Merger Qualifies as Tax-Free A Reorganization, Despite Surviving Corporation's Immediate Sale of Assets

Manufacturing corporation P is organized under the laws of state A. T is also a manufacturing corporation organized under A's laws. P organizes corporation S as a wholly owned A subsidiary of P, and S merges with (and into) T in a statutory merger. In the merger, the shareholders of T holding 90% of the T stock exchange their T stock for P voting stock. The remaining T shareholders receive $y for their T stock. Immediately after the merger and as part of a plan that includes the merger, T sells 50% of its operating assets for $z to X, an unrelated corporation. After the sale of the assets to X, T retains the sales proceeds. Without regard to the requirement that T hold substantially all of the assets of T and S, the merger satisfies all the other requirements applicable to reorganizations under Sec. 368(a)(1)(A) and (a)(2)(E).

Analysis

Sec. 368(a)(1)(A) states that the term "reorganization" means a statutory merger or consolidation. Sec. 368(a)(2)(E) provides that a transaction otherwise qualifying under Sec. 368(a)(1)(A) will not be disqualified by reason of the fact that stock of a corporation (the controlling corporation) that, before the merger was in control of the acquiring corporation, is used in the transaction, if (1) after the transaction, the corporation surviving the merger holds substantially all of its properties and the properties of the merged corporation (other than stock of the controlling corporation distributed in the transaction) and (2) in the transaction, former shareholders of the surviving corporation exchanged, for an amount of voting stock of the controlling corporation, an amount of stock in the surviving corporation that constitutes control of such corporation.

Regs. Sec. 1.368-2(j)(3)(iii) provides that the term "substantially all" has the same meaning as in Sec. 368(a)(1)(C). Rev. Rul. 88-48 held that the requirement of Sec. 368(a)(1)(C) that the acquiring corporation acquire "substantially all" of the properties of a target corporation is satisfied when, immediately prior to the target corporation's transfer of assets to the acquiring corporation, the target corporation sells 50% of its historic assets to unrelated parties for cash and immediately transfers that cash, along with its other properties, to the acquiring corporation. Sec. 368(a)(2)(E) uses the term "holds" rather than the term "acquisition," as do Sec. 368(a)(1)(C) and (a)(2)(D), because it would be inapposite to require the surviving corporation to "acquire" its own properties. The "holds" requirement of Sec. 368(a)(2)(E) does not impose requirements on the surviving corporation before and after the merger that would not have applied had such corporation transferred its properties to another corporation in a reorganization under Sec. 368(a)(1)(C) or under Sec. 368(a)(1)(A) and (a)(2)(D).

In this case, T's post-merger sale of 50% of its operating assets for cash to X prevents T from holding substantially all of its historic business assets immediately after the merger. As in Rev. Rul. 88-48, however, the sales proceeds continue to be held by T. Therefore, the post-acquisition sale of 50% of T's operating assets when T holds the proceeds of such sale along with its other operating assets does not cause the merger to violate the requirement of Sec. 368(a)(2)(E) that the surviving corporation hold substantially all of its properties after the transaction.

Accordingly, the merger qualifies as a reorganization under Sec. 368(a)(1)(A) and (a)(2)(E), notwithstanding T's sale of a portion of its assets to X immediately after the merger and as part of a plan that includes the merger.

Holding

Under these facts, a merger qualifies as a tax-free reorganization under Sec. 368(a)(1)(A) and (a)(2)(E), notwithstanding the fact that the surviving corporation sells a portion of its assets to an unrelated party immediately after the merger and as part of a plan that includes the merger.

Rev. Rul. 2001-25, IRB 2001-22

REFLECTIONS. Other recent rulings involving mergers and acquisitions include:

COBE. In Rev. Rul. 2001-24, the IRS ruled that a controlling corporation's transfer of an acquiring corporation's stock to a controlled subsidiary, following the merger of the acquired corporation into the acquiring corporation, satisfied the continuity-of-business-enterprise (COBE) requirement of Sec. 368, and did not disqualify the merger. Because the acquiring company and the controlled subsidiary are members of the controlling corporation's group, the controlling corporation will be treated as directly holding the acquiring company's businesses and assets; because the acquiring company will continue the acquired corporation's historic business following the merger, the transaction will satisfy the COBE requirement.

Control for voting stock. The Service ex-plained circumstances under which a series of integrated steps was a tax-free A reorganization and satisfied Sec. 368(a)(2)(E)'s control-for-voting-stock requirement (Rev. Rul. 2001-26). In the ruling, a tender offer and statutory merger were treated as an integrated transaction. With stock in excess of 80% of voting stock exchanged, the control-for-voting-stock requirement was satisfied and the transaction was an A reorganization, with Sec. 354 or 356 applying to each exchanging shareholder.