Post-Reorganization Restructuring

Marc Countryman Jasper L. Cummings, Jr. Office of the Tax Legislative Counsel Alston & Bird LLPU.S. Department of Treasury

Mark Schneider Scott M. LevineDeputy Associate Chief Counsel (Corporate) Jones DayInternal Revenue Service

Washington, DCDecember 18, 2007

2

IntroductionCertain Reorganization Requirements:

• Statutory• Basic Types of Reorganization – Sections 368(a)(1)(A)-(G)• Types of “Remote Continuity” Reorganization –

Sections 368(a)(1)(B) (triangular), (C) (triangular), (2)(C), (D), (E)• Party to a reorganization (definition) - Section 368(b)

• Non-Statutory• Business Purpose – Treas. Reg. section 1.368-1(c)

• Continuity of business enterprise (“COBE”) – Treas. Reg. section 1.368-1(d)

• Continuity of Proprietary Interest (“COI”) – Treas. Reg. section 1.368-1(e)

3

COBE: Judicial Origins• Introduced by courts as a prohibition against reorganization

treatment when T’s businesses and assets are disposed of by the acquiring corporation. • Graham, 37 B.T.A. 623 (1938), showing the doctrine derived from

Gregory v. Helvering, 293 U.S. 465 (1935). • Some historical T assets or businesses may be disposed of as long as

a minimum quantum of assets or business is retained. • Lewis v. Comm’r, 176 F.2d 646 (1st Cir. 1949) (court held that

retention of one out of three separate businesses previously conducted by T was sufficient); Treas. Reg. section 1.368-1(d)(5)(Ex. 1) (same).

• Laure v. Comm’r, 70 T.C. 1087 (1978), aff’d in part and rev’d in part, 653 F.2d 253 (6th Cir. 1981) (retention of approximately 27 percent of T’s assets was “substantial”).

4

Remote Continuity of Interest• Groman v. Comm’r, 302 U.S. 82 (1937) & Helvering v. Bashford,

302 U.S. 454 (1938). • P not a “party to the reorganization” where S actually acquired T

using P Stock.• Implied violation of continuity of interest focusing on separation of

T shareholders from T’s business assets.• “Remote Continuity” addressed statutorily in sections 368(a)(1)(B)

(triangular), (C) (triangular), (2)(C), (D), (E) and 368(b).• “Remote Continuity” addressed administratively in Treas. Reg.

sections 1.368-2(f), (k).

5

COBE: Regulatory Development

• Basic COBE requires the “issuing corporation” (P) – the company whose stock is used to acquire target (T) or T’s assets - to either continue T’s historical business or use a significant portion of T’s historical business assets in a business. Treas. Reg. section 1.368-1(d)(1) (1980).

• P is deemed to conduct T’s business if any member(s) of its “qualified group” conduct such business. • Treas. Reg. section 1.368-1(d)(4) (1998).• IRS and Treasury first assert their belief that “the COBE requirements

adequately address the issues raised in Groman and Bashford and their progeny.” T.D. 8760 (1998).

• COBE “Remoteness” fine-tuning - permits T shareholders to retain a significant indirect interest in T’s businesses or assets through a tiered ownership structure.• Treas. Reg. section 1.368-1(d)(4)(i), (ii), (iii) – COBE proper • Treas. Reg. section 1.368-2(f) – “party to the reorganization”• Treas. Reg. section 1.368-2(k) – transfers of T assets/stock

6

1998: COBE Proper• The issuing corporation is treated as conducting all of the

businesses and holding all of the assets of the members of the qualified group. Treas. Reg. section 1.368-1(d)(4)(i).

• A qualified group is:• one or more chains of corporations connected through stock

ownership with the issuing corporation, but• only if the issuing corporation owns directly stock meeting the

requirements of section 368(c) in at least one other corporation; and

• stock meeting the requirements of section 368(c) in each of the corporations (except the issuing corporation) is owned directly by one of the other corporations.

• Treas. Reg. section 1.368-1(d)(4)(ii).

7

1998 COBE “Qualified Group”

COBE satisfied when S-1transfers acquired assets to anynumber of controlledsubsidiaries, each of which usesthe assets in a business - in theaggregate, a significant portion of T’s historical assets are beingused by the qualified group in a business.

See Rev. Rul. 68-261 (post-merger, P transferred T assets to 6 wholly owned corporate subsidiaries, qualifying “A”reorganization; predated the 1998 COBE regulations and relied on section 368(a)(2)(C) without a reference to COBE).

P

S-1

S-1 transfers acquired assets to a number of controlled subsidiaries (section 368(c) “control”)

S-4 S-5S-3S-2

TMerger

T assets T assets

Ts/hs P stock

8

1998 “Qualified Group”: Death Diamond

P

S-3

S-2S-1

• Under 1998 COBE Regulations, S-3 is not a member of the P qualified groupbecause neither S-1 nor S-2 directly owns S-3 stock representing section 368(c) control.• Therefore, S3’s ownership/operation of T’s assets/business does not satisfy COBE.• NOTE: If S-3 is a partnership, COBE is satisfied.

50%50%

9

1998 COBE “Qualified Group”: Partnership

P

XS-1

67%33%(no participation)

P

XS-1

80%20%(participation)

PRS’s former T assets/businesses treated proportionately held/conducted by P qualified group in satisfaction of COBE requirement under both 1998 and 2007 COBE Regulations.

PRS PRS

10

1998: Remote Continuity• “A”, “B”, “C”, and “G” reorganizations are not

disqualified by transfer of T assets/stock to one or more corporations controlled by transferor corporation. SeeSection 368(a)(2)(C). • Treas. Reg. section 1.368-2(k)(1), (2) (applying/expanding

section 368(a)(2)(C)). • Note: Consistent with section 368(a)(2)(C), regulations excluded

“D” reorganizations.• A “party” to the reorganization remains so

notwithstanding subsequent transfers under Treas. Reg. section 1.368-2(k). Treas. Reg. section 1.368-2(f) (applying section 368(b)).

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Post-1998 Remote Continuity: Administrative Expansion

• Section 368(a)(2)(C) and Treas. Reg. section 1.368-2(k) are “permissive,” not “exclusive or restrictive” –thus, where COBE otherwise satisfied:• Drop-down of acquiring stock after reorganizations

pursuant to 368(a)(2)(D) (forward triangular) merger is permitted – Rev. Rul. 2001-24.

• Drop-down of assets acquired in “D” reorganization is permitted – Rev. Rul. 2002-85.

12

2007 COBE Regulations

• Effective date: October 25, 2007.• Expanded the definition of “qualified group” for COBE proper.

• Definition still tracks section 368(c) rather than section 1504(a).• Aggregation concept in the new definition of “qualified group” is

similar, however, to that used under section 1504(a).• Post-reorganization transfer permissibility expanded under remote

continuity rules provided COBE proper rules are satisfied.

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• A “qualified group” is one or more chains of corporations connected through stock ownership with the issuing corporation, but only if the issuing corporation owns directly stock meeting the requirements of section 368(c) in at least one other corporation, and stock meeting the requirements of section 368(c) in each of the corporations (except the issuing corporation) is owned directly by one or more of the other corporations.

2007 Regulations: “Qualified Group”

14

Diamond no Longer “Deadly”

P

S-3

S-2S-1

S-3 is now a member of the P qualified groupbecause P owns stock of both S-1 and S-2representing section 368(c) control and S-1 andS-2, in the aggregate, own stock of S-3 representing section 368(c) control.

50%50%

15

Reorganization Treatment Still Elective

P

S-2

S-1

COBE requirement not satisfied becauseS-1 does not “control” S-2 but S-2 remainsMember of P affiliated group. See Treas.Reg. section 1.368-1(d)(4)(ii).

Is Treas. Reg. section 1.368-1(d) a safe harbor or a requirement?

What if the nonvoting stock heldby Unrelated is worth $1 and the voting stock held by S-1 is worth $1 billion?

100%

Section 1504but NOT

section 368(c)control

T100% ofT assets

(2)100% ofT assets

(1)

Unrelated

Nonvoting low/value stock

T s/hs P voting stock

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Definition of Qualified Group Expanded to Include Certain Partnerships• Solely for purposes of determining whether a corporation is a

member of the qualified group, if members of the qualified groupown interests in a partnership meeting the requirements equivalent to section 368(c), any stock owned by such partnership shall be treated as owned by members of the qualified group.

• Does “equivalent to section 368(c)” mean 80% of voting power and 80% of each other type of interest?

• How should percentage owned of each “other type” of interest be defined?

• Profits? • Capital? • LP interests?

• Cf. Rev. Rul. 59-259 (does not treat all classes of nonvoting stock as fungible).

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Section 368(c) Controlled Partnership

P

S-2

S-2 is now a member of the P qualified groupbecause P owns stock of S-1 representing section 368(c) control, P and S-1, in the aggregate, own interests in PRS representing section 368(c) equivalent control, and PRS ownsstock of S-2 representing section 368(c) control.

PRS

S-150%

50%

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COBE-Curing Drops to Corporations

P

Newco

P must retain either ⅓ of T’s historical business assets or ⅓ of the T historical businesses. Treas. Reg. section 1.368-1(d)(1), (5) (Ex. 1).

P is treated as owning 26.7% (80% of ⅓) of T’s historical business assets. Treas. Reg. section 1.368-1(d)(4)(iii)(A). COBE may not be satisfied.

If PRS, pursuant to overall plan, transferred the assets received in (3) to Newco, COBE would be satisfied because Newco is a member of the P qualified group. Treas. Reg. section 1.368-1(d)(4)(iii)(D).

PRS

T

80%

Unrelated(1)

merger

(2)

Sale of⅔ of T’s

historicalbusiness assets

100%

(3)⅓ of T’s

historicalbusinessassets*

(4)⅓ of T’s historicalbusiness assets*

*Assume that PRS and Newco (as the case may be) no longer conduct theT historical business but use T’s historical assets in a business.

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• Step Transaction Doctrine• Treas. Reg. section 1.368-1(a) provides that “…in determining

whether a transaction qualifies as a reorganization under section 368(a), the transaction must be evaluated under relevant provisions of law, including the step transaction doctrine. Butsee [Treas. Reg. section] 1.368-2(f) and (k).”

• 2004 Proposed Regulations did not explicitly rule out application.

• 2007 Regulations provide that one or more transfers of assets/stock will not cause reorganization to be disqualified orrecharacterized if –

• COBE proper is satisfied (Treas. Reg. section 1.368-1(d)) and• Transfers described in either Treas. Reg. section 1.368-

2(k)(1)(i) (“Distribution Rule”), or (ii) (“Other Transfers Rule”).

2007 Regulations: Remote Continuity

20

Post-Reorganization Transfers and Step Transaction Doctrine: Historical View

P

T

Rev. Rul. 67-274

Service rules that stock-for-stock exchange NOT a good “B”reorganization but rather must be tested as a “C” reorganization because the substance of the transaction was a transfer of T assets to P.

100%

T

Ts/hs

(1)T stockfor Pstock

(2)T liquidates

into P

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2007: Permitted DistributionsTreas. Reg. Section 1.368-2(k)(1)(i)

• Post-reorganization distributions permitted if:• COBE satisfied;• Property distributed consists of:

• Assets of T, S, or P (as the case may be) or an interest in an entity received in exchange for such assets in a transfer described in the Other Transfer Rule;

• Stock of T provided T remains a qualified group member; or• A combination thereof; and

• The aggregate of such distributions does not consist of:• The amount of assets of T, S, or P (as the case may be) distributed

is not treated as a liquidation of such entity for U.S. federal income tax purposes (taking only the acquired entity’s assets into account); or

• All of the T stock that was acquired in the transaction.

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Changes from 2004 Proposed Regulations to 2007 Final Regulations: Asset Distribution Rule

• Asset Distribution Rule changed from “substantially all” to “liquidation”.• Presumably a reference to a “complete liquidation” as defined in section 346(a).• Treas. Reg. section 1.332-2(c)

• Provides that a “status of liquidation” can exist prior to a complete liquidation and requires a corporation ceasing to be a going concern and only activities are “winding up”.

• Presumably being in a status of liquidation is not sufficient to be liquidated.• Irrelevant, as regulation only assesses whether distribution causes a liquidation.• Indicates that retention of nominal assets for sole purpose of preserving

corporate legal existence does not prevent complete liquidation.• Presumably retention of more than nominal assets, even if not in operation of a

“going concern,” and even for the purpose of preventing liquidation, should prevent liquidation.

• As a result, issues related to de facto liquidation definition substituted for practitioner concerns over “substantially all” definition.

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De Facto Liquidation• Rev. Rul. 61-191

• “De facto liquidation occurs when a corporation has disposed of its operating assets, terminated its business activities, and became a mere shell, a corporation in name and semblance only, without real corporate substance, serving no real corporate purpose, and having no valid or compelling reason for continuing its existence, eventhough not formally dissolved.”

• Rev. Rul. 74-462• No de facto liquidation of corporation in process of complete

liquidation was found even though operating business terminated,where corporation retained assets as a reserve for contingent liabilities from pending lawsuits and where it continued to defend against those suits and to prosecute actions brought by it.

• Conclusion reached even though retained assets were reinvested as required by investment judgments.

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De Facto Liquidation Example

P

S-1

• Is the Distribution Rule satisfied?• What if two percent remaining in S-1 solely cash?• Is there some degree of liquidation that would cause S-1 to be disregarded resulting in the application of the step transaction doctrine to recharacterize the transaction into an acquisition by a different entity? Cf. Rev. Rul. 72-405 (acquisition of T in forward triangular merger followed by liquidation of S-1 tested as a “C” reorganization).

100%

T merger

P votingstock

(1)

(2)98% ofT assets

(gross assetvalue)

Ts/hs

25

Distribution Rule“Substantially All” vs. Liquidation

P

S-2

S-1

2007 Treas. Reg. section 1.368-2(k) NOT satisfied (S-2’s assets—disregarding assets held prior to the potential reorganization—would result in S-2’s de facto liquidation).

2004 Treas. Reg. section 1.368-2(k)satisfied (no one corporation receives“substantially all” of T assets).

100%

80%

T

100% ofT assets

P votingstock

(2)50% ofT assets

(2)50% ofT assets

(1)

20%

26

Changes from 2004 Proposed Regulations to 2007 Final Regulations: Stock Distribution Rule

• Stock Distribution Rule changed from T stock representing “control” to “all” of the T stock.

• Retention of one share of T stock prevents application of step transaction doctrine.

• Why permit the tax consequences of a transaction to hinge on the retention of one share?

P

S-1

100%

T

T stock forP voting

stock

(1)

(2)All but one

T share

Ts/hs

T

27

2007: The “Other Transfers” RuleTreas. Reg. Section 1.368-2(k)(1)(ii)

• Post-reorganization transfers (other than transfers covered under Distribution Rule) permitted if:• COBE satisfied;• Not described under Distribution Rule;• The property transferred consists of:

• Part or all of the assets of T, S, or P (as the case may be);• Part or all of the stock of T, S, or P (as the case may be)

provided such stock transfer does not result in such entity ceasing to be a member of the qualified group; or

• A combination thereof; and• T, S, or P (as the case may be) does not terminate its

corporate existence in connection with such transfer(s).

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Example 1: T Assets Transferred to Members of Qualified Group

P

S-3

S-2

S-1

• Other Transfers Rule satisfied.

• What if S-1 sells the T assets to S-2 for cash and then liquidates?

• The Other Transfers Rule should not apply because S-1 “terminates”.

• If S-1 was not transitory, presumably the original asset acquisition from T would be by S-2 for P stock and would not qualify as a reorganization (issuance of grandparent stock).

• If S-1 was transitory, T did not “merge” into S-2 and deemed direct asset transfer to S-2 would not qualify as a reorganization (violation of “C” solely for voting stock requirement). See Rev. Rul. 72-405.

100%

80%

80%

Tmerger

$70 Pvoting

stock + $30 cash

(2)100% ofT assets

(3)100% ofT assets

(1)

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Example 2: Distribution of T Assets and Assumption of T Liabilities

P

S-1

• Distribution Rule satisfied.

• Rev. Rul. 70-107 has similar facts except in ruling no assets distributed to P. Service concluded that solely for voting stock requirement was violated because P assumed liabilities.

• Preamble provides that “[t]hese final regulations do not implicate the fact pattern in Rev. Rul. 70-107.” Why? Because in Rev. Rul. 70-107, P’s assumption occurred “in the exchange” with T?

• Treas. Reg. section 1.368-2(k)(1)(i) permits distributions “that involve the assumption of liabilities…”. What if no assets are distributed to P in Step 2 and only former T liabilities are assumed? Presumably outside regulatory scope which requires an “asset” distribution.

100%

T

100% ofT assets

P votingstock

(1)

(2)50% of

T assets;P assumes50% of T’sliabilities

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Example 3: Indirect Distribution of T Assets

P

S-6(Newco)

S-1

• Other Transfers Rule satisfied with respect to Step (2) and Distribution Rule satisfied with respect to Step (3) (treated as an indirect distribution of S-1 assets).

• See Treas. Reg. section 1.368-2(k)(1)(i)(A)(1) providing that Distribution Rule satisfied if the property distributed “consists of an interest in an entity (S-6 stock) received in exchange for such assets (some of the T assets) in a transfer described in the Other Transfers Rule.

• Is the result the same if S-1 distributes 50% of the T assets to P and P assumes 50% of T’s liabilities followed by P contributing the T assets to S-6 in exchange for S-6 stock and S-6’s assumption of the T liabilities previously assumed by P?

100%

80%

T

100% ofT assets

P votingstock

(1)(2)

50% ofT assets;

S-6 assumes50% of T’sliabilities

(3)S-6

Stock

31

Example 4: Distribution of T Stock

P

T

S-4

S-1

Distribution Rule satisfied because less than100% of T stock distributed and T remains amember of the Qualified Group

80%

PRS

20%

80%80%

20%

Ts/hs

(1)T stockfor Pstock

(2)90%

of T stock inredemption

of 5% of S-1 stock

P

S-4

S-1

80%

PRS20%

80%80%

15%

T

90%

10%

Final Structure

32

Example 5: Transfers of T Stock to a Non-Qualified Group Member

P

S-2

S-1

Step (4) transfer of T stock to PRSviolates Other Transfers Rule because T no longer a member of Qualified Group notwithstanding that COBE requirement still satisfied.

Under step transaction doctrine, not a good “B” reorganization because S-1 did not control T immediately after the acquisition. What is it?

Indicates that Treas. Reg. section1.368-1(d) is not a safe harbor.

100%

80%

T

Ts/hs

(1)T stockfor Pstock

(2)50% of

T assets;S-1 assumes50% of T’sliabilities

T

(3)T stock

PRS

U

(4)T stockfor 50%

interest in PRS

50%50%(4)

$ for 50%interest in PRS

33

Example 6: Transfers of T Assets After “D”Reorganization

S-3

S-2

S-1

100%

80%

80%

T

100% ofT assets

S-1 stockand

assumption of T

liabilities

(3)100% ofT assets

(4)100% ofT assets

(1)

100%

P(2)S-1 stock

• Other Transfers Rule satisfied.

• Incorporates the principle of Rev. Rul. 2002-85 (permitting the transfer of acquired assets to a controlled subsidiary following a “D” reorganization).

34

Example 7: Transfer of Subsidiary Stock After Forward Triangular Merger

P

S-1

100% 80%

T

(2)100% ofS-1 stock

(1)Merger

Ts/hs (1)

P stock

S-4

Other Transfers Rule satisfied.

Incorporates the principle of Rev. Rul. 2001-24 (permitting the transfer of acquiring subsidiarystock to a controlled subsidiary following a forward triangular merger).

35

Example 9: Sale of T Asset to Member of Qualified Group

P

S-5

S-4S-1

Other Transfers Rule satisfied.

100% 80%

T

100% ofT assets

P votingstock

(2)100% ofT assets

for $

(1)

50%50%

36

2007 Regulations and “B” Reorganizations

P

T

100%T

Ts/hs

Step (1)T stockfor P

votingstock

a. Assets can be distributed by T so long as it is not “liquidated”

b. Assets can be dropped down from T provided T does not “terminate”.

c. T stock can be distributed provided one share is retained.

d. Future vitality of Rev. Rul. 67-274?

S-1

100%

Newco

100%

37

2007 Regulations and Section 355

P

S-1

100%

T

(2)95% ofT stock(1)

T stock

Ts/hs (1)

P stock

T

Ps/hs

(3)95% ofT stock

Step (2): The Distribution Rule is satisfied because COBE satisfied, T remains a member of the P qualified group, and less than all of the T stock was distributed to P. But see Section 355(a)(1)(D).

Step (3): The Distribution Rule is NOT satisfied because T does not remain a member of the P qualified group.

38

Why Pushups?• P wishes to be the acquiring corporation but is unable

for non-tax reason(s).• P wants T in another P corporate chain (common in

bank acquisitions). • Acquisition is for S stock but P wants the assets and T

shareholders do not want S stock (the “Up-REIT”structure).

39

Other Effects of Pushups

• Section 311 event to which Treas. Reg. section 1.1502-13(f) will apply in consolidation, unless section 355 applies.

• Note: deferral of gain recognition in consolidation may not apply for state tax purposes.

• Section 355 could apply, but in the typical acquisitive reorganization case a section 355(e) change of ownership could occur resulting in gain recognition at the distributing corporation level without a basis step up to the parent/shareholder.

40

Step Transaction Doctrine and the 2007 Regulations Revisited

CFC2

100%

CFC1(2)

CTB election(deemed

liquidation)

100%

USP

(1)100% of

CFC2 stock

• If CTB election is made effective for same day as CFC2 stock transfer to CFC1:

• CTB regulations provide that CFC2 deemed to liquidate day before stock transfer. See Treas. Reg. section 301.7701-3(g)(3)(i).• The transaction should be treated as an upstream “C” reorganization followed by transfer of CFC2 assets to CFC1. See Treas. Reg. section 1.368-2(d)(4).• Step transaction doctrine should not apply pursuant to section 368(a)(2)(C) and Part B of the Preamble to 2007 Regulations. See also Rev. Rul. 69-617.

• If CTB election is not made until two days after CFC2 stock transfer to CFC1:

• CTB regulations provide that CFC2 deemed to liquidate day after stock transfer.• The transaction should be treated as a “D”reorganization. See Rev. Rul. 67-274 and Rev. Rul. 2001-46.

• What is at stake?• “All E&P” inclusion; and• Section 367(a) and/or section 367(d) transfer.

CFC2