LTR 200737019 involves a corporate inversion and what happens to “hook stock.” The ruling did not use that term, but it is sometimes used to refer to the stock in the former subsidiary that the former parent retains when it becomes a subsidiary of its former subsidiary.
It is in this sort of transaction that the client may ask: can’t we just cancel the subsidiary stock “for nothing”? This ruling shows why the answer is yes and no, but in any event you should think about it.
P owns S, which operates a business. P also owns other subsidiaries. For some business reason S needs to be the group parent. In order to invert P under S, S forms a Newco, which merges into P for S stock. P will still own the S stock that it started with. The ruling ignored the merger and treated the P shareholders as having contributed their P stock to S in a section 351 exchange. The more interesting part is how the ruling handled the S stock held by P.
First P had the S stock valued and recapped the S stock so that P would hold a number of shares that will preserve the pre-merger value of the S stock, after the public receives its S shares. Then Newco merges into P. Finally, P distributes its S stock to S and the stock is cancelled.
S will receive a dividend equal to the value of the S stock it receives from P and P will recognize any gain in that stock. The ruling states the “amount of the Distribution and the value of the shares of S common stock distributed by P will equal the fair market value of the S common stock owned by Parent immediately prior to the merger."
Owner (“O”) (the public) holds all of the outstanding P stock. P holds land worth $300 and all 10 of the outstanding shares of the stock of S. S holds land worth $100 and the stock of S is worth $100. O contributes their P stock to S for S shares; the issue is how many S shares. Should O receive 30 shares of S while P keeps 10 (after all, S was ¼ the value of P to start with); or should O receive 40 shares of S while P keeps 10?
If you analyze it from the viewpoint of what an unrelated third-party purchaser would pay P for its S shares, the right answer is to give O 40 shares so that P has 1/5 of the S shares, for which a third-party purchaser should pay $100. This replicates what the purchaser would have paid for the S shares before the inversion. Once P received the $100 cash from the purchaser on an actual sale of the 20 percent of the S stock, S would really be worth $500, of which 1/5 is the right amount for P to have owned.
Notice 94-93, 1994-2 CB 563
This letter ruling appears to be the first ruling issued under 13-year old Notice 94-93, which forecast regulations that never came. The notice described the case in the example above and the 40/10 share answer. Its purpose was to prevent avoidance of recognition of General Utilities gain in the S stock by P, or creation of improper losses. The case the notice was worried about was where O got 90 shares, thus diluting and reducing the value of the S stock P held and reducing or eliminating General Utilities gain or creating loss to P on a disposition of the S stock.
One approach to solving problems in the case of dilutive inversions would be to deem a distribution by P either before or after the inversion. If the distribution is after the inversion, it may be subject to deferral under the consolidated return regulations. If the distribution is before the inversion, there may be a tax imposed up front at both the corporate and shareholder level even though General Utilities repeal may not compel imposing a shareholder level tax.
In effect, this is what the ruling did. The facts of the ruling stated that P would distribute the S stock to S immediately after the merger. If the taxpayer had not proposed to do that, the IRS probably would have strongly recommended it.
How Many Shares?
The issue then became how many shares of S stock should be issued in the recap and what were they worth? The ruling stated that they would be worth what the S stock was worth to P before the merger. That gets to the right answer on these facts, $100; but presumably the actual number of shares would be 1/5 of the post merger total, as described in the notice. By focusing on the value of S before the merger you avoid confusion about what is the value when S owns P that owns S that owns P, etc.
This ruling illustrates that when a shareholder becomes a subsidiary of the corporation in which it owns shares, you can’t just cancel those shares and forget about them. They have some value and that value has to go somewhere and that process normally will cause one or more taxpayers to incur tax liability.