It used to be that only stock counted on the "plus side" of the continuity-of-interest equation, when it came to figuring out whether a transaction could garner tax-free treatment. But a new private-letter ruling by the Internal Revenue Service revisits the concept, with a surprising result. That is, in the case of so-called G reorganizations, warrants may do the trick as well as stock.
At its core, the ruling (LTR 201032009) — filed in May with an answer from the IRS released in August — provides guidance on income-tax consequences related to a series of proposed transactions that include bankruptcy proceedings. In the case described in the letter, a corporate taxpayer (TP) is in a situation in which it owns all of the stock of two subsidiary companies, Sub1 and Sub2. TP is a holding company that does not directly engage in the conduct of a trade or business.
On a day referred to as "petition date," TP and its subsidiaries voluntarily file with the U.S. Bankruptcy Court for Title 11 bankruptcy protection. The bankruptcy plan agreed upon calls for the "downstream" merger of TP with and into Sub1. The "senior claims" held by creditors of TP will be exchanged, in connection with the merger, for (1) new term loans and (2) new common stock and warrants ("new equity"). The general unsecured claims held by TP's creditors will be exchanged for a combination of new equity and cash. However, the holders of TP's common shares will receive no consideration with respect to their shares.
When the proposed transaction is completed, Sub1 will be the sole owner of the stock of Sub2, and each of Sub1 and Sub2 will continue their historical operations. Following the merger, Sub1 will have outstanding Class A voting common stock, "limited-vote" Class B common stock, and warrants to purchase Class B common stock. Each share of Class B common stock will be convertible into Class A common stock upon the satisfaction of certain unspecified "agency restrictions."
In its letter, the IRS concludes that the merger constitutes a reorganization within the meaning of the tax code — specifically, Section 368(a)(1)(G). Accordingly, no gain or loss will be recognized by TP with respect to the transfer of its assets to Sub11, and the latter will inherit the "tax attributes" of the former.2 (See LTR 201032009, May 12, 2010.)
This "G" reorganization is defined as a transfer by a corporation of all or part of its assets to another corporation in a Title 11 or similar case, but only if stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under Section 354, 355, or 356. In addition, the transaction must exhibit both continuity of interest (COI) and continuity of business enterprise (COBE).3 To meet the COI requirement, a "substantial part" of the value of the proprietary interests in the acquired corporation must be "preserved" in the potential reorganization. For this purpose, it is generally agreed that at least 40% represents a substantial part. (See Regulation Section 1.368-1T(e)(2)(v), Example 1.)
In the case described in the August ruling, TP will be under the jurisdiction of the Bankruptcy Court, which will have "signed off" on the restructuring plan. So for the distribution of stock or securities to meet the conditions of Section 354, the transferor must liquidate in accordance with the plan. In addition, the corporation to which the assets are transferred — Sub1 — must acquire "substantially all" of the transferor's assets.
Therefore, the IRS states in its letter that Sub1 will acquire the requisite quantum of TP's assets. Further, Sub1 will acquire more than 50% of the fair-market value of the gross assets held by TP as of the petition date — and more than 70% of the fair-market value of the "operating assets" held by TP as of such date. For this purpose, the ruling concedes that the stock of Sub1 and Sub2 (and intercompany debt owed by Sub1 and/or Sub2 to TP) will be treated as operating assets.
Ordinarily, the phrase "substantially all of the assets" means at least 90% of the fair-market value of the gross assets, and at least 70% of the fair-market value of the net assets. However, owing to the exigencies of bankruptcy, a more liberal definition has been adopted for G reorganization purposes. (See LTR 201025018, July 8, 2009.)
Further, the August ruling observes that the senior claim holders will be the most senior class of creditors to receive an "equity interest" in Sub1, and goes on to find that the merger exhibits a sufficient degree of COI. The ruling concludes that at least 40% of the fair-market value of the total consideration received by all such holders with respect to their proprietary interests will consist of new common stock and warrants. That is because of two important facts: (1) the value of the new equity and new term loans to be received by the senior claim holders and (2) the value of all consideration to be received by creditors with claims that are equal and junior to that of the senior claim holders.
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