In Chief Counsel Advice (CCA) 201340016, IRS has determined that several transactions entered into by members of an affiliated group to restructure ownership of its operations and financing activities should be considered separately, rather than stepped together, and that each qualifies for nonrecognition treatment. The CCA found that the transactions were supported by valid business purposes and that notes issued from one subsidiary to another qualified as debt for tax purposes.
Background.To qualify as a tax-free reorganization, a transaction must fit one of the statutory definitions of Code Sec. 368 and also must meet certain regulatory requirements, including that the reorganization serves a valid business purpose.(Reg. § 1.368-1(b))
Code Sec. 368(a)(1)(F) provides that a reorganization includes a mere change in identity, form, or place of organization of one corporation, however effected. In the case of an F reorganization, the acquiring corporation is treated (for purposes of Code Sec. 381) just as the transferor corporation would have been treated if there had been no reorganization.(Reg. § 1.381(b)-1(a)(2)) Under Code Sec. 381, a corporation that acquires the assets of another corporation in certain tax-free reorganizations or liquidations also carries over numerous tax items of the transferor (predecessor) corporation.
Under Rev Rul 96-29, 1996-1 CB 50, an F reorganization that effects a mere change may be a step in a larger transaction such that the related preceding or succeeding transactions do not disqualify it from F reorganization treatment, even where there is change in ownership or a distribution of a portion of the business assets.
Under Code Sec. 368(a)(1)(C), a type C reorganization is the acquisition by one corporation of substantially all of the properties of a target corporation in exchange for voting stock of the acquiring corporation (or the stock of its parent in the case of a triangular C reorganization).
Code Sec. 1032 provides that a corporation doesn’t recognize gain or loss when it transfers its own stock in exchange for money or property. In a triangular C reorganization in which an acquiring corporation exchanges the stock of its parent to acquire property or stock of another corporation, the parent stock provided by the parent to the acquiring corporation for the exchange or provided directly to the target shareholders on behalf of the acquiring corporation under the reorganization plan is treated as a disposition by the parent of its own stock for target assets or stock.(Reg. § 1.1032-2(b)) However, the acquiring corporation must recognize gain or loss on its exchange of parent stock as consideration if the acquirer doesn’t receive the parent stock from the parent under the reorganization plan.(Reg. § 1.1032-2(c))
Facts. Taxpayer, through its wholly-owned U.S. subsidiary (U.S. Sub), had highly profitable operations generating cash in Country A through a Country A corporate group held by a Country A parent, F Sub 1. In addition to its Country A operating subsidiaries, F Sub 1 also owned a non-Country A finance company and subsidiary, F Sub 2 and F Sub 3. Taxpayer documented potential foreign currency volatility and foreign tax reasons for restructuring the ownership of its Country A operations and non-Country A financing activities.
The restructuring occurred in two stages a few months apart during Year 1. The first stage, referred to as the “F reorganization,” generally consisted of the contribution of F Sub 1 to F Sub 6, a Country B corporation, after which F Sub 1 elected to be treated as a disregarded entity (DE). Following the DE election, F Sub 1 distributed $a million of its cash to F Sub 6. Taxpayer treated this contribution and election as a type F reorganization under Code Sec. 368(a)(1)(F). Also in this stage, F Sub 1 distributed the stock of F Sub 2 to F Sub 6, selected subsidiaries of F Sub 1 were sold to F Corporation (a Country A corporation), F corporation and its subsidiaries filed elections to be treated as DEs, and F corporation paid off various third-party debentures.
The second stage (“the Transaction”) consisted of creating a leveraged acquisition vehicle, F Sub 5, a Country C corporation held by F Sub 4, a Country B entity treated as a corporation for U.S. tax purposes. The leverage consisted of preferred equity certificates, a term note, and a demand note totaling approximately $c issued to F Sub 4 in exchange for its stock.F Sub 5 used the F Sub 4 stock, which Taxpayer established had not appreciated since this exchange, to acquire F Sub 6 from U.S. Sub 1. Following this acquisition, F Sub 6 elected to be treated as a DE, and F Sub 2 was distributed up through F Sub 5 to F Sub 4.
During Years 2 and 3, F Sub 5 repaid the term and demand notes, with interest, to F Sub 4 (the Payments).
Taxpayer treated the F Reorganization, Transaction, and Payments as nonrecognition transactions and tax-free repayment of debt.
Question raised. The issue addressed in the CCA is whether a notice of deficiency should be issued with regard to these transactions – i.e., whether they may be treated as giving rise to taxable gain, or distributions taxable as dividends or under Subpart F.
Conclusion. The CCA concluded that the F Reorganization and the Transactions should each be respected as qualifying for nonrecognition treatment under Code Sec. 368(a)(1)(F) and Code Sec. 368(a)(1)(C), respectively, and should not be stepped together or with the subsequent Payments.Applying Rev Rul 96-29, 1996-1 CB 50, it found that the F Reorganization should be treated separately from the Transaction, even though they occurred in proximity together.Notably, the F Reorganization was supported by a sufficient business purpose – to help preserve and insulate F Sub 1’s assets from the unstable Country A economy while approvals for the ultimate F Sub 4/F Sub 5 structure were being obtained – which avoided what could have been a substantial economic loss to Taxpayer. Taxpayer further documented potential foreign currency volatility and exposure for foreign tax reasons for restructuring the ownership of its Country A operations and its non-Country A financing activities in the manner chosen. Thus, the CCA found that these reasons, in regard to the F Reorganization and the Transaction, satisfied the business purpose requirement for Code Sec. 368 reorganizations.
The CCA further found that, under the facts and circumstances of this case, the fact that the acquisition vehicle (F Sub 5) wasn’t capable of economically completing the acquisition of F Sub 6 wasn’t a sufficient basis to challenge the Transaction. It reasoned that in many leveraged buyouts, the acquirer is a much smaller capitalized corporation which acquires a much larger capitalized corporation.The CCA found that it was immaterial that F Sub 5 was initially capitalized with a lesser amount than the F Sub 4 stock that it ultimately acquired.It also found that the total consideration that F Sub 5 paid to F Sub 4 for its stock was equal to the value of the F Sub 6 stock later acquired by F Sub 5 in the Transaction.Thus, the Transaction was a value-for-value exchange.
Next, the CCA determined that F Sub 5 wasn’t required to recognize gain due to Reg. § 1.1032-2(c) on the use of F Sub 4 stock as consideration to acquire F Sub 6 since that reg contemplates a subsidiary purchasing its parent’s stock and then using that stock as consideration in a triangular reorganization.Although Reg. § 1.1032-2 provides that a subsidiary is fully taxable on any appreciation in that stock upon such use, the facts of this case show that the F Sub 4 stock had not appreciated between F Sub 5’s receipt of it and subsequent use of it to acquire F Sub 6. In addition, once a subsidiary’s acquisition of its parent stock is respected as a purchase, the parent receives a Code Sec. 1012 cost basis in property acquired in a Code Sec. 1032 transaction. Accordingly, F Sub 5’s acquisition of the F Sub 4 stock in part for the two notes, which qualify as debt for federal tax purposes, resulted in F Sub 4 receiving basis in the notes.In turn, based on its conclusion that the notes should be respected as debt, the CCA concluded that the Payments should constitute prepayments of such debt and not dividends or other amounts that would give rise to Subpart F income.