Foreign-To-Foreign Mergers and Reorganizations Explained

In response to changing business conditions, foreign corporations owned by U.S. shareholders routinely merge or reorganize with other foreign corporations. In certain cases, these corporate adjustments are tax-free transactions for U.S. tax purposes. In other cases, these transactions are subject to U.S. taxation. This article discusses the most common types for foreign-to-foreign mergers and reorganizations along with their potential U.S. tax consequences.

The Section 367(a) “Toll Charge”

We will begin this article by discussing Section 367(a) of the Internal Revenue Code.

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.

The Section 367 toll charge may also apply in cases where U.S. shareholder (a U.S. shareholder who owns 10% or more of the total voting power or 10% or more of the total value of a foreign corporation’s stock, including through direct, indirect, or constructive ownership rules) holds shares in a foreign corporation that is involved with a merger or reorganization of another foreign corporation. Consequently, anytime a foreign corporation that is owned wholly or partially by U.S. shareholders mergers or is reorganized, Section 367 could be triggered and the transaction could be subject to the Section 367(a) “toll charge.” In certain cases, a foreign corporation owned wholly or in part by U.S. shareholders could avoid the Section 367(a) “toll charge” through a qualified merger or acquisition that qualifies as a tax-free merger or reorganization under Section 368 of the Internal Revenue Code.

Section 368 Reorganizations

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 Internal Revenue Code 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.

Foreign-To-Foreign Type A Merger

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 Internal Revenue Service (“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.

Type A Merger In the Foreign-to-Foreign Context

As discussed above, to qualify as a Type A merger, the merger must be pursuant to the corporate laws of a U.S. state. Although the IRS has previously taken the position that Type A merger could not occur with a foreign corporation, the IRS has changed its position and now permits Type A mergers that may occur between foreign corporations. See Treas. Reg. Section 1.368-2(b)(1)(iii)(Ex. 13). Pursuant to these rules, a merger may include foreign corporations. Below, please see Illustration 1, which discusses how a Type A merger may operate between foreign corporations.

Illustration 1.

Let’s assume a foreign target corporation merges into a foreign acquiror corporation. Let’s also assume that the foreign target corporation shares are valued at $10 million at the time of the merger and that foreign target corporate U.S. shareholders have a $1 million basis in their stock. In addition, let’s assume that the merger consideration received by foreign target corporation’s stockholders consisted of foreign acquiror’s stocks with a fair market value of $10 million. If the former foreign target corporation is not classified as a controlled foreign corporation (“CFC”) five years prior to the merger, the merger would not likely be treated as the sale of the U.S. shareholder’s shares. In addition, the individual U.S. shareholders of foreign target corporation’s shares may potentially avoid a dividend to the extent of their share of the foreign target corporation’s earnings and profits. If the former foreign target corporation is classified as a CFC within 5 years of the merger, if a number of conditions are satisfied, the merger may still potentially avoid being treated as the sale of the U.S. shareholders’ foreign target corporation’s stock. However, the individual U.S. shareholders may be required to recognize a dividend for U.S. tax purposes to the extent of their share of the foreign target corporation’s earnings and profits under the GILTI and Net Tested Income (“NCTI”) tax regime. If the foreign target corporation was wholly owned by a U.S. C corporation, the foreign target corporation may potentially utilize Section 245A to convert the Subpart F and NCTI into a 100% deemed dividend deduction and avoid the Subpart F and NCTI tax regimes.

Foreign-To-Foreign Type B Share-For-Share Acquisition

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 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 Acquisition in the Foreign Context

A Type B share-for-share acquisition is tax-free as long as there is no other consideration and the acquisition is tax-free as there is no other consideration and the acquiror has control of the target immediately after the transaction. Below, please see Illustration 2, which discusses how a Type B merger may operate between foreign corporations.

Illustration 2.

S, a U.S. citizen, wholly owns F, a foreign corporation. In what would otherwise constitute a share-for-share acquisition, S exchanges 100% of his shares of F for 3% of the shares of C, a publicly-held Cayman Islands corporation. If S owns his F shares through a U.S. corporation, the transaction will likely be tax-free for U.S. purposes. If S directly holds his F foreign corporate shares, the transaction will only potentially be tax-free if S can satisfy the limited-interest exception rule.

In order to satisfy the limited-interest exception rule, five tests must be met.

The U.S. transferor receives 50% or less of the shares of the transferred foreign corporation in the exchange.

2) There is not a control group of U.S. persons with respect to the transferred foreign corporation immediately after the transfer. Under this control group test, officers, directors and 5% or greater shareholders of the domestic corporation may not, in the aggregate, own more than 50% of the voting power or value of the transferred foreign corporation immediately after the transfer.

3) The transaction satisfies the active trade or business test, which is comprised of two parts, both of which must be satisfied:

a) The transferred foreign corporation has engaged in an active trade or business outside the United States for 36 months; and

b) At the time of the exchange, neither the transferors nor the transferee foreign corporation intend to discontinue or dispose of the trade or business.

4) A U.S. transferor who owns 5% or more of the transferee foreign corporation immediately after the exchange must enter into a five-year gain recognition agreement. Under the gain recognition agreement, the U.S. transferor must recognize any gain deferred on the initial transfer if the transferee foreign corporation disposes of the transferred shares within five years; and

5) The value of the transferee foreign corporation is, at the time of the exchange, equal to or greater than the value of the domestic corporation.

Here, S will exchange 100% of his shares of F for 3% shares of C. This transaction satisfies the Type B rules and the limited-interest exception should apply to avoid sale treatment of S’s F shares.

However, since S is no longer a U.S. shareholder of a CFC, S must recognize a dividend to the extent of F’s earnings and profits for U.S. tax purposes.

Foreign-To-Foreign Type C Shares-For-Shares Acquisitions

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. For advance ruling purposes, the 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.

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.

Type C Acquisitions in the Foreign Context

As aforementioned, a Type C acquisition allows an acquiror, for all or part of its shares, to acquire substantially all the assets of the target. However, under the Subpart F and NCTI a Type C reorganization could be taxed. Below, please see Illustration 3, which discusses how a Type C share-for-asset acquisition may be taxed for U.S. purposes.

Illustration 3.

S, a U.S. citizen, wholly-owns F, a foreign corporation. In what would otherwise constitute a tax-free share-for-assets acquisition, C, a publicly-held corporation traded on the London Stock Exchange, acquires all of F’s assets for 3% of C’s shares. Further, assume that F subsequently distributes the C shares to S in liquidation. As a result, the transaction should qualify as a Type C acquisition. However, because S, who was formerly a U.S. shareholder in a CFC (F) now owns only 3% of the shares of a non-CFC (C), S will be subject to the Subpart F and NCTI tax regimes. Any earnings and profits of F before its liquidation will be taxed under the Subpart F and NCTI tax regimes.

Forward Triangular Reorganizations

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. Typically, 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 Buyer’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 an acquisition subsidiary 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 subsidiary, 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.
5. The transaction must be entered into for a legitimate business purpose and not to avoid tax.

Foreign-To-Foreign Forward Triangular Reorganization

As discussed above, a forward triangular reorganization occurs when an acquiror uses the shares of its parent as the target merges into the acquiror, resulting in the acquiror receiving substantially all of the target’s assets. Below, please see Illustration 4, which provides an example of a forward-to-forward triangular reorganization.

Illustration 4.

Assume that Foreign Parent, a foreign corporation, wishes to acquire Foreign Target’s business, but does not want to incur the expense of obtaining its shareholder’s approval for a straight merger of Foreign Target into Foreign Parent. Further assume that Foreign Parent wholly owns a subsidiary, Foreign Acquiror, for the purpose of obtaining Foreign Target’s business. Finally, assume that Foreign Target merges with and into Foreign Acquiror, with Foreign Target’s U.S. shareholders receiving Foreign Parent shares as the merger consideration and Foreign Acquiror surviving the merger while obtaining the assets of Foreign Target. If the various requirements are satisfied, the merger qualifies as a forward triangular reorganization. If this transaction satisfies the limited interest exception, the Section 367(a) toll-charge should not apply.

Reverse Triangular Reorganizations

Section 368(a)(2)(E) permits a “reverse triangular merger” reorganization. In a 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 traditional 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.

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 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.

Foreign-to-Foreign Reverse Triangular Reorganization

As discussed above, a reverse triangular reorganization is similar to a forward triangular reorganization, except that the surviving entity is the target and not the acquiror. More specifically, after the transaction, the surviving target corporation holds substantially all of its own and the acquiror’s assets and the former shareholders of the surviving target exchange their shares for shares of the acquiror’s parent.  Below, please see Illustration 5, which provides an example of a forward-to-forward reverse triangular reorganization.

Illustration 5.

Assume that Foreign Parent, a publicly-traded foreign corporation, wishes to acquire Foreign Target’s business, but does not want to incur the expense of obtaining its shareholders’ approval for a straight merger of Foreign Target into Foreign Parent. Further assume that Foreign Parent forms a wholly-owned subsidiary, Foreign Acquiror, as an acquisition vehicle. Finally, assume that Foreign Acquiror mergers with and into Foreign Target, with Foreign Target’s shareholder receiving Foreign Parent shares as the merger consideration and the Foreign Target surviving the merger. This transaction satisfies the limited-interest exception and should be classified as a tax-free merger in U.S. tax law.

Conclusion

This article is intended to provide the reader with a basic overview of the types of foreign-foreign mergers and acquisitions and some of the U.S. tax consequences associated with these types of transactions. 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 merger or reorganization consult with a qualified international tax attorney. We have significant experience advising clients, law firms, and accounting firms regarding the U.S. tax implications of cross-border reorganizations and mergers.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is the author of a number of published articles addressing cross-border taxation. Anthony also frequently provides continuing educational programs regarding various international tax topics.

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.