Gabe B. Gartner is a principal, and Neha Prabhakar is a senior associate, in the mergers and acquisitions group of PricewaterhouseCoopers LLP's National Tax Services practice. The authors thank T. Bart Stratton and Derek Cain for their insights and commentary. The views expressed herein are solely the authors' and do not necessarily reflect those of PwC.
In this article, the authors explore the ability of taxpayers to use a check-the-box election to change the tax treatment of a prior stock transfer into that of a reorganization under section 368(a)(1)(D).
Copyright 2014 Gabe B. Gartner and
All rights reserved.
U.S. multinationals frequently use a reorganization under section 368(a)(1)(D) (a type D reorganization) when restructuring their foreign subsidiaries. It is common for a type D reorganization to take the form of (1) a transfer of the stock of the target corporation, followed by (2) the filing of a check-the-box election for the target corporation to be disregarded for U.S. tax purposes1 (resulting in a deemed liquidation of the target corporation).2 Assuming these two steps are undertaken in accordance with a prearranged plan, taxpayers can apply the step transaction doctrine to treat the target corporation as transferring its assets in a type D reorganization.3
In contrast, a type D reorganization would not result if the parties simply transferred the stock of the target corporation (with no plan to liquidate it). However, the check-the-box regulations potentially give a taxpayer the ability to change its mind if it is later determined that a type D reorganization would be preferable. For example, if a taxpayer transfers the stock of the target corporation without a plan to liquidate but within 75 days decides to make an election for the target corporation to be disregarded, can a type D reorganization be achieved? This article explores whether taxpayers can properly invoke the step transaction doctrine in that scenario.
Requirements for Type D Reorganization
Section 368(a)(1)(D) defines a type D reorganization as a transfer by one corporation of all or part of its assets to another corporation if (1) immediately after the transfer, the transferor corporation, one or more of its shareholders, or any combination thereof is in control4 of the acquiring corporation; and (2) in pursuance of the plan, stock or securities of the acquiring corporation are distributed5 in a transaction that qualifies under section 354, 355, or 356. In an acquisitive type D reorganization, the acquiring corporation must acquire substantially all6 the assets of the transferor corporation.7 Further, to qualify as a type D reorganization, a transaction must satisfy the nonstatutory requirements of business purpose,8 continuity of interest,9 and continuity of business enterprise.10
Two-Step Stock Type D Reorganization
As an example of a two-step stock type D reorganization, assume USP owns all the stock of CFC1 and CFC2. Under a prearranged plan, the steps are (1) USP transfers the stock of CFC2 to CFC1 in exchange for additional voting shares of CFC1, and (2) CFC2 files an election to be disregarded from CFC1 for U.S. tax purposes.
Viewed independently, the first step should qualify as a tax-deferred transaction under sections 368(a)(1)(B)11 and 351.12 However, USP would be required to file a gain recognition agreement in order to preserve this tax-deferred treatment.13 Viewed independently, the second step should qualify as a tax-deferred liquidation under section 332.14
However, under the step transaction doctrine, CFC2 should be treated as transferring all its assets to CFC1 in exchange for voting stock of CFC1 and then liquidating into USP in a type D reorganization.15 This principle is illustrated in Rev. Rul. 67-274, 1967-2 C.B. 141,16 in which under a plan of reorganization, Y Corp. acquired the stock of X Corp. solely in exchange for voting stock of Y Corp., and X Corp. was then liquidated. The IRS treated the transaction as an acquisition by Y Corp. of the assets of X Corp. in a reorganization under section 368(a)(1)(C). Similarly, the IRS in Rev. Rul. 2001-46, 2001-2 C.B. 321, addressed a transaction in which X Corp. first acquired the stock of T Corp. solely in exchange for voting stock of X Corp. (under the merger of newly formed and wholly owned Y Corp. into T Corp.). Under an integrated plan, T Corp. was then merged into X Corp. Viewed independently, the steps would qualify as a reorganization under section 368(a)(2)(E) followed by a tax-deferred liquidation under section 332.17 However, the IRS treated the transaction as a merger of T Corp. directly into X Corp. in a reorganization under section 368(a)(1)(A).18
Two-Step Cash Type D Reorganization
As an example of a two-step cash type D reorganization, assume USP owns all the stock of CFC1 and CFC2. CFC2 in turn owns all the stock of CFC3. Under a prearranged plan, the steps are (1) CFC2 sells the stock of CFC3 to CFC1 in exchange for cash (equal to the fair market value of the stock of CFC3), and (2) CFC3 files an election to be disregarded from CFC1 for U.S. tax purposes.
Viewed independently, the first step should be treated as a transaction under section 304(a)(1).19 Accordingly, CFC2 should be treated as receiving a dividend -- first from CFC1 (to the extent of CFC1's earnings and profits) and then from CFC3 (to the extent of CFC3's earnings and profits).20 Depending on the tax year of the parties,21 this dividend may qualify for the exception from foreign personal holding company income treatment provided in section 954(c)(6).22 Viewed independently, the second step should qualify as a tax-deferred liquidation under section 332.23
However, under the step transaction doctrine, CFC3 should be treated as transferring all its assets to CFC1 in exchange for the cash consideration and then liquidating into CFC2 in a type D reorganization.24 This principle is illustrated in Rev. Rul. 2004-83, 2004-2 C.B. 157, in which P Corp. owned all the stock of S Corp. and T Corp. Under an integrated plan, S Corp. acquired the stock of T Corp. in exchange for cash, and T Corp. was liquidated. The IRS treated the transaction as an acquisition by S Corp. of the assets of T Corp. in a type D reorganization.
Alternative Scenarios -- No Prearranged Plan
Each of the authorities discussed above involved a prearranged plan: When the stock of the target corporation was transferred to the acquiring corporation, the parties planned to liquidate the target corporation. In the absence of such a prearranged plan, will the step transaction doctrine apply? Returning to the question posed above, if, for example, a taxpayer transfers the stock of the target corporation without a plan to liquidate but within 75 days decides to file an election for the target corporation to be disregarded, can a type D reorganization be achieved?
For example, assume in the first scenario above that USP transfers the stock of CFC2 to CFC1 in exchange for additional voting shares of CFC1 (with no plan to liquidate CFC2). Alternatively, assume in the second scenario above that CFC2 sells the stock of CFC3 to CFC1 (with no plan to liquidate CFC3). Within 75 days following the transfer of the stock of the target corporation, the parties determine that a transaction qualifying as a type D reorganization would be preferable. In the first scenario, a type D reorganization would eliminate the requirement to file a gain recognition agreement.25 In the second scenario, a type D reorganization would limit the amount of the potential dividend recognized by CFC2 to its gain (if any) in the stock of CFC3.26
The check-the-box regulations potentially provide taxpayers flexibility in this regard by permitting the effective date of the election to be up to 75 days before the date on which the election is filed.27 The check-the-box election would cause a deemed liquidation of the target corporation for U.S. tax purposes, effective immediately before the close of the day preceding the effective date.28 Moreover, a plan of liquidation would be considered to exist at the time of the deemed liquidation.29
For example, if USP transferred the stock of CFC2 to CFC1 on August 1, USP could decide two months later that it preferred the transaction to qualify as a type D reorganization. To accomplish that result, USP on October 1 could file an election -- with an effective date of August 3 -- to treat CFC2 as disregarded for U.S. tax purposes. That election would cause a deemed liquidation of CFC2 into CFC1 immediately before the close of August 2. As a result, the transfer of the stock of CFC2 and deemed liquidation of CFC2 would be separated by a single day.
Reg. section 301.7701-3(g)(2)(i) expressly recognizes that the U.S. tax treatment of a change in the classification of an entity by election will be "determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine."30 However, as discussed below, a taxpayer's ability to successfully argue for a type D reorganization in this scenario will depend on the particular formulation of the step transaction doctrine that is applied and the importance given to the temporal proximity of the steps.
Formulations of the Step Transaction Doctrine
The courts have developed three distinct formulations of the step transaction doctrine: the binding commitment test, the mutual interdependence test, and the end result test.31 Under the binding commitment test, a series of steps will be integrated if, when the first step is undertaken, there is a commitment (for example, a legally binding agreement) to take the subsequent steps.32 The courts generally have applied the binding commitment test only when multiple steps were undertaken over several tax years.33 Under the mutual interdependence test, a series of steps will be integrated if they are so interdependent that the legal relationships created by one step would be fruitless without the completion of the subsequent steps.34 However, steps that have independent economic significance should not be integrated under the mutual interdependence test.35 Under the end result test, a series of steps will be integrated if they are components of a single transaction intended from the outset to reach an ultimate result.36 Accordingly, the fundamental inquiry under the end result test is whether the taxpayer intended at the time of the first step to undertake the subsequent steps.37
In applying these tests, the courts and the IRS have tended to integrate a series of steps that are undertaken within a short time frame.38 Some of the authorities apparently integrate steps solely because they occur in close temporal proximity,39 while others interpret temporal proximity as evidence of the taxpayer's intent to undertake the subsequent steps.40 Under the latter view, proximity in time alone would be an insufficient reason to integrate steps if, at the time of the first step, the taxpayer lacked the intent to undertake the subsequent steps.41
If the binding commitment test were applied to the alternative scenarios, a type D reorganization would not result, since there was no commitment to liquidate the target corporation at the time its stock was transferred. Similarly, if the mutual interdependence test were applied, a type D reorganization would likely not result, since the acquisition of the stock of the target corporation has independent economic significance (apart from the subsequent election to liquidate the target corporation for U.S. tax purposes).
What is less clear is whether a type D reorganization would result if the end result test were applied. The temporal proximity of the steps and existence of a deemed plan of liquidation42 weigh infavor of applying the end result test to create a type D reorganization. However, taxpayers should expect an uphill battle. As discussed above, the end result test focuses on whether the taxpayer intended at the time of the first step to undertake the subsequent steps. Although the check-the-box election causes a deemed liquidation of the target corporation shortly after the time the stock of the target corporation is transferred, it does not create an intent to liquidate the target corporation at the time of that stock transfer. In short, the check-the-box election does not change the taxpayer's mind at the time of the first step.
1 See reg. section 301.7701-3(c)(1)(i) (providing that an eligible entity can elect to change its classification for U.S. tax purposes by filing Form 8832, "Entity Classification Election").
2 Reg. section 301.7701-3(g)(1)(iii).
3 Taxpayers generally are bound by the chosen form of their transactions. See Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967); Estate of Durkin v. Commissioner, 99 T.C. 561 (1992); and FSA 200206010. However, the courts have permitted taxpayers to apply the step transaction doctrine to determine the tax consequences of multi-step acquisitions. See, e.g., King Enterprises Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969); and South Bay Corp. v. Commissioner, 345 F.2d 698 (2d Cir. 1965). Further, taxpayers are entitled to rely on the conclusions set forth in revenue rulings regarding transactions that involve substantially similar facts and circumstances. Reg. section 1.6662-4(d)(3)(ii).
4 For this purpose, control is defined as the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote, or at least 50 percent of the total value of shares of all classes of stock. Section 368(a)(2)(H)(i); section 304(c).
5 See also section 354(b)(1)(B); and reg. section 1.368-2(l)(2)(i) (providing that the distribution requirements of sections 368(a)(1)(D) and 354(b)(1)(B) will be satisfied -- even though there is no actual issuance of stock or securities of the acquiring corporation -- if the same person or persons own, directly or indirectly, all the stock of the transferor corporation and the acquiring corporation in identical proportions).
6 See Rev. Proc. 77-37, 1977-2 C.B. 568 (defining substantially all assets as 90 percent of the fair market value of the net assets and 70 percent of the FMV of the gross assets).
7 Section 354(b)(1)(A).
8 See reg. section 1.368-1(b), -2(g).
9 See reg. section 1.368-1(e).
10 See reg. section 1.368-1(d).
11 See section 368(a)(1)(B) (defining a reorganization to include the acquisition by one corporation, solely in exchange for its voting stock, of the stock of another corporation if, immediately after that acquisition, the acquiring corporation is in control (as defined in section 368(c)) of the acquired corporation).
12 See section 351(a) (providing that no gain or loss is recognized if property is transferred to a corporation solely in exchange for stock of the corporation, and immediately after the exchange, the transferor(s) is in control (as defined in section 368(c)) of that corporation).
13 Reg. section 1.367(a)-3(b)(1)(ii). See reg. section 1.367(a)-8 for the requirements for a gain recognition agreement.
14 See section 332(a) (providing that no gain or loss is recognized on the receipt by a parent corporation of property distributed in the complete liquidation of an 80-percent-owned subsidiary corporation); and section 337 (providing that no gain or loss is recognized by a subsidiary corporation on the distribution of property to its 80 percent parent corporation in a complete liquidation to which section 332 applies).
15 This assumes that all the requirements of a type D reorganization are otherwise satisfied.
16 Rev. Rul. 67-274 cited Rev. Rul. 54-96, 1954-1 C.B. 111 (concluding that under the predecessors to sections 351 and 368(a)(1)(D), two steps that were part of a prearranged integrated plan cannot be considered independently of each other for U.S. tax purposes). See also Rev. Rul. 72-405, 1972-2 C.B. 217; Rev. Rul. 78-130, 1978-1 C.B. 114; Rev. Rul. 87-66, 1987-2 C.B. 168; and reg. section 1.1361-4(a)(2)(ii), Example 3.
17 See supra note 14.
18 The courts have also treated the acquisition of the stock of a target corporation followed by a merger of the target corporation into the acquiring corporation (or a wholly owned subsidiary) under a prearranged plan as a reorganization under section 368(a)(1)(A) (or section 368(a)(2)(D)). See, e.g., King Enterprises, 418 F.2d 511; and J.E. Seagram Corp. v. Commissioner, 104 T.C. 75 (1995).
19 See section 304(a)(1) (providing that for purposes of sections 302 and 303, if (1) one or more persons are in control (as defined in section 304(c)) of each of two corporations; and (2) one of the corporations acquires stock of the other corporation from the person(s) in control in exchange for property, that property will be treated as a distribution in redemption of the stock of the acquiring corporation).
20 See section 304(b)(2).
21 Section 954(c)(6) applies to the tax years of foreign corporations beginning after December 31, 2005, and before January 1, 2014, and to the tax years of U.S. shareholders "with or within which such tax years end."
22 See Notice 2007-9, 2007-1 C.B. 401 (providing that for purposes of section 954(c)(6), the term "dividend" includes any amount treated as a distribution under section 301(c)(1) as a result of section 304).
23 See supra note 14.
24 This assumes that all the requirements of a type D reorganization are otherwise satisfied. See also Rev. Rul. 70-240, 1970-1 C.B. 81; Atlas Tool Co. v. Commissioner, 70 T.C. 86 (1978), aff'd, 614 F.2d 860 (3d Cir. 1980); Armour v. Commissioner, 43 T.C. 295 (1964); and reg. section 1.368-2(l)(2)(i) (providing for the deemed issuance by CFC1 to CFC3 of a nominal share of stock).
25 See reg. section 1.367(a)-3(a)(2)(ii); and reg. section 1.367(a)-3(d)(3), Example 16.
26 See section 356(a) (providing that upon receipt of money or other nonqualifying property in a reorganization, a shareholder will recognize gain (if any) in the stock of the target corporation, but in an amount not in excess of the sum of that money and the FMV of the nonqualifying property).
27 Reg. section 301.7701-3(c)(1)(iii).
28 Reg. section 301.7701-3(g)(3)(i).
29 See reg. section 301.7701-3(g)(2)(ii) (providing that in satisfying the requirement under section 332 to adopt a plan of liquidation, the making of an election for the target corporation to be disregarded for U.S. tax purposes is considered the adoption of such a plan immediately before the deemed liquidation, unless a formal plan of liquidation is adopted on an earlier date).
30 See reg. section 1.368-1(a).
31 See generally Martin Ginsburg et al., Mergers, Acquisitions, and Buyouts, section 6.08.3 (Feb. 2013).
32 See, e.g., Commissioner v. Gordon, 391 U.S. 83 (1986); and J.E. Seagram, 104 T.C. 75.
33 See, e.g., McDonald's Restaurant of Illinois v. Commissioner, 688 F.2d 520 (7th Cir. 1982) (describing the binding commitment test as "formulated to deal with the characterization of a transaction that in fact spanned several tax years").
34 See, e.g., American Bantam Car Co. v. Commissioner, 11 T.C. 397 (1948), aff'd, 177 F.2d 1235 (5th Cir. 1949); and McDonald's of Zion v. Commissioner, 76 T.C. 972 (1981), rev'd sub nom. McDonald's Restaurants of Illinois v. Commissioner, 688 F.2d 520.
35 See Reef Corp. v. Commissioner, 368 F.2d 125 (5th Cir. 1966); and Rev. Rul. 79-250, 1979-2 C.B. 156, modified by Rev. Rul. 96-29, 1996-1 C.B. 50.
36 See, e.g., King Enterprises, 418 F.2d 511; and Penrod v. Commissioner, 88 T.C. 1415 (1987).
37 See True v. United States, 190 F.3d 1165 (10th Cir. 1999); and Andantech LLC v. Commissioner, T.C. Memo. 2002-97.
38 See, e.g., Waterman Steamship Corp. v. Commissioner, 430 F.2d 1185 (5th Cir. 1970) (steps undertaken an hour and a half apart were integrated); InterTAN v. Commissioner, T.C. Memo. 2004-1, aff'd, 117 Fed. Appx. 348 (5th Cir. 2004) (steps undertaken on same day were integrated); D'Angelo Assoc. Inc. v. Commissioner, 70 T.C. 121 (1978) (steps undertaken less than 10 days apart were integrated); LTR 8742033 (steps undertaken within four months of each other were integrated); and reg. section 1.368-2(c) (steps undertaken within "a relatively short period of time such as twelve months" of each other should be integrated for purposes of section 368(a)(1)(B)). But cf. Henricksen v. Braicks, 137 F.2d 632 (9th Cir. 1943) (steps undertaken less than one hour apart not integrated); and Zachry Co. v. Commissioner, 49 T.C. 73 (1967) (steps undertaken three days apart not integrated).
39 See reg. section 1.368-2(c); and Rev. Rul. 87-66, 1987-2 C.B. 168.
40 Weikel v. Commissioner, T.C. Memo. 1986-58 (noting that "if two transactions occur within an hour of each other it would be reasonable to assume that the second transaction was prearranged given the fact that it would be difficult to conceive and execute the second transaction in the interval of time available"); ILM 200610019 (redemption of preferred stock shortly after the time of issuance was strong evidence that the parties intended the stock's existence to be transitory); NSAR 08935 (taking the position that the amount of time between steps in and of itself is not determinative).
41 See, e.g., Penrod, 88 T.C. 1415; and Estate of Christian v. Commissioner, T.C. Memo. 1989-413. This principle is particularly relevant when there is an unanticipated change in circumstances between the time of the first step and the subsequent steps. See Vest v. Commissioner, 57 T.C. 128 (1971), aff'd in part and rev'd in part on other grounds, 481 F.2d 238 (5th Cir. 1973). See generally Joint Committee on Taxation, "Background and Present Law Relating to Tax Shelters," JCX-19-02 (Mar. 19, 2002) ("If a taxpayer can provide evidence that at the time the first of a series of steps was undertaken, there was no plan or intention to effectuate the other steps, then the transactions should not be stepped together. An important factor that supports a taxpayer's lack of intent is found where subsequent steps are prompted by external, unexpected events that are beyond the taxpayer's control.").
42 Notwithstanding the existence of a deemed plan of liquidation under reg. section 301.7701-3(g)(2)(ii), taxpayers should consider whether a plan of reorganization exists. See reg. section 1.368-1(c), -2(g). The courts and the IRS have adopted a broad definition of the phrase "plan of reorganization." See Seagram, 104 T.C. 75 (referring to the concept of a plan of reorganization as one of "substantial elasticity"); C.T. Investment Co. v. Commissioner, 88. F.2d 582 (8th Cir. 1937) (holding that a plan of reorganization need not be in any particular form or reduced to writing); and TAM 9708001. However, similar to the discussion of the end result test, the mere fact that two steps occurred in close temporal proximity may not be sufficient to establish that they were undertaken in accordance with a plan of reorganization. Mathis v. Commissioner, 19 T.C. 1123 (1953); Kind v. Commissioner, 54 T.C. 600 (1970); Swanson v. United States, 319 F. Supp. 959 (D.C. Calif. 1970), aff'd, 479 F.2d 539 (9th Cir. 1973).
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