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Final sec. 338 regs. on solely-for-voting-stock requirement.

On Feb. 2, 2001, Treasury issued final Secs. 338 and 1060 regulations (Final Regulations), which include rules for allocating the amount realized and bases of assets transferred in either an actual asset acquisition or a deemed asset acquisition under Sec. 338. In addition to the allocation provisions, the Final Regulations include other provisions that affect tax-free reorganizations following a qualified stock purchase (QSP).

Generally, a transaction qualifies as a C reorganization if a corporation acquires substantially all of the assets of a target solely in exchange for the acquiring corporation's voting stock (Sec. 368(a)(1)(C)). Since the 1950s, the state of the law has been if an acquiring corporation owned some target stock and, in exchange for the target's assets, the acquiring corporation surrendered the target stock, it could violate the solely-for-voting-stock requirement (depending on the amount of target stock the acquiring corporation owned); see Bausch & Lomb Optical Co., 267 F2d 75 (2d Cir. 1959) and Rev. Rul. 54-396, which addressed the same facts as Bausch & Lomb.

Newly issued Regs. Sec. 1.368-2(d)(4) (the" anti-Bausch & Lomb regulations") effectively overturned the long-standing Bausch & Lomb doctrine, by providing that target stock historically owned by an acquiring corporation no longer counts against the solely-for-voting-stock requirement in a C reorganization. However, the use of property (other than the acquiring corporation's voting stock) to acquire target stock in connection with a subsequent transfer of the target's assets to the acquiring corporation is outside the scope of these regulations and could invalidate a C reorganization by violating the solely-for-voting-stock requirement (Regs. Sec. 1.368-2(d)(4)(ii), Ex. 2).

With the forgoing as a backdrop, the Final Regulations provide that, when a corporation's acquisition of a target's stock is a QSP, special rules apply. Generally, a QSP is a transaction in which stock possessing at least 80% of a corporation's vote and value (Sec. 1504(a)(2)) is "purchased" by another corporation within a 12-month period (Sec. 338(d)(3)). A "purchase" is generally any stock acquisition in a taxable acquisition; see Sec. 338(h)(3) for specific rules. The Final Regulations now provide that the acquisition of a target's stock for consideration other than solely an acquiring corporation's voting stock only in connection with a QSP does not prevent the subsequent transfer of the target's assets to the acquiring corporation from qualifying as a C reorganization (the QSP-solely-for-voting stock (SFVS) exception); see Regs. Sec. 1.338-3(d)(4).

Uncertainty still exists as to the proper tax treatment of a QSP followed by an asset transfer from a target to an acquiring corporation (and the dissolution of a target). For example, applying the QSP-SFVS exception to these facts, if both the QSP (for most of the acquiring corporation's voting stock) and the subsequent asset transfer are collapsed, the transaction may qualify as a C reorganization of the target into the acquiring corporation (King Enterprises, 189 Ct. Cl. 466 (1969), and Rev. Rul. 67-274).

Alternatively, the QSP may be independent from a subsequent asset transfer; the stock acquisition would constitute a stock acquisition for which a Sec. 338 election is available, followed by an unrelated asset transfer from a target to an acquiring corporation; see generally, Rev. Rul. 90-95 (involving an all-cash QSP).

Under this latter view, despite the anti-Bausch & Lomb regulations, the transfer of assets could be classified simply as a Sec. 332 liquidation; see Rev. Rul. 90-95. If an acquiring corporation were to subsequently contribute all or a portion of the target's assets to a subsidiary (or otherwise reincorporate all or a portion of the target assets), such a transaction could be considered a liquidation/reincorporation (L/R) transaction. Generally, an L/R transaction is characterized as either a Sec. 368(a) reorganization of a target into a subsidiary (Atlas Tool Co., 70 TC 86 (1978)) or a failed Sec. 332 liquidation of the target into the acquiring corporation, with the subsidiary becoming the target's alter ego (Telephone Answering Service Co., 63 TC 423 (1974)). Under either characterization, the target corporation owes tax on any built-in gain on the distributed property under Sec. 311(b) or 361(c) (that it is not recontributed by the acquiring corporation to its subsidiary).

Further, acquiring corporations are subject to gain recognition under Sec. 356 on any retained property. However, if the transfer of assets from the target to the acquiring corporation qualifies as a C reorganization, the acquiring corporation may receive all of the target's assets tax-free, and may transfer part or all of them to the subsidiary under Sec. 368(a)(2)(C) (which permits the transfer of a target's assets to an 80%-or-more directly controlled subsidiary following a C reorganization). Likewise, the target would also avoid paying tax on any gain in the assets distributed to the acquiring corporation.

The Service has ruled that an upstream merger of a more-than-80%-owned subsidiary into its parent, followed by the parent's transfer of all of the subsidiary's assets to a new subsidiary, was an A reorganization of the subsidiary into the acquiring corporation, followed by a Sec. 368(a)(2)(C) transfer of the subsidiary's assets to the new subsidiary; see Rev. Rul. 69-617.

Therefore, assuming that a transaction occurring after a QSP should be respected as an independent step in the overall transaction, the following example illustrates the effect of the QSP-SFVS exception.

Example: J and K own 85% and 15%, respectively, of the only outstanding class of a target's stock. A corporation wants to acquire an unrelated target and transfers substantially all of the target's assets into its wholly owned subsidiary. The acquiring corporation seeks to effectuate its goal in the following manner: Without making a Sec. 338(g) election, the acquiring corporation purchases J's 85% interest for cash (a QSP) and then, as part of the same plan, the target transfers all of its assets to the acquiring corporation in a purported C reorganization, with K receiving acquiring corporation voting stock. Subsequently, the acquiring corporation transfers substantially all of the target's assets to its wholly owned subsidiary. For the acquiring corporation to avail itself of Sec. 368(a)(2)(C), the transfer of assets from the target to it must qualify as a C reorganization.

The validity of the purported C reorganization is called into question; the solely-for-voting-stock requirement does not seem to be satisfied, due to the acquiring corporation's acquisition of J's target stock for cash "in connection with" the acquiring corporation's acquisition of substantially all of the target's assets; see Regs. Sec. 1.368-2(d)(4)(ii), Ex. 2. The QSP-SFVS exception, however, modifies the results obtained under the anti-Bausch & Lomb regulations for C reorganizations occurring in connection with a QSP. Specifically, the QSP-SFVS exception provides that the acquiring corporation's use of consideration other than solely the acquiring corporation's voting stock to acquire the target in a QSP "will not prevent the subsequent transfer of [the target's] assets from satisfying the solely-for-voting-stock requirement for purposes of determining if the transfer of [the target's] assets qualifies as a [C reorganization]" (Regs. Sec. 1.338-3(d)(4)). Thus, the transfer of assets from the target to the acquiring corporation should qualify as a C reorganization, and the transfer of the target's assets to a subsidiary should be treated as a transfer under Sec. 368(a)(2)(C), thereby preserving C reorganization status. Finally, K will recognize gain on the exchange of his target stock for the acquiring corporation's stock received in the C reorganization; see Kass, 60 TC 218 (1973), and Regs. Sec. 1.338-3(d)(1) and (5)(iv).

Prior to the Final Regulations, this example could not have qualified as a C reorganization. Arguably, it would have been treated as an asset sale, resulting in a stepped-up basis in the target's assets. The QSP-SFVS exception addressing the solely-for-voting-stock requirement was adopted to effectuate congressional intent to deny deemed asset-sale treatment for transactions within an acquiring corporation's affiliated group following a QSP, if a Sec. 338(g) or (h)(10) election was not made by that group. Put simply, the acquiring corporation's affiliated group should not be allowed to receive a basis step-up in assets acquired in a QSP, absent making an election under Sec. 338. The QSP-SFVS exception effectively furthers this policy.

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Title Annotation:IRC section 338 regulations on tax-free reorganizations following a qualified stock purchase
Author:Madden, David
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jun 1, 2001
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