Focus on Tax Strategies & Developments

Achieving Tax-Free 'Rollover' Treatment for Certain Shareholders in Acquisition of Publicly Traded Target Company

Michael J. Wilder | Britt Haxton


A common issue that arises when structuring a corporate acquisition of a public company is that a tax-sensitive shareholder of the target corporation (T) requires tax-free treatment while the remaining shareholders do not. For example, assume that an acquiring corporation (P) seeks to purchase T (which has fair market value of $100), that 60 percent of the T stock is widely held by the public and that 40 percent of T is owned by a single family or individual (Individual). P would prefer to acquire all of T for cash, and the public shareholders may generally be indifferent to tax considerations (e.g., where T stock is held primarily by tax-exempt pension funds), but Individual demands tax-free rollover treatment of his/her T shares. This article addresses four methods for structuring P’s acquisition of T to achieve taxable treatment for the public and tax-free treatment for Individual. In the discussion below, P and T are domestic corporations, but a similar analysis frequently applies when P and T are foreign.

Reorganization Under Section 368(a)(1)(A)

The simplest structure from a U.S. federal tax perspective for providing Individual with tax-free rollover treatment under the scenario presented above is a reorganization under section 368(a)(1)(A) (an “A” reorganization) of the Internal Revenue Code. The A reorganization can be accomplished through a direct statutory merger of T into P or a merger of T into a disregarded entity or subsidiary of P. In order for the reorganization to be tax-free, at least 40 percent of the value of the total consideration paid to T shareholders must be in the form of P stock (the “continuity of interest” requirement). Thus, T can merge directly into P, with the T shareholders collectively receiving a total of $40 of P stock and $60 of cash.

In the example above, all tax objectives will be achieved if the $40 of P stock can be directed to Individual (who will receive tax-free rollover treatment on the exchange of T stock for P stock) and the $60 cash can be directed to the public T shareholders. Depending on the jurisdiction, securities and corporate law may or may not prevent P from effectively ensuring that the public receives solely cash and Individual receives solely the P stock. For example, certain states permit the P stock to be offered to shareholders that tender the most T stock (i.e., Individual). Other jurisdictions impose stricter protections for public shareholders, which may necessitate P offering potentially costly financial incentives to obtain the necessary cooperation from the T shareholders.

Meeting the 40 percent continuity of interest requirement can also pose practical issues. The parties will typically want to negotiate the major economic terms of the reorganization, but fluctuations in the value of T or P before closing can impact whether the amount of P stock and cash intended to be delivered at closing will actually meet the 40/60 ratio on that date. Treasury regulations provide a helpful “signing date” rule for measuring continuity of interest that allows the parties to agree to an exchange ratio that satisfies the 40/60 test when the original merger agreement is signed (so that subsequent value fluctuations do not disqualify the merger on the closing date). However, the signing date rule can prove difficult to satisfy, particularly where disparate consideration must be offered to different groups of T shareholders (as described above).

The ‘Double Dummy’ Structure

A second structure for combining P and T with tax-free rollover treatment is known as the “double dummy” structure. In a double dummy structure, P may acquire T using a larger percentage of cash consideration than 60 percent because the transaction is not geared to satisfy the requirements of an A reorganization, but rather the more flexible requirements for a tax-free section 351 exchange. Note that section 351(a) provides that a transfer of property (including stock) to a corporation in exchange for stock will be tax-free if one or more transferors own at least 80 percent of the stock (within the meaning of section 368(c) of the transferee corporation immediately after the exchange (the “control” requirement). The double dummy structure thus commonly is used when P seeks to issue more than 60 percent cash in the exchange (e.g., where Individual owns only 25 percent of T and P wants to purchase the remaining 75 percent of T for cash).

A double dummy structure involves P or T forming a new holding corporation (New Holdco), which in turn forms two wholly owned merger subsidiaries (the “double dummy” corporations). Dummy One merges into P (the P merger) and Dummy Two merges into T (the T merger), with P and T each surviving the merger as wholly owned subsidiaries of New Holdco. In the P merger, the P shareholders receive solely New Holdco stock in exchange for their P stock; in the T merger, Individual receives $25 of New Holdco stock and the T public shareholders receive $75 cash in exchange for their T stock.

Because T and P survive the reverse mergers, the transitory existence of the dummy corporations is disregarded for federal tax purposes and the transaction is treated as if the P and T shareholders transferred their stock to New Holdco in exchange for New Holdco stock (or $75 cash in the case of the T public). Treating the reverse mergers as stock transfers ensures that there is no risk of a corporate level tax on the assets of P and T. In addition, the P and T stock exchanges are designed to qualify for tax-free treatment at the shareholder level under section 351. That is, the shareholders of P and Individual constitute a section 351 “control group” who own in the aggregate 100 percent of the stock of New Holdco following the exchanges. Thus, the P shareholders and Individual should each obtain tax-free treatment under section 351(a).

As stated above, this structure is frequently useful for a merger of equals where Individual owns less than 40 percent of T or the continuity of interest requirement is otherwise difficult to satisfy. Drawbacks of this structure include the fact that the P shareholders generally must participate in and vote for the exchanges (although under Delaware law, the vote by P shareholders can sometimes be avoided) and that P, which may be a much larger publicly traded company than T, will end up as a subsidiary of a new public holding company. If it is undesirable for P to become a subsidiary of New Holdco, the “single dummy” structure (discussed below) is a viable alternative.

The ‘Single Dummy’ Structure

A single dummy structure is a variation of the double dummy structure where P merges directly into New Holdco rather than becoming a subsidiary of New Holdco, thus enabling P’s business to continue in the top-tier public company. In a single dummy structure, P forms New Holdco and New Holdco, in turn, forms a single new subsidiary (Dummy One). Dummy One then merges into T, with T surviving as a wholly owned subsidiary of New Holdco. Here, the T public receives $75 of cash and Individual receives $25 of New Holdco stock. Immediately after T’s merger, P merges into New Holdco, with New Holdco surviving and the P shareholders receiving New Holdco stock. Once again, the combination of T and P into New Holdco is designed to qualify as an overall section 351 exchange, so that Individual can obtain rollover treatment, but the technical tax analysis differs slightly. Specifically, Individual and P will be considered co-transferors in a section 351 exchange, with Individual obtaining section 351 treatment and the P shareholders obtaining tax-free reorganization treatment under section 354.

To reach a good comfort level for a single dummy acquisition, it is important that (i) the transaction be structured so that the merger of P into New Holdco cannot qualify as a reorganization under section 368(a)(1)(F) (which is achieved by completing the T merger before the P merger), and (ii) the incorporation of New Holdco or the P merger achieves some business objective beyond satisfying section 351 (which is usually the case).

Convertible Stock

A fourth alternative is for P to form a new subsidiary (S) with cash and cause S to acquire the T stock. In this alternative, S buys out the T public shareholders with the cash and acquires Individual’s T stock in exchange for S stock; P and Individual are treated as co-transferors in the section 351 exchanges with S, with Individual obtaining tax-free treatment. Although Individual will initially hold a less liquid minority interest in S stock, Individual will also be given a conversion right so that he/she can exchange the S stock for a more liquid interest in P’s publicly traded common stock after a period of time (e.g., one year after the acquisition).

Due to the issues presented by the conversion feature, this structure is less desirable, but it has been used when the alternatives listed above are not workable (for example, News Corporation acquired all of the shares of Dow Jones & Company using this structure in 2007). Crucially, the subsequent conversion of S stock into P stock will be a taxable exchange for Individual. Other planning considerations also should be kept in mind when structuring the transaction (e.g., the S stock should participate to some extent in corporate growth to avoid potential concerns under section 351(g)) in order to successfully defer the recognition of Individual’s gain until the time of conversion.

Thus, while this structure has the advantage that P does not have to merge or be contributed to a holding company, the additional tax complexities of the conversion arrangement mean that the tax treatment is somewhat less assured.

German Real Estate Transfer Tax: A Trap for the Unwary Multinational

Annette Keller | Nina Siewert

German Real Estate Transfer Tax (RETT) is an important cost factor in mergers and acquisitions, real estate transactions in Germany and intra-group restructurings. Despite the German legislature’s widely advertised intentions to enable RETT-neutral intra-group restructurings, recent developments have increased the scope of the tax’s application. Based on the wide range of transactions that trigger RETT and the steady increase of the applicable tax rates in recent years, the application of exemption rules and anti-abuse provisions in the RETT is among the key structuring considerations for many transactions.

What Kinds of Transactions Trigger RETT?

German RETT is triggered by the following transactions in particular:

  • Transfer of ownership in German real estate to another legal entity, e.g., by way of a sale. The rule also applies to transfer of real estate in corporate restructurings, such as mergers, spin-offs, split-ups or contributions of assets.
  • Transfer of at least 95 percent of the interests of a real estate holding partnership to new partners within a period of five years (New Partner Rule).
  • Acquisition of at least 95 percent of the shares or interests of a real estate holding corporation or partnership by one acquirer or a group of related acquirers (not necessarily in one transaction) (Unification Rule).

The New Partner Rule and the Unification Rule refer to direct and indirect changes in the holding structure of a German or foreign entity that holds German real estate. Therefore, a multinational’s engagement in an M&A transaction or a corporate restructuring could also trigger German RETT, even if various intermediary holding levels are interposed, since all indirect changes to the shareholding structure must be taken into account.

Which Tax Rate Applies?

The RETT rate depends on the German federal state in which the real estate is located. Since the federal states have been able to determine the rates, rates have been on the rise and now vary between 3.5 percent (Bavaria and Saxonia) and 6.5 percent (North Rhine-Westphalia, Saarland and Schleswig-Holstein). In light of the precarious financial situation in which many federal states find themselves, a further increase in tax rates is to be expected.

The tax base is generally the purchase price of the real estate or, where no such purchase price exists, the specially determined real estate value, which in most cases is slightly below the market value.

When a RETT rate increase is imminent, notaries observe a marked increase in purchase notarizations, as parties aim to trigger RETT at the old rate by signing the purchase agreement prior to the change in law. The old rate remains applicable if the purchase agreement as a whole is subject to conditions precedent (e.g., the approval of the tenants regarding amended lease agreements), provided the conditions are outside of the discretion of the parties. A condition precedent has the benefit that RETT only arises once the condition is fulfilled. Otherwise, the signing of the agreement triggers RETT, and the purchaser might have to fund its payment shortly after the signing, before the acquisition financing is available.

What Exemptions Are Available for Intra-Group Restructurings?

Certain transfers of real estate from a partnership to its partners, and vice versa, are tax exempt provided the applicable five-year holding periods are observed. Prior to December 31, 2009, no other exemption was available for intra-group restructurings, meaning that any direct or indirect transfer of real estate or real estate holding companies between related companies was subject to RETT. As a result, the RETT burden was considered one of the main obstacles to corporate restructurings. Another hindrance to group restructurings was the forfeiture of tax losses as a consequence of a share transfer, even where transferor and transferee were members of the same group of companies.

On December 31, 2009, the so-called intra-group restructuring exemption clause was introduced (together with group restructuring relief and the hidden reserves exemption rules for the preservation of tax losses) in order to facilitate economically reasonable restructurings. Although the exemption rule has been amended three times since its implementation, it still has limited relevance in practice, partly because the German tax authorities have published binding administrative guidelines that limit the scope of the exemption rule even further.

The exemption rule for intra-group restructurings is only applicable to mergers, spin-offs, split-ups or contributions of assets under German restructuring law or comparable rules of a Member State of the European Union or the European Economic Area. Restructurings under U.S. law are not within the ambit of the exemption. The exemption rule further requires that the entities involved in the restructuring be part of the same group. A group only exists if there is a controlling entity that holds at least 95 percent of the shares in all controlled entities involved for a period of five years before the restructuring and five years after the restructuring. Even a holding structure that has been in place for considerable time might not be eligible for the exemption rule, however, because the German tax authorities also require that the controlling entity conduct an active business, i.e., be more than a mere holding entity.

What Structuring Scenarios Are Available, and Which Anti-Abuse Provisions Should Be Taken into Account?

Based on the New Partner Rule and the Unification Rule applicable to real estate holding entities, certain structuring scenarios allow for the sale of all or almost all of the shares or partnership interests without triggering RETT. The common denominator of such scenarios is that they require the participation of a party unrelated to the purchaser, which may be undesirable for a number of reasons.

RETT is not triggered if one person or group of related persons purchases less than 95 percent of the shares. Two joint venture partners may therefore purchase a real estate holding entity that is a corporation; each may acquire 50 percent of the shares without any RETT (provided the joint venture partners are not considered to be related persons for RETT purposes). However, such involvement of an unrelated person is rare in a group restructuring.

In the past, it was common to find so-called RETT-blocker structures that at least economically minimized third-party participation. If an acquirer directly purchased 94 percent of the shares of a real estate corporation and also acquired 94 percent of interest in the partnership that held the remaining 6 percent of the shares of the real estate corporation, the acquirer economically held more than 99 percent of the shares in the corporation (94 percent + 94 percent x 6 percent). This did not trigger RETT under the Unification Rule because, based on the formal understanding of the concept of partnership interests, the shares indirectly held through the partnership were not taken into account for the calculation of the 95 percent threshold of the Unification Rule.

The so-called Anti-RETT-Blocker Rule, applicable since June 7, 2013, introduced a substance-over-form approach for calculating the 95 percent threshold. Under this anti-abuse rule, RETT becomes due if a person or entity directly or indirectly acquires an economic participation of at least 95 percent in a real estate holding partnership or corporation. All direct or indirect shareholdings of a person or entity in a real estate entity are now taken into account, including any and all indirect minority shareholdings.

As a result, RETT-blocker structures with an economic 99 percent participation are now effectively prevented. Under the new rules, the involvement of a “real” minority shareholder will be the price for not triggering RETT, which may make blocker structures less attractive to both investors and financing institutions.

What Developments Are to Be Expected?

RETT rates are expected to increase to meet the federal states’ funding needs. The German legislature is currently planning to amend the RETT Act in order to broaden the scope of the application of the New Partner Rule. It will most likely be several years until the fiscal courts decide whether the German tax authorities’ narrow interpretation of the applicability of the intra-group restructuring exemption clause is legitimate. Taking all these factors into account, diligent RETT planning and structuring will become even more important in the future.

New IRS Rulings Should Provider Greater Certainty for Corporate Restructurings

Philip J. Levine | Timothy S. Shuman

On May 5, 2015, the Internal Revenue Service (IRS) issued two long-awaited rulings, Rev. Rul. 2015-09 and Rev. Rul. 2015-10, that should alleviate some of the uncertainties in corporate tax planning. The rulings address increasingly common transaction structures—the “drop and sideways merger” and the “triple drop and check”—that had provoked frequent corporate tax panel debates and some uncertainty for tax practitioners and taxpayers.

In Rev. Rul. 2015-09, revoking Rev. Rul. 78-130, the IRS departed from a 37-year-old application of the step transaction doctrine to a stock transfer followed by an asset reorganization, or a “drop and sideways merger” transaction. The facts presented in Rev. Rul. 2015-09 are identical to those in Rev. Rul. 78-130. P, a domestic corporation, owns all of the stock of S1 and S2, both of which are incorporated in foreign country R. S1 is an operating company, and S2 is a holding company that owns all of the stock of corporations X, Y and Z, all of which are country R operating companies. Pursuant to a plan to combine the four operating companies into a new subsidiary, S-2 forms corporation N, and P transfers all of the stock of S-1 to S-2 in exchange for additional shares of S-2 voting common stock. Immediately after P’s transfer, X, Y and Z, as well as S-1, transfer all of their assets (subject to liabilities) to N, in exchange for additional shares of N common stock. Each of X, Y, Z and S-1 then liquidates and distributes all of its N stock to S-2. Following the transaction, N continues to conduct the businesses formerly conducted by S-1, X, Y and Z.

Rev. Rul. 78-130 described the tax treatment of the transaction as follows:

Since the two steps of P’s transfer of the stock of S-1 to S-2 immediately followed by N’s acquisition of S-1’s assets are part of a prearranged, integrated plan which has as its objective the consolidation of all of the operating companies in N, the two steps should not be viewed independently of each other for Federal income tax purposes.

Accordingly, the transfer by P of the stock of S-1 to S-2 will not constitute an exchange within the meaning of section 351 of the Code. Instead, N will be viewed as directly acquiring substantially all of the assets of S-1 in exchange for stock of S-2. This recast transaction does not meet the definitional requirements of a section 368(a)(1)(D) reorganization because neither S-1 nor P (the transferor or its shareholder) will be in control of N, within the meaning of section 368(c), immediately after the transaction. (Citations omitted.)

Rev. Rul. 78-130 concludes, however, that the acquisition of the S-1 assets (subject to liabilities) “in exchange for stock of S-2 by N, as recast,” may be properly characterized as a triangular reorganization under section 368(a)(1)(C)—that is, a transaction in which a corporation (N) acquires, solely in exchange for voting stock of a corporation in control of the acquiring corporation (S-2), substantially all of the properties of the target corporation (S-1).

Much has changed in the corporate reorganization landscape since Rev. Rul. 78-130 was issued. In 1984, the definition of “control” for a section 368(a)(1)(D) reorganization was amended to conform with section 304. In addition, the IRS issued “all-cash D reorganization” guidance in Treasury regulations section 1.368-2(l), which deems stock of nominal value to have been issued in such transactions for purposes of qualifying the transaction under section 368(a)(1)(D) (namely, to satisfy the requirement of section 354(b)(1)(B) that the target corporation distribute stock of the acquiring corporation in the target’s liquidation). This change confirms that an all-cash cross-chain reorganization can qualify under section 368(a)(1)(D) even if the target and acquiring corporations are not directly owned by the same person. The regulations include a priority rule, in section 1.368-2(l)(2)(iv), that provides that the nominal share rule will not apply if the transaction is described as a triangular reorganization in section 1.358-6(b)(2) (i.e., a transaction that otherwise would qualify as a triangular reorganization will not be treated as an all-boot D reorganization).

In recent years, the IRS had issued two private letter rulings, PLR 201252002 and PLR 201150021, that arguably are inconsistent with Rev. Rul. 78-130 in treating a triple drop down of stock of a company (e.g., P to S1 to S2 to S3), followed by a deemed liquidation of the company (into S3), as two successive section 351 transactions followed by a reorganization under section 368(a)(1)(D). Rev. Rul. 2015-09 reaches a similar conclusion as these private letter rulings, holding that P’s transfer of S-1 to S-2 satisfies section 351, and that S-1’s transfer of all of its assets (subject to liabilities) to N followed by S-1’s liquidation qualifies as a D reorganization. The IRS reasons as follows:

A transfer of property may be respected as a § 351 exchange even if it is followed by subsequent transfers of the property as part of a prearranged integrated plan. However, a transfer of property in an exchange otherwise described in § 351 will not qualify as a § 351 exchange if, for example, a different treatment is warranted to reflect the substance of the transaction as a whole.

Under the facts of this revenue ruling, P’s transfer satisfies the formal requirements of § 351, including the requirement that P control S-2 within the meaning of § 368(c) immediately after the exchange. Moreover, even though P’s transfer and S-1’s transfer and liquidation are steps in a prearranged, integrated plan that has as its objective the consolidation of S-1 and the other operating companies in N, an analysis of the transaction as a whole does not dictate that P’s transfer be treated other than in accordance with its form in order to reflect the substance of the transaction. Accordingly, P’s transfer is respected as a § 351 exchange, and no gain or loss is recognized by P on the transfer of all of the stock of S-1 to S-2.

S-1’s transfer followed by S-1’s liquidation is a reorganization under § 368(a)(1)(D). (Citations omitted.)

Rev. Rul. 2015-10 applies the same approach as Rev. Rul. 2015-09 to a “triple drop and check” transaction, similar to that addressed in PLR 201252002 and PLR 201150021. In the revenue ruling, a corporation transfers a limited liability company taxable as a corporation down a chain of three subsidiaries, immediately after which the transferred company elects pursuant to Treasury regulations section 301.7701-3(c) to become a disregarded entity. Rev. Rul. 2015-10 treats the transaction as two successive section 351 stock transfers followed by a D reorganization.

Rev. Ruls. 2015-09 and 2015-10 are welcome additions to the IRS’s body of law under Subchapter C, providing certainty of treatment in an area that reasonably could be viewed as needlessly uncertain. The key difference in the analytical underpinnings of Rev. Rul. 78-130 versus the 2015 revenue rulings appears to be the application of the step transaction doctrine. Rev. Rul. 78-130 applies what appears to be the “end result” test (the broadest version of the step transaction doctrine) in concluding that the relevant target shareholder is P, and in finding that the fact that the steps constitute an integrated plan requires the interim stock transfer to be ignored. On that basis, Rev. Rul. 78-130 concludes that the transaction cannot qualify as a section 351 transfer followed by a section 368(a)(1)(D) reorganization but instead must be characterized based on where the assets of the target company, S-1, end up within the corporate group. The 2015 revenue rulings stay closer to the form of the transaction and conclude that, in effect, there are two separate transactions—the section 351 transfer (or transfers) and then a D reorganization.

Rev. Rul. 2015-09 relies on a 1977 ruling (Rev. Rul. 77-449) not even cited in Rev. Rul. 78-130 that illustrates that a transfer of property may be respected as a section 351 exchange even if the property transferred is further transferred as part of a prearranged plan. Under Rev. Ruls. 2015-09 and 2015-10, a section 351 transfer that is not immediately followed by a liquidation or upstream merger generally will be respected, provided that the transferor does not surrender control of the transferee as a result of a transfer of the stock of the transferee corporation in a related transaction. The IRS could have taken a similar approach to the application of the step transaction doctrine in its analysis in Rev. Rul. 78-130 and reached the conclusion now embodied in Rev. Rul. 2015-09 and Rev. Rul. 2015-10 under the law in effect at that time. That is, although corporate reorganization law has changed since 1978, none of the changes has necessarily rendered the analysis or conclusion in Rev. Rul. 78-130 obsolete. Thus, the difference between Rev. Rul. 78-130 and the new rulings appears to be the result of a change in the IRS’s view of how the step transaction doctrine should apply rather than the result of a change in substantive law.

Rev. Ruls. 2015-09 and 2015-10 are consistent with a trend in IRS guidance over the past 15 years or so to apply the step transaction doctrine in a somewhat less aggressive fashion than it had been applied previously. This approach increases taxpayers’ certainty that the form that they choose will be respected notwithstanding planned future steps. However, Rev. Rul. 2015-09 does caution taxpayers not to get too comfortable, observing that “a transfer of property in an exchange otherwise described in section 351 will not qualify as a section 351 exchange if, for example, a different treatment is warranted to reflect the substance of the transaction as a whole.” For better or worse, this indicates that the potential for uncertainty has not been eliminated completely, and that issues remain for taxpayers, tax practitioners and the government to debate in the years to come.