By Anthony Diosdi
In the corporate tax context, the term “reorganization” is a statutory term of art. Rather than providing a general definition, the Internal Revenue Code attempts to provide precise definitions for the term “reorganization” in Section 368(a)(1) with an exclusive list of seven specific types of transactions that will be considered “reorganizations.” Subparagraphs (A) through (G) of Section 368(a)(1) each provide a description of a particular reorganization transaction. Unless a transaction fits into one of the seven categories stated in subparagraphs (A) through (G), it is not a corporate reorganization.
In a Type C reorganization, the purchasing corporation acquires “substantially all of the properties” of another corporation. Thus, a Type C reorganization is often referred to as an “asset acquisition.” If the target corporation transfers less than substantially all of its assets, the transaction does not qualify as a Type C tax-free reorganization. The Internal Revenue Service (“IRS”) requires a transfer of “assets representing at least 90 percent of the fair market value of the net assets and at least 70 percent of the fair market value of the gross assets held by the target corporation immediately preceding the transfer.” See Rev.Proc. 77-37, Section 3.01 1977-2 C.B. These guidelines also provide that “all payments to dissenters and all redemptions and distributions (except for regular, normal distributions) made by the corporation immediately preceding the transfer and which are part of the plan of reorganization immediately preceding the transfer Other authorities are not as demanding.
With regard to permissible consideration paid to target shareholders, the language in Internal Revenue Code Section 368(a)(1)(C) (the rules governing Type C reorganizations) is virtually identical to the language of Internal Revenue Code Section 368(a)(1)(B) (Type B reorganizations). In each case, the statutory definition requires that the acquisition be in exchange “solely for all or part of its (the target corporation’s) voting stock (or in exchange solely for all or part of the voting stock of a corporation which is in control of the acquiring corporation).” Despite these similarities, Type C reorganizations are different in a number of ways. One unique aspect of a Type C reorganization is the treatment of the assumption of target liabilities. In a Type B reorganization, the purchasing corporation becomes the new owner of the target corporation. However, in a Type B reorganization there are no formal assumptions of the target’s liabilities; the liabilities remain with the target corporation. On the other hand, in a Type C reorganization, the purchasing corporation becomes the owner of substantially all of the target’s assets. The target corporation’s liabilities do not transfer to the acquiring corporation along with these assets unless an express agreement to assume liabilities are made part of the acquisition.
Another difference between Type B and Type C reorganizations is the so-called boot relation rule. Under Section 368(a)(2)(B) of the Internal Revenue Code, a transaction that may qualify as a Type C reorganization will not be disqualified by the addition of money or other property (boot) as long as the acquiring corporation does not acquire, solely for voting stock, target property with a fair market value of at least 80 percent of the fair market value of all of the target corporation’s property. In other words, despite the “solely for voting stock” requirement stated in Section 368(a)(1)(C), the use of consideration other than voting stock for up to 20 percent of the acquisition will not disqualify the Type C reorganization. Thus, in a case where P is acquiring 100 percent of T’s assets, as long as 80 percent of the acquisition was “solely for voting stock,” the remaining 20 percent of the assets may be acquired for other consideration or “boot.” However, the boot relation rule of Section 368(a)(2)(B) requires that at least 80 percent of all the property of the target corporation be acquired in exchange solely for voting stock. Thus, where the purchasing corporation acquires less than all of the assets, the amount of boot that will be permitted is reduced accordingly. For example, if P is acquiring 90 percent of T’s assets, only 10 percent of T’s assets may be acquired for so-called boot.
For example, let’s assume that T has $100,000 of assets and no liabilities. P acquires all of T’s assets in exchange for $80,000 of P voting stock and $20,000 cash. The transaction qualifies because P has acquired at least 80% of T’s assets solely for P voting stock.
Now let’s assume that P acquires $90,000 of T’s assets for $75,000 of P voting stock and $15,000 cash, and T retains $10,000 in its assets. The transaction does not satisfy the boot relaxation rule because P only acquires 75% of T’s assets for P voting stock.
Now let’s assume that T has $100,000 of assets and $20,000 of liabilities, and P acquires all of T’s assets in exchange for $79,000 P voting stock, $1,000 cash, and the assumption of all $20,000 of T’s liabilities. The transaction does not satisfy the boot relaxation rule because the liability assumption is treated as cash consideration and thus P only acquires 79% of T’s assets for P voting stock.
If P previously acquired more than 20 percent of T’s stock (even in an unrelated transaction) and then acquires all of T’s assets solely in exchange for P voting stock, and T distributes the P voting stock to its shareholders (other than P) in complete liquidation, one case holds that the transaction fails to qualify as a Type C reorganization. See Bausch & Lomb Optical Co. v. Commissioner, 267 F.2d 75 (2d Cir. 1959). The rationale is that P acquired more than 20 percent of T’s assets in the liquidation of T in exchange for the T stock that P previously owned. Even accepting this rationale, the transaction still may qualify under the boot relaxation rule if P owned 20 percent or less of T’s stock. If P owned more than 80 percent of T stock and acquired all of its assets in a complete liquidation of T, the transaction would qualify as a tax-free liquidation of a subsidiary under Internal Revenue Code Sections 332 and 337. Several other techniques are available to avoid the result in Bausch & Lomb.
Tax Consequences of a Type C Reorganization
Let’s assume that corporation (T) transfers all of its assets to purchasing corporation (P) solely in exchange for P voting stock. In this example, T itself is transferring its assets to P in return for P voting stock. This exchange will not be taxable to T. T’s basis in the P voting stock will be the same basis it had in the transferred assets. Since T shareholders are exchanging their T stock for P stock upon this liquidation, they also will be entitled to nonrecognition of tax treatment. The T shareholder’s basis in the stock received will be the same as the T shares surrendered in the liquidation. If the purchasing corporation takes advantage of the opportunity to pay up to 20 percent of the consideration in the form of boot, T will not be required to report any pursuant to Internal Revenue Code Section 361(b) so long as the boot is distributed to the T shareholders in pursuance of the plan or reorganization or to the creditors in connection with the reorganization. Since such distribution is required as part of a Type C reorganization, there will be no taxable gain to T upon the receipt of boot. Nor will T be entitled to deduct any losses.
Forward Triangular Mergers
If P wishes to acquire T’s assets in a tax-free acquisitive reorganization, it may be unwilling to incur the risk of T’s unknown or contingent liabilities. This risk might continue even if vP drops down T’s assets and liabilities to a P subsidiary after a merger of T into P. P also may not wish to incur the expense and delay of securing formal approval of its shareholders to a merger or direct asset acquisition. The forward triangular merger solves many of these non tax issues. In its easiest form, a forward triangular merger consists of the following steps:
1. P forms a new subsidiary, S, by transferring P stock (and possibly other consideration) for S in an exchange that is tax free under Internal Revenue Code Section 351.
2. T is merged into S under state law. T shareholders receive P stock and any other consideration provided by the merger agreement. P ordinarily does not need to secure approval from its shareholders because S is the party to the merger and P is the only shareholder of S. All of T’s assets and liabilities are automatically transferred to S, which remains a wholly owned subsidiary of P.
A forward triangular merger qualifies as a tax-free reorganization under Section 368 if the following requirements are satisfied:
1. S must acquire substantially all of the properties of T. This is the same requirement imposed on Type C reorganizations, and similar standards are applied.
2. No stock of S may be used as consideration for the merger.
3. The transaction must have qualified as a Type A reorganization if T had merged directly into P. This means that the transaction must satisfy the judicial continuity of interest requirement.
P may wish to acquire the stock of T in a tax-free reorganization and keep T alive as a subsidiary in order to preserve certain rights under state law or assets such as a lease or franchise might be lost if T is liquidated. The reverse triangular merger was developed to accommodate these situations. It consists of the following steps:
1. P forms a new subsidiary, S, by transferring P voting stock and other consideration for S stock in an exchange that is tax-free under Section 351 of the Internal Revenue Code.
2. S merges into T under state law. T shareholders receive P voting stock and any other consideration provided by the merger agreement. P exchanges its S stock for T stock. S disappears and T survives as a wholly owned subsidiary of P.
A reverse triangular merger qualifies as a tax-free reorganization under Internal Revenue Code Section 368(a)(2)9E) if the following requirements are satisfied:
1. After the merger, T must hold substantially all of its properties and the properties of S (other than the stock of P distributed in the transaction and any boot used by S to acquire shares of minority shareholders).
2. In the merger transaction, P must acquire 80 percent “control” of T in exchange for P voting stock. The remaining 20 percent of T may be acquired for cash or other boot. However, the 80 percent of T stock must be acquired for P voting stock in a single merger transaction; prior T stock held by P will not meet this requirement. Thus, the permissible consideration in a reverse triangular merger is more restrictive than in a forward triangular merger, and so-called creeping acquisitions will not qualify.
For example, let’s assume that S, a wholly owned subsidiary of P, has no assets other than P voting stock and cash. P owns no stock of T. S mergers into T. In the merger, T shareholders owning 90 percent of T stock receive P voting stock and the holders of the remaining 10 percent of T stock receive cash. T continues to hold all of its own assets. This transaction qualifies as a reverse triangular merger. Now let’s assume that P had acquired 21 percent of T five years ago in an unrelated transaction. In the merger of S into T, shareholders holding the remaining 79 percent of T stock receive P voting stock in exchange for their T stock. P does not acquire “control” of T in one transaction in exchange forP voting stock, and thus the transaction does not qualify as a reverse triangular merger.
For purposes of the “control” requirement, T stock that is redeemed for cash or T property prior to a reverse merger is not treated as outstanding prior to the reorganization even if the redemption is related to the merger. But cash and property of T used to redeem stock of dissenting shareholders is taken into account in applying the “substantially all of the properties” requirement.
For example, let’s assume that T has 1,000 shares of common stock outstanding, of which 800 shares are owned by A and 200 by B. S, a wholly owned subsidiary of P. mergers into T. In a related transaction prior to the merger, T distributes cash in redemption of B’s 200 shares. In the merger, P acquires 640 of A’s shares for P voting stock and the remaining 160 shares for cash. Since B’s shares are not treated as outstanding for purposes of determining whether P has acquired “control” of T and P voting stock, the acquisition satisfies the control requirement. But the cash used by T to redeem B’s stock is treated as a T asset in applying the “substantially all of the properties” test. See Treas. Reg. Section 1.368-2(j)(7) Ex. 3.
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.