The use of "boot" in B-type reorganizations.

The Use of "Boot" in B-Type Reorganizations

A B-type reorganization allows one corporation to acquire another corporation tax free where it is advantageous to keep the acquired corporation alive. To qualify for a B-type reorganization, section 368(a)(1)(B) of the Internal Revenue Code requires the acquiring corporation to use only voting stock as consideration in the acquisition of control of the acquired corporation. Control for this purpose is 80 percent of voting stock and 80 percent of each other class of stock. Before 1954, the Code required that the acquiring corporation acquire 80 percent of the stock of the acquired corporation. This requirement made it impossible for a corporation already owning more than 20 percent of a corporation to acquire the remainder of the stock or merely enough to result in holding 80 percent of the acquired company's stock and have the transaction fall within the definition of a reorganization. The section was amended in 1954 to read:

The acquisition by one corporation, in exchange solely for all or part of its voting stock . . ., of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation (whether or not such acquiring corporation had control immediately before the acquisition).

Although the amended Code provision answered the questions surrounding "creeping reorganizations" in B-type reorganizations, many gray areas remained unanswered. The principal problems in B-type reorganizations stem from the "solely for voting stock" requirement. The ITT-Hartford merger in 1980 brought to the fore several questions concerning B-type reorganizations. This article analyzes the court cases and questions that sprang from this merger. In addition, the article analyzes (1) the issues concerning "poison pills" and Letter Ruling No. 8808081 in which the Internal Revenue Service held that "poison pill" stock rights were taxable boot in an otherwise tax-free reorganization, and (2) Revenue Ruling 90-11 in which the IRS discussed the federal income tax consequences of a corporation's adoption of a poison pill plan.

ITT-Hartford Merger

In April 1969, International Telephone and Telegraph (ITT) reached an agreement with the Hartford Fire Insurance Company (Hartford) for a takeover of the Connecticut insurance company. The plan met the requirements of a B-type reorganization. In a private letter ruling dated October 21, 1969, however, the IRS held that the plan would not qualify as a reorganization under 368(a)(1)(B) unless ITT disposed of the Hartford stock it had purchased for cash in the previous year. ITT did dispose of this stock by selling it to an Italian bank. The merger was never effected, however, because it was disapproved by the Connecticut Insurance Commissioner. Subsequently, ITT tried to exchange with the Hartford shareholders the same stock they would have received under the original merger plan. The insurance commissioner allowed this tender offer. ITT subsequently submitted an exchange offer to the Hartford shareholders and by June 8, 1970, more than 95 percent of the Hartford shares had been tendered, including those held by the Italian bank.

In March 1974, the IRS retroactively revoked the October 1969 letter ruling on the grounds that the nature of the obligations and rights of the parties to the sale had been misrepresented. The IRS asserted that the disposition had not been unconditional and, thus, had not removed the "tainted" shares acquired for cash from consideration as stock acquired as part of the plan of reorganization. Accordingly, the IRS concluded that the requirements of section 368(a)(1)(B) were not met.

The acquisition of the Hartford Insurance Company by International Telephone and Telegraph gave rise to litigation where the taxpayers-shareholders claimed the acquisition qualified as a tax-free, B-type reorganization. The IRS disagreed since it retroactively revoked its favorable private letter ruling. In Pierson v. Commissioner, 472 F. Supp. 957 (D. Del. 1979), and Reeves v. Commissioner, 71 T.C. 727 (1979), the taxpayers set forth two arguments. First, the taxpayers argued that the "reorganization" relevant to determining gain or loss on the exchange of stock was the plan approved by the insurance commissioner in 1970 in ITT-Hartford. Since there were no cash purchases in the 1970 exchange, the requirements of 368(a)(1)(B) would be met, allowing a tax-free stock for voting stock exchange. The second argument assumed, arguendo, that the ITT cash purchases of stock and the 1970 exchange offer were a single transaction. Nevertheless, the plaintiff argued that where at least 80 percent of the stock of the acquired corporation is exchanged for voting stock in the acquiring corporation, the literal requirements of section 368(a)(1)(B) are met. Therefore, the presence of non-stock consideration (or "boot") in the same transaction would not preclude its qualifying as a reorganization.

In both Pierson and Reeves, the trial court ruled in favor of the taxpayer based on the second argument. These two decisions appeared to make a B-type reorganization almost synonymous with a C-type reorganization, allowing boot consideration to be given as long as the controlling purchase was made with voting stock. These decisions were reversed, however, in Heverly v. Commissioner, 621 F.2d 1227 (3d Cir. 1980), and Chapman v. Commissioner, 618 F.2d 856 (1st Cir. 1980).

The Third Circuit and First Circuit, respectively, reasoned that in a stock-for-stock transaction in which control is achieved, the acquiring corporation may exchange no consideration other than voting stock to effect a tax-free, B-type reorganization. The appellate courts, however, remanded the cases for consideration of the taxpayers' first argument -- that ITT's exchange offer in 1970 was a separate plan of reorganization. Because of an out-of-court settlement, the trial court never reconsidered this issue, which raises several questions concerning the B-type reorganization.

Heverly and Chapman support the proposition that acquisitions that are part of a single transaction are to be considered together when testing for B-type reorganization requirements. No guidance is provided in the decisions, however, to determine when several purchases are to be examined as part of one single acquisition transaction. In addition, no mention is made of the tax consequences of prior stock purchases for consideration other than voting stock (i.e., "boot") that were not part of the acquisition involving only voting stock. The only guideline is that the prior purchases must be "old and cold," but no time period is specified for determining what constitutes "old and cold."

In both Reeves and Pierson, the acquiring corporation had obtained a controlling interest with a single purchase of stock. Thus, questions remain concerning creeping acquisitions, for no guidelines are given for grouping purchases into one acquisition plan for determining B-type reorganization status. The only requirement is that the purchases that are part of the plan of reorganization must be solely for voting stock. These questions are usually answered by the courts and IRS using the step-transaction doctrine.

The Step-Transaction Doctrine in B-Type

Reorganizations

Revenue Ruling 85-139, 1985-2 C.B. 123, provides that the solely-for-voting-stock requirement applies to the entire transaction in which stock of a corporation is acquired, not just to the acquisition of a block of stock constituting control. Revenue Ruling 70-65, 1970-1 C.B. 77, requires that all steps or purchases in a single plan be for voting stock of the acquiring corporation to qualify as a B-type reorganization. Revenue Ruling 75-123, 1975-1 C.B. 115, makes the solely-for-voting-stock requirement even stricter by requiring that the consideration given for whatever stock is acquired by the acquiring corporation be voting stock. Although this ruling appears to make the issue clear-cut, it is in conflict with Treas. Reg. [section] 1.368-2(c), which includes the following example sanctioning a B-type reorganization where prior cash purchases had been used to acquire stock of the acquired corporation:

[C]orporation A purchased 30 percent of the common stock of corporation W (the only class of stock outstanding) for cash in 1939. On March 1, 1955, corporation A offers to exchange its own voting stock for all the stock of corporation W tendered within 6 months from the date of the offer. Within the 6 months' period, corporation A acquires an additional 60 percent of the stock of corporation W solely for its own voting stock, so that it owns 90 percent of the stock of corporation W. No gain or loss is recognized with respect to the exchanges of stock of corporation A for stock of corporation W.

From the regulations and the revenue rulings, it is apparent that purchases of stock falling within the plan of reorganization must be solely for voting stock to qualify for a B-type reorganization. To determine whether a prior stock purchase falls within the plan of reorganization, the courts use the step-transaction doctrine, which focuses on three factors: an intent factor, a time factor, and the interdependence of the purchases.

Intent Factor

The closer the purchases are in time, the more significant the intent factor becomes. In Reeves and Pierson, the Commissioner argued that all transactions sharing a single acquisitive purpose from the viewpoint of the acquiring corporation should be aggregated for purposes of determining the "acquisition." This argument presumes that only unilateral or non-reciprocal (i.e., one-party) intent is necessary to combine transactions into one acquisition. The Commissioner based his argument on the report of the Senate Committee on Finance that accompanied the enactment of the Internal Revenue Code of 1954. With respect to creeping acquisitions, the report stated that when a corporation already owning 30 percent of the stock of a corporation acquired an additional 60 percent of the stock solely in exchange for its voting stock during a relatively short period of time -- giving both 12 months and 6 months as examples -- pursuant to a tender offer, then all of the individual exchange transactions would be deemed to be part of the reorganization. From this legislative history, the Commissioner reasoned that all cash acquisitions and stock exchanges must be aggregated unless completely and thoroughly separated both in time and purpose.

In Elizabeth Bruce, 30 BTA 80 (1934), the taxpayer sold 200 shares of stock of E.E. Bruce & Company to Churchill Drug Company for cash. On the same day, immediately following the sale, Churchill proposed to acquire all of the remaining outstanding shares of Bruce & Company from the taxpayer and other shareholders in exchange for stock. The offer following the sale was the first time the taxpayer had any indication of the full extent of Churchill's acquisition plan. The Commissioner argued the 200 shares purchased for cash should be included in the reorganization and, therefore, all gain or loss on the shares received by the shareholders should be recognized.

Although the Board of Tax Appeals sustained the Commissioner's position, the United States Court of Appeals for the District of Columbia in Bruce v. Helvering, 76 F.2d 442 (D.C. Cir. 1935), held that the transactions should not be treated as one. The appellate court reasoned that the taxpayer's sale of shares for cash was entered into before and without prior knowledge of Churchill's intention to acquire all of Bruce Company's stock. The court's opinion suggests that mutuality of intent (intent of both parties) is necessary before individual transactions can properly be aggregated. Consequently, unilateral intent of the acquiring corporation that two or more transactions were pursuant to the same goal is not, standing alone, sufficient. Applying this logic to the two separate ITT-Hartford plans of reorganization at issue in Reeves and Pierson, the taxpayer's position would seem to be correct, assuming the shareholders of Hartford Insurance had no knowledge of the 1970 exchange offer prior to the failure of the original offer in 1969. (From the court opinions, however, it appears that the taxpayers probably were at least aware of ITT's intentions.)

In dealing with creeping reorganizations, any prior purchases of stock of the acquired corporation using consideration other than voting stock may be allowed as long as those prior purchases are "old and cold." Thus, if prior cash purchases of stock were not intended to be a part of the acquisition to obtain control, those prior purchases will not constitute "boot" and the B-type reorganization will be permitted to stand. A creeping acquisition, however, usually must be carried out within a short period of time. (Recall that 6 and 12 months were the examples set forth in the Senate Report on the 1954 Code.) Therefore, any consideration other than voting stock would probably be considered boot since both parties intended a reorganization to happen. Any prior purchases using consideration other than voting stock clearly outside this creeping reorganization plan, however, would not disqualify the B-type reorganization.

Time Factor

As previously stated, any prior purchases involving boot must be "old and cold" to prevent inclusion with the acquisition of control using voting stock. There is no definite rule, however, concerning how much time must pass before a transaction will be considered "old and cold." As previously mentioned, Treas. Reg. [section] 1.368-2(c) includes an example of a valid B-type reorganization when boot was used in the purchase of stock that occurred 16 years earlier. In contrast, in Fry v. Commissioner, 5 T.C. 1058 (1945), the court held that the distribution of stock six years after the adoption of a plan of reorganization was still pursuant to that reorganization and was, therefore, a tax-free exchange with the shareholder. In Fry, it appears that the intent of the corporation was to eventually effectuate the reorganization; therefore, the court allowed the reorganization to stand.

Conversely, the 16 years' passing between the two purchases set forth in Treas. Reg. [section] 1.368-2(c) apparently evidenced little serious intent for an eventual reorganization at the time the first purchase was made. Since no strict guidelines for a time limit between purchases exists, it appears any questionable purchases have to be viewed within the context of both the intent of the parties involved and the length of time separating the purchases. In other words, the time factor alone may not be enough to secure the B-type reorganization.

Interdependence of the Steps

Another factor in applying the step-transaction doctrine is the interdependence of the various purchases of stock of the acquired corporation. Interdependence is found by examining whether an exchange for voting stock is dependent on another prior purchase to meet the control requirement for a B-type reorganization. Based on this factor, it would appear that any exchange solely for voting stock that acquires less than 80 percent of the acquired corporation would be dependent on a prior or subsequent purchase or exchange of stock to gain control. If this were true, control acquired in a single transaction (i.e., 80 percent of the stock acquired in one transaction) would be allowed based on this interdependence factor. As evidenced by the Reeves and Pierson cases, however, a single exchange for voting stock resulting in the acquisition of at least 80-percent control does not necessarily allow a proposed B-type reorganization to stand. Therefore, to determine the purchases' interdependence, one must determine the acquiring corporation's intent and the amount of time separating the two purchases.

Poison Pill Stock Rights

"Poison pills" are contingent stock rights that are incorporated into a stock certificate or distributed as a dividend, which serve to enable a corporation to defend itself against an unsolicited tender offer. In a typical tender offer, a company (P) offers to purchase shares of the target company (T) at a premium over the market value of T's shares. Often P staggers the offering price by offering to purchase shares at a higher price initially and at a lower price once it has acquired more than 50 percent of the shares. (1) A two-tiered tender offer means that shareholders who fail to tender immediately will not maximize the value of their shares. Poison pills address this problem by providing T and its shareholders with the opportunity either to defeat the tender offer or to gain time to negotiate a fair price for all T shareholders.

A recent private letter ruling cast a cloud over the nontaxable status of B-type (as well as C-type) reorganizations in which the shareholders of the target corporation have been given "poison pill" rights to obtain stock in either the acquiring or the target corporation at a large discount in the event of a hostile takeover. In Letter Ruling No. 8808081 (Dec. 3, 1987), the acquiring company in a proposed reverse triangular A-type merger was to issue its stock and poison pill rights that, in the absence of certain events, would be transferred "with and only with" the underlying shares. The IRS concluded that the rights were "other property," or boot, received in an exchange and, consequently, that any gain realized by shareholders of the target corporation should be recognized to the extent of the boot's value pursuant to section 356(a)(1) of the Code. Because the combination examined was an A-type reorganization, the presence of boot did not disqualify the transaction.

In a B-type (or C-type) reorganization, however, the issue is more significant because a specified target must be acquired "solely for voting stock." Thus, if the poison pill is considered "other property," a B-type reorganization using stock carrying such rights will be disqualified and any gain realized will be subject to tax. (2)

Many commentators have argued that the adoption of a poison pill plan is, at most, a recapitalization of old common for new common -- or a stock swap -- and that the rights should not be treated as separate property prior to their becoming separately transferable and exercisable upon a triggering event. Until early 1990, however, the IRS held that the rights constituted taxable warrants.

The central issue involving the poison pill is whether the adoption of a poison pill plan results in the current distribution of "other property." Resolution of that issue determines whether section 354 of section 356 is applicable. Section 354(a)(1) provides that gain is not recognized "if stock or securities in a corporation a party to a reorganization . . . are exchanged solely for stock or securities in such corporation or another corporation a party to the reorganization."

In contrast, section 356 governs the receipt of "other property." Where a taxpayer receives boot in addition to nonrecognition property, gain recognition is required to the extent of the boot. Section 356(a)(1)(B) provides that if the property received is not nonrecognition property, but "consists . . . of other property . . . then the gain . . . to the recipient shall be recognized . . . but not in excess of the fair market value of such other property."

Three types of poison pills enable T to achieve these results. The first type provides T shareholders with the right to sell their shares to P at fair market value. The second type provides all T shareholders other than P with the right to purchase additional stock from the issuer (T) for less than fair market value. The third type of poison pill provides all T shareholders other than P with the right to purchase the stock of P for less than fair market value.

If the poison pill right entitles shareholders to purchase additional shares of the target company's stock at a discount, the effect will be to dilute the hostile acquirer's equity ownership in the target company or to force the acquirer to pay more to attain the desired level of control. If the poison pill right entitles shareholders to purchase the hostile acquirer's voting stock at a deep discount, the effect will be to place a large block of the acquirer's stock in the hands of the shareholders of the target corporation. In either case, these rights provide the target company with time to negotiate a fair price for all shares or to defeat the tender offer entirely.

The alleged effectiveness of poison pill rights has triggered a number of lawsuits. For example, in Moran v. Household International, 500 A.2d 1346 (Del. 1985), a poison pill rights plan was challenged on the ground that directors could not distribute the poison pill rights without shareholder approval. Opponents of the rights plan charged that poison pills prevented shareholders from receiving and accepting tender offers. The poison pill rights in Moran in fact did provide shareholders with significant rights in the event of a tender offer. The rights plan entitled Household shareholders to one right per share under certain triggering conditions. This right entitled Household shareholders to purchase one one-hundredth of a share of new preferred stock for $100, in the event of an announced tender offer for over 30 percent of Household's shares or the acquisition of 20 percent of Household's shares. This right also was redeemable by the board of directors for 50 cents. If the rights were not exercised and a merger occurred, Household shareholders were entitled to purchase $200 of the common stock of the tender offeror for $100. It was the latter flip-over provision that formed the basis of the lawsuit against Household.

The opponents of the Household Rights Plan contended that the plan's flip-over provision would prevent a tender offer for Household's shares. Opponents of the plan argued that, in the absence of shareholder approval, the board of directors lacked authority under Delaware law to distribute rights that had such drastic consequences. The Delaware court, however, held that the board of directors had the power to distribute the rights because the rights did not affect the financial structure of the corporation and also did not deprive shareholders of their right to receive and reject tender offers.

Poison Pill Rights and B-Type Reorganizations

The piston pill rights entitling shareholders to purchase stock in either the issuer or the hostile tender offeror do not violate the tax policy considerations underlying the "solely for voting stock" requirement. An important tax policy objective underlying the solely-for-voting-stock requirement is to ensure that shareholders maintain a continuity of interest in the reorganized assets. (3) Poison pill rights do not subvert this tax policy objective. In fact, by providing shareholders with the ability either to defeat a hostile tender offer or to purchase stock in the hostile tender offeror, poison pill rights preserve the shareholder's continuity of interest in the reorganized assets. That poison pill rights may preserve continuity of interest in the reorganized assets is a strong argument that poison pill rights are not "other property" that violate the solely-for-voting-stock requirement.

Nevertheless, poison pill stock rights are not discussed in the IRS's guidelines on contingent stock rights in B-type reorganizations. In fact, poison pills generally are unrelated to the reorganization and are instead the result of corporate management's fear of unsolicited tender offers. Therefore, the issue is whether the IRS will permit the exchange of voting stock with poison pill rights in an otherwise qualifying B-type reorganization. The answer depends upon whether poison pill rights constitute "other property." In light of the IRS's rulings before Letter Ruling No. 8808081 (Dec. 3, 1987) and the tax policy objectives underlying the solely-for-voting-stock requirement, it appears that, with possibly two exceptions, poison pill rights are not separate property that would otherwise violate the solely-for-voting-stock requirement.

Right to Fair Market Value for Stock

The original and most basic poison pill right provides shareholders of T with the right to sell their stock to P for fair market value. This right is designed to defeat a two-tiered tender offer by preventing the tender offeror from offering a lower price for shares once the tender offeror has acquired control of the company. This type of poison pill arguably does not violate the IRS's rulings on other property in B-type reorganizations for three reasons.

First, the right does not provide shareholders with a right to convert stock into the stock of a corporation unrelated to the reorganization. Thus, this poison pill right does not violate Revenue Ruling 69-265, 1969-A C.B. 109, which holds that rights to convert stock into the stock of a corporation unrelated to the reorganization constitute other property in violation of the solely-for-voting-stock requirement.

Second, this right does not violate Revenue Ruling 70-108, 1970-1 C.B. 78, which holds that voting stock with a right to purchase additional stock of the issuer is not solely voting stock. The poison pill right to sell stock to a tender offerer at fair market value is not a stock purchase warrant and, therefore, does not violate Revenue Ruling 70-108.

Finally, this right does not constitute "other property" because it complies with the IRS's rule in Revenue Ruling 57-586, 1957-2 C.B. 249, prohibiting negotiable contingent rights in B-type reorganizations. The rule is designed to ensure that shareholders maintain a continuity of interest in the reorganized assets. All poison pill rights, including the right to sell stock at fair market value, meet the IRS's nonnegotiability test -- i.e., they generally are not assignable, are affixed to the common shares, and in the absence of a triggering event are not separately tradeable or exercisable.

Right to Purchase Additional Stock of the Target

A poison pill right that may violate the solely-for-voting-stock requirement is the right to purchase additional stock of the target in the event of a tender offer. Revenue Ruling 70-108, 1970-1 C.B. 78, holds that voting stock with rights to purchase additional stock in the issuer violates the solely-for-voting-stock requirement. The poison pill right entitling shareholders of the target company to purchase additional shares in the target is very similar to the stock purchase rights banned in Revenue Ruling 70-108.

The second poison pill right that may violate the solely-for-voting-stock requirement is the right to purchase the stock of the hostile tender offeror at a discount. This right may violate Revenue Ruling 69-265, 1969-1 C.B. 109, which holds that voting stock with the right to convert shares into the stock of a company unrelated to the reorganization is separate property in violation of the solely-for-voting-stock requirement. When viewed in the context of a B-type reorganization, the poison pill right entitling shareholders to "flip over" into the stock of the hostile tender offeror is a right to convert into stock of a company unrelated to the reorganization.

Despite arguments suggesting that poison pill rights to purchase stock in either the target or the hostile tender offeror constitute other property and violate the solely-for-voting-stock requirement, there are strong arguments that these rights should not be considered property. First, these poison pill rights -- unlike the conversion right in Revenue Ruling 69-265 and the stock purchase warrant in Revenue Ruling 70-108 -- are not exercisable on a shareholder's initiative. Holders of these poison pill rights have no rights if the tender offer never materializes. Consequently, these poison pill rights do not provides shareholders with anything more than a future interest in the shares of another company.

The unripened, or inchoate, nature of these rights is a second reason why these rights do not violate Revenue Rulings 69-265 and 70-108. The future equity interest represented by the poison pill rights is not comparable to the proprietary equity interest provided by the conversion right in Revenue Ruling 69-265 and the stock purchase right in Revenue Ruling 70-108. For example, the conversion right in Revenue Ruling 69-265 was a proprietary equity interest in the stock of another company (P) because shareholders could convert into the stock of P at any time. The right to P stock was absolute and thus legally enforceable at the holder's option. By contrast, the poison pill right to purchase stock of the tender offeror is not guaranteed and -- in the absence of a tender offer -- is not legally enforceable. Moreover, not even a tender offer will guarantee that shareholders of the target company will be entitled to purchase shares of the tender offeror because the tender offer may be defeated or the target company may redeem the poison pill rights and effectuate a merger with the tender offeror. The right to purchase the stock of another company -- or additional shares of the issuer -- is not a proprietary interest in the stock of another company but instead is a mere expectancy.

Letter Ruling No. 8808081

In Letter Ruling No. 8808081 (Dec. 3, 1987), the IRS held that poison pill rights that were received by a target corporation's shareholders along with the parent corporation's stock in an A-type reorganization were taxable boot. In the ruling, a publicly held corporation acquired a closely held target company through a reverse subsidiary merger. The parent corporation (P) created a subsidiary, which it merged with and into the target company (T). All requirements under section 368(a)(2)(E) were met. As a part of the transaction, however, each share of P voting stock contained a right to purchase one share of P preferred stock. Until the occurrence of specific events (which were not set forth in the ruling), the preferred stock purchase rights were transferable with, and only with, the underlying shares.

The most significant issue in Letter Ruling No. 8808081 was the tax treatment of the preferred stock purchase rights. The IRS ruled that the rights constituted "other property":

Gain, if any, will be recognized by each target shareholder on the receipt of both the Parent stock and other property (the Rights) in exchange for Target stock, but in an amount not in excess of the fair market value of the other property received.

The rights did not disqualify the reorganization, however, because unlike B-type reorganizations, reverse subsidiary mergers may be tax-free without all the consideration being stock. The IRS concluded that the reorganization qualified as a merger under sections 368(a)(1)(A) and 368(a)(2)(E) even though the rights were treated as other property and gain was taxed to the extent of their value under section 356(a)(1).

Tax Planning for Poison Pills and B-Type

reorganizations

If the position expressed in Letter Ruling No. 8808081 becomes IRS's policy, a contingent stock right to purchase P preferred stock, when distributed with stock in a B-type reorganization, would violate the solely-for-voting-stock requirement. Thus, the private ruling suggests that tax planners seeking to distribute poison pill rights in a tax-free reorganizations should avoid using forms of reorganizations -- such as a B-type reorganization -- that do not permit the use of consideration other than voting stock.

Poison pill rights, however, do not necessarily violate the solely-for-voting stock requirement. Acceptable poison pill rights -- i.e., nonnegotiable rights to receive stock and which is not consideration unique to the shareholder -- may be structured to comply with the ITS's guidelines on contingent stock rights in reorganization transactions and a letter ruling may be requested. (4)

Revenue Ruling 90-11

In revenue Ruling 90-11, 1990-1 C.B. 10, the IRS resolved the issue of the federal income tax consequences, if any, of a corporation's adoption of a poison pill plan. In the ruling, the board of directors of X, a publicly held domestic corporation, adopted a plan that provides the common shareholders with poison pill rights. The principal purpose of the plan, the adoption of which constituted the distribution of a dividend under state law, was to provide shareholders with rights to purchase stock at less than fair market value as a means of responding to unsolicited tender offers.

The poison pill rights granted under the plan are rights to purchase a fraction of a share of preferred stock for each share of common stock held upon the occurrence of certain events. The fractional share has voting, dividend, and liquidation rights that make it the economic equivalent of one common share. Until the issuance of a certificate, the rights are not exercisable or separately tradable, and if no triggering event occurs, the rights will expire. At the time X's board of directors adopted the plan, the likelihood that the rights would, at any time, be exercised was both remote and speculative.

The IRS stated that the adoption of the poison pill plan does not constitute the distribution of stock or property by X to its shareholders, an exchange of property or stock (either taxable or nontaxable), or any other event giving rise to the realization of gross income by any taxpayer. The IRS noted, however, that the ruling does not address the federal income tax consequences of any redemption of rights, or of any transaction involving rights subsequent to a triggering event.

The IRS, pursuant to its authority under Temp. Reg. [section] 1.382-2T(h)(4)(x), also held that similar poison pill rights are excepted from the option attribution rules of Temp. Reg. [section] 1.382-2T(h)(4)(i) until the rights can no longer be redeemed for a nominal amount by the issuing corporation without shareholder approval. Rights will be considered similar only if the principal purpose for the adoption of the plan providing for the rights is to establish a mechanism by which a publicly held corporation can subsequently provide shareholders with rights to purchase stock at substantially less than fair market value as a means of responding to unsolicited tender offers. Excepting poison pill rights from the option attribution rules is effective for all poison pill rights, regardless of a plan's adoption date.

Conclusion

Several terms need to be specifically defined in order to determine the use of consideration other than voting stock in a B-type reorganization. In order to determine whether a prior purchase of stock using boot will disqualify a B-type reorganization, one must know exactly what constitutes the acquisition of control or the plan of reorganization.

The only stipulation for the prior purchases is that they must be "old and cold" before the acquisition of control is attempted; yet no amount of time is given to determine what makes a prior purchase "old and cold." The key factor used in combining several purchases in one acquisition of control is the parties' intent. Based on Bruce v. Helvering, both parties to the reorganization must seemingly be aware of the acquiring corporation's intent to acquire control of the acquired corporation. Applying this logic to the argument never addressed by the courts in Reeves or Pierson, a B-type reorganization would apparently not be allowed to stand since both ITT and the Hartford Fire Insurance Company knew of ITT's intent to acquire Hartford.

Although the regulations sanction the presence of "boot" in a prior purchase that occurred 16 years earlier, it seems the intent factor must be used to determine if a prior purchase is "old and cold." Thus, despite ITT's two reorganization plans being separated in time by almost a year, the plans were considered as one since ITT persisted in developing a scheme to acquire Hartford. In addition, Hartford was aware of ITT's intent to try to develop a scheme to acquire the Connecticut insurance company. Therefore, when contemplating an exchange solely for voting stock to acquire control of a corporation tax free, the acquiring corporation should be aware of the problems prior purchases involving boot could cause. If prior purchases were made using boot and a B-type reorganization is attempted, the acquiring corporation should be sure the acquired corporation had no knowledge of an intent to acquire control of it. Even if the acquired corporation has no knowledge of the acquiring corporation's intent, it is advisable to wait for at least a year after the "boot" purchase before developing a plan to acquire control of a corporation using only voting stock.

Finally, in accordance with Letter Ruling No. 8808081, the acquiring corporation should not issue "poison pill" stock rights along with voting stock in a B-type reorganization to qualify for tax-free treatment. At the same time, Revenue Ruling 90-11 provides that a corporation's adoption of a poison pill plan does not constitute the distribution of stock or property. Before being too aggressive, taxpayers should consider requesting a letter ruling when "poison pill" stock rights are to be used.

(1) Cases in which poison pill rights have been litigated include: Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985); Moran v. Household International, 500 A.2d 1346 (Del. 1985); Horwitz v. Southwest Forest Industry, 604 F. Supp. 1130 (D. Nev. 1985); Unilever Acquisition Corp V. Richardson-Vicks, 618 F. Supp. 407 (S.D.N.Y. 1985); Asarco v. M.R.H. Holmes a Court, 611 F. Supp. 468 (D.N.J. 1985).

(2) With respect to a C-type reorganization, the reorganization will not be disqualified, but poison pill rights, as "other property," will cause any target liabilities assumed by the acquiring corporation to be treated as a taxable cash payment. For example, if a target with assets having a fair market value of $100 and $20 in liabilities is acquired for voting shares with a fair market value of $80, even one dollar of "other property" will cause the recognition of $20.

(3) See Treas. Reg. [section] 1.368-1(b), which provides that the tax policy underlying tax-free reorganizations is to preserve a continuity of shareholder interest in the reorganized assets and a continuity of business enterprise.

(4) See Rev. Proc. 77-37, 1977-2 C.B. 568, for operating rules for letter rulings on section 368(a) transactions, including guidelines on contingent stock payouts.

RAY A. KNIGHT is a professor of accounting at Middle Tennessee State University. He received a B.S. degree in accounting from the University of Houston, an M.A. degree in accounting from the University of Alabama, and a J.D. degree from Wake Forest University. He is a member of the American Institute of Certified Public Accountants, the American Bar Association, the American Taxation Association, and several other professional organizations. Mr. Knight has published articles in several professional journals including The Tax Executive.

LEE G. KNIGHT is a professor of accounting at Middle Tennessee State University. She received a B.S. degree in accounting from Western Kentucky University, and M.A. and Ph.D. degrees from the University of Alabama. She is a member of the American Accounting Association and the American Taxation Association. Ms. Knight has published articles in several professional journals including The Tax Executive