Hertz’s Reorganization Plan Has Something for Everyone

The Hertz Corp. will soon emerge from bankruptcy, seemingly healthier than it ever was. In fact, the spirited bidding for Hertz not only will permit its numerous creditors to be paid in full but will leave quite a bit on the table for Hertz’s shareholders. There will be new infusions of equity capital that should allow Hertz to resuscitate its struggling business and perhaps become the force that it had been before its troubles set in.

Thus, Hertz plans to undertake a recapitalization. The “reorganized debtor” will issue new “reorganized Hertz parent company interests” as follows:

• Not less than 42% of such interests will be purchased by CK Amarillo LP;
• 3% will be issued to holders of “existing Hertz parent interests";
• 17% is slated to be purchased by what is referred to as the “equity commitment parties,” including the ubiquitous Apollo Global Management;
• 35% will be offered to various constituents pursuant to the “rights offering"; and
• 3% will be distributed to the equity commitment parties in consideration of their agreeing to “backstop” the rights offering.

Not only that, the bankruptcy plan also provides for the issuance of $1.5 billion in preferred stock, also to Apollo Global Management, which will either hold the preferred stock or syndicate it to other investors.

The holders of existing Hertz parent interests, i.e., the shareholders of old Hertz, will receive in exchange for their interests, (1) $1.53 in cash, and (2) 3% of reorganized Hertz parent company interests. In addition, such holders will receive rights to purchase additional reorganized Hertz parent company interests.

Hertz’s counsel has opined that the transaction, for federal income tax purposes, is a “recapitalization,” and, hence, a reorganization under tax code Section 368(a)(1)(E). Where stock in a corporation that is a “party” to a reorganization is, in pursuance of the plan of reorganization, exchanged solely for stock in such corporation (or in another corporation which is a party to the reorganization), no gain or loss shall be recognized. See Section 354(a)(1). However, here, the Hertz shareholders are receiving, in addition to stock, other securities and money. Thus, they will be governed by Section 356.

If Section 354 would apply to an exchange, but for the fact that the property received consists not only of property permitted to be received without the recognition of gain (i.e., property described in Section 354(a)(1)), but also of other property or money, then the gain will be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property. See Section 356(a)(1). Here, the Hertz shareholders will receive (1) reorganized Hertz parent company interests (i.e., stock in a corporation which is party to the reorganization), (2) cash, and (3) stock purchase rights.

In general, under Section 356(d), the term, “other property,” includes securities. Treasury Regulation Section 1.356-3(b) provides that “a right to acquire stock that is treated as a security…has no principal amount. Thus, “such right is not other property when received in a transaction to which section 356 applies (regardless of whether securities are surrendered in the exchange).” Accordingly, as regards Section 356, it appears that stock purchase rights are, effectively, treated the same as outright stock, and, therefore, can be received on a tax-free basis in an otherwise qualifying reorganization.

Therefore, for the holders of existing Hertz parent interests, it would appear that the gains they realize in the recapitalization exchange will be recognized, but in an amount not in excess of the cash they receive in the recapitalization. The stock and the stock purchase rights will be treated as “non-recognition property,” such that the Hertz shareholders should experience a “manageable” amount of gain recognition as a consequence of the recapitalization exchange: Such gain recognition will be limited to the cash component of the package of consideration for which they will be surrendering their existing Hertz parent interests.

This recognized gain might be treated as a dividend, to the extent of each shareholder’s ratable share of the undistributed accumulated earnings and profits of Hertz, but only if the exchange has “the effect of the distribution of a dividend” within the meaning of Section 356(a)(2). Whether the exchange has the proscribed effect will be determined by reference to the rules found in Section 302.

If the exchanging shareholder sustains a reduction of his or her proportionate interest in Hertz, even a small reduction, the deemed redemption would qualify under Section 302(b), with the result that the exchange would not have the effect of the distribution of a dividend. In that event, the “boot gain” would be “gain from the exchange of property, i.e., a capital gain.

Ownership Change

Hertz is under the jurisdiction of a court in a “title 11 or similar case.” Hertz will be experiencing an “ownership change” as a result of the implementation of the recapitalization. Thus, CK Amarillo LP and the equity commitment parties, including Apollo Global Management, will be increasing their percentage ownership interest by more than 50 percentage points relative to such shareholders’ lowest percentage ownership of Hertz’s stock at any time during the testing period ending on the date of the recapitalization. This increase in ownership on the part of two of Hertz’s 5% shareholders is more than sufficient to give rise to an ownership change.

Hertz’s ownership change will not qualify under Section 382(l)(5) since its old shareholders and qualified creditors will not own, immediately after the ownership change, by reason of being shareholders and qualified creditors of the “old loss corporation,” 50% or more of the stock of the “new loss corporation,” by vote and value. Thus, Hertz’s net operating losses will be subject to the unabated rigors of the Section 382 limitation.

Ordinarily, the Section 382 limitation is equal to the product of (1) the value of the loss corporation’s stock immediately before the ownership change; and (2) the long-term tax-exempt rate (currently only 1.64%). Presumably, the value of Hertz’s equity, immediately before the ownership change, is exceedingly low, assuming it is even a positive number. That would make for a very small Section 382 limitation, meaning that the amount of taxable income, in any year ending after the date of the ownership change, that could be offset by Hertz’s pre-change losses would be correspondingly small.

Fortunately, Section 382(l)(6) applies to any ownership change occurring pursuant to a plan of reorganization in a Title 11 or similar case to which Section 382(l)(5) does not apply. In such a case, the value of the loss corporation (for the purpose of calculating the Section 382 limitation) is equal to the lesser of: (1) The value of the stock of the loss corporation immediately after (not immediately before) the ownership change; or (2) The value of the loss corporation’s pre-change assets. See Treasury Regulation Section 1.382-9(j).

So, not only will Hertz receive a much needed infusion of capital as a result of the execution of the recapitalization plan, its net operating losses should be eminently usable, since the Section 382 limitation to which such losses will be subject should be a substantial figure that will allow the relatively rapid utilization of Hertz’s net operating losses.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.