Demystifying an Outbound Cross-Border Tax-Free Type B Reverse Triangular Merger

This article discusses outbound tax-free cross-border Type B reverse triangular mergers. A reverse triangular reorganization is similar to a forward triangular reorganization, except that the surviving entity is the target and not the acquirer. Before examining the tax consequences of an outbound tax-free cross-border Type B reverse triangular merger, a Type B tax-free reorganization must be explained. We will begin this article with a discussion regarding the requirements of a Type B reorganization.

Description of the Basic Type B Reorganization

In a Type B reorganization, the purchasing corporation (P) acquires a controlling interest in the target corporation (T) stock from the T shareholders solely in exchange for all or part of P’s voting stock. Type B reorganizations have two significant requirements. First, the purchasing corporation must have control over the target corporation immediately after the stock acquisition from the target shareholders. The term “control” for purposes of Type B reorganizations is defined in Section 368 of the Internal Revenue Code. Control for purposes of Section 368 requires ownership by the acquiring corporation of “at least 80 percent of the total combined voting power of all classes of stock entitled to vote” and “at least 80 percent of the total number of shares of all other classes of stock.” See IRC Section 368(c).

Second, voting stock is the only permissible consideration in a Type B reorganization. One minor exception to this rule is that the “solely for voting stock” requirement…will not be violated where the cash paid by the acquiring corporation is in lieu of fractional share interests to which the shareholders are entitled, representing merely a mechanical rounding-off of the fractions in the exchange, and is not separately bargained for consideration.” See Rev. Rul. 66-365, 1966-2 C.B. 116, 117. The rigid requirements for a Type B reorganization have placed considerable pressure on the definition of “voting stock.” However, the term is not defined in the Internal Revenue Code. Although the term “voting stock” is not defined in the Internal Revenue Code, “voting stock” has been interpreted to require an unconditional right to vote on regular corporate decisions and not merely extraordinary events such as mergers or liquidations. See Treas. Reg. Section 1.302-3(a).

Buyouts of Dissenting Shareholders

If any shareholders of the target corporation object to the acquisition transaction, the target corporation may redeem their shares for cash prior to the acquisition without violating the solely for voting stock requirement provided that the consideration is not provided by the purchasing corporation. See Rev.Rul. 55-440, 1955-2 C.B. 226. In addition, other shareholders of the target may acquire or purchase shares from the dissenting shareholders prior to the Type B reorganization.

Corporate Liabilities

A Type B reorganization is a transfer of stock ownership. After the reorganization, the target corporation has a new owner, the purchasing corporation. If the target owner has liabilities on its book prior to the merger, the target corporation will remain liable for these debts. The fact that the purchasing corporation has acquired these pre-merger debts does not violate the “solely for voting stock” requirement. For the most part, the Internal Revenue Service (“IRS”) regards the relationship between the acquiring corporation and the target corporation’s creditors as a transaction or transactions separate from the Type B reorganization. See Rev. Rul. 69-142, 1969-1 C.B. 107; Rev. Rul. 70-41, 1970-1 C.B. 77.However, if the target corporation’s shareholders guaranteed the target debts and the debts are satisfied by the acquiring corporation, the payment of these types may be classified as impermissible consideration and could disqualify the Type B reorganization. See Rev. Rul. 73-54, 1973-1 C.B. 187.

Type B Reverse Triangular Mergers

Section 368(a)(2)(E) permits a “reverse triangular merger” to qualify as a Type B reorganization. In the reverse triangular merger, the purchasing corporation’s subsidiary is merged directly into the target corporation so that the target corporation survives the mergers and the acquiring subsidiary corporation disappears. In other words, the target shareholders exchange their target stock for the purchasing corporation stock. As in a forward triangular merger, the basic merger of a subsidiary corporation into the target corporation must qualify as a Type B merger. In addition, a reverse merger will qualify as a tax-free reorganization if: 1) the surviving target corporation holds substantially all of the properties formerly held by both the target and subsidiary corporation, and 2) the former target corporation shareholders exchange stock constituting “control” (measured by the 80 percent test discussed in Section 368(c)(1) of the Internal Revenue Code).

Section 368(c) of the Internal Revenue Code defines “control” as the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote, and at least 80% of the total number of shares of all other classes of stock in the corporation.

Thus, in order for a transaction to qualify for tax-free reverse triangular treatment, the following requirements must be satisfied:

1. After the merger, the target corporation will hold substantially all of its properties and the properties of the subsidiary corporation (other than the stock of the purchasing corporation distributed in the transaction and any boot (any cash or other property) used by the subsidiary corporation to acquire the shares of the minority shareholders.
2. In the merger transaction, the purchasing corporation must acquire 80% of the “control” of the target corporation in exchange for the purchasing corporation’s voting stock. The remaining 20% of the target corporation may be acquired for cash or other cash or property. It is important to understand that 80% of target corporate stock must be acquired for the purchasing company voting stock in a single merger transaction. It should be noted that target corporate stock held by the purchasing corporation prior to a reverse triangular merger cannot be utilized to satisfy the 80% requirement discussed above.

As for tax consequences, the shareholders of the target corporation exchanging target stock for the purchasing corporation stock in the reverse triangular merger may be entitled to nonrecognition of tax pursuant Section 354 of the Internal Revenue Code. Section 354 of the Internal Revenue Code deals with the nonrecognition of gain or loss in certain corporate reorganizations when stock or securities are exchanged. Specifically, Section 354 states that no gain or loss is recognized if shareholders or security holders exchange their stock or securities for stock or securities in a corporation that is a party to the reorganization.

Outbound Cross-Border Reverse Triangular Reorganization Considerations

An example of an outbound cross-border reverse triangular reorganization is as follows:

Assume that foreign corporation wishes to acquire a U.S. Target’s business. In order to acquire the U.S. Target, the foreign corporation may form a wholly-owned subsidiary, U.S. Acquiror, as an acquisition vehicle. Next assume that the U.S. Acquiror mergers into U.S. Target, with U.S. Target’s shareholder receiving Foreign Parent shares as the merger consideration and the U.S. Target survives. This merger should qualify as a reverse triangular reorganization. See Temp Reg. Section 1.367(a)-3(d)(1)(ii); Treas. Reg. Section 1.368-2(b)(1)(iii)(Ex. 13). However, the U.S. Target’s U.S. shareholders will recognize taxable gain unless the limited-interest exception discussed below applied.

Here, Section 367(a)’s indirect stock transfer rule a reverse triangular merger 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 foreign entity’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.

Information Reporting for Outbound Transfers

If a U.S. person transfers property to a foreign corporation, the U.S. person must attach a Form 926, Return by Transferor of Property to a Foreign Corporation, to their regular tax return for the tax year of the transfer. U.S. shareholders participating in a cross-border Type A reverse triangular merger may have an obligation to report the transaction on a Form 926 to the IRS. The penalty for a failure of a U.S. person to properly report a transfer to a foreign corporation equals 10% of the fair market value of the property transferred. The penalty does not apply if the U.S. person can show that the failure to comply was due to reasonable cause. In addition, the total penalty cannot exceed $100,000 unless the failure is due to an intentional disregard of the reporting requirements.

Conclusion

This article is intended to provide the reader with a basic understanding of the basic planning considerations of an outbound cross-border tax-free Type B reverse triangular merger. 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 reverse triangular merger 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 corporate mergers, acquisitions, and 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.