Acquisition of Holding Company Assets by Less-Than-80%-Owned Subsidiary Should Satisfy COBE Requirement

The tax law is not clear as to whether the acquisition of the assets of a holding company by its less-than-80%-owned subsidiary satisfies the continuity-of-business-enterprise (COBE) requirement, a necessary element to qualify the acquisition as a tax-free reorganization. A recent Tax Court case provides additional support to the implicit direction of the IRS that such an acquisition should satisfy the COBE requirement.

For a transaction to qualify as a tax-free reorganization under Sec. 368, an acquiring corporation must satisfy the COBE requirement; see Laure, 653 F2d 253 (6th Cir. 1981), and Regs. Sec. 1.368-1(b). The acquiring corporation must either continue the acquired corporation's historic business or use a significant portion of its historic business assets. The application of this requirement to certain transactions (e.g., the merger of holding companies) depends on all the facts and circumstances.

A holding company is a corporation that holds shares in other corporations for investment purposes. It includes a parent corporation with stock ownership in subsidiary corporations sufficient to control their operations and management; see Culcal Atylco, Inc. v. Vornado, Inc., 103 Cal. Rptr. 419 (Ct. App. 1972).

In applying the COBE requirement to the acquisition of a holding company, the Service has treated the activities of a holding company's wholly owned operating subsidiary as the holding company's historic business. In Rev. Rul. 85-197, the IRS ruled that an acquiring company satisfied the COBE requirement following a merger of a holding company into its wholly owned operating subsidiary, reasoning that the holding company's historic business was also the subsidiary's historic business. Similarly, in Rev. Rul. 85-198, the Service ruled that an acquiring company satisfied the COBE requirement following a merger of two bank holding companies, because the acquiring holding company continued to indirectly operate a significant historic business through its ownership of the acquired holding company's second-tier subsidiary. Neither of these rulings mentioned the holding company's ownership of subsidiary stock as a historic business or viewed the stock as a historic business asset. Also, neither mentioned whether a similar rule would apply in the case of an acquisition of a holding company into its less-than-wholly-owned operating subsidiary.

The IRS touched on the issues implicitly in Rev. Rul. 78-47, in which an acquisition of a holding company's assets by its five-percent-owned operating subsidiary was deemed a valid tax-free reorganization under Sec. 368(a)(1)(C). Although the ruling did not discuss the COBE requirement, it implied that the company satisfied it. Perhaps the Service was comfortable looking through the holding company's five-percent stock ownership in the operating subsidiary for purposes of the COBE requirement, though a five-percent-stock-ownership interest seems rather modest for such look-through treatment. Compare Sec. 318 (attribution rules based generally on stock ownership of 50% or more) with Sec. 304(c) (a more stringent application of the same attribution rules, but based on stock ownership of five-percent or more). More likely, the IRS viewed the holding company's ownership of stock in the operating subsidiary as a historic business asset of the holding company that the subsidiary somehow continued after its acquisition of the holding company's assets. These, though, are merely impressions drawn from the ruling.

The Service touched on the same issues in Letter Ruling 9506036. In the ruling, a Target (a holding company) was also the parent of a consolidated group. Target and its subsidiaries were engaged in Business A. The Target group collectively owned less than 80% of the stock in Acquiring, a company engaged in Businesses B and C. Target proposed a series of transactions, the effect of which would be a pre-acquisition disposition of its group's A assets, followed by transfer of the remaining assets (the stock in Acquiring and cash) to Acquiring in exchange for Acquiring's stock. The target would liquidate after the exchange, distributing the newly acquired stock to its shareholders. Relying on Gilmore's Estate, 130 F2d 791 (3rd Cir. 1942), aff'g 44 BTA 881 (1941), acq., 1946-2 CB 5, and Rev. Ruls. 85-197 and 85-198, the IRS ruled that the proposed series of transactions qualified as a valid reorganization under Sec. 368(a)(1)(C).

Recently, the Tax Court provided helpful counsel on the same issues. In Honbarrier, 115 TC No. 23 (2000), it had to decide whether the COBE requirement was met in a merger of two corporations. The target corporation had sold its trucking business assets and invested the proceeds of the sale in tax-exempt bonds. The court reasoned that the target corporation was in the historic business of investing for COBE purposes. Admittedly, the target corporation in Honbarrier was not a holding company with respect to the acquiring corporation. However, there is no good reason not to apply this rationale to a case in which the target corporation is a holding company.

Thus, Honbarrier should support a position that a holding company can be in the business of investing, even investing in the stock of its operating subsidiary. With that support, and the implications of Rev. Rul. 78-47 and Letter Ruling 9506036, the acquisition of a holding company's assets by its less-than-80%-owned subsidiary should satisfy the COBE requirement, and aid the acquisition in qualifying as a tax-free reorganization.

From Sahel Assar, Washington, DC