New regulations would permit cross-border "A" reorganizations for the first time in 70 years.

• Author: Silverman, Mark J.

Introduction

Section 368(a)(1)(A) of the Internal Revenue Code (1) provides that the term "reorganization" includes "a statutory merger or consolidation." Since 1935, this term has been defined to exclude mergers under foreign law. On January 5, 2005, however, the Department of the Treasury and the Internal Revenue Service issued proposed amendments to Temp. Reg. [section] 1.3682(b)(1) (which defines the term "statutory merger or consolidation") that would reverse this longstanding interpretation--an interpretation for which there is no strong policy support. The proposed amendments expand the definition of statutory merger to include certain mergers effected pursuant to the laws of a foreign country or a U.S. territory in addition to the laws of the United States, a State, or the District of Columbia. The proposed amendments also remove the limitations in the current regulations on the ability of a target corporation to merge into a foreign corporation or disregarded entity. In order to qualify as a merger, however, cross-border mergers must satisfy the same requirements as domestic mergers, namely that the merged entity must transfer all of its assets to the acquiring entity and go out of existence and the shareholders of the merged entity receive acquiring stock.

Concurrently with the proposed regulations, Treasury and the Service issued proposed regulations under sections 358, 367, and 884 to address, among other issues, the collateral consequences of cross-border corporate reorganizations. (2)

This article briefly describes the history of the merger statute and applicable regulations and the amendments in the proposed regulations. The article then examines the disparities created by the current rules and the benefits provided by the proposed regulations. In general, the proposed amendments offer additional flexibility for corporate restructurings while preserving the requirements for a merger that have evolved under U.S. tax law, which limits the potential for any abuse.

Background

1. History of Merger Statute

   Section 368(a)(1)(A) includes in the term "reorganization" a "statutory merger or consolidation" (an "A" reorganization). The provision originated in 1921, when the statute defined reorganization to include a "merger or consolidation (including the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation, or of substantially all the properties of another corporation)." (3)

   In 1934, Congress separated this rule into two distinct provisions. The predecessor of sections 368(a)(1)(B) and (C) treated as a reorganization "the acquisition by one corporation in exchange solely for all or part of its voting stock: of at least 80 per centum of the voting stock and at least 80 per centum of the total number of shares of all other classes of stock of another corporation; or of substantially all the properties of another corporation." (4) The predecessor of section 368(a)(1)(A) continued to treat a "merger or consolidation" as a reorganization but qualified the term with the word "statutory." (5) The legislative history explained that the qualification was intended to make the definition conform more closely to the general requirements of corporation law. (6)

2. History of Merger Regulations

   Since their promulgation in 1935, the corporate reorganization regulations defined the phrase "statutory merger or consolidation" as a "merger or a consolidation effected in pursuance of the corporation laws of a State or Territory or the District of Columbia." (7) Thus, the statute has always been interpreted to exclude mergers involving foreign corporations. (8)

   Effective on January 1, 1997, the so-called check-the-box regulations introduced the concept of a disregarded entity, which is an entity that is ignored as separate from its owner for federal tax purposes. (9) These regulations required the Treasury and IRS to revisit the definition of statutory merger or consolidation to consider how it should be applied in the context of disregarded entities. On May 16, 2000, the Treasury and IRS issued proposed regulations under section 368(a)(1)(A). (10) The 2000 proposed regulations retained the same basic definition of statutory merger or consolidation as the 1955 regulations, except that they deleted the word "corporation" in order to conform the regulations to the IRS's longstanding position that a merger or consolidation may qualify as an "A" reorganization even if it is undertaken pursuant to laws other than the corporation law of the relevant jurisdiction. (11) The 2000 proposed regulations also added certain requirements to qualify as an "A" reorganization: (12)

   In order to qualify as a reorganization under section 368(a)(1)(A), the transaction must be a merger or consolidation involving two corporations effected pursuant to the laws of the United States or a State or territory, or the District of Columbia. In addition, by operation of such a merger law, the transaction must result in one corporation acquiring the assets of the merging corporation and the merging corporation ceasing to exist. Similarly, by operation of such a consolidation law, the transaction must result in one newly formed corporation acquiring the assets of both consolidating corporations, and both consolidating corporations ceasing to exist. These additional requirements were consistent with existing case law. (13) The 2000 proposed regulations took the position that the merger of a target corporation into a disregarded entity owned by a corporation could not qualify as an "A" reorganization, because the owner of the disregarded entity, the only potential "party to the reorganization" within the meaning of section 368(b), was not a party to the state or federal law merger transaction. (14)

   Commentators criticized the 2000 proposed regulations as being inconsistent with the check-the-box regulations, which treat a disregarded entity as not separate from the corporate owner for all federal tax purposes. On November 15, 2001, the Treasury and IRS withdrew the 2000 proposed regulations and issued new proposed regulations that permitted certain statutory mergers into disregarded entities to qualify as "A" reorganizations, if all of the assets and liabilities of the target were transferred to the acquiror and the target went out of existence. (15) The 2001 proposed regulations did not substantively change the definition of statutory merger or consolidation from the 2000 proposed regulations, except to delete the word "Territory" from the types of jurisdictions pursuant to the laws of which a transaction may be effected. This change was intended to make the definition of statutory merger or consolidation consistent with the definition of domestic under section 7701(a)(4). (16) A number of new terms, however, were introduced in order to accommodate the application of the regulation to disregarded entities. In addition, mergers involving one or more foreign entities were carved out of the 2001 proposed regulations, because cross-border mergers were the subject of a separate guidance project. (17)

   On January 24, 2003, the Treasury and IRS made certain minor clarifications to the 2001 proposed regulations and issued them as temporary regulations. (18)

   On January 5, 2005, the Treasury and IRS completed the next phase of their anticipated guidance project on cross-border mergers, issuing proposed regulations under sections 358, 367, and 884 to address the collateral consequences of cross-border corporate reorganizations. For example, the proposed regulations include special basis rules that are intended to preserve section 1248 amounts in reorganizations and priority rules where sections 367(a) and (b) both apply to a transaction. As a result of the completion of this phase of the guidance project, the Treasury and IRS proposed amendments to the 2003 temporary regulations to expand the definition of statutory merger or consolidation to include transactions effected pursuant to the laws of a foreign country or a U.S. territory and eliminate the carve-out for mergers involving foreign entities. (19)

3. Description of 2003 Temporary Regulations and 2005 Proposed Regulations

   1. 2003 Temporary Regulations

      The 2003 temporary regulations define a statutory merger or consolidation, as follows: (20)

      [A] transaction effected pursuant to the laws of the United States or a State or the District of Columbia in which, as a result of the operation of such laws, the following events occur simultaneously at the effective time of the transaction--

      (A) All of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of one other combining unit (transferee unit); and (21)

      (B) The combining entity of each transferor unit ceases its separate legal existence for all purposes....

      Several new terms were introduced by the 2003 temporary regulations for purposes of defining statutory merger or consolidation to accommodate disregarded entities. A disregarded entity is defined as a business entity that is disregarded as an entity separate from its owner for federal tax purposes. Examples include domestic single-member limited liability companies that do not elect to be treated as corporations, qualified REIT subsidiaries, and qualified subchapter S subsidiaries. (22) A combining entity is defined as a business entity that is a corporation (as defined in Treas. Reg. [section] 301.7701-2(b)) that is not a disregarded entity. (23) A combining unit is comprised solely of a combining entity and all disregarded entities, if any, owned by the combining entity. (24)

      A simple example illustrates how the temporary regulations apply to mergers involving...