The first four sections of this article discuss the tax consequences of domestic and cross-border tax-free acquisitions and spinoffs. The balance of the article applies these rules to the types of intra-group transactions that multinational groups typically employ before and after acquisitions and dispositions.
I. TAX-FREE ACQUISITIONS UNDER SECTION 368
A. General Requirements
Acquisitive reorganizations include mergers, consolidations, acquisitions by one corporation of the stock or assets of another corporation, and changes in form or place of organization. As a general matter, reorganizations described in section 3681 have the following tax consequences: (i) the target corporation generally recognizes no gain or loss on any transfer of its property in exchange for stock or securities of another corporation that is "a party to the reorganization under section 361"; (ii) the target shareholders and creditors may exchange their stock and securities for such new stock and securities without recognizing gain or loss under section 354 (although holders would recognize gain, but not loss, equal to the lesser of the amount of "boot" received, and the holder's gain realized, in the reorganization); and (iii) if a target corporation's assets are acquired in a reorganization, its tax attributes carry over to the acquiring corporation under section 381.2
To qualify for tax-free treatment under section 368, all transactions other than 368(a)(1)(E) reorganizations ("E reorganization") and 368(a)(1)(F) reorganizations ("F reorganization")3 must satisfy the judicial requirements of a valid business purpose, continuity of interest ("COI"), continuity of business enterprise ("COBE") and a plan of reorganization, and also must satisfy the requisite statutory requirements, which differ for each specific form of reorganization.4 The Code also limits the consideration that may be used in certain types of reorganizations.5
The business purpose requirement is designed to ensure that the parties to the reorganization engage in the transaction for a legitimate business purpose, rather than to avoid tax.6 Either a corporate or shareholder business purpose will suffice for this purpose, and the business purpose requirement for a reorganization is much less rigorous than the corresponding requirement for a tax free spinoff.7 However, the IRS will seek to tax transactions that satisfy the technical requirements of a reorganization if the business purpose for the transaction is to avoid tax on what, in substance, amounts to a sale.8
The COI doctrine once required that target shareholders indirectly retain their interest in the target's assets by both receiving and retaining ownership of acquirer stock for some period of time after the transaction. Although IRS ruling guidelines have historically adopted a 50% threshold for such continuing target shareholder ownership of acquirer stock, practitioners generally advise that 40% continuity is adequate for purposes of section 3689 and the IRS now seems to have adopted 40% as the COI threshold as well.10 Other COI regulations, which are discussed in Section I.B. below, have significantly altered the contours of the COI requirement, including, in particular, largely eliminating the requirement that acquirer stock be retained.
The continuity of business enterprise doctrine, which historically required that the acquirer itself continue a significant business of the target, has also been expanded to permit attribution of the activities of certain group members, including partnerships, to an acquirer for purposes of satisfying the COBE requirement. The section 368 regulations also require a "plan of reorganization." It is advisable, although not strictly required,11 to prepare a written plan that includes a general description of the reorganization and the parties thereto, the specific transaction steps, the acquisition consideration and the business purpose for the transaction.12
B. Continuity of Business Enterprise and Continuity of Interest
All reorganizations other than E or F reorganizations must satisfy COBE and COI.13 Five sets of COBE and COI regulations issued in the past decade have dramatically altered the contours of the COI and COBE requirements for corporate reorganizations.14 The IRS ruling guidelines set forth in Revenue Procedures 77-37 and 86-42 for blessing tax-free reorganizations will have to be modified in several respects, including to conform the guidelines to the current COI and COBE regulations.15 The American Bar Association ("ABA") has submitted a helpful report suggesting changes to Revenue Procedures 77-37 and 86-42 to reflect subsequent amendments to reorganization law, including the enactment of section 362(e) and modifications to the COI and COBE rules and section 357(c) and (d).16
1. Continuity of Business Enterprise
An acquirer may satisfy the COBE requirement for a tax free reorganization, notwithstanding a post-reorganization transfer of acquired stock or assets to a corporation or partnership if the "issuing corporation" either (i) continues the historic business of the target corporation (business continuity), or (ii) uses a significant portion of the target corporation's historic business assets in the issuing corporation's business (asset continuity).17 The "issuing corporation" refers to the acquiring corporation, or, in a triangular reorganization, the corporation that controls the acquiring subsidiary.18 The regulations require an analysis of all the facts and circumstances in light of COBE's policy goal, which is to limit reorganizations to transactions that are mere readjustments of continuing property interests in modified form and do not "involve the transfer of the acquired stock or assets to a 'stranger'."19 More generally, COBE policy requires a link between the target corporation shareholders and the assets or stock acquired in the reorganization.20
The current Treasury Regulations treat an acquirer as conducting the business, and owning the assets, of its "qualified group",21 which includes the issuing corporation, one or more corporations with respect to which the issuing corporation directly owns stock representing section 368(c) control,22 and any other corporations in which group members' aggregate ownership constitutes section 368(c) control directly or through certain partnerships, as described below.23 The government has finally concluded in the current regulations that aggregation adequately preserves the link between the former target shareholders and the target's business assets while further facilitating the postacquisition relocation of assets and stock as necessary within the qualified group.24 The 2007 COBE regulations first expanded the qualified group definition by permitting group members to aggregate their stock ownership in a lower-tier subsidiary to determine whether the subsidiary is itself a member of the qualified group,25 and the current regulations expand the definition further to permit compliance with COBE through the attribution of target stock or assets contributed into and held through a "diamond pattern".26
In testing target asset contributions to partnerships, the regulations treat an issuing corporation as conducting a partnership's business if (i) members of the issuing corporation's qualified group, in the aggregate, own a significant interest in the partnership business (a "significant interest"), or (ii) at least one member of the qualified group performs an active and substantial management function as a partner with respect to the partnership business (a "substantial management function").27 An issuing corporation's contribution of a significant target business to a partnership, which business the issuing corporation is treated as conducting, will tend to satisfy the COBE requirement, but is not alone sufficient to do so.28
Although the regulations do not detail when a significant partnership interest and/or a partnership interest that includes a substantial management function will satisfy the COBE requirement, the examples indicate that, following the contribution of a significant line of a target's historic business to a partnership, (i) if the qualified group, in the aggregate, performs a substantial management function for the partnership, a qualified group's ownership of a 20% partnership interest, but not a 1% partnership interest, would satisfy the COBE requirement, and (ii) if the qualified group does not perform a substantial management function, the qualified group's ownership of a 33â..."% aggregate partnership interest would satisfy the COBE requirement.29 In light of the clear rules set forth in these examples, the reason the regulation provides only that such a transfer to a partnership "tends to" satisfy the COBE requirement, "but is not alone sufficient," is not immediately apparent. One reason Treasury may have included this qualification could be to exclude partnership interests that may satisfy the letter of the examples but do not reflect a proportionate amount of the economic risk and benefit of the target or surviving corporation's assets or business held or conducted by the partnership. Except with respect to these types of interests, most practitioners treat the examples as tantamount to safe harbors.30
In a significant change from prior law, the 2007 COBE regulations also attribute target stock owned by a partnership to the qualified group if the group's members own partnership interests meeting requirements equivalent to section 368(c) control (a "section 368(c) controlled partnership").31 The government described the purpose of importing this section 368(c) control standard as treating "partnerships in a manner similar to [corporate] members of the COBE qualified group."32 The definition of a section 368(c) controlled partnership is not clear, as the regulation examples indicate only that a "straight up" 80% partnership interest is equivalent to section 368(c) control, while the same 50% interest is not.33
1 All references to "sections" are to sections of the Internal Revenue Code of 1986, as amended (the "Code"), and all references to "regulations" or "Treasury Regulations" are to regulations promulgated thereunder.
2 Under current law, the allocation of earnings and profits (sometimes referred to herein as "E&P") under requirement (iii) above is ambiguous. See, e.g., Treasury Addresses Earnings, Profits Transfers for Corporate Reorganizations, Daily Tax Rep. (BNA), at G-6 (Nov. 18, 2011) (acknowledging conflicts between sections 381 and 312 and noting various proposals, such as allocating earnings and profits in accordance with tax basis in a reorganization); Michael L. Schler, Eric Solomon, Karen Gilbreath Sowell, Jonathan J. Katz & Gary Scanlon, Updating the Tax-Free Reorganization Rules: Attributes, Overlaps and More, Taxes the Tax Magazine, 87 (Mar. 2012) (examines current law and sets forth new proposals regarding the location of attributes resulting from asset transfers after reorganizations); Amy S. Elliott, 'Substantially All' Unlikely to Replace 'All' in Reorg Rules, 2011 TNT 220-7 (Nov. 15, 2011) (noting ambiguity in section 381 and 312 regulations as to whether earnings and profits can be allocated between corporations when only a portion of a corporation's assets are transferred following a reorganization).
The Internal Revenue Service ("IRS") recently released proposed regulations providing that no portion of the transferor's E&P is allocated to the transferee following a tax-free property transfer, unless the transfer is described in section 381(a). 77 Fed. Reg. 22515 (Apr. 16, 2012). See generally Amy S. Elliot, Treasury Proposes to Clarify that E&P Can't Be Allocated Between Parties to Asset Reorg, 2012 TNT 73-5 (Apr. 16, 2012); Proposed Rules on Divvying of Earnings, Profits Aim to Clarify Antiquated Provision, Daily Tax Rep. (BNA), at G-4 (Apr. 16, 2012); Mark Boyer, David Friedel, Julie Allen & Elizabeth Wivagg, Practitioners Look for Further Guidance on E&P Allocation, 2012 TNT 78-16 (Apr. 23, 2012). However, these new E&P rules may be elective. See Amy S. Elliot, Electivity of Proposed Asset Reorg E&P Rule Is Inevitable, Alexander Says, 2012 TNT 77-1 (Apr. 20, 2012). The proposed regulations also clarify that, where parties engage in a section 381(a) transaction, only the "acquiring corporation" (defined in Treasury Regulation section 1.381(a)-1(b)(2)) succeeds to the transferor corporation's E&P. 77 Fed. Reg. 22515 (Apr. 16, 2012).
3 Recent final regulations exempt E and F reorganizations from both the COI and COBE requirements, stating that the requirements are not necessary to protect a reorganization policy in the case of E or F reorganizations. See T.D. 9182, 2005-1 C.B. 713; Treas. Reg. Â§ 1.368-1(b).
4 Additional judicial doctrines such as the "substance over form", "economic substance" and "step transaction" doctrines may also apply, depending on the facts and circumstances of a particular transaction. For the codification of the economic substance doctrine, which incorporates its judicial legacy, see section 7701(o). For excellent discussions of these issues, see Lewis R. Steinberg, Substance and Directionality in Subchapter C, 52 Tax Law. 457 (Spring, 1999); Robert Willens, Form and Substance in Subchapter C - Exposing the Myth, 84 Tax Notes 739 (Aug. 2, 1999) and Transactions: Form, Substance, and Understanding the Limits, New York State Bar Association Panel by William D. Alexander, Kimberly Blanchard, Michael A. DiFronzo, Gordon E. Warnke and Karen Gilbreath-Sowell on January 26, 2010; New IRS Directive Offers Some Guidance but Leaves in Question Cross-Entity Mergers' Treatment Under Codified Economic Substance Doctrine, Daily Tax Rep. (BNA), at J-1 (Aug. 11, 2011).
5 For example, no boot is permitted in B reorganizations and certain C reorganizations in which liabilities are assumed.
6 See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935) (reorganization that lacked business purpose was re-characterized as taxable stock transfer). Minimization of state and local taxes is, however, an acceptable business purpose. See Rev. Rul. 76-187, 1976-1 C.B. 97. Additional acceptable business purposes should include, among others, reducing administrative expenses; broadening customer base; expanding into new lines of business; transfers of voting power; rewarding key employees with equity interests; squeezing out minority target shareholders; and enabling shareholders of several related corporations to consolidate their interests through combinations of such affiliated corporations. See also P.L.R. 2011- 05-019 (Feb. 4, 2011) (one corporate business purpose of A reorganization was to enable acquirer to establish a voting trust).
7 See, e.g., Easson v. Commissioner, 294 F.2d 653 (9th Cir. 1961).
8 See CC-2002-003 (Oct. 18, 2001) (transaction was equivalent to a sale where target shareholders received acquirer stock representing an indirect interest in cash equivalent to target's fair market value and appreciation in the value of investments made with such cash, but no significant continuing interest in the business of acquirer or target).
9 For ruling purposes, the IRS requires that target shareholders receive at least 50% of the total acquisition consideration in the form of acquirer (or acquirer parent) stock. See Rev. Proc. 77-37, 1977-2 C.B. 568, Â§ 302. However, courts have upheld reorganization treatment where a smaller percentage of stock was used as consideration. See, e.g., John A. Nelson Co. v. Helvering, 296 U.S. 374 (1935) (38% preferred stock; 62% cash); Miller v. Commissioner, 84 F.2d 415 (6th Cir. 1936) (25% stock; 75% cash). As discussed in more detail in Section I.B.2.a. below, COI is generally determined based on the fair market values of stock consideration and boot at the time of closing. Temporary regulations ameliorate the potential problem that a sufficient change in their relative fair market values between signing and closing could cause the COI requirement to be violated by providing that, under certain circumstances, acquisition consideration is valued for COI purposes when a deal is signed. See T.D. 9316, 2007-1 C.B. 962; Temp. Reg. Â§ 1.368-1T(e)(2)(i).
10 See Temp. Reg. Â§ 1.368-1T(e)(2)(v), Exs. 1 & 5.
11 See Transport Prods. Corp. v. Commissioner, 25 T.C. 853, aff'd, 239 F.2d 859 (6th Cir. 1956); C.T. Invs. Co. v. Commissioner, 88 F.2d 582 (8th Cir. 1937).
12 See Treas. Reg. Â§ 1.368-1(c).
13 See T.D. 9182, 2005-1 C.B. 713; Treas. Reg. Â§ 1.368-(b).
14 T.D. 9361, 2007-2 C.B. 1026; T.D. 8760, 1998-1 C.B. 803; T.D. 8761, 1998-1 C.B. 812. See generally George R. Goodman, Postacquisition Restructuring and Beyond, 120 Tax Notes 577 (Aug. 11, 2008); Robert Willens, New IRS Regulations Mark Demise of "Remote Continuity", Daily Tax Rep. (BNA), at J-1 (Nov. 20, 2007); Mark Silverman & Andrew Weinstein, The New Continuity of Interest and Continuity of Business Enterprise Regulations, 25 J. Corp. Tax'n 219, 239 (1998); Robert Willens, New Continuity Regs. Increase Flexibility in Planning and Implementing Tax-Free Reorganizations, 88 J. Tax'n 133 (Mar. 1998). Cf. ABA, Tax Section Proposal for Revision of Revenue Procedure 86-42, reprinted in Daily Tax Rep. (BNA) (Apr. 11, 2007).
15 The New York State Bar Association tax section (the "NYSBA") also submitted an excellent report in 1998 suggesting changes to the ruling guidelines. See NYSBA, Report on Conforming Rev. Proc. 77-37 and Rev. Proc. 86-42 to the New Continuity Regulations, reprinted in Highlights and Documents, July 17, 1998, at 556. As indicated above, however, the NYSBA's 1998 report does not take into account any of the changes in reorganization law since 1998, including additional COI and COBE amendments. See, e.g., T.D. 9225, 2005-2 C.B. 716.
16 See ABA, Tax Section Proposal for Revision of Revenue Procedure 86-42, reprinted in Daily Tax Rep. (BNA) (Apr. 11, 2007).
17 Treas. Reg. Â§ 1.368-1(d)(1).
18 Treas. Reg. Â§ 1.368-1(b).
19 See 69 Fed. Reg. 51026 (Aug. 17, 2004) (citing H.R. Rep. No. 83- 1337 at A134 (1954)); Treas. Reg. Â§ 1.368-1(d)(1).
20 Preamble, COBE Regulations, 1981 Fed. Tax Rep. CCH Â¶ 6342, Vol. 10.
21 Treas. Reg. Â§ 1.368-1(d)(4)(i).
22 Section 368(c) control requires ownership of at least 80% of the relevant corporation's total combined voting power and 80% of the total number of shares of each other class of stock. See Rev. Rul. 59- 259, 1959-2 C.B. 115.
23 Treas. Reg. Â§ 1.368-1(d)(4)(ii). See generally George R. Goodman, Postacquisition Restructuring and Beyond, 120 Tax Notes 577 (Aug. 11, 2008); IRS Expands Definition of "Qualified Group" for Transfers But Not as Practitioners Asked, Daily Tax Rep. (BNA), at G-3 (Dec. 19, 2007); Robert Willens, New IRS Regulations Mark Demise of "Remote Continuity", Daily Tax Rep. (BNA), at J-1 (Nov. 20, 2007). Some commentators argued that the qualified group definition should not be restricted by the section 368(c) control standard but rather should be expanded to parallel the affiliated group definition in section 1504(a). The government rejected this argument, primarily because the section 368(c) standard is a "major structural component underlying the framework of the reorganization provisions." T.D. 9361, 2007-2 C.B. 1026.
24 See T.D. 9361, 2007-2 C.B. 1026.
25 Treas. Reg. Â§ 1.368-1(d)(4)(ii).
26 A "diamond pattern" is created when target stock is contributed to multiple 80% controlled subsidiaries which, in turn, contribute their target stock to a corporation in which no single transferor holds section 368(c) control.
27 Treas. Reg. Â§ 1.368-1(d)(4)(iii)(B). See generally Robert Willens, A.G. Edwards/Wachovia: No Remote COI Problem, 116 Tax Notes 395 (July 20, 2007) (A.G. Edwards' merger into Wachovia subsidiary in 368(a)(2)(D) ("A2D") reorganization and dropdown of its assets to Wachovia partnership should satisfy COBE). 28 Treas. Reg. Â§ 1.368-1(d)(4)(iii)(C).
29 See Treas. Reg. Â§ 1.368-1(d)(5), Exs. 8-10.
Ownership in tiered partnership structures would be calculated by multiplying each successive tiered partnership ownership interest percentage. For example, if an issuing corporation transferred a target corporation's assets to a 50% owned partnership, and such transferee partnership in turn transferred such assets to a 75% owned second-tier partnership, the issuing corporation would be deemed to have an interest of 37Â½% (50% multiplied by 75%) in the second partnership for purposes of determining whether the issuing corporation's interest is a significant interest. See Treas. Reg. Â§ 1.368-1(d)(5), Ex. 13.
30 See, e.g., ABA Comments on Proposed Regulations (REG-130863- 04) on Transfers of Assets and Stock after a Corporate Reorganization, 2005 TNT 26-7 (Feb. 9, 2005) (concurring that 33% partnership interest with no management function or 20% partnership interest with a substantial management function should be a safe harbor, since the relevant examples do not suggest any concern about any facts or circumstances other than active management and ownership percentage).
31 See Treas. Reg. Â§ 1.368-1(d)(4)(iii)(D). The prior COBE rules did not permit post-reorganization contributions of target stock to partnerships. See Former Treas. Reg. Â§ 1.368-2(k), Ex. 3. The government concluded, as it did with diamond structures, that transfers to section 368(c) controlled partnerships adequately preserve the link between the former target shareholders and the target's assets. See T.D. 9361, 2007-2 C.B. 1026.
32 T.D. 9361, 2007-2 C.B. 1026.
33 See Treas. Reg. Â§ 1.368-1(d)(5), Exs. 14-15
To view this article in full together with its remaining footnotes please click here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.