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Court applies Code Sec. 356(c) to determine gain and loss in merger transaction

Tseytin, TC Memo 2015-247

The Tax Court has concluded that a shareholder, who purchased a block of stock from another shareholder to effectuate a corporate merger, should be treated as the owner of that block of stock and not merely as an agent or nominee who held the stock for another. Further, in determining the amount of cash received in the merger that was taxable to the shareholder, under Code Sec. 356(c), he couldn’t subtract the loss he realized on the purchase of that block of stock from the gain to be recognized on the stock he already owned.

Background. If the nonrecognition rules of Code Sec. 354 or Code Sec. 355 would apply to an exchange but for the fact that property other than stock or securities (i.e., boot) is also received in the exchange, gain is recognized only up to the sum of the money received and the fair market value of the other property. (Code Sec. 356(a)(1), Reg. § 1.356-1(a)(1))

No loss is recognized on the exchange or distribution if the nonrecognition rules of Code Sec. 354 or Code Sec. 355 would apply to an exchange or distribution but for the fact that property other than stock or securities is also received in the exchange. (Code Sec. 356(c))

In Rev Rul 68-23, 1968-1 CB 144, IRS concluded that, in determining gain or loss on a merger transaction to which Code Sec. 356 applies, blocks of stock in which a taxpayer has different bases are to be considered separately, and a loss on one block of stock may not offset or reduce a gain recognized on another block of stock.

Facts. US Strategies, Inc. (USSI), a domestic corporation, owned a majority (91%) interest in two limited liability companies organized under the laws of the Russian Federation, which in turn owned and operated Pizza Hut and Kentucky Fried Chicken franchises throughout the Russian Federation.

Archer Consulting Corp. (Archer) owned 250 shares (or 25%) of the issued and outstanding shares of stock in USSI (Archer shares).

Micheal Tseytin owned the other 750 shares (or 75%) of the issued and outstanding shares of stock in USSI (non-Archer shares) and had a zero tax basis in the non-Archer shares.

In May of 2007, USSI, Mr. Tseytin, and AmRest Holdings, NV (AmRest) agreed to the merger of USSI into AmRest. The merger was to qualify as a tax-free reorganization under Code Sec. 356 and Code Sec. 368(a). In order to effect the transfer and merger, Mr. Tseytin agreed to purchase the Archer shares for $14 million and then to transfer to AmRest 100% of the shares of stock in USSI. In exchange for transferring all of the USSI stock to AmRest, Mr. Tseytin was to receive as consideration approximately $23 million in cash and AmRest stock equal to approximately $30.8 million. Archer was not a party to the AmRest agreement.

On May 25, 2007, Mr. Tseytin entered into a securities purchase agreement with Archer, under which he agreed to purchase the Archer shares for $14 million. Under the agreement, he was to receive “all right, title and interest in and to the Archer shares, free and clear of all liens, claims and other encumbrances” and he agreed to purchase the Archer shares for his “own account.” AmRest was not a party to the Archer agreement.

In further preparation for the USSI-AmRest merger, Mr. Tseytin took a number of actions as sole shareholder of USSI, including amending its bylaws, appointing himself its sole director, and giving shareholder approval for the merger. On July 2, 2007, the merger between USSI and AmRest closed.

On his 2007 Form 1040, Mr. Tseytin treated the 1,000 shares of stock in USSI involved in the merger as one block of stock, all owned and transferred by him to AmRest. He treated the $23 million cash received as taxable, but he reduced that amount by the $6 million portion of his $14 million total cost basis in the USSI stock, which he allocated to the cash received (i.e., $23 million cash ÷ $54 million total consideration received = 42.7%). He reported a net taxable long-term capital gain of $17 million relating to the $23 million cash boot he received on the USSI-AmRest merger and a total Federal income tax due of $3.8 million.

On an amended return, Mr. Tseytin treated all 1000 shares of stock in USSI as owned and transferred by him to AmRest, but treated the 250 Archer shares as separate from the 750 non-Archer shares, and in calculating the taxable portion of the $23 million total cash petitioner received, ignored the $30.8 million value of the AmRest shares that he received and that constituted part of the total merger consideration.

He treated 25% (or $5.8 million) of the total $23 million cash received as allocable to the 250 Archer shares, from which he subtracted the $14 million cost of the Archer shares, producing a claimed short-term capital loss of $8.2 million. He treated the remaining 75% balance (or $17.3 million) of the $23 million total cash received as allocable to the non-Archer shares with a zero basis, and he reported with regard to the non-Archer shares a resulting taxable long-term capital gain of $17.3 million—an increase over the $17 million in long-term gain reported on his original return relating to the merger. However, he also offset or reduced the $17.3 million long-term capital gain by the $8.2 million short-term capital loss on the Archer shares, for a reported net long-term capital gain relating to the USSI-AmRest merger of just over $9 million and a reduced reported total tax liability of $2.6 million.

On audit, IRS treated the Archer and non-Archer shares of USSI stock as owned by the taxpayer and as separate blocks of stock with identifiable and different cost bases (as the taxpayer did on his amended return). IRS calculated the taxable portion of the $23 million total cash received on the merger using the total $54 million merger consideration—not just the $23 million total cash received (as the taxpayer had done on his amended return). As a result, the amount of the taxpayer’s long-term capital gain realized on the transfer of the non-Archer shares increased to $40.4 million, and the entire $17.3 million (i.e., 75% of the total cash received allocable to the non-Archer shares) was charged or taxed to the taxpayer as long-term capital gain. The taxpayer sought relief in the Tax Court.

Taxpayer’s position. At trial, Mr. Tseytin argued that in transferring the Archer shares to AmRest he acted only as a nominee or agent for Archer, that he never owned the Archer shares, and that the Court should treat the Archer shares as either (i) sold directly by Archer to AmRest, or (ii) redeemed by USSI or by AmRest from Archer. Under this view, he should treat $14 million (the amount paid to Archer for the Archer shares) of the $23 million total cash consideration received from AmRest as not received by him, but rather as received by and taxable to Archer. In the alternative, if he was to be treated as owner of the Archer shares on their transfer to AmRest, he argued he should be allowed to subtract the $527,297 short-term capital loss realized on the transfer of the Archer shares from the $17.3 million long-term gain to be recognized and taxed as cash boot.

Court’s conclusion. The Tax Court held that the taxpayer was bound by the form of the transactions he entered into and so was to be treated as the recipient of the portion of the cash boot received in the merger that was allocable to the Archer shares. There was no persuasive evidence that would support a finding of a nominee or agency relationship between the taxpayer and Archer or that the Archer shares of stock in USSI were redeemed from Archer by USSI or by AmRest. Nor was there any argument that there was any mistake, fraud, undue influence, duress, or the like, that might support a recharacterization of the transaction.

Mr. Tseytin warranted that he would hold of record and beneficially own all 1,000 shares of USSI stock. He received all right, title, and interest in the Archer shares, and he agreed to purchase them for his own account. He acted as sole shareholder of USSI, amending USSI’s bylaws, appointing himself sole director, and approving the merger. The Tax Court found that the taxpayer purchased from Archer the Archer shares of stock in USSI in a related and essentially simultaneous transaction independent from the merger and then transferred to AmRest the Archer shares he had purchased. Neither AmRest nor USSI was a party to the stock purchase agreement between the taxpayer and Archer. Archer was not a party to the merger agreement between the taxpayer and AmRest.

Netting of losses and gains. The Tax Court also concluded that the taxpayer could not net his $527,297 realized loss on the Archer shares against the $17.3 million gain to be recognized and taxed on the non-Archer shares allowing him to be taxed on only a net gain of $16.8 million in the merger transaction. No authority supported such a calculation.

The Court rejected the taxpayer’s argument that Code Sec. 356(c) should be interpreted only as prohibiting the tax recognition of a net bottom line cumulative loss on a merger transaction and that internal netting of losses and gains should be allowed of different blocks of stock involved in a merger transaction up to, but limited by, the total amount of the overall gain to be recognized. The Court further noted that, even if internal netting were allowable, the taxpayer cited no authority that would allow a loss realized to offset or be netted against a gain to be recognized.

The Cout also pointed out, as IRS had noted, that if (contrary to the loss disallowance rule of Code Sec. 356(c)) internal netting were allowable here it would allow only the $527,297 loss the taxpayerrealizedon the Archer shares to reduce the $40.4 million gain herealizedon the non-Archer shares, and his tax liability would be significantly increased over the tax liability determined by IRS (i.e., the taxpayer would be taxed on the entire $23 million cash boot that he received).

References:For the rule on nonrecognition of loss where boot is received, see FTC 2d/FIN ¶  F-4018; United States Tax Reporter ¶  3564.02; TaxDesk ¶  232,529; TG ¶  5193.

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