One of the most vexing issues in structuring acquisitions is whether the steps of the acquisition will be collapsed with the resulting tax treatment being other than what was expected. On July 5, 2006, the IRS released regulations under §338(h)(10) that provide helpful guidance in the area.
In Rev. Rul. 90-95, the IRS advised that if an acquisition is a “qualified stock purchase,” it would be treated as independent from subsequent events, even if they were pre-planned. A QSP is a purchase by a corporation of more than 80 percent of the stock of the target in a transaction that does not give the buyer a carryover basis. For example, if Company T bought all of the stock of Company A for cash and immediately liquidated A into T, the independence of the steps would be respected, and there would be (1) a purchase of the A stock and (2) a liquidation of A into T, pursuant to §332. The goal was to provide that the only way to get into deemed asset sale treatment was through the making of an election under §338.
Rev. Rul. 90-95 dealt solely with transactions that could not have been reorganizations governed by §368 even if they were stepped together, because they would not have met the continuity of proprietary interest test.
A healthy debate developed over the impact of Rev. Rul. 90-95 on the use of the step transaction doctrine to determine if a multi-step structure resulted in a tax free reorganization and the potential impact on the ability to make a §338 election. For example: T acquires 100 percent of A’s stock for T stock worth $100 and cash of $1.00. T immediately liquidates A into T pursuant to a prearranged plan. If the steps were respected, the first step results in a taxable stock purchase (the cash blows the “B” reorganization), and the second step is a tax free liquidation under §332. But, if the steps are collapsed, the overall transaction may well qualify as a “C” reorganization under §368(a)(1)(C). Thus the question: was the acquisition of the A stock a QSP? If the transaction were a reorganization, there would be a carryover basis in the stock, which would preclude QSP status.
Rev. Rul. 2001-46 settled this issue by providing that if the steps were collapsed and the overall transaction meet the tests of §368, it would be a reorganization and Rev. Rul. 90-95 would not prevent such a conclusion. As a result, a §338(h)(10) election could not be made for the target because there would not have been a QSP. Tax professionals were quick to ask for a middle ground and the IRS responded with Treas. Reg. §1.338(h)(10)-1(c)(2).
Under the regulations, a taxpayer may choose to effectively apply Rev. Rul. 90-95 to separate two steps in a transaction if it wishes to make the election under §338(h)(10) with respect to the stock acquisition, even if the overall transaction would otherwise qualify as a reorganization if the steps were collapsed.
Example: P owns 100 percent of the stock of Y. A owns 100 percent of the stock of T. P wants to acquire the stock of T. Y merges with and into T, T survives and A receives P stock and cash of equal value. Immediately thereafter, T merges into P.
The first step is a QSP, if viewed independently, because there is too much cash to qualify as a reorganization under §368(a)(2)(E). But, if the transaction is viewed as one integrated transaction, it qualifies as a reorganization under §368(a)(1)(A), and thus there is no QSP.
If both of T and A agree to make an election pursuant to §338(h)(10) as to the first step, the regulations provide that the acquisition of the T stock will be a QSP. If no election is filed, the transaction will be a reorganization pursuant to §368(a)(1)(A).
It’s important to note that these rules apply solely to elections made pursuant to §338(h)(10). They do not apply to §338(g) elections. Thus, acquisitions in which a §338(h)(10) election cannot be made are still governed by Rev. Rul. 90-95 and Rev. Rul. 2001-46.
Pepper Perspective
The benefit of a §338(h)(10) election can be quite substantial and frequently impacts the sales price of a company. The ability to make the election and not worry about it being tainted by subsequent events is welcome relief.
Joan C. Arnold
