Characterizing multistep transactions: Form can make the difference

Editor: Annette B. Smith, CPA

Taxpayers generally are bound by their chosen transaction form (National Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (1974)). However, the substance-over-form doctrine dictates that substance prevails over form when the form of a transaction does not comport with economic reality (Gregory v. Helvering, 293 U.S. 465 (1935); Cox, 56 T.C. 1270, 1280 (1971)). In the corporate tax context, it is foolhardy to assume that form inexorably accords with substance. By the same token, it also is foolhardy to assume that the form chosen by a taxpayer does not play a role in driving the U.S. federal income tax characterization of the various transactions occurring pursuant to a multistep plan.

Consider Rev. Ruls. 2001-46 and 2008-25. These rulings presented transactions that had economically similar results and similar legal relationships, yet the U.S. federal income tax characterization and consequences of the transactions differed materially. The sole distinguishing fact that drove the difference was the form by which the parent corporation ultimately acquired all of the target corporation’s assets — a statutory merger, as opposed to a complete liquidation. In other words, form can make the difference. Because the transaction’s characterization determines its U.S. federal income tax consequences to the parties, it is imperative that tax advisers carefully select the form of a transaction — even one subject to the step-transaction doctrine — to obtain the desired U.S. federal income tax consequences.

This discussion explores the step-transaction doctrine and the facts, analysis, and rulings of Rev. Ruls. 2001-46 and 2008-25, then analyzes the rulings to illustrate how form can make a difference in multistep transactions.

Step-transaction doctrine

The step-transaction doctrine is a part of the substance-over-form doctrine and applies where a taxpayer has embarked on a series of transactions that in substance are single, unitary, or indivisible (see, e.g., Minnesota Tea Co. v. Helvering, 302 U.S. 609 (1938); Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942)). Under the doctrine, certain transactions, particularly multistep transactions, may be ignored, while other discrete steps may be recast or integrated (see, e.g., Penrod, 88 T.C. 1415 (1987)). Courts have identified three formulations of the step-transaction doctrine: (1) the end-result test; (2) the binding-commitment test; and (3) the mutual-interdependence test (King Enterprises, Inc., 418 F.2d 511 (Ct. Cl. 1969); Gordon, 391 U.S. 83 (1968); Redding, 630 F.2d 1169 (7th Cir. 1980), cert. denied, 450 U.S. 913 (1981)).

Rev. Rul. 2001-46

In Rev. Rul. 2001-46, Situation 1, Corporation X formed a transitory subsidiary, Y, which effected a statutory merger with and into a target corporation, T, with T surviving. T’s shareholders received X voting stock (70%) and cash (30%) in the transaction. Following the Y-T merger, T merged with and into X pursuant to state law, with X surviving. Using the approach in Rev. Rul. 67-274, the IRS treated the integrated transactions as a single statutory merger that qualified as a reorganization under Sec. 368(a)(1)(A) (a type A reorganization). In evaluating Situation 1, the IRS reasoned that “unless the policies underlying [Sec.] 338 dictate otherwise, the integrated asset acquisition . . . is properly treated as a statutory merger of T into X that qualifies as a reorganization under [Sec.] 368(a)(1)(A).”

In Situation 2 of the revenue ruling, corporation X formed a transitory subsidiary, Y, which effected a statutory merger with and into a target corporation, T, with T surviving. T’s shareholders received solely X voting stock in exchange for their T stock. Following the merger, T merged with and into X, with X surviving. The IRS disregarded the Y-T merger, ruling in substance that T merged directly with and into X pursuant to state law. This position was in accordance with, and amplified, Rev. Rul. 67-274.

Rev. Rul. 2008-25

In Rev. Rul. 2008-25, corporation P formed a transitory subsidiary, X, which effected a statutory merger with and into a target corporation, T, with T surviving. T’s shareholders received $90x of P voting stock and $10x cash in the transaction. Thereafter, and as part of the same plan, T completely liquidated into P. In evaluating the facts, the IRS stated that because T completely liquidated, the safe-harbor exception under Regs. Sec. 1.368-2(k) regarding the application of the step-transaction doctrine did not apply. As a result, the IRS concluded that the merger and liquidation could not be considered independently of each other for purposes of determining whether the transaction qualified as an A reorganization by reason of Sec. 368(a)(2)(E).

The IRS also distinguished the result in Rev. Rul. 2001-46. In particular, the IRS concluded that the transactions in Rev. Rul. 2008-25 could not be integrated into a single merger of T with and into P because T was liquidated into P instead of merging with and into P pursuant to state law. After an exhaustive analysis, the IRS concluded that the transactions could not be collapsed into a tax-free reorganization under Sec. 368(a)(1) and, therefore, treated the transactions as a qualified stock purchase followed by a tax-free liquidation under Sec. 332.

Analysis

Under the facts of Rev. Ruls. 2001-46 (Situation 1) and 2008-25, a merger subsidiary was formed, followed by a merger of the merger subsidiary with and into a target corporation in exchange for similar ratios of stock and cash. In Rev. Rul. 2001-46, the surviving corporation thereafter merged with and into its parent corporation, with the parent corporation surviving, while the surviving corporation in Rev. Rul. 2008-25 thereafter completely liquidated into its parent corporation.

From an economic perspective, the parties to the transactions in Rev. Ruls. 2001-46 and 2008-25 were in the same position immediately prior to and following the transactions because all of the assets of the target corporation ultimately were acquired by the parent corporation of the merger subsidiary, the shareholders of the target corporation received some cash, and the shareholders of the target corporation ceased to be shareholders of the target corporation and became shareholders of the parent corporation of the merger subsidiary. Thus, the transfers of economic value between the parties to the transactions in Rev. Ruls. 2001-46 and 2008-25 were analogous.

Likewise, notwithstanding that the parent corporation in Rev. Rul. 2001-46 acquired the assets of the target corporation by a statutory merger and in Rev. Rul. 2008-25 by a complete liquidation, the parties in each revenue ruling were in identical legal relationships immediately prior to and following the transactions. Although the form of the legal mechanism by which the parent corporation acquired the assets of the target corporation differed in the two rulings, the legal relationships created or eliminated by reason of the upstream statutory merger in Rev. Rul. 2001-46 were analogous to those of the complete liquidation in Rev. Rul. 2008-25. In other words, while the legal forms were different, their effects were identical.

Notwithstanding that the economic and legal relationships immediately prior to and following the transactions in Rev. Ruls. 2001-46 and 2008-25 were identical, the U.S. federal income tax consequences were materially dissimilar. The U.S. federal income tax characterization of the transactions in Rev. Rul. 2001-46 qualified for nonrecognition treatment, while the transactions in Rev. Rul. 2008-25 resulted in a taxable qualified stock purchase followed by a tax-free liquidation. The sole distinguishing fact that drove the difference in the U.S. federal income tax characterization and consequences of the transactions was the form by which the parent corporation of the transitory subsidiary acquired all the target corporation’s assets. Accordingly, form made the difference in characterizing the multistep transactions in Rev. Ruls. 2001-46 and 2008-25.

Tax treatment is guided by the form of the transaction

Although two transactions may be economically and legally similar, Rev. Ruls. 2001-46 and 2008-25 illustrate that the form of a transaction can materially affect the U.S. federal income tax characterization. Because the characterization of a transaction determines the U.S. federal income tax consequences to its parties, in seeking the desired U.S. federal income tax consequences, tax advisers must analyze the legal mechanisms by which transactions may be consummated.

EditorNotes

Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.

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