Expansion of A Reorg. Provisions

Under Sec. 368(a)(1)(A), the term “reorganization” includes a “statutory merger or consolidation.” The statute places no restrictions on the type of consideration used, even if money is exchanged, as long as the transaction satisfies the continuity-of-interest requirement.

A statutory merger is a tax-free, type A reorganization, representing a combination of two corporations in which the continuity-of-interest requirement is met by a sufficient amount of consideration received being the surviving corporation’s stock. The A reorganization is the most flexible of all the reorganization techniques; there is no “substantially all” (of the assets) or “solely for” (voting stock) rule.

A statutory merger or consolidation was historically limited to transactions effected pursuant to the corporation laws of the U.S. (i.e., a state, a territory or the District of Columbia); the definition has not changed much since 1935.

Disregarded Entity Mergers

Treasury has been liberal in expanding the definition of an A reorganization. In January 2003 (REG-126485-01, TD 9038 (1/24/03)), it amended the regulations to expand the scope of the term “statutory merger or consolidation,” to allow limited liability companies (LLCs) to be a party to an A reorganization. Consequently, it removed the word “corporation” from the regulatory definition of statutory merger or consolidation.

Foreign vs. Domestic Mergers

In January 2005 (REG-125628-01 (1/5/05)), the IRS further expanded the scope of a statutory merger or consolidation by eliminating the requirement that the transaction be effected pursuant to domestic law. As many foreign jurisdictions now have merger statutes that operate like those of the states, under which all assets and liabilities move by operation of law, the IRS changed the definition of an A reorganization to allow transactions effected pursuant to these statutes to qualify as statutory mergers or consolidations for Sec. 368(a)(1)(A) purposes. The Service believes that these transactions should be treated as reorganizations if they satisfy the functional criteria applicable to transactions under domestic statutes.

Foreign law: The applicability of the “substantially all” and the “solely for” requirements could adversely affect an otherwise “good” foreign merger. Prop. Regs. Sec. 1.368-2(b)(1)(iii), Example (9), illustrates the changes to the definition of an A reorganization in the international context. Pursuant to Country Q’s merger statutes, Corp. Z and Corp. Y, each incorporated under Q law, combine in a transaction in which all of Z’s assets become Y’s assets; Z then ceases to exist separately.

Domestic law: Despite the fact that each of the merger participants is a foreign entity, the transaction nevertheless is a statutory merger and, thus, a good A reorganization, because both Z and Y are qualified participants, and the transaction is not divisive.

In Prop. Regs. Sec. 1.368-2(b)(1)(iii), Example (8), a merger of one domestic corporation with and into another, pursuant to the necessary state law, is an A reorganization, even though the merger was preceded by the acquired corporation’s sale of one of its two, equally sized, historical businesses. In this case, the net proceeds were distributed to the acquired corporation’s shareholders immediately before the merger. This transaction qualifies because an A reorganization, in particular, does not have a “substantially all” requirement.

New rules: Before foreign entities fell under the A reorganization provisions, the transaction in Example (9) would have been deemed a C reorganization (for unrelated parties) or a D reorganization (for related parties). In the example above, the transaction could not have qualified as a C reorganization or a forward triangular merger (by reason of Sec. 368(a)(2)(D)), or as a reverse triangular merger (by reason of Sec. 368(a)(2)(E)) if a subsidiary were involved. In each case, there is a “substantially all” (of the assets) requirement that would cause the preliminary distribution, which took place as “part of the plan,” not to qualify under the respective statutes.

By allowing tax-free treatment for cross-border mergers organized under foreign law, there will be tremendous flexibility in structuring foreign reorganizations in an increasingly global business market. Previously, such mergers were allowed only if based on domestic law. The proposed rules would also allow, for the first time, tax-free, cross-border mergers involving foreign disregarded entities, even if those transactions were structured under a foreign statute.

The proposed regulations also address many technical issues on cross-border mergers under Sec. 368(a)(1)(A), including basis and holding periods, triangular reorganizations, the application of Secs. 367 and 1248 and asset transfers. For example, they provide basis and holding-period guidelines for certain transactions involving foreign corporations with Sec. 1248 shareholders, to preserve relevant Sec. 1248 amounts.

Sec. 1248: Sec. 1248 applies to shareholders with a 10%-or-more voting power in a controlled foreign corporation. These shareholders are generally required to include in income as a dividend (to the extent of the corporation’s earnings and profits), gain they recognize on the sale or exchange of the corporation’s stock at any time during the five-year period ending on the sale or exchange date. This rule preserves Sec. 1248 amounts in certain tax-free reorganizations effectuated with foreign stock.

The proposed rules also contain basis and holding-period rules for shareholders in tax-free exchanges. They would also apply to foreign corporate shareholders whose company is involved in the reorganization, if at least one participating U.S. person is a Sec. 1248 shareholder.

Moreover, these rules attempt to coordinate the cross-border merger basis rules with recently proposed basis rules under Sec. 358, including the application of statistical sampling techniques in a B reorganization, and a choice between the “assets over” approach or carryover stock basis approach in a reverse triangular merger. The new rules also set out a complex series of additional rules on triangular mergers and address a wide range of Sec. 367 issues.

Notice 2005-6

Under Sec. 367(a), a U.S. person recognizes gain, but not loss, on a property transfer to a foreign corporation in certain tax-free exchanges, unless an exception applies. Taxpayers questioned the fact that the exceptions applied only to stock and not securities in certain tax-free reorganizations, because U.S. reorganizations permit use of both stock and securities. For the first time, Notice 2005-6, which was issued concurrently with the new regulations, treats U.S. and foreign reorganizations comparably, allowing both stock and securities to qualify for tax-free treatment if either or both are received in exchange for each other.

Domestic Changes

The proposed regulations also provide several examples of transactions that will not meet the expanded definition of a statutory merger or consolidation. In Prop. Regs. Sec. 1.368-2(b)(1)(iii), Example (1), a transfer by a corporation of only a portion of its assets to another corporation, defined as a merger under local law, is not a statutory merger or consolidation, because it is “divisive” in nature.

Prop. Regs. Sec. 1.368-2(b)(1)(iii), Example (5), clarifies that there is no A reorganization when the acquiring entity is an LLC owned by a partnership, and partnership interests are transferred to the shareholders of the acquired corporation that merged with and into the LLC. In this case, there is no qualified entity on the acquiring side of the transaction.

In Prop. Regs. Sec. 1.368-2(b)(1)(iii), Example (3), an S corporation with a qualified subchapter S subsidiary merges into a disregarded entity of an acquiring C corporation or a disregarded entity of an acquiring C corporation subsidiary. Assuming all of the regulations for an A reorganization and a forward triangular merger are met, the transaction would be treated as a good, tax-free reorganization, followed by a deemed Sec. 351 exchange to a newly formed Sec. 368(a)(2)(C) subsidiary.

Conclusion

This taxpayer-friendly guidance should help tax advisers plan for international reorganizations with more certainty in an increasingly global economy.

From Randy A. Schwartzman, CPA, MST, Melville, NY