Tax Case Studies
TAX-FREE SPIN-OFF OF SUBSIDIARY
Situation: Company A, a conglomerate, sought to distribute its stock in one of its subsidiaries to its shareholders on a tax-free basis. Following the "spin-off", the subsidiary would merge with a REIT and the combined business would seek to qualify as a REIT. The merger would result in the shareholders of the conglomerate owning at least 60% of the newly organized REIT. The parties applied for a private letter ruling with the IRS and, following a delay of many months, the IRS refused to rule on whether the spin-off qualifies as tax-free under Section 355.
Issue: The primary issue on which the tax-free status of the spin-off could be challenged is whether Company A, the distributing corporation, had a valid corporate business purpose for undertaking the spin-off. This is a subjective test but can be confirmed and corroborated by objective evidence - e.g., board meeting minutes, correspondence, etc. A second issue - whether an "active business" was spun-off - usually is an objective test that may not require insurance. However, in this case, as the newly organized business had to qualify as a REIT (which is essentially passive), this was an additional issue for which the insured sought coverage.
IRC Section: §355
TRANSFER OF CONTROL FOLLOWING SPIN-OFF
Situation: Company A effectuated a tax-free spin-off to its shareholders of its stock in Subsidiary X. The corporate business purpose of the spin-off was to allow Subsidiary X to effectively raise capital. More than six months later, Company A received an unsolicited, unexpected offer to be purchased at a significant premium to its widely accepted value. Because the offer came within two years of the spin off of Subsidiary X, it is likely that the tax-free status of the spin-off will be challenged by the IRS.
Issue: A "change of control" of either Company A or its Subsidiary X following a spin-off could, if found to be part of a plan (or series of transactions), requires Company A to recognize gain as if it sold Subsidiary X for fair market value. The Tax Insurance policy insures Company A (or its successor) from tax liability resulting from the spin-off being stripped of its tax-free status.
IRC Section Implicated: § 355(e)
TAX-FREE CORPORATE REORGANIZATION
Situation: Company A has acquired Company B in a statutory merger. Forty percent of the purchase price was paid in Company A voting stock and the remainder was paid in cash. After the deal closed, the parties became concerned that a portion of the compensation paid to certain Company B executives under employment agreements entered into in connection with the transaction could be re-characterized by the IRS as additional consideration for the Company B stock. If so, such a re-characterization could jeopardize the tax-free status of the merger.
Issue: In order to qualify as a tax-free statutory merger, the parties must satisfy, among other things, a "continuity of interest" requirement. This requirement in general is satisfied where at least 40% of the consideration is paid in stock of the acquiring company. If a portion of the executive compensation is re-characterized as consideration for Company B stock, which results in the cash consideration in the transaction exceeding 60% of the purchase price, the transaction may not qualify as a tax-free reorganization. As a result, Company B shareholders would have to recognize gain on the difference between the fair market value of the shares and their basis in the stock. The Tax Insurance policy insures the Company B shareholders for this risk.
IRC Section Implicated: § 368(a)(1)(A)
CHARACTERIZATION OF PAYMENTS BY BUYER TO SHAREHOLDER EMPLOYEES OF SELLER AS CAPITAL GAIN
Situation: Company A is acquiring Company B. Some shareholder employees of Company B received promissory notes from Company A as partial payment of the purchase price.
Issue: The shareholder employees are concerned that the IRS will challenge the characterization of payments of principal under the notes as return of capital and attempt to have them recognized as ordinary income. The Tax Insurance policy insures the shareholder employees of Company B from loss arising out of this risk.
IRC Section Implicated: § 1221
USING NET OPERATING LOSSES TO AVOID TAX ON CAPITAL GAIN
Situation: Company A plans to sell two subsidiaries, Subsidiary X and Subsidiary Y, that have generated net operating losses, and then itself via a merger. The successor company to Company A seeks to use the net operating losses generated by Subsidiary X and Subsidiary Y to offset the gain Company A will recognize as a result of the sale of the subsidiaries.
Issue: The buyers of Subsidiary X and Subsidiary Y wish to be indemnified for any shared tax liability arising from Company A's attempt to absorb its gain by using the net operating losses. The Tax Insurance policy insures both Company A (as well as its successors and assigns) and the buyers of Subsidiary X and/or Subsidiary Y.
IRC Section Implicated: § 382
DEDUCTIBILITY OF INTANGIBLE DRILLING COSTS BY AN OIL DRILLING FUND
Situation: An oil drilling fund is seeking investors, acquiring interests, and preparing to drill.
Issue: Some investors are concerned that the IRS will challenge the characterization of outlays as intangible drilling costs. The Tax Insurance Policy insures that the investors will be able to deduct the intangible drilling costs as incurred.
IRC Section Implicated: § 263(c)