The IRS has adopted final regs (TD 9242, 2006-7 IRB 422) governing the type of transaction necessary to establish tax-free reorganizations under Code section 368. In particular, tax-free statutory mergers or consolidations can now be effected under foreign law and can involve foreign entities. The new regs also provide clarification and, in some cases, greater flexibility in structuring cross-border transactions.

Code section 368 contains provisions for corporations to engage in tax-free reorganizations, including a statutory merger or consolidation (type A merger or reorganization) under section 368(a)(1)(A). Temporary (TD 9038, 2003-1 CB 524) and proposed (REG-126485-01, 2003-1 CB 542) regs issued in 2003 revised the definition of a statutory merger or consolidation, generally providing that such a transaction is effected under the laws of the United States, a state, or the District of Columbia if, as a result of the operation of such laws, all of a target corporation's assets and liabilities are acquired by the acquiring corporation, and the target's separate legal existence ceases for all purposes. Proposed regs issued on January 5, 2005 revised the type A reorganization definition to include transactions effected pursuant to foreign law and transactions involving entities organized under foreign law. Changes were also proposed to the section 367(a) and (b) regs to, inter alia, account for type A reorgs involving one or more foreign entities. After receiving comments on the 2005 proposals, the IRS adopted them as final on January 23, 2006 with certain technical changes, generally effective for transactions occurring on or after that date. This change will be welcome in the many situations in which it would be beneficial for a merger involving a Canadian corporation to qualify as a type A merger. Previously, a cross-border transaction generally qualified as a type A merger only if the transaction involved the foreign acquisition of a US company--for example, if a Canadian acquiror formed a US acquisition sub that then merged with the US company.

The final regs also provide some guidance and clarification related to section 367 regs as they apply to foreign reorganizations. For example, the regs clarify that section 367(a) does not apply to any section 354 exchange of stock or securities of a domestic or foreign corporation under a section 368(a)(1) asset reorganization, unless the exchange is considered an indirect stock transfer under the section 367 regs. A US person recognizes gain under section 367(a) on an exchange of property with a foreign corporation as described in section 351, 354, 356, or 361, unless an exception applies. The former section 367 regs say that the rule does not apply to a section 354 (or 356) exchange in which a US person transfers stock of a domestic or foreign corporation "for stock of a foreign corporation" in an asset reorganization described in section 368(a)(1) that is not treated as an indirect stock transfer. Commentators pointed out that in certain triangular asset reorganizations in which a US person transfers stock of a foreign acquired corporation to a foreign aquiring corporation in a section 354 (or section 356) exchange, but receives stock of the domestic parent of the foreign acquiring corporation, the transfer by the US person might be subject to section 367(a), because the US person does not receive "stock of a foreign corporation." The IRS and Treasury said that this result was not intended, and the final regs clarify the rule by removing the requirement that the transfer must be made "for stock of a foreign corporation."

The final regs also permit the non-recognition of gain in exchanges under section 354 by a US person of securities of a foreign corporation in a transaction described in section 368(a)(1)(E) (a type E reorganization) or of securities of a domestic or foreign corporation pursuant to an asset reorganization described in section 368(a)(1). Before the 2005 proposed regulations were introduced, commentators noted that the exception in the regs to the application of section 367(a) applied to exchanges of stock only and not to exchanges of securities, in type E reorganizations and certain asset reorganizations. Notice 2005-6, issued concurrently with the 2005 proposed regs (2002-5 IRB 448), indicated the IRS's intention to except exchanges of both stock and securities, and that change has materialized in the final regs.

The regs also amend the indirect stock transfer rules: an exchange by a US person of stock or securities of an acquired corporation for stock or securities of the corporation that controls the acquiring corporation in a triangular B reorganization (section 368(a)(1)(B)) is treated as an indirect transfer of the target's stock or securities subject to the rules of section 367(a). The prospective effective date of this amendment is not intended to raise any inference that the current law is different.

For certain triangular B reorganizations, the final regs provide that a disposition of stock of the foreign acquiring corporation is not an event triggering a gain recognition agreement. Under current regs, in a triangular B reorganization, if a US person exchanges stock of an acquired corporation for voting stock of a foreign corporation that controls the acquiring corporation, the US person is treated as making an indirect transfer of the acquired corporation's stock to the foreign controlling corporation in a transfer subject to section 367(a), but not if the acquiring corporation is foreign and the controlling corporation is domestic. Commentators have suggested that a gain recognition agreement should not be triggered when a domestic controlling corporation disposes of the foreign acquiring corporation's stock because any built-in gain in the stock of the acquired corporation is reflected in the stock of the foreign acquiring corporation held by the domestic controlling corporation under Treas. reg section 1.358-6(c)(3). The final regulations provide that the disposition of the foreign acquiring corporation's stock is not a triggering event in certain cases; for instance, the gain recognition agreement terminates if the domestic controlling corporation disposes of such stock in a taxable exchange.