Tax on corporate transactions in United States: overview

A Q&A guide to tax on corporate transactions in the United States.

The Q&A gives a high level overview of tax in the United States and looks at key practical issues including, for example: the main taxes, reliefs and structures used in share and asset sales, dividends, mergers, joint ventures, reorganisations, share buybacks, private equity deals and restructuring and insolvency.

To compare answers across multiple jurisdictions, visit the Tax on Corporate Transactions Q&A tool Country Q&A tool. The Q&A is part of the PLC multi-jurisdictional guide to tax on corporate transactions. For a full list of jurisdictional Q&As visit www.practicallaw.com/taxontransactions-mjg.

Contents

Tax authorities

1. What are the main authorities responsible for enforcing taxes on corporate transactions in your jurisdiction?

The Internal Revenue Service (IRS) is the main authority responsible for enforcing US federal taxes. Individual states have authorities that enforce state taxes.

 

Pre-completion clearances and guidance

2. Is it possible to apply for tax clearances or obtain guidance from the tax authorities before completing a corporate transaction?

If requested by the taxpayer, the IRS will issue a private letter ruling on the tax consequences of certain proposed corporate transactions. At the beginning of each year, the IRS issues a Revenue Procedure describing:

  • The procedures for applying for a ruling.

  • The fee to apply, the fee is currently US$18,000 for most rulings.

  • Areas in which the IRS will not rule.

Due to the time and expense required to obtain a private letter ruling, most corporate transactions proceed based on the opinions of tax counsel, which are not binding on the tax authorities. Spin-offs, on the other hand, often do involve IRS private letter rulings, at least if public shareholders are involved.

Taxpayers usually rely on a federal tax ruling to determine state tax consequences where the state tax rules conform to the federal rules. Some states require the filing of notice for certain types of transactions. Further, some states require clearance from their taxing authority before a merger or liquidation becomes final.

 

Main taxes on corporate transactions

Transfer taxes and notaries' fees

3. What are the main transfer taxes and/or notaries' fees potentially payable on corporate transactions?

Transfer or stamp taxes and notaries' fees

There are no federal transfer taxes or notaries' fees payable on corporate transactions.

State or local transfer taxes, stamp taxes or fees can apply to some transactions, particularly those involving asset transfers. There may be recording fees and transfer taxes if real property is transferred directly or indirectly, which is usually based on a percentage of the sales price, with either the seller or buyer responsible, depending on the jurisdiction and the nature of the transaction.

 

Corporate and capital gains taxes

4. What are the main corporate and/or capital gains taxes potentially payable on corporate transactions?

Federal income tax

US corporations, US tax resident individuals and citizens are subject to federal income tax on their worldwide income, including capital gains. Credits for income taxes paid or accrued to foreign jurisdictions are available to limit double taxation.

Corporate income is subject to tax at the corporate level when earned and again at the shareholder level when distributed to the shareholder, or realised through a sale of shares in the corporation.

Dividends

Dividends historically have been taxed to individuals as ordinary income. However, qualified dividends received by US individuals are now taxed at long-term capital gains rates, generally 15% (20% for high income taxpayers). Qualified dividends are generally dividends received from the following corporations:

  • Domestic corporations.

  • Corporations incorporated in US possessions.

  • Foreign corporations eligible for the benefits of a "comprehensive" US income tax treaty (other than passive foreign investment companies).

  • Foreign corporations (other than passive foreign investment companies), the stock of which is readily tradable on an established US securities market.

Beginning in 2013, an additional 3.8% Medicare contribution tax is imposed on an individual's net investment income (generally including dividends and capital gains), to the extent that the individual's adjusted gross income exceeds certain high-income thresholds.

Dividends paid to a domestic corporation are generally eliminated if both corporations are members of the same US consolidated group (see Question 10). Alternatively, a dividend paid by a US corporation to a non-consolidated US corporation qualifies for a dividends-received deduction of between 70% to 100%, depending on the percentage of ownership by the dividend receiving corporation in the dividend paying corporation.

Capital gains

Transfers of corporate shares or a corporation's assets can trigger capital gains tax. These transfers typically result in a capital gain for the seller, but may result in ordinary income when, for example, the asset transferred is inventory property held for sale to customers in the ordinary course of business. Gain is generally determined by subtracting the taxpayer's basis in the asset or stock from the amount realised on the transfer. The taxpayer's basis is its original cost, adjusted for such items as expenditures that enhance the asset's value and allowances for depreciation and amortisation. No adjustments for inflation are allowed.

State income taxes

Most, but not all, of the 50 states and some municipalities impose income taxes on individuals and corporations. Some states' tax laws mirror the federal tax law, using federal taxable income as the starting point to calculate state taxable income. Income determined under federal rules is usually adjusted to:

  • Eliminate certain income.

  • Reflect only the income which can be allocated to the activities occurring in the state, using either the corporation's separate return or a combined return of all members of the same unitary business. In combined return states, business income is apportioned using a formula based on the location of such factors as sales, payroll, and property. Because states use different apportionment formulae, the total state tax bases can exceed or be less than 100% of the combined group's federal taxable income.

  • Add back income taxable for state, but not federal, purposes. For example, state income taxes are allowed as a deduction for federal tax purposes, but generally not for state tax purposes.

  • Adjust expenses that can be treated differently for federal and state purposes, such as depreciation.

Most states tax ordinary income and capital gains at the same rate.

Not all states mirror the federal income tax, and some have multiple tax bases. A taxpayer must review the laws of each state in which it does business to determine:

  • Whether the state will tax a corporate transaction.

  • What amount will be subject to tax.

  • What rate of tax will be applied.

Federal income tax rates

Corporations are taxed on ordinary income and capital gains at the same graduated tax rates ranging from:

  • 15% for taxable income below US$50,000.

  • 35% on taxable income in excess of US$10 million.

Capital losses are only deductible against capital gains and not against ordinary income. In the case of a corporation, net capital losses can be carried back three years and forward five years. In the case of an individual, net capital losses can be carried forward indefinitely, but generally cannot be carried back.

Individuals are taxed on ordinary income and short-term capital gains (gains on assets held for not more than one year) at graduated rates currently ranging from 10% to 39.6%. Individuals are taxed on long-term capital gains at a maximum of 20%, plus the 3.8% Medicare contribution tax (if applicable). Individuals can deduct capital losses each year only to the extent of capital gains plus US$3,000.

State income tax rates

State income tax rates vary depending on the state. There are a few states that do not impose an income tax on individuals and/or on corporations. A few municipalities, such as New York City and Philadelphia, impose a local income tax in addition to the state income tax.

 

Value added and sales taxes

5. What are the main value added and/or sales taxes potentially payable on corporate transactions?

Value added tax

There are no federal or state value added taxes, although some states impose a gross receipts tax.

Sales and use taxes

Most states, but not the federal government, impose sales and use taxes that are potentially payable on corporate transactions. These taxes apply to transfers of tangible personal property, are based on the property's sale price and are generally the buyer's obligation. Sales tax is generally collected by the seller and remitted to the state taxing authority. Use tax, on the other hand, is reported and paid by the buyer directly to its state taxing authority. Significantly, important exceptions may apply to corporate transactions (see Question 14).

 

Other taxes on corporate transactions

6. Are any other taxes potentially payable on corporate transactions?

No other taxes generally apply to corporate transactions.

 

Taxes applicable to foreign companies

7. In what circumstances will the taxes identified in Questions 3 to 6 be applicable to foreign companies (in other words, what "presence" is required to give rise to tax liability)?

Transfer taxes and notaries' fees

Transfer taxes and notaries' fees apply to transactions involving US real property and sometimes shares, generally regardless of whether the company is foreign or has a presence in the US.

Income and capital gains taxes

Foreign corporations engaged in a trade or business in the US are subject to federal income tax on income effectively connected to that trade or business (or attributable to a US permanent establishment (PE), in the case of a foreign company entitled to the benefits of a US double tax treaty). This tax is imposed on a net basis, at the same rates that apply to domestic corporations. Whether a PE exists depends on the terms of the applicable US double tax treaty. Many (but not all) US tax treaties conform to the Organisation for Economic Co-operation and Development (OECD) standards for determining the existence of a PE.

Foreign corporations that are not engaged in a trade or business in the US (through a PE, in the case of a US double tax treaty company) are generally subject to federal income tax only on certain US-source dividends, interest (with exceptions), and other fixed and determinable annual and periodical income. The tax is a withholding tax of 30% of the gross amount of that income, but can be reduced or eliminated by a US double tax treaty.

Except for sales of US real property interests, foreign persons and entities do not pay federal income tax on capital gains, unless the gains are effectively connected to a trade or business within the US (or attributable to a US PE, in the case of a US double tax treaty company). Gains on the disposition of US real property interests (including shares in a US real property holding corporation) are subject to federal income tax on a net basis, which the buyer tentatively collects through a 10% withholding tax on the gross proceeds. The seller can obtain a pre-transaction withholding certificate from the IRS to permit reduced withholding if 10% of the gross proceeds will exceed the tax due on the disposition of the US real property interest. Alternatively, a US income tax return can be filed to obtain a refund of the excess tax withheld.

For state income tax purposes, if a foreign corporation has sufficient "nexus" with a state, that state may also tax the company.

Sales and use taxes

Foreign corporations doing business in a state generally pay the same sales or use taxes as domestic companies.

Other taxes

Foreign corporations engaged in a trade or business in the US (through a PE, in the case of a US double tax treaty company) are also subject to a 30% branch profits tax, unless that tax is reduced or eliminated by a US double tax treaty. A branch level interest tax also applies under certain circumstances, for example where the US branch's interest expense deduction is greater than the amount of interest it pays due to an allocation of home office interest expense. The rate of branch interest tax is 30%, unless reduced or eliminated by a US double tax treaty.

 

Dividends

8. Is there a requirement to withhold tax on dividends or other distributions?

The payer of a dividend (defined as distributions out of current or accumulated earnings and profits) to a foreign corporation is generally required to withhold 30% of the gross amount of the dividend. US double tax treaties usually reduce, and in the case of certain dividends paid to a foreign parent company by its US subsidiaries, may eliminate this dividend withholding tax.

A distribution in excess of current or accumulated earnings and profits is treated as a non-taxable return of capital, to the extent of the recipient's basis in the shares. Amounts received in excess of basis give rise to capital gain taxable in the manner described above (see Question 7). Generally, there is no obligation to withhold on capital gains distributions.

 

Share acquisitions and disposals

Taxes potentially payable

9. What taxes are potentially payable on a share acquisition/share disposal?

Transfer taxes and notaries' fees

Transfer taxes are not usually payable on a share acquisition (see Question 3).

Income and capital gains taxes

Federal income tax is payable by the seller on the net capital gains (see Question 4) realised on the sale or exchange of shares.

An acquisition of shares is generally tax-free to the buyer, unless the buyer exchanges appreciated property for the shares.

If a share sale is taxable to the seller for federal income tax purposes, it is typically also taxable for state income tax purposes (see Question 4). Depending on the relationship between the seller and the corporation whose shares are sold, the gain from the sale may be apportioned to the states in which the seller does business (using each state's apportionment formula) or allocated to a specific state (usually the seller's corporate domicile). If the shares sold are held only for investment purposes, the gain is usually allocated to the seller's corporate domicile, which is generally the state of its main administrative office or its state of incorporation.

 

Exemptions and reliefs

10. Are any exemptions or reliefs available to the liable party?

Tax-free reorganisations

A gain can be deferred (not currently taxed) in transactions meeting the statutory reorganisation requirements to the extent that the selling shareholder receives stock of the acquiring corporation in the transaction (see Questions 21 and 27).

Section 338(h)(10) elections

If a corporation acquires at least 80% of a target's shares in a taxable purchase, the parties can elect to treat the sale of shares as an asset sale (section 338(h)(10), Internal Revenue Code) (Code). This election can reduce future tax burdens of the buyer by permitting the buyer to recover its purchase price through increased depreciation and amortisation deductions (see Question 13). However, this can cause tax problems for the seller.

Transfers within consolidated groups

A gain on share transfers between US consolidated group members is generally deferred until the seller leaves the group or the shares are transferred outside the group. A consolidated group consists of two or more US corporations, or chains of corporations, owned by an 80% or more (vote and value) common parent, which elect to file a consolidated return.

Target losses

The ability to use a target's operating loss carryovers from pre-acquisition periods against post-acquisition income is limited (section 382, Code). However, a target corporation's net operating loss can be used to offset the gain on the disposition of its assets. These rules can be quite complicated.

Subsidiary liquidations

No gain is generally recognised by the parent corporation or the subsidiary on liquidation of a solvent 80% or greater US subsidiary, although there would be tax on any minority shareholder(s) (less than 20%), and to that extent, also on the distributing corporation.

Section 351 incorporation transactions

No gain or loss is generally recognised on the transfer of property to a corporation in which the transferors own at least an 80% controlling interest immediately after the transaction.

These rules and those discussed in Questions 13, 15, 21 and 27 may also minimise state income taxes, particularly in states whose tax laws mirror the federal income tax.

 

Tax advantages/disadvantages for the buyer

11. Please set out the tax advantages and disadvantages of a share acquisition for the buyer.

Advantages

The biggest advantage is in negotiation of price. The seller typically will want to sell shares (where one level of tax applies). If the seller has the corporation sell its assets and then liquidate, there are two levels of tax.

Basis reduction can be avoided where the target's asset basis (original cost adjusted for such items as depreciation) is higher than fair market value.

Subject to limitations under section 382 of the Code (which apply when there is a change in ownership of 50% or more), buyer corporations can generally use net operating and capital loss carryovers (see Question 10).

Disadvantages

The buyer assumes all of the target's liabilities (including contingent and unknown) and, if the target belonged to a consolidated group, of the potential liability to pay other group members' federal income tax.

The bases of the corporation's assets are not increased to reflect the corporation's value unless an election under section 338 of the Code is made (see Questions 10 and 13). However, a 338 election can trigger tax at the corporate level, meaning there is potentially a price to be paid for the asset basis step up.

The amount paid for the target's goodwill cannot generally be amortised unless an election under section 338 of the Code is made.

 

Tax advantages/disadvantages for the seller

12. Please set out the tax advantages and disadvantages of a share disposal for the seller.

Advantages

Generally, federal income taxation applies at the shareholder level, but there is no corporate level tax.

There is generally no federal income tax to a foreign non-resident shareholder on the gain from the sale of a US corporation that is not a US Real Property Holding Corporation.

The buyer can make an election under section 338 of the Code to treat a stock sale as an asset sale, resulting in tax benefits (see Questions 10 and 13), but this should be discussed during negotiations in case the buyer's election will cause problems for the seller.

Disadvantages

Built-in gain in the target shares is recognised immediately. However, deferral of gain is possible if the acquisition is structured as a tax-free reorganisation (see Questions 21 and 27).

 

Transaction structures to minimise the tax burden

13. What transaction structures (if any) are commonly used to minimise the tax burden?

Tax-free reorganisations

Target shareholders (sellers) do not recognise a taxable gain in their target shares at the time of the acquisition if the transaction qualifies as a tax-free reorganisation under the Code (see Questions 21 and 27). Built-in gain or loss is generally deferred to the extent the sellers receive stock in the exchange.

Section 338 elections

In a taxable share acquisition, a buyer that is a corporation can make an election under section 338(h)(10) (joint election with seller) or under section 338(g) of the Code to treat the acquisition as an asset purchase.

To make either the section 338(g) or section 338(h)(10) election, the buyer must be a corporation that acquires at least 80% of the target's shares. The section 338(h)(10) election, which is more common to domestic acquisitions, is available if the target either:

  • Qualifies as, and has made an election to be taxed as, a qualifying small business (that is, under Subchapter S of the Code) corporation.

  • Is a member of a US affiliated group filing, or eligible to file, a consolidated return.

As a result of the election, the target is deemed to sell all of its assets to the buying corporation and then liquidate in what is generally a non-taxable transaction (see Question 10). The target's assets receive a stepped-up basis for depreciation and amortisation purposes, sometimes with little or no additional tax cost to the seller.

A section 338(g) election similarly results in a stepped-up basis in the assets on the deemed asset sale, but the shareholders are also taxed on the sale of target's stock. In addition, in a domestic transaction, the target must file a one-day tax return and pay tax as though it sold all of its assets. This often makes a section 338 election unattractive in domestic acquisitions. The target's gain on the deemed sale of its assets can be offset by the target's net operating losses.

The election may not result in any additional corporate tax if the target is a foreign corporation. While a section 338(g) election for an acquired foreign corporation generally does not result in any tax on the deemed asset sale, recently enacted legislation under section 901(m) of the Code may limit the benefits of the election. It can cause a loss of foreign tax credits, but most international acquisitions still involve section 338(g) elections.

Similar techniques can be used to reduce state corporate income taxes in states that mirror the federal income tax.

 

Asset acquisitions and disposals

Taxes potentially payable

14. What taxes are potentially payable on an asset acquisition/asset disposal?

Federal income tax

Federal income tax is generally payable on capital gains and ordinary income from the sale or exchange of assets. The character of the gain (capital or ordinary) depends on the nature of the assets. Inventory, for example, is ordinary income property while stock in another corporation usually constitutes capital gain property. Certain capital gains resulting from the sale or exchange of depreciable property may be recharacterised as ordinary income. For corporations, the tax rates that apply to capital gains and ordinary income are the same. For individuals, capital gains are subject to a lower tax rate than ordinary income (see Question 4).

State and local tax

The sale of assets is also taxable at the state and local level.

Sales and use tax

The laws of each relevant state (there is no federal sales and use tax) should be considered to determine whether sales and use taxes apply. Generally, states impose sales and use taxes to sales of tangible property. Certain exemptions may be available (for example, for resellers or occasional sales).

Transfer tax and notaries' fees

See Question 3.

 

Exemptions and reliefs

15. Are any exemptions or reliefs available to the liable party?

Tax-free reorganisations

A gain (or loss) may be deferred in a transaction that qualifies as a reorganisation under section 368(a) the Code (see Questions 21 and 27).

Section 351 exchanges

A gain (or loss) is not triggered if the assets are transferred to a corporation that is at least 80% owned by the transferring shareholder(s) (immediately after the transfer) in exchange for shares in the transferee corporation.

Contributions to partnerships

A gain (or loss) is not triggered if contributed to a partnership or limited liability company taxed as a partnership in exchange for a membership interest in the partnership or Limited Liability Company (LLC). No minimum ownership by the transferring members is required.

Transfers within consolidated groups

Asset transfers within a consolidated group generally do not trigger gain recognition while the assets and affected members remain within the same consolidated group (see Question 10).

Subsidiary liquidations

No gain (or loss) is recognised on the distribution of assets by an 80% or greater subsidiary in complete liquidation.

Section 1031 exchanges

A gain (or loss) is not triggered when property used in a trade or business, or held for investment, is exchanged for like-kind property. Some types of property, such as shares and securities, are not eligible. This provision most frequently applies to real property.

Depreciation

Depreciation is allowed as a deduction in computing taxable income. The amount of depreciation allowed per year is based on the tax basis of the property. In an asset acquisition (other than a tax-free reorganisation) the depreciable basis will generally be its cost at the time of the acquisition. Section 338 elections can be made to treat an acquisition of stock as a deemed acquisition of assets resulting in an increase in cost basis for US tax purposes (see Question 12).

Amortisation of intangibles

Most acquired intangibles used in a trade or business, or held for the production of income, are amortised on a straight-line basis over 15 years under section 197 of the Code. Deductions for acquired goodwill are generally not available in share acquisitions, unless the transaction is treated as a deemed asset acquisition as a result of a section 338 election.

 

Tax advantages/disadvantages for the buyer

16. Please set out the tax advantages and disadvantages of an asset acquisition for the buyer.

Advantages

In a taxable asset acquisition the buyer will hold the assets with a cost basis equal to the amount paid in the acquisition. Because depreciation and amortisation deductions are calculated based on asset basis, the buyer will realise a greater tax benefit in comparison to the case where the buyer purchased shares (assuming there is no section 338 election).

The buyer's exposure to tax and other contingent liabilities of the target is limited. For example, the buyer does not incur the potential residual tax liability of a selling consolidated group.

Disadvantages

The seller is likely to seek a higher sales price to compensate for increased aggregate taxes (due to two eventual levels of taxation) (see Question 4).

Transfer, sales and use taxes may apply.

If loss is recognised on the exchanged assets, the buyer will claim reduced depreciation and amortisation deductions. The buyer may mitigate this by negotiating a lower sales price.

 

Tax advantages/disadvantages for the seller

17. Please set out the tax advantages and disadvantages of an asset disposal for the seller.

Advantages

There is a higher potential sales price due to the buyer obtaining a higher depreciable/amortisable basis in the assets. The seller's net operating losses may offset gains.

Disadvantages

Structuring the disposition of a business as an asset sale generally triggers two levels of taxation in the year of the disposition. The asset sale is subject to a corporate level tax, generally imposed at 35% of the amount of the gain plus applicable state income taxes (see Question 4). Then, the individual shareholders are subject to capital gains or dividend taxes on the distribution of the after-tax proceeds, each generally at 15% (or for high income individual taxpayers, 20%, plus the 3.8% Medicare contribution tax), assuming the proper holding period requirements are met (see Question 4).

Transfer, sales and use taxes may apply.

 

Transaction structures to minimise the tax burden

18. What transaction structures (if any) are commonly used to minimise the tax burden?

Built-in gain can be deferred for federal and state income tax purposes on asset acquisitions that qualify as tax-free reorganisations (section 368(a), Code) (see Questions 21 and 27).

 

Legal mergers

Taxes potentially payable

19. What taxes are potentially payable on a legal merger?

Income and capital gains tax

Acquisitive mergers are usually tax-free to the seller. For acquisitive mergers that do not qualify as tax-free reorganisations, the following tax results apply:

  • To the seller. Taxation of the gain realised on the exchanged shares.

  • To the target. In some cases, there can be taxation of the gain realised on a deemed sale of the target's assets transferred in the merger for fair market value.

Transfer tax and notaries' fees

See Question 3.

 

Exemptions and reliefs

20. Are any exemptions or reliefs available to the liable party?

Mergers under the relevant corporation laws and other acquisitive reorganisations generally qualify as tax-free reorganisations to the seller (see Questions 21 and 27). Tax is generally deferred to the extent that stock or securities of the target are exchanged for stock or securities of the buyer (or in some cases of the buyer's parent). The seller's basis in the exchanged stock or assets is preserved in the same stock or assets in the transferee's hands or in other shares received in the exchange.

However, sellers are taxed immediately on the lesser of the gain realised on their target shares, or the amount of cash or property other than shares (boot) that is received in the merger.

Structuring an acquisition as a merger can result in a potential detriment to the buyer, since the buyer succeeds to the target's historic basis in its assets and, therefore, does not obtain increased depreciation or amortisation deductions for its purchase price. A section 338 election cannot be made with respect to a corporation that is acquired in a tax-free reorganisation.

 

Transaction structures to minimise the tax burden

21. What transaction structures (if any) are commonly used to minimise the tax burden?

Reorganisation: with buyer's shares

The target merges into the buyer with sellers exchanging their shares of the target for shares of the buyer, or a combination of shares and boot. This is an "A" reorganisation.

To qualify, the merger must:

  • Be effected under state or foreign statutes by which, by operation of law, the target's assets and liabilities become assets and liabilities of the buyer, and the target ceases to exist.

  • Be undertaken for non-tax business reasons (business purpose requirement).

  • Result in at least 40% of the consideration received by the sellers consisting of shares in the buyer ("continuity of interest" or "COI" requirement).

  • Satisfy the continuity of business enterprise (COBE) requirement that the buyer continues after the merger at least one of the target's significant historic businesses, or uses a significant portion of the target's historic business assets in a business.

Reorganisation: forward subsidiary merger

The target merges into a wholly-owned subsidiary of the buyer (parent), with the sellers exchanging their shares of the target for shares of the parent, or a combination of shares and boot.

To qualify:

  • The surviving subsidiary must acquire substantially all the target's assets in exchange for the parent's shares (subsidiary's shares cannot be used).

  • The merger must have qualified as an "A" reorganisation if the target had merged directly into the parent.

  • The business purpose, COI and COBE must be met (see above, Reorganisation: with buyer's shares).

Reorganisation: reverse subsidiary merger

A wholly-owned subsidiary of the buyer (parent) merges into the target, with the sellers exchanging their target shares for shares of the parent, or a combination of shares and boot. This is commonly used in acquisitive reorganisation transactions.

To qualify:

  • The target must hold substantially all of its own and the merged subsidiary's assets.

  • The sellers must exchange, for the parent's voting shares, target shares that constitute control. Typically, this means that at least 80% of the consideration received must consist of parent's voting shares.

  • The business purpose, COI and COBE must be met (see above, Reorganisation: with buyer's shares).

Additionally, reverse subsidiary mergers involving 100% cash consideration are commonly used to effect taxable acquisitions. Such all-cash mergers do not satisfy the requirements for tax-free treatment and for tax purposes are characterised as a taxable purchase of shares.

Two-step forward subsidiary merger

As a preliminary step, a wholly-owned subsidiary of the buyer (parent) merges into the target in a reverse subsidiary merger. The target then merges into a second wholly-owned subsidiary of the buyer.

To qualify, the same requirements applicable to a forward subsidiary merger above must be satisfied. However, in the event that any of the applicable requirements are not satisfied, the transaction is treated as a taxable stock purchase (see Question 12), rather than a taxable merger which would be subject to both corporate and shareholder-level tax (see Question 19).

"B" reorganisation: acquisition of shares for voting shares

The acquiring corporation acquires shares of the target directly from the target's shareholders solely in exchange for its own voting shares or the voting shares of its parent. The target continues to exist as a subsidiary of the acquiring corporation.

The basic requirements for this structure are that:

  • Immediately after the acquisition, the acquirer must own at least 80% of the total combined voting power of all classes of the target's voting shares, and at least 80% of the total number of shares of each class of non-voting shares. The acquirer need not acquire all such shares in the exchange.

  • The acquirer must acquire the target's shares solely in exchange for its own voting shares or its parent's voting shares. A combination of the two is not permitted.

  • The reorganisation must meet the business purpose, COI and COBE requirements.

  • The solely-for-voting-shares requirement is strictly construed. If the target's shareholders receive any other consideration, the transaction is not a tax-free reorganisation, but may qualify as a section 351 transaction (see Question 15).

"C" reorganisation: acquisition of assets for voting shares

The acquiring corporation acquires substantially all of the target's assets in exchange for its own voting shares or the voting shares of its parent, or for a combination of shares and cash or boot. The target must liquidate and distribute the shares and any boot to its shareholders, along with any other assets not transferred to the acquirer.

The basic requirements for this structure are that:

  • The acquirer must acquire substantially all of the target's assets.

  • At least 80% of the target's assets must be acquired for voting shares (that is, the share consideration must be voting stock and no more than 20% of the consideration the target receives can be boot). The acquirer's assumption of the target's liabilities is treated as money paid for the target's property unless the target receives only voting shares in addition to the liability assumption.

  • The reorganisation must satisfy the business purpose, COI and COBE requirements.

  • If the target's shareholders receive boot, they recognise a gain equal to the lesser of the amount of the boot or the gain realised.

These structures result in similar state tax consequences in states that mirror federal income tax law.

 

Joint ventures

Taxes potentially payable

22. What taxes are potentially payable on establishing a joint venture company (JVC)?

Structures

JVCs can be structured as a corporation, partnership or limited liability company (LLC). A JVC that is a domestic LLC is taxed as a partnership unless its members elect to have it taxed as a corporation. It is quite common to structure a JVC as a partnership for US tax purposes. If a JVC is formed as a partnership, the parties must include a number of tax provisions in the partnership agreement, or if formed as an LLC, in the company's operating agreement.

Income and capital gains taxes

Contributions of appreciated property to a partnership, or to an LLC taxed as a partnership, are not subject to federal income tax under section 721 of the Code regardless of the transferor's percentage ownership in the JVC. Distributions of property from a partnership also are generally non-taxable. Therefore, it is easy to form and restructure a JVC organised as a partnership.

Contributions of appreciated property to a corporation, or to an LLC taxed as a corporation, are subject to federal income tax, unless the exchange qualifies as a section 351 Exchange (see Question 15).

Intangibles also often present important questions in structuring a JVC, for example, whether intellectual property should be licensed, sold or contributed to the JVC in exchange for a partnership interest. In addition, transfers of intangible property to foreign JVCs organised outside the US present special issues under section 367 of the Code.

State income tax consequences are often the same as under the federal rules (see Question 4).

Transfer tax and notaries' fees

Transfer taxes and fees may apply if real property is transferred to a JVC (see Question 3).

Sales and use taxes

Sales and use taxes may apply to transfers of tangible personal property (see Question 4).

 

Exemptions and reliefs

23. Are any exemptions or reliefs available to the liable party?
 

Transaction structures to minimise the tax burden

24. What transaction structures (if any) are commonly used to minimise the tax burden?
 

Company reorganisations

Taxes potentially payable

25. What taxes are potentially payable on a company reorganisation?

Transfer taxes and notaries' fees

See Question 3.

Corporate and capital gains taxes

Unless the reorganisation qualifies as tax-free (see Questions 21 and 27), which can often be easily done, both the target and its shareholders may incur federal and state income tax on gains or other income realised on their transfers of shares and assets.

Value added and sales taxes

Sales and use taxes are potentially payable on the transfer of tangible personal property (see Question 5).

 

Exemptions and reliefs

26. Are any exemptions or reliefs available to the liable party?

Income and capital gains taxes

If the requirements of a tax-free reorganisation are satisfied, the parties generally defer federal income tax on gains on their shares and asset transfers. However, the selling shareholders will generally recognise capital gains to the extent that they receive cash or "boot" in the reorganisation.

The following types of reorganisations may minimise state income taxes, particularly in states that mirror the federal income tax:

  • "A" reorganisation. A tax-free merger (see Questions 19 to 21).

  • "B" reorganisation. An acquisition of shares solely in exchange for voting shares, which can qualify as tax free (see Question 21).

  • "C" reorganisation. An acquisition of substantially all of the assets of a target corporation in exchange for voting shares, which can qualify as tax free (see Question 21).

  • "D" reorganisation. A transfer of substantially all of the assets of the transferor to a corporation under common control, which can qualify as tax free.

  • Divisive "D" reorganisation and spin-off. Certain corporate divisions can qualify as tax-free divisive "D" reorganisations and certain spin-offs, split-offs or split-ups can be tax free under section 355 of the Code. The dividing corporation transfers some of its assets to a newly formed subsidiary and distributes the subsidiary's shares to its shareholders. In the transaction, the dividing corporation must distribute, to one or more of its shareholders, shares in the subsidiary possessing at least 80% of the total combined voting power of all voting shares, and at least 80% of the total number of shares of each class of non-voting shares.

    In addition, in the context of a divisive "D" reorganisation and spin-off, all of the following requirements must be met:

    • solely shares or securities of the subsidiary must be distributed to shareholders with respect to the dividing corporation's shares or to security holders in exchange for the dividing corporation's shares or securities;

    • the distribution must not be principally a device for distributing earnings and profits;

    • the distribution must further one or more corporate, business purposes;

    • both the dividing corporation and the subsidiary each must have been engaged in an active business for the five years preceding the distribution;

    • all of the subsidiary's shares and securities held by the dividing corporation, or enough to constitute control of the subsidiary, must be distributed;

    • the reorganisation must meet the COBE and COI tests (see Question 21). The COI test is modified for this purpose (some of the original shareholders must retain a meaningful interest in each of the resulting corporations). If the distribution is undertaken as part of a plan that includes the acquisition of more than 50% of the stock of either the dividing corporation or the subsidiary, the distribution is taxable to the dividing corporation (but not its shareholders).

  • "E" reorganisation. Modification of a single corporation's capital structure can qualify as tax free "E" reorganisation.

  • "F" reorganisation. Mere changes in identity, form or place of incorporation can qualify as a tax-free "F" reorganisation.

  • "G" reorganisation. Asset transfers to another corporation in a bankruptcy case can qualify as tax-free "G" reorganisations.

 

Transaction structures to minimise the tax burden

27. What transaction structures (if any) are commonly used to minimise the tax burden?

Corporate and capital gains taxes

Company reorganisations are often structured to qualify as tax free. In addition to the "A" reorganisations (mergers), "B" reorganisations and "C" reorganisations (see Questions 19 to 21), the following forms of reorganisations are available.

"D" reorganisation: transfer to controlled corporation

A corporation transfers substantially all of its assets to a related acquiring corporation in exchange for shares of the acquirer, and immediately after the transfer the seller and/or one or more of its shareholders owns (including shares owned by attribution) at least 50% of either the acquirer's total:

  • Combined voting power of voting shares.

  • Value of all classes of shares.

The basic requirements are that:

  • The seller must distribute the shares or securities of the acquirer acquired in the reorganisation.

  • Where the acquiring corporation and target corporation are owned by the same shareholder(s) in identical proportions, a "D" reorganisation may also occur where the only consideration is cash or boot.

  • The reorganisation must meet the business purpose, COI and COBE requirements (see Question 21).

  • If the seller's shareholders receive boot, they recognise a gain equal to the lesser of the amount of the boot or the gain realised in the exchange.

"E" reorganisation: recapitalisation

The financial structure of a single corporation is adjusted by, for example, having equity shareholders exchange their shares for a different class of shares in the same corporation. "E" reorganisations may also afford tax-free treatment to the exchange of certain long-term debt securities for either shares or new, long-term debt securities.

Similar structures can be used to minimise state income taxes in states that mirror the Federal Tax Code.

 

Restructuring and insolvency

28. What are the key tax implications of the business insolvency and restructuring procedures in your jurisdiction?

Tax implications for the business

For US corporations, there are two principal alternatives under bankruptcy law:

  • Proceedings under Chapter 11 of the Bankruptcy Code, which contemplate a restructuring and continuation of the business.

  • Liquidation under Chapter 7 of the Bankruptcy Code.

Corporations that enter bankruptcy proceedings often have net operating losses and other carry-forwards that are potentially valuable to the reorganised business or a buyer of the business. Much of the tax planning for corporations in or near bankruptcy involves preserving favourable tax attributes. There is an annual limitation on the ability of a corporation to use net operating loss carry-forwards following an ownership change under section 382 of the Code (section 382 limitation). Section 382 also provides a detailed set of rules for determining whether there has been an ownership change. If an ownership change occurs, the section 382 limitation is generally equal to the value of the loss corporation's stock at the time of the ownership change, multiplied by the long-term tax-exempt rate. In the context of a bankruptcy reorganisation, however, section 382 does not apply if the reorganisation is structured to meet an exemption from section 382, or if this exemption is not satisfied or elected, the base for calculating the annual section 382 limitation is increased to reflect the debt cancelled in the reorganisation. Many companies in bankruptcy impose restrictions on the transfer of their shares and debt to prevent an unintended ownership change that might eliminate or sharply limit their net operating loss carry-forwards.

Since bankruptcy reorganisation often involves cancelling a significant amount of the bankrupt corporation's debt, the tax rules regulating income from the discharge of indebtedness are important. Under section 108 of the Code, income generally includes the amount of the discharged principal balance of any debt. There is an exception if the discharge of debt occurs in bankruptcy or when a taxpayer is insolvent (but only to the extent of the insolvency). In return for this favourable treatment, the debtor must reduce its net operating losses, credit carryovers or asset bases by an amount equal to the discharged debt.

Tax implications for the owners

Shareholders recognise a loss on their equity investment when an identifiable event occurs that wipes out all current and potential future value of the stock. Such losses are generally treated as capital losses under § 165(g), and may be subject to limitations (see Question 4).

Tax implications for the creditors

The tax treatment of the creditors depends on the nature of debt instruments surrendered and received in the exchange. If the creditor both surrenders and receives a debt instrument that qualifies as a "security" under section 354 of the Code (generally, a "security" is long-term debt with a maturity of at least five years on the date of original issuance), then the creditor will not recognise a loss in the reorganisation. However, if either instrument is not a "security", then the creditor will recognise a loss in the reorganisation to the extent the debt has not been previously written down, which will generally be a capital loss that may be subject to limitations (see Question 4).

 

Share buybacks

Taxes potentially payable

29. What taxes are potentially payable on a share buyback? (List them and cross-refer to Questions 3 to 6 as appropriate.)

Income and capital gains taxes

A corporation's redemption of its shares is classified as a distribution or a sale and exchange. If classified as a distribution, the amount received is taxed to the shareholder under the general following rules:

  • The distribution is treated as a dividend to the extent of the corporation's current and accumulated earnings and profits allocated to the distribution (see Question 4).

  • The balance of the distribution is treated as a tax-free return of basis, up to the amount of the shareholder's basis in shares. Any remaining amount is treated as capital gain (see Question 4).

A redemption is treated as a sale or exchange if the redemption is substantially disproportionate, which occurs if, after the redemption, the shareholder owns less than 50% of the corporation's outstanding shares, and the shareholder's ownership percentage in the corporation is less than 80% of his ownership percentage before the redemption. Attribution of ownership rules apply.

Other exceptions (which can lead to capital gain treatment) include:

  • A redemption that completely terminates the shareholder's share ownership in the corporation. Attribution of ownership rules apply.

  • A redemption that is not essentially equivalent to a dividend, based on a subjective facts and circumstances test.

  • A redemption that results from partial liquidation of the corporation's business and the shareholder is not a corporation.

Therefore, redemptions of public shareholders often are taxed at capital gains rates.

If a redemption is treated as a sale or exchange, the shareholder recognises gain or loss on the difference between the amount received and the shareholder's tax basis in the shares redeemed. If the shares have been held for more than one year, the gain is long-term capital gain.

State income tax consequences are generally the same in those states that mirror the federal income tax.

 

Exemptions and reliefs

30. Are any exemptions or reliefs available to the liable party?

Redemptions are often structured to provide the treatment most beneficial to the shareholders (generally, capital gains treatment for individual shareholders or dividend treatment for corporate shareholders).

 

Transaction structures to minimise the tax burden

31. What transaction structures (if any) are commonly used to minimise the tax burden?

See Questions 29 and 30.

 

Private equity financed transactions: MBOs

Taxes potentially payable

32. What taxes are potentially payable on a management buyout (MBO)?

Income and capital gains tax

In an MBO, management, usually acting with other equity investors, purchases the shares of the corporation for cash typically in a highly leveraged transaction. The selling shareholders generally recognise a capital gain (see Question 4).

Private equity transactions are usually accomplished through the creation of a new corporation or LLC (taxed as a partnership for US purposes) to which management shareholders contribute the target's shares (in a tax-free rollover) and new investors contribute cash. Either the new entity or the target borrows a substantial portion of the necessary funds, and the selling shareholders' shares are purchased or converted into cash through a merger.

Following the transaction, the taxable income of the continuing corporation is typically greatly reduced by interest expense deductions. Limitations apply, in certain cases, to the carry-back of NOLs attributable to such interest expense deductions to the pre-MBO period.

 

Exemptions and reliefs

33. Are any exemptions or reliefs available to the liable party?

No provision generally relieves a selling shareholder from tax on a gain on the sale or redemption of shares, although an instalment sale treatment can defer tax until sales proceeds are actually received.

 

Transaction structures to minimise the tax burden

34. What transaction structures (if any) are commonly used to minimise the tax burden?

Private equity transactions, including MBOs, are usually structured to be all cash sales by the selling shareholders, resulting in the payment of capital gains taxes (see Question 4). Management shareholders can usually achieve a tax-free rollover of their shares in the target by participating in a section 351 of the Code transaction for a corporate acquirer or contribution to capital for an acquirer that is an LLP or LLC not taxed as a corporation (see Question 15).

 

Reform

35. Please summarise any proposals for reform that will impact on the taxation of corporate transactions.

The President's Fiscal Year 2014 Budget has not yet been released. His Fiscal Year 2013 Budget included the following proposals:

  • Provide business incentives, including:

    • making a permanent research tax credit;

    • providing tax credits for energy efficient investments (but eliminating fossil fuel tax preferences);

    • increasing the domestic production activities deduction under section 199 of the Code from 6% to 18%, while narrowing the qualifying activities to focus on core manufacturing;

    • creating a tax credit equal to 20% of the expenses of "in-sourcing" a trade or business into the US; and

    • making permanent the exemption for a gain realised on qualified small business stock.

  • Impose a 0.17% "financial crisis responsibility fee" on certain liabilities of large financial firms operating in the US.

  • Repeal the gain limitation for dividends received in reorganisation exchanges.

  • Make various changes to the international tax rules, including:

    • deferring the deduction of interest expense apportioned to foreign-source income until the foreign-source income is subject to US tax;

    • amending the foreign tax credit rules to limit cross-crediting by determining the foreign tax credit on a pooling basis;

    • tightening the rules for the transfer of intangible property to foreign subsidiaries; and

    • treating excess returns on intangibles earned by foreign subsidiaries in low-taxed jurisdictions as subpart F income immediately taxable to the US parent.

  • Repeal last-in, first-out (LIFO), lower of cost or market, and subnormal goods methods of determining inventory value and cost of goods sold.

  • Reinstate the limitation on itemised deductions for upper-income taxpayers.

  • Tax as ordinary income a partner's share of income on an "investment services partnership interest" (a carried interest in an investment partnership held by a partner who provides services the partnership), regardless of the character of the income at the partnership level.

It is expected that the President's Fiscal Year 2014 Budget Proposals will include many of the same proposals above. The President's framework for business tax reform, circulated in the past year, also proposed a minimum tax on the income of foreign subsidiaries.

In addition, legislation has been proposed in Congress to move the US to a “territorial” system that would largely exempt US corporations' active foreign business income from US tax. Any such reforms would likely be combined with measures designed to prevent avoidance of US corporate tax, such as tightening the rules applicable to Controlled Foreign Corporations (CFCs) or limiting the deductions for interest expense. International tax reform is not, however, expected to be enacted in 2013.

 

Online resources

Internal Revenue Service (IRS)

W www.irs.gov

Description. This website is maintained by the IRS. It contains all US tax forms, instructions, and relevant publications issued by the IRS.

The Legal Information Institute of Cornell University Law School

W www.law.cornell.edu/uscode/text/26

Description. This website is maintained by The Legal Information Institute of Cornell University Law School. It provides access to the full text of the Internal Revenue Code (Title 26 of the US Code).

Internal Revenue Code from TaxAlmanac

W www.taxalmanac.org

Description. This website is maintained by Intuit. It contains the Internal Revenue Code, Treasury Regulations, and other relevant resources.

26 CFR, Government Printing Office (GPO)

W www.gpo.gov/CFR-2012-title26-vol1

Description. This website is maintained by the US GPO. It provides access to the full text of the Treasury Regulations promulgated under the Internal Revenue Code (Title 26 of the US Code).



Contributor details

William R Skinner

Fenwick & West LLP

T +1 650 335 7669
F +1 650 938 5200
E wrskinner@fenwick.com
W www.fenwick.com

Qualified. California, US, 2005

Areas of practice. International and corporate tax planning; tax controversy.

Recent transactions

  • Represented Diamond Foods in a proposed acquisition of Pringles from P&G through spin-off / reverse Morris Trust transaction.
  • Represented Asthmatx in its sale to Boston Scientific in a transaction with significant contingent value right (CVR) payments.
  • Counselled multinational corporations on a wide range of international and corporate tax planning and controversy matters.

Professional Associations / Memberships. American Bar Association (ABA), Tax Section; International Fiscal Association (IFA).

Selected Publications

  • Notices 2012-39 and 2012-15: The Service's Continued Use of § 367 as an Anti-Repatriation Provision, with David L. Forst, Journal of Taxation, January 2013.

  • Earn-Outs in Public Company Acquisitions: New CVRs Raise Unsettled Tax Issues, Journal of Taxation, December 2010.

  • IRS Creates a New Category of Intangible Property-Significant Implications for Section 367, with James P. Fuller and Barton W.S. Bassett, The International Tax Journal, May 2007.

Idan Netser

Fenwick & West LLP

T +1 650 335 7119
F +1 650 938 5200
E inetser@fenwick.com
W www.fenwick.com

Qualified. California, US, 2008

Areas of practice. Corporate and partnership taxation; US and international tax planning and restructuring; M&A; transfer pricing; tax controversy.

Recent transactions

  • Representing Cisco in acquisition of Intucell.
  • Represented Solera Holdings in acquisition of License Monitor.
  • Represented US and foreign multinationals in transfer pricing controversies before the Internal Revenue Service.

Natalie Pardo de Zela

Fenwick & West LLP

T +1 650 988 8500
F +1 650 938 5200
E npardodezela@fenwick.com
W www.fenwick.com

Qualified. California, US, 2006

Areas of practice. US and foreign tax planning; M&A.

Recent transactions

  • Represented Facebook in acquisition of Instagram.
  • Represented Crowd Factory in acquisition by Marketo.
  • Represented FlashSoft in acquisition by SanDisk.
  • Represented Picochip in acquisition by Mindspeed.

Ora Grinberg

Fenwick & West LLP

T +1 650 335 7845
F +1 650 938 5200
E ogrinberg@fenwick.com
W www.fenwick.com

Qualified. California, US, 2011

Areas of practice. US corporate and international tax planning; taxation of mergers and acquisitions; tax controversy.


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