New IRS Rulings Should Provide Greater Certainty for Corporate Restructurings
On May 5, 2015, the Internal Revenue Service (IRS) issued two long-awaited rulings, Rev. Rul. 2015-09 and Rev. Rul. 2015-10, that should ease the lives of corporate tax planners. Each ruling addressed an increasingly common transaction structure—the “drop and sideways merger” and the “triple drop and check”—that had provoked frequent corporate tax panel debates and some uncertainty for tax practitioners and taxpayers.
In Rev. Rul. 2015-09, the IRS revoked a 37-year-old application of the step transaction doctrine to a stock transfer followed by an asset reorganization, or a “drop and sideways merger” transaction. The facts presented in Rev. Rul. 2015-09 are identical to those in Rev. Rul. 78-130. P, a domestic corporation, owns all of the stock of S1 and S2, both of which are incorporated in foreign country R. S1 is an operating company, and S2 is a holding company that owns all of the stock of corporations X, Y and Z, all of which are country R operating companies. Pursuant to a plan to combine the four operating companies into a new subsidiary, S-2 forms corporation N, and P transfers all of the stock of S-1 to S-2 in exchange for additional shares of S-2 voting common stock. Immediately after P’s transfer, X, Y and Z, as well as S-1, transfer all of their assets (subject to liabilities) to N, in exchange for additional shares of N common stock. Each of X, Y, Z and S-1 then liquidates and distributes all of its N stock to S-2. Following the transaction, N continues to conduct the businesses formerly conducted by S-1, X, Y and Z.
Rev. Rul. 78-130 described the tax treatment of the transaction as follows:
Since the two steps of P’s transfer of the stock of S-1 to S-2 immediately followed by N’s acquisition of S-1’s assets are part of a prearranged, integrated plan which has as its objective the consolidation of all of the operating companies in N, the two steps should not be viewed independently of each other for Federal income tax purposes.
Accordingly, the transfer by P of the stock of S-1 to S-2 will not constitute an exchange within the meaning of section 351 of the Code. Instead, N will be viewed as directly acquiring substantially all of the assets of S-1 in exchange for stock of S-2. This recast transaction does not meet the definitional requirements of a section 368(a)(1)(D) reorganization because neither S-1 nor P (the transferor or its shareholder) will be in control of N, within the meaning of section 368(c), immediately after the transaction. (Citations omitted.)
Rev. Rul. 78-130 concludes, however, that the acquisition of the S-1 assets (subject to liabilities) “in exchange for stock of S-2 by N, as recast,” may be properly characterized as a triangular reorganization under § 368(a)(1)(C)—that is, a transaction in which a corporation (N) acquires, solely in exchange for voting stock of a corporation in control of the acquiring corporation (S-2), substantially all of the properties of the target corporation (S-1).
Much has changed in the corporate reorganization landscape since Rev. Rul. 78-130 was issued. In 1984, the definition of “control” for a § 368(a)(1)(D) reorganization was amended to conform to § 304. In addition, the IRS issued the “all-cash D reorganization” regulations, Treas. Reg. § 1.368-2(l), which deem an issuance of stock, of nominal value, for purposes of causing a transaction to qualify as a reorganization under § 368(a)(1)(D) (namely, to satisfy the requirement of § 354(b)(1)(B) that the target corporation distribute stock of the acquiring corporation in the target’s liquidation). This change confirms that an all-cash cross-chain reorganization can qualify under § 368(a)(1)(D) even if the target and acquiring corporations are not directly owned by the same person. The regulations include a priority rule, in Treas. § 1.368-2(l)(2)(iv), that provides that the nominal share rule will not apply if the transaction is described as a triangular reorganization in Treas. Reg. § 1.358-6(b)(2) (i.e., a transaction that otherwise would qualify as a triangular reorganization will not be treated as an all-boot D reorganization).
In recent years, the IRS issued two private letter rulings, PLR 201252002 and PLR 201150021, that arguably are inconsistent with Rev. Rul. 78-130, treating a series of three contributions of stock of a company, followed by a deemed liquidation of the company, as two successive § 351 transactions followed by a reorganization under § 368(a)(1)(D). Rev. Rul. 2015-09 reaches a similar conclusion as these private letter rulings (Rev. Rul. 2015-10, discussed later, reaches the same conclusion), holding that P’s transfer of S-1 to S-2 satisfies § 351 and that S-1’s transfer of all of its assets (subject to liabilities) to N followed by S-1’s liquidation qualifies as a D reorganization. The IRS reasons as follows:
A transfer of property may be respected as a § 351 exchange even if it is followed by subsequent transfers of the property as part of a prearranged integrated plan. However, a transfer of property in an exchange otherwise described in § 351 will not qualify as a § 351 exchange if, for example, a different treatment is warranted to reflect the substance of the transaction as a whole.
Under the facts of this revenue ruling, P’s transfer satisfies the formal requirements of § 351, including the requirement that P control S-2 within the meaning of § 368(c) immediately after the exchange. Moreover, even though P’s transfer and S-1’s transfer and liquidation are steps in a prearranged, integrated plan that has as its objective the consolidation of S-1 and the other operating companies in N, an analysis of the transaction as a whole does not dictate that P’s transfer be treated other than in accordance with its form in order to reflect the substance of the transaction. Accordingly, P’s transfer is respected as a § 351 exchange, and no gain or loss is recognized by P on the transfer of all of the stock of S-1 to S-2.
S-1’s transfer followed by S-1’s liquidation is a reorganization under § 368(a)(1)(D). (Citations omitted.)
Rev. Rul. 2015-10 applies the same approach as Rev. Rul. 2015-09 to a “triple drop and check” transaction, similar to that addressed in PLR 201252002 and PLR 201150021. In the revenue ruling, a corporation transfers a limited liability company taxable as a corporation down a chain of three subsidiaries, immediately after which the transferred company elects pursuant to Treas. Reg. § 301.7701-3(c) to become a disregarded entity. Rev. Rul. 2015-10 treats the transaction as two successive § 351 stock transfers followed by a D reorganization.
Rev. Ruls. 2015-09 and 2015-10 are welcome additions to the IRS’s body of law under Subchapter C, providing certainty of treatment in an area that reasonably could be viewed as needlessly uncertain. The key difference in the analysis of Rev. Rul. 78-130 and Rev. Rul. 2015-09 appears to be in the application of the step transaction doctrine. Rev. Rul. 78-130 applies what appears to be the “end result” test, the broadest version of the step transaction doctrine, in concluding that the relevant target shareholder is P, and that the fact that the steps comprise an integrated plan means that the interim stock transfer should be ignored. Based on that premise, Rev. Rul. 78-130 concludes that the transaction cannot qualify as a § 351 transfer followed by a § 368(a)(1)(D) reorganization, but must instead be characterized based on where the assets of the target company, S-1, end up within the corporate group. Rev. Rul. 2015-09 stays closer to the form of the transaction and concludes that, in effect, there are two separate transactions—a § 351 transfer of S-1 to S-2, and then a D reorganization of S-1 into N.
Rev. Rul. 2015-09 relies on another ruling (Rev. Rul. 77-449), not even cited in Rev. Rul. 78-130, that illustrates that a transfer of property may be respected as a § 351 exchange even if the property transferred is further transferred as part of a prearranged integrated plan. Under Rev. Ruls. 2015-09 and 2015-10, a § 351 transfer that is not immediately followed by a liquidation or upstream merger generally will be respected, provided that the transferor does not surrender control of the transferee as a result of a transfer of the stock of the transferee corporation in a related transaction. If the IRS had taken a similar approach to the application of the step transaction doctrine in its analysis in Rev. Rul. 78-130, it would have reached the same conclusion as in Rev. Rul. 2015-09 under the law in effect at that time. Although corporate reorganization law has changed since 1978, no change has necessarily caused the analysis or conclusion in Rev. Rul. 78-130 to become obsolete. Thus, the difference between Rev. Rul. 78-130 and Rev. Rul. 2015-09 appears to be the result of a change in the IRS’s view of how the step transaction doctrine should apply rather than the result of a change in substantive law.
Rev. Ruls. 2015-09 and 2015-10 are consistent with a trend in IRS guidance over the past 15 years or so to apply the step transaction doctrine in a somewhat less aggressive fashion than it had been applied previously. This approach increases taxpayers’ certainty that the form that they choose will be respected notwithstanding planned future steps. However, Rev. Rul. 2015-09 does caution taxpayers not to get too comfortable, observing that “a transfer of property in an exchange otherwise described in § 351 will not qualify as a § 351 exchange if, for example, a different treatment is warranted to reflect the substance of the transaction as a whole.” For better or worse, this indicates that the potential uncertainty has not been eliminated completely, and that issues remain for taxpayers, tax practitioners and the government to debate for years to come.