Lewis J. Greenwald is a U.S. international tax partner and Christopher M. Flanagan is a tax partner with Sullivan & Worcester LLP in Boston.
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On November 18, 2011, the IRS and Treasury released temporary and proposed regulations for determining the basis of stock or securities deemed to be received in certain D reorganizations (the 2011 regulations).1 The 2011 regulations confirm what many taxpayers had feared -- that some cash D reorganizations do indeed result in the loss of basis in the transferor corporation's stock.
To best explain the full import of the 2011 regulations, this article first contains a discussion of D reorganizations generally. It then examines the regulations relating to D reorganizations issued by the IRS and Treasury on December 19, 2006 (the 2006 regulations),2 and those issued on December 18, 2009 (the 2009 regulations).3 Together, those regulations formed the basis for applying some of the technical requirements for D reorganizations to cash D reorganizations, and they serve as precursors to the 2011 regulations. Finally, this article reviews the 2011 regulations and the resulting potential for the loss of basis thereunder.
D Reorganizations Generally
In the basic D reorganization, one corporation (the Transferor Corporation) transfers all (or substantially all) of its assets to another corporation (the Transferee Corporation). Immediately thereafter, the Transferor Corporation (or one or more of its shareholders) must be in control (generally, 50 percent) of the Transferee Corporation and, as part of an overall plan, stock or securities of the Transferee Corporation and other property received in exchange for the transferred assets must be distributed (along with any other properties of the Transferor Corporation) to the Transferor Corporation's shareholders in a transaction described in section 354 or section 356.4 Assuming that the other requirements of section 368 are satisfied,5 such a transaction can protect the parties to the reorganization fromrecognizing either corporate- or shareholder-level gain (but also prevents the recognition of loss).6
As with other types of reorganizations described in section 368, the consideration provided by the Transferee Corporation in a D reorganization can include property other than its stock or securities (boot).7 In fact, in some intragroup D reorganizations, the consideration provided by the Transferee Corporation can consist entirely of cash or other property on the theory that the issuance of shares of the Transferee Corporation would constitute a meaningless gesture.8 Those types of reorganizations are commonly referred to as cash D reorganizations.9
In a reorganization in which the consideration provided by the Transferee Corporation includes boot, section 358(a)(1) requires that the basis of the stock or securities of the Transferee Corporation received by the Transferor Corporation's shareholders equal the basis of the shares of the Transferor Corporation stock given up in the exchange (i) decreased by the amount of money or the fair market value of the other property received in the exchange and (ii) increased by any gain recognized by the shareholders on the exchange.10
Figure 1. Basic D Reorganization
The 2006 Regulations
In response to requests for immediate guidance on the issue, on December 19, 2006, the IRS and Treasury issued the 2006 regulations describing the circumstances under which the distribution requirement of sections 368(a)(1)(D) and 354(b) would be deemed satisfied in a D reorganization when no actual stock or securities of the Transferee Corporation are issued and distributed in connection with the transaction (that is, in a cash D reorganization).11
In cases where the same persons own all the stock of the Transferor and Transferee Corporations in identical proportions, the 2006 regulations addressed this distribution requirement by deeming a nominal share of stock of the Transferee Corporation to be issued in addition to the actual consideration exchanged in the transaction.12 The nominal share is then deemed to be distributed by the Transferor Corporation to its shareholders (as part of the liquidation of the Transferor Corporation) and, in appropriate cases, further transferred through the ownership chain to the extent necessary to reflect the actual ownership of the Transferee Corporation.13 In those deemed transfers, section 301(d) or section 362(e)(2) would potentially cause the shareholders in the Transferor Corporation to lose basis in the nominal share (because, presumably, the nominal share has a fair market value of zero).14
Figure 2. Transfer of the Nominal Share
Through the Chain of Ownership
Curiously, the 2006 regulations did not distinguish between the situation in which the value of the consideration actually provided in the transaction equals the value of the Transferor Corporation's assets and the situation in which the actual consideration falls short (by value), as compared with the assets transferred. In either case, only a single, nominal share was deemed issued in the transaction. Also, the 2006 regulations did not address the basis implications of the issuance of the nominal share and the subsequent transfers thereof.15
The preamble to the 2006 regulations made clear that the regulations were being issued in the midst of a broad review of the topics they covered and therefore were potentially subject to future change.16 In fact, the text of the 2006 regulations provided that they would expire on December 18, 2009.17
The 2009 Regulations
After receiving comments on the 2006 regulations, and as part of the broad review previewed in the preamble to the 2006 regulations, on December 18, 2009,18 the IRS and Treasury issued the 2009 regulations. They retain the rules of the 2006 regulations with some modifications, but also add provisions addressing the basis implications of the deemed issuance of a nominal share in a cash D reorganization.19
More specifically, the 2009 regulations retain the rules of the 2006 regulations that are based in part on the meaningless gesture doctrine. When the value of the consideration received in the transaction is equal to the FMV of the Transferor Corporation's assets, the 2009 regulations continue the treatment of the 2006 regulations that deem the Transferee Corporation to issue a nominal share to the Transferor Corporation in addition to the actual consideration exchanged for the Transferor Corporation's assets.20 Consistent with the IRS's and Treasury's view of those transactions and in response to comments received, the 2009 regulations further provided that if no consideration was received, or if the value of the consideration received in the transaction was less than the FMV of the Transferor Corporation's assets, the Transferee Corporation would be treated as issuing stock with a value equal to the excess of the FMV of the Transferor Corporation's assets over the value of the consideration actually received in the transaction.21
While the IRS and Treasury believed that all the normal tax consequences occur from the issuance of the nominal share, commentators noted that those consequences were unclear for the allocation of basis in the shares of the stock or securities surrendered when the consideration received in the transaction consists solely of cash.22 In particular, commentators believed that the basis in the shares of the stock or securities surrendered should be preserved in the basis of the stock of the transferee, but the mechanics for achieving that result were unclear.23
The IRS and Treasury pointed out that reg. section 1.358-2(a)(2)(iii) addressed how basis is determined in a reorganization in which no property is received or property (including property permitted by section 354 to be received without the recognition of gain or other property or money) with an FMV less than that of the stock or securities surrendered is received in the transaction.24 The IRS and Treasury noted that those rules do not literally apply to a transaction -- including a cash D reorganization -- when the other property or money provided equals the value of the assets transferred.25
To correct that gap, reg. section 1.358-2(a)(2)(ii) was amended to provide that in the case of a reorganization in which the property received consisted solely of non-qualifying property equal to the value of the assets transferred (as well as a nominal share described in the 2009 regulations), the shareholder or security holder could designate a share of stock of the Transferee Corporation to which the basis, if any, of the stock or securities surrendered would attach. The IRS and Treasury believed that that approach was most consistent with then-current law regarding basis determinations, because a similar result would occur under reg. section 1.358-2 if stock was actually issued in the transaction.26
The 2011 Regulations
Following the promulgation of the 2009 regulations, the IRS and Treasury became aware that taxpayers were interpreting the portion of those regulations enabling them to designate the share of stock of the Transferee Corporation to which the basis of a nominal share will attach in a manner that the agencies deemed inappropriate. Specifically, taxpayers were interpreting the 2009 regulations to allow a person who did not own any direct shares in the Transferee Corporation to allocate the basis in the nominal share received in a cash D reorganization across the ownership chain to a related person (who directly owned shares in the Transferee Corporation), thereby avoiding the elimination of that basis that would potentially occur upon the deemed transfer of the share through the ownership chain (as required by reg. section 1.368-2(l)). The 2011 regulations were a direct response to this perceived abuse.
Figure 3. Perceived Abuse
The 2011 regulations make clear that the allocation of the basis in a nominal share can only be made by a person that otherwise directly owns at least one actual share in the Transferee Corporation.27 The preamble to the 2011 regulations states that the IRS and Treasury "did not intend for the [2009 regulations] to allow such an inappropriate allocation of basis and do not believe that the current regulations support such an allocation."28
If the shareholders of the Transferor Corporation are also shareholders of the Transferee Corporation, that requirement should not present a problem. The shareholders would be able to allocate the basis in the nominal share to a directly held share of Transferee Corporation stock and potentially realize the benefit of that additional basis on a later disposition of the stock.
However, a very different result follows if the shareholders of the Transferor Corporation do not directly own any shares of stock of the Transferee Corporation. Then, the shareholders of the Transferor Corporation would not be able to allocate the basis in the nominal share to any other shares of the Transferee Corporation, and that basis would potentially disappear in the deemed transfer through the ownership chain required by reg. section 1.368-2(l).
The 2011 regulations provide an example regarding the loss of basis in that situation, similar to that shown in Figure 4.
Facts. F1 and F2 each have a single class of stock outstanding, all of which is owned by USP. F3 has a single class of stock outstanding, all of which is owned by F1. The corporations do not join in the filing of a consolidated return. F1 acquired 100 shares of F3 stock on date 1 for $1.50 each. On date 2, F2 acquires the assets of F3 for $100 of cash (their FMV) in a transaction described in reg. section 1.368-2(l). Under the terms of the exchange, F3 does not receive any F2 stock. F3 distributes the $100 of cash to F1 in a liquidation. Under reg. section 1.368-2(l), F2 will be deemed to issue a nominal share of F2 stock to F3 in addition to the $100 of cash actually exchanged for the F3 assets, and F3 will be deemed to distribute all the consideration to F1. F1 will have a basis of $50 in the nominal share of F2 stock under section 358(a). F1 will be deemed to distribute the nominal share of F2 stock to USP. F1 does not recognize the loss on the deemed distribution of the nominal share to USP under section 311(a).29 USP's basis in the nominal share is zero (its FMV) under section 301(d).
Analysis. F1 is deemed to receive the nominal share of F2 stock described in reg. section 1.368-2(l). However, under reg. section 1.358-2T(a)(2)(iii), F1 is not an actual shareholder of F2, the issuing corporation. Therefore, F1 cannot designate any share of F2 stock to which the basis, if any, of the nominal share of F2 stock will attach. Further, USP cannot designate a share of F2 stock to which basis will attach because USP receives the nominal share with a basis of zero.30
Figure 4. Illustration of Basis Loss Example
As noted above, the 2011 regulations confirm what many taxpayers had feared -- that some cash D reorganizations do indeed result in the loss of basis in the transferor corporation's stock. However, this loss of basis issue can likely be sidestepped by avoiding the deemed issuance of a nominal share through having the Transferee Corporation issue an actual share that is not transferred up or down the ownership chain.31
1 Reg. section 1.358-2T(a)(2)(iii) and (c), examples 15 and 16; T.D. 9558, Doc 2011-24298, 2011 TNT 224-15. The text of the temporary regulations also serves as the proposed regulations.
4 Sections 368(a)(1)(D) and 354(b). This type of transaction is often referred to as an acquisitive D reorganization. While the statute also permits a second type of D reorganization, often referred to as a divisive D reorganization (which must also qualify under the spinoff rules of section 355), this article focuses only on acquisitive D reorganizations and the provisions of the 2011 regulations that apply to them.
5 For example, the transaction must satisfy the business purpose and continuity of business enterprise requirements of such section. In addition, for purposes of this article, we assume that both the Transferor and Transferee Corporations are solvent immediately before the reorganization.
6 Sections 354, 356, and 361. Structural developments have permitted transactions to deviate from this precise form and still qualify as a D reorganization under those provisions. In particular, many transactions treated as acquisitive D reorganizations are structured as a sale of the stock of the Transferor Corporation to the Transferee Corporation, followed by an actual or deemed (check-the-box) liquidation of the Transferor Corporation. Under the step transaction theory, the transaction is treated as a D reorganization (rather than a section 304 exchange followed by a section 332 liquidation) if all the other requirements of section 368 are met.
7 When boot is included in the consideration provided by the Transferee Corporation, the shareholders of the Transferor Corporation may be required to recognize gain (but not loss) on the transaction. The amount of gain required to be recognized is equal to the lesser of (i) the gain realized on the transaction (that is, the excess of the aggregate value of the consideration provided by the Transferee Corporation over the shareholders' basis in their shares in the Transferor Corporation) and (ii) the amount of the boot. Section 356(a)(1). A portion of that gain may be treated as a dividend to the extent of the earnings and profits of the Transferor Corporation. Section 356(a)(2). However, the IRS and at least one court have said that the E&P of both the Transferor and Transferee Corporations are taken into account when measuring dividend equivalence when both entities are commonly controlled. See Rev. Rul. 70-240, 1970-1 C.B. 81; Davant v. Commissioner, 366 F.2d 874 (5th Cir. 1966). But see Atlas Tool Co. Inc. v. Commissioner, 614 F.2d 860 (3d. Cir. 1980).
8 Reg. section 1.1502-13 generally addresses the treatment of some intercompany reorganizations involving members of a consolidated group. Its provisions are beyond the scope of this article, which thus assumes that the entities involved in the transactions discussed are not members of a consolidated group subject to the regulation for U.S. federal income tax purposes (for example,, a U.S. parent owning stock of non-U.S. Transferor and Transferee Corporations).
9 The application of the meaningless gesture doctrine to D reorganizations has its origins in the courts (see, e.g., Commissioner v. Morgan, 288 F.2d 676 (3d. Cir. 1961), and James Armour Inc. v. Commissioner, 43 T.C. 295 (1964)) and was endorsed by the IRS in Rev. Rul. 70-240, 1970-1 C.B. 81. Although generally accepted, this application of the meaningless gesture doctrine has usually been limited to times when the same persons own all the shares of the Transferor and Transferee Corporations in identical proportions.
10 Section 367 contains specific provisions that can affect the application of the nonrecognition rules for reorganizations that include one or more foreign corporations. This article focuses on the application of the current proposals regarding the computation of basis in cash D reorganizations, and leaves for another day the overlay of the section 367(a) and (b) implications of a foreign-to-foreign D reorganization, a U.S.-to-foreign D reorganization, or a foreign-to-U.S. D reorganization.
11 Absent satisfaction of this requirement, a transaction structured as a cash D reorganization would be treated as a taxable transaction. See Warsaw Photographic Associates Inc. v. Commissioner, 84 T.C. 21 (1985).
12 Reg. section 1.368-2T(l)(2)(i). For this purpose, ownership is determined by applying the principles of section 318(a)(2), without regard to the 50 percent limitation of section 318(a)(2)(C), and by disregarding some "plain vanilla" preferred stock. Further, the same persons are treated as owning (directly or indirectly) all the stock of the Transferor and Transferee Corporations, notwithstanding that there is a de minimis variation in shareholder identity or proportionality of ownership. See reg. section 1.368-2T(l)(2)(ii) and (iii), respectively.
13 Reg. section 1.368-2T(l)(2)(i).
14 It is our understanding that the government treats this share, as a nominal share, as essentially having no value. This is borne out by the examples in the 2011 regulations.
15 T.D. 9244, Doc 2006-1335, 2006 WTD 16-17, issued earlier in 2006, revised reg. section 1.358-2(a)(2)(iii) to provide basis allocation provisions covering transactions in which the consideration actually provided falls short (by value) when compared with the stock or securities surrendered in the transaction. Since those regulations applied only to transactions in which there was such a shortfall in value, they arguably did not apply to a transaction in which only a nominal share was deemed to be issued.
16 In connection with that review, the IRS and Treasury requested comments on several issues relating to acquisitive D reorganizations. In particular, comments were requested on whether the meaningless gesture doctrine is inconsistent with the distribution requirement of sections 368(a)(1)(D) and 354(b)(1)(B), especially when the cash consideration received equals the full FMV of the property transferred so that there is no missing consideration for which the nominal share can be a substitute.
17 Reg. section 1.368-2T(l)(4)(ii).
18 The expiration date for the 2006 regulations.
19 But see infra note 26.
20 Reg. section 1.368-2(l)(2).
21 Id. This change to the 2006 regulations cures the curious feature of the 2006 regulations that deemed only a nominal share to be issued even when there was a shortage of consideration by value.
22 Preamble to T.D. 9475.
24 Id. Specifically, reg. section 1.358-2(a)(2)(iii) treats the acquiring corporation as issuing an amount of stock equal to the FMV of the stock surrendered, less any amount of consideration actually received by the exchanging shareholder in the form of stock, securities, other property, or money. The basis of the deemed issued stock is determined by reference to the basis of the shares surrendered in the reorganization, as adjusted. The shareholder's stock in the acquiring corporation is then treated as being capitalized. In the recapitalization, the shareholder is treated as surrendering all its shares of the acquiring corporation, including those shares owned immediately before the reorganization and those shares the shareholder is deemed to receive, in exchange for the shares that the shareholder actually holds immediately after the reorganization. The basis of the shares that the shareholder actually owns is determined under the rules that would have applied had the recapitalization actually occurred with respect to the shareholder's actual shares and the shares the shareholder is deemed to have received.
25 Preamble to T.D. 9475.
27 Reg. section 1.358-2T(a)(2)(iii)(C).
28 T.D. 9558. The 2011 regulations seemingly perpetuate a drafting issue in the 2009 regulations relating to the failure of the latter to apply when only a nominal share of the Transferee Corporation is deemed issued in the transaction. That is to say, the first sentence of reg. section 1.358-2T(a)(2)(iii) states that the provisions of that section apply to a shareholder who surrenders stock in a transaction in which the aggregate value of the property provided by the Transferee Corporation is "less than that of the stock or securities surrendered in the transaction." Arguably, that results in the 2011 regulations not applying to a cash D reorganization in which only a nominal share is deemed issued, because the cash paid in such a transaction (by definition) equals the value of the stock or securities surrendered in the transaction. That said, the last sentence of reg. section 1.358-2T(a)(2)(iii) and both of the examples nonetheless apply the provisions of the regulation to situations involving full value transfers. It is thus presumably the case that this is simply an unintended slip of the drafter's pen. The IRS and Treasury should confirm and correct to ensure proper interpretation of the 2011 regulations.
29 It is worth noting that this loss of basis will generally occur in this type of fact pattern only when the original basis of the Transferor Corporation stock exceeds the value of the Transferor Corporation's assets (and thus the actual consideration received in the transaction).
30 Reg. section 1.358-2T(c), Example 16. A similar loss of basis could result in a case involving a Transferor Corporation shareholder that owns stock directly in the Transferee Corporation, if the shareholder actually transfers the stock to which the nominal share's basis attaches through the ownership chain in a manner similar to that required by reg. section 1.368-2(l). The same basis adjustments under sections 301(d) and 362(e)(2) as would apply to the deemed transfer under the Treasury regulation would also apply to an actual transfer. The IRS and Treasury believe that the result for the treatment of a nominal share should be the same as the treatment that would result if an actual share were issued. Preamble to T.D. 9558.
31 Taxpayers should also be aware that legislative proposals exist to more generally eliminate some benefits associated with cash D reorganizations. See, e.g., H.R. 62, International Tax Competitiveness Act of 2011, Doc 2011-576, 2011 WTD 7-24.
END OF FOOTNOTES
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