Rationalizing the taxation of reorganizations and other corporate acquisitions.

The merger now proceeds apace. X merges with and into RUC, and X's Class A shareholders each receive $50 per share of cash consideration; X's Class B shareholders, including H, receive one share of RUC common stock for each of their shares of X's Class B Common Stock. Thus, after the combination, H owns exactly the same thing that he owned in Acquisition #2A: 5% of the outstanding equity of RUC. Moreover, RUC has exactly the same assets and the same capitalization in each case. However, under a Shakow-type analysis, X is now the target corporation (its shareholders own only 25% of the surviving corporation) and RUC is now the purchasing corporation (it shareholders own 75% of the surviving corporation). Accordingly, all of X's shareholders, including H, are taxed on all of their gain. This result is not only unfair--it is completely arbitrary. The fact that H, who engages in a single course of economic conduct, is sometimes taxed and is sometimes not, irrefutably demonstrates the lack of any sound theoretical underpinning for this tax mechanism.

Is there any way to fix the Shakow-style regime, or create a robust alternative intermediate option from the ground up? I do not think either of these is possible in the absence of a clear answer to the question: what exactly is an intermediate tax regime seeking to accomplish? Consistency, sure. But not consistency for its own sake, since there are extreme options--universal nonrecognition and universal recognition--that are also consistent. Rather, an intermediate option by definition seeks to sort the entire universe of corporate combinations into two categories: those in which something sufficiently significant happened to warrant taxation, and those in which it did not.

What, as a purely conceptual matter, should constitute significance? Shakow does not provide a clear answer, and that is what leads him astray. Two further examples will illustrate the quandary. First, suppose that H is a human shareholder who owns 25% of the only class of X stock and J is a second human shareholder who owns the remaining 75% of X's stock. If J sells all of his X stock to K, a third human, should H be taxed? Under the facts, X has experienced a 75% ownership change, but it has experienced such change without experiencing any accompanying change in its assets. While Shakow does not explicitly address this fact pattern, I do not think he would impose tax on H.

Second, suppose that H and J own all of the stock of X, exactly as above, and that X is unleveraged. Suppose X borrows an amount equal to three times its entire net worth from Bank and uses the proceeds to purchase a new (possibly corporate) business. Should H be taxed? Under these facts, the assets underlying H's X stock have significantly changed; fully 75% of such assets are new. But the change in H's indirectly owned assets has not been accompanied by any change in X's ownership. Once again, although Shakow does not explicitly address this fact pattern, I do not think that he would impose tax on H.

Thus, while neither a stand-alone change in a corporation's assets nor a stand-alone change in its ownership is or even can be sufficiently significant to trigger recognition, a combination of such changes can be. This result is not defensible. In order to design a defensible intermediate option, one which can deal with fact patterns such as the two immediately above, I will fill the theoretical void by offering my own definition of significance.

Significance for tax purposes must be an economic concept. What matters to a human shareholder, H, of X corporation is neither the corporate name that X plasters on his shares of stock, nor (except in rare cases) the names of the other human and nonhuman owners of X's stock, but rather the economic characteristics of the assets (and/or businesses) that H's shares represent. Thus, if a tax regime seeks to tax H on the basis of something that matters, it should focus exclusively on events that affect H's interest in the assets of X. What are such events? The most obvious are events that actually change the assets that X owns. (75) These come in four basic types:

Concentration. X can sell assets and use the proceeds to retire debt, retire stock, or pay dividends. In each of these cases, H's post-event shares will no longer represent an indirect interest in certain of X's original assets, but will represent a more concentrated indirect interest in X's remaining assets. (76) From H's perspective, it is as if he has exchanged his indirect interest in some assets for an indirect interest in other assets (admittedly assets in which he already had an indirect interest).

Exchange. X can sell assets and use the proceeds to buy new assets of either a similar or an entirely different sort. In each of these cases, H's post-event shares will no longer represent an indirect interest in certain of X's original assets, will represent an unchanged indirect interest in the remainder of X's original assets, and will represent a wholly new indirect interest in X's newly purchased assets. (77) From H's perspective, it is as if he has exchanged his indirect interest in some assets for an indirect interest in other assets (in this case, assets in which he did not previously have an indirect interest).

Dilution with Leverage. X can borrow and use the proceeds to buy new assets of either a sort that is similar to X's existing assets or a sort that is entirely different from X's existing assets. In each of these cases, H's post-event shares will represent a reduced indirect interest in X's existing assets (in the case of a sufficiently bad outcome for the combination of the original and the newly purchased assets, X will turn over some or all of the original assets to its lenders) and a wholly new indirect interest in X's newly purchased assets. From H's perspective, it is as if he has exchanged an indirect contingent interest in all of his assets for an indirect interest in other assets (in which he did not previously have an indirect interest).

Dilution without Leverage. X can issue new equity and use the proceeds to buy new assets of either a sort that is similar to X's existing assets or a sort that is entirely different from X's existing assets. In each of these cases, H's post-event shares will represent a reduced indirect interest in X's existing assets (X's new shareholders will enjoy both a share of the upside and a share of the downside of such assets' performance) and a wholly new, indirect interest in X's newly purchased assets. From H's perspective, it is as if he has exchanged an indirect proportional interest in all of his assets for an indirect interest in other assets (in which he did not previously have an indirect interest).

Note that in each of these circumstances, the transaction, from H's perspective, is exactly the same: H "exchanges" an indirect interest in some or all of the assets he originally owns (either some but not all of those assets are disposed of in their entirety, or a contingent or proportional undivided interest in all of those assets is disposed of) for an indirect interest in other assets (which may be assets in which he already owns an indirect interest, or not). Thus there cannot be any justifiable reason to impose realization on H under some, but not all, of these circumstances. Nonetheless, a robust reorganization provision that imposes tax on some, but not all, reorganizations, would attempt to do precisely that. Such a provision would single out the fourth pattern above for taxation (assuming further that the corporation's assets changed to a sufficiently great degree), while leaving the other patterns untouched.

Would it be possible to impose realization on H under any of the foregoing patterns, provided only that X's assets change to a sufficient degree? It would be difficult, to say the least. First, a number of threshold questions would need to be addressed, such as whether it is appropriate to ignore passive assets, or asset sales and purchases that occur in the ordinary course of business, or subsequent sales of newly purchased assets (since they do not constitute sales of an original asset), and so forth.

Second, however such questions are answered, X would need to keep a separate record and perform a separate calculation for each shareholder. This is somewhat analogous to the records and calculations generally required in the publicly traded partnership context, but now imposed on all entities irrespective of their size, the number of their owners, their legal form, etc. It would certainly be possible. However, it is difficult to argue that it would be worthwhile. Indeed, Shakow very likely limited his proposal to asset changes that occur as a result of one type of readily observable event because he deemed it not to be worthwhile. Unfortunately, while such compromises may be necessary in the interest of sound tax administration, they are impossible to justify as a matter of theory.