On December 31, 1997, prior to the acquisition, MCI had $576 million of U.S. NOL carryovers and $179 million of minimum tax credit carryovers. MCI WorldCom incurred expenses of $127 million in connection with the acquisition. MCI WorldCom recorded the transaction as a purchase for financial accounting purposes with the excess of cost over FMV being recorded as a combination of goodwill,

Question

in-process R&D costs, and other intangible assets. In addition, MCI WorldCom incurred $21 million in employee severance pay outlays. MCI stock options were converted into MCI WorldCom stock options. What type of reorganization did WorldCom and MCI engage in? What tax issues should the parties to the reorganization (MCI, BT, TC Investments Corporation, WorldCom, and the MCI and WorldCom shareholders) consider when evaluating the acquisition?

WorldCom is a telecommunications company that provides national and international service to local and long-distance customers. On September 14, 1998, WorldCom acquired MCI Communications Corporation (MCI) pursuant to a merger agreement. The acquisition can be divided into three stages:

1) WorldCom created an acquisitions subsidiary (TC Investments Corporation) by transferring WorldCom stock and cash to TC Investments Corporation in exchange for newly issued TC Investments Corporation stock. TC Investments Corporation then used the WorldCom stock and cash to acquire MCI as described in the next two steps.
2) TC Investments Corporation used cash to purchase all the outstanding MCI Class A common stock from British Telecommunications (BT) for $51 per share. BT had acquired the MCI Class A common stock two years earlier in a failed merger attempt involving BT and MCI. In addition, TC Investments Corporation used WorldCom stock to acquire all outstanding shares of regular MCI common stock from other MCI shareholders. In this exchange, MCI shareholders received 1.2439 shares of WorldCom stock for each share of regular MCI common stock surrendered. TC Investments Corporation paid cash in lieu of issuing fractional WorldCom shares to MCI shareholders who were entitled to such fractional shares. More than 50% of the consideration used to acquire MCI was composed of WorldCom stock.
3) After the stock acquisition, MCI transferred its assets to TC Investments Corporation in a liquidation transaction, after which TC Investments Corporation held MCI assets instead of MCI stock. TC Investments Corporation then changed its name to MCI Communications Corporation, and WorldCom changed its name to MCI WorldCom.

After these three steps, MCI Communications Corporation, which held the acquired MCI assets, ended up as a subsidiary of MCI WorldCom. Total assets of MCI WorldCom after the merger were $86 billion, including the stock of its subsidiary, MCI Communications Corporation.

Answer 1

The following points should be addressed in connection with the MCI-WorldCom merger:

• Reorganization Type: What type of reorganization did WorldCom and MCI engage in?
• MCI Regular Shareholder Issues: What gain or loss (if any) does a shareholder recognize when he or she receives WorldCom stock in exchange for MCI common stock? What is the character of the recognized gain? What gain or loss (if any) does a shareholder recognize when he or she receives cash in lieu of fractional WorldCom shares the shareholders are entitled to? What is the character of the recognized gain? What basis does each shareholder take in the WorldCom shares received? What holding period does each shareholder have in the WorldCom shares received? Is the conversion of MCI options into WorldCom options a taxable or tax-free event for the option holders?
• British Telecommunications (BT) Issues: What gain or loss (if any) does BT recognize when it receives cash in exchange for the MCI Class A common stock? What is the character of the recognized gain?
• WorldCom Issues: What gain or loss (if any) does WorldCom recognize when it transfers WorldCom stock and cash to create the TC Investments Corporation subsidiary? What gain or loss does WorldCom recognize when TC Investments Corporation is renamed MCI Communications Corporation? What gain or loss does WorldCom recognize when WorldCom is renamed MCI WorldCom?
• TC Investments Corporation Issues: What gain or loss does TC Investments Corporation recognize when WorldCom creates it as a subsidiary? What gain or loss (if any) does TC Investments Corporation recognize when it exchanges the WorldCom stock for the MCI common stock? What basis and holding period does TC Investments Corporation take for the MCI regular common stock and the MCI Class A common stock acquired? What gain or loss does TC Investments Corporation recognize when it surrenders the MCI stock upon the liquidation of MCI into TC Investments Corporation? What basis does TC Investments Corporation take in the MCI assets? Is any goodwill created on the tax books by the acquisition? Is the goodwill on the tax books amortizable? Do the MCI tax attributes become available to TC Investments Corporation? If so, are the NOLs subject to the Sec. 382 limitations? Is the employee severance pay deductible?
• MCI Issues: What gain or loss does MCI recognize when it liquidates into TC Investments Corporation?

Had MCI not liquidated into TC Investments Corporation, the transaction would have been a failed triangular B reorganization because of the cash used in the transaction. However, because MCI liquidated, the transaction qualifies as a triangular reorganization (a variation on the Type A reorganization). The cash did not exceed 50% of the total consideration, or conversely, the stock comprised more than 50% of the consideration. Therefore, the acquisition has sufficient continuity of interest to satisfy the IRS's ruling policy.

MCI shareholders recognize no gain or loss on exchanging their MCI stock for WorldCom stock (Sec. 354). Shareholders recognize gain only when they receive cash in lieu of fractional shares of WorldCom stock (Sec. 1001). The receipt of cash is treated as a stock redemption of the WorldCom fractional share the shareholders were entitled to receive. Thus, this part of the transaction should receive capital gain treatment under Sec. 302(b)(1) since all MCI shareholders own less than 50% of WorldCom's outstanding stock at the time of the hypothetical redemption. Each shareholder takes a carryover basis for his or her WorldCom stock that references the basis of the MCI shares surrendered (Sec. 358). The holding period for the WorldCom shares includes the holding period for the MCI shares (Sec. 1223(1)). The conversion of the MCI stock options for WorldCom stock options is a nontaxable event (Secs. 424(a) and (c)).


BT recognizes gain when it exchanges the MCI Class A common shares for cash (Sec. 1001). The capital gain should be long-term, although a corporate taxpayer receives no tax rate advantage with long-term capital gains. No holding period or basis issues are involved with the cash received.

WorldCom recognizes no gain or loss when it transfers cash and WorldCom stock to TC Investments Corporation in exchange for TC's initial stock issue (Sec. 351 or Sec. 361). Nor does TC Investments Corporation recognize a gain or loss on its formation (Sec. 1032). TC Investments Corporation recognizes no gain or loss when it subsequently exchanges the WorldCom stock for MCI common stock (Sec. 354). The basis for the MCI common stock carries over from MCI to TC Investments Corporation (Sec. 362). TC Investments Corporation's holding period for the MCI common stock includes that of the shareholders from whom it acquired the stock (Sec. 1223). The basis for the MCI Class A common stock acquired from BT is its acquisition cost (Sec. 1012). The holding period for the Class A common stock begins on the day after the acquisition date.
Neither TC Investments Corporation nor MCI recognize gain or loss when MCI liquidates as part of the tax-free reorganization. The basis and holding period for MCI's assets carry over to TC Investments Corporation from MCI (Secs. 362 and 1223). Likewise, MCI's tax attributes carry over to TC Investments Corporation (Sec. 381). Quite likely, MCI's NOL carryovers are subject to the Sec. 382 limitation because an equity structure shift and a substantial change in stock ownership has occurred. The problem does not provide sufficient information to assess the extent of the Sec. 382 limitation. The transaction created no goodwill since the carryover basis rules apply. Consequently, no goodwill amortization is available under Sec. 197. The name of TC Investments Corporation was changed to MCI.

Communication Corporation is a Type F reorganization and should be tax-free. No basis adjustment occurs as a result of the change. Similarly, the subsequent renaming of WorldCom as MCI WorldCom should have no tax consequences. The employee severance pay is deductible by the "new" MCI under