Planning Considerations of Tax-Free Forward Triangular Mergers for Cross-Border Acquisitions of S Corporations Tax-Free

U.S. corporations are routinely acquired by foreign corporations. 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 objection 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 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 proceeding or a similar proceeding. 

Example as to How a Forward Triangular Merger Operates

Let’s assume that A Technologies, a Cayman Islands corporation headquartered in Singapore proposes to acquire from a U.S. citizen (“Seller”), his 100% interest in B., a California corporation, which owns two subsidiaries: C, a California corporation, and D, a California limited liability company. For U.S. federal income tax purposes, B is a subchapter S corporation and C is a qualified subchapter S subsidiary (“QSub”), and D is a disregarded entity.

In this example, the consideration to be paid by A on the transaction’s closing date will consist of 1) U.S. $1.6 million in cash (representing about 30% of the closing date consideration) and 2) U.S. $3.7 million of A stock (representing about 70% of the closing date consideration).

Transaction Exchanges

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 (“IRC”), the transaction will compromise the following three exchanges, all of which would occur simultaneously on the closing date:

1. First Exchange. A transfers the consideration to a wholly owned subsidiary formed by it for purposes of the transaction (“A Sub”). In return, A receives stock issued by the A Sub. This stock would be in addition to any stock issued to A when it formed the A Sub prior to the closing date. Neither A nor the A Sub would recognize gain or loss on this exchange. A’s basis in the A Sub stock should generally be the same as B’s basis in the assets that B transfers to the A Sub in the second exchange discussed below (less any liabilities assumed by the A Sub). See Treas. Reg. Section 1.358-6(c)(1).

2. Second Exchange. B merges into the A Sub pursuant to the merger statute (or statutes) under applicable local law, with the A Sub being the surviving corporation. For U.S. federal income tax purposes, the statutory merger is treated as an exchange in which the A Sub transfers to B the consideration (received in the first exchange) and, in return, receives all of the assets and liabilities of B (including those of C and D). Neither the A Sub nor B would recognize gain or loss on this exchange. See IRC Section 1032. A Sub’s basis in the assets that it receives from B should generally be the same as B’s basis in the transferred assets (less any liabilities assumed by the A Sub). See IRC Section 362(b).

3. Third Exchange. Seller surrenders all of the outstanding B stock for cancellation and, in return, receives the consideration from B. No gain or loss would be recognized by B on its distribution of the consideration. See IRC Section 361(c). The Seller, however, would recognize gain on the surrendered B stock in an amount equal to the lesser of i) the cash component of the consideration and ii) the calculated (i.e., realized) gain on the surrendered B stock. See IRC Section 354(a) and 356(a)(1). Summing that the Seller has presumably held the stock for more than a year, his recognized gain would be taxed at favorable long-term capital gain rates. The Seller’s basis in the A stock that he receives should generally equal his basis in the B stock, less the cash component of the consideration, plus the amount of the gain he recognizes on the B stock. See IRC Section 358(a).

Deemed Post-Transaction Exchange Between A Sub and C

Since A is a foreign corporation, the corporation that it forms to be the A Sub cannot elect to be an S corporation. See IRC Section 1361(b)(1)(B). As a result, C will cease to be a QSub and will become a subchapter C corporation (“C corp”) on the closing date. See IRC Section 1361(b)(3)(B). For U.S. federal income tax purposes, C will be deemed to be a newly formed corporation that, immediately after completion of the transaction, acquires all its assets (and assumes all of its liabilities) from the A Sub in exchange for C stock. See Treas. Reg. 1.368-2(b)(1)(iii) Example 3 (addressing a forward triangular merger in which an S corp, which owns a QSub, merges into a DRE that is wholly owned by a C corp). Since the A Sub will be C’s sole shareholder, neither the A Sub nor C recognizes gain or loss on this deemed post-transaction exchange. See IRC Section 351(a) and 357(a). This deemed exchange also should not disqualify the forward triangular merger as a tax-free reorganization under IRC Section 368(a)(1)(A) and (a)(2)(D). See IRC Section 368(a)(2)(C). C’s basis in the assets that it is deemed to receive from the A Sub should generally be the same as the A Sub’s basis in these assets (less any liabilities assumed by C). See IRC Section 362(a). The IRC does not prohibit C corps, such as the A Sub, from being sole members of limited liability companies classified as DREs.

U.S. Acquisition Sub

Let’s assume for purposes of the above example that a significant portion of B’s assets that will be transferred immediately before closing will consist of intangible property, such as goodwill, going concern value, and/or trademarks. This property would affect the jurisdiction where the A Sub is formed, due in large part to IRC Section 367(d).

IRC Section 367(d) denies the non-recognition (i.e., tax-deferred) treatment afforded under IRC Sections 351 or 361 if a U.S. person transfers intangible property to a foreign corporation. Under IRC 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.

IRC 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 IRC Section 367(d) does not apply if the transferee is incorporated in one of the U.S. states. Specifically, IRC Section 367(d) should not apply to the second exchange of the forward triangular merger (described above) if the A Sub is a U.S. corporation. It bears noting, however, that there is no guidance or commentary confirming this interpretation of IRC 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 IRC Section 367(d).

If IRC Section 367(d) does not apply, the general provisions of IRC Section 367(a) apply instead. Like IRC Section 367(d), IRC Section 367(a) also denies non-recognition treatment to outbound transfers of property by U.S. persons to foreign corporations. However, unlike IRC Section 367(d), IRC 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 IRC Section 367(a) to apply to a transaction when it otherwise would not.

Here, IRC Section 367(a)’s indirect stock transfer rules would treat the transfer of B’s assets to A Sub (in the second exchange) as an indirect transfer of B’s stock by the Seller to A. See Treas. Reg. 1.367(a)-3(d)(1)(i). See also Treas. Reg. 1.367(a)-3(d)(3) Example 1 (addressing a forward triangular merger in which a U.S. corporation merges into a U.S. acquisition subsidiary owned by a parent foreign corporation). As a result, the transaction would fail to qualify as a tax-free reorganization under IRC 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 B’s assets (and liabilities) to A Sub, followed by a complete liquidation of B to the Seller.

Nevertheless, IRC Section 367(a) 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 A’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, together with each officer or director of B, C, and D who is a U.S. person, must not own more than 50% (by vote or value) of A’s total outstanding stock immediately after closing.

3. A 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 A has an intention to substantially dispose of or discontinue such trade or business.

5. A’s fair market value must equal or exceed the fair market value of B, C, and D.

Transaction Requirements

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

1. The statutory merger of B into A Sub must be effected pursuant to the merger statute (or statutes) under applicable local law. See Treas. Reg. 1.368-2(b)(1)(ii). California’s merger statute applies here since B is a California corporation. Unless the A Sub is incorporated in another state, no other state’s merger statute would apply.

2. By operation of law under the merger statute (or statues), all of the assets and liabilities of B (including those of C and D) must become those of the A Sub, and B 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. See Treas. Reg. 1.368-1(c). 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 interest (“COI”) requirement applicable to forward triangular mergers. Here, this requirement would be met if 40% or more of the consideration consists of A stock. See Treas. Reg. 1.368-1(e)(2)(v) Example 1. Post-closing purchases or redemptions by A (or a related person) of A stock from the Seller do not preserve COI. See Treas. Reg. Section 1.368-1(e)(1)(i).

5. The transaction must meet the continuity of business enterprise (“COBE”) requirement. Here, A must either i) continue B’s historic business or ii) use a significant portion of B’s historic business assets in A’s business. See Treas. Reg. Section 1.368-1(d)(1).

6. The transaction must be entered into for a legitimate business purpose and not to avoid tax.

7. Stock in the A Sub must not be included in the consideration, or otherwise used in the transaction. See IRC Section 368(a)(2)(D)(i).

8. The transaction must qualify as a Type A statutory merger under IRC Section 368(a)(1)(A) if the merger had been between B and A, instead of B and the A Sub. Type A statutory mergers are subject to the same 40% COI requirement applicable to forward triangular mergers.

Other Structures under IRC Section 368(a)

Because consideration to be paid by A on the closing date will be about 30% in cash and 70% in A stock, the transaction cannot be structured as one of the other tax-free acquisitive reorganizations under IRC Section 368(a).

1. Reverse triangular mergers under IRS Section 368(a)(1)(A) and (a)(2)(E) (where A Sub merges into B, with B being the surviving corporation) require that at least 80% of the consideration be A voting stock.

2. Type B stock-for-stock reorganizations under IRC Section 368(a)(1)(B) require the consideration to consist of A voting stock.

3. Type C assets-for-stock reorganizations under IRC Section 368(a)(1)(C) and (a)(2)(B) require that at least 80% of the consideration be A voting stock.

4. Type D acquisitive reorganizations under IRC Section 368(a)(1)(D) require the Seller to be in control of the entity that acquires B’s assets.

We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also  provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.

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.