Overview of Reorganizations
Reorganization is a transaction aspect of foreign corporate entry and exit activity that can have great importance in the considerations accompanying financial planning. To provide an adequate foundation to the fundamental understanding of reorganization considerations, a cursory overview of basic domestic, reorganization concepts is helpful.
These concepts can be divided into three types of reorganizing transactions. First, there are reorganizations deemed to be exiting the taxing jurisdiction of the United States. Second, reorganization transactions occur in the transnational process of the reorganization of a foreign corporation within a United States taxing jurisdiction. This would be a transaction structured in a manner that subjects it to United States taxing jurisdiction. Last, there is reorganization in which the taxing consequences involve the reorganization of one foreign corporation with another. In this regard, it is helpful to note where the terminology foreign corporation is used, the entity may be one that is owned by United States persons but regarded as a foreign corporation. These transnational activities fully expand the initial domestic fundamentals as they occur in the international market place.
A reorganization can conceptually be differentiated in a transactional sense as types of transactions that accomplish certain purposes. There are acquisitive forms of reorganization. (1) There is a reformation form of reorganization. (2) There are divisive reorganizations. (3) As with corporate organization and the nonrecognition domestic provisions of Section 351 of the Code, (4) a qualifying Section 368 reorganization (5) is provided nonrecognition treatment in transactional consequences that are provided a taxpayer in Sections 354, 356, and 361 of the Code. In turn, Section 367 of the Code and its taxing scheme seeks to modify the tax treatment accorded domestic reorganizations as it would apply to a foreign transaction.
Section 367 and Reorganizations
To facilitate an understanding of the role foreign corporate reorganizations play in financial planning, it is productive to appreciate the objectives of the transactional consideration. These are instances where the establishment of a new foreign corporate entity may not be desirable. Rather it may be advantageous to acquire an established business in the target foreign location.
There may be practical considerations dictating an acquisition as opposed to a new enterprise. Licensing and other regulatory considerations may have a bearing on such a determination. There may be circumstances where a foreign enterprise seeks to make a market expansion in the United States. However, it may make more financial sense to buy an existing, established United States enterprise to achieve this expansion. The tax consequences of such an acquiring transaction to United States shareholders of a target United States company may be such that an outright sale may not be prudent. Reorganization can remedy tax consequence concerns and promote fluid business activity.
In the organizational sense the acquisitive reorganization can be a significant financial tool in accomplishing these types of objectives. Also, during the actual operational phase of corporate activities, corporate reformations and recapitalizations can add important potentials. Reformative reorganizations may not necessarily have the same impact initially as an acquisitive reorganization. But in the duration of operational activities, it can offer important flexibility to the planner whether used to restructure debt and equity to satisfy banks, bondholders, and equity ownership percentages, or to attain various other corporate objectives.
Current market conditions may compel a need to change bond terms, and the reshuffling of the corporate structure is an attractive alternative to accomplish such a result. There may be instances when the corporate entity or entities find a need to increase per share earnings to better position the corporate entity for additional acquisitions or other financial transactions. (6) The utility of recapitalization provides an additional dimension to corporate planning. Though techniques of recapitalization may enable the practitioner to achieve certain goals, the initial capitalization or organization selection can preclude the necessity.
Along this same reasoning, the practitioner may anticipate an expansion of the corporate structure and an eventual division of shareholders. The divisive reorganization provides these alternatives and opportunities. Conceptually, the divisive reorganization embraces sheltered distributions. These corporate transformations contemplate spin-off’s, split-off’s, and split-up’s. A spin-off is a distribution by one corporation of the stock of a subsidiary corporation and is viewed in the context of a nonrecognition transaction as opposed to dividend treatment.
A split-off is the same as a spin-off with the exception that the shareholder of the parent company surrenders a part of his parent corporation stock in exchange for the stock of a subsidiary. In the scheme of nonrecognition of gain provided by the shelter of reorganization, it circumvents a taxable corporate redemption. A split-up, the third type of divisive reorganization, is a transaction in which the parent corporation distributes its stock in two or more subsidiaries in a complete liquidation. This circumvents a taxable liquidation and provides nonrecognition treatment in carrying out a business purpose. (7)
The treatment of exiting or outbound reorganizational transactions in the foreign setting becomes fundamental. The benefits that can be derived are important to the practitioner. A discussion of exit reorganization transactions amounts to a transferring of United States assets to a foreign corporation. Assets in this sense would be the stock of a domestic corporation or its actual assets. This would be an acquisitive reorganization in which a foreign corporation acquires the interest of United States shareholders or domestic corporate assets.
The consideration in return to the United States shareholders can be structured in the form of equity ownership of the foreign corporate transferee. The United States domestic corporate shareholder is in effect transferring appreciated stock in exchange for the stock of a foreign corporate transferee. The United States shareholder exchanges the domestic stock or assets of the domestic corporation and ends up with an equity ownership in a foreign corporation. Is it possible for such a transaction to be accorded nonrecognition treatment to a United States shareholder? It broaches the question of whether shareholders’ appreciated gain of the acquired company or the assets would go untaxed, and the United States shareholder would obtain ownership in a foreign corporation. The carryover cost basis would leave the shareholders with deferred gain on the nonrecognition exchange. A domestic reorganization would receive this type of transactional treatment. A foreign reorganization is treated differently.
As in the organizational consideration, Section 367 is intertwined with domestic nonrecognition provisions governing reorganizations. Section 367 of the Code generally overrides the nonrecognition reorganization provisions. It specifically supercedes the nonrecognition treatment Sections 354, 355, 356, and 361 of the Code provide to domestic transactions. With respect to international reorganizations, it further defines the consequences of corporate acquisition, reformation, and division as it relates to foreign entry and exit taxation.
As it does with the domestic organization nonrecognition provisions, Section 367 imposes an income tax upon various corporate reorganizations in which transfers exit United States taxing jurisdiction. This Code provision deems transfers of property to a foreign corporation in connection with an exchange otherwise sheltered in Sections 354, 355, 356, and 361 as taxable transfers. These basic nonrecognition Code sections in domestic reorganization provide shelter to Section 368 defined reorganizations. The basic nonrecognition treatment accorded a domestic reorganization is denied in an exiting reorganization. This is accomplished by deeming the transferee corporation, not to have corporate status for purposes of statutory construction. The nonrecognition treatment relies upon the statutory requirement that the transferee must be recognized as a corporation. (8)
A reorganization in which a United States person (9) transfers (10) property (11) to a foreign corporation is not, as a general rule, entitled to nonreocgnition of gain. On the other hand, where a reorganization results in a loss there is no recognition. (12) The gain to be recognized on such a reorganization is not to exceed the gain that would have been recognized on a taxable sale of property as though it were sold individually and without offsetting individual losses against individual gains. (13)
Where United States shareholders in an exiting reorganization are required to recognize gain, the character and source of gain are to be determined as though a taxable exchange occurred. Appropriate corresponding adjustments to earnings and profits, basis to shareholders, and other affected attributes to corporate entities are to be made. (14) Increases in the basis of property received by a foreign corporate transferee are allocated over the transferred property proportionately to the gain that is realized as to each item of property attributable to the United States person on transfer. (15)
Though in accordance with this rule a taxpayer is required to recognize gain, there are several benefits gained by a realization and recognition on reorganization. These benefits include such things as a reduction of a transferor’s accumulated earnings and profits and eventual dividend liability. A transferee corporation receives a stepped-up basis which reflects consideration attributable to the recognition of gain, and that in turn provides depreciation and amortization benefits. (16)
1. IRC Section 368 (a) (1) (A), (B), and (C) (1986).
2. IRC Section 368 (a) (1) (E) (1986).
3. IRC Section 355 (1986).
4. IRC Section 351 (1986).
5. With respect to divisive reorganizations Section 355 of the Code can be distinguished from Section 368 by virtue of the fact that Section 355 (a) (2) states that it is not to be applied without regard to whether or not distribution is in pursuance of a plan of reorganization within the meaning of Section 368 (a) (1) (D) . See Section 355 (a) (2) (C) (1986).
6. By way of illustration the following demonstrates this kind of technique: Y corporation has 20,000 outstanding shares of voting common stock and the earnings per share for a particular year are $1.00. If a qualifying recapitalization was implemented to achieve a resulting 10,000 outstanding shares of common stock, plus convertible bonds, the earnings per share would increase two-fold, bring to an acquisitive reorganization a more valued stock.
7. IRC Section 355 (1986).
8. Treas. Reg. Section 1.367 of the IRC of 1986 and as thereafter amended.
9. Treas. Reg. Section 1.367 of the IRC of 1986 and as thereafter amended.
10. Treas. Reg. Section 1.367 of the IRC of 1986 and as thereafter amended.
11. Treas. Reg. Section 1.367 of the IRC of 1986 and as thereafter amended.
12. Treas. Reg. Section 1.367 of the IRC of 1986 and as thereafter amended.
13. Treas. Reg. Section 1.367 of the IRC of 1986 and as thereafter amended.
14. Treas. Reg. Section 1.367 of the IRC of 1986 and as thereafter amended.
15. Treas. Reg. Section 1.367 of the IRC of 1986 and as thereafter amended.
16. IRC Section 1014 (1986).