Current Tax Planning Techniques in U.S. and International Transactions - December 8, 2015
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Current Tax Planning Techniques in U.S. and
International Transactions
December 8, 2015
© 2015 Winston & Strawn LLP
Today’s Speakers Edmund S. Cohen Rachel Ingwer Dean Burau Roger Lucas Partner Associate Partner Partner +1 (212) 294-2634 +1 (212) 294-4760 +1 (312) 558-7885 +1 (312) 558-5225 ecohen@winston.com ringwer@winston.com dburau@winston.com rlucas@winston.com © 2015 Winston & Strawn LLP 2
Current Issues in International Transactions
• Introduction: General Considerations
• Inversions
• After Notice 2014-52, 2014-42 I.R.B 172
• After Notice 2015-79
• Other Cross-Border Acquisitions
© 2015 Winston & Strawn LLP 3
Introduction: Considerations in Cross Border
Transactions
• Objectives with Respect to Successful Ventures
• Deferral of U.S. tax
• Reduction of tax in foreign jurisdiction
• Tax-efficient repatriation (discussed below)
• Tax-free return of basis
• Tax credit shelter
• QDI for individuals
• Objectives with Respect to Unsuccessful Ventures
• Ordinary loss
• Section 165(g)(3)
• Staged Alternatives
© 2015 Winston & Strawn LLP 4
Introduction: Considerations in Cross Border
Transactions
• Attribute Review
• Acquiring group
• Target
• Foreign Basis Step Up / Eliminate Prior Tax History
• Foreign asset purchase (unlikely)
• Stock purchase – Section 338 elections
• “Check-the-box” election for target
• Use of Leverage
• Interest deductions
• Local limitations including “thin capitalization” rules
• Ability to use debt to aid repatriation
• Overall foreign loss (OFL) issues
© 2015 Winston & Strawn LLP 5Introduction: Considerations in Cross Border
Transactions
• Intangibles – Licensing, IP Purchases, and Cost Sharing Agreements
• Withholding on Dividends, Interest and Royalties Between U.S.
Parent and Foreign Subsidiaries – Treaty Availability
• “Check-the-Box” Planning
• Section 954(c)(6) and avoiding subpart F income
• Branch rules
• Utilization of foreign tax credits by individuals
• Tax-Efficient Repatriation
• Dealing with low-taxed income
• Return of basis / basis accumulation/ repayment of debt
• Two-tier repatriation structures
• Used to avoid earnings and profits in distributing corporation
• Illinois Tool Works being challenged in Tax Court
• Obama Administration proposal
© 2015 Winston & Strawn LLP 6Introduction: Considerations in Cross Border
Transactions
• Foreign Tax Credits
• Dual holding company structure for high taxed and low tax subsidiaries
• Anti-foreign tax credit splitter rules
• Hybrid Entities / Instruments
• BEPs Issues / Future restrictions
© 2015 Winston & Strawn LLP 7Introduction: Considerations in Cross Border Transactions Useful Source Materials T. Timothy Tuerff et al., Outbound Tax Planning for Multinational Corporations, BNA Portfolio 6380-1st. Edward C. Osterberg, Basic Considerations in Buying or Selling a Non-U.S. Business, Practising Law Institute, The Corporate Tax Practice Series (Oct. 2010, supp. Oct. 2014). James P. Fuller, U.S. Tax Consequences of International Acquisitions, Practising Law Institute, Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 2015 (Oct. 2015). Robert H. Dilworth and Caroline Ngo, Financing Foreign Subsidiaries of U.S. Multinationals, Practising Law Institute, The Corporate Tax Practice Series (Oct. 2010, supp. Oct. 2014). Intelligize (SEC filing and various legal documents searchable by jurisdiction) © 2015 Winston & Strawn LLP 8
Acquisition of Foreign Target –
Alternative Structures
• U.S. Company (“Parent”) is considering acquiring a specific foreign
corporation (“Target”).
• Parent is the publicly-traded parent of the U.S. consolidated group.
• Parent also owns all of the stock of a foreign subsidiary (“Foreign Sub”)
that is treated as a corporation for U.S. Federal income tax purposes and
that has substantial un-repatriated cash. Foreign Sub may own other
foreign entities (whether corporations or disregards).
• Foreign Sub operates in low-tax jurisdictions, so any dividend from
Foreign Sub to Parent would carry with it minimal foreign tax credits.
• In this relatively common situation, Parent is itself a prime target for a
foreign acquisition and may wish to invert as a protective measure.
• Target has minimal operations in the United States and holds
substantial cash balances in low-taxed non-U.S. subsidiaries.
© 2015 Winston & Strawn LLP 9Acquisition Structures – Summary
• Option 1: The Non-Inversion
• New Foreign HoldCo (“Foreign HoldCo”) acquires both Parent and
Target stock, through a “reverse subsidiary merger” as described below.
• Target shareholders receive only Foreign HoldCo shares.
• Parent shareholders receive Foreign HoldCo shares and, if necessary,
other consideration so that Parent shareholders own less than 60% of
the shares of Foreign HoldCo.
• The transaction is not an inversion subject to Section 7874, Notices
2014-52, and Notice 2015-79, two recent IRS notices limiting the
benefits of such inversions.
© 2015 Winston & Strawn LLP 10Acquisition Structures – Summary
• Option 2: The Inversion
• Foreign HoldCo acquires both Parent stock and Target stock, through a
“reverse subsidiary merger” as described below.
• Target shareholders receive both Foreign HoldCo shares and cash.
• Parent shareholders receive Foreign HoldCo shares and, if necessary,
other consideration so that Parent shareholders own at least 60% but
less than 80% of the shares of Foreign HoldCo.
• The transaction is an inversion subject to Section 7874 and Notices
2014-52 and 2015-79.
• Option 3: The Foreign Subsidiary Non-Stock Acquisition
• Foreign Sub uses current cash reserves, Target cash balances, and
proceeds of borrowing to purchase Target stock in a tender offer/freeze-
out merger.
• Parent, a U.S. corporation, continues to be the publicly-traded parent of
the group and Parent’s foreign subsidiaries and Target would be
subsidiaries of Parent.
© 2015 Winston & Strawn LLP 11Acquisition Structures – Summary
• Option 4: The Foreign Subsidiary Part-Cash Acquisition
• Foreign Sub uses Parent stock (including newly-issued Parent stock
purchased from Parent with Foreign Sub’s cash reserves), Target cash
balances, and proceeds of borrowing to purchase Target stock.
• Parent, a U.S. corporation, continues to be the publicly-traded parent of
the group and Parent’s foreign subsidiaries and Target would be
subsidiaries of Parent.
© 2015 Winston & Strawn LLP 12Inversions: General
• Under Section 7874, the tax consequences of an inversion generally depend
on the percentage of shares of the new foreign holding company that after
the inversion are owned by the former shareholders of the U.S. acquired
corporation.
• If less than 60%, there generally is no adverse treatment under the inversion rules
of Section 7874.
• If at least 60% but less than 80%, the transaction will be subject to Section 7874,
but the new foreign parent corporation will not be treated as a domestic
corporation.
• In general, Section 7874(a) requires a U.S. person deemed related to such an
expatriated entity to recognize certain taxable income (the “inversion gain”) during the
ten years following the inversion.
• If at least 80%, the new foreign holding company will be treated as a domestic
corporation. Section 7874(b). This alternative is not discussed in this
presentation, as it provides no benefits to Parent or the Target.
• In addition, in Fall 2014, the IRS issued Notice 2014-52, 2014-52 I.R.B. 712,
which attempts to limit inversion transactions that the IRS perceived to be
abusive and provides that the IRS will issue regulations with an effective date
that is retroactive to the date of the Notice.
© 2015 Winston & Strawn LLP 13Notice 2015-79
• Notice 2015-79 goes beyond Notice 2014-52 in attacking inversion transactions.
• Most significantly, Notice 2015-79 provides a “third-country” rule, intended to limit
transactions where a U.S. entity and an existing foreign entity combine under a
new holding company established in a third jurisdiction. Notice 2015-79, at §
2.02(b).
• Regulations will provide that, in such transactions, stock that otherwise would be
included in the ownership fraction will be excluded, causing the new foreign holding
company to be treated as a domestic corporation.
• Any change of jurisdiction in a transaction related to the foreign target acquisition will
be subject to the same rules.
• Notice 2015-79 also provides that an expanded affiliated group (EAG) will not be
treated as having substantial business activities in a foreign country unless it is
subject to tax as a resident of the foreign country. Notice 2015-79, at § 2.02(b).
• Notice 2015-79 also expands the limitations on post-inversion activities.
• It expands inversion gain to include subpart F income from certain restructuring or
licensing transactions.
• It requires all built-in gain in the stock of a controlled foreign corporation (“CFC”) that
loses its CFC status to be recognized regardless of the amount of untaxed earnings of
the CFC.
© 2015 Winston & Strawn LLP 14Inversions: Shareholder Consequences
• Section 367(a) may require the shareholders of the expatriating U.S. corporation
to recognize gain (but not loss) as a result of the inversion transaction.
• This is true even though the shareholders may receive no cash as a result of the
inversion.
• In particular, under Treas. Reg. § 1.367(a)-3(c), an inversion generally will be
taxable to such shareholders unless 50% or less of both the total voting power
and the total value of the stock transferred to the transferee foreign corporation is
received in the transaction, in the aggregate, by U.S. transferors (and certain
other conditions are met).
• Treas. Reg. § 1.367(a)-3(c)(2) presumes all transferors of stock of the U.S. corporation
to be U.S. persons, unless this presumption is rebutted in accordance with specified
rules (which are difficult for a publicly traded corporation to satisfy).
• If an inversion will result in a taxable event to the current Parent shareholders
regardless, there should be no negative tax consequences of issuing boot to such
shareholders in connection with the inversion.
• Certain transaction have been structured as “Up-C” partnerships to attempt to
avoid tax to the U.S. shareholders.
© 2015 Winston & Strawn LLP 15Option 1: The Non-Inversion – Initial Structure
Parent Shareholders Target Shareholders
Target
Parent (U.S.) Foreign HoldCo
(Foreign)
U.S. Subsidiaries Foreign Merger
Foreign Sub U.S. Merger Sub
(“U.S. Subs”) Sub
© 2015 Winston & Strawn LLP 16Option 1: The Non-Inversion – Transaction
Steps Shares and Notes/Cash Shares
Parent Shareholders Target Shareholders
1b 1b 2b 2b
Target
Parent (U.S.) Foreign HoldCo
(Foreign)
1a 2a
U.S. Subs Foreign Sub U.S. Merger Sub Foreign Merger Sub
Steps
1a: U.S. Merger Sub merges into Parent in a reverse subsidiary merger.
1b: Parent Shareholders exchange Parent shares for shares and notes/cash of Foreign HoldCo. In
total, Parent Shareholders receive no more than 59% of shares of Foreign HoldCo.
2a: Foreign Merger Sub and Target are merged or amalgamated pursuant to applicable corporate law.
2b: Target Shareholders exchange Target shares for shares of Foreign HoldCo. In total, Target
Shareholders receive at least 41% of shares of Foreign HoldCo.
© 2015 Winston & Strawn LLP 17Option 1: The Non-Inversion – Final Structure
Former Parent Shareholders Former Target Shareholders
Notes
Potential
“Hopscotch”
Foreign HoldCo Loan
Debt
Target
Parent (U.S.)
(Foreign)
U.S. Subs Foreign Sub
© 2015 Winston & Strawn LLP 18Option 1: The Non-Inversion
• From a U.S. Federal income tax standpoint, this is the optimal
structure.
• Because the transaction should not be treated as an inversion under
Section 7874, none of that Section, the provisions of Notice 2014-52
limiting post-inversion activity, or the “third country” rule of Notice 2015-
79 should apply to the transaction.
• Accordingly, there should be no restriction on a cash-rich foreign
subsidiary, such as Foreign Sub, making loans directly to Foreign
HoldCo (a “Hopscotch Loan”).
• The Pfizer-Allergan merger is utilizing a structure where Pfizer
shareholders receive less than 60% of the shares of the combined
company, thereby avoiding the restrictions in Section 7874, Notice 2014-
52, and Notice 2015-79 applicable to inversion transactions.
© 2015 Winston & Strawn LLP 19Option 1: The Non-Inversion
• In this structure, any cash or notes received by the Parent shareholders can
be funded using Target’s cash or bank debt.
• However, it is important to avoid indirect “distributions” subject to Notice 2014-52.
• For at least three years, Foreign Sub cash should not be used to make any debt
service payments with respect to notes issued to Parent shareholders or bank
debt borrowed to fund cash distributions to Parent shareholders.
• In order for Target shareholders to receive more than 40% of the shares of
Foreign HoldCo, the Target shareholders would not receive any non-stock
consideration, which may not be attractive to Target.
• As Foreign HoldCo stock will be publicly traded, it may be possible to structure an
all-stock deal to provide Target shareholders with post-transaction liquidity. If this
is an important consideration, other post-transaction alternatives can be
considered.
• As noted above, Section 367(a) may require Parent’s shareholders to
recognize gain (but not loss) as a result of this transaction.
• This is true regardless of whether such shareholders receive any cash.
© 2015 Winston & Strawn LLP 20Option 2: The Inversion – Initial Structure
Parent Shareholders Target Shareholders
Target
Parent (U.S.) Foreign HoldCo
(Foreign)
Foreign Merger
U.S. Subs Foreign Sub U.S. Merger Sub
Sub
© 2015 Winston & Strawn LLP 21Option 2: The Inversion – Transaction Steps
Parent Shareholders Target Shareholders
1b 2b
Target
Parent (U.S.) Foreign HoldCo
(Foreign)
1a 2a
U.S. Subs Foreign Sub U.S. Merger Sub Foreign Merger Sub
Steps
1a: U.S. Merger Sub merges into Parent in a reverse subsidiary merger.
1b: Parent Shareholders exchange Parent shares for shares of Foreign HoldCo and other
consideration. In total, Parent Shareholders receive at least 60% but less than 80% of shares of
Foreign HoldCo.
2a: Foreign Merger Sub and Target are merged or amalgamated pursuant to applicable corporate law.
2b: Target Shareholders exchange Target shares for shares of Foreign HoldCo. In total, Target
Shareholders receive more than 20% but no more than 40% of shares of Foreign HoldCo.
© 2015 Winston & Strawn LLP 22Option 2: The Inversion – Final Structure
Former Parent Shareholders Former Target Shareholders
Debt
Foreign HoldCo
Target
Parent (U.S.)
(Foreign)
U.S. Subs Foreign Sub
© 2015 Winston & Strawn LLP 23Option 2: The Inversion
• To the extent that Parent wants to provide Target’s shareholders with cash as well
as stock, this structure makes it easier, as less cash is paid to Parent’s
shareholders.
• The transaction should be treated as an inversion under Section 7874 and thus
should be subject to the restrictions applicable under Section 7874, Notice 2014-
52, and Notice 2015-79. These restrictions include the following:
• Notice 2014-52 provides that a Hopscotch Loan, such as a loan from Foreign Sub to
Foreign HoldCo, will be treated as an “investment in U.S. property” if made within 10
years of the inversion. See Notice 2014-52, at § 3.01.
• Accordingly, under Notice 2014-52, Parent would be required to recognize a dividend
equal to the lesser of (i) the amount of such Hopscotch Loan and (ii) the CFC lender’s
current and accumulated earnings and profits.
• Transactions to de-control a CFC, such as causing Foreign HoldCo to transfer assets
to such CFC in exchange for shares, also are addressed by Notice 2014-52. See
Notice 2014-52, at § 3.02.
• Notice 2014-52 states that de-controlled CFCs will continue to be treated as CFCs
pursuant to regulations to be issued.
• Notice 2015-79 effectively provides that Foreign HoldCo will be treated as a domestic
corporation, unless it is located in the same jurisdiction as Target.
© 2015 Winston & Strawn LLP 24Option 2: The Inversion
• Multiple commentators have concluded that Section 956 does not provide the
IRS with an adequate statutory basis for the anti-Hopscotch Loan rule
described on the prior slide.
• See Kimberley S. Blanchard, Extensive New Anti-Inversion Rules Issued, Tax
Notes Today (Oct. 6, 2014); Jeffrey S. Korenblatt, The “New Section 956 Anti-
Hopscotch Rule”—Is Treasury Overreaching?, 42 J. Corp. Tax’n 1 (Jan.-Feb.
2015); Lowell D. Yoder, Section 956: IRS Treats Foreign Property as U.S.
Property, 44 TM Int’l J. 157 (Mar. 13, 2015).
• However, we are not aware of any taxpayer who is planning to challenge this
aspect of Notice 2014-52.
• There should be no such restrictions on the ability to utilize Target’s cash
post-inversion.
• Although there has only been limited commentary on new Notice 2015-79 to
date, commentators have begun to question whether the IRS has the
authority to enact the third country rule, which goes beyond merely ignoring
transactions intended to circumvent the inversion rules.
• See Alison Bennett, Anti-Inversions Guidance Raising Eyebrows, Practitioners
Say, Daily Tax Reporter (Nov. 23, 2015).
© 2015 Winston & Strawn LLP 25Option 2: The Inversion
• In general, the tax consequences to Parent’s shareholders should be
the same as described for Option 1.
• However, because the current Parent shareholders would not be
receiving any cash with which to pay any resulting tax liability, the fact
that the transaction is fully-taxable may require taxable Parent
shareholders to sell their Foreign HoldCo shares in order to have the
liquidity with which to pay the resulting taxes.
© 2015 Winston & Strawn LLP 26Option 3: The Foreign Subsidiary Non-Stock
Acquisition – Transaction Steps
2
Parent Shareholders Target Shareholders
Parent (U.S.) Target
(Foreign)
1
Lender Foreign Sub
Steps
1: Foreign Sub borrows cash. Such loan can be guaranteed by Parent.
2. Foreign Sub purchases Target shares from Target shareholders in a taxable transaction in which
Target shareholders receive all cash.
2 - Alt. Alternately, Foreign Sub could form a “merger subsidiary” which would merge into Target, with
the Target shareholders receiving cash. Such a transaction would be treated as the purchase of the
shares of Target.
© 2015 Winston & Strawn LLP 27Option 3: The Foreign Subsidiary Non-Stock
Acquisition – Final Structure
Original Parent Shareholders
Parent (U.S.)
Foreign Sub
Other Current
Foreign Sub Target (Foreign)
Subsidiaries
© 2015 Winston & Strawn LLP 28Option 3: The Foreign Subsidiary Non-Stock
Acquisition
• In this structure, the Target shareholders would receive only non-
stock consideration which they may prefer.
• In addition to using Foreign Sub’s cash on hand, the purchase price
also can be funded with borrowings and the cash balances of Foreign
Sub and Target.
• By having the borrowing at the Foreign Sub level, there will be no
need for Foreign Sub to make dividend payments to Parent to repay
the debt.
• There also should be no adverse U.S. Federal income tax consequences
to Parent guaranteeing the debt incurred by Foreign Sub.
© 2015 Winston & Strawn LLP 29Option 4: The Foreign Subsidiary Part-Cash
Acquisition – Transaction Steps
3
Parent Shareholders Target Shareholders
Parent (U.S.) Target
2 (Foreign)
1
Lender Foreign Sub
Steps
1: Foreign Sub borrows cash. Such loan can be guaranteed by Parent.
2: Foreign Sub purchases shares of Parent for cash.
3. Foreign Sub purchases Target shares from Target shareholders in a taxable transaction in which
Target shareholders receive Parent shares and boot directly or through a reverse subsidiary merger.
© 2015 Winston & Strawn LLP 30Option 4: The Foreign Subsidiary Part-Cash
Acquisition – Final Structure
Original Parent Shareholders Former Target Shareholders
Parent (U.S.)
Foreign Sub
Other Current
Target
Foreign Sub
(Foreign)
Subsidiaries
© 2015 Winston & Strawn LLP 31Option 4: The Foreign Subsidiary Part-Cash
Acquisition
• The acquisition of stock of Parent by Foreign Sub is intended to
qualify for non-recognition treatment under Section 1032 and permit
cash to be repatriated to Parent in a tax-efficient manner.
• That is, there should not be a deemed dividend by Foreign Sub to a U.S.
taxpayer.
• In addition, the acquisition of shares of Parent by Foreign Sub should
not be taxable under Section 956 even though such shares should
constitute an investment in United States property, provided that
Foreign Sub does not own the Parent shares at the end of any
quarter.
• While Notice 2014-52 states that Treasury intends to issue broader
regulations to cover ongoing abuses, neither it nor Notice 2015-79
expressly addresses this transaction structure.
© 2015 Winston & Strawn LLP 32Other Considerations: Earnings Stripping
• In addition, under Options 1 and 2, related party debt could be put in
place between the new foreign holding company and the U.S.
acquired corporation.
• The purpose of such debt is to enable deductible interest payments
by the U.S. acquired corporation to the new foreign holding company
(subject to limitation under the current interest stripping rules of
Section 163(j)).
• Notice 2014-52 asks for comments “to address strategies that avoid
U.S. tax on U.S. operations by shifting or ‘stripping’ U.S.-source
earnings to lower-tax jurisdictions, including through intercompany
debt.” See Notice 2014-52, at § 5. New Notice 2015-79 also
requests comments on this issue. See Notice 2014-52, at § 6.
• Treasury has suggested it will issue guidance in the coming months.
© 2015 Winston & Strawn LLP 33Other Considerations: Proposed Treaty
Developments
• On May 20, 2015, Treasury released new provisions for inclusion in the next
U.S. model income tax treaty.
• These provisions would insert language into the Dividend, Interest, Royalty,
and Other Income articles relaxing to “expatriated entities”.
• In particular, these provisions would provide that dividends, interest, royalties, and
other income paid by an expatriated entity may be taxed in accordance with U.S.
law for a 10-year period beginning on the date on which the acquisition of the
domestic entity is completed.
• In general, the term “expatriated entity” is defined in Section 7874(a)(2)(A) to
mean a domestic corporation or partnership with respect which a foreign
corporation is a surrogate foreign corporation and any U.S. person related to such
domestic corporation or partnership.
• This provision is not limited to payments to related persons.
• Of course, any such changes to the U.S. treaty network would need to be
negotiated with treaty partners and ratified by the Senate.
© 2015 Winston & Strawn LLP 34Benefits of Step-Up in Basis
• A step-up in basis provides for larger depreciation and amortization
deductions for the acquirer
• These larger deductions provide tax savings
• The value of the potential tax savings is often significant
• If a $1 billion Target with tax basis of $100 million in its assets is purchased
by Buyer, the tax savings (at a 40% corporate tax rate) due to a step-up in
basis are $24 million every year for 15 years, or $260 million over the 15
year period
• Discounted to present value (8% discount rate), these tax savings are worth
$205 million (or approximately 20% of the deal price of $1 billion)
35Scenario 1: Stock Deal
$1B
Shareholders
Target Stock (Basis = $100M)
Buyer Target
• In Scenario 1, there is no step-up in basis.
• Target continues to have original basis in assets ($100 million).
36Scenario 2: Asset Deal
Shareholders
$1B
Buyer Target
Assets (Basis = $100M)
• In Scenario 2, there is a step-up in basis.
• Target steps-up the basis of the assets to $1 billion ($900 million greater
than Scenario 1).
• The additional $900 million in basis can be depreciated/amortized over
time.
• Assuming that (i) all of the basis step-up attributable to goodwill is
depreciable over 15 years, (ii) Buyer pays tax at a 40% corporate tax rate,
and (iii) an 8% discount rate applies, the present value of this benefit is
$205 million.
37Scenario 3: Asset Deal with Benefit Shareholders
For Both Parties
$1.116B
Buyer Target
Assets (Basis = $100M)
• In Scenario 3, Buyer compensates Stockholders for some of the benefit realized
due to a step-up in basis by increasing the purchase price by $116 million.
• Buyer acquires assets with basis of $1.116 billion ($1.016 billion greater than in
Scenario 1).
• The $1.116 billion in basis can be depreciated and amortized over time.
• Assuming that (i) all of the basis step-up attributable to goodwill is depreciable
over 15 years, (ii) Buyer pays tax at a 40% corporate tax rate, and (iii) an 8%
discount rate applies, the present value of this benefit is $232 million.
• Taking into account the increase in purchase price by $116 million, the present
value of Buyer’s tax benefit is $116 million more than the benefit of the stock deal
in Scenario 1.
• Because of the tax benefit of the step-up in basis, both parties are better off
by $116 million.
38Opportunities for Basis Step-Up
• Common Opportunities:
• S Corporations
• Partnerships and “Disregarded Entities”
• Other Opportunities:
• C Corporations with Significant Net Operating Losses
• Subsidiaries within Consolidated Groups
39S Corporations – 338(h)(10) Election
Purchase Price
Shareholders
Target Stock
Buyer Target
338(h)(10) Election
• S Corporations can obtain a basis step-up through an election under
Section 338(h)(10).
• Section 338(h)(10) allows an S corporation and the shareholders of
that S corporation to elect to have the disposition of their S corporation
shares treated as an asset sale rather than a stock sale for U.S.
federal income tax purposes.
40S Corporations – 338(h)(10) Election
• Some potential issues arise when making a Section 338(h)(10) election:
• Tax-Deferred Rollover
• Sellers cannot defer tax on any rollover portion (if one exists) when an election under Section
338(h)(10) is made
• Anti-Churning
• Anti-churning rules may disallow amortization on certain intangibles and property (negating
some of the benefits of the election)
• Section 1374 Tax
• Section 1374 imposes tax on some corporate level built-in gains when a C corporation has
converted into an S corporation
• Invalid S corporation election by Target disallows the Section 338(h)(10) Election
• If the Target’s S corporation election is invalid, the section 338(h)(10) election will be invalid and
there will be no step-up in basis
• Buyer must be a corporation and not an individual or partnership
• All S corporation shareholders must make the election for the election to be valid
41S Corporations – 336 Election
Purchase Price
Shareholders
Target Stock
Buyer Target
336 Election
• Alternatively, S Corporations can obtain a basis step-up through an
election under Section 336.
• Section 336 allows shareholders of an S corporation who dispose of 80% or
more of their interests to elect to have the disposition treated as an asset
sale rather than a stock sale for U.S. federal income tax purposes.
42S Corporations – 336 Election
• Some potential issues arise when making a Section 336 Election:
• Tax-Deferred Rollover
• Sellers cannot defer tax on any rollover portion (if one exists) when an election under Section
336 is made
• Anti-Churning
• Anti-churning rules may disallow amortization on certain intangibles and property (negating
some of the benefits of the election)
• Section 1374 Tax
• Section 1374 imposes tax on some corporate level built-in gains when a C corporation has
converted into an S corporation
• Invalid S corporation election by Target disallows the Section 336 Election
• If the Target’s S corporation election is invalid, the Section 336 election will be invalid and there
will be no step-up in basis
• All S corporation shareholders must make the election for the election to be valid
• Some potential benefits arise in connection with a Section 336 Election
(compared with a Section 338(h)(10) Election):
• Buyer can be a partnership or an individual
43S Corporations – F Reorganization
• S Corporations can utilize a reorganization under Section 368(a)(1)(F)
of the Code to deliver a step-up in basis to the buyer while avoiding
some of the issues associated with elections under 338(h)(10) and 336
• Benefits of an F reorganization:
• Allows for tax-deferred rollover
• Eliminates issues related to an invalid S corporation election
• Buyer does not have to be a corporation
• All of the shareholders are not required to make an election
• Issues an F reorganization does not solve:
• Historic tax liabilities
• Section 1374 taxes still exist (but are left behind)
• Anti-churning rules are still implicated
• Disproportionate rollover may be tax inefficient
44F Reorganization Steps
Original Step 1 Step 2 Final Sale
Structure Structure
Shareholders Shareholders Shareholders Shareholders Shareholders
Contribute
shares of
S Corp.
100% 100% 100% 100% 100%
Target Corp New Corp Target Corp New Corp New Corp New Corp Buyer
(S Corp) (S Corp) (S Corp) (S Corp) (S Corp) (S Corp)
NewCo sells
interests in
LLC to
Buyer
100% 100% 100%
Target Corp Target LLC Target LLC
(Q Sub) (Disregarded) (Disregarded)
New Corp makes
Q Sub Election for Old
Corp and New Corp
converts Old Corp to
an LLC
45Partnerships
Purchase Price
Partners
100% of Partnership Interests
Buyer
Partnership
• Buyer automatically obtains a basis step-up in an acquisition of 100%
of a partnership.
• Benefits of partnership acquisitions:
• Allows for tax-deferred rollover and basis step-up
• No Section 1374 taxes
• Buyer does not have to be a corporation
• No election is necessary for the step-up in basis
• Fewer issues related to ensuring Target is a partnership than to ensuring
Target is a valid S corporation
46Partnerships – Mitigating Anti-Churning Problems
Purchase Price
Partners
60% of Partnership Interests
Buyer
Partnership
• Anti-Churning
• Partnership can have rollover and avoid anti-churning on basis step-up on
portion acquired
• See Treas. Reg. § 1.197-2
• Partnership must make an election under Section 754 to provide for basis
step-up
47Initial Public Offering of a Partnership
• Basic Structure:
• An entity taxed as a partnership wishes to go public.
• Public companies generally need to be C corporations.
• A C corporation can acquire 100% of a partnership for cash and stock and
obtain a basis step-up just like any other deal.
• Issues:
• Issue 1: Investing public does not place value on basis step-up when valuing
an IPO.
• Issue 2: Historic partners become shareholders in a C corporation and lose
the benefit of partnership investing.
• Issue 3: No further basis step-up on sale of stock.
• Opportunity: Up-C structure combined with Tax Receivable Agreements
(“TRAs”)
48IPOs – Up-C Structure
Cash
Shareholders Partners
[TBD]% of Partnership Interests
IPO Cash
Public Company Partnership
• Basic Structure:
• In an Up-C structure a public corporation is formed to raise cash to purchase the
majority of interests in a partnership.
• Pre-IPO partners retain interests in the partnership.
• This purchase results in a step-up in basis for the public company (assuming
the partnership makes an election under Section 754).
• Pre-IPO owners of the partnership retain interests in the partnership, which
can be exchanged for stock in the new public company.
49IPOs – Up-C Structure Continued
• Benefits of the Up-C structure from the perspective of pre-IPO owners:
• Allows pre-IPO owners to obtain the benefits of the IPO (including liquidity
by converting partnership interests to public company stock)
• Maintains flow-thru treatment
• Captures material tax benefits through the use of TRAs
50IPOs – Tax Receivable Agreements
• TRAs allow for tax benefits to be allocated to a certain party
• In this instance those tax benefits derive from the depreciation and
amortization deductions due to the step-up in basis
• TRAs are used to allocate to the pre-IPO owners a percentage of the
tax benefits from the step-up in basis
• Generally, transactions using this structure have allocated 85% of the
increased tax deductions to the pre-IPO owners
• TRAs generally trigger payments on a change in control
51Examples of Up-C Transactions and TRAs in IPOs
• GoDaddy:
• Value: ~ $800 million of tax benefits
• Blackstone Group:
• Value: ~ $870 million of tax benefits
• Graham Packaging Company:
• Value: ~ $200 million of tax benefits
• National CineMedia:
• Value: ~ $200 million of tax benefits
52Partnerships Revisited – Bipartisan Budget Act of 2015
• The Bipartisan Budget Act of 2015 (“Act”), signed into law on November 2,
enhances the IRS’s ability to audit partnerships.
• The Act provides that tax adjustments resulting from an audit will generally be
determined and collected at the partnership level (as opposed to at the partner
level).
• If the percentage interests in the partnership have changed between the tax year audited
and the current year, the cost of the adjustment will not be borne in the same proportions as
it would have been had the tax been paid in the taxable year.
• The Act provides for a procedure to mitigate this consequence through elective
Form K-1 adjustmens.
• The partnership may elect to send amended Form K-1s to individuals and entities who were
partners in the earlier year.
• Under this procedure, the partners are required to pay a higher rate of interest on the
underpayments (5% instead of 3%).
• The new procedures under the Act should be taken into account when
contemplating an acquisition of a partnership, because an audit of a previous year
may create tax liability that is borne by the acquirer if no procedures are put in
place to reassign such a loss.
• These changes apply to partnership taxable years beginning after December 31,
2015.
53Questions? Edmund S. Cohen Rachel Ingwer Dean Burau Roger Lucas Partner Associate Partner Partner +1 (212) 294-2634 +1 (212) 294-4760 +1 (312) 558-7885 +1 (312) 558-5225 ecohen@winston.com ringwer@winston.com dburau@winston.com rlucas@winston.com © 2015 Winston & Strawn LLP 54
Thank You © 2015 Winston & Strawn LLP
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