What is a Tax-Free Reorganization?

A corporation may undergo restructuring or reorganization for various strategic reasons, whether
it be for increased operational efficiency or to cut costs. That reorganization may be conducted to
increase profits. A tax-free reorganization is often implemented to find efficiencies within the
law that allow for reduced tax. These types of reorganizations can be triggered by certain tactical
actions, such as takeovers, buyouts, new acquisitions.

These techniques are generally implemented with the mindset that the seller looks to avoid
income tax on any realized gains, such as the gain on trading shares in another corporation.
While there are other occurrences in which a seller would want to avoid income tax recognition,
income tax deferral is often accomplished through using a proper reorganization that follows
federal income tax recognition laws.

Tax rules

Managing a tax-free reorganization is entirely dependent on the tax jurisdiction a company is in.

A tax-free reorganization is done not necessarily to grant a tax exemption and thereby put the
company in a better position. It is done to reduce any tax consequences of an already impending
reorganization. In other words, a business reorganization is not triggered by the need to conduct
a tax-free reorganization. Rather, the tax-free reorganization is triggered when a business
reorganization is expected. With the incoming restructuring, the business hopes to neither incur a
tax advantage nor a disadvantage.

In essence, the term “tax-free” is misleading because the expense is not entirely mitigated, but
may be deferred, transferred, or minimized.

Two factors

To reduce tax concerns in a business reorganization, there are two factors to consider. The
reorganization implies that:
 1. After reorganizing, taxable profits in the company joining the parent company (hence
known as the transferee) are calculated using the metrics of the parent company prior to
the reorganizing; and,

2. No tax is immediately incurred during the restructuring.

This results in a deferred tax on unrealized gains, rather than an exemption to these taxes. So in
essence, the reorganization is tax-free because the tax is not immediately due. The proper term,
however, should be a tax-deferred reorganization.

Types of reorganizations

Tax-free reorganizations can be divided into the following four types:

 Acquisitive reorganizations

 Divisive reorganizations

 Corporate restructuring reorganizations

 Bankruptcy reorganizations

1 Acquisitive Reorganizations

Acquisitive reorganizations, as the name implies, involves a restructuring where one corporation
acquires another corporation. This can happen via a stock acquisition or asset deal. These
reorganizations can be further divided into four sub-categories. The letters attached to each type
of category are based on their subsection clause as found in IRC Section 368.

1. Type A reorganization: A merger or consolidation, all privy to the relevant state or

federal tax laws. In a Type A reorganization, the target corporation dissolves after the
merging. All of the target’s balance sheet is absorbed by the acquiring or parent company
(IRC § 368(a)(1)(A)).
 2. Type B reorganization: A form of corporation restructuring where the acquiree exchanges
its stock for voting stock in the acquirer’s corporation. The sole requirement here is that
the acquiring/parent company own above and beyond majority ownership of the acquiree
after the transaction. This requires that the target corporation exchange around 75-85%
ownership to the acquiring company (IRC § 368(a)(1)(B)).

3. Type C reorganization: A stock-for-asset deal, where the target company “sells” all of its
targets to the parent company, in exchange for voting stock. Included in this transaction is
a necessary amount of consideration that is not equity. This is known as a boot. The
target company then liquidates (IRC § 368(a)(1)(C)).

4. Type D acquisitive reorganization: The transfer of “substantially all” of the target

corporation’s assets to an acquiring corporation, provided that the target corporation or its
stockholders (or a combination of the two) has “control” (generally 80% ownership) of
the acquiring corporation immediately after the transfer. The target corporation also must
liquidate and distribute to its stockholders the acquiring corporation stock and any other
consideration received by the target corporation from the acquiring corporation (as well
as the target’s other properties, if any) in a transaction that qualifies under IRC § 354
(IRC § 368(a)(1)(D)). There is also a type D divisive reorganization, as described further
below.

These types of reorganizations can also be classified as triangular reorganizations (excluding

reorganization type D). Types A, B, and C can be used in conjunction with the three parties,
involving a target corporation, a parent, and a subsidiary.

#2 Divisive Reorganizations

As the name implies, a divisive reorganization involves a corporation dividing into smaller
corporations. This results in two or more companies, and must qualify under the rules as set out
in the divisive Type D reorganization under IRC 368(a)(1)(D). Divisive reorganizations take
three different forms:
  Split-offs: A subsidiary “splits-off”. The parent company’s shareholders then offer parent
stock in exchange for some controlling shares in the subsidiary.

 Spin-offs: The parent corporation “spins-off” some of its assets into a new subsidiary.
This spin-off can typically include a specific line of business, or divisional assets, and is
spun-off sometimes for better divisional control. The parent company trades these assets
or lines of business to the subsidiary in exchange for stock and dividends in the new
subsidiary.

 Split-ups: A transfer of the assets of the parent corporation to two or more newly formed
corporations and dividends of the stock of the newly formed corporations to the parent
corporation’s stockholders. The parent corporation liquidates and the stockholders hold
shares in the two or more newly formed companies.

#3 Restructuring Reorganizations

Restructuring, though sometimes used synonymously with reorganization, is another form of

reorganization. This involves keeping the current corporate entity structure intact, but perhaps
moving around the organization chart. There are two main types of restructurings:

 Type E Restructuring: A restructuring involving not the organizational structure, but

rather the existing corporation’s capital structure. As such, this is classified as
a recapitalization under IRC § 368(a)(1)(E)). This can occur when the corporation issues
a new class of stock in exchange for existing common stock or preferred stock. 

 Type F restructuring: A simple formality change to the corporation. This involves a

change in identity, form, or location of the corporation under  IRC § 368(a)(1)(F). For
example, changes in the state or jurisdiction of incorporation generally qualify as Type F
reorganizations.

#4 Bankruptcy Reorganizations
Bankruptcy reorganizations are transactions that involve the transfer of assets from one
corporation to another corporation in a bankruptcy or similar case and that qualify as Type G
reorganizations under IRC 368(a)(1)(G).

Additional resources

Thank you for reading this guide to achieving a tax-free reorganization.  To keep learning and
advancing your career we highly recommend these additional resources:

 IRC 382

 M&A process

 IPO process

 Financial modeling guide

Tax Implications on Corporate Reorganization

As discussed above that the government has come up with provisions which are favorable for the
purposes of reorganization of corporations, let us now discuss the provisions of Income Tax Act,
1961.

· If capital gains arise on transfer of any capital asset in the scheme of amalgamation, by an
amalgamating company to the amalgamated company, such capital gains shall be exempt from
tax provided the amalgamated company is Indian.

· If capital gains arise on transfer of shares held in Indian company by amalgamating foreign
company to amalgamated foreign company, such capital gains shall be exempt from tax but there
is a proviso to this exemption.

· Capital gains arising from the transfer of shares in the scheme of amalgamation on the
fulfillment of a few conditions which are given in the act are exempt from tax.
· In case the shares received from the amalgamated company are later sold or transferred, the
cost of shares of the amalgamating company shall be the cost of shares of the amalgamated
company and also for determining whether the shares in the amalgamated are long-term capital
assets or not, the period of the holding shall be computed from the date of acquisition of shares
in the amalgamating company.

· Depreciation charge on assets are waived and are not strictly observed in case of amalgamation
or demerger of companies where an asset is transferred to an Indian amalgamated or resulting
company under the scheme or amalgamation or demerger.