If your company is still dealing with a Section 338 tax election from years past, you may want to double check on how the Internal Revenue Service is likely to view the expected depreciation deductions. In some cases, the tax rule may have triggered some unexpected consequences, as was the case in a recent ruling against Brunswick Corporation, the consumer goods maker that manufactures products for the marine, fitness, bowling and billiards sectors.
In this particular case, the issue dates back 23 years. On Dec. 8, 1986, Brunswick acquired all of the stock of BM Corporation, an ‘S’ corporation, as well as all the shares of USM Corporation, a C corporation. Each acquisition constituted a “qualified stock purchase”1 and, in connection with each acquisition, Brunswick executed an election under Section 338(g) of the U.S. tax code.2
As a result of the Section 338 election, BM and USM were first treated as having sold all of their assets as of the acquisition date (12/8/86), and then treated as new corporations that purchased all the assets of the old corporations that placed those assets in service as of the day after the acquisition, Dec. 9, 1986.
Under the tax code — and unless otherwise stated in Section 338(a)(1) and Regulation Section 1.338-1(b)(1) — the new target is treated as a new corporation that is unrelated to the old target for purposes of subtitle A of the Internal Revenue Code. In addition, on December 30, 1986, Brunswick acquired the stock of R Corporation, a C corporation. The acquisition of R Corp.’s stock also constituted a qualified stock purchase, and Brunswick executed a Section 338 election with respect to that purchase as well.3
In each case, the assets acquired by the trio of new companies (Newcos) included tangible personal property which qualified recovery property. For the 1986 tax year, Brunswick filed a consolidated income tax return that included BM, USM, and R Corp. as its members for the portion of the year beginning after their acquisitions. As Section 168(b)(1) of the tax codes was in effect at the time, the rule required taxpayers to depreciate all tangible personal property placed in service at any point during “the taxable year” as if such property was placed in service at the mid-point of such year.
An exception was noted: If the taxable year of a corporation is less than 12 months in duration, the annual depreciation deduction otherwise allowable is limited to a pro-rata portion of the annual depreciation deduction. As such, Brunswick contended that the taxable year at issue was its taxable year.
More specifically, Brunswick contended that it was entitled to calculate depreciation by applying the half-year convention method to the full taxable year. The company based the argument its use of its taxable year to control the amount of depreciation deductions, rather than the length of the taxable year for each acquired subsidiary while in Brunswick’s consolidated group.
Accordingly, in Brunswick’s estimation, the half-year convention applied and would allow a claim of six months of depreciation (from July 1, 1986 through Dec. 31, 1986) for the property.
The Internal Revenue Service saw it differently. The IRS argued that the Newcos’ taxable year was the relevant taxable year, and they were all short taxable years. Therefore, Brunswick was entitled to only one-twelfth of the annual depreciation deduction otherwise allowable under the half-year convention. To be sure, the government reasoned that the Newcos placed in service the assets they were treated as having purchased, and the depreciation deduction with respect to those assets depended upon their short taxable years — and not on the length of Brunswick’s taxable year.
Subsequently, a U.S. district court in Illinois found in favor of the IRS in Brunswick Corp. v. United States, F.Supp 2d_ (USDC N.D. Ill. 2008).
Which Corporation Purchased the Assets?
In the court case, the parties agreed that the property was placed in service by the Newcos on the day after Brunswick acquired the stock of the old corporations. After the acquisitions, each Newco was part of a consolidated group, and did not file its own tax return.
As a result, Brunswick asserted that it — not the Newcos — acquired the assets of the old corporations and therefore was entitled to claim depreciation deductions. Further, Brunswick contended that the short taxable year provision, on which the government relied, was applicable only if the consolidated group had a short taxable year, which Brunswick claimed was not the case.
But court disagreed. In fact, the court noted that under the relevant tax code provisions the Newcos, not Brusnwick, directly acquired the assets of the old corporations. The only property acquired by Brunswick was the stock in each of the old corporations.
The court observed that when a corporation becomes a member of a consolidated group during the parent’s taxable year, that member’s income is included in the consolidated return for that year from the date it first became a member. In addition, the new member must adopt the annual accounting period of its parent. Moreover, the regulations4 provide that the consolidated taxable income for a consolidated return year shall be determined by taking into account the separate taxable income of each member of the group.
The court had already concluded that United Dominion Industries, Inc. v. United States (532 US 822 (2001)) does not stand for the proposition that depreciation is determined at the consolidated return level. Instead, it teaches that courts deciding whether to look at the consolidated return level or the subsidiary level should look to the applicable tax code provisions and the regulations for guidance. In the instant case, such an approach exposed the fallacy of Brunswick’s reasoning.
Indeed, the tax code — specifically Regulation Section 1.1502-11(a) and -12 — says that the separate taxable income of each member of a consolidated group must be computed (with exceptions not relevant here) on the subsidiary level. So, looking at the subsidiary level reveals that each Newco had a short taxable year. This means that under Section 168(f)(5), as it then existed, each Newco must prorate their depreciation deductions in computing their separate taxable incomes that are included in Brunswick’s consolidated tax return.
In summary, the court found that the depreciation rules applicable to each member control the amount of the depreciation deductions the parent may take, not the rules that are applicable to the parent.Moreover, for a consolidated group, the parent’s taxable year does not control the depreciation deductions it is entitled to for property owned and placed in service by its subsidiaries.
Accordingly, when each Newco is viewed at the subsidiary level, their short taxable years, and not Brunswick’s taxable year, constitute the relevant taxable periods. In turn, this reasoning “dooms” Brunswick’s contention that the court should use the half-year convention and Brunswick’s taxable year in assessing depreciation for each Newco.
In the Brunswick case, the manufacturer also asserted that because the target corporations were treated as having sold their assets, it follows that Brunswick’s purchase of their stock should be treated, in the interest of symmetry, as an asset purchase. If the transaction was viewed as an asset purchase, the use of the half-year convention would benefit Brunswick because under that rule, property acquired in the second half of the taxable year is treated as acquired at the mid-point of the year. As a result, that a full six months’ worth of depreciation, with respect to an investment made as late as the last day of the taxable year, may be garnered.
The court gave this argument short shrift. It concluded that Brunswick’s argument could not be seriously entertained because its view of the transaction is patently inconsistent with the “statutory scheme.” In fact, and in law, Brunswick acquired stock and not assets. The court noted that if Brunswick wished to acquire assets and get the additional depreciation deductions it now seeks, it could have purchased the assets instead of acquiring stock.
Since Brunswick did not purchase the assets, it had to be denied the tax benefits that flow from such an acquisition format. After all, the court noted, “…while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefits of some other route he might have chosen to follow but did not…” See National Alfalfa Dehydrating & Milling Co. v. Commissioner, 417 US 134 (1974).
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com
1 A qualified stock purchase is a transaction, or series of transactions within a 12-month acquisition period, in which the amount of stock referred to in Section 1504(a)(2) of one corporation is acquired by another corporation by means of “purchase”. See Section 338(d)(3). For this purpose, the amount of stock referred to in Section 1504(a)(2) encompasses at least 80 percent of the stock, by both voting power and value.
2The election, to be effective, must be made not later than the 15th day of the ninth month beginning after the month in which the acquisition date occurs. The acquisition date, in turn, is the first day on which there is, with respect to the stock of a corporation, a qualified stock purchase.
3 As of Dec. 31, 1986, the General Utilities doctrine was finally repealed. Accordingly, the “deemed asset sale” triggered by the execution of an election under Section 338 became a fully taxable transaction. Thus, what had been a single level of tax route to a cost basis in a target’s assets became, with the repeal of the General Utilities doctrine, a double level of tax route: The shareholders of the target recognize gain on the sale of their stock to the acquiring corporation and the target, itself, recognizes gain with respect to the deemed sale of its assets. This change in the law rendered Section 338 elections singularly unattractive and, in the current environment, these elections are rarely made. However, during the period between the enactment of the Tax Reform Act of 1986 (Oct. 22, 1986) and its Dec. 31, 1986 effective date, numerous acquisitions were made. In most cases, Section 338 elections were executed in connection with these acquisitions. This period between enactment and effectiveness marked the last period in which significant numbers of “regular” Section 338 elections were made.
4 Regulation. Section 1.1502-11(a).