At your request, we have examined three alternative plans for restructuring Gapple s

MEMORANDUM TO: Senior Partner FROM: LL.M. Team Number DATE: November 18, 2011 SUBJECT: 2011 Law Student Tax Challenge Problem At your request, we have examined three alternative plans for restructuring Gapple s foreign operations in light of the U.S. Subchapter C tax consequences. Under Plan 1, Gapple transfers all of its GmbH stock to Luxco in exchange for $1 billion cash. Under Plan 2, Gapple sells its GmbH stock to Luxco for $1 billion cash, which then elects to treat GmbH as a disregarded entity. Under Plan 3, Gapple elects to treat GmbH as a disregarded entity, then sells its GmbH stock to Luxco for $1 billion cash. It appears that GmbH is worth more than $1.5 billion, Gapple s original investment in GmbH, because Gapple presently has unrecognized gain with respect to its GmbH stock. For the purposes of the analysis, it has been assumed that GmbH is worth $1.7 billion and that the value above $1 billion is represented by additional Luxco stock deemed to be issued to its sole shareholder, Gapple. You have also asked that we determine the year, if any, in which Gapple sold a patent to Sumsang with respect two contractual arrangements between the parties. In year 2, the parties renegotiated the original license agreement with the sole modification being a reduction in Sumsang s option price to purchase the patent from $2 million to $500. It is assumed that this renegotiation reflects a settlement of a dispute between Gapple and Sumsang. SUMMARY OF CONCLUSIONS Plan 1, which results in an I.R.C. 304 taxable dividend of $1 billion, is not recommended. Plan 2 results in acquisitive D reorganization treatment, with a taxable dividend of at least $200 million. Plan 2 is more favorable than Plan 1; however, it is unclear whether it is more favorable than Plan 3. 1

There are not enough facts to make a determination on Plan 3, which could be treated as a complete liquidation followed by an I.R.C. 351 contribution, an upstream C reorganization followed by an I.R.C. 368(a)(2)(C) contribution, or an acquisitive D reorganization. The economic effect of a complete liquidation followed by a sale will be identical to that of an upstream C reorganization and 368(a)(2)(C) contribution. The ultimate determination of whether Plan 3 is better than Plan 2 hinges on the extent of GmbH s all earnings and profits amount ( all E&P amount ) as well as the built-in-gain in GmbH s assets. If there is little or no all E&P amount in GmbH and there is no gain in individual GmbH assets, the result in Plan 3 would be the most favorable. However, if GmbH has a substantial all E&P amount and there is gain in GmbH assets, the all E&P amount would be taxed as a dividend and the gain in the assets would be taxed to the extent of the $1 billion boot. In that case, it is unlikely that Plan 3 will be more beneficial than Plan 2. Although conceivable, it is unlikely that Plan 1 would be more favorable than Plan 3. Subject to confirmation of certain factual assumptions, the patent should be considered sold in year 2 for $17,500,500, which will be treated as capital gain under the installment method assuming Gapple s I.R.C. 1231 gains exceed its 1231 losses. I. RESTRUCTURING GAPPLE s FOREIGN OPERATIONS PLAN 1. Gapple transfers all of its GmbH stock to Luxco in exchange for $1 billion. Under the related party redemption rules of I.R.C. 304, the $1 billion will be treated as a dividend sourced from the earnings and profits ( E&P ) of Luxco, a low-tax entity. Given the low tax source and the fact that Gapple will not receive a dividends received deduction ( DRD ), this is the worst option for Gapple. (See I.R.C. 245(b)(2)). 2

The $1 billion will be treated under I.R.C. 304(a)(1) as a distribution in redemption of Luxco stock since Gapple is in 100% control of GmbH and Luxco both before and after the exchange and, in return for property, Luxco acquires GmbH stock from Gapple. I.R.C. 304(c); Treas. Reg. 1.304-5(b)(iii). 304(a) will treat this distribution as a deemed I.R.C. 351 transaction in which Gapple transfers GmbH stock to Luxco in exchange for deemed Luxco stock, followed by a redemption by Luxco of its stock. I.R.C. 304(a),(b). The stock Luxco receives will be treated as a contribution of capital to Luxco, and the cash Gapple receives will be treated as a distribution of property under I.R.C. 302(d) and 301. Treas. Reg. 1.304-2. Under I.R.C. 302(a), sale or exchange treatment will not result because there is no reduction in Gapple s direct or indirect ownership of GmbH under the tests provided in I.R.C. 302(b). Under the deemed 351 transaction, Gapple will not recognize any gain or loss on the deemed contribution of the GmbH stock to Luxco. I.R.C. 351(a); 368(c). I.R.C. 367 should not deny nonrecognition for this deemed outbound transaction because its application is barred by Treas. Reg. 1.367(a)-9T(a)&(b). With respect to the deemed redemption, under I.R.C. 304 Luxco will be treated as having redeemed its own stock for cash. The $1 billion Gapple receives will be treated as a low tax sourced dividend from Luxco s E&P. I.R.C. 301; 316; 302(b)(5). Gapple would not receive a DRD for the $1 billion dividend, assuming Luxco s E&P is all foreign source. I.R.C. 245(b); 11(b). PLAN 2. Under Plan 2, Gapple sells its GmbH stock to Luxco in exchange for $1 billion. Immediately following the stock sale, GmbH elects to be disregarded. Treas. Reg 1.301.7701-3. This appears to be an I.R.C. 304(a)(1) redemption of stock followed by an 3

I.R.C. 332 liquidation of GmbH into Luxco. However, Rev. Rul. 2004-83; 2004-2 C. B. 157, and Treas. Reg. 1.368-2(l) would treat this transaction as an acquisitive type D reorganization. To qualify as an acquisitive D reorganization under I.R.C. 368(a)(1)(D), a corporation must transfer substantially all or part of its assets to another corporation (See I.R.C. 354(b)(1)(a)); the corporation transferring the assets (or its shareholders) must have at least 50% direct or indirect control (See I.R.C. 304(c); 368(a)(2)(h)) of the corporation to which the assets are transferred immediately after the transfer; and stock or securities of the transferee corporation must be distributed, pursuant to a plan, in a transaction that qualifies under I.R.C. 354, or 356. (Treas. Reg. 1.368-1(b) contains three additional non-statutory requirements business purpose, continuity of interest, and continuity of business enterprise - all of which appear to be met.) Rev. Rul. 2004-83 addressed the tax treatment of a parent when, pursuant to a plan, it sold a wholly owned subsidiary s stock for cash to another wholly owned subsidiary and the target subsidiary then completely liquidated into the acquiring subsidiary. The Treasury applied the step transaction doctrine to the transaction and held that 368(a)(1)(D) applied, assuming the other requirements thereof were met. The Treasury relied on Rev. Rul. 67-274; 1967-2 C.B. 141 and Rev. Rul. 70-240; 1970-1 C.B. 81, deeming the transfer an asset sale, protected from gain recognition by I.R.C. 361(a), and acknowledging that the actual issuance of stock would be a meaningless gesture. Treas. Reg. 1.368-2(l) reiterates the Treasury s positions in Rev. Rul. 2004-83, and states that a transaction will be treated as satisfying I.R.C. 368(a)(1)(D) notwithstanding that there is no actual issuance of stock, so long as the control requirements, defined under I.R.C. 4

304(c), are met. Gapple, owning 100% of Luxco before and after the distribution, meets the control requirement. I.R.C. 368(a)(2)(H). In addition to the deemed issuance of Luxco stock, $1 billion cash has also been transferred to Gapple. The cash will be treated as boot under I.R.C. 356(a). Rev. Rul. 70-240. Under I.R.C. 356(a)(1), the $1 billion cash boot received will be taxed only to the extent of realized gain on the overall transaction. Thus, Gapple will be treated as receiving $700 million in stock in addition to the $1 billion of cash. The entire realized gain ($1.7 billion total consideration less $1.5 billion stock basis), $200 million, will be recognized as it does not exceed the amount of boot received. Further, Treas. Reg. 1.367(b)-4(b)(1)(ii) exempts the application of I.R.C. 367 from foreign to foreign D reorganizations such as this one. The character of the gain will be determined under C.I.R. v. Clark, 489 U.S. 726 (1989), which used the principles of I.R.C. 302(b) to determine whether boot received was a dividend equivalent or capital gain. Here, given the common control, the Clark analysis will treat the boot gain as a dividend. The source of the dividend is uncertain given that 356(a)(2) refers to the corporation. However, it appears that the dividends will be sourced from GmbH, and then Luxco. Rev. Rul. 70-240. Given GmbH is a high tax entity, this will allow Gapple to carry out more foreign tax credits. However, Gapple will not be eligible for a DRD. PLAN 3. Under Plan 3, GmbH elects to be treated as a disregarded entity. Gapple then sells its GmbH stock to Luxco in exchange for $1 billion in cash. If the steps of this transaction are respected, it would be characterized as an I.R.C. 332 liquidation, followed by an I.R.C. 351 transfer of GmbH assets and liabilities by Gapple to Luxco in exchange for $1 billion cash and a deemed amount of additional Luxco stock. It could be recharacterized as an upstream C reorganization followed by a 368(a)(2)(C) contribution, which would have the same economic 5

result as if the steps were respected. Finally, Plan 3 could be characterized as a D reorganization, in which case it would have the same economic result as Plan 2. When GmbH, a C corporation for U.S. tax purposes, elects to be treated as a disregarded entity, it is deemed to distribute all of its assets to Gapple in pursuance of a plan of complete liquidation and the tax treatment of that election is determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine. Treas. Reg. 301.7701-3(g)(1),(2). I.R.C. 332 provides for non-recognition of gain or loss on the receipt of property received in a complete liquidation of a solvent subsidiary if there is a complete cancellation or redemption of stock and the control requirements of I.R.C. 1504(a)(2) (at least 80% of a controlled subsidiary) are met. Under our facts, the requirements of I.R.C. 332 are met. Gapple s basis in the GmbH assets deemed received would be determined asset by asset. For those GmbH assets with a built in loss, Gapple would receive a fair market value basis. I.R.C. 334(b)(1)(B), 362(e). However, gain assets would have a transferred basis. I.R.C. 334(b). This deemed transaction would be subject to I.R.C. 367(b), which denies nonrecognition treatment to inbound I.R.C. 332 liquidations. Treas. Reg. 1.367(b)-3(a). Gapple, a U.S. shareholder as defined by I.R.C. 951(b), will be taxed, on a dividend sourced from GmbH, based on the all E&P amount. Treas. Reg. 1.367(b)-3(b)(3). The all E&P amount cannot be determined without further information. Following the deemed I.R.C. 332 liquidation of GmbH, Gapple would be treated as transferring the assets of GmbH to Luxco for $1 billion cash, the assumption of GmbH s liabilities, if any, and a deemed issuance of 700 million of Luxco stock, under I.R.C. 351. Assuming the transferred assets are used in the trade or business, I.R.C. 367 would not apply to 6

prevent non-recognition. See I.R.C. 367(a)(3); Treas. Reg. 1.367(a)-2T(b). I.R.C. 367(d), however, would govern the transfer of the trademark, and Gapple would be deemed to receive annual payments contingent on productivity or use, over the useful life of the asset, regardless of whether such payments are made by Luxco. Treas. Reg. 1.367(d)-1T. Under I.R.C. 351(b), Gapple s realized gain would be recognized, but not in excess of the $1 billion cash boot received. Therefore, to the extent there is gain (but not loss) in the individual assets, such gain would be recognized. However, it would not be eligible for a DRD. The Service might contend that a complete liquidation did not occur because of the immediate reincorporation and as a result might recharacterize this transaction as an upstream C reorganization followed by an I.R.C. 368(a)(2)(C) contribution. See Rev. Rul. 69-617, 1969-2 C.B. 57, Treas. Reg. 1.368-2(d)(4), -2(k). If characterized as such, I.R.C. 367(a) would be implicated resulting in taxation of the all E&P amount. Treas. Reg. 1.367(b)-3(b)(3). The subsequent I.R.C. 368(a)(2)(C) contribution would be treated as a 351 transaction. Id. Thus, the economic result would be the same as if the steps were respected. Finally, the Service might ignore the up and down steps involving GmbH assets and liabilities and treat this as a direct transfer of GmbH assets into Luxco, resulting in characterization as a D reorganization of GmbH into Luxco. If that were the case, the outcome here would be no different than the outcome of Plan 2. Under Plan 3, there are not enough facts to make a determination. If there is little or no all E&P amount in GmbH and there is little or no gain in individual GmbH assets, Plan 3 would result in the least amount of tax. However, if GmbH has a substantial all E&P amount and there is gain in GmbH assets, the all E&P amount would be taxed as a dividend and the gain in the assets would be taxed to the extent of the $1 billion boot. Because of this uncertainty, 7

Plan 3 could be more beneficial than Plan 2, with a worst case scenario of D reorganization treatment. However, it could also result in a less beneficial outcome than Plan 2, with a best case scenario of D treatment. Therefore, the final determination hinges on the amount of the all E&P amount and built in gain assets. II. SALE OR LICENSE TREATMENT OF GAPPLE PATENT For the purposes of this analysis, it is assumed that: (i) the license is exclusive; (ii) it has not been filed or registered in any foreign country; (iii) the reduction in option price reflects a settlement of a dispute between the parties; and (iv) that Gapple held the patent for more than one year. Under these assumptions, the original contract should constitute a license, but the new contract likely converted this license into a sale. The determination of whether this is a license or a sale is important because sales are governed by I.R.C. 1001 and would allow Gapple to recover its basis and potentially receive capital gain treatment. See Rev. Rul. 69-482; 1969-2 C.B. 164. On the other hand, if the transfer is a license, the royalties received will be treated as ordinary income and the advance royalty of $2 million must be included in Gapple s gross income for year 1. Treas. Reg. 1.61-8(a)-(b). In Waterman v. McKenzie, 138 U.S. 252 (1891), the Supreme Court held a sale of a patent had to include the exclusive right to make, use, and vend the patented invention. Although I.R.C. 1235 governs the sale of patents by holders, corporations are not considered holders for purposes of this provision; therefore it does not apply. See I.R.C. 1235(a)-(b); Treas. Reg. 1.1235-1(b). However, courts have adopted the all substantial rights test under I.R.C. 1235 in determining whether a sale or license of a patent has occurred with respect to corporate transferors. See Merck & Co. v. Smith, 261 F.2d 162 (1958)(patent sold by a corporation). The test turns on whether the transferor has parted with all substantial rights 8

under the patent, and whether the retained right is substantial turns on the circumstances of each case. C.A. Norgren Co. v. US, 268 F.Supp. 819 (1967); Bell Intercontinental Corp. v. U.S., 180 Ct.Cl. 1071, 1090 (1967). The original contract constitutes a license of the patent because the parties intended to execute a license and all substantial rights under the patent were not transferred to Sumsang. Both parties agree that this was a licensing agreement and it was labeled as such. However, the form or label of the licensing agreement is not necessarily dispositive; rather, the substance of the transaction controls. Oak Manufacturing v. US, 301 F.2d 259, 261 (1962). The contract term, geographic limitation, and the transfer of the exclusive right to make, use, and sell the patented property are also essential in determining whether all substantial rights have been transferred. See Postlewaite, Cameron et al, Federal Income Taxation of Intellectual Properties and Intangible Assets 2.04 at 3 (1997). Generally, a transfer for less than the remaining life of the patent has been held to constitute a license. See Bell, 381 F.2d 1004. Gapple retains a reversion (1/2 year) in the patent if the option is not exercised; indicating Gapple has retained a substantial right. Transfers limited to a geographic area within the country of issuance of the patent also support license treatment of the transfer. See 1-6 Taxation of Intellectual Property 6.10 n.7 (Matthew Bender & Company 2011). Assuming the patent was issued in the U.S. and has not been filed in any foreign countries, there is no geographic limitation on the patent within the U.S. Lastly, the facts are ambiguous as to whether the license is exclusive. Assuming it is exclusive, Gapple transferred the right to make and use the patented property but not the right to sell. Accordingly, Gapple s reversion and failure to transfer the right to sell support treating this transfer as a license and not a sale. 9

The new contract most likely converted the license into a sale in year 2. Though the facts are ambiguous, it is assumed that the reduction in the option price reflects a settlement of the dispute between the parties where Gapple agreed to sell the patent to Sumsang for $500 (instead of the originally agreed $2 million) to settle the dispute. Generally, sale versus lease case law has supported the idea that if the reversionary interest of property is nominal or an option is more than nominal but substantially less than the fair market value, the transfer will be treated as a sale of the property because of the likelihood that the transferee will exercise the option. See Hilton v. Commissioner, 74 T.C. 305 (1980), aff d, 671 F.2d 316 (9 th Cir. 1982). The reversionary interest is only 6 months and the $500 option in light of millions that Gapple receives in royalties prompts sale treatment. See Rev. Rul. 2003-28; 2003-1 C.B. 594. The reversion and omission of the right to sell seem insubstantial in light of the nominal option. Based on the assumptions made above, the $2 million and royalty payment ($7 million) in year 1 ($9 million total) should be ordinary income to Gapple but Gapple has no losses in year 1 to offset this income, forcing Gapple to recognize the entire $9 million in gross income in year 1. See I.R.C. 61. However, the agreement in year 2 will most likely be treated as an installment sale with contingent payments and Gapple can recover its basis ratably over the term of the agreement, 2.5 years. See I.R.C. 453(b)(1); Treas. Reg. 15a.453-1(c)(3). Gapple will recognize income of $7 million as royalty payments in the first 2 years and $3.5 million and the $500 option in the last year. Rev. 57-40; 1957-1 C.B. 266. These payments would be eligible for capital gain treatment if Gapple has held the patent for more than a year and its 1231 gains exceed its 1231 losses. See I.R.C. 1221(a)(2); 1231(a); 453(c). This may be beneficial if Gapple has losses in year 2 and any subsequent years under the new contract because they can be used to offset the income Gapple realizes. 10

LAW OFFICES OF LL.M. TEAM NUMBER Tax Town, ABA State, 10000 Client Tax Town, ABA State, 10000 Dear Client, Re: 2011 Law Student Tax Challenge Problem This letter is in response to your request for advice on the U.S tax consequences of restructuring Gapple s foreign operations. You have also asked that we determine whether and when Gapple sold a patent to Sumsang pursuant to certain contractual arrangements between the parties. For the purposes of our analysis, we have made certain assumptions, as noted herein. To the extent that any of our assumptions are incorrect, please notify us as soon as possible. Further, our analysis requires additional information in some areas. To the extent you have access to such information, please forward it to our offices at your earliest convenience. Restructuring Gapple s Foreign Operations We have examined three alternative plans for restructuring Gapple s foreign operations in light of U.S. Subchapter C tax consequences. Without further information, it is impossible for us to make a definitive recommendation at this time. However, Plan 1 would result in a taxable dividend of $1 billion, resulting in more tax than the result in Plan 2. It can be eliminated as an option. The determination of our recommendation hinges on the all earnings and profits amount ( all E&P amount ) of GmbH and the gain in GmbH assets. For purposes of this letter, it is sufficient to understand that the all E&P amount is a function of GmbH s earnings and profits ( E&P ). If there is little or no all E&P amount and there is little or no gain in individual GmbH assets, Plan 3 would result in the least amount of tax and would be favored. 11

However, if GmbH has a substantial all E&P amount and/or there is substantial gain in GmbH assets, Plan 3 would result in more tax than Plan 2. Thus, Plan 2 would, in that, event be favored. Under Plan 2, Gapple sells its GmbH stock to Luxco for $1 billion cash. Luxco then elects to treat GmbH as a disregarded entity. The Service will collapse the two steps, based on the overall economic effect of the transaction, and will treat Plan 2 as a direct transfer of GmbH assets into Luxco. Technically, the Service considers this to be an asset reorganization. Generally, asset reorganizations are not taxed. However, if cash changes hands in connection with an asset reorganization, that cash may be taxed to the recipient. For the purposes of our analysis, we have assumed that GmbH is worth at least $1.7 billion, representing a gain to Gapple in its GmbH stock of at least $200 million. Here, Gapple will be taxed on the entire amount of the gain because the gain is less than the amount of cash it received. The $200 million will be treated as a dividend from GmbH, assuming GmbH has sufficient E&P. If GmbH has insufficient E&P, it will be sourced first from GmbH, to the extent of its E&P, then from Luxco s E&P. Sourcing the dividend first from GmbH, a high tax entity, is significant in that it will result in more foreign tax credits available to Gapple as compared to the dividend being sourced from Luxco, a low tax entity. There will be no dividends received deduction because the income that resulted in the dividend was from foreign operations. Plan 2 is clearly a much better option than Plan 1, i.e. a $200 million dividend sourced to a high tax entity rather than $1 billion dividend sourced to a low tax entity. Under Plan 3, Gapple elects to treat GmbH as a disregarded entity, and then sells its GmbH stock to Luxco for $1 billion cash. Plan 3 could be characterized by Service in three different manners. First, the Service could ignore the steps and recharacterize the transaction, based on its overall economic effect, as a direct transfer of assets between GmbH and Luxco. 12

This recharacterization would result in Plan 3 receiving the same tax treatment as Plan 2. Second, the Service could respect the steps of the transaction as separate (with the caveat that the second step would be considered a contribution of assets, not a sale). Finally, the Service could recharacterize the transaction based on the timing between the liquidation and the immediate transfer of the assets to Luxco thereafter. The transaction would be treated as a stock for asset reorganization of GmbH into Gapple, followed by a contribution of assets by Gapple to Luxco. Generally, a stock for asset reorganization followed by a contribution of assets is not taxed. The same is true for the liquidation of a wholly owned subsidiary followed by a contribution of assets another wholly owned subsidiary. However, because this transaction involves transfers to and from foreign subsidiaries, different rules apply. Gapple will be taxed, as a dividend, on GmbH s all E&P amount. Gapple will also be a taxed, capped at $1 billion (the amount of cash that changed hands in the transaction), on any built-in-gain in the GmbH assets. Further, because one of the assets is a trademark, an additional tax will be imposed on the second step of both transactions. Thus, regardless of whether the Service respects the steps as separate transactions or recharacterizes the transaction as a stock for asset reorganization, the economic result will be identical. As stated above, our recommendation as to the best option hinges on the all E&P amount of GmbH and the built-in-gain in the GmbH assets. If there is little or no all E&P amount and there is no gain in the GmbH assets, Plan 3 would be recommended because it results in a lower tax liability to Gapple than in Plans 1 and 2. However, if there is a substantial all E&P amount and/or substantial gain in individual GmbH assets, Plan 3 would not be recommended because it would result in a higher tax liability to Gapple than in Plan 2. 13

Therefore, without more information, we must reserve judgment on a final recommendation on whether Plan 2 or Plan 3 would be the most beneficial for Gapple. Sale or License of Gapple s Patent We have also considered in which year, if any, Gapple sold the patent to Sumsang. Pending confirmation of certain assumptions stated below, the new contract will likely be treated as an installment sale in Year 2 allowing Gapple to receive potential capital gain treatment for royalties paid under the modified contract (including the option price paid) and to offset this gain with any of its losses incurred during the term of the new contract. The determination of sale versus license hinges on whether substantial rights were transferred from Gapple. We assumed that (i) the license is exclusive; (ii) it has not been filed or registered in any foreign country; (iii) the reduction in option price reflects a settlement of a dispute between the parties, and (iv) Gapple has held the patent for more than one year. Accordingly, Gapple seems to have agreed to sell the patent in year 2 to Sumsang (at a negligible option price) to settle the dispute. The proceeds from the sale will generally be treated as capital gain, subject to certain limitations. Since a sale does not occur until year 2, the $9 million received in year 1 ($7 million royalty; $2 million advance) will be considered payments made under the licensing agreement and will be treated as ordinary income and included in Gapple s year 1 gross income. The royalty payments received under the modified contract will be considered sale proceeds and will be treated as capital gain to Gapple in the year in which they are received; supplemented by the $500 option in the last year. Please feel free to contact us should you have any additional questions or concerns. Sincerely, LL.M. TEAM NUMBER 14