The Internal Revenue Service (IRS) just released a significant private letter ruling (PLR 200928001) approving a tax-free reorganization in a situation that arises often in practice and poses difficult technical challenges. The ruling reflects the IRS’s increasing willingness to respect taxpayers’ form.
The application of the “step transaction” and “substance over form” doctrines to tax-free reorganizations is often unpredictable. Although in most cases the steps of a transaction cannot be reordered by the IRS into an equal number of different steps, in the reorganization context certain sequences of steps are routinely collapsed. For example, numerous revenue rulings hold that when the stock of a target corporation (T) is transferred to another corporation (S), and then T liquidates or merges into S, the first-step stock transfer will be disregarded (as transitory) and the overall transaction will be recast as a direct asset merger of T into S (an “asset recast”). The transactions in these revenue rulings, as recast, typically qualify for tax-free treatment.
Revenue Ruling 78-130 illustrates an asset recast. In the ruling, P, a parent corporation that owned all of T and S, transferred its T stock to S in exchange for S voting stock; T then merged into a wholly owned subsidiary of S (S1). The ruling treats the transfer of T stock and subsequent merger of T into S1 as a direct merger of T into S1, with T constructively receiving S stock from S1 in exchange for its assets and then distributing the S stock to P in dissolution. The recast transaction could not qualify as reorganization under section 368(a)(1)(D), but did qualify as a tax-free “triangular” merger under section 368(a)(1)(C).
Notwithstanding asset recasts in the reorganization context, in section 338, Congress limited the application of such recasts in cases in which the result of a stock purchase (generally from an unrelated person) followed by a liquidation would be a taxable asset acquisition. In addition, a variety of post-reorganization transactions are expressly exempted from the step transaction doctrine under “safe harbors” provided for in the Code and section 368 regulations. The IRS has recently expanded the scope of these safe harbor regulations dramatically. See Treas. Reg. § 1.368-2(k) (the “-2(k) regulations”). In general, the -2(k) regulations provide that if the first step of a transaction qualifies as a reorganization then the transaction will not be “disqualified or recharacterized” as a result of certain later transfers of the target’s stock or assets.
Final -2(k) regulations were issued in October 2007. However, the 2007 regulations were drafted in a manner that unintentionally allowed certain post-reorganization transfers to or from the target shareholders to be exempted from recast. The IRS responded by issuing amended final-2(k) regulations in May 2008. Under the amended -2(k) regulations, most transfers between the target shareholders and the acquiring corporation following a reorganization are no longer automatically exempt from the step transaction doctrine (and can potentially disqualify the reorganization). Thus, while taxpayers can avoid step transaction concerns by using the -2(k) safe harbors, they often face uncertainty when a proposed multi-step reorganization does not fit within the -2(k) safe harbors.
One question that remains unanswered by the -2(k) regulations and section 338 is whether a tax-free transfer of T stock to S followed by a liquidation or merger of T would be subject to an asset recast if the resulting transaction were taxable (instead of tax-free, as in the revenue rulings). PLR 200928001 addresses an alternative to such a fact pattern that presents similar issues.
In the ruling, P, the parent of a consolidated group, wholly owned T and S, and S wholly owned S1. Pursuant to a plan of reorganization, T distributed assets to P and then merged, under state law, into S1. As a result of the merger, P received S1 stock in exchange for its T stock. P then contributed all of the S1 stock it received in the merger down to S. At the end of the day, P continued to own 100 percent of the S stock, S continued to own 100 percent of the S1 stock, and S1 owned all of T’s assets. The PLR respected the form of the transaction, holding that T’s merger into S1 qualified as a direct tax-free section 368(a)(1)(A) reorganization.
The IRS had to wrestle with the issue of whether to recast the PLR transaction into a triangular asset acquisition in which S1 would be treated as constructively acquiring the T assets in exchange for S stock (rather than S1 stock). The possibility of such a recast arises because P holds the portion of S1’s stock received in the merger only transitorily, and immediately converts such stock into equity of S. Because P has enhanced its equity interest in S and S has enhanced its equity interest in S1, in each case by the value of the T assets, the overall transaction resembles the triangular reorganization described in Revenue Ruling 78-130.
An important distinction between the PLR and the revenue ruling is that if the PLR transaction were recast into a triangular asset acquisition, it might not qualify for tax-free treatment under any reorganization provision. The reason is that the distribution of assets from T to P in connection with the merger was sufficiently large so that less than “substantially all” of the assets of T may have been transferred in the merger. Because the potentially applicable triangular reorganization provisions (i.e., sections 368(a)(2)(D) and 368(a)(1)(C)) both require a transfer of substantially all of the target’s assets, recasting the transaction as described above could result in a failed reorganization that is taxable at both the corporate and shareholder levels.
The IRS sensibly decided to respect the steps of the PLR transaction (rather than recast it into a taxable triangular merger) even though the transfers of S1 stock were somewhat circular. Note that, because the form was a direct merger followed by a contribution of the S1 stock down to S, the IRS was able to sidestep the question of whether a transfer of T stock followed by a T/S merger could be recast into a taxable asset acquisition.
Significance of PLR 200928001
PLR 200928001 is important in several respects. First, the ruling provides a favorable resolution to a commonly occurring problem—how to effectuate a tax-free merger among lower-tier subsidiaries when it is desirable to preserve 100 percent ownership of the acquiring corporation in its original chain. The possibility that the IRS might treat such a transaction as a taxable asset acquisition poses a significant risk in these cases. (In many instances, the merger may involve subsidiaries multiple tiers below the common parent, and, as in the PLR, will not qualify for tax-free treatment if recast into a triangular acquisition.) Thus, PLR 200928001 provides a roadmap for achieving tax-free treatment while avoiding cross-ownership.
Second, the PLR is noteworthy in light of the May 2008 amendments to the -2(k) regulations, which highlighted the uncertainty regarding recontributions by former target shareholders (in this case, P) of stock received in a reorganization by removing such contributions from the -2(k) safe harbors. In fact, the drafters of the amended -2(k) regulations had in mind transactions very much like the one in the PLR where P transfers S1 stock back down to S after a reorganization. The drafters were concerned that such transactions resembled Revenue Ruling 78-130, and had not intended for the -2(k) regulations to override the principles of the revenue ruling. However, preserving the revenue ruling, which involves a recast into a tax-free transaction, does not resolve the issue of whether similar transactions should be recast if the result is taxable.
The key to PLR 200928001 is that the amended -2(k) regulations merely removed such transactions from the safe-harbor exemptions of -2(k) but did not presumptively determine that transactions outside of the safe harbors would be recast. Therefore, transactions outside of the -2(k) safe harbors will still be respected as long as the general step transaction authorities do not compel a recast.
Under these general authorities, the form of a reorganization should be honored where the policies of the reorganization provisions are not offended. Because the T assets were transferred to S1 entirely for equity, and because there would be other ways for the taxpayer to structure a tax-free asset transfer to S1, the IRS properly concluded that reorganization policies were satisfied and that the PLR transaction should be treated in accordance with its form.
Does PLR 200928001 suggest that the IRS would also refrain from imposing an asset recast if instead the T stock had been transferred to S and T had then been merged into S1? Such a transaction arguably should be respected based on the same rationale exemplified by the PLR—namely, the absence of a good policy reason for reordering the steps to create a taxable sale.
Unfortunately, the rules in this area are unclear, and there is still a risk that a stock transfer and merger could be collapsed into a taxable asset acquisition. The IRS has been reluctant to issue PLRs in certain of these fact patterns, perhaps because, without regulations, the IRS is uncertain whether the asset recast should result in a taxable transaction. Nonetheless, by following the form (rather than reordering) a series of steps that are economically equivalent to the triangular transaction in Revenue Ruling 78-130, PLR 200928001 demonstrates that the IRS is continuing to expand the list of reorganization structures that will be respected and supports the argument that a transaction should not be mechanically recast as taxable in the absence of a compelling policy reason to do so.