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Today in Tax: Spin-offs, Tax Elections, and Subpart F



Taxpayers Not Allowed to Revoke Tax Elections Based on Later Change in Regulation

Regulations frequently change as Congress adopts new policies and the IRS issues new or revised regulations implementing those policy changes. Tax elections based on existing law cannot be revoked if later regulatory changes makes an alternate approach more attractive. So, taxpayers should monitor proposed regulations and other areas where guidance is expected in near future, and expand tax models to account for changes in regulation.

On October 29, 2021, the Internal Revenue Service issued a letter ruling (PLR 202143009) denying a taxpayer’s request to revoke an election to capitalize certain “research or experimental expenditures” rather than deduct those expenditures. The taxpayer’s election to capitalize the expenditures was intended to allow the taxpayer to take foreign-derived intangible income deductions and foreign tax credits against certain foreign income (specifically global intangible low taxed income, or “GILTI”).

In 2020, the IRS issued final regulations governing GILTI. The final regulations included provisions allowing taxpayers to amend past tax returns to take deductions against GILTI income if that income was subject to high tax rates in foreign jurisdictions. The crux of the taxpayer’s request to revoke its past tax election was the perceived opportunity to gain the benefit of deducting past research expenditures (and carrying those deductions to prior years as a net operating loss carryback) and GILTI deductions, as now permitted under the final GILTI regulations. This ruling emphatically closed that door, as the IRS determined that a regulatory change is neither rare nor unusual, and therefore not the appropriate basis for revoking a past tax election.

Staged Approach—With up to 5-Year Delay Between Stages—Will Not Disqualify Tax-Free Spin-Off

Tax free spin-off transactions are subject to complex statutory and regulatory requirements designed to prevent corporate taxpayers and shareholders from evading tax. Generally, reorganizations may occur in multiple stages while still constituting the same transaction; in cases where a corporate business purpose exists for delay, the IRS may permit significant delays, including up to five years after the initial transaction. These transactions can be very complicated and can have a high cost if they do not qualify for tax-free treatment. This ruling illustrates that, although the IRS will not rule on whether an entire spin-off transaction will qualify for tax-free treatment, there is still value in obtaining rulings on specific issues and successful planning can effectuate a tax-free spin-off even if the transaction stretches across several years.

On October 1, 2021, the IRS released PLR 202139006, ruling that a delay in the distribution of subsidiary stock in a spin-off transaction would not adversely affect the transaction’s qualification for tax-free treatment. The circumstances of the ruling are too complex to recite in any meaningful way here, but taxpayer in this ruling essentially sought to separate a line of business from the taxpayer’s remaining business, and in doing so, refinance a number of existing and new debts so that, after the transaction, the taxpayer and the spun-off subsidiary would have appropriate capital structures and the taxpayer’s balance sheet would be in a stronger position (carrying less debt). Because there is no way to predict the most efficient and productive approach to this transaction, given the number of shareholders and the appetite of those shareholders, banks, and other parties for engaging in the transaction, the ruling proposed a multi-step approach that would stretch the taxpayer’s final disposition of subsidiary stock up to five years after the first transaction took place.

Failure to Report Subpart F Income Extends the Statute of Limitations for an Entire Tax Return

Generally, the IRS has three years to audit a tax return and make an assessment. However, several exceptions apply to extend this limitations period. Some exceptions will keep an entire tax return open while other exceptions only apply to a specific item. The failure to report Subpart F extends the limitations period for the entire return, not just Subpart F related items.

On October 22, 2021, the IRS released CCM 202142009, concluding that the extension of the statute of limitations for failure to report Subpart F income applies to a taxpayer’s entire tax return, not just the Subpart F related items. Generally, the IRS must assess a tax within three years after the filing of a tax return. There are, however, several exceptions to this rule that extend the statute of limitations. Relevantly to this memorandum, IRC § 6501(e)(1)(C) provides a six-year statute of limitations if a taxpayer omits amounts that must be included in income under the Subpart F rules.

Courts have found that, based on the statutory language, some of the extended limitation periods described in IRC § 6501 apply to the entire return while others only apply to the specific item of omitted income. In a 1994 case called Colestock, the Tax Court analyzed whether the extended limitation period under IRC § 6501(e)(1)(A) applied to the entire return. In concluding that it did apply to the entire return, the Court focused on the prefatory language that applies the extended limitation to “any tax imposed by subtitle A.”

IRC § 6501(e)(1)(C) shares the same prefatory language, so the memorandum concludes that the analysis under the Colestock case regarding the scope of the limitations period under 6501(e)(1)(A) equally applicable to 6501(e)(1)(C). Taxpayers should be cautious to properly and timely report Subpart F income so that the limitations period on their entire return is not extended.

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