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 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. There are two important requirements for a Type B reorganization. First. The purchasing corporation must control the target corporation immediately after the stock acquisition from the target shareholders. “Control,” for purposes of Internal Revenue Code Section 368 typically requires ownership 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 classes of stock.” See IRC Section 368(c). Second, 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. In other words, the only consideration that may be used in a Type B reorganization is voting stock of the acquiring corporation or its parent. (the one exception to this rule is if cash is used to pay a small fractional share interest).
To satisfy the “control” requirement in Section 368(a)(1)(B), P must be in control after the stock-for-stock exchange, but P is not required to acquire 80 percent or more of T’s stock in a Type B reorganization. The final step of a “creeping” acquisition thus may qualify as a Type B reorganization of voting stock are “old and cold.” Whether or not an earlier cash acquisition is “old and cold” is usually a factual question, but the regulations assume acquisitions are related if they take place over a relatively short time span (e.g., 12 months) but not if they are separated by very long intervals. See Treas. Reg. Section 1.368-2(c).
The rigid requirements for a Type B reorganization have placed considerable pressure on the definition of “voting stock.” Although the term is not specifically defined in the Internal Revenue Code, “voting stock” has been interpreted to require an unconditional right to vote on regular corporate decisions (election of directors, shareholder proposals, etc) and not merely extraordinary events such as mergers or liquidations. See Treas. Reg. Section 1.302-3(a). The class of stock transferred is immaterial provided that it has voting rights. Although the United States Supreme Court has held that hybrid equity securities, such as warrants to purchase additional voting stock, do not constitute voting stock, contractual rights to receive additional voting stock may qualify.
The Internal Revenue Service (“IRS”) has allowed the parties to a Type B reorganization some flexibility despite the stringency of the voting stock requirement. For example, the “solely” requirement is not violated if the acquiring corporation issues cash in lieu of fractional shares. The acquiring also may pay the target corporation’s expenses (e.g., registration fees, legal and accounting fees and other administrative costs) related to the reorganization, but payment of legal, accounting or other expenses of the target’s shareholders are not permitted. See Rev.Rul. 73-54, 1973-1 C.B. 187.
A particular challenge in planning a Type B reorganization involves shareholders of the target who insist on receiving cash. If the acquiring corporation pays cash directly to these dissenters, the transaction will violate the solely for voting stock requirement and all the target’s shareholders must recognize taxable gain and the transaction will not qualify for tax-free treatment. But the IRS permits the target to redeem the shares of dissenters prior to a valid Type B reorganization provided that the cash does not emanate from the acquiring corporation and continuity of interest requirements are satisfied. Another possible approach might be for the transaction to proceed as a stock-for-stock exchange, followed by a later redemption of the acquiring corporation stock held by dissenters.
Triangular Reorganizations
In a basic acquisitive reorganization transaction discussed above, only two corporate parties- a target corporation (T) and a purchasing corporation (P) are involved. Such basic reorganization exchanges sometimes are inadequate to meet the needs of the parties to certain acquisition transactions. For a number of reasons, a purchasing corporation may not want to own the assets of T or stock directly. Instead, T may wish for the stock or assets of T to be owned by a subsidiary. A triangular reorganization typically involves three corporations- a target (T), a parent (P), on one side of the transaction and a subsidiary (S) on the purchaser side of a transaction.
Under case law interpreting early versions of statutory reorganization provision, P’s acquisition of T stock and assets followed by an immediate contribution of the T stock or assets to a P subsidiary was not eligible for tax-free treatment. Eventually, Congress added a special rule in Section 368(a)(2)(C) of the Internal Revenue Code providing that a transaction otherwise qualifying as a Type B reorganization will not be disqualified from tax-free treatment if the stock acquired is transferred or “dropped-down” to a subsidiary. In addition, the definition of “party to a reorganization” was amended to insure that P would be considered a “party” in this drop-down type transaction. The stock may be dropped down to second-tier as well as first-tier subsidiaries of the parent acquiring the corporation.
In the Type B triangular reorganization, T shareholders transfer T stock to P’s subsidiary solely in exchange for P voting stock. The consideration must be entirely voting stock of the acquiring corporation (S) itself or entirely voting stock of the parent of the acquiring corporation (P). T shareholders who receive P stock are entitled to nonrecognition of tax through the transaction. S will also be entitled to nonrecognition treatment upon the exchange of P shares for T shares through a triangular reorganization. What about the tax consequences to P? P was not directly involved in the exchange, which technically took place between T and S. Nevertheless, P’s stock was used in the exchange and it is the parent corporation now indirectly in control of T through its subsidiary. The regulations under Internal Revenue Code Section 1032 treat the transfer of P shares by S “as a disposition by P of shares of its own stock for T’s…stock.” See Treas. Reg. Section 1.1032-2(b). Thus, P is entitled to nonrecognition of tax after the transaction.
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.