In Ralphs Grocery Co. & Subsidiaries v. Commissioner, the Tax Court held that a joint election under IRC Section 338(h)(10) with respect to an acquisition of all of the outstanding common stock of a grocery store chain was valid, and did not constitute an IRC Section 368 reorganization because the continuity-of-interest requirement was not met. In Ralphs, Federated Stores Inc. ("FSI") was the parent of a consolidated group. FSI wholly owned Holdings III, Inc. ("Holdings III") which in turn indirectly owned Allied Stores Corp ("Allied"). Holdings III and Allied directly owned approximately 83.75% and 16.25% percent of the stock of Ralphs Grocery Co., respectively. In 1990, FSI, Holdings III, and Allied filed for bankruptcy under Chapter 11. As part of the Chapter 11 plans of reorganization, Allied and Holdings III formed a new corporation, Ralphs Holding Co., Inc. ("RHC"), by contributing their Ralphs stock in exchange for RHC stock. Holdings III transferred 100 percent of its RHC stock to FSI creditors, and Allied transferred approximately 60 percent of its RHC stock to certain Allied creditors. Ralphs Grocery Co. & Subsidiaries v. Comm'r, T.C. Memo 2011-25 (T.C. 2011).
The taxpayer argued that Holdings III and Allied's contribution of Ralphs stock in exchange for RHC stock was a qualified stock purchase under IRC Section 338(d)(3), and not a tax-free reorganization under IRC Section 368 because the transaction failed to satisfy the continuity of interest requirement. By treating the acquisition as a taxable stock purchase, RHC would receive a step-up in basis in Ralphs assets following an IRC Section 338(h)(10) election, and benefit from future depreciation and amortization deductions. Pursuant to an IRC Section 338(h)(10) election, a stock acquisition is treated as an asset acquisition followed by a deemed liquidation of the target corporation. The IRS argued that the transaction qualified as a reorganization under IRC Section 368, and therefore RHC could not benefit from a step-up in basis in Ralphs assets. The IRS maintained that the continuity-of-interest requirement would be satisfied with respect to the Ralphs transaction if certain FSI creditors were treated as equity owners of FSI for purposes of the IRC Section 368 reorganization provisions.
COI requires that the taxpayer's ownership interest in the prior organization must continue in a meaningful way in the reorganized enterprise. If the target corporation's shareholders do not have a continuing interest in the acquiring corporation, then the shareholders should not benefit from deferral. To determine whether the transaction satisfied the COI requirement, the Tax Court considered Helvering v. Alabama Asphaltic Limestone Co., and distinguished Ralphs from Alabama Asphaltic. Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (U.S. 1942). The Tax Court found that the FSI creditors did not have "effective command" over FSI's assets. Moreover, the creditors of the insolvent corporation in Alabama Asphaltic took proactive steps to obtain effective command over the insolvent corporation's property. Accordingly, the Tax Court held that the continuity of interest ("COI") requirement was not satisfied in the Ralphs transaction, and therefore the transaction was not a reorganization under IRC Section 368(a)(1)(B), (C), or (G). The Tax Court in Ralphs concluded that the acquisition of stock was an IRC Section 338(h)(3) purchase and constituted a qualified stock purchase under IRC Section 338(d)(3), and held that the joint IRC Section 338(h)(10) election was valid.
Practitioners were surprised by what they called a "disregard of bankruptcy law" in the Ralphs Tax Court decision. Elliott, Amy S., Tax Court Disregarded Bankruptcy Rules in Upholding Taxable Bruno's Structure, 2011 TNT 22-1 (Feb 2, 2011). Practitioners commented that the decision disregarded tax changes that resulted from the Bankruptcy Reform Act of 1978 and the Bankruptcy Tax Act of 1980, and the court may have been unaware of the impact bankruptcy law changes made on the COI requirement. Id. Practitioners expressed that the COI test from 1980 through 2008 (final regulations were issued on December 12, 2008 that provide guidance regarding when and to what extent creditors of a corporation will be treated as proprietors of the corporation in determining COI in a potential reorganization. Treas. Reg. § 1.368-1(e)(1), (6)) should be whether creditors and shareholders in the exchange received the required quantity. Id. Although the significance of this case is somewhat limited due to the regulations issued in 2008, it will be interesting to see the results if the IRS appeals this decision, and its impact on such transactions implemented before the final regulations.
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