IRS expands the scope of tax-free treatment in reorganizations.

• Author: Friedel, David B.

On Jan. 5, 1998, the Service issued final regulations under Secs. 354,355 and 356 on the taxation of rights to acquire stock exchanged in reorganizations and corporate divisions (e.g., spin-offs). The final regulations became effective March 9, 1998. The Service also issued temporary and proposed regulations to coordinate the final regulations with the treatment of "nonqualified preferred stock" and new Secs. 354(a)(2)(C), 355(a)(3)(D) and 356(e).

The IRS wished to extend the nonrecognition rules of Secs. 354,355 and 356 to certain exchanges involving rights to acquire stock. Sec. 354 generally provides that, in most tax-free reorganizations, no gain or loss is recognized to a shareholder on an exchange of stock for stock, or on an exchange of securities for stock or securities of the same or lesser principal amount. Sec. 355 generally provides that, if various requirements are met, the distribution by a corporation of the stock or securities of a controlled subsidiary is tax-free to the distributing corporation and its shareholders. Sec. 356 generally provides that gain (but not loss) is recognized on receipt of "other property" in a tax-free reorganization or distribution.

To extend the nonrecognition rules of these sections, the rights to acquire stock (e.g., warrants) had to be characterized as either stock or securities. Logically, rights to acquire stock appear to be most like an equity interest; however, the Supreme Court has held that warrants are not stock. Consequently, the IRS needed to characterize rights to acquire stock as securities (albeit with no principal amount). In reorganizations, this characterization allows a tax-free exchange of warrants for warrants, while requiring at least some gain recognition if securities are received in exchange for warrants.

The characterization of rights to acquire stock as securities is somewhat unnatural, and may cause an awkward analysis of some transactions from an economic perspective. Nevertheless, the final regulations under Secs. 354, 355 and 356 adopt this characterization and confirm that the term "rights to acquire stock" has the same meaning as the term has in Secs. 305 (distributions of stock and stock rights) and 317(a) (providing the term "property" means any property other than stock or rights to acquire stock in the corporation making the distribution). The final regulations have no effect on other rules that pertain to securities, including Secs. 83 (generally treating...