The following comments are the individual views of the members of the Section of Taxation who prepared them and do not represent the position of the American Bar Association or the Section of Taxation.

These comments were prepared by individual members of the Committee on Corporate Tax of the Section of Taxation. Principal responsibility was exercised by Erik H. Corwin and Philip B. Wright. Substantive contributions were made by John Barrie, Julie A. Divola, and R. David Wheat. The Comments were reviewed by Jasper L. Cummings of the Section’s Committee on Government Submissions and by Terrill A. Hyde, Council Director for the Committee on Corporate Tax.

Although many of the members of the Section of Taxation who participated in preparing these comments have clients who would be affected by the federal tax principles addressed by these comments or have advised clients on the application of such principles, no such member (or the firm or organization to which such member belongs) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these comments.

Contact Person: Erik H. Corwin
(202) 663-6883
ecorwin@wilmer.com

Date: June 18, 1999

The Administration proposal would require an issuer of tracking stock to recognize gain in an amount equal to the fair market value of the tracked assets over their adjusted basis. Our principal comments are:

The proposal does not adequately recognize legitimate purposes for the issuance of tracking stock.

It is inappropriate to treat the issuance of tracking stock as a gain recognition event at the corporate parent level in all instances.

Abuses would be more appropriately addressed through specific regulations or other specific administrative guidance based on existing authority, rather than by enacting a complex new statutory regime.

Significant issues with respect to valuation of the tracked assets for gain recognition purposes need to be addressed.

The fundamental issue of basis in the assets with respect to which gain is recognized should be addressed rather than left for regulatory guidance.

The proposal does not address transition issues.

The Administration proposal provides that upon the issuance of tracking stock or a recapitalization of stock or securities into tracking stock, gain will be recognized at the corporate level in an amount equal to the fair market value of the tracked assets over their adjusted basis. General principles of tax law would continue to apply to determine whether tracking stock is stock of the issuer or not stock of the issuer. The Secretary of the Treasury would in addition have authority to treat tracking stock as nonstock (e.g., debt, a notional principal contract, etc.) or as stock of another entity as appropriate to prevent tax avoidance, and to provide for increased basis in the tracked assets as a result of gain recognized.

The Administration proposes to define tracking stock as stock that relates to, and tracks the economic performance of, less than all of the assets of the issuing corporation (including stock of a subsidiary), and either (1) dividends on the stock are directly or indirectly determined by reference to the value or performance of the tracked entity or assets, or (2) the stock has liquidation rights directly or indirectly determined by reference to the tracked entity or assets. The Administration proposal provides that the issuance of tracking stock will not result in another class of stock of the corporation becoming tracking stock if the dividend and liquidation rights of such other class are determined by reference to the corporation’s general assets, even though limited by the rights attributable to the tracking stock.

The Administration proposal describes current law as follows:

"Tracking Stock" is an economic interest that is intended to relate to, and track the economic performance of, one or more separate assets of the issuer, and gives its holder a right to share in the earnings or value of less than all of the corporate issuer’s earnings or assets (a vertical slice of the issuer). Subsidiary tracking stock is in form stock of a parent corporation that is intended to relate to and track the economic performance of a subsidiary of the parent. The Internal Revenue Service has not issued any guidance regarding whether tracking stock is treated as stock of the issuer. Such determination is dependent upon the correlation to the underlying tracked assets.

The General Explanation describes the reasons for change as follows:

The use of tracking stock is clearly outside the contemplation of subchapter C and other sections of the Internal Revenue Code. As a result, a principal consequence of treating such a stock interest as stock of the issuer is the potential avoidance of these provisions. The use of tracking stock permits the circumvention of General Utilities repeal by allowing a corporation to "sell" an economic interest in a subsidiary without recognizing any gain. By treating tracking stock as stock of the issuer/parent, there is no gain or loss on the issuance of the tracking stock, the subsidiary may remain a member of the parent’s consolidated group, a distribution of the shares is tax free to the shareholders and to the issuer, and the issuer can achieve separation from the tracked assets or subsidiary without satisfying the strict requirements for tax-free distributions.

The term tracking stock is used to refer to a class of stock of an issuing corporation that is designed to provide a return based on the performance of less than all of the issuer’s assets. Tracking stock differs from conventional common and preferred stock in that it represents a "vertical" rather than a "horizontal" division of a corporation’s assets. News reports indicate that publicly traded tracking stock with current market capitalization of approximately $50 billion has been issued. Robert McGough & Rebecca Buckman, Tracking Stock, Now the Rage, Has Drawbacks, Wall Street Journal, March 19, 1999, at C1. By comparison, the overall market capitalization of the NYSE and NASDAQ is estimated to be approximately $16.1 trillion. A Good Year to List and Be Listed, Investor Relations Business, 1999 WL 5954071 (Feb. 1, 1999).

Although the Administration proposal may reflect the view that tracking stock is primarily a tax avoidance device, tracking stock often is issued for valid non-tax business reasons. One use of tracking stock is to enable an issuer to achieve a degree of economic separation of diverse businesses without losing control of either business. This, in turn, can facilitate financing of business operations and maximize shareholder value by causing the market to recognize the distinct value of each business. A second common use of tracking stock is as a form of acquisition currency in cases in which the parties have differing views on valuation but the combined entities would permit operational efficiencies. In this context, tracking stock resembles other approaches used to effect an earn-out, and it facilitates acquisitions. Tracking stock may also be used to provide employees with equity-based incentive compensation that is tied more closely to the performance of the business units for which they work. See generally Dickson G. Brown & Karen S. Handler, Tracking Stock, in 8 Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 445, 450 (Practising Law Inst. ed. 1998) ("Tax Strategies"); Stuart M. Finkelstein & Joseph K. Todd, Tracking Tracking Stock, in 8 Tax Strategies 475, 481-84.

Different issues of tracking stock may have dramatically different features. In order to reflect the performance of the tracked assets, tracking stock may confer dividend rights based on the earnings attributable to those assets, liquidation rights reflecting the value of the tracked assets as compared to the value of other assets of the issuer, and/or rights with respect to the proceeds of a sale of the tracked assets. Because the mechanics for implementing these rights differ, there is significant variation in the extent to which tracking stock correlates with the value of the tracked assets. To take just one example, the rights of tracking stock holders to share in the assets of the issuer on liquidation are in some cases based on a fixed ratio that is established at the time the tracking stock is issued. In other cases, the sharing ratio that applies on liquidation fluctuates based on changes in the fair market value of the tracking and non-tracking stock. See Finkelstein & Todd, Tracking Tracking Stock, 8 Tax Strategies at 503 (comparing the liquidation rights of tracking stock issued by different corporations).

Perhaps more importantly, special rights conferred on holders of tracking stock are typically subject to limitations that tie the economic performance of the tracking stock to the performance of the issuer, rather than simply the performance of the tracked assets. Tracking stock dividends are subject to state law restrictions on dividends that may be paid by the issuer; holders of tracking stock do not have specific rights to the tracked assets in liquidation; and the tracked assets remain subject to the issuer’s liabilities. In addition, holders of tracking stock typically have the right to vote only as to the issuer, not as to the tracked entity or assets.

Current Law

There is uncertainty under current law as to when tracking stock is properly treated as stock of the issuer, principally because the Internal Revenue Service will not rule on this question. See Rev. Proc. 87-59, 1987-2 C.B. 764. The Service has, however, issued private letter rulings in which it has accepted representations that tracking stock qualifies as issuer stock. See, e.g., PLR 9826030 (Mar. 27, 1998); PLR 9802048 (July 11, 1997); PLR 9625038 (Mar. 25, 1996).

Treating tracking stock as stock of the issuer has a variety of well-documented tax advantages. These include (1) a pro rata distribution of tracking stock to the issuer’s shareholders is tax free to both the shareholders under section 305(a) and the issuer under section 311(a); (2) the issuer recognizes no gain or loss under section 1032 in a public offering of tracking stock; (3) tracking stock is qualifying consideration that may be received tax-free by target shareholders in a reorganization under section 368; (4) an exchange of previously-issued tracking stock for common stock of the issuer is tax free under section 368(a)(1)(E) or section 1036; and (5) the issuer may generally include a tracked subsidiary in its consolidated return. Finkelstein & Todd, Tracking Tracking Stock, 8 Tax Strategies at 486-87; Brown & Handler, Tracking Stock, 8 Tax Strategies at 453; see also New York State Bar Association Tax Section Corporations Committee and Reorganizations Committee Report Regarding "Tracking Stock" Arrangements, 43 Tax L. Rev. 51, 58 (1987) ("NYSBA Report").

The Administration’s proposal appears premised on the view that the use of tracking stock is "clearly outside the contemplation of subchapter C," and in particular that "tracking stock permits the circumvention of General Utilities repeal by allowing a corporation to ‘sell’ an economic interest in a subsidiary without recognizing any gain."

This rationale can be faulted in several important respects. Except in unusual cases, an issuance of tracking stock is not fairly characterized as the sale of an "interest in a subsidiary." To be sure, the value of tracking stock is determined by reference to the economic performance of the tracked subsidiary or assets -- indeed, that is the intent. But such stock ultimately remains an interest in the issuer. A holder of tracking stock, even one who owns 100 percent of such stock, has no rights against a tracked subsidiary or access to the underlying tracked business or assets. Instead, its rights are exclusively against the issuer.

The rights of a tracking stock holder are the familiar rights attendant to an equity interest in a corporation. Holders of tracking stock have the right to vote for members of the issuer’s board of directors and approve certain corporate actions by the issuer. They have the right to participate in dividends to the extent declared by the issuer’s board of directors, but subject to the requirement that the issuer have funds legally available for payment thereof. The fact that the amount of the dividends may fluctuate based on a benchmark not tied to the performance of the issuer as a whole should not be considered unprecedented or even unusual. Cf. Rev. Rul. 90-27, 1990-1 C.B. 50 (concluding that dutch-auction rate preferred stock represents stock of the issuer rather than debt). Tracking stock holders also have the right to share in the general assets of the issuer on liquidation, subject to the prior claims of the issuer’s creditors and without specific rights to any particular subset of the issuer’s assets. As such, they are exposed to the actual and contingent liabilities of the issuer.

It is important to recognize that an issuer of tracking stock remains subject to corporate level tax with respect to the tracked assets because it continues to own those assets (directly or indirectly) and has not disposed of them. Thus, it is an overstatement to say that the issuance of tracking stock results in "circumvention" of General Utilities repeal, at least to the extent that the term "circumvention" implies permanent avoidance of corporate level tax. Rather, the issuer will generally be taxable in full on the value of the tracked assets as they generate operating income over time or upon the ultimate sale or other disposition of those assets. In this respect, an issuer of tracking stock is in a position similar to that of a corporation that issues debt secured by stock of a subsidiary or by a subset of the corporation’s assets. Such debt issuances are not treated as gain recognition events or regarded as circumventing General Utilities repeal.

This is not to say that tracking stock cannot be used as a tax avoidance tool. It may be possible for an issuing corporation to so effectively and permanently isolate the economic performance and control of a separate subsidiary, division, or group of assets from the issuer’s remaining assets that the treatment of tracking stock as stock of the issuer may be outside the scope of the relevant subchapter C provisions regarding the issuance of issuer stock. Consider, for example, a case in which a corporation, P, is a pure holding company that has as its only assets stock in two separate subsidiaries, S1 and S2. P has no liabilities, employees, or business operations, and is restricted from having any liabilities, employees, or business operations. P issues a separate class of stock that is intended to track the value of the S1 subsidiary. Any dividends declared by S1 to P must in turn be distributed by P to the holders of the S1 tracking stock; the tracking stock holders are entitled to receive the proceeds of a sale of substantially all of the assets of S1 and have governance rights that would enable them to cause such a sale to occur; and the tracking stock holders would share in the proceeds of a liquidation of P based on the market value of the S1 tracking stock. Such an extreme case may warrant the conclusion that P has effectively distributed S1 to the tracking stock holders.

Nevertheless, we believe that such instances are rare, and that they may be adequately addressed under existing law, either by treating the tracking stock as other than stock of the issuer or by application of existing authorities relating to whether an asset has been sold or exchanged. To the extent that the Administration views existing law as unclear, its concerns regarding circumvention of General Utilities repeal would be more appropriately addressed pursuant to the Treasury’s regulatory authority under section 337(d). In this regard, the 1986 Conference Committee Report accompanying the repeal of the General Utilities doctrine provides:

The repeal of the General Utilities doctrine is designed to require the corporate level recognition of gain on a corporation’s sale or distribution of appreciated property, irrespective of whether it occurs in a liquidating or nonliquidating context. The conferees expect the Secretary to issue, or to amend, regulations to ensure that the purpose of the new provisions is not circumvented through the use of any other provision, including the consolidated return regulations or tax-free reorganization provisions of the Code (part III of subchapter C).

H. Rep. No. 99-841, 99th Cong., 2d Sess. II-204 (1986).

Finally, in those rare cases in which tracking stock is so closely tied to the performance of a subsidiary and so insulated from the issuer’s liabilities that it might fairly be treated as stock of the subsidiary, the Administration’s proposal would provide for treatment less favorable than would apply to a comparable issuance of subsidiary stock. As a result, economically equivalent transactions would have dramatically different tax consequences. Consider the following examples:

A parent corporation issues subsidiary tracking stock in an offering, the proceeds of which are contributed to and used to finance the business operations of the tracked subsidiary. Although the subsidiary could itself have issued stock directly without being subject to tax, I.R.C. § 1032, the Administration’s proposal would require full corporate gain recognition by the parent. See Testimony of Edward D. Kleinbard on behalf of the Securities Industry Association before the Committee on Finance, United States Senate 6 (Apr. 27, 1999) ("Kleinbard Testimony"). Even if the proceeds of the tracking stock offering were retained by the parent corporation, this result is economically equivalent to an issuance of common stock in the subsidiary followed by a dividend to the parent. Assuming that the parent retains at least 80 percent of the subsidiary’s stock, this transaction can also be effected free of federal income tax. See I.R.C. § 243(a)(3); Treas. Reg. § 1.1502-13(f)(2).

A parent corporation acquires a target in a forward subsidiary merger and issues subsidiary tracking stock as consideration. The Administration proposal would appear to require that the parent corporation recognize gain in such a transaction, despite the fact that the same transaction effected with subsidiary stock would qualify for tax-deferral under Code section 368(a)(1)(A).

A parent corporation makes a pro rata distribution to its shareholders of subsidiary tracking stock. The Administration proposal would treat this transaction as a gain recognition event, even if a distribution of stock in the subsidiary would otherwise satisfy the requirements of Code section 355.

These examples demonstrate that, if legislation were to be enacted, a more equitable approach would be to identify those circumstances in which tracking stock is properly treated as an equity interest in the tracked entity or assets, and to actually treat it as such, with the tax consequences that follow from that characterization.

The Administration proposal would define tracking stock as stock that relates to, and tracks the performance of, less than all of the assets of the issuing corporation, and either (1) the dividends are directly or indirectly determined by reference to the value or the performance of the tracked entity or assets, or (2) the stock has liquidation rights directly or indirectly determined by reference to the tracked entity or assets. To the extent that the proposal is intended to cover instruments that are economically equivalent to ownership of the tracked entity or assets -- and the fair market value gain recognition rule suggests that this is the case -- this definition is overbroad. Economic equivalence is achieved only when both dividend and liquidation rights are determined by reference to the tracked entity or assets. Nor does the proposed definition take into account at all the extent to which the tracked entity or assets are subject to the liabilities and the operational risk of the nontracked assets of the issuer.

In addition, because the definition proposed by the Administration is so broad, it may sweep within its ambit commonly-used instruments that should not be treated as triggering gain recognition. For example, one technique used in acquisitive tax-free reorganizations to effect post-closing price adjustments is to provide target shareholders with preferred stock that is convertible into common stock of the acquiror based on a conversion ratio that fluctuates with the post-acquisition performance of the target’s business. See generally 1 Martin D. Ginsburg & Jack S. Levin, Mergers, Acquisitions and Buyouts § 606.1.3, at 6-75 (Apr. 1999). Arguably, such stock could be viewed as "indirectly" conferring dividend and liquidation rights that are determined with reference to a tracked entity (i.e., the target), and hence as tracking stock that would require the acquiror to recognize gain with respect to the newly-acquired assets or subsidiary. The Administration’s proposal might also produce uncertainty in the case of a corporation issuing debt secured by some but not all of its assets. If such debt were recharacterized as equity, either as of the time of its issuance or subsequently pursuant to section 1.1001-3(e)(5)(i) of the Treasury Regulations, that equity could in turn be treated as tracking stock, thereby requiring gain recognition with respect to the assets used as security.

One possible analogy for developing a more satisfactory definition would be the section 1259 constructive sale rules. To the extent that these rules provide an appropriate framework for determining whether an issuance of tracking stock should constitute a gain recognition event at the corporate level, the definition could turn on whether the issuer has substantially eliminated its potential for gain and risk of loss with respect to the tracked assets or stock. See Staff of the Joint Committee on Taxation, 105th Cong., General Explanation of Tax Legislation Enacted in 1997, at 173 (Comm. Print 1997). Under this approach, the definitional focus would be on whether the issuer has disposed of the tracked assets or subsidiary economically, not whether tracking stock holders receive a return that is linked to the performance of the assets or subsidiary rather than all of the issuer’s assets.

The Administration’s proposal provides for corporate-level gain recognition upon the issuance of tracking stock in an amount equal to the excess of the fair market value of the tracked assets over their adjusted basis. This approach to measuring the extent of the gain to be recognized is harsh, and raises substantial and complex issues.

An issuer of tracking stock should not be treated as having disposed of the entire value of a tracked asset if the features of the tracking stock are such that it does not fully reflect the value of that asset and effectively divest the issuer of that asset. As discussed above, except in unusual cases, an issuance of tracking stock is not the economic equivalent of a sale of the tracked asset. Economic equivalence may be diluted for a number of reasons, including (1) the terms of the stock may reflect an intent on the part of the issuer to retain a portion of the value of the tracked asset and may more or less closely track of the performance of that asset, and (2) the holder of tracking stock remains exposed to the issuer’s liabilities. If and to the extent that economic equivalence is diluted, the issuer should not be subject to tax on the entire value of the tracked asset. Indeed, applying the full fair market value gain recognition rule in all cases would give the tracking stock proposal, if enacted, an in terrorem effect that would effectively discourage any future deliberate issuances of stock having any "tracking" features.

The Administration’s approach also presents significant valuation issues. If adopted, it would presumably require that fair market value be determined without regard to those features of the tracking stock that result in an imperfect correlation between the value of the tracking stock and the value of the tracked assets. As such, the trading price of the tracking stock generally could not be used to establish fair market value. Absent the ability to use trading price as a benchmark, however, valuing the tracked entity or assets becomes a complex task.

An additional valuation issue is presented in the case of an offering of subsidiary tracking stock in which the proceeds are to be contributed in whole or in part to the tracked subsidiary. Logically, if the offering proceeds are not included in basis for gain recognition purposes, they also should not be included in the determination of fair market value, even though they will be reflected in the trading price of the tracking stock.

The Administration proposal also raises questions concerning the treatment of loss assets in cases in which the tracked entity is a division. The proposal appears to reflect a section 311(b) rather than a section 336 approach in that it addresses only the recognition of gain, not recognition of loss. An alternative that would yield more equitable results in the case of tracking stock relating to a division would be to utilize the fiction of a deemed contribution to a hypothetical entity, with the tax consequences associated with a sale or distribution of an interest in the hypothetical entity. Such a proposal would effectively permit the netting of gain and loss assets since the issuer would have a single unified basis in the stock of the hypothetical entity. See generally NYSBA Report, 43 Tax L. Rev. at 73-76 (analyzing tracking stock as representing an interest in a hypothetical separate entity holding the tracked property).

D. Basis Issues

The Administration proposal leaves for future regulations whether to provide for increased basis in the tracked assets as a result of the gain recognized. The question of the basis consequences of gain recognition under the tracking stock proposal is, however, so critical that its resolution should not be deferred until some indefinite point in the future.

Absent clear guidance providing for a basis step-up or equivalent relief, the Administration’s proposal could have irrational results. For example, suppose an issuer were to issue tracking stock and recognize gain as required by the Administration’s proposal. Without a basis step-up, a subsequent offering of additional shares of the same class of tracking stock would require that the issuer recognize gain a second time. Similarly, if subsequent to the issuance of the tracking stock the issuer were to sell the tracked stock or asset, the issuer would be taxed again on the same gain.

This is not to suggest that determining an appropriate basis rule is necessarily a straightforward exercise. Simply providing for a basis step-up in all cases could leave open possible abuses. For example, a corporation with expiring net operating losses could, by issuing a class of tracking stock that loosely tracks the performance of some substantial subset of its total assets, effectively refresh its losses while retaining control of the assets and substantially all of the economic returns to be generated by those assets. Given that developing appropriate basis rules may involve significant complexities, it is reasonable to expect that guidance would not be available to taxpayers for a substantial period of time, with significant uncertainty as to the appropriate treatment in the interim.

The Administration proposal, while providing for gain recognition upon the issuance of tracking stock, provides further that "general principles of tax law would continue to apply to determine whether tracking stock is stock of the issuer or not stock of the issuer." Given the breadth of the definition of tracking stock embodied in the proposal, it is clear that a wide range of tracking stock instruments could be subject to the gain recognition rule while still qualifying as stock of the issuer under general principles. Numerous complexities and issues may result from the existence of instruments that trigger gain recognition to an issuer but which do not alter other tax consequences that may result from characterization of the stock as stock of the issuer. As a general matter, provisions treating one thing as something else in subchapter C should not continue to proliferate. See I.R.C. §§ 304, 306, 351(g), 355(d), 355(e).

The Administration proposal raises a number of difficult transitional issues. For example, the proposal does not address how and whether the new rules would apply to a corporation that already has outstanding a class of tracking stock. Transitional relief should be provided so that such a corporation would be able to issue additional stock of the same class without triggering gain recognition. See Kleinbard Testimony at 6. The proposal also does not answer the question whether a material modification with respect to an outstanding class of tracking stock would result in gain recognition.

The Administration’s tracking stock proposal is not supported by an adequate rationale, given that it is overly broad, leaves many questions unanswered, and promises significant complexity. It would create uncertainty as taxpayers await administrative guidance to resolve the open questions. In light of these uncertainties, and the harsh results that could be generated by the proposal (e.g., taxation based on fair market value of the tracked asset even when not all of such value is embodied in the tracking stock, the potential for double taxation of the same gain), the proposal would, if adopted, likely bring new tracking stock issuances to a halt, even though such issuances may be motivated by valid business purposes that do not offend or undermine the policies of subchapter C. A more reasonable approach would be for the Administration to use the authority available to it under current law, and to more narrowly target the abuses, if any, which may exist.