The three basic types of reorganization (Type A, Type B, and Type C) offer rather limited flexibility if the acquiring corporation desires to operate a target corporation 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 non tax reasons. Although this objective could be satisfied by a Type B reorganization, the difficult “solely for voting stock” requirement may be an obstacle if P wants to utilize non voting stock as consideration or if a significant number of T shareholders are unwilling to accept any class of P stock. An A reorganization may also not be feasible in all cases. Suppose that P does not wish to incur the risk of T’s unknown liabilities which it would assume if T’s assets were dropped down into a subsidiary through a Type A reorganization.
To get around these problems, P may want to acquire T’s assets in a qualifying Type A reorganization and immediately drop these assets into a newly created subsidiary. In the alternative, P could transfer stock to a new subsidiary (“S”) and then cause T to merge directly into S, with the T shareholders receiving P stock and other consideration in exchange for their T stock. The tax consequences of these and other triangular acquisition techniques are often used to acquire target corporations tax-free. Section 368(a)(2)(C) provides that an otherwise qualifying Type A reorganization will not lose its tax-free status merely because the acquiring corporation drops down acquired assets to a subsidiary and it is later added to a transaction that is similar to a Type B reorganization. (Section 368 permits the acquiring corporation to use voting stock of its parent to make the acquisition).
Forward Triangular Mergers
From the time it was authorized as a tax-free reorganization, the forward triangular merger has become one of the most widely used acquisition techniques. 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. In determining whether the “substantially all” requirement is met, one should look at the entire integrated transaction; 2) The second requirement for a Type A forward triangular merger is that no stock of the acquiring corporation (S) be used in the transaction. Thus, the stock consideration used is limited to P stock; it will not be possible to use a mixture of P and S stock as consideration in a forward triangular merger.
The final requirement for a Type A forward triangular merger is that the transaction would have qualified as a Type A reorganization if it had been a merger of T directly into P. See IRC Section 368(a)(2)(D)(ii). The transaction would have qualified as a Type A reorganization if T had merged directly into P. The “could have merged with parent” test requires that the transaction to satisfy the continuity of interest requirement rule. See Treas. Reg. Section 1.368-2(b)(2). As a result, T shareholders should receive at least 50 percent P stock (voting or nonvoting). This allows the parties the ability to use up to 50 percent cash and other non equity consideration.
What about the tax consequences to P and S? The “right answer” appears to be nonrecognition for both corporations on the acquiring side of the corporation, yet the Internal Revenue Code is not clear with respect to the proper tax treatment for P and S. Non Recognition under Section 1032 technically applies only upon the corporation’s use of its own stock. The regulations under Section 1032 provide that no gain or loss is recognized to S or P in a forward triangular merger, except to the extent that S uses P stock in the transaction that it did not receive from P under the reorganization plan. See Treas. Reg. Section 1.1032-2. T’s assets will retain their basis as in a basic Type A merger.
Another issue in a forward triangular Type A merger is P’s merger is P’s basis in its S stock after the merger. Under the Section 1.358-6 regulations, P’s basis in its S stock is adjusted as if P first received the T assets and liabilities through a direct merger of T into P and subsequently P transferred the T assets and liabilities to S in a Section 351 transaction. See Treas. Reg. Section 1.358-6(c)(1). In other words, in a Type A forward triangular merger, we must assume that P had first done a Type A merger in which P acquired all of T’s assets and liabilities with a substitute basis in these assets. Next, we should assume that P contributed these assets and liabilities in a subsequent Section 351 nonrecognition transaction in which P’s basis in the S stock is equal to the basis of the assets transferred under Section 358. Consequently, P’s basis in its S stock will include the basis of T’s assets please any basis that P previously had in the S stock.
Reverse Triangular Mergers
Before examining the tax consequences of a reverse triangular merger, the transaction itself must be explained. Suppose P desires to acquire the stock of T in a tax-free reorganization and keep T as a subsidiary, but P is unable to structure the transaction as a Type B reorganization because of the “solely for voting stock” requirement. One approach to this dilemma is for P to create S, contributing to its P voting stock, and then for S to merge into T under an agreement providing that T shareholders will receive P stock (and, possibly, other consideration) in exchange for their T stock.
Internal Revenue Code Section 368(a)(2)(E) provides that a Type A reverse triangular will qualify as a tax-free reorganization if: 1) the surviving corporation (T) holds substantially all of the properties formerly held by both corporations (T and S), and 2) the former T shareholders exchange stock constituting “control” (measured by an 80 percent test promulgated by Section 368(c)(1)) for P voting stock. See IRC Section 368(a)(2)(E)(ii).
Although forward and reverse triangular Type A reorganizations share several characteristics in common, there are several differences. One inexplicable difference is that the use of S stock as consideration to the T shareholders is expressly prohibited in the former, while permitted in the latter. Another significant difference between a Type A forward and reverse reorganization is the requirement in the case of reverse Type A mergers, that the P stock used to acquire the 80 percent control over the target be voting stock.
As for the tax consequences, the T shareholders exchanging T stock for P stock in the Type A reverse triangular merger are entitled to nonrecognition pursuant to Section 354 and are subject to the Section 356 boot rules. T, as the surviving corporation, is receiving S assets upon the merger of S into T. As a result, there should be no gain or loss on the receipt of these assets. When P contributes its stock and other assets to S to be used as consideration to the T shareholders, there will be no gain or loss to P pursuant to Section 351 and no gain or loss to S should be recognized. Thus, when S is merged into T, there are no tax consequences to S. Its assets simply transfer to T along with their historic bases. P should receive nonrecognition treatment upon the receipt of T stock pursuant to Section 1032 of the Internal Revenue Code.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or 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.
