Paying Liabilities of Another, Who Gets the Deduction?

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Annette M. Ahlers, Esq.
Pepper Hamilton LLP, Washington, DC

In Chief Counsel Advice 200942038 (June 26, 2009), the IRS Chief Counsel's Office reiterated its position on the tax consequences to all the parties involved when a parent corporation (or taxpayer) pays employees of the parent's subsidiary corporation. In the CCA, a parent corporation lost control of its subsidiary when the creditors of the subsidiary obtained stock ownership in a bankruptcy proceeding. The Chief Counsel addressed the following two issues:

1. “What is the proper character of a loss resulting from payments on nonqualified stock options by the parent to employees of the former subsidiary?”

2. “When stock option payments are made to employees of the former subsidiary, which entity may properly claim a compensation deduction for such payments?”


Issue One -- Character of the Loss

When the subsidiary corporation's stock was cancelled in the bankruptcy proceeding, the parent corporation claimed a capital loss for its investment in the subsidiary. When the subsidiary corporation was part of the parent's group, the subsidiary's employees were issued nonqualified stock options every year. These options generally had a 10-year window from the date of grant in which the recipient could exercise them. While the parent ceased issuing the options to the subsidiary after the bankruptcy, the employees of that subsidiary still held the options and continued to exercise them under the terms of the options. Prior to the bankruptcy of the subsidiary, when one of the subsidiary employees exercised their parent options, the parent would sell newly issued shares to cover the payment option being exercised and the sales proceeds to pay the employee. The parent corporation would treat the cash payment as a capital contribution to the subsidiary.

After the bankruptcy of the subsidiary, the parent treated the payments made to the subsidiary employees as capital losses. The parent then changed its position and filed an informal claim for refund that the payments made after the bankruptcy were ordinary losses to them, not capital losses.

In denying the parent's new position, the Chief Counsel focused on the relation-back doctrine applied in Rev. Rul. 2002-1, 2002-1 C.B. 268, which focused on the exercise of stock options in a former parent (distributing) company by a spun-off company's (controlled's) employees. In the ruling, the IRS treated the exercise of the distributing company's options by the controlled employees as if they happened prior to the distribution of the controlled stock, and allowed an ordinary deduction to the controlled corporation under §§83(h) and 162, citing to Regs. §1.1032-3. Under this analysis, the parent company is treated as selling its stock on the market (a 1032 transaction), followed by a transfer of the proceeds to its subsidiary as a capital contribution.

The taxpayer in the CCA argued that a recent tax court case, Santa Fe Pacific Gold Company v. Comr., 132 T.C. No. 12 (2009), changes the result discussed above and allows the parent to take an ordinary loss on the payment of the stock option to its former subsidiary's employee. The taxpayer stated that the payments to the former subsidiary's employees “produced no long term future benefit to [p]arent, and therefore [p]arent can deduct the payments as ordinary deductions.” In the alternative, the parent stated that the payments were associated with an abandoned transaction and could be deducted under §165. The Chief Counsel would not be dissuaded from applying the relation-back doctrine and did not entertain application of the Santa Feanalysis. The Chief Counsel stated that the Santa Fecase involved the payment of a termination fee in a hostile takeover bid and found no analogy or application to the clearly established relation-back doctrine for payments made under stock options that were issued when the subsidiary was a member of the parent corporation's group. Thus, the Chief Counsel applied a strict origin-of-the-claim approach in deciding the character of the payment, and which taxpayer could take it into account.

Issue Two -- Can the Parent Corporation Take the Section 83(h) Deduction for the Option Payment?

The Chief Counsel cited to Regs. §§1.83-6(d) and 1.1032-3 to conclude that when a parent corporation pays an employee of its subsidiary for the exercise of a stock option, the parent is treated as making a capital contribution to the subsidiary and the subsidiary is entitled to the deduction for payment to its employee. This is the result, even if the subsidiary is no longer in existence, as was the case in the CCA where the Chief Counsel stated that the successor to the subsidiary was the proper party to take the deduction for the payments made to the employee.


In this CCA, the Chief Counsel reiterated several key legal concepts that have broad application to many transactions, including mergers, spin-offs, sales of subsidiaries, and workout situations. For example, the IRS is readily supportive of a relation-back approach to determine proper tax treatment for multi-party, multi-year transactions. Additionally, a successor entity can take into account tax consequences of the settlement of pre-existing obligations of the selling or distributing group long after the transaction has closed and the subsidiary is no longer part of that group. As a result, careful attention should be paid in drafting transaction documents to address payments to employees under pre-existing compensation and benefit plans. Because these amounts are typically significant, clear instructions and tax allocations should be provided for in the transaction documents to obtain the best financial results for all relevant parties.

For more information, in the Tax Management Portfolios, see Utz, 384 T.M., Restricted Property - Section 83, and in Tax Practice Series, see ¶5810, Nonstatutory Stock Options.


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