Big A, Little C: Baby Steps Toward Modernizing Reorganizations

Since 1934, a tax-free reorganization has included a statutory merger or consolidation (an A reorganization).1 However, the words "statutory merger or consolidation" have meant many things. Today, a statutory merger or consolidation includes transactions that Congress could not have conceived of in 1934. As the contours of state statutes have shifted, Treasury and the IRS have embraced an increasingly functional interpretation of the statutory merger or consolidation requirement that now encompasses state law mergers into disregarded entities and mergers and consolidations effected under foreign law.2

Against that backdrop, the government requested comments on whether A reorganization treatment should extend to (1) the acquisition by an acquiring corporation (Acquirer) of all of Target's stock followed by Target's related conversion under state law into a limited liability company (a stock acquisition/conversion3), or (2) an acquisition of all of Target's outstanding equity interests followed by a related election to change Target's U.S. tax entity classification from a corporation to a disregarded entity under reg. section 301.7701-3 (a stock acquisition/check-the-box (CTB) election4). This report refers to these transactions as "functional mergers."5 Neither transaction can qualify as an A reorganization under the Treasury regulations, and an example in the regulations concludes that a stock acquisition/conversion was not an A reorganization because Target continued to exist as a "juridical entity" after the second-step conversion.6 Consequently, functional mergers must satisfy the more demanding statutory requirements of section 368(a)(1)(C) (a C reorganization) or section 368(a)(1)(D) (a D reorganization) for tax-free treatment, which may be impossible in some cases. However, as the preamble to the regulations recognizes, each form of functional merger is similar to a technical merger insofar as the transaction accomplishes the simultaneous transfer of Target's assets to Acquirer and Target's elimination as a corporation for U.S. tax purposes.7

This report considers whether it is appropriate to extend A reorganization treatment to functional mergers that satisfy the business purpose, continuity of interest (COI), and continuity of business enterprise (COBE) requirements in reg. section 1.368-1. We acknowledge that a literal interpretation of section 368(a)(1)(A) would limit A reorganizations to acquisitions effected under a technical merger or a consolidation effected under applicable law; however, we note that section 368 does not define the phrase "statutory merger or consolidation." Moreover, Congress obviously did not foresee the advent of disregarded entities, which make functional mergers possible, when it created A reorganizations in 1934. Disregarded entities are unique in that they are separate legal entities but, absent an election to the contrary, are considered a branch or division of the entity's owner for U.S. tax purposes.8 Today, Acquirer can use a disregarded entity to acquire Target's assets for tax purposes without participating in the acquisition transaction for corporate law purposes. The question is whether transactions involving this unique entity warrant a unique definition of a statutory merger or consolidation.

Significantly, the government already has appropriately recognized that A reorganization treatment does not require that Target's assets and liabilities become the direct assets and liabilities of Acquirer under a statutory mechanic. The government's extension of the regulations to permit Target's merger into Acquirer's disregarded entity to qualify as an A reorganization is a particularly compelling example of this type of logical extension, because those transactions now qualify as A reorganizations even though Acquirer and Target do not merge under state law and the acquiring disregarded entity — the only Acquirer group party to the merger — is not a party to a reorganization under section 368(b).9 Likewise, we seek to establish that the absence of a technical merger under applicable law does not preclude a functional merger's treatment as an A reorganization.

As discussed below, compelling policy reasons support the treatment of functional mergers as A reorganizations, despite the absence of a technical merger or consolidation under current law. Functional mergers are substantially equivalent to technical mergers under state law; as such, amending the regulations to conform the treatment of functional mergers to those substantially equivalent transactions would continue the government's logical and measured pattern of broadening the regulations to address modern commercial realities.10 Moreover, treating functional mergers as A reorganizations would not contravene Congress's intent in promulgating A reorganizations, which was to preserve COI by Target shareholders. Finally, the government has ample authority under Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc.11 and its progeny to adopt our proposed regulatory changes.12

1. BACKGROUND

1. Section 368

   The tax-free reorganization rules under section 368(a) exempt from gain recognition specified corporate combinations that "effect only a readjustment of continuing interest in property under modified corporate forms."13 An A reorganization is a statutory merger or consolidation.14 A C reorganization generally is an acquisition of substantially all of Target's properties15 solely in exchange for voting stock of Acquirer (or its immediate controlling parent corporation), or in exchange for that voting stock and a limited amount of money and/or other property16 if Target makes a liquidating distribution of the stock received and any other assets (with limited exceptions) to Target shareholders.17 A D reorganization generally includes Target's transfer of part or all of its assets to Acquirer if, immediately after the transfer, Target (or one or more of its shareholders) controls18 Acquirer and Acquirer stock or securities are distributed in a transaction qualifying under section 354 or 356.19

   In addition to the applicable statutory requirements, an acquisitive reorganization must satisfy the business purpose, COI, and COBE requirements in reg. section 1.368-1. First, a reorganization requires a valid corporate business purpose,20 such as the synergistic benefits that Acquirer expects to realize from the combination of Acquirer's and Target's respective businesses.21 Second, to prevent transactions that are in substance taxable sales from qualifying as reorganizations, the COI test generally requires that Acquirer stock represent at least 40 percent of the aggregate consideration delivered to Target shareholders.22 Third, the qualified group must satisfy the COBE test by either continuing Target's historic (most recently conducted) business or using a significant portion of Target's historic business assets in the qualified group's business.23

2. Section 368(a)(1)(A) Regulations

   For approximately 65 years after the 1934 adoption of the statutory merger or consolidation provision, the regulations generally defined the term "statutory merger or consolidation" simply as a merger or consolidation effected under the corporation laws of the United States, a...