We have seen any number of foreign corporations “domesticate” by means of a merger of the foreign corporation with and into a newly created (almost always) Delaware corporation, which, by operation of law, succeeds to the assets and liabilities of the foreign transferor.
The merger is often a prelude to another transaction, often an acquisition by the newly minted Delaware corporation, using its stock as the currency—at least in part—to acquire the stock or assets of another corporation. Soon, for example, MDC Partners, Inc. (MDC Canada) will be “re-incorporating” in the U.S., by means of a merger with and into “MDC Delaware,” in preparation for a business combination involving MDC Delaware and Stagwell Media L.P.
Frequently, special purpose acquisition companies (SPACs) are organized under the laws of, say, the Cayman Islands. Once the SPAC locates a suitable acquisition target, it is almost standard operating procedure for the “offshore” entity to domesticate, by means of a re-incorporation merger, in advance of the new corporation’s acquisition of the identified target. In those instances, the shareholders of the SPAC’s target can receive the newly incorporated SPAC’s stock on a tax-free basis, something that would not be possible if the SPAC retained its foreign situs and the SPAC target’s shareholders. As is almost always the case, the target’s shareholders received more than 50%, by either vote or value, of the SPAC’s post-acquisition stock. See Treasury Regulation Section 1.367(a)-3(a) and (c).
A reincorporation fits squarely within the definition of a reorganization under tax code Section 368(a)(1)(F). An ‘F’ reorganization is defined as a “mere change in identity, form, or place of organization of one corporation, however effected.” ‘F’ reorganization treatment also requires that there be no change in existing shareholders or in the assets of the corporation involved in the transaction. The IRS has adopted the so-called “‘F’ in a bubble” philosophy when evaluating whether a re-incorporation passes muster as an ‘F’ reorganization.
So long as the re-incorporation itself (i.e., “in a bubble”) does not give rise to a change in the shareholders or in the assets of the reorganized corporation, the fact that the re-incorporation is an integral part of a larger transaction that, when fully consummated, welcomes new shareholders into the fold, will not preclude the re-incorporation from attaining ‘F’ reorganization status. See Revenue Ruling 96-29.
Ordinarily, in the case of an ‘F’ reorganization, certainly one involving purely domestic players, no gain or loss is recognized to the shareholders of the reorganized corporation upon the exchange of their stock in the acquired corporation for stock in the acquiring corporation. See tax code Section 354(a)(1). Moreover, under tax code Section 381(b), the taxable year of the distributor or transferor corporation does not end on the date of distribution or transfer. In all other “acquisitive” reorganizations, the taxable year of the acquired corporation abruptly terminates on the date of distribution or transfer.
Surprisingly, a wholly different set of “operating” rules is applicable in the case of a so-called “in-bound” 'F’ reorganization, of the type practiced, as discussed above, by many offshore SPACs. In these instances, the non-recognition rules available in the case of most reorganizations, and certainly as regards domestic ‘F’ reorganizations, do not operate—except for certain shareholders owning de minimis amounts of stock in the reorganized corporation—and gain recognition or income inclusion is the order of the day. Moreover, the taxable year of the transferor will terminate on the date of distribution or transfer, notwithstanding the exemption from this rule normally afforded ‘F’ reorganizations.
All E&P Amount
Treasury Regulation Section 1.367(b)-3 applies to an acquisition by a domestic corporation of the assets of a foreign corporation in a liquidation described in tax code Section 332 or, as relevant here, “an acquisition described in section 368(a)(1)” of the tax code.
In a reorganization described in ‘F’ in which the transferor is a foreign corporation, there is considered to exist:
- a transfer of assets by the foreign transferor to the acquiring corporation in exchange for stock of the acquiring corporation and the assumption by the acquiring corporation of the foreign acquired corporation’s liabilities;
- a distribution of such stock by the foreign transferor corporation to its shareholders; and
- an exchange by the foreign transferor corporation’s shareholders of their stock for stock of the acquiring corporation.
Moreover, the taxable year of the foreign acquired corporation must end with the close of the date of transfer. See Treasury Regulation Section 1.367(b)-2(d)(2) and (4).
In the case of an exchanging shareholder who is a “U.S. person,” but who is not a “U.S. shareholder” of the foreign acquired corporation, the exchanging shareholder shall recognize realized gain (but not loss) with respect to the stock of the foreign acquired corporation. Thus, in these cases, tax code Section 354(a)(1) is “displaced” by tax code Section 1001.
A “U.S. shareholder” means—with respect to any foreign corporation, regardless of whether it is a controlled foreign corporation (CFC)—a U.S. person who owns (within the meaning of tax code Section 958(a)) or is considered as owning by applying the rules of ownership of Section 958(b), 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10% of or more of the total value of shares of all classes of stock.
An exchanging shareholder, in the case of an in-bound ‘F’ reorganization, who is a U.S. shareholder, shall include in income as a deemed dividend the “all earnings and profits amount” with respect to its stock in the foreign acquired corporation. Such a shareholder cannot choose, instead, to recognize the realized gain from the exchange.
Election to ‘all earnings and profits’
It is, however, not inevitable that the exchanging U.S. person will be constrained to recognize the gain realized on his or her exchange. “In lieu of the treatment described above,” i.e., unrestricted gain recognition, an exchanging shareholder “may instead elect to include in income, as ‘a deemed dividend,’ the so-called ‘all earnings and profits amount’ with respect to its stock in the foreign acquired corporation.” Treas. Reg. Section 1.367(b)-3(c)(3).
This election may, in the case of a SPAC domestication, be an astute strategy since, given their limited history and dearth of activities, SPACs, particularly those of the offshore variety, have not had an opportunity to amass a meaningful amount of earnings and profits.
The regulations admonish that this election may be made only if the foreign acquired corporation “cooperates,” in the sense that it has provided information “to substantiate the exchanging shareholder’s all earnings and profits amount” with respect to its stock in the foreign acquired corporation; and the exchanging shareholder complies with the tax code Section 367(b) notice requirement described in Treas. Reg. Section 1.367(b)-1(c).
As indicated, there is, mercifully, a de minimis rule that allows smaller shareholders of the foreign acquired corporation to avoid the rigors of Treas. Reg. Section 1.367(b)-3. Thus, Treas. Reg. Section 1.367(b)-3(c) provides that “this paragraph shall not apply in the case of an exchanging shareholder whose stock in the foreign acquired corporation has a fair market value of less than $50,000 on the date of the section 367(b) exchange.”
Consequently, U.S. taxpayers owning stock in a foreign corporation that seeks, for valid business reasons, to set up shop in the U.S. by means of a re-incorporating merger, may be surprised to find that the “normal” rules associated with reorganizations are not accessible.
The “all earnings and profits” amount with respect to stock in a foreign acquired corporation means the net positive earnings and profits attributable to such stock accumulated by the foreign acquired corporation during the exchanging shareholder’s ownership period with respect to the stock.
Except in the case of a small, as defined in Treas. Reg. Section 1.367(b)-3(c), shareholder, the U.S. taxpayer will be surprised to find that he or she is not entitled to non-recognition treatment on the exchange of his or her foreign acquired corporation stock for the stock of the newly organized domestic successor corporation.
One’s only hope, here, is that the foreign acquired corporation has not earned much, if any, in the way of earnings and profits and that an effective election to include in income such non-existent earnings and profits can be successfully navigated.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.
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