By Anthony Diosdi
The Internal Revenue Code provides for nonrecognition of gain or loss realized in connection with a considerable number of corporate organizational changes. These include acquisitive and other reorganization defined in Internal Revenue Code Section 368(a)(1) and divisive reorganizations under Internal Revenue Code Section 355. They are permitted on a tax-free basis on the rationale that they involve a change in the organizational form of the conduct of the business and that there should be no tax penalty imposed on such a change. Equally important in the context of international reorganizations and merger transactions is Internal Revenue Code Section 367. Instead, this article will focus on Sections 368 and 355 of the Internal Revenue Code. This article will not discuss Section 367. However, we have written extensively on Section 367 and its impact on tax-free transfers by U.S. taxpayers of appreciated property to foreign corporations in other articles.
Reorganizations, as defined in Internal Revenue Code Section 368(a)(1), include statutory mergers and consolidations, acquisitions by one corporation of the stock or assets of another corporation, recapitalizations, changes in form or place of organization. If the translation qualifies as a reorganization, neither gain nor loss will be recognized by the corporation or corporations involved or by their shareholders who may exchange their stock for other stock.
The purpose of the reorganization provisions of the Internal Revenue Code is to permit a tax-free basis “such readjustments of corporate structures as required by business exigencies and which affect only a readjustment of continuing interests in property under modified corporate forms.” See Treas. Reg. Section 1.368-1(b). Implicit in this statement of purpose are three general requirements for qualification of a transaction as a tax-free reorganization: 1) the transaction must have a business purpose; 2) the original owners must retain a continued proprietary interest in the reorganized corporation; and 3) in an acquisitive reorganization, the acquiring corporation must either continue the acquired corporation’s historic business or use a significant portion of the acquired corporation’s historic business assets in a business.
The basic types of reorganizations are as follows:
Type A Reorganization
In the context of international corporate acquisitions, tax-free mergers often take the form of forward triangular mergers, in which the acquired corporation is merged into a subsidiary of the acquired corporation; these mergers must meet the requirements of Section 368(a)(2)(D). International tax-free statutory mergers may also take the form of reverse triangular mergers, in which a subsidiary of the acquiring corporation is merged into the acquired corporation; these mergers must meet the requirements of Section 368(a)(2)(E).
To qualify as a Type A reorganization, the transaction must satisfy all of the applicable merger or consolidation requirements under the corporation laws of the federal and state governments. In the typical merger transaction, one corporation is absorbed into another corporation, with only one of the two corporations surviving. In a typical consolidation, two corporations are combined into a new entity, and both of the old corporate entities disappear. A Type A reorganization must also meet the continuity of proprietary interest, continuity of business enterprise, and business purpose tests developed by the courts and incorporated into the regulations under Section 368. The continuity requires that the target shareholders receive a “definite and substantial interest” in the acquiring corporation and that this interest must represent a “material part of the value of the transferred assets.” See Helvering v. Minnesota Tea Co, 296 U.S. 378, 386 (1935).
The Internal Revenue Service (“IRS”) takes the position for purposes of of issuing advance rulings, that the continuity of proprietary interest test is satisfied if the former shareholders of the target corporation receive a stock interest “equal in value, as of the effective date of the reorganization, to at least 50 percent of the value of all of the formerly outstanding stock of the acquired or transferor corporation as of the same date.” See Rev. Proc. 77-37, 1977-2 C.B. 568. Under this IRS interpretation, fully one-half of the consideration paid in a Type A reorganization may be something other than stock.
At one time a foreign corporation could not qualify for Type A reorganization. However, in REG-117969-00 2005-7 I.R.B. 533, the Treasury and the IRS issued proposed regulations to “allow a transaction effected pursuant to the statutes of a foreign jurisdiction or of a United States possession to qualify as a statutory merger or consolidation under Section 368(a)(1)(A), provided that it otherwise qualifies as a reorganization.”
Below, please see Illustration 1 for a simple example of an international Type A merger.
Assume that U.S. Target merges with and into Foreign Acquirer. Further assume that Target’s shares are worth $1 million at the time of the merger and that Tarbet’s U.S. shareholders have $100,000 of basis in their U.S. Target shares and that the U.S. Target shareholders receive Foreign Acquirer shares with a fair market value of $1 million.
Although the merger occurs with a foreign corporation, the merger qualifies as a Type A merger. Assuming that Section 367 does not apply, there will be no immediate U.S. tax consequence as a result of the merger. However, if the merger does not qualify as a Type A merger, it will be taxed as a taxable transfer of the target corporation’s assets. If the above example does not qualify as a Type A reorganization or merger, U.S. Target’s U.S. shareholder should recognize taxable gain of $900,000 (the $1 million fair market value of the Foreign Acquiror’s shares less the $100,000 basis in their shares of U.S. Target).
Type B Reorganization
In a Type B reorganization, the purchasing corporation (“P”) acquires a controlling interest in the target corporation (“T”) stock from the T shareholders solely in exchange for all or part of P’s voting stock. See IRC Section 368(a)(1)(B). Two significant elements of the Type B reorganization should be noted at the outset. First, and most importantly, the purchasing corporation must have control over the target corporation immediately after the stock acquisition from the target shareholders. “Control,” for purposes of Section 368, generally requires ownership by the acquiring corporation of “at least 80 percent of the total combined voting power of all classes of stock entitled to vote” and “at least 80 percent of the total number of shares of all other classes of stock.” See IRC Section 368(c).
Second, the Type B reorganization provides explicit rules regarding the type of consideration that may be used to compensate target shareholders for their stock. The target shareholders must exchange T stock solely for all or part of the acquiring corporation’s voting stock or solely for all or part of the voting stock of the acquiring corporation’s parent. Thus, the only consideration that may be used in a Type B reorganization is voting stock of the acquiring corporation or its parent.
A Type B share for share acquisition is tax-free as long as there is no consideration other than the voting shares and the acquiring corporation has control of the target corporation immediately after the transaction.
Below, please see Illustration 2 for a simple example of an international Type B share for share acquisition.
Assume that Foreign Corporation wants to acquire U.S. Target. Also let’s assume that the U.S. Target’s single class of voting shares are worth $1 million. In addition, let’s assume that the Foreign Corporation issues $1 million worth of Foreign Corporation voting shares to U.S. Target’s U.S. shareholders in exchange for their U.S. Target shares. In this ase, the transaction will likely qualify as a tax-free Type B acquisition. However, if the Foreign Corporation would provide a small amount of cash along with the voting shares, the transaction would not qualify as a Type B tax-free acquisition.
Type C Reorganization
A Type C acquisition involves the acquisition by a corporation of all or part of its voting shares for substantially all of the properties of the target corporation and the subsequent liquidation of the target corporation. If the target transfers less than substantially all of its assets. The transaction is not “acquisitive” in nature. A transfer of only part of a corporation’s assets may still qualify for tax-free reorganization treatment, but authority for such nonrecognition will be found in Internal Revenue Code Section 368(a)(1)(D), which generally applies to divisive reorganizations.
Given the tremendous importance of the “substantially all of the properties” requirements in distinguishing acquisitive from divisive reorganizations, it is surprising to discover that neither the statute itself nor the regulations specify what constitutes “substantially all” of a corporation’s properties for purposes of Section 368(a)(1)(C). There is no precise percentage of asset rule. The term “substantially all” typically means 90% of the fair market of T’s net assets and 70% of the fair market value of T’s gross assets.
Below, please see Illustration 3 for a simple example of an international Type C share for asset acquisition.
Let’s assume that Foreign Corporation acquires U.S. Target’s assets for Foreign Corporation voting shares. Let’s also assume that U.S. Target subsequently distributes the Foreign Corporation’s shares to its shareholders in a liquidation. This transaction should qualify as a tax-free Type C share for asset acquisition.
Type D Reorganization
Most reorganizations that rely upon Section 368(a)(1)(D) to qualify as nonrecognition transactions are divisive reorganizations. In a Type D reorganization one corporation transfers “all or part of its assets to another corporation” and the transferring corporation or one or more of its shareholders (or a combination of the two) must be in control of the corporation to which the assets are transferred immediately after the transfer. See IRC Section 368(a)(1)(D). The Type D reorganization definition does not require the purchasing corporation to use its own stock or securities or stock or securities of a subsidiary. Instead, continuity of proprietary interest is assured by requiring that the target, or one or more of T’s shareholders, be in control of the purchasing corporation immediately after the transfer of assets. In the case of non divisive Type D reorganizations, the applicable “control” test is the 50% test in Section 304(c), rather than the 80% control test in Section 368(c) that would otherwise apply. See IRC Section 368(a)(2)(H).
The transferor corporation and/or its shareholders in a Type D reorganization must retain control over the purchasing corporation. This is quite unlike the typical acquisitive reorganization, in which the target shareholders typically lose control over the target and its assets. Since the Type D reorganization involves transfer of “all or part” of the target’s assets, there can be overlaps with Type A and Type C acquisitive asset reorganization definitions.
Type E Reorganization
A Type E reorganization is a recapitalization, a term that is not defined in the Internal Revenue Code but has been described by the United States Supreme Court as a “reshuffling of a capital structure within the framework of an existing corporation.” See Helvering v. Southwest Consolidated Corp., 315 U.S. 194, 202, 62 S.Ct. 546, 551 (1942). In a recapitalization, a corporation;s shareholders or creditors exchange their interests for other equity or debt interests. The assets of the corporation generally remain unchanged. Because a recapitalization involves only a single corporation, the IRS gas ruled that neither continuity of proprietary interest nor continuity of business enterprise is required for a recapitalization to qualify as a Type E reorganization. See Rev. Rul. 77-415, 1977-2 C.B. 311; Rev.Rul. 82-34, 1982-1 C.B, 59. However, a recapitalization still must serve some corporate business purpose to qualify for nonrecognition. See Treas. Reg. Section 1.368-1(b).
Type F Reorganization
A Type F reorganization is a mere change in identity, form, or place of organization of one corporation, however effected. See IRC Section 368(a)(1)(F). Some courts once held that an F reorganization could include a combination of two or more active corporations. Although these transactions also qualified as Type A reorganizations, Type F status was preferable because post acquisition net operating losses of the new corporation could be carried back to offset profits earned by the previous corporation that conducted that same business. Congress amended the Internal Revenue Code to make it clear that F reorganizations are limited to transactions involving only a single operating corporation.
Below, please see Illustration 4 for a simple example of a Type F change in form reorganization.
X Corp, which is incorporated in California, wishes to change its state of incorporation to Delaware. To that end, X merges into newly formed Y Corp., a Delaware corporation. Pursuant to the merger, the X shareholders receive Y stock and X dissolves by operation of law. The merger qualifies as an F reorganization.
Type G Reorganization
A Type G reorganization is a transfer by one corporation of all or part of its assets to another corporation in a bankruptcy proceeding under Title 11 of the United States Code or a similar proceeding (e.g., receivership or foreclosure) in federal or state court, provided that the stock or securities of the transferred corporation are distributed pursuant to a plan of reorganization in a transaction that qualifies under Internal Revenue Code Sections 354, 355, 356, or 368.
The tax-free provisions of the Internal Revenue Code are not confined to corporate reorganizations. Sometimes a corporate split can qualify as a tax-free transfer. Under Internal Revenue Code Section 355, the parent (distributing) corporation is permitted to distribute stock or securities in a controlled subsidiary without recognition of gain or loss. Corporate divisions tend to come in three basic flavors: spin-off, split-off, or split-up. Each variation involves a slightly different type of distribution of stock or securities. In general, if the transaction successfully runs the gauntlet of Section 355, the tax treatment to the shareholders and the corporation will be the same regardless of whether the transaction is a spin-off, split-off, or split-up.
In a spin-off, the distributing corporation distributes stock of a controlled corporation (a subsidiary) to its shareholders. The subsidiary may either be a recently created subsidiary “spun off” through the parent corporation’s transfer of assets in return for stock or an existing subsidiary. The shareholders in a spin-off generally receive a pro rata share of the controlled corporation’s stock and do not transfer anything in return for this stock. If the transaction fails to qualify for nonrecognition under Section 355, the distribution is treated as a dividend to the shareholder distributees to the extent of the corporation’s earnings and profits and any gain on the distribution of the appreciated assets is taxable to the distributing corporation.
A split-off is very much like a spin-off except that the parent’s shareholders receive stock in the subsidiary in return for some of their stock in the parent corporation. In a split-up, the corporation transfers all of its assets to two or more new corporations in return for stock, which is then distributed to the shareholders of the parent corporation in return for all of the parent stock. The split-up effectively liquidates the original parent corporation.
A distribution of stock in a controlled corporation will be eligible for Section 355 nonrecognition treatment only if it meets numerous statutory and nonstatutory requirements. The statute itself requires:
1. The distributing corporation must control the subsidiary (or subsidiaries) of the stock or securities of which are distributed;
2. Immediately after the distribution, both the distributing corporation and the controlled subsidiary (or subsidiaries) must be engaged in the active conduct of a trade or business (or, if the assets of the distributing corporation consists solely of stock or securities in two or more controlled subsidiaries, each of the latter must be so engaged);
3. Certain tests must be met with respect to the amount of stock and securities of the controlled subsidiary (or subsidiaries) that is distributed;;
4. The transaction must not be used principally as a device for the distribution of the earnings and profits of any corporation involved; and
5. The distribution must not constitute a disqualified distribution or a distribution..
A Closer Look at the Section 355 Requirements
Control “Immediately Before the Distribution”
Nonrecognition under Internal Revenue Code Section 355 is limited to corporate distributions of stock or securities of a controlled corporation. Such distributions of stock or securities in a controlled subsidiary to shareholders of the parent arguably reflects a “mere change in form.” The distributing parent may distribute stock or securities in either a preexisting or a newly created subsidiary. As a practical matter, corporations planning for a division frequently create new subsidiaries for the purpose of effecting a spin-off or split-off. So, for example, the distributing corporation may create a new subsidiary under Internal Revenue Code Section 351 or as part of a Type D reorganization or other tax-free reorganization provision.
Distribution of Control
A further requirement for Internal Revenue Code Section 355 nonrecognition involves the amount of stock or securities distributed. The distributing corporation must either distribute all of the stock or securities of the controlled corporation held immediately before the distribution or enough stock to constitute control. If the distributing corporation exercises the latter option, it must also establish to the satisfaction of the IRS that retention of stock (or stock or securities) are not principally for tax avoidance purposes. See IRC Section 355(a)(1)(D).
Active Trade or Business Requirement
Post-Distribution Active Trade or Business Requirement
Much of Section 355’s complexity is the result of the “active trade or business” requirements detailed in Section 355(b). Section 355 requires that both distributing corporations and the controlled corporation or corporations be “engaged immediately after the distribution in the active conduct of a trade or business.” In the case of a split-up, the distribution effectively is a liquidating distribution of stock in multiple controlled corporations after which the distributing corporation will cease to exist. In such a case, each of the controlled corporations must be “engaged immediately after the distribution in the active conduct of a trade or business.”
Whether or not the corporation is actively, as opposed to passively engaged in a trade or business will depend upon the facts and circumstances. To be considered an active trade or business, however, the corporation is “required itself to perform active and substantial management and operational functions.” If the corporation can establish that it provides significant operation and management services, the business will be considered an active trade or business. The regulations specifically eliminate from the active conduct of a trade or business definition the holding of stock, securities, land or other property, for investment purposes as well as certain ownership and operation of real or personal property. See Treas. Reg. Section 1.355-3(b)(2)(iv).
Pre-Distribution Active Trade or Business Requirement
The language in Internal Revenue Code Section 355(b)(1) begins by including only a post-distribution trade or business requirement. The definition section that follows in Section 355(b)(2) treats a corporation as engaged in the active trade or business only if the trade or business “has been actively conducted throughout the five-year ending on the date of the distribution.” See IRC Section 355(b)(2)(B). Thus, the particular trade or business relied upon to meet this requirement cannot be a new trade or business, but must have a five-year history. Finally, the distributing corporation must not have acquired the trade or business, or control over the corporation conducting the trade or business, in a taxable transaction within five years prior to the distribution. See IRC Section 355(b)(2)(C), (D).
Device for the Distribution of Earnings and Profits
In addition to all of the restrictions and requirements discussed above, Section 355 explicitly demands that “the transaction was not used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both.” See IRC Section 355(a)(1)(B). Treasury Regulation Section 1.355-2(d)(1) that “Section 355 recognizes that a tax-free distribution of the stock of a controlled corporation presents a potential for tax avoidance by facilitating the avoidance of the dividend provisions of the Internal Revenue Code through the subsequent sale or exchange of stock of one corporation and the retention of the stock or any corporation.” The restrictions and requirements found in Section 355 are directed at preventing bailouts of corporate earnings and profits without paying a dividend.
The regulations on the “device” requirement list a number of “device factors” to be considered in making the facts and circumstances analysis required to determine whether the transaction was used to bail out earnings and profits. The regulations indicate that “the fact that a distribution is pro rata or substantially pro rata is evidence of device.” See Treas. Reg. Section 1.355-2(d)(2)(ii). A subsequent sale of the distributed stock can also be evidence of a device. The greater the percentage of the stock sold and the shorter the time period of time between the distribution and the subsequent sale, the stronger the evidence of device becomes. See Treas. Reg. Section 1.355-2(d)(2)(iii). A prearranged or negotiated sale is considered “substantial evidence of device,” whereas a subsequent sale that was not arranged or negotiated prior to the distribution merely is “evidence of device.” See Treas. Reg. Section 1.355-2(d)(2)(iii)(B), (C).
Non Statutory Requirements
Even if a Section 355 tax free separation is not a Section 368(a) reorganization, the transaction must also meet the business and continuity of interest requirements applied the Section 368 reorganizations. This means that there must be an “independent business purpose” under which the overall transaction is motivated “in whole or substantial part, by one or more corporate business purposes.” See Treas. Reg. Section 1.355-2(b)(1).
Tax Consequence to Shareholders and Corporations
If all of the requirements for a tax-free division or tax-free reorganization are met, the shareholders and corporations will not report gain or loss or otherwise include any income upon receipt of stock or securities in the controlled subsidiary from the distributing parent corporation.
This article was designed to provide the reader with an introduction to the different types of international and domestic tax-free reorganizations, divisions, mergers and acquisitions. These transactions can be incredibly complicated. Anyone planning a tax-free cross-border transaction or transactions should consult with a tax attorney who is not only experienced in the tax-free provisions of the Internal Revenue Code, but will also seek to ensure that the cross-border transaction is structured in a way to minimize or eliminate the global tax consequences of the transaction.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.