Withdrawal of Proposed Regulations
Earlier this year, the President directed the Secretary of the Treasury to review all “significant tax regulations” issued on or after January 1, 2016, and to take steps to alleviate the burden of regulations that meet certain criteria.
Although not falling within the literal reach of this directive, but perhaps in keeping with its spirit, the IRS recently withdrew proposed regulations (issued in 2005) that would have required an exchange or distribution of “net value” among the parties to certain corporate reorganizations in order for the reorganizations to qualify for non-recognition (“tax-free”) treatment under the Code.
Before taxpayers breathe a sigh of relief over the withdrawal of these proposed regulations, they need to understand the IRS’s long-held position – which it sought to formalize in the proposed regulations – that a corporation has to be solvent in order for its shareholders to benefit from favorable tax treatment under the reorganization provisions of the Code.
In particular, taxpayers should note that, in announcing the withdrawal, the IRS explained that “current law” is sufficient to ensure that tax-free treatment is accorded only to those corporate reorganizations that effectuate a “readjustment” of shareholders’ continuing proprietary interests in a corporate-held business, and that it cited various authorities that generally limit reorganization treatment to solvent corporations.
The Reorganization Rules, In Brief
In general, upon a taxpayer’s exchange of property, gain must be recognized and taxed if the new property differs materially in kind from the old property, and the amount realized in the exchange exceeds the taxpayer’s adjusted basis in the property exchanged.
In the context of a corporate reorganization, there are generally two types of exchanges: (1) the exchange in which one corporation exchanges property for stock in a second corporation; and (2) the exchange in which stock in the first corporation is exchanged by its shareholders for stock in the second corporation.
The purpose of the tax-free reorganization provisions of the Code is to except these types of exchanges from the general gain recognition rule where they (i) are incident to a plan to reorganize a corporate structure in one of the particular ways specified in the Code, (ii) are undertaken for bona fide business or corporate purposes, and (iii) effect only a readjustment of the shareholders’ continuing interest in the corporation’s property under a modified corporate form.
In order to effect only a readjustment of the shareholders’ continuing interest in the corporation’s property, and to thereby secure tax-free treatment under the Code, a reorganization must satisfy a “continuity of business enterprise” requirement and a “continuity of interest” requirement.
In general, under the continuity of business enterprise test, the acquiring corporation must either continue the target corporation’s historic business or use a significant portion of the target’s historic business assets in a business.
The continuity of interest test requires that a substantial part of the value of the proprietary interests in the target corporation be preserved in the reorganization. A proprietary interest in the target corporation is preserved if it is exchanged for a proprietary interest in the acquiring corporation.
All facts and circumstances must be considered in determining whether, in substance, a proprietary interest in the target corporation is preserved. Thus, for example, a proprietary interest in the target corporation is not preserved to the extent that creditors of the target corporation that own a proprietary interest in the corporation – for example, because the target corporation’s liabilities exceed the fair market value of its assets immediately prior to the potential reorganization – receive money for their claims prior to the potential reorganization.
The policy underlying these rules is to ensure that tax-free reorganization treatment is limited to those reorganizations and exchanges that effectuate a readjustment of the shareholders’ continuing interests in property under a modified corporate form, and to prevent transactions that resemble sales from qualifying for non-recognition treatment.
The Proposed Regulations
In general, the Code provides that no gain shall be recognized if a shareholder’s stock in a target corporation is exchanged, pursuant to a plan of reorganization, “solely for stock” in the acquiring corporation. It also provides that no gain shall be recognized to the target corporation if it exchanges property, pursuant to a plan of reorganization, “solely for stock” in the acquiring corporation.
The IRS has consistently stated that the language “solely for stock” requires that there be an exchange of net value among the parties to the reorganization, meaning that both the target corporation and the acquiring corporation must be solvent.
According to the IRS, transactions that fail this requirement – that is, transfers of property that are in effect made in exchange for the assumption of liabilities or in satisfaction of liabilities, as in the case of an insolvent corporation – resemble sales and should not receive non-recognition treatment.
The proposed regulations sought to formalize this position by providing that an exchange of net value was requisite to a tax-free corporate reorganization. According to the proposed regulations, an exchange of net value requires that there be both a surrender of net value and a receipt of net value.
Whether there is a surrender of net value is determined by reference to the assets and liabilities of the target corporation. Whether there is a receipt of net value is determined by reference to the assets and liabilities of the acquiring corporation. The purpose of the “exchange of net value” requirement, the proposed regulations stated, is to prevent transactions that resemble sales (including transfers of assets in satisfaction of liabilities) from qualifying for non-recognition treatment.
Thus, in the case of an asset transfer, the fair market value of the property transferred by the target corporation to the acquiring corporation must exceed the sum of the amount of liabilities of the target corporation that are assumed by the acquiring corporation in connection with the exchange and the amount of any money and the fair market value of any other property (other than stock in the acquiring corporation) received by the target corporation in connection with the exchange. Similarly, the fair market value of the assets of the acquiring corporation must exceed the amount of its liabilities immediately after the exchange.
In the case of a stock transfer, the fair market value of the assets of the target corporation must exceed the sum of the amount of the liabilities of the target corporation immediately prior to the exchange and the amount of any money and the fair market value of any other property (other than stock of the acquiring corporation) received by the shareholders of the target corporation in connection with the exchange. The fair market value of the assets of the acquiring corporation must exceed the amount of its liabilities immediately after the exchange.
Withdrawn, But Not Useless
It is doubtful that the withdrawal of the proposed “net value” regulations signals any change in the IRS’s position. Indeed, almost all of the case law addressing the application of the continuity of interest rule to the reorganization of an insolvent corporation is consistent with the proposed regulations.
A taxpayer would be ill-advised to draw any conclusion to the contrary. After all, the IRS did not announce a change in the representations that must be made by a taxpayer in submitting a request to the IRS for a ruling with respect to a proposed reorganization. For example, a taxpayer must still represent that the fair market value of the assets of the target corporation transferred to the acquiring corporation pursuant to the plan of reorganization is at least equal to the sum of the target liabilities assumed by the acquiring corporation, plus the amount of liabilities, if any, to which the transferred assets are subject; in other words, there must be a transfer of net value.
Rather, taxpayers would be well-served to view the withdrawn proposed rules as a useful summary of the IRS’s thinking on “net value” issues, and as a guide for assessing the qualification of a proposed corporate restructuring or acquisition as a tax-free reorganization within the meaning of the Code.