Stock options plr
Corporate Tax Bulletin April Proposal for Rationalizing the Treatment of Options and Warrants in Reorganizations By Timothy P. Burnsnow a tax partner in the San Francisco office of Stock Winthrop Shaw Pittman LLP. If you have or can obtain the Acrobat Readeryou may wish to download the printed version of this bulletin a Plr pdf filealso available via ftp at ftp. The comments set forth herein represent the individual views of the members of the Taxation Section making them and not the position of the State Bar of California or its Taxation Section. Although the participants in the preparation of this proposal might have clients affected by, and may have advised clients concerning the rules discussed herein, no such participant has been specifically engaged stock a client to participate in the preparation of this proposal. This bulletin setting forth a proposal concerning certain U. Comments are welcome on the design or content of this material. However, this material is not intended and cannot be regarded as legal or tax advice. Summary of Proposal Under current law, gain or loss is generally not recognized by holders of employee stock options in a reorganization. This proposal will address three issues raised by non-employee options and warrants in the reorganization context: In general, the proposal suggests that options which are substantially certain of being exercised be treated differently than options which are not substantially certain of being exercised. Thus, stock acquired upon exercise of an option which was substantially certain of being exercised would be considered owned by an historic shareholder, if the option were owned by the historic optionholder. Similarly, acquisition of such an option for cash or other non-qualifying consideration would be taken into account in determining the qualification of the transaction under the various "solely for voting stock" reorganizations. Finally, and more generally, the proposal suggests that the treatment of options or warrants in a reorganization should be clarified, we believe, to comply more closely with the "exchange" requirements of Section Description of Current Law It is unclear how holders who exercise their warrants for stock immediately prior to a reorganization are treated for continuity of interest purposes. Each stock these different positions appears to have some support. For example, a deep in the money option or warrant can in certain situations be considered economically equivalent to an equity interest in a company. In General," Tax Management Portfolio, d at A, plr that under Rev. In this regard, courts and the Service have determined that in certain situations the relevant "owners" of a corporation for continuity of interest purposes may be persons other than nominal equity holders. Alabama AsphalticU. On the other hand long-standing authority in the reorganization context holds that options and warrants are merely contractual rights and not "stock" for purposes of the reorganization provisions. Thus, in Helvering v. However, both the Southwest Consolidated case and Treasury Regulation Section 1. See GCM formation of holding company in a Section or a 2 E transaction results in a taxable exchange of Target options for Parent options ; see also Rev. However, warrants in a company which undergoes a Section a 1 F reorganization generally do not appear to be subject to these taxable exchange rules. See PLR publicly traded warrants in an Section a 1 F reorganization not considered exchanged under Stockand accordingly no gain or loss is recognized on the reorganization. Recent Developments Certain recent developments have made reliance on the existing precedent in the warrant and option area even more problematic. Thus, a recent private ruling, PLRheld that the receipt of replacement options in a Section a 1 A reorganization did not require gain or loss to be recognized with respect to such options. The basis for the ruling appears to be that there was no exchange of the options for purposes of Sectiona rationale which is similar to the reasoning of PLRsuprainvolving an "F" reorganization. There is little clear guidance on this issue, however. In addition, as discussed in more detail below, the Cottage Savings decision and its reliance on certain pre-"F" reorganization cases casts some doubt on the options validity of the position that there is no exchange of options in an "F" reorganization, a situation which should be clarified. Another recent ruling, PLRheld that stock of plr professional corporations owned of record by a physician were "directly owned" for purposes of Section by a health insurance company, based in large part on the existence of an option to acquire control of the stock of such professional corporations for a nominal exercise price. As with other areas of the tax law, such as President Clinton's proposal relating to "short against the box" and similar transactions and the remarks of various commentators who have noted that, even stock existing law, such transactions may raise continuity of interest concerns plr, there appears to be a growing trend to treat owners of options, warrants and other such instruments as if they were owners of the underlying equity instruments. United StatesF. We believe that this trend will continue and will create confusion about the proper treatment of warrants and options in reorganizations in the near term. Reasons for Change As noted above, current law appears to provide that the formation of a plr company results in a taxable exchange of options of the operating company for options of the holding company and, e. This seems to conflict with the rationale underlying the tax treatment of convertible debt, which permits the conversions of such instruments pursuant to their terms without the recognition of gain or loss. Arguably, the assumption of an option pursuant to its own terms is not a change in a legal right, but merely the exercise of such a right. Compare Cottage Savings Association stock. CommissionerU. The basis for the position taken in GCMhowever, appears to be based on the fact that the plr company would only have shareholder-type rights with respect to the operating company, and accordingly that the option would be an option to acquire shares of a "shareholder" rather than an operating company. Thus, although from an economic perspective and most practical perspectives the holder of an option would be in a virtually identical position, the GCM takes the position that there would be an "exchange" of the options for purposes of Section The holding in the GCM focuses on an analysis of the underlying stock and its rights, rather than the contractual rights provided for in the option itself. As indicated above, options the holding in Southwest Consolidatedan option is a contractual right separate and apart from any underlying stock. Accordingly it would seem that the proper analysis in such a situation would be to focus not on whether the stock underwent a significant enough change to constitute an exchange for Section purposes, but on whether the contractual rights which comprise the option underwent such a change. For the reasons discussed herein, it would seem that no material change in such contractual rights would occur as a result of such a transaction. For example, the holder of an option on the stock of a company may be holding such option as a hedge, or as a separate and distinct investment in a company, and especially where the option is publicly traded, may have no intention whatsoever to exercise the option and acquire stock of the company. To such a holder, the value of the option is based not on its ability to be converted into stock of the underlying company although this forms the basis for determining its valuebut on the market for such an option which exists independently of the market for the underlying stock. In this regard, such an option is not materially different than any other derivative. Accordingly, minor changes in the rights of the options stock or the rights of the company under the laws of a different state are largely irrelevant to the holder of such stock option. The positions taken in GCM and in PLR are somewhat inconsistent. The GCM takes a rather strict view of the existing law under Section generally consistent with that applied in Cottage Savings to the effect that any change options a legal right of a stockholder results in a taxable exchange. The private letter ruling, however, seems inconsistent with the holdings in United States v. PhellisU. United StatesU. In either situation, however, from a practical as well as an economic view, no material change has happened to the contractual rights which comprise the option. It is also interesting to note that, of all of the types of contracts a company may have, options appear to be peculiarly singled out for taxation in reorganizations. Thus, a party to a supply agreement which plr materially more valuable as a result of a counterparty's merger with another company that has, for example, a significantly better credit rating, is not generally required to recognize gain or loss on such agreement. Similarly, the proposed regulations relating to exchanges of debt options provide a specific exception for reorganizations as material modifications. In such a case, the value of the debt instrument might be materially impacted by a merger into an entity with a materially worse credit rating options the target company. However, an option in an operating company which is converted into an option in a new holding company representing no change in value in such option and, if appropriately drafted, stock change in any of the contractual terms of such option apparently is subject to gain or loss recognition. In addition, it is now fairly common for start-up companies to issue warrants in connection with early non-public financings, and to issue substantial amounts of employee options. In some instances the amount of shares exercisable by option and warrant holders may exceed the amount of outstanding shares outstanding. In such situations, the treatment of option or warrant holders as "historic" or non-historic shareholders may have a material impact on whether continuity of interest will be options, especially if the transaction is a cash election merger or other, similar, type of transaction in which continuity of interest is a material consideration. Likewise, the ability of an acquiring corporation to purchase options of the company for cash which may represent a large portion plr the stock of the company on a fully diluted basiswhile simultaneously engaging in a tax-free reorganization, would seem to present certain opportunities for abuse. Explanation of Proposal Continuity Issues. We propose that shares received upon the exercise of an option that is "substantially certain" of being exercised should be treated as owned by the historic owner of such option, and accordingly, such an historic owner would be treated as an historic shareholder with respect to the stock acquired upon the exercise of such option. Options which are not exercised in connection with a reorganization would also be ignored for purposes of determining continuity of interest unless such options are substantially stock of being exercised and are acquired by the acquiring company or persons acting in concert with the acquiring company in connection with the transaction for non-qualifying options consideration other than a options option or stock. A test based on the "substantial certainty" of exercise would appear to have some support under the reasoning of, e. Other factors which might be considered include whether such options are publicly traded, plr exercise plr of the option in absolute dollar terms, and the total cost of the option option premium and exercise price to the holder stock such option, and whether the option or warrant holder is also a shareholder or other interested party in the transaction. Options propose two alternatives for purposes of determining whether transactions involving options may result in "boot" being present. Under one alternative, options which are "substantially certain" of being exercised and which are acquired for non-qualifying consideration something other than stock or a replacement option by the acquiring company in a reorganization would be treated the same as options stock. Options which were not substantially certain of being exercised would be ignored. The alternative is to clarify the existing treatment provided for under Rev. The proposal suggests two alternatives for determining exchange treatment in reorganizations. Under one alternative, options would be treated as equity securities having a principal amount, for purposes of Section dof zero. Under the other alternative, the determination of whether a warrant is exchanged, for purposes of Sectionwould be based on a facts and circumstances approach which would consider whether the various rights comprising the warrant itself and not the underlying stock had been modified to such an extent that exchange treatment is appropriate. In general, we believe that a safe harbor should exist for transactions such as "F" reorganizations and holding company transactions, but that the determination of whether an acquisitive reorganization results in an "exchange" of options should be based on factors similar to those under Proposed Treasury Regulation section 1. Accordingly, relevant factors would include changes in the term of the stock, its exercise price, and whether a change in the terms of the option anticipating a reorganization was provided for in the original option agreement. Other provisions which appear to be relevant would include changing the instrument into which the option may convert from common to preferred stock, the percentage of assets of the new entity which the assets of the target company represents, and changes or modifications of other terms or features which affect the value of the option. We recognize that this approach seems somewhat inconsistent with the more general view that contractual rights such as warrants and options should generally not be subject to gain or loss recognition as a result of a reorganization under any circumstances, but believe that a general rule providing that no gain or loss would be recognized as a result of a reorganization might lead to abuses. A simple, bright-line alternative to all of the foregoing would be to treat all options which are substantially certain of being exercised as equivalent to stock. This approach may raise certain additional problems, such as whether the receipt of such an option would be treated the same as the receipt of stock contrary to the holding in Southwest Consolidated, supraand generally plr in a requirement that in any "solely for voting stock" transaction that the options and warrants be acquired for stock in the transaction, both of which the present proposal tries to avoid. On the other hand, it would be somewhat easier to administer such a bright-line rule. These rules generally permit the holder of an employee option to avoid the current recognition of gain or loss in a reorganization when options in the target company are replaced by similar options in the acquiring company, although under Treasury Regulation section 1. CommissionerT. Commissioner40 T. Commissioner37 B. Accordingly, this rule would generally only apply where an Acquiring corporation pays cash for deep-in-the-money options of the Target corporation. We believe this result is appropriate although contrary to existing lawand will maintain the integrity of the reorganization provisions.
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