By Anthony Diosdi
Introduction
If a U.S. corporation is liquidated and its assets are distributed to foreign shareholders, U.S. federal income tax will be imposed on the gain realized by the distributing corporation except to the extent that a tax-free-exchange provision provides otherwise. If the stock or assets of a U.S. corporation are acquired by a foreign corporation in exchange for stock of the foreign corporation, gain realized by U.S. shareholders and the U.S. corporation will also be subject to tax, except to the extent that the gain is sheltered by a tax-free-exchange provision provided by the Internal Revenue Code. Under the Internal Revenue Code, taxable gains typically realized in exchange of property in connection with a variety of transactions involving only U.S. corporations will result in a tax-free-exchange. However, when the same transaction involves one or more corporations organized in a foreign country, nonrecognition of taxable gain is significantly reduced and a transfer of appreciated assets or stock of a U.S. corporation to a foreign corporation can trigger a significant U.S. tax liability. This is due to the enactment of Internal Revenue Code Section 367.
Internal Revenue Code Section 367 has two parts. First, Section 367 imposes a U.S. tax liability (sometimes referred to as a “toll charge”) when property with untaxed appreciation is transferred outside the United States. Second, Section 367 ensures the earnings of a controlled foreign corporation (“CFC”) does not avoid U.S. tax to a foreign entity that is not a CFC.
Even with Section 367, the Internal Revenue Code provides for nonrecognition of taxable gains realized in connection with a number of corporate organizational changes. These include acquisitions and other reorganizations defined in Internal Revenue Code Section 368(a)(1) and divisive reorganizations discussed in Internal Revenue Code Section 355. They are permitted on a tax-free basis on the rationale that they involve merely changes in the organizational forms for the conduct of business and that there should be no tax recognition imposed on such reorganizations.
Reorganizations, as defined in the Internal Revenue Code, include statutory mergers and consolidations, acquisitions by one corporation of the stock or assets of another corporation, recapitalization, changes in form or place or organization and certain corporate bankruptcies. See IRC Section 368(a)(1). The purpose of the reorganization provisions is to permit on a tax-free basis “such readjustments of corporate structure made in one of the particular ways specified in the Internal Revenue Code, as are required by business exigencies and which affect only a readjustment of continuing interest[s] in property under modified corporate forms.” See Treas. Reg. Section 1.368-1(b).
In general, reorganizations involving the sale of a domestic corporation to a foreign corporation can be divided U.S. Real Property Holding Corporations (“USRPH”) and the reorganization rules applicable to other corporations. The special rules discussing the acquisition of a USRPH by a foreign corporation will be discussed in a later article. This article will focus on the reorganization of non-USRPH corporations.
In the context of international reorganizations, most of them will be classified as one of the following types:
1. A statutory merger (“Type A”);
2. An exchange of the shares of the acquiring corporation for the shares of the target corporation (“share for share acquisition,” also known as “Type B”);
3. An exchange of the shares of the acquiring corporation for the assets of the target corporation (“share-for-asset acquisitions,” also known as “Type C”);
4. Forward triangular mergers; and
5. Reverse triangular mergers.
6. A transfer by a corporation of part or all of its assets to another corporation if immediately after the transfer the transferor and/or its shareholders are in control of the transferee corporation and if the stock or securities of the transferee corporation are distributed in a transaction qualifying under Sections 354, 355, or 356 are known as Type D reorganizations.
7. Type F reorganizations involve the recapitalization of corporations.
8. Type G reorganizations involve a transfer by a corporation of part or all of its assets to another corporation in a Title 11 or similar bankruptcy case if the stock or securities of the transferee of the assets are distributed in a transaction qualifying under Sections 354, 355, or 356.
Each above discussed transaction must satisfy certain statutory requirements (which vary by transaction type) to qualify as a reorganization. (This article will not discuss Type D, Type F, and Type G reorganizations). Any reorganization must satisfy four non-statutory requirements: 1) a continuity of interest requirement; 2) a continuity of business enterprise requirement; 3) a business purpose requirement; and 4) a plan of reorganization requirement. A transaction that fails to qualify as one of these reorganization types is often referred to as a “failed reorganization” and generally results in a taxable transaction.
Outbound Acquisitive Reorganizations
Special Tax Treatment for Minority Shareholders
The policy behind taxing the U.S. shareholder is to tax appreciation in the shares before the shares leave the U.S taxing jurisdiction. However, the regulation drafters at the Internal Revenue Service (“IRS” or “Service”) and the Department of the Treasury recognized that an outbound transfer of shares occurs and the owners of the U.S. corporation whose shares are minority shareholders should not be subject to taxation on their shares. Thus, the outbound toll charge should not apply in these cases because there is little chance for abuse of the tax system. As a result, a limited-interest exception provides for the nonrecognition of gain on the transfer of U.S. shares to a transferee foreign corporation provided five tests are met:
1. The U.S. transferors receive 50 percent or less of the shares of the transferee foreign corporation in the exchange.
2. There is not a control group of U.S. persons with respect to the transferee foreign corporation immediately after the transfer. Under this control group test, officers, directors and 5 percent or greater shareholders of the domestic corporation may not, in the aggregate, own more than 50 percent of the voting power or value of the transferee foreign corporation immediately after the transfer;
3. The transaction satisfies the active trade or business test, which is comprised of two parts, both of which must be satisfied: i) the transferee foreign corporation has engaged in an active trade or business outside the United States for 36 months; and ii) at the time of the exchange, neither the transferors nor the transferee foreign corporation intend to discontinue or dispose of the trade or business.
4. A U.S. transferor who owns 5 percent or more of the transferee foreign corporation immediately after the exchange must enter into a five-year gain recognition agreement. Under the gain recognition agreement, the U.S. transferor must recognize any gain deferred on the initial transfer if the transferee foreign corporation disposes of the transferred shares with five years; and
5. The value of the transferee foreign corporation is, at the time of the exchange, equal to or greater than the value of the domestic corporation.
Below, please see Illustration 1 which demonstrates how the limited interest rule applies in an international acquisition transaction.
Illustration 1.
Henry Ford, a U.S. citizen, wholly-owns and is the only officer of Ford Motor Corporation, a domestic corporation in the auto manufacturing business. In what would otherwise constitute a tax-free share for share transaction, Ford exchanges 100 percent of his shares of Ford Motor Corporation for 3 percent of the voting shares of Porsche, a German corporation, which produces sports cars.
Ford, who wants to stay in the car manufacturing business, but wants to produce highly desirable sports cars rather than bloated and oversized SUVs. Ford acquires shares of Porsche so he can gain the expertise to develop exciting desirable automobiles. Ford does not recognize taxable gain on the transaction as a result of satisfying the limited-interest exception as follows:
Henry Ford, who wants to stay in the auto manufacturing business, does not recognize gain as a result of satisfying the limited-interest exception as follows:
1. Henry Ford receives less than 50 percent of Porsche (only 3%).
2. As the only shareholder, officer or 50 percent shareholder of Ford, Henry Ford does not own more than 50 percent of Porsche, the transferee foreign corporation, immediately after the transfer (Henry Ford only owns 3%);
3. Porsche has operated for more than 36 months and neither Henry Ford nor Porsche intends to discontinue or dispose of Porsche’s trade or business;
4. By acquiring only 3 percent of Porsche, Henry Ford does not need to enter a gain recognition agreement. However, if Henry Ford acquires between 5 percent and 50 percent of Porsche, he would have to file a five-year gain recognition agreement; and
5. Assuming that the value of Porsche is, at the time of exchange, equal to or greater than the value of Ford, there will be no tax considerations.
Outbound Type A Statutory Mergers
The Type A reorganization is defined in the Internal Revenue Code as a statutory merger or consolidation. For this purpose, “statutory” refers to a merger or consolidation pursuant to local corporate law. Unde a typical state merger statute, the assets and liabilities of the target corporation are transferred to the acquiring corporation without the need for deeds or bills of sale, and the target dissolves by operation of law. See e.g., 8 Del.Code Section 251. The consideration received by the target’s shareholders is specified in a formal agreement of merger between the two companies. The shareholder may receive stock or debt instruments of the acquiring corporation, cash or a combination, cash or a combination of all three. A consolidation involves a similar transfer of the assets and liabilities of two corporations to a newly created entity followed by the dissolution of the transferor corporations, and the shareholders of the transferors become shareholders of the new entity by operation of law. Either transaction typically requires approval by a simple majority or two-thirds vote of the shareholders of both corporations, and under state corporate law dissenting shareholders often are granted the right to be bought out for cash at a price determined in an appraisal proceeding.
In the context of international corporate acquisitions, tax-free statutory mergers often take the form of forward triangular mergers, (which will be discussed in more detail below), in which the acquired corporation is merged into a subsidiary of the acquired corporation; these mergers must meet the requirements of Internal Revenue Code Section 368(a)(2)(D). International tax-free statutory mergers may also take the form of reverse triangular mergers, (which will be discussed in more detail below) in which a subsidiary of the acquiring corporation is merged into the acquired corporation; these mergers must meet the requirements of Internal Revenue Code Section 368(a)(2)(E).
Although the IRS has previously taken the position that Type A mergers could not occur with a foreign corporation, sometime ago the Service relaxed its position and Type A mergers may occur with foreign corporations. See Treas. Reg. Section 1.368-2(b)(1)(iii)(Ex. 13).
Below, please see Illustration 2 which demonstrates a Type A merger in the outbound international context.
Illustration 2.
Assume that Airbus, a French corporation is an aircraft manufacturer. Airbus would like to increase the safety of its planes. Airbus learned that Boeing, a U.S. corporation, has developed what it believes is the world’s safest plane, the 737 MAX. Airbus acquires Boeing so it can acquire exclusive rights to manufacture the 737 MAX. Boeing, U.S. Target merges with and into Foreign Acquirer, Airbus. Further assume that Boeing’s shares are worth $1 billion at the time of the merger and that Boeing’s shareholders have $ million of basis in their shares and that the Boeing’s shareholders receive Airbus shares with a fair market value of $1 billion. A merger has occured between a U.S. and foreign corporation and that the merger qualifies as a Type A merger. Since the merger involves a foreign corporation acquiring a U.S. corporation, pursuant to the outbound toll charge, gain recognition would result by treating Foreign Acquirer as if it were not a corporation. Unless the limited interest exception (discussed above applies), Boeing’s shareholders should recognize gain of $9,000,0000 (the $1 billion fair market value of Foreign Acquiror’s shares less the $1 million basis in their shares of U.S. Target).
A merger that does not qualify as a Type A merger is taxed as a taxable transfer of the target corporation’s assets and liabilities to the acquiring corporation in exchange for the merger consideration, followed by a liquidation of the target corporation. Unless, the acquirer owns 80 percent of the U.S. target corporation. In some cases, this type of acquisition would qualify for tax-free treatment.
Outbound Type B Share-For-Share Acquisition
Under the Internal Revenue Code, 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. The concept of “control” is defined in Internal Revenue Code Section 368(c) as “the ownership of stock possessing 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 the corporation.” Type B reorganizations establish two basic requirements for a valid, tax free stock-for-stock reorganization. First, “the acquisition” of another’s stock must be “solely for * * * voting stock.” Second, the acquiring corporation must have control over the other corporation immediately after the acquisition. In Type B reorganizations, the outbound toll charge would apply to treat the foreign corporation as if it were not a corporation and, thereafter, result in gain recognition, unless the limited-interest exception applies.
As with domestic Type B reorganizations, in the international context, 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. The outbound toll charge would apply to treat the foreign corporation as if it were not a corporation and, therefore, result in gain recognition, unless the limited-interest exception applies.
Below, please see Illustration 3 which demonstrates a Type B share acquisition in the international context.
Illustration 3.
Assume that Jaguar, a British automaker is suffering from quality issues. In order to obtain the knowhow to build a “quality” automobile, Jaguar wishes to acquire the U.S. automaker Chrysler. Jaguar believes that Chrysler’s quality is superior to its own quality. Chrysler is a U.S. corporation and a U.S. Target for mergers and acquisition purposes. Further assume that Chrysler’s single class of voting shares is worth $1 billion. Finally, assume that Jaquar, the foreign acquirer issues $1 billion worth of foreign acquirer voting shares to the U.S. Target’s U.S. shareholders in exchange for their U.S. Target shares. The share exchange should qualify as a Type B acquisition. However, pursuant to the outbound toll charge, gain recognition would result by treating the foreign acquirer as if it were not a corporation. Unless the limited interest exception applies, U.S. target’s U.S. shareholders should recognize gains in the amount of the fair market value of the foreign acquirer shares received over their basis in their U.S. target shares. However, if Jaguar provided $1 cash, the solely for voting shares requirement would not be satisfied and the transaction would become a failed reorganization. Consequently, U.S. Target’s U.S. shareholders would still recognize capital gain in the amount of the fair market value of the Foreign Acquirer’s shares received over their basis in their U.S. target shares.
Outbound Type C Share For Asset Acquisition
Type C reorganizations are known as “practical mergers” because their end result is generally the same as a merger. The only difference may be the form of the transaction under local corporate law. In a statutory or Type A merger, all the assets and liabilities of the target are absorbed by the acquiring corporation automatically, while an acquisition technically requires a “transfer” of assets and liabilities under a negotiated agreement and does not necessarily require the target to sell all of its assets or to liquidate.
Despite their similarities in form, it is far more difficult to qualify as a Type C stock-for assets exchange than a Type A statutory merger because of the more stringent consideration requirements. Internal Revenue Code Section 368(a)(1)(C) requires the target to transfer “substantially all” of its assets solely in exchange for voting stock of the acquiring corporation. Although “voting stock” has the same meaning for Both B and C reorganizations, the term “solely” in Section 368(a)(1)(C) is subject to two important exceptions. First, the assumption of liabilities by the acquiring corporation (or the taking of property subject to liabilities) is not treated as disqualifying boot. See IRC Section 368(a)(2)(B). Second, a “boot relaxation rule” permits the acquiring corporation to use up to 20 percent boot, but this purpose the transferred liabilities are considered as cash consideration. See Rev.Proc. 77-37, Section 3.01 1977-2 C.B. 568, 569. A transaction thus can qualify as a Type C reorganization when the consideration consists of a substantial amount of debt relief as long as no other boot is used and sufficient voting stock is transferred to maintain continuity of interest.
In the international context, a Type C acquisition involves the acquisition by a corporation for 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. In determining whether the exchange is solely for voting shares, the acquirer’s assumption of the target’s liabilities is disregarded.
Below, please see Illustration 4 which demonstrates a Type C reorganization in the international context.
Illustration 4.
Assume Foreign Acquirer, Alibaba acquires U.S. Target’s, Amazon assets for Alibaba’s voting shares. Further assume that Amazon subsequently distributes Alibaba’s shares to its shareholders in liquidation. As a result, the transaction should qualify as a Type C acquisition. However, the outbound toll charge requires U.S. Target’s shareholders to recognize gain on the transfer of assets to Alibaba unless the limited interest exception applies.
As described above, a Type C acquisition is subject to a voting shares requirement, similar to Type B’s solely for voting shares requirement. However, unlike Type B acquisition rules, the Type C acquisition rules provide for a boot relaxation rule, which allows up to 20 percent of the consideration to take the form of non-stock consideration. If the boot relaxation rule applies, liabilities are no longer ignored, but are included in the calculation as boot. Thus, even if Amazon had significant liabilities incurred in the ordinary course of business, the transaction would still be a good Type C acquisition.
Outbound Forward Triangular Reorganizations
The three basic types of reorganizations offer rather limited flexibility if the acquiring corporation desires to operate the target as a wholly owned subsidiary. Assume for example, that Parent Corporation (“P”) wishes to acquire Target Corporation (“T”) and keep T’s business in a separate corporate shell for nontax reasons. Although this objective could be met by a Type B reorganization, the stringent “solely for voting stock” requirement might be an insurmountable obstacle if P desired to use nonvoting stock as consideration or if a large number of T shareholders were unwilling to accept any class of P stock. Even the flexible A reorganization may not be feasible from a nontax standpoint. P may not wish to incur the risk of T’s unknown or contingent liabilities which would remain P’s responsibility even if T’s assets were dropped down to a subsidiary. P also may be reluctant to bear the expense and delay of seeking formal shareholder approval of a merger or unwilling to provide both P and T shareholders with the appraisal rights to which they would be entitled under state law.
To maneuver around these problems, corporate tax planners have developed other acquisition methods involving the use of a subsidiary. One approach is for P to acquire T’s assets in a qualifying Type A or C reorganization and immediately drop down acquired assets to a newly created subsidiary. An alternative is for P to transfer its shares to a new subsidiary (“S”), and then cause T to merge directly into S, with the T shareholders receiving P stock and, perhaps, other consideration in exchange for their T stock. Or P could form S and have S acquire substantially all of the assets of T in exchange for P voting stock.
Eventually, the Internal Revenue Code added Section 368(a)(2)(C), which provides that an otherwise qualifying Type A, Type B, or C reorganization will not lose its tax-free status because the acquiring corporation drops down the acquired assets to a subsidiary. The Internal Revenue Code also permits the acquired corporation in a Type B or C reorganization to use the voting stock of its parent to make the acquisition. For both drop downs and triangular reorganizations, Internal Revenue Code Section 368(b) provide that the controlling parent will be a “party” to the reorganization.
Forward Triangular Mergers
A forward triangular reorganization occurs in the international context, when an acquirer uses the shares of the parent as merger consideration when the target merges into the acquiror, resulting in the acquiror receiving substantially all of the target’s assets. See IRC Section 368(a)(2)(D). For example, Internal Revenue Code Section 368(a)(2)(D) permits S to acquire T in a statutory merger, using P stock as consideration, provided that: 1) S acquires “substantially all” of the properties of T; 2) no stock of S is used in the transaction; and 3) the transaction would have qualified as a Type A reorganization if T had merged directly into P. It is now clear that the “could have merged with parent” test merely requires the transaction to pass muster under the continuity of interest doctrine. As a result, T shareholders only must receive at least 50 percent P stock (voting or nonvoting) under the Service’s continuity guidelines, allowing the parties the freedom to use up to 50 percent cash and other nonequity consideration. Of course, the T shareholders who receive boot must recognize their realized gain to that extent, but those who receive solely stock will enjoy nonrecognition if the transaction qualifies under these standards.
Below, please see Illustration 5 which demonstrates a forward triangular merger.
Illustration 5.
Assume that Foreign Parent, a publicly traded corporation, wished to acquire U.S. Target’s business, but does not want to incur the expense of obtaining its own shareholders’ approval for a straight merger of U.S. Target into Foreign Parent. Further, assume that Foreign Parent forms a wholly-owned subsidiary, U.S. Acquiror, for the purpose of obtaining U.S. Target’s business. Finally, assume that U.S. Target merges with and into U.S. Acquiror, with U.S. Target’s shareholders receiving Foreign Parent’s shares as the merger consideration and the U.S. Acquiror surviving the merger. This should qualify as a forward triangular reorganization. Although the forward triangular reorganization rules require a merger that “would have qualified” as a Type A merger, the IRS provides guidance that this qualifies as a forward triangular reorganization. However, the U.S. Target’s shareholders should recognize gain unless the limited interest exception applies.
Reverse Triangular Mergers
A reverse triangular reorganization is similar to a forward triangular reorganization, except that the surviving entity is the target and not the acquiror. In addition, the parent stock issued as merger consideration must be voting stock and must constitute at least 80 percent of the merger consideration. Moverover, after the transaction, the surviving target holds substantially all of its own and the acquirer’s properties and former shareholders of the surviving target exchange their shares for shares of the acquirer’s parent. For example, Internal Revenue Code Section 368(a)(2)(E) provides that this type of reverse merger will qualify as a tax-free reorganization if: 1) the surviving corporation (T) holds substantially all of the properties held by both corporations (T and S), and (2) the former T shareholders exchange stock constituting “control” (measured by the 80 percent tests in Section 368(c)(1) for P voting stock. The Internal Revenue Code borrowed from its bag of requirements (from other merger provisions) and combined tests from Type A (merger), Type B (control) and Type C (substantially all of the properties) reorganizations.
Below, please see Illustration 6 which demonstrates a typical reverse triangular merger.
Illustration 6.
Assume that Foreign Parent, a publicly traded corporation, wishes to acquire U.S. Target’s business, but does not want to incur the expense of obtaining its own shareholders’ approval for a straight merger of U.S. Target into Foreign Parent. Further assume that Foreign Parent forms a wholly-owned subsidiary, U.S. Acquiror, as an acquisition vehicle. Finally, assume that U.S. Acquiror merges with and into U.S. Target, with U.S. Target’s shareholders receiving Foreign Parent shares as the merger consideration and with U.S. Target surviving the merger. This merger should qualify as a reverse triangular reorganization. However, the U.S. Target’s U.S. shareholders should recognize gain unless the limited interest exception applies.
Conclusion
The area of cross-border transfers and reorganizations is an incredibly complicated area. The professionals at Diosdi Ching & Liu, LLP have substantial experience assisting our clients with international tax transactions.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
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.