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

This article discusses outbound tax-free cross-border Type A 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 A reverse triangular merger, a Type A tax-free reorganization must be explained. We will begin this article with a discussion regarding the requirements of a 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.

Type A Reverse Triangular Mergers

Section 368(a)(2)(E) permits a “reverse triangular merger” to qualify as a Type A 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 A 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 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 A 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.