Finishing the Job on Section 356(a)(2): Closing Loopholes and Providing Consistent Treatment to Boot in Tax-Free Reorganizations

By Crowley, Trevor | Brigham Young University Law Review, March 1, 2015 | Go to article overview

Finishing the Job on Section 356(a)(2): Closing Loopholes and Providing Consistent Treatment to Boot in Tax-Free Reorganizations


Crowley, Trevor, Brigham Young University Law Review


INTRODUCTION

The Obama administration has recently taken aim at a provision in the tax code that allows shareholders to repatriate offshore earnings from corporations without ever paying U.S. taxes on the money earned. This loophole, called the "boot-within-gain limitation," is one of several problems in section 356(a)(2) of the Internal Revenue Code.

This loophole works when a shareholder in the United States- let's say the shareholder is a corporation itself-owns two foreign corporations with earnings that have not been taxed in the United States. The shareholder causes the foreign corporations to merge in a tax-free reorganization. The shareholder structures the transaction so that the acquiring corporation gives its own stock and cash to the shareholder in exchange for all of the shareholder's stock in the target corporation. The shareholder takes care to ensure that the cash and stock received from the acquiring corporation do not exceed the value of the target corporation's stock. If the shareholder is successful, section 356(a)(2)1 allows the shareholder to receive the cash without being taxed2-but for this provision, the cash would have finally been subject to U.S. federal income tax.3 This loophole also applies when the parties to the reorganization are domestic corporations.

Tax-free reorganizations allow corporations to merge or be acquired by other corporations without being taxed on gain realized in the transaction. To qualify for tax-free treatment, the transaction has to meet specific requirements. The general requirement is that the shareholders of the target corporation must receive stock in the acquiring corporation as consideration in the transaction. The rationale for not taxing these transactions is that the shareholders are not "cashing out" their interests in the corporation; instead they are continuing their interest in another form. But section 356(a)(2) allows shareholders to do just that-cash out their interest in the corporation.

Generally, if a shareholder receives cash in a reorganization, the shareholder is taxed on the cash but can defer tax on the stock received.4 But when the cash has the effect of a dividend, section 356(a)(2) limits the amount of cash that is taxed to the overall gain realized in the transaction.5 In other words, if the total consideration received in a qualifying reorganization provides a ten-dollar profit to the shareholder, but the shareholder receives fifty dollars in cash, only ten dollars of that cash is subject to tax. Thus, parties can receive cash and avoid paying taxes by throwing some cash, which would otherwise be taxed as a dividend, into a reorganization. But when does cash have the effect of a dividend? Congress has not provided an answer to this question.

This is not the only problem with section 356(a)(2); it contains further opportunities for tax avoidance, it is inconsistent with the rest of the Internal Revenue Code, and it is full of uncertainties that have existed for ninety years without resolution.

Because of these shortcomings, section 356(a)(2) has been attacked by Congress on-and-off over the last sixty years6 and the Obama administration has renewed its focus on this provision for 2016.7 This Comment discusses the Obama administration's proposals for section 356(a)(2) and provides further recommendations for those proposals. I argue that Congress should specify when boot has the effect of a dividend and should supplant the current Clark rule that has developed in the courts. The replacement test should compare the shareholder's interest in the target corporation before the reorganization with the shareholder's interest in the acquiring corporation after the reorganization to determine whether there has been a meaningful reduction in interest under section 302(b).

Part I of this Comment describes the policy, operation, and tax consequences of tax-free reorganizations. Part II presents a detailed analysis of section 356(a)(2) and its shortcomings. …

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