Favorable ruling on gain exception but not tax-free reorganization
In PLR 201935004 the IRS ruled on the application of the exception to gain recognition of section 367(a)(1) to a purported tax-free reorganization. However, the ruling was silent on the overall tax-free nature of the transaction; leaving the taxpayer to conclude on certain aspects of the reorganization such as the substantially all requirement.
The reorganization and fluctuation in value
The ruling involved the two-step merger of a domestic target corporation (T) with and into the foreign acquiring subsidiary (FA) of a publicly traded foreign corporation (FP) in a transaction intended to represent a tax-free reorganization pursuant to section 368(a)(2)(D). The transaction was likely structured as a two-step merger to alleviate the risk of corporate level gain if the transaction failed to satisfy the requirements of section 368(a). 1
Because the reorganization involved the transfer of appreciated stock of a U.S. corporation by U.S. persons to a foreign corporation, the reorganization would result in a taxable exchange under section 367(a)(1), unless the exceptions of Reg. section 1.367(a)-3(c)(1) are met. One of those exceptions requires that the U.S. persons transferring the stock must hold 50 percent or less of the vote and value of the foreign transferee corporation’s stock. In the ruling, between the time the parties entered into the merger agreement and submission of the ruling, the value of FP common stock had dropped to a point where, due to the mix of common and preferred stock issued in the merger, T shareholders could end up with greater than 50 percent of the value of FP after the merger.
As a result of the drop in value of FP common stock, the taxpayer sought a ruling from the IRS that the fluctuation of value between the merger agreement date and the transaction date would not cause the reorganization to fail the exception to section 367(a)(1) gain recognition. Based upon taxpayer representations, including that the transaction will qualify as a reorganization pursuant to section 368(a)(2)(D), the IRS ruled that, upon entering into a gain recognition agreement, the transaction satisfied the exceptions to the section 367(a)(1) gain recognition provision.
What the ruling didn’t say
As mentioned above, the ruling was based upon the representation that the two-step merger will qualify as a section 368(a)(2)(D) reorganization. Reorganizations pursuant to section 368(a)(2)(D) must meet certain statutory and regulatory requirements including:
1. Continuity of interest and continuity of business enterprise;
2. Business purpose;
3. The merger must occur pursuant to state (or foreign) law whereby the target merges with and into a direct subsidiary of the acquiring corporation and ceases to exist; and
4. Substantially all assets of the target are acquired by the subsidiary corporation.
Based upon the limited facts in the ruling, there could be cause for concern as to satisfaction of the substantially all test. In determining whether substantially all assets are acquired, it may be necessary to consider transactions occurring prior to the merger as dispositions of assets and distribution of such proceeds may result in failure of the substantially all test. 2 Where the assets not acquired are non-operating assets, such as investment assets, the courts have allowed as little as 51 percent of the assets to satisfy the substantially all test.3 In the ruling T held certain investments that the acquirer did not want to acquire, so T sold the assets and distributed those assets to the shareholders of T. The ruling does not disclose the amount of the distribution or what percentage of the assets of T the investments represented. As a result, it is unclear whether the distribution caused the parties any concern as to the satisfaction of the substantially all test, but it may play a role in the decision to perform a two-step merger to accomplish the reorganization.
In conclusion, the ruling provides the taxpayer with a favorable outcome by disregarding the fluctuation in value of the stock between the signing of the merger agreement and the closing. However it also serves as a good reminder that private letter rulings are limited to the specific rulings addressed within them. Taxpayers should consult a tax advisor prior to engaging in a reorganization implicating sections 367 and 368.
1 See Rev. Rules. 2008-25, 2008-1 C.B. 986; 2004-83, 2004-2 C.B. 157; 2001-46, 2001-2 C.B. 321; and 90-95, 1990-2 C.B. 67, which address the application of step-transaction doctrine and support the position that if the two-step merger did not qualify as a reorganization, the first step would represent a stock purchase followed by a liquidation as opposed to a taxable sale of assets by the target to the acquiring corporation.
2 See, e.g., Helvering v. Elkhorn Coal Co., 95 F2d 732 (4th Cir. 1937) , cert. denied, 305 U.S. 605 , reh’g denied, 305 U.S. 670 (1938); but see Rev. Rul. 2003-79, 2003-2 C.B. 80.
3 James Armour, Inc., 43 T.C. 295 (1965)