It used to be that only stock counted on the “plus side” of the continuity-of-interest equation, when it came to figuring out whether a transaction could garner tax-free treatment. But a new private-letter ruling by the Internal Revenue Service revisits the concept, with a surprising result. That is, in the case of so-called G reorganizations, warrants may do the trick as well as stock.
At its core, the ruling (LTR 201032009) — filed in May with an answer from the IRS released in August — provides guidance on income-tax consequences related to a series of proposed transactions that include bankruptcy proceedings. In the case described in the letter, a corporate taxpayer (TP) is in a situation in which it owns all of the stock of two subsidiary companies, Sub1 and Sub2. TP is a holding company that does not directly engage in the conduct of a trade or business.
On a day referred to as “petition date,” TP and its subsidiaries voluntarily file with the U.S. Bankruptcy Court for Title 11 bankruptcy protection. The bankruptcy plan agreed upon calls for the “downstream” merger of TP with and into Sub1. The “senior claims” held by creditors of TP will be exchanged, in connection with the merger, for (1) new term loans and (2) new common stock and warrants (“new equity”). The general unsecured claims held by TP’s creditors will be exchanged for a combination of new equity and cash. However, the holders of TP’s common shares will receive no consideration with respect to their shares.
When the proposed transaction is completed, Sub1 will be the sole owner of the stock of Sub2, and each of Sub1 and Sub2 will continue their historical operations. Following the merger, Sub1 will have outstanding Class A voting common stock, “limited-vote” Class B common stock, and warrants to purchase Class B common stock. Each share of Class B common stock will be convertible into Class A common stock upon the satisfaction of certain unspecified “agency restrictions.”
In its letter, the IRS concludes that the merger constitutes a reorganization within the meaning of the tax code — specifically, Section 368(a)(1)(G). Accordingly, no gain or loss will be recognized by TP with respect to the transfer of its assets to Sub11, and the latter will inherit the “tax attributes” of the former.2 (See LTR 201032009, May 12, 2010.)
This “G” reorganization is defined as a transfer by a corporation of all or part of its assets to another corporation in a Title 11 or similar case, but only if stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under Section 354, 355, or 356. In addition, the transaction must exhibit both continuity of interest (COI) and continuity of business enterprise (COBE).3 To meet the COI requirement, a “substantial part” of the value of the proprietary interests in the acquired corporation must be “preserved” in the potential reorganization. For this purpose, it is generally agreed that at least 40% represents a substantial part. (See Regulation Section 1.368-1T(e)(2)(v), Example 1.)