Example

OLDCO TAX BALANCE SHEET²⁰

Note: Acquisition price: shares of Newco valued at $100,000 plus assumption of all liabilities equals $150,000.Taxable profit: $150,000 minus $100,000 (tax basis of the assets on the balance sheet) equals $50,000.

Assets		Liabilities
Inventory	$20,000	Capital	$30,000
Receivables	$20,000	Reserves	$20,000
Fixed assets	$60,000	Liabilities	$50,000
Total	$100,000		$100,000

Note: Acquisition price: shares of Newco valued at $100,000 plus assumption of all liabilities equals $150,000.Taxable profit: $150,000 minus $100,000 (tax basis of the assets on the balance sheet) equals $50,000.

View Table

Assets		Liabilities
Inventory	$20,000	Capital	$30,000
Receivables	$20,000	Reserves	$20,000
Fixed assets	$60,000	Liabilities	$50,000
Total	$100,000		$100,000

Note: Acquisition price: shares of Newco valued at $100,000 plus assumption of all liabilities equals $150,000.Taxable profit: $150,000 minus $100,000 (tax basis of the assets on the balance sheet) equals $50,000.

The rate at which the acquired company’s gain is taxed depends on the general rules for taxation of profits and capital gains. While in some systems capital gains are taxed at the same rate as ordinary profits, in others there are special arrangements for capital gains. Many countries tax ordinary profits and capital gains of companies at the same rate.²¹ Capital gains on business assets are still taxed at preferential rates in Belgium, France, Greece, and Ireland, and recently the capital gains preference has been reintroduced in the United States. When a tax system provides for lower rates on capital assets, it is necessary to allocate the total consideration to the individual assets transferred. The greater the portion of the consideration allocated to capital assets, the lower the amount of tax.

The transferor and the transferee have conflicting interests in allocating the purchase price. The transferor will be interested in minimizing its tax burden by shifting the price to capital assets, whereas the transferee will be interested in recouping the acquisition cost as soon as possible through direct expenses, by shifting the acquisition price to items that are immediately deductible, like the cost of inventory.²² However, the parties can often reach an agreement to optimize their joint tax situation at the expense of the government, particularly when both companies are members of the same corporate group.²³

1. Taxability of Shareholders

Whether the shareholders are taxed in a taxable reorganization is determined by the general rules on the taxation of capital gains. These rules vary in many tax systems depending on the category of taxpayer that realizes a capital gain and on the purpose for which the shares are held (business or private investment).²⁴

Some countries tax all capital gains on shares regardless of who holds the shares and why the shares are held. Consequently, the transfer of the shares of the acquired company in exchange for the shares of the transferee company, bonds, cash, or other forms of compensation is a taxable event, absent special nonrecognition rules.²⁵

In many other countries, however (in particular in the European Union, with the exception of the United Kingdom and the Scandinavian countries), individual shareholders are not taxed on the gains resulting from the sale of shares when the shares are held on a long-term basis for private investment.²⁶ The gains will also be exempt when realized by charities or other exempt organizations. In some countries, however, gains on shares are taxable when the individual shareholder holds a “substantial” share in a company.²⁷ When an individual shareholder holds shares for business purposes, practically all countries will tax the gain realized on the sale or exchange of the shares.

Shares held by companies are a special case. Many tax systems treat them as assets held for business purposes, and, consequently, any gain on the sale or exchange of shares is a taxable event. However, some countries (e.g., Belgium and Netherlands²⁸) consider the gain realized on shares held by a company in a subsidiary company as the expression of the profits that have already been realized and taxed in the hands of the subsidiary. In such countries, capital gains realized on the transfer of shares held by the parent are exempt from tax.

2. Calculation of Taxable Gain

When the gain on the exchange of shares is taxable to the shareholder, the general rules applicable to calculating gains on the disposition of other assets will apply, together with any special rules as to the rate of tax and the deductibility of capital losses.²⁹ An exchange of shares, or a receipt of a distribution of the proceeds of the corporation’s exchange of its assets, may also be treated as a dividend or a liquidating distribution, in which case any special rules applicable to those transactions will come into play.³⁰

3. Cost Base of Assets Received in Exchange for Shares

The cost base of the new shares or other forms of consideration (other than cash) received by the shareholders in the exchange is also determined by ordinary tax rules. The value they receive for tax purposes is equal to their acquisition cost. The acquisition cost is the price agreed upon between the parties to the reorganization and should be equal to the value of the shares that are surrendered. In the reorganization agreement, that value should reflect the fair market value of the shares, and, if it does not, the value may be subject to correction under a general provision enabling the tax administration to adjust the price agreed upon between the parties.³¹

1. Cost Base of the Transferred Assets

After a taxable merger, the assets of the transferor will be valued in the hands of the transferee at the value that has been used to determine the transferor’s tax liability in the merger or division, as discussed above in section B. Subsequent profits, depreciation, capital gains, and capital losses on assets will be calculated not on the basis of the old value that the assets had before the reorganization, but on the basis of the new value that was assigned to them in the merger or division. As a consequence, some of the assets of the transferee (assets transferred by the transferor) will be valued for tax purposes at current prices, while others (assets that the transferee owned before the reorganization) will reflect historic and depreciated values. Absent nonrecognition rules, in the case of an assets transfer, the tax law clearly takes a position of discontinuity. It considers the merger or division as a sale of assets for tax purposes, resulting in their revaluation.

A problem that is specific to reorganizations is the allocation of acquisition cost to goodwill. In most cases the total acquisition cost will exceed the total sum of the values of the individual assets. The difference is often accounted for as goodwill. Whether goodwill can be depreciated is determined by the general depreciation rules.³² When depreciation is disallowed, the transferee company will try to minimize the amount allocated to goodwill; when it is allowed, the transferee will be tempted to inflate goodwill.

2. Transfer of Tax Benefits and Preferential Tax Regimes

In the case of taxable reorganizations in which the transferor company disappears (e.g., mergers and divisions), tax credits, exemptions, and other tax benefits enjoyed by the transferor are commonly canceled. The logic of this rule is apparent in cases of exemption. When an item has been temporarily exempt in the hands of the transferor (i.e., when taxation has been deferred), the logical consequence of taxing a merger is that all exempt items become subject to taxation at the time of the reorganization. Tax credits and other tax benefits from which the acquired company may have benefited are typically treated in the same way; that is, they expire with the transferor.³³

In some cases, however, the benefit may be continued, subject to certain conditions. A typical example is an investment credit. Such a credit is typically recaptured³⁴ when the asset for which the credit has been granted is sold or transferred, but maintained when the asset continues to be used in the same business.³⁵ In a merger, the business situation has indeed not changed, because the same asset is still used in the same economic activity, but it is used by the legal entity succeeding the transferor company. However, the continuation of tax benefits in a taxable reorganization might be subject to a continuity-of-interest requirement, similar to the requirement applicable to tax-free reorganizations.³⁶

3. Transfer of Tax Loss Carryovers

In the transfer of tax characteristics of the transferor company, tax loss carryovers play a special role.³⁷ To avoid a situation where profitable companies would chase loss companies to be able to use their tax loss carryovers in a merger or division, tax systems typically limit the carryover of tax losses from one company to another in a corporate reorganization.³⁸ In the case of a taxable transfer of assets, the transferee would in any event not inherit any loss carryovers of the transferor. In this case, the transferor could offset the loss against any gain realized on the transfer.

4. Transfer of Rights and Obligations in Litigation

The extent to which rights and obligations in tax litigation are transferred from the transferor to the transferee company may be decided by the rules of company law, contract law, or tax law.³⁹ When there is a formal merger transferring de jure all rights and obligations to the acquiring company, the latter will be entitled to immediately continue all tax protests, appeals, and other forms of litigation of the acquired company. Alternatively, the transferee may be liable on the basis of a contractual agreement or under special transferee liability provisions of the tax laws.⁴⁰

5. Methods of Accounting

The transferor and transferee may use different methods of accounting (e.g., one may use cash and the other accrual, or one may use last in, first out (LIFO) and the other first in, first out (FIFO), or the two companies may use different accounting years). After the reorganization, this inconsistency must be resolved. It may be particularly difficult to resolve if there are rules in the tax law that if a company has started to use one method it cannot switch to another. Provision needs to be made to reconcile this rule with the fact that a reorganization will necessarily involve some change in accounting method when the parties use different methods. A purely formal approach would look to continuity of corporate identity: whichever company continues is the one that keeps its methods of accounting. When the successor is a newly formed company, does this mean that the taxpayer has the right to select whatever method it wants?

In addition to dealing with the question of what method of accounting the successor may use, the tax law should deal with the issue of transition. In a taxable reorganization, this is not difficult. For example, in the case of inventory accounting, the successor will typically continue its accounting method and will be treated as having purchased the inventory of the transferor. This inventory will be accounted for no differently from inventory purchased in the ordinary course of business. The result in the case of LIFO accounting in an inflationary situation can be harsh, however, in that the difference between the fair market value of the inventory and its historic valuation (which will be artificially low because of the use of LIFO) is taxable.

1. Change of Corporate Seat or Form

The change of corporate seat or form is a simple form of reorganization involving a change in the legal structure of the business but not its economic structure. A change in corporate seat should not have any tax consequence as long as the seat of the company stays within the same tax jurisdiction. When the seat changes from one tax jurisdiction to another, however, there may be full taxation of the company, as if it had distributed all its assets in a liquidating distribution.⁴¹ This rule reflects the fact that after the move the company will no longer be subject to the national tax jurisdiction.

A mere change in corporate form (e.g., from a limited-liability company to a share company) should in principle not give rise to any tax liability. All assets and liabilities of the business remain within a single legal entity, albeit a different one, and the shareholders maintain their equity interest unchanged. In a few countries, a change of form may result in tax problems because company law may require a formal liquidation in order to change the company form, so that there is a legal transfer of assets and liabilities from the old company to the new.⁴² Typically, however, the transfer is automatic and everything remains unchanged except for the company form. For tax purposes, the mere change of company form should not be considered a taxable event, as long as the change is limited to the legal form of the company and its assets, capital, debt, and outstanding shares remain unchanged.

There may be a problem, however, when, as a result of a change in corporate form, the company changes its taxpayer status from corporate to flow-through treatment or vice versa.⁴³ It is clear that the tax law should provide for adjustments, when, as a result of a change in the form of the legal entity, its tax regime is also changed from one regime to the other. In such cases a change of form may be treated as a liquidation or an incorporation for tax purposes, resulting in taxation of any untaxed reserves or temporarily exempt profits.⁴⁴

2. Recapitalizations

Increases and decreases in the capital of a company as a rule do not result in any tax liability for the company concerned. The principal tax issue in a recapitalization is whether the receipt of debt by the shareholders has the effect of the distribution of a dividend. If so, it should be taxable as a dividend absent a special rule. A distribution (through a decrease in capital) of what has been effectively paid in by the shareholders will commonly not be taxed as a dividend. Any other distribution should in principle be treated as a taxable dividend or liquidating distribution.

1. Conditions Set in Tax Law or in Company Law

Two different techniques are used in varying degrees to impose conditions on a tax-free reorganization: (1) autonomous conditions provided by tax law and (2) conditions for a reorganization imposed by company law. Sometimes there is a combination of the two.

The advantage of having independent conditions in the tax code is obvious. Regardless of the legal form in which the parties may structure the reorganization, it should benefit from tax exemption only if it meets conditions set in tax law.⁴⁸ In addition, as is generally the case when one law refers to another, any reference to company law can be problematic because if there is a change in the conditions of company law there will be a simultaneous change in the conditions for tax exemption. Because the drafters of company law are often not tax experts, changes in company law may lead to unexpected surprises in tax law.

2. Degree of Continuity

The degree of required continuity of shareholder interest determines the degree of flexibility that the parties have in negotiating a tax-free reorganization. When, in an asset acquisition, company law or tax law subjects a tax-free reorganization to the condition that all assets and liabilities must be transferred and that such transfer is compensated exclusively in voting shares, the room for introducing changes in the way of doing business at the occasion of a reorganization is very limited.

Yet there are good business reasons to grant some leeway to the parties to the reorganization to make the necessary changes in the conduct of business or in the distribution of the property interests of the shareholders. As far as the transfer of assets is concerned, the transferor company often maintains some assets that are totally unattractive to the transferee company or for which it has no use (e.g., old equipment, dilapidated buildings, or scrap) and for which it is not prepared to pay. If the condition for tax exemption is that all assets need to be transferred, the transferee company will pay a higher price than is economically justified for the transfer and it will try to shed the useless assets after the merger.

A similar problem arises with the continuity of the shareholder’s interest. Particularly when a small company is merged into a big one and the shareholders of the former receive only a small fraction of the total shares outstanding in the new company, they may prefer to sell their shares. In other cases, depending on the rules in company law, minority shareholders who are opposed to the merger may wish to exercise their rights to be bought out and receive the fair market value of their shares in cash. When the condition for tax exemption requires compensation of all the shareholders in voting shares of the acquiring company, this means that if the merger goes through, the buyout of the minority shareholders will result in a taxable merger. When this is the situation, the minority shareholders in effect hold a veto power over the merger being tax free. Therefore, the room left in the tax law or the company law for compensation in forms other than voting shares is very important.

An example of a statute that leaves sufficient flexibility with respect to the transfer of assets and the compensation in shares in a merger is the U.S. Internal Revenue Code. The text of the statute does not impose any hard-and-fast conditions, but requires only that the reorganization take the form of a merger under state law.⁴⁹ Conditions of continuity of the proprietary interest of the shareholders and of the continuity of business activity have been set by case law and are therefore rather flexible.⁵⁰

Generally, a merger will qualify as tax free in the United States if at least half of the net value of the transferor company is remunerated in shares of the acquiring company.⁵¹ As far as the continuity of the business activities of the transferor company is concerned, case law permits nonoperating assets to be excluded from those transferred in the merger and leaves room for changes in business activity.⁵² This approach leaves enough room to accommodate the demands of minority shareholders who ask for the redemption of their shares at the time of the merger.

The requirements for other types of reorganizations in the U.S. Internal Revenue Code are more strict and mechanical. For example, in a type C reorganization,⁵³ the transfer of assets must cover “substantially all” assets, and at least 80 percent of the remuneration for the assets transferred, not taking into account the transfer of liabilities, must consist of voting shares of the acquiring company. Yet, these requirements for a tax-free merger leave room to shed some of the useless assets and to buy out minority shareholders.⁵⁴

An example of a far stricter application of the principle of continuity can be found in the European Union directive on the taxation of cross-border mergers.⁵⁵ In defining a merger, the directive refers to a “legal merger.” This concept has been developed in the draft directive on cross-border mergers in company law.⁵⁶ The directive requires that all assets and liabilities, without exception, be transferred to the acquiring company. This requirement is of course closely linked to the idea that the acquiring company is the universal legal successor to the acquired company and therefore acquires title to all assets and liabilities of the latter without exception. This concept leaves little room for shedding some useless assets or for changing the conduct of business at the time of the merger.

Similar restrictions apply to the continuity of the shareholder’s interest. The part of the remuneration that can be paid in a form other than shares of the acquiring company is limited to 10 percent of the nominal value of the capital increase that is necessary to compensate for the transfer of assets.⁵⁷ Since the fair market value of the shares is in most cases a multiple of their nominal value, only a small fraction of a few percentage points can typically be paid to the shareholders of the acquired company in a form other than the shares of the acquiring company. The measure in the European Union directive is in most cases just sufficient to compensate in cash shareholders who would receive fractions of a whole share from the acquiring company, thereby eliminating these fractional shares. However, in those countries where minority shareholders have a right to be bought out, the narrow limits imposed by the directive will spell trouble. Paying out a small minority holding in cash would make the merger a taxable one if the holding exceeded the small level stipulated by the directive.

Bankruptcy reorganizations pose a particular problem for continuity of interest, because the shareholders of the bankrupt company may receive few or no shares in the surviving company. Instead, it is typically the creditors who obtain shares in exchange for their debt. To facilitate this type of transaction, it can be provided that no gain or loss is recognized to a transferor company on the transfer of its assets to a new company in a bankruptcy reorganization where creditors of the transferor obtain enough stock to provide continuity of interest.⁵⁸ For this purpose, continuity of interest is determined by considering the creditors as owners of the debtor company.

3. Transfer of Liabilities

Another problem related to the continuity of the proprietary interest of shareholders is how to take account of the transfer of the liabilities of the acquired company. Part of the compensation for the assets of the acquired company takes the form of the assumption of its liabilities. To the extent of this compensation, the assets of the acquired company are not transferred in exchange for shares. However, practically all statutes will disregard the transfer of liabilities and apply the criterion of transfer for voting shares only to the net value of the transferor company. Only the transfer of the net value of the assets of the acquired company—that is, after deduction of all liabilities outstanding at the time of the merger—must be compensated for in shares. Thus, the transfer of liabilities is generally disregarded in evaluating the degree of continuity.⁵⁹

4. Nonvoting Shares

Another problem is whether nonvoting shares qualify for the continuity test. In many countries, company law provides for various categories of nonvoting shares. Because most of these types of shares guarantee a minimal fixed return on capital and a payout of the capital value of the shares in priority to common shares, the risk in these categories of shares is much lower. Generally speaking, they are very much like long-term bonds. Therefore, nonvoting shares are often not accepted as equivalent to voting shares for a tax-free reorganization.⁶⁰ When this rule is applied, a practical problem may arise with some categories of shares, which may be voting or nonvoting from time to time. For example, preferred shares may normally be nonvoting as long as the preferred dividend is paid out, but may become voting when the company fails to pay out the guaranteed preferred dividend. In such a case, the common shares, which are normally voting shares, may become nonvoting. To know whether shares are voting shares, the situation should be judged as it is in fact at the time of the reorganization. If preferred shares are voting at that time, such shares should be considered as voting shares. If common shares are nonvoting at that time, they should be considered as nonvoting shares. However, when these different categories of shares are distributed, it should be taken into account that preferred shareholders may lose control and that common shareholders may gain control some time after the reorganization.⁶¹

5. Step Transaction Doctrine

When the conditions for a tax-free reorganization are so narrow that, in some cases, unavoidable changes in the business activity or the necessity to buy out shareholders will result in taxation of the reorganization, the question arises as to whether the parties can do after or before the reorganization what the law prohibits them from doing at the time of the reorganization. If the parties can get rid of unwanted assets by selling them or transferring them to a different company before or after the reorganization, the problems in qualifying for a tax-free reorganization are more apparent than real. The same principle applies to the redemption of minority shareholders’ interests.

The U.S. reorganization rules, which are rather flexible for changes at the time of the reorganization, are generally rather inflexible before and after; that is, the same restrictions that apply at the time of the reorganization also apply before and after it. This is the result of the application of the “step transaction doctrine” in case law.⁶² Under this doctrine, different transactions before and after the reorganization are considered to be “single steps” of the overall transaction if it appears that they were necessary and indispensable steps to reach a general agreement on the reorganization. Therefore, sales of assets or shares before or after the reorganization will be taken into account in determining whether the continuity requirement has been met, when it appears that these sales were implemented as part of the overall reorganization agreement.

Countries with very strict rules on continuity traditionally have not had such a step transaction doctrine.⁶³ This diversity of experience suggests a choice between, on the one hand, a formalistic system—with strict requirements for qualifying for reorganization treatment—and, on the other hand, a more flexible system policed by antiavoidance rules like the step transaction doctrine. While the latter approach can work in countries such as the United States with its sophisticated system of tax lawyers, tax administrators, and courts, it may be difficult to apply in countries whose tax system is not as developed, except by leaving considerable discretion to the tax administrators. While a formalistic system may therefore be more attractive in developing and transition countries, it also suffers from the potential disadvantage of being open to abuse. If the former choice is adopted, care should be given to defining the transactions eligible for tax-free reorganization treatment.

6. Corporate Divisions

While some countries spell out the requirements for tax-free corporate divisions in their statutes, others allow them by administrative practice, and yet others do not have provisions for tax-free divisions.⁶⁴ In some countries, all three techniques of division (spin-off, split-off, and split-up) can qualify for tax-free treatment, while in others only one or two of these can.⁶⁵

There are often requirements concerning which assets can be contributed to a subsidiary that will be divided from the parent, but there are substantial differences in this requirement from country to country.⁶⁶ For example, in Germany, the assets of a division must be contributed together, and in the United States both the parent and the subsidiary must hold assets of an active business.

Tax law generally requires that all transferee companies carry on a business activity after a division (not necessarily the same business activity as before the division). If this condition is not imposed either by statute or by case law, it will become possible to split the corporate assets into two parts: one continuing the business and another to be liquidated. Such a transaction should be taxed as a distribution in partial liquidation, rather than as a division.

Another typical question is whether the shareholders of the transferor company need to continue their equity interest proportionally in all the transferee companies, or whether it is sufficient that they exchange their shares for voting shares of one or more of the transferee companies. This is an important question, because it determines to a great extent the flexibility of a corporate division. If all shareholders of the transferor are required to acquire the same proportional part in all the transferee companies as the part of the shares they own in the transferor, there is no flexibility at all. Often in a corporate division, some shareholders (group A) of the old company will be interested in continuing part of the business, while other shareholders (group B) will be interested in continuing some other part of the business. Therefore, group A shareholders should receive shares only in company A and group B shareholders, shares only in company B. As long as all, or the largest part, of the shareholders continue their equity interest in one of the transferee companies, the reorganization should maintain its tax-exempt character.

7. Elective Taxable Treatment

Treatment of a proposed transaction as taxable or tax free is often elective in that the taxpayer can change the form of the transaction slightly to make it qualify as tax free or, if the taxpayer considers it more advantageous, to make it fail to qualify. Some countries go beyond this degree of electivity in some cases by allowing the taxpayer to elect for particular transactions whether it will be treated as taxable or as a tax-free reorganization.⁶⁷ The theory behind this approach is that it is inefficient to require the taxpayer to manipulate the corporate form of the reorganization to accomplish the particular tax result desired.

8. Requiring Approval

Although there are disadvantages in requiring approval from the tax authorities before a transaction can be engaged in (delays may impede transactions and approval requirements may be invitations for corruption), the technique of requiring a ruling from the tax authority before a reorganization can be carried out on a tax-free basis⁶⁸ does have the advantage of simplifying the drafting requirements and alleviating the concern that statutory rules allowing such transactions might be used for tax avoidance. Approval requirements might be impractical in countries experiencing a large volume of reorganizations, but might be manageable in countries where this is not the case.

1. Tax Position of the Transferor Company

The tax exemption of a reorganization in itself is very simple: no tax is levied on the gain that is realized in exchange for shares.⁶⁹ When the reorganization rules allow compensation partly in shares and partly in cash and other property, the most common approach is to provide a partial exemption. This means that the gains realized in a reorganization will be tax exempt to the extent that the transfer of assets by the transferor is compensated by voting shares of the transferee, or to the extent that the shares of the acquired company are exchanged for shares in the transferee company.

For problems related to applicable tax rates and differences in tax rates between ordinary profits and capital gains and the allocation of gains to various categories of assets, we refer to the discussion of taxable reorganizations.⁷⁰ One problem that is specific to the partially taxable transaction is how the amount of the taxable profit is calculated. Basically there are two approaches. One approach is to allocate the total compensation (shares and taxable compensation) proportionally to all assets.

Examples

2. Tax Position of Transferor Shareholders

The same rule should apply to the transferor company and to its shareholders: to the extent that the reorganization is compensated for with voting shares, the gain realized by the shareholders of the transferor should be tax exempt.⁷⁴ In many countries, however, gains realized by individual nonbusiness shareholders, nonprofit organizations, or tax-exempt institutions such as pension funds are tax exempt in any case. In these tax systems, it is not necessary to provide a specific exemption for these types of shareholders.

A special case of exemption is the gains realized by holding companies. In some countries, capital gains realized on shares by holding companies are fully tax exempt in order to eliminate double taxation.⁷⁵ It follows that even when there is a fully or partially taxable reorganization, the gains realized by a company that is a shareholder in the transferor or acquired company are always tax exempt, even when the latter company is fully or partially taxed on the reorganization.

For business taxpayers, the exchange of shares for consideration other than voting shares should always be a taxable event even within the framework of a “tax-free” reorganization. The reason is that it is easier to partially tax the consideration that has taken a form other than voting shares than it is to transfer the old cost base of the shares surrendered to the assets received. Particularly when the compensation is in cash, it would be awkward to have cash booked with a cost base equal to the value of the old shares surrendered. However, to the extent that compensation is not in cash, it should be possible to exempt the transfer and to defer the tax liability by continuing the cost base of the old assets for the new assets received in exchange.⁷⁶

The taxable profit will be calculated as the difference between the total compensation received and the cost base of the shares surrendered.⁷⁷ The alternatives for calculating the amount of profit are the same as those discussed above in connection with taxing the transferor in a partially taxable reorganization. Either the total profit will be proportionally allocated over total compensation in shares and other forms of compensation, or total nonshare compensation will be taxed to the extent that there is an overall profit on the transfer of shares.⁷⁸

Finally, there is the problem of eliminating double taxation between companies and shareholders. As already indicated,⁷⁹ this problem has been solved in Belgium and the Netherlands. In other countries, it has not been solved for the simple reason that it is not perceived as a problem. Gain on the exchange of shares in a reorganization is conceptually qualified as a capital gain, which is a category separate from dividends. Therefore, in most countries the concept of double taxation of companies and shareholders is simply not applied to this situation.⁸⁰ However, in some countries the gain is considered as a liquidating distribution by the transferor at the time of the reorganization. The liquidating distribution is sometimes considered as the equivalent of a dividend, thereby raising the question of relief for double taxation. The shareholders of the transferor company may therefore receive a tax credit or an exemption for dividends received as in an ordinary distribution of a dividend. The problem with these solutions is that in most cases the tax credits or the amount of the exemption for dividends received for the transferor company and its shareholders do not match because, as stated, the gains of the transferor company and its shareholders do not match either. As a consequence, the elimination of double taxation between the transferor company and its shareholders in a partially tax-free reorganization is far from perfect.

The position of the shareholders of the transferor company after the merger is subject to the continuity principle, implying that (1) to the extent that the exchange of shares is free of tax, all the tax attributes of the shares in the transferor company will be carried over to the shares in the transferee company as if the reorganization had not taken place; and (2) to the extent that the exchange of shares has been taxed, the tax basis of the shares in the transferee company will be revalued and all tax attributes of the shares in the transferor company will disappear.

3. Tax Position of the Transferee Company

The transferee company is not taxed in a merger unless it is at the same time a shareholder of the transferor company. This special case will not be discussed here. In a reorganization, the transferee company is mainly interested in what happens after the reorganization. The position of the transferee company is determined by two elements: (1) the tax basis of the assets received from the transferor, and (2) the carryover of other tax attributes of the transferor.