Demystifying a Cross-Border Tax-Free Forward Triangular Type C 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.

Hypothetical Case Study

Suppose Union Jack, a corporation incorporated in the United Kingdom wishes to acquire Tom Tom, a company incorporated in California. Suppose that Union Jack will establish Hold Co, a Delaware C corporation to acquire Tom Tom’s assets through a forward triangular Type C tax-free acquisition. Suppose Tom Tom is valued at $1 million and Suppose that Union Jack will pay Tom Tom $100,000 at closing to acquire the corporation’s assets. The buyer, Union Jack, will use a stock-for-stock exchange as consideration for the remainder of the acquisition price to acquire Tom Tom’s assets.

Type C Reorganization

The “Substantially All of the Properties” Requirement

In a Type C reorganization, the purchasing corporation acquires “substantially all of the properties” of another corporation. Consequently, the Type C transaction is referred to as an “asset acquisition.” If the target transfers less than substantially all of its assets, the transaction is not “acquisitive” in nature. A transfer of only part of a corporation’s assets may still qualify for tax-free reorganization treatment, but authority for such nonrecognition will be found in Section 368(a)(1)(D), which generally applies to divisive reorganizations.

Given the tremendous importance of the “substantially all of the properties” requirement, it is surprising to discover that neither the statute itself nor the regulations specify what constitutes “substantially all” of a corporation’s properties for purposes of Section 368(a)(1)(C). There is no precise percentage of assets rule. For advance ruling purposes, the Internal Revenue Service (“IRS”) has required a transfer of assets representing at least 90% of the fair market value of the target’s “net assets” (i.e., assets less liabilities) and at least 70% of the fair market value of the gross assets held by the target immediately prior to the transfer. See Rev.Proc. 77-37, 1977-2 C.B. 568. Some authorities interpret this requirement more flexibly by stating that no particular percentage is controlling and by looking at the type of assets retained by the target and the purpose for the retention. For example, it may be permissible for the target to retain nonoperating liquid assets (e.g., cash) to pay liabilities. See Rev.Rul. 57-518, 1957-2 C.B. 253. If the target sells 50% of its historic assets to unrelated parties for cash and then transfers all its assets (including the sales proceeds) to a purchaser, the “substantially all” requirement is met because the target transfers all its assets and the effect of the transaction was not divisive. See Rev.Rul. 88-48, 1988-1 C.B. 177. In our example, Union Jack will acquire all of Tom Tom’s assets. Thus, the “substantially all” requirement discussed above is satisfied.

Disregarding the Assumption of Liabilities

With regard to permissible consideration paid to target shareholders, the language in Section 368(a)(1)(C) is virtually identical to the language in Section 368(a)(1)(B). In each case, the statutory definition requires that the acquisition be in exchange “solely for all or part of its [the acquiring corporation’s] voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation).” Despite the virtually identical language, Type C reorganizations are different in several respects. One unique issue in the Type C reorganization context is treatment of the assumption of the target’s liabilities. In a Type B stock acquisition, the purchasing corporation simply becomes the new owner of the target. There is no formal assumption of the target’s liabilities; the liabilities simply remain with the target. On the other hand, in a Type C reorganization, the purchasing corporation becomes the new owner of substantially all of the target’s assets. The target corporation’s liabilities do not transfer to the purchasing corporation along with these assets unless an express agreement to assume liabilities is made part of the transaction.

The Relaxed Solely for Voting Stock Requirement

Perhaps the most significant statutory distinction between Type B and C reorganizations is the so-called boot relation rules for Type C asset acquisitions found in special rules under Section 368(a)(2)(B). Under this provision, a transaction that would otherwise qualify as a Type C reorganization will not be disqualified by the addition of money or other property (boot) so long as the purchasing corporation does acquire, solely for voting stock, target property with a fair market value of at least 80% of the fair market value of all of the corporation’s property. See IRC Section 368(a)(2)(B)(iii). In other words, despite the “solely for voting stock” requirement explicitly stated in Section 368(a)(1)(C), the use of consideration other than voting stock for up to 20% of the acquisition will not disqualify the Type C reorganization.

One caution should be noted. In computing the allowable 20% “boot” in a Type C reorganization, the statute requires that liabilities assumed or liabilities to which any property is subject shall be considered as money (boot) paid for the property. This provision considers the assumption of liability as boot solely for purposes of the boot relaxation rule. Consequently, if the assumption of liabilities is the only consideration other than voting stock, the limitation generally should not present problems. On the other hand, if a purchasing corporation is to assume liabilities and also pay cash, the 20% permissible boot must be reduced by the liabilities assumed.

In the example discussed above, Union Jack will provide consideration in the amount of $100,000 for Tom Tom’s assets that are valued at $1,000,000. Union Jack will also not satisfy any of Tom Tom’s liabilities. Thus, the 20% permissible boot requirement is satisfied.

Post-Closing Earnout Consideration

In a Type C reorganization, future payments (often referred to as contingent consideration, deferred payments, or earnouts) can be structured to incentivize sellers and bridge valuation gaps. The tax treatment of these payments depends on their characterization, primarily whether they are considered part of the purchase price or compensation for services. Many acquisitions of smaller and mid-sized U.S. corporations by foreign corporations  involve contingent consideration, deferred payments and earnouts. In order to avoid violating the 20% boot rules discussed above, sometimes contingent consideration, deferred payments, and earnouts can be classified as payment for services rather than payment for the acquisition of assets. By characterizing these types of payments as payment for future services rather than payment for assets, these future payments may potentially avoid violating the 20% boot rule.

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 this case, Union Jack will establish a U.S. subsidiary (Delaware C-corporation) to acquire the assets of Tom Tom. The same requirements and standards imposed on Type C reorganizations discussed above will apply. Neither Union Jack nor its Delaware subsidiary would recognize gain or loss on this exchange. However, the Seller will recognize taxable gain on any cash payments received in connection with the acquisition transaction.

Let’s assume that a significant portion of Tom Tom’s assets consist of intangible property and/or goodwill. If so, this may trigger Section 267(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 Tom Tom’s assets to the Acquisition Sub and ultimately to Union Jack 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. In this case, the statutory merger would be treated as a sale of Tom Tom’s assets (and liabilities) to the Acquisition Sub. 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 Union Jack’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. We understand that the Seller is expected to acquire less than 5% of Union Jack’s total outstanding stock.
2. The Seller, who is a U.S. person, must not own more than 50% (by vote or value) of Union Jack’s total outstanding stock immediately after closing.
3. Union Jack 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 Seller nor Union Jack may have an intention to substantially dispose of or discontinue such trade or business.
5. Union Jack’s fair market value must equal or exceed the fair market value of Tom Tom.

Transaction Requirements

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

1. The statutory merger of Tom Tom 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 Tom Tom must become those of the Acquisition Sub, and Tom Tom 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, Union Jack must either i) continue to hold Tom Tom’s historic business or ii) use a significant portion of Tom Tom’s historic business assets in Union Jack’s 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 C 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.