THE NUTS AND BOLTS OF THE TAXATION OF MERGERS AND ACQUISITIONS. Presented by the American Bar Association and Section of Taxation

Transcription

1 THE NUTS AND BOLTS OF THE TAXATION OF MERGERS AND ACQUISITIONS Presented by the American Bar Association and Section of Taxation

2 American Bar Association Center for Professional Development 321 North Clark Street, Suite 1900 Chicago, IL CDs, DVDs, ONLINE COURSES, DOWNLOADS, and COURSE MATERIALS ABA self-study products are offered in a variety of formats. To take advantage of our full range of options, visit the ABA Web Store at The materials contained herein represent the opinions of the authors and editors and should not be construed to be the action of the American Bar Association or Section of Taxation unless adopted pursuant to the bylaws of the Association. Nothing contained in this book is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This book and any forms and agreements herein are intended for educational and informational purposes only American Bar Association. All rights reserved. This publication accompanies the audio program entitled The Nuts and Bolts of the Taxation of Mergers and Acquisitions broadcast on March 9, 2016 (Event code: CETX1603W1).

3 M&A for New Tax Lawyers ABA Webcast Slides Layla Asali Miller & Chevalier Devon Bodoh KPMG William Curran Davis Polk & Wardwell Ross Poulsen Jones Day

4 Agenda I. Taxable Acquisitions A.Stock v. Asset B.Section 338 C.Section 336(e) D.CTB Planning II. Tax Free Reorganizations A.Overview B.Statutory Requirements C.Non-Statutory Requirements D.Triangular Reorganizations E.Revenue Ruling F. Tax Free Spin Offs 2

5 I. Taxable Acquisitions 3

6 A. Stock v. Assets 4

7 A. Stock v. Assets Common Business Issues What will be the form of the consideration? Who will be responsible for T s liabilities? Who will control T and A after the acquisition? Are there any issues with transferring T s assets? Consider: Whether contracts are assignable, real property must be retitled, or creditor consents obtained; Whether licenses or regulatory approvals are needed; and Transfer taxes. Does T have unwanted assets or businesses? Does any post-acquisition planning need to be considered or accommodated? 5

8 A. Stock v. Assets (continued) Common Federal Income Tax Issues Will any corporate-level tax apply to T? Will any shareholder-level tax apply to SH? What is T s basis in its assets? What happens to T s tax attributes (e.g., net operating loss carryovers)? 6

9 A. Stock v. Assets (continued) Stock Acquisitions A acquires T stock from SH for cash. SH recognizes gain or loss on each share of stock sold. o The amount of gain or loss recognized on a share is the difference between the amount realized on the share and SH s basis in the share. A obtains a cost basis in each share of T stock it purchases. T survives the stock sale intact. o The tax bases of T s assets do not change. o T s tax attributes do not change, though the future use of the attributes to offset income or tax liability may be limited (e.g., 382) o T s tax history (e.g., T s ability to carry future losses back to preacquisition taxable years) does not change. 7

10 A. Stock v. Assets (continued) Asset Acquisitions A acquires T assets from T for cash. T recognizes gain or loss on the assets sold. o T s tax attributes are generally available to offset T s asset sale gain. o If T does not liquidate, T s tax attributes remain with T. o If T liquidates, T s tax attributes may carry over to >80% corporate SH. Taxation of SH on receipt of sales proceeds from T: o >80% corporate SH generally is not taxed. o Other SHs generally recognize dividend or capital gain income. A obtains a cost basis in T assets it purchases. A receives no T tax attributes. 8

11 A. Stock v. Assets (continued) Asset Acquisitions Compare Direct Asset Acquisition with Cash Merger Instead of purchasing T assets for cash, T can merge into A, with SH receiving cash in exchange for T stock. Both alternatives result in: o Stepped-up tax basis in T assets. o Two levels of tax. o Disappearance of any unused T tax attributes. Merger: o Requires approval of SH and A shareholders. o No re-titling of assets is necessary. o A has unlimited liability exposure. Direct Asset Acquisition: o Only SH must approve. o A can assume specific T liabilities. Note: Can also generally effect a stock acquisition by reverse cash merger. 9

12 A. Stock v. Assets (continued) Asset Acquisitions Section 1060 If an asset acquisition is an applicable asset acquisition, 1060 applies to determine seller s gain and buyer s basis. If goodwill or going concern value could attach to the assets, it is an applicable asset acquisition. T s gain or loss and A s cost basis are determined under 1060: Using the residual allocation method, and Under general tax principles, which Delinks the amount realized from the cost basis. 10

13 A. Stock v. Asset (continued) Asset Acquisitions Section 1060 Asset Classes Class I = Cash and general deposit accounts (up to amount). Class II = Marketable securities, CDs, governments, foreign currencies. Class III = Assets that taxpayer marks-to-market at least annually and certain debt instruments, including accounts receivable. Class IV = Inventory. Class V = All assets not in Class I, II, III, IV, VI, or VII. Class VI = All 197 intangibles (whether or not amortizable) (excluding goodwill and going concern value). Class VII = Goodwill and going concern value, whether or not amortizable. 11

14 A. Stock v. Assets (continued) Asset Acquisitions Section 1060 Residual Allocation Method The consideration is allocated, beginning with the first class and continuing down the line, up to the fair market value of the assets in that class (until no consideration remains). Consideration is allocated within a class in proportion to the fair market value of each asset in that class. Any consideration remaining after allocation to each class is allocated to goodwill. For a taxable asset acquisition, the parties generally must agree to the amount allocated to a class and are bound to that allocation unless the Service determines the allocation is not appropriate. 12

15 B. Section

16 B. Section 338 Stock Acquisition Treated as an Asset Acquisition If there are business reasons for structuring the deal as a stock acquisition, but the tax results of an asset acquisition would be more favorable, a 338 election might be desirable. Two types of elections are available: A 338(g) election might be available for a stand-alone T. A 338(h)(10) election might be available if T is a subsidiary or an S corporation. 338 elections may only be made for qualified stock purchases : Within 12 months, an eligible corporate purchaser Must acquire T stock that meets the requirements of 1504(a)(2) (80% of the vote and value) By purchase. 14

17 B. Section 338 (continued) Purchase A purchase can occur through the combination of a purchase by A and the redemption of T stock from an unrelated SH. A purchase can occur in an IPO. An acquisition from a related person does not qualify as a purchase. A person is related to A if that person s stock ownership would be attributed to A under 318. If the acquisition is one of a series of transactions, test the relationship after the completion of the series. Liquidating and non-liquidating distributions of T stock may be purchases. If a 338 election is made for T, the deemed sale of the stock of T s subsidiaries is a purchase. Generally, any acquisition of stock qualifies as a purchase, other than: A carryover basis transaction. 351, 354, 355, or 356, or other tax-free transactions (generally even if the transferor recognizes all of its gain because of boot). An acquisition from a related person. 15

18 B. Section 338 (continued) Section 338(g) Election A 338(g) election is a unilateral election by A. The gain or loss of Old T (the seller) and the cost basis of New T (the surviving company owned by A) in its assets are determined under the asset sale rules. General tax principles apply. The 338(g) election delinks the amount realized from the cost basis in the assets. The residual method of allocation applies amounts are allocated to each asset in a Class in proportion to their fair market value. However, parties are bound by allocation agreements unless the Service deems the allocation or fair market value is inappropriate. Old T s tax attributes that are not used by the end of the tax year ending with the QSP disappear they do not carry over to New T. SHs recognize gain or loss on the sale of T stock. Effect to A: purchase of stock. Effect to T: sale of assets, with cost basis in assets after sale, but loss of tax attributes. Effect to SH: sale of stock. 16

19 B. Section 338 (continued) Section 338(h)(10) Election A 338(h)(10) election is a joint election by A and SH. T must be an eligible target corporation (corporation where an actual asset sale would result in only one level of tax): Member of a selling consolidated group, Affiliated target (SH has direct 1504(a)(2) ownership), or A subchapter S corporation. The gain or loss of Old T (the seller) and the cost basis of New T (the surviving company owned by A) in its assets are determined under the asset sale rules. General tax principles apply. The 338(h)(10) election delinks the amount realized from the cost basis in the assets. The residual method of allocation applies amounts are allocated to each asset in a Class in proportion to their fair market value. However, parties are bound by allocation agreements unless the Service deems the allocation or fair market value is inappropriate. Old T s tax attributes that are not used by the end of the tax year ending with the QSP do not carry over to New T, but may carry over to a corporate SH. SHs recognize gain or loss on the sale of T assets. Effect to A: purchase of stock. Effect to T: treated as selling all of its assets and liabilities to New T, distributing the proceeds, and liquidating; New T has a cost basis in its assets after the sale, but no tax attributes. Effect to SH: consolidated group recognizes gain or loss on sale of assets, and may receive tax attributes. 17

20 B. Section 338 (continued) Section 338(h)(10) Election (continued) Effect of Election on Minority Shareholders T is a subchapter C corporation: o Election has no effect on minority shareholders who do not sell T stock. o Minority shareholders who sell T stock are treated as selling stock. T is a subchapter S Corporation: o All T shareholders are affected by the election because of the flowthrough rules. o All shareholders must consent to the election, even if they do not sell T stock. 18

21 C. Section 336(e) 19

22 C. Section 336(e) Overview Enacted in Not self-executing. Final regulations promulgated May 10, In effect, applies 338(h)(10) concepts: Treats certain sales and distributions of 80% of Target stock over a period of 12 months as a sale or distribution of Target assets. Does not require a corporate purchaser to acquire 80%: Can be diffuse acquisitions by, e.g., corporations, individuals, partnerships, public shareholders; Need not be part of a plan. Seller and Target must be domestic corporations (or Target must be an S corporation). Loss limitation rule for distributions. 20

23 C. Section 336(e) (continued) Terminology Comparison with Section (h)(10) 336(e) 1. Purchase 2. Qualified stock purchase (QSP) 3. Selling consolidated group (Selling affiliate) month acquisition period 5. Acquisition date 6. Purchaser corporation 7. Recently/nonrecently purchased stock 8. Aggregate deemed sales price (ADSP) 9. Adjusted grossed-up basis (AGUB) 1. Disposition 2. Qualified stock disposition (QSD) 3. Seller (includes distributing corporation) month disposition period 5. Disposition date 6. Purchaser (includes distributee) 7. Recently/nonrecently disposed stock 8. Aggregate deemed asset disposition price (ADADP) 9. Adjusted grossed-up basis (AGUB) 21

24 C. Section 336(e) (continued) Qualifying for the section 336(e) Election A QSD occurs if in: In a transaction or series of transactions within a 12 month period; A domestic corporation (including a consolidated group or an S Corp s shareholders) disposes of the stock meeting the requirements of 1504(a)(2) (80% of the vote and value); Of a domestic corporation (C or S). Disposition includes: A sale, exchange, distribution, or combination thereof. A Disposition does not include: Carryover basis transactions; Transactions in which the basis is determined under 1014; Transactions to which 351, 354, 355, or 356 applies (except for transactions within the meaning of section 355(d) and (e)); or A sale, exchange, or distribution to a related person. o Whether a person is related is determined under 318(a). o In the case of partnerships, 5% ownership is required for attribution. 22

25 C. Section 336(e) (continued) Basic Operational Rules Sale of Target Stock The Basic Model: Old Target sells assets to New Target Old Target liquidates into Seller. Seller doesn t recognize stock gain or loss; grossed-up cost basis for retained stock. Old Target recognizes gain or loss difference between ADADP and basis. o Allocated among the assets in the same manner as under 338. Seller inherits Target s remaining tax attributes. New Target gets AGUB (i.e., cost basis) in assets. Distribution of Target Stock in non- 355(d)/(e) transaction Basic Model with Loss Limitation Rule. Seller doesn t recognize stock gain or loss; grossed-up cost basis for retained stock. Target recognizes gain, loss to amount of gain based on ADADP. Seller inherits Target s remaining tax attributes. New Target gets AGUB in assets. Distribution of Stock in 355(d)/(e) Transaction Sale-to-Self Model. Same as a general distribution except that Target keeps its attributes. 23

26 C. Section 336(e) (continued) Making the Section 336(e) Election Making the 336(e) Election Seller and Target must agree to make the 336(e) election in a written, binding agreement entered into on or before the due date of seller or Target s tax return (whichever is earlier and including extensions) for the taxable year that includes the disposition date. Seller and Target must retain a copy of the agreement and attach a section 336(e) election statement to its tax return for the taxable year that includes the disposition date. The results of the deemed sale of Target s assets must be reported by Old Target and New Target on Form 8883 (generally used for 338 elections), making appropriate adjustments. When is the 336(e) election valuable? Sales of stock to a person or persons other than a 338 eligible corporate purchaser where it is not practical to set up sale to a Newco (e.g., series of stock sales that are not part of a plan). Certain stock distributions that do not qualify for 355. Protective elections for certain distributions that are intended to qualify under 355 (to be effective if 355 does not apply or if 355(d)/(e) does apply). Elections for certain intended 355(d)/(e) transactions. Transactions involving both sales and distributions of stock. 24

27 D. CTB Planning 25

28 D. CTB Planning Types of Business Entities What is a corporation? A business entity organized under U.S. (federal or state) law, if referred to as incorporated or as a corporation An insurance company A U.S. federal or state-chartered banking entity Certain foreign entities that are per se corporations under Treas. Reg An eligible entity that elects to be classified as a corporation under Treas. Reg Publicly traded partnerships Certain other entities, as specified by regulation 26

29 D. CTB Planning (continued) Types of Business Entities (continued) What is a partnership? Generally not a U.S. federal income tax paying entity income, gain, deduction and loss flow through to the partners Partners are generally taxable on their allocable share of partnership income/gain, and generally can deduct their allocable share of partnership losses Partners normally are not taxed on partnership distributions unless the distribution exceeds the basis of their partnership interests Some contractual arrangements may be taxable as partnerships, even if not intended by the parties 27

30 D. CTB Planning (continued) Types of Business Entities (continued) What is the Check the Box regime? Certain eligible entities (limited liability companies, for example) may elect their entity classification for U.S. federal income tax purposes If a single-owner, the default classification is as a disregarded entity, but entity may elect to be classified as a corporation If multiple-owners, the default classification is as a partnership, but entity may elect to be classified as a corporation Different default classification rules apply for eligible foreign entities What is a disregarded entity? Most typically, a single-member limited liability company that has not elected to be classified as a corporation Assets, liabilities and activities of a disregarded entity are treated as the assets, liabilities and activities of the disregarded entity s owner 28

31 D. CTB Planning (continued) Stock Sale Treated as Assets Sale Dover Corp. v. Comm r, 122 T.C. 324 (2004) Dover Corp. (Del.) Dover UK (UK) H&C (UK) Step 1 Step 2 Unrelated Corp. H&C (UK) Step 1: Dover UK sold its wholly-owned subsidiary H&C to an unrelated corporation. o H&C was treated as a corporation for U.S. tax purposes at the time of the sale Step 2: H&C filed a retroactive check the box election to be treated as a disregarded entity of Dover UK immediately before the sale in Step 1. Issue: Under the check the box regulations, is Dover UK considered to have conducted the business of H&C prior to the sale of H&C? o If yes, then the sale is not considered foreign personal holding company income under Subpart F. 29

32 D. CTB Planning (continued) Stock Sale Treated as Assets Sale (continued) Dover Corp. v. Commissioner, 122 T.C. 324 (2004) (continued) The court found that Dover UK was considered to have engaged in the business of H&C as if H&C were a branch or division of Dover UK prior to the sale of H&C. The Court found that under 332 and 381, the parent corporation is viewed as if it has always operated the business of the liquidated subsidiary and a distribution of those assets is treated as if the parent corporation distributed the assets of a branch or a division. E.g., Rev. Rul , C.B. 109; Rev. Rul , C.B The sale of H&C was thus treated as a sale of H&C s assets used in Dover UK s business. Consequently, the sale did not result in Subpart F income to Dover Corp. The court found that despite contrary prior caselaw, Acro Manufacturing v. Comm r, 39 T.C. 377 (1962), the check the box regulations and prior administrative guidance prevent the IRS from arguing for a different result. 30

33 II. Tax Free Reorganizations 31

34 A. Overview 32

35 A. Overview Boot: Generally, any property other than stock and securities of A (or P), including: o Cash, land, equipment, buildings, etc.; o Certain securities; and o Certain nonqualified preferred stock ( 351(g)). Boot generally does not include stock warrants or other stock rights. Certain proposed legislation could affect the definition of boot and its treatment. 368(c) control = 80% voting power of all classes of stock and 80% total number of all other classes of stock Meaningless gesture. Economic substance. Investment Company Prohibition - 368(a)(2)(F). 33

36 A. Overview (continued) Basic Types of Tax Free Reorganizations 368(a)(1)(A) Statutory merger ( A Reorganization ). 368(a)(1)(B) Stock-for-stock exchange ( B Reorganization ). 368(a)(1)(C) Stock-for-assets exchange ( C Reorganization ). 368(a)(1)(D) Transfer of assets to controlled corporation ( Acquisitive D Reorganization ). 368(a)(1)(F) Mere-change-in-identity ( F Reorganization ) 368(a)(2)(D) Forward triangular statutory merger (or forward subsidiary merger ). 368(a)(2)(E) Reverse triangular statutory merger (or reverse subsidiary merger ). 368(a)(1)(D) Transfer of assets to controlled corporation followed by distribution of controlled corporation stock ( Divisive D Reorganization ). Note: Section 368(a)(1)(G) provides for another type of tax-free acquisitions, a bankruptcy reorganization. It is not discussed in this presentation. 34

37 A. Overview (continued) Non-Statutory Requirements for these Tax Free Acquisition Types Continuity of business enterprise ( COBE ). Continuity of proprietary interest ( COI ). Business Purpose. Plan of Reorganization. Proposed Net Value Regulations. 35

38 A. Overview (continued) Consequences of Tax Free Reorganizations Target ( T ) Acquiror ( A ) Shareholders ( SHs ) Consequences Under 361 & 357, T does not recognize gain or loss on the transfer of its assets. Under 1032, no gain or loss is recognized on the transfer of A stock. Under 362(b), A takes a transferred basis in the T stock or assets received. Under 381, A inherits T s tax attributes (e.g., NOLs, E&P, capital loss carryovers). o Applies to certain asset reorganizations (A, C, F, Acquisitive D, and G reorgs) Under 354 and 356, SHs do not recognize gain or loss on the transfer of T stock except to the extent of boot received. Under 358, SHs take an exchanged basis in the A or P stock received. 36

39 B. Statutory Requirements 37

40 B. Statutory Requirements A Reorganizations Section 368(a)(1)(A) T liquidates T SHs T Consideration All T assets A T merges into A in a statutory merger or consolidation. T is treated as transferring all of its assets to A in exchange for the merger consideration, followed by a distribution of the merger consideration by T to its SH in liquidation (for all purposes). Note: other mechanics may be possible through the use of disregarded entities. Advantages: Flexible consideration requirements continuity of interest only constraint. Administratively easy all assets move to A by operation of law. Disadvantages: T liabilities automatically assumed in merger. Approval by T and A shareholders is generally required by corporate law. 38

41 B. Statutory Requirements (continued) B Reorganizations Section 368(a)(1)(B) T SHs T Solely A voting stock T stock A A acquires T stock from SH in exchange solely for A voting stock. Acquisition must be solely for A voting stock. A must have 368(c) control of T immediately after the acquisition. No boot is allowed. Advantages: Easier shareholder approval procedures apply. T assets and liabilities are not transferred. T remains intact. Creeping acquisitions permitted. Disadvantage: Consideration limited all consideration must be A voting stock. Beware payment of shareholder expenses. Monitor pre-transaction acquisitions of T stock. 39

42 B. Statutory Requirements (continued) C Reorganizations Section 368(a)(1)(C) In exchange solely for voting stock of A, A acquires substantially all of the properties of T. T must liquidate. Instead of A voting stock, may use parent ( P ) voting stock. Boot: o Boot relaxation rule applies (20% boot okay). T liquidates T SHs T A voting stock (with no more than 20% boot) Substantially all of T assets A o o o Assumption of liabilities does not violate solely voting stock rule (but beware actual boot plus assumption of liabilities both count toward 20%). Substantially All - Quantitative test: The Service ruling standard for substantially all is 90% of the fair market value of T s net assets and 70% of the fair market value of T s gross assets. Substantially All - Qualitative test: Courts consider the nature of the assets retained and the reasons for retention in determining whether the substantially all requirement is satisfied. o Extraordinary distributions by T before the acquisition may impair satisfaction of the substantially all requirement. 40

43 T liquidates B. Statutory Requirements (continued) C Reorganizations Section 368(a)(1)(C) (continued) T SHs T A voting stock (with no more than 20% boot) A Advantages: May isolate liabilities can leave them behind in T corporate shell Facilitates sales of corporate charters. Can combine entities where there is no applicable merger law. Disadvantage: Difficult if T is an ongoing business with liabilities if boot is also paid. Substantially all of T assets 41

44 T liquidates B. Statutory Requirements (continued) Acquisitive D Reorganizations Section 368(a)(1)(D) T SHs T A stock (50% voting power or 50% value) Substantially all of T assets A T transfers substantially all of its assets to A. T liquidates, distributing A stock or securities to SH. Immediately after the acquisition, SH has 304(c) control of A. Immediately after the transfer, one or more SHs (including persons who were SHs immediately before the transfer) must have control (50% vote or value) of A. Pursuant to the plan of reorganization, stock or securities of A must be distributed in a transaction that qualifies under 354 or 356. Note: Many intra-group transactions may be Acquisitive D Reorganizations, even when no A stock is issued. 42

45 T liquidates B. Statutory Requirements (continued) Acquisitive D Reorganizations Section 368(a)(1)(D) (continued) T SHs T A stock (50% voting power or 50% value) Substantially all of T assets A Advantages: May isolate liabilities can leave them behind in T corporate shell. Very flexible consideration requirements. Can combine entities where there is no applicable merger law. Disadvantages: Scope of rule is uncertain. Traps for the unwary exist. IRS liquidation-reincorporation weapon. 43

46 B. Statutory Requirements (continued) F Reorganizations Section 368(a)(1)(F) T (Transferor Corp) P New T (Resulting Corp) A mere change in identity, form, or place of organization of one corporation, however effected. 368(a)(1)(F). This includes a change in the country or state of jurisdiction, including changes of jurisdiction effectuated by a redomestication under local law. Rev. Rul ; Rev. Rul Neither the COI Requirement nor the COBE Requirement applies to an F reorganization. 44

47 B. Statutory Requirements (continued) F Reorganizations Section 368(a)(1)(F) (continued) T (Transferor Corp) P New T (Resulting Corp) Treas. Reg (m) Six requirements to qualify as an F Reorganization All of the stock of the resulting corporation must have been distributed (or deemed distributed) in exchange for stock of the transferor corporation in the transaction; The same persons who own all of the stock of the transferor corporation immediately before the transaction generally must own all of the stock of the resulting corporation immediately after the transaction, in identical proportions; The resulting corporation generally may not hold any property or have any tax attributes immediately before the transaction; The transferor corporation must completely liquidate for U.S. federal income tax purposes; Immediately after the transaction, no other corporation other than the resulting corporation may hold property that was held by the transferor corporation if such other corporation would, as a result, succeed to 381(c) items of the transferor corporation; and Immediately after the transaction, the resulting corporation may not hold property acquired from a corporation other than the transferor corporation if the resulting corporation would, as a result, succeed to 381(c) items of the transferor corporation of the other corporation. 45

48 B. Statutory Requirements (continued) Section 368(a)(2)(C) Dropdown In an A, B, C, or D Reorg, A can drop T assets or stock to a controlled corporation after the acquisition. T A, B, C, or D Reorg A Note: See also Treas. Reg (f) (definition of party to a reorganization ), -2(k) (application of 368(a)(2)(C)). T assets A Sub 46

49 C. Non-Statutory Requirements 47

50 C. Non-Statutory Requirements COBE Treasury Regulations (d) provides that COBE requires that A must continue T s historic business or use a significant portion of T s historic business assets in a business. If T has more than one line of business, only one significant line needs to be conducted by A. Continuing one of three business lines of equal size satisfies COBE. A is treated as conducting all businesses conducted by and holding all assets held by members of its qualified group. A qualified group is a chain of corporations connected by 368(c) control. Attribution through partnerships is generally permitted. 48

51 C. Non-Statutory Requirements (continued) COI Treasury Regulations (e)(1)(i) provides: Continuity of interest requires that in substance a substantial part of the value of the proprietary interests in the target corporation be preserved in the reorganization. COI is measured against the total consideration received by T shareholders. COI will be satisfied if 40% of the consideration received by Target shareholders is equity in Acquiror. Some reorganizations have a statutorily built-in COI requirement, i.e., B and C Reorganizations (100% and 80% voting stock threshold, respectively). Target shareholders may receive stock, other property, or both as part of the consideration, so long as the threshold is met in the aggregate. 49

52 C. Non-Statutory Requirements (continued) Business Purpose There must be a bona fide business purpose for the transaction to qualify as a tax free reorganization. Gregory v. Helvering, 293 U.S. 465 (1935). The purpose of the reorganization provisions of the Code is to except from the general rule certain specifically described exchanges incident to such readjustments of corporate structures made in one of the particular ways specified in the Code, as are required by business exigencies and which effect only a readjustment of continuing interest in property under modified corporate forms. [A] sale is nevertheless to be treated as a sale even though the mechanics of a reorganization have been set up. Treas. Reg (b) A scheme, which involves an abrupt departure from normal reorganization procedure in connection with a transaction on which the imposition of tax is imminent, such as a mere device that puts on the form of a corporate reorganization as a disguise for concealing its real character, and the object and accomplishment of which is the consummation of a preconceived plan having no business or corporate purpose, is not a plan or reorganization. Treas. Reg (c) The transaction must be undertaken for reasons germane to the continuance of the business of a corporation a party to the reorganization. Treas. Reg (g) Cases often refer to a corporate business purpose, but shareholder purposes may suffice if they are at least co-extensive with corporate business purposes. Examples of business purpose include simplification of business records and paperwork, avoiding local/state taxes, cost savings, and achieving better management of the business. 50

53 C. Non-Statutory Requirements (continued) Plan of Reorganization The exchange must be pursuant to a plan of reorganization in order to qualify as tax free. Plan of reorganization is not defined under 368, but the operative provisions require that the exchange be made in pursuance of a plan of reorganization. See 368, 354, and 361. Courts have not required the plan to be evidenced by a formal document; the parties discussions and negotiations may provide evidence that a plan exists. Treasury Regulations (g) explains that the term plan of reorganization refers to a consummated transaction specifically defined as a reorganization under section 368(a). Treas. Reg provides that each corporation that is a party to the reorganization under 368(b) must adopt the plan of reorganization. Such parties generally include the Target and Acquiror. Treas. Reg also provides that the transactions contemplated by the plan of reorganization must be undertaken for reasons germane to the continuance of the business of a corporation that is a party to the reorganization. 51

54 C. Non-Statutory Requirements (continued) Proposed Net Value Regulations Proposed regulations issued on March 10, 2005, provide guidance regarding reorganizations involving insolvent corporations. These proposed regulations generally require an exchange of net value in a reorganization described under 368(a). The proposed regulations, if enacted as proposed, would require that there be both a surrender (by Target) and a receipt (by Target s shareholder from the Acquiror) of net value in a reorganization. o For a surrender of net value to occur, the fair market value of the property transferred by Target to the Acquiror must exceed the sum of the amount of liabilities of Target that are assumed by the Acquiror in connection with the exchange and the amount of any money and the fair market value of any other property (other than stock permitted to be received under 361(a) without the recognition of gain) received by Target in connection with the exchange. o For a receipt of net value to occur, the fair market value of the assets Acquiror must exceed the amount of its liabilities immediately after the exchange. 52

55 D. Triangular Reorganizations 53

56 D. Triangular Reorganizations Forward Subsidiary Merger Section 368(a)(2)(D) T merges into A in a statutory merger or consolidation. SH receives P stock. No A stock may be transferred. T SHs P Stock P Any boot must come from P. P must have 368(c) control of A. T A Transaction must satisfy the requirement that T merger into P would have qualified as a reorganization under 368. The substantially all requirement applies. 54

57 D. Triangular Reorganizations (continued) Forward Subsidiary Merger Section 368(a)(2)(D) (continued) T SHs T P Stock P A Advantages: Flexible consideration requirements continuity of interest and A stock prohibition only constraints. Can isolate T s liabilities in A (rather than exposing all of P s assets). More easily satisfied shareholder approval procedures. Disadvantage: T subject to corporate-level tax if the reorganization fails to qualify as tax-free. Unlike merger under 368(a)(1)(A), substantially all requirement applies. 55

58 D. Triangular Reorganizations Reverse Subsidiary Merger Section 368(a)(2)(E) A merges into T in a statutory merger or consolidation. T becomes a subsidiary of P, and SH receives P stock. T SHs P Stock P SH must surrender 368(c) 80% control of T solely for P voting stock. A/P s ability to do a creeping acquisition is limited. T A All consideration must come from P. P s ability to pay boot is limited. P must control A prior to the acquisition. T must hold substantially all of its assets and the assets of A after the acquisition 56

59 D. Triangular Reorganizations Reverse Subsidiary Merger Section 368(a)(2)(E) (continued) T SHs T P Stock P A Advantages: Transaction is effectively an acquisition of T stock. More easily satisfied shareholder approval procedures. T assets and liabilities are not transferred. T remains intact. Some boot is allowed. Disadvantage: Consideration limited must use 80% voting stock to acquire control, so only 20% of consideration can be boot. Substantially all requirement applies. 57

60 E. Revenue Ruling

61 E. Revenue Ruling Overview Step Transaction Issues The tax consequences of a transaction are governed by the substance of the transaction rather than its form. See generally Gregory v. Helvering, 293 U.S. 465 (1935). The step transaction doctrine treats a series of formally separate steps as a single transaction if such steps are in substance integrated, interdependent, and focused toward a particular result. Rev. Rul , C.B. 157, quoting Penrod v. Comm r, 88 T.C. 1414, 1428 (1987). Specific non-application of step-transaction Section 368(a)(2)(C) and Treas. Reg (k); Treas. Reg (m) F in a bubble ; and Section 338 exclusivity. The Kimbell-Diamond Doctrine If a corporation acquires all of the stock of another corporation in order to acquire its assets pursuant to a pre-arranged liquidation, is the transaction treated, as to the acquiring corporation, as an acquisition of assets or an acquisition of stock? 59

62 E. Revenue Ruling Situation 1 Step 1 70% P voting stock and 30% cash Step 2 T SHs P P Merger T Merger S T Facts: P owns all of the stock of S, a newly formed wholly owned subsidiary. Pursuant to an integrated plan, P acquires all of the stock of T, an unrelated corporation, in a statutory merger of S into T, with T surviving. In the merger, the T shareholders exchange their stock for consideration of 70% P voting stock and 30% cash. Immediately thereafter, T merges upstream into P. Result: If the acquisition were viewed independently from the upstream merger of T into P, the result should be a QSP of T stock followed by a section 332 liquidation. See Rev. Rul , C.B. 67. However, because step transaction principles apply, see King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969), the transaction is treated as a single statutory merger of T into P under section 368(a)(1)(A). P acquires the T assets with a carry-over basis under section 362, and P may not make a section 338 election for T. Note: On July 8, 2003, the IRS issued final and regulations that permit taxpayers to turn off the step transaction doctrine and to make a section 338(h)(10) election in the transaction described above. See Reg (c)(1)(i), (2) and Reg (h)(10)-1(c)(2). 60

63 E. Revenue Ruling Situation 2 Step 1 100% P voting stock Step 2 T SHs P P Merger T Merger S T Facts: Same facts as in Situation 1, except that the T shareholders receive solely P stock in exchange for their T stock, so that the merger of S into T, if viewed independently of the upstream merger of T into P, would qualify as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(E). Result: Step transaction principles apply to treat the transaction as a merger of T directly into P. Note: The taxpayers cannot not change this result under the new section 338 regulations because, standing alone, P's acquisition of T does not constitute a qualified stock purchase. 61

64 F. Tax Free Spin Offs 62

65 C stock F. Tax Free Spin Offs Section 355 Generally Before SH D C Spin-Off C After SH D Nomenclature D = distributing corporation C = controlled corporation Generally, a distribution by a corporation to its shareholder may be taxable to both the corporation and the shareholder. 311(b), 301. If 355 applies to the distribution, however, there is no tax at either the corporate or the shareholder level. As a result of the spin-off, SH s basis in D stock is allocated between D and C stock based on relative value. Treas. Reg (a)(2), 358(a)(1), (b), and (c). Possible corporate level tax if 355(d) or (e) applies. When C is old and cold, the distribution is a 355 distribution. When D contributes assets to it before the spin-off, the transaction is a Divisive D Reorganization followed by a 355 distribution. 63

66 F. Tax Free Spin Offs (continued) Other Types of Section 355 Transactions Before Split-Off After D distributes C stock to SH #2 in redemption of the D stock held by SH #2. SH 1 SH 2 D C stock for D stock SH 1 SH 2 A failed tax-free split-off is analyzed as a redemption under 302. D C C 64

67 F. Tax Free Spin Offs (continued) Other Types of Section 355 Transactions (continued) C1 stock for D Stock Before SH 1 SH 2 D C2 stock for D stock Split-Up After SH 1 SH 2 C1 C2 D distributes C1 stock to SH #1 in redemption of the D stock held by SH #1 and C2 stock to SH #2 in redemption of the D stock held by SH #2. A failed tax-free split-up is analyzed under 331 and/or 332. C1 C2 65

68 F. Tax Free Spin Offs (continued) Section 355 Basic Requirements 355(a) Statutory Requirements Control immediately before Distribution of all of D s C stock and securities (or, with Service permission, an amount constituting control) Not a device for distribution of E&P D & C Engaged in an active trade or business (ATB) 355(a) Non-Statutory Requirements Business Purpose COI COBE Special Corporate-Level Requirements 355(d) and (e) 355(g): Disqualified Investment Corporations 66

69 F. Tax Free Spin Offs (continued) Control Immediately Before and Distribution Immediately before the distribution, D owns an amount of C stock constituting control of C. 355(a)(1)(A). Control defined in 368(c) as 80% vote and 80% number of shares of each nonvoting class. C may recapitalize to satisfy control requirement. Recap must result in a permanent realignment of voting control; it cannot be transitory and illusory. See Rev. Rul D must distribute all of its C stock or, at least, an amount constituting 368(c) control. 355(a)(1)(D). Parties must justify any retained stock to the Service. 355(a)(1)(D)(ii). 67

70 F. Tax Free Spin Offs (continued) Device The distribution cannot be used principally as a device for the distribution of the E&P of either D or C. 355(a)(1)(B). The requirement seeks to prohibit the bail-out of a corporation s E&P at capital gains rates. Ordinarily, a 355 transaction won t be a device if: D and C have no accumulated E&P (and no generation of E&P by application of 311(b)) (Treas. Reg (d)(5)(ii)) or There would have been capital gains to the shareholders if the transaction had been taxable (i.e., a split-off that would have been an exchange under 302(a)) (Treas. Reg (d)(5)(iv)). Whether a distribution is a device depends on the facts and circumstances. Device factors include Pro-rata distribution. Sale or exchange of D or C after distribution. o A sale or exchange of D or C stock pursuant to an arrangement negotiated or agreed upon prior to the distribution is substantial evidence of device. D or C has excessive non-business assets. Non-device factors include Corporate business purpose. D is publicly traded and no 5% shareholder. All distributee corporations entitled to DRD. 68

71 F. Tax Free Spin Offs (continued) Active Trade or Business Overview D and C must each be engaged in an active trade or business immediately after the distribution. Both D s and C s businesses must have been actively conducted throughout the 5-year period ending on the date of the distribution. Changes and expansion of business are permissible provided they are not of such character as to constitute the acquisition of a new or different business. Treas. Reg (b)(3)(ii). Neither D s nor C s business (nor control of a corporation conducting such business) was acquired in a taxable transaction within 5 years of distribution. See 355(b), Treas. Reg , Prop. Treas. Reg What is an active trade or business? Treas. Reg (b). Carrying out activities for profit, including every operation that forms a part of the process of earning income, including collection of income and payment of expenses, and Performance of substantial managerial and operational functions. The Service is currently studying the size of the business, in particular relative to the amount of nonbusiness assets held by D or C, needed to satisfy the active trade or business requirement. Notice , Rev. Proc The five year active trade or business requirement is not satisfied if The active trade or business was acquired in a transaction in which gain or loss was recognized in whole or in part. 355(b)(2)(C). Control of a corporation conducting the business was acquired in a transaction in which gain or loss was recognized in whole or in part. 355(b)(2)(D). Exceptions to the above for acquisition within an affiliated group and permissible expansions or changes in the business. Treas. Reg (b)(3)(ii), (4)(iv), Notice

72 F. Tax Free Spin Offs (continued) Active Trade or Business (continued) Conduct of an active trade of business through a separate affiliated group (SAG) For purposes of determining whether a corporation is engaged in the active conduct of a trade or business, all members of the SAG of such corporation are treated as a single corporation. 355(b)(3)(A). SAG Affiliated group that would be determined under 1504(a) (80% vote and value) if the corporation in question were the common parent and the limitation in 1504(b) (regarding the definition of an includible corporation) did not apply. 355(b)(3)(B). Indirect conduct of an active trade or business through a partnership. Assume D conducts an active trade or business through a partnership o Does D have a significant interest (1/3 ownership) in the partnership? o If not, does D perform active and substantial management functions? o See Rev. Rul , Rev. Rul , Prop. Treas. Reg (b)(2)(v). 70

73 F. Tax Free Spin Offs (continued) Business Purpose General The distribution must be carried out for one or more corporate business purposes. The transaction must be motivated, in whole or substantial part, by such corporate purposes. Treas. Reg (b)(1). It must be a real and substantial non-federal tax purpose germane to the business of D, C or D s affiliated group. Treas. Reg (b)(2). There must be no impractical or unduly expensive nontaxable alternative. Treas. Reg (b)(3). There may still be a good business purpose even if the business purpose never comes to fruition due to a change in circumstance. See Rev. Rul (the business purpose for the spin-off to enable C to raise capital never came to fruition. The Service ruled that the business purpose was satisfied because it existed at the time of the spin-off). 71

74 F. Tax Free Spin Offs (continued) Business Purpose (continued) Examples of permissible business purposes Splitting up a family owned business would prevent family discord. Rev. Rul Provide equity interests to key employees. Rev. Rul , Rev. Rul Facilitate post-distribution stock offering. Rev. Rul Facilitate borrowing. Rev. Rul , Rev. Rul Fit and Focus (enhance success of D and C by enabling the corporations to resolve management, systemic and other problems). Rev. Rul , Rev. Rul Friction with customers/suppliers regarding competition. Rev. Rul Regulatory problems. Rev. Rul Required divesture. Rev. Rul State or foreign tax savings. Rev. Rul , Rev. Rul o But see Treas. Reg (b)(2). Increase stock price of public company. Rev. Rul o Still need to show corporate level benefit. Facilitate an acquisition of C or D. Rev. Rul o See the discussion of 355(e) below. 72

75 F. Tax Free Spin Offs (continued) COI and COBE COI: One or more pre-distribution direct or indirect shareholders of D must own, in the aggregate, an amount of stock establishing a continuity of interest in each of D and C post-distribution. Treas. Reg (c). COBE: Section 355 contemplates continued operation of the business or businesses existing prior to the reorganization. Treas. Reg (b). Generally less of a point of focus in 355 than in the reorganization context because of 355 s active trade or business requirement. 73

76 F. Tax Free Spin Offs (continued) Section 355(d) In the case of a disqualified distribution, D recognizes gain on the distribution of C stock. A disqualified distribution is a distribution if immediately after the distribution, any person holds disqualified stock in D or C which constitutes a 50% or greater interest (by vote or value). Disqualified stock is any D or C stock acquired by purchase during the five year period ending on the date of the distribution OR any C stock received with respect to disqualified D stock. o Purchase does not include An acquisition of stock permitted to be received by a transferor of property without the recognition of gain under 351(a) or without the recognition of gain under 354, 355 or 356 (to the extent stock basis is determined under Section 358(a)(1)). Treas. Reg (d)(2)(i)(A)(1). 355(d) does not apply if the purposes of 355(d) are not violated. Treas. Reg (b)(3). The purposes of 355(d) are not violated if the effect of the distribution and any related transaction is neither o To increase direct or indirect ownership in D or any C by a disqualified person or o To provide a disqualified person with a purchased basis in the stock of any C. Disqualified person is any person that, immediately after the distribution, holds disqualified stock D or C constituting a 50% or greater interest in such corporation. A disqualified distribution is generally still tax-free to shareholders. 74

77 F. Tax Free Spin Offs (continued) Section 355(e) If the distribution is part of a plan (or series of related transactions) pursuant to which one or more persons acquire, directly or indirectly, 50% or more (by vote or value) of the stock of either D or C, then D recognizes gain on the distribution of C stock. 355(e)(2)(A). A plan is presumed to exist if one or more persons acquire 50% or more of D or C stock during the 4 year period beginning on the date which is 2 years before the date of the distribution. 355(e)(2)(B). Guidance as to what is a plan (or series of related transactions) is also provided in the Regulations. Treas. Reg Nine safe harbors. Otherwise, facts and circumstances (lists non-exclusive plan and non-plan factors). If 355(e) applies, D will recognize gain on the distribution but the distribution is still tax-free to shareholders. 75

78 F. Tax Free Spin Offs (continued) Section 355(g) 355 will not apply if Immediately after the transaction, either D or C is a Disqualified Investment Corporation ( DIC ), and Immediately after the transaction, any person owns a 50% (vote or value, applying 318 attribution) or greater interest in any DIC, but only if such person did not hold such an interest in such corporation immediately before the transaction. 355(g)(1). D or C is a DIC if 2/3 (by fair market value) of all of its assets constitutes Investment Assets: Cash, stock or securities, certain partnership interests, debt, options, forward or futures contract, notional principal contract, derivative, foreign currency, or any similar asset. 355(g)(2)(A), (B). Exception for certain assets used in financial trade or business, certain mark-tomarket assets. Look-through rule applies for certain interests in corporations and partnerships. 355(g)(2)(B)(iv), (v). 76