Rationalizing the taxation of reorganizations and other corporate acquisitions.

More recently, Yariv Brauner has argued for doing away with nonrecognition treatment in the context of reorganizations and other corporate acquisitions. (67) Brauner notes that empirical evidence supports the proposition that corporate acquisitions involving cash consideration (and which are therefore taxable under current law) are no less and probably actually more efficient (in the sense of wealth-creating) than corporate acquisitions involving stock consideration. (68) Indeed, the latter are likely not efficient (in the sense of wealth-creating) at all. If these propositions are correct, then current tax rules are not inhibiting efficient transactions, but are likely encouraging inefficient ones. At a minimum, they should cease doing the latter.

In order to ensure that the tax law does not favor corporate acquisitions involving stock consideration, Brauner would repeal the section 368 reorganization provisions. (69) Thus, every corporate acquisition, however structured, would be taxable. Unfortunately, tax would only be imposed on parties who experience a realization event, since Brauner does not argue for repeal of the realization requirement. (70) Thus, H would be taxed in Acquisition #1, whether carried out by means of Variant 1A or Variant 1B (but not if carried out by having X swallow GE). Moreover, H would be taxed in Acquisition #2A, but not in Acquisition #2B, since the latter does not produce a realization event for H. Note that Brauner, like Shakow, would not allow tax results to depend on such niceties as valuation or liquidity.

If one is interested in serious tax reform, it is easy to dismiss Brauner's proposal, since it does not satisfy the threshold consistency requirement that substance rather than form should determine tax consequences. Accordingly, parties would continue to expend significant energy determining which form of transaction will result in the least amount of tax. One could ask if it is possible to resurrect Brauner's proposal. The answer has already been stated above. A consistent tax regime that mandated recognition for corporate reorganizations would need to repeal the realization principle at least as currently applied to shareholders of corporations that acquire other corporations in exchange for stock.

VII. CHOOSING FROM THE MENU OF CONSISTENT TAX TREATMENTS

A. The Spectrum of Choices

From the foregoing discussion, it should be clear that there are a number of consistent ways in which to tax corporate acquisitions or combinations, and that these ways span a spectrum ranging from those that generally favor nonrecognition treatment to those that generally favor recognition treatment. The following table repeats the choices.

The first three options in the table are all relatively permissive. The most permissive option follows the general approach of the qualified stock rollover: any shareholder who receives cash (or other nonstock) consideration as a result of a corporate acquisition would be entitled to nonrecognition treatment so long as he reinvested such cash, during some suitably short window (e.g., sixty days), in any other corporate stock of his choice. The next most permissive option follows the general approach applied by the Code to involuntary conversions, (71) and thus allows a nonrecognition rollover of cash consideration only when a shareholder is divested, against his will (as generally manifested by his vote), of his corporate stock. The final and least permissive of the permissive options is that of the ALI: a shareholder is granted nonrecognition treatment so long as he receives consideration consisting solely of stock.

Note that I call each of these tax treatments "consistent," in spite of the apparent inconsistency that can be seen in the first column of the table. This is because such tax treatments are consistent so long as one ascribes substantive significance to a shareholder's (even very temporary) receipt of cash. Ascribing such substantive significance is by no means irrational, since the even very temporary receipt of cash opens the door to a wide array of investment and consumption choices. Nonetheless, since it is possible that such inconsistency would be exploited by taxpayers seeking to accelerate losses, it may be that the most permissive option should be preferred as the one that is "most consistent." (72) On the other hand, it is less than clear, at least in the public company context, that any significant amount of exploitation would occur. (73)

The intermediate options, and there are an infinite continuum of such options, follow Shakow. In essence, these options treat diversification as a possible realization event, and hence as a possible trigger for recognition. Shakow's actual proposal set the diversification threshold at more than 50%: if as a result of a corporate acquisition, one corporation's shareholders own less than a 50% equity interest in their corporation or the successor to their corporation, they are taxed. But there is no necessary reason to set the threshold at "more than 50%." Thus, one could as easily and as coherently, albeit marginally more arbitrarily, set the threshold at, for example, more than 40%: if as a result of a corporate acquisition, one corporation's shareholders own less than a 60% equity interest in their corporation or the successor to their corporation, they are taxed. Note that this modification would affect the taxation of Acquisition #2: whereas H would not be taxed under Shakow's actual proposal, he would be taxed under this modification.

Finally, one could, and probably should, modify Shakow's measurement criterion to one that focuses on asset ownership rather than equity ownership. (74) That is, the true extent to which H has modified his investment is not determined by post-combination equity ownership, but rather by post-combination asset ownership. For example, in Acquisition #2, although X's shareholders continue to own a 50% equity interest in their pre-combination assets, their pre-combination assets only comprise 37.5% of the total value of their post-combination investment. Thus, they have diversified their investment by more than 50%. A rule based on assets might read as follows: if as a result of a corporate acquisition, one corporation's shareholders indirectly own assets of which less than 50% constitute pre-acquisition assets, they will be taxed. Under this rule, H would be taxed in Acquisition #2, however structured.

Moving out of the realm of intermediate options and into that of pro-recognition options, the first possibility would be essentially Brauner's proposal made consistent by taxing not only those parties to a corporate acquisition who experience a classic realization event but also those parties to a corporate acquisition who do not. Thus, for example, in Acquisition #1, not only would H be taxed, but so would all of GE's shareholders. Such a rule, while consistent, could be expected to bring to a screeching halt all corporate acquisition activity making use of stock as consideration. The GEs of the world would simply not be able to foist such recognition on their shareholders. Thus, any attempt to move to the full recognition rule should at least lead one to consider a further move to mark-to-market taxation. Under such a regime, corporate acquisitions making use of stock as consideration could once again proceed unimpeded by tax considerations. Since all gains and losses would be realized and recognized as they occur, an actual corporate acquisition would not lead to incremental taxation of either the target corporation's or the purchasing corporation's shareholders.

B. Intermediate Options

Intermediate options have two features that recommend them. First, by taking only part of a loaf, they necessarily leave part of a loaf. The true believer in nonrecognition will deprecate the taking, but will find a tad of solace in the leaving. The true believer in full and immediate recognition will do the opposite. But it is at least possible that each will rally behind an intermediate option if it is sufficiently clear that their preferred extreme option is unlikely to be adopted.

Second, intermediate options have the aura of scientific precision about them. In Shakow's version, it is possible, at least under certain sets of facts, to say with precision that one corporation is the target, that the other is the purchaser, and that those categories are independent of the actual corporate machinations. In a more generalized version, it is theoretically possible to say that a shareholder's investment represented by his shares of a corporation's stock has been altered by z%. If the alteration is sufficiently great, it is proper for the tax law to treat the shareholder as now owning shares in a new and different corporation, and thus as having engaged in an exchange of the original shares for the new shares.

Of course, applying intermediate options may prove difficult in practice. If all relevant corporations have only shares of common stock outstanding, it is easy to measure the impact of a corporate acquisition on the original shareholders' interest in their corporation's underlying assets. For example, in Acquisition #1, the shareholders of X (i.e., H) owned 100% of the shares of X before its combination with GE, and own 0.00025% of GE's shares after the combination. Thus, such shareholders' participation in X's original assets falls by an objectively measurable 99.99975% from 100% to 0.00025%.