Corporate Reorganizations
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- Nigel Osborne
- 5 years ago
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1 IRS Finalizes Regulations on the Extent To Which Creditors of a Corporation Will Be Treated as Proprietors in Determining Whether Continuity of Interest Is Preserved in a Potential Reorganization SUMMARY On December 12, 2008, the Internal Revenue Service adopted final regulations providing that stock of the acquiring corporation received by creditors of the target corporation may count for purposes of preserving continuity of interest in a potential reorganization of an insolvent corporation under Section 368(a) of the Internal Revenue Code (the Code ), whether or not the target is in bankruptcy. The final regulations do not include the exchange of net value requirement 1 that was included in the proposed regulations 2 published in the Federal Register on March 10, The final regulations are generally effective for transactions occurring after December 12, BACKGROUND As a general matter, no gain or loss is recognized in a transaction that is a reorganization under Section 368(a) of the Code, except to the extent of any boot received. The continuity of interest doctrine under the Treasury Regulations Section (e) seeks to ensure that a substantial part of the value of the proprietary interests in the target corporation is preserved following a reorganization. The final regulations provide that proprietary interests in the target corporation include certain creditor s rights that are exchanged for stock of the acquiring corporation. Similar rules exist under Section 368(a)(1)(G) of the Code applicable to corporations in title 11 or similar cases. 4 The final regulations adopt the standard 5 for reorganization under Section 368(a)(1)(G) of the Code and expand the application of such rules to potential reorganizations of insolvent corporations outside of the bankruptcy proceedings. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney
2 IDENTIFICATION OF CREDITOR S CLAIM AS PROPRIETARY INTEREST A creditor s claim against a target corporation may be a proprietary interest in the target corporation if the target corporation is in a title 11 or similar case (as defined in Section 368(a)(3)). The final regulations expand this treatment to all situations where the target corporation is insolvent (i.e., the amount of the target corporation s liabilities exceeds the fair market value of its assets immediately prior to the potential reorganization). 6 In order to determine the percentage of the target corporation that is preserved as a proprietary interest in the acquirer, the final regulations start by determining which of the creditors claims constitute proprietary interests in the target corporation and then determine what portion of those proprietary interests has been preserved by being exchanged for equity of the acquirer. To determine whether a creditor s claim is a proprietary interest, the regulations distinguish between senior and junior claims: First, the final regulations require the identification of the most senior class of creditors that is to receive more than a de minimis amount of equity in the acquirer. Those claims and claims of all equal classes of creditors are together treated as the senior claims. 7 The final regulations provide that a senior claim is treated as being a proprietary interest in the target corporation to the extent of the product of the fair market value of the creditor s claim and a fraction, the numerator of which is the aggregate of the fair market value of the equity interests in the acquirer that are received in exchange for the senior claims, and the denominator of which is the sum of the amount of money and the fair market value of all consideration (including the equity interests in the acquirer) received in exchange for all such senior claims. 8 A junior claim is treated entirely as a proprietary interest in the target corporation, in an amount equal to the entire fair market value of the claim. The effect of these rules is to provide for 100% continuity if all senior claims receive the same proportion of acquirer stock and no junior claim receives cash or other boot. 9 One example in the final regulations 10 illustrates how the rules apply to reorganizations with more than one class of creditor receiving issuing corporation stock. T, the target corporation, has assets with a fair market value of $150x and liabilities of $200x. T has two classes of creditors: two senior creditors with claims of $25x each; and one junior creditor with a claim of $150x. T transfers all of its assets to P, the acquirer, in exchange for $95x in cash and shares of P stock with a fair market value of $55x. Each T senior creditor receives $20x in cash and P stock with a fair market value of $5x in exchange for its claim. The T junior creditor receives $55x in cash and P stock with a fair market value of $45x in exchange for its claim. The T shareholders receive no consideration in exchange for their T stock. In this example, the value of the proprietary interest of each of the senior creditors claims is $5x (the fair market value of the senior creditor s claim, $25x, multiplied by a fraction, the numerator of which is $10x, the fair market value of the P stock received by all the creditors in the senior class, and the denominator of which is $50x, the sum of the total consideration received by all the creditors in the senior class). The value of the junior -2-
3 creditor s proprietary interest in T immediately prior to the transaction is $100x, the value of his claim. Thus, the value of the creditors proprietary interests in T in total is $110x. For this $110x of proprietary interest, the creditors received, in the aggregate, $55x worth of P stock. Thus there is 50% continuity of proprietary interest ($55/$110), which is sufficient to satisfy the requirement that continuity of interest be preserved. A second example in the final regulations 11 illustrates how the rules apply to reorganizations with only one class of creditor receiving issuing corporation stock and cash in disproportionate amounts: T has assets with a fair market value of $80x and liabilities of $200x. T has one class of creditor with two creditors, A and B, each having a claim of $100x. T transfers all of its assets to P for $60x in cash and shares of P stock with a fair market value of $20x. A receives $40x in cash in exchange for its claim. B receives $20x in cash and P stock with a fair market value of $20x in exchange for its claim. The T shareholders receive no consideration in exchange for their T stock. The value of the proprietary interest of each of the senior creditors is $10x (the fair market value of a senior creditor s claim, $40x, multiplied by a fraction, the numerator of which is $20x, the fair market value of the P stock received by all the creditors in the senior class, and the denominator of which is $80x, the total consideration received by the creditors in the senior class). Thus, the value of the creditors proprietary interests in T in total is $20x and the creditors received $10x worth of P stock in total in exchange for their proprietary interests, thereby satisfying the continuity of interest requirement. Effective Dates The final regulations are generally effective for transactions occurring after December 12, * * * ENDNOTES The net value requirement generally requires that there be a surrender and receipt of positive net value in order for a transaction to qualify as a reorganization. Prop. Treas. Reg. Section (f). The IRS and Treasury Department continue to consider the issues raised and to evaluate the complexity and necessity for valuation under the exchange of net value requirement. See T.D In the legislative history to that statute, Congress stated its expectation that the courts and the Treasury Department would determine whether the continuity of interest requirement is satisfied in a potential reorganization under Section 368(a)(1)(G) by treating as proprietors the most senior class of creditors who received stock, together with all interests equal and junior to them, including shareholders. See S. Rep. No. 1035, 96 th Cong., 2d Sess (1980). Such standards as recommended in the Senate Finance Committee Report on Bankruptcy Tax Act of (endnotes continued...) Copyright Sullivan & Cromwell LLP
4 (... endnotes continued) Treas. Reg. Section (e)(6)(i). Treas. Reg. Section (e)(6). Treas. Reg. Section (e)(6)(ii)(B). Id. Treas. Reg. Section (e)(8) Example 10(i). Treas. Reg. Section (e)(8) Example 10(ii). -4-
5 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; rishj@sullcrom.com) or Alison Alifano ( ; alifanoa@sullcrom.com) in our New York office. CONTACTS New York Ronald E. Creamer, Jr creamerr@sullcrom.com David C. Spitzer spitzerd@sullcrom.com Vivian Y. Ouyang ouyangy@sullcrom.com London Andrew P. Solomon solomona@sullcrom.com NY12530:
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