Question

Be familiar with the consequences of a tax-free reorganization under Section 368. Be familiar with the judicial doctrines common to all types of reorganizations

Answer 1

Overview and Fundamentals of Section 368

Section 368(A)(1) outlines a format for tax treatment to reorganizations, as described in the Internal Revenue Code of 1986. The reorganization transactions, however, must meet certain legal requirements to classify for favorable treatment. Additionally, there has been further precedent outside of the codified requirements that have developed in case law.

A variety of transactions can be tax-free reorganizations for federal income tax purposes. To qualify as a tax-free reorganization, a transaction must meet the statutory requirements for one of the types of tax-free reorganizations. In addition, a tax-free reorganization generally must also satisfy the three judicial requirements (continuity of interest, continuity of business enterprise, and business purpose) that apply to all tax-free reorganizations.

Identification of the Tax-Free Reorganization Structures

Section 368 Subsection	Type of Restructuring
368(a)(1)(A)	Tax-free mergers and consolidations
368(a)(1)(B)	Stock-for-stock exchanges
368(a)(1)(C)	Stock-for-asset exchanges
368(a)(1)(D)	Divisive reorganizations
368(a)(1)(E)	Recapitalization
368(a)(1)(F)	Changes in place or form of organization
368(a)(1)(G)	Insolvency reorganization

IRC Section 368(a)(1) Subsections A through C

The first three acquisitions outlined above are categorized as acquisitive reorganizations, wherein they are constituted by the acquisition of a subsidiary.

A tax-free merger and consolidation as outlined IRC Section 368(a)(1)(A) is fairly cut and dry. In a merger-type of reorganization, a subsidiary corporation is absorbed into a parent company, following any applicable state law or merger statute. A consolidation, on the other hand, involves a combination of two equally grounded companies. In terms of business organization, these two companies may actually dissolve and band together as a new corporation.

IRC Section 368(a)(2)(D) outlines a different type of merger, known as a forward triangular merger. In this reorganization, a target corporation is acquired by the subsidiary of a parent company, as opposed to acquisition from the parent company directly. IRC Section 368(a)(2)(E) outlines a reverse triangular merger, wherein a subsidiary of the parent acquiring company is absorbed into the target corporation.

Subsection B of Section 368(a)(1) defines a stock-for-stock exchange, which results in a parenthetical B reorganization (as dictated by the subsection). This type of transaction involves trading all target company stock for a portion of the stock of the acquiring parent corporation. This removes ownership of the target company from target company shareholders and gives it to the acquiring company. In exchange, target company shareholders become minority shareholders of the acquiring company.

Subsection C of Section 368(a)(1) defines a stock-for-asset exchange, also known as a parenthetical C reorganization.

IRC Sections 368(a)(1)(D)

As opposed to an acquisitive reorganization, a divisive reorganization involves divestiture of a portion of a group’s holdings, or division of that corporation into smaller subsidiaries. This results in a tax-free reorganization, which can be described as the reverse of an acquisition.

IRC Section 368(a)(1)(D) defines that a division of assets by a parent company can constitute as a binding and legal reorganization if the holders of each divided part admit control immediately after the transfer, and these holders were a shareholder of the previous parent company. Section 354 further outlines a supporting structure where replacement shares can be received in this type of reorganization in a tax-free manner.

IRC Section 368(a)(1)(E)

A recapitalization occurs when a company restructures the proportion of debt and equity within the company. This may be due to adverse economic environments that lead the company to a restructure, but not insofar as to require a merger or deconsolidation.

There are two types of recapitalization – a downstream recap and an upstream recap. An upstream recapitalization results in common shareholders scaling up into preferred shareholders. A downstream recapitalization removes debt by turning debt holders into shareholders, however diluting the ownership of previously existing shareholders.

IRC Section 368(a)(1)(F)

A relocation or organizational structure change may result in a reorganization for federal tax purposes. This movement may be accomplished by merging an old entity with a shell corporate entity in a new location or holding the desired organizational structure. Subsection F simply states that this type of restructuring, which includes “a mere change in identity, form, or place” is considered a reorganization for tax purposes..

IRC Section 368(a)(1)(G)

The final sub-section outlines the reorganization classification in the event of bankruptcy or insolvency proceedings. Divestiture of equity stakes in a liquidating corporation may constitute a reorganization and become income tax recognition events.

The judicial doctrines common to all types of reorganizations

When the conditions for a tax-free reorganization are so narrow that, in some cases, unavoidable changes in the business activity or the necessity to buy out shareholders will result in taxation of the reorganization, the question arises as to whether the parties can do after or before the reorganization what the law prohibits them from doing at the time of the reorganization. If the parties can get rid of unwanted assets by selling them or transferring them to a different company before or after the reorganization, the problems in qualifying for a taxfree reorganization are more apparent than real. The same principle applies to the redemption of minority shareholders' interests.

The U.S. reorganization rules, which are rather flexible for changes at the time of the reorganization, are generally rather inflexible before and after; that is, the same restrictions that apply at the time of the reorganization also apply before and after it. This is the result of the application of the "step transaction doctrine" in case law. Under this doctrine, different transactions before and after the reorganization are considered to be "single steps" of the overall transaction if it appears that they were necessary and indispensable steps to reach a general agreement on the reorganization. Therefore, sales of assets or shares before or after the reorganization will be taken into account in determining whether the continuity requirement has been met, when it appears that these sales were implemented as part of the overall reorganization agreement. Countries with very strict rules on continuity traditionally have not had such a step transaction doctrine. This diversity of experience suggests a choice between, on the one hand, aformalistic system— with strict requirements for qualifying for reorganization treatment— and, on the other hand, a more flexible system policed by antiavoidance rules like the step transaction doctrine. While the latter approach can work in countries such as the United States with its sophisticated system of tax lawyers, tax administrators, and courts, it may be difficult to apply in countries whose tax system is not as developed, except by leaving considerable discretion to the tax administrators. While a formalistic system may therefore be more attractive in developing and transition countries, it also suffers from the potential disadvantage of being open to abuse. If the former choice is adopted, care should be given to defining the transactions eligible for taxfree reorganization treatment.