Editor: Jon Almeras, J.D., LL.M.
On December 18, 2009, the IRS published final regulations addressing the qualification and treatment of certain acquisitive transactions as reorganizations under Sec. 368(a)(1)(D) where no stock or securities of the acquiring corporation are issued in the transaction (cash D reorganizations) (T.D. 9475). The final regulations also address the determination of basis of stock or securities under Sec. 358 in a cash D reorganization as well as how the rules apply in a consolidated group context.
Prior to the issuance of the final regulations, cash D reorganizations were subject to the temporary regulations issued in 2006 (T.D. 9303). The final regulations generally retain the rules of the temporary regulations, though the IRS and Treasury made certain modifications in response to comments they received, including the following:
- In cases in which no consideration is received by the shareholders or the value of the consideration received in the transaction is less than the fair market value (FMV) of the target corporation’s assets, the acquiring corporation is deemed to issue stock with a value equal to the excess of the FMV of the target corporation’s assets over the consideration actually issued, if any.
- The taxpayer may designate the actual share of stock to which stock basis of the nominal share, determined under Sec. 358, will attach.
- The final regulations provide an example that clarifies the consequences of a cash D reorganization between members of a consolidated group.
A reorganization under Sec. 368(a) (1)(D) (a D reorganization) generally involves a transfer by one corporation (target corporation) of all or a part of its assets to another corporation (acquiring corporation) if, immediately after the transfer, the target corporation or one or more of its shareholders, or any combination thereof, is in control of the acquiring corporation. Notably, Sec. 368(a)(1)
(D) requires that the acquiring corporation’s stock or securities be distributed in pursuance of a plan of reorganization in a transaction that qualifies under Secs. 354, 355, or 356.
In order for a purported acquisitive reorganization to qualify under Sec. 368(a)(1)(D), Sec. 354(b)(1)(B) provides (in part) that the acquiring corporation’s stock or securities must be distributed by the target corporation in pursuance of the plan of reorganization (the distribution requirement). As such, under a literal reading of Secs. 368(a)(1)(D) and 354(b)(1)(B), an acquisitive transaction cannot qualify as a D reorganization unless one or more of the target corporation’s shareholders receive at least some stock or securities of the acquiring corporation.
The temporary regulations generally provided that the distribution requirement of Secs. 368(a)(1)(D) and 354(b)(1)
(B) will be treated as satisfied even though no stock or securities are actually issued in the transaction if the same person or persons own, directly or indirectly, all the stock of the target and acquiring corporations in identical proportions. In order to satisfy the distribution requirement in those instances, the temporary regulations deemed the acquiring corporation to issue a nominal share of stock to the target corporation in addition to the actual consideration exchanged for the target corporation’s assets. The nominal share was then deemed to be distributed to the target corporation’s shareholders and, when appropriate, further transferred through the chain of ownership to the extent necessary to reflect actual ownership of the target and acquiring corporations after the transaction.
Meaningless Gesture Doctrine Reaffirmed
The IRS based the temporary regulations in part on the longstanding “meaningless gesture” doctrine. Where there is complete and proportional shareholder identity between the target corporation and the acquiring corporation, the IRS and the courts have previously applied the meaningless gesture doctrine in the context of D reorganizations (see, e.g., Rev. Rul. 70-240; James Armour, Inc., 43 T.C. 295 (1964); and Wilson, 46 T.C. 334 (1966)).
When it issued the temporary regulations, the IRS requested comments on whether the meaningless gesture doctrine may be viewed as being inconsistent with the distribution requirement, especially where the consideration received by the target corporation actually equals the net value of the assets transferred. The preamble to the final regulations confirms the government’s view that a deemed issuance of stock is appropriate even in such cases. To that end, the final regulations clarify the following:
- If no consideration is received, or the value of the consideration received in the transaction is less than the FMV of the target corporation’s assets, the acquiring corporation is treated as issuing stock with a value equal to the excess of the net value of the target corporation’s assets over the value of the consideration actually received in the transaction; and
- If the value of the consideration received in the transaction is equal to the net value of the target corporation’s assets, the acquiring corporation will be deemed to issue a nominal share of stock to the target corporation in addition to the actual consideration exchanged for the target corporation’s assets.
The final regulations retain the example from the temporary regulations clarifying that a de minimis amount of stock ownership will be disregarded in determining whether there is complete shareholder identity and proportionality of ownership in the target corporation and the acquiring corporation.
Nominal Share Concept Retained
The following basic example illustrates the concept of the deemed issuance of a nominal share in cash D reorganizations.
Example: Individual A owns all the stock of corporations T and S. T sells all its assets at FMV to S in exchange for cash and liquidates immediately thereafter. Under both the temporary and the final regulations, the distribution requirement is treated as satisfied because A owns 100% of T and S (i.e., the same person owns the stock of each corporation in identical proportions). As a result, S, the acquiring corporation, is deemed to issue a nominal share of S stock to T, the target corporation, in addition to the cash actually exchanged for the T assets. T is then deemed to distribute the cash as well as the nominal share of S stock to A in liquidation. As described below, A may then designate the share of S stock, to which the basis of the nominal share (if any) will attach.
Despite some degree of criticism from commentators, the preamble to the final regulations sets forth the IRS’s view that the nominal share concept is appropriate (rather than simply deeming the distribution requirement to be satisfied) because it provides a useful mechanism for tracking stock basis consequences to the exchanging shareholder. For example, when appropriate, the nominal share is deemed to be further transferred through the chains of ownership to the extent necessary to reflect actual ownership of the acquiring corporation. Because the nominal share is treated as nonrecognition property under Sec. 358(a), following basis adjustments (for example, under Sec. 358 or Regs. Sec. 1.1502-32 if in a consolidated group), the nominal share preserves remaining basis, if any, and facilitates future stock gain or loss recognition by the appropriate shareholder.
Basis Allocation and Deemed Recapitalization
The preamble to the final regulations acknowledges the uncertainty under current law with respect to the allocation of basis in the shares of the target corporation’s stock (surrendered by the shareholder) to the acquiring corporation shares deemed received in cash D reorganizations.
The preamble provides that Regs. Sec. 1.358-2(a)(2)(iii) addresses how to determine stock basis in the case of a reorganization in which no property is received, or property with FMV less than that of the stock or securities surrendered is received. Under these rules, the relevant shareholders participate in a two-step fiction. The first step deems the shareholders to surrender all their target corporation shares in exchange for acquiring corporation stock. Next, the shareholders are deemed to participate in a recapitalization of the acquiring corporation’s stock.
The final regulations provide a clarifying amendment to Regs. Sec. 1.358-2(a) (2)(iii) where the value of the assets transferred by the target corporation equals the value of the cash or other nonqualifying property received in exchange. Under that amendment, in the case of a reorganization in which the property received consists solely of nonqualifying property equal to the value of the assets transferred (as well as a nominal share), after the nominal share’s basis is determined under Sec. 358, the taxpayer may designate the actual share of stock to which such basis will attach.
In the IRS’s view, this approach is consistent with current law. However, the IRS and Treasury will reexamine the mechanics of the approach as part of a broader study of the basis allocation rules under Sec. 358.
Cash D Reorgs. in a Consolidated Group
Generally, in the case of an acquisitive reorganization between members of a consolidated group involving the receipt of money or other property (boot), Regs. Sec. 1.1502-13(f)(3) specifically requires that boot be taken into account immediately after the reorganization in a separate transaction. In effect, the boot is removed from Sec. 356 (i.e., dividend within gain treatment) and instead is treated as having been received in a dividend-equivalent redemption. In the case of a cash D reorganization, under the temporary regulations, practitioners were concerned that the treatment of the cash (received in exchange for the target corporation’s stock) as a dividend would create an excess loss account (ELA) that would attach to the nominal share of acquiring corporation stock. The subsequent deemed distribution of the nominal share in such cases appeared to generate an intercompany gain under Sec. 311(b), which subsequently would be taken into account under the matching and acceleration rules of Regs. Sec. 1.1502-13(c).
The final regulations added an example clarifying that the nominal share concept is equally applicable to cash D reorganizations between members of a consolidated group. By adding this example, the final regulations confirmed the fears of practitioners that the interaction of the consolidated return rules and the final regulations may produce an unwelcome result of creating an ELA (and an intercompany item of gain).
Further Comments Invited
As part of a broader study, the IRS and Treasury continue to study various issues in the context of D reorganizations, including the continuity of interest requirement and the liquidation-reincorporation doctrine. Comments are specifically requested on the application of the final regulations to reorganizations involving foreign corporations or shareholders.
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, DC.
This article does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.
For additional information about these items, contact Mr. Almeras at (202) 758-1437 or email@example.com.