A Reorganization By Any Other Name Would Smell As Sweet . . . Or Maybe Not

What's in a name? As Juliet asked Romeo, so the Court asked in the recent case of Community Health Systems Professional Services Corp. LLC ("Community Health") v. the California Credits Group LLC ("CCG")[i] as it examined the meaning of the word "reorganization." The case has something for everyone: tax nerds will be interested to know that a tax-free spinoff under IRC Section 355 may not always be a "reorganization;" wordsmiths will appreciate the discussion of California's laws regarding the interpretation of words in a contract; and everyone else can take away a cautionary tale of careless drafting.

1. Facts

Community Health provides consulting services to hospitals. CCG provides services identifying California enterprise zone tax credits. Community Health and CCG entered into a contract under which CCG would identify certain tax credits available to Community Health under California law in exchange for Community Health paying CCG a contingency fee of 25% of any such credits. CCG was not entitled to payment unless Community Health used the identified credits to reduce its tax liability.

The contract provided the following "reorganization exception" to CCG's agreement to work on a contingency fee basis: "Any reorganization by [Community Health] that results in the suspension or elimination of Credits identified by [CCG] will be treated as being utilized by [Community Health] at such time or reorganization," thus obligating Community Health to pay CCG's fee.

CCG identified approximately $898,125 in tax credits generated by the business activities of one of Community Health's subsidiaries, Watsonville Hospital Corp. Watsonville used approximately $685,481 of those tax credits, and CCG received its 25% contingency fee from Community Health. The parties' dispute centers on Watsonville's unused tax credits.

In 2016, Community Health completed a spinoff of Watsonville by distributing, to Community Health's shareholders, the stock of Watsonville's parent, Quorum Health Corp. Importantly, no assets were transferred by Community Health to its subsidiary, Quorum, in anticipation of the spinoff. Following the spinoff, the credits traveled with Watsonville and continued to exist.

Much later, in February 2020, when it became clear that Quorum was unlikely to use Watsonville's unused tax credits before they expired, CCG suggested to Community Health for the first time that the spinoff might have fee implications as a "reorganization." CCG informed Community Health that the spinoff of Quorum constituted a reorganization that resulted in the elimination of the tax credits, entitling CCG to payment of its 25% contingency fee under the above-described "reorganization exception" in the contract. Community Health's resistance to CCG's assertions spawned the lawsuit.

The trial court entered an order denying CCG's motion and granting summary judgment to Community Health because "the spin-off did not trigger [the "reorganization exception"] of the contract." CCG appealed.

1. Tax Background

Before examining the Court's analysis, a little tax background is necessary. A "spinoff" involves the distribution by a corporation (Distributing Corporation) of a subsidiary (Controlled Corporation) to the Distributing Corporation's shareholders by distributing the Controlled Corporation's stock to those shareholders. If the requirements of Internal Revenue Code (IRC) Section 355(a) are satisfied, the spinoff does not result in gain recognition or income inclusion for the recipients of the stock of the Controlled Corporation distributed in the transaction.

IRC Section 368(a)(1) defines "reorganization," and describes seven different transactions that qualify as tax-free reorganizations. IRC Section 368(a)(1)(D) describes a particular type of reorganization: "a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, . . . is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under Section 354, 355, or 356."

Sections 368(a)(1)(D) and 355 work together to create a tax-free spinoff reorganization, typically called a D Reorganization. The Distributing Corporation first transfers the assets it wants to spin off to a Controlled Corporation (tax-free to the corporation under Section 368(a)(1)(D)); and then the Distributing Corporation distributes the stock of the Controlled Corporation to the Distributing Corporation's shareholders (tax-free to the shareholders under Section 355).

But what if the Controlled Corporation already owns the assets that the Distributing Corporation wants to spin off, like in the case of the spinoff by Community Health? This eliminates the "transfer of assets" step for which Section 368(a)(1)(D) is utilized. Can the Distributing Corporation still rely on Section 355 to make the distribution of the Controlled Corporation stock to the Distributing Corporation's shareholders tax-free? Yes, under Section 355(c)(1), which provides: "[N]o gain or loss shall be recognized to a corporation on any distribution to which this section . . . applies, and which is not in pursuance of a plan of reorganization" (emphasis added). Thus, participants in a spinoff can receive the same tax-free outcome under Section 355 whether or not the spinoff is a component part of a D Reorganization.

But since we didn't need to use Section 368(a)(1)(D), can we still call this spinoff a "reorganization?" It seems like it fits the common usage of the word-they're reorganizing things after all. But what about the technical tax meaning of the word, which is defined in Section 368(a)(1)? This is what the Appeals Court had to decide in determining whether the above-described "reorganization exception" in the Community Health-CCG contract had been triggered.

• The Wordsmithing

CCG took issue with the trial court's determination that the parties intended the term "reorganization" to have a technical, tax-based meaning that corresponded to the definition of "reorganization" in Section 368(a)(1). According to CCG, the contract contained no language indicating the parties intended for the term to have any sort of technical meaning. Thus, CCG argued, the only reasonable construction of "reorganization" was its "ordinary and popular" meaning. CCG argued that, under this interpretation, the spinoff constituted a reorganization because it resulted in a change to the composition or structure of Community Health.

The Court first noted that, "in interpreting a contract's terms, courts apply 'the meaning a layperson would ascribe to contract language' if unambiguous, but courts also recognize the 'interpretational principle that a contract must be understood with reference to the circumstances under which it was made and the matter to which it relates.' . . . The threshold question under California law is whether the terms of a contract are ambiguous-that is, reasonably susceptible to more than one interpretation."

The Court noted that CCG was correct that the plain language of the contract did not reference the IRC. But Community Health presented extrinsic evidence showing that the term "reorganization" was "reasonably susceptible" to having a technical, tax-based meaning that corresponded to the IRC's definition. With regard to the application of this extrinsic evidence, the Court noted that generally there are two types of extrinsic evidence that California courts consider when interpreting a contract as a matter of law. The first type is evidence regarding the circumstances surrounding the making of the agreement, including the object, nature and subject matter of the writing. The second type is evidence of the parties' subsequent conduct, known as "the rule of practical construction."

Regarding the first type of extrinsic evidence, the Court noted that "the nature and subject matter" of the contract was tax-based: "The contract concerns identifying and realizing California Enterprise Zone tax credits, and the contract uses the term 'reorganization' in the context of whether an event has occurred that has a specific effect on those tax credits. Furthermore, the contract states that CCG's services are provided by 'professionals' that 'work exclusively in [the] specialized area' of California Enterprise Zone tax credits, and [Community Health's] in-house tax professionals reviewed and signed the contract. This evidence indicates that, despite not referencing the Internal Revenue Code, the parties intended 'reorganization' to have a tax-based meaning."

Regarding the second type of extrinsic evidence, the Court found that the parties' conduct showed they understood "reorganization" to have a tax-based meaning. For more than four years after the spinoff, CCG neither sent an invoice to Community Health for the unused tax credits nor told it that the "reorganization exception" had been triggered. It wasn't until four and half years later, after Quorum informed CCG that it didn't anticipate being able to use the tax credits in the foreseeable future, that CCG began claiming that the spinoff had triggered the reorganization exception under the contract.

The Court concluded that CCG's silence on the topic for over four years after the spinoff showed that it did not interpret the contract as entitling it to fees resulting from the spinoff of Quorum. CCG's actions showed that it didn't consider the spinoff to constitute a reorganization. The judgment of the trial court was affirmed.

1. The Takeaway.

When a contract uses a term that has both popular and technical meanings, it is essential to specify which meaning the parties intend. A spinoff of the type engaged in by Community Health, where only IRC Section 355(c)(1) is relied upon for tax-free treatment, certainly may fall within the popular definition of "reorganization." But since it does not implicate Section 368(a)(1), it is not a "reorganization" for tax purposes. Precision in drafting is important.

[i] No. M2023-0040-COA-R3-CV (Tenn. Ct. App. 2024), 2024 WL 1626018. Although Community Health v. CCG was decided by the Tennessee Court of Appeals, the events took place in California and the contract in question provided that it would be governed by California law. The Tennessee court analyzed and applied California law for all substantive matters.

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