Internal Revenue Service Issues Guidance Affecting the Qualification of Multi-Step Merger Transactions as Tax-Free Reorganizations

Article by Los Angeles partner Larry Stein and associate Ana Genender

Two significant developments in the corporate tax area occurred in July 2003 that may affect the structure of certain corporate acquisitions. First, pursuant to temporary Treasury regulations under Section 338 of the Internal Revenue Code, taxpayers will now be able to treat multi-step mergers, consisting of an initial acquisition merger followed by an upstream merger or liquidation of the acquired corporation into the acquiror, as two separate transactions, rather than a single integrated transaction. Second, the Internal Revenue Service (the Service) announced that a newly formed subsidiary that is spun off to the parent corporation’s stockholders may be acquired in a tax-free merger by an unrelated purchaser following the spin-off. As a result of these developments, taxpayers are afforded additional flexibility in structuring various transactions, though in certain respects they also put a renewed emphasis on the form of a transaction as it impacts the tax consequences, since in both situations the Service, in effect, suspends the operation of the step transaction doctrine.

Background

In the case of a "qualified stock purchase" (generally defined as the acquisition by purchase of 80 percent of a target corporation’s stock), Section 338 allows the purchasing corporation to elect to treat the target corporation as having sold all of its assets at the close of the acquisition date at their fair market value in a taxable transaction. In general, a Section 338 election results in the target paying tax on the deemed asset sale, in addition to the target’s stockholders paying tax on the sale of target stock. However, where the target is a member of a consolidated group, the parties may make an election under Section 338(h)(10), in which case the selling consolidated group does not recognize gain on the sale of target stock. Thus, while a regular section 338 election is frequently not tax efficient, an election under Section 338(h)(10) often is.

The principal effect of making an election under Section 338 (including an election under Section 338(h)(10)) is that an acquiring corporation obtains a basis in the acquired corporation’s assets equal to the purchase price paid in the transaction (i.e., a cost basis), rather than a carryover basis, even though the form of the transaction is a stock purchase. The legislative history of Section 338 indicates that it was intended to replace any nonstatutory treatment of a stock purchase as an asset purchase for tax purposes.

In Revenue Ruling 2001-46, the Service applied the "step transaction doctrine" to treat the acquisition of a target corporation pursuant to a reverse triangular merger (i.e., a merger of a newly-formed subsidiary (S) of an acquiring corporation (P) into a target corporation (T) with T surviving as a subsidiary of P) (the Acquisition Merger) followed by an upstream merger of T into P (the Upstream Merger) as a single tax-free statutory merger of T into P which met the requirements of Section 368(a)(1)(A). Two factual situations were addressed in that ruling. In the first situation, the Acquisition Merger, if viewed independently of the Upstream Merger, would have been treated as a taxable stock purchase (and hence, a qualified stock purchase for purposes of Section 338). Under the facts of the second example, the Acquisition Merger would have qualified as a tax free reorganization pursuant to Section 368(a)(2)(E) if it were viewed independently of the Upstream Merger. The Service held that, in each case, the two mergers should be viewed as a single integrated transaction.

The Service’s conclusion regarding the first example in Revenue Ruling 2001-46 required consideration of several seemingly contrary authorities (such as Revenue Ruling 90-95) in which a two-step acquisition was treated as two separate and independent steps because the first step considered alone constituted a qualified stock purchase. The Service distinguished those authorities on the basis that in those cases, integrating the two steps would have resulted in a taxable transaction with a cost basis for T’s assets, which would have violated the policy of Section 338 because that section is intended to be the exclusive means for P to acquire a cost basis in T’s assets when it acquires the stock of T. By contrast, applying the step transaction doctrine to integrate the two steps in Revenue Ruling 2001-46 did not violate the policy of Section 338, because the result was a statutory merger of T into P (qualifying as a tax-free reorganization under Section 368(a)(1)(A)) in which P acquired T’s assets with a carryover basis and not a cost basis. Accordingly, for this reason, applying the step transaction doctrine to integrate the two steps in Revenue Ruling 2001-46 did not violate the policy of Section 338.

Many commentators suggested that where the Acquisition Merger would independently constitute a qualified stock purchase, taxpayers should at least be permitted to make an affirmative election to "turn off" the step transaction doctrine and have the two steps treated separately. In that case, an election under Section 338 could be made with respect to the Acquisition Merger, and P could obtain a cost basis in T’s assets.

The temporary Treasury regulations, applicable to stock acquisitions occurring on or after July 9, 2003, allow a taxpayer to make an election pursuant to Section 338(h)(10) in the case of a multi-step transaction consisting of a qualified stock purchase followed by the merger or liquidation of T into P. The exercise of the election allows the taxpayer to "turn off" the step transaction doctrine and to treat the stock acquisition as a qualified stock purchase separate and apart from the merger of T into P. T would pay tax on the built-in gain in its assets, and P would obtain a cost basis in such assets. Absent an election pursuant to Section 338(h)(10), a qualified stock purchase followed by an Upstream Merger would be treated as an integrated transaction qualifying as a reorganization in accordance with the principles set forth in Revenue Ruling 2001-46.

Background

A qualifying spin-off transaction allows a distributing corporation to distribute to its stockholders the stock of a controlled subsidiary corporation without triggering any gain or income at either the corporate or stockholder levels. A qualifying reorganization under Section 368(a)(1)(C) (a C reorganization) allows a corporation to acquire the properties of another corporation in exchange solely for all or part of the acquiring corporation’s voting stock. In order to so qualify, the acquiring corporation must acquire "substantially all" of the target corporation’s assets, which generally means at least 90 percent of a target company’s gross assets, and 70 percent of its net assets (the substantially all requirement).

In Helvering v. Elkhorn Coal Co., 95F.2d 732 (4th Cir. 1937), cert. denied, 305 U.S. 605, reh’g denied, 305 U.S. 670 (1938), in anticipation of being acquired by a third party pursuant to a C reorganization, a distributing corporation transferred part of its operating assets to a newly formed controlled subsidiary corporation and distributed the stock of such subsidiary to the distributing corporation’s stockholders in a qualifying spin-off transaction. The court held that the subsequent acquisition involving the distributing corporation did not qualify as a C reorganization because, as a result of the spin-off, the acquiring corporation did not acquire substantially all of the distributing corporation’s historic assets.

In Revenue Ruling 2003-79, a distributing corporation (D), which operated two businesses X and Y of equal size, transferred its business X assets to a newlyformed controlled subsidiary corporation (C) and then distributed the stock of C to D’s stockholders in a qualifying spin-off transaction. Following the spin-off and as part of the same plan, an unrelated corporation (A) acquired the assets of C solely for voting stock of A in a transaction that was intended to qualify as a C reorganization. The Service ruled that the subsequent acquisition satisfied the substantially all requirement applicable to C reorganizations, even though C’s assets (i.e., business X) represented less than substantially all of the assets of D immediately prior to the spin-off.

In reaching its conclusion, the Service cited various authorities regarding the treatment of certain combination spin-off/acquisition transactions (i.e., so-called Morris Trust transactions) in which A desires to acquire some but not all of D’s assets in a tax-free manner. In these types of transactions, D would transfer its "unwanted" assets to C and distribute C to its stockholders and then A would acquire D (or alternatively D would transfer its "wanted" assets to C and distribute C to its stockholders and then A would acquire C, although this latter form often faced additional technical impediments to tax-free treatment prior to the Taxpayer Relief Act of 1997 (the 1997 Act)). In particular, the Service cited Revenue Ruling 98-27, as well as the legislative history of the 1997 Act, for the proposition that the step transaction doctrine does not apply to determine whether D fails to "control" C for purposes of qualifying as a tax-free spin-off solely because of any restructurings of C that occur immediately after the spin-off (even if they are part of the same plan as the spin-off). Because these authorities treat C as a separate corporation for these purposes, the Service concluded that the same should be true in making the determination of whether the substantially all requirement of a C reorganization is met in connection with A’s acquisition of C’s assets following D’s spin-off of C.

It is important to note that the ruling does not change the tax treatment of the transaction described in Elkhorn Coal. Thus, if D transferred its Y assets to C and distributed the stock of C to its stockholders and then A acquired the assets of D solely for A voting stock, the acquisition would fail the substantially all requirement and thus not qualify as a C reorganization, even though A ends up with precisely the same assets of D (i.e., business X) as in the fact pattern described in Revenue Ruling 2003-79. Accordingly, Revenue Ruling 2003-79 demonstrates that if an acquiror A desires to acquire only a portion of the assets of a target corporation D, the form in which D segregates its wanted and unwanted assets in advance of the acquisition by A can be critical in determining whether the acquisition qualifies as a tax-free reorganization.

In addition, the ruling does not specifically address the application of Section 355(e) to the transactions. That section provides that a distribution of a controlled corporation’s stock in a spin-off will be taxable to the distributing corporation where the distribution is part of a plan where one or more persons acquire, directly or indirectly, stock representing a 50 percent or greater interest in the distributing corporation or any controlled corporation. Such a plan is generally presumed to exist in the case of acquisitions occurring within two years prior to or after a spin-off. Accordingly, under the facts of Revenue Ruling 2003-79, unless C’s stockholders held more than 50 percent of A’s stock following the transaction, D would be required to recognize gain under Section 355(e) with respect to its distribution of C’s stock.

Each of the developments discussed above affords taxpayers additional flexibility in structuring transactions to meet their business objectives. With the release of the temporary Treasury regulations, a taxpayer considering a multi-step acquisition may choose whether to effect a tax-free transaction and obtain a carryover basis in a target’s assets or a taxable transaction and obtain a cost basis in such assets. Similarly, with the release of Revenue Ruling 2003-79, taxpayers are provided guidance with respect to the tax treatment of certain acquisitive transactions following spin-offs. Both developments illustrate that in certain types of multi-step acquisitions, taxpayers may, in effect, suspend operation of the step transaction doctrine and thereby achieve certain desired tax results.

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