. as appeared in . WorldTrade Executive www.wtexec.com/tax.html WTE PRACTICAL U.S./DOMESTIC The International Business Information SourceTM TAX STRATEGIES 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 2 © WorldTrade Executive, Inc. 2009 August 2009 U.S. 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.