Tax Update. Also In This Issue JANUARY Radio Show Appearance. Pepper Sponsors Annual Federal Bar Tax Conference.

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1 Tax Update JANUARY 2006 Corporate Clean Up - New Rules on Reorganizations Using Foreign Entities, and Disregarded Entities, and Somewhat Surprising Clarification of Basis Rules in Reorganizations O n January 23, 2006 the Treasury issued final regulations that allow for certain merg-ers with foreign entities to qualify as tax free organizations, confirmed that disregarded entities are disregarded, and clarified basis rules with respect to stock received in a reorganization. 1 This article will highlight certain aspects of these new regulations, but is not intended to be a complete discussion of all relevant provisions. Foreign Corporations and Certain Disregarded Entities Can Satisfy Rules of Section 368(a)(1)(A) In general, the new regulations provide that mergers or amalgamations involving foreign corporations may qualify for reorganization treatment under Section 368(a)(1)(A) (an A Reorganization). In an A Reorga- Also In This Issue 4 Section 409A and Its Impact on the Taxation of Deferred Compensation nization the merger must be effectuated by means of a statutory merger. Historically, the IRS view was that a statutory merger could only occur between two entities formed under the laws of any state or the District of Columbia, thus, precluding mergers involving foreign entities. In the proposed regulations issued in 2003, the stated view was that a statutory merger could only occur if it was undertaken under the laws of a state or the District of Columbia. Some states do permit mergers of non-us companies, but it was still unclear if a merger would be a statutory merger if one of the parties was a non-us entity. The final regulations solve this problem by eliminating all references to U.S. entities or laws in the definition of a statutory merger. Specifically, Treas. Reg. Section (b)(1)(i) expands the ability of certain foreign and disregarded entities to qualify under Section 368(a)(1)(A) as statutory mergers, if two events occur simultaneously at the effective time of the transaction. (1.) All of the assets and liabilities of the transferor become assets and liabilities of one or more of the members of one other combining Radio Show Appearance Todd Reinstein and Lance Jacobs were guests on the January 30th broadcast of Tomorrow s Business, on Baltimore s Business Radio WBIS 1190 and on Washington D.C. s FM WGMS, discussing Current Trends in Federal and State Taxation. An audio file of the program can be downloaded at Pepper Sponsors Annual Federal Bar Tax Conference Pepper Hamilton LLP is a sponsor of this year s Federal Bar Tax Law Conference, slated for March 3 at the Ronald Reagan Building in Washington, D.C. Key government and private sector experts will speak on topics such as corporate tax, FAS 109, financial products, international tax, tax accounting, tax practice and procedure, and ethics. See the conference brochure at Quotable Todd Reinstein was quoted in the January 17th Outlook issue of the BNA Daily Tax Report.

2 unit; and (2) the combining entity of each transferor unit ceases its separate legal existence for all purposes. For purposes of these rules, a combining entity is a corporation that is not a disregarded entity, and a combining unit is defined as a combining entity and all of its disregarded entities. As a result, if a target corporation is merged into a wholly owned LLC of the acquiring corporation, that transaction will be a statutory merger, and, if the requirements of Section 368 are met, it can be a tax free transaction. On the other hand, if the acquiring corporation forms an acquisition subsidiary, and the LLC merges into the target company (in a reverse reorganization) that will not be a statutory merger because the target does not cease its separate legal existence. The rules can be used to alleviate the problem of grandfather stock in mergers. For example, If Corp A owns Corp B, and Corp B owns LLC, which is a disregarded entity, and Target is merged into LLC, this transaction is treated as a merger into Corp B. In this example, Corp B issues Corp A stock in the deal, with qualifies under Section 368(a)(2)(D) as a forward triangular merger. If the LLC had been a corporation the merger would not have been within the literal terms of Section 368(a)(2)(D) (i.e., the grandfather stock problem). These rules apply to transactions occurring on or after January 23, Coordination of Rules Impacting Mergers and Asset Reorganizations Involving Foreign Corporations Treas. Reg. Sections 1.367(a)-3 and (b)(2)(i) provide that a transfer of foreign stock or securities described in Section 367(a) of the regulations thereunder as well as in Section 367(b) or the regulations thereunder shall be subject concurrently to Sections 367(a) and (b) and the regulations thereunder, except in limited circumstances. The effect of the concurrent application of both 367(a) and 367(b) is that a shareholder would be required to include in income as a deemed dividend the all earnings and profits amount pursuant to 1.367(b)-3 without regard to whether the exchanging shareholder files a gain recognition agreement as provided under Sections 1.367(a)-3(b) and 1.367(a)-8. See Preamble to T.D (January 23, 2006). The government did not want shareholders to elect to be taxed on the lesser amount of gains under Section 367(a) simply by failing to file a gain recognition agreement. Id. The regulations also attempt to coordinate the indirect stock transfer rules and the asset transfer rules by providing that both 367(a) and (d) generally would apply to a domestic corporation s transfer to a foreign corporation, even if that foreign corporation re-transfers all or part of the assets to a domestic corporation. Certain exceptions apply where the domestic corporation is controlled by certain U.S. entities; or no asset basis disconformities exist and other requirements are met. These rules are attempting to prevent a step-up for divisive transactions that compare to a Section 355 transaction. The rules also provide for electronic filing of Form 926 Return by a U.S. Transferor of Property to a Foreign Corporation. The required signature is sufficiently provided on the signed income tax return for the relevant tax year, and thus, the Form 926 can be filed electronically. Tax Basis Determinations Modified in Cases of Corporate Transactions. Treas. Reg. Sections , and provide clarification on basis determinations that must be made upon certain corporate events. These rules adopt a tracing approach and attempt to allocate basis initially upon a corporate transaction to the individual shares or blocks of shares held by the transacting parties. Thus, if a target corporation s stock is acquired in a corporate transaction the gain or loss on the sale of such stock in a taxable transaction is determined by comparing the consideration received for each share and calculating the gain or loss on a shareby-share basis. Where more than one class of stock of the target company is outstanding, these rules allow an economically reasonable allocation of purchase consideration to be made by the parties. If no specific allocation is made, the allocation is presumed to be pro rata among the shares based upon a fair market value approach. In the case of a stock-for-stock or other carryover basis transaction, the same share-by-share approach is taken and the target shareholders will hold the shares of the acquiring company with differing basis in each to reflect their historic basis in the target company shares they exchanged. The rules even allow for split basis amounts for a single share, if for example, the target shareholders received one share of 2

3 acquiring corporation stock for each two shares of the target company stock. The rules of Treas. Reg. Section have also been modified to encourage the elimination of excess loss accounts where two affiliated companies merge in a 368(a)(1)(D) reorganization. The old rules appeared to achieve elimination of an excess loss account if the merging parties merged one direction and deny such elimination if these same parties merged in the opposite direction. The rules now allow elimination of an excess loss account (if that in fact occurs) no matter which direction the merger is effectuated. Pepper Perspective These three regulation packages represent very significant clarifications of rules that apply in virtually every corporate transaction, whether solely domestic or involving foreign parties. The tracing of basis rules, for example, will require that detailed records be maintained by shareholders (both corporate and individual) on the tax basis of each share of stock they hold. Without such detailed information the results of any merger, sale, corporate division or other exchange may not be readily ascertainable without a detailed process of transaction forensics in some cases. In addition, the longstanding prohibition of foreign corporations not qualifying for taxfree reorganization treatment under Section 368(a)(1)(A) has been reversed, thus allowing for much more flexibility in structuring crossborder transactions. In this regard, the historic categorization was a 368(a)(1)(C) reorganization, which has many more restrictions on its application. The changes in the Section 367 regulations, however, seem to be attempting to limit planning opportunities in certain cases. As stated above, this article merely highlights a few of the significant implications of these three regulation packages, and we will devote time in future articles to provide insight into more of the practical implications of these changes in the rules affecting M&A transactions. Endnotes Author: Annette M. Ahlers Phone: ahlersa@pepperlaw.com 1 T.D. 9242, amending Treas. Reg. Section , T.D. 9243, amending Treas. Reg. Sections 1.367(a)-3, 1.367(b), , B-1, and T.D. 9244, amending Treas. Reg. Sections , , , T and Philadelphia Washington, D.C. Detroit New York Pittsburgh Berwyn Harrisburg Orange County Princeton Wilmington The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. A Pennsylvania Limited Liability Partnership 2006 Pepper Hamilton LLP ALL RIGHTS RESERVED. 3

4 Section 409A and Its Impact on the Taxation of Deferred Compensation O ne of the most significant changes wrought by the American Jobs Creation Act (AJCA) is Section 409A and its impact on the taxation of deferred compensation. Section 409A broadly applies to all forms of deferred compensation, including equitybased compensation and severance arrangements. The penalties for violating its requirements are expensive, for employee and employer. Bottom-Line Impact Violations of Section 409A subject the participant to the recognition of income currently on the amount attempted to be deferred, the payment of a 20 percent excise tax on the amount deferred and the payment of interest on the deferred amount retroactive to the original deferral date. On a Section 409A violation, all non-grandfathered deferred amounts of the same type are includable in income and subject to the excise tax and interest penalties. For this purpose, the deferral types are expected to include: defined contribution or account-based deferrals; defined benefit or non-accountbased deferrals; and other deferrals, such as equity-based or severancebased deferrals. Although Section 409A penalties are imposed only on the participant, an employer may have related withholding obligations. In General Plans that provide for the deferral of compensation, as defined by Section 409A, are subject to the following rules: Participants must elect to defer compensation under plans subject to 409A on or before December 31 of the year preceding the year in which the compensation to be deferred is earned, and must concurrently elect the time and form of distributions under such plan (i.e., an employee must elect by December 31, 2006 whether to defer any income earned in 2007). Newly eligible participants generally have 30 days from the date of hire to make elections. Distributions may not be accelerated or paid prior to the date of payment elected by the participant or set by the plan. Deferred compensation may be distributed only upon one of the following events: a specified time or pursuant to a fixed schedule, separation from service, death, disability, change in control or in the event of an unforeseen emergency. A plan may not maintain an offshore trust to satisfy its obligations under the plan, or include triggers related to the employer s financial condition that result in funding of the obligation under the plan. Stock options must use a strike price that is equal to the value of the underlying stock, and modifications to existing options are subject to potential income inclusions. Grandfathered Benefits Deferred amounts that were earned and vested as of December 31, 2004 are not subject to Section 409A unless the plan is materially modified after October 3, Grandfathered deferrals may continue to be administered and operated under the pre- AJCA plan terms without violating Section 409A. Recent Developments The Proposed Regulations (insert date) provide flexibility with respect to the valuation of service recipient stock. For stock that is readily tradable on an established securities market, valuation can occur as of a specific date or an average of 30 days before or after the grant date may be used. If the stock is not readily tradable on an established securities market, the Proposed Regulations permit employers to use a reasonable valuation method (and provides examples and factors). Other recent developments include: Employers have no new reporting requirements under Section 409A for Income recognized as the result of a violation of Section 409A is not considered income for purposes of the Alternative Minimum Tax. Employers sponsoring deferred compensation plans, including pre-2005 grandfathered plans, which are funded with an impermissible rabbi trust (e.g. an 4

5 offshore trust), will have 90 days to correct the violation from the date the rules regarding impermissible funding are finalized. These rules are expected to be issued early in Special Issues Employers should be aware of the following 409A special issues in 2006: Under the Proposed Regulations, plan sponsors may allow participants to change the time and form of distribution elections, provided the plan amendments and revised participant elections are in place on or before December 31, The participant may not change the time and form of payments currently scheduled to be made in 2006, or accelerate payment from a later year into Additionally, deferred compensation plans that utilize equity instead of cash are limited to granting service recipient stock. For public companies, this means stock that is readily tradable on an established securities market. For private companies, this means the common stock of the company that has the highest aggregate value. In a controlled group context, this may limit a company s choices with respect to equity compensation. Specifically, the proposed rule may limit the ability to grant non-qualified stock options or stock appreciation rights in a subsidiary entity to employees of that subsidiary or any other employees within the group. The IRS is expected to revisit the rules relating to service Federal and International Tax Issues Annette M. Ahlers ahlersa@pepperlaw.com Joan C. Arnold arnoldj@pepperlaw.com James W. Barson barsonj@pepperlaw.com Gordon R. Downing downingg@pepperlaw.com W. Roderick Gagné gagner@pepperlaw.com Howard Goldberg goldbergh@pepperlaw.com Michiel Muizelaar muizelaarm@pepperlaw.com Lisa B. Petkun petkunl@pepperlaw.com Todd B. Reinstein reinsteint@pepperlaw.com Joan M. Roll rollj@pepperlaw.com David Young* youngrd@pepperlaw.com State and Local Tax Issues David H. Adams adamsd@pepperlaw.com Philip E. Cook, Jr cookp@pepperlaw.com Lance S. Jacobs jacobsls@pepperlaw.com Charles L. Potter, Jr potterc@pepperlaw.com Employee Benefits Issues Pepper Hamilton LLP Tax Practice Group Jonathan A. Clark clarkja@pepperlaw.com David M. Kaplan kapland@pepperlaw.com Andrew J. Rudolph rudolpha@pepperlaw.com *Admitted in New Jersey; Not admitted in the District of Columbia For more information about any of our tax professionals listed, please visit our Web site,. recipient stock this year because of its unanticipated and controversial effects. Author: Benjamin A. Bigler biglerb@pepperlaw.com PROMOTIONAL MATERIAL 5