Attorneys Question Private Letter Ruling and 'D' Reorganizations

Dear Bill:

Enclosed is a letter regarding section 368(a)(1)(D) and the determination in PLR 200551018 that the transaction in question was not a "D" reorganization. The letter is being submitted on behalf of the named signatories thereto. The letter is not intended to be an exhaustive analysis of "D" reorganizations. Instead, the letter is being submitted in order to facilitate further consideration and discussion of the issues raised by PLR 200551018 and, hopefully, the issuance of additional guidance by the Internal Revenue Service.

We look forward to meeting with you at your convenience to further discuss these issues.

Mr. Michael J. Desmond, Tax Legislative Counsel, Department of the Treasury

The Honorable Mark W. Everson, Commissioner, Internal Revenue Service Mr. Donald L. Korb, Chief Counsel, Internal Revenue Service

Mr. Mark Schneider. Deputy Associate Chief Counsel (Corporate), Internal Revenue Service

Letter Signatories

Dear Mr. Alexander:

We are writing to raise questions about the determination in PLR 200551018 that the transaction in question was not a reorganization under section 368(a)(1)(D). In PLR 200551018, unrelated corporate shareholders A and B each owned 50 percent of the stock of Corporation X ("X"). Corporation C ("C") was unrelated to A and B. B and C formed Newco, with B owning 90 percent of the Newco stock and C owning the remaining 10 percent. X sold all of its assets to Newco in exchange for two installment notes. Immediately thereafter, X liquidated, distributing one note to A and one note to B. PLR 200551018 held that Newco was entitled to amortize the cost of the goodwill acquired as a result of the purchase of assets from X.

Although not specifically stated or analyzed, this ruling assumed that the transaction did not qualify as a reorganization under section 368(a)(1)(D), Informal conversations with government representatives indicate that this determination represents the reasoned judgment of the Internal Revenue Service (the "Service") that the transaction in question did not qualify as a "D" reorganization. PLR 200551018 does not discuss the reasons for rejecting the application of section 368(a)(1)(D) to the transaction. In turn, the ruling raises questions concerning the viability of past guidance. This letter is intended to identify some of those questions and facilitate further consideration, and discussion of these issues by the Service and practitioners.

The Service and the courts have historically held that, under certain circumstances, an actual transfer and distribution of stock either is not required or is deemed to have occurred because an actual transfer and distribution would be a "meaningless gesture.'" The circumstances where the Service and the courts have so ruled can be divided into three categories: (1) Target and Acquiring are 100% owned by a single party (or multiple parties in the same percentages) through direct stock ownership ("Category V): (2) Target and Acquiring are 100% owned by a single party (or multiple parties in the same percentages) as a result of taking into account indirect ownership through subsidiaries ("Category 2"); and (3) Target and Acquiring are 100% owned by a single party as a result of applying the other attribution rules of section 318 ("Category 3").

PLR 200551018 represents yet a fourth category of transactions because Target and Acquiring are commonly controlled, but do not have 100% common ownership in the same percentages, either actually, indirectly, or through other section 318 attribution ("Category 4"). We understand that PLR 200551018 represents the government's position that the Category 4 transactions do not qualify as "D" reorganizations. What is not clear is the reasoning supporting this conclusion and whether such unstated reasoning implies a change to the government's longstanding view as to the proper treatment of any of the transactions described in Categories 1, 2, and 3.

These four categories of transactions and the historical guidance from the Service and the courts relating to "D" reorganizations where no stock is issued or distributed are reviewed briefly below. This discussion, however, is not intended to be an exhaustive analysis of "D" reorganizations; rather, we hope it will promote meaningful dialogue regarding the issues raised by PLR 200551018 and result in additional guidance from the Service.

I. Statutory Background

The source of the requirement that there be an issuance or distribution of Acquiring stock is found in the last clause of section 368(a)(1)(D), which states that a transaction qualifies as a "D" reorganization "only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356." In addition, section 354(a) states, "[n]o gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization." Section 354(b) provides that section 354(a) will not apply to an exchange in pursuance of a "D" reorganization unless "the stock, securities, and other properties received by the transferor, as well as the other properties of such transferor, are distributed in pursuance of the plan of reorganization." Together, these provisions have generally been interpreted to require a distribution of Acquiring stock for a transaction to be treated as a "D" reorganization.¹ However, as noted above and discussed more fully below, under certain circumstances the Service and the courts have held that an actual issuance or distribution is not required.

II. Relevant Authority

 

 

In PLR 8911067, the consideration received by Target (in addition to the Acquiring stock constructively received) was $1 plus the assumption of Target's liabilities. The ruling is unclear as to how much stock is deemed to be distributed. In the other two rulings, there was no cash paid and the consideration was limited to the assumption of Target's liabilities (in addition to the constructive distribution of Acquiring stock). These rulings state that the value of the Acquiring stock, deemed issued would be equal to the value of the Target stock surrendered by Target's owner upon Target's liquidation. PLR 9336029 expressly concludes that section 311(b) would cause the recognition of gain on the deemed distribution of Acquiring stock from the owner of Target "up the chain." The other two rulings do not address potential gain under section 311(b).

We note that PLR 9336029, described above, involved members of a consolidated group and was issued before the 1995 amendments to the consolidated return regulations. Under the current consolidated return regulations, if p, S, S1, Acquiring, and Target are members of a consolidated group, the transaction is treated differently and the following events are deemed to occur: (i) Acquiring is treated as issuing its stock to Target in exchange for Target's assets; (ii) Target is treated as distributing Acquiring stock to S in a liquidation; and (iii) Acquiring is treated as redeeming its stock from S in exchange for cash. See Treas. Reg. § 1.1502-13(f)(3) and (f)(7), ex. 3. This treatment is similar to the analysis in Commissioner v. Clark 489 U.S. 726 (1989). Clark did not address cross-chain "D" reorganizations such as those discussed in this letter, but did present an analysis in the context of treating cash boot as dividend income or capital gain thai is potentially relevant. To date, the Service has not expressly adopted the Clark analysis in the context of cross-chain "D" reorganizations.

As noted above, in the Service's rulings involving Category 2 transactions, Acquiring paid only nominal consideration for Target's assets. Presumably, if Acquiring paid cash equal to the net value of Target's assets in a Category 2 transaction (as shown in the picture above), the transaction would still qualify as a "D" reorganization (i.e., the payment of such cash would not disqualify the transaction as a "D" reorganization).⁴ Where Acquiring pays cash equal to the net value of Target's assets. Acquiring stock presumably would be distributed to Target's shareholder under one of two alternative approaches. Under the first alternative, following the approach of Rev. Rul. 70-240 and case law, Acquiring would be deemed to issue a nominal share of stock to Target in addition to the cash actually paid to Target: applying the approach of the Category 2 rulings, such share then would be deemed to be distributed up to Target's shareholder and distributed up and/or contributed down chains of corporations to Acquiring's shareholder. Under the second alternative, following the approach of Clark and the consolidated return regulations described above, Acquiring would be deemed to issue solely stock to Target in exchange for Target's assets; such stock then would be deemed to be distributed to Target's shareholder and then redeemed by Acquiring for the cash consideration.

 

 

PLR 200551018 apparently reflects the Service's conclusion that this transaction foils to qualify as a "D" reorganization because there is no actual issuance or distribution of Acquiring stock.⁷ It is possible that the Service is basing its position in PLR 200551018 on language in Warsaw Photographic Associates, Inc. v. Comm. 84 T.C. 21 (1985), noting that: all the meaningless gesture authorities involved transactions where the ownership of Target and of Acquiring was identical. The court in Warsaw Photographic Associates distinguished the transaction at issue in that case by stating that it was materially different from these authorities because there was not identical ownership. It should be noted, however, that the common shareholders in the transaction in Warsaw Photographic Associates only owned 20% of Target. The 80% shareholder of Target did not own an interest in Acquiring. This is arguably different than the transaction in PLR 200551018, where a 90% shareholder of Acquiring owned 50% of Target. In addition, Warsaw Photographic Associates was decided before the Service issued any of the rulings holding that the Category 2 and 3 transactions discussed above qualify as "D" reorganizations.⁸

III. The Meaning of a "Meaningless Gesture"

As discussed above, the courts and the Service have concluded that no stock needs to be distributed in transactions described in Categories 3, 2, and 3 because such a stock distribution would be a meaningless gesture. It is not clear, however, what constitutes a meaningless gesture for these purposes.

For example, where a sole shareholder contributes assets to a corporation in exchange for no consideration, the transaction typically qualifies under section 351 even though (i) section 351 applies to transfers of property solely in exchange for stock and (ii) the shareholder receives no stock in the transaction. This is because the company's issuance of additional shares to the shareholder would be a meaningless gesture. See Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989). In the section 351 transaction discussed above, however, the actual issuance of additional shares would result in the same ownership of the corporation.

In transactions described in Category 1, the actual issuance of additional shares also would result in the same ownership of the Acquiring corporation. Where Acquiring paid cash equal to the value of Target's assets (less liabilities assumed), such a deemed issuance seems to be inconsistent with the economics of the transaction. In effect, the deemed issuance and distribution of Acquiring stock would cause Acquiring to pay too much for Target's stock.⁹ Nonetheless, the courts and the Service consistently have treated such a stock issuance and distribution as a meaningless gesture.

In transactions described in Category 2, Acquiring's actual issuance of shares to Target (and the distribution of such shares to Target's shareholder) would not result in the same ownership of Acquiring as results from a transaction without such stock issuance and distribution. Instead, cross-chain ownership of Acquiring stock would result. To reflect the absence of such cross-chain ownership following a Category 2 transaction involving no such issuance/distribution of Acquiring stock, the rulings cited above treat the deemed stock as having been distributed up and/or contributed down chains of corporations. Thus, in this context, an actual distribution of stock is not a "meaningless gesture" in the Lessinger sense; to the contrary, additional distribution and/or contribution transactions are deemed to occur in order to render the first deemed distribution "meaningless." Nonetheless, once again, the Service consistently has treated such an actual stock issuance and distribution as a meaningless gesture and thus not required for "D" reorganization treatment in Category 2 transactions. As noted above, if Acquiring paid cash equal to the net value of Target's assets (as opposed to the nominal consideration paid in the Service's Category 2 rulings), then Acquiring presumably would be deemed to acquire Target's assets in exchange for either (i) a nominal share of stock, in addition to such cash, and such share would be deemed to be distributed to Target's shareholder and then distributed up and/or contributed down chains of corporations, or (ii) solely Acquiring stock, and such stock would be deemed to be distributed to Target's shareholder and then redeemed by Acquiring for the cash consideration.

In transactions described in Category 3, Acquiring's actual distribution of Acquiring shares to Target's shareholder also would result in cross-chain ownership of Acquiring, Nevertheless, the Service consistently has concluded that an actual distribution of such stock is not required (citing Rev. Rul. 70-240 and case law), effectively concluding that such a distribution would be a meaningless gesture. Moreover, the Service has done so without providing for additional deemed distribution/contribution transactions to reflect the actual absence of such cross-chain ownership following a Category 3 transaction.

If the distribution of stock in transactions described in Categories 1, 2, and 3 is treated as a "meaningless gesture," should transactions described in Category 4 also be deemed to be in exchange for cash and one share of Acquiring stock (or solely Acquiring stock) under the meaningless gesture doctrine of Rev. Rul. 70-240? For example, in a Category 4 transaction in which Acquiring paid cash equal to the value of Target's assets (less liabilities assumed), Acquiring could be treated as having issued one share of its stock to Target, Target could be treated as distributing such share, and then Acquiring could be treated as redeeming such share with a small portion of the cash actually paid in the transaction.¹⁰ Alternatively, Acquiring could be treated as having issued all stock to Target, Target could be treated as distributing such stock, and then Acquiring could be treated as redeeming all such stock for the cash actually paid. One reasonably can conclude that a Category 4 transaction should be treated similarly to transactions described in. Categories 1, 2, and 3. Nevertheless, in PLR 200551018, the Service appears to have concluded that Category 4 transactions are materially different from Category 1,2, and 3 transactions, and that Category 4 transactions are not properly treated as "D" reorganizations. It would be helpful for the Service (i) to confirm that it continues to view Category L 2, and 3 transactions as "D" reorganizations, (ii) to confirm that it views Category 4 transactions as distinguishable from Category 1, 2, and 3 transactions, and (iii) to explain why it views Category 4 transactions as distinguisable.

IV. Questions Raised by PLR 200551018

The ruling in PLR 200551018 raises many questions in the context of the authority discussed above, including the following:

• Would the distribution of a single share of Acquiring stock to B in PLR 200551018 cause the transaction to be a "D" reorganization? If so, has the Service effectively made "D" reorganization treatment elective, at least in the case of Category 4 transactions discussed above?

• If one share of stock is not sufficient to cause the transaction to qualify as a "D" reorganization, how much stock is necessary?

• What if A and B each owned 50% of the stock of Target, but only 49% of the stock of Acquiring, with C owning the remaining 2% of Acquiring stock? Would such a fact pattern be treated as a Category 4 transaction (i.e., not a "D" reorganization because there is not identical ownership)?

• What if A and B each owned 50% of the common stock of Target and Acquiring and C simply owned some nonparticipating preferred stock of Acquiring? Would such a fact pattern be treated like a Category 1 transaction or a Category 4 transaction?

• In light of the uncertain application of section 368(a)(1)(D) to Category 4 transactions, would the Service consider allowing taxpayers affirmatively to elect to treat such transactions as "D" reorganizations?¹¹

We would welcome the opportunity to meet with you to discuss the questions raised in this letter.

Mr. Michael J. Desmond, Tax Legislative Counsel, Department of the Treasury

The Honorable Mark. W. Everson, Commissioner, Internal Revenue Service

Mr. Donald L. Korb, Chief Counsel Internal Revenue Service

Mr. Mark Schneider, Deputy Associate Chief Counsel (Corporate), Internal Revenue Service

²See, e.g., Rev. Rul. 2004-83 (treating the purchase of Sub2's stock by Sub1, followed by the liquidation of Sub2, as a "D" reorganization); Rev. Rul. 75-383 1975-2 C.B. 127;American Manufacturing Co, v. Comm'r, 55 T.C. 204 (1970); Alias Tool Co. v Comm'r 614 K2d 860 (3rd Cir. 1980); PLR 7950044; PLR 8108112; PLR 8305091 PLR 8334014; PLR 8339081; PLR 8529030; PLR 8530012; PLR 8624054; PLR 8635040; PLR 8645062; PLR 8751023; PLR 8806081; PLR 8830006; PLR 8909012; PLR 8924006; PLR 8924034; PLR 8945043; PLR 9014028; PLR 9023046; PLR 9045058; PLR 9105039; PLR 9112026; PLR 91324058; PLR 9127023; PLR 9132020; PLR 9220046; PLR 9223027; PLR 9320010: PLR 9331018; PLR 9335045; PLR 9441018; PLR 200011041. But see Preamble to Proposed Regulations on Transactions Involving the Transfer of No Net Value, 70 Fed Reg 11,903 (March 10, 2005} (noting that the Service and Treasury intend to study the issues surrounding acquisitive "D" reorganizations, including "the continuing vitality of the authorities discussed with respect to the first category transactions in this letter).

³See, e.g., Wilson v. Comm'r 46 T.C. 334 (1966); James Armour, Inc. v Comm'r 43 T.C. 295 (1964); Davant v. Comm'r, 366 F.2d 874 (5^th Cir. 1966); Moffatt v. Comm'r 363 F 2d 262 (9^th Cir. 1966): Smothers v. U.S., 642 F.2d 894 (5^th Cir. 1981); Rose v. US 640 F. 2d 1030 (9th Cir. 1981); PLR 8042111. '

⁴ None of the Category 2 rulings suggests that the transactions qualified as "D" reorganizations because Acquiring paid cash less than the net value of Target's assets (or put differently. would not have qualified as "D" reorganizations if Acquiring bad paid cash equal to the net value oi Target s assets). Indeed, such a conclusion would be irreconcilable with Rev. Rul. 70-240 (assets sold for cash in an amount equal to the fair market value of the assets),

⁵See PLR 9111055; PLR 8402001; FSA 200117008.

⁶See TAM 8402001; FSA 200117008 (not referring to section 318 specifically, but requiring attribution to conclude that Target and Acquiring are 100-percent commonly owned).

⁷ Note that in PLR 200551018, the distribution of notes to A and B would not satisfy a distribution requirement based on the literal language of section 368(a)(1)(D) even if the notes were securities; because section 354 requires any securities received to be received in exchange for securities of the same principal amount. Section 356 also would not apply to the distribution of the notes because it only applies if there is also an exchange that otherwise qualifies under section 354 (which, without an actual distribution of Newco stock, the transaction in question apparently did not have).

⁸ We also note that in PLR 8810942 Parent owned 100% of Target, but only owned 99.9% of Acquiring. The Service nonetheless concluded that Rev. Rul. 70-240 applied and treated the transaction as a "D" reorganization.

⁹ If Acquiring paid full value for the transferred assets, and Acquiring also actually issued Acquiring stock in the transaction. Target would receive more than the value of its assets. How would such a transaction be treated? Would a portion of the cash equal in value to the stock issued in the transaction be recharacterized as a cross-chain transfer of cash to die Target shareholder in a separate transaction?

¹⁰Cf. Treas. Reg. § 1.1502-13(f)(3) and (f)(7), ex, 3.

¹¹Cf. Temp. Treas. Reg. § 1.338(h)(10)-1T(c)(2) (permitting a section 338(h)(10) election for P's acquisition of T even though, "after P's acquisition of T stock, T merges or liquidates into P (or another member of the affiliated group that includes P), whether or not, under relevant provisions of law, including the step transaction doctrine, the acquisition of the T stock and the merger or liquidation of T qualify as a reorganization described in section 368(a)").