Expansion of Merger and Consolidation Provisions

By Randy A. Schwartzman

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JUNE 2005 - In IRC section 368(a)(1)(A), the term “reorganization” includes a “statutory merger or consolidation.” No restrictions are placed on the type of consideration used, even permitting money to be exchanged, as long as the continuity-of-interest requirement is satisfied. A tax-free merger is considered a type A reorganization, which is a combination of two companies for at least 40% stock consideration. The A reorganization is the most flexible of the reorganization techniques. There is no “substantially all” (of the assets) rule and no “solely for” (voting stock) rule in order to have a valid A reorganization. A statutory merger or consolidation had been limited since 1935 to transactions structured in conformity with the corporation laws of the United States (i.e., a state, a territory, or the District of Columbia). This restriction has been relaxed in recent years.

Defining Mergers

In January 2003, the IRS issued regulations to expand the scope of the term statutory merger or consolidation to allow limited liability companies (LLC) to be party to an A reorganization. Consequently, the word “corporation” was removed from the regulatory definition of statutory merger or consolidation.

In January 2005, the IRS issued proposed regulations to expand the meaning of a statutory merger or consolidation by eliminating the requirement that such transactions conform only to domestic laws. Because many foreign jurisdictions now have merger statutes that operate like those of the states, whereby all assets and liabilities move by operation of law, this change in the definition of an A reorganization allows such foreign transactions to qualify, for purposes of IRC section 368(a)(1)(A), as a statutory merger or consolidation if they satisfy the functional criteria applicable to transactions under domestic statutes.

Analysis of Merger Transactions

In the past, foreign mergers between unrelated parties needed to qualify as type C reorganizations if they did not meet the requirements for type A reorganizations. In a type C reorganization, a target company must transfer “substantially all” of its assets to the acquiring corporation solely for voting stock and, in some instances, a limited amount of new stock consideration.

The applicability of the “substantially all” and the “solely for” requirements adversely affected otherwise good foreign mergers. The new regulations contain an example that illustrates a transaction in which Corporation Z and Corporation Y, each incorporated under the laws of Country Q, combine in a transaction in conformity with Q’s statutes in which all of the assets of Z become assets of Y and Z ceases its separate legal existence. Even though the merger participants are foreign entities, it qualifies under the new IRS regulations as an A reorganization because the transaction is a statutory merger under Q’s statutes, Z and Y are qualified participants, and the transaction is not divisive.

In addition, a legally valid merger of two domestic corporations can still be an A reorganization even if the merger was preceded by a sale by the acquired corporation of one of its two, equally sized, historical businesses. In this case, the net proceeds of such a sale could be distributed to the shareholders of the acquired corporation immediately before the merger. Although half of the assets were sold before the reorganization, this transaction qualifies as an A reorganization because it did not have to meet the “substantially all” requirement in a type C reorganization.

Before foreign entities fell under the A reorganization provisions, the transaction would have needed to qualify as a C reorganization (for unrelated parties, as discussed above) or a D reorganization (for related parties). In the example above, which involved a sale of half of the target’s assets immediately before the transaction, if a subsidiary corporation was used, this combination could not have qualified as a C reorganization, a forward triangular merger [by reason of IRC section 368(a)(2)(D)], or a reverse triangular merger [by reason of Section 368(a)(2)(E)], because in each case the “substantially all” (of the assets) requirement would apply to the preliminary distribution. In the past, the asset sale would not affect the qualification of a transaction if sufficient time had passed between the sale and distribution and the subsequent reorganization, and if the sale was part of the plan of reorganization.


By allowing tax-free treatment for cross-border mergers organized under foreign law, a tremendous amount of flexibility has been provided in structuring foreign reorganizations in an increasingly global business market. Previously, such mergers were allowed only under domestic law. The proposed rules would also allow tax-free cross-border mergers involving foreign disregarded entities, even if those transactions were structured under a foreign statute.

The proposed regulations also address a wide range of technical issues on cross-border mergers under IRC section 368(a)(1)(A), including basis and holding periods, triangular reorganizations, the application of sections 367 and 1248, and asset transfers.

For example, the proposed rules provide basis and holding-period guidelines for certain transactions involving foreign corporations with section 1248 shareholders in order to preserve relevant IRC section 1248 amounts. Section 1248 applies to shareholders with 10% or more of the voting power in a controlled foreign corporation. These shareholders are generally required to include, in gross income, an appropriate amount as a dividend related to the gain they recognize on the sale or exchange of the stock of the corporation at any time during the five-year period ending on the date of the sale or exchange. This rule preserves section 1248 amounts in certain tax-free reorganizations effected with foreign corporation stock.

The rules also contain basis and holding-period rules for shareholders in tax-free exchanges that would also apply to foreign corporate shareholders whose company is involved in the reorganization, if at least one U.S. individual participant is a section 1248 shareholder. These rules also attempt to coordinate the cross-border merger basis rules with recently proposed domestic basis rules under section 358, including the application of statistical sampling techniques in a B reorganization and the choice between the “assets over” approach or the “carryover stock basis” approach in a reverse triangular merger. The new rules also set out a complex series of additional rules on triangular mergers, and address a wide range of issues under IRC section 367.

Notice 2005-6. Under IRC section 367(a), a U.S. individual recognizes gain, but not loss, on a transfer of property to a foreign corporation in certain tax-free exchanges unless an exception applies. Taxpayers questioned why exceptions applied to stock and not securities in certain tax-free reorganizations, because both are covered in U.S. reorganizations. Notice 2005-6 was issued concurrent with the new regulations and, for the first time, applies comparable treatment between U.S. and foreign reorganizations, allowing both stock and securities to qualify for tax-free treatment if they are received in exchange for each other.

Domestic Changes

The proposed regulations also provide several examples of transactions that will not meet the expanded definition of a statutory merger or consolidation. For example, a transfer by one corporation to another of only a portion of its assets that is defined as a merger under local law will not be considered a statutory merger or consolidation, because it is “divisive” in nature and therefore not considered an A reorganization.

The regulations also clarify that there is no A reorganization where the acquiring entity is an LLC that is owned by a partnership and the interests in the partnership are transferred to the shareholders of the acquired corporation that merged with and into the LLC. There can be no statutory merger or consolidation, because there is no qualified entity on the acquiring side of the transaction.

The regulations also provide examples where an S corporation, with a qualified subchapter S subsidiary, merges into a disregarded entity of an acquiring C corporation or a disregarded entity of an acquiring C corporation subsidiary. Assuming that all of the requirements of an A reorganization and a forward triangular merger are met, respectively, the transaction would be treated as a tax-free reorganization followed by a deemed IRC section 351 exchange to a newly formed subsidiary under section 368(a)(2)(C). To be a qualified subchapter S subsidiary, a corporation must be wholly owned by an S corporation. In this example, the qualified subchapter S subsidiary effectively converts its status from a disregarded entity to a newly formed corporation, because it is owned by a C corporation immediately after the reorganization.

Other Recent Changes

On March 9, 2005, the IRS issued proposed regulations that would require the exchange or distribution of “net value” in order to maintain nonrecognition of a gain or loss in certain corporate reorganizations. In tax-free reorganizations, there is generally an exchange of net assets for stock. If the liabilities transferred by the target corporation exceed the fair market value of the assets (i.e., the target is insolvent), no net value would be transferred to the acquiring corporation. Under these regulations, a merger of an insolvent target into a solvent acquirer would not qualify as a tax-free reorganization. The final rules are consistent with the rules involving tax-free liquidations of an 80% or more owned subsidiary into its parent corporation. Under Treasury Regulations section 1.332-2(b), a liquidation is tax free only if the parent corporation receives at least a partial payment for its stock. Revenue Ruling 59-296 holds that the principles relevant to IRC section 332 liquidations also apply to section 368 reorganizations. Not all authorities were consistent with this ruling, however; most notably, the Tax Court held in Norman Scott, Inc., v. Comm’r [48T.C. 598 (1967)] that a transaction involving an insolvent target qualified as a statutory merger. These regulations now clarify ambiguities that previously existed and are intended to conform the treatment under the liquidation and reorganization provisions of transactions involving insolvent target corporations.

In February 2005, the IRS issued final regulations stating that the continuity-of-business enterprise requirement and the continuity-of-interest requirement are not required for a transaction to qualify as a recapitalization under IRC section 368 (a)(1)(E) or as a reorganization involving a change in name, state of incorporation, or form under IRC section 368 (a)(1)(F). Consistent with these regulations, the proposed regulations state that the net-value requirement is not necessary in these types of reorganizations.

Randy A. Schwartzman, CPA, MST, is a tax partner at BDO Seidman, LLP, a member of BDO’s corporate consulting group, and a member of the NYSSCPA’s Closely Held and S Corporations Committee and its Mergers and Acquisitions Committee, of which he is also a past chair.




















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