Notice 2001-45 attacks basis-increase transactions as tax shelters.

• Author: Sair, Edward A.
• Position: IRS notice

On July 26, 2001, Treasury and the IRS issued Notice 2001-45 to shut down what they perceived as a tax shelter designed to create an artificially high tax basis in stock, which is then sold at a loss or at less gain. The notice warned that the Service intends to challenge the asserted tax benefits. In addition, it informed corporate taxpayers of their obligation to disclose their participation in such transactions, and informed promoters of their obligation to register the transactions and keep a list of customers that engage in them.

Transactions Affected

Notice 2001-45 describes the following transaction: A U.S. taxpayer owns stock options to purchase 50% or more of the stock in a foreign corporation (first corporation). The U.S. taxpayer and the first corporation are considered related parties for tax purposes because of the stock attribution from the options. The U.S. taxpayer and the first corporation each own stock in a second corporation. The second corporation then redeems its stock held by the first corporation, and the first corporation treats the redemption as a dividend, because it is related to the U.S. taxpayer. The U.S. taxpayer claims that the first corporation's cost for the redeemed stock attaches to the U.S. taxpayer's stock in the second corporation, by relying on a regulation that provides for an increase in basis in a "similar" redemption. The U.S. taxpayer then sells its stock of the second corporation and claims a loss.

According to the notice, the purported basis increase relies on Example 2 of Regs. Sec. 1.302-2(c), which illustrates a proper adjustment when the entire amount received in redemption of the stock held by one spouse is treated as a dividend (because the redeemed spouse is treated as owning stock held by the other spouse). In that example, the basis of the nonredeemed-spouse's stock is properly increased by the basis of the redeemed-spouse's stock. According to Notice 2001-45, the example in the regulations is premised on the concept that an adjustment is appropriate when the redeemed spouse is required to include the full redemption proceeds as a dividend in gross income, subject to U.S. tax, and such spouse retains no stock to which the basis of the redeemed stock could attach. Therefore, the Service will disallow losses claimed (or increase gains) in the transactions described in the notice to the extent a taxpayer derives a tax benefit attributable to stock basis purportedly shifted from the...