Corporate Tax-Free Reorganizations 1

Corporate Tax Segment 7 Tax-Free Reorganizations 4/30/2007 1 Acquisitive Corporate Reorganizations Concept of a “corporate reorganization” - the exchange of an interest in the old corporation for shares in the new corporation; cf., §1001. Effects of tax-free corporate reorganizations: 1) Corporate parties to the transaction - no gain or loss on transfers of properties. 2) Exchanging shareholders - no gain or loss. 3) Tax attributes transferred to the acquirer. 4/30/2007 2 1 AcquisitiveReorganizations (cf., Divisive Reorgs) One corporation acquires the stock or assets of another corporation in exchange for stock of the acquiring corporation: 1) "A" reorganization - statutory merger 2) "B" reorganization - stock/stock exchange 3) "C" stock for assets exchange, and 4) certain triangular variants (e.g., using acquisition subsidiaries). 4/30/2007 3 Tax Code Provisions re Tax-free Reorgs §354 - no gain or loss is to be recognized upon an exchange of shares by shareholders who are parties to a reorganization. Cf. §351. §361 - no gain or loss to the acquired corporation. Also, §1032 for the stock issue. §§356/357 - treatment of boot received and liabilities assumed in the transaction. §358/362(b) - substitute tax basis rules. §4/30/2007 4 2 Judicial Limitations Tax Common Law 1) Business purpose doctrine. 2) Continuity of interest (COI) (or ownership) requirement. 3) Continuity of business enterprise (COBE) requirement. Note: a “step" or "integrated" transaction rule or an "old and cold" rule also often applies. 4/30/2007 5 Concepts of Tax-free Corporate Reorganizations 1) Limit on the character of the consideration received - a proprietary interest in the acquirer. Must be stock in the acquirer (cf., nonqualified preferred). 2) Substantially all the transferor's properties must be acquired, i.e., the "business" must be acquired. 3) A business purpose (i.e., non-tax objective) for the transaction must exist. 6 4/30/2007 3 Statutory Merger or Consolidation Code §368(a)(1)(A). 1) Merger: Shareholders of the target corporation receive shares of the acquiring corporation as a result of a “statutory merger”. 2) Consolidation: mergers of two existing corporations into a third (often new) corporation. 4/30/2007 7 Divisive Mergers Rev. Rul. 2000-5 – for tax-free corporate reorganization treatment the merger must be acquisitive, rather than divisive (i.e., subject to the §355 rules). Mere compliance with the local corporate law merger statute (i.e., calling the transaction a “merger”) does not constitute a merger transaction as a corporate tax-free reorganization. 4/30/2007 8 4 Mergers involving Disregarded Entities Example: Mergers between a corporation and a disregarded entity. A. Merger of a target corporation into a disregarded entity (e.g., LLC) is treated as a “merger” into another corporation. B. Merger of an LLC into a corporation does not qualify (since only divisional assets are transferred, presumably not all of the assets of the transferor corp.). 9 4/30/2007 Continuity of Proprietary Interest – Quantity Test Southwest Natural Gas Co. Merger of Peoples Gas into Southwest. Less than 1 percent of the consideration received was paid in common stock. The remaining portion was paid in bonds or cash. Held: No “continuity of interest” results. The stock received was not a substantial part of the value of the property transferred. 4/30/2007 10 5 Rev. Rul. 66-224 Four 25 percent shareholders - A & B received cash for their 25% interests; C & D received stock for their 25% interests. Held: COI requirement was satisfied. Alternative: COI requirement is satisfied if each shareholder received 1/2 cash and 1/2 stock (total 50% in the form of stock as the consideration for the acquisition). 4/30/2007 11 J.E. Seagram Corp. case Competing tender offers for Conoco between Seagram and DuPont. Neither gets 50%. DuPont then acquires the remaining Conoco shares for DuPont stock (including Seagram shares – purchased previously for cash). Seagram claims a loss - but IRS is successful in asserting that this was a reorganization (i.e., continuity of interest did exist). Pre-deal trading not negating tax-free status. 4/30/2007 12 6 Continuity by Historic Target Shareholders Kass v. Commissioner Squeeze-out upstream merger after a cash stock acquisition in a tender offer and a prior 80% plus purchase of Target’s stock. 5.82 percent of the outstanding stock was not tendered but then subjected to a squeeze-out. This enabled acquisition of entire business. Held: Not a merger - even though shareholder received exclusively shares. 13 4/30/2007 Continuity of Interest (COI) Regulations Reg. § 1.368-1(e)(1)(i). Disposition of stock prior to a reorganization to unrelated persons will be disregarded and will not affect continuity of interest into the acquirer by exchanging party. Requirement: exchange Target stock for Purchaser stock to have at least 50 percent of the entire consideration being equity. 4/30/2007 14 7 Post-Acquisition Continuity How long must the target shareholders hold their stock in the acquiring corporation? What is the impact of a pre-arranged stock sale commitment? COI regulations focus on exchanges between target shareholders and the purchaser corp. Sales of stock by former target shareholders generally are disregarded (unless made to P). 4/30/2007 15 Rev. Rul. 99-58 Open Market Repurchase Reorganization acquisition (50/50 stock & cash) followed by open market reacquisition of the Purchaser’s stock. Purpose of the reacquisition was to prevent stock ownership dilution. No understanding that the P share ownership by T shareholders would be transitory. No impact on COI status. 4/30/2007 16 8 Continuity of Business Enterprise Bentsen v. Phinney Corporation engaged in land development business transferred property to a life insurance company. Shareholders received stock of insurance co. Type of business carried on by the survivor entity was the insurance business (acquirer). Held: COBE requirement satisfied - need not engage in the same business – only some business activity. Correct result? 4/30/2007 17 Rev. Rul. 81-25 Transferor Business Important COBE requirement – per IRS Look to the business assets of the transferor corporation (not the transferee corporation) to determine whether the continuity of business enterprise (COBE) test is satisfied. Reg. § 1.368-1(d)(1980). Must look to transferor's historic business. 4/30/2007 18 9 Continuity of Business Enterprise Regulations COBE regulations - Reg. §1.368-1(d). COBE requires that the issuing corporation either continue the Target's historic business or use a significant portion of the Target's historic business assets. COBE requirement is not violated if P transfers acquired T assets or stock to (1) controlled subsidiaries or (2) a controlled 4/30/2007 19 partnership. Example 1(a) All Cash Merger "All cash" merger - valid under state law. Lacks continuity of interest (but satisfying the §368(a) (1)(A) mechanical rules). No continuing proprietary interest exists (see Southwest Natural Gas). Therefore, the transaction is taxable to: (i) Target (i.e., a cash asset sale), and (ii) its shareholders (a §331 taxable liquidation). 10 Example 1(b) Non-Voting Preferred Stock T shareholders receive P non-voting preferred stock in exchange for their T stock. The “continuity of interest” rule is satisfied. This stock is a “proprietary interest”; the nature of the equity interest is not considered in an “A” reorganization. But, cf., what result if “nonqualified preferred stock” is received? 4/30/2007 21 Example 1(c) Commitment to Sell Stock Shareholders holding 75% of Target have a binding commitment to sell one week after the merger transaction is completed. The only consideration received is stock and, therefore, a tax-free merger has occurred. But, what is the adverse impact (if any) of the post-acquisition stock disposition? None. See Reg. §1.368-1(e)(7), Example 1(i). 4/30/2007 22 11 Example 1(d) Target Assets Sold P sells T’s assets (after the merger and as part of the plan) to an unrelated party and uses proceeds to expand another P business. The COBE requirements are not satisfied. Reg. §1.368-1(d)(1). A significant line of T’s business must be continued after the merger, and T’s business not continued here. 4/30/2007 23 Example 1(e) Stock & Notes Received Nonvoting preferred stock ($200,000) and notes ($100,000) are received in the merger. 2/3rds of the consideration received by T shareholders is P stock. The continuity of interest rule is satisfied (see the 50% test under Rev. Proc. 77-37). Nonrecognition to the shareholders - except to the extent that they receive "boot” - again assuming no nonqualified preferred stock. 4/30/2007 24 12