Demystifying a Cross-Border Tax-Free Forward Triangular Type A Merger and Acquisition

Once a U.S. corporation is acquired by a foreign corporation, the ultimate disposition of the U.S. corporation’s appreciated property may occur outside the U.S. taxing jurisdiction. Section 367 was enacted to prevent tax-free transfers by U.S. taxpayers of appreciated property to foreign corporations that could then sell the property free of U.S. tax. Section 367 stands sentinel to ensure that (with certain exceptions) a U.S. tax liability (sometimes called a “toll charge”) is imposed when property with untaxed appreciation is transferred beyond U.S. taxing jurisdiction. It generally accomplishes this objective by treating the foreign transferred corporation as not qualifying as a “corporation” for purposes of certain tax-free-exchange provisions.

When property is transferred to a corporation in exchange for stock, recognition of gain or loss is governed by Section 351 and, if gain on a transfer to a foreign corporation is involved, Section 367 may reclassify the transaction. Under Section 351, no gain or loss is recognized 1) if property is transferred to a U.S. corporation by one or more persons solely in exchange for stock in the corporation and 2) if immediately after the exchange such person or persons are in control of the corporation. “Control” for this purpose means ownership of at least 80 percent of the total combined power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of each other class of stock. Section 351 thus may come into play whenever property with a value greater or less than its basis is transferred to a newly formed corporation by the initial subscribers to its stock. It may also operate to prevent recognition of gain or loss when such property is transferred to an existing corporation. However, as discussed above, where a transfer of property to a foreign corporation in exchange for its stock is involved, the nonrecognition of gain under Section 351 will apply only to the extent provided in Section 367.

Section 368 Reorganizations

The Internal Revenue Code provides for nonrecognition of gain or loss realized in connection with a number of corporate organizational changes.  The basic types of reorganization found in Section 368 of the Internal Revenue Code are:

• Type A reorganization. In a Type A reorganization, the assets and liabilities of a target corporation are transferred to an acquiring corporation in a statutory merger or consolidation, and the target corporation is dissolved. The consideration received by the target’s shareholders is determined by the merger agreement. Internal Revenue Code Section 368(a)(1)(A) does not expressly limit the permissible consideration in a merger or consolidation. The IRS requires that at least 50% of the consideration paid must consist of stock. In the context of international corporate acquisitions, tax-free mergers may take the form of forward triangular mergers, in which the acquired corporation is merged into a subsidiary of the acquiring corporation.
• Type B reorganization. A Type B reorganization takes place when a purchaser acquires the stock of a target corporation solely in exchange for the purchaser’s voting stock, provided that the purchaser is in “control” of the target immediately after the acquisition. See IRC Section 368(a)(1)(B). For this purpose, “control” is ownership of 80% or more of the target’s voting power and 80% or more of the total shares of each class of the target’s nonvoting stock.
• Type C reorganization. A Type C reorganization generally takes place when the purchaser acquires substantially all of the target’s assets solely in exchange for the purchaser’s voting stock (or voting stock of the purchaser’s parent).
• Type D reorganization. A Type D reorganization takes place when there is a transfer by a corporation of part or all of its assets to another corporation if immediately after the transfer the transferor and/or its shareholders are in control of the transferee corporation and if the stock of the transferred corporation are distributed in a transaction qualifying under Section 354, 355, or 356.
• Type E reorganization. A Type E reorganization is recapitalization of a corporation.
• Type F reorganization. A Type F reorganization is a mere change in identity, form, or place of organization of one corporation, however effected.
• Type G reorganization. A Type G reorganization is a transfer by one corporation of all or part of its assets to another corporation in a bankruptcy or similar proceeding.

This article will discuss Type A forward triangular mergers in the cross-border context. From the time it was authorized as a tax-free reorganization, the forward triangular merger has become one of the most widely used acquisition techniques. Section 368(a)(2)(D) permits a subsidiary (“S”) to acquire a target (“T”) in a statutory merger, using purchaser’s (“P”) stock as consideration, provided that: (1) S acquires “substantially all” of the properties of T; (2) no stock of S is used in the transaction; and (3) the transaction would have qualified as a Type A reorganization if T had merged directly into P.

Type A Reorganization

Description of the Basic Type A Reorganization

The Type A reorganization is defined in the Internal Revenue Code as a statutory merger or consolidation. For this purpose, “statutory” refers to a merger or consolidation pursuant to local corporate law. Under a typical state merger statute, the assets and liabilities of the target corporation are transferred to the acquiring corporation without the need for deeds or bills of sale, and the target dissolves by operation of law. See, e.g., 8 Del.Code Section 251. The consideration received by the target’s shareholders is specified in a formal agreement of merger between the two companies. The shareholders may receive stock or debt instruments of the acquiring corporation, cash or a combination of all three. A consolidation involves a similar transfer of the assets and liabilities of two corporations to a newly created entity followed by the dissolution of the transferor corporations, and the shareholders of the transferors become shareholders of the new entity by operation of law.

The Internal Revenue Code is strangely silent as to the permissible consideration in a Type A reorganization. To fill the gap and preserve the integrity of the nonrecognition scheme, courts developed the continuity of proprietary interest and continuity of business enterprise requirements. Section 368(a)(1)(A) does not expressly limit the permissible consideration in a merger or consolidation. It is settled, however, that a transaction will not qualify as a Type A reorganization continuity of proprietary interest (“COI”) requirement is met. See Southwest Natural Gas Co. v. Commissioner, 189 F.2d 332 (5th Cir. 1951). The test focuses on the quality of consideration received by the target’s shareholders (stock maintains continuity, debt or cash does not) and the percentage (by value) of equity consideration received by the target’s shareholders as a group relative to the total consideration paid by the purchaser in the reorganization. For ruling purposes, the IRS requires that at least 50% of the consideration paid by the purchaser to the target’s shareholders must consist of the purchaser’s stock, which may be common or preferred and need not be voting stock. Rev.Proc. 77-37, 1977-2 C.B. 578; Prop. Reg. Section 1.368-2(e)(3) Example 1. Some older cases have held that COI is met by lesser percentages. See, e.g., John A. Nelson Co. v. Helvering, 296 U.S. 374, 56 S.Ct. 273 (1935) (38% preferred stock sufficient). The test is even satisfied if some of target’s shareholders receive only cash or purchaser’s debt as long as the target shareholders as a group maintain COI. See Rev.Rul. 66-224, 1966-2 C.B. 114.

A target’s shareholders have never been required to maintain continuity of interest in the purchasing corporation for any particular period of time after a Type A reorganization. But in determining if the COI has been met, the IRS historically has considered sales and other dispositions of stock occurring subsequent to a merger which are part of the overall “plan.” See Rev.Proc. 77-37, 1977-2 C.B. 568. Thus, if a former target shareholder sold stock of the purchasing corporation pursuant to a contractual obligation prior to a merger, the merger and sale could be classified as one integrated transaction that may fail the COI test.

Continuity of Shareholder Proprietary Interest Requirement

Case law holds that future rights to receive stock generally are not treated as “boot” and, instead, are treated as “stock equivalents” for COI purposes if the rights exist for a valid business purpose and represent only rights to additional stock and nothing more. Consistent with case law, the IRS has provided in Revenue Procedure 84-42, 1984‍-‍1 C.B. 521, something akin to a non-exclusive “safe harbor” for this treatment. Under the procedure, rights to receive contingent stock in the future are stock equivalents (and not boot) for COI purposes if:

1. all the stock will be issued within 5 years;
2. there is a valid business reason for not issuing all the stock immediately;
3. the maximum number of shares which may be issued in the exchange is stated;
4. at least 50 percent of the maximum number of shares of each class of stock which may be issued is issued in the initial distribution;
5. the rights to receive stock cannot be assigned or transferred;
6. such rights can give rise to the receipt only of additional stock of the corporation making the underlying distribution;
7. the stock issuance will not be triggered by an event the occurrence or nonoccurrence of which is within the control of shareholders;
8. the stock issuance will not be triggered by the payment of additional tax or reduction in tax paid as a result of an IRS audit of the shareholders or the corporation; and
9. the mechanism for the calculation of the additional stock to be issued is objective and readily ascertainable.

The IRS, however, has not provided guidance either in Revenue Procedure 84-42 or, as far as we can tell, anywhere else on how one actually performs a COI determination with contingent consideration. In this absence, many practitioners have apparently developed and applied to their transactions a “rule of thumb” described in a report issued by the NYC Bar Association in 2010. This rule involves calculating the present values of the respective stock and non-stock components of the consideration that would be paid post-closing to selling stockholders, and including these present values in the overall COI determination. For this purpose, the future amounts are discounted to the closing date using an applicable federal interest rate.

Transaction Exchange

If structured as a forward triangular merger that qualifies as a tax-free (or, more accurately, tax-deferred) reorganization under Section 368(a)(1)(A) and (a)(2)(D) of the Internal Revenue Code, the transaction may in part be tax-free. In a cross-border forward triangular Type A reorganization involving the acquisition of a U.S. corporation, the foreign acquiring corporation will establish a U.S. subsidiary or Acquisition Sub (typically a Delaware C-corporation) to acquire the assets of the U.S. target. The same requirements and standards imposed on Type A reorganizations discussed above will apply. However, the foreign purchaser’s corporate stock will be utilized to acquire the U.S. target corporation. If the rules governing a Type A reorganization are followed, the domestic target corporation, the Acquisition Sub, or the foreign purchaser will recognize gain or loss on this exchange. However, the U.S. shareholders of the selling corporation will recognize taxable gain on any cash payments received in connection with the acquisition transaction.

Sometimes a U.S. target’s assets consist of intangible property and/or goodwill. If so, this may trigger Section 367(d). Internal Revenue Code Section 367(d) denies the non-recognition (i.e., tax-deferred) treatment afforded under Internal Revenue Code Sections 351 or 361 if a U.S. person transfers intangible property to a foreign corporation. Under Section 367(d), the U.S. transferor is treated as having sold the intangible property to the foreign corporation in return for annual royalty payments received over the property’s useful life. These royalty payments would be classified as ordinary income and would be taxed to the U.S. transferor at ordinary, rather than capital gain, rates.

Internal Revenue Code Section 367(d) provides that it applies to transfers of intangible property where the transferee is a foreign corporation. Given this wording, it should follow that Section 367(d) does not apply if the transferee is incorporated in one of the U.S. states. Specifically, Section 367(d) should not apply to the second exchange of the forward triangular merger if Acquisition Sub is a U.S. corporation. It bears noting, however, that there is no guidance or commentary confirming this interpretation of Section 367(d)’s plain language. Namely, that structuring a forward triangular merger to use a U.S. acquisition subsidiary would indeed cause the transfer of intangible property to fall outside the scope of Section 367(d).

If Section 367(d) does not apply, the general provisions of Section 367(a) apply instead. Like Internal Revenue Code Section 367(d), Section 367(a) also denies non-recognition treatment to outbound transfers of property by U.S. persons to foreign corporations. However, unlike Section 367(d), Internal Revenue Code Section 367(a) includes provisions, referred to as “indirect stock transfer rules,” that treat a transfer of property to a U.S. subsidiary owned by a foreign corporation as an indirect transfer of stock to that parent foreign corporation. These rules allow Section 367(a) to apply to a transaction when it otherwise would not.

Here, Section 367(a)’s indirect stock transfer rule would treat the transfer of the U.S. target’s assets to the Acquisition Sub and ultimately to the foreign purchaser as an indirect transfer of stock or assets.  As a result, the transaction would fail to qualify as a tax-free reorganization under Internal Revenue Code Section 368(a)(1)(A) and (a)(2)(D) and would be taxable. Section 367 will typically treat a statutory merger as a sale of the domestic corporation’s assets (and liabilities) to the Acquisition Sub (held by foreign acquiring corporation) as a taxable transaction.

Nevertheless, Section 367(a) of the Internal Revenue Code provides for a “limited interest exception” pursuant to which non-recognition treatment may still be obtained, but only if the requirements in Treasury Regulation 1.367(a)-3(c) are met. Included among these requirements are the following:

1. If the Seller owns at least 5% (by either vote or value) of Beyonk’s total outstanding stock immediately after closing, the Seller must execute a five-year gain recognition agreement (“GRA”) with the IRS meeting the requirements of Treasury Regulation 1.367(a)-8.
2. The Seller, who is a U.S. person, must not own more than 50% (by vote or value) of the acquiring foreign corporation’s total outstanding stock immediately after closing.
3. The foreign acquiring corporation must be engaged in an active trade or business outside the United States for the entire 36-month period immediately before closing.
4. At closing, neither the selling corporation nor buying corporation may not have an intention to substantially dispose of or discontinue such trade or business.
5. The purchasing foreign corporation’s fair market value must equal or exceed the fair market value of the domestic corporation.

Transaction Requirements

As a forward triangular merger, the transaction must satisfy the following requirements:

1. The statutory merger of the domestic acquired company into Acquisition Sub must be effected pursuant to the merger statute (or statutes) under applicable local law.
2. By operation of law under the merger statute (or statutes), the assets of the domestic acquired corporation must become those of the Acquisition Sub, and the acquired domestic corporation must cease to exist as a separate legal entity.
3. All parties to the transaction must adopt a plan of reorganization (“Plan or Reorg”) setting forth, among other things, the specific transfers to occur on the closing date.  Plans of Reorg often take the form of a master agreement that is executed by all parties before the closing date.
4. The transaction must meet the continuity of business enterprise requirements. Here, the purchasing foreign corporation must either i) continue to hold Audience’s historic business or ii) use a significant portion of the domestic acquired corporation’s historic business assets in its business.
5. The transaction must be entered into for a legitimate business purpose and not to avoid tax.

Conclusion

This article is intended to provide the reader with a basic understanding of the basic planning considerations of a forward triangular cross-border tax-free Type A reorganization (stock-for-assets acquisition). It should be evident from this article that this is a relatively complex subject. In addition, it is important to note that this area is constantly subject to new developments and changes. As a result, it is crucial that any organization considering a cross-border reorganization consult with a qualified international tax attorney. We have advised a significant number of entities, law firms, and accounting firms regarding the U.S. tax implications of cross-border reorganizations.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.