General Considerations
Overview
General Requirements for § 368
Reorganizations
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 To be a tax-free reorganization, the following requirements must be met,
regardless of the form of the transaction:
 Continuity
of interest IRS Reg.
Sec. 1.368-1(e)
("COI")
- Doctrine requires that a substantial percentage of
merger
consideration be Parent (or Buyer) stock
-
Typically at least 50%, but sometimes as low as 40%
- Target shareholders are free to dispose of the Parent
(or
Buyer)
stock following the transaction
-
Even pursuant to binding commitments entered into in anticipation of
the transaction
- As 1998 IRS regulations shifted focus of this
test
- Now look solely to the amount of stock consideration
in the
transaction
- Before, used to consider post-transaction dispositions
by
Target shareholders
- IRS Final Regulations
1.28.98
- COI
is a judicially created doctrine
- Required Target shareholders to retain some element of equity
participation in the surviving or continuing enterprise to be a
reorganization
- Nelson v. Helvering 296 US 374 (1935) - held at least 38% of package of
consideration must be stock
- In a cash election, Target shareholders can elect different mixes of
cash or stock subject to aggregate constraints
- IRS has proposed regulations so that if the number of
Buyer
shares is fixed, their value will now be measured at the date of the binding agreement, not at closing
- Tender offers are eligible for this treatment
- Proposal doesn't cover floating exchange ratios or
earnouts
-
IRS Proposed Regulations
Rev. Bull. 2004-37 8.10.04
-
IRS
explanation
Continuity
of business enterprise
- Buyer must continue at least one significant line of Target's
historic business,
or
- Buyer must use a significant portion of Target's historic
business assets in a business
Control
- Some IRC corporate reorganization and liquidation provisions
require one corporation to be in control of another corporation
- Per IRC 368(c), control of a corporation is
defined as the ownership of:
- Stock possessing at least 80% of the combined voting power
of all classes of stock entitled to vote,
and
- At least 80% of the total number
of shares of all other classes of stock
- Interpreted to require ownership of at least 80% of the number of shares
of each class of nonvoting stock
- voting power is defined
as the power to elect directors
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Other Requirements for § 368 Reorganizations
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Substantially All the Assets
- Applies to certain transactions,
per judicial decision and IRS
rulings and practice
- For advance ruling purposes, defined by IRS as Target assets having
a fair market value of:
- At least 90% of the fair market value of all of Target's assets
less liabilities, and
- At least 70% of the fair market value of all of Target's assets
without regard to liabilities
- Cases allow lesser percentages to satisfy this test
- Can complicate post-merger asset
divestitures
Step Transaction doctrine
- Judicially created: an ostensibly independent series of steps
can be
aggregated for tax purposes
- Example. Corporation A acquires all the
outstanding stock of Corporation B in exchange for
A stock and immediately liquidates
B. This transaction is equivalent to, and under the step transaction
doctrine is taxed as, A's acquisition of all the assets of
B in exchange
for A stock and the assumption by
A of
B's liabilities with
B dissolving
and distributing the A stock to the former
B shareholders
- Two or more transactions can be integrated for tax purposes when:
- Binding commitment test: if at the time of the first transaction there exists a
binding commitment to undertake the second
-
Mutual interdependence test: if
the legal relationships created by the first transaction would be
meaningless or fruitless without completion of the second
-
End result test:if there is
intent to undertake ostensibly independent transactions in order to achieve a
specific end result
Court Holding Company doctrine
- Commissioner v Court Holding Company 324 U.S. 331 1945
- similar to the
step transaction doctrine
- A series of steps can be reordered for tax purposes
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Result for Security Holders
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Per
IRC §§ 354 and
356
Target Shareholders
- No gain or loss is recognized on the receipt of
Buyer or Parent
stock in exchange for Target stock
- Gain, but not loss, is recognized to the extent any other property,
e.g., cash or Buyer or Parent indebtedness, is received
- Any recognized gain is recharacterized as ordinary income if the
distribution of such other property has the effect of distribution of a
dividend
- A right to receive contingent or escrowed stock is regarded as stock,
and not other property, if the IRS specified conditions are satisfied
- Gain recognized with respect to the receipt of indebtedness may in some
circumstances be reportable under the installment sale method
- The basis of Buyer or Parent stock received by a Target shareholder
is generally equal to such shareholder's basis in the surrendered Target
stock
- Any other property received will ordinarily have a fair market value basis
Other
Target Securityholders
- Not always clear whether a particular Target debt instrument is a
security for reorganization purposes
- Generally, less than five year debt
is not a security, while greater than ten year debt
is
- Gain, but not loss, is recognized to Target securityholders upon receipt
of Buyer or Parent securities equal to the fair market value of the
amount by which the principal amount of securities received exceeds the
principal amount of the Target securities
- Under the original issue discount rules, adjusted issue price is used in place of principal amount
- Buyer or Parent debt issued to the former Target security holders can
have original issue discount, even where
the Target debt did not
- e.g., where the newly issued debt initially
trades publicly at a discount or where none of the debt is publicly traded and
the newly issued debt bears interest at a rate less than the applicable federal
rate
- Basis of Buyer or Parent securities received tax-free in the
reorganization will generally equal the basis of the Target securities
- Any other property, including the excess principal amount (or excess
adjusted issue price) of any Buyer or Parent securities, will ordinarily
have a fair market value basis
Target Optionholders and Warrantholders
- Do not result in any transfer of property when
granted
- Accordingly, the exchangeof nonstatutory Target options for
nonstatutory Buyer or Parent options is not a taxable event
- Incentive stock options ISOs
- It is usually important that any assumption of Target ISOs or
substitution of Buyer or Parent ISOs for Target ISOs not be considered
the grant of a new option, as a newly granted ISO would need to be repriced
at the underlying stock's then fair market value
- Typical adjustment formulae based on the
exchange ratio in the reorganization will ordinarily satisfy the requirement
that the ISO holder not obtain an increase in the aggregate
spread in the holder's ISOs
- Under regulations adopted in January of 1998, non-service related
options and warrants are treated as "securities" with no principal amount
- Thus, other holders of options and warrants (e.g., prior purchasers of
debt-warrant investment units) will recognize no gain or loss upon exchange
of Target options or warrants for Buyer or Parent options, warrants or
stock
- In addition, holders of Target stock can receive a combination of
Buyer or Parent options, warrants or stock
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Result for Participating Corporations
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Per
IRC §§ 361 and
362
Target
- Target will recognize no gain or loss upon the transfer of its assets to
Buyer in an A reorganization or
C reorganization (or to Sub in a
forward triangular merger)
- In
C or triangular C
reorganizations, Target recognizes no gain upon receipt of property
other than voting stock of Buyer or Parent as long as Target distributes
that other property to its shareholders, as will generally be the case
because of the usual
C
reorganization requirement that Target liquidate
- However, Target does recognize
gain, but not loss, upon distribution to its shareholders of any
assets not transferred to Buyer
- In
B or triangular B
reorganizations, Target does not participate in any exchange, even
constructively, and therefore has no gain or loss to recognize
Buyer, Parent and Sub
- No gain or loss recognized
- In A reorganizations and
C and triangular C reorganizations,
Buyer's basis in the assets acquired from Target is generally equal to
Target's former basis in those assets. In addition, in these cases,
Buyer succeeds to Target's tax attributes (e.g., earnings and profits
and net operating loss carryovers)
- Similarly, in
forward triangular
mergers, Sub's basis in the assets acquired from Target is generally
equal to Target's former basis in those assets and Sub succeeds to Target's
tax attributes
- In
B and triangular B
reorganizations, Buyer's basis for the Target stock acquired from a
Target shareholder is equal to the Target shareholder's basis, increased by
any gain recognized by the shareholder in the reorganization
- In
B and triangular B
reorganizations and reverse triangular
mergers, Target is the surviving corporation and retains its historic
asset bases and tax attributes. In
reverse
triangular mergers Target succeeds to Sub's basis for its assets and tax
attributes, although ordinarily Sub will be a newly formed Buyer
subsidiary without assets or tax attributes
- Under regulations adopted in 1995, in triangular reorganizations the
effect of the reorganization on Parent's basis for its Buyer (or Target)
stock is generally determined as if Parent had acquired the Target assets
tax-free and then contributed them to Buyer (or Target)
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Related Topics
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