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  • Bankruptcy & Workouts Committee

    G Reorganizations

    January 21, 2011

    Elliot Freier

    Irell & Manella LLP, Los Angeles, CA

    Lisa Fuller

    Internal Revenue Service, Washington, D.C.

    Matt Gareau

    Deloitte Tax LLP, Washington, D.C.

    Larry Garrett

    Ernst & Young LLP, Washington, D.C.

    Milt Hyman

    Irell & Manella LLP, Los Angeles, CA

  • Tax-free Reorganizations

    Section 368(a)(1) of the Internal Revenue Code generally defines certain corporate transactions that are treated as tax-free reorganizations

    A transaction must satisfy multiple statutory and regulatory requirements in order to qualify as a reorganization under section 368(a)

    2

  • Examples of Section 368 Reorganizations

    Statutory Mergers section 368(a)(1)(A)

    Acquisitions of stock for stock section 368(a)(1)(B)

    Acquisitions of assets for stock sections

    368(a)(1)(C), (D)

    Recapitalizations section 368(a)(1)(E)

    Change in form or identity section 368(a)(1)(F)

    Transfers of assets while in bankruptcy section

    368(a)(1)(G)

    3

  • G Reorganization Definition

    A reorganization under section 368(a)(1)(G) (a G Reorganization) means:

    a transfer by a corporation of all or part of its

    assets to another corporation in a title 11 or

    similar case; but only if, in pursuance of the plan,

    stock or securities of the corporation to which the

    assets are transferred are distributed in a

    transaction which qualifies under section 354,

    355, or 356

    4

  • G Reorganization Definition (Cont.)

    If a transaction qualifies as a G Reorganization and also under any other provision of section 368(a) (reorganizations), section 332(subsidiary liquidations), or section 351 (corporate formations), then the transaction shall be treated as qualifying only as a G Reorganization (section 368(a)(3)(C))

    A transaction in a bankruptcy that does not satisfy the requirements for a G Reorganization can still qualify as anothertype of reorganization

    A G reorganization may be accomplished by means of a divisive transaction, although such a transaction is rare in the bankruptcy context. In a divisive G reorganization, assets are generally transferred by the debtor corporation to a controlled corporation, the stock of which is distributed under section 355 (see, e.g., PLR 200345049)

    5

  • Acquisitive G Reorganization

    Example

    Typically, the following may occur in the transaction:

    Debtor transfers substantially all of its assets to Acquiror for Acquiror stock (and

    possibly nonstock consideration)

    Debtor liquidates and distributes Acquiror stock (and any other consideration) in

    cancellation of debt not assumed

    Existing shares are cancelled for no consideration

    G Reorganization requirements must be met

    Old

    Equity

    Holders

    Acquiror

    Cancelled

    Assets + Certain

    Liabilities Assumed

    Acquiror StockDebtor

    (Transferor)

    Old Debt

    Cancelled

    Creditors*New

    Equity

    Holders

    * Including at least one security holder

    Acqu

    iror S

    tock

    6

  • General Acquisitive G Reorganization

    Requirements

    Statutory Requirements Title 11 or similar case

    Debtor must liquidate

    Distribution and receipt of acquiring companys stock or securities under section 354

    Substantially all test under section 354 Plan of reorganization

    Regulatory Requirements Continuity of shareholder interest test Continuity of business enterprise test

    Business purpose test

    Proposed net value test

    7

  • Substantially All Test

    Tax-free reorganization treatment applies only if the corporation to which the assets are transferred acquires substantially all the assets of the transferor (section 354(b)(1)(A))

    For IRS advance ruling purposes for reorganizations other than G Reorganizations, substantially all generally means at least: 90% of the FMV of transferors net assets,

    and 70% of the FMV of transferors gross assets.

    For G Reorganizations, a more relaxed standard applies Generally, G Reorganization PLRs include a representation

    suggesting that substantially all means 70% of the FMV of transferors operating assets, and 50% of the FMV of transferors gross assets held as of the measuring date

    8

  • Substantially All Test (Cont.)

    A company in bankruptcy will often downsize prior to emergence by selling off or otherwise disposing of assets, causing uncertainty as to when one begins to measure the assets of the company for purposes of applying the substantially all test

    G Reorganization PLRs have applied the substantially all test by reference to different measurement dates The date on which the company determined it could no longer

    operate as a going concern

    The date of the filing of the bankruptcy petition Effective date of the bankruptcy plan Assets taken out of service and held for sale have been excluded

    Query whether the measurement date begins when the plan to undertake a G Reorganization comes into existence?

    9

  • Continuity of Business Enterprise

    Continuity of Business Enterprise test is satisfied if the acquiror either continues the targets historic business or uses a significant portion of the targets historic business assets in a business (Treas. Reg. 1.368-1(d)(1))

    Regulations provide that continuing a significant historical business line (e.g., 1 of 3 lines), or using a significant amount of historical assets in a business (e.g., one-third of the value of targets historical business assets), is sufficient

    COBE is met if the business is conducted by one or more members of the issuing corporations acquirors qualified group

    10

  • Continuity of Interest

    In order to qualify as a reorganization (except E and F reorgs.), there must be a continuity of interest (COI) on the part of

    those persons who, directly or indirectly, were the owners of

    the enterprise prior to the reorganization (Treas. Reg. 1.368-

    1(b))

    A substantial part of the value of the proprietary interests in the target corporation must be preserved (Treas. Reg. 1.368-1(e))

    COI test is generally satisfied if 40% or more of the aggregate consideration issued for the former equity consists of stock

    In a typical reorganization, the shareholders are the owners

    of the proprietary interests for purposes of the COI test

    11

  • Continuity of Interest (Cont.) In a G Reorganization, the shareholders may receive nothing

    and only the creditors receive proprietary interests

    Special rule for reorganizations of insolvent or bankrupt corporations in Treas. Reg. 1.368-1(e)(6)

    In a Title 11 or similar case, or if the corporation is insolvent, a creditors claim

    may be considered a proprietary interest for satisfying the COI test. See also

    Alabama Asphaltic Limestone Co., 315 U.S. 179

    If any creditor receives a proprietary interest in the issuing corporation in

    exchange for its claim, every claim of that class of creditors and every claim of

    all equal and junior classes of creditors is a proprietary interest immediately

    prior to the potential reorganization

    The most senior claim to receive a proprietary interest is treated as part

    creditor claim and as part proprietary interest in order to determine whether

    COI test is met

    The value of a proprietary interest represented by junior classes will be the

    FMV of the junior creditors claim

    Value of proprietary interest

    represented by most senior classFMV of proprietary interests received

    FMV of all consideration received= FMV of all sr. claims x

    12

  • Additional G Reorg. Requirements

    Title 11 or similar case section 368(a)(3)

    A case under the Bankruptcy Code or a

    receivership, foreclosure, or similar proceeding in

    a Federal or State court

    The transfer must be pursuant to a plan of

    reorganization approved by the bankruptcy court

    Distribution of acquiring corporations stock or securities under section 354

    13

  • Securities

    To qualify as an exchange under section 354, there must be an exchange of a target

    corporations stock or securities for acquirors stock or securities

    What is a security?

    An interest in a corporation other than stock

    Certain obligations of a corporation may constitute securities

    Generally, a debt instrument with a term of at least 10 years is considered a security

    and less than 5 years is not, but the determination of whether a debt instrument is a

    security is generally based on facts and circumstances

    See, e.g., Lagerquist v. Commissioner, 53 T.C.M. (CCH) 530 (1987); United States v.

    Mills, 399 F.2d 944 (5th Cir. 1968); and other cases in which obligations with a term

    of less than 5 years were held to be securities based on other facts and

    circumstances

    Securities may also include stock rights, such as warrants

    See PLRs 201025018 and 201032009

    No representation that at least one security holder received acquirors stock or

    securities

    Departure from earlier G Reorganization PLRs, which included such a representation

    Nevertheless, at least one security holder must receive stock or securities to meet the

    statutory requirement for a G Reorganization 14

  • Tax Consequences

    To Creditors and Shareholders Exchange of securities for new securities or new stoc