The U.S. Internal Revenue Service (the "Service") has long provided in regulations that a tax-free "statutory" merger (known as a type "A" merger), a particular type of the tax-free mergers and reorganizations defined in the U.S. Internal Revenue Code (the "Code"), can take place only when the merging corporations are both incorporated within the U.S. On January 4, 2005, however, the Service announced that it was proposing regulations that would at last allow type A mergers to take place between international corporations, and between international and U.S. corporations, if the merger takes place pursuant to the law of a foreign jurisdiction. The significance of this regulatory change cannot be overstated.
Absent the proposed regulations, lawyers seeking to qualify mergers involving one or more international corporations as taxfree in the U.S. have had to try to qualify the mergers under one of the Code’s other definitions of tax-free mergers. Unfortunately, and largely for historical reasons rather than as a result of any cohesive tax policy, all of the tax-free mergers defined in the Code other than a type A have stringent technical requirements that have proved difficult to comply with.
For example, where a non-U.S. acquiring corporation has bought a toe-hold position in a target prior to launching a share for share acquisition for the target’s remaining shares, it has been virtually impossible to qualify the subsequent share exchange as tax-free in the U.S. unless the acquiror first sells the stake it has bought for cash. Other difficult problems occur where the target has large number of options outstanding, where a significant number of target shareholders are expected to exercise dissenter’s rights, where the acquiror wishes or needs to acquire less than all of the target’s existing business assets, or where the acquiror wishes to offer to purchase some of the target’s shares for cash. In all of these situations, mergers involving international corporations that desire tax-free treatment in the U.S. – for example where a portion of the shareholders are U.S. shareholders who do not want to recognize gain – have had to occur pursuant to elaborate structures that serve no purpose other than ensuring compliance with the Code’s often archaic technical requirements for reorganizations other than type A mergers.
All of this will be changed for the better by Proposed Regulation Section 1.368- 2(b)(1) (REG-117969-00), which revises the definition of a statutory merger under Code Section 368(a)(A)(A). The proposed regulation removes the former requirement that a merger be effected pursuant to the laws of the United States or a State or the District of Columbia. Under the proposed regulation, mergers effected under foreign law may also qualify as a tax-free reorganization under Sec. 368(a)(1)(A); consequently, this regulation, when finalized, provides new flexibility under U.S. federal income tax law when restructuring foreign entities. In particular, tax-free reorganization treatment under Code Section 368(a)(1)(A) will not be conditioned on meeting the so-called "substantially all" of the business assets requirement (which is a necessary condition for all of the Code’s other types of tax-free acquisitions). Also, the rules which allow for consideration other than acquiror’s shares – known as boot in tax parlance – are much more favourable in the context of Code Section 368(a)(1)(A) type A mergers.
At present, there are only a few jurisdictions where the proposed regulation will be able to be utilized in a cross-border merger. For example, Canada has amalgamation provisions which will allow for a cross-border merger under the new regulations.1 However, internal restructuring within a specific jurisdiction will also benefit from the proposed regulation, where tax-free treatment is desired in the U.S. for the relevant U.S. shareholders.
The proposed regulations are not effective until they are published as temporary or permanent regulations, and no timetable is given for this to take place. It is unlikely that the regulations will become effective in the near future, but there is reason to hope that it will be a matter of months rather than years. Once they are effective, the availability of type A mergers involving international corporations should greatly simplify the structures used when U.S. tax-free treatment is desired.
In connection with the proposed regulations involving type A mergers, the Service also took the opportunity to propose changes to regulations under Section 367 of the Code, which restricts the ability of certain U.S. taxpayers to be involved in tax-free reorganizations involving foreign corporations without either paying tax or entering into an agreement with the Service to pay tax upon the occurrence of certain future events that would not otherwise be taxable events. Most of these proposed changes apply only to U.S. shareholders who own more than 10% of the voting power of a foreign corporation involved in the reorganization, and many apply only where at least 50% of the foreign corporation is owned by U.S. shareholders (a "CFC"). A 10% U.S. shareholder of a CFC is often referred to as a Section 1248 shareholder, because of the requirement under Section 1248 of the Code that the shareholder recognize certain income of the CFC upon a sale or deemed sale of the shares owned in the CFC.
The Service has invited comments on the proposed regulations and it is likely that the final version will differ in many respects from the proposed regulations. It is not clear whether the Service would be willing to finalise the proposed regulations regarding Type A mergers prior to finalizing the proposed regulations regarding Section 367, but the Service will probably seek to finalize both at the same time out of concerns that the flexibility provided by the type A changes make finalizing the technical restrictions under Section 367 more important.
1 There are several European jurisdictions which have merger provisions that will also allow for use of the proposed regulations.
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