The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 8, March 1999, Panel Publishers, New York, NY.
CROSSING BORDERS: LEGITIMIZING OUTBOUND REORGANIZATIONS
By Robert W. Wood, San Francisco
Many tax lawyers, accountants, investment bankers and dealmakers are not familiar with the so-called outbound reorganization rules. Whenever a foreign corporation is involved in a merger or acquisition transaction, someone's antennae should go up to address the tax implications of that foreign status.
IRS Perceives Leaks
Let's look at an example of the kind of problem outbound reorganizations can present. In 1994, Helen of Troy expatriated by establishing a new company in Bermuda to which its shareholders conveyed their stock in exchange for all of the new company's stock. The restructuring was followed by certain asset transfers which enabled Helen of Troy to avoid the U.S. tax that would otherwise have been imposed on the Subpart F income generated by its erstwhile foreign subsidiaries.
Under the law then existing, this exchange of stock by Helen of Troy's shareholders was accomplished on a tax-free basis. The IRS was concerned that the Helen of Troy example would engender a host of similar transactions and, in the process, erode the U.S. tax base. Accordingly, it promptly issued Notice 94-46 in which it signaled its intention to alter the rules in this area. Such rules were issued several years later and are now embodied in Reg. Sec. 1.367(a)-3(c).
These Section 367 regulations are designed to discourage Helen of Troy-type transactions. They apply to cases in which a U.S. person exchanges his or her stock for stock in a foreign corporation in a transaction that would, if it only involved domestic corporations, qualify for tax-free treatment. The rules, therefore, are designed to distinguish between legitimate business combinations, which the I.R.S. was not seeking to discourage, and those undertaken, in its view, primarily for purposes of tax-avoidance.
The regulations provide that an exchange can qualify for tax-free treatment only if the following conditions are satisfied:
50% Rule for U.S. Transferors. The U.S. transferors (target shareholders
who are U.S. persons) must not receive, in the transaction, more than 50%
of the stock (by voting power or value) of the stock of the transferee.
For this purpose, All target shareholders are presumed to be U.S. persons
and this presumption can only be rebutted if the target obtains ownership
statements from its non-U.S. shareholders that attest to their status.
50% Rule for U.S. Persons. U.S. persons, who are officers, directors,
or 5% target shareholders, must not own, immediately after the transfer,
more than 50% of the stock of the transferee. There is an enforcement mechanism
for this. A U.S. person who becomes a 5% transferee shareholder must, for
his or her exchange to be tax free, enter into a five-year gain recognition
agreement. Such agreement is triggered if, during the five-year period
following consummation, the transferred corporation disposes of substantially
all its assets or the transferee disposes of all or a portion of such transferred
Active Trade or Business. The active trade or business test must be met. Such test is met if the transferee is engaged, outside the United States, for the entire 36-month period preceding the transfer, in the active conduct of a trade or business. In addition, the test also encompasses a substantiality test—such test requires that, at the time of the transfer, the value of the transferee be equal or greater than the value of the target.
A transaction that meets all these conditions is presumed to be a legitimate business combination that is entitled to tax-free treatment. But this may seem a pretty touch standard.
For example, the recent transaction involving Vodafone and AirTouch Communications points up a defect in these rules. Fortunately, the regulations allow the I.R.S. to rectify the problem. That transaction will be, more or less, a merger of equals. Accordingly, it is difficult for the parties to be sure that, at the time of the transfer, the value of the Vodafone stock will be equal, or greater, in value, than the stock of AirTouch Communications. However, by any standard, this business combination is clearly legitimate and is not the type of transaction that the I.R.S. is seeking to discourage.
Fortunately, in these cases, Reg. Sec. 1.367(a)-3(c)(9) provides the I.R.S. with the degree of flexibility it needs to avoid the disastrous consequences that could flow from a strict and literal application of the regulations. This regulation allows the I.R.S. to issue to the parties a tax-free ruling in cases in which the first two requirements listed above have been satisfied and the taxpayer is in substantial compliance with the dictates of the active trade or business test. In other words, it is a kind of 2½ = 3 application of the three requirements that can cut taxpayers some slack. Substantial compliance with the active trade or business test will be considered to exist in cases in which the value of the transferee's stock was greater than that of the target during a representative period prior to the business combination (see, in this regard, LTR 9903048).
Likewise, substantial compliance will be considered to exist in all cases in which, during a meaningful period prior to the combination, the transferee was the dominant constituent on the basis of certain operating measures, such as gross operating revenues, assets, or employees. (See LTR 9720024.)
This kind of flexibility should lead to a favorable ruling in the Vodafone/AirTouch case. In the process, it should smooth over at least some of the concerns of the arbitrage community, which has correctly noticed that obtaining a tax-free ruling is a condition to getting that deal consummated.
Crossing Borders: Legitimizing Outbound Reorganizations, Vol. 7, No. 8, The M&A Tax Report (March 1999), p. 6.