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Friday, October 13, 2023

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Reexamining Triangular B Reorganizations By Narotzki & Shanan

This week, Mirit Eyal-Cohen (Alabama; Google Scholar) reviews Doron Narotzki (Akron; Google Scholar) & Tamir Shanan (College of Management; Google Scholar), Reexamining Triangular B Reorganization: Requirements and Potential Tax Traps or a Time to Revisit Its Favorable Application, 24 U.C. Davis Bus. L.J. __ (2024).

Mirit-eyal-cohen

This week, when it was my turn to review new SSRN scholarship, I never expected to do so with such a broken heart. How can one function after witnessing videos taken of infants, children, and women being murdered, incinerated alive, kidnapped, and mutilated? Sadly, while we cannot do much from a distance to mitigate such abhorrent cruelty, I am confident that the Authors  of the aforementioned article (and others with families in Israel) will appreciate the TaxProf Blog community's prayers and words of consolation during these trying times. Thank you in advance for your support. And now, sigh, back to this week’s SSRN Roundup.    

One of the most frequently used schemes for tax-free reorganizations, which the vast majority of scholars and tax practitioners intuitively believe to be justified, is the Triangular B Reorganization. 

U.S. companies typically reorganize in accordance with the triangular B reorganization structure under §368(a)(1)(B) that provides qualified transactions tax deferral treatment and possibly tax windfall when exchanging the stock of one company for the stock of another. While the enactment of such favorable tax provisions by Congress nearly a century ago was necessary for corporations to survive because the corporate income tax environment was so burdensome and the effective tax rates were so high, a great deal has changed since then. The corporate income tax rates have been substantially reduced over the years, the distribution of corporate earnings is rarely levied twice, and the aggregate corporate tax payments (both at the corporate and shareholder levels) have decreased significantly. Also, while corporate structures were predominately domestic a century ago, we now live in an era of globalization that allows taxpayers to form complex cross-border corporate structures at an affordable cost and within the reach of even small businesses.

The Article suggests that these changes may explain why, over the years, the Service and the Courts have restricted the favorable federal income tax treatment for a variety of triangular B reorganizations. While previous scholarship on B reorganizations and triangular B reorganizations have analyzed the technicalities involved in obtaining the favorable treatment, this Article focuses on the various income tax issues that arise upon the execution of triangular B reorganizations and how the Service and the Courts have gradually come to appreciate the need to limit the favorable tax treatment in a wide range of these transactions.

The triangular B reorganization consists of three different companies. It is an acquisition of Target corporation (“Target”) stock by Subsidiary corporation (“Subsidiary”) of Parent corporation (“Parent”) in exchange for Parent stock in a transaction that qualifies as a reorganization under Code Section 368(a)(1)(B). The stock of the acquiring company’s Parent is used as payment for the voting shares of the target company. In addition to the statutory requirements for a reorganization under Code Section 368(a)(1)(B), the Regulations contain additional requirements concerning the continuity of the business enterprise, the continuity of shareholder interest, and the existence of a non-tax business purpose. A further requirement for valid triangular B reorganization status is that there must be an exchange of net value and that the transaction occurs pursuant to a “plan of reorganization.”  

The Article uses a hypothetical triangular B reorganization while discussing each of these requirements in depth and serves as an excellent primer to Triangular B Reorganizations.  It points out to some points of contention with the IRS and examines prominent judicial decisions on the issues. For instance, the Service determined, and the Supreme Court affirmed, that the term “solely” “leaves no wiggle room” for avoiding payments of Target’s shareholder expenditures that are not solely and directly related to the reorganization, such as personal tax planning or costs associated with evaluating other offers. Code Section 368(c) defines “control” as the ownership of stock possessing immediately prior to and immediately following the transaction at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of each other class of stock of the corporation. Congress, the courts, and the Service have not established clear, definitive criteria for determining whether a stock is “voting stock” for these purposes. Nevertheless, the courts and the Service have consistently held that the power to elect a corporation’s directors is the most significant factor in determining whether stock may vote for purposes of determining affiliation. Lastly, the courts have never established a bright-line test for determining the percentage of the Target corporation’s value that must be exchanged for equity in the acquiring corporation in order to satisfy the continuity of interest requirement and have instead made a determination based on the specific facts and circumstances. The Service provides a safe harbor requiring ownership of at least fifty percent of the value of all outstanding stock of the formerly outstanding stock of the target company.

Proposed regulations from 2005 that amend Treas. Reg. 1.368-1(b)(1) require an exchange of net value for certain reorganizations under § 368 in order to prevent transactions that resemble sales from receiving nonrecognition treatment. Under the proposed Regulations, for a reorganization to qualify under §368(a)(1)(B), both the surrender and receipt of net value would be required. Specifically, the proposed Regulations provide that there would be a surrender of net value if the fair market value of the Target corporation’s assets exceeds the sum of the value of its liabilities immediately before the transaction plus the amount of money and value of other property that the Target’s shareholders received in the transaction other than stock. Assets and liabilities of the Target corporation that are extinguished for federal income tax purposes as a result of the exchange are disregarded for this purpose.

When it comes to basis and holding period, the Article indicates there is a great deal of complexity and ambiguity. For example, when the Subsidiary acquires the Parent shares in exchange for property, it is unclear whether such shares are “provided by” Parent corporation for purposes of Treas. Reg. 1.358-6(d)(1). A straightforward reading of the phrase “provided by” would imply that regardless of whether Subsidiary paid for the shares, such Parent shares were in fact “provided by” Parent corporation, just as a service provider “provides” services to third parties in exchange for payment. However, regarding such shares as having been “provided by” Parent corporation could be regarded as inconsistent with the policy as stated in the preamble to the Regulations. Adoption of the approach suggested by the Regulations follows the congressional intent that the basis results in a triangular reorganization should conform to the basis results in its counterpart parent/drop by treating economically comparable reorganizations similarly. Thus, it appears that the Regulations provide for basis adjustments to the Subsidiary stock basis to equate economically equivalent transactions, such as when Parent acquires Target’s shares directly and contributes them to the Subsidiary corporation.

In cases where the impact of the basis adjustments would create a different economic result, such as when the Subsidiary corporation purchases the Parent’s shares used in the triangular B reorganization, the Article points out it is essentially allowing Parent corporation to “double up” on basis (Parent corporation obtaining basis in both the note and the shares of the acquiring Subsidiary). Thus, the policy underlying the Regulations may require that Parent corporation maintain its historical basis in the Subsidiary corporation without any triangular B upward basis adjustment. In contrast, if the Subsidiary corporation’s “purchase” of the Parent shares is treated as a distribution for U.S. tax purposes according to Treas. Reg. 1.367(b)-10, obtaining basis in both the note and other property, on the one hand, and the Subsidiary shares, on the other hand, may be appropriate and consistent with the policy underlying Treas. Reg. 1.358-6. In addition, the constructive distribution and recontribution created by Treas. Reg. 1.367(b)-10(b) offers additional arguments that the Parent corporation’s shares used in the triangular reorganization were provided by Parent, as the Regulations state that the deemed distribution is a separate and distinct transaction.

The Article concludes by urging Congress to reexamine the rationale for such favorable tax treatment that was enacted a century ago, when economic conditions and corporate income tax rules were drastically different, and when cross-border corporate structures were extremely limited. Although the Article could benefit from elaborating further on such international tax complexities, the time has come to reexamine these provisions in the domestic context and even more so in the cross-border context, as such income tax deferrals may end up exempt from U.S. federal income taxes entirely (or almost entirely).

Here's the rest of this week's SSRN Tax Roundup:

https://taxprof.typepad.com/taxprof_blog/2023/10/weekly-ssrn-tax-article-review-and-roundup-eyal-cohen-reviews-reexamining-triangular-b-reorganizatio.html

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