Cross Chain… 351?
LTR 201150021 is a surprising cross chain restructuring ruling that treats the transfer of the assets of one subsidiary of P to a subsidiary at the bottom of another chain of subsidiaries below P as a series of section 351 exchanges and a D reorganization at the bottom of the acquiring chain. This is somewhat inconsistent with Rev. Rul. 78-130, 1978-1 C.B. 140. Although not the focus of the ruling, it appears that what was actually going on with the taxpayer was repatriation of foreign earnings in a most efficient manner, plus a reshuffling of assets to facilitate further repatriations.
Facts: U.S. Parent (“P”) owned three groupings of subsidiaries: (1) USS (with its foreign subs), (2) several foreign subs including particularly FS 1, 4 and 5, and (3) US Holdco, which owned F Holdco2, Acquiring and F Holdco1. The first relevant transaction was the purchase by F Holdco2 of Target, using cash borrowed by F Holdco 2 from US Holdco. So US Holdco held a note from F Holdco2 and F Holdco2 owned Target, which had been bought with the borrowed cash.
One part of the transactions ruled on involved merging Target into Acquiring. This separated the purchased asset (Target) from the purchase money debt, which was owed by F Holdco2. Next US Holdco contributed F Holdco 1 to F Holdco 2. F Holdco 1 assumed the debt to US Holdco; also preferred equity certificates (PECS) were created or transferred so that F Holdco 1 owed PECS to FHoldco2, and F Holdco2 owed PECS to USHoldco. PECS are treated as debt for foreign tax purposes but the taxpayer treated them as equity for US tax purposes (the ruling caveated this treatment and did not rule on it).
As a result of these restructurings, Acquiring got the Target assets (by merger) free and clear of the purchase money debt that was incurred to buy Target; meanwhile that debt was transferred to F Holdco1 at the bottom of a parallel chain under US Holdco, with F Holdco1 owing both the purchase money debt to US Holdco and PECS to its immediate parent F Holdco2. The merger was treated as a Type A reorganization. However, Target’s original purchaser, F Holdco2, got no actual stock of Acquiring in exchange for the merger of Target.
Another preliminary step was a sale by USS of some of its foreign subs to F Holdco 1 for cash. This was treated as a section 304 sale, producing dividends.
These parts of the restructuring set up the next part, which entails moving assets under F Holdco1, presumably with the aim of producing income that can be used to repay the debt to US Holdco and service the PECS. The movement of those assets is the focus of the ruling.
In that movement, P contributed the stock of FS 1, FS 4 and FS 5 to US Holdco, which contributed the same stock to F Holdco2, which contributed the same stock to F Holdco1. Finally, FS 1, FS 4 and FS 5 checked the box to be disregarded entities owned by F Holdco 1.
Follow the cash: Before addressing the rulings, it is important to understand where the cash went in these transactions. First, as noted above, US Holdco loaned cash to buy Target and then Target was removed from its purchaser, which received nothing in exchange for the transfer of Target to Acquiring, but leaving that purchaser indebted to US Holding. Thus, debt was incurred offshore with no apparent means of repayment.
Second, another foreign sub, F Holdco 1, paid its cash to USS to purchase other foreign subs. This constituted a second impoverishment of the same chain of foreign subs, because F Holdco 1 was to be dropped under F Holdco2, the debtor on the purchase money debt. These steps had both repatriated cash, and set up a mechanism for foreign earnings to be repatriated as loan repayment or as dividends paid on PECS, which were designed to produce foreign deductions.
The only remaining step left was to provide a cash source to repay the debt and replenish US Holdco. Evidently taxpayer did not want Target burdened with this debt so it pushed the three other foreign subs into F Holdeco1, presumably to produce future cash flow.
Perhaps the taxpayer plans to sell the chain that is now loaded up with debt, and keep Target?
Section 304. The cross chain stock sales were treated as section 304/302/301 dividends, which is not surprising.
Type A reorganization. The cross chain merger of Target into Acquiring for no consideration was treated as a section 368(a)(1)(A) reorganization. The ruling treated the parent of Target, F Holdco1, as receiving deemed stock of Acquiring. It did not discuss what happened to that deemed stock. Of course that deemed stock could not stay in F Holdco1, under normal tax constructs, because it owns no stock in Acquiring. Normally. F Holdco1 would have to be deemed to distribute that stock to F Holdco2, which would be deemed to distribute it to US Holdco, which actually owed Acquiring.
However, the taxpayer represented that F Holdco1 would not dispose of the deemed issued stock. This is strange. The ruling does not caveat what happens to the deemed issued stock. If the deemed issued stock of Acquiring were deemed pushed up to to F Holdco 2 there would be no section 311 gain, because Target was just acquired and the exchanged basis would presumably be equal to the value of the Acquiring stock deemed received in the merger. However, its push out to US Holdco would be a dividend?
Type D reorganizations. The two level drops of stock down the chain with a check the box liquidation at the bottom was treated as two section 351 exchanges followed by a D reorganization of the subs as owned by F Holdco2 into F Holdco1. In other words the final drop of the stock to F Holdco1 followed by the check the box liquidation was treated not as a final section 332 liquidation but as a final sideways reorganization of FS1, FS4 and FS5 into F Holdco1.
The possible alternate treatment was under Rev. Rul. 78-130, cited above. In that ruling, P owned S1 and in another chain owned S2, which owned N. P contributed S1 to S2 and then S1 transferred its assets to N and S1 liquidated. At that time the section 304 rules were not applied to attribute ownership of N to P for purposes of finding a Type D reorganization. The Rev. Rul. stated that the stock drop and asset transfer were integrated and so the stock drop would be ignored as an independent step. Even though viewing the integrated transaction as a cross chain asset transfer from S1 to N could not be a D reorganization, it could be a triangular C reorganization, and the IRS so ruled.
If the same approach were applied to the letter ruling, the part of the transaction treated as section 351 exchanges and a D reorganization would be treated as one cross chain D reorganization (because section 304 attribution rules now apply to find a D reorganization).
When publicly questioned, a representative of the IRS stated that the Rev. Rul. faced a different situation in that the alternate characterization would have been a taxable cross chain transfer. In contrast in the letter ruling there were two potentially tax deferred characterizations. The IRS chose to respect each step in the letter ruling. Therefore, the construct in the Rev. Rul. must not be an all purpose recast.
This suggests that the explanation for the Rev. Rul. is that the IRS went out of its way to help the taxpayer by applying a step transaction analysis to ignore steps. When the taxpayer did not need such help in the letter ruling, at least when the alternative was another reorganization exchange, the IRS let form control.
Takeaways. Cross chain transfers are perhaps the most common corporate event of tax significance for multinationals today. They can be accomplished through section 355, they can be accomplished through direct cross chain sales, and they can be accomplished by this drop and check methodology. This letter ruling takes some of the uncertainty out of the last alternative, but it is only a letter ruling. Taxpayers planning to do something like this should analyze the transaction as being treated in every possible way and try to satisfy themselves that it “works” however it is characterized; otherwise, consider seeking a ruling like this taxpayer did.