Foreign merger stock exchange received section 367 exception

Plain-English summary

A U.S. corporate group agreed to exchange stock of a domestic subsidiary for common and preferred shares of a publicly traded foreign corporation in a two-step forward triangular merger. The foreign corporation's value exceeded the adjusted domestic target value when the agreement was signed, but market fluctuations could cause it to fall below that value at closing. The IRS ruled that the indirect stock transfer substantially complied with the active-trade-or-business test and could qualify for the regulatory exception to section 367(a)(1). The U.S. parent could use the exception only by entering into a gain recognition agreement that met the applicable regulations. The IRS did not rule on whether the merger qualified as a section 368 reorganization or on section 6038B reporting.

Ruling snapshot

• Question: Could the indirect transfer of domestic target shares to the foreign acquirer qualify for the section 367(a)(1) exception despite possible value-test failure at closing?
• Outcome: approved, with the U.S. parent's exception conditioned on a conforming gain recognition agreement
• Key authorities: IRC § 367(a)(1); Treas. Reg. §§ 1.367(a)-3(c) and 1.367(a)-8

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201935004                                              Third Party Communication: None
Release Date: 8/30/2019                                        Date of Communication: Not Applicable
Index Number: 367.00-00, 367.03-00
                                                               Person To Contact:
------------------------                                       ------------------------------, ID No. ------------
------------------------------------------------------------   -----------------
--------------------                                           Telephone Number:
------------------------------------------------------------   ----------------------
--------------                                                 Refer Reply To:
------------------------                                       CC:INTL:B04
--------------------------------------------                   PLR-109182-19
                                                               Date:
                                                               May 31, 2019




LEGEND:

USP = -----------------------------------------------------------------------------------------------------------
-----------------------------------------------------

UST = ------------------------------------------------------------------------------------

DRE1 = ---------------------------------------------------------------------------------------------------------

FA = ---------------------------------------------------------------------------------------

Merger Sub 1 = ------------------------------------------------------------------------

Merger Sub 2 = -------------------------------------------------------------------------------

Industry A = ----------------------------------------------------------

Business A = ----------------------------------------------

Business B = -------------------------------------------------------------

b-percent = ---------------

c-percent = --------------

Amount D = -----------------

Amount E = ------------------
PLR-109182-19                                 2


Date E = ------------------------

Date F = ----------------------

Amount F = ------------------

g = ------------------

h = ------

i = ----

Amount J = -------------

k = ------

L-percent = ---------------


Dear --------------:

This is in reply to your letter dated April 19, 2019, requesting a ruling under § 1.367(a)-
3(c)(9) of the Income Tax Regulations that the indirect transfer of shares in a domestic
corporation by U.S. persons described below will qualify for an exception to the general
rule of § 367(a)(1) of the Internal Revenue Code (the “Code”). Supplemental
information was provided in letters dated May 8, May 16, May 22, and May 29, 2019.

The rulings contained in this letter are predicated upon facts and representations
submitted by the taxpayers and accompanied by penalty of perjury statements executed
by an appropriate party. This office has not verified any of the material submitted in
support of the request for rulings. Verification of the factual information,
representations, and other data may be required as part of the audit process.

FACTS

USP is a domestic corporation and the common parent of an affiliated group of
corporations that files a consolidated federal income tax return (USP Consolidated
Group). The USP Consolidated Group is engaged in Business A and Business B.

UST is a domestic corporation that is a member of the USP Consolidated Group. USP
owns all of UST’s stock by vote and more than b-percent of UST’s stock by value; the
UST stock is owned by USP through DRE1, an entity wholly-owned by USP and
disregarded as separate from USP for federal income tax purposes. Management
employees of UST own the remaining c-percent of UST stock. UST is engaged in
Business A.
PLR-109182-19                               3

UST has three classes of stock outstanding: Class A shares, Class B shares, and Class
C shares. USP owns all of the outstanding Class A and Class B shares; both classes of
stock have voting rights. USP and UST management own all of the currently
outstanding Class C shares; the C class shares do not have voting rights. Additionally,
UST has both unvested restricted stock awards (RSAs) and stock-settled appreciation
rights (SSARs) outstanding.

FA is a foreign corporation that is engaged in Business A. FA has one class of stock,
and its shares are publicly traded. As of Date F, FA has g shares of common stock
outstanding. FA serves clients around the globe and has a significant global presence
in Industry A.

FA operates an Employee Stock Purchase Plan (ESPP) that allows FA employees to
purchase FA stock in annual intervals at less than fair market value. All FA stock
purchased through the ESPP is treated as stock outstanding, and thus, such stock is
included in the valuation of FA. FA employees paid Amount F for FA stock under the
ESPP within the last 36 months.

On Date E, USP and FA entered into a merger agreement (Merger Agreement)
pursuant to which the UST shareholders will exchange their UST stock for FA common
stock and newly-issued FA preferred stock pursuant to a series of transactions
described below (Merger).

Typically, USP invests seed capital on behalf of its subsidiaries. USP did not pursue
this structure with UST; instead, UST invested Amount D itself. During Merger
negotiations, FA informed the UST shareholders that FA did not want to issue shares to
account for some of the investments made by UST because FA considered those
investments undesirable. Accordingly, in order to effectuate the Merger, UST sold
Amount D of the investments to USP and distributed the proceeds of the sale to the
UST shareholders in a transaction characterized as a non-ordinary course distribution
(NOCD) under § 1.7874-10. The Amount D NOCD accounts for the majority of the
NOCDs issued by UST. The total amount of NOCDs is Amount E, which also includes
dividends and employee share repurchases.

Pursuant to the Merger Agreement, UST shareholders will exchange their UST stock for
a mixture of FA common stock and newly-issued FA preferred stock, and the unvested
RSAs will be exchanged for FA restricted shares. Under the Merger Agreement, cash
will be issued in lieu of fractional shares for any UST shareholders that would otherwise
be entitled to a fractional share of FA common stock or FA preferred stock by virtue of
the Merger. Under the Merger Agreement, the SSARs will vest upon closing of the
Merger and will be exchanged for a nominal amount of cash.

Pursuant to the Merger Agreement, the Merger will be effectuated through a two-step
forward triangular merger under § 368(a)(1)(A) and (a)(2)(D). Specifically, FA will form
two domestic corporations, Merger Sub 1 and Merger Sub 2, which will be combined
with UST as follows:
PLR-109182-19                                4

(i) Step 1. Merger Sub 1 will merge with and into UST, with UST surviving as a wholly-
owned subsidiary of FA. Merger Sub 1 shares will be converted into UST shares. In
exchange for their UST shares, UST shareholders will receive: (a) h FA common shares
for each UST common share outstanding; (b) i newly-issued FA preferred shares for
each UST common share outstanding (value of Amount J); and (c) k FA restricted
shares for each UST unvested RSA.

(ii) Step 2. Immediately following Step 1, and as part of a single, integrated transaction,
UST will merge with and into Merger Sub 2, with Merger Sub 2 surviving as a wholly-
owned subsidiary of FA.

Thus, under the terms of the Merger Agreement, FA will acquire UST in exchange for
consideration provided to the UST shareholders consisting of FA common stock;
perpetual, non-cumulative FA preferred stock; FA restricted shares; cash for the
SSARs; and cash for the fractional shares. The value of the preferred stock is fixed
and, therefore, will not vary due to fluctuations in the value of FA common stock.
Accordingly, the Merger consideration will be fixed to the extent of Amount J. The
shares held by USP will be subject to an agreement not to sell those shares for a period
of two years following the Merger.

On Date E, UST’s fair market value, adjusted to take into account the Amount E of
NOCDs, was equal to approximately L-percent of the aggregate of UST’s adjusted fair
market value and the fair market value of FA, reduced by Amount F, the amount paid by
FA employees for FA stock under the ESPP.

Since Date E, however, the value of FA’s common stock has fluctuated. Thus, UST’s
fair market value has also fluctuated, as part of UST’s fair market value is tied to the
Merger consideration. Specifically, the fair market value of UST fluctuates to the extent
of the Merger consideration consisting of FA common stock. The remaining Merger
consideration, totaling Amount J, consists of FA preferred stock and is not subject to
fluctuation. After adjusting to account for the NOCDs, UST’s approximate fair market
value has approached that of FA. Accordingly, it is possible that FA’s fair market value
may not be at least equal to UST’s adjusted fair market value on the closing date.

The taxpayer, therefore, requests a private letter ruling under § 1.367(a)-3(c)(9)(i)
providing that the taxpayer is in substantial compliance with the active trade or business
test and thus qualifies for an exception to the general rule of § 367(a)(1).

REPRESENTATIONS

The taxpayer has made the following representations:

(a) The Merger will qualify as a two-step forward triangular merger under § 368(a)(1)(A)
and (2)(D) and will, therefore, qualify as a reorganization within the meaning of § 368(a)
of the Code.

(b) UST will satisfy the reporting requirements of § 1.367(a)-3(c)(6).
PLR-109182-19                                   5


(c) The requirements set forth in § 1.367(a)-3(c)(1)(i), (ii), and (iii)(B) will be met
immediately following the Merger.

(d) FA and USP will satisfy the requirements set forth in § 1.367(a)-3(c)(3)(i)(A) and (B).

(e) FA has not acquired any assets in the 36-month period preceding the exchange in
violation of the anti-stuffing provision of § 1.367(a)-3(c)(3)(iii)(B).

(f) The fair market value of FA exceeded UST’s adjusted fair market value on Date E.
Specifically, on Date E, UST’s adjusted fair market value was equal to approximately L-
percent of the aggregate of UST’s adjusted fair market value and the fair market value
of FA. Since that date, the market price of FA’s common stock has occasionally
declined, which caused UST’s adjusted fair market value to approach FA’s fair market
value.

LAW AND ANALYSIS

When a U.S. person transfers appreciated property to a foreign corporation in a
transaction that would otherwise qualify as a nonrecognition exchange, the transfer will
generally be treated as a taxable exchange under § 367(a)(1). If the appreciated
property consists of stock, § 1.367(a)-3 applies. Under that section, a transfer of
appreciated stock of a domestic corporation by a U.S. person to a foreign corporation
constitutes a taxable exchange unless the requirements of § 1.367(a)-3(c)(1) are met.

Certain reorganizations under § 368(a)(1)(A) and (a)(2)(D) trigger the application of
§ 367(a)(1). Specifically, when a U.S. person exchanges appreciated stock in a
domestic target corporation for stock in a foreign corporation that controls the acquiring
corporation, § 1.367(a)-3(d)(1) provides that the U.S. person will be treated as having
made an indirect transfer of stock in a domestic corporation to a foreign corporation and
the indirect stock transfer rules of § 1.367(a)-3(d) will apply. Accordingly, unless the
requirements of § 1.367(a)-3(c)(1) are satisfied, the indirect transfer of appreciated
stock constitutes a taxable exchange under § 367(a)(1) to the extent the exchange
would otherwise have qualified for nonrecognition treatment under § 354 or § 356.

The requirements of § 1.367(a)-3(c)(1) are as follows:

(i) The U.S. target company must comply with the reporting requirements of § 1.367(a)-
3(c)(6).

(ii) U.S. persons transferring U.S. target stock must receive, in the aggregate, 50% or
less of both the total voting power and total value of the stock in the transferee foreign
corporation.

(iii) U.S. persons who are officers or directors of the U.S. target corporation, or who are
5% shareholders of the U.S. target corporation, will own, in the aggregate, 50% or less
PLR-109182-19                                  6

of each of the total voting power and the total value of the stock of the transferee foreign
corporation immediately after exchange of the U.S. target stock.

(iv) U.S. persons transferring the U.S. target stock cannot be five-percent transferee
shareholders. If a U.S. person is a five-percent transferee shareholder, the U.S. person
may still qualify for the exception. To do so, the U.S. person must enter into a gain
recognition agreement that conforms to the requirements set forth in § 1.367(a)-8.

(v) The active trade or business test of § 1.367(a)-3(c)(3) must be satisfied. The three
elements of the active trade or business test are as follows:

(a) The transferee foreign corporation (or any qualified subsidiary or qualified
partnership as defined under § 1.367(a)-3(c)(5)(vii) and (viii)) must have been engaged
in the active conduct of a trade or business outside the United States, within the
meaning of § 1.367(a)-2(d)(2), (3), and (4), for the entire 36-month period immediately
preceding the transfer.

(b) At the time of the transfer, neither the transferors nor the transferee foreign
corporation (or any qualified subsidiary or qualified partnership engaged in the active
trade or business) has an intention to substantially dispose of or discontinue such trade
or business.

(c) The substantiality test of § 1.367(a)-3(c)(3)(iii) must be satisfied.

Under the substantiality test, the fair market value of the transferee foreign corporation
must equal or exceed the fair market value of the U.S. target company at the time of the
exchange of U.S. target company stock (see § 1.367(a)-3(c)(3)(iii)(A)). For this
purpose, § 1.367(a)-3(c)(3)(iii)(B) provides an anti-stuffing rule that requires the fair
market value of the transferee foreign corporation to be reduced by the value of certain
assets. The value of the transferee foreign corporation is further reduced by the value
of any assets that it received within the 36-month period preceding the exchange if
those assets were owned by the U.S. target company or an affiliate (see § 1.367(a)-
3(c)(3)(iii)(B)(3)).

The substantiality test also includes an NOCD rule aimed at preventing a U.S. target
company from reducing its value for purposes of satisfying the substantiality test.
Specifically, § 1.367(a)-3(c)(3)(iii)(C) provides that the fair market value of the U.S.
target includes the aggregate amount of NOCDs made by the U.S. target company
within the 36-month period preceding the exchange.

After these adjustments, if the fair market value of the transferee foreign corporation
continues to equal or exceed the fair market value of the U.S. target company, then the
substantiality test of § 1.367(a)-3(c)(3)(iii) will be satisfied.

Under § 1.367(a)-3(c)(9), the Service may, in limited circumstances, issue a private
letter ruling to permit the taxpayer to qualify for an exception to § 367(a)(1) if the
taxpayer is unable to satisfy all the requirements of the active trade or business test but
PLR-109182-19                                  7

is in substantial compliance with such test and meets all of the other requirements of
§ 1.367(a)-3(c)(1).

CONCLUSION

Based solely on the information submitted and on the representations set forth above,
we hold as follows:

(1) Subject to ruling (2), below, the indirect transfer of UST shares by U.S. persons in
exchange for shares of FA will qualify for an exception to the general rule of § 367(a)(1).
§ 1.367(a)-3(c)(1) and 1.367(a)-3(c)(9)(i).

(2) USP will qualify for this exception only upon entering into a gain recognition
agreement. § 1.367(a)-3(c)(1)(iii)(B). This gain recognition agreement must conform to
the requirements set forth in § 1.367(a)-8.

No opinion is expressed as to the tax treatment of the transactions under other
provisions of the Code and regulations, and no opinion is expressed about the tax
treatment of any conditions existing at the time of, or effects resulting from, the
transactions that are not specifically covered by this ruling. In particular, no opinion is
expressed or implied as to whether the Merger qualifies as a reorganization within the
meaning of §§ 368(a)(1)(A) and (a)(2)(D). Nor is an opinion expressed as to the
reporting requirements of U.S. persons exchanging stock under § 6038B and the
regulations thereunder.

In accordance with the power of attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling. This ruling is directed only to the taxpayer who requested it. Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.


Sincerely,



Charles P. Besecky
Branch Chief, Branch 4
(International)