IRS Replaces Intermediary Transaction Tax Shelter Notice

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By Steven D. Bortnick, Esq. Pepper Hamilton LLP, Philadelphia, PA

In January 2008, the IRS issued Notice 2008-20, which had the potential to treat transactions that were not tax motivated as tax shelters subject to various reporting rules, and to subject unsuspecting participants to significant penalties for failure to comply with these reporting obligations. In response to a wave of criticism relating to the breadth of Notice 2008-20, the IRS on December 1, 2008, retroactively susperseded Notice 2008-20 with new Notice 2008-111.

As in the case of Notice 2008-20, Notice 2008-111 clarifies Notice 2001-16 and defines those transactions that will be considered as Intermediary Transactions. If a transaction is considered to be an Intermediary Transaction, it will be treated as a listed transaction, and, thus, bring into play the tax shelter rules and the penalties for failure to comply with these rules. Notice 2008-111 is intended to narrow the scope of Notice 2001-16 by: (1) providing that a transaction will be an Intermediary Transaction as to a person only if the transaction was pursuant to a Plan; (2) providing revised objective criteria indicative of an Intermediary Transaction; (3) providing certain safe harbor exceptions to the definition of an Intermediary Transaction; and (4) indicating that a transaction may be an Intermediary Transaction with respect to some people and not others.

Components of an Intermediary Transactions

According to Notice 2008-111, a transaction must have all four of the following components to be the same or substantially similar to the listed transaction described in Notice 2001-16. Accordingly, even if a transaction is engaged in pursuant to a Plan (described below), a transaction will not be an Intermediary Transaction unless each of the following components exist.

1. A corporation, “T,” directly or indirectly owns (e.g., through a pass-through entity, such as a partnership, or a member of a consolidated group of which T is a member) assets, the sale of which would result in taxable gain (T's Built-in Gain Assets) and as of the “Stock Disposition Date” (defined in 2, below) T does not have (and any consolidated group of which T is a member does not have) sufficient tax benefits to entirely eliminate or offset such taxable gain or the tax on such gain. The tax that would result from a sale of T's Built-in Gain Assets is referred to as the “Built-in Tax.” However, the Built-in Tax is deemed to be zero (and, thus, the transaction is not an Intermediary Transaction) if the amount of the Built-in Tax is less than five percent of the value of the T stock disposed of in component 2, below.1

2. At least 80% of the stock of T (determined by vote or value) is disposed of by T's shareholders other than in liquidation, in one or more related transactions within a 12-month period (the Stock Disposition). The first date on which at least 80 percent of T's stock has been disposed of is the “Stock Disposition Date.”

3. Within 12 months of the Stock Disposition Date, at least 65% (determined by value) of T's Built-in Gain Assets are disposed of (the Sold T Assets) to one or more buyers in one or more transactions in which gain is recognized with respect to the Sold Assets. Sales to other members of a controlled group (within the meaning of §1563) or certain partnerships are disregarded provided there is no plan to dispose of at least 65% (by value) of T's Built-in Gain Assets to one or more persons that are not members of such controlled group or such partnerships.

4. At least 50% of T's Built-in Tax that would otherwise result from the disposition of the Sold T Assets is offset, avoided or not paid.

The Plan

A transaction will be an Intermediary Transaction only if it involves a corporation T that would have a federal income tax obligation with respect to the disposition of T's Built-in Gain Assets in a transaction that would afford the acquirer or acquirers a cost or fair market value basis in the assets. An Intermediary Transaction is structured to cause the tax obligation for the taxable disposition of T's Built-in Gain Assets to arise in connection with the disposition by shareholders of T of all or a controlling interest in T's stock under circumstances where the person or persons primarily liable for any federal income tax obligation with respect to the disposition of T's Built-in Gain Assets will not pay that tax (the Plan).

The Plan can be effected regardless of the order in which T's stock or assets are disposed. No Intermediary Transaction will be deemed to exist if there is no shareholder engaging in the transaction pursuant to the Plan and no buyer of assets engaging in the transaction pursuant to the Plan.

Engaging in the Transaction Pursuant to a Plan

A transaction that has all four components of an Intermediary Transaction, described above, will only be treated as an Intermediary Transaction with respect to a person that engages in the transaction pursuant to the Plan, described above. A person engages in a transaction pursuant to the Plan only if the person knows or has reason to know the transaction is structured to effectuate the Plan. Knowledge is imputed to certain people. A shareholder of T who is any of (1) a five percent shareholder (determined by vote or value), (2) officer or (3) director of T is deemed to engage in the transaction pursuant to the Plan if any of the following persons knows or has reason to know the transaction is structured to effectuate the Plan: (i) Any officer or director of T; (ii) any of T's advisors engaged by T to advise T or the shareholders with respect to the transaction; or (iii) any advisor engaged by that shareholder to advise it with respect to the transaction. Where T has more than five officers, the term officer for these purposes is limited to the chief executive officer of T (or the person acting in such capacity) and the four highest compensated officers for the taxable year, other than the chief executive officer.

Notice 2008-111 specifies that a person will not be treated as engaging in a transaction pursuant to the Plan merely because he or she has been offered attractive pricing terms. However, the notice also indicates that a person can engage in the transaction pursuant to the Plan even if he or she does not understand the mechanics of how the tax liability purportedly might be offset or avoided, or the specific financial arrangements or relationships of other parties or of T after the Stock Disposition.

Importantly, the notice provides that a transaction may be an Intermediary Transaction with respect to a shareholder and not an asset buyer or vice versa. Similarly, a transaction may be an Intermediary Transaction with respect to some shareholders and not others or some buyers and not others. However, as discussed above, at least one selling shareholder or one buyer of assets must engage in the transaction pursuant to the Plan in order for the transaction to be an Intermediary Transaction. This is an important improvement over Notice 2008-20.

Participants in an Intermediary Transaction

A person who engages in a transaction pursuant to the Plan will be considered to be a participant in an Intermediary Transactions (and, thus, be subject to disclosure rules) if (1) all four components of an Intermediary Transaction are present; (2) no safe harbor (described below) applies to such person; (3) at least one shareholder or one buyer of assets participated in the transaction pursuant to the Plan; and (4) either (a) the person's tax return reflects tax consequences or a tax strategy described in Notice 2008-111 or (b) such person known or has reason to know that the taxpayer's tax benefits are derived directly or indirectly from tax consequences or a tax strategy described in Notice 2008-111.

Safe Harbor Exceptions

Notice 2008-111 contains three safe harbors that apply to specific persons who otherwise would be treated as participants in an Intermediary Transaction. These are:

1. Any shareholder if the only T stock he or she disposes of is traded on an established securities market and prior to the disposition, the shareholder and persons related to such shareholder did not hold at least five percent (determined by vote or value) of any class of T stock disposed of by the shareholder;

2. Any shareholder, T or M 2 if after the acquisition of the T stock, the acquirer of the T stock is the issuer of stock or securities that are publicly traded on an established securities market in the United States, or is consolidated for financial reporting purposes with such an issuer; and

3. Any buyer of assets of the only Sold T Assets it acquires are either (a) securities that are traded on an established securities market and represent less than a five percent interest in that class of security or (b) the assets are not securities and do not include a trade or business.

Effective Date

Transactions similar to those identified in Notice 2001-16 were treated as listed transactions since January 19, 2001. Accordingly, Notice 2008-111 provides that it generally is effective as of January 19, 2001. However, Notice 2008-111 does not impose any requirements with respect to certain reporting obligations before December 1, 2008, that were not otherwise imposed by Notice 2001-16.

Penalties and Other Considerations

Notice 2008-111 goes on to identify certain penalties and other considerations arising from the treatment of a transaction as an Intermediary Transaction, including: the $200,000 penalty for failure of a participant to disclose a listed transaction; the penalty ($200,000, or 50 to 75% of gross income derived) for failure of a material advisor to make disclosure; the $10,000-per-day penalty for the failure by a material advisor to provide a list of persons advised in connection with the transaction; the excise tax on tax-exempt investors that invest in listed transactions; a 20% penalty for underpayments related to negligence, substantial understatements or reportable transactions; and the tolling of the statute of limitations on the assessment for persons who fail to disclose reportable transactions.

Author's Perspective

Notice 2008-111 represents a significant improvement over Notice 2008-20 in limiting the possibility of inadvertently engaging in a transaction deemed to be a tax shelter. However, some ambiguities will have to be clarified over time (e.g., if a T has tax benefits sufficient to offset either gain/tax with respect to Built-in Gain Assets or operating income for the year, but not both, does Intermediary Transaction component 1 exist or not). Given the potentially significant penalties and other adverse consequences to the treatment of a transaction as an Intermediary Transaction, potential participants and their advisors will need to continue to be very careful to avoid such treatment.

For more information, in the Tax Management Portfolios, see Paravano and Reynolds, 798 T.M., Tax Shelters, and in Tax Practice Series, see ¶3835, Tax Shelters -- Disclosure, Excise Tax, Penalties and Suspension of Interest.

1 For purposes of determining whether T (or its consolidated group) has sufficient tax benefits to offset gain/tax with respect to T's Built-in Gain Assets, any tax benefits attributable to other listed transactions are ignored, as are tax benefits attributable to built-in loss property acquired within 12 months before any Stock Disposition (defined in connection with component 2) to the extent such built-in losses exceed built-in gains.

2 Notice 2008-111 does not use the abbreviation M for any entity up until this point. Rather, M was used to represent the tax-indifferent entity that acts as an intermediary corporation that purchases stock of T in the Intermediary Transaction initially described in Notice 2001-16. Thus, while the existence of an intermediary is not necessary in order to find an Intermediary Transaction after the effective date of Notice 2008-111, the application of a safe harbor to such an intermediary serves as a reminder that such an intermediary would be a participant in an Intermediary Transaction under the general rules set out in the reportable transactions regulations.