internal_revenue_service number release date index numbers dollar_figure ------------------------ --------------------------------------- ----------------------------------- -------------------------------------- -------------------------- department of the treasury washington dc person to contact ---------------------------------- telephone number --------------------- refer reply to cc corp plr-165182-04 date date legend date a date b date c date d date e date f date g date h date i a b c ----------------- ------------- ----------------------- ------- ------------------------ ----------------- ------------------ --------------------------- ------------------- --- ------------------- --- plr-165182-04 d e f g h i j k l m n o p q r s t u v w country a country b ------------------- ------------------- ----------------- ------------------ -------------------------------------------- ------------------- ------------------- ----------------------------------- --- --- -- ------------------- 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-------------------------------------------------- --------------------------------------------------------------------- sub ------------------------------------------------------ -------------------------------------------------- -------------------------------- sub --------------------------------------------------------- ----------------------- ----------------------------------- plr-165182-04 dear ------------- this letter responds to your date request that we further supplement our letter_ruling dated date plr-166869-03 the original letter_ruling as supplemented by our letter_ruling dated date plr-154390- together the prior letter rulings additional information was submitted in letters dated date date and date capitalized terms not defined in this ruling have the meanings assigned to them in the original letter_ruling the ruling contained in this letter is based on facts and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party although this office has not verified any of the material submitted in support of the requested ruling it is subject_to verification on examination the prior letter rulings address certain federal_income_tax consequences of the acquisition of target by acquiror and acquiror sub the acquisition was completed on date a in date b through steps i through ix below target and certain country a subsidiaries of target sold a number of their subsidiaries to acquiror one subsidiary to a wholly owned indirect country a subsidiary of acquiror and one subsidiary to an approximately a percent owned indirect subsidiary of acquiror incorporated in country b in exchange for in the aggregate approximately dollar_figureb prior to the completion of steps i through ix target directly owned all of the outstanding_stock of sub sub sub and sub and l percent of the outstanding_stock of sub each of which is a corporation for u s federal_income_tax purposes a corporation sub owned all of the outstanding_stock of sub a corporation sub owned all of the outstanding_stock of sub which elected to be treated as an entity that is disregarded as separate from its owner for u s federal_income_tax purposes pursuant to sec_301_7701-3 a disregarded_entity effective date f and sub a corporation sub owned all of the outstanding_stock of sub a corporation sub owned the remaining m percent of the outstanding_stock of sub sub owned all of the outstanding_stock of sub which elected to be treated as a disregarded_entity effective date a and sub a corporation acquiror indirectly owned all of the outstanding_stock of sub through sub a member of the acquiror group and approximately a percent of the outstanding_stock of sub sub and sub are corporations the remaining approximately n percent of the outstanding_stock of sub was owned by third parties acquiror directly owned all of the outstanding_stock of sub which elected to be treated as a disregarded_entity effective date g and sub a corporation sub owned all of the outstanding_stock of sub which elected to be treated as a disregarded_entity effective date h plr-165182-04 the following series of transactions has been undertaken to achieve certain local country ie non-u s tax planning and consolidation goals in country b country c and country d and to integrate certain of target’s businesses with the existing acquiror entities in the appropriate country i sub formed sub sub elected to be treated as a disregarded_entity effective date i ii sub sold all of the outstanding_stock of sub to acquiror for dollar_figureo iii sub sold all of the outstanding_stock of sub to sub for dollar_figurep iv target sold all of the outstanding_stock of sub and sub to sub for q and r respectively v target sold all of the outstanding_stock of sub to sub for s vi sub sold all of the outstanding_stock of sub to sub for dollar_figuret together with steps ii iii iv and v the upstream sale and together with steps ii and iv the upstream acquiror sale vii sub sold all of the outstanding_stock of sub to sub for dollar_figureu viii acquiror contributed sub to sub ix sub sold sub to sub for dollar_figurev sub sub sub sub sub and sub the target corporations which were sold by target sub and sub the selling corporations in the upstream sale and the upstream acquiror sale represented approximately c percent and w percent of the value of target’s total assets respectively following the upstream sale target i directly held substantial operating_assets the stock of the remaining operating companies and a portion of the cash proceeds from the upstream sale and ii indirectly held through wholly owned country a subsidiaries the remaining cash proceeds from the upstream sale acquiror and acquiror sub caused target to distribute approximately dollar_figured of this cash to acquiror and acquiror sub proportional to their shareholdings on date c which is expected to exhaust the distributable reserves of target for date d under country a company law to facilitate additional cash distributions from target to acquiror and acquiror sub including the distribution of an amount equal to the remaining proceeds from the upstream sale acquiror and acquiror sub propose to cause target to engage in a restructuring and preferred_stock offering the proposed transaction the steps of the proposed transaction one of which has occurred include the new target transfers the conversion elections the preferred share subscriptions and the distributions each defined below i on date e target converted its corporate form from a public limited_company to a private limited_company under the laws of country a and changed its name to name a the conversion plr-165182-04 ii the acquiror and acquiror sub each will transfer its shares of target to a newly incorporated unlimited liability company organized under the laws of country a new target in exchange for such transfers the new target transfers acquiror will receive the same number of shares of common_stock of new target as it currently owns in target with a value of at least dollar_figuree acquiror sub will receive the same number of shares of common_stock of new target as it currently owns in target with a value of at least dollar_figuref new target will elect under sec_301_7701-3 to be treated as a corporation effective on or before the date of the new target transfers iii after the new target transfers new target will elect to treat target as a disregarded_entity the elections under sec_301_7701-3 with respect to new target and target are collectively referred to herein as the elections iv two affiliates of acquiror will contribute cash to new target in exchange for newly issued preferred shares of new target the preferred share subscriptions sub will contribute approximately g in cash to new target in exchange for new target class b preferred shares with an equivalent face_amount and value sub is a country a unlimited liability company that is a disregarded_entity and is wholly owned by sub in addition sub will contribute through a disregarded_entity approximately dollar_figureh in cash to new target in exchange for new target class a preferred shares with an equivalent face_amount and value the class a and class b preferred shares will be voting shares sub is a limited_liability partnership formed under the laws of country a that has elected to be treated as a corporation and is indirectly wholly owned by acquiror neither acquiror nor acquiror sub have ownership interests in sub or sub constituting sec_368 control sub and sub will receive preferred shares none of which are currently outstanding at target to facilitate the possible conversion of their interests into debt of new target if allowed by a taxing authority of country a in addition sub 1’s ownership of preferred shares is intended to permit sub to avoid potential unfavorable accounting treatment under current country a accounting rules which would in turn cause unfavorable results under country a thin_capitalization rules as part of the proposed transaction sub will distribute approximately dollar_figurei to sub which will distribute approximately dollar_figurei to target which will loan approximately dollar_figurej to new target the new target loan v new target will use a portion of its total cash of k to reduce country a equivalent of paid-in_surplus on the common shares held by acquiror and acquiror sub the distributions neither acquiror nor acquiror sub will surrender any shares in new target as part of this paid-in_surplus reduction in connection with its request for a supplemental ruling the taxpayer reaffirms as of the date of the acquisition the representations made in connection with the original letter_ruling the taxpayers have made the following representations with respect to the upstream sale and the upstream acquiror sale plr-165182-04 a the purchase_price of the shares of the target corporations sold to acquiror in the upstream acquiror sale was equal to the approximate fair_market_value of such shares b there was and is no plan or intention by sub to redeem or otherwise reacquire any of its shares held by acquiror there is also no plan or intention by sub to reimburse acquiror for the cash acquiror used to purchase the target corporations in the upstream acquiror sale c neither the new target transfers nor the elections were planned at the time of the consummation of the upstream sale d at the time of the upstream sale the basis of the stock of each target_corporation was not in excess of the value of the stock of such target_corporation in the hands of its selling corporation the taxpayers have made the following representations with respect to the new target transfers and the elections e disregarding the distributions the fair_market_value of the new target shares received by acquiror and acquiror sub will be approximately equal to the fair_market_value of the of the target shares surrendered in the new target transfers f there is no plan or intention by acquiror or acquiror sub to sell or otherwise dispose_of any shares of new target received in the new target transfers g immediately following the new target transfers and the effectiveness of the elections acquiror and acquiror sub will own all of the shares of new target other than those issued to facilitate its incorporation solely by reason of their ownership of the shares of target immediately prior to the new target transfers and the elections h other than the preferred share subscriptions new target has no plan or intention to issue additional shares following the new target transfers and the elections i immediately following the new target transfers and the effectiveness of the elections and prior to the preferred share subscriptions and the distributions new target will possess the same assets and liabilities as those possessed by target immediately prior to the new target transfers and the effectiveness of the elections for purposes of this representation assets sold by target and its subsidiaries in the upstream sale and cash distributed by target on date c will not be treated as assets held immediately prior to the new target transfers and the elections other than the distributions no assets are planned to be distributed plr-165182-04 j at the time of the new target transfers and the elections target will not have outstanding any warrants options convertible securities or any other type of right pursuant to which any person could acquire stock in target k new target has no plan or intention to reacquire any of its shares issued in the new target transfers and the elections l except as disclosed new target has no plan or intention to sell or otherwise dispose_of any of the assets of target deemed acquired in new target transfers and the elections except for dispositions made in the ordinary course of business and the distributions m at the time of the new target transfers and the effectiveness of the elections target's liabilities assumed within the meaning of sec_357 will not exceed the aggregate basis or value of target's assets n the liabilities of target deemed assumed by new target plus the liabilities if any to which the transferred assets of target are subject were incurred by target in the ordinary course of its business and are associated with the assets transferred o following the new target transfers and the effectiveness of the elections new target will continue the historic_business directly conducted by target or use a significant portion of target’s directly held assets in a business p target new target acquiror and acquiror sub will each pay their expenses if any incurred in connection with the new target transfers and the elections q target is not under the jurisdiction of a court in a title_11_or_similar_case within the meaning of sec_368 r none of the parties to the transaction are investment companies as defined in sec_368 and iv s target is not a passive_foreign_investment_company as defined in sec_1297 t target will be a controlled_foreign_corporation within the meaning of sec_957 cfc immediately before the new target transfers and the elections and new target will be a cfc immediately after the new target transfers and the elections u acquiror and acquiror sub will be sec_1248 shareholders of target before the new target transfers and the elections and each of acquiror and acquiror sub will plr-165182-04 be a sec_1248 shareholder of new target the acquiring foreign_corporation after the new target transfers and the elections v the notice requirements of sec_1_367_b_-1 will be met with respect to the transaction resulting from new target transfers and the elections w acquiror and acquiror sub will comply with sec_1_367_b_-4 rules for subsequent exchanges when and where applicable based solely on the information submitted in the original and supplemental ruling requests we rule as follows with respect to the upstream acquiror sale no sale for cash by any selling corporation of its target_corporation stock to acquiror in the upstream acquiror sale constituted an acquisition of stock by a related corporation within the meaning of sec_304 based solely on the information submitted in the original and supplemental ruling requests we rule as follows with respect to the new target transfers and the elections the new target transfers and the elections taken together qualify as a reorganization under sec_368 see revrul_96_29 1996_1_cb_50 target and new target will each be a_party_to_a_reorganization within the meaning of sec_368 target will not recognize any gain_or_loss by virtue of the new target transfers or the elections sec_361 new target will not recognize any gain_or_loss on the deemed receipt of the assets of target by virtue of the new target transfers and the elections in exchange for new target shares sec_1032 the basis of the assets of target deemed held by new target will be the same as the basis of such assets in the hands of target immediately prior to the new target transfers and the elections sec_362 the holding_period of the target assets deemed held by new target will include the period during which such assets were held by target sec_1223 neither acquiror nor acquiror sub will recognize any gain_or_loss on its receipt of new target shares in exchange for target shares sec_354 the basis of acquiror and acquiror sub in their new target shares will be the same as their basis in their target shares surrendered in exchange therefor sec_358 plr-165182-04 the holding_period of the new target shares received by acquiror and acquiror sub will include the period during which the target shares were held provided that the shares are held as capital assets on the date of the new target transfers and the effective date of the elections sec_1223 no amount will be included in income under sec_367 as a result of the new target transfers or the elections for the purposes of applying sec_367 or sec_1248 to subsequent exchanges of new target stock the determination of the earnings_and_profits attributable to an exchanging shareholder's stock in new target shall be computed in accordance with sec_1_367_b_-4 based solely on the information submitted in the original and supplemental ruling requests we rule as follows with respect to the preferred share subscriptions and transfer of cash by target and new target to acquiror and acquiror sub new target will not recognize any gain_or_loss on the receipt of cash in exchange for new target class a and class b preferred shares sec_1032 the distributions of cash by target and new target to acquiror and acquiror sub and the distributions including any portion thereof funded by the preferred share subscriptions will be treated as distributions from target and new target to acquiror and acquiror sub that are separate from the new target transfers and the elections and will be governed by sec_301 sec_1_301-1 no opinion is expressed regarding whether gain realized if any on the sale for cash by any selling corporation of its target_corporation stock to acquirer in the upstream acquirer sale is characterized as foreign_personal_holding_company_income under sec_954 of the code additionally no opinion is expressed about the federal tax treatment of the proposed transaction under other provisions of the code or regulations or the tax treatment of any conditions existing at the time of or effects resulting from the proposed transaction that are not specifically covered by the above ruling this ruling letter is directed only to the taxpayer who requested it sec_6110 provides that it may not be used or cited as precedent each taxpayer involved in the transaction should attach a copy of this ruling letter to the taxpayer’s federal_income_tax return for the taxable_year in which the proposed transaction is completed plr-165182-04 under a power_of_attorney on file in this office a copy of this letter is being sent to your authorized representative sincerely richard k passales senior counsel branch office of associate chief_counsel corporate cc


internal_revenue_service number release date index number -------------------------- ------------------------------ ------------------------------- --------------------- ---------------------------------- in re ------------------------------- ----------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ------------------------- id no ------------- telephone number --------------------- refer reply to cc ita b03 plr-118469-05 date legend legend ------------------------------- taxpayer ------------------------- corp x ------------------------------------------- a b --------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- ----------------------- date ----------------------- date ------ w ----- x ------------------- date --------------------- date ------------------ date ------------------ date ------- y --------------------- date court a --------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- case a ------------------------------------------------------------------ date date date date date complaint firm firm z ----------------------- -------------------------- ----------------------- ---------------------- ------------------------- --------------------------------------------------------------- ---------------------------------- ------------------------ ----------------- ------------------------------------------------------ this letter responds to your request of date supplemented by letters dear ----------------- dated date and date in which you requested a ruling on behalf of the above-referenced taxpayer specifically you have requested a ruling that amounts incurred to settle a class action lawsuit as well as attorney fees and other fees attributable to the lawsuit may be deducted as ordinary and necessary business_expenses under sec_162 of the internal_revenue_code facts following the merger taxpayer’s financial statements were consolidated with taxpayer is engaged in the business of a corp x was engaged in the business of providing b after extensive due diligence on date taxpayer and corp x announced that they had signed a definitive merger agreement pursuant to which taxpayer would acquire corp x the transaction closed on date on that date a specially created single purpose merger subsidiary of taxpayer merged with and into corp x with corp x surviving as a wholly owned subsidiary of taxpayer in the merger the former corp x shareholders received w shares of taxpayer’s stock in exchange for each share of corp x stock approximately x years later corp x was converted into a single member limited_liability_company that was wholly owned by taxpayer taxpayer then treated and continues to treat this entity as a division of taxpayer for u s federal_income_tax purposes those of corp x on date taxpayer issued a press release in which it announced its preliminary earnings for the quarter and fiscal_year ending date the first post-merger financial_accounting period shortly thereafter however taxpayer discovered that corp x may have improperly recognized revenue and on date taxpayer issued an additional press release in this press release taxpayer stated that certain transactions for the fiscal_year ending date were improperly recorded and had been reversed taxpayer also indicated that an audit was ongoing and that additional problems might be found on that date the price of taxpayer’s stock dropped on date taxpayer issued a press release describing the conclusions of its internal investigation of corp x and restated its financial results by revising revenues downwards for y fiscal years beginning with the fiscal_year ending date restatement was necessitated by several accounting improprieties allegedly perpetrated by corp x management over a period of years these accounting improprieties included the improper booking of revenues before the conditions required for revenue recognition were satisfied the improper booking of revenues that were contingent on future events the premature booking of revenue with respect to backdated contracts and other miscellaneous revenue adjustments relating to the timing of recognition of according to the date press release and taxpayer’s related sec filings the following the date press release numerous class action lawsuits were filed in the complaint the plaintiffs made claims against both taxpayer and corp x certain items expense underaccruals and the reversal of certain excess accruals the result of these improprieties was publication by corp x of false financial statements for the y fiscal years ending date against taxpayer and corp x under the federal securities laws the majority of these lawsuits were consolidated into a single case in court a under the caption case a in general the plaintiffs alleged that the public dissemination of inflated financial results by corp x management during the period from date the first date that corp x published allegedly fraudulent financial results through the day before date the date that taxpayer issued the first press release disclosing certain accounting improprieties had the effect of artificially inflating the value of corp x’s securities from date and taxpayer’s securities from date the prayer for relief sought compensatory_damages on behalf of all class members costs and expenses and such other relief that court a may require under various sections of the securities exchange act of the exchange act u s c sec_78j b 78n 78t a and the rules promulgated thereunder c f_r 10b-5 14a-9 with regard to corp x the complaint alleged that corp x and certain of its officers violated section b of the exchange act u s c sec_78j b and rule 10b-5 c f_r 10-5b collectively the section b claims by participating in a scheme to intentionally defraud investors and the public markets through conduct designed to inflate corp x’s financial results and conceal its true financial condition according to the complaint this scheme was accomplished by a variety of devices to create revenue and earnings including the use of the accounting improprieties discussed above moreover the complaint alleged that the scheme enabled corp x to publish false financial results with such information appearing in year-end and quarterly financial statements 10k and 10q filings registration statements press releases the taxpayer corp x joint proxy statements and annual and quarterly reports finally the complaint alleged that the publication of these fraudulent results allowed corp x to use its stock as currency to acquire other companies at artificially low prices and accomplish the merger with taxpayer these claims against corp x were brought on behalf of persons who purchased or otherwise acquired corp x securities from date the first date that corp x published all allegedly fraudulent financial results through date the merger date these claimants included not only those persons who acquired corp x stock on the open market but also those persons who acquired corp x stock in exchange for the stock of various target corporations that were acquired by corp x between the specified dates these section b claims against corp x were also made on behalf of persons who purchased taxpayer’s securities from date the merger announcement date through the day before date the date that taxpayer issued the first press release disclosing the accounting improprieties with regard to taxpayer the complaint alleged that taxpayer and certain of its officers had also violated section b of the exchange act and rule 10b-5 promulgated thereunder by knowingly making untrue and misleading statements about corp x’s financial condition and operating results these statements were claimed to have appeared in information published after the merger including press releases and taxpayer’s form 10-q in addition taxpayer was alleged to be jointly and severally liable with corp x as a control person with respect to corp x for corp x’s alleged violations of section b after the merger under section a of the exchange act u s c sec_78t a the section a claim the section b and section a claims against taxpayer were brought on behalf of persons who purchased taxpayer’s securities on the open market after the merger through the day before the date press release exchange act u s c sec_78 and rule 14a-9 c f_r 14a-9 promulgated thereunder hereinafter the section a claim because the taxpayer corp x joint proxy statement contained false and misleading statements regarding corp x’s financial results the section a claim against taxpayer was brought on behalf of persons who held taxpayer’s common_stock on date the date that the joint proxy statement was issued continuously through date the date that the shareholders voted to approve the merger the factual allegations underlying the section a claim were that taxpayer had engaged firm to perform accounting due diligence on corp x and had engaged firm to render a fairness opinion for the benefit of taxpayer’s shareholders that in its evaluation firm discovered certain accounting errors ie failures to comply with gaap which were communicated to taxpayer’s management and that taxpayer instructed firm not to consider these accounting in addition the plaintiffs alleged that taxpayer violated section a of the the complaint also alleged that taxpayer violated section b of the exchange act and rule 10b-5 promulgated thereunder with regard to its conduct and statements prior to the merger however in an order dated date court a dismissed these claims indicating that it found no strong inference of scienter and suggesting that taxpayer itself was a victim of corp x’s fraud accordingly this claim is not addressed in this ruling letter according to taxpayer’s submission the joint proxy statement consisted of a consolidation of taxpayer’s and corp x’s historical financial statements and other previously released information all of which was previously available to the public in an earlier complaint the plaintiffs also asserted an identical section a claim directly against corp x however the court dismissed the section a claim against corp x holding it was filed after the expiration of the applicable statute_of_limitations these accounting errors were different from the accounting improprieties that resulted in the date press release describing the alleged large-scale fraud at corp x and the ensuing restatement of financial results for y fiscal years these smaller errors were corrected in earnings releases dated date and date prior to the announcement of the larger accounting improprieties and their correction created no adverse market reaction on date taxpayer and the plaintiffs entered into a stipulation and agreement errors in issuing a fairness opinion on the potential merger the plaintiffs contended that taxpayer knew or should have known that the accounting errors observed by firm were relevant in that they put corp x’s management’s integrity into question and pointed to the possibility of a larger scale fraud perpetrated by corp x over a period of years thus they alleged that taxpayer and its management acted negligently in failing to make adjustments and disclosures in the joint proxy statement in recognition of these accounting errors of settlement settlement agreement between lead plaintiff taxpayer and corp x pursuant to which the parties agreed to settle the litigation in exchange for the payment of z by taxpayer while the defendants including taxpayer and corp x continued to deny the claims they decided to settle and terminate the claims to avoid the substantial uncertainties expense inconvenience and the distraction of continued defense of the litigation the settlement was intended by the parties to fully and finally compromise resolve discharge and settle the released claims against taxpayer corp x their officers directors and employees amount to an escrow account to be established on behalf of the plaintiffs and ultimately distributed to the plaintiffs pursuant to a plan of allocation drafted by the plaintiffs and approved by the court pursuant to the plan of allocation the damages per share determined with respect to claimants that held taxpayer’s stock on the date of the issuance of the joint proxy statement were calculated in the same manner as the damages per share with respect to claimants that purchased taxpayer’s stock on the open market after the merger announcement and with respect to claimants that acquired corp x stock during the same timeframe whether on the open market or through an exchange of shares in an acquisition except that in the case of the corp x shareholders an adjustment was made to account for the exchange ratio in the merger with taxpayer fees in connection with the litigation these include amounts incurred for attorneys expert witnesses court reporters document management support reporter transcripts document copying accounting advisors consultation damages consultants insurance in addition to the settlement amount taxpayer incurred legal and administrative under the settlement agreement taxpayer agreed to contribute the settlement taxpayer represented that during the class period taxpayer and corp x had by-laws providing for mandatory indemnification with respect to amounts incurred by any person in settlement of any lawsuit to which that person was made a party by reason of being an employee or director of the corporation the same methodology would be applied regardless of whether the claim was brought against taxpayer under section a of the exchange act or against taxpayer or corp x under section b of the exchange act coverage attorneys investigative expenses trial graphic support jury focus groups general trial support and audit committee investigative expenses law and analysis sec_162 provides in part that there shall be allowed as a deduction all the generally amounts paid in settlement of lawsuits are currently deductible if the ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying_on_a_trade_or_business sec_263 prohibits a deduction for capital expenditures specifically sec_263 disallows a deduction for any amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property sec_1_263_a_-4 of the income_tax regulations provides in part that a taxpayer must capitalize an amount_paid to another party to acquire any intangible from that party in a purchase or similar transaction for these purposes an intangible includes an ownership_interest in a corporation partnership trust estate limited_liability_company or other entity sec_1_263_a_-4 in addition a taxpayer must capitalize amounts paid to facilitate ie investigate or otherwise pursue the acquisition of an intangible see sec_1_263_a_-4 sec_1 e i cf sec_1_263_a_-5 costs to facilitate an acquisition of a trade_or_business a change in capital structure and certain other transactions acts which gave rise to the litigation were performed in the ordinary conduct of the taxpayer's business see eg 27_tc_960 allowing petitioner to deduct amounts paid in settlement of legal proceedings charging petitioner with mismanagement in the liquidation of assets revrul_80_211 1980_2_cb_57 allowing corporation to deduct amounts paid as punitive_damages that arose from a civil lawsuit against the corporation for breach of contract and fraud in connection with the ordinary conduct of its business activities revrul_79_208 1979_2_cb_79 permitting taxpayer to deduct payments to settle lawsuit and obtain a release from claims under a franchise agreement similarly amounts paid for legal expenses in connection with litigation are allowed as business_expenses where such litigation is directly connected to or proximately results from the conduct of a taxpayer's business see eg 276_us_145 holding that taxpayer may currently deduct amounts paid in defense of a suit against it by its former law partner 22_bta_375 deciding that legal fees incurred by taxpayer to settle a shareholder's claim of misrepresentation in the conduct of business are deductible as business_expenses however if the litigation arises from a capital_transaction then the settlement costs and legal fees associated with such litigation are characterized as acquisition costs and must be capitalized under sec_263 see 397_us_572 holding litigation costs incurred by corporation in appraisal proceedings mandated by state law to determine the value of dissenter’s shares were part of the cost of acquiring those shares 397_us_580 similarly deciding that litigation costs incurred in appraisal action to determine fair purchase_price were costs to acquire property berry petroleum co v commissioner 143_f3d_442 9th cir concluding that legal expenses to defend class action lawsuit alleging breach of fiduciary duty in accomplishing merger were non- deductible acquisition costs 473_f2d_1217 7th cir deciding that amounts paid in settlement of nuisance action that was brought to establish price of property were capital expenditures nevertheless business_expenses are not converted into capital expenditures solely because they have some connection to a capital_transaction in determining whether litigation costs are deductible expenses or capital expenditures the courts and the service have looked to the origin of the claim to which the settlement or other litigation costs relate see woodward v commissioner u s pincite 372_us_39 under the origin_of_the_claim_test the character of a particular expenditure is determined by the transaction or activity from which the taxable_event proximately resulted gilmore u s pincite the purpose consequence or result of the expenditure is irrelevant in determining the origin of the claim and therefore the character of the litigation cost for tax purposes mckeague v commissioner cl_ct aff'd without opinion 852_f2d_1294 fed cir the claim doctrine does not contemplate a mechanical search for the first in the chain of events which led to the litigation but rather requires an examination of all the facts 59_tc_708 citing gilmore u s pincite acq 1973_2_cb_1 revrul_80_119 1980_1_cb_40 this examination must include consideration of the issues involved the nature and objectives of the litigation the defenses asserted the purpose for which the claimed deductions were expended the background of the litigation and all facts pertaining to the controversy morgan's 332_f2d_144 5th cir furthermore where the litigation costs are incurred in conjunction with multiple claims each claim must be analyzed to determine its nature and origin boagni t c pincite revrul_80_119 if certain claims originate in ordinary business transactions and others originate in capital_transactions the litigation costs may be allocated among the various claims see eg 59_tc_634 allocating settlement amount between negligence claim which was deductible and release of stock claim which related to sale of capital_asset class action lawsuit as well as its attorney and other administrative fees may be the courts have indicated and the service has acknowledged that the origin of in the present case the issue involves whether taxpayer’s payment to settle its deducted by taxpayer under sec_162 as ordinary and necessary business_expenses or must be capitalized under sec_263 as costs incurred in connection with the acquisition of assets under the origin_of_the_claim_test the inquiry in this case involves examining the particular claims in the class action litigation and determining whether each claim had its origin in the conduct of taxpayer’s and corp x’s ordinary and necessary business activities or whether any of the claims were rooted in the merger of taxpayer and corp x or in any other corporate acquisitions made by corp x during the class period taxpayer argues that the costs of settling all the claims made against it and corp x in the litigation were attributable to the alleged fraud occurring during the defendants’ ordinary course business activities and did not originate in the merger of taxpayer and corp x or any other capital acquisition several courts have addressed the origin of the claim doctrine in contexts similar to taxpayer’s situation in missouri pacific corp v united_states cl_ct the taxpayer made a public offer to acquire shares of a target corporation’s stock in exchange for its own common_stock the exchange_offer was contained in a prospectus and letter to target’s shareholders the prospectus was then incorporated into a registration_statement filed with the sec following the consummation of the exchange the target’s former shareholders filed a class action lawsuit against the taxpayer and the former target alleging that the prospectus and letter contained false representations that overstated the value of taxpayer’s shares and understated the value of the target’s shares specifically the claims alleged that the prospectus did not properly reflect target’s net_income earnings dividends available and falsely gave the impression that all target’s officers considered the offer to be favorable in addition the prospectus understated taxpayer’s expenses and failed to reveal the business’s lack of growth potential pursuant to a settlement the taxpayer paid damages to shareholders who participated in the exchange_offer in an amount that compensated for the true value of the stocks exchanged on the exchange date the taxpayer claimed that the settlement costs were deductible as ordinary and necessary business_expenses because the complaints were the product of an ongoing dispute between target’s shareholders and the taxpayer as controlling shareholder of target for withholding dividends issuing fraudulent and incomplete financial statements and artificially depressing its stock price the claims_court disagreed with the taxpayer and determined that the settlement payments constituted an adjustment to the amount_paid for the target stock moreover the court analyzed the settlement payment under the origin_of_the_claim_test and determined that the claims originated in the taxpayer’s purchase of the target stock the claims_court noted first that the district_court had dismissed the class action claim dealing with the ongoing dispute between taxpayer and target shareholders as inappropriate to state a basis for a class action then the court looked to the district_court order approving the settlement which specifically stated that the action resulted from a public offer made by the taxpayer to acquire target’s stock lastly the court noted that the settlement payment was made only to the shareholders that exchanged their stock for taxpayer’s stock and not to the target shareholders in general based on these facts the court concluded that the predominant nature of the proceedings involved the adequacy of the consideration paid for the target’s stock in the exchange_offer and thus was grounded in a capital_transaction similarly in 104_tc_584 aff’d 142_f3d_442 wl 9th cir unpublished disposition the petitioner purchased a controlling portion of target_corporation shares from another corporation subsequently the petitioner and target effected a freeze-out exchange of stock merger whereby the petitioner acquired the remaining shares of the target from the public shareholders later the target’s former minority shareholders filed a class action lawsuit against petitioner the claimants included a selling class those former shareholders who sold their target stock on the open market following the petitioner’s acquisition of control of target but before the merger and a merger class those shareholders who exchanged their target stock for taxpayer’s stock in the freeze-out merger the classes sued for breach of fiduciary duty - merger fraud which according to the complaint had its origins in the freezeout merger and was the result of fraud perpetrated in the prospectus by misrepresenting and concealing the actual values of the target and certain of its properties id pincite more specifically the complaint alleged that the petitioner had material information and took actions with respect to target and its assets which it failed to disclose to the minority shareholders and that in sec filings made prior to the merger the petitioner belittled the value of target and its properties causing an improper evaluation of the exchange ratio eventually the petitioner and the classes entered a stipulation of settlement under which the petitioner agreed to pay the former minority shareholders dollar_figure million the petitioner then deducted the legal expenses and other costs attributable to its defense of the class action as ordinary and necessary business_expenses the service challenged the deduction on the grounds that the legal expenses constituted capital expenditures under sec_263 and the courts agreed using the origin_of_the_claim_test the tax_court concluded that the litigation originated in the taxpayer’s acquisition of the target stock which culminated in the merger the court noted that the class action complaint specifically stated that the breach of fiduciary duty had its origins in the merger and that the factual allegations and legal arguments made by both parties in the litigation focused on the merger and the establishment of a fair exchange ratio the court_of_appeals for the ninth circuit affirmed the tax_court in an unpublished decision determining that there was no difference between the claims of the selling class or the merging class and that the origin of the claim for both classes was fraud in the representations made to accomplish the merger at a good price not merely fraud in the operation of the companies which was incidental to the merger and related to it only in a but for sense berry petroleum 142_f3d_442 wl at claims against corp x because the litigation at issue in taxpayer’s ruling_request involves several different claims each claim must be analyzed in order to determine its origin and accordingly the character of the settlement payments and litigation costs relating to the claim see revrul_80_119 1980_1_cb_40 as discussed above part of the litigation at issue involves section b claims filed against corp x under these claims the complaint alleges that corp x and certain of its officers engaged in a scheme to intentionally defraud investors and the public markets through conduct that was designed to inflate corp x’s financial results and to conceal its actual financial status this conduct included the use of improper accounting devices in the reporting of business transactions which had the effect of creating revenue and earnings according to the complaint these devices enabled corp x to publish false financial statements and other public reports and regulatory filings which then allowed corp x to acquire other corporations at artificially low prices and to eventually accomplish the merger with taxpayer the class members making these claims include persons who purchased or otherwise acquired eg through exchange of shares corp x securities from the first date that corp x allegedly published allegedly fraudulent financial results through the date of the merger with taxpayer these class members also include persons who purchased taxpayer’s securities on the open market from the merger announcement date until the day before the press release announcing the possible fraud under these circumstances we believe that the origin of these claims was in the ordinary conduct of corp x’s trade_or_business specifically based on our review of the various litigation documents we believe that these claims had their basis in the accounting improprieties allegedly perpetrated by corp x and its officers over a period of years and the publication over these years of the allegedly fraudulent financial results that incorporated these improprieties generally the preparation and publication of financial statements is a common and routine activity in the carrying on of a trade_or_business thus the plaintiffs’ claims accusing corp x and its officers of using improper accounting devices in the reporting of its business transactions and of including this allegedly fraudulent information in corp x’s financial statements and other filings have their origin in the ongoing operation and conduct of corp x’s business both the courts and the service have allowed taxpayers to deduct the costs of settling and defending claims arising out of fraudulent misrepresentations made in the conduct of their trade_or_business see 234_f2d_660 6th cir 77_tc_608 22_bta_375 revrul_80_211 1980_2_cb_57 since the section b claims against corp x arose in the ordinary conduct of the corp x’s business the costs of litigating and settling these claims constitute ordinary and necessary business_expenses under sec_162 furthermore the section b claims against corp x did not arise out of any capital_transactions although corp x’s alleged accounting improprieties and resulting publication of fraudulent financial results may have affected the value or perception of the value of corp x’s stock in various corporate acquisitions made by corp x during years in which the fraud occurred and may have affected the price paid for corp x stock in the merger with taxpayer these consequences are not probative of the origin of the claims most importantly as discussed above the pleadings make clear that the section b claims against corp x have their basis in the accounting improprieties allegedly perpetrated by corp x and its officers in the ordinary conduct of corp x’s business over a period of years the complaint provides no indication that these accounting improprieties stemmed from any conduct by corp x in the course of any acquisition transaction or in the merger with taxpayer further the section b claims against corp x would exist regardless of whether corp x engaged in any acquisition or merger transactions while some of the claimants acquired their corp x securities in corporate acquisition transactions the parties making these claims also include parties that purchased their securities on the open market unrelated to any particular acquisitive transaction in either case the section b claims against corp x are identical in all of these cases the claims originated from corp x’s use of allegedly improper and fraudulent accounting practices in reporting its business transactions while this conduct had the ultimate effect of artificially inflating the value of corp x’s stock this inflation was a result of the accounting improprieties the fact that certain claimants acquired their shares in or after an acquisition transaction would not recharacterize the origin of their claims and berry petroleum t c pincite discussed above in these cases the courts determined that the claims at issue originated in the taxpayers’ acquisitions of targets’ stock rather then in their ordinary business operations in missouri pacific the alleged misrepresentations were made solely in the preparation of information for taxpayer’s public offer and involved only those parties that participated in the exchange_offer see missouri pacific cl_ct pincite in berry petroleum the complaint specifically alleged that the taxpayer’s breach of fiduciary duty had its origins in the merger see berry petroleum t c pincite in that case the allegations focused on the taxpayer’s misrepresentations and omissions in the prospectus for the purpose of accomplishing the merger at a good price and in establishing a fair exchange price and ratio id pincite further the litigation documents characterized the berry litigation as a ’quasi-appraisal’ action id to the contrary in the present case the section b claims against corp x involve accounting improprieties that occurred independent of and outside the context of any particular acquisitions by corp x or the merger with taxpayer moreover these section b claims were not limited to parties that purchased or exchanged securities in an acquisition but were brought by all parties who purchased and acquired securities during the time the alleged accounting improprieties occurred in addition unlike missouri pacific and berry petroleum the in addition this situation is distinguishable from missouri pacific cl_ct pincite complaint and the litigation documents underlying the claims against corp x do not focus on the facts surrounding the establishment of a fair exchange price for purposes of the acquisitions or merger rather the factual allegations underlying these claims focus on the fraudulent and deceptive accounting practices allegedly perpetrated by corp x over the course of several years thus the origin of the section b claims against corp x was not in the process of any acquisition or the merger with taxpayer but in the ongoing accounting fraud accordingly the settlement and litigation costs allocable to these claims should not be treated as capital expenditures under sec_263 claims against taxpayer the section b and section a claims these claims were almost identical to the claims brought against corp x under in addition to the claims asserted against corp x the litigation also includes certain claims against taxpayer the first set of claims against taxpayer involves alleged violations of sections b and a of the exchange act these claims were brought on behalf of parties who purchased taxpayer’s securities on the open market after the merger of corp x and taxpayer and alleged that taxpayer violated these statutes in its own capacity and as a controlling person with respect to corp x’s violations by knowingly making untrue and misleading statements about corp x’s financial condition and operating results in documents published after the merger section b of the exchange act except they were based on statements published by taxpayer and corp x after the merger in essence taxpayer is being held accountable for the long-term accounting fraud allegedly perpetrated by corp x and its own failure to discover and or reveal the fraud in financial statements and other documents filed after the merger until date for the same reasons discussed above with regard to the claims against corp x we believe that the section b and section a claims asserted against taxpayer also had their origin in the ongoing operation and conduct of taxpayer’s trade_or_business as with corp x the allegations of fraud under these claims originated in taxpayer’s preparation and publication of financial statements and related documents a routine activity in the conduct_of_a_trade_or_business moreover these claims do not have their origin in the merger of taxpayer and corp x while the litigation came soon after the merger and the merger itself may have triggered taxpayer’s potential liability by connecting it to corp x these facts do not establish that the merger was the origin of the claim see eg 539_f2d_929 3d cir legal expenses were deductible where government could not show litigation was integral part of the corporate acquisition as previously noted these claims were brought by persons that purchased stock after the merger and were based on alleged misrepresentations in statements published after the merger thus these particular claims were not based on taxpayer’s the section a claim an additional claim against taxpayer involves taxpayer’s alleged violations of activities in the process of the merger but rather were based on alleged misrepresentations occurring in the course of its business operations after and outside the context of the merger accordingly the settlement and litigation costs allocable to the section b and a claims against taxpayer are not treated as capital expenditures under sec_263 but may be deducted under sec_162 section a of the exchange act and rule 14a-9 promulgated thereunder the section a claim against taxpayer was brought on behalf of persons who held taxpayer’s common_stock on the date that the joint proxy statement was issued and continued to hold such stock through the date that the shareholders approved the merger under this claim the plaintiffs alleged that taxpayer knew or should have known that the joint proxy statement issued in the merger of taxpayer and corp x contained materially false and misleading statements regarding corp x’s financial results in addition the complaint alleged that for purposes of the joint proxy statement taxpayer failed to reveal and instructed firm not to consider certain accounting errors ie failures to comply with gaap discovered by firm during the due diligence process according to the complaint the discovery of these accounting errors and their proper consideration in the joint proxy process should have caused taxpayer to question corp x’s management’s integrity and would have alerted taxpayer to the possibility of larger scale fraud perpetrated by corp x over the several preceding years characterization of the claim and instead considered the substance of the entire transaction see 473_f2d_1217 7th cir holding that amounts paid to settle a nuisance action in substance had their origin in the acquisition of a capital_asset and thus were considered capital expenditures 114_tc_458 holding that legal fees incurred in defending against an anti-trust action had their origin in the taxpayer’s acquisition transaction while on its face the section a claim appears to arise in the context of the merger ie in the preparation of the joint proxy a thorough consideration of the facts in this case suggests that the actual origin of this claim was not the merger itself but rather was the ongoing fraud allegedly perpetrated by corp x during the years prior to the merger first although the section a claim is based on the inclusion of false and misleading statements in the joint proxy statement many of these statements did not originate in the merger transaction according to taxpayer the joint proxy statement consisted of a combination of taxpayer’s and corp x’s previously published financial statements and previously these accounting errors were different from the accounting improprieties that were the main subject of the litigation and that resulted in the date press release and restatement see supra note in determining the origin of a claim the courts have looked beyond the formal second although the section a claim also alleges that taxpayer made disseminated financial information as asserted in the section a claim and the claims previously discussed corp x’s historical financial statements incorporated the results of corp x’s ongoing accounting fraud thus in essence these claims are identical to the claims alleged by the other claimants in the litigation ie that the parties were damaged by the accounting improprieties allegedly perpetrated by corp x in the reporting of its business transactions and in the publication of fraudulent financial results incorporating these improprieties as discussed above we believe these claims originated in the ordinary conduct of corp x’s business and not in the merger or any other capital_transaction additional misrepresentations in the joint proxy statement by failing to consider and by instructing firm not to consider certain additional accounting errors discovered by firm during the due diligence process this allegation by itself does not provide the foundation for the claim the complaint suggests rather that these accounting errors were significant primarily because of their relationship to the larger fraud perpetrated by corp x as noted above the plaintiff’s allege that these accounting errors although different from the accounting irregularities perpetrated by corp x in their ongoing fraud should have caused taxpayer to question corp x’s management’s integrity and alerted taxpayer to the possibility of larger scale fraud perpetrated by corp x over the several preceding years furthermore the allegation regarding taxpayer’s failure to reveal or consider the accounting errors by itself appears to have only incidental value to the claim in fact after the merger and prior to taxpayer’s announcements regarding the finding of corp x’s large-scale accounting fraud taxpayer corrected these accounting errors by issuing earnings releases which created no adverse market reaction thus the value of this allegation appears to be in its relationship to the larger accounting fraud specifically in connecting taxpayer by means of the joint proxy statement to the ongoing accounting fraud allegedly perpetrated by corp x over the years prior to the merger distinguishable from the situations addressed in missouri pacific cl_ct pincite and berry petroleum t c pincite as noted above in both of these cases the courts denied deductions for amounts to settle claims because the claims arose from corporate acquisitions unlike the section a claim presently at issue the allegations in these cases involved misrepresentations and omissions made solely in the context of and for the purpose of an acquisition in both cases the courts looked to the various litigation documents which specifically characterized the claims as arising out of the mergers or in the process of the acquisition see missouri pacific cl_ct pincite looking to the language of the complaint and the district_court order approving the settlement berry in fact an identical section a claim was brought directly against corp x in an earlier version of the complaint however the court dismissed this claim holding it was filed after the expiration of the applicable statute_of_limitations third like the foregoing claims we believe that the section a claim is in contrast in the current case the litigation documents expressly connect the petroleum t c pincite citing language in the class action complaint and the petitioner’s brief moreover in both cases the courts rejected the taxpayers’ contentions that the claims arose from any ongoing disputes or breaches of fiduciary duty in the management of the corporation see missouri pacific cl_ct pincite noting that the ongoing dispute between shareholders and management could hardly have been a substantial basis for the subsequent settlement of the class action berry petroleum t c pincite aff’d f3d pincite wl at suggesting that fraud in the operation of the companies was merely incidental to the merger section a claim to corp x’s on-going accounting fraud specifically under the complaint the claim is based primarily on fraudulent information contained in financial documents published well before the merger and only republished as a consequence of the merger in addition the section a claim is based in substantial part on the inclusion or omission of information in the joint proxy statement that the plaintiff asserts is relevant in its relationship to the possible discovery by taxpayer of the ongoing accounting fraud at corp x in fact the litigation documents consistently characterize all the financial misrepresentations in the litigation as arising from massive accounting fraud carried out by corp x and after the merger by the combined entity of taxpayer and corp x this identity of claims is consistent with the taxpayer’s draft settlement agreement which pays out similar damages to all the claimants regardless of whether their claims arise under section a or b of the exchange act thus unlike the facts in missouri pacific and berry petroleum the section a claim in the present case had a direct and substantial relationship to the fraud perpetrated in the operation of corp x’s business the section a claim with its connection to the joint proxy statement was merely the mechanism by which certain of taxpayer’s shareholders could show harm by and receive damages for corp x’s ongoing accounting fraud as such we believe that in substance the origin of the section a claim was not in the process of the merger but in the long-term accounting fraud accordingly the settlement and litigation costs allocable to this claim are not treated as acquisition costs under sec_263 but may be deducted as ordinary and necessary business_expenses under sec_162 conclusion thus for the reasons discussed above and based solely on the facts and circumstances presented herein we conclude that amounts incurred by taxpayer to settle the above-referenced class action lawsuit as well as legal fees and other administrative fees attributable to the claims discussed above may be deducted as ordinary and necessary business_expenses under sec_162 concerning the tax consequences of any aspect of any transaction or item discussed or except as expressly provided herein no opinion is expressed or implied referenced in this letter further except as expressed herein no opinion is expressed or implied regarding the application of any section of the code including but not limited to sec_482 thus the conclusion determined herein shall not preclude an adjustment under any other applicable code provisions including sec_482 representations submitted by taxpayer and accompanied by a penalties of perjury statement executed by an appropriate party while this office has not verified any of the material submitted in support of the request for rulings it is subject_to verification on examination the rulings contained in this letter are based upon information and a copy of this letter must be attached to any income_tax return to which it is relevant alternatively taxpayers filing their returns electronically may satisfy this requirement by attaching a statement to their return that provides the date and control number of the letter_ruling this ruling is directed only to the taxpayer requesting it sec_6110 of the code provides that it may not be used or cited as precedent in accordance with the provisions of a power_of_attorney on file with this office we are sending copies of this letter_ruling to taxpayer’s authorized representatives sincerely yours robert m casey senior technician reviewer branch office of associate chief_counsel income_tax accounting cc


internal_revenue_service department of the treasury number release date index number washington dc person to contact telephone number refer reply to cc psi 2-plr-141487-02 date date partnership a b c d e f d1 year dear this responds to a letter dated date submitted on partnership's behalf requesting an extension of time to make an election under sec_754 of the internal_revenue_code facts a and b each own of partnership and c owns the remaining a is a subsidiary of d and b is a subsidiary of e on d1 e purchased the stock of b from f in a transaction in which e and f jointly filed a sec_338 election partnership included an election under sec_754 with its return for the year taxable_year and the return was filed plr-141487-02 as though the sec_754 election had been made however the election was not properly executed partnership represents that it has acted reasonably and in good_faith that granting relief will not prejudice the interests of the government and that it is not using hindsight in making the election law and analysis sec_754 provides that a partnership may elect to adjust the basis of partnership property in the case of a distribution_of_property or in the case of a transfer of a partnership_interest the election applies with respect to all distributions of property by the partnership and to all transfers of interests in the partnership during the taxable_year with respect to which such election is filed and all subsequent taxable years sec_1_754-1 of the income_tax regulations provides that an election under sec_754 and this section to adjust the basis of partnership property under sec_734 and sec_743 with respect to a distribution_of_property to a partner or a transfer of an interest in a partnership shall be made in a written_statement filed with the partnership return for the tax_year during which the distribution or transfer occurs for the election to be valid the return must be filed no later than the time prescribed by sec_1_6031_a_-1 including extensions thereof for filing the return for that tax_year under sec_301_9100-1 of the procedure and administration regulations the commissioner may grant a reasonable extension of time to make a regulatory election or a statutory election but no more than six months except in the case of a taxpayer who is abroad under all subtitles of the code except subtitles e g h and i sec_301_9100-1 defines the term regulatory election as an election whose deadline is prescribed by a regulation published in the federal_register or a revenue_ruling revenue_procedure notice or announcement published in the internal_revenue_bulletin sec_301_9100-2 and sec_301_9100-3 provide the standards the commissioner will use to determine whether to grant an extension of time to make an election sec_301_9100-2 provides automatic extensions of time for making certain elections sec_301_9100-3 provides extensions of time for making elections that do not meet the requirements of sec_301_9100-2 requests for relief under sec_301_9100-3 will be granted when the taxpayer provides evidence to establish that the taxpayer acted reasonably and in good_faith and that granting relief will not prejudice the interest of the government conclusion plr-141487-02 in this case based on the information submitted and the representations made we conclude that the requirements of sec_301_9100-1 and sec_301_9100-3 have been met consequently partnership is granted an extension of time for making the sec_754 election until sixty days following the date of this letter the election should be made in a written_statement filed with the applicable service_center for association with partnership's return for the year taxable_year a copy of this letter should be attached to the statement filed except as specially set forth above we express no opinion concerning the federal_income_tax consequences of the transactions described above under any other provision of the code specifically we express no opinion as to whether or not partnership is a partnership for tax purposes this ruling is directed only to the taxpayer requesting it sec_6110 provides that it may not be used or cited as precedent pursuant to the power_of_attorney on file with this office copies of this letter will be sent to partnership’s authorized representatives sincerely heather c maloy associate chief_counsel passthroughs and special industries enclosures copy of this letter copy for purposes


number release date tam-101237-00 cc fip b4 uil date internal_revenue_service national_office technical_advice_memorandum district_director name of taxpayer taxpayer’s address taxpayer’s ein year s involved date of conference issue whether taxpayer may compute the tax_reserves under sec_807 of the internal_revenue_code for certain structured_settlement annuities issued in through using graded valuation interest factors consistent with the interest rates assumed in computing the statutory_reserves for the contracts rather than the prevailing state assumed interest rates under sec_807 for single premium immediate annuities issued in each of those years taxpayer’s use of graded valuation interest factors to compute the tax_reserves under sec_807 for structured_settlement annuities issued in through was appropriate conclusion a general background facts taxpayer is a life_insurance_company within the meaning of sec_816 of the internal_revenue_code and is subject_to the tax imposed by sec_801 among its various life_insurance products taxpayer issues traditional individual single premium immediate_annuity contracts such as retirement income annuities during the years involved taxpayer also issued annuities in connection with structured_settlement arrangements to fund the payment of damages in connection with wrongful death or injury claims unlike traditional single premium immediate annuities such as those issued as retirement annuities the level of guaranteed benefits under a structured_settlement annuity often varies substantially over the payout period based on changes in the injured party’s specific situation and income needs moreover the injured party and or dependents receiving benefit payments under a structured_settlement annuity are often younger than the normal_retirement_age so that the payout period of a structured_settlement annuity may exceed the term in which the insurer can invest the premium in fixed income investments in light of these variations in the payment pattern and potentially long payout periods associated with its structured_settlement annuities taxpayer developed a special method of applying valuation interest rates when computing its statutory_reserves for these annuities for state insurance regulatory purposes b statutory_reserves in date taxpayer’s domiciliary state adopted the amendments to the standard valuation law svl which introduced a system of dynamic valuation interest rates for purposes of computing minimum statutory_reserves for different types of life_insurance and annuity_contracts the dynamic interest rate system was designed to allow an insurance_company to use assumed interest rates in computing its reserve liabilities which roughly correspond to the insurer’s anticipated investment earnings rates based on i the year in which the premiums were received and ii the contract’s guarantee duration or period of deferral between the issue_date of the contract and the date when the guaranteed contract benefits are assumed to be paid the maximum interest rate allowed in valuing the future_benefits provided by an insurance_or_annuity_contract under the amendments generally decreases as the guarantee duration associated with that contract benefit increases the use of lower valuation interest assumptions reflects the reinvestment risk associated with long-term guarantees for traditional single premium immediate annuities however the amendments did not change the basic methodology for computing the minimum formula reserve which was simply the present_value of the future annuity payments using a single valuation interest rate based on the issue_date of the contract moreover the valuation interest rate allowed under the amendments for a single premium immediate_annuity or spia rate was generally higher than the interest rates allowed for other types of annuities following its domiciliary state’s adoption of the amendments to the svl taxpayer began computing its statutory_reserves for structured_settlement annuities using graded valuation interest rates under this reserve_method taxpayer computed the present_value of the guaranteed annuity benefits using different valuation interest rates grading from higher to lower for different benefit durations under the same contract for contracts issued through year-end taxpayer computed its statutory_reserves using an assumed interest rate of percent for payments during the first years percent for payments during the next years and percent for payments thereafter because the spia rate for issues was percent taxpayer’s graded reserve_method resulted in relatively high reserves compared to the reserves that would have been determined using a level interest assumption beginning with structured_settlement annuities issued in taxpayer’s graded interest method involved the use of a valuation interest rate for benefit payments during the first years that was higher than the applicable spia rate and progressively lower valuation interest rates for annuity payments during the next years and for payments after years the interest rate used in determining the value of future annuity benefits during the first years was computed mathematically so that taken together with the lower assumed interest rates used in determining the value of the future annuity benefits in later durations the initial policy reserve would be equal to the reserve that would have been determined if all guaranteed payments under the annuity had been valued using the applicable spia rate thus taxpayer’s graded reserve_method for contracts issued in through was designed to produce a pattern of reserve increases which minimized the initial surplus strain associated with the issuance of a structured_settlement annuity but which through the use of a lower discount rate for scheduled payments after years also reflected the reinvestment risk inherent in funding guaranteed payments for later durations of the contract in the national association of insurance commissioners naic adopted actuarial guideline ix-b which provided specific guidance for applying the dynamic interest rates of the svl to structured_settlement annuities actuarial guideline ix-b reaffirmed the naic’s requirements for an immediate_annuity as set forth in actuarial guideline ix but clarified the treatment of an annuity that failed to meet these requirements because it provided increasing payment schedules more specifically actuarial guideline ix-b allowed the insurer to carve- out for reserve computation purposes the portion of any scheduled payments under a structured_settlement annuity that exceeded percent of the prior year’s payments by treating these amounts either as lump sum payments or as part of a new annuity depending upon the circumstances actuarial guideline ix-b also specified two methods for applying the dynamic interest rates to a structured_settlement annuity including a block of structured_settlement annuities of the same year of issue which did not satisfy the requirements to be treated as an immediate_annuity under the first method or so-called carve-out method the portion of the future annuity benefits provided by the contract which would meet the immediate_annuity test taxpayer computed its statutory_reserves for structured_settlement annuities issued in using the applicable spia rate from the dynamic interest rate table to determine the present_value of all of the future annuity benefits regardless of duration although taxpayer’s reasons for deviating from the revised graded reserve_valuation method adopted in were not documented it appears that taxpayer’s actuaries reasoned that because the valuation interest assumptions that had been used in computing the statutory_reserves for structured_settlement annuity_contracts issued in had resulted in a relatively high level of reserves taxpayer could use the spia rates in reserving for issues without impairing the overall adequacy of its statutory_reserves may be valued using the applicable spia rate whereas any deferred lump sum payments should be valued using an appropriate interest rate factor for deferred annuities based on the guarantee duration of the deferred_benefit payment alternatively actuarial guideline ix-b allows an insurance_company to compute the minimum formula reserves for a structured_settlement annuity using a graded valuation interest method the graded interest method specified in actuarial guideline ix-b is similar to taxpayer’s graded interest rate method except that actuarial guideline ix-b provides for_the_use_of only two valuation interest rates an initial rate for guaranteed durations during the first years and another rate for guaranteed durations after years in addition the reserve produced by actuarial guideline ix-b’s graded reserve_method could not be less than a baseline level interest rate reserve actuarial guideline ix-b contained a transition rule so that if an insurance_company had adopted in good_faith a reserve computation method which had resulted in lower statutory_reserves for structured_settlement annuities than those required by the guideline the insurance_company was permitted to continue using that method for purposes of computing its statutory_reserves for contracts issued in but had to comply with the guideline’s requirements for and later issues actuarial guideline ix-b also required the insurance_company to conform the reserves for all structured_settlement annuities with the guideline’s minimum reserve requirements by no later than the year-end valuation based on the above transition rule taxpayer computed its statutory_reserves for structured_settlement annuities issued in and later years in accordance with the graded interest valuation method specifically prescribed in actuarial guideline ix-b beginning with the annual_statement taxpayer also recomputed the statutory_reserves with respect to all structured_settlement annuities issued prior to in accordance with the graded interest valuation method specifically prescribed in actuarial guideline ix-b c tax_reserves in contrast to the method used in computing its statutory_reserves taxpayer initially computed its tax_reserves under sec_807 for structured_settlement annuities issued in through using the applicable prevailing state assumed interest rates under sec_807 for single premium immediate annuities for annuity_contracts issued in the prevailing_state_assumed_interest_rate under sec_807 for individual single premium immediate annuities was based on prevailing state assumed interest rates which existed prior to the amendments to the svl see revrul_87_26 1987_1_cb_158 under those pre-1980 valuation standards the maximum valuation interest rate for a single premium immediate_annuity was percent whereas the maximum valuation interest rate for other annuities wa sec_5 percent the prevailing_state_assumed_interest_rate for immediate annuities issued in was substantially lower than the graded interest rate factors used by taxpayer in computing the statutory_reserves for those contracts thus the amounts taken into account by taxpayer as the tax_reserves for structured_settlement annuities for the tax_year taxpayer changed its method of computing tax_reserves under sec_807 for structured_settlement annuities issued in through to adopt the same assumed interest rates as had been used in determining the statutory_reserves for the related contracts thus for structured_settlement annuities issued in through other than issues taxpayer computed the tax_reserves under sec_807 using graded reserve interest factors no change was made to the amount of taxpayer’s tax_reserves with respect to structured_settlement annuities issued in because the statutory_reserves for those contracts had been computed using the applicable spia rate from the dynamic interest rate table pursuant to sec_807 taxpayer deducted the net increase in year-end tax_reserves for structured_settlement annuities issued in through other than ratably over ten taxable years beginning with the taxable_year beginning in the tax_year taxpayer changed its method of computing the tax_reserves under sec_807 for structured_settlement annuities issued in through including contracts issued in to parallel the change made in computing the statutory_reserves for those contracts based on actuarial guideline ix-b the use of the graded interest rate factors specified by actuarial guideline ix-b in computing the statutory_reserves for structured_settlement annuities issued in resulted in a net decrease in the allowable tax_reserves under sec_807 due to a reduction in the ceiling under sec_807 with respect to the amount of statutory_reserves conversely the use of the graded reserve factors specified by actuarial guideline ix-b in computing the tax_reserves for structured_settlement annuities issued in resulted in a significant reserve increase since the tax_reserves with respect to those contracts had previously been computed using the higher spia rate pursuant to sec_807 taxpayer deducted the net increase in year-end tax_reserves for structured_settlement annuities issued in through which resulted from the adoption of the graded reserve interest factors specified by actuarial guideline ix-b over taxable years beginning with the taxable_year the district_director has questioned whether taxpayer’s use of a graded reserve_method in computing its tax_reserves with respect to structured_settlement annuities issued in through is proper under the reserve computation rules of sec_807 the district_director contends that since sec_807 requires the reserves for a life_insurance or annuity_contract issued prior to to be computed using the prevailing_state_assumed_interest_rate taxpayer’s use of multiple interest rates in computing the tax_reserves for structured_settlement annuities issued in through was incorrect taxpayer’s position is that the use of graded interest rates in computing the tax_reserves for structured_settlement annuities issued in through was a permissible method of applying carvm to structured_settlement annuities prior to the naic’s adoption of specific recommendations concerning these contracts in actuarial guideline ix-b taxpayer also contends that since there were no specific recommendations from the naic or a majority of the states regarding how to apply the prevailing state assumed interest rates to structured_settlement annuities prior the adoption of actuarial guideline ix-b issued in was limited by sec_807 to the statutory_reserves for the contracts taxpayer was required was the rules of sec_807 to compute the tax_reserves for those contracts consistent with the valuation interest assumptions employed in computing the statutory_reserves applicable law and rationale sec_805 authorizes a deduction with respect to the net increase in certain reserves required under sec_807 to be taken into account under sec_807 the reserves to which this treatment applies include life_insurance_reserves as defined in sec_816 sec_807 provides that other than for purposes of sec_816 relating to qualification as a life_insurance_company the amount of the life_insurance_reserve with respect to any contract is the greater of i the net_surrender_value of the contract or ii the reserve determined under sec_807 in no event may the reserve for any contract exceed the amount taken into account with respect to that contract as of that time in determining the statutory reserve reduced by any deferred and uncollected premiums taken into account in determining the statutory_reserves see sec_807 flush language sec_807 provides that the reserve for any contract must be determined using i the tax_reserve_method applicable to such contract ii the prevailing_state_assumed_interest_rate or for contracts issued in and later years the higher of this rate or the applicable_federal_interest_rate and iii the prevailing_commissioners’_standard_tables for morbidity and mortality adjusted as appropriate to reflect the risks such as substandard risks incurred under the contract which are not otherwise taken into account sec_807 and sec_807 provide in the case of an annuity_contract covered by carvm the prescribed tax_reserve_method is the carvm in effect when the contract is issued sec_807 defines the prevailing_state_assumed_interest_rate as the highest assumed interest rate permitted to be used in computing life_insurance_reserves for insurance or annuity_contracts under the laws at least states as of the beginning of the calendar_year in which the contract was issued sec_807 provides that if the basis for determining any item referred to in sec_807 as of the close of any taxable_year differs from the basis for determining that item as of the close of the preceding_taxable_year then so much of the difference between i the amount of the item at the close of the taxable_year computed on the new basis and ii the amount of the item at the close of the taxable_year computed on the old basis as is attributable to contracts issued before the taxable_year is taken into account ratably over taxable years either as an increase or decrease in taxable_income sec_811 provides that all computations entering into the determination of life_insurance_company_taxable_income are to be made under an accrual_method of accounting or to the extent permitted by regulations under a combination of an accrual_method of accounting with any other recognized method other than the cash_receipts_and_disbursements_method to the extent that they are not inconsistent with federal tax_accounting rules all such computations are made in a manner consistent with the manner required for purposes of the annual_statement approved by the naic taxpayer was required by the reserve computation rules of sec_807 to determine the tax_reserves for structured_settlement annuities issued in through using i the federally prescribed tax_reserve_method applicable to those contracts ii the prevailing_state_assumed_interest_rate as defined in sec_807 and iii and the prevailing commissioners’ standard mortality_table adjusted as appropriate to reflect substandard risks under sec_807 the federally prescribed tax_reserve_method for taxpayer’s structured_settlement annuities issued in through was the carvm prescribed by the naic which was in effect on the issue_date of those contracts the legislative_history of sec_807 indicates that the method to be used by an insurance_company in determining the amount of the tax_reserves for an insurance_or_annuity_contract is prescribed regardless of the method employed in computing the insurer’s statutory_reserves for the contract for state regulatory purposes the federally prescribed reserve methods are those recommended by the naic in computing the minimum required formula reserves for the particular type of contract in applying the federally prescribed reserve methods an insurance_company must take into account any factors specifically recommended by the naic if the naic prescribed method is silent as to particular factors the prevailing state interpretation of that method should be considered for purposes of determining what factors can be taken into account for tax purposes h_rep_no pt 98th cong 2d sess s prt no vol 98th cong 2d sess the overall purpose of this calculation is to limit the amount of life_insurance_reserves to the minimum reserve that most states would require with such reserves being determined based on a computational method that minimizes state-by- state variations h_rep_no pincite s prt no pincite the amendments to the svl which introduced the system of dynamic interest rates were approved by states in accordingly for annuity_contracts issued in and later years the prevailing state assumed interest rates under sec_807 are based on the system of dynamic interest rates adopted by the naic as part of the amendments to the svl the selection of the appropriate dynamic interest rate table for a particular annuity_contract is complex and depends not only on the nature or classification of the annuity but also on various product features such as whether the contract is valued on an issue year or change in fund basis whether the contract provides a future_interest guarantee the nature of the policyholder’s withdrawal rights and the length of the contract’s guarantee duration because the amendments provide a multitude of possible valuation interest rates for different categories of annuities or combinations of product features the classification of an annuity_contract together with an analysis of the benefit provisions of the contract are necessary when determining the appropriate prevailing_state_assumed_interest_rate under sec_807 to be used in applying carvm to the contract in the naic adopted actuarial guideline ix for purposes of identifying those types of annuity_contracts which qualified as single premium immediate annuities for purposes of the higher valuation interest rates allowed under the amendments to the svl under actuarial guideline ix an individual single premium annuity is treated as an immediate as opposed to deferred_annuity for purposes of the applicable valuation and nonforfeiture requirements provided that it satisfies the following three-prong test i the first annuity_payment is due no more than months after the issue_date of the contract ii after the initial payment succeeding payments under the annuity_contract are due at regular intervals no less frequently than annually and iii in the case of a fixed benefit annuity the total guaranteed payments due in any contract_year do not exceed by more than percent the total guaranteed payments in the immediately preceding contract_year the explanatory material accompanying actuarial guideline ix notes that the higher valuation interest rates for immediate annuities in the amendments to the svl are premised on the concept that an insurance_company may lock-in higher rates of investment return in the year the premiums are received to the extent that the contract provides a regular and fixed pattern of benefit payments moreover the amount of policy reserve reflecting the issuer’s liability to make future payments under an immediate_annuity should decrease from year to year as fewer payments remain to be made accordingly actuarial guideline ix sought to limit the classification of immediate annuities to those contracts where there were no gaps between scheduled benefit payments or where there were no substantial benefit increases that could cause the policy reserve to increase from one year to the next see proceedings of the national association of insurance commissioners most of taxpayer’s structured_settlement annuities did not qualify as single premium immediate annuities under the requirements set forth in actuarial guideline ix because there were some years when the guaranteed benefits provided by the contracts exceeded percent of the guaranteed payments due in the preceding year with the adoption of the dynamic interest rate system as the prevailing state assumed interest rates under sec_807 therefore it would have been improper for taxpayer to compute its tax_reserves for structured_settlement annuities under carvm using the higher dynamic interest rates for immediate annuities when those contracts did not qualify as immediate annuities based on the naic’s recommendations in actuarial guideline ix although actuarial guideline ix provided a three-prong test for determining whether a particular annuity_contract was classified as a single premium immediate_annuity for purposes of the applicable valuation requirements the actuarial guideline did not address how to apply the dynamic interest rates to an annuity_contract that failed to satisfy this test because it provided scheduled benefit increases that exceeded percent of the prior year’s payments for example it was unclear under actuarial guideline ix whether the portion of the payments provided by a structured_settlement annuity that did not exceed the guideline’s percent limitation could be valued using the spia rates actuarial guideline ix also did not address whether a graded valuation interest rate reserve could be used in computing the minimum formula reserves for a structured_settlement annuity in the new york insurance department issued regulation which among other issues addressed the minimum reserve requirements for structured_settlement annuities regulation required the carvm reserves for structured_settlement annuities to be computed using a carve-out procedure similar to one of the methods eventually adopted by the naic in actuarial guideline ix-b unlike actuarial guideline ix-b there was no provision in regulation allowing the use of graded interest rates see new york regulation revisited record society of actuaries vol no with the exception of this new york regulation however it does not appear that other state insurance regulators addressed the issue of how to apply the dynamic interest rates in applying carvm to structured_settlement annuities prior to the naic ‘s adoption of specific recommendations in actuarial guideline ix-b given these circumstances taxpayer’s use of a graded interest rate method in computing the tax_reserves with respect to structured_settlement annuities issued in through other than issues was a permissible interpretation of carvm prior to the adoption of actuarial guideline ix-b although taxpayer might have applied carvm to those contracts using a different combination of valuation interest rates such as the carve-out procedure required by new york regulation taxpayer’s graded reserve_method was consistent with carvm requirements and naic guidelines pursuant to sec_6110 names addresses and taxpayer identification numbers are required to be deleted from the copy of this technical_advice_memorandum that will be open to public inspection a copy of this technical_advice_memorandum is to be given to taxpayer sec_6110 provides that it may not be used or cited as precedent