In 2015, final regulations issued by the IRS (T.D. 9739) encapsulated a pair of principles applicable to tax-free reorganizations under Sec. 368(a)(1)(F) (F reorganizations). The first of those principles is that an F reorganization can consist of a series of transactions that, when viewed individually, could be subject to other provisions. The second principle, which is often invoked as "F in a bubble," is that an F reorganization cannot be stepped together with other transactions because it is merely a change in identity, form, or place of organization of a single corporation. The tension between these two principles can cause taxpayers uncertainty.
F Reorganization Defined
Sec. 368(a)(1)(F) defines an F reorganization as "a mere change in identity, form, or place of organization of one corporation, however effected." The final regulations, at Regs. Sec. 1.368-2(m)(1), clarify that to qualify as a "mere change," a transaction or series of transactions must meet the following requirements: (1) The resulting corporation stock is distributed in exchange for transferor corporation stock; (2) the same person or persons own all the transferor corporation stock immediately before the transaction and all the resulting corporation stock immediately after the transaction; (3) the resulting corporation has no prior assets or attributes; (4) the transferor corporation liquidates; (5) the resulting corporation is the only acquiring corporation; and (6) the transferor corporation is the only acquired corporation. Regs. Sec. 1.368-2(m)(1) specifies that for purposes of determining whether those requirements have been met, a transaction or series of transactions:
begins when the transferor corporation begins transferring (or is deemed to begin transferring) its assets, directly or indirectly, to the resulting corporation, and it ends when the transferor corporation has distributed (or is deemed to have distributed) to its shareholders the consideration it receives (or is deemed to receive) from the resulting corporation and has completely liquidated for federal income tax purposes.
Step Transaction Principles and F Reorganizations
The final regulations incorporate the long-standing position expressed in IRS guidance that multiple transactions can be stepped together and characterized jointly as an F reorganization if they together have the effect of a mere change. This principle is addressed in Regs. Sec. 1.368-2(m)(3)(i), which provides that:
[a] potential F reorganization consisting of a series of related transactions that together result in a mere change of one corporation may qualify as a reorganization under section 368(a)(1)(F), whether or not certain steps in the series, viewed in isolation, could be subject to other Code provisions, such as sections 304(a), 331, 332, or 351.
The final regulations also incorporate the "F in a bubble" concept, which is that an F reorganization is incapable of being stepped together with other transactions. On that topic, Regs. Sec. 1.368-2(m)(3)(ii) provides:
A potential F reorganization that qualifies as a reorganization under section 368(a)(1)(F) may occur before, within, or after other transactions that effect more than a mere change, even if the resulting corporation has only transitory existence. Related events that precede or follow the potential F reorganization generally will not cause that potential F reorganization to fail to qualify as a reorganization under section 368(a)(1)(F). Qualification of a potential F reorganization as a reorganization under section 368(a)(1)(F) will not alter the character of other transactions for federal income tax purposes, and step transaction principles may be applied to other transactions without regard to whether certain steps qualify as a reorganization or part of a reorganization under section 368(a)(1)(F).
Uncertainty With Back-to-Back F Reorganizations
One potential point of conflict between these two principles is that there are situations in which a series of transactions can be characterized either as multiple F reorganizations or grouped together as a single F reorganization.
Example: Parent is a corporation that wholly owns Sub, a U.S. captive insurance company. For nontax business reasons, Parent wants to change Sub's place of incorporation from the United States to Country A. Parent plans for Sub to subsequently make an election under Sec. 953(d), which provides that certain insurance companies that are controlled foreign corporations may elect to be treated as domestic corporations (the "domestication election").
Sec. 953(d)(4)(A) provides that "any foreign corporation making an election under paragraph (1) shall be treated as transferring (as of the 1st day of the 1st taxable year to which such election applies) all of its assets to a domestic corporation in connection with an exchange to which section 354 applies." Regs. Sec. 1.367(b)-2(h) provides that a foreign corporation that makes a domestication election shall be treated as transferring "all of its assets to a domestic corporation in a reorganization described in section 368(a)(1)(F)."
Parent causes the following steps to occur:
- Step 1: Sub migrates its country of incorporation from the United States to Country A; and
- Step 2: Sub makes a Sec. 953(d) domestication election.
One way to characterize those steps is as the following two separate F reorganizations: (1) Step 1 constitutes one F reorganization because the migration of Sub from the United States to Country A is a mere change in the place of organization of Sub; and (2) Step 2 constitutes a distinct separate F reorganization because Sec. 953(d) and Regs. Sec. 1.367(b)-2(h) provide that the domestication election is treated as an F reorganization. That interpretation is supported by the "F in a bubble" principle that an F reorganization should not affect or be affected by any transactions occurring around it. Arguably, because Regs. Sec. 1.367(b)-2(h) explicitly deems the domestication election in Step 2 an F reorganization, that step is "in a bubble" and cannot be stepped together with Step 1.
Characterizing this transaction as two F reorganizations could have negative tax consequences for Parent. For example, that characterization could implicate the U.S.-to-foreign, or "outbound," transfer provisions of Sec. 367 for the first F reorganization and the "inbound" transfer provisions of Sec. 367 for the second F reorganization. Another potential consequence of separating the two steps is that Sub may be viewed as a foreign corporation in the moment between its migration to Country A and the domestication election, which could trigger deferred gain under the consolidated return regulations.
Alternatively, Step 1 and Step 2 could be jointly characterized as constituting a single F reorganization in which Sub merely changes its place of incorporation (except for tax purposes) to Country A. That characterization is supported by the principle that an F reorganization can consist of a series of transactions that constitute a mere change, even when those transactions are subject to other tax provisions when viewed in isolation. Parent might prefer such a characterization because it would prevent any outbound or inbound transfers that might implicate Sec. 367 and avoid triggering deferred gain under the consolidated return regulations.
Although there is no guidance addressing back-to-back F reorganizations in the context of insurance company domestication elections, the IRS has issued guidance on a pair of transactions that could be characterized as either one F reorganization or two F reorganizations.
In Letter Ruling 201122002, a U.S. corporation (Parent) wholly owned FSub1, a Country A entity that was treated as a controlled foreign corporation under Sec. 957(a). FSub1 wholly owned FSub2, a Country B entity that was treated as a disregarded entity for U.S. federal tax purposes. FSub2 in turn wholly owned FSub3, a Country B entity treated as a disregarded entity for U.S. federal tax purposes. FSub3 owned a number of foreign operating businesses. To reduce accounting, banking, systems, legal, regulatory, and stewardship costs through the elimination of unnecessary legal entities, Parent caused the following steps to occur:
- Step 1: FSub1 migrated its country of incorporation from Country A to Country B, resulting in a new entity, New FSub1;
- Step 2: FSub2 elected to be treated as an association taxable as a corporation for U.S. federal tax purposes; and
- Step 3: New FSub1 merged into FSub2, with FSub2 surviving, under applicable Country B law.
As with the insurance company transaction described above, it is possible to frame the steps outlined in the letter ruling as two separate F reorganizations: (1) Step 1 constitutes one F reorganization because the migration of FSub1 from Country A to Country B was a mere change in the place of organization of a corporation; and (2) Step 2 and Step 3 combine to constitute a distinct second F reorganization, because together they effected a mere change in the identity of Parent's wholly owned subsidiary. In this case, framing the transaction as two F reorganizations implicates the indirect stock transfer provisions of Sec. 367.
Alternatively, the three steps outlined in Letter Ruling 201122002 can be framed as a single F reorganization in which Parent merely migrated its wholly owned subsidiary from Country A to Country B. Framing the three steps this way avoids any Sec. 367 consequences. The IRS ruled that the three steps described above constituted a single F reorganization and that there was not an indirect transfer of stock under the Sec. 367 regulations.
The IRS reached a different result in Letter Ruling 201239003. In that letter ruling, a U.S. corporation wholly owned DSub, a U.S. corporation. DSub, together with the foreign corporations FCo1 and FCo2, owned FSub, a Country X entity treated as a corporation for U.S. tax purposes. DSub, FCo1, and FCo2 incorporated TopCo1 and TopCo2, two Country Y entities treated as corporations for U.S. tax purposes. DSub, FCo1, and FCo2 engaged in the following steps, which have been simplified for purposes of this item:
- Step 1: DSub, FCo1, and FCo2 contributed all of their shares of FSub stock to TopCo1 in exchange for additional shares of TopCo1.
- Step 2: TopCo1 assumed all of the obligations of FSub.
- Step 3: FSub elected to be treated as a disregarded entity for U.S. tax purposes.
- Step 4: DSub, FCo1, and FCo2 contributed all of their shares of TopCo1 stock to TopCo2 in exchange for additional shares of TopCo2.
- Step 5: TopCo2 assumed all of the obligations of TopCo1.
- Step 6: TopCo1 elected to be treated as a disregarded entity for U.S. tax purposes.
- Step 7: All the outstanding shares of TopCo1 were acquired by a third party for cash.
As in the fact patterns described above, it is possible to frame these steps as two F reorganizations: (1) Steps 1-3 constitute one F reorganization because they resulted in FSub's merely changing its identity to TopCo1 and its place of organization to Country Y; and (2) steps 4-6 constitute a distinct second F reorganization because they result in TopCo1's merely changing its identity to TopCo2. Alternatively, steps 1-6 can be characterized as a single F reorganization in which FSub merely changed its identity to TopCo2 and its place of organization to Country Y. This time, the IRS characterized the steps described above as two back-to-back F reorganizations followed by a sale.
Arguably, the contradictory results of Letter Rulings 201122002 and 201239003 suggest that taxpayers have some flexibility in characterizing back-to-back F reorganizations. For example, these rulings suggest that the IRS might be willing to entertain a taxpayer-favorable ruling that the steps in the insurance company fact pattern described above constitute a single F reorganization. However, given the express language in Sec. 953(d) and Regs. Sec. 1.367(b)-2(h) that a domestication election is one F reorganization, it may be difficult without obtaining a letter ruling to be confident that the two steps would be stepped together. In the absence of further guidance, it may be wise to avoid the uncertainty by planning around that fact pattern and similar situations involving back-to-back F reorganizations.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.