From its inception, the Internal Revenue Code has contained provisions designed to facilitate corporate restructurings by reducing (and, in some cases, eliminating) the current tax bills that would otherwise be payable by corporations and their shareholders for engaging in reorganization transactions. Essentially, these provisions reward corporate taxpayers for continuing the businesses that they acquire and reward shareholders for continuing the investment they made in the acquired corporation by taking an equity interest in the acquiring corporation. Unfortunately, the Code provisions themselves are highly technical, so technical that tax lawyers have often had to resort to diagrams of circles, squares and triangles in order to understand their limits.

One of the principal technical bottlenecks in structuring reorganizations has been the so-called "asset continuity" doctrine that the Supreme Court imposed to restrict the tax-free treatment of these transactions in Groman v. Commissioner, 302 US 82 (1937) and Helvering v. Bashford, 302 US 454 (1938). In brief, asset continuity required that the acquired corporation's shareholders not only continue their investment after the reorganization, but also that the shareholders continue their investment in the "right" corporation. Because the Code required the acquired corporation's shareholders to hold stock of a "party to the reorganization," the Court reasoned that only a "party to the reorganization" could receive the assets of the acquired corporation. Therefore, unless the corporation issuing the stock to the acquired corporation's shareholders in the reorganization was also in receipt of the acquired corporation's assets, the technical Code requirements for tax-free treatment would be violated, and the transaction would be taxable at both the corporate and shareholder levels. Subsidiary corporations were precluded from using the stock of their parent corporations as consideration if they desired tax-free treatment for their acquisitions.

Legislative changes subsequent to 1938 mitigated the harshness of these Supreme Court decisions by specifically authorizing the use of stock of the acquiring corporation's immediate parent in triangular reorganizations and the drop of acquired assets to an 80% subsidiary of the acquiring corporation. However, these legislative changes appeared not to go any further than their literal terms would permit. Transactions that were still not literally described by the Code provisions appeared vulnerable to attack under the principles of Groman and Bashford. For example, while the Code permitted acquired assets to be dropped to a subsidiary of the acquiring corporation, there was no parallel provision permitting a "push-up" of the acquired assets to the parent corporation of the acquiring corporation. Likewise, while the Code permitted a drop of assets to a first-tier subsidiary, a second drop of the same assets to a second-tier subsidiary was literally not authorized. Drops of acquired assets to partnerships and limited liability companies also appeared to be without statutory authorization, even though a likely business purpose for an acquisition might be to employ part of the acquired assets in a joint venture.

A start was made to remove the deadwood of the Groman and Bashford cases in Treasury regulations issued in 1998, but far too many gray areas remained until the release of the latest set of Treasury regulations on October 24, 2007, with Treasury Decision 9361. Under the new regulations, it is possible to push up assets to the parent or any other shareholder(s) of the acquiring corporation that is a member of its "qualified group" so long as the push-up does not effect the complete liquidation of the acquired corporation. The new regulations further authorize drops and other transfers of assets by the acquired corporation to any other corporation that is a member of its "qualified group" so long as the transfer is not a push-up (and therefore subject to the "no-liquidation" rule described above) and the corporate existence of the acquiring corporation does not terminate. For purposes of both the push-up and the drop rules, a "qualified group" consists of the corporation issuing stock in the reorganizations and all corporations below it in one or more ownership chains, where the issuing corporation owns at least 80% of the stock of at least one other corporation and at least 80% of the stock of the other corporations is owned by the issuing corporation and one or more of the other corporations in the "qualified group." The drop section of regulations promotes the maintenance of the initial acquiring corporation as a "shell corporation" (a corporation with no assets other than their charters) apparently because of the statutory necessity of finding an identifiable successor to the acquired corporation’s tax attributes.

Transfers to partnerships and limited liability companies are not directly addressed by the new regulations. However, it is clear from the provisions the new regulations cross-reference that transfers to such entities (that are not push-ups) will not disqualify an otherwise qualifying transaction for reorganization treatment so long as members of the qualified group own in the aggregate a "significant interest" in the transferee partnership (which is generally understood to be an interest of at least 33-1/3%) or one or more members of the qualified group have active and substantial management functions as a partner of the transferee partnership. Thus, substantial flexibility exists under the new regulations to move acquired assets among related corporations, partnerships and limited liability companies without destroying the tax-free character of the acquisition. This flexibility should enable businesses to employ acquired assets1 in ways that will permit optimal realization of the synergies expected from most business combinations.

One word of caution, however. The new regulations relate only to the qualification of the acquisition transaction for treatment as a tax-free reorganization—that is, the tax consequences arising from the transfer of assets from the acquired corporation and the exchange of the acquired corporation's stock for equity in the acquiring corporate family. The regulations do not describe the tax consequences of the secondary transfers (the push-ups and drops) themselves. These secondary transfers may well be taxable at the corporate level, though often another Code or regulatory provision may be available to defer tax. The key point of the new regulations is that the tax-free consequences of the initial acquisition will not blow up if transfers are made within their permitted framework.

The new regulations apply to transactions occurring on or after October 25, 2007, but they do not apply to any transaction occurring after that date pursuant to a written agreement that was binding before October 25, 2007, and at all times after such date.

1. The new regulations also permit transfers of stock of subsidiaries involved in triangular reorganizations. For the sake of simplicity, discussion of the provisions relating to such stock transfers has not been covered in this Tax Alert.

Copyright © 2008 by Ballard Spahr LLP.
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