structuring tax -free type d business...

Structuring Tax-Free Type "D" Business Reorganizations Navigating IRC 368(a)(1)(D) Complexities and Selecting the Appropriate Transaction

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William R. Skinner, Attorney, Fenwick & West, Mountain View, Calif.

Richard M. Nugent, Partner, Cadwalader Wickersham & Taft, New York

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Strafford CLE Webinar March 18, 2014

Tax-Free Acquisitive D Reorganziations

William R. Skinner, Esq. [email protected]

Overview

Statutory Requirements for the Two Types of D Reorganizations

All Cash Acquisitive D Reorganizations

Tax Consequences to the Parties to the D Reorganization

Characterization Issues

6

The Type D Reorganization – Statutory Requirements

Sec. 368(a)(1)(D) defines a D reorganization as involving the following elements:

Transfer of “all or part” of transferor’s assets to a corporation

Transferor and/or its shareholders “control” the corporation immediately after the transfer

Transferor distributes the stock or securities received as part of plan of reorganization in a distribution qualifying under § 354, § 355 or § 356

7

The Type D Reorganization – Two Paradigms

8

P

S

§ 355 Distribution

Shareholders

Assets

2

1

Divisive D Acquisitive D

P

S1 S2

Liquidation of S1

2

“Substantially All” S1’s Assets

1

The Type D Reorganization – Two Paradigms

Divisive D reorganizations.

Acquiring’s stock must be distributed in a spin-off that qualifies under § 355.

“Control” test looks to § 368(c) definition.

Acquisitive D Reorganizations.

Acquiring must acquire “substantially all” of the assets of Transferor. § 354(b)(1)(A).

Definition of “control” looks to § 304(c):

• Control = 50% vote or value

• Control may be direct or indirect.

• § 318 constructive ownership rules also apply.

9

Acquisitive D Reorganizations- Liquidation – Reincorporation Doctrine

Under pre-1986 law, the shareholder sought to receive T’s cash in a tax-favored capital gain transaction.

D reorganization treatment resulted in A being taxable at ordinary rates on the “boot dividend” (see § 356(a)(2)).

10

S T

A

$300 Cash

$700 Business Assets

Sell T Business Assets

$700 Cash

§ 331 Liquidation

2

1

Special Rules for Acquisitive Ds

Non-Statutory Reorganization Requirements.

Continuity of interest test appears not to apply to Acquisitive D reorganizations. See Prop. Reg. § 1.368-1(b)(1); Reg. §1.368-2(l).

Continuity of business enterprise does apply, but usually is met by virtue of T transferring substantially all of its assets to A.

A non-tax corporate business purpose is also required.

Reg. § 1.368-2(l) permits “all cash” D reorganizations to satisfy § 368(a)(1)(D) so long as A and T’s shareholders own the two companies in identical proportions.

T is deemed to receive a “nominal share” of A stock in order to satisfy the “distribution requirement.”

11

Cash D Reorganization Reg. § 1.368-2(l)(3), Example 3

Conclusion: T undergoes a § 368(a)(1)(D) reorganization into S4.

12

S2 S1

P “Nominal Share”

S4 S3

T

“Nominal Share”

Distribution of “Nominal” S4

Share

T Liquidates 2 1

FMV $70

3

Integrated Transaction Doctrine

Under integrated transaction doctrine, two steps (Drop and Check) are treated as a D reorganization of T into S. See Rev. Rul. 2004-83.

13

S T

T Convert T to an LLC

2

Transfer T Shares to S for $

P

T LLC

Tax Consequences of Acquisitive D Reorganizations

Generally, no gain or loss is recognized to the transferor corporation. See § 361(b)(1)(A). Acquiring corporation succeeds to Transferor’s tax attributes under § 381(a).

Shareholder recognizes gain, but not loss, to the extent that (A) money and other property exceeds (B) gain on the exchange. § 356(a)(1) (the “Boot-within-Gain Limitation”).

If the gain has the effect of a dividend, the shareholder shall recognize a dividend to the extent of its ratable share of the undistributed earnings of “the corporation.” See § 356(a)(2).

Compare results of a § 304 transaction.

14

Example of Boot Treatment

Under § 356(a)(2), D’s gain / deemed dividend is limited to its gain realized on the exchange of F1’s stock for cash (here $0).

What would be the results if D’s basis in F1’s stock was only $50?

15

F2 F1

D

D Reorganization

$20 E&P

$10 Foreign Taxes (33% rate)

$500 E&P

$55 Foreign Taxes (10% rate)

Basis $100

FMV $100

$100 Cash

Cash D Reorganization vs. Section 304 Transaction

Comparison Point Cash D § 304 Basis Recovery Recognize gain to the

extent of cash, and then recover basis

Recognize dividend to the extent of E&P, then recover basis before recognizing gain.

Source of Dividend Unclear (Target only vs. Target and Acquiring Combined)

Both Companies’ E&P Combined

Whose E&P First? Unclear Acquiring First, then Target

Section 367(a) Consequences

None. US Transferor must enter Gain-Recognition Agreement (GRA). See Notice 2012-15.

Tax Attributes T’s attributes carryover to A under § 381

No carryover of attributes.

16

Rev. Rul. 70-240

B recognized a $30 deemed dividend (out of X and Y’s combined E&P). See also CCA 201032035.

Compare case law - e.g., American Manufacturing, 55 T.C. 204 (1970) (§ 356(a)(2) looks to Target’s E&P only).

17

Y X

B

Sale of Operating Assets

X Liquidates

Gain $30

E&P $10 E&P $50

2

1

Gain Recognition Agreement Consequences

Result: No gain recognition agreement (GRA) under § 367(a) is required to be filed on the D reorganization of F1 into F2. Reg. § 1.367(a), Example 16.

18

F2 F1

D

Transfer F1’s Stock to F2

F1

F1 checks the box to liquidate

2

1

Basis Recovery and the Nominal Share

In D reorganization, basis is recovered against boot under normal § 356 rules (pro rata unless terms specify that particular shares are exchanged for cash).

Loss cannot be recognized. See § 356(c).

If there is unrecovered basis, it attaches to the nominal share deemed issued in the reorganization. Reg. § 1.368-2(l)(2) provides for deemed transfers that may

eliminate basis in the “nominal share.”

The shareholder may designate a share of stock in Acquiring to which any basis in the nominal share attaches. See Reg. § 1.358-1T(a)(2)( iii).

19

Example of Basis Allocation

D receives $100 of cash (as recovery of basis) and a nominal F2 share with $30 of basis.

D can designate an F2 share to receive $30 of basis.

20

F2 F1

D

D Reorganization

Basis $130

FMV $100

$100 Cash

A More Complex Nominal Share Example

FS receives $100 of cash and a nominal share of FA with $30 of basis. FS is deemed to distribute the nominal share under §311(b). P is then deemed to transfer the nominal share to FP in a § 351 transaction.

21

FP FS

P

Sale of Assets for $100

P Contributes “Nominal Share”

FA FT

FS Distributes “Nominal Share”

FT Liquidates Basis $130 FMV $100 1

2

3 4

Slide Intentionally Left Blank

Consolidated Return Treatment

The foregoing treatment does not apply to D reorganizations with boot inside of a consolidated group.

Rather, Reg. § 1.1502-13(f)(3) treats the shareholder member as if it received hypothetical stock in Acquiring, followed by a §302(d) redemption of the hypothetical stock.

This deemed dividend will generally be excluded from income under Reg. § 1.1502-13(f)(2).

However, negative investment adjustments may cause the nominal share to have an Excess Loss Account (ELA) that is triggered on the subsequent transfers.

23

Reg. § 1.1502-13(f)(7), Example 4 – Part 1

Facts: All Entities are domestic corporations. S undergoes a cash D reorganization into B.

24

M

P

S

Basis $25

Value $100

B S Liquidates $100 2 1

Assets

Reg. § 1.1502-13(f)(7), Example 4 – Part 2

Analysis. § 302(d) redemption creates a $75 excess loss account (ELA) in nominal share of B stock. Following S’s liquidation, M distributes the nominal share to P.

Distribution of nominal share gives rise to $75 gain under §311(b) that is deferred under § 1.1502-13.

25

M

P

B

Distribution of Nominal Share

$100 302(d) Redemption of Hypothetical Shares

2

1

Nominal Share

Hypothetical Shares

Selected Characterization Issues

Liquidation-reincorporation vs. Upstream merger and asset drop

D reorganization with Boot vs. F reorganization and Separate § 301 dividend.

Rev. Rul. 78-130 and drop-and-check transactions.

26

Liquidation – Reincorporation

Assume the sequencing of Rev. Rul. 2004-83 is reversed – i.e., Parent converts Target to a disregarded entity, and then transfers Target DRE to Acquiring Corporation.

Is the form respected (upstream merger followed by § 351 transfer) or is this recast as a sideways D reorganization of Target into Acquiring?

Reg. § 1.368-2(k) – a merger followed by an asset transfer within the “qualified group” is not to be “disqualified or re-characterized” as a result of certain stock or asset transfers.

The qualified group is defined by Reg. § 1.368-1(d)(4) as the Issuing corporation and all corporations owned by issuing through one or more chains of § 368(c) control.

27

Example

See PLRs 201201012, 201127004 and 200952032 (form is respected under Reg. § 1.368-2(k)).

Would result be the same if substantially all of S1’s assets were reincorporated into S2? 28

S2 S1

Assets Group A Extracted from S1 to P

Assets A

P

S1 LLC Contributed to S2

2

1 Convert S 1 to LLC / DRE

3

Assets B

PLR 201037026

29

S6 S7

Parent

1 Liquidate S 40

S13

NewCo

S 40

IRS characterized transaction as cash D reorganization of S40 into NewCo. Note S40’s assets left the “qualified group.”

D Reorganization vs. F Reorganization

Under IRS ruling practice, F reorganization treatment trumps D reorganization treatment. See Rev. Rul. 87-27; Rev. Rul. 57-276.

This characterization may be significant through:

Determining whether cash distributions are boot taxable under § 356 vs. separate § 301 distributions

Determining manner in which Target’s E&P carries over to Successor. See Reg. § 1.367(b)-9.

30

PLR 201001002

Holding: Transaction was an F reorganization of F7 into NewCo, with cash distributed in a § 301 distribution. The later § 351 transfer was respected as a separate step. See also PLR 201406005. 31

F7 NewCo

F7

Transfer Property into NewCo

Liquidate F7

Transfer F7

USP Distribute cash/ property

2

1

3

4

Rev. Rul. 78-130

IRS treated transaction as a Triangular C of Foreign OpCo into NewCo instead of a § 351 transfer followed by a D reorganization. Query whether this ruling remains valid. Cf. PLR 201150021.

32

Foreign HoldCo

Foreign OpCo

USP

Transfer of Other Assets

NewCo Foreign OpCo Transfer Assets

and Liquidate

§ 351Transfer

CIRCULAR 230 DISCLOSURE

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice in this communication is not intended or written by Fenwick & West LLP to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

33

Divisive “D” Reorganizations

Richard M. Nugent Cadwalader, Wickersham & Taft LLP March 18, 2014 [email protected]

35

Topics

Page

Introduction 2

IRS Private Letter Rulings 8

General Section 355 Requirements for Tax-Free Distributions 10

Section 355(e) Anti-Morris Trust Rules 19

Monetization Strategies for Section 355 Transactions 24

Sample Market Transactions 38

36

Introduction

*Portions of these slides were drawn from slides I previously prepared with my partner, Linda Z. Swartz. Any errors are mine alone.

What is a Divisive D Reorganization?

37

Parent Newco

Business A Business B

AFTER

Shareholders

Business A Business B

BEFORE

Shareholders

Parent

• Unless otherwise noted, Parent and Newco are U.S. corporations, and Parent conducts at least 2

independent businesses and contributes 1 to Newco in the restructuring.

Divisive Section 368(a)(1)(D) Requirements

● A D reorganization includes a corporation’s transfer of all or part of its assets to another corporation if, immediately after the transfer, the transferor corporation or 1 or more of its shareholders controls the transferee corporation within the meaning of section 368(c), and the transferor distributes the transferee’s stock in a transaction qualifying under section 355.

● Section 368(c) requires ownership of at least 80% of a corporation’s total voting power and 80% of the shares of each class of the corporation’s nonvoting stock (“80 Control”).

● Obama Administration proposal would require ownership of at least 80% of a corporation’s stock by voting power AND value.

38

Section 368 Divisive D Reorganization Requirements

● Asset transfer from Parent to Newco.

● Section 368 control test.

● IRS disregards subsequent disposition of Newco stock by Parent shareholders.

● Section 368 business purpose test.

● Section 368 continuity of business enterprise test.

● Newco’s assumption of Parent liabilities and Parent’s potential receipt of Newco cash and/or debt securities (discussed in “monetization” Section below).

39

40

Section 355 Introduction

● Basic section 355 structures: spin-offs, split-offs and split-ups.

● Spin-off is a pro rata distribution of Newco stock to all Parent shareholders.

● Common form of business separation.

● Split-off is a distribution of Newco stock in full or partial redemption of 1 or more shareholders’ Parent stock. If split-off is undersubscribed, Parent must distribute remaining Newco stock to all eligible shareholders in a “clean-up” spin-off.

● Parent avoids gain recognition on distribution of appreciated Newco stock in retirement of Parent shares.

● Share repurchases may improve Parent’s earnings per share (“EPS”).

● Split-offs present significant deal execution risk due to need for sufficient shareholder participation.

41

Section 355 Introduction

● Split-up is division of 2 or more Parent businesses between 2 Newcos.

● Parent contributes 2 or more businesses to 2 Newcos, and distributes the stock of each Newco to Parent shareholders.

● Parent must liquidate.

42

IRS Private Letter Rulings

IRS Private Letter Rulings

● Significant corporate and shareholder taxes are generally at stake in a transaction structured to qualify as a tax-free divisive D reorganization.

● Therefore, historically, receipt of an IRS PLR confirming the transactions tax-free status was a condition precedent to consummation.

● In 2013, the IRS announced 2 substantial curtailments to obtaining PLRs for divisive D reorganizations.

● First, in Revenue Procedure 2013-3, the IRS announced it would no longer issue PLRs relating to 3 particular transactions that may occur in connection with a divisive D reorganization.

● Second, in Revenue Procedure 2013-32, the IRS announced that it will no longer rule on whether a transaction satisfies section 355, although the IRS will rule on 1 or more issues related to section 355 to the extent the issue is significant.

● Given these IRS announcements, transactions generally must need to proceed on the basis of counsel’s tax opinion. However, counsel may not be able to deliver a “will” opinion in some cases due to an absence of on-point authority.

43

44

General Section 355 Requirements for Tax-Free Distributions

45

General Section 355 Requirements

● Parent must have valid corporate business purpose for separation. Treas. Reg. § 1.355-2(b).

● Good business purposes include:

● improving “fit and focus”,

● facilitating subsequent merger involving Parent or Newco with a third party.

● allowing issuance of stock of 1 business to employees of that business,

● isolating assets of 1 business from risks of another,

● rendering stock of Parent or Newco more attractive as acquisition currency, and

● See, e.g., Treas. Reg. § 1.355-2(b)(4), Exs. 3 & 8; Rev. Rul. 2004-23, 2004-1 C.B. 585; Rev. Rul. 2003-74, 2003-2 C.B. 77; Rev. Rul. 2003-75, 2003-2 C.B. 79; Rev. Rul. 76-527, 1976-2 C.B. 103; Rev. Proc. 96-30, 1996-1 C.B. 696, modified by Rev. Proc. 2003-48, 2003-2 C.B. 86.

46


● Post-distribution continuing relationships between Parent and Newco may include transition services, overlapping directors and commercial arrangements, e.g., leases/licenses. Continuing relationships must be consistent with stated business purpose for distribution and facilitate Newco’s transition to independent company.

● The IRS logically subjects all continuing relationships to enhanced scrutiny in “fit and focus” distributions. See Rev. Proc. 96-30, 1996-1 C.B. 696, modified by Rev. Proc. 2003-48, 2003-2 C.B. 86.

47


● Parent must hold 80% Control of Newco immediately before the distribution. Section 355(a)(1)(A).

● Parent may be able to recap into 80% Control as long as recap represents a permanent change in Newco’s capital structure. See, e.g., Rev. Rul. 76-223, 1976-1 C.B. 103; Rev. Rul. 69-407, 1969-2 C.B. 50. The IRS will no longer rule on this issue pending further announcement.

● Parent may acquire 80% Control of Newco less than 5 years before the distribution, but only in a wholly tax-free transaction. Section 355(b)(2)(D).

● If Parent acquired less than 20% of Newco stock in taxable transactions within preceding 5-year period (such stock, “hot stock”), Parent must recognize any built-in gain on the distribution of the hot stock, and the hot stock constitutes taxable boot to Parent shareholders. Section 355(a)(3)(B), (c)(2)(A).

● Parent must distribute Newco stock representing 80% Control, and may not retain any Newco stock as part of a tax avoidance plan. Section 355(a)(1)(D).

● A tax avoidance plan may exist if a distribution of the relevant Newco shares would constitute a distribution of “other property.” Treas. Reg. § 1.355-2(e)(2).

48


● Prior IRS ruling guidelines for permitted stock retention established a four-part test: (i) sufficient business purpose for retention, (ii) no officer or director overlap, (iii) disposition of retained stock within 5 years after distribution, and (iv) Parent and/or affiliates will vote retained stock in proportion to votes cast by other Newco shareholders. Rev. Proc. 96-30, 1996-1 C.B. 696, modified by Rev. Proc. 2003-48, 2003-2 C.B. 86.

● Sufficient business purposes for retention include (i) satisfaction of Parent’s employee compensation obligations, (ii) avoiding disruption to orderly trading of Newco stock, (iii) using retained stock to secure Parent’s loans, (iv) satisfaction of legal or regulatory requirements, and (v) signaling confidence in Newco’s business as a standalone enterprise.

49


● Immediately after the distribution, both Parent and Newco must be engaged in the active conduct of a business (“ATOB”). Section 355(b)(1).

● Parent and Newco must have either actively conducted their respective ATOBs for at least 5 years prior to the distribution or acquired them in wholly tax free transactions within such period. Section 355(b)(2)(B)-(D).

● Each ATOB must be of meaningful size. See, e.g., Rev. Proc. 2003-48, 2003-2 C.B. 86 (eliminating advance ruling requirement that relevant business represent at least 5% of Parent’s gross assets for advance ruling purposes).

● ATOB test applies on an affiliated group basis, eliminating need for complicated restructurings to reposition active businesses required under prior law. Section 355(b)(3).

50


● Distribution must not be a “device” for distribution of Parent or Newco earnings and profits (“E&P”). Treas. Reg. § 1.355-2(d).

● Post-distribution taxable sale of Parent or Newco stock may raise device concerns. Treas. Reg. § 1.355-2(d)(2)(iii). This is especially true if the sale was already agreed to at the time of the distribution.

● Must consider all device and non-device factors under a facts and circumstances test. Treas. Reg. § 1.355-2(d).

● Reduced risk of device issue in 100% split-off because tendering shareholders generally would receive capital gain treatment in the event of a taxable distribution (given their reduced interest in Parent after the share redemption). Treas. Reg. § 1.355-2(d)(5)(iv).

51


● Generally need 50% shareholder continuity of interest in Parent and Newco after distribution. Treas. Reg. § 1.355-2(c)(1), Exs. 2-3.

● Parent will be taxed on distribution if any shareholder receives at least 50% of Parent or Newco stock in exchange for Parent stock purchased within 5 years of the distribution. Section 355(d)(1).

● Section 355 will not apply if either Parent or Newco is a disqualified investment corporation (“DIC”) immediately after the distribution, and any person holds at least a 50% interest in the DIC (by vote or value) immediately after the transaction that such person did not hold immediately before the transaction.

52


● Parent must allocate a portion of its E&P to Newco. Section 312(h).

● E&P allocation is generally based on respective FMV of Parent’s retained and transferred businesses. Treas. Reg. § 1.312-10(a). In a “proper case”, Parent may use net basis of retained and transferred assets as basis for allocation. See Bennett v. U.S., 427 F.2d 1202 (Ct. Cl. 1970).

● Newco generally must be a U.S. corporation, because section 367 limits tax-free distributions of foreign Newco stock.

● Tax-free to U.S. Parent only to extent stock is distributed to qualified U.S. persons (U.S. individuals and corporations). Treas. Reg. § 1.367(e)-1(b).

● Presumption of foreign status for shareholders. Treas. Reg. § 1.367(e)-1(d).

● Foreign Parent that is not itself subject to U.S. tax generally will still focus on section 355 qualification if Parent has a significant U.S. shareholder base.

54

Section 355(e) Anti-Morris Trust Rules

55

Section 355(e) - Distributions Before Acquisitions ● Imposes corporate level tax on a distribution that is followed by an acquisition of 50% or more

of Parent or Newco stock (by vote or value) effected pursuant to plan or series of related transactions. Section 355(e)(2).

● Enacted in 1997 in response to Congressional concern that some spin/merge transactions more closely resembled a sale of Newco’s business, rather than a tax-free restructuring.

● A “plan” generally exists only if there was an agreement, understanding, arrangement or substantial negotiations between Parent/Newco and an acquirer during the 2-year ending on the distribution date.

● The Treasury regulations provide several safe harbors that, if applicable, disregard a subsequent acquisition of Parent or Newco stock after a section 355 distribution.

● Immediate Acquisition Safe Harbor: No agreement, arrangement, understanding or substantial negotiations, which each require discussion of significant economic terms, such as price, have occurred within 2-year period before the distribution. Treas. Reg. § 1.355-7(b)(2), (h)(1).

● 6 Month Acquisition Safe Harbor:

● No agreement, understanding, arrangement or substantial negotiations during period beginning 1 year before, and ending 6 months after, the distribution;

● Acquisition occurs more than 6 months after distribution; and

● Substantial non-acquisition business purpose for the distribution. Treas. Reg. § 1.355-7(d)(1).

56

Distributions Before Acquisitions

● 1 Year Acquisition Safe Harbor:

● No agreement, understanding, arrangement or substantial negotiations on the distribution date or within 1 year after the distribution. Treas. Reg. § 1.355-7(d)(3).

● IPO Safe Harbor:

● Non-acquisition business purpose for the distribution; and

● No agreement, arrangement, understanding or substantial negotiations concerning the acquisition of 25% or more of the company during the period beginning 1 year before, and ending 6 months after, the distribution. Treas. Reg. § 1.355-7(d)(2).

57


● Facts and Circumstances Test:

● If no safe harbor applies to a distribution, a facts and circumstances test governs. Regulations contain several examples of plan and non-plan factors.

● A strong non-acquisition business purpose for a distribution that would have occurred regardless of a subsequent acquisition may demonstrate the absence of plan for section 355(e) purposes. Treas. Reg. § 1.355-7(b)(2); see, e.g., Rev. Rul. 2005-65, 2005-2 C.B. 684 (merger of Parent and acquirer after Parent publicly announced, but before it effected, the distribution of Newco, did not violate section 355(e) because (i) there was a business purpose for the distribution other than completion of the merger, (ii) distribution would have occurred regardless of the merger, (iii) merger discussions followed public announcement of the distribution, and (iv) Parent did not need to merge with acquirer to continue its business).

58


● An unexpected change in market or business conditions tends to demonstrate the independence of the distribution and the acquisition. Treas. Reg. § 1.355-7(b)(4); see, e.g., P.L.R. 2001-15-001 (Apr. 16, 2001) (permitting Parent’s acquisition of third party after announcement of the split-off of a Parent subsidiary; unanticipated regulatory changes permitted Parent to pursue acquisition).

● Regulations include “hot stock” example where third party acquired Newco within 6 months after the distribution. Treas. Reg. § 1.355-7(j), Ex. 3 (acquisition of Newco shortly after distribution was “reasonably certain”; distribution and acquisition were not part of a plan because, prior to the distribution, neither Parent nor Newco had an agreement, arrangement, understanding or substantial negotiations concerning the acquisition).

59

Monetization Strategies for Section 355 Transactions

60

Economic Benefits of Monetization Strategies

● A spin-off generally dilutes Parent’s EPS because Newco’s earnings are removed from the Parent group. Monetization techniques may minimize dilution.

● A split-off of Newco may also minimize the distribution’s dilutive EPS effect.

Strategies to Retire Parent Stock:

● Effect distribution as split-off in which electing Parent shareholders tender all or a portion of their Parent stock for Newco shares.

● Use cash borrowed (and distributed) by Newco to repurchase additional Parent stock.

Strategies to Eliminate Parent Third Party Debt:

● Transfer Parent liabilities to Newco prior to distribution.

● Retire Parent debt with cash, debt and/or stock distributed by Newco.

61

Monetization Strategies for Section 355 Transactions

● Parent distributes Newco stock to Parent shareholders in divisive D reorganization/section 355 transaction.

● Monetization strategies include liability assumption, leveraged distribution, debt-for-debt exchange, stock-for-debt exchange, pre-distribution partial IPO of Newco and post-distribution stock sale by Newco.

● These are discussed below.

Shareholders

Parent Newco

(Former Parent Assets)

Shareholders

Newco Stock

Assets

Parent

Newco

62

Liability Assumptions by Newco

● Newco generally can assume Parent liabilities up to Parent’s tax basis in assets transferred to Newco. Section 357(c)(1).

● Section 357(c) applies to liability assumption between consolidated group members if transferee member (Newco) leaves consolidated group as part of the same plan or arrangement as the liability assumption. Treas. Reg. § 1.1502-80(d)(1).

Shareholders

Parent Newco

(Former Parent Assets & Liabilities)

Shareholders

Newco Stock

Assets &

Liabilities

Parent

Newco

63

Leveraged Distributions by Newco

● Newco can borrow and distribute cash up to Parent’s tax basis in assets transferred to Newco (after reduction for assumed liabilities).

● Parent generally must keep Newco cash in a segregated account and distribute it within 1 year after the distribution pursuant to the plan of reorganization.

Shareholders

Parent

Newco (Former Parent

Assets & Liabilities; New Newco Debt)

Shareholders

Newco Stock &

Cash

Assets &

Liabilities

Parent

Newco

Creditors

64

Leveraged Distributions by Newco

● Subject to caveats below, Parent generally should not recognize gain on the receipt of Newco cash that is redistributed to Parent shareholders or Parent creditors under the plan of reorganization. Section 361(b)(1).

● Parent generally may distribute Newco cash to Parent’s shareholders either as a special dividend or, under certain circumstances, to redeem Parent shares.

● The IRS generally requires a recipient of Newco cash, debt securities and/or stock who exchanges Parent debt to exchange “historic debt” of Parent in order to qualify as a “creditor” of Parent for Section 361 purposes. See, e.g., Alexander Sheds Light on meaning of No-Rule’s “In Anticipation of “ a Spin-Off, 2014 TNT41-6 (Mar. 3, 2014) (suggesting key date is whether Parent issued relevant debt before spin-off was first presented to Parent’s board of directors); Lee A. Sheppard, “NYSBA Considers ‘Cash Wreck’ in Spinoffs,” 114 Tax Notes 507 (Feb. 5, 2007) (discussing Alexander’s comments on historic debt).

● Newco’s distribution of cash in excess of Parent’s tax basis in Newco stock to Parent may create an excess loss account (“ELA”) that generally would be recaptured on the distribution of the Newco stock outside of Parent’s consolidated group. See Sections 358(a)(1)(A) and 361; Treas. Reg. § 1.1502-19(c)(1)(ii).

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Exchanges of Newco Debt Securities for Parent Debt

● Newco can issue “securities” to Parent in a D reorganization, which Parent may use to retire Parent debt. The only limit on the amount of Newco securities is the “debt for tax” requirement. Section 361(a).

● Parent debt retired in the debt exchange must constitute “historic debt” of Parent.

● In order to provide Parent debt holders with cash, an Investment Bank (“IB”) may purchase Parent debt and exchange it for Newco securities.

Shareholders

Newco Stock &

Securities

Assets &

Liabilities

Parent

Newco

Creditors

Shareholders

Parent


Assets & Liabilities; New Newco Debt)

Creditors

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Exchanges of Newco Debt Securities for Parent Debt

● IB must act as a principal for its own account, rather than as Parent’s agent, in order to qualify as a section 361 “creditor”. If IB is treated as Parent’s agent, Parent would likely be treated as selling Newco securities for cash and using the cash to repurchase Parent debt.

● The IRS has issued PLRs approving structures where IB holds (i) Parent debt for at least 5 days before executing exchange agreement with Parent, and (ii) Newco debt for an additional period thereafter (9 days).

● IB generally can hedge its risks, e.g., interest rate and credit exposure with respect to the debt, with parties unrelated to Parent.

● Newco can also distribute non-security debt tax-free, up to Parent’s tax basis in the assets contributed to Newco (after reduction for assumed liabilities). Section 361(b)(3).

● In the past, legislation has been introduced in Congress to equate the treatment of the distribution of Newco debt securities with that of a Newco cash dividend. If enacted, such legislation would preclude tax-free distributions of Newco securities in excess of Parent’s tax basis in Newco stock.

Distribution of Newco Stock to Parent Debtholders

● Parent must distribute Newco stock representing 80% Control to Parent shareholders, which effectively caps the amount of Newco stock Parent can issue to Parent’s creditors at 20%. Section 368(a)(1)(D).

● Parent may be able to effect section 355 distribution and also provide Parent creditors with more than 20% of Newco’s value if Newco adopts a permanent high vote/low vote (e.g., 5:1 votes per share) structure, and Parent’s shareholders receive at least 80% of Newco’s total voting power. Rev. Rul. 69-407, 1969-2 C.B. 50.

● Note that Obama Administration would change the 80% Control test.

Newco

Shareholders

Newco Stock Assets

Parent

Creditors

Historic Shareholders

Parent Newco


Former Parent

Creditors

67

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Distribution of Newco Stock to Parent Debtholders

● Parent debt retired in a stock-for-debt exchange must satisfy the “historic debt” and agency rules referenced above.

● Newco stock distributed in a stock-for-debt exchange generally should be treated as distributed pursuant to plan of reorganization if Parent (i) is obligated to distribute Newco stock, and (ii) completes all steps contemplated by the plan of reorganization within 1 year. See Comm’r v. Gordon, 391 U.S. 83 (1968); P.L.R. 2003-01-011 (July 2, 2002).

● Any Newco stock not treated as distributed pursuant to the plan of reorganization will be treated as retained stock. Parent must demonstrate the absence of a tax avoidance plan for the retained stock in order to preserve the distribution’s tax-free qualification under section 355.

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Pre-Distribution Partial IPO of Newco

● Newco can issue high vote stock to Parent in exchange for contributed assets and low vote stock, representing up to 49.99% of Newco’s value and 20% of Newco’s voting power, to public in IPO, and then distribute IPO proceeds to Parent as a dividend. Parent can use cash to repay Parent debt and then distribute its high vote Newco stock to Parent shareholders under section 355.

● Note that Obama Administration proposal would change 80% Control test.

High Vote & Low Vote Newco Stock

Newco

Parent

Shareholders

Creditors

Assets

Parent

Shareholders


Assets)

IPO Purchasers

Low Vote Stock

High Vote Stock

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Pre-Distribution Partial IPO of Newco

● Newco will not be subject to tax on the sale of stock in the IPO. Section 1032.

● Under current law, Newco’s formation and distribution should qualify as a divisive D reorganization and section 355 transaction if the IPO is limited to 20% of Newco’s voting power.

● Structures that could be recast as a pre-distribution sale of more than 20% of Newco’s voting power would, if recast, preclude (i) a D reorganization because Parent’s shareholders would not have 80% Control of Newco immediately after the transaction, and (ii) section 355 qualification because Parent would not distribute 80% Control of Newco.

● Note that distribution of IPO proceeds to Parent may create an ELA in Newco stock that would be triggered upon distribution of Newco stock outside Parent consolidated group.

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Post-Distribution Stock Sale by Newco

● Parent contributes assets to Newco in exchange for Newco stock and a demand note with FMV equal to 20% of Newco stock. Parent distributes 100% of Newco stock to Parent shareholders.

● After distribution, Newco approaches IB, which purchases up to 20% of Newco’s stock. Newco repays demand note with sales proceeds, and Parent uses funds received to repay Parent debt.

Shareholders

Newco Stock &

Demand Note Assets

Parent

Newco

Creditors

Shareholders

Parent Newco


Purchaser

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Post-Distribution Stock Sale by Newco

● Risk that order of transactions will not be respected, and Parent will be treated as selling Newco stock to IB before distribution.

● Limiting demand note to 20% of Newco stock should preserve section 355 treatment even if Parent were forced to recognize some gain under a pre-distribution deemed sale recast. See Waterman Steamship v. Commissioner, 430 F.2d 1185 (5th Cir. 1970); Section 355(a)(1)(D).

● Issue regarding whether Parent can distribute loan proceeds tax-free to creditors because Parent receives demand note from Newco, but distributes cash to creditors. See Section 361(b)(3) (Parent must transfer to creditors the property received in the exchange).

● Even if distribution of demand note is tax-free, it may produce an ELA, which would be triggered upon distribution of Newco stock to Parent’s shareholders.

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Sample Market Transactions

PPG Spin-Off of Commodity Chemicals Business and Merger with Georgia Gulf

75

Debtholders

Shareholders

PPG

PPG contributed commodity chemicals business to Commodity Newco in exchange for 100% of Commodity Newco’s stock, cash, Newco debt securities and Newco’s assumption of PPG liabilities.

Bank Commodity Newco

Loan Proceeds

1. Newco Stock 2. Cash 3. Newco Securities

1. Commodity Chemical Assets 2. Assumed Liabilities

76


● PPG distributed 100% of Commodity Newco stock to PPG shareholders in a split-off.

● PPG used cash dividend and Commodity Newco debt securities to repay PPG debt.

Shareholders

PPG Commodity Newco

77


● After distribution, Georgia Gulf acquired Commodity Newco, and Newco’s shareholders received approximately 50.5% of combined company’s stock.

● IRS issued PLR confirming transaction’s tax-free status.

Georgia Gulf Shareholders

PPG Shareholders

PPG Shareholders

Historic Georgia Gulf Shareholders

Georgia Gulf Commodity Newco Georgia Gulf

Commodity Newco

49.5% 50.5%

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Alltel Spin-Off of Wireline Business and Merger with Valor Communications

Alltel contributed wireline business to Wireline Newco in exchange for 100% of Newco’s stock, Newco debt securities, cash and Newco’s assumption of Alltel liabilities.

1. Wireline Assets 2. Liabilities

1. Newco Stock 2. Cash 3. Newco Securities

Bank

Commercial Paperholders

Senior Noteholders

Alltel Corp.

Wireline Newco

Loan Proceeds

Shareholders

79


● Alltel distributed 100% of Newco stock to shareholders pro rata.

● Alltel used cash from Newco to retire Alltel debt and/or repurchase Alltel stock

● Alltel used Newco securities to retire Alltel commercial paper and senior notes (“Alltel Debt”) through IB. IB acquired Alltel Debt for its own account at least 14 days before Newco distribution, and held Alltel Debt for at least 5 days before executing exchange agreement with Alltel.

Shareholders

Alltel Corp. Wireline Newco

Creditors

80


● After distribution, Newco merged into Valor with Valor surviving, and Alltel’s shareholders received approximately 85% of combined entity’s stock.

Alltel Shareholders

Valor Communications

Historic Valor Shareholders

85% 15% Creditors

Alltel Shareholders

Valor Shareholders

Valor Communications

Wireline Newco

Creditors

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Alltel Spin-Off and Merger–Tax Analysis

● Newco Spin-Off

● Corporate business purposes include improving “fit and focus” and facilitating merger. See, e.g., Rev. Rul. 2003-74, 2003-2 C.B. 77; Rev. Rul. 2003-75, 2003-2 C.B. 79; Rev. Rul. 76-527, 1976-2 C.B. 103; Rev. Proc. 96-30, 1996-1 C.B. 696, modified by Rev. Proc. 2003-48, 2003-2 C.B. 486.

● Distribution of Newco securities to IB in retirement of Alltel debt is also permitted in connection with a section 355 distribution. Section 361(c)(1).

● Valor Merger

● Section 355(e) satisfied because former Alltel shareholders owned 85% of combined entity’s stock after merger. Section 355(e)(2).

● The IRS confirmed the transaction’s tax-free status. See P.L.R. 2006-29-007 (July 21, 2006).

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Weyerhaeuser’s Split-Off of Fine Paper Business and Merger with Domtar

Weyerhaeuser contributed fine paper business to Newco in exchange for 100% of Newco stock, assumption of Weyerhaeuser liabilities and cash distribution of Newco loan proceeds.

1. Newco Stock 2. Cash

1. Fine Paper Assets 2. Liabilities

Bank

Weyerhaeuser Inc.

Newco

Loan Proceeds

83


● Weyerhaeuser distributed 100% of Newco stock to its shareholders, including holders of Weyerhaeuser exchangeable shares, in a split-off.

● Weyerhaeuser used Newco cash distribution to repay Weyerhaeuser’s debt.

Weyerhaeuser Shareholders

Weyerhaeuser Newco

84


● Domtar, a Canadian company, merged into Newco with Newco surviving.

● Weyerhaeuser shareholders owned approximately 55% of Newco’s stock immediately after the merger.


Newco

Former Domtar Shareholders

55% 45%

Domtar Shareholders


Newco Domtar Inc.

85

Weyerhaeuser’s Distribution and Merger – Tax Analysis

● Newco cash dividend was tax-free to Weyerhaeuser up to amount of its net tax basis in assets contributed to Newco because Weyerhaeuser distributed the cash to its creditors under Newco plan of reorganization. Section 361(b)(3).

● No apparent section 355(e) concerns with Domtar merger because Weyerhaeuser shareholders received approximately 55% of combined entity’s stock. Section 355(e)(2).

● Tax-free treatment not certain if Domtar were surviving corporation.

● Under section 367, U.S. person’s transfer of U.S. target’s stock to foreign corporation such as Domtar would be taxable if U.S. transferors receive more than 50% of foreign acquirer’s stock (which is necessary to satisfy Section 355(e)). Treas. Reg. § 1.367(a)-3(c)(1).

● Difficult to rebut section 367 presumption that all target shareholders are U.S. persons. Treas. Reg. § 1.367(a)-3(c)(2).

● The IRS confirmed the distribution’s tax-free status. See P.L.R. 2007-18-024 (May 4, 2007).

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This presentation was not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties.

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