Final regulations on "cash D reorganizations" were issued on December 17, 2009. The regulations address the qualification of certain transactions as tax-free reorganizations where, by virtue of the fact that the same owners hold all the stock of the transferor and transferee corporations, no stock or securities of the transferee corporation are required to be issued and distributed.
The final regulations retain the "nominal share" approach of the predecessor temporary regulations. They also modify and clarify the prior regulations, addressing in particular the treatment of transactions where no consideration is received by the transferor corporation or the value of such consideration is less than the value of the transferor corporation’s assets transferred.
D Reorganizations – Generally
A D reorganization requires the transfer by one corporation of substantially all of its assets to another corporation and that, immediately after the transfer, the transferor corporation or one or more of its shareholders (or a combination thereof) is in control of the transferee corporation. One requirement of a D reorganization is that stock of the transferee corporation be received by the transferor corporation and distributed to its shareholders in the reorganization.
Example 1: Corporation A owns all of the stock of each of Corporation B and Corporation C. Corporation B transfers its assets with a fair market value of $100 to Corporation C in exchange for Corporation C stock and cash together worth $100. Corporation B then liquidates, distributing the stock and cash to Corporation A. The transaction qualifies as a D reorganization.
The Meaningless Gesture Doctrine
Over time, the courts and IRS have held that in cases in which there is an exact identity and proportionality of ownership by the shareholders of both the transferor and transferee corporations, a sale by the transferor corporation of its assets to the transferee corporation for cash will be treated instead as a D reorganization. The rationale is that an issuance of stock by the transferee corporation would be a "meaningless gesture" and therefore is not required for D reorganization qualification.
Example 2: Same as Example 1, except that Corporation C pays for Corporation B’s assets solely with $100 cash. Since Corporation A owns all of both Corporation B and Corporation C, the transaction is recast as a D reorganization instead of an asset sale. No shares of Corporation C stock need be issued.
The Temporary Regulations
Temporary Regulations issued on December 18, 2006 set forth the IRS’ position on cash D reorganizations and the meaningless gesture doctrine. These regulations provided:
- in cases where the same person or persons own, directly or indirectly, all of the stock of the transferor and the transferee corporations in identical proportions, the stock distribution requirement under the D reorganization rules will be treated as satisfied even though no stock is actually issued in the transaction
- for purposes of number 1, above, an individual and all members of his family, as defined in Section 318(a)(1) of the Internal Revenue Code, will be treated as one individual
- a de minimis exception, which permitted a one percent ownership deviation in determining the existence of shareholder identity and proportionality
- that non-voting, non-convertible preferred stock, which is limited and preferred as to dividends and liquidation and redemption rights, is disregarded for purposes of determining shareholder identity and proportionality, and
- in each case where it is determined that the same person or persons own all the stock of the transferor and transferee corporations in identical proportions, a nominal share of stock of the transferee corporation will be deemed issued in addition to the actual consideration exchanged in the transaction.
The Final Regulations
The final regulations retain the above five items of the temporary regulations. In addition, they provide that if the transferor corporation receives no consideration from the transferee corporation, or the value of the consideration received from the transferee corporation in the transaction is less than the value of the transferor corporation’s assets that are transferred, the transferee corporation will be treated as issuing stock with a value equal to the excess of the fair market value of the transferor corporation’s assets over the value of the consideration actually received by the transferor corporation in the transaction.
Further, with respect to the deemed issuance of the nominal share, the regulations provide that such nominal share is deemed to be transferred upward through the chain of ownership to the extent necessary to reflect the ultimate, actual ownership of the transferor and transferee corporation. By deeming the transfer of the share up the chain, the preservation of the potential future gain or loss in the share is held by the appropriate shareholder. This may facilitate future planning as to when the nominal share is sold.
Consolidated Return Issues
One major change between the temporary and final regulations is the consolidated return effect the nominal share creates. Under the temporary regulations, practitioners were concerned as to the effect the nominal share would have in the case of an excess loss account. The final regulations provide that in the event an intercompany cash D reorganization results in an excess loss account in the nominal share (by virtue of the cash being treated as a distribution by the transferor corporation to its direct owner that reduces stock basis), the amount of this excess loss account will result in intercompany gain (to be taken into account under the matching and acceleration rules) to the extent the nominal share is deemed distributed by the direct owner of the transferor corporation up the chain of corporations.1
Pepper Perspective
The final regulations cement the meaningless gesture doctrine and cash D reorganization in the tax law. Where the regulations apply, a taxpayer cannot choose between a sale and D reorganization merely by deciding whether to have the transferee corporation issue stock. A consolidated group must be wary of the intercompany gain a cash D reorganization may create by virtue of triggering an excess loss account attributable to a nominal share. Importantly, however, a group may be able to avoid triggering such an excess loss account by keeping the transaction out of the cash D reorganization rules (and thus avoiding the deemed distribution of the nominal share that triggers the excess loss account, as discussed above) through actually issuing a small amount of stock in the transaction.
The final regulations are not the end of the cash D reorganization saga. The IRS and Treasury are seeking comments on the application of the final regulations to reorganizations involving foreign corporations. More guidance in this area is on the horizon.
Endnote
1 The Treasury confirmed this treatment by adding an example in Treas. Reg. 1.1502-13(f)(7)(i)Ex. 4.
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