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Statutory mergers.

The IRS recently finalized regulations under Kegs. Sec. 1.368-2, defining the term statutory merger or consolidation for purposes of applying Sec. 368(a)(1)(A)'s tax-flee reorganization provisions.

Background

While there are many different types of tax-flee reorganization or restructuring provisions, a statutory merger (also known as a Sec. 368(a)(1)(A) reorganization or type A reorganization) is the most flexible for the following reasons:

1. There are few restrictions on the type of consideration (even if money is exchanged), as long as the continuity-of-interest requirement is satisfied (i.e., courts generally require at least 40% stock consideration);

2. There is no "substantially all" (of the assets) rule; and

3. There is no "solely for" (voting stock) rule.

Definition

On Jan. 24, 2003, the IRS issued temporary and proposed regulations defining a statutory merger or consolidation as:

1. A transaction effected under the laws of the U.S., a state or the District of Columbia,

2. In which all of the assets and liabilities of the target are acquired by the acquiring corporation, and

3. The target ceases its separate legal existence for all purposes.

A statutory merger or consolidation was historically limited to transactions effected pursuant to the corporate laws of the U.S. (i.e., a state, a territory or the District of Columbia), and until the recent changes (as discussed below), the definition had not changed much since 1935.

Disregarded Entity Mergers

The 2003 regulations expanded the applicability of the statutory merger or consolidation provisions, by expressly permitting a merger of a target into a limited liability company (LLC) that is disregarded as a separate entity from the acquiring corporation for Federal income tax purposes. Examples of disregarded entities include a domestic single-member LLC that does not elect to be classified as a corporation for Federal income tax purposes, a corporation that is a qualified real estate investment trust subsidiary and a corporation that is a qualified subchapter S subsidiary (QSub).

In analyzing the effect of these rules on various transactions, the new regulations have examples that refer to combining entities, combining units and transferor units. By definition a combining entity is a business entity that is a corporation and is not a disregarded entity. A combining unit is composed solely of a combining entity and all disregarded entities (if any), the assets of which are treated as owned by such combining entity for Federal income tax purposes.

For Sec. 368(a)(1)(A) purposes, a statutory merger or consolidation is a transaction effected pursuant to the statute, and all of the assets (other than those distributed in the transaction) and liabilities of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of one other combining unit (the transferee unit), and the combining entity of each transferor unit ceases its separate legal existence for all purposes.

Foreign Mergers

In January 2005, the IRS further expanded the meaning of a statutory merger or consolidation by issuing proposed regulations eliminating the necessity for a transaction to be effected pursuant to domestic laws. Thus, the definition of statutory mergers or consolidations allowed transactions effected pursuant to the statutes of foreign jurisdictions or U.S. possessions to qualify as statutory mergers or consolidations. In January 2006, the Service adopted the proposed regulations as final (with certain minor technical changes), thus permitting practitioners to plan for tax free, cross-border mergers with more certainty.

Because many foreign jurisdictions now have merger statutes that operate like those of the states, under which all assets and liabilities move by operation of law, the change in the definition of an A reorganization now allows transactions effected pursuant to these statutes to qualify as statutory mergers or consolidations for Sec. 368(a)(1)(A) purposes.

According to the Service, these transactions should be treated as reorganizations if they satisfy the functional criteria applicable to transactions under domestic statutes. Before the issuance of these proposed regulations, the applicability of the "substantially all" and "solely for" requirements adversely affected an otherwise valid foreign merger from qualifying.

Example 1: Pursuant to Country Q's merger statutes, Corporation Z and Corporation Y, each incorporated under the laws of Q, combine in a transaction in which all of Z's assets become assets of Y, and, in the transaction, Z ceases its separate legal existence.

Despite the fact that each of the merger participants is a foreign entity, the transaction nevertheless could be a statutory merger and thus a "good" type A reorganization under the new regulations, because both Z and Y are qualified participants and the transaction is not divisive.

Suppose the merger of one foreign corporation with and into another foreign corporation was preceded by a sale by the acquired corporation of one of its two, equally sized, historical businesses. If the net proceeds of the sale were distributed to the acquired corporation's shareholders immediately before the merger and not retained, the transaction could continue to qualify as a type A reorganization, because a statutory merger does not have a "substantially all" requirement (as in other types of reorganizations).

Before foreign entities fell under the A reorganization provisions, the trans action would have been considered a C reorganization (for unrelated parties) or a D reorganization (for related parties). In Example 1 above, this transaction could not have qualified as a C reorganization, or for that matter as a forward triangular merger (by reason of Sec. 368(a)(2)(D)) or as a reverse triangular merger (by reason of Sec. 368(a)(2)(E)) if a subsidiary corporation were used. Each type has a "substantially all" requirement that the preliminary distribution, which took place as "part of the plan" would disqualify.

Tax-free treatment for cross-border mergers organized under foreign law allows a tremendous amount of flexibility in structuring foreign reorganizations in an increasingly global business market. It avoids unexpected corporate-level gains on the difference between the tax basis of a target's assets and the fair market value (FMV) of an acquirer's stock and shareholder-level gains on the difference between the target's tax basis and the FMV of the acquirer's stock (which could affect U.S. shareholders of foreign corporations that merge).

Final Regulations

The final regulations contain 14 examples covering a variety of different types of restructurings that either qualify or fail to qualify for type A treatment. These regulations should be carefully reviewed before structuring transactions that involve disregarded entities as well as foreign entities. What follows is a summary of some of the final regulation's more significant changes and clarifications.

Stock Acquisition Followed by LLC Conversion

Under Regs. Sec. 1.368-2(b)(1)(iii), Example (9), a stock acquisition of a target followed by the conversion of the target from a corporation to an LLC under state law cannot qualify as a statutory merger or consolidation.

Example 2: Corporation Y acquires Corporation V's stock from the V shareholders in exchange for consideration that consists of 50% voting stock of Y and 50% cash. Immediately after the stock acquisition, V files the necessary documents to convert from a corporation to an LLC under state W law. Y's acquisition of V's stock and the conversion of V to an LLC are steps in a single integrated acquisition by Y of V's assets.

This acquisition does not satisfy the requirements for a statutory merger because V (the combining entity of the transferor unit) does not cease its separate legal existence. Although V is an entity disregarded from its owner for Federal income tax purposes, it continues to exist as a juridical entity after the conversion. Accordingly, Y's acquisition of V's assets does not qualify as a statutory merger or consolidation for Sec. 368(a)(1)(A) purposes. Moreover, because a type C reorganization requires using at least 80% voting stock as consideration (without regard to the boot relaxation rule), this transaction would not satisfy those requirements and thus could be taxable.

Because income tax principles for multiple related transactions are based on the step-transaction doctrine and because the end result in form is the same as if V merged into a newly-formed, wholly owned LLC of Y (which would have qualified), the Service will continue to consider the issue. However, it seems for now it will continue to rely on long-standing Rev. Rul. 67-274. Under this ruling; an acquisition of target stock followed by the target's liquidation qualified as a type C reorganization. Another long; standing ruling, Rev. Rul. 72-405, provided that a forward triangular merger of an acquiring corporation's subsidiary followed by a liquidation of the subsidiary qualified as a type C reorganization. The conclusions presented in these rulings would be called into question by the final regulations.

A similar example was provided in Kegs. Sec. 1.368-2(b)(1)(iii), Example (10). It indicated that a stock acquisition followed by state law dissolution (as opposed to conversion) would not qualify as a statutory merger for the same reasons.

Merger of Corporate Partner into Partnership

The merger of a corporate partner into a partnership resulting in the corporate partner going out of existence can qualify as a statutory merger or consolidation under Regs. Sec. 1.3682(b)(1) (iii), Example (11).

Example 3: Corporation A and Corporation T together own all of the membership interests in P, an LLC treated as a partnership for Federal income tax purposes. T merges into P under state law. In the merger, the T shareholders exchange their T stock for A stock. As a result of the merger, P becomes an entity disregarded as an entity separate from A.

Example 3 illustrates that the existence and composition of the transferee unit is only tested immediately after the transaction and not before, which would have caused it to fail, because a partnership cannot be a part of a transferee unit. The transaction satisfies the Sec. 368(a)(1)(A) requirements because the merger is effected pursuant to state law, and T ceases its separate legal existence for all purposes. In this example, the Service's test for disregarded-entity status immediately after the transaction is important. While the Service believes this transaction qualifies as a tax-free disregarded-entity merger, it is considering ancillary issues such as whether P would recognize any gain or loss on termination.

Mergers Involving QSubs

Regs. Sec. 1.368-2(b)(1)(iii), Example (3), analyzes a situation in which an S corporation with a QSub merges into a disregarded entity of a qualified C corporation. The regulations discuss the deemed formation by the QSub as a consequence of the termination of the QSub election once the S corporation is merged out of existence. The transaction would be treated as a transfer of the target's assets to the LLC owner followed by the owner's transfer of these assets to the newly-formed corporation in exchange for stock.

Consequently, the transaction will satisfy the requirements of Regs. Sec. 1.368(b)(1)(ii) because the transaction is effected pursuant to state law, and the following events occur simultaneously at the time of the transaction:

1. All of the assets and liabilities of the S corporation and its QSub become the assets and liabilities of one or more members of the transferee unit;

2. The disregarded entity takes ownership of the assets of which its parent is treated as owning for Federal income tax purposes; and

3. The S corporation ceases its separate legal existence for all purposes. Moreover, the deemed transfer of the former QSub assets in exchange for stock in the newly-formed corporation does not cause the transaction to fail to qualify as a statutory merger or consolidation. Asset drop-downs following many types of reorganizations, including statutory mergers, are allowed by Sec. 368(a)(2)(C).

Consolidation and Amalgamation

In a state law consolidation and a foreign law amalgamation, typically two or more corporations combine and continue in the resulting entity, which is a new corporation that is formed in the consolidation transaction. Given the fact that each of the consolidating corporations or amalgamating corporations continues in the resulting corporation, there was a Concern that the transferee corporation would not be considered to have ceased its separate legal existence, and consequently the transaction would not adhere to the strict definitional requirements.

Despite these concerns, the final regulations allow consolidations and amalgamations to qualify, because the Service did not believe that the existence of the consolidating or amalgamating entities within the resulting corporation prevents a consolidation or an amalgamation from qualifying as a statutory merger or consolidation. Additionally, Regs. Sec. 1.368-2(b) (1)(iii), Example (4), will allow a triangular consolidation or amalgamation to qualify if the transaction meets all the tests (including the "substantially all" test) under the reorganization rules applicable to forward triangular mergers under Sec: 368(a)(2)(D).

Nonqualifying Transactions

The new rules contain examples indicating that certain transactions will not qualify as tax-free reorganizations under Sec. 368(a)(1)(A).

Divisive transaction pursuant to a merger statute: A divisive transaction is one in which assets and/or liabilities are split up among more than one corporation(s) (Kegs. Sec. 1.368-2(b)(1)(iii), Example (1)).

Example 4: Under state law, Corporation Z transfers some of its assets and liabilities to Corporation Y, retains the remainder of its assets and liabilities and remains in existence for Federal income tax purposes following the transaction. The transaction qualifies as a merger under state corporate law.

The transaction does not satisfy the requirements of Sec. 368(a)(1)(A) because all of the assets and liabilities of Z, which is the combining entity of the transferor unit, do not become the assets and liabilities of Y, which is the combining entity and sole member of the transferee unit. In addition, the transaction does not satisfy the requirements of Kegs. Sec. 1.368-2(b)(1) (ii)(B) because Z's separate legal existence does not cease for all purposes. Accordingly, the transaction does not qualify as a statutory merger or consolidation under Sec. 368(a)(1)(A).

Merger of a target corporation into a disregarded entity owned by a partnership (Regs. Sec. 1.368-2(b)(1)(iii), Example (5)): Tax-free reorganization principles generally apply only when there are only two corporations. A merger of a target corporation into a partnership or a disregarded entity owned by a partnership would not satisfy the statutory merger requirements because all of the assets and liabilities of the target, which is the combining entity and sole member of the transferor unit, do not become the assets and liabilities of one or more members of a transferee unit. This is because neither the partnership nor the disregarded entity owned by the partnership qualifies as a combining entity. Accordingly, the transaction cannot qualify as a statutory merger or consolidation for Sec. 368(a) (1) (A) purposes.

Merger of a disregarded entity into a corporation: In a statutory merger, at least one corporation must go out of existence (Regs. Sec. 1.368-2(b)(1)(iii), Example. (6)).

Example 5: Under state law, target corporation T merges its disregarded entity into acquiring corporation W. The transaction does not satisfy the requirements of Regs. Sec. 1.368-2(b)(1)(ii)(A) because all of the transferor unit's assets and liabilities do not become the assets and liabilities of one or more members of the transferee unit. The transaction also does not satisfy Reg. Sec. 1.368-2(b)(1)(ii)(B)'s requirements became the disregarded entity does not qualify as a combining entity. Accordingly, the transaction cannot qualify as a statutory merger or consolidation for Sec. 368(a) (1)(A) purposes.

Effective Date

The final regulations under Sec. 1.368-2(b) apply to transactions occurring after Jan. 22, 2006. For rules regarding statutory mergers or consolidations occurring before that date, the temporary regulations under Temp. Regs. Sec. 1.368-2T will apply.

FROM RANDY A. SCHWARTZMAN, CPA, MST, MELVILLE NY
COPYRIGHT 2006 American Institute of CPA's
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Author:Schwartzman, Randy A.
Publication:The Tax Adviser
Date:May 1, 2006
Words:2647
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