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An Introduction to Type A Corporate Tax- Free Reorganizations

An Introduction to Type A Corporate Tax- Free Reorganizations

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. A Type A reorganization is a reorganization that fits within the Section 368(a)(1)(A) definition.

A Type A reorganization is defined in the Internal Revenue Code as a statutory merger or consolidation. The term “statutory” refers to a merger or consolidation pursuant to state corporate law. In a typical merger, the assets and liabilities of T are transferred to P, and T dissolves by operation of law. The consideration received by T’s shareholders is determined by a merger agreement. A consolidation is a transfer of assets and liabilities of two or more existing corporations to a newly created corporation. The transferor corporations dissolve by operation or law and their shareholders own stock of the new corporation.

Continuity of Shareholder Proprietary Interest Requirement

Internal Revenue Code Section 368(a)(1)(A) does not expressly limit the permissible consideration in a merger or consolidation. It is settled, however, that a transaction will not qualify as a Type A reorganization unless the continuity of shareholder proprietary interest requirement is met. See Southwest Natural Gas Co. v. Commissioner, 189 F.2d 332 (5th Cir.1951). Unlike the Type B and C reorganizations, Congress failed to specify precise statutory requirements for the continuity of proprietary interest requirements in the case of Type A reorganizations.

Continuity of proprietary interest is central to the tax-free reorganization provisions. Taxpayers are entitled to nonrecognition treatment on a reorganization exchange since they are viewed as continuing their investment in the old, albeit modified, corporate enterprise. If investors remain invested in the modified corporate enterprise, the logic is that the transaction should not trigger immediate recognition of gain or loss. Internal Revenue Code Section 368(a)(1) includes a built-in continuity of investment requirement. The type and amount of proprietary interest that the transferor must receive to be eligible for tax-free nonrecognition treatment is defined by the statute itself. Under Section 368(a)(1)(B), for example, the exchange must be solely for all or part of the purchasing corporation’s voting stock or solely for all or part of the voting stock of the purchasing company’s parent corporation. In other words all of the consideration paid to the sellers must be in the form of voting stock; no cash consideration is permitted.

Case law provides that the continuity of proprietary interest has two components. First, the sellers must receive a “definite and material” interest in the purchasing corporation. The focus here is on the quality or type of consideration sufficient to represent a “definite and material” interest in the acquiring corporation. Voting stock of the acquiring corporation, whether common or preferred, represents a definite and material interest in the acquiring corporation. Voting trust certificates representing the purchasing corporation’s voting stock may also be sufficient. However, the continuity of interest test is not met when the transferor receives only cash and long-term bonds of the purchasing corporation.

The second component of the test focuses on the proportion of the total consideration that must come from the “definite and material” types of consideration. Some portion of the consideration may be paid in the form of cash, notes, securities, or other property without disqualifying the reorganization. However, the IRS takes the position, for purposes 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.

Post-Reorganization Continuity

Another aspect of the continuity of interest doctrine relates to the length of time that the target shareholders are required to hold their stock in the acquiring corporation. For example, assume that the shareholders of the target corporation in an otherwise qualifying merger receive only stock of the acquiring corporation but holders of 80 percent of that stock previously made a commitment to sell their shares to a third party. Does the prearranged sale violate the continuity of interest doctrine and result in a taxable sale? The McDonald’s Restaurants of Illinois case explores this issue.

In McDonald’s Restaurants of Illinois, 688 F.2d 520 (7th Cir. 1982), a group of McDonald’s franchisees were interested in being bought out for cash. For various reasons, McDonald’s preferred to acquire the franchisees’ interest as part of a stock merger. To satisfy the franchisees’ demands for cash, the merger agreement provided that the McDonald’s stock transferred to the old franchisees would be included in a registered public sale of stock for cash arranged by the purchasing corporation. Consistent with this plan, the franchisees’ corporations were first merged into numerous McDonald’s subsidiaries in exchange for McDonald’s stock. Several months later, the franchisees sold the McDonald’s stock they had received in the earlier merger for cash as part of a McDonald’s registered public stock sale.

Taking the position that the transaction was a cash purchase rather than a tax-free reorganization, McDonald’s used a cost or stepped up basis in the assets acquired. Viewing the transaction under Step-transaction analysis, the court agreed with McDonald’s, concluding that the transaction failed to satisfy the continuity of interest requirement. Integrating the various parts of the transaction together, the court concluded that the transaction was not a tax-free reorganization, but instead a cash sale. The court’s opinion in the McDonald’s case took the position that post-reorganization sales of the acquired corporation’s stock by the target shareholders should be taken into account in testing for continuity of shareholder interest.

In Yoc Heating Corp. v. Commissioner, 61 T.C. 168 (1973), involving a purchasing corporation interested in acquiring assets of a target corporation. Because of opposition from minority shareholders, the target was unable to sell its assets. Instead, the purchasing corporation acquired approximately 85 percent of the target corporation’s stock from the target shareholders for cash and notes. As the new owner of an 85 percent interest in the target, the purchasing corporation then arranged for transfer of all of the target’s assets to a newly formed subsidiary in exchange for the new subsidiary’s stock, which was distributed to participating target shareholders. Not surprisingly, the only target shareholder to participate was the purchasing corporation itself. The minority shareholders who disapproved of the asset transfer were paid cash.

The IRS took the position that the transaction was a reorganization under Section 368(a)(1)(D), which requires that the transferor, or one or more of its shareholders, have control of the new corporation immediately after the exchange. (A Section 368(a)(1)(D) reorganization is “a transfer by a corporation of all or part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders…or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction). Since the purchasing corporation was the primary shareholder of the target transferor immediately before the exchange, and since the purchasing corporation controlled the new corporation immediately after the exchange, the IRS argued that the control requirements of Section 368(a)(1)(D) were met. Under Section 362, the purchasing corporation’s basis in the target assets in a reorganization transaction should be the same as the basis of the assets in the target corporation’s hands. The purchasing corporation in Yoc Heating used an integrated transaction argument to claim that the target transferors did not have sufficient “control” immediately after the exchange to be considered a reorganization.

The court found that there was no reorganization by a parity of reasoning rooted in the judicial ‘continuity of interest’ principle application to reorganizations. In other words, it is not enough to meet the literal requirement of the Section 368 reorganization definitions; the court in Yoc Heating held that the historic shareholder must retain a continuity of proprietary interest in the newly reorganized enterprise. Since the original or historic shareholders in Yoc Heating had sold their shares for cash and were no longer invested in the reorganized corporation, the court held that the transaction was not a reorganization. Yoc Heating and McDonald’s Restaurants of Illinois tells us that participants of a Type A reorganization must take into account both post-reorganizations and pre-reorganization sales or transfers of stock into account in assessing continuity of interest.

In another case involving the continuity of interest doctrine is the Tax Court’s decision in J.E. Seagram Corp. v. Commissioner, 104 T.C. 75 (1995) which involved a take-over battle for corporate control. DuPont and Seagrams, along with several other corporations, were competing for control over the target corporation, Conoco. Each of the competitors successfully acquired substantial amounts of Conoco stock for cash. DuPont, however, was the ultimate winner, having acquired approximately 46 percent of Conoco’s stock. DuPont then arranged for a merger of Conoco into one of its subsidiaries. Conoco shareholders received DuPont stock in connection with the merger. The Conoco shareholders included in this exchange included DuPont itself (approximately 46 percent), Seagrams (approximately 32 percent), and the public (approximately 22 percent). 

Seagrams hoped to recognize its realized loss on the exchange of its Conoco stock for DuPont stock. Loss recognized was unavailable to Seagrams, however, if the transaction was classified as a tax-free reorganization and if Seagrams had received its DuPont stock as part of a “plan of reorganization.” Although the merger appeared to be a legitimate Section 368(a)(1)(A) reorganization, Seagrams argued that the transaction failed to meet the shareholder continuity of interest requirement, since only 22 percent of the participating shareholders to the merger were the original or historic shareholders who owned Conoco stock before the integrated series of events relating to the takeover battle.

The Tax Court in Seagrams took a limited view of the historic shareholder test, distinguishing Yoc Heating by observing that in Yoc Heating it was the acquiring corporation itself whose recently acquired shares were not counted towards meeting the continuity of interest requirement. Under this view of the historic shareholder continuity of interest doctrine, the shares recently acquired by the purchasing corporation should not count toward continuity of interest. Thus, DuPont’s recently acquired 46 percent of the target Conoco’s stock would not count toward continuity. On the other hand, the Tax Court in Seagrams held that the 32 percent shares held by Seagrams immediately before the merger should be counted towards meeting the continuity of interests requirement even though Seagrams had recently acquired these shares.

In the end, the Tax Court in Seagrams held that the transaction was a reorganization despite the fact that 78 percent of the transferring shareholders in the merger had recently acquired their stock in the target and, therefore, arguably were not the historic shareholders. The petitioner in Seagrams lost the case and was unable to recognize its loss from the exchange of its Conoco stock for DuPont stock. Nevertheless, the Seagrams case ultimately represents a victory for taxpayers since many acquisitive reorganizations involving recent purchases of stock for cash can qualify under the Seagrams for reorganization treatment without violating the continuity of interest requirement.

Continuity of the Business Enterprise

To qualify for a reorganization, the new corporation needs to engage in a business activity. However, the new corporation does not have to engage in an identical or similar type of business. All that is required is that there must be continuity of the business activity.

Tax Consequences of a Type A Reorganization

Assume that the target corporation T is merged into the purchasing corporation P in a state law merger that qualifies as a Type A reorganization. T shareholders who receive only P stock will have no gain or loss pursuant to Internal Revenue Code Section 354 and their basis in the P shares will be the same basis they previously had in their T shares under Section 358. Shareholders who receive P stock and boot will get tax-free treatment with respect to the stock, but will be taxable on the boot to the extent of realized gain under Internal Revenue Code Section 356. The boot will either be taxed as capital gain or as a dividend.

P will not report any gain or loss upon the receipt of assets from T as part of the merger transaction pursuant to Section 1032. P’s basis in the assets acquired from T will be the same basis as in T’s hands under Section 362(b). In effect, the transaction is viewed as if T first transferred its assets and liabilities to P in exchange for P stock and then immediately distributed the P stock to its shareholder. T has no gain or loss upon the receipt of P stock or securities under Section 361(a). In addition, T is entitled to nonrecognition even for any boot under Section 361(b), since the boot is viewed as immediately distributed to the shareholders.

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.