Securities exchanges incident to B reorgs.

On Feb. 23,1998, the IRS ended its self-imposed year-long moratorium on issuing subchapter C rulings when it issued Rev. Rul. 9810. Effective for exchanges occurring on or after March 9,1998, Rev. Rul. 98-10 involves the determination of whether the surrender of target debentures in exchange for acquiring debentures is subject to nonrecognition treatment if the acquiring and target corporations are both parties to the same reorganization under Sec. 368(a)(1)(B).

The facts of Rev. Rul. 98-10 (substantially similar to those in Rev. Rul. 69-142) involve Corporation X, which acquires A of the stock of Corporation Y in exchange for voting stock. Pursuant to the reorganization, X acquires all of the outstanding Y debentures in exchange for an equal amount of X debentures. Some of the Y debentures were held by Y shareholders, but a substantially portion were held by nonshareholders. The X and Y debentures are "securities" within the meaning of Sec. 354(a) (1) and, thus, are not equity interests.

In Rev. Rul. 69-142, the Service determined that the parties had undertaken a valid B reorganization, but that the exchange of the debentures was a separate, taxable exchange. The underlying legal memorandum for Rev. Rul. 69-142--GCM 34014--cited GCM 34004 in attempting to articulate the rationale for treating the debenture-for-debenture exchange as "not part of the reorganization exchange for purposes of sections 368(a)(1)(B) and 354(a)(1)." GCM. 34004 provided two theories. The first was that a separately bargained-for debenture-for-debenture exchange should be treated as separate. The facts of Rev. Rul. 69-142 did not indicate, however, whether the debenture-for-debenture exchange therein was separately bargained for. The second (and more plausible) theory was that, although the "solely-for-voting-stock" requirement must be tested by looking at indirect, as well as direct, payments to the transferor, payment of the target corporation's liability was not a receipt of nonstock consideration by a shareholder of the acquired corporation; see Rev. Rul. 68-637, which treated an exchange of options and warrants for options and warrants incident to a C reorganization as the assumption of a liability.

Rev. Rul. 69-142 specifically stated (the same statement appears in Rev. Rul. 98-10) that, although some of the Y shareholders also own Y debentures, a substantial portion of the Y debentures were owned by persons who own no Y stock. This statement, however, only ensured that the value of the debentures issued by X in exchange for the Y debentures realistically reflected die value of the Y debentures alone and did not constitute indirect nonqualifying consideration for they Y stock. It did not eliminate the possibility that the debentures were received in exchange for stock, a violation of the solely-for-voting-stock requirement in a B reorganization.

By providing that the two transactions (stock-for-stock and debenture-for-debenture) were separate, the IRS was able to conclude that the stock-for-stock exchange, uninfected by the debenture-for-debenture exchange, satisfied the B reorganization requirements. Following through with that separation, however, the debenture-for-debenture exchange was omitted from the "plan of reorganization" and Sec. 354(a)(1). The resulting taxable debenture-for-debenture exchange could thus be viewed as a "toll charge" for the satisfaction of the B reorganization requirements.

Rev. Rul. 98-10 is important for two reasons. First, it affirms the conclusion in Rev. Rul. 69-142 that the stock-for-stock requirement is not violated by a concomitant exchange by debenture holders. Second, Rev. Rul. 98-10 changes the conclusion in Rev. Rul. 69-142 on the accompanying debenture exchange. Instead of treating that exchange as taxable, Rev. Rul. 98-10 provides that Sec. 354 applies to the debenture exchange (and that a tax-free exchange occurs), if the debentures are considered "securities" for purposes of Sec. 354(a)(1).

The ultimate rationale for this new position is that the "reorganization," once accomplished, can be accompanied by other transactions that, as part of the plan of reorganization, receive tax-free treatment on the reorganization's coattails without violating the core reorganization requirements. In practical terms, Rev. Rul. 98-10 has reaffirmed the validity of the B reorganization, without imposing the toll charge on the debenture-for-debenture exchange. Rev. Rul. 98-10 specifically modifies and supersedes Rev. Rul. 69-142 and also modifies the results of several other rulings:

* Rev. Rul. 70-41 involved facts similar to Rev. Rul. 69-142, except that the target debenture holders exchanged them for acquiring stock. The Service concluded that the taxpayers had undertaken a valid B reorganization accompanied by a taxable exchange of debentures for stock.

* Rev. Rul. 70-269 involved a B reorganization, accompanied by an exchange of options for options. The IRS again concluded that the B reorganization was valid. This ruling was silent, however, on the proper treatment of the option-for-option exchange.

* Rev. Rul. 78-408 also involved a B reorganization, accompanied by an exchange of warrants for warrants. The Service concluded that the taxpayers had undertaken a valid B reorganization accompanied by a taxable warrants-for-warrants exchange.

* Rev. Rul. 68-637 involved a C reorganization accompanied by an exchange of options and warrants for options and warrants. The IRS concluded that the accompanying exchange did not violate the solely-for-voting-stock requirement of a C reorganization. The ruling did not treat the accompanying exchange as a taxable transaction, rather, the Service determined that the assumption of an acquired corporation's unexercised warrants and options was a valid assumption of liabilities under Sec. 368(a)(1)(c).

Rev. Rul. 98-10 modifies each of these rulings by providing that the exchange of debentures, warrants or options will be a valid exchange under Sec. 354, provided the instruments exchanged constitute securities within the meaning of Sec. 354. Note that Regs. Sec. 1.354-1(c) (effective March 9, 1998) generally provides that rights to acquire stock (i.e., warrants and options) will be treated as securities (with a zero principal amount) for Sec. 354 purposes.

Rev. Rul. 98-10 is consistent with the regulations governing reverse triangular mergers. Regs. Sec. 1.368-2(j)(4) (previously (j)(5)) implies that a tax-free debenture-for-debenture exchange is allowed (i.e., does not adversely affect the reorganization) in a reverse triangular merger under Sec. 368(a)(2)(E). It refers to Secs. 354 and 356 (nonrecognition treatment) if, in pursuance of the plan of reorganization, securities of the surviving corporation are exchanged for securities of the controlling corporation or for other securities of the surviving corporation.