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IRS abandons Bausch & Lomb doctrine.

In recently issued Prop. Regs. Sec. 1.368-2, the IRS reversed its long-standing position that an acquisition of a partially controlled subsidiary's assets does not qualify as a tax-free C reorganization. When these proposed regulations become final, an acquiring corporation will no longer be automatically prevented from using a C reorganization due to prior stock ownership in a target.


To qualify as a nontaxable reorganization under Sec. 368(a)(1)(C), an acquiring corporation must acquire substantially all of the properties of a target in exchange solely for its voting stock (or solely for voting stock of its parent). The solely-for-voting-stock requirement is relaxed by Sec. 368(a)(2)(B), which provides that the use of money or other property will not prevent an exchange from qualifying as a C reorganization if at least 80% of the value of the target's property is acquired for voting stock. This "boot relaxation" rule allows up to 20% of the target's assets to be acquired for cash or other property. Because liabilities assumed by (or taken subject to) the acquiring corporation are treated as cash paid for the property, however, solely voting stock must be used any time the target's liabilities exceed 20% of its assets' fair market value (FMV).

The Service has long taken the position that the acquisition of a partially controlled subsidiary's assets does not qualify as a C reorganization. In Rev. Rul. 54-396, an acquiring corporation already owned 79% of the target's outstanding stock. Shares of the acquiring corporation were issued in exchange for all the target's properties, subject to its liabilities. The target was liquidated and the shares of the acquiring corporation were distributed pro rata to its shareholders. The IRS ruled that the transaction failed to qualify as a tax-free C reorganization. Only 21% of the target's assets were acquired with the acquiring corporation's stock; the remaining 79% were acquired as a liquidating dividend of the previously held stock in the target.

The Service's position was upheld in Bausch & Lomb Optical Co., 30 TC 602 (1958), aff'd, 267 F2d 75 (2d Cir. 1959), cert. den. Bausch & Lomb exchanged shares of its voting stock for all of the property of a 79.9% subsidiary. The subsidiary was then dissolved and the Bausch & Lomb shares were distributed pro rata to its shareholders. Both the Tax Court and the Second Circuit upheld the IRS position that the subsidiary stock owned by Bausch & Lomb was noncash consideration and the transaction failed to qualify as a C reorganization. Since then, the "Bausch & Lomb doctrine" has prevented the acquisition of a partially controlled subsidiary's assets from qualifying as a C reorganization.

IRS Change of Position

In the preamble to the proposed regulations, the Service stated that the purpose of the solely-for-voting-stock requirement is to prevent transactions that resemble sales from qualifying as tax-free reorganizations. The IRs has now concluded, however, that an acquiring corporation converting an indirect ownership interest in assets to a direct interest in those assets does not resemble a sale, and that Congress "did not intend to disqualify a transaction from qualifying under section 368(a)(I)(C) merely because the acquiring corporation has prior ownership of a portion of a target corporation's stock."

The Service also cited the inconsistent treatment of upstream A reorganizations with upstream C reorganizations as a reason for the change. In an upstream A reorganization, a parent's indirect interest in a target's assets is converted to a direct interest in the target's assets through a merger or consolidation that meets state law requirements. The IRS has now concluded that an upstream reorganization under Sec. 368(a)(1)(C) should not be treated differently than an upstream reorganization under Sec. 368(a)(1)(A) solely because the acquiring corporation already owns stock in the target.

Proposed Regulations

When finalized, the proposed regulations will add Regs. Sec. 1.3682(d)(4). Prop. Regs. Sec. 1.368-2(d)(4)(i) provides that prior ownership of a target's stock will not, by itself, prevent the solely-for-voting-stock requirement from being satisfied. The proposed regulations make it clear that, if an acquiring corporation acquires the target's stock for anything other than its own voting stock, such consideration is treated as money or other property exchanged for the target's assets, and the transaction will not qualify as a C reorganization unless the Sec. 368(a)(2)(B) boot relaxation rule is satisfied. Prop. Regs. Sec. 1.368-2(d)(4)(i) provides that the boot relaxation rule is not satisfied if the sum of money or other property distributed to the shareholders of a target corporation other than the acquiring corporation and to its creditors under Sec. 361(b)(3), plus all of the target's liabilities assumed by the acquiring corporation, exceed 20% of the value of the target's properties.

Example 1: Corporation P purchased 60 of Corporation T's 100 shares of stock in an unrelated transaction several years ago. The other 40 shares are owned by X, an unrelated corporation. T has properties with an FMV of $110 and liabilities of $10. T transfers all of its properties to P in exchange for $30 of P voting stock and $10 of cash. P also assumes T's $10 of liabilities. T distributes the P voting stock and $10 cash to X and liquidates. The transaction satisfies the solely-for-voting-stock requirement, because the $10 cash paid to X and the assumption by P of $10 of liabilities does not exceed 20% of the value of T's properties.

Example 2: The facts are identical to Example 1, except that P purchased the 60 shares of T for $60 in cash in connection with the acquisition of T's assets. P is treated as having acquired all of T's assets for $70 cash, $10 of liability assumption and $30 of P voting stock. The solely-for-voting-stock requirement is not satisfied; more than 20% of the value of T's properties are acquired for cash or other property (the $70 cash and the assumption of $10 of liabilities).


The proposed regulations apply to transactions occurring after they are finalized, except for transactions occurring pursuant to a written agreement binding on such date. When finalized, the regulations will make structuring a parent's acquisition of a partially controlled subsidiary's assets easier. There will no longer be any need to consider the Bausch & Lomb doctrine. The assumption of or taking property subject to a significant amount of target liabilities, however, will continue to be a problem because of the boot relaxation rule.


Philip E. Moore, CPA, MBA Brown, Dakes & Wannall, P.C. DFK International Fairfax, VA
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Article Details
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Author:Koski, Timothy R.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Oct 1, 1999
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