Double Merger: Structuring a Tax-Free Acquisition by a Public Corporation Using Stock & Cash
Date: May 06, 2010
When a public corporation considers a mixture of stock and cash to acquire another corporation, certain basic tax considerations must be satisfied for the selling shareholders to receive the shares tax-free. The relative mix of cash and shares is critical because the per share value of the acquiring corporation can fluctuate downward from the date the merger agreement is signed through the closing date. If the per share value of the acquiring corporation drops below a certain level, the receipt of the shares will be taxable to the selling shareholders. This article addresses steps that can be taken to structure the merger to avoid taxation of the shares received.
BASE CASE: A common approach to acquire a corporation is by a reverse subsidiary merger through which the acquiring corporation’s shell corporate subsidiary merges into the Target Corporation. Pursuant to the merger, the shares of the Target Corporation are cancelled and the selling shareholders receive the agreed-to consideration from the acquiring corporation. Under this structure, the acquiring corporation shares can be received tax-free only if the cash component of the consideration (the “Boot”) does not exceed 20 percent of the aggregate consideration paid. This tax-free reverse merger is governed by Section 368(a)(2)(E) of the Internal Revenue Code. For purposes of determining whether the 20 percent test is met, the acquiring public corporation’s per share value as of the day immediately preceding the closing date is used.
Based on these rules, the parties might agree to maximize the cash payable and have cash represent 20 percent of the aggregate consideration as of the merger signing date. Under such an arrangement, a reduction in the acquiring corporation’s share value would cause the cash to exceed 20 percent of the total consideration, which would cause the merger to be a taxable transaction. Also, depending on how conservative the parties are in the calculation of the 20 percent test, the per share value of the acquiring corporation might actually have to increase following the merger signing date for the requirements of a tax-free reverse subsidiary merger to be satisfied.
SOLUTION: Double Merger transaction. The merger agreement can provide that in the event the stock consideration is less than 80 percent of the aggregate consideration determined as of the day immediately preceding the closing date, the merger of the shell subsidiary corporation into the Target Corporation can be followed by the merger of the Target Corporation into a second subsidiary corporation of the acquiring corporation. The integrated second merger causes the entire transaction to be treated as a forward triangular merger governed by Section 368(a)(2)(D) of the Internal Revenue Code. The important difference is that a forward triangular merger can be tax-free even if up to 60 percent of the aggregate consideration is payable in cash.
Q1. Why not structure the transaction as a forward triangular merger from the outset to utilize the higher threshold for cash consideration?
A1. Because in a forward merger the Target Corporation assets are deemed to be transferred to the surviving corporation, a forward triangular merger might require third-party consents for a greater number of contracts than a reverse triangular merger and might also require the retitling of certain properties.
Q2. The federal income tax regulations provide a special rule that allows using the per share value of the acquiring corporation as of the merger signing date, rather than on the closing date, to be taken into account for tax purposes. Why doesn’t such special rule apply to allow the 20 percent test to be met since such requirement would normally be met as of the merger signing date?
A2. The merger signing date special rule is not applicable for purposes of satisfying the 20 percent maximum Boot requirement of Section 368(a)(2)(E) relating to reverse mergers. The special rule was scheduled to expire in March 2010 but was extended by the IRS. The special rule can be useful to assure that the second merger qualifies for the more relaxed rules associated with a forward triangular merger. The special rule is beyond the scope of this summary but there are certain limitations that require the consideration to be locked in for such rule to be available in any event.
Q3. Must the second merger occur immediately after the first merger for the Double Merger transaction to be effective for tax purposes?
A3. NO. The second merger can occur within a short period after the first merger, provided the merger agreement states that the second merger is automatic on not satisfying the 20 percent Boot requirement. The short period provides an opportunity to obtain any additional necessary consents to contracts that are triggered by the second forward merger.
Q4. Is it permissible for the second merger to be into a subsidiary corporation?
A4. Yes. Many Double Merger transactions have been structured with the second merger being into a single member LLC wholly owned by the acquiring corporation. However, a second merger into a subsidiary corporation is also permissible and might be preferred to achieve the same result as a stock acquisition.
Q5. Should the merger document provide detail on how the 80 percent stock requirement will be tested? In other words, should the merger document reference what amount of cash consideration should be taken into account in the denominator and which shares should be taken into account in the numerator of the calculation?
A5. Yes, it would seem advisable that the merger agreement address the mechanics of how the 80 percent stock consideration will be met. For example, tax advisers representing both sides should agree on whether (1) shares issued by the acquiring corporation in exchange for restricted shares of the Target Corporation will be taken into account in the numerator and (2) whether cash payable to cash out the Target Corporation’s stock options will be included in the denominator. The mechanics of knowing whether the 80 percent test is met at the closing date and whether a second merger is necessary should not require additional negotiations by the parties at that time.
Q6. How should cash payable to shareholders of the Target Corporation who exercise dissenter’s rights be taken into account?
A6. The cash amount payable toward dissenter’s rights will not be known as of the closing date. Accordingly, whether the 20 percent Boot test might be exceeded, and whether a second merger is necessary, will not be known as of the closing date if there are any dissenters. An approach to assure that the Double Merger transaction qualifies as a tax-free transaction is to have the merger agreement state that the second merger will occur in all events if any shareholder exercises dissenter’s rights.
Q7. If a second merger occurs, will the transaction be treated as tax-free in all events?
A7. No, but most likely. If the special rule discussed in Q/A2 is available, then the transaction should qualify as a tax-free triangular forward merger described in Section 368(a)(2)(D) allowing the shares received by the selling shareholders to be tax-free. However, if such special rule is unavailable either because the terms of the agreement allow for a fluctuation in the consideration payable or the parties fail to agree that such rule will be used, then the mix of the consideration between stock and cash is measured on the day immediately preceding the closing date based on the share value of the acquiring corporation as of that date. With respect to this calculation, it would take a very sizeable reduction in share value from the merger signing date to the closing date to cause the cash to be greater than 60 percent of the aggregate consideration and prevent the transaction from qualifying for tax-free status. Note that if the per share value of the acquiring corporation drops significantly, there could be other events occurring affecting whether the transaction goes forward.
Q8. How is the determination of whether the second merger qualifies as a tax-free transaction taken into account in the merger agreement?
A8. Typically, the merger agreement requires a tax opinion that the transaction qualifies as a tax-free reorganization described in Section 368 of the Code. The opinion is issued on the closing date based on the respective values of the cash and per share value of the acquiring corporation on the appropriate dates. If, for some reason, a tax opinion cannot be issued, then most times the transaction will not close. There are arrangements, however, that mandate that the closing occur even if a tax opinion cannot be issued on the tax-free status issue.
NOTE: There are other requirements that must be satisfied for any merger to qualify for tax-free treatment. Those additional requirements are beyond the scope of this article.
NOTE: Acquisitions can be structured in many ways. This article addresses only one common approach.
NOTE: Many reverse merger acquisitions are structured as all cash (taxable) or all stock (tax-free) transactions. One reason for the mixture of stock and cash in certain situations is because the selling shareholders might be interested in some immediate cash rather than making a 100 percent continued investment in the surviving entity and the acquiring corporation might want to limit the dilutive effect of issuing shares.
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