Rationalizing the taxation of reorganizations and other corporate acquisitions.

Given that GE's equity has a market value of nearly $400 billion, H's block of stock represents approximately 0.00025% of GE's outstanding equity. Given that GE's liabilities total nearly an additional $600 billion, so that its assets total nearly $1 trillion, X's assets represent approximately 0.0003% of GE's assets. It follows that for every dollar worth of GE stock H owns, only 0.0003 cents of such dollar reflects a continuing indirect interest in the assets of X. Nonetheless, providing that certain nominal conditions are satisfied, (4) H is not taxed upon his exchange of X stock for GE stock, since such exchange qualifies as a corporate reorganization within the meaning of section 368. (5) Note that this tax result is not adversely impacted by any of the following facts:

The consideration H receives is extremely liquid, since GE stock is actively traded on the New York Stock Exchange.

The consideration H receives is easy to value, since GE stock is actively traded on the New York Stock Exchange.

The consideration H receives represents only a de minimis continuing investment in the assets of X; of the assets underlying any given dollar of H's GE stock, only 0.0003 cents are H's original indirectly owned assets.

The consideration H receives is received as a result of a transaction that H entered into willingly.

B. Acquisition #1, Variant B

The facts are the same as for Acquisition #1A, but the mechanics are different. GE finances the acquisition of X by selling $1 million of newly issued shares in the public equity market. It uses the $1 million of cash proceeds to purchase all of X's stock from H. H immediately uses the $1 million of cash he receives from GE to purchase $1 million of GE common stock in the public equity market. Thus, the net effect of the sequence of transactions in Variant B is identical, from the vantage of every single party to the acquisition, including H, to the transaction in Acquisition #1A. However, the tax consequences under current law are different from those of Acquisition #1A. In particular, since H received cash in exchange for his X stock, he is fully taxed on his gain with respect to such stock, irrespective of how quickly he reinvested such cash in GE's common stock. (6)

C. Acquisition #2, Variant A

Suppose that an individual (H) is a shareholder of a closely held corporation (X) who has a tax basis of essentially $0 in his stock. X's capitalization consists solely of 500,000 shares of Class A Common Stock and 500,000 shares of Class B Common Stock; it has no debt or liabilities of any kind. The Class A shares have a liquidation preference of $40 per share; after satisfaction of such liquidation preference the Class A shares participate equally with the Class B shares in the receipt of any additional liquidation proceeds. Finally, the Class A shares are entitled to five votes per share, and the Class B shares are entitled to one vote per share. Suppose that H owns 100,000 of the Class B shares. Thus, in rough terms, H owns 10% of the upside appreciation of X. However, H's shares entitle him to only 3.33% of X's vote.

X is in the oil exploration business. It owns several parcels of land and has several active wells. Given the wells and related assets, an appraiser has estimated the fair value of X's assets at approximately $30 million. If the appraisal is accurate, then taking the aggregate $20 million liquidation preference of the Class A stock into account, H's stock in X should be worth approximately $1 million. But given the uncertainty inherent in any appraisal, as well as the absence of a liquid market in either X's assets or its stock, who really knows!

X has come to the attention of Roll-Up Co. (RUC), a small portfolio company controlled by a private equity fund. RUC's capitalization consists solely of 1 million shares of common stock and $40 million of long-term debt. An appraiser has estimated the fair value of RUC's assets at approximately $50 million. If the appraisal is accurate, then taking the $40 million of debt into account, RUC's stock should be worth approximately $10 million in the aggregate. But once again, who really knows!

RUC and the principals of X enter into negotiations regarding a business combination. After a fair bit of back and forth, centered largely on questions of valuation, they reach an agreement, subject to the approval of X's shareholders, pursuant to which RUC will acquire X. Under the terms of the agreement, X will become a wholly owned subsidiary of RUC; the Class A shareholders of X will receive $40 of cash (funded by $20 million of new borrowing by RUC from a bank (Bank)) and one newly issued share of RUC in exchange for each Class A share of X; the Class B shareholders of X will receive one newly issued share of RUC in exchange for each Class B share of X.

X's shareholders vote on the proposed acquisition. H would like to continue deferring tax on his unrealized gain and accordingly votes "No." However, a large number of X's other shareholders are largely indifferent to tax recognition. Some of these may be tax-exempt organizations that are exempt from capital gains taxation. (7) Others may be mutual funds that do not pay any tax themselves, although some of their shareholders might. (8) And still others may be individuals who have a high tax basis in their shares, either as the result of having recently purchased such shares, or as a result of having been the beneficiaries of the stepped-up basis at death. (9) All of these tax indifferent shareholders vote "Yes."

Accordingly, the acquisition proceeds apace. First, RUC borrows $20 million from Bank. Then, RUC organizes a transitory subsidiary (S) and transfers $20 million in cash and 1 million newly issued shares of RUC common stock to S in exchange for all of S's stock. Immediately thereafter, S merges with and into X, with X surviving. Pursuant to the merger agreement, each Class A share of X stock is exchanged for $40 of the cash and one share of the RUC common stock owned by S, each Class B share of X stock is exchanged for one share of the RUC common stock owned by S, and RUC's S stock is converted into all of the outstanding stock of X. Thus, in particular, H walks away with 100,000 shares of RUC common stock.

Whether or not the aforementioned appraisals were reasonably accurate, H's block of stock represents 5.0% of RUC's outstanding equity. What that equity represents, however, does depend on the accuracy of the appraisals. Thus, if the appraisals were reasonably accurate, then X's $30 million of gross assets represent 37.5% of RUC's post-acquisition gross assets. As such, it follows that for every dollar worth of RUC stock H owns, 37.5 cents of such dollar reflects a continuing indirect interest in the assets of X. Nonetheless, H is taxed upon his exchange of X stock for RUC stock, since such exchange does not qualify as a corporate reorganization within the meaning of section 368. (10) Note that this tax result is not ameliorated by any of the following facts:

The consideration H receives is illiquid, since RUC stock is not traded and is, in fact, effectively controlled by a private equity fund.

The consideration H receives is difficult to value. Note that there were no contemporaneous cash transactions involving the Class B stock. Moreover, the exchange ratio between the Class B stock and the RUC common stock would have been the same for any other combination of values of Xs and RUC's aggregate pre-acquisition equity that valued the former at $20 million more than the latter.

The consideration H receives represents a significant continuing investment in the assets of X; of the assets underlying any given dollar of H's RUC stock, 37.5 cents are H's original indirectly owned assets.

The consideration H receives is received over his objections as a result of a transaction that he did everything in his power to avoid.

D. Acquisition #2, Variant B

The background facts are the same as for Acquisition #2A, but the mechanics are different. In this variant, it is X that acquires RUC. First, X borrows $20 million from Bank. Second, X recapitalizes its Class A Common Stock; each share of Class A Common Stock is exchanged for one share of Class B Common Stock and $40 of cash. Third, RUC merges with and into X, with X surviving. Pursuant to the merger agreement, all issued and outstanding shares of RUC are converted on a one-for-one basis into shares of X's Class B Common Stock and all issued and outstanding shares of X remain outstanding. From the vantage of each and every party to the acquisition, including H, the net effect of the sequence of transactions in Variant B is economically identical to the transaction in Acquisition #2A (the only difference is that the name of the surviving corporation is RUC in the first case and X in the second). However, the tax consequences under current law are different from those of Acquisition #2A. In particular, since H did not sell, exchange, or otherwise dispose of any of his shares of X's Class B Common Stock, he has not suffered a realization event. Accordingly, he is not taxed as a result of Acquisition #2B.

E. Consistent Frameworks

I posit that a rational tax law should be consistent. By this I mean that it should tax the substance of H's transactions, rather than their form. Thus, so long as one agrees that the substance of Acquisition #1A is the same as the substance of Acquisition #1B and that the substance of Acquisition #2A is the same as the substance of Acquisition #2B, there are only four possible ways for a rational tax law to handle Acquisitions #1 (however consummated) and #2 (however consummated). This is illustrated in Table 1.