The Upside to a Downstairs Merger

Can Retail Ventures Inc., the parent of shoe retailer DSW, be eliminated in a tax-efficient way?
Robert WillensMay 17, 2010

Retail Ventures Inc. (RVI) is a holding company whose principal asset is 62% of the stock of DSW Inc., a footwear retailer. From an organizational perspective, DSW has a “high vote/low vote” stock structure — with RVI holding all of the high-vote, Class B stock. In fact, RVI’s 62% equity interest translates into 93% of the voting power of all of DSW’s stock entitled to vote.

There are several other key structural facts to note, including that about 53% of RVI stock is owned by Schottenstein Stores Corporation (SSC), a closely-held company; RVI has accumulated approximately $320 million in federal net operating loss (NOL) carryovers; and RVI holds outstanding premium income exchangeable securities (PIES) — which are mandatory convertible securities. In this case, the PIES convert to a portion of RVI’s stock in DSW. That means that RVI has the option to “settle” the PIES in cash, or in a combination of cash and DSW stock. So if RVI were to “deliver” shares of DSW in satisfaction of these instruments, RVI would recognize a gain for tax purposes measured by the excess of the liability defrayed with the stock over RVI’s adjusted basis in such stock.

Downstairs Merger

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If the overall business objective was to eliminate RVI as the corporation standing between its shareholders and its DSW stake, at least two avenues exist for accomplishing this goal. The first would be a complete liquidation of RVI. In that event, the corporation would adopt a plan of liquidation and distribute its assets to its shareholders in complete cancellation of its stock. However, this approach would be anything but tax-efficient.

Indeed, the Internal Revenue Code — specifically Section 336(a) — states that a gain or loss is recognized by a liquidating corporation on the distribution of property in complete liquidation as if such property were sold to the distributee at its fair market value. Therefore, in a liquidation, the gain inherent in the DSW’s stock that RVI holds would be recognized. What’s more, a second level of tax would be assessed under the tax code’s Section 331(a).

Under Section 331(a), amounts received by a shareholder in a distribution resulting from a complete liquidation of a corporation are treated as in full payment in exchange for the stock. So, with respect to the stock surrendered in the liquidation, each shareholder of RVI would recognize a gain in the amount by which the value of the property he or she received in the liquidation that exceeded the shareholder’s adjusted basis. Based on the tax treatment alone, an outright liquidation of RVI will not, we are confident, be pursued.

Fortunately, the same economic outcome (eliminating RVI) that a liquidation delivers can be achieved via a “downstairs” or downstream merger. Unlike a liquidation, a downstairs merger does not have current tax consequences. To be sure, such a merger should constitute a reorganization within the meaning of Section 368(a)(1)(A), with the result that RVI will not recognize gain or loss on the “movement” of its assets to DSW. Further, RVI’s shareholders will not recognize gain or loss on the exchange of their RVI stock for shares in DSW.

Willens 05-17-10

Witness the decades-old case of Commissioner v. Estate of Gilmore1, in which a holding company called WFI owned a majority of the stock of an operating company, known as WWC. On October 28, 1935, the directors of each company executed an “agreement of merger and consolidation” in connection with which the operating company was to be the surviving entity. The agreement was duly filed with the Secretary of State of New Jersey, and the taxpayers — shareholders of WFI — surrendered their stock to the surviving company and received its shares in return. At the time, the Internal Revenue Service asserted that the transaction was taxable on the gain received from the exchange. However, the Board of Tax Appeals disagreed, and the Court of Appeal for the Third Circuit upheld the board’s decision.

At issue was whether the merger constituted a reorganization. The IRS argued that while the definitions of the term “merger” required that there be a “transfer of property,” there was no transfer of property in the surrender by the holding company to the operating company.

However, the court rejected the IRS’s argument that there was no merger, saying that the term “statutory merger or consolidation,” as used in the predecessor to Section 368(a)(1)(A), meant a merger or consolidation completed as per of the corporation laws of a state, territory, or the District of Columbia. In this case, the merger was effected according to the laws of New Jersey.

The court said it found no provision under New Jersey statutes that called for the transfer of property as a merger pre-requisite. Were the IRS’s contention valid, it would follow that a “pure” holding company could never be a party to a merger: no statute or decision of New Jersey stands for that proposition. Accordingly, the transaction at issue was a merger.

Whether a transaction qualifies as a reorganization does not turn alone upon compliance with the literal language of the statute. Rather, requisite to a reorganization are two conditions: (1) a continuity of the business enterprise under the modified corporate form, and (2) a continuity of interest on the part of those persons who were the owners of the enterprise prior to the transaction. In the Gilmore case, the court concluded that there was a continuity of interest of all prior owners of the merged corporation, and that none of the proprietary interests in the merged corporation was converted into cash or other property.

But the IRS asserted that the result to be reached through the merger (elimination of the holding company) could have been reached more directly by an out and out liquidation which would have been taxable. In the view of the IRS, if there are two (or more) ways of accomplishing a legitimate business result — one that creates a taxable transaction, the other being a tax-efficient transaction — then a taxpayer is equally subject to tax if it chooses the tax-efficient method, unless there is an adequate business reason for making that choice.

Then in Gilmore, absent an independent business reason for pursuing the merger alternative in lieu of the liquidation approach, the IRS would conclude that the tax consequences flowing from the merger should be identical to those that would attend a liquidation. But the court categorically rejected such a rule. It noted that the cases cited by the IRS in ostensible support of the rule do not, singly or in the aggregate, extend the doctrine of Gregory v. Helvering2, that far. What took place in Gilmore, unlike in Gregory v. Helvering, was a “reorganization in reality.”

As a result, we can safely conclude that a merger of RVI with and into DSW — in which the RVI shareholders are compensated with stock of the DSW — would qualify as a reorganization.3 Accordingly, no gain or loss would be recognized by RVI with respect to the exchange of its property (its shares in DSW and other assets) solely for stock in DSW. That’s because each corporation would be a party to the reorganization. (See Section 361(a) of the Internal Revenue Code.) Moreover, under Section 361(c), no gain or loss would be recognized by RVI on the distribution of the stock in DSW to its shareholders in exchange for, and in retirement of, their RVI stock. Finally, under Section 354(a)(1), the shareholders of RVI would recognize neither gain nor loss on the exchange of their RVI stock for stock in DSW.

Net Operating Losses

Furthermore, under Section 381(a)(2), and as of the date of the distribution or transfer, DSW (the acquiring corporation) would “succeed to and take into account,” the items described in Section 381(c) — most notably the acquired corporation’s NOLs. Thus, DSW would “inherit” its parent company’s NOL. Would the merger give rise to an ownership change? If that were the case, the change in ownership would limit the amount of taxable income the NOL can offset. We think the answer is no.

In the event of a downstairs merger which qualifies as a reorganization, DSW would be the new loss corporation. And thanks to Section 381(a)(2), it would be entitled to use a net operating loss carryover.4

To be sure, there is only is an ownership change if, immediately after any equity structure shift, the percentage of the stock of the loss corporation owned by one or more 5% shareholders has increased by more than 50 percentages points over the lowest percentage of stock of the loss corporation (or any predecessor corporation) owned by the shareholders at any time during the testing period. That period is defined as the three-year term ending on the testing date. In our view, the 5% shareholders in the RVI case will not have experienced the requisite increase in ownership, and therefore the merger will not produce an ownership change.

Note that in the RVI case, there are three 5% shareholders of DSW: (1) the shareholders of SSC (a “first tier entity” with respect to DSW); (2) the non-SSC shareholders of RVI; and (3) the public group comprised of all of the holders of DSW’s Class A (low vote) stock. The percentage of stock of the loss corporation owned by these 5% shareholders will increase by not more than 38 percentage points as a result of the merger. The percentage of stock of the loss corporation owned by the first two 5% shareholders will decline from 100% to 62%, and the percentage owned by the new 5%  shareholder — the public group comprised of all of the holders of DSW’s Class A stock — will increase by some 38 percentage points.

However, for an ownership change to transpire, the 5% shareholders, in the aggregate, must increase their percentage ownership of the loss corporation’s stock by more than 50 percentage points. Accordingly, it would appear that a merger of RVI with and into DSW would have no adverse affect on the latter’s ability to freely use the NOL it would inherit in the merger.

Also with regard to the merger, it seems likely that DSW would assume its predecessor’s liability with respect to the PIES.

The good news is that the satisfaction of such PIES with the obligor’s own stock would not give rise to a gain or loss.5 That is, if RVI satisfy the PIES with its stock in DSW the gain that RVI would recognize could be avoided if, prior to the satisfaction of the PIES, the obligation were assumed by DSW and then defrayed with DSW’s stock.6

The bad news is that the persons to whom such stock was issued would constitute a new 5% shareholder of DSW whose increase in ownership would have to be taken into account in determining whether there has been an ownership change. Accordingly, in order to preserve, DSW’s inherited NOL, it might be prudent to satisfy the PIES with cash, rather than DSW stock. Thus, it would appear that a downstream merger would be effective in this case. This technique was legitimized in 2000 when Seagate Technology completed a downstairs merger with and into Veritas Software, with the result that the discount at which Seagate’s stock was trading (to the value of Seagate’s stock in Veritas) was eliminated. We see no reason why a similar outcome could not occur with respect to RVI and DSW.

Contributor Robert Willens, founder and principal of

Robert Willens LLC,

writes a weekly tax column for


1 Commissioner v. Estate of Gilmore, 130 F.2d 791 (3rd Cir. 1942).
2Gregory v. Helvering, 293 US 465 (1935).
3 The merger would also exhibit the requisite degree of continuity of business enterprise. See Rev. Rul. 85-197, 1985-2 C.B. 120; P Corporation, (P), is a holding company whose only asset consists of all of the stock of an operating subsidiary, (S). P merges with and into S and the P shareholders exchange their P stock for S stock. Requisite to a reorganization is a continuity of the business enterprise under modified corporate form. Continuity of business enterprise is satisfied if the acquiring corporation (S) continues the “historic business” of the acquired corporation (P). Here, of course, P has no historic business. The ruling states that the application of this general rule to certain transactions, such as mergers of holding companies, will depend on all facts and circumstances. The policy underlying this general rule “provides the guidance necessary to make these determinations”. The ruling concludes that the policy enunciated in the regulations (to insure that reorganizations are limited to readjustments of continuing interests in property under modified corporate forms) is satisfied here. Thus, for purposes of the continuity of business enterprise requirement, the historic business of P is the business of S. Accordingly, after the merger S continues to conduct P’s historic business with the result that the continuity of business requirement was satisfied.
4  See Section 382(k)(1) and (k)(3).
5 See Section 1032.
6 However, the debtor could realize income from discharge of indebtedness (“COD income”) if, and to the extent that, the value of the stock issued is less than the adjusted issue price of the debt defrayed through such issuance. See Sec. 108(e)(8); for purposes of determining income of a debtor from discharge of indebtedness, if a debtor corporation transfers stock to a creditor in satisfaction of its recourse or non-recourse indebtedness, such corporation shall be treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the stock.

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