tax free organisations
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Tax-Free Reorganizations: Acquisitive Reorganizations
Resource type: Practice Note
Status: Maintained
Jurisdiction: USA
This Note provides an overview of tax-free acquisitive reorganizations. Acquisitive reorganizations
are transactions where one corporation acquires the stock or assets of another corporation.
PLC Corporate & Securities
Contents
General Categories of Tax-Free Reorganizations
Acquisitive Reorganizations
Divisive Reorganizations
Restructuring Reorganizations
Bankruptcy Reorganizations
General Requirements to Qualify as a Tax-Free Reorganization
Judicial Requirements for All Tax-Free Reorganizations
Direct Type A Reorganization
Tax Consequences of a Direct Type A Reorganization
Direct Type A Reorganization with a Disregarded Entity
Direct Type B Reorganization
Tax Consequences of a Direct Type B Reorganization
Direct Type C Reorganization
Tax Consequences of a Direct Type C Reorganization
Acquisitive D Reorganization
Tax Consequences of an Acquisitive Type D Reorganization
Triangular Reorganizations
Type A Forward Subsidiary Merger
Type A Reverse Subsidiary Merger
Triangular Type B Reorganization
Triangular Type C Reorganization
Carryover of NOLs after a Tax-Free Reorganization
Limitations of the Use of NOLs After a Tax-Free Reorganization
Double Dummy Merger: Tax-Free Transaction but not Tax-Free Reorganization
Certain types of corporate acquisitions, divisions and other restructurings can be structured to
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qualify as tax-free reorganizations for US federal income tax purposes. If the requirements of a tax-
free reorganization are satisfied, the parties generally defer current US federal income tax on gains
on their stock and asset transfers. Tax is deferred rather than eliminated, because the
b a si s ( w w w .p r a ct ic a ll a w .c o m / 5 - 3 8 2 - 3 2 6 2 )of the stock or assets received in a tax-free
reorganization is a ca r r y o v e r b as is ( w w w .p r ac t ic a ll aw .c o m / 2 - 3 8 2 - 3 3 1 0 ). The receipt of a
carryover basis in a tax-free reorganization preserves the unrecognized gain for later recognition in
a taxable sale or other disposition.
This Note focuses on acquisitive tax-free reorganizations. Acquisitive reorganizations are
transactions where one corporation acquires the stock or assets of another corporation.
Unless otherwise indicated, this Note addresses only US federal income tax considerations of tax-
free reorganizations and assumes that the:
Acquiring corporation (or parent and subsidiary, as applicable) and target corporation are US
corporations that are C- co r p o r a t io n s ( w w w .p r ac t ic a ll a w .c o m / 1 - 3 8 3 - 9 8 6 8 ).
Target corporation has only US stockholders.
Acquiring corporation and target corporation are not related parties.
A tax-free reorganization may have state law tax consequences so it is important to consult with a
state law tax specialist when structuring an acquisition.
For a discussion of tax-free reorganizations in public merger transactions, including links to recent
deals summarized in PLC What's Market, see Practice Note, What's Market: Tax-free
Transactions (www.practicallaw.com/5-386-1032).
For more information about taxable transactions, see Practice Notes, Asset Acquisitions: Tax
Overview (www.practicallaw.com/6-383-6235), Stock Acquisitions: Tax
Overview (www.practicallaw.com/9-383-6719) and Mergers: Tax
Overview (www.practicallaw.com/0-383-6747).
General Categories of Tax-Free Reorganizations
Tax-free reorganizations can be divided into four basic categories:
Acquisitive reorganizations.
Divisive reorganizations.
Corporate restructuring reorganizations.
Bankruptcy reorganizations.
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Acqu is it ive Reorganizat ions
Acquisitive reorganizations are transactions where one corporation acquires the stock or assets of
another corporation. Included in this category are the following types of reorganizations:
A reorganization. A merger or consolidation that is effected under state or foreign statutes. In
a typical A reorganization, the target corporation's assets and liabilities become assets and
liabilities of the acquiring corporation and the target corporation ceases to exist (see
I RC ( w w w .p r a c t i ca ll a w .c o m / 2 -3 8 2 - 3 5 5 5 ) 368(a)(1)(A)).
B reorganization. An acquisition of stock of the target corporation in exchange solely for
voting stock of the acquiring corporation, provided that the acquiring corporation has "control"
(generally 80% ownership) of the target corporation immediately after the transaction (see IRC
368(a)(1)(B)).
C reorganization. An acquisition of "substantially all" the assets of the target corporation in
exchange for voting stock of the acquiring corporation (and a limited amount of considerationother than qualifying stock, also known as boot) followed by a liquidation of the target (see IRC
368(a)(1)(C)).
Acquisitive D reorganization. The transfer of "substantially all" of the target corporation's
assets to an acquiring corporation, provided that the target corporation or its stockholders (or a
combination of the two) has "control" (generally 80% ownership) of the acquiring corporation
immediately after the transfer. The target corporation also must liquidate and distribute to its
stockholders the acquiring corporation stock and any other consideration received by the target
corporation from the acquiring corporation (as well as the target's other properties (if any)) in a
transaction that qualifies under IRC 354 (see IRC 368(a)(1)(D)).
Triangular reorganizations. Types A, B and C acquisitive reorganizations can often also be
structured as triangular tax-free reorganizations. Unlike a direct reorganization which involves
two parties (the target corporation and the acquiring corporation), a triangular reorganization
generally involves three parties: the target corporation on the seller side and a parent
corporation and a subsidiary on the buyer side.
Divisive Reorganizations
Divisive reorganizations are transactions where one corporation divides into two or morecorporations and that qualify as a divisive Type D reorganization under IRC 368(a)(1)(D).
Divisive reorganizations take three different forms:
Spin-offs. A transfer of the assets of the parent corporation (typically the assets of a division or
line of business) to a newly formed corporation and dividend of the stock of the newly formed
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corporation to the parent corporation's stockholders.
Split-offs. An exchange offer in which the stockholders of the parent corporation exchange
their stock in the parent for stock in a new entity.
Split-ups. A transfer of the assets of the parent corporation to two or more newly formed
corporations and dividend of the stock of the newly formed corporations to the parentcorporation's stockholders. The parent corporation liquidates and the stockholders hold shares in
the two or more newly formed companies.
Restruc turing Reorganizations
Restructuring reorganizations are adjustments to the corporate structure of an existing (and
continuing) corporation. Included in this category are the following types of reorganizations:
E reorganization. A recapitalization under IRC 368(a)(1)(E)). A recapitalization is a
reshuffling of an existing corporation's capital structure. For example, a corporation's issuanceof common stock for outstanding preferred stock (or an issuance of preferred stock for
outstanding common stock) generally qualifies as a recapitalization (see Tr ea s .
Re g . ( w w w .p r a ct ic al la w .c o m / 0 - 3 8 2 - 3 8 8 2 ) 1.368-2(e)).
F reorganization. A mere change in identity, form or place of organization of a corporation
under IRC 368(a)(1)(F). For example, changes in the state or jurisdiction of incorporation
generally qualify as Type F reorganizations. In addition, if a corporation converts from one type
of organization to another, it may qualify as a Type F reorganization (see Rev. Rul. 67-376).
Bankruptcy Reorganizations
Bankruptcy reorganizations are transactions that involve the transfer of assets from one
corporation to another corporation in a bankruptcy or similar case and that qualify as Type G
reorganizations under IRC 368(a)(1)(G).
General Requirements to Qualify as a Tax-Free Reorganization
To qualify as a tax-free reorganization, a transaction must meet the statutory requirements for one
of the types of tax-free reorganizations (for example, the direct Type B reorganization
requirements) which are discussed in detail below (see IRC 368 and the accompanying Treasury
Regulations). In addition, a tax-free reorganization generally must also satisfy the three judicial
requirements (continuity of interest, continuity of business enterprise and business purpose) that
apply to all tax-free reorganizations.
The type of consideration generally determines whether a transaction can qualify, in whole or in
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part, as a tax-free reorganization. Stock of the acquiring corporation (or its affiliate) generally must
be used as a significant portion of the consideration and, in certain tax-free reorganizations, the
stock must be voting stock. If a selling stockholder receives boot (meaning, consideration other
than qualifying stock), the stockholder generally is taxed on the receipt of the boot.
Judicial Requirements for All Tax-Free Reorganizations
In addition to the specific statutory requirements for each of the different types of tax-free
reorganizations (which are discussed in detail below), a tax-free reorganization generally must also
satisfy three judicial requirements: continuity of interest (COI), continuity of business enterprise
(COBE) and business purpose.
Continuity of Interest
The COI requirement generally requires that the historic stockholders of the target corporation
receive a substantial equity interest in the acquiring corporation (or its affiliate). This requirement
prevents transactions that resemble sales from qualifying as tax-free reorganizations. It is satisfied
by using stock of the acquiring corporation (or its affiliate) as a significant portion of the
consideration (varying from about 40% to 100% of the consideration, depending on the type ofreorganization). Stock of any class (common or preferred and voting or non-voting) generally
counts towards the COI requirement. Debt, cash and cash equivalents do not count towards the
COI requirement. Many of the different types of reorganizations have built-in statutory COI
requirements. For example, the only permissible consideration in a B reorganization is voting stock.
Continuity of Business Enterprise
After the transaction, the acquiring corporation must continue at least one of the target's significant
historic businesses or use a significant portion of the target's historic business assets in a business.
Business Purpose
A bona fide business reason (other than tax savings) is required for the transaction.
Direct Type A Reorganization
A direct Type A reorganization is a merger or consolidation under state or foreign law that satisfies
the COI, COBE and business purposes requirements (see IRC 368(a)(1)). Unlike many other tax-
free reorganizations, a direct Type A reorganization does not have any statutory restrictions on the
type of stock that can be used as consideration (common or preferred and voting or non-voting are
all permissible) and only requires that 40% of the consideration consist of the acquiring
corporation's stock (this is the COI requirement, see Temp. Treas. Reg. 1.386-1T(e)(2)(v), ex.
1). A direct Type A reorganization that fails to meet the necessary requirements generally is taxedas an asset acquisition (see Practice Notes, Asset Acquisitions: Tax
Overview (www.practicallaw.com/6-383-6235) and Mergers: Tax
Overview (www.practicallaw.com/0-383-6747)).
A typical direct Type A merger is structured as a forward merger. In a forward merger, the target
corporation merges into the acquiring corporation. For corporate purposes, the target corporation's
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assets and liabilities become assets and liabilities of the acquiring corporation and the target ceases
to exist.
A typical direct Type A merger is shown in the diagrams below:
In a typical Type A consolidation, two corporations are combined into a new corporate entity. For
corporate purposes, the old corporations' assets and liabilities become assets and liabilities of the
new corporate entity and the old corporations cease to exist.
A typical Type A consolidation is shown in the diagrams below:
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If some stockholders receive all cash (for example, dissenters) and others receive stock (or a mix
of stock and cash), the transaction can still qualify as a direct Type A reorganization. However, only
the target corporation stockholders who receive stock are entitled to tax-free treatment.
After a direct Type A reorganization, the acquiring corporation can generally transfer the acquired
assets to an 80% or more owned subsidiary (existing or newly formed) without jeopardizing tax-
free reorganization status (see IRC 368(a)(2)(C) and Treas. Reg. 1.368-2(k)(1)). Alternatively,
if a drop down is planned, the transaction can be structured as a triangular Type A reorganization
(see Type A Forward Subsidiary Mergerand Type A Reverse Subsidiary Merger). However, the
requirements for the triangular Type A reorganizations are more onerous than a direct Type A
reorganization.
Tax Consequences of a Direct Type A Reorganization
If the requirements of a direct Type A reorganization are satisfied, the parties generally defer
current US federal income tax on gains on their stock and asset transfers.
Target Corporation Stockholders
The target corporation stockholders do not recognize taxable gain or loss on the exchange of their
target stock for acquiring stock (see IRC 354). However, the target corporation stockholders that
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receive boot are taxed on the receipt of that boot as either capital gain or a dividend (see IRC
356). The taxable amount is the lesser of the amount of boot or the total gain on the transaction.
Non-qualified preferred stock (generally redeemable preferred stock which does not participate in
corporate growth to any significant extent) generally is considered boot and, therefore, is taxable to
a target corporation stockholder.
The target corporation stockholder takes a carryover basis in the acquiring corporation stock
(generally the same basis that the stockholder had in its target corporation stock) (see IRC 358).
The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable
sale or other disposition.
Target Corporation
The target corporation generally does not recognize gain or loss in the tax-free reorganization (see
IRC 361). After the tax-free reorganization, the target ceases to exist.
Acquir ing Corporation
The acquiring corporation does not recognize gain or loss in the tax-free reorganization and takes a
carryover basis in the target corporation's assets (generally the same basis that target corporation
had in the assets) (see IRC 362). The receipt of a carryover basis preserves the unrecognizedgain for later recognition in a taxable sale or other disposition.
Direct Type A Reorganization with a Disregarded Entity
In certain cases, a state law merger involving a disregarded entity can qualify as a direct Type A
reorganization. A disregarded entity is an entity with a single owner that is generally ignored for tax
purposes even though it is a separate legal entity for state law purposes. For example, a single-
member l i m it e d li a b il i t y co m p an y ( w w w .p r a ct ica ll a w .c o m / 6 -3 8 2 - 3 5 8 2 )(LLC) is treated as
a disregarded entity for tax purposes unless it elects to be taxed as a corporation. The single owner
of the disregarded entity is considered to own the assets (and is subject to the liabilities) of the
disregarded entity for tax purposes and reports the entity's income and expenses on its own
income tax return. For more information about disregarded entities, see Practice Note, Choice of
Entity: Tax Issues (www.practicallaw.com/1-382-9949).
The merger of a target corporation into an acquiring corporation's disregarded entity may qualify as
a direct Type A reorganization if the COI, COBE and business purpose requirements are satisfied.
However, the merger of a target corporation's disregarded entity into an acquiring corporation
generally does not qualify as a direct Type A reorganization (see Treas. Reg. 1.368-2(b)(1)(iii),
ex. 2). The acquiring corporation may prefer a merger of the target corporation into the acquiring
corporation's disregarded entity if the acquiring corporation wants to shield itself from the target's
liabilities.
Direct Type B Reorganization
In a direct type B reorganization, the acquiring corporation acquires the stock of target corporation
solely in exchange for voting stock of the acquiring corporation and, immediately after the
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transaction, the acquiring corporation has "control" of the target corporation (see IRC 368(a)(1)
(B)). Control means at least 80% of the total combined voting power of all classes of stock entitled
to vote and at least 80% of the total number of shares of all other classes of stock (see IRC 368
(c)). The COI requirement is built into the statute for a Type B reorganization (voting stock is the
only permissible consideration) but the transaction must also meet the COBE and business
purposes requirements. A Type B reorganization that fails to meet the necessary requirements is
taxed as a stock acquisition (see Practice Note, Stock Acquisitions: TaxOverview (www.practicallaw.com/9-383-6719)).
A direct Type B reorganization is shown in the diagrams below:
After a direct Type B reorganization, the target corporation is 80% or more owned by the acquiring
corporation. Because the target corporation continues to exist, stockholders that opted not to
participate in the reorganization may continue to own target corporation stock as minority
stockholders if that is permitted under state law.
The only permissible consideration in a Type B reorganization is voting stock. In many instances,
voting preferred stock can be used if the holder has the right to vote on the election of directors
(see Rev. Rul. 63-234). However, the use of any other consideration (even a single penny)
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generally disqualifies the transaction.
However, the "solely in exchange for voting stock" requirement will not be violated if:
Target corporation stockholders receive cash in lieu of fractional shares.
Acquiring corporation pays target corporation's transaction expenses (legal, accounting and so
on).
Target corporation redeems shares of stockholders that opted not to participate in the
reorganization using its own funds (and not cash provided by the acquiring corporation).
Because of the strictness of the "solely in exchange for voting stock" requirement, a Type B
reorganization is often less desirable than other types of tax-free reorganizations.
To qualify as a Type B reorganization, an acquiring corporation does not need to acquire all of the
stock at one time if all of the acquisitions are part of an integrated plan and the only consideration
used for any of the acquisitions is voting stock. For example, this could be the case if the acquiring
corporation acquired some target stock in an earlier stock-for-stock tender offer.
If a liquidation of the target corporation is planned following a transaction structured as a Type B
reorganization, the transaction generally is treated as a Type C reorganization and not a Type B
reorganization (see Rev. Rul. 67-274 and Direct Type C Reorganization).
After a Type B reorganization, the acquiring corporation can generally transfer the acquired stock to
an 80% or more owned subsidiary (existing or newly formed) without jeopardizing tax-free
reorganization status (see IRC 368(a)(2)(C) and Treas. Reg. 1.368-2(k)(1)). Alternatively, if a
drop down is planned, the transaction can be structured as a triangular Type B reorganization (see
Triangular Type B Reorganization).
Tax Consequences of a Direct Type B Reorganization
If the requirements of a direct Type B reorganization are satisfied, the parties generally defer
current US federal income tax on gains on their stock transfers.
Target Corporation Stockholders
The target corporation stockholders do not recognize taxable gain or loss on the exchange of their
target stock for acquiring corporation voting stock (see IRC 354). The target corporation
stockholders take a carryover basis in the acquiring corporation voting stock (generally the same
basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt of a
carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other
disposition.
Target Corporation
The target corporation does not recognize gain or loss in the tax-free reorganization. In addition,
the target corporation's basis in its assets remains unchanged. After the tax-free reorganization,
the target corporation is 80% or more owned by the acquiring corporation.
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Acquir ing Corporat ion
The acquiring corporation generally does not recognize gain or loss in the tax-free reorganization
(see IRC 1032). The acquiring corporation takes a carryover basis in the target corporation stock
(generally the same basis that the target corporation stockholders had in the target corporation
stock) (see IRC 362). The receipt of a carryover basis preserves the unrecognized gain for later
recognition in a taxable sale or other disposition.
Direct Type C Reorganization
In a direct Type C reorganization, the acquiring corporation acquires "substantially all" the assets of
the target corporation in exchange for voting stock of the acquiring corporation and the target
liquidates (see IRC 368(a)(1)(C)). In the liquidation, the target corporation distributes the
acquiring corporation stock and other consideration received in the transaction (as well as any
other target assets) to the target corporation stockholders. After the transaction, the target
corporation stockholders who participated in the transaction become stockholders of the acquiring
corporation. The COI requirement is built into the statute for a Type C reorganization (voting stock
plus limited boot as permissible consideration), but the transaction must also satisfy the COBE and
business purposes requirements. A Type C reorganization that fails to meet the necessary
requirements is taxed as an asset acquisition (see Practice Note, Asset Acquisitions: Tax
Overview (www.practicallaw.com/6-383-6235)).
A direct Type C reorganization is shown in the diagrams below:
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Substantially all the assets means assets representing at least 90% of the target corporation's net
assets (assets less liabilities) and at least 70% of the target corporation's gross assets. This
requirement prevents the target corporation from spinning-off or otherwise disposing of unwanted
assets before the transaction.
The only permissible consideration in a Type C reorganization is voting stock and a limited amount
of boot. In many instances, voting preferred stock is treated as voting stock (generally if the holder
of the voting preferred stock has the right to vote on the election of directors) (see Rev. Rul. 63-
234).
Up to 20% of the consideration in a Type C reorganization can be boot (for example, cash and non-
voting stock). The acquiring corporation's assumption of target corporation's liabilities generally is
not treated as boot. However, if actual boot (for example, cash or non-voting stock) is used in the
transaction, the assumption of a liability will be treated as cash boot in the amount of the assumedliability for purposes of calculating the 20% of permissible boot. This rule prevents the use of actual
boot if the acquiring corporation assumes liabilities that equal or exceed 20% of the consideration
in the transaction.
Prior ownership of stock of the target corporation by an acquiring corporation will not by itself
prevent the transaction from qualifying as a Type C reorganization provided that the acquiring
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corporation did not purchase the target corporation stock in connection with the acquisition of the
target's assets in the Type C reorganization (see Treas. Reg. 1.368-2(d)(4)).
After a Type C reorganization, the acquiring corporation can generally transfer the acquired assets
to an 80% or more owned subsidiary (existing or newly formed) without jeopardizing tax-free
reorganization status (see IRC 368(a)(2)(C) and Treas. Reg. 1.368-2(k)(1)). Alternatively, if a
drop down is planned, the transaction can be structured as a triangular Type C reorganization (see
Triangular Type C Reorganization).
Tax Consequences of a Direct Type C Reorganization
If the requirements of a direct Type C reorganization are satisfied, the parties generally defer
current US federal income tax on gains on their stock and asset transfers.
Target Corporation Stockholders
The target corporation stockholders do not recognize taxable gain or loss on the distribution of
voting stock of the acquiring corporation on the liquidation of the target corporation (see IRC
354). However, the target corporation stockholders that receive boot in the liquidation are taxed on
the receipt of that boot as either capital gain or a dividend (see IRC 356). The taxable amount is
the lesser of the amount of boot or the total gain on the transaction. Non-qualified preferred stock
(generally redeemable preferred stock which does not participate in corporate growth to any
significant extent) generally is considered boot and, therefore, is taxable to a target corporation
stockholder.
The target corporation stockholder takes a carryover basis in the acquiring corporation stock
(generally the same basis that the stockholder had in its target corporation stock) (see IRC 358).
The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable
sale or other disposition.
Target Corporation
The target corporation generally does not recognize gain or loss in the tax-free reorganization (see
IRC 361). After the tax-free reorganization, the target ceases to exist.
Acquir ing Corporat ion
The acquiring corporation does not recognize gain or loss in the tax-free reorganization and takes a
carryover basis in the target corporation's assets (generally the same basis that the target
corporation had in the assets) (see IRC 362 and 1032). The receipt of a carryover basis
preserves the unrecognized gain for later recognition in a taxable sale or other disposition.
Acquis it ive D Reorganization
For a transaction to qualify as an acquisitive Type D reorganization (see IRC 368(a)(1)(D)), the
following requirements must be satisfied:
The acquiring corporation acquires "substantially all" the assets of the target corporation.
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Immediately after the transfer of assets, the target corporation or its stockholders (or a
combination of the two) has "control" of the acquiring corporation (see IRC 368(a)(1)(D)).
The target corporation must liquidate and distribute the acquiring corporation stock and any
other consideration received by the target corporation from the acquiring corporation (as well as
the target's other properties (if any)) to the target corporation stockholders in a transaction that
qualifies under IRC 354.
The transaction must meet the COBE and business purposes requirements.
A corporate group may engage in an acquisitive Type D reorganization to facilitate a corporate
restructuring. An acquisitive Type D reorganization that fails to meet the necessary requirements is
taxed as an asset acquisition (see Practice Note, Asset Acquisitions: Tax
Overview (www.practicallaw.com/6-383-6235)).
An acquisitive Type D reorganization is shown in the diagrams below:
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In an acquisitive Type D reorganization, a special control test applies. Control means at least 50%
of the total combined voting power of all classes of stock entitled to vote or at least 50% of the
total number of shares of all other classes of stock.
Although an acquisitive Type D reorganization does not specifically require the use of acquiring
corporation stock as consideration, the "control" requirement effectively requires the use of
acquiring corporation stock as consideration. For example, unless the target corporation or its
stockholders owned significant amounts of acquiring stock before the transaction, the transaction
will not qualify as an acquisitive Type D reorganization treatment unless the consideration includes
substantial amounts of acquiring corporation stock.
"Substantially all" has the same meaning as in a Type C reorganization (assets representing at least
90% of the target corporation's net assets and at least 70% of the target corporation's gross
assets).
Under a tiebreaker rule, a reorganization that qualifies as both a Type C and Type D is treated as a
Type D reorganization (see IRC 368(a)(2)(A)).
After an acquisitive Type D reorganization, the acquiring corporation can generally transfer the
acquired assets to an 80% or more owned subsidiary (existing or newly formed) without
jeopardizing tax-free reorganization status (see Rev. Rul. 2002-85).
Tax Consequences of an Acqu isitive Type D Reorganization
If the requirements of an acquisitive Type D reorganization are satisfied, the parties generally defer
current US federal income tax on gains on their stock and asset transfers.
Target Corporation Stockholders
The target corporation stockholders do not recognize taxable gain or loss on the distribution of
stock of the acquiring corporation on the liquidation of the target corporation (see IRC 354).
However, the target corporation stockholders that receive boot in the liquidation are taxed on the
receipt of that boot as either capital gain or a dividend (see IRC 356). The taxable amount is the
lesser of the amount of boot or the total gain on the transaction. Non-qualified preferred stock
(generally redeemable preferred stock which does not participate in corporate growth to any
significant extent) generally is considered boot and, therefore, is taxable to a target corporation
stockholder.
The target corporation stockholder takes a carryover basis in the acquiring corporation stock
(generally the same basis that the stockholder had in its target corporation stock) (see IRC 358).
The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable
sale or other disposition.
Target Corporation
The target corporation generally does not recognize gain or loss in the tax-free reorganization (see
IRC 361). After the tax-free reorganization, the target ceases to exist.
Acquir ing Corporation
The acquiring corporation does not recognize gain or loss in the tax-free reorganization and takes a
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carryover basis in the target corporation's assets (generally the same basis that target corporation
had in the assets) (see IRC 362 and 1032). The receipt of a carryover basis preserves the
unrecognized gain for later recognition in a taxable sale or other disposition.
Triangular Reorganizations
Types A, B and C acquisitive reorganizations can often be structured as triangular tax-free
reorganizations. Unlike a direct reorganization which involves two parties (the target corporation
and the acquiring corporation), a triangular reorganization generally involves three parties: the
target corporation on the seller side and a parent corporation and a subsidiary (typically wholly-
owned) on the buyer side.
There are two types of triangular Type A reorganizations: a Type A forward subsidiary merger and a
Type A reverse subsidiary merger.
Type A Forward Subsid iary Merger
In a forward subsidiary merger, the target corporation merges under state law into an existing or
newly formed subsidiary in exchange for parent corporation stock (and any other consideration that
is specified in the merger agreement). For corporate purposes, the target's assets and liabilities
become assets and liabilities of the subsidiary (which remains wholly owned by the parent) and the
target ceases to exist.
A forward subsidiary merger qualifies as a tax-free reorganization (see IRC 368(a)(2)(D)) if the
following requirements are satisfied:
Type of subsidiary. The subsidiary must be 80% or more "controlled" by the parent
corporation. This means that the parent corporation must own at least 80% of the total
combined voting power of all classes of stock entitled to vote and at least 80% of the totalnumber of shares of all other classes of stock of the subsidiary corporation. The subsidiary that
is used in a forward subsidiary merger can be a disregarded entity for tax purposes (see Type A
Forward Subsidiary Merger with a Disregarded Entityand Direct Type A Reorganization with a
Disregarded Entity).
Amount of assets. The subsidiary must acquire "substantially all" the assets of the target
corporation in merger. Substantially all has the same meaning as in a Type C reorganization
(assets representing at least 90% of the target corporation's net assets and at least 70% of the
target corporation's gross assets). This requirement limits the target corporation's ability to spin-
off or otherwise dispose of unwanted assets before the merger.
Type of stock. The stock consideration in the merger is limited to parent corporation stock but
there are generally not any restrictions on the type of parent stock (common or preferred and
voting or non-voting) that can be used as consideration. The target corporation cannot receive
any subsidiary stock in the transaction. However, it is permissible to use subsidiary debt
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securities in the transaction.
Qualification as a direct Type A reorganization. The merger would have qualified as a direct
Type A reorganization if the target corporation merged directly into the parent corporation (see
Treas. Reg 1.368-2(b)(2)). This means that 40% or more of the merger consideration must be
parent corporation stock (COI requirement) and the transaction must also meet the COBE and
business purpose requirement.
A Type A forward subsidiary merger that fails to meet the necessary requirements is taxed as an
asset acquisition (see Practice Note, Mergers: Tax Overview (www.practicallaw.com/0-383-6747)).
A Type A forward subsidiary merger is shown in the diagrams below:
In the transaction, the parent corporation can assume liabilities of the target corporation without
jeopardizing tax-free reorganization status (see Treas. Reg 1.368-2(b)(2)).
After a Type A forward subsidiary merger, the acquired assets and subsidiary stock can generally
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be transferred to or dropped into a sister or second-tier subsidiary (provided that the sister or
subsidiary are 80% or more owned by the transferor) without jeopardizing tax-free reorganization
status (see Rev. Rul. 2001-24 and Treas. Reg. 1.368-2(k)(1)).
Tax Consequences of a Type A Forward Subsidiary Merger
The tax consequences of a Type A forward subsidiary merger are as follows:
Target corporation stockholders. The target corporation stockholders do not recognize
taxable gain or loss on the exchange of their target stock for parent stock (see IRC 354).
However, the target corporation stockholders that receive boot are taxed on the receipt of that
boot as either capital gain or a dividend (see IRC 356). The taxable amount is the lesser of the
amount of boot or the total gain on the transaction. Non-qualified preferred stock (generally
redeemable preferred stock which does not participate in corporate growth to any significant
extent) generally is considered boot and, therefore, is taxable to a target corporation
stockholder.
The target corporation stockholder takes a carryover basis in the parent stock (generally the
same basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt
of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or
other disposition.
Target corporation. The target corporation generally does not recognize gain or loss in the tax-
free reorganization (see IRC 361). After the tax-free reorganization, the target ceases to exist.
Subsidiary corporation. The subsidiary corporation generally does not recognize gain or loss
in the tax-free reorganization and takes a carryover basis in the target corporation's assets
(generally the same basis that target corporation had in the assets) (see Treas. Reg. 1.1032-2
and IRC 362). The receipt of a carryover basis preserves the unrecognized gain for later
recognition in a taxable sale or other disposition.
Parent corporation. The parent corporation does not recognize gain or loss in the tax-free
reorganization (see Treas. Reg. 1.1032-2).
Type A Forward Subsidiary Merger with a Disregarded Entity
In certain cases, a forward subsidiary merger involving a disregarded entity can qualify as a Type A
forward subsidiary merger. A disregarded entity is an entity with a single owner that is generally
ignored for tax purposes even though it is a separate legal entity for state law purposes. For
example, a single-member LLC is treated as a disregarded entity for tax purposes unless it elects to
be taxed as corporation. The single owner of the disregarded entity is considered to own the assets
(and is subject to the liabilities) of the disregarded entity for tax purposes and reports the entity's
income and expenses on its own income tax return. For more information about disregarded
entities, see Practice Note, Choice of Entity: Tax Issues (www.practicallaw.com/1-382-9949).
A forward subsidiary merger of a target corporation into a disregarded entity may qualify as a Type
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A forward subsidiary merger. For this to be the case, there are four entities involved in the
transaction rather than three because the disregarded entity is ignored for tax purposes. There is a
target corporation on the seller side and a parent corporation, a subsidiary, and disregarded entity
on the buyer side. For example, the merger of a target corporation into a disregarded entity owned
by a subsidiary (which is in turn 80% or more owned by the parent corporation) may qualify as a
Type A forward subsidiary merger. To qualify, the target stockholders must receive parent
corporation stock and the target corporation must transfer substantially all of its assets to thedisregarded entity (see Treas. Reg. 1.368-2(b)(1)(iii), ex. 4). For a direct Type A merger with a
disregarded entity, see Direct Type A Reorganization with a Disregarded Entity.
Type A Reverse Subsidiary Merger
In a reverse subsidiary merger, a subsidiary of the parent corporation (usually newly formed)
merges under state law into the target corporation in exchange for parent corporation stock (and
any other consideration that is specified in the merger agreement). For corporate purposes, the
subsidiary's assets and liabilities (usually a newly formed subsidiary with little or no assets or
liabilities) become the assets and liabilities of the target, the target is now wholly owned by parent
and the subsidiary ceases to exist.
A reverse subsidiary merger qualifies as a tax-free reorganization (see IRC 368(a)(2)(E)) if the
following requirements are satisfied:
Type of subsidiary. The subsidiary must be 80% or more "controlled" by the parent
corporation. This means that the parent corporation must own at least 80% of the total
combined voting power of all classes of stock entitled to vote and at least 80% of the total
number of shares of all other classes of stock of the subsidiary corporation.
Control and voting stock. The target corporation stockholders must exchange an amount of
stock representing "control" of target solely in exchange for parent voting stock. In many
instances, voting preferred stock is treated as voting stock (generally if the holder of the voting
preferred stock has the right to vote on the election of directors). Other consideration (including
subsidiary stock) may be used to acquire the remaining target corporation stock. Control has
the same meaning as in a Type B reorganization (at least 80% of the total combined voting
power of all classes of stock entitled to vote and at least 80% of the total number of shares of
all other classes of stock).
Amount of assets. After the merger, the target corporation must continue to
own "substantially all" of the assets of the target corporation and of the subsidiary of the parent
corporation (usually a newly formed subsidiary is used with little or no assets). Substantially all
has the same meaning as in a Type C reorganization (assets representing at least 90% of the
target corporation's net assets and at least 70% of the target corporation's gross assets).
Judicial requirements. The reverse subsidiary merger must also satisfy the COBE and
business purpose requirements. The COI requirement is built into the statute for a Type A
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reverse subsidiary merger (voting stock plus a limited amount of boot as permissible
consideration).
A Type A reverse subsidiary merger that fails to meet the necessary requirements is taxed as an
stock acquisition. For more information, see Practice Note, Mergers: Tax
Overview (www.practicallaw.com/0-383-6747).
A Type A reverse subsidiary merger is shown in the diagrams below:
In the transaction, the parent corporation can assume liabilities of the target corporation without
jeopardizing tax-free reorganization status (see Treas. Reg 1.368-2(j)(4))). In addition, drop
downs (either of acquired target stock or acquired assets) to an 80% or more owned subsidiary
after a Type A reverse subsidiary merger do not jeopardize tax-free reorganization status (see
Treas. Reg. 1.368-2(k)(1)).
A significant difference between a Type A reverse subsidiary merger and a direct Type A
reorganization or Type A forward subsidiary merger is that the stock consideration used in a Type A
reverse subsidiary merger must be voting stock. In a direct Type A reorganization or Type A
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forward subsidiary merger, non-voting stock is permissible.
Because the Type A reverse subsidiary merger rules are more restrictive than the direct Type A
reorganization and Type A forward subsidiary merger rules, a Type A reverse subsidiary merger is
typically used only when it is important for corporate purposes that the target corporation survive
(for example, the target corporation's assets are difficult to transfer or are non-transferable).
Tax Consequences of a Type A Reverse Subsidiary Merger
The tax consequences of a Type A forward subsidiary merger are as follows:
Target corporation stockholders. The target corporation stockholders do not recognize
taxable gain or loss on the exchange of their target stock for parent voting stock (see IRC
354). However, the target corporation stockholders that receive boot are taxed on the receipt of
that boot as either capital gain or a dividend (see IRC 356). The taxable amount is the lesser
of the amount of boot or the total gain on the transaction.
The target corporation stockholder takes a carryover basis in the parent stock (generally the
same basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt
of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or
other disposition.
Target corporation. The target corporation generally does not recognize gain or loss in the
reorganization. The target corporation's basis in its assets remains unchanged (see IRC 361)
and the target corporation takes a carryover basis in the subsidiary corporation's assets (usually
a newly formed subsidiary with little or no assets).
Subsidiary corporation. The subsidiary corporation generally does not recognize gain or loss
in the tax-free reorganization. After the tax-free reorganization, the subsidiary ceases to exist.
Parent corporation. The parent corporation does not recognize gain or loss in the tax-free
reorganization.
Triangular Type B Reorganization
In a triangular Type B reorganization, a subsidiary of the parent corporation acquires the stock of
the target corporation solely in exchange for voting stock of the parent corporation and,
immediately after the transaction, the subsidiary corporation has "control" of the target corporation
(see IRC 368(a)(1)(B)). Control is the same 80% control test that is used in a direct Type B
reorganization (see Direct Type B Reorganization). The COI requirement is built into the statute for
a triangular Type B reorganization (parent voting stock as the only permissible consideration) but
the transaction must also meet the COBE and business purposes requirements. A triangular Type B
reorganization that fails to meet the necessary requirements is taxed as a stock acquisition (see
Practice Note, Stock Acquisitions: Tax Overview (www.practicallaw.com/9-383-6719)).
A triangular Type B reorganization is shown in the diagrams below:
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Like the Type A triangular reorganizations, the subsidiary used in the transaction must be 80% or
more "controlled" by the parent corporation.
After the transaction, the target corporation is 80% or more owned by the subsidiary corporation
and the target corporation stockholders who participated in the transaction become stockholders of
the parent corporation. Because the target corporation continues to exist, stockholders that opted
not to participate in the reorganization can continue to own target corporation stock as minority
stockholders if that is permitted under state law.
The stock consideration in the transaction is limited to voting stock (common or preferred) of either
the parent corporation or the subsidiary corporation. A mixture of parent and subsidiary stock is not
permitted. If the subsidiary used its own stock, the transaction would be a direct Type B
reorganization (see Direct Type B Reorganization).
Drop downs of acquired target corporation stock to an 80% or more owned subsidiary after a
triangular Type B reorganization do not jeopardize tax-free reorganization status (see Treas. Reg.
1.368-2(k)(1)).
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Tax Consequences of a Triangular Type B Reorganization
The tax consequences of a triangular Type B reorganization are as follows:
Target corporation stockholders. The target corporation stockholders do not recognize
taxable gain or loss on the exchange of their target stock for parent voting stock (see IRC
354). The target corporation stockholders take a carryover basis in the parent corporation
voting stock (generally the same basis that the stockholder had in its target corporation stock)(see IRC 358). The receipt of a carryover basis preserves the unrecognized gain for later
recognition in a taxable sale or other disposition.
Target corporation. The target corporation does not recognize gain or loss in the tax-free
reorganization. In addition, the target corporation's basis in its assets remains unchanged. After
the tax-free reorganization, the target corporation is 80% or more owned by the subsidiary
corporation.
Subsidiary corporation. The subsidiary corporation generally does not recognize gain or loss
in the tax-free reorganization (see IRC 1032). The subsidiary corporation takes a carryoverbasis in the target corporation stock (generally the same basis that the target corporation
stockholders had in the target corporation stock) (see IRC 362). The receipt of a carryover
basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition.
Parent corporation. The parent corporation does not recognize gain or loss in the tax-free
reorganization (see Treas. Reg. 1.1032-2).
Triangular Type C Reorganization
In a triangular Type C reorganization, a subsidiary of parent corporation acquires "substantially all"the assets of the target corporation in exchange for voting stock of the parent corporation and the
target corporation liquidates (see IRC 368(a)(1)(C)). In the liquidation, the target corporation
distributes the parent corporation stock and other consideration received in the transaction (as well
as any other target assets) to the target corporation stockholders. After the transaction, the target
corporation stockholders who participated in the transaction become stockholders of the parent
corporation. The COI requirement is built into the statute for a Type C reorganization (voting stock
plus limited boot as permissible consideration) but the transaction must also meet the COBE and
business purposes requirements. A triangular Type C reorganization that fails to meet the
necessary requirements is taxed as an asset acquisition (see Practice Note, Asset Acquisitions: Tax
Overview (www.practicallaw.com/6-383-6235)).
A triangular Type C reorganization is shown in the diagrams below:
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Like the Type A triangular reorganizations, the subsidiary used in the transaction must be 80% or
more "controlled" by the parent corporation.
Like a triangular Type B reorganization, the stock consideration in the transaction is limited to
voting stock (common or preferred) of either the parent corporation or the subsidiary corporation.
A mixture of parent and subsidiary stock is not permitted. If the subsidiary used its own stock, the
transaction would be a direct Type C reorganization (see Direct Type C Reorganization).
Like a direct Type C reorganization, up to 20% of the consideration can be boot (for example, cash
and nonvoting stock). If any actual boot is paid, the assumption of a liability will also be treated as
cash boot for purposes of calculating the 20% of permissible boot (see Direct Type C
Reorganization).
Drop downs of acquired assets to an 80% or more owned subsidiary after a triangular Type C
reorganization do not jeopardize tax-free reorganization status (see Treas. Reg. 1.368-2(k)(1)).
Tax Consequences of a Triangular Type C Reorganization
The tax consequences of a triangular Type C reorganization are as follows:
Target corporation stockholders. The target corporation stockholders do not recognize
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taxable gain or loss on the distribution of voting stock of the parent corporation on the
liquidation of the target corporation (see IRC 354). However, the target corporation
stockholders that receive boot (consideration other than parent voting stock) in the liquidation
are taxed on the receipt of that boot as either capital gain or a dividend (see IRC 356). The
taxable amount is the lesser of the amount of boot or the total gain on the transaction. Non-
qualified preferred stock (generally redeemable preferred stock which does not participate in
corporate growth to any significant extent) generally is considered boot and, therefore, istaxable to a target corporation stockholder.
Target corporation. The target corporation generally does not recognize gain or loss in the tax-
free reorganization (see IRC 361). After the tax-free reorganization, the target ceases to exist.
Subsidiary corporation. The subsidiary corporation does not recognize gain or loss in the tax-
free reorganization and takes a carryover basis in the target corporation's assets (generally the
same basis that the target corporation had in the assets) (see IRC 362 and 1032). The
receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable
sale or other disposition.
Parent corporation. The parent corporation does not recognize gain or loss in the tax-free
reorganization (see Treas. Reg. 1.1032-2).
Carryover of NOLs after a Tax-Free Reorganization
Before a tax-free reorganization, the target corporation may have valuable tax attributes that can
be used to offset its taxable income and the acquiring corporation may want to obtain access to
those pre-reorganization tax attributes. One example of a valuable tax attribute is n et o p er at in glo ss e s ( w w w .p r a ct ica ll a w .c o m / 8 - 3 8 2 - 3 6 4 2 )(NOLs). A taxpayer has a NOL when its allowable
deductions exceed its gross income in a specific taxable year (see IRC 172).
In a transaction that is structured as a tax-free acquisitive reorganization, the acquiring corporation
obtains access (directly or indirectly) to the pre-reorganization tax attributes (such as NOLs) of the
target corporation, subject to several limitations. The most significant limitations on the use of the
target corporation's tax attributes after a tax-free reorganization are IRC 269 and 382 (see
Limitations of the Use of NOLs After a Tax-Free Reorganization). The tax attributes carryover
regardless of whether the tax-free reorganization is structured as a stock or asset transfer for tax
purposes. By contrast, in a taxable asset acquisition, the target corporation's NOLs do not carryover
to the acquiring corporation (see Practice Notes, Asset Acquisitions: TaxOverview (www.practicallaw.com/6-383-6235) and Mergers: Tax
Overview (www.practicallaw.com/0-383-6747)).
NOLs of a target corporation in tax-free reorganizations are treated as follows:
Direct asset transfers. In direct Types A, C and acquisitive D reorganizations, the acquiring
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corporation inherits the target corporation's NOLs (see IRC 381), subject to the limitations in
IRC 269 and 382.
Indirect asset transfers. In Type A forward subsidiary mergers and triangular Type C
reorganizations, the subsidiary corporation inherits the target corporation's NOLs (see IRC
381), subject to the limitations in IRC 269 and 382.
Stock transfers. In a direct and triangular Type B reorganization as well as in Type A reverse
subsidiary mergers, the target corporation's NOLs remain with the target and can be used by
the target after the tax-free reorganization, subject to the limitations in IRC 269 and 382.
Limitations o f the Use of NOLs After a Tax-Free Reorganization
Under IRC 269, the target corporation's tax attributes do not carryover if the principal purpose of
the reorganization was to avoid tax by acquiring the tax attributes (for example, NOLs).
IRC 382 generally limits the post-acquisition use of pre-reorganization NOLs (and certain built-in
losses) of the target corporation after certain ownership changes. A tax-free acquisitive
reorganization generally triggers an IRC 382 ownership change if the target corporation
stockholders own less than 50% of the acquiring corporation's stock immediately after the tax-free
reorganization (see IRC 382(g)).
After a IRC 382 ownership change, the use of pre-reorganization NOLs (and certain built-in
losses) is limited annually to an amount equal to the value of the target corporation's stock at the
time of the reorganization multiplied by a statutory interest rate (see IRC 382(b)(1)).
Double Dummy Merger: Tax-Free Transaction but not Tax-FreeReorganization
The COI requirement for tax-free reorganizations requires that 40% or more of the
consideration be stock of the acquiring corporation (or its affiliate). In some cases, the parties
may want to use less stock consideration but still desire tax free treatment for the stockholders
receiving stock consideration.
A "double dummy" merger can be used to avoid the COI requirement because it is a tax-free
transaction under IRC 351 and therefore not subject to the COI requirement. Like a tax-free
reorganization, a double dummy merger provides tax-free treatment on the stock portion of the
transaction (however, the cash/non-stock portion of the deal is taxable). It is used most
frequently in a merger of equals.
A double dummy merger is a transaction using double reverse subsidiary mergers with a new
permanent holding corporation at the top. To facilitate the double dummy merger, three new
companies are formed:
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New corporation (which will be the new holding company after the mergers).
Subsidiary 1 (which will be merged into the target company).
Subsidiary 2 (which will be merged into the acquiring company).
A double dummy merger is shown in the diagrams below:
After the double dummy merger, the new holding corporation must be maintained permanentlyfor the transaction to qualify as tax free under IRC 351. In addition, the former stockholders of
the target and acquiring companies must "control" the new holding corporation. Like many of the
tax-free reorganizations, control means at least 80% of the total combined voting power of all
classes of stock entitled to vote and at least 80% of the total number of shares of all other
classes of stock.
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The tax advantages of the double dummy structure over a tax-free reorganization are:
No COI requirement.
No "substantially all" the assets requirement.
No requirement that the new holding corporation "control" the target or the acquiringcompany.
Target and acquiring companies do not need to be corporations.
For corporate reasons, the double dummy merger is not used frequently despite the tax
advantages. For example, the parties often do not want a new corporate structure with a
permanent holding company at the top. In addition, the double reverse mergers may double the
amount of necessary third party consents.
Resource information
Resource ID: 0-386-4212
Products: PLC Corporate and Securities, PLC US Law Department
This resource is maintained, meaning that we monitor developments on a regular basis and update it as
soon as possible.
Resource history
Resource created
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