The “Substantially All” Requirement: A Momentary Concept

By Gabriel Cohen, CPA, Washington, DC

Editor: Annette B. Smith

The requirements for certain tax-free reorganizations under Sec. 368(a) (e.g., C, acquisitive D, and triangular A reorganizations) include a “substantially all” test. That term generally refers to the quantity of assets that must be transferred (or held) to qualify a transaction as a reorganization. For IRS ruling purposes, “substantially all” means 90% of the net assets and 70% of the gross assets, while courts have applied a facts-and-circumstances test focused on operating assets.

Regardless of the amount of assets that must be transferred, final regulations dealing with continuity of business enterprise (COBE) (Regs. Sec. 1.368-1(d)) and postacquisition transfers (Regs. Sec. 1.368-2(k)) appear to indicate that “substantially all” is only a momentary concept. Immediately after a reorganization, as part of a plan, the acquiring company may distribute, transfer, or sell acquired assets, provided certain requirements are met. These new rules may give taxpayers certain flexibility in relocating assets within their corporate structure for business reasons while maintaining the tax-free nature of the initial reorganization.

Final COBE and Postacquisition Transfer Regs.

New final regulations (TD 9361 and TD 9396), generally applicable to transactions occurring on or after October 25, 2007, significantly expand the range of permissible post-reorganization transfers. The regulations add an aggregation concept to the definition of a qualified group, permit certain distributions, and provide that the qualified group is treated as owning any stock owned by a Sec. 368(c) controlled partnership for purposes of the COBE test.

Under the regulations, a taxpayer can transfer assets anywhere within a qualified group without risk of the reorganization being “disqualified or recharacterized,” provided the COBE requirement is met and the transfer is of a type described in Regs. Sec. 1.368-2(k). The prior regulations did not include the term “recharacterized” and thus did not turn off the step-transaction doctrine.

A qualified group is defined under Regs. Sec. 1.368-1(d)(4)(ii) as

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 (or indirectly . . . [through a 368(c) controlled partnership]) by one or more of the other corporations.

Under prior guidance, a qualified group was a “straight 368(c) chain” and did not include an aggregation concept.

The types of transfers permissible under Regs. Sec. 1.368-2(k) include both distributions and other transfers. A distribution of target assets is permitted under Regs. Sec. 1.368-2(k)(1)(i), provided the amount of target assets distributed does not cause the target to be treated as having de facto liquidated and the assets are not pushed up to certain former target shareholders.

Asset transfers other than distributions (i.e., other transfers) are permitted under Regs. Sec. 1.368-2(k)(1)(ii), provided that:

  • COBE is satisfied;
  • The transfer is not of a type described in the distributions rule;
  • The property transferred consists of part or all of the target’s assets; and
  • The target does not terminate its corporate existence.

Asset Sale Following Triangular C Reorg.

Regs. Sec. 1.368-1(d)(1) indicates that assets can be sold to third parties following a reorganization as long as the qualified group “either continue[s] the target corporation’s . . . historic business or use[s] a significant portion of [the target’s] historic business assets.” Regs. Sec. 1.368-1(d)(5), Example 1, indicates that retention of one-third of the assets is a “signifi-cant portion.”

Practice tip: After a triangular C reorganization, an acquiring company may distribute unwanted assets up to its parent shareholder and have the parent shareholder sell the assets to a third party for cash without disqualifying the original reorganization. This technique can be effective for disposing of unwanted assets while getting cash to a parent shareholder.

Tax-Free Spin-Off After Triangular C Reorg.

Sometimes after a reorganization, the target corporation has certain assets or business lines that the acquiring group would like to place in a different part of its corporate structure.

Example: A Corp. acquires all the assets and liabilities of T Corp. solely for voting stock of P Corp., A’s parent, in a triangular C reorganization. T owns Business X and Business Y. P would like A to continue X, but P wants to conduct Y in a separate corporation under P.

The final COBE and postacquisition transfer regulations appear to permit A to effect a tax-free spin-off of Y to P without having the initial triangular C reorganization disqualified or recharacterized. This technique could only be effected tax free to the extent that Y’s spin-off met all the requirements for a Sec. 355 transaction.

Lodging Target Liabilities with Parent After Triangular C Reorg.

In Rev. Rul. 70-107, the IRS held that in a triangular C reorganization, a parent’s direct assumption of some of the target’s liabilities violated the “solely for voting stock” requirement of a C reorganization. Interestingly, the final regulations (Regs. Sec. 1.368-2(k)) permit the assumption of liabilities by a parent corporation in a triangular C reorganization, provided the liabilities are not assumed directly in the transaction. For example, in Regs. Sec. 1.368-2(k)(2), Example 2, following a triangular C reorganization the subsidiary/acquirer transferred one-half of the target’s assets and liabilities to its parent. The example held that the described indirect liability assumption did not disqualify the otherwise qualified C reorganization.

Presumably, under Rev. Rul. 70-107, if those liabilities had been assumed directly in the transaction by the parent, the reorganization would have been disqualified. Accordingly, if an acquiring corporation desires to disqualify a triangular C reorganization (e.g., for a basis step-up), it may be able to do so by having the parent directly assume target liabilities in the transaction. On the other hand, if the acquiring corporation wants to have its parent assume certain liabilities of the target and preserve the tax-free nature of the initial reorganization, it may distribute some of the assets and have its parent assume the unwanted liabilities after the initial qualified reorganization.


“Substantially all” now appears to be a momentary concept. Corporations seem free to sell, transfer, or otherwise rearrange target assets following an otherwise qualifying reorganization, provided certain requirements are met. In addition, target liabilities now may be assumed by a parent corporation after a triangular C reorganization under the new final regulations without running afoul of Rev. Rul. 70-107.


Annette B. Smith is with Washington National Tax Services PricewaterhouseCoopers LLP in Washington, DC

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

If you would like additional information about these items, contact Ms. Smith at (202) 414-1048 or

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