Tax Strategies

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August 2009 How US Business Manages its Tax Liability Volume 9, Number 8

The Forward Triangular Merger: A Not-So-Straight-Forward Transaction

By Joseph B. Darby III (Greenberg Traurig LLP)

A fun aspect of doing tax-free reorganizations is that you Why Tax-Free Acquisitions Are Less Common get to use really cool jargon. For example, it allows you to have than Taxable Acquisitions important-sounding conversations like this: The large majority of acquisition transactions are Tax Lawyer: “I was trying to structure this taxable, and for a very easy-to-explain reason: follow acquisition as a reverse triangular merger but the money. In particular, both the acquiring corporation there is too much boot in the transaction and a (Acquirer) and the target corporation (Target) usually have double dummy is too complicated for this crowd, financial incentives to structure the transaction as a cash so I am thinking that so long as the target does purchase rather than as a merger (which, in substance, is not flunk the ‘substantially-all-the-assets test,’ a “purchase” of Target stock from the Target shareholders we could flip over and do a forward triangular using Acquirer stock instead of money). merger instead, which works because of the boot relaxation rules and, just to be careful, As a practical matter, no more than 20 we can implement the transaction safely by stacking a reverse triangular merger followed percent of the acquisition can be given immediately by a Type A, so that the transaction will be aggregated into a forward if it works and as cash boot. disaggregated into a reverse if it doesn’t. That is certainly the right way to implement a forward For Target shareholders, the issue is one of liquidity: triangular merger in my opinion. What do you Few owners of a Target corporation want to give up control think?” of their business (and their destiny) in order to become a Bewildered Client: “Huh?” minority shareholder in a privately-owned corporation The purpose of this article is to translate the preceding controlled by others. conversation from Internal Revenue Code1 jargon into the Meanwhile, on the Acquirer’s side, the leverage play English language. In particular, this article will explain why that comes from a cash purchase is that it allows the the “right” way to implement a forward triangular merger2 Acquirer to obtain a dynamic and growing business for a is sometimes to do a “two-step” transaction comprised of fixed price, so that the “up side” of future growth accrues (1) a reverse triangular merger,3 followed immediately by solely to the benefit of the Acquirer shareholders, without (2) a “Type A” merger.4 undue dilution. A principal drawback with any type of merger transaction (from the Acquirer’s perspective) is that the Acquirer shareholders suffer dilution in their ownership Joseph B. “Jay” Darby III ([email protected]) is a Shareholder (i.e., as a result of the shares of Acquirer issued to Target at the Boston office of Greenberg Traurig, LLP, concentrating shareholders in the acquisition), which may make it difficult his practice in the areas of tax law, corporate transactions and to enjoy a meaningful upside, even if the merger transaction intellectual property. He is a lecturer at law in the Graduate is successful. Tax Program at Boston University Law School and an adjunct In my experience, tax-free acquisitions are most easily professor at Bentley University in the Masters in Taxation Program, teaching courses at both schools that include implemented when the following factors are present: (1) Taxation of Intellectual Property and Tax Aspects of Buying the Acquirer is a publicly-traded corporation, and therefore and Selling a Business. He is a member of Tax Strategies’ the Acquirer stock received by Target shareholders will, Advisory Board, and winner of the “Tax Writer of the Year- after lock-up periods and securities law restrictions lapse, 2007” Award. become freely tradable in the public markets; and (2) the U.S.

anticipated synergies of the Acquirer and the Target are such that the Acquirer comes to believe in what I call “investment Section 368 Reorganizations banker arithmetic:” The belief that two plus two equals five. 7 A “Type A” reorganization is a transaction that qualifies as a merger or consolidation under the laws of Investment Banker Arithmetic Explained an applicable jurisdiction. A Type A transaction combines Investment banker arithmetic is more precisely two separate legal entities into one, and I sometimes illustrated by the following example. Assume a $200M call it an “I love you merger” because it is typically company wants to acquire a $20M company. Assume, in the nature of a business marriage—two businesses for the sake of simplicity, that there are 200M shares of consummating the joining together of approximate the Acquiring company and 20M shares of the Target business equals. Type A transactions, though common, company (i.e., shares in each company are worth about $1 are not generally popular or appropriate for transaction per share without regard to other factors, such as illiquidity where a significantly larger entity is acquiring a smaller or minority discounts). Assume the Acquirer is publicly- entity. traded and the Target is privately held. Under those facts, 8 A “Type B” reorganization is a de facto contribution the shareholders of the Target company would probably be (the language is more obtuse, but it basically requires a very happy to merge the two businesses into a combined contribution) of all the stock of the Target corporation $220M business, and exchange tax-free 20M shares of Target to Acquirer solely in exchange for voting stock of the stock for 20M shares of publicly traded Acquirer stock. Even Acquirer. My analysis of this transaction is simple: never though the shares of each company have the same nominal do it! A Type B is simply too easy to botch in the execution. value ($1) following the transaction, the Acquirer stock is In particular, a transaction flunks the requirements of a very attractive to current Target shareholders because (1) its Type B if any boot (non-stock consideration) whatsoever offers the benefits of a publicly-traded stock (i.e., liquidity) is received in the transaction—even a penny is too and (2) the investment is now in a much larger business much cash. With this in mind, be aware that at a typical (i.e., arguably offering greater stability, but perhaps, as a transaction closing, everyone shows up with checkbooks trade-off, offering less-rapid growth prospects). to write checks, and even something as seemingly But the shareholders of the Acquirer, meanwhile, may innocuous as paying for the other side’s legal fees—or, look askance at this transaction. If the Acquirer is going to for that matter, for their lunch—can potentially put the issue 20M Acquirer shares for the Target stock, the result transaction at risk. The substance of a Type B transaction will be a $220M company with 220M issued in outstanding can often be easily replicated through a reverse shares, and this (intentionally simple) arithmetic suggests triangular merger (Code § 368(a)(2)(E))(described more that all of the “value” of the acquisition (i.e., adding a fully in the accompanying article), which itself has business worth $20M to the aggregated businesses owned boot limitations, but at least allows some boot (up to by Acquirer) has been “given” back through dilution of 20 percent, as discussed in the accompanying article), the Acquirer shareholders. In other words, the Acquirer or can potentially be engineered using Code § 351 (see, shareholders own shares with a nominal value of $1 per e.g., the “double dummy” transaction)(described more share both before and after the transaction, and any future fully in the accompanying article). growth in the company will be shared proportionately, in a 9 A “Type C” reorganization is a transfer of 10:1 ratio, with the new shareholders (i.e., the former Target “substantially all” the assets of the Target corporation to shareholders). In such case, the Acquirer’s shareholders the Acquirer corporation “solely” (in this case meaning can legitimately ask the timeless question, “What’s in it for “predominantly” rather than “exclusively”) for voting us?” stock of the Acquirer, and immediately following which Enter investment banker arithmetic. The investment the Target corporation liquidates and distributes the banker concludes that if you take the $20M company, and Acquirer stock to the Target shareholders. A Type C merge it with and into the $200M company, the resulting reorganization is designed to allow an Acquirer to obtain company does not have a combined value of $220M the business assets of a Target without also taking on its but rather—due to the economies of scale, the synergies legal liability history, including its debts and potential between the two businesses, greater market penetration, tort/contract liabilities. All well and good—except the and so forth—now has an aggregate value of $250M. If phrases “substantially all” the assets and “solely” for you believe in the investment banker arithmetic—a topic voting stock are the subject of mathematical (percentage) on which the public markets will weigh in on the day the safe harbors under Rev. Proc. 77-37, and these safe acquisition is announced—then a tax-free acquisition can make strong economic sense to the Acquirer shareholders and well as the Target shareholders. 5 Sidebar, continued on page 4

Practical Guide to Mergers and Acquisitions—The Acquiring corporation creates a new subsidiary that merges Alphabet Soup of Reorganizations with the Target corporation, with either the Target or the Turning now to the mechanics of “tax-free acquisitions” new subsidiary surviving. The transaction is a “forward” the provisions of the Internal Revenue Code governing tax- triangular merger if the Target corporation mergers with free reorganizations, and tax-free corporate formations, run and into the newly created subsidiary, leaving the newly from Code § 3516 through Code § 368, and are among the most well-traveled (and frequently litigated) provisions of tax law. In short, these rules are often punctilious and A forward triangular merger under Code complex, but they are always familiar. § 368(a)(2)(D) offers more flexible boot For those who have not had the regular pleasure of traveling down these particular mean streets, let me give rules, and thus can accommodate a you a brief guide to the landscape of the Internal Revenue transaction where Target shareholders Code and its most popular destinations. Code § 368(a)(1), which generally defines the scope insist on cash payments in excess of of tax-free “reorganizations,” has a list of capitalized the amounts of boot allowable under a sub-paragraphs that define and describe various types of eligible “reorganization” transactions. This, in turn, leads reverse triangular merger. to the identification and labeling of certain reorganization transactional structures by their corresponding sub- paragraph letter. For example, a “Type A reorganization” created subsidiary as the legal survivor; it is a “reverse” is a transaction that qualifies as a “reorganization” under triangular merger if the newly created subsidiary is merged Code § 368(a)(1)(A), a “Type B reorganization” is a with and into the Target, leaving the Target as the legal transaction that qualifies as a “reorganization” under Code survivor. In either case, the Target business (including all § 368(a)(1)(B), and so forth (see Sidebar). of Target’s operating assets) is now held in the surviving Enormous amounts of time are devoted by tax (post-merger) entity, which is a wholly-owned subsidiary professionals to learning this alphabet soup of reorganization of the Acquirer. structures under Code § 368. Granted, it gives you lots of In order for a reverse triangular merger to qualify as a cool jargon to use when talking to the uninitiated. Much of tax-free “reorganization,” four requirements must be met: it, however, is a waste of time. In truth, a majority of real- • There must be a statutory merger under Code § world acquisition transactions are structured as one of two 368(a)(1)(A) (the “Statutory Merger Requirement”). kinds of “subsidiary mergers” (also known as “triangular • The surviving corporation (i.e., Target) must hold, mergers”), which qualify for tax-free treatment under either after the transaction, substantially all of its properties Code § 368(a)(2)(D) or (E). An “(a)(2)(D)” transaction is often and all of the properties of the merged corporation called a “forward triangular merger” and an “(a)(2)(E)” is (i.e., the transitory subsidiary)(the “Substantially All often called a “reverse triangular merger.” Requirement”). The acquisition is usually structured as a subsidiary • The former shareholders of the surviving corporation (triangular) merger because the Acquirer corporation (i.e., shareholders of Target) must surrender in the (typically much larger and often publicly traded) wants to transaction, in exchange for an amount of voting hold and operate Target (or its successor entity) as a legally stock of the controlling corporation (i.e., Acquirer), an separate subsidiary following the acquisition. In particular, amount of the stock of the surviving corporation (i.e., the Acquirer typically wants to avoid the risks associated Target) that constitutes control of such corporation with a direct “Type A” merger, namely, that the legal, tax (i.e., at least 80 percent of the voting stock of Target, and business problems and risks of the Target thereby and 80 percent of each class of stock of non-voting become pooled for liability purposes with the assets of the stock of Target, must be exchanged for voting stock of Acquirer. Acquirer)(the “Control Requirement”). • The transaction must satisfy certain judicially Technical Differences Between a created requirements, including the business purpose “Forward” and a “Reverse” requirement, the continuity of interest requirement, As between a forward and a reverse triangular merger, the continuity of business requirement, and the each has technical requirements that can make it appealing plan of reorganization requirement (the “Judicial or unappealing in a particular circumstance. A reverse Doctrines”). triangular merger is by far the more popular acquisition The biggest drawback to implementing a reverse structure because the Target corporation remains legally triangular merger is frequently the “boot” limitation, intact as a result of the transaction. In both cases, the meaning the amount of consideration other than Acquirer voting stock that can be received by Target shareholders. In

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order to qualify as a tax-free transaction, a reverse triangular merger must result in the surviving corporation (i.e., Target) harbors are surprisingly nuanced and complicated to holding “substantially all” of its properties (which term was apply in the real world. The acid test of how difficult construed in the Rev. Proc. 77-3715 advance ruling guidelines it is to be 100 percent certain that one has complied to mean 70 percent of the gross assets and 90 percent of the with all the requirements of a Type C reorganization net assets of Target as determined immediately before the is that few responsible law firms will render a “clean” opinion on a Type C reorganization—meaning that the transaction is always so fact-intensive and dependent The forward triangular merger structure on ultimately unknowable assumptions about, for does not have the boot restrictions of a example, the fair market value of corporate assets, that the opinion must necessarily “assume” the crucial and reverse triangular merger. necessary facts in order to render the opinion. As a practical matter, it is difficult to reach a sufficient level transaction) as well as substantially all of the properties of of comfort and certainty that a particular transaction the transitory subsidiary. In addition, the reverse triangular will qualify as a Type C reorganization, and therefore merger also must satisfy the requirement that voting this transactional structure is relatively uncommon stock of the Acquirer must be exchanged for a sufficient except in situations where the Target’s liabilities are so amount of stock of the Target corporation such that the pronounced and so necessary to avoid that they dwarf Acquirer acquires at least 80 percent of all the issued and all other considerations. 10 outstanding Target voting shares, and 80 percent of each A “Type D” reorganization comes in two categories of the other classes of Target stock, in exchange for its or flavors: A “divisive D” is a division of an existing (Acquiring corporation’s) voting stock.16 This means that, as corporation or corporate family into two separate a practical matter, no more than 20 percent of the acquisition corporations (or families); while a “non-divisive D” consideration (boosted to a theoretical maximum of 28 is a restructuring of a corporate group—moving, for percent of the total consideration if one can combine a example, the ownership of a third-tier subsidiary cash redemption immediately before the transaction with from one second-tier subsidiary to another second-tier a reverse triangular merger)17 can be given as cash boot. subsidiary. Type D reorganizations are common (and Needless to say, a prudent advisor will keep a client well often nuanced and tricky), but by their nature are not back from this 20 percent cliff, reducing the practical amount generally used for acquisition transactions. 11 of boot even further. A “Type E” reorganization is a recapitalization of an existing corporation through a restructuring of its stock “Substantially All the Assets” and securities. This is inherently an “internal” corporate A forward triangular merger, by contrast, has at least transaction (i.e., involving only the existing shareholders two notable drawbacks. First, as a result of a forward and securities holders) and so a Type E reorganization triangular merger the Target corporation ceases to exist is not generally used in an acquisition transaction. 12 legally, and the transaction is viewed by most attorneys A “Type F” reorganization is a mere change of identity, as an assignment and transfer of the Target’s assets to the form, or state of incorporation, e.g., if a Massachusetts newly-formed subsidiary under the applicable state law. corporation is merged with and into a Delaware Many times, a Target corporation is attractive precisely corporation, so that the corporation’s governing law is because it has valuable contracts with third parties (e.g., a changed from Massachusetts to Delaware. Again, this license of technology), and the valuable contract may require is not a provision used in acquisition transactions. the consent of the third party in order for the contract to 13 A forward triangular merger is a form of transaction be assigned to any new party (i.e., from the Target to the pursuant to which an Acquirer forms a new subsidiary newly-formed subsidiary). The often-problematical result of and then merges the Target corporation with and into a forward triangular merger is that each valuable contract the newly formed subsidiary, with the subsidiary as containing an assignment clause (i.e., the vast majority the survivor. Target shareholders receive voting stock of valuable contracts) allows the contracting third party of the Acquirer, and may receive some boot, up to the to object to the transaction and potentially terminate the limitations discussed in the related article. contract. By contrast, relatively few contracts contain a 14 “change of control” provision, and so the result is that A reverse triangular merger is a form of transaction acquiring the stock of a Target through a reverse triangular pursuant to which an Acquirer forms a new subsidiary merger will generally not disrupt or affect the value of the and then merges the newly formed subsidiary with Target’s contract rights. A second problem with a forward triangular merger is Sidebar, continued on page 5

inherent in conventional reorganization transactions, and into a Target corporation, with the Target as tax lawyers have invented, with the connivance and the survivor. Target shareholders receive voting stock blessing of the IRS, an increasingly broad use of Code § of the Acquirer, and may receive some boot, up to the 351 as an alternative method to implement the equivalent limitations discussed in the related article. of a “reorganization” without having to comply with A double dummy transaction is acquisition/ the stringent particulars of Code § 368. Basically, the merger transaction structured to meet the technical IRS has interpreted certain provisions of Code § 351 requirements for tax-free (or partially tax-free) treatment broadly, and has concluded, among other things, that if under Code § 351, rather than under the traditional the shareholders of Target engage in a reverse triangular “reorganization” provisions of Code § 368. The structure merger, they can be treated, simultaneously, for purposes and technical requirements of a double dummy are of Code § 351, as contributing the shares of Target to discussed in detail in the related article, but basically Acquirer in exchange for Acquirer shares.19 (The form of involve forming a new parent corporation, two new the transaction afterwards is substantively equivalent to (transitory) subsidiary corporations, and then merging a stock contribution, so the IRS essentially says “what Acquirer into one transitory sub and Target into the the heck” and allows taxpayers to treat it as such.) other transitory sub, with Acquirer and Target as the The result is that, by coming under Code § 351 rather survivors and with Acquirer and Target shareholders than Code § 368, a transaction may qualify for tax-free exchanging their respective shares for Newco stock. treatment with respect to the exchange of stock, while A single dummy transaction is a transaction likewise structured to qualify for tax-free treatment under Code allowing a greater amount of boot than would be permitted § 351, except that instead of implementing a corporate under a reverse triangular merger itself. To illustrate, combination of two separate existing corporations, it assume Acquirer wants to acquire Target, but the Target generally involves one existing corporation (which is shareholders want 50 percent cash and 50 percent stock merged with a Newco subsidiary and its shareholders of Acquirer in the transaction. That is too much boot to qualify under Code § 368(a)(2)(E) as a reverse triangular receive Newco stock) and a contribution of other 20 (generally non-stock) assets and property to Newco, merger. However, the parties might agree to implement also in exchange for Newco shares. a so-called “double dummy” structure, pursuant to which they would form Newco as a new “parent” corporation, and in turn have Newco create two new transitory (temporary) that, while it is not subject to the 80 percent control test of subsidiaries. Acquirer would merge with one of the a reverse triangular merger, it is subject to a substantially- 18 transitory subsidiaries, with Acquirer as the survivor, and all-the-assets test with respect to the Target corporation. Target would merge with the other transitory subsidiary, Here’s the rub: If a reverse triangular merger blows up with Target as the survivor. As a result of this transaction, because it flunks one or more of the qualifications, the Newco would be the new parent, with Acquirer as a Target shareholders are the parties who get stuck with the first-tier subsidiary and Target as a first-tier subsidiary. unexpected tax bill; by contrast, if a forward triangular (Acquirer and Target end up as brother-sister corporations merger flunks the substantially-all-the-assets test, not only instead of being in a parent-subsidiary relationship, but do the Target shareholders get whacked with taxes (they are often that is not a major issue or problem.) Because each of treated as exchanging their Target shares for Acquirer shares the reverse triangular merger transactions is treated as if in a taxable transaction, and thus may trigger boatloads of the applicable shareholders contributed their stock to the taxable gain with no cash to pay the tax), but the Acquirer Newco in connection with the formation of Newco, and corporation itself will bear unexpected tax costs, because because the former shareholders of Acquirer and Target will it will acquire the tax attributes of the Target, and those tax now (very likely) collectively meet, with respect to Newco, attributes will include a deemed sale of Target’s assets to the 80 percent “control test” under Code § 351 (a separate, the newly-formed subsidiary as part of the (unsuccessful) long and mathematically dreary discussion for another day) forward triangular reorganization. In effect, there is a immediately after completion of the integrated transaction, single tax triggered by a blown reverse triangular merger the result is that the Target shareholders can receive 50 (and borne solely by the Target shareholders) while there percent cash and 50 percent stock of Newco and the later is a double tax triggered by a blown forward triangular can be received tax-free (the cash consideration, of course, merger, one imposed on the Target shareholders, and a will be taxable under the boot rules). At the same time, the second imposed on the Target (but, in effect, borne by the Acquirer shareholders will swap their Acquirer stock for Acquirer). That is not a good tax result. stock of Newco (they can even get cash as well, if the parties want that as part of the transaction), and this transaction Double Dummy Is Sometimes the Smart Alternative likewise qualifies for non-recognition under Code § 351 Because of the technical problems and restrictions to the extent that any of the Acquirer shareholders are

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receiving stock of Newco in exchange for their Acquirer Target) violates the “substantially-all-the-assets” test. If the shares (again, cash consideration will be taxable under the contract issue is a deal killer—and it can be, especially if the boot rules). Target’s primary asset is one or more valuable contracts— This is a very good solution from the perspective of a then a forward triangular merger is a non-starter. But if tax lawyer. However, one obvious drawback of the double contracts are not a central issue, or if, as often happens, the dummy transaction described above is that, if Acquirer third parties can be convinced to approve an assignment is currently a publicly-traded company, the parties will of their contracts under appropriate terms, then the first likely want to create Newco as a publicly-traded company, problem can be ameliorated. if they want to achieve the (typical) goal of having all shareholders hold publicly-traded stock at the end of Doing the “Two Step” When the Target is the transaction. However, creating Newco as a publicly- a Distressed Company traded company is not easily, quickly or inexpensively Meeting the substantially-all-the-assets test (which, accomplished. This factor, and others, can make a double as noted above, is generally interpreted under Rev. Proc. 21 dummy unattractive for largely non-tax reasons. 77-37 to mean that the Acquirer acquires 70 percent of Target’s gross assets and 90 percent of Target’s net assets The Forward Triangular Merger as an Alternative in the acquisition transaction) is a legitimate worry for an So, back to the drawing board. As an alternative to Acquirer, particularly if (as is increasingly common is these a reverse triangular merger under Code § 368(a)(2)(E), economically challenging times) the Target is a distressed a forward triangular merger under Code § 368(a)(2)(D) company that has been scrambling to stay alive through offers more flexible boot rules, and thus can accommodate a variety of transactions between and among itself, its a transaction where Target shareholders insist on cash shareholders and other outside parties. For example, if the payments in excess of the amounts of boot allowable under Target shareholders receive a distribution of Target assets a reverse triangular merger (e.g., more than 20 percent). In immediately before the acquisition (e.g., to pay business particular, the forward triangular merger structure does not creditors who insisted on lending funds personally to the have the stringent boot restrictions of a reverse triangular Target shareholders because of credit concerns regarding the merger, and therefore the only real boot limitation is the Target) and such distribution represents 11 percent of the requirement that the transaction meet the judicially created net assets of the Target, this could potentially trigger double continuity of interest limitation (COIL). In Rev. Proc. 77-37, tax consequences24 even though no one is doing anything the IRS established a ruling guideline (often treated as a de that might be considered unreasonable or improper. facto “safe harbor”) concluding that the shareholders of the To forestall this extremely painful tax result, the current Target corporation in a forward merger (including a forward wisdom is to implement a forward triangular merger as triangular merger) will satisfy the COIL requirement if a two-step process, namely, (1) the first step (Step 1) is to they have a continuing interest through stock ownership implement a reverse triangular merger of the Target into in Acquirer which is, in the aggregate, equal in value a newly-formed transitory subsidiary of the Acquirer, and to at least 50 percent of the value of all of the formerly (2) immediately thereafter, as part of a single integrated outstanding Target stock.22 Case law has ruled favorably plan (Step 2), merge the newly-acquired Target corporation on transactions where the percentage of Acquirer equity (which the instant before has become a wholly-owned received by Target shareholders was as low as 38 percent, subsidiary of Acquirer) with and into a second newly- and the boot amount was as large as 62 percent.23 Based on formed subsidiary of the Acquirer in a “Type A” merger, this long, old and venerable case law, some law firms are with this second newly-formed subsidiary as the surviving comfortable opining that the cash (non-stock) consideration corporation. can be as high as 60 percent, and in all events the IRS is To repeat in a little more detail, the Acquirer sets comfortable with 50 percent cash. Obviously, this allows a up two newly-formed subsidiaries, Subsidiary 1 and pretty substantial amount of leeway for boot in a forward Subsidiary 2. Subsidiary 1 mergers with and into the triangular merger. Target corporation in a reverse triangular merger, and, as However, a forward triangular merger still has the a result of this first transaction, the Target shareholders two potential drawbacks noted above, namely, (1) the receive Acquirer stock and the Target is now a wholly- transaction likely results in a legal assignment and transfer owned subsidiary of the Acquirer. Immediately thereafter, of Target assets, notably its valuable contracts, which in as part of a single integrated plan, the Acquirer merges turn will likely trigger the “assignment” clauses in those the Target corporation (now a wholly-owned subsidiary contracts, and (2) there is a concern about a nasty tax hit to of Acquirer) with and into the second newly-formed Acquirer if Target (through actions unknown to Acquirer subsidiary, Subsidiary 2, with Subsidiary 2 as the and possibly not even necessarily known or recognized by survivor.

IRS Position on Two-Step Transactions had to be assigned where third party consent was likely The IRS has indicated in authority such as Rev. Rul. to be a problem. Therefore, a forward triangular merger 2001-2625 and Rev. Rul. 2001-4626 that certain two-step structure (allowing 50 percent cash boot) was feasible. transactions can be combined or “stepped together” into However, because the Target had been scrambling to raise a single integrated transaction that will be treated as a financing during the recent economic downturn and had “reorganization.” However, the combining of the steps sold or distributed various assets, repaid various loans, assumes that the integrated transaction as a whole will and entered into various other financing transactions meet the requirements of Code § 368(a)(2)(D). The clever (none of which were particularly well-documented, since element in this two-step transaction structure is that, if the struggling companies rarely keep outstanding records) it transaction does not qualify as a forward triangular merger made sense to do a two-step forward triangular merger because it flunks the substantially-all-the-assets test, it will in order to minimize the tax risks to my client, the also flunk the substantially-all-the-assets requirement of a Acquirer. reverse triangular merger, and thus will become a taxable Explaining the mechanics of a not-so-straight-forward transaction instantly upon the implementation of Step triangular merger took a little bit of time, because no 27 1. Thus, in effect, if and when the proposed transaction one really understands why you have to form two new “blows up,” it blows up on Step 1 and hurts only the Target subsidiaries and then do back-to-back mergers. What shareholders, causing that transaction to be fully taxable at happens is this: You explain it the first time, then a second that point in time. In particular, if Step 1 is not a successful time and maybe a third time. At that point everyone turns reverse triangular merger then the Target shareholders to the other tax advisers at the table and asks, “Is this the will have a fully taxable exchange of their shares for the right way to do it?” You now turn to the tax advisors at Acquirer shares. Immediately following this fully taxable the table, and you hope they will nod and say “Yes, it is.” transaction, the Type A merger of Target into Subsidiary (If you are ever in this situation and are worried about 2 will occur and arguably will not trigger any further tax their answer, you might want to give them a copy of this consequences to any party, because a Type A merger of article.) Target into Subsidiary 2 will be analyzed as a Type A merger The not-so-straight-forward triangular merger is badly under Code § 368(a)(1)(A) and will not have a substantially- lacking in elegance and simplicity: It is a cross between an 28 all-the-assets requirement. Instead, so long as the COIL albatross and an armadillo—it is no pretty thing. A camel requirements are met (e.g., no more than 50 percent boot) has been described as a “horse designed by a committee” the Step 2 transaction should be treated as a stand alone and so perhaps it is appropriate to describe the not-so- tax-free Type A reorganization. straight-forward triangular merger as “a forward triangular That, at any rate, is the state-of-the-art thinking on how merger designed by tax lawyers.” to implement a forward triangular merger. The key thing to recognize is that, though it may not be sleek and elegant, a camel is a beautifully efficient animal Fast Forward to an Actual Two-Step Transaction for a desert environment—ask any bedouin. I recently represented a publicly-traded corporation And, likewise, the not-so-straightforward triangular that was seeking to acquire a Target as a wholly-owned merger accomplishes very efficiently the task that it is subsidiary, and the parties had agreed, well before designed to accomplish—ask any tax attorney. my involvement, to a transaction in which the Target ______shareholders would receive 50 percent cash/50 percent 1 Unless otherwise noted, all “Code §” references are to stock. As happens in many acquisition transactions, this the Internal Revenue Code of 1986, as amended. “deal point” on the term sheet quickly became carved in 2 A “forward triangular merger” means a transaction granite, and so, when I joined this transaction in progress, that qualifies as a “reorganization” pursuant to Code § it was necessary to implement a “tax free” acquisition that 368(a)(1)(A) and Code § 368(a)(2)(D), as discussed more included 50 percent cash boot. It obviously could not be fully in this article. The transaction generally entails an implemented as a reverse triangular merger because of the Acquirer that forms a new subsidiary and then merges excessive boot, but it could be implemented as a forward the Target corporation with and into the newly formed triangular merger (which transaction, while often not- subsidiary, with the subsidiary as the survivor. Target so-straight-forward, is still far-more-straight-forward shareholders receive voting stock of the Acquirer, and than a double dummy structure) and it seemed to make may receive some boot, up to the limitations discussed sense. First, the Target shareholders were adamant about in this article. receiving 50 percent cash in the transaction—otherwise, 3 A “reverse triangular merger” means a transaction no deal. At the same time, the Acquirer did a very that qualifies as a “reorganization” pursuant to Code § careful review of the business assets of the Target, and 368(a)(1)(A) and Code § 368(a)(2)(E), as discussed more concluded that there were no significant contracts that fully in this article. The transaction generally entails an

Acquirer that forms a new subsidiary and then merges 13 This is a transaction that qualifies as a “reorganization” the newly formed subsidiary with and into a Target pursuant to Code § 368(a)(1)(A) and Code § 368(a)(2)(D), corporation, with the Target as the survivor. Target as discussed more fully in this article. shareholders receive voting stock of the Acquirer, and 14 This is a transaction that qualifies as a “reorganization” may receive some boot, up to the limitations discussed pursuant to Code § 368(a)(1)(A) and Code § 368(a)(2)(E), in this article. as discussed more fully in this article. 4 A “Type A merger” is a merger that qualifies as a 15 1977-2 C.B. 568. “reorganization” pursuant to Code § 368(a)(1)(A), as 16 In Rev. Rul. 59-259, the IRS addressed the meaning of discussed more fully in this article. the “control” requirement under Code § 368(c) as used 5 This discussion does not address the fact that an for purposes of Code § 351, and in particular addressed acquisition may be driven more by the goals and whether “control” as defined in Code § 368(c) requires objectives of Acquirer management, rather than by the ownership of at least 80 percent of the total number of economic interests of the Acquirer shareholders—a shares of each class of non-voting stock. In that ruling, the discussion for another day in another forum. IRS stated that “Section 368(c) of such Code in defining 6 Although Code § 351 technically deals with non- ‘control’ states, in part, as follows: … the term ’control’ recognition of gain in connection with the formation means the ownership of stock possessing at least 80 of a corporation, rather than a true “reorganization” percent of the total combined voting power of all classes transaction, as discussed more fully in this article, Code of stock entitled to vote and at least 80 percent of the total § 351 has become a viable alternative to Code § 368 number of shares of all other classes of stock of the corporation.” when structuring corporate acquisitions, thanks to a [Italics supplied in Rev. Rul. 59-259]. variety of determinations by the IRS that reorganization 17 The regulations, see 1.368-2(j)(6), Example 2, suggest transactions can simultaneously qualify for non- that a Target corporation can redeem up to 10 percent recognition under Code § 351. See PLR 9143025, in which of its shares for cash immediately before the acquisition, the IRS ruled on the federal income tax consequences and the remaining 90 percent of the Target stock would of a “single dummy” transaction. In PLR 9143025, one then be acquired such that 80 percent is acquired for party to the transaction (T1) participated by transferring Acquirer stock and 20 percent is acquired for cash. This assets to a parent corporation (P) in exchange for 22.5 means that there is a theoretical maximum of 28 percent percent of P’s outstanding stock. As part of the same (10 percent acquired for cash in the redemption, plus 20 transaction, P formed a subsidiary (S) and merged S percent of the remaining 90 percent, or an additional 18 with and into a second party to the transaction (T2) in a percent, acquired in the merger) that can be given as cash reverse triangular merger under Code § 368(a)(2)(E), with in the aggregate transaction. However, this “maximum” T2 becoming a wholly-owned subsidiary of P and T2’s is theoretical indeed, because, as a practical matter, no shareholders receiving 77.5 percent of P’s outstanding sensible tax advisor wants to come anywhere close to the shares in exchange for their T2 shares. The IRS ruled that theoretical maximum 10 percent line on the redemption, the merger transaction involving T2, S and P qualified or the theoretical 20 percent line on the merger, because as a tax-free “reorganization” under Code § 368(a)(2)(E). if you inadvertently step one inch (or, in monetary terms, The IRS then addressed the tax treatment of T1, and ruled one penny) over the line, then it blows up the deal. that “solely for purposes of determining whether the 80 Approaching these limitations is the legal equivalent of percent requirement [of Code § 351] has been met so as walking up to the rim of the Grand Canyon in order to to qualify [T1] for treatment under Code § 351, [T2’s] enjoy the view: If you are smart, you don’t actually want shareholders will be considered “transferors” described to walk up to the rim, because the view is plenty good in Code § 351, and accordingly [T2’s] shareholders’ from 100 feet back, while, if you go from one step too far, ownership of [P] common stock will be included in the view becomes a plummet into the abyss. the computation.” The IRS concluded that, with T2’s 18 Technically, Code § 368(a)(2)(D) requires that the newly shareholders included in the “control group” for formed subsidiary must acquire “substantially all of purposes of the 80 percent control test under Code § 351, the properties” of the Target, and further requires that T1’s transfer of assets to P qualified for non-recognition (i) the Acquirer must be in control of the newly formed treatment under Code § 351. subsidiary, (ii) no stock of the subsidiary can be used in 7 Code § 368(a)(1)(A). the transaction (i.e., only Acquirer stock can be used), 8 Code § 368(a)(1)(B). and (iii) the merger would have qualified as a Type A 9 Code § 368(a)(1)(C). merger had the merger been into the Acquirer instead 10 of into the newly formed subsidiary. Realistically, the Code § 368(a)(1)(D). 11 “substantially all” requirement usually proves to be the Code § 368(a)(1)(E). most problematic of these statutory requirements. 12 Code § 368(a)(1)(F). 19 See footnote 6, above. See PLR 9143025 (7/24/91),

PLR 200049026 (12/8/2000), and PLR 200136023, 26 2001-2 CB 321. In this ruling, the merger of transitory which generally treat a reverse triangular merger under subsidiary into Target, followed by merger of Target with Code § 368(a)(2)(E) as a “contribution” of property for Acquirer was re-characterized as a “Type A” merger. purposes of qualifying the aggregate transaction for non- See also Rev. Rul. 2004-83, 2004-2 CB 157, where the recognition treatment under Code § 351 for another party IRS ruled that where, pursuant to an integrated plan, to the transaction. See also PLRs 199911028 and 199911029 Parent corporation sold the stock of a wholly-owned (12/17/1998), two nearly identical rulings in which the subsidiary stock for cash to another wholly-owned IRS concluded that, in a “double dummy” transaction subsidiary, and then, as part of the plan, the acquired where two target corporations were each engaged in a subsidiary was completely liquidated into the acquiring reverse subsidiary merger in exchange for parent holding subsidiary, the step transaction applied to treat the stock company stock, and neither of the two reverse subsidiary sale and liquidation as a “reorganization” under Code merger transactions qualified as a reorganization under § 368(a)(1)(D). Code § 368(a)(2)(E) because neither reverse subsidiary 27 The authority suggesting a “disaggregation” for tax merger met the applicable control requirement due to the purposes upon Step 1 includes Rev. Rul. 2008-25, 2008- fact that a third party acquired and retained non-voting 21 IRB 986, where Acquirer acquired Target in a “good” preferred stock issued by each of Targets, the transaction reverse triangular merger, for 90 percent Acquirer stock could nonetheless qualify for non-recognition treatment and less than 10 percent cash, but then followed the under Code § 351. merger with a preplanned liquidation of Target into 20 See the discussion of boot limitations, above, at footnote Acquirer. The IRS ruled that the integrated transaction, 17. taken collectively, did not qualify as a reorganization 21 A vexing real-life constraint for tax professionals is (because Target liquidates and distributes its assets to that an elegant tax solution is not always a practical Acquirer as part of the integrated transaction, it does not business answer to a particular transactional challenge. satisfy the “substantially all the assets” test immediately A double dummy transaction generally has “tax plusses after the transaction). Instead, the IRS ruled that the first and business minuses,” meaning that it solves certain tax step in that two-step transaction was a failed (taxable) problems but introduces cost and complexity that may make transaction under Code § 368(a)(2)(E), and thus the it unacceptable from a business standpoint. transfer of Target shares by the Target shareholders 22 Rev. Proc. 77-37, § 3.02. for Acquirer stock was a fully taxable transaction. The 23 J.A. Nelson Co., 296 U.S. 374, 56 S.Ct. 273 (1936). second step of the transaction under Rev. Rul. 2008- 24 Target shareholders are deemed to make a taxable 25 was then characterized by the IRS as a Code § 332 exchange of their Target stock for Acquirer stock, liquidation of Target into Acquirer (i.e., a liquidation and Acquirer, through its ownership of the surviving of a controlled subsidiary into its parent, resulting in subsidiary, takes on Target’s tax liabilities under Code non-recognition of gain on the transfer of Target assets § 381, which tax liabilities immediately following the to Acquirer and carryover tax basis in such assets in transaction are deemed to include a taxable exchange the hands of Acquirer). Significantly, as a result of the of Target’s assets as part of the transaction. integration analysis, the first step in 2008-25 was treated 25 2001-1 CB 1297. In this ruling, Acquirer made an all as a taxable transaction (even though, if standing alone, stock tender offer for 51 percent of Target stock, followed it would have been a “good” reverse triangular merger), immediately by a preplanned reverse triangular merger and the second step was nonetheless treated as eligible of Acquirer’s wholly owned subsidiary with and into for the non-recognition benefits of the applicable Code Target, with merger consideration being comprised provision (in that case, Code § 332). of two-thirds Acquirer stock and one-third cash. The 28 See preceding footnote and discussion of Rev. Rul. IRS ruled that since more than 80 percent of the total 2008-25. q consideration to Target shareholders was Acquirer stock, and less than 20 percent was cash, the two steps could Reprinted from the August, 2009 issue of Practical U.S./ be integrated into a single transaction characterized Domestic Tax Strategies as a “reorganization” under Code § 368(a)(1)(A) and § 368(a)(2)(E). ©2009 WorldTrade, a part of Thomson Reuters www.wtexecutive.com