REGULATIONS OVERRIDE STEP TRANSACTION DOCTRINE IN CONTEXT OF COMBINED §338(h)(10) ELECTION AND SUBSEQUENT MERGER

Under Code §338(h)(10), if a corporation makes a qualified purchase of the stock of another corporation, and that corporation is a member of a consolidated group, the buyer and the selling consolidated group can jointly elect to have the selling consolidated group recognize and report any gain or loss on the transaction as though the acquired corporation (the “target”) sold all of its ASSETS while still a member of the selling consolidated group. This reporting is in lieu of the selling consolidated group reporting gain or loss on the sale of the STOCK of the target corporation. This elective treatment can result in different net gain or loss treatment to the selling consolidated group, and also allows for an adjustment to the basis of the target’s assets for the purchase since they are being deemed to be purchased and sold in the transaction.

However, if the target corporation is then merged into the buying corporation, the “step transaction doctrine” will likely void the application of Code §338(h)(10). Instead, the IRS will treat the entire transaction as a Code §368(a)(1)(A) reorganization (an “A” reorganization). This will have very different tax consequences to all of the parties.

That is, until now. Under final Regulations issued July 13, 2006, the IRS will now allow the Code § 338(h)(10) election to apply (and not “A” reorganization treatment) - the Regulations expressly override the application of the step transaction doctrine, or any other similar doctrine that might otherwise recharacterize the transaction.

T.D. 9271, Reg. §1.338(h)(10)-1