Rationalizing the taxation of reorganizations and other corporate acquisitions.

The realization or fairness justification may be adapted to the corporate acquisition context by asking the question: When will a taxpayer view both his original X stock and the consideration he receives in exchange for such X stock as constituting a single investment? While there may be no universal answer to this question, attempts at answers explain at least some of the contours of the current reorganization provisions. (54) For example, the Treasury itself has asserted (albeit without historical support) that it is the fairness justification that lies at the bottom of a host of nonrecognition provisions, including specifically the corporate reorganization provisions: "The underlying assumption of [the corporate reorganization provisions] is ... that the new enterprise, the new corporate structure, and the new property are substantially continuations of the old still unliquidated." (55) And it has further elaborated, albeit with a narrowing caveat: "The purpose of the reorganization provisions of the Code is to except from the general rule [of income recognition] certain specifically described exchanges ... which effect only a readjustment of continuing interest in property under modified corporate forms." (56) In other words, the taxpayer still owns his original investment.

But what does it mean for H's consideration to be substantially a continuation of his X stock (per the first quote), or a continuing interest in his X stock under a modified corporate form (per the second quote)? The tautological answer, supported by the narrowing caveat (emphasized by my added italics) in the second quote, is: it means whatever section 368 says it means. But given the inconsistencies found in current law, that answer is as unprincipled as it is unhelpful. The better answer, I think, is that H must at a minimum continue to possess an ownership interest, however indirect and attenuated, in at least some of the former assets or business of X. Such a requirement has in fact been implemented by the so-called "continuity of business enterprise" regulations, albeit as one of many requirements for nonrecognition treatment rather than as a be-all-and-end-all. (57) Note that as a be-all-and-end-all, it would not serve to distinguish between Acquisitions #1 and #2. In each, H retains an indirect and either greatly or somewhat attenuated interest in the former assets or business of X. (58)

VI. THE AMERICAN LAW INSTITUTE PROPOSAL AND OTHER ACADEMIC PROPOSALS

Among proposals to rationalize the taxation of reorganizations and other corporate acquisitions, the best known is surely the American Law Institute's Proposal D1--Exchange of Stock for Stock of an Acquiring Corporation pursuant to which H would not be taxed either in Acquisition #1A (he would, however, be taxed in Acquisition #1B) or in Acquisition #2:

No gain or loss shall be recognized by any noncorporate shareholder if

stock of an acquired corporation is, in pursuance of the plan of

acquisition, exchanged solely for stock of one or more acquiring

corporations. (59)

There is a curious aspect to the ALI's proposal. Its grant of nonrecognition treatment is not premised on any single unifying theme, such as concern about valuation or taxpayer liquidity or the unfairness of taxing a substantial continuation of an investment. To be sure, each of these potential justifications is mentioned, as are others. (60) And much is also made of the unnecessary complexity of the law. (61) But in the end, the reader is left with the sense that the overriding reason why the ALI recommended keeping a nonrecognition provision in the context of corporate acquisitions is historical: the Code has contained such a provision almost since the inception of the income tax.

Given this non-reason for continuing nonrecognition treatment, albeit in some modified and vastly simplified form, it is not surprising that academic commentators have not in general rallied behind the ALI's proposal. Perhaps the most withering attack on nonrecognition treatment came from David Shakow, who proposed a tax system in which all mergers and acquisitions are fully taxed (immediately, and twice). (62) His justification was primarily simplification. He saw no significant countervailing consideration: "Reducing the number of nonrecognition provisions generally simplifies the application of the Code by narrowing the area in which complicated tax planning can go on. Accordingly, transactions should be taxable unless such a change will substantially restrict normal economic activity." (63)

Just as it is relatively easy to design a generally consistent tax regime that places a heavy thumb on the scales in favor of nonrecognition, it is relatively easy to design a generally consistent tax regime that places a heavy thumb on the scales in favor of recognition. The former type of regime must be grounded on a proposal very like that of the ALI: it will necessarily grant nonrecognition treatment to any shareholder who exchanges target corporation stock for purchasing corporation stock because such shareholder would have received nonrecognition treatment (albeit as the result of the lack of realization) had the acquisition instead been structured as the acquisition of the purchasing corporation by the target corporation. (Acquisitions #2A and #2B illustrate the ease with which corporations that are parties to an acquisition can reverse roles.)

The latter type of regime, meanwhile, would probably approach mark-to-market taxation. The reason can be illustrated by reference to Acquisition #1. If the Code is bereft of corporate reorganization provisions, then H is taxed when GE acquires H's X stock in exchange for GE stock. But consistency then demands that H must be taxed even if the transaction is restructured so that X acquires all of GE's stock in exchange for newly issued X stock (the classic example of a minnow swallowing a whale). But in the absence of any corporate reorganization provisions, such an acquisition of GE by X would result in all of GE's shareholders being taxed. It then follows that such shareholders must be taxed even if GE acquires X.

Thus, a tax regime that entirely abolishes anything like the corporate reorganization provisions and also insists on consistency must tax all of the shareholders of both the target corporation and the purchasing corporation, at least in the case of an acquisition making use of stock as consideration. Accordingly, under such a tax regime, stock acquisitions would never occur--GE's shareholders would not stand for being taxed every time GE made a stock acquisition, however small--unless they did not recognize any incremental gain as a result of such acquisition. The only way that they uniformly would not recognize any incremental gain would be that they have no incremental gain to recognize. And that, in turn, would only be possible if they have already recognized all of their gain, even in the absence of a stock acquisition. The tax regime that ensures that they have indeed recognized all of their gain, even in the absence of a stock acquisition, is mark-to-market taxation. The realization principle, in other words, would be dead.

While Shakow is no fan of nonrecognition treatment, he does not base his corporate reorganization reform proposal on a wholesale abandonment of the realization principle. (64) Rather, he chooses to occupy an intermediate position, making some but not all corporate reorganizations and other acquisitions taxable. To occupy such a position, and yet satisfy the demands of consistency, Shakow seeks robust definitions of what constitutes a target corporation and what constitutes a purchasing corporation. Once those robust definitions are in hand, he gives them consequences. The consequence of being the target is that the target's pre-transaction shareholders are taxed on all of the gain or loss with respect to their target stock; the consequence of being the purchaser is that the purchaser's pre-transaction shareholders are not taxed on any of the gain or loss with respect to their purchaser stock. (65)

How does Shakow robustly identify the target and the purchaser? He looks to post-transaction ownership. If a corporation's equity ownership has changed by more than 50% (which must be true for one and only one of the two corporations involved in any reorganization or other corporate acquisition, except in the unusual case in which each corporation's equity ownership changes by exactly 50%), such corporation is treated as the target. (66) If a corporation's equity ownership has changed by less than 50%, such corporation is treated as the purchaser.

Thus, in Shakow's model, H would be taxed on Acquisition #1 whether it is structured as an acquisition of X by GE (as it is under either Variant 1A or Variant 1B) or even as an acquisition of GE by X. And H would not be taxed in Acquisition #2, whether it is structured as in Variant 2A as an acquisition of X by RUC or as in Variant 2B as an acquisition of RUC by X, since, in either case, pre-acquisition X and RUC shareholders will each own exactly 50% of the equity of the surviving corporation. Finally, note that for Shakow, everything turns solely on the question of which corporation is the target and which is the purchaser; nothing at all turns on such historically critical notions as valuation, liquidity, and the like.