Rationalizing the taxation of reorganizations and other corporate acquisitions.

Current law, as noted, taxes Acquisition #1A differently from Acquisition #1B, and taxes Acquisition #2A differently from Acquisition #2B. Thus, it must either be the case that current law is irrational, or that current law divines some substantive difference between Acquisition #1A and Acquisition #1B, and similarly between Acquisition #2A and Acquisition #2B. The substantive difference in the first case could only be that the interposition of cash in H's hands in Acquisition #1B temporarily gives H lower (transaction) cost access to alternative investment (and consumption) choices than does his receipt of GE stock in Acquisition #1A. The substantive difference in the second case could only be that the name of the surviving corporation somehow matters.

I do not accept that the name of the surviving corporation can ever matter enough that it should determine the tax outcome; after all, the name of the surviving corporation can always be changed. (11) Thus, there is no rational reason to tax Acquisition #2A differently from Acquisition #2B. On the other hand, I do accept the notion that the interposition of cash may be a sufficiently substantive difference that the tax law can reasonably give it outcome determinative importance, particularly if, as in Acquisition #1B, such interposition is not wholly formal. (12) Still, given the fleeting nature of the interposition of the cash in such acquisition, this is surely not the best position for a rational tax law to take.

If as just suggested the circumstances support taxing H in a consistent way for his role in each of Acquisition #1 (however consummated) and Acquisition #2 (however consummated), the most intuitively appealing way to tax him is surely to tax him for his part in the former, but not for his part in the latter. (It follows that the least intuitively appealing way to tax H is to tax him for his part in the latter, but not for his part in the former.) Why? In Acquisition #1, H affirmatively chooses to exchange his highly illiquid corporate stock for highly liquid corporate stock that has no meaningful economic connection with his original investment. Such a transaction all but screams for the recognition of gain and the imposition of tax. On the other hand, in Acquisition #2, H's investment is modified without his acquiescence, his highly illiquid corporate stock remains highly illiquid, and the assets underlying such stock in significant measure continue to be the same. Such a transaction may or may not scream for nonrecognition treatment. But if there is any proper place for nonrecognition treatment in the context of corporate reorganizations or other acquisitions, this is surely it.

There are two other ways for a rational tax law to handle H's part in Acquisitions #1 and #2. The one generally favored by tax academics would call for expanded recognition: H would be condemned to full and immediate recognition of gain for his part in Acquisition #1 (however consummated) and Acquisition #2 (however consummated). The most prevalent argument in support of this treatment is based on the premise that the realization principle, with its attendant deferral of tax on some economic income, damages an income tax system by distorting taxpayer behavior. (13) In particular, taxpayers disproportionately invest in assets that provide potential deferral, and then hold such assets far longer than they would in the absence of deferral (the so-called "lock-in effect"). (14)

Of course, under current law, attempted corporate reorganizations (such as Acquisitions #1A and #2A) do not actually rely on the realization principle for special tax treatment. Such reorganizations are conceded to involve realization events; they merely involve realization events that, if a number of specific requirements are satisfied (as they are in Acquisition #1A but not in Acquisition #2A), are statutorily favored with nonrecognition treatment, i.e., additional deferral above and beyond that generally provided by the realization principal. (15) To an academic who is predisposed to opposing the deferral of tax even in the case of nonrealization events (such as Acquisition #2B), extending such deferral to instances of conceded realization is like rubbing salt in a wound, unless some very good alternative justification for deferral can be found. Unfortunately, the one such justification which would probably serve--namely that the corporate reorganization provisions encourage economically efficient transactions that otherwise would not occur--is woefully lacking in empirical support. (16)

The final possibility for a rational income tax regime is to expand the availability of nonrecognition treatment, and specifically to favor H with nonrecognition treatment for his part in both Acquisition #1 (however consummated) and Acquisition #2 (however consummated). So long as the context is a modification of the income tax, this possibility has not elicited much recent academic support. (17) Nonetheless, it did elicit considerable support in an earlier age when scholars did not so universally revile the deferral of tax. (18) The primary motivation for expanding nonrecognition treatment to all shareholders, like H, who (ultimately) receive consideration consisting solely of stock of the acquiring corporation, was tax simplification. (19) But a secondary motivation was the unfairness of making one shareholder's tax treatment depend on the tax treatment of his fellow shareholders (as is the case with H's tax treatment in Acquisition #2A). (20)

III. NONRECOGNITION TREATMENT IN GENERAL

A. Non-Corporate Contexts

In order to put corporate reorganizations and other acquisitions into an appropriate context, it is useful to compare them with transactions outside of the corporate context that are favored with nonrecognition (and in some cases nonrealization) treatment. But in what ways should these transactions be compared? I think that the only way to meaningfully compare transactions is to measure their impact on the one thing that the investing taxpayer cares most about: his investment return. I propose an admittedly ad hoc arithmetic approach. An individual (H) initially owns a capital asset (X) in which he has a significant unrealized capital gain. If H does nothing, but remains the owner of X, he will experience a certain additional (positive or negative) investment return over some relevant time horizon. If X does something, that is, if X modifies his ownership position in X in some way, he will over the same time horizon experience a possibly very different additional investment return. I ask initially: "Is favorable tax treatment in any way limited to circumstances where the post-modification additional investment returns do not differ too materially from the unmodified additional investment returns?"

Consider the following hypothetical investment. H owns asset X which has a tax basis of $2 million and a fair value of $3 million, and which is subject to a liability of $2 million. Over the relevant time horizon, assume that X generates sufficient current cash flow to exactly provide both the lender and H with appropriate risk-adjusted returns, but no more. (21) At the end of the relevant time horizon, X generates a single terminal random cash flow that with equal probability lies anywhere between $1 million and $5 million. Thus, 25% of the time, H's unrealized gain of $1 million will evaporate (since X's terminal cash flow of less than or equal to $2 million will be entirely dedicated to repaying the lender). The remaining 75% of the time, H will receive an additional capital-gain-type return that with equal probability lies anywhere between -100% and +200%. H's expected additional "capital gain" is +12.5%.

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There are a number of transactions that H, as the owner of X, can engage in that will modify the returns from his investment in X but that will not subject him to immediate taxation on his $1 million of unrealized gain. The first I will consider is an installment sale subject to section 453. (22) While the ability to report gain on the installment method may not appear to be a typical nonrecognition provision--after all, the realized gain is reported and taxed--it has the same effect. Gain is reported and taxed only as cash is received. This pattern of taxation is precisely the same as that under the broader run of nonrecognition provisions, such as the reorganization provisions themselves. (23) The only difference is that in the case of an installment sale, but not in the case of any of the other nonrecognition provisions, H generally knows at the time of such sale exactly when and how much cash is likely to be received. (24)

The generally parroted rationale for allowing nonrecognition treatment in the case of a gain realized by virtue of an installment sale is that the recipient of an installment sale note has not received a liquid asset, and hence has no cash with which to pay his tax liability. (25) While this bleak characterization of the recipient's posture may be technically true (i.e., among other things, the recipient may have no other liquid assets with which to pay the tax that is imposed on his $1 million realized gain), it should never be forgotten that the recipient's difficulties are to at least some extent self-inflicted. Indeed, given the modern world's relatively robust capital markets, I would venture to say that of the two statements--(1) H paid tax on his gains under the installment method because the buyer of X insisted on paying for X with a note, and (2) H insisted that the buyer of X pay for X with a note so that H would be able to pay tax on his gains under the installment method--the second is far more likely to be true.