all the consideration received.

Tiered Targets

The proposed regulations provide that, in the case of parent-

subsidiary chains of corporations making section 338(h)(10) elections,

the deemed asset sale at the parent level is considered to precede that

at the subsidiary level. The proposed regulations then provide,

however, that the deemed liquidation of

[[Page 43472]]

the subsidiary is considered to precede the deemed liquidation of the

parent.

Additional Information Required

The proposed regulations provide that the Commissioner may exercise

the authority granted in section 338(h)(10)(C)(iii) to require the

provision of any information deemed necessary to carry out the

provisions of section 338(h)(10) by requiring submission of information

on any tax reporting form. The IRS and Treasury are considering

requiring that the information about the amount and allocation of AGUB

and ADSP currently submitted on the election form (Form 8023) instead

be submitted by the purchaser and seller(s) separately on their income

tax returns, and is interested in comments on this approach.

J. Section 1.1060-1

Definition of Trade or Business

Section 1060 applies to the direct or indirect transfer of a trade

or business. Under the current regulations, a group of assets

constitutes a trade or business if the use of such assets would

constitute an active trade or business for purposes of section 355.

Further, even if a group of assets would not qualify as an active trade

or business for purposes of section 355, a group of assets will

constitute a trade or business for purposes of section 1060 if goodwill

or going concern value could attach under any circumstances. The

current regulations set out factors that will be considered in

determining whether goodwill or going concern could attach.

Although the current regulations set out factors, there are still

ambiguities regarding when goodwill or going concern value could

attach. For example, Sec. 1.1060-1T(b)(2) has been misinterpreted to

mean that a trade or business exists only when basis is allocated to

goodwill or going concern value under the residual method. Under the

misinterpretation, a taxpayer would be required to filter every bulk

asset purchase through the residual allocation method in order to

determine whether the transaction is subject to section 1060. The

proposed regulations clarify that a trade or business is present if

goodwill or going concern value could attach to the group of assets,

regardless of whether any value will eventually be allocated to the

residual class (Class VII).

In addition, the proposed regulations provide that the presence of

assets in the nature of section 197 assets is a factor to be considered

in determining whether goodwill or going concern value could attach.

This clarification recognizes that many section 197 assets would have

been considered part of goodwill or going concern value at the time

Congress enacted section 1060. However, the proposed regulations make

it clear that the transfer of an isolated section 197 asset will not be

subject to section 1060.

The proposed regulations clarify that an applicable asset

acquisition can occur even if the trade or business is transferred from

seller to purchaser in a series of related transactions and that the

residual method must be applied once to all of the assets transferred

in a series of related transactions. The proposed regulations also

incorporate the principles of the anti-abuse rule from Sec. 1.338-1(c)

of the proposed regulations to determine which assets must be included

for purposes of applying the residual method.

Asymmetrical Transfers of Assets

Section 1060 applies to the direct or indirect acquisition of a

trade or business when the purchaser's basis in the assets (other than

assets to which section 1031 applies) is determined wholly by reference

to the consideration paid by the purchaser. This rule clarifies that a

purchaser of assets in an applicable asset acquisition is subject to

the allocation rules set out in Secs. 1.338-6 and 1.338-7 even if the

transferor in the transaction is treated as transferring something

different from the assets the transferee is treated as receiving. For

example, Rev. Rul. 99-6 (1999-6 I.R.B. 6) concerns the purchase, by one

person, of all of the interests in a limited liability company which is

classified as a partnership under Sec. 301.7701-3. The revenue ruling

sets forth two situations and holds that each seller is treated as

having transferred its interests in the partnership, while each

purchaser is treated as having purchased the assets of the limited

liability company. The proposed regulations make it clear that each

purchaser described in Rev. Rul. 99-6 must use the residual method

prescribed under Secs. 1.338-6 and 1.338-7 to allocate the

consideration paid for the purchased assets (provided that the asset

transfer otherwise qualifies as an applicable asset acquisition).

Multiple Trades or Businesses Transferred in a Single Transaction

The current regulations are silent on the proper application of the

residual method to situations when a seller transfers a group of assets

that could be categorized as constituting more than one trade or

business. The proposed regulations clarify that, as long as any part of

the assets are a trade or business, all of the assets are to be treated

as a single trade or business for purposes of applying the residual

method. Therefore, the residual method should be applied once to all of

the assets transferred, rather than to blocks of the assets separately.

This rule is intended to reduce valuation conflicts regarding how much

consideration should be allocated to each separate group of assets. By

treating all of the assets as a single trade or business, all assets in

Classes I through VI can receive full fair market value allocation

before the goodwill of any trade or business is allocated basis. In

addition, this rule brings actual asset acquisitions into conformity

with deemed asset acquisitions by allocating consideration paid across

all assets acquired, without looking to the trade or business with

which they are associated.

Miscellaneous Changes

The proposed regulations incorporate two miscellaneous changes

addressing issues that have arisen under the current regulations.

First, the proposed regulations include any covenants entered into

between the seller and the purchaser in connection with an applicable

asset acquisition as an asset transferred as part of a trade or

business even though, to the seller, the covenant is a contract for

services. As a result, sellers must include any covenants in the asset

pool for purposes of applying the residual method, thus allowing for

greater symmetry to be achieved between the purchaser and seller.

Second, the like-kind exchange rule in the current regulation has

been expanded. Under this expanded rule, if an applicable asset

acquisition includes property that is transferred subject to any

provision of the Code or regulations that has the tax effect of section

1031, the tax treatment determined under such provision is given

effect. The residual method is then applied to the remaining assets and

consideration exchanged.

In addition, the proposed regulations no longer separately state

the residual allocation method. Instead, proposed Sec. 1.1060-1

incorporates the residual method by cross reference to proposed

regulations Secs. 1.338-6 and 1.338-7. Proposed regulation Sec. 1.1060-

1 only sets out rules in which the treatment of an actual asset

acquisition differs from the treatment of a deemed asset acquisition.

By cross-referencing the section 338 regulations rather than separately

stating the residual method, the proposed regulations ensure that

deemed and actual asset acquisitions will be treated similarly to the

extent possible.

[[Page 43473]]

Transaction Costs

Under the current regulations, consideration is allocated to each

asset to the extent of that asset's fair market value as long as there

is sufficient consideration to provide full allocation of basis to each

asset in the class. The fair market value limitation and the residual

allocation method of the current regulations do not permit costs

associated with specific assets to be allocated to those assets. For

example, if a purchaser incurred costs to acquire an asset and section

1060 did not apply to the acquisition, the basis of that asset would be

increased to reflect those costs. However, the fair market value

limitation under the current regulations would limit a purchaser's

basis in the asset to its fair market value. The proposed regulations

allow the buyer and seller to adjust their allocation of consideration

to particular assets for costs incurred which are specifically

identified with those assets. Thus, the total amount the seller

allocates to an asset for which it incurs specifically identifiable

costs would be less than its fair market value and, for the buyer,

greater than its fair market value. The parties are not allowed to

apportion costs associated generally with the overall transaction to

specific assets. A similar rule is not necessary, and therefore not

included, under section 338, because the underlying transaction is a

stock sale. Any costs associated with a deemed asset sale are of the

type generally associated with the overall sale of stock and,

therefore, the parties would not be allowed to apportion those costs to

specific assets under the rule.

Written Allocation Agreements

After the current regulations were adopted, Congress amended

section 1060 to provide that a written agreement allocating purchase

price is binding on both parties. See section 1060(a). The legislative

history indicates that parties must report consistent with their

agreed-upon allocations, unless the parties are able to refute the

agreement under the standards set forth in Commissioner v. Danielson,

378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967). The proposed

regulations incorporate the Danielson standard by reference.

Specific Requests for Comments and Matters Under Study

A. Examples in the Section 338 and Section 1060 Regulations

The proposed regulations, for the most part, retain the examples of

the current regulations. The retained examples are updated to reflect

the changes in the location, terminology, and substance of the

regulations which they illustrate. Some examples have been dropped as

it was thought that they were unnecessary. Comments are requested as to

whether any of the retained examples (or new examples) are superfluous

and whether other examples are necessary to illustrate the regulations.

B. Discharge of Indebtedness Income in the Case of Tiered Targets Under

Section 338 and the Current Regulations

Taxpayers may inadvertently experience adverse tax consequences

when there is intercompany indebtedness owing between tiered targets

acquired in the same qualified stock purchase. Such consequences might

include the realization of discharge of indebtedness income and changes

to the issue price of the indebtedness. The latter could affect the

total amount of AGUB to be allocated.

For example, assume that T owns 100 percent of the stock of T1, T

and T1 do not file a consolidated return, and T is indebted to T1.

Assume also that P acquires all the stock of T in a qualified stock

purchase and makes section 338 elections for both T and T1. Under

Sec. 1.338-2(b)(4), first old T is considered to sell its assets to new

T, and new T is deemed to assume the debt of old T to old T1. Next, old

T1 is deemed to sell its assets to new T1. New T1 thus may be

considered to acquire debt owed by new T (to old T1) at a time when new

T1 is related to new T.

Under section 108(e)(4), this may trigger discharge of indebtedness

income for new T if new T1's adjusted basis in the acquired debt is

less than the amount of the debt (see Sec. 1.108-2(f)(1)). That might

occur when the T stock is purchased partly for contingent consideration

not originally taken into account in AGUB. A variety of similar issues

may arise under Sec. 1.1502 13(g).

The IRS and Treasury solicit comments on whether the application of

section 108(e)(4) and Sec. 1.1502-13(g) is appropriate in these

circumstances and how one might best address these consequences.

C. Ideas for Revision of Application of the Residual Method of

Allocation Under Section 338 in the Case of Tiered Targets

In General

The IRS and Treasury are studying ways of addressing the allocation

of ADSP and AGUB in the case of tiered targets making section 338

elections. Set forth below is the framework for one potential method

that would equalize the amount of impairment for assets in a given

class without regard to which target corporation owns the assets. This

method uses a lookthrough approach. The method is incomplete, raises

difficult issues, and is more complicated than the current rules. For

these reasons, the proposed regulations do not adopt the method.

However, the IRS and Treasury request comments as to the value and

feasibility of the method; how best to resolve its issues; and what

alternative approaches might be better. For instance, would it be

better to have a complicated special method such as that described

below that operates in every case of tiered targets or, as the proposed

regulations do, retain the approach of the current regulations with the

addition of an anti-abuse rule, the goal of which is to restrict

movement of assets in advance of the qualified stock purchase

undertaken to benefit from the shortcomings of the current top-down

rules?

Essentially, the lookthrough approach referred to above would

revise the treatment of Classes I through V (referring to the class

numbering system of the proposed regulations). In allocating to these

senior classes, the tiered targets would be aggregated for purposes of

calculating the overall purchase price and allocating that amount among

the individual assets. This rule would apply to a target (referred to

as the parent target) and to those of its lower tier subsidiaries for

which a section 338 election is also made (referred to as subsidiary

targets). Stock in subsidiaries for which section 338 elections are not

or cannot be made would continue to be treated for all purposes as a

Class V asset (or Class II if publicly traded)--in other words, such

entities would not participate in the aggregation.

The method would thereafter switch back to the normal top-down

system for allocation to assets in Classes VI and VII, because the

process of dividing up the amount allocated to the aggregate goodwill

of all the targets under the residual method would be antithetical to

the notion that goodwill is best valued by looking at what value is

left over rather than being separately valued, and because both Class

VI and VII assets generally get the same 15 year amortization period

pursuant to section 197-hence determining which of those two classes or

assets within the classes receives a given dollar of basis is

relatively insignificant.

An issue in applying the method is how to treat liabilities owed by

one group member to another. The IRS and Treasury request comments as

to whether such liabilities should be

[[Page 43474]]

treated for all allocation purposes as not debt but as stock in the

debtor-member held by the creditor-member, and whether to do so even if

the creditor-member is a subsidiary of the debtor-member.

One possible method of implementing the method is set forth in

greater detail, below. Possible method of implementation of the

lookthrough approach

The first step under the method would be to calculate the total

amount to be allocated (ADSP and AGUB). Under the method, this would be

the sum of (a) the amount realized or basis, as appropriate, of the

parent target stock (grossed-up as appropriate to reflect stock not

recently purchased, etc.) and (b) liabilities.

In the second step, all Class I through Class V assets in the

parent target and subsidiary targets (other than stock of subsidiary

targets) would be combined into aggregate Classes I, II, III, IV, and

V. Then, the total basis would be allocated (as basis is under the

current system, except that the allocation would be across such joint

classes, not merely within individual members) first to Class I assets,

then, if there is any remainder, to Class II assets, then, if there is

any remainder, to Class III assets, then, if there is any remainder, to

Class IV assets, and then, if there is any remainder, to Class V

assets. The allocations thus made to individual Class I through V

assets would be the final, binding allocations to them.

In the third step, if there were no amount of the total basis

remaining to be allocated to Class VI and VII assets, one would proceed

to determine the basis in subsidiary target stock. If the aggregate

amount assigned to all the subsidiary's Class I through V assets

pursuant to the second step above exceeded the amount of the

subsidiary's liabilities, then the amount of the excess would become

its parent's basis in that subsidiary's stock.

If the aggregate amount were, however, less than the liabilities,

then the stock basis would be zero. A subissue is whether in such case

other action should also be taken: whether, in the case of a

consolidated group, an excess loss account should be created equal to

the amount of the shortfall; and whether, if the tiered entities do not

join in filing a consolidated return but other nonconsolidated

investment adjustment rules apply, future positive basis increases

should be denied to the extent of the excess loss account that would

have been created under the method had they been filing consolidated.

The rule could apply, for example, to increases in basis of controlled

foreign corporations for undistributed earnings taxed currently under

subpart F.

Under the method, if there were an amount of the total ADSP or AGUB

remaining to be allocated to Class VI and VII assets, then one would

proceed to allocate basis to Class VI and VII assets. At this point,

the aggregating of members' assets into joint classes would be

abandoned and the method would revert to a top-down system similar to

that of current rules. The process is top-down in that any basis not

already allocated to the parent target's Class I through V assets

(other than subsidiary target stock) would be allocated among its Class

VI and VII assets and subsidiary target stock, then the subsidiary

target would in turn make its own allocation of its own basis among its

own Class VI and VII assets and any stock it might own in other

subsidiary targets.

Certain adjustments, as yet undetermined, would have to be made to

this method for minority interests outstanding in subsidiaries.

Possible Disadvantages of the Method

The method has drawbacks:

(1) Complexity. The method is more complicated than the existing

rules. When, for example, there is a subsequent change in the amount of

a liability of a subsidiary target that changes the amount of AGUB or

ADSP, under the method one would recalculate the allocations to all the

assets of the parent target and all subsidiary targets, not just the

assets of the indebted subsidiary target and its own subsidiary

targets.

Also, questions arise regarding subsequent changes in AGUB and

ADSP, with respect to subsidiary targets already disposed of. What if,

for instance, at the time of a subsequent adjustment to AGUB or ADSP,

the group had already disposed of the stock of a particular subsidiary

target should one change the allocation to that former subsidiary's

assets? Separately, in determining whether AGUB or ADSP has changed,

should one take into account changes in the amount of liabilities of

former subsidiary targets? How would the group be made aware of such

changes?

(2) Lack of inside-outside basis conformity. The current system,

although it tolerates large disparities in the allocations to identical

assets based on location, assures conformity between stock basis and

net asset basis. The look-through approach does so only in a

consolidated setting (employing excess loss accounts to do so).

(3) The method would not eliminate all allocation disparities. The

method would not completely eliminate disparate allocations based on

location within the acquired group, because it applies only to tiered

targets. Similar disparities can exist in acquisitions of sister

corporations or in mixed stock and asset purchases. The method does not

include a mechanism for equalizing basis impairment in such cases.

Thus, the method would not fully solve the disparity problem. (Note,

however, that the new anti-abuse rule included in the proposed

regulations may operate in some cases.)

Proposed Effective Date

The regulations are proposed to be effective on the date that final

regulations are published in the Federal Register and apply to

qualified stock purchases or applicable asset acquisitions occurring on

or after the date that final regulations are published in the Federal

Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in Executive Order

12866. Therefore, a regulatory assessment is not required. An initial

regulatory flexibility analysis has been prepared pursuant to 5 U.S.C.

section 604 for the collections of information in this Treasury

Decision. The analysis is set forth below under the heading ``Initial

Regulatory Flexibility Analysis.'' Pursuant to section 7805(f) of the

Code, these regulations will be submitted to the Chief Counsel for

Advocacy of the Small Business Administration for comment on its impact

on small business.

Initial Regulatory Flexibility Analysis

This regulatory action is intended to simplify and clarify the

current rules relating to both deemed and actual asset acquisitions.

The current rules were developed over a long period of time and have

been repeatedly amended. The IRS and Treasury believe these proposed

regulations will significantly improve the clarity of the rules

relating to both deemed and actual asset acquisitions.

The major objective of the proposed regulations is to modify the

rules for allocating purchase price in both deemed and actual asset

acquisitions. In addition, the proposed regulations replace the general

rules for electing to treat a stock sale as an asset sale.

These collections of information may affect small businesses if the

stock of a corporation which is a small entity is acquired in a

qualified stock purchase or if a trade or business which is also a

small business is transferred in a

[[Page 43475]]

taxable transaction. Form 8023 (on which an election to treat a stock

sale as an asset sale is filed) has been submitted to and approved by

the Office of Management and Budget. With respect to Form 8023, the IRS

estimated that 201 forms would be filed each year and that each

taxpayer would require 12.98 hours to comply. Form 8594 (on which a

sale or acquisition of assets constituting a trade or business is

reported) has also been submitted to and approved by the Office of

Management and Budget. With respect to Form 8594, the IRS estimated

that 20,000 forms would be filed each year and that each taxpayer would

require 12.25 hours to comply. These estimates have been made available

for public comment and no public comments have been received. These

proposed regulations do not impose new requirements on small businesses

and, in fact, should lessen any difficulties associated with the

existing reporting requirements by clarifying the rules associated with

deemed and actual asset acquisitions.

The collections of information require taxpayers to file an

election in order to treat a stock sale as an asset sale. In addition,

taxpayers must file a statement regarding the amount of consideration

allocated to each class of assets under the residual method. The

professional skills that would be necessary to make the election or

allocate the consideration would be the same as those required to

prepare a return for the small business.

Consideration was given to limiting the reporting requirements

under section 1060 to trades or businesses meeting a threshold level of

business activity. However, any threshold derived without further

information would be arbitrary. Instead, the proposed regulations

authorize the Commissioner to exclude certain transactions from the

reporting requirements.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are timely submitted to the IRS. The IRS and

Treasury request comments on the clarity of the proposed rule and how

it may be made easier to understand. All comments will be available for

public inspection and copying.

A public hearing has been scheduled for October 12, 1999, beginning

at 10 a.m. in the NYU Classroom, Room 2615, Internal Revenue Service

Building, 1111 Constitution Avenue, NW., Washington, DC. Due to

building security procedures, visitors must enter at the 10th Street

entrance, located between Constitution and Pennsylvania Avenues, NW. In

addition, all visitors must present photo identification to enter the

building. Because of access restrictions, visitors will not be admitted

beyond the immediate entrance area more than 15 minutes before the

hearing starts. For information about having your name placed on the

building access list to attend the hearing, see the FOR FURTHER

INFORMATION CONTACT section of this preamble.

The IRS recognizes that persons outside the Washington, DC, area

may also wish to testify at the public hearing through

teleconferencing. Requests to include teleconferencing sites must be

received by September 20, 1999. If the IRS receives sufficient

indications of interest to warrant teleconferencing to a particular

city, and if the IRS has teleconferencing facilities available in that

city on the date the public hearing is to be scheduled, the IRS will

try to accommodate the requests. The IRS will publish the locations of

any teleconferencing sites in an announcement in the Federal Register.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who

wish to present oral comments at the hearing must request to speak, and

submit written comments and an outline of the topics to be discussed

and the time to be devoted to each topic (a signed original and eight

(8) copies) by September 20, 1999. A period of ten minutes will be

allocated to each person for making comments. An agenda showing the

scheduling of the speakers will be prepared after the deadline for

receiving outlines has passed. Copies of the agenda will be available

free of charge at the hearing.

Drafting information. The principal authors of these proposed

regulations are Richard Starke and Stephen R. Wegener, Office of the

Assistant Chief Counsel (Corporate). However, other personnel from the

IRS and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are proposed to be amended as

follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

removing the entries for 1.338(b)-1, 1.338(b)-3T, and 1.1060 1T and by

adding entries in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.338-6 also issued under 26 U.S.C. 337(d), 338, and

1502.

Section 1.338-7 also issued under 26 U.S.C. 337(d), 338, and

1502.

Section 1.338-8 also issued under 26 U.S.C. 337(d), 338, and

1502.

Section 1.338-9 also issued under 26 U.S.C. 337(d), 338, and

1502.

Section 1.338-10 also issued under 26 U.S.C. 337(d), 338, and

1502.* * *

Section 1.1060-1 also issued under 26 U.S.C. 1060.* * *

Par. 2. Sections 1.338-0 through 1.338-3 are revised to read as

follows:

Sec. 1.338-0 Outline of topics.

This section lists the captions contained in the regulations under

section 338 as follows:

Sec. 1.338-1 General principles; status of old target and new

target.

(a) In general.

(1) Deemed transaction.

(2) Application of other rules of law.

(3) Overview.

(b) Treatment of target under other provisions of the Internal

Revenue Code.

(1) General rule for subtitle A.

(2) Exceptions for subtitle A.

(3) General rule for other provisions of the Internal Revenue

Code.

(c) Anti-abuse rule.

(1) In general.

(2) Examples.

Sec. 1.338-2 Nomenclature and definitions; mechanics of the section

338 election.

(a) Scope.

(b) Nomenclature.

(c) Definitions.

(1) Acquisition date.

(2) Acquisition date assets.

(3) Affiliated group.

(4) Common parent.

(5) Consistency period.

(6) Deemed asset sale.

(7) Deemed sale gain.

(8) Deemed sale return.

(9) Domestic corporation.

(10) Old target's final return.

(11) Purchasing corporation.

(12) Qualified stock purchase.

(13) Related persons.

(14) Section 338 election.

(15) Section 338(h)(10) election.

(16) Selling group.

(17) Target; old target; new target.

(18) Target affiliate.

(19) 12-month acquisition period.

(d) Time and manner of making election.

(e) Special rules for foreign corporations or DISCs.

(1) Elections by certain foreign purchasing corporations.

(i) General rule.

[[Page 43476]]

(ii) Qualifying foreign purchasing corporation.

(iii) Qualifying foreign target.

(iv) Triggering event.

(v) Subject to United States tax.

(2) Acquisition period.

(3) Statement of section 338 may be filed by United States

shareholders in certain cases.

(4) Notice requirement for U.S. persons holding stock in foreign

market.

(i) General rule.

(ii) Limitation.

(iii) Form of notice.

(iv) Timing of notice.

(v) Consequence of failure to comply.

(vi) Good faith effort to comply.

Sec. 1.338-3 Qualification for the section 338 election.

(a) Scope.

(b) Rules relating to qualified stock purchases.

(1) Purchasing corporation requirement.

(2) Purchase.

(i) Definition.

(ii) Purchase of target.

(iii) Purchase of target affiliate.

(3) Acquisitions of stock from related corporations.

(i) In general.

(ii) Time for testing relationship.

(iii) Cases where section 338(h)(3)(C) applies--acquisitions

treated as purchases.

(iv) Examples.

(4) Acquisition date for tiered targets.

(i) Stock sold in deemed asset sale.

(ii) Examples.

(5) Effect of redemptions.

(i) General rule.

(ii) Redemptions from persons unrelated to the purchasing

corporation.

(iii) Redemptions from the purchasing corporation or related

persons during 12-month acquisition period.

(A) General rule.

(B) Exception for certain redemptions from related corporations.

(iv) Examples.

(c) Effect of post-acquisition events on eligibility for section

338 election.

(1) Post-acquisition elimination of target.

(2) Post-acquisition elimination of the purchasing corporation.

(3) Consequences of post-acquisition elimination of target.

(i) Scope.

(ii) Continuity of interest.

(iii) Control requirement.

(iv) Example.

Sec. 1.338-4 Aggregate deemed sale price; various aspects of

taxation of the deemed asset sale.

(a) Scope.

(b) Determination of ADSP.

(1) General rule.

(2) Time and amount of ADSP.

(i) Original determination.

(ii) Redetermination of ADSP.

(iii) Example.

(c) Grossed-up amount realized on the sale to the purchasing

corporation of the purchasing corporation's recently purchased

target stock.

(1) Determination of amount.

(2) Example.

(d) Liabilities of old target.

(1) In general.

(2) Time and amount of liabilities.

(3) Interaction with deemed sale gain.

(e) Calculation of deemed sale gain.

(f) Other rules apply in determining ADSP.

(g) Examples.

(h) Deemed sale of target affiliate stock.

(1) Scope.

(2) In general.

(3) Deemed sale of foreign target affiliate by a domestic

target.

(4) Deemed sale producing effectively connected income.

(5) Deemed sale of insurance company target affiliate electing

under section 953(d).

(6) Deemed sale of DISC target affiliate.

(7) Anti-stuffing rule.

(8) Examples.

Sec. 1.338-5 Adjusted grossed-up basis.

(a) Scope.

(b) Determination of AGUB.

(1) General rule.

(2) Time and amount of AGUB.

(i) Original determination.

(ii) Redetermination of AGUB.

(iii) Examples.

(c) Grossed-up basis of recently purchased stock.

(d) Basis of nonrecently purchased stock; gain recognition

election.

(1) No gain recognition election.

(2) Procedure for making gain recognition election.

(3) Effect of gain recognition election.

(i) In general.

(ii) Basis amount.

(iii) Losses not recognized.

(iv) Stock subject to election.

(e) Liabilities of new target.

(1) In general.

(2) Time and amount of liabilities.

(3) Interaction with deemed sale gain.

(f) Adjustments by the Internal Revenue Service.

(g) Examples.

Sec. 1.338-6 Allocation of ADSP and AGUB among target assets.

(a) Scope.

(1) In general.

(2) Fair market value.

(i) In general.

(ii) Transaction costs.

(iii) Internal Revenue Service authority.

(b) General rule for allocating ADSP and AGUB.

(1) Reduction in the amount of consideration for Class I assets.

(2) Other assets.

(i) In general.

(ii) Class II assets.

(iii) Class III assets.

(iv) Class IV assets.

(v) Class V assets.

(vi) Class VI assets.

(vii) Class VII assets.

(3) Other items designated by the Internal Revenue Service.

(c) Certain limitations and other rules for allocation to an

asset.

(1) Allocation not to exceed fair market value.

(2) Allocation subject to other rules.

(3) Special rule for allocating AGUB when purchasing corporation

has nonrecently purchased stock.

(i) Scope.

(ii) Determination of hypothetical purchase price.

(iii) Allocation of AGUB.

(4) Liabilities taken into account in determining amount

realized on subsequent disposition.

(d) Examples.

Sec. 1.338-7 Allocation of redetermined ADSP and AGUB among target

assets.

(a) Scope.

(b) Allocation of redetermined ADSP and AGUB.

(c) Special rules for ADSP.

(1) Increases or decreases in deemed sale gain taxable

notwithstanding old target ceases to exist.

(2) Procedure for transactions in which section 338(h)(10) is

not elected.

(i) Deemed sale gain included in new target's return.

(ii) Carryovers and carrybacks.

(A) Loss carryovers to new target taxable years.

(B) Loss carrybacks to taxable years of old target.

(C) Credit carryovers and carrybacks.

(3) Procedure for transactions in which section 338(h)(10) is

elected.

(d) Special rules for AGUB.

(1) Effect of disposition or depreciation of acquisition date

assets.

(2) Section 38 property.

(e) Examples.

Sec. 1.338-8 Asset and stock consistency.

(a) Introduction.

(1) Overview.

(2) General application.

(3) Extension of the general rules.

(4) Application where certain dividends are paid.

(5) Application to foreign target affiliates.

(6) Stock consistency.

(b) Consistency for direct acquisitions.

(1) General rule.

(2) Section 338(h)(10) elections.

(c) Gain from disposition reflected in basis of target stock.

(1) General rule.

(2) Gain not reflected if section 338 election made for target.

(3) Gain reflected by reason of distributions.

(4) Controlled foreign corporations.

(5) Gain recognized outside the consolidated group.

(d) Basis of acquired assets.

(1) Carryover basis rule.

(2) Exceptions to carryover basis rule for certain assets.

(3) Exception to carryover basis rule for de minimis assets.

(4) Mitigation rule.

(i) General rule.

(ii) Time for transfer.

(e) Examples.

(1) In general.

(2) Direct acquisitions.

(f) Extension of consistency to indirect acquisitions.

(1) Introduction.

(2) General rule.

(3) Basis of acquired assets.

(4) Examples.

(g) Extension of consistency if dividends qualifying for 100 percent

dividends received deduction are paid.

[[Page 43477]]

(1) General rule for direct acquisitions from target.

(2) Other direct acquisitions having same effect.

(3) Indirect acquisitions.

(4) Examples.

(h) Consistency for target affiliates that are controlled foreign

corporations.

(1) In general.

(2) Income or gain resulting from asset dispositions.

(i) General rule.

(ii) Basis of controlled foreign corporation stock.

(iii) Operating rule.

(iv) Increase in asset or stock basis.

(3) Stock issued by target affiliate that is a controlled foreign

corporation.

(4) Certain distributions.

(i) General rule.

(ii) Basis of controlled foreign corporation stock.

(iii) Increase in asset or stock basis.

(5) Examples.

(i) [Reserved]

(j) Anti-avoidance rules.

(1) Extension of consistency rules.

(2) Qualified stock purchase and 12-month acquisition period.

(3) Acquisitions by conduits.

(i) Asset ownership.

(A) General rule.

(B) Application of carryover basis rule.

(ii) Stock acquisitions.

(A) Purchase by conduit.

(B) Purchase of conduit by corporation.

(C) Purchase of conduit by conduit.

(4) Conduit.

(5) Existence of arrangement.

(6) Predecessor and successor.

(i) Persons.

(ii) Assets.

(7) Examples.

Sec. 1.338-9 International Aspects of Section 338.

(a) Scope.

(b) Application of section 338 to foreign targets.

(1) In general.

(2) Ownership of FT stock on the acquisition date.

(3) Carryover FT stock.

(i) Definition.

(ii) Carryover of earnings and profits.

(iii) Cap on carryover of earnings and profits.

(iv) Post-acquisition date distribution of old FT earnings and

profits.

(v) Old FT earnings and profits unaffected by post-acquisition date

deficits.

(vi) Character of FT stock as carryover FT stock eliminated upon

disposition.

(4) Passive foreign investment company stock.

(c) Dividend treatment under section 1248(e).

(d) Allocation of foreign taxes.

(e) Operation of section 338(h)(16). [Reserved]

(f) Examples.

Sec. 1.338-10 Filing of Returns.

(a) Returns including tax liability from deemed asset sale.

(1) In general.

(2) Old target's final taxable year otherwise included in

consolidated return of selling group.

(i) General rule.

(ii) Separate taxable year.

(iii) Carryover and carryback of tax attributes.

(iv) Old target is a component member of purchasing corporation's

controlled group.

(3) Old target is an S corporation.

(4) Combined deemed sale return.

(i) General rule.

(ii) Gain and loss offsets.

(iii) Procedure for filing a combined return.

(iv) Consequences of filing a combined return.

(5) Deemed sale excluded from purchasing corporation's consolidated

return.

(6) Due date for old target's final return.

(i) General rule.

(ii) Application of Sec. 1.1502 76(c).

(A) In general.

(B) Deemed extension.

(C) Erroneous filing of deemed sale return.

(D) Erroneous filing of return for regular tax year.

(E) Last date for payment of tax.

(7) Examples.

(b) Waiver.

(1) Certain additions to tax.

(2) Notification.

(3) Elections or other actions required to be specified on a timely

filed return.

(i) In general.

(ii) New target in purchasing corporation's consolidated return.

(4) Examples.

Sec. 1.338(h)(10)-1 Deemed Asset Sale and Liquidation.

(a) Scope.

(b) Definitions.

(1) Consolidated target.

(2) Selling consolidated group.

(3) Selling affiliate; affiliated target.

(4) S corporation target.

(5) S corporation shareholders.

(6) Liquidation.

(c) Section 338(h)(10) election.

(1) In general.

(2) Simultaneous joint election requirement.

(3) Irrevocability.

(4) Effect of invalid election.

(d) Certain consequences of section 338(h)(10) election.

(1) P.

(2) New T.

(3) Old T--deemed sale.

(i) In general.

(ii) Tiered targets.

(4) Old T and selling consolidated group, selling affiliate, or S

corporation shareholders--deemed liquidation; tax characterization.

(i) In general.

(ii) Tiered targets.

(5) Selling consolidated group, selling affiliate, or S corporation

shareholders.

(i) In general.

(ii) Basis and holding period of T stock not acquired.

(iii) T stock sale.

(6) Nonselling minority shareholders other than nonselling S

corporation shareholders.

(i) In general.

(ii) T stock sale.

(iii) T stock not acquired.

(7) Consolidated return of selling consolidated group.

(8) Availability of the section 453 installment method.

(i) In deemed asset sale.

(ii) In deemed liquidation.

(9) Treatment consistent with an actual asset sale.

(e) Examples.

(f) Inapplicability of provisions.

(g) Required information.

Sec. 1.338(i)-1 Effective dates.

Sec. 1.338-1 General principles; status of old target and new target.

(a) In general--(1) Deemed transaction. Elections are available

under section 338 when a purchasing corporation acquires the stock of

another corporation (the target) in a qualified stock purchase. One

type of election, under section 338(g), is available to the purchasing

corporation. Another type of election, under section 338(h)(10), is, in

more limited circumstances, available jointly to the purchasing

corporation and the sellers of the stock. (Rules concerning eligibility

for these elections are contained in Secs. 1.338-2, 1.338-3, and

1.338(h)(10)-1.) Although target is a single corporation under

corporate law, if a section 338 election is made, then two separate

corporations, old target and new target, generally are considered to

exist for purposes of subtitle A of the Internal Revenue Code. Old

target is treated as transferring all of its assets to an unrelated

person in exchange for consideration that includes the assumption of,

or taking subject to, liabilities, and new target is treated as

acquiring all of its assets from an unrelated person in exchange for

consideration that includes the assumption of or taking subject to

liabilities. (Such transaction is, without regard to its

characterization for Federal income tax purposes, referred to as the

deemed asset sale and the income tax consequences thereof as the deemed

sale gain.) If a section 338(h)(10) election is made, old target is

also deemed to liquidate following the deemed asset sale.

(2) Application of other rules of law. Other rules of law apply to

determine the tax consequences to the parties as if they had actually

engaged in the transactions deemed to occur under section 338 and the

regulations hereunder except to the extent otherwise provided in the

regulations hereunder. See also Sec. 1.338-6(c)(2). Other rules of law

may characterize the transaction as something other than or in addition

to a sale and purchase of assets; however, it must be a taxable

transaction. For example, if target is an insurance company for which a

section 338 election is made, the deemed asset

[[Page 43478]]

sale would be characterized and taxed as an assumption-reinsurance

transaction under applicable Federal income tax law. See Sec. 1.817-

4(d).

(3) Overview. Definitions and special nomenclature and rules for

making the section 338 election are provided in Sec. 1.338-2.

Qualification for the section 338 election is addressed in Sec. 1.338-

3. The amount for which old target is treated as selling all of its

assets (the aggregate deemed sale price, or ADSP) is addressed in

Sec. 1.338-4. The amount for which new target is deemed to have

purchased all its assets (the adjusted grossed-up basis, or AGUB) is

addressed in Sec. 1.338-5. Section 1.338-6 addresses allocation both of

ADSP among the assets old target is deemed to have sold and of AGUB

among the assets new target is deemed to have purchased. Section 1.338-

7 addresses allocation of ADSP or AGUB when those amounts change after

the close of new target's first taxable year. Asset and stock

consistency are addressed in Sec. 1.338-8. International aspects of

section 338 are covered in Sec. 1.338-9. Rules for the filing of

returns are provided in Sec. 1.338-10. Eligibility for and treatment of

section 338(h)(10) elections is addressed in Sec. 1.338(h)(10)-1.

(b) Treatment of target under other provisions of the Internal

Revenue Code--(1) General rule for subtitle A. Except as provided in

this section, new target is treated as a new corporation that is

unrelated to old target for purposes of subtitle A of the Internal

Revenue Code. Thus--

(i) New target is not considered related to old target for purposes

of section 168 and may make new elections under section 168 without

taking into account the elections made by old target; and

(ii) New target may adopt, without obtaining prior approval from

the Commissioner, any taxable year that meets the requirements of

section 441 and any method of accounting that meets the requirements of

section 446. Notwithstanding Sec. 1.441-1T(b)(2), a new target may

adopt a taxable year on or before the last day for making the election

under section 338 by filing its first return for the desired taxable

year on or before that date.

(2) Exceptions for subtitle A. New target and old target are

treated as the same corporation for purposes of--

(i) The rules applicable to employee benefit plans (including those

plans described in sections 79, 104, 105, 106, 125, 127, 129, 132, 137,

and 220), qualified pension, profit-sharing, stock bonus and annuity

plans (sections 401(a) and 403(a)), simplified employee pensions

(section 408(k)), tax qualified stock option plans (sections 422 and

423), welfare benefit funds (sections 419, 419A, 512(a)(3), and 4976),

voluntary employee benefit associations (section 501(c)(9) and the

regulations thereunder);

(ii) Sections 1311 through 1314 (relating to the mitigation of the

effect of limitations) if a section 338(h)(10) election is not made for

target;

(iii) Section 108(e)(5) (relating to the reduction of purchase

money debt);

(iv) Section 45A (relating to the Indian Employment Credit),

section 51 (relating to the Work Opportunity Credit), section 51A

(relating to the Welfare to Work Credit), and section 1396 (relating to

the Empowerment Zone Act);

(v) Sections 401(h) and 420 (relating to medical benefits for

retirees);

(vi) Section 414 (relating to definitions and special rules); and

(vii) Any other provision designated in the Internal Revenue

Bulletin by the Internal Revenue Service. See Sec. 601.601(d)(2)(ii) of

this chapter (relating to the Internal Revenue Bulletin). See

Sec. 1.1001-3(e)(4)(F) providing that an election under section 338

does not result in the substitution of a new obligor on target's debt.

(3) General rule for other provisions of the Internal Revenue Code.

Except as provided in the regulations under section 338 or in the

Internal Revenue Bulletin by the Internal Revenue Service (see

Sec. 601.601(d)(2)(ii) of this chapter), new target is treated as a

continuation of old target for purposes other than subtitle A of the

Internal Revenue Code. For example--

(i) New target is liable for old target's Federal income tax

liabilities, including the tax liability for the deemed sale gain and

those tax liabilities of the other members of any consolidated group

that included old target that are attributable to taxable years in

which those corporations and old target joined in the same consolidated

return (see Sec. 1.1502-6(a));

(ii) Wages earned by the employees of old target are considered

wages earned by such employees from new target for purposes of sections

3101 and 3111 (Federal Insurance Contributions Act) and section 3301

(Federal Unemployment Tax Act); and

(iii) Old target and new target must use the same employer

identification number.

(c) Anti-abuse rule--(1) In general. For purposes of applying the

residual method of Secs. 1.338-0 through 1.338-10, 1.338(h)(10)-1, and

1.338(i)-1, the Commissioner is authorized to treat any property

(including cash) transferred by old target in connection with the

transactions resulting in the application of the residual method as,

nonetheless, property of target at the close of the acquisition date if

the property so transferred, within 24 months after the deemed asset

sale, is owned by new target, or is owned, directly or indirectly, by a

member of the affiliated group of which new target is a member and

continues after the election to be held or used to more than an

insignificant extent in connection with one or more of the activities

of new target. The Commissioner is authorized to treat any property

(including cash) transferred to old target in connection with the

transactions resulting in the application of the residual method as,

nonetheless, not being property of target at the close of the

acquisition date if the property so transferred by the transferor is,

within 24 months after the deemed asset sale, not owned by new target

but owned, directly or indirectly, by a member of the affiliated group

of which new target is a member or owned by new target but held or used

to more than an insignificant extent in connection with an activity

conducted, directly or indirectly, by another member of the affiliated

group of which new target is a member in combination with other

property acquired, directly or indirectly, from the transferor of the

property (or a member of the same affiliated group) to old target. For

purposes of this paragraph (c)(1), an interest in an entity is

considered held or used in connection with an activity if property of

the entity is so held or used. The authority under this paragraph

(c)(1) includes the making of any necessary correlative adjustments.

(2) Examples. The following examples illustrate this paragraph (c):

Example 1. Prior to a qualified stock purchase under section

338, target transfers one of its assets to a related party. The

purchasing corporation then purchases the target stock and also

purchases the transferred asset from the related party. After its

purchase of target, the purchasing corporation and target are

members of the same affiliated group. A section 338 election is

made. Under an arrangement with the purchaser, target continues to

use the separately transferred asset to more than an insignificant

extent in connection with its own activities. Applying the anti-

abuse rule of this paragraph (c), the Commissioner may consider

target to own the transferred asset for purposes of applying section

338 and its allocation rules.

Example 2. Target (T) owns all the stock of T1. T1 leases

intellectual property to T, which T uses in connection with its own

activities. P, a purchasing corporation, wishes to buy the T-T1

chain of corporations. P, in connection with its planned purchase of

the T stock, contracts to consummate a purchase of all the stock of

T1

[[Page 43479]]

on March 1 and of all the stock of T on March 2. Section 338

elections are thereafter made for both T and T1. Immediately after

the purchases, P, T and T1 are members of the same affiliated group.

T continues to lease the intellectual property from T1 and to use

the property to more than an insignificant extent in connection with

its own activities. Thus, an asset of T, the T1 stock, was removed

from T's own assets prior to the qualified stock purchase of the T

stock, T1's own assets are used after the deemed asset sale in

connection with T's own activities, and the T1 stock is after the

deemed asset sale owned by P, a member of the same affiliated group

of which T is a member. Applying the anti-abuse rule of this

paragraph (c), the Commissioner may, for purposes of application of

section 338 both to T and to T1, consider P to have bought only the

stock of T, with T at the time of the qualified stock purchases of

both T and T1 (the qualified stock purchase of T1 being triggered by

the deemed sale under section 338 of T's assets) owning T1. The

Commissioner would accordingly apply section 338 first at the T

level and then at the T1 level.

Sec. 1.338-2 Nomenclature and definitions; mechanics of the section

338 election.

(a) Scope. This section prescribes rules relating to elections

under section 338.

(b) Nomenclature. For purposes of the regulations under section 338

(except as otherwise provided):

(1) T is a domestic target corporation that has only one class of

stock outstanding. Old T refers to T for periods ending on or before

the close of T's acquisition date; new T refers to T for subsequent

periods.

(2) P is the purchasing corporation.

(3) The P group is an affiliated group of which P is a member.

(4) P1, P2, etc., are domestic corporations that are members of the

P group.

(5) T1, T2, etc., are domestic corporations that are target

affiliates of T. These corporations (T1, T2, etc.) have only one class

of stock outstanding and may also be targets.

(6) S is a domestic corporation (unrelated to P and B) that owns T

prior to the purchase of T by P. (S is referred to in cases in which it

is appropriate to consider the effects of having all of the outstanding

stock of T owned by a domestic corporation.)

(7) A, a U.S. citizen or resident, is an individual (unrelated to P

and B) who owns T prior to the purchase of T by P. (A is referred to in

cases in which it is appropriate to consider the effects of having all

of the outstanding stock of T owned by an individual who is a U.S.

citizen or resident. Ownership of T by A and ownership of T by S are

mutually exclusive circumstances.)

(8) B, a U.S. citizen or resident, is an individual (unrelated to

T, S, and A) who owns the stock of P.

(9) F, used as a prefix with the other terms in this paragraph (b),

connotes foreign, rather than domestic, status. For example, FT is a

foreign corporation (as defined in section 7701(a)(5)) and FA is an

individual other than a U.S. citizen or resident.

(10) CFC, used as a prefix with the other terms in this paragraph

(b) referring to a corporation, connotes a controlled foreign

corporation (as defined in section 957, taking into account section

953(c)). A corporation identified with the prefix F may be a controlled

foreign corporation. The prefix CFC is used when the corporation's

status as a controlled foreign corporation is significant.

(c) Definitions. For purposes of the regulations under section 338

(except as otherwise provided):

(1) Acquisition date. The term acquisition date has the same

meaning as in section 338(h)(2).

(2) Acquisition date assets. Acquisition date assets are the assets

of the target held at the beginning of the day after the acquisition

date (other than assets that were not assets of old target).

(3) Affiliated group. The term affiliated group has the same

meaning as in section 338(h)(5). Corporations are affiliated on any day

they are members of the same affiliated group.

(4) Common parent. The term common parent has the same meaning as

in section 1504.

(5) Consistency period. The consistency period is the period

described in section 338(h)(4)(A) unless extended pursuant to

Sec. 1.338-8(j)(1).

(6) Deemed asset sale. The deemed asset sale is the transaction

described in Sec. 1.338-1(a)(1) that is deemed to occur for purposes of

subtitle A of the Internal Revenue Code if a section 338 election is

made.

(7) Deemed sale gain. Deemed sale gain refers to, in the aggregate,

the Federal income tax consequences (generally, the income, gain,

deduction, and loss) of the deemed asset sale. Deemed sale gain also

refers to the Federal income tax consequences of the transfer of a

particular asset in the deemed asset sale.

(8) Deemed sale return. The deemed sale return is the return on

which target's deemed sale gain is reported that does not include any

other items of target. Target files a deemed sale return when a section

338 election (but not a section 338(h)(10) election) is filed for

target and target is a member of a selling group (defined in paragraph

(c)(16) of this section) that files a consolidated return for the

period that includes the acquisition date or is an S corporation. See

Sec. 1.338-10.

(9) Domestic corporation. A domestic corporation is a corporation--

(i) That is domestic within the meaning of section 7701(a)(4) or

that is treated as domestic for purposes of subtitle A of the Internal

Revenue Code (e.g., to which an election under section 953(d) or

1504(d) applies); and

(ii) That is not a DISC, a corporation described in section

1248(e), or a corporation to which an election under section 936

applies.

(10) Old target's final return. Old target's final return is the

income tax return of old target for the taxable year ending at the

close of the acquisition date that includes the deemed sale gain. If

the disaffiliation rule of Sec. 1.338-10(a)(2)(i) applies or if target

is an S corporation, target's deemed sale return is considered old

target's final return.

(11) Purchasing corporation. The term purchasing corporation has

the same meaning as in section 338(d)(1). The purchasing corporation

may also be referred to as purchaser. Unless otherwise provided, any

reference to the purchasing corporation is a reference to all members

of the affiliated group of which the purchasing corporation is a

member. See sections 338(h)(5) and (8). Also, unless otherwise

provided, any reference to the purchasing corporation is, with respect

to a deemed purchase of stock under section 338(a)(2), a reference to

new target with respect to its own deemed purchase of stock in another

target.

(12) Qualified stock purchase. The term qualified stock purchase

has the same meaning as in section 338(d)(3).

(13) Related persons. Two persons are related if stock in a

corporation owned by one of the persons would be attributed under

section 318(a) (other than section 318(a)(4)) to the other.

(14) Section 338 election. A section 338 election is an election to

apply section 338(a) to target. A section 338 election is made by

filing a statement of section 338 election pursuant to Sec. 1.338-2(d).

The form on which this statement is filed is referred to in the

regulations under section 338 as the Form 8023 Elections Under Section

338 for Corporations Making Qualified Stock Purchases.

(15) Section 338(h)(10) election. A section 338(h)(10) election is

an election to apply section 338(h)(10) to target. A section 338(h)(10)

election is made by making a joint election for target under

Sec. 1.338(h)(10)-1.

(16) Selling group. The selling group is the affiliated group (as

defined in section 1504) eligible to file a

[[Page 43480]]

consolidated return that includes target for the taxable period in

which the acquisition date occurs. However, a selling group is not an

affiliated group of which target is the common parent on the

acquisition date.

(17) Target; old target; new target. Target is the target

corporation as defined in section 338(d)(2). Old target refers to

target for periods ending on or before the close of target's

acquisition date. New target refers to target for subsequent periods.

(18) Target affiliate. The term target affiliate has the same

meaning as in section 338(h)(6) (applied without section

338(h)(6)(B)(i)). Thus, a corporation described in section

338(h)(6)(B)(i) is considered a target affiliate for all purposes of

section 338. If a target affiliate is acquired in a qualified stock

purchase, it is also a target.

(19) 12-Month acquisition period. The 12-month acquisition period

is the period described in section 338(h)(1), unless extended pursuant

to Sec. 1.338-8(j)(2).

(d) Time and manner of making election. The purchasing corporation

makes a section 338 election for target by filing a statement of

section 338 election on Form 8023 in accordance with the instructions

to the form. The section 338 election must be made not later than the

15th day of the 9th month beginning after the month in which the

acquisition date occurs. A section 338 election is irrevocable. See

Sec. 1.338(h)(10)-1(c)(2) for section 338(h)(10) elections.

(e) Special rules for foreign corporations or DISCs--(1) Elections

by certain foreign purchasing corporations--(i) General rule. A

qualifying foreign purchasing corporation is not required to file a

statement of section 338 election for a qualifying foreign target

before the earlier of 3 years after the acquisition date and the 180th

day after the close of the purchasing corporation's taxable year within

which a triggering event occurs.

(ii) Qualifying foreign purchasing corporation. A purchasing

corporation is a qualifying foreign purchasing corporation only if,

during the acquisition period of a qualifying foreign target, all the

corporations in the purchasing corporation's affiliated group are

foreign corporations that are not subject to United States tax.

(iii) Qualifying foreign target. A target is a qualifying foreign

target only if target and its target affiliates are foreign

corporations that, during target's acquisition period, are not subject

to United States tax (and will not become subject to United States tax

during such period because of a section 338 election). A target

affiliate is taken into account for purposes of the preceding sentence

only if, during target's 12-month acquisition period, it is or becomes

a member of the affiliated group that includes the purchasing

corporation.

(iv) Triggering event. A triggering event occurs in the taxable

year of the qualifying foreign purchasing corporation in which either

that corporation or any corporation in its affiliated group becomes

subject to United States tax.

(v) Subject to United States tax. For purposes of this paragraph

(e)(1), a foreign corporation is considered subject to United States

tax--

(A) For the taxable year for which that corporation is required

under Sec. 1.6012 2(g)-(other than Sec. 1.6012-2(g)(2)(i)(B)(2)) to

file a United States income tax return; or

(B) For the period during which that corporation is a controlled

foreign corporation, a passive foreign investment company for which an

election under section 1295 is in effect, a foreign investment company,

or a foreign corporation the stock ownership of which is described in

section 552(a)(2).

(2) Acquisition period. For purposes of this paragraph (e), the

term acquisition period means the period beginning on the first day of

the 12-month acquisition period and ending on the acquisition date.

(3) Statement of section 338 election may be filed by United States

shareholders in certain cases. The United States shareholders (as

defined in section 951(b)) of a foreign purchasing corporation that is

a controlled foreign corporation (as defined in section 957 (taking

into account section 953(c))) may file a statement of section 338

election on behalf of the purchasing corporation if the purchasing

corporation is not required under Sec. 1.6012-2(g) (other than

Sec. 1.6012-2(g)(2)(i)(B)(2)) to file a United States income tax return

for its taxable year that includes the acquisition date. Form 8023 must

be filed as described in the form and its instructions and also must be

attached to the Form 5471 (information return with respect to a foreign

corporation) filed with respect to the purchasing corporation by each

United States shareholder for the purchasing corporation's taxable year

that includes the acquisition date (or, if paragraph (e)(1)(i) of this

section applies to the election, for the purchasing corporation's

taxable year within which it becomes a controlled foreign corporation).

The provisions of Sec. 1.964-1(c) (including Sec. 1.964-1(c)(7)) do not

apply to an election made by the United States shareholders.

(4) Notice requirement for U.S. persons holding stock in foreign

market--(i) General rule. If a target subject to a section 338 election

was a controlled foreign corporation, a passive foreign investment

company, or a foreign personal holding company at any time during the

portion of its taxable year that ends on its acquisition date, the

purchasing corporation must deliver written notice of the election (and

a copy of Form 8023, its attachments and instructions) to--

(A) Each U.S. person (other than a member of the affiliated group

of which the purchasing corporation is a member (the purchasing group

member)) that, on the acquisition date of the foreign target, holds

stock in the foreign target; and

(B) Each U.S. person (other than a purchasing group member) that

sells stock in the foreign target to a purchasing group member during

the foreign target's 12-month acquisition period.

(ii) Limitation. The notice requirement of this paragraph (e)(4)

applies only where the section 338 election for the foreign target

affects income, gain, loss, deduction, or credit of the U.S. person

described in paragraph (e)(4)(i) of this section under section 551,

951, 1248, or 1293.

(iii) Form of notice. The notice to U.S. persons must be identified

prominently as a notice of section 338 election and must--

(A) Contain the name, address, and employer identification number

(if any) of, and the country (and, if relevant, the lesser political

subdivision) under the laws of which is organized, the purchasing

corporation and the relevant target (i.e., target the stock of which

the particular U.S. person held or sold under the circumstances

described in paragraph (e)(4)(i) of this section);

(B) Identify those corporations as the purchasing corporation and

the foreign target, respectively; and

(C) Contain the following declaration (or a substantially similar

declaration): THIS DOCUMENT SERVES AS NOTICE

[[Page 43481]]

OF AN ELECTION UNDER SECTION 338 FOR THE ABOVE CITED FOREIGN TARGET THE

STOCK OF WHICH YOU EITHER HELD OR SOLD UNDER THE CIRCUMSTANCES

DESCRIBED IN TREASURY REGULATIONS SECTION 1.338-2(e)(4). FOR POSSIBLE

UNITED STATES FEDERAL INCOME TAX CONSEQUENCES UNDER SECTION 551, 951,

1248, OR 1293 OF THE INTERNAL REVENUE CODE OF 1986 THAT MAY APPLY TO

YOU, SEE TREASURY REGULATIONS SECTION 1.338-9(b). YOU MAY BE REQUIRED

TO ATTACH THE INFORMATION ATTACHED TO THIS NOTICE TO CERTAIN RETURNS.

(iv) Timing of notice. The notice required by this paragraph (e)(4)

must be delivered to the U.S. person on or before the later of the

120th day after the acquisition date of the particular target or the

day on which Form 8023 is filed. The notice is considered delivered on

the date it is mailed to the proper address (or an address similar

enough to complete delivery), unless the date it is mailed cannot be

reasonably determined. The date of mailing will be determined under the

rules of section 7502. For example, the date of mailing is the date of

U.S. postmark or the applicable date recorded or marked by a designated

delivery service.

(v) Consequence of failure to comply. A statement of section 338

election is not valid if timely notice is not given to one or more U.S.

persons described in this paragraph (e)(4). If the form of notice fails

to comply with all requirements of this paragraph (e)(4), the section

338 election is valid, but the waiver rule of Sec. 1.338-10(b)(1) does

not apply.

(vi) Good faith effort to comply. The purchasing corporation will

be considered to have complied with this paragraph (e)(4), even though

it failed to provide notice or provide timely notice to each person

described in this paragraph (e)(4), if the Commissioner determines that

the purchasing corporation made a good faith effort to identify and

provide timely notice to those U.S. persons.

Sec. 1.338-3 Qualification for the section 338 election.

(a) Scope. This section provides rules on whether certain

acquisitions of stock are qualified stock purchases and on other

miscellaneous issues under section 338.

(b) Rules relating to qualified stock purchases--(1) Purchasing

corporation requirement. An individual cannot make a qualified stock

purchase of target. Section 338(d)(3) requires, as a condition of a

qualified stock purchase, that a corporation purchase the stock of

target. If an individual forms a corporation (new P) to acquire target

stock, new P can make a qualified stock purchase of target if new P is

considered for tax purposes to purchase the target stock. Facts that

may indicate that new P does not purchase the target stock include new

P merging downstream into target, liquidating, or otherwise disposing

of the target stock following the purported qualified stock purchase.

(2) Purchase--(i) Definition. The term purchase has the same

meaning as in section 338(h)(3).

(ii) Purchase of target. A purchase of a share of target stock

occurs so long as more than a nominal amount is paid for such share.

(iii) Purchase of target affiliate. Stock in a target affiliate

acquired by new target in the deemed asset sale of target's assets is

considered purchased if, under general principles of tax law, new

target is considered to own stock of the target affiliate meeting the

requirements of section 1504(a)(2), notwithstanding that no amount may

be allocated to target's stock in the target affiliate.

(3) Acquisitions of stock from related corporations--(i) In

general. Stock acquired by a purchasing corporation from a related

corporation (R) is generally not considered acquired by purchase. See

section 338(h)(3)(A)(iii).

(ii) Time for testing relationship. For purposes of section

338(h)(3)(A)(iii), a purchasing corporation is treated as related to

another person if the relationship specified in section

338(h)(3)(A)(iii) exists--

(A) In the case of a single transaction, immediately after the

purchase of Target stock;

(B) In the case of a series of acquisitions otherwise constituting

a qualified stock purchase within the meaning of section 338(d)(3),

immediately after the last acquisition in such series; and

(C) In the case of a series of transactions effected pursuant to an

integrated plan to dispose of Target stock, immediately after the last

transaction in such series.

(iii) Cases where section 338(h)(3)(C) applies--acquisitions

treated as purchases. If section 338(h)(3)(C) applies and the

purchasing corporation is treated as acquiring stock by purchase from

R, solely for purposes of determining when the stock is considered

acquired, target stock acquired from R is considered to have been

acquired by the purchasing corporation on the day on which the

purchasing corporation is first considered to own that stock under

section 318(a) (other than section 318(a)(4)).

(iv) Examples. The following examples illustrate this paragraph

(b)(3):

Example 1. (i) S is the parent of a group of corporations that

are engaged in various businesses. Prior to January 1, Year 1, S

decided to discontinue its involvement in one line of business. To

accomplish this, S forms a new corporation, Newco, with a nominal

amount of cash. Shortly thereafter, on January 1, Year 1, S

transfers all the stock of the subsidiary conducting the unwanted

business (Target) to Newco in exchange for 100 shares of Newco

common stock. Prior to January 1, Year 1, S and Underwriter (U) had

entered into a binding agreement pursuant to which U would purchase

60 shares of Newco common stock from S and then sell those shares in

an Initial Public Offering (IPO). On January 6, Year 1, the IPO

closes.

(ii) Newco's acquisition of Target stock is one of a series of

transactions undertaken pursuant to one integrated plan. The series

of transactions ends with the closing of the IPO and the transfer of

all the shares of stock in accordance with the agreements.

Immediately after the last transaction effected pursuant to the

plan, S owns 40 percent of Newco, which does not give rise to a

relationship described in section 338(h)(3)(A)(iii). See paragraph

(b)(3)(ii)(C) of this section. Accordingly, S and Newco are not

related for purposes of section 338(h)(3)(A)(iii).

(iii) Further, because Newco's basis in the Target stock is not

determined by reference to S's basis in the Target stock and because

the transaction is not an exchange to which section 351, 354, 355,

or 356 applies, Newco's acquisition of the Target stock is a

purchase within the meaning of section 338(h)(3).

Example 2. (i) On January 1 of Year 1, P purchases 75 percent in

value of the R stock. On that date, R owns 4 of the 100 shares of T

stock. On June 1 of Year 1, R acquires an additional 16 shares of T

stock. On December 1 of Year 1, P purchases 70 shares of T stock

from an unrelated person and 12 of the 20 shares of T stock held by

R.

(ii) Of the 12 shares of T stock purchased by P from R on

December 1 of Year 1, 3 of those shares are deemed to have been

acquired by P on January 1 of Year 1, the date on which 3 of the 4

shares of T stock held by R on that date were first considered owned

by P under section 318(a)(2)(C) (i.e., 4 x .75). The remaining 9

shares of T stock purchased by P from R on December 1 of Year 1, are

deemed to have been acquired by P on June 1 of Year 1, the date on

which an additional 12 of the 20 shares of T stock owned by R on

that date were first considered owned by P under section

318(a)(2)(C) (i.e., (20 x .75) -3). Because stock acquisitions by P

sufficient for a qualified stock purchase of T occur within a 12-

month period (i.e., 3 shares constructively on January 1 of Year 1,

9 shares constructively on June 1 of Year 1, and 70 shares actually

on December 1 of Year 1), a qualified stock purchase is made on

December 1 of Year 1.

Example 3. (i) On February 1 of Year 1, P acquires 25 percent in

value of the R stock

[[Page 43482]]

from B (the sole shareholder of P). That R stock is not acquired by

purchase. See section 338(h)(3)(A)(iii). On that date, R owns 4 of

the 100 shares of T stock. On June 1 of Year 1, P purchases an

additional 25 percent in value of the R stock, and on January 1 of

Year 2, P purchases another 25 percent in value of the R stock. On

June 1 of Year 2, R acquires an additional 16 shares of the T stock.

On December 1 of Year 2, P purchases 68 shares of the T stock from

an unrelated person and 12 of the 20 shares of the T stock held by

R.

(ii) Of the 12 shares of the T stock purchased by P from R on

December 1 of Year 2, 2 of those shares are deemed to have been

acquired by P on June 1 of Year 1, the date on which 2 of the 4

shares of the T stock held by R on that date were first considered

owned by P under section 318(a)(2)(C) (i.e., 4 x .5). For purposes

of this attribution, the R stock need not be acquired by P by

purchase. See section 338(h)(1). (By contrast, the acquisition of

the T stock by P from R does not qualify as a purchase unless P has

acquired at least 50 percent in value of the R stock by purchase.

Section 338(h)(3)(C)(i).) Of the remaining 10 shares of the T stock

purchased by P from R on December 1 of Year 2, 1 of those shares is

deemed to have been acquired by P on January 1 of Year 2, the date

on which an additional 1 share of the 4 shares of the T stock held

by R on that date was first considered owned by P under section

318(a)(2)(C) (i.e., (4 x .75)--2). The remaining 9 shares of the T

stock purchased by P from R on December 1 of Year 2, are deemed to

have been acquired by P on June 1 of Year 2, the date on which an

additional 12 shares of the T stock held by R on that date were

first considered owned by P under section 318(a)(2)(C) (i.e.,

(20 x .75)--3). Because a qualified stock purchase of T by P is made

on December 1 of Year 2, only if all 12 shares of the T stock

purchased by P from R on that date are considered acquired during a

12-month period ending on that date (so that, in conjunction with

the 68 shares of the T stock P purchased on that date from the

unrelated person, 80 of T's 100 shares are acquired by P during a

12-month period) and because 2 of those 12 shares are considered to

have been acquired by P more than 12 months before December 1 of

Year 2 (i.e., on June 1 of Year 1), a qualified stock purchase is

not made. (Under Sec. 1.338-8(j)(2), for purposes of applying the

consistency rules, P is treated as making a qualified stock purchase

of T if, pursuant to an arrangement, P purchases T stock satisfying

the requirements of section 1504(a)(2) over a period of more than 12

months.)

Example 4. Assume the same facts as in Example 3, except that on

February 1 of Year 1, P acquires 25 percent in value of the R stock

by purchase. The result is the same as in Example 3.

(4) Acquisition date for tiered targets--(i) Stock sold in deemed

asset sale. If an election under section 338 is made for target, old

target is deemed to sell target's assets and new target is deemed to

acquire those assets. Under section 338(h)(3)(B), new target's deemed

purchase of stock of another corporation is a purchase for purposes of

section 338(d)(3) on the acquisition date of target. If new target's

deemed purchase causes a qualified stock purchase of the other

corporation and if a section 338 election is made for the other

corporation, the acquisition date for the other corporation is the same

as the acquisition date of target. However, the deemed sale and

purchase of the other corporation's assets is considered to take place

after the deemed sale and purchase of target's assets.

(ii) Examples. The following examples illustrate this paragraph

(b)(4):

Example 1. A owns all of the T stock. T owns 50 of the 100

shares of X stock. The other 50 shares of X stock are owned by

corporation Y, which is unrelated to A, T, or P. On January 1 of

Year 1, P makes a qualified stock purchase of T from A and makes a

section 338 election for T. On December 1 of Year 1, P purchases the

50 shares of X stock held by Y. A qualified stock purchase of X is

made on December 1 of Year 1, because the deemed purchase of 50

shares of X stock by new T because of the section 338 election for T

and the actual purchase of 50 shares of X stock by P are treated as

purchases made by one corporation. Section 338(h)(8). For purposes

of determining whether those purchases occur within a 12-month

acquisition period as required by section 338(d)(3), T is deemed to

purchase its X stock on T's acquisition date, i.e., January 1 of

Year 1.

Example 2. On January 1 of Year 1, P makes a qualified stock

purchase of T and makes a section 338 election for T. On that day, T

sells all of the stock of T1 to A. Although T held all of the T1

stock on T's acquisition date, T is not considered to have purchased

the T1 stock because of the section 338 election for T. In order for

T to be treated as purchasing the T1 stock, T must hold the T1 stock

when T's deemed asset sale occurs. The deemed asset sale is

considered the last transaction of old T at the close of T's

acquisition date. Accordingly, the T1 stock actually disposed of by

T on the acquisition date is not included in the deemed asset sale.

Thus, T does not make a qualified stock purchase of T1.

(5) Effect of redemptions--(i) General rule. Except as provided in

this paragraph (b)(5), a qualified stock purchase is made on the first

day on which the percentage ownership requirements of section 338(d)(3)

are satisfied by reference to target stock that is both--

(A) Held on that day by the purchasing corporation; and

(B) Purchased by the purchasing corporation during the 12-month

period ending on that day.

(ii) Redemptions from persons unrelated to the purchasing

corporation. Target stock redemptions from persons unrelated to the

purchasing corporation that occur during the 12-month acquisition

period are taken into account as reductions in target's outstanding

stock for purposes of determining whether target stock purchased by the

purchasing corporation in the 12-month acquisition period satisfies the

percentage ownership requirements of section 338(d)(3).

(iii) Redemptions from the purchasing corporation or related

persons during 12-month acquisition period--(A) General rule. For

purposes of the percentage ownership requirements of section 338(d)(3),

a redemption of target stock during the 12-month acquisition period

from the purchasing corporation or from any person related to the

purchasing corporation is not taken into account as a reduction in

target's outstanding stock.

(B) Exception for certain redemptions from related corporations. A

redemption of target stock during the 12-month acquisition period from

a corporation related to the purchasing corporation is taken into

account as a reduction in target's outstanding stock to the extent that

the redeemed stock would have been considered purchased by the

purchasing corporation (because of section 338(h)(3)(C)) during the 12-

month acquisition period if the redeemed stock had been acquired by the

purchasing corporation from the related corporation on the day of the

redemption. See paragraph (b)(3) of this section.

(iv) Examples. The following examples illustrate this paragraph

(b)(5):

Example 1. QSP on stock purchase date; redemption from unrelated

person during 12-month period. A owns all 100 shares of T stock. On

January 1 of Year 1, P purchases 40 shares of the T stock from A. On

July 1 of Year 1, T redeems 25 shares from A. On December 1 of Year

1, P purchases 20 shares of the T stock from A. P makes a qualified

stock purchase of T on December 1 of Year 1, because the 60 shares

of T stock purchased by P within the 12-month period ending on that

date satisfy the 80-percent ownership requirements of section

338(d)(3) (i.e., 60/75 shares), determined by taking into account

the redemption of 25 shares.

Example 2. QSP on stock redemption date; redemption from

unrelated person during 12-month period. The facts are the same as

in Example 1, except that P purchases 60 shares of T stock on

January 1 of Year 1 and none on December 1 of Year 1. P makes a

qualified stock purchase of T on July 1 of Year 1, because that is

the first day on which the T stock purchased by P within the

preceding 12-month period satisfies the 80-percent ownership

requirements of section 338(d)(3) (i.e., 60/75 shares), determined

by taking into account the redemption of 25 shares.

Example 3. Redemption from purchasing corporation not taken into

account. On December 15 of Year 1, T redeems 30 percent of its stock

from P. The redeemed stock was

[[Page 43483]]

held by P for several years and constituted P's total interest in T.

On December 1 of Year 2, P purchases the remaining T stock from A. P

does not make a qualified stock purchase of T on December 1 of Year

2. For purposes of the 80-percent ownership requirements of section

338(d)(3), the redemption of P's T stock on December 15 of Year 1 is

not taken into account as a reduction in T's outstanding stock.

Example 4. Redemption from related person taken into account. On

January 1 of Year 1, P purchases 60 of the 100 shares of X stock. On

that date, X owns 40 of the 100 shares of T stock. On April 1 of

Year 1, T redeems X's T stock and P purchases the remaining 60

shares of T stock from an unrelated person. For purposes of the 80-

percent ownership requirements of section 338(d)(3), the redemption

of the T stock from X (a person related to P) is taken into account

as a reduction in T's outstanding stock. If P had purchased the 40

redeemed shares from X on April 1 of Year 1, all 40 of the shares

would have been considered purchased (because of section

338(h)(3)(C)(i)) during the 12-month period ending on April 1 of

Year 1 (24 of the 40 shares would have been considered purchased by

P on January 1 of Year 1 and the remaining 16 shares would have been

considered purchased by P on April 1 of Year 1). See paragraph

(b)(3) of this section. Accordingly, P makes a qualified stock

purchase of T on April 1 of Year 1, because the 60 shares of T stock

purchased by P on that date satisfy the 80-percent ownership

requirements of section 338(d)(3) (i.e., 60/60 shares), determined

by taking into account the redemption of 40 shares.

(c) Effect of post-acquisition events on eligibility for section

338 election--(1) Post-acquisition elimination of target. (i) The

purchasing corporation may make an election under section 338 for

target even though target is liquidated on or after the acquisition

date. If target liquidates on the acquisition date, the liquidation is

considered to occur on the following day and immediately after new

target's deemed purchase of assets. The purchasing corporation may also

make an election under section 338 for target even though target is

merged into another corporation, or otherwise disposed of by the

purchasing corporation provided that, under the facts and

circumstances, the purchasing corporation is considered for tax

purposes as the purchaser of the target stock.

(ii) The following examples illustrate this paragraph (c)(1):

Example 1. On January 1 of Year 1, P purchases 100 percent of

the outstanding common stock of T. On June 1 of Year 1, P sells the

T stock to an unrelated person. Assuming that P is considered for

tax purposes as the purchaser of the T stock, P remains eligible,

after June 1 of Year 1, to make a section 338 election for T that

results in a deemed asset sale of T's assets on January 1 of Year 1.

Example 2. On January 1 of Year 1, P makes a qualified stock

purchase of T. On that date, T owns the stock of T1. On March 1 of

Year 1, T sells the T1 stock to an unrelated person. On April 1 of

Year 1, P makes a section 338 election for T. Notwithstanding that

the T1 stock was sold on March 1 of Year 1, the section 338 election

for T on April 1 of Year 1 results in a qualified stock purchase by

T of T1 on January 1 of Year 1. See paragraph (b)(4)(i) of this

section.

(2) Post-acquisition elimination of the purchasing corporation. An

election under section 338 may be made for target after the acquisition

of assets of the purchasing corporation by another corporation in a

transaction described in section 381(a), provided that the purchasing

corporation is considered for tax purposes as the purchaser of the

target stock. The acquiring corporation in the section 381(a)

transaction may make an election under section 338 for target.

(3) Consequences of post-acquisition elimination of target--(i)

Scope. The rules of this paragraph (c)(3) apply to the transfer of

target assets to the purchasing corporation (or another member of the

same a

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