Liquidations and C Reorganizations Through the Prism of the IRS 2021 Audit of Bausch Health’s 2017 Granite Trust Transaction

In a September 30, 2021 securities filing, Bausch Health Companies Inc. (Bausch Health) announced that it had received an IRS notice of proposed adjustment (NOPA) disallowing a 2017 capital loss. Bausch Health estimated that it could owe an additional $2,100 million in taxes, not including interest and penalties, in a “worst case scenario.”

This article discusses the tax provisions implicated by the NOPA. It also considers the broader implications of substance-over-form doctrines by which a transaction that otherwise complies with tax statutory provisions may be disregarded.

I. What We Know About the Bausch Health NOPA

Bausch Health’s third quarter 2021 10-Q disclosed that the NOPA stems from a 2017 internal restructuring in the form of a Granite Trust transaction that resulted in a 2017 capital loss to Bausch Health (the 2017 Transaction). As of the filing, Bausch Health had not been assessed but expected a notice of proposed tax deficiency. Bausch Health stated that it would “vigorously defend its position” and believed it would be able to deduct the loss. At a presentation by Bausch Health Credit at the November 10, 2021 Suisse Healthcare Conference, Bausch Health criticized the IRS’s inquiry.

IRS is now taking the novel position that a pro rata distribution of 69% of [a] liquidating corporation’s assets constitutes “substantially all” of [a] liquidating subsidiary’s assets such that the transaction is [a] tax-free “reorganization” in which no loss is recognized.

As is explained below, this characterization of the IRS’s position suggests a C reorganization rather than a liquidation transaction.

II. Nonrecognition Transactions

Disclosures surrounding the NOPA and the 2017 Transaction implicate two distinct types of nonrecognition (i.e., non-taxable) events. First, Bausch Health’s calling it a “Granite Trust transaction” suggests that the company treated the transaction as the liquidation of a controlled corporation under section 332 (section 332 liquidation). Second, Bausch Health’s characterization of the IRS’s position implicates section 368(a)(1)(C), providing that the transfer of “substantially all” of a target corporation’s assets “solely for voting stock” in the acquiring corporation (or its parent) is a tax-free reorganization (a C reorganization). If the 2017 Transaction were characterized as either a section 332 liquidation or a C reorganization, it would be a non-recognition transaction that would not allow the recognition of the capital loss to Bausch Health.

A. Taxable and Non-Taxable Liquidations

Whether a liquidation of a target corporation and the corresponding distribution of its assets is a taxable event depends on the acquiring corporation’s ownership, by vote and value, of the target corporation stock. When the distributee corporation owns less than 80% of the liquidating corporation, the liquidation is a taxable event to the liquidating corporation under section 336(a), with gains or losses recognized unless certain loss disallowance provisions under section 336(d)(1)-(2) apply, and the distributee corporation recognizes gains or losses on its stock, depending on the value of the distributed assets, under section 331(a).

If, on the other hand, the parent corporation owns 80% or more of the vote and value of the liquidating corporation at the time that the plan of liquidation is adopted, a liquidation is generally nontaxable to both the liquidating corporation and the distributee corporation. A section 332 liquidation also requires that the acquiring corporation satisfy the ownership requirement at all times from the adoption of the liquidation plan through the distribution of the properties.

B. Granite Trust Liquidations

The requirement in section 332 that the receiving corporation’s ownership of the liquidating corporation be satisfied as of the date of the adoption of a plan of liquidation creates the possibility for transactions like that in Granite Trust Co. v. U.S. and its progeny. A receiving corporation could, prior to the adoption of the plan of liquidation, sell enough of the liquidating stock to fall below the 80% threshold. If the timing of the plan in relation to the change in ownership is accepted, the transaction would allow recognition of losses on a taxable liquidation under sections 331 and 336, rather than coming within the tax-free liquidation provisions of sections 332 and 337.

The First Circuit upheld Granite Trust Co.’s pre-liquidation divestiture of 20.5% ownership in the liquidating corporation and allowed it to recognize its losses under the predecessor provisions to sections 331 and 332. The IRS claimed that the “end result” was a complete liquidation of a controlled subsidiary and the preceding divestiture should be characterized “as artificial, unessential, transitory phases of a completed tax avoidance scheme which should be disregarded.” In rejecting this argument the Granite Trust court reasoned that the liquidation provision was “not an ‘end result’ provision” and that the tax code is written such that “taxpayers can, by taking appropriate steps, render the subsection applicable or inapplicable as they choose.” Although the facts did “show a tax avoidance, they also show legal transactions not fictitious or so lacking in substance as to be anything different from what they purported to be.”

Since Granite Trust, a number of cases have upheld a corporation’s ability to effectively elect favorable tax treatment by divesting ownership prior to a complete liquidation.

C. C Reorganizations Under Sections 361 and 368(a)(1)(C)

Recall that Bausch Health characterized the IRS’s position as a distribution of “substantially all” of the liquidating corporation’s assets, resulting in a “reorganization” that did not permit loss recognition. The IRS apparently characterized the 2017 Transaction as a C reorganization.

Section 361(a) provides for nonrecognition of gains and losses by a distributing corporation upon the distribution of assets to a shareholder. That section applies to corporations that are each a “party to a reorganization” and exchange property of one corporation for stock in another. A “reorganization” is defined, inter alia, in section 368(a)(1)(C) (a C reorganization), as “the acquisition by one corporation, in exchange solely for all or part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), of substantially all of the properties of another corporation.”

The “solely for” voting stock requirement is relaxed in section 368(a)(2)(B). That so-called “boot relaxation rule” allows for part of the consideration in the C reorganization to be paid in cash or property (with liabilities assumed counting as boot only if there is other cash or property boot). A transaction with boot still qualifies as a C reorganization if: “(i) one corporation acquires substantially all of the properties of another corporation,” (ii) the acquiring corporation exchanges voting stock and money or other property (and thus otherwise fails the “solely for” voting stock requirement), and “(iii) the acquiring corporation acquires, solely for voting stock described in paragraph (1)(C), property of the other corporation having a fair market value which is at least 80 percent of the fair market value of all of the property of the other corporation.” It is hard to view subparts (i) and (iii) as two independent requirements in this context since subpart (i) will always be met when subpart (iii) is met.

In its guidance on sections 368(a)(1)(C) and (a)(2)(B), the IRS states that qualification as a C reorganization requires that the acquiring corporation acquire “solely for voting stock” assets of the target with “a fair market value which is at least 80 percent of the fair market value of all the properties” of the target. While the “substantially all” requirement in bootless reorganizations clearly may be less than 80% of target’s value, for transactions with cash or property consideration in addition to acquirer stock for which the boot relaxation rule must apply, it appears that the acquirer must acquire 80% of the target’s value with stock. Those Treasury regulations are, of course, binding on the IRS.

A C reorganization also has continuity of business enterprise (COBE) and continuity of interest (COI) requirements. The COBE requirement is met if the acquiring corporation either (i) continues a line of the target’s historic business or (ii) uses a significant portion of the target’s historic business assets in any business (whether or not that business was historically conducted by the target). The COI requirement is met if the target shareholders have a sufficient continuing interest in the target assets and target business through the acquisition of acquiring stock.

D. Economic Substance (and Related Doctrines)

Granite Trust and its form-over-substance principle has been slowly eroded under the economic substance doctrine (the ESD). The ESD has its genesis in the Supreme Court’s ruling in Gregory v. Helvering, in which a taxpayer caused her wholly-owned corporation to transfer stock to a new corporation which then transferred the stock directly to the taxpayer who sold it, achieving the equivalent income that a taxable dividend would have provided by using reorganization provisions. Although the taxpayer had followed each step required by the reorganization provision, the Court nonetheless held that the transaction was a “mere device” for the “consummation of a preconceived plan” and not a reorganization within the intent of the tax code.

Over the past 80 or so years, the Court’s Gregory decision and its progeny have served as the foundation for various substance-over-form doctrines, including the “step-transaction doctrine” and related “mutual interdependence test,” the “sham transaction doctrine,” the “substance over form doctrine,” and the ESD. The ESD was incorporated into the tax code when Congress added subsection (o), titled “Clarification of economic substance doctrine,” to section 7701 as part of the Health Care and Education Reconciliation Act of 2010.

1. Application of Doctrine. In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if —
   1. the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
   2. the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

Subsection (o) goes on to define the ESD as “the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.” Congress thus did not clearly set out the full meaning of the ESD but rather deferred a substantial degree of rulemaking to the IRS and the courts by providing that “[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.”

This codification of the ESD leaves questions for tax preparers and taxpayers, in particular regarding when the ESD is “relevant.” The section does provide, however, that the ESD’s two elements—an objective non-tax economic effect and a subjective non-tax-related business purpose—are conjunctive. The taxpayer, in seeking to overturn an adjustment by the IRS, carries the initial burden to show that both of these elements are met.

Similar to the ESD, and relevant to the Bausch Health case, is the “beneficial use” doctrine, set out in the U.S. Claims Court’s 1983 decision of Viereck v. United States, which found a type of “D” tax-free reorganization, which also requires the transfer of “substantially all” of the target’s assets, by imputing a value to the target corporation’s intangible assets. Under the “beneficial use” test, the court said the core question of “substantially all” assets was “whether the transferee corporation received the beneficial use of those assets.” Although the acquiring corporation reported that it received 20% of the target corporation’s assets, the court held that the “substantially all” requirement was met because “plaintiff’s own evidence shows that [it] had this sufficient beneficial use of the properties so as to satisfy the continuity requirements implicit in the ‘substantially all’ test.”

III. Characterization of the 2017 Transaction

Whether the 2017 Transaction was a nonrecognition section 332 liquidation depends on whether Bausch Health was an 80%-or-more owner of the liquidating corporation on the date of the adoption of the plan of liquidation. The IRS may argue that the step-transaction doctrine should be applied to disregard a transfer of 31% ownership to a minority shareholder prior to adoption of a plan of liquidation. More generally, the IRS may argue that the ESD should be applied to re-characterize this as a section 332 liquidation transaction. This might take the form of arguing that any pre-liquidation divestment of ownership had neither economic effect nor valid business purpose (recognition of a tax benefit does not count) and should therefore be disregarded.

Whether the 2017 Transaction was a nonrecognition C reorganization depends on whether Bausch Health received (i) “substantially all” of the target corporation’s assets, (ii)“solely in exchange” for its (or its parent corporation’s) voting stock; (iii) with continuity of business enterprise; and (iv) with continuity of interest. If it was a part-boot transaction, the second provision would, subject to section 368(a)(2)(B) and the regulations promulgated thereunder, require that at least 80% of the target corporation’s property be received “solely in exchange” for voting stock. In arguing that the 2017 Transaction was a C reorganization, the IRS would have to prevail on each of these requirements. In doing so, the IRS may apply the beneficial use doctrine to recharacterize the distribution percentages reported by Bausch Health or to impute a value to intangible assets it received. Additionally, the IRS could apply the ESD to argue that the 2017 Transaction had neither an objective, non-tax economic effect nor a valid, non-tax business purpose.

IV. Conclusions and Takeaways

There are a number of potential re-characterizations of the 2017 Transaction. At its foundation is a question of form versus substance. Two relevant Circuit Court cases illustrate this battle: the Ninth Circuit’s 1966 Moffatt v. Commissioner of Internal Revenue opinion and the Fifth Circuit’s 1981 Smothers v. United States opinion both ruled squarely in favor of substance-over-form. Both were accompanied by dissents favoring form-over-substance.

The resurgence of the ESD should also be understood as important in the context of the Biden administration’s stated goal of raising corporate taxes, closing corporate tax loopholes, and increasing enforcement of corporate taxation. The issues presented by the Bausch Health transaction are underpinned by decades of policy divides.