Replies to post #5691 on Conversion Solutions Holdings (fka CSHD)

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IRS Issues Final Regulations Allowing Foreign Merger Section 368 Reorganizations

David J. Plewa
Stacy M. Paz

The IRS has issued final regulations defining the term “statutory merger” or “consolidation” as it is used in Internal Revenue Code (Code) Section 368(a)(1)(A) (an “A Reorganization). The new regulations also affect statutory mergers or consolidations in forward triangular and reverse triangular reorganizations under Code Sections 368(a)(2)(D) and (E).

Background on the Section 368 Reorganization Rules

Code Section 368 reorganizations generally allow U.S. target corporation shareholders to exchange target stock for buyer corporation stock without gain recognition. An A Reorganization is defined in the Code as a “statutory merger or consolidation.” Previously the term “statutory merger" was interpreted by regulations as a merger or consolidation effected under the corporate law of a "State or Territory or the District of Columbia." Although many foreign jurisdictions have merger statutes that operate similarly to those of U.S. state laws, a merger involving entities organized under foreign law and effected pursuant to foreign corporate law did not qualify as an A Reorganization.

Burden under Prior Regulations

The A Reorganization is the most flexible form of tax free reorganization under the Code primarily because it confers the ability to use up 60 percent of consideration in the form of non-stock, “boot” consideration (e.g., cash).* In addition, a transaction may qualify as an A Reorganization whether or not the target corporation retains substantially all its assets after the transaction, and whether or not the buyer issues voting or non-voting stock in the acquisition.

In contrast, a reorganization pursuant to Code Section 368(a)(1)(B)(B Reorganization) prohibits the use of boot altogether, and a reorganization pursuant to Code Section 368(a)(1)(C)(C Reorganization) limits the use of boot to 20 percent (subject to the “boot relaxation” rule, which ignores assumption of liabilities provided there is no boot). Therefore, buyers desiring to acquire foreign target corporations with US shareholders in a tax-free reorganization were generally required to carefully structure stock and asset purchase transactions subject to the limitations of the no boot, stock–for-stock B Reorganization rules, and limited boot, stock-for-assets C Reorganization rules.

Final Regulations Revise Definition of an A Reorganization

On January 5, 2005, the IRS issued proposed regulations (REG-117969-00) that would revise the definition of an A Reorganization to include transactions effected pursuant to foreign law and transactions involving entities organized under foreign law. On January 23, 2006, the IRS adopted the proposed regulations as final (T.D. 9242), therefore allowing cross-border mergers to come within Code Section 368.

Note, however, that a statutory merger of a US target corporation into a foreign corporation remains subject to Code Section 367 additional requirements for tax-free treatment. Final regulations have also been issued under Code Sections 358, 367, and 884 that would account for an A Reorganization involving one or more foreign corporations. The regulations are effective January 26, 2006.

Also Changed: How Target Corporation Shareholders Determine Tax Basis in Buyer Stock

As a separate matter, the IRS also recently issued final regulations allowing target corporation shareholders to determine their tax basis in buyer stock using a tracing method, under which shares of buyer stock may be designated as having been received in exchange for particular blocks of target stock. For example, this allows target corporation shares purchased at a higher price than other target corporation shares to be traced to buyer shares received in an exchange, so that the higher basis buyer shares may be sold first. In contrast, under an “averaging method,” a shareholder’s basis in target shares would be spread pro-rata to buyer shares received.