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)

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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)

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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

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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)

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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

Acquiror S

tock

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General Acquisitive G Reorganization

Requirements

• Statutory Requirements– Title 11 or similar case

– Debtor must liquidate

– Distribution and receipt of acquiring company’s 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

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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 transferor’s net assets,

– and 70% of the FMV of transferor’s 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 transferor’s operating assets, and 50% of the FMV of transferor’s gross assets held as of the measuring date

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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?

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Continuity of Business Enterprise

• Continuity of Business Enterprise test is satisfied if the acquiror either continues the target’s historic business or uses a significant portion of the target’s 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 target’s historical business assets), is sufficient

– COBE is met if the business is conducted by one or more members of the issuing corporation’s acquiror’s “qualified group”

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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

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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 creditor’s 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 creditor’s 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

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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 corporation’s stock

or securities under section 354

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Securities

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

corporation’s stock or securities for acquiror’s 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 acquiror’s 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 stock by creditors is tax-free (section 354)

– Tax-free to old shareholders that receive new stock (section 354)

– Receipt of other property may be taxable (section 356)

– Substituted basis adjusted for gain/loss recognized and any boot received (section 358) and tacked holding period (section 1223(1)) with respect to new securities or new stock received by old stock/security holders

– Taxable to non-security holders

• To Target Corporation– Tax-free transfer of assets in exchange for stock/securities (section 361(a))

– If boot is received but not distributed, gain may be recognized (section 361(b))

– Tax-free distribution of new stock or securities to shareholders, security holders, and other creditors (section 361(c))

• To Acquiring Corporation– Issuance of its stock is tax-free (section 1032)

– Acquires target corporation’s tax basis and holding periods in transferred assets (sections 362 and 1223(2))

– Tax attributes of target corporation carry over to acquiring corporation (section 381)

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Bankruptcy Restructuring Tax

Concepts

– The primary domestic issues and considerations facing a corporation entering into a debt restructuring or bankruptcy are:

– What are the differences between bankruptcy and non-bankruptcy restructurings?

– What are the section 108 implications of the potential cancellation of indebtedness?

– What are the section 382 ownership change implications of the transaction?

– What is the impact of potential asset dispositions?

– Is the restructuring transaction taxable or tax-free?

– May a worthless stock deduction be claimed?

– What are the state tax considerations of the transaction?

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IRC §108: Cancellation of Debt Income

• Cancellation of debt (“COD”) for less than its face amount (or adjusted issue price) results in taxable COD

income under section 61, unless excludible or deferred under section 108

• COD income is generally excluded from gross income if a corporation is insolvent (to the extent of

insolvency) or in a Title 11 bankruptcy (section 108(a))

– To meet the bankruptcy exception for COD income, the debt must be discharged in a case under

Title 11 of the U.S. Code

– Distinguished from a “Title 11 or similar case” as required for G Reorganizations or for section 382

purposes

• If COD income is excluded from gross income under section 108, the debtor must reduce its tax attributes

as described in section 108(b)

– If a taxpayer realizes excluded COD income either during or after a taxable year in which the

taxpayer is the transferor or distributor of assets in a section 381 transaction (e.g., the target

corporation in a G Reorganization), any tax attributes to which the acquiring corporation succeeds

must reflect the reductions required by IRC §108(b). See Treas. Reg. § 1.108-7(c).

• Section 108(i) permits a taxpayer to elect to defer COD income arising from reacquisition of certain debt

instruments after 12/31/2008 and before 1/1/2011

– The deferred COD income is generally included in gross income ratably over the five taxable year

period beginning in 2014

– Deferred COD income is not eligible to be excluded under section 108(a) (i.e., due to insolvency or

bankruptcy) when included in gross income in later years

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Basics of Section 382

• Section 382 limits the amount of “pre-change losses” that a “loss corporation” may utilize to offset its “post-change income” following an “ownership change”

• Thus, the two major components to a section 382 analysis are:

– Determining whether there has been an ownership change• In general, an “ownership change” occurs when there has been a more than 50

percentage point change in the ownership of the corporation (by value) by the “5% shareholders” over a rolling 3-year testing period

– Determining the section 382 annual limitation• Base limitation = “value” of loss corporation * applicable monthly IRS prescribed

long term tax exempt rate

• NUBIGs - The base limitation may be increased for recognized built-in gains (RBIG) recognized during the “recognition period” if the company is in a “net unrealized built-in gain” (NUBIG) position at the time of the ownership change

• NUBILs - If the corporation has a “net unrealized built-in loss” (NUBIL), any portion of such loss recognized within the 5-year period following the ownership change will be part of the tax attributes limited by the annual limitation

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Section 382 Bankruptcy

Considerations

• Section 382 contains multiple provisions that

are relevant in a bankruptcy proceeding

– Special rules in sections 382(l)(5) and 382(l)(6)

– Impact on post-emergence deductions

– Net Unrealized Built-in Loss Rules

– Adjusted Current Earnings

– Alternative Minimum Tax concerns

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Section 382: Bankruptcy

Considerations – AlternativesTax Consequences under

Section 382(l)(5)

• If requirements are met, applies in cases

of bankruptcy unless corporation

affirmatively elects to apply

Section382(l)(6).

• No limitation imposed from section 382

• Application of interest haircut on NOLs

• May eliminate tax attributes if experience

an ownership change in the 2-yr period

following emergence

• Institution of trading restriction may limit

future ownership changes

Tax Consequences Under

Section 382(l)(6)

• No application of interest haircut

• Application of section 382

limitation

• Base limitation on attributes is

calculated on FMV of equity

immediately following emergence

• Limitation may be increased by

equity contributions to the extent

of liabilities remaining pursuant

to the plan

• NUBIG may enhance the use of

tax attributes, NUBIL increases

the number of attributes to be

subject to limitation 20

Example 1

Bankruptcy Asset Sale to Existing

Creditor

Example 1 – Background

• 5 years ago

Target

FMV = 100x

Basis = 20x

Shareholders

Private Equity Fund

Lender

70x

Secured

Loan

Buyer30x cash

70x cash

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Example—Current Facts

• Change of Circumstances

Target

FMV = 50x

Basis = 20x

Private Equity Fund

Lender

70x

Secured

Loan

Buyer

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Example— Additional Facts

• Target files for Chapter 11

• Target plans to sell assets in a Bankruptcy

Code section 363 sale

• Secured lender plans to bid its debt to acquire

Target assets

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Example--Issues

• Does lender want a taxable asset acquisition or a G Reorganization?

– Low asset basis

– Section 382 issues

– COD Issues

• Can lender use an LLC as the acquisition entity?

• Is lender’s secured debt a security for tax purposes?

• Does a Bankruptcy Code section 363 sale constitute a plan of reorganization approved by a bankruptcy court?

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Example—Basic Structure

Private Equity Fund Lender

Acquisition Corp.

Target

70x

Secured

Loan

Assets

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Overview of Transaction:

1. Lender transfers secured loan to Target

2. As part of Lender’s credit bid, Target’s assets are transferred directly to Acquisition Corp. in a “cause to be directed”transaction

► What if Target doesn’t liquidate? What if Target transfers less than substantially all of its assets?

► Query: Does this transaction qualify as a G Reorganization?

Structures to Avoid G Reorg.

Private Equity Fund Lender

Acquisition Corp.

Newco 1 Newco 2

50%50%

Target

70x

Secured

Loan

Assets

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Characterization

• Debt for Asset exchange with LLC, then dropdown of assets through Newco 1 and 2 to Acquisition Corp. (5 steps)

• Debt for Asset Exchange with Newco 1 and Newco 2 followed by dropdown of assets to Acquisition Corp. (6 steps)

• Debt for Asset Exchange with Acquisition Corp., then drop into Newco 1 and 2 (4 steps)

• Asset for Stock Exchange with Acquisition Corp. followed by stock-for-debt exchange and stock dropdown (4 steps)

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Other Structures

• Keep Target around with property secured by

debt and triple net lease

• Structure where consideration for assets is

grandparent stock

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Example 2

Application to Tiered Structure

G ReorganizationTiered Structure

Guarantee

P

S

Overview:

► P is an operating company. P owns all of the stock of S, which also is an operating company

► P is substantially insolvent

► P has issued long-term bonds that qualify as securities for section 354 purposes

► The value of S’s assets exceed the value of liabilities for which S is the primary obligor. These liabilities do not constitute securities for section 354 purposes. In addition, S has guaranteed P’s bonds. Taking into account S’s expected liability under the P bonds, S is insolvent too

► Both P and S file voluntary petitions for relief under Chapter 11 of the Bankruptcy Code

► P’s and S’s cases are not substantively consolidated, but they are jointly administered

P SHsSecurity

Holders

CRS

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G ReorganizationTiered Structure

P

S

Overview of Transaction:

► As part of a court-approved plan of reorganization, A acquires S’s assets and P’s assets in exchange for A stock

► Pursuant to the plan, (i) the P security holders receive A stock, (ii) the S CRs receive A stock, and (iii) the P shares are cancelled without consideration. The P bonds and S’s liabilities are discharged. P and S are dissolved

► A’s acquisition of P’s assets appears to qualify as a reorganization pursuant to section 368(a)(1)(G), notwithstanding that A does not acquire S’s stock. See, e.g., Rev. Rul. 68-526, 1968-2 C.B. 156

► Query: Does A’s acquisition of S’s assets qualify as a G Reorganization?

P SHsSecurity

Holders

CRS

AP assets

S assets

A SHs

A stock

A stock

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G ReorganizationTiered Structure

Scenario 1:

� S’s guarantee of P’s debt is junior to the claims of S’s creditors, and the S creditors receive 100 cents on the dollar

� Query: Should P be treated as receiving A stock in its capacity as S’s shareholder and then distributing such stock to P’s security holders? If so, does the transaction as to S qualify as a G Reorganization?

Scenario 2:

� S’s guarantee of P’s debt is pari passu with, or senior to, the claims of the S creditors, and the S creditors take a significant haircut

� Query: Should P still be considered to have received A stock in its capacity as S’s shareholder and then distributed such stock to the P security holders? Alternatively, should the P security holders be considered to have received some portion of their A stock directly from S? If so, can the transaction as to S still qualify as a G Reorganization?

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TAM 9841006

(June 25, 1998)

*Simplified Facts

Corp B creditor

Corp B

Corp C

► Corp B is insolvent. The value of Corp C’s assets exceed its liabilities, but Corp C has also pledged its most valuable asset (stock in Corp H) in support of Corp B’s borrowing

► As part of the plan of reorganization confirmed by the Bankruptcy Court, Corp C forms a new corporation, Corp G, and contributes all its Corp H stock to Corp G in exchange for Corp G stock

► As part of the plan, Corp C liquidates and distributes the Corp G stock to Corp X, who had a first priority claim on the Corp H stock

Conclusion:

► Because the value of the Corp H stock held by Corp C (and the value of the Corp G stock received by Corp C in exchange therefor) substantially exceeded the obligations of Corp C to its direct creditors, the transfer of Corp G stock by Corp C to Corp X in satisfaction of its shareholder’s debt pursuant to the pledge should be viewed as a constructive distribution of that stock to its shareholder (i.e. Corp B) such that section 354(a) applies and the transaction as to Corp C is a G Reorganization

SH Corp X

Corp H Corp G

CRsPledge of

Corp H’s

stock

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