Determining Control in Public M&A Transactions

On October 15 the IRS released LTR 202141005 (the ruling), in which the IRS ruled that section 304 did not apply to an acquisition of the stock of one publicly traded corporation by another publicly traded corporation based on information gathered and analyzed by the taxpayer and taxpayer representations. The ruling illustrates the difficulty of determining whether the same persons control each of an issuing corporation and an acquiring corporation under section 304(c) in the case of mergers and acquisitions transactions between publicly traded corporations (public M&A transactions). Further, based on the facts and representations in the ruling, some broad inferences may be drawn regarding the IRS’s view of the sufficiency of some methods of gathering and interpreting data for purposes of applying section 304(c) in public M&A transactions. Still, because of the breadth of those inferences, the ruling mainly underscores the need for further guidance on the issue.

Part I of this article reviews the policy of section 304 and the historical development of the section 304(c) control requirement. Part II examines the general inapplicability of the policy to public M&A transactions, the inherent complexity of determining whether the requirement is met in the case of public M&A transactions, and practical problems that result from the inability to make this determination. Part III summarizes the ruling and discusses the extent to which it provides guidance for determining whether the section 304(c) control requirement is met in public M&A transactions. Part IV provides our recommendations regarding future guidance for purposes of applying section 304 to public M&A transactions and reiterates the rather sensible recommendations set forth in a report published by the New York State Bar Association Tax Section last year.¹

I. Policy of Section 304

A. General Overview of Section 304

Section 302 governs distributions in redemption of corporation stock other than in complete liquidation. If a redemption is described in section 302(b), it is treated as partial or full payment in exchange for the stock regarding which gain or loss may be recognized.² Otherwise, the redemption is treated as a distribution to which section 301 applies.³ First, the distribution is treated as a dividend to the extent of the corporation’s current and accumulated earnings and profits; second, the non-dividend portion reduces the shareholder’s tax basis in the stock; and, finally, to the extent the non-dividend portion exceeds the tax basis, the excess is gain from the sale or exchange of property.⁴ Whether a redemption is described in section 302(b) (and, thus, is treated as a sale or exchange) generally depends on the extent to which the redemption alters the redeemed shareholders’ proportionate ownership interests in the stock of the redeeming corporation.⁵ The extent of the alteration is determined under the attribution rules of section 318(a), subject to modifications,⁶ and after taking into account later transactions that occur as part of the same plan.⁷

Section 304 was enacted “to prevent the inappropriate bailout of corporate earnings and profits as either capital gain or return of capital by extending the reach of [section] 302 to stock sales between related corporations under common ‘control.’”⁸ Absent this antiabuse provision, a person that controls two corporations could avoid dividend treatment even while extracting cash from corporate solution without altering its proportionate ownership in either corporation by causing one corporation to purchase the stock of the other corporation. Section 304 was designed to prevent these abuses by recasting stock sales between related corporations under common control as distributions in redemption of the stock of the acquiring corporation that must be tested for dividend- or sale-or-exchange-equivalence under section 302 rules.

The application of section 304(a)(1) may be illustrated by the following basic example: An individual (I) owns 100 percent of the outstanding stock of each of two corporations (A and T). The T stock has a tax basis of $100 and a value of $150. A has E&P of $300. I wants to cause A to distribute E&P but does not want to pay tax on the full amount of the dividend. Therefore, instead of causing A to make a distribution, I causes A to purchase all of I’s T stock in exchange for $150, intending to pay tax on only $50 of capital gain recognized regarding the stock sale.

Because I controls A (the acquiring corporation) and T (the issuing corporation) within the meaning of section 304(c), section 304(a)(1) applies to recast the transaction as a distribution in redemption of the stock of A under section 302. Because I’s proportionate ownership interest in T remains the same after the transaction (that is, I continues to indirectly own 100 percent of the stock of T by attribution from A),⁹ the distribution is not treated as a sale or exchange of the A stock under section 302(a) but as a distribution to which sections 302(d) and 301 apply. Because A has E&P over the distribution amount, the distribution to I ($150) is treated as a dividend out of the E&P.¹⁰

B. History of Section 304(c) Control

The predecessor to section 304 was enacted in response to Wanamaker Trust,¹¹ in which a shareholder’s sale of stock of one controlled corporation to a wholly owned subsidiary of the corporation was held not to be substantially equivalent to a dividend under the predecessor to section 302(b)(1).¹² Under section 115(g)(2), as enacted in 1950, if an acquiring corporation acquired the stock of an issuing corporation, and the issuing corporation directly or indirectly controlled (that is, owned at least 50 percent of the vote or value of the stock of) the acquiring corporation, the amount paid constituted a dividend from the issuing corporation to the extent it would have been considered that if paid by the issuing corporation in redemption of its stock.¹³ Thus, under the 1950 law, the scope of the antiabuse provision was restricted to bailouts of E&P through purchases of stock of a parent corporation by the corporation’s direct or indirect subsidiary; however, a broader scope of application was considered and rejected.¹⁴

In 1954 section 304 was expanded to apply to acquisitions of stock of an issuing corporation by an acquiring corporation when the corporations are directly or indirectly controlled by the same persons.¹⁵ Since 1954 section 304(a)(1) has provided that if one or more persons control two corporations and, in return for property, one of the corporations acquires stock in the other from those persons, the property is treated as distributed in redemption of the acquiring corporation’s stock. Further, since then, section 304(c)(1) has provided that for these purposes, control means ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or at least 50 percent of the total value of shares of all classes of stock.¹⁶ Also since then, control has been determined using modified attribution rules under section 318(a); however, those rules as relevant to section 304(c) have been amended.

The attribution rules of section 318 (both under the 1954 Act¹⁷ and under current law) provide that for some purposes: (1) partners are treated as proportionately owning stock owned by or for a partnership;¹⁸ (2) a partnership is treated as owning stock owned, directly or indirectly, by or for its partners;¹⁹ (3) a shareholder that owns at least 50 percent of a corporation’s stock value is treated as proportionately owning stock owned, directly or indirectly, by or for the corporation;²⁰ and (4) a corporation is treated as owning stock owned, directly or indirectly, by or for a shareholder that owns at least 50 percent of the corporation’s stock value.²¹ Under the 1954 Act, for purposes of determining control under section 304(c), the attribution rules of section 318(a) applied, except that section 318(a)(2)(C) was applied without regard to its 50 percent limitation.²² As a result, for purposes of section 304(c), if a shareholder owned any stock of a corporation, the corporation was treated as owning any stock owned or treated as owned by or for the shareholder.²³ As discussed below, the scope of the attribution rules for purposes of section 304 was narrowed in 1984.

In 1982 the definition of control for purposes of section 304 was further expanded under section 304(c)(2), which provides that (1) stock of the acquiring corporation received by one or more persons in exchange for issuing corporation stock is taken into account in determining whether the persons are in control of the acquiring corporation, and (2) two or more persons in control of an issuing corporation who transfer the stock of the corporation to an acquiring corporation and, after the transfer, are in control of the acquiring corporation are considered to be in control of each corporation.²⁴ Thus, when persons transfer issuing corporation stock and retain or acquire an interest in the acquiring corporation, this interest is taken into account for purposes of determining whether the same persons are in control of both corporations, even if they do not receive any property other than stock of the acquiring corporation in the exchange (that is, if some persons that transfer stock receive property).²⁵

In 1984 the scope of the section 318(a) attribution rules was narrowed for purposes of determining section 304(c) control.²⁶ A de minimis rule was added so that there is attribution of stock ownership only between a corporation and a shareholder that owns at least 5 percent of the value of its stock.²⁷ Also, a rule was added to provide that if a shareholder owns less than 50 percent of a corporation’s stock, the corporation is attributed stock ownership from the shareholder only in proportion to the value of the shareholder’s stock.²⁸ The attribution rules were narrowed because of their tendency to disqualify stock acquisitions as qualified stock purchases under section 338 (that is, taxable purchases by one corporation of 80 percent of the stock of another corporation within a 12-month period for which an election is available to treat the transaction as an asset acquisition) when any amount of stock of the target corporation and acquiring corporation was owned by the same persons.²⁹ The attribution rules set forth under the 1984 Act for purposes of section 304 remain in effect.

II. Section 304 and Public M&A Transactions

A. Inapplicability of Section 304 Policy in Public M&A Transactions

As discussed above, section 304(a) was designed to prevent shareholders from engaging in structured transactions to facilitate the bailout of E&P. Although the policy makes sense for transactions involving closely held corporations, it is less compelling for public M&A transactions when the stock is widely held by shareholders with no ability to influence corporate affairs. As the NYSBA report explains:

Thus, because of the limited ability of shareholders to influence the economic decision-making of widely held publicly traded corporations, a public M&A transaction is unlikely to constitute the type of abusive transaction for which section 304(a) was enacted.³¹ Congress appears to have acknowledged the difference in policy considerations for publicly traded and closely held corporations when drafting the corporate reorganization provisions in the 1954 Act. Indeed, the 1954 House bill distinguished between publicly held and closely held corporations and created tighter restrictions for reorganizations of closely held corporations because publicly held corporations are less likely than closely held corporations to engage in corporate reorganizations to facilitate bailouts of corporate E&P to shareholders.³² This distinction was excluded from the 1954 Act because of the difficulty of precisely distinguishing between publicly held and closely held corporations and concerns about granting preferential tax treatment to larger corporations.³³

B. Complexity of Determining Section 304(c) Control in Public M&A Transactions

As the NYSBA report explains, determining whether the control requirement is met in public M&A transactions is “exceedingly difficult (and indeed, often impossible).”³⁴ The NYSBA report describes circumstances that contribute to this difficulty or impossibility. First, “in light of the growing presence of broad-based index mutual funds and industry-specific exchange-traded funds as well as hedge funds, merger arbitrageurs and other traders, two publicly traded corporations in the same industry are likely to have significant overlap in shareholder bases even where the ownership of each corporation is relatively dispersed.”³⁵ In short, two publicly traded corporations whose stocks are widely held are likely to have numerous common shareholders, so whether section 304(c) control exists likely needs to be considered for any public M&A transactions. “Often, this overlapping ownership is attributable in part to brokers holding the stock of either corporation in ‘street name,’ and may not represent beneficial ownership from a tax perspective,” the report continues.³⁶ Consequently, it may be difficult to determine the extent to which there is overlapping ownership of publicly traded corporations.

Second, “as a practical matter, a publicly-traded corporation generally cannot reliably identify its beneficial stockholders apart from those beneficial owners that are required to provide ownership information under applicable securities laws (e.g., on Securities and Exchange Commission (‘SEC’) Schedule 13D or Schedule 13G). While some sophisticated services exist that can provide more information, the reliability of such information is limited to a moment in time and availability of information to that service.”³⁷ The beneficial owners required to provide ownership information under applicable securities laws generally include only persons that own at least 5 percent of the stock of the corporation.³⁸ Thus, a publicly traded corporation is likely to have ready access to reliable information only about shareholders that own at least 5 percent of its stock.

Finally, as discussed above, section 304(c) control is determined under the attribution rules of section 318, subject to modifications. In accordance with those rules as modified, for example: (1) partners are treated as proportionately owning stock owned by or for a partnership; (2) a partnership is treated as owning stock owned, directly or indirectly, by or for its partners; (3) a shareholder that owns at least 5 percent of the value of the stock of a corporation is treated as proportionately owning stock owned, directly or indirectly, by or for the corporation; (4) a corporation is treated as owning stock owned, directly or indirectly, by or for a shareholder that owns at least 50 percent of the value of the corporation stock; and (5) a corporation is treated as owning stock owned, directly or indirectly, by or for a shareholder that owns at least 5 percent but less than 50 percent of the value of the stock of the corporation in proportion to the value of the corporation stock owned by the shareholder.³⁹ The attribution rules are extremely difficult to apply in the context of a public M&A transaction because of the quantity of shareholders, the fluidity of their ownership, and the lack of information about shareholders that are not required to report their ownership interests in SEC filings. Each of these complexities is compounded by the potential for multiple tiers of ownership (that is, through partnerships, corporations, and other entities) that must be considered under the attribution rules and the numerous classes of stock and other equity interests that need to be valued and analyzed. As the NYSBA report explains regarding the partnership attribution rules:

The difficulty of applying the attribution rules to public M&A transactions can be illustrated by the following example. Assume that all persons are unrelated and all equity interests are held by unrelated persons except to the extent provided below. Both the acquiring corporation (A) and target corporation (T) are publicly traded and their stocks widely held. A plans to acquire 100 percent of the stock of T from its shareholders in exchange for cash. Five partnerships (P1, P2, P3, P4, and P5) and a corporation (C1) are publicly traded, and their equity interests are widely held. P1 directly owns 2.5 percent of the stock of A. P2 directly owns 40 percent of the stock of A and 5 percent of the stock of T. P3 directly owns 5 percent of the stock of A and 40 percent of the stock of T. C1 directly owns 25 percent of the stock of T. P4 directly owns 1 percent of the partnership interests of P1. P5 directly owns 2.5 percent of the stock of T, 1 percent of the partnership interests of P1, and 10 percent of the stock of C1. An individual (I1) directly owns 2.5 percent of the stock of A and 1 percent of the partnership interests of P4. A second individual (I2) directly owns 2.5 percent of the stock of T and 1 percent of the partnership interests of P5. Assume that all the other stock of A and T is widely held. The relevant entities and ownership interests are depicted below.

Presumably, based on publicly available information (for example, SEC forms 13D and 13G), the parties should be able to identify the direct interests in A and T held by P2, P3, and C1, and the direct interest in C1 held by P5 because the equity of those entities is publicly traded and the direct interests of those entities are at least 5 percent. Based on that information, it is apparent that the same persons — P2 and P3 — directly own 45 percent of the stock of both A and T. Also, based on that information, it should be possible to determine that P5 is treated as owning 2.5 percent of the stock of T through its interest in C1 (that is, 10 percent interest of P5 in C1 * 25 percent interest of C1 in T = 2.5 percent interest of P5 in T) consistent with section 318(a)(2)(C).

However, information would unlikely be readily available to identify the direct less-than-5-percent interests of P1 in A; P4 in P1; P5 in T and P1; I1 in A and P4; or I2 in T and P5. Still, P1 would be treated as owning 5 percent of the stock of A on account of P1’s 2.5 percent direct interest in A and the 2.5 percent interest constructively owned by P1 under section 318(a)(3)(A). Specifically: (1) because I1 owns an interest (1 percent) in P4, I1’s 2.5 percent direct interest in A is attributed to P4; and (2) because P4 owns an interest (1 percent) in P1, P4’s 2.5 percent indirect interest in A attributed from I1 is attributed to P1. Similarly, under section 318(a)(3)(A), P1 would be treated as constructively owning 7.5 percent of the stock of T. Specifically: (1) because I2 owns an interest (1 percent) in P5, I2’s 2.5 percent direct interest in T is attributed to P5; and (2) because P5 owns an interest (1 percent) in P1, P5’s 2.5 percent direct interest in T and its 5 percent indirect interest in T attributed from C1 and I2 (that is, 2.5 percent each) are attributed to P1.⁴¹

Based on the application of the foregoing attribution rules, A plans to acquire the stock of T in exchange for property (cash) from persons that control each of A and T within the meaning of section 304(c). Specifically, 50 percent of the stock of A is owned by P1, P2, and P3,⁴² and 52.5 percent of the stock of T is owned by P1, P2, and P3.⁴³ Consequently, section 304(a) applies to recast the stock purchase as a distribution in redemption of the stock of A, and it must be determined whether that deemed distribution is treated as a sale or exchange under section 302(a) and (b) or as a distribution to which sections 302(d) and 301 apply and which may give rise to the distribution of a taxable dividend. Problematically, the determination that section 304(a) applies to the transaction depends on obtaining not only nonpublicly available information about small minority interests in corporations the stock of which is publicly traded and widely held (that is, the 2.5 percent interests of P1 and I1 in A and of both P5 and I3 in T), but also nonpublicly available information about small minority interests in multiple tiers of partnerships the interests in which are widely held (that is, the 1 percent interests of P4 and P5 in P1, of I1 in P4, and of I2 in P5).

The foregoing example, of course, is overly simplistic, and there may be significantly greater complexity in real-world scenarios, such as those in which there are not shareholders that own large minority interests and in which there are numerous overlapping small minority interests and numerous tiers of public and nonpublic investment entities. The complexity may be exacerbated in situations in which the acquiring corporation issues its stock (in addition to property) in exchange for the stock of a target corporation because the stock must be considered for determining whether the section 304(c) control requirement is satisfied.⁴⁴ The fluidity with which stock is held and traded and the possibility for multiple classes of stock and other equity instruments, including options, further muddy the waters.

In summary, it is often difficult, if not impossible, to determine whether the section 304(c) control requirement is met in public M&A transactions because publicly traded corporations with widely held stock commonly have overlapping ownership, there is no readily available and reliable source of information to determine the stock ownership of these corporations by persons not required to report their ownership in SEC filings, and the attribution rules of section 318 as modified for purposes of section 304(c) are complex and broad.

C. Practical Problems Because of Inability to Determine Section 304(c) Control

The inability to determine section 304(c) control in public M&A transactions gives rise to uncertainty regarding the characterization and consequences of these transactions, which, in turn, creates difficulties in complying with reporting requirements and withholding obligations.

If section 304(a)(1) applies to an acquisition of the stock of an issuing corporation by an acquiring corporation, there may be reporting requirements and withholding obligations regarding the deemed distribution in redemption of the acquiring corporation’s stock. For example, if section 301 applies and results in a dividend, the distributor is generally required to timely file with the IRS an information return on Form 1099-DIV and furnish the form to each distributee.⁴⁵ If a foreign shareholder receives a U.S.-source dividend, the distributor generally has a withholding obligation.⁴⁶ As explained in the NYSBA report, if the parties decide to conservatively assume that section 304 applies to the transaction for withholding and information reporting purposes or withholding agents decide to assume that section 304 applies because its potential application is disclosed as a risk in public SEC filings regarding the transaction, in the case of foreign shareholders, “filing a U.S. tax return and attempting to claim a refund of withheld amounts may not be an adequate remedy, since those non-U.S. holders will have limited knowledge (or ability to obtain knowledge) of the shareholder base of either the issuing corporation or the acquiring corporation in order to determine whether [section] 304 in fact applied to the transaction.”⁴⁷

Further, if a portion of a section 301 distribution is applied to reduce the tax basis of the stock regarding which the distribution is made, the distributor must timely report the distribution to the IRS on Form 5452.⁴⁸ Moreover, if a publicly traded corporation undertakes an organizational action that affects the tax basis of its stock (including a non-dividend distribution), the issuer is required to timely file with the IRS an information return on Form 8937 and either provide a copy of the form (or a written statement with the same information) to each security holder of record as of the date of the organizational action or post the required information on its website.⁴⁹ Finally, for some distributions in a corporation stock redemption to which section 302(a) and (b) applies, every significant holder redeemed (any person that owns at least 5 percent of the publicly traded stock of a corporation) must file a statement with its tax return for the tax year in which the redemption occurs under reg. section 1.302-2(b)(2). Thus, when section 304(a)(1) applies to an acquisition of the stock of one corporation by another, reporting and withholding obligations can apply.

Moreover, the application of section 304(a)(1) to an acquisition of the stock of one corporation by another may prevent the acquisition from qualifying as a “qualified stock purchase” under section 338(h)(3).⁵⁰ Section 338 generally provides that if one corporation purchases at least 80 percent of the voting power and value of the stock of another corporation within a 12-month period, an election may be made to treat the transaction as a purchase of the assets of the acquired corporation by a new corporation, resulting in a fair market value basis in the assets.⁵¹ For the election to be available, the stock acquisition must be a purchase, which does not include any stock acquisition in an exchange to which section 351 applies.⁵² If section 304(a)(1) applies to a stock acquisition, to the extent the resulting deemed distribution in stock redemption of the acquiring corporation is treated as a distribution to which section 301 applies, the transferor shareholder and the acquiring corporation are treated as if the transferor shareholder had transferred the issuing corporation’s stock to the acquiring corporation in exchange for the acquiring corporation’s stock in a transaction to which section 351(a) applies, and the acquiring corporation later redeemed the stock it was treated as issuing in the transaction in exchange for the property.⁵³ Thus, if section 304(a)(1) applies to a stock acquisition by a corporation, and the resulting deemed distribution in the stock redemption of the acquiring corporation is treated as a distribution to which section 301 applies, the acquisition is likely not a purchase under section 338(h)(3)(A), and no election may be made to treat the acquisition as an asset acquisition.⁵⁴ Because it is often difficult or impossible to determine whether the section 304(a)(1) control requirement is met in public M&A transactions, it may be impossible to determine whether a section 338 election may be made even in the context of an all-cash stock acquisition.⁵⁵

Finally, other issues abound, including the effect of the transaction on E&P and whether the payment can qualify for a dividend received deduction under section 245.

In summary, as stated in the NYSBA report, “uncertainty regarding the scope of [section] 304 imposes unnecessary compliance burdens on taxpayers (as well as Treasury in the event of an audit or other enforcement action).”⁵⁶ This makes it difficult or impossible for the parties to public M&A transactions to determine the proper characterization and consequences of these transactions for tax purposes and to correctly and timely comply with the reporting and withholding requirements.

III. The Ruling

A. General Facts and Analysis

In LTR 202141005, the domestic common parent of a worldwide group of entities and a U.S. consolidated group of corporations whose stock is publicly traded and widely held (Parent), through one of its wholly owned domestic subsidiary corporations (Acquiring), acquired 100 percent of the outstanding stock of a foreign parent corporation (Target) in exchange for cash and Parent stock. Target was the common parent of a worldwide group of entities, and its stock was — before the acquisition — publicly traded and widely held. Several institutional investors owned shares in both Parent and Target through various mutual funds and exchange-traded funds before the Acquisition. Consequently, there was potential for the Acquisition to be treated as a transaction described in section 304(a)(1). A high-level illustration of the relevant entities and ownership interests is depicted below.

To determine whether section 304 was applicable to the Acquisition, Parent attempted to identify information about the stock ownership of its and Target’s shareholders. First, Parent reviewed publicly available shareholder information from SEC schedules 13D and 13G and SEC forms 13F, 10-K, 10-Q, 3, and 4 as of the closest point in time preceding the Acquisition and the closest reporting date after the Acquisition. Based on those filings, Parent was able to determine the number of shares of Parent and Target that were issued and outstanding and information about the ownership of investors that held a 5 percent beneficial interest in Parent or Target, as applicable (the SEC 5 percent shareholders). Parent was also able to determine that each SEC 5 percent shareholder was not the ultimate beneficial owner (that is, the holder of the benefits and burdens of ownership other than legal title) of the stock of Parent or Target, as applicable, but instead managed individual funds that were the beneficial owners.

Second, Parent retrieved data sets from three subscription services and conducted a comparative analysis to determine the service with the most in-depth Parent and Target shareholder information on the date the Target stock was acquired. Based on this information, Parent could determine, as of that date: (1) the number of shares of Parent and Target issued and outstanding; (2) the number of shares of Parent or Target, as applicable, beneficially owned by each investment fund managed by an SEC 5 percent shareholder; and (3) the number of shares of Parent or Target, as applicable, beneficially owned by each Parent or Target officer and director (the investment funds in (2) and the officers and directors in (3), collectively, the original identified shareholders (OIS)). However, the total number of shares of each of Parent and Target issued and outstanding as reported by the subscription service was less than the shares issued and outstanding as reported in the SEC filings (the undisclosed shares).

Third, to identify the holders of the undisclosed shares, Parent contacted a transfer agent to obtain shareholder information regarding Parent and Target shares directly registered with the transfer agent. Through this, Parent was able to identify additional shareholders (new identified shareholders (NIS)) that held interests in Parent, Target, or both corporations. Based on this information, Parent determined the percentage of Parent shares owned by these shareholders after the Acquisition that were owned by the shareholders that held an interest in both corporations immediately before the Acquisition (the NIS percentage).

Fourth, Parent verified that the subscription service it used to identify the OIS included changes in the position of shares of the corporation for which an individual was an officer or director by (1) inquiring with its officers and directors about their stock ownership of Parent and Target, and (2) reviewing Target regulatory filings required by the Target jurisdiction takeover rules.⁵⁷ This revealed that the subscription service data set did not include shares held by an officer or director of one of the corporations for which the person was not an officer or director. Accordingly, Parent identified additional shares from the undisclosed shares that were held by an officer or director of the other corporation (collectively with the OIS and the new identified shareholders, the identified shareholders). However, the number of shares issued and outstanding as reported in the SEC filings remained more than the number of shares held by identified shareholders, and a percentage of the Parent and Target shares remained undisclosed.

Finally, Parent appeared to use a three-step method to estimate the “post-closing percentage of Acquiring shares owned indirectly by shareholders who held Target stock immediately before the Acquisition” (the overlap percentage). First, based on the exchange ratio of Parent shares for Target shares under the terms of the Acquisition, Parent computed the post-Acquisition percentage ownership of Parent stock by the Target shareholders received because of the Acquisition. Second, Parent grouped the identified shareholders into three categories based on their pre-closing share ownership: (1) those owning solely Parent shares; (2) those owning solely Target shares; and (3) those owning both Parent and Target shares (the overlapping shareholders). Parent calculated the post-closing percentage ownership of Parent stock by the overlapping shareholders considering both the number of Parent shares issued to these shareholders in exchange for Target stock in the Acquisition and the number of Parent shares held by these shareholders before the Acquisition. Third, Parent extrapolated the NIS percentage to the remaining undisclosed shares to estimate the overlap for these shares. The ruling then states that “taking into account the due diligence described above to identify the Identified Shareholders and the inability to identify the shareholders of the remaining Undisclosed Shares, Parent calculated that the [overlap percentage]” was less than 50 percent.

Parent represented that it “performed all means available by which to identify the holders of the Parent Undisclosed Shares and Target Undisclosed Shares immediately before the Acquisition (or at the closest point in time preceding the closing of the Acquisition for which the relevant information is available) that would not be unreasonable, impractical, or unduly burdensome to perform.” Also, Parent represented that it had “no actual knowledge that would give it reason to believe that there is sufficient overlap in ownership among the holders of the Parent Undisclosed Shares and Target Undisclosed Shares that would result in an acquisition of control, as defined in section 304(c), of Acquiring by virtue of their ownership of Parent stock.”

Based on these facts and representations, the IRS ruled that section 304 did not apply to the exchanges of Target stock for cash and Parent stock in accordance with the Acquisition.

B. Scope of the Ruling and Unanswered Questions

Because of the complexities of determining section 304(c) control in public M&A transactions and the practical problems from the inability to make this determination, guidance is needed. In that regard, the ruling represents a welcome development. It also represents an opportunity for taxpayers to seek additional assurance through the private letter ruling process. As discussed below, we commend the IRS for seeming to consider some of the recommendations in the NYSBA report in rendering the ruling — recommendations we view as sound and sensible, consistent with the aim of the statute, and facilitative of tax law administration.

We also note significant limitations of the ruling and questions and uncertainty that arise from the ruling itself, specifically that it consists solely of the facts, representations, and ruling summarized in Part III of this article. It contains no analysis or guidance on the appropriateness of any method or conventions for determining section 304(c) control. Further, because the taxpayer engaged in an exhaustive due diligence exercise to determine the shareholder interests and broadly represented that it performed “all means available” that were not “unreasonable, impractical, or unduly burdensome” to make this determination, one may justifiably question whether the ruling provides any guidance regarding sufficiency of any method. Indeed, that the taxpayer made such a broad representation may suggest that the IRS is not amenable to any specific procedures or simplifying conventions for determining section 304(c) control and that only case-by-case is the IRS willing to consider whether a taxpayer has undertaken all the necessary actions to obtain all relevant information. Consequently, the ruling does not provide the level of guidance suggested by the NYSBA report or clearly indicate whether the IRS is amenable to the recommendations set forth therein. Thus, additional guidance is still needed regarding the sufficiency of evidentiary considerations.

Also, the ruling indicates that if a taxpayer engages in an exhaustive due diligence exercise and undertakes all actions that are not unreasonable, impractical, or unduly burdensome to identify the interests of all shareholders, but the taxpayer is unable to identify all relevant interests, the taxpayer may estimate unidentified ownership interests for purposes of determining section 304(c) control in public M&A transactions. Consequently, taxpayers will likely engage in similar due diligence exercises and develop similar estimation methods to obtain private rulings or perform a sensitivity analysis to support a conclusion on the tax treatment of public M&A transactions.⁵⁸ In the ruling, Parent extrapolated the NIS percentage to the remaining undisclosed shares to estimate the overlap percentage. Clearly, this method was sufficient for purposes of the ruling. But it provides no guidance on why the NIS percentage — instead of the percentage of overlapping ownership of the OIS identified through SEC filings and subscription service data sets — provided a reasonable or better basis for estimating shareholder overlap regarding the undisclosed shares. For example, was the NIS percentage greater than the percentage of overlapping ownership of the OIS so that the use of the former percentage was a more conservative estimation? Alternatively, did the NIS percentage provide the taxpayer with a more favorable estimation, albeit one that was acceptable to the IRS? Further published guidance regarding appropriate methods for estimating unidentified ownership interests would help provide taxpayers with direction and greater certainty for purposes of determining section 304(c) control in public M&A transactions. We also note that Cohan⁵⁹ and its progeny might provide taxpayers with guidance regarding that issue.⁶⁰

Perhaps, most notably, the ruling raises unanswered questions about ownership attribution. As discussed above, section 304(c) control is determined under the attribution rules of section 318(a) with modifications. Recall that the ownership of stock by a partner is attributed to a partnership in which it owns any interests for section 318(a)(3)(A) purposes. This attribution is colloquially referred to as downward attribution. For example, in the context of Illustration 2, I1’s direct ownership of A is attributed to P4 because of its 1 percent ownership of P4, and then this ownership by P4 is attributed to P1 on similar grounds. Similar rules apply to attribute ownership to P5 and additional ownership to P1.

In the ruling, the taxpayer identified numerous funds managed by SEC 5 percent shareholders that were identified as owning interests in Parent or Target. Presumably, many of the funds were treated as partnerships for U.S. federal tax purposes. The ruling indicates that “it was necessary to identify the individual funds that owned stock in Parent, Target, or both corporations.” But the ruling does not discuss downward attribution of ownership to these partnerships or describe any steps that the taxpayer took to determine to what extent the funds that were the ultimate beneficial owners of Target should be attributed ownership of Acquiring through their partners’ direct, indirect, or constructive ownership of Parent, including through another fund that was a beneficial owner of Parent. There could have been a greater overlap percentage if any person that owned direct or indirect interests in a managed fund identified as owning solely stock of Parent also directly or indirectly owned interests in Target through ownership of interests in managed funds that owned those interests.

Does the IRS’s acceptance of the taxpayer’s overlap percentage calculation without any significant discussion of the issue imply that the IRS agreed to relax the downward attribution rules in the context of public M&A transactions, at least when the taxpayer obtains a private letter ruling? On one hand, the ruling could be read as limiting the attribution inquiry to persons and entities that directly own at least 5 percent of the stock of the putative issuing corporation or acquiring corporation (as the only indirect ownership that appears to have been considered is the beneficial ownership of stock by funds managed by the SEC 5 percent shareholders). On the other hand, attribution of ownership may have been handled during the supplemental submission process and simply determined to not be an issue in this transaction. However, the ruling contains none of the typical references to any supplemental submissions, and there is no indication that the potential for overlapping funds and downward attribution was considered by the IRS or the taxpayer. Perhaps, while performing exhaustive due diligence in determining direct overlapping ownership, the potential for a greater overlap percentage because of partnership attribution fell out of focus and was not considered. In fact, the only express determination made regarding ownership by the managed funds was that those funds were the ultimate beneficial owners of the stock legally held by the SEC 5 percent shareholders.

IV. Recommendations

In Part IV, we review the NYSBA report recommendations, which we generally view as a sound and sensible way to narrow section 304 in the context of public M&A transactions. Next, we analyze the extent to which those recommendations are reflected in the ruling. Finally, we add our own observations and recommendations.

A. The NYSBA Recommendations

The stated goal of the NYSBA report is to “narrow the application of [section] 304 where the risk of anti-bailout concerns [is] particularly low and the administrative burden on taxpayers and the government to determine the applicability of [section] 304 is relatively high.”⁶¹ Accordingly, the report recommends four counting conventions for purposes of determining whether section 304(c) control is met in public M&A transactions.⁶²

The first recommendation is to generally require only the ownership of shareholders that own at least 5 percent of the stock of a corporation to be taken into account for determining section 304(c) control in public M&A transactions.⁶³ The NYSBA report argues that this 5 percent convention is consistent with various code provisions that differentiate between smaller and larger shareholders, including:

• reg. section 1.355-7(h)(3), which applies a 5 percent threshold for purposes of identifying controlling shareholders for distributions under section 355;

• section 382(g), which generally limits the determination of whether a corporation has undergone an ownership change to changes in shareholder ownership that meets the threshold;

• reg. section 1.367(a)-3(b), which generally exempts shareholders whose ownership does not meet the threshold from the requirement of a gain recognition agreement for outbound corporate nonrecognition transactions; and

• section 897(h)(5)(B)(iv) and reg. section 1.897-1(c)(2)(iii)(A), which generally exempt foreign shareholders of publicly traded corporations whose ownership does not meet a 5 percent threshold from the recognition rules regarding dispositions of stock of domestic corporations treated as U.S. real property interests.⁶⁴

The report argues that the 5 percent convention is consistent with modification of the attribution rules of section 318(a) under section 304(c)(3)(B).⁶⁵ Indeed, in 1984 the scope of these attribution rules was narrowed.⁶⁶ The 1984 Act added a de minimis rule so that there is attribution of stock ownership only between a corporation and a shareholder that owns at least 5 percent of the value of the corporation’s stock.⁶⁷ The report states that “if it is not appropriate to attribute the assets of a corporation to a holder of less than [5 percent] of the stock of that corporation, it seems similarly sensible (at least in the context of a public M&A transaction) to exclude these small shareholders from the calculation of ‘control’ under” section 304(c).⁶⁸

The NYSBA report also argues that the convention is consistent with U.S. securities laws.⁶⁹ “Specifically, owners of [5 percent] or more of the stock of publicly traded corporations are generally required to file periodic statements with the SEC identifying and detailing their ownership interest in the corporation,” by filing SEC schedules 13D and 13G.⁷⁰ As the NYSBA report notes, temporary regulations under section 382 authorize a loss corporation with stock registered with the SEC to rely on the existence and absence of schedules 13D and 13G (or similar schedules) to identify the corporation’s shareholders who have a direct ownership interest of at least 5 percent on a particular date for purposes of determining whether the corporation has undergone an ownership change.⁷¹ Although stock ownership is not always defined in the same way for SEC and federal income tax purposes, the ability of taxpayers to rely on SEC filings enhances administrability and reduces uncertainty.⁷²

The NYSBA report’s second recommendation is to create an exception to the 5 percent convention to require corporations in public M&A transactions to consider stock owned by officers and directors for determining whether the section 304(c) control requirement is met (the O&D convention).⁷³ The report explains that the convention is analogous to reg. section 1.367(a)-3(c)(1)(ii) rules, which require ownership of officers and directors of a domestic target corporation to be considered for determining whether U.S. owners of the target corporation have control of the foreign acquiring corporation immediately after the transfer of the stock of the target corporation to the acquiring corporation.⁷⁴ The reason for creating an exception to the 5 percent convention for officers and directors is that they may be “in a position to facilitate a bailout transaction even if they own a relatively small amount of stock of either” the issuing or acquiring corporation.⁷⁵

The NYSBA report’s third recommendation is to require that for purposes of determining whether the section 304(c) control requirement is met in public M&A transactions, either: (1) information in SEC schedules 13D and 13G may be relied on like that in reg. section 1.382-2T(k) (the SEC filing convention); or (2) in addition to this information, actual knowledge and publicly available information must be considered (the actual knowledge convention, and together with the SEC convention, the information conventions).⁷⁶

Reg. section 1.382-2T(k)(1)(i) authorizes a loss corporation with stock registered with the SEC to rely on the existence and absence of filings of schedules 13D and 13G (or similar schedules) to identify the corporation’s shareholders who have a direct ownership interest of at least 5 percent on a specific date for determining whether the corporation has undergone an ownership change. A loss corporation has a duty to inquire as to actual ownership of its stock by shareholders so identified, but it generally has no further obligation to determine actual stock ownership.⁷⁷ However, if the loss corporation has actual knowledge of stock ownership on a testing date or acquires this knowledge before the date the income tax return is filed for the tax year in which the testing date occurs, the loss corporation is generally required to take this actual knowledge into account for determining whether an ownership change has occurred on the testing date (except for permissible presumptions).⁷⁸ For purposes of section 382, investment advisers, who are not the actual economic owners of the stock and hold it for clients that do not own at least 5 percent of the stock and are not acting in concert in acquiring, holding, or disposing of the stock based on information in applicable SEC filings, are not treated as 5 percent shareholders.⁷⁹

The majority of the NYSBA Executive Committee supports the SEC filing convention, which would incorporate rules like those described in the preceding paragraph for purposes of identifying 5 percent shareholders and determining whether the section 304(c) control requirement is met in public M&A transactions. However, the recommendation appears to dispense with the requirement that actual knowledge be taken into account.⁸⁰ Alternatively, a significant minority of the executive committee recommends the actual knowledge convention, which would require the parties to take into account actual knowledge and conduct due diligence to obtain publicly available information beyond that reflected in schedules 13D and 13G.⁸¹ This information would include SEC Form 13F (filed by large investment managers), voluntary disclosures to investment research companies, and voluntary postings on investors’ or investment advisers’ websites.⁸² The report notes that the IRS has permitted taxpayers to consider this additional publicly available information in determining whether section 355(e) applies to public M&A transactions.⁸³ For the latter approach, the NYSBA report recommends that guidance be provided regarding the sources from which taxpayers are expected to seek publicly available information so that taxpayers are able “to determine with confidence whether the required amount of review of publicly available information has been completed.”⁸⁴

The final counting convention recommended by the NYSBA report is that taxpayers in public M&A transactions be permitted to apply the foregoing counting conventions reasonably in advance of the transaction’s closing (the pre-closing convention).⁸⁵ The report compares the pre-closing convention to the rules of reg. section 1.368-1(e)(2), which permit shareholders to measure the value of stock consideration for determining whether the nonstatutory continuity of proprietary interest requirement for reorganizations under section 368(a) is met as of the signing date of a transaction (rather than the closing date), and private letter rulings issued under section 355(e), which permitted taxpayers to rely on the most recently filed publicly available documents to determine whether section 355(e) applies to a transaction.⁸⁶ The report notes that section 304 “by its terms requires testing for ‘control’ as of the closing of a transaction.”⁸⁷ However, the report argues that allowing the determination of whether the section 304(c) control requirement is met reasonably in advance of the closing of public M&A transactions would prevent “arbitrary shifts in the parties’ shareholder base that naturally arise over time (including as a result of passive algorithmic trading) from affecting the result in” section 304.⁸⁸ Further, this allowance would simplify and enhance the ability of “withholding agents who must disburse transaction proceeds at (or shortly following) the time of the closing of a transaction” to timely comply with withholding obligations.⁸⁹ This allowance would aid taxpayers in timely making section 338 elections and satisfying the various compliance burdens described above. It would also help provide the relevant parties greater certainty regarding the actual economics and terms of public M&A transactions.

We view the four NYSBA recommendations as sensible counting conventions for limiting evidentiary considerations in determining section 304(c) control in public M&A transactions. We note internal disagreement among executive committee members regarding whether the IRS should apply the SEC filing convention or the actual knowledge convention. We note that the SEC filing convention would be more convenient for taxpayers than the actual knowledge convention and would facilitate dispute resolution, as it would limit consideration to specific public filings, as in section 382. However, we acknowledge that there is no basis under the law for limiting evidentiary considerations to the extent of the convention. Regardless of which convention is adopted, limiting evidentiary considerations in determining section 304(c) control in public M&A transactions to at least some extent is sensible both because the determination is often difficult or impossible and because these transactions are not likely to be undertaken for the abusive purposes that section 304 was designed to counteract. Further, the NYSBA recommendations are consistent with provisions of tax and securities laws. Adoption of the recommendations would enhance the administrability of section 304, provide taxpayers with greater certainty as to the tax consequences of public M&A transactions, and enable taxpayers to timely and correctly fulfill compliance and withholding obligations that arise in these transactions.

B. Implications of the Ruling for the NYSBA Recommendations

As noted, the ruling does not clearly adopt or indicate whether the IRS is amenable to the NYSBA recommendations. However, in some instances, the ruling provides some flavor of the NYSBA recommendations. First, the ruling does not indicate whether the IRS may be amenable to limiting the stock ownership considered for purposes of section 304(c) in public M&A transactions according to the 5 percent convention and the O&D convention. The ruling reflects that Parent conducted the inquiries recommended by the 5 percent convention and the O&D convention, but Parent seems to have been required to seek information beyond these shareholders. Parent identified the additional new identified shareholders by reviewing data sets from subscription services and a transfer agent. The ruling does not state that attempting to identify additional shareholders through subscription services and transfer agents is necessary for determining whether the section 304(c) control requirement is met in public M&A transactions. Still, one cannot infer from the ruling whether simply following the 5 percent convention and the O&D convention may be sufficient for a favorable determination.

Similarly, the ruling does not clearly indicate whether the IRS may be amenable to limiting information considered for purposes of section 304(c) in public M&A transactions according to either of the recommended information conventions. The ruling reflects that Parent began by considering information recommended by both the SEC filing convention and the actual knowledge convention (that is, Parent considered information from publicly available sources, including SEC forms and Target’s foreign regulatory filings, and represented that it had “no actual knowledge” as to the ownership of the remaining undisclosed shares). However, Parent also considered information from other available nonpublic sources, including data sets from subscription services, data sets from a transfer agent, and communications with officers and directors. The ruling does not state that consideration of all information sources considered by Parent is necessary for determining whether the section 304(c) control requirement is met in public M&A transactions. Yet, one cannot infer from the ruling that following either of the information conventions may be sufficient for a favorable determination; and a strong inference can be gleaned from the ruling that assessing information beyond publicly available information may be necessary.

Finally, the ruling does not indicate whether the IRS may be amenable to restricting the determination of whether section 304(c) applies in a public M&A transaction according to the pre-closing convention. The ruling reflects that Parent reviewed publicly available shareholder information from the SEC schedules and forms as of the closest point preceding the Acquisition and the closest reporting date after the Acquisition. Also, the ruling indicates that Parent considered data sets from the subscription service on the date the stock of Target was acquired, indicating that Parent did not have assurance that section 304 did not apply until after the Acquisition. While consideration of publicly available information as of the closest point before the Acquisition may be consistent with the pre-closing convention, consideration of post-closing information and information on the date of closing is not consistent with that convention. The ruling does not state that determination of the precise ownership percentages of all shareholders on the closing date is a necessary condition for determining whether the section 304(c) control requirement is met in public M&A transactions, and the ruling, in some instances, accepts information as of a date before the closing date — at least when closing date information cannot be obtained by means that are “not unreasonable, impractical, or unduly burdensome.” Nevertheless, one cannot infer from the ruling that following the pre-closing convention may be sufficient for a favorable determination.

In summary, the ruling does not clearly indicate whether the IRS is amenable to any of the NYSBA recommendations. Based on the facts and representations in the ruling, some broad inferences may be drawn regarding the sufficiency of methods of gathering and interpreting data for purposes of applying section 304(c) in public M&A transactions. Because of the breadth of those inferences, the ruling mainly underscores the need for further guidance on the issue. Absent further guidance, taxpayers ought to consider seeking a pre-submission conference with the IRS or approaching the IRS on a “no names” basis before beginning the endeavor of requesting a similar ruling.

C. Additional Recommendations

Ultimately, we view the ruling as a helpful step in the right direction because it indicates, at the very least, that if a taxpayer engages in an exhaustive diligence exercise and undertakes all actions that are not unreasonable, impractical, or unduly burdensome to identify the ownership interests of all shareholders, the taxpayer may be permitted to make some estimates of shareholder ownership percentages to account for unavailable information. However, based on the format of the guidance, the IRS may be unwilling to permit these estimates absent an ability to review the taxpayer’s proposed methods and estimates during the private letter ruling submission process.

We reiterate that determining section 304(c) control in public M&A transactions is often difficult or impossible and note that these transactions are not likely to be undertaken for the abusive purposes that section 304 was designed to counteract. The inability to make this determination renders taxpayers and the IRS unable to determine the proper tax treatment of these transactions and timely and correctly satisfy compliance and withholding obligations. In this regard, we note that the ruling was requested by Parent on March 27, 2020, but not issued until about 15 months later on July 16 — after the Acquisition. Accordingly, the parties affected by the Acquisition did not have assurance as to the transaction’s tax consequences until after closing.

We believe that more formal and substantive guidance is needed to enhance the administrability of section 304 in public M&A transactions. We also believe that this guidance could be issued in the form of an IRS notice or revenue procedure as guidance in this format would allow taxpayers to timely assess the section 304 risk associated with a public M&A transaction. This guidance could establish broadly applicable counting conventions or even a safe harbor overlap percentage that, together with a sufficient level of documented inquiry and numerical analysis by taxpayers, would enable taxpayers to conclude on section 304(c) control absent complete ownership information. Alternatively, the safe harbor could be limited to providing taxpayers with only penalty protection. This guidance could also be narrowly tailored and, for example, be limited to public M&A transactions involving two more-widely held public corporations, neither of which has a majority or significant minority owner. Any guidance could be backstopped by an antiabuse rule or a rule limiting application of any safe harbor to public M&A transactions in which there is no plan to avoid application of section 304.

Also, this guidance could limit evidentiary considerations regarding determining attribution of ownership and provide guidelines for making estimates absent complete information. If, however, the IRS is not amenable to limiting evidentiary considerations with specific procedures and simplifying conventions (such as those recommended in the NYSBA report), more general guidance may be provided, such as in the form of an exemplary list of sources of information that should be considered and investigative procedures that should be followed by taxpayers. This list would provide taxpayers with greater certainty regarding their compliance with evidentiary burdens under section 304. Most importantly, any guidance issued by the IRS should address whether and under what circumstances a taxpayer may assume that no higher-tier equity owners exist such that there is not section 304(c) control because of ownership attribution under section 318(a)(3). Determining whether a structure entails the downward attribution of ownership is one of the greatest complexities in evaluating section 304(c) control in public M&A transactions. And if the private letter ruling process is a way to mitigate these complexities, then an IRS endorsement would be helpful to the sound administration of the tax law. While we acknowledge that the complexities of a section 304(c) control analysis may limit the IRS’s desire to or make it challenging for the agency to make broad pronouncements as to this analysis, we believe that a public M&A transaction is unlikely undertaken for an abusive purpose should mitigate this concern.⁹⁰