In what looks like an explanation for a corporate “do-over,” the Internal Revenue Service issued guidance in December to take companies through the steps of backing out of a merger. The private letter ruling, dated December 12, 2008, lays out the situation, and its resolution, in the following way:
Prior to April 1, Tau Corp. had two classes of stock outstanding — convertible preferred stock and common stock. During April 1 and May 1, Alpha Corp. made a cash purchase of all of Tau’s convertible preferred stock. On June 1, Alpha, Tau, and certain Tau shareholders executed an agreement and plan of merger. Specifically, Tau would merge with and into Alpha in exchange for a combination of Alpha stock, notes, and cash.
On July 1, the Tau shareholders approved the union and the merger was effected by filing with the appropriate authorities certificates of merger. Accordingly, on July 1, Alpha acquired all of Tau’s assets subject to its liabilities, and Tau’s separate legal existence ceased.
Continuity of Interest
Later, Alpha discovered that the merger could yield “adverse tax consequences” that could be “devastating” to the continued viability of the company as a going concern. Although the ruling does not specify what the adverse tax consequences might be, it seems clear that Alpha discovered that the merger of Tau did not qualify as a tax-free reorganization within the meaning of the tax code, specifically Section 368(a)(1)(A).
The failure to qualify was probably due to the transaction’s inability to meet the continuity of interest (COI) requirement. A merger cannot qualify as a reorganization unless it exhibits COI.1 In turn, COI requires that no less than a “substantial part” of the value of the proprietary interests in the target be “preserved” in the potential reorganization.2
For this purpose, a proprietary interest is preserved if it is exchanged for a proprietary interest in the issuing corporation. Further, a proprietary interest is not preserved if, in connection with the potential reorganization, it is acquired by the issuing corporation for consideration (such as notes or cash) other than stock.
Regarding the notion of a “substantial part,” which is the quantitative aspect of the COI requirement, the IRS has announced in recently issued regulations that it considers 40% to be sufficient.3 But in the example case, it appears that less than 40% of the proprietary interests in Tau were exchanged for Alpha stock, with the result that the transaction flunked the COI test.
“The failure to qualify was probably due to the transaction’s inability to meet the continuity of interest (COI) requirement. A merger cannot qualify as a [tax-free] reorganization unless it exhibits COI.” — Robert Willens
Since the transaction did not qualify as a reorganization based on a lack of COI, the “movement” of Tau’s assets to Alpha would be taxable.4 If the assets so moved were highly appreciated, a substantial taxable gain would arise from the merger, and clearly the payment of taxes with respect to such gain could certainly be described as devastating.
Alpha, Tau, and certain shareholders of Tau then took steps to rescind the merger and complete a taxable sale of Tau’s common stock to Alpha. The prior sale of Tau’s convertible preferred stock to Alpha was to remain undisturbed.
On August 1, a court rendered a judgment that rescinded the merger agreement and directed that the appropriate state officials reinstate Tau as a state corporation “in good standing.” Next, on September 1, Alpha acquired the common stock of Tau for the same amount (and type) of consideration agreed to in the merger agreement. Alpha noted that it had no plan or intention to liquidate Tau.
The IRS private letter ruling concludes that Tau will be treated as not having merged into Alpha. In addition, Tau and Alpha will be treated as two separate corporations at all times during the taxable year.
Crisis averted. There would be, with respect to the transaction as rescinded, no movement of assets. Therefore, the appreciation inherent in Tau’s assets would not become subject to taxation.5
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 Reg. Sec. 1.368-1(b)
2 See Reg. Sec. 1.368-1(e)(1)(i)
3 See Reg. Sec. 1.368-1T(e)(2)
4 See Rev. Rul. 69-6, 1969-1 C.B. 104
5 Even if Alpha chooses to liquidate Tau (via merger or assignment) following the acquisition of its stock, the “upstream” asset movement will be tax-free to Tau. The transaction would be a purchase of stock followed by a Section 332 liquidation of Tau into Alpha, a transaction that does not trigger the gain inherent in the transferred assets. (See Section 337(a).) The acquisition of stock and liquidation would each be viewed as separate transactions even if Alpha had firmly intended, at the time Tau’s stock was acquired, to liquidate Tau. An acquisition of stock and liquidation only will be collapsed into a single transaction — a direct asset acquisition — if the steps, so viewed, produce a reorganization. That would not be the case here, because of the transaction’s infirmities on the COI front. (See IRS Revenue Ruling 90-95, 1990-2 C.B. 67; Revenue Ruling 2001-46, 2001-2 C.B. 321; and Revenue Ruling 2008-25, I.R.B. 2008-21, May 8, 2008.)