Corporate Taxation Chapter Nine: Acquisitive Reorganizations

Transcription

1 resentation: Corporate Taxation Chapter Nine: Acquisitive Reorganizations rofessors Wells March 23, 2015

2 Chapter 9 Acquisitive Corporate Reorganizations p. 392 Concept of a corporate reorganization the exchange of an equity interest in the old corporation for shares in the new corporation. This is a realization event under 1001(a) but Section 368 turns off recognition for certain reorganizations. Why? Because a reorganization is a mere readjustment of a continuing interest in property, albeit in modified corporate form. Effects on tax-free corporate reorganizations: 1) Corporate parties to the transaction no gain or loss on transfers of corporate properties. 2) Exchanging shareholders no gain or loss. 3) Tax attributes are transferred to the acquirer. 2

3 Acquisitive Reorganizations p.394 One corporation acquires the stock or assets of another corporation in exchange for the stock of the acquiring corporation. Tax-Free Forms of Acquisitive Reorganizations: 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 an acquisition subsidiary of Acquirer). 3

4 Judicial Limitations Tax Common Law p.394 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

5 Concepts of Tax-Free Corporate Reorganizations p.395 1) Limit is imposed 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 operating business must be acquired. 3) A business purpose (i.e., non-tax objective) for the transaction must exist. 5

6 Tax Code rovisions Re Tax-Free Reorgs. p no gain or loss is to be recognized upon an exchange of shares by shareholders who are parties to a reorganization. Cf., no gain or loss to the acquired corporation. Also, 1032 for the stock issuance by acquirer. 356/ 357 treatment of boot received and liabilities assumed in the transaction. 358/ 362(b) substitute tax basis rules. 381 carryover of tax attributes. 6

7 How Assure Tax-Free Reorganization Treatment? p.396 Options: 1) IRS rivate Letter Ruling but, limited availability, unless a significant issue. -See Rev. roc See Rev. roc (fn., p.417) re guidelines for issuing corporate reorganization tax private letter rulings. Is this Rev. roc. substantive law? 2) Law firm/accounting firm tax opinion letter. 7

8 Statutory Merger or Consolidation p (a)(1)(A) For purposes of parts I and II and this part, the term reorganization means (A) a statutory merger or consolidation; 1) Merger: Shareholders of the target corporation receive shares of the acquiring corporation as a T1 result of a statutory merger of target into purchaser under Target local law (including foreign law) merger statute. Shareholders T Shareholders Stock Target Merger Acquirer Target Assets and Liabilities (by law) Merger Stock Target Assets and Liabilities (by law) Stock Merger Acquirer T2 Shareholders Target Assets and Liabilities (by law) 2) Consolidation: Mergers of two existing corporations into a third (often new) corporation. Target 8

9 Divisive Mergers (i.e., Not Acquisitive ) p.397 Rev. Rul For tax-free corporate reorganization treatment the merger must be acquisitive, rather than divisive (note: divisive transactions are 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 tax-free corporate reorganization. 9

10 Mergers Involving Disregarded Entities p.398 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. Why? 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., the owner of the LLC). 10

11 Continuity of roprietary Interest p.399 Southwest Natural Gas Co. v. Commissioner Merger of eoples Gas into Southwest Natural Gas. Southwest Natural Gas paid cash, bonds, and stock. T Shareholders eoples Gas Merger Cash ($230,700) Bonds ($340,350) Stock (FMV=$5,592.50) S.W. Nat. Gas Taxpayer says that a state law merger occurred and in fact a state law merger did occur, so why did the taxpayer lose in the Tax Court? Held: Fifth Circuit upheld the Tax Court decision stating that 1% of the consideration to selling shareholders represented a continuing interest in the resultant enterprise and this was not a sufficient continuity of interest to justify reorganization treatment. 11

12 Rev. Rul p % of Consideration as Stock X merged under state law into Y Corporation. Shareholders A & B received cash for their respective 25% interests; Shareholders C & D received stock for their respective 25% interests. A Cash ($50,000) B C D 25% 25% 25% 25% X Stock ($50,000) Merger Stock ($50,000) Y Held: COI requirement was satisfied. Alternative: COI requirement is satisfied if each shareholder received ½ cash and ½ stock (total 50% in the form of stock as the consideration for the acquisition). 12

13 What Stock % is Required? p.402 1) Nelson case (Sup. Ct. 1935) 38% nonvoting preferred stock was OK. 2) To obtain an IRS LR Rev. roc requires a 50% stock value issuance. 3) Reg T(e)(2)(v), Example 1 (40% OK). Larger firm practice seems to be that 40% continuity is the threshold that taxpayers should maintain in order to be on safe ground. erhaps older cases would allow reorganization treatment with less continuity, but this is risky. 13

14 Other Continuity of Interest Issues: p.403 1) Remote continuity Can assets be dropped down into subsidiaries by Acquirer and not violate COI test? If two controlled (80%) subsidiaries? 2) When to measure the COI test compliance (to avoid possibly violating the COI threshold)? -Day before the binding contract if a fixed number of shares is to be delivered. -Alternative if variable consideration, i.e., shares are increased if Acquirer s share value declines. 14

15 J.E. Seagram Corp. v. Commissioner (simplified) Reorg. Treatment p.404 Competing tender offers for Conoco between Seagram and Duont. Neither gets 50%. Duont acquires remaining Conoco shares for Duont stock (including the 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). re-deal trading not negating the tax-free status. Step One: Dupont and Seagram acquire Conoco stock for cash Dupont Cash 46% Stock ublic Conoco ublic Cash 32% Stock Conoco Seagram Step Two: Dupont acquires remaining 54% of Conoco stock (including Seagram s stock) for Dupont stock Dupont Dupont Tenderor Merger 22% Dupont Stock Seagram 32% 15

16 Continuity by Historic Target Shareholder Kass v. Commissioner p.407 Squeeze-out upstream merger. Track TRACK acquired 84% of ACRA with cash, Stock 10.23% were transferred to TRACK upon its formation, and 5.82% TRACK Kass transferred as part of squeeze-out 84% 16% merger. This enabled acquisition of the Merger ACRA entire business. Held: Not a merger even though Kass received exclusively shares of Acquirer because 16% shareholder continuity is not enough. The TRACK shares of ACRA acquired with cash were not old and cold. Distinction with Seagram: Seagram & Dupont were independent actors, so Seagram is old and cold as to Dupont. 16

17 Continuity of Interest (COI) Regulations p.407 Reg (e)(1)(i). Adopts the Seagram approach. Disposition of stock prior to a reorganization to unrelated persons will be disregarded and will not affect continuity of interest in the acquirer by the exchanging party unless disposed to a person related to the parties to the reorganization. Requirement: Exchange Target stock for urchaser stock and have at least 50 percent of the entire consideration received being equity. 17

18 ost-acquisition Continuity p.409 How long must the target shareholders hold their stock in the acquiring corporation after their acquisition? What is the impact of a pre-arranged stock sale commitment by majority shareholders? The COI regulations focus on exchanges between target shareholders and the purchaser corp. Sales of stock by the former target shareholders generally are disregarded (unless made to ). 18

19 Reorganization acquisition (50/50 stock & cash) followed by open market reacquisitions of the urchaser s stock (redemptions? 302(b)(2)). The purpose of the reacquisition was to prevent stock ownership dilution for the urchaser. Rev. Rul p.410 Open Market Repurchase Step One: T Merges into with shareholders getting 50% and 50% cash No understanding that the share ownership by the T shareholders would be transitory. Held: No impact on the COI status. The post-reorganization stock redemption is okay if not prearranged with T shareholders and was 19 done as open market transactions. T UBLIC Merger Step Two: redeems stock in an amount equal to amount issued in Step One

20 Continuity of Business Enterprise (COBE) Bentsen v. hinney p.411 Facts: Rio Development merges along with 2 other land development companies into a new life insurance company. The life insurance company disposes of the historic business assets and reinvest the proceeds into a life insurance business. Shareholders received 50% stock in insurance company and 50% cash. Type of business carried on by the survivor entity was the insurance business (acquirer). Rio Dev. Corp. Merger Life Ins. Co. Held: COBE requirement was satisfied need not engage in the same business only some business activity. 20

21 Rev. Rul p.415 Transferor Business Important COBE requirement per IRS: Look to the historic business assets of the transferor corporation (not the transferee corporation) to determine whether the continuity of business enterprise (COBE) test is satisfied in the acquisition transaction. T Merger Reg (d): Continuity of business enterprise requires that the issuing corporation either continue the target corporation's historic business or use a significant portion of target s historic business assets in a business. Reg (d)(4): COBE requirement is not violated if transfers acquired T assets or stock to (1) controlled subsidiaries or (2) a controlled partnership. 21

22 The B Reorganization Solely Stock-for-Stock Exchange p.416 Stock for stock exchange (completed at the Target shareholder level): Step 1: A stock exchange occurs between the Target shareholders and the urchaser Corporation (for or s Target arent Shares). Step 2: The acquired Target Corporation becomes a subsidiary of the urchaser as a result of the stock acquisition transaction. Stock-for-Stock Exchange stock or s arent Stock Target 22

23 B Reorganization Limitation on Eligibility p.417 Solely for voting stock requirement (No boot in a B reorganization) Solely Issues: 1. Creeping acquisitions: cash purchases within 12 months presumed to be part of plan. 2. Assumption of Target shareholder liabilities & guarantees okay 3. ayment of Target debts to shareholder as creditors are okay if those payments are made only in their creditor capacity. 4. Target shareholder employment agreements can present issues. 5. Acquiror s payment of reorganization expenses of Target is okay, but payment of expenses of Target shareholders is not. 6. Contingent Stock (subject to IRS guidelines). 7. Cash in lieu of fractional shares is okay. Dissenters: Target redeems dissenters with its own funds (not Acquiror s funds). Voting Stock Issues: referred voting stock is okay as long as not nonqualified preferred stock. Control requirement: 80% control by vote and value after the exchange and must be met by Acquiring directly (no attribution rules). No need to acquire control only need control after exchange. No substantially all requirement allows T to dispose of unwanted assets. 23

24 Chapman Case (note 4) p.416 ITT/Hartford No Boot in a B Solely for Voting Stock Means Solely. ITT as the urchaser of Hartford acquires 8% for cash and then an 80% exchange of stock for stock occurs. Held: Cannot exclude the prior acquisition for cash if linkage exists. The 8% is not essentially irrelevant. The entire payment must not contain any non-stock consideration. On remand, the court was to consider whether the two transactions were linked. 24

25 The C Reorganization The ractical Merger p.419 Acquisition of substantially all the properties of target corporation by the acquiring corporation, in exchange for all or part of its voting stock or the voting stock of its parent corporation. Target is thereafter liquidated. Target S/H Acquiring Shares plus any boot Liquidation Target Acquiring or Acquiring arent s Shares Exchange Acquiring Target Assets 25

26 The C Reorganization The ractical Merger p.419 Criteria for a valid C reorganization: 1) Voting stock of the acquirer or acquierer s parent is received. 2) A transfer of substantially all properties. Case law looks to operating assets while IRS ruling standard is met only if (i) 90% of fmv of net assets and (ii) 70% of gross assets and assets are acquired. IRS counts assets used in non-routine redemptions. 3) Liquidation of Target with the distribution to the shareholders of the Acquirer s stock received. 4) Assumption of some liabilities is permitted. 5) Boot Relaxation Rule: At least 80% of assets must be acquired with voting common stock. i. Assumption of liabilities are disregarded if other types of boot are not received. ii. Non-Compete and consulting agreements boot exception but a 20% limitation rule (including the liabilities assumed). 26

27 Liquidation of the Target Corporation p (a)(2)(G) requires the Target to distribute all its assets (including the shares of the purchaser corporation) in liquidation. ossible waiver of the liquidation requirement can be obtained from the Service. Then treated as if (1) the distribution to Target shareholders had actually occurred, and (2) the assets were thereafter contributed to the capital of a new corporation. 27

28 Creeping Acquisitions p.421 rior purchase of stock of the Target is this purchase transaction old and cold urchaser s prior holding of stock not invalidating the solely for voting stock requirement. See the prior Bausch & Lomb history. Under the boot relation rule the non-qualifying consideration cannot exceed 20% of the value of all of the Target s properties. Reg (d)(4)(i) & (ii). 28

29 Rev. Rul p.422 C Not a B Reorganization 1) Y Corporation acquired X Corporation shares from X Corporation shareholders. X S/Hs Stock-for-Stock Exchange followed by X liquidation. Y stock Y 2) Y Corporation then liquidated X Corporation into Y Corp. and Y then conducted the X business. X X stock Held: A step transaction not a B reorganization, but a C reorganization i.e., a stock for assets exchange. X Liquidate Why differentiate between the B and C? 29

30 Triangular Reorganizations p.423 A Reorg followed by drop down. 368(a)(2)(C) T Merger T arenthetical C 368(a)(1)(C) Stock Exchange A arenthetical B 368(a)(1)(B) Stock A A T T Forward Triangular Merger ( 368(a)(2)(D) T Stock Merger S Stock Reverse Triangular Merger ( 368(a)(2)(E) T Stock Merger S Stock 30

31 Type A Reorganization: 368(a)(2)(D) Forward Triangular Merger 1. Advantages over type A type: arent has flexibility regarding assumption of liabilities 2. Disadvantages: substantially all requirement limits ability to dispose of unwanted assets. 3. Qualifies as type A if a) Acquiring parent stock is used and Acquiring arent controls Acquiring b) Substantially all of Target assets are acquired by Acquiring c) Merger of Target into Acquiring arent would qualify as A type d) Stock of acquiring may not be used e) Must be merger; cannot be a consolidation f) Boot can be used limited only by the general continuity-of-interest test. Forward Triangular Merger ( 368(a)(2)(D) T Stock Merger A Stock 31

32 Type A Reorganization: 368(a)(2)(E) Reverse Triangular Merger Similar to Type B in result, despite Type A statutory classification. Requirements: 1. Use of first-tier Subsidiary 2. Use of Acquiring arent s voting stock 3. Acquiring arent must acquire stock representing 80% control of Target in the actual reorganization exchange. Thus, unlike a B reorganization, 80% control must be acquired as new exchange. Reverse Triangular Merger ( 368(a)(2)(E) T Stock Merger S Stock 4. Limited boot relaxation rule similar to a C reorganization requirement. 5. Substantially all assets must be acquired i. Acquiring Sub s assets are considered ii. ost acquisition drop down of Target stock or assets permitted iii. Treatment of Acquiring arent contributions to Acquiring Sub iv. T s distribution of assets to its shareholders counts against meeting the substantially all test. * On February 12, 2014, Comcast agreed to issue $45 billion worth of its own stock for all of the Time Warner stock in a reverse triangular merger, thus beating out Charter Communications competing offer (discussed later). Comcast divestitures are discussed with in Chapter

33 Multi-Step Transactions p.426 Objectives in multi-step transactions: 1) Achieve business plan including regulatory and financial accounting issues. 2) Tax result based on overall transaction basis. 3) Relevance of Section 338/cash asset purchase transaction treatment. Overall objective: (1) get assets & control position acquired; (2) then, restructure to rationalize operations. 33

34 Multi-Step Transactions Rev. Rul p.427 Situation 1: Two Step Acquisition. (1) makes a tender offer of stock for 51% of T s stock followed by (2) merger of s sub into T and remaining T shareholders receive 2/3 rd voting stock and 1/3 rd cash combination. Overall, 83%+ consideration is stock and cash accounts for < 17% Reverse Triangular Merger ( 368(a)(2)(E) T Stock Merger X Stock Situation 2: S initiates tender offer in step one using stock. Held: When segments are integrated at least 80% of the was acquired for stock & tax-free reorg. status is available (under 368(a)(2)(E)). 34

35 Multi-Step Transactions Rev. Rul p.429 1) forms X (MergerSub) to merge into T. T shareholders receive 10x cash and 90x voting stock. T Stock Merger 2) T then liquidates into (not a merger) and then conducts the T business. T X Stock Liquidate Analysis If separate transactions, then 368(a) (2)(E) would apply. But, these steps are integrated per step transaction doctrine principles. Holding 1. Not a C because substantially all T assets not acquired solely for voting stock (even considering boot relaxation rule). 2. Not an A because T did not merge into. 3. So, taxable gain to shareholder, but not a stock purchase without 35 a 338 election.

36 Use of Disregarded Entities AT&T / Direct TV Merger 5/18/2014 p.429 1) AT&T forms X (Disregarded Analysis Entity). DirectTV merges into X. T shareholders receive 30% cash What is this? and 70% AT& ($49 billion) Holding T Stock Merger 2) Question: Why was transaction not done as a follows? T Stock Merger X Stock X Stock 1. Straight A because T merged away and is viewed as merging into AT&T (as X is disregarded. 2. Note that if X had been a regarded C corporation then this would have been tested under 368(a)(2)(D) which requires substantially all assets to be retained whereas straight Section 368(a)(1)(A) reorganization does not. 36

37 roblem 1(a) p.437 Nonvoting referred Received FACTS: Each Target shareholders receive nonvoting preferred with value of $300,000 per share and $100,000 -Note. $300,00 Nonvoting fd $100,000 -Note RESULT: Good 368(a)(1)(A) reorganization. 1. Continuity of Interest Satisfied: 75% of the consideration is stock. T Merger 2. The fact that stock is nonvoting preferred is not a problem as long as the stock is not nonqualified preferred stock. 37

38 roblem 1(b) p.437 Sufficiency of 40% for COI FACTS: Same as (a) except four T shareholders (holding 40% of ) receive $400,000 of voting common stock while the other six T shareholders (representing 60%) receive $400,000 in cash. T $400,00 voting c.s. $400,000 cash Merger 1. Continuity of Interest Likely Satisfied. 40% continuity is not enough to meet IRS ruling guidelines (see Rev. roc ), but regulatory example indicates 40% continuity is okay (see Treas. Reg (e)(2)(v) Example The fact that some shareholders only receive cash while others only receive stock is not problematic per Rev. Rul

39 roblem 1(c) p.437 Decline in Value of stock Before Closing FACTS: Same as (b) except the value of stock declines between time of execution of agreement and closing with the result that the four T shareholders holding 40% of T stock receive only $250,000 of voting common stock. T $250,00 voting c.s. $400,000 cash Merger Result: No change. The Continuity of Interest requirement is tested on the last business day before the first date such contract is a binding contract, if such contract provides for fixed consideration. See Treas. Reg (e)(2)(i). 39

40 roblem 1(d) p.437 Continuity of T Shareholders ost-merger T merges directly into, and each T shareholder receives $400,000 of voting common stock. ursuant to a binding commitment entered into prior to the merger, six of the former T shareholders (who held 60% of the ) sell their new 60% voting c.s. Unrelated for cash to a third party three weeks after the merger. T $400,00 voting c.s. Merger RESULT: Treas. Reg (e)(1)(i) and -1(e)(6) Example 1(i) now provide that the subsequent disposition of stock by former T shareholders to unrelated parties is generally not considered in determining whether the COI test is met, even if the dispositions were pursuant to a preexisting binding contract. 40

41 roblem 1(e) p.437 Continuity of Business Enterprise Same as (a), above, except shortly after the merger and as part of its original plan, sells T s assets to an unrelated party at a nice profit and uses the sales proceeds to expand its professional textbook business. T $300,00 Nonvoting fd $100,000 -Note Merger T assets X ANALYSIS: The issue is whether, a professional textbook business, is continuing T's historic business, which was the sale of law student study aids. The fact that is in the same general line of business (selling books) as T tends to establish the requisite continuity, but this fact is not alone sufficient. Reg (d)(2)(i). The COBE requirement may well not be satisfied here unless can claim that is in the same line of business. 41

42 roblem 1(f) p.437 rohibition of Any Boot in a B Reorganization In exchange for their respective 400 shares of T stock, transfers to each T shareholder $360,000 of voting preferred stock and $40,000 cash. Stock-for-Stock Exchange Target $360,000 stock + $40,000 Target RESULT: Even though the predominant consideration is voting preferred stock (not nonqualified preferred) and acquired 100% control of T, the transaction is not a valid Type B reorganization because did not use "solely" voting stock. There can be "no boot in a B." As a result, all the T shareholders must fully recognize their realized gain. 42

43 roblem 1(g) p.437 Creeping B Reorganization purchases 400 shares of from Dee Minimis for $400,000 cash. Three months later, T S/H transfers $400,000 of voting preferred stock to each of the nine remaining T shareholders in exchange for their respective 400 shares of. RESULT: Failed because Dee purchase is not old and cold. See Treas. Reg (c). Cash urchase of 400 T Stock Target Dee $400,000 cash 400 Stock-for-Stock Exchange $400,000 stock T S/H 400 Target Target 43

44 roblem 1(h) p.437 Boot Relaxation Rule acquires all the T assets and assumes the $1 million liability in exchange for $3.6 million of voting common stock and $400,000 in - Notes. Immediately thereafter, T completely liquidates, distributing the shares and -Notes to T shareholders. drops down the T assets to S. Target Shares ($3.6 million) -Note ($400k) Exchange Target Assets ($5 million) T Liability ($1 million) RESULT: The -Notes is problematic here. Under the 368(a)(2)(B) boot relaxation rule, may use up to 20% boot in making the acquisition, but any transferred liabilities are treated as cash consideration for this purpose. Accordingly, is treated as acquiring 72% of T's assets for voting stock and 28% for cash and notes, causing the transaction to fail as a C reorganization. Shares ($3.6 million) -Note ($400k) Liquidation S 44 T Assets

45 roblem 1(i) p.437 Substantially All Requirement Same as (h), above, except that T retains $400,000 of its cash, acquires the balance of T s assets, and assumes the liability, for $3.6 million of voting common stock, and T distributes the shares and cash pro rata to its shareholders in complete liquidation. Shares ($3.6 million T Cash ($400k) Liquidation Target Shares ($3.6 million) Exchange Target Assets ($4.6 million) T Liability ($1 million) RESULT: This should qualify as a Type C reorganization. transfers solely voting stock and its assumption of T's liability is not treated as disqualifying boot. 368(a)(1)(C). The 368(a)(2)(G) distribution requirement is met when T completely liquidates. The principal issue is whether T has transferred "substantially all of its properties" to. T has transferred 92% of its gross assets ($4.6 million out of $5 million) and 90% of its net assets ($3.6 million out 45 of $4 million) and all T's operating assets were transferred. S T Assets

46 roblem 1(j) p.437 Multi-Step Acquisitions: A(2)(E) or A Reorg? acquires all the in a reverse triangular merger in which Y 1, a transitory subsidiary of, merges into T. In the merger, four T shareholders (holding 40% of the T stock) each receive $400,000 cash and the other six T shareholders each receive $400,000 of nonvoting preferred stock. T then merges upstream into. RESULT: Viewed in isolation, T is acquired for too much cash for an (A)(2)(E). But, in Rev. Rul , which is discussed in Rev. Rul , the Service held that the step transaction doctrine would apply to similar facts and treated the transaction as a single statutory merger of T into and thus qualified as a Type A reorganization. Stock & Cash T Step One 60% Nonvoting Stock 40% cash Step Two T Merger Y-1 Merger Cash & Stock 46

47 roblem 1(k) p.437 Step Transaction? Same as (j), above, except the second step in the transaction is a merger of T into Y 2, a subsidiary of. RESULT: Applying the rationale of Rev. Rul to view the two transactions steps as an integrated whole, the end result is that T merges into s subsidiary (Y-2). Viewed as such, this transaction should qualify as a 368(a)(2)(D) forward triangular merger. Step One Stock & Cash T 60% Nonvoting Stock 40% cash Step Two Merger Y-1 Cash & Stock T Merger Y-2 47

48 Consider: Wisconson Energy (WEC) / Integrys Energy Group (TEG) WEC wants to acquire TEG. WEC forms MS#1 to merge into TEG with T ublic shareholders receiving 76% stock and 24% cash. As part of a binding commitment, T is merged into MS#1. Step One: MS#1 merges into TEG with T s shareholders receiving 24% cash and 76% as WES stock. T ublic TEG 26% Cash + 76% Stock Merger MS#1 WES Step Two: TEG merges into S as part of binding commitment. WES S TEG Merger S Merger End Result: acquires T with 14% stock WES S TEG Business Question #1: What is the tax treatment if the two steps are treated as independent steps? Question #2: What is the tax treatment if the two steps are integrated? 48 Question #3: What is the right characterization?

49 roblem 1(l) p.438 Multiple Acquisitions Same as (j), above, except the second step is the complete liquidation of T into in a transaction that is not a statutory merger under state law. RESULT: Under Rev. Rul , the IRS would treat this integrated transaction as a failed Type C reorganization (the flaw being that none of the consideration consisted of voting stock). The integrated transaction also could not be treated as a Type A reorganization because T did not merge into T. Step One 60% Nonvoting Stock 40% cash Stock & Cash T Step Two T Merger Y-1 Cash & Stock Liquidate 49

50 roblem 1(m) p.438 Multiple Acquisitions Same as (j) above, except T is a wholly owned subsidiary of S, Inc. Y 1 merges into T and, in the merger, S, Inc. receives $500,000 cash and $500,000 of nonvoting stock. and S jointly make an election under 338(h)(10). RESULT: Treas. Reg (h)(1)-1(c)(2) provides that the step transaction doctrine will not apply to a multi-step acquisition if the first step is a qualified stock purchase and the parties make a 338(h)(10) election. Old T recognizes gain/loss on the deemed asset sale. New T takes a cost basis in the T assets. S does not recognize gain or loss on the sale. The merger of T into is tax- free liquidation under 332 and 337. See Reg (h)(10)-1(e) Examples 11 and 12. Step One S T 50% Nonvoting Stock 50% cash Step Two Merger Y-1 T Merger 50

51 roblem 2 p.438 Creeping Acquisition purchased 10% of T s stock five years ago for cash and purchased an additional 50% of T s stock one year ago for cash. now wishes to acquire the remaining 40% of T s stock for voting stock or, if possible, nonvoting preferred stock. Target 1. 5 Years Ago: 10% cash 2. 1 Year Ago: 50% cash 3. Now: 40% for voting or nonvoting stock Target RESULT: 1. If T merges into, then it should be a good A reorganization even if prior year 50% stock acquisition is not old and cold. 2. If T is liquidated into, then fails as a C reorganization if the prior year 50% stock acquisition is not old and cold. 3. If T is not liquidated, then fails as a B if prior year acquisition is not old and cold 51

52 Acquisitive Reorganization Treatment of the arties Consider the income tax treatment resulting from a tax-free corporate reorganization for the following parties to that reorganization: 1) The shareholders of the Target Corporation. 2) The Acquiring Corporation and any Acquisition Subsidiary. 3) The Target Corporation. 52

53 Acquisitive Reorganization Treatment of the arties Target Shareholders Shareholders exchange of stock-forstock or securities-for-securities is generally given nonrecognition treatment. 354(a). Gain recognized in an amount equal to the lesser of the boot received or built-in gain in the stock. 356(a). Gain is treated as a dividend to the extent provided in section 301 and then as capital gain. 356(a). Note discussion of Clark (p.440). Basis in new stock takes substitute basis, increased by any gain recognized and reduced by any boot received and liabilities assumed under Section 358(a)(1). 1223(1) gives tacked holding period. Target Transfer of target assets & liabilities is tax-free to target. See 361(a) & 357(a). Boot received is non-taxable to Target if Target distributes the boot but taxable if not distributed. 361(b). If Target retains some historic Target assets and distributes them to Target shareholders, then Target recognizes built-in gain. 361(c). Acquirer No gain or loss on shares issued Target assets take carryover basis, increased by gain recognized by Target. 362(b). Exception: 362(e)(1) prevents built-in losses from being imported to Acquierer. 53

54 Commissioner v. Clark p. 440 (n.10) Code 356(a)(2) Code 368(a)(2)(D) reorganization. Received 300,000 shares and $3.25 mil. cash. Could have received 425,000 shares. T Shareholders Deemed to Only Receive Stock First Stock Result: Deemed to have received 425,000 shares and then post-merger to have exchanged 125,000 shares for cash. Applying 302 testing after the T shareholders are considered shareholders makes the hypothetical redemption to be more likely not essentially equivalent to a dividend. T Merger A T Shareholders Deemed to Only Receive Stock First Hypo Stock Cash Historic S/Hs 54

55 Characterization of Boot as Dividend or Capital Gain p.442 Boot within Gain Rule Boot dividend is limited to the gain amount. 356(a)(2) (dividend within gain) Tax rate of 20% on both dividend and long-term capital gain reduces tax significance; but: 1) The Clark approach reduces the opportunity for a dividends received deduction (DRD) for a corporate T shareholder. 2) Boot gain is received in form of installment notes not if dividend characterization applies. 55

56 Basis and Holding eriod for Target Shareholders p basis in the stock received is derived from the basis of the stock transferred. However, boot takes a fair market value basis. What about multiple tax lots for shares received? Tracing or prorata allocation? Allocation to each block of stock is required. Average basis method not available Cf., basis reporting by brokers (g) regulations (effective in 2011). 56

57 Target Corporation p.444 Consequences - Issues 361(a) no gain or loss is recognized by Target on the transfer of assets in the reorganization transaction. 357(a) assumption of the target s liabilities is not treated as boot. These rules apply to (1) A & C reorganizations, and (2) forward triangular mergers; but, not for B reorganizations, or reverse triangular mergers, since stock, no assets, is acquired in these transactions. 57

58 Shareholder Distribution Tax Effects to the Target p.445 No gain or loss is recognized to Target when it distributes qualified property. See 361(c). Qualified property requirement is under 361(c) stock of the other party in the reorganization. Distribution of other than qualified property e.g., boot gain recognition on the distribution is required. 361(c)(1) & (2) (but prior step-up when transferred by to Target)? 58

59 Acquiring Corporation p.447 Asset Reorganization Consequences 1032(a) issuance of Acquiring shares or Acquiring arent s shares is not a taxable event. Same result if issuance of debt securities by the acquirer occurs. But, transfer of boot causes any realized gain or loss to be recognized under general tax principles. Tax basis for assets received by Acquirer: 362(b) carryover from the transferor. 1223(2) provides a tacked holding period. This relevant in acquisition of target s assets: A or C & forward triangular merger. 59

60 Acquiring Corporation p.447 Stock Reorganization Consequences 362(b) provides that the basis of stock or securities received by the Acquiring Corporation will be the same as the basis was in the hands of the Target shareholders. ractical roblem: How does Acquiring Corporation find out what is the tax basis of the hundreds of thousands of publicly traded Target shareholders? In Rev. roc , the IRS set forth detailed rules for the allowance of statistical analysis. 60

61 Acquiring Corporation Triangular Reorganization p.448 Treas. Reg (c) provides that arent s stock basis is equal to T s net asset basis plus any preexisting basis that had in its S stock 61

62 roblem 1(a) p.449 A Reorganization T merges into in a qualified Type A reorganization. Each T shareholder receives 4,000 shares of voting common stock (FMV=$40,000) and nonvoting preferred stock (not nonqualified preferred stock ) (FMV=$10,000). What if the nonvoting preferred were nonqualified preferred stock? x voting 100x Nonvoting fd 62 basis in T assets and a tacked holding period. 362(b); 1223(2). T (B=20 FMV=50) Merger T Assets (B=300 FMV=500) Acc. E& (500) RESULT: Good A reorg. Acc. E& (100) 1. T's shareholders qualify for nonrecognition because they receive solely stock for. 354(a). Each T shareholder will take a substituted basis of $20x allocated according to relative FMV. 358(a)(1); 358(b)(1); Reg (a)(2)(i). The holding period of the old stock is tacked onto the new stock. 1223(1). 2. T and A Corporations. T has no gain and its E& carries over to. 361(a); 381(a). takes a $300,000 transferred

63 roblem 1(b) p.449 Securities in Exchange (b) Same as (a), above, but instead of the preferred stock each T shareholder receives 20 year market rate interest bearing B notes with a principal amount and fair market value of $10,000 ($100,000 total). 10 T 400x voting 100x Securities (B=20 FMV=50) Merger RESULT: Same except as follows-- T Assets (B=300 FMV=500) 1. Securities are boot causing T Acc. E& (100) shareholders to recognize gain under 356(a)(1). 2. Boot is capital gain under Clark/ 302(b)(1) analysis. 3. The hypothetical redemption of T shareholders should permit a reduction to s E& under 317(n)(7). Acc. E& (500) 63

64 roblem 1(c) p.449 Securities as Boot Same as (b), above, except that two of the shareholders receive all the notes (with a principal amount and fair market value of $100,000), and the remaining eight shareholders each receives voting common stock worth $50,000 ($400,000 total). 10 T 400x voting 100x Securities (B=20 FMV=50) Merger T Assets (B=300 FMV=500) Acc. E& (500) RESULT: Same except as follows-- Acc. E& (100) 1. T shareholders who only receive stock have nonrecognition under 354(a)(1), a $20,000 exchanged basis in their new stock under 358(a)(1) and a tacked holding period under 1223(1). 2. T shareholders who receive securities do not qualify for nonrecognition under 354. See 354(a)(2)(A). Their gain is a capital gain under 302(a). See Treas. Reg (d) Ex.(3). 3. T and have same consequences as in 1(b). 64

65 roblem 1(d) p.450 What E& is used to Test for Dividends? Same as (b), above, except that T had $50,000 of accumulated earnings and profits x voting 10x Securities (B=20 FMV=50) Result: The question is interesting if there were a T shareholder who would have the boot taxed as a T Merger T Assets (B=300 FMV=500) Acc. E& (100) Acc. E& (50) dividend. In Clark, the parties stipulated that the E & of the target would be the sole measure of any dividend and, in fact, the $3.5 million boot received by Mr. Clark exceeded the target's $2.3 million earnings and profits, limiting Mr. Clark's dividend (in the IRS's view) to $2.3 million without regard to the acquiring corporation's earnings and profits. But, the rationale of Clark suggests that the E& of both T and should be taken into account. 65

66 T has assets (FMV=600x and B= $300x) and a $100x liability. acquires all T s net assets in a in exchange for voting stock worth 500x and s assumption of T s 100x liability. T distributes the stock to T shareholders in liquidation. roblem 1(e) p.450 Basic C Reorganization Target Shares (500x) Exchange T Assets (FMV=600 B= 300) T Liability (100x) RESULT: 1. T Corporation recognizes no gain or loss on transfer of its assets. 361(a). Transfer of liabilities does not alter this result. 357(a). 2. T recognizes no gain when it distributes the voting stock to T shareholders. 361(c). 3. recognizes no gain on its stock under 1032 & takes a carryover basis and tacked holding period in T assets. 362(b); 1223(2). 4. T shareholders get nonrecognition per 354(a), take substitute 66 basis per 358(a)(1), and a tacked holding period per 1223(1). Shares (500x) Liquidation

67 Same as (e) except transfers 500x of voting stock and 100x cash to T. T uses the cash to pay off its liability and then distributes the stock to its shareholders in complete liquidation. roblem 1(f) p.450 C Reorganization Target Shares (500x) Cash (100) Exchange T Assets (FMV=600 B= 300) 67 basis per 358(a)(1), and a tacked holding period per 1223(1). Shares (500x) Liquidation T Cash (100) T Liability (100x) RESULT: 1. T Corporation recognizes no gain or loss on transfer of its assets. 361(a). Although T received 100x of boot, it does not recognize gain because the boot was distributed. 361(b)(3). 2. T recognizes no gain when it distributes the voting stock to T shareholders. 361(c). 3. recognizes no gain on its stock under 1032 & takes a carryover basis and tacked holding period in T assets. 362(b); 1223(2). 4. T shareholders get nonrecognition per 354(a), take substitute

68 roblem 1(g) p.450 C Reorganization Same as (e) except transfers 500x voting stock and securities (FMV=100x B=40x). T sells the securities for 100x using the proceeds to pay off its liability, and then liquidates and distributes Shares (500x) Liquidation Target Shares (500x) Securities (FMV=100 B=40) Exchange stock to T shareholders. Securities (100) T Assets T Liability (100x) (FMV=600 B= 300) RESULT: 1. T recognizes 100x of gain on securities as they were sold to pay creditors and not directly transferred to them. 361(b)(1)(B). 2. T recognizes no gain when it distributes the voting stock to T shareholders. 361(c). 3. recognizes no gain on its stock under 1032 but recognizes $60 of gain on transfer of appreciated securities (Rev. Rul ). takes T assets with basis of 400x. 4. T shareholders (no change). 68

69 roblem 1(h) p.450 C Reorganization Same as (e) except transfers 600x of voting stock and does not assume T s liability. T sells 100x of voting stock and uses the proceeds to pay off the liability. T then distributes the remaining 500x of stock to T shareholders in complete liquidation. Shares (500x) Liquidation Target stock(100) T Liability (100x) Shares (600x) Exchange T Assets (FMV=600 B= 300) RESULT: 1. T recognizes no gain on transfer of assets to. 361(a). 2. Read literally, T recognizes gain on sale of 1/6 th of stock (100 1/6 th of 300 basis per 358(a)(1) since T did not transfer stock to creditors but sold the stock. See 361(c)(1) and (3). 3. recognizes no gain on its stock under takes T assets with basis of 300x. 362(b); 381(a)(2). 4. T shareholders (no change). 69

70 roblem 1(i) p.450 C Reorganization Same as (h), above, except T transfers $100,000 of voting stock directly to its creditor in payment of the liability and then distributes the remaining stock to its shareholders in complete liquidation. Shares (500x) Liquidation Target stock(100) T Liability (100x) Shares (600x) Exchange T Assets (FMV=600 B= 300) RESULT: Same as (h) except that T now clearly does not recognize gain on transfer of 1/6 th of stock as this transfer of stock to creditors meets the exception of 361(c)(3). 70

71 roblem 2(a) p.450 Forward Triangular Merger 368(a)(2)(D) creates S and transfers stock. S-1 merges into T in a valid 368(a)(2) (D) forward triangular merger. What are the tax consequences to, S, T and T s shareholders? T Stock Merger T Assets (FMV=100 B= 100) RESULT: 1. recognizes no gain on creating S per 361 or 354(a)(1). s basis in S is equal to T s carryover asset basis. Reg (c)(1) 2. S recognizes no gain on issuance of its S stock ( 1032) and takes zero basis in stock ( 362(b)). S recognizes no gain on transfer of stock. Reg (b) & (d). S takes carryover basis in T s assets and tacked holding period. 362(b) & 1223(2). 3. T has no gain or loss in merger ( 361(a) and 361(c)) and T shareholders recognize no gain on receipt of stock ( 358(a)(1) and take substitute basis and tacked holding period ( 358(a)(1) and 1223(1)). 71 S

72 roblem 2(b) p.450 Forward Triangular Merger creates S and transfers stock. S-1 merges into T in a valid 368(a)(2)(E) reverse triangular merger. What are the tax consequences to, S, T and T s shareholders? Reverse Triangular Merger ( 368(a)(2)(E) RESULT: 1. recognizes no gain on creating S per 361 or 354(a)(1) and nonrecognition on deemed liquidation of S per 332. s basis in equals its basis in S (zero) plus net basis in T assets under Reg (c)(1). 2. S has nonrecognition on issuance of its S stock ( 1032) and takes zero basis in stock ( 362(b)). S has nonrecognition under 361(a) and (c) when it transfers stock for & liquidates. 3. T shareholders have nonrecognition under 354(a)(1) on their exchange and 50x substite basis and tacked holding period 72 ( 358(a)(1) and 1223(1)). T Stock Merger S Stock

73 roblem 2(c) p.450 Forward Triangular Merger Failed 368(a)(2)(D). RESULTS 1. : non-recognition on the formation of S (per 351) 2. S: no gain on issuing its own stock ( 1032). S receives stock with zero basis T Stock Merger T Assets (FMV=200 B= 100) per 362(a). S has STCG of 200x when it transfers stock for T stock. S takes cost basis in T assets. 3. T: recognizes 100x of gain on transfer of assets and takes 1012 cost basis of 200x in stock. 4. T s shareholders recognize 150x capital gain under 331 and they hold the stock with 200x FMV basis per 334. S 73

74 roblem 2(d) p.450 Reverse Triangular Merger Failed 368(a)(2)(E). RESULTS 1. : non-recognition on the formation of S (per 351). holds S stock with zero basis per 358(a)(1). has no gain on liquidation of S per S receives stock with zero basis per 362(a). S has STCG of 200x when it transfers stock for. S acquires with 200x cost basis per S has no gain on its liquidation per T: recognizes no gain when it transfers for stock per T s shareholders: recognize 150x capital gain under 1001 and acquire 200x cost basis per T Stock Merger S Stock 74

75 National Starch: The Dummy Structure Rev. Rul wants T. T Shareholder A (president of company) does not want gain. ublic T shareholders want cash. We know 14% COI is not enough for a reorganization. How do we give everyone what they want? Step One: and A contribute property to S as part of larger transaction A 14% T stock S fd Stock 100% C.S. S 86x Cash Step Two: S forms D to merge into T in a cash-only merger T ublic 86x Cash A S T Merger D 86x Cash 14% T stock End Result: acquires T with 14% stock Merger Held: A has nonrecognition of gain under 351. The fact that A s transfer is part of a larger transaction that would fail 368 continuity does not prevent A from being able to avail herself of 351. A S T 75

76 Horizontal Double Dummy T-1 wants to acquire T-2, but instead of acquiring T-2 directly, T-1 & T-2 both are the subject of reverse subsidiary mergers and both become subsidiaries of a New. The public shareholders of both companies are now shareholders of New. T-1 S/Hs T-2 S/Hs T-1 Stock Stock Merger S-1 New 50% stock 50% Cash S-2 Merger T-2 50% stock 50% Cash Held: (a)(2)(E), 351, and 368(a) (1)(B) all could apply as to T applies as to T-2. High rofile Deals Using Horizontal Double Dummy 1. Oracle Corp/Siebel Systems 2. Disney/ABC Capital Cities Time Warner/Turner Broadcasting

77 Horizontal Double Dummy (Charter Communications Failed Acquisition of Time Warner) TW S/Hs TW Merger CC Question: Charter Communications losing bid for Time Warner would not be a taxfree reorganization. Why not? Solution: Horizontal Double Dummy CC S/Hs CC New CC stock New CC stock Merger S-1 New CC 63% Cash 37% New CC Stock TW S/Hs S-2 Merger TW TW S/Hs New CC CC S/Hs 45% 55% Analysis: (a)(2)(E), 351, and 368(a)(1)(B) all could apply as to CC applies as to TW. 77