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Demystifying International Forward and Reverse Tax-Free Mergers

Demystifying International Forward and Reverse Tax-Free Mergers

By Anthony Diosdi


The three basic types of reorganizations (Type A, Type B, and Type C) offer rather limited flexibility if the acquiring corporation desires to operate the target as a wholly owned subsidiary. Assume, for example, that Parent Corporation (“P”) wishes to acquire Target Corporation (“T”) and keep T’s business in a separate corporation entity for reasons not related to tax. Although this objective may be met by a Type B reorganization, the Type B reorganization requirement of  “solely for voting stock” requirement might be too much of a hurdle to overcome. Even the flexibility A reorganization may not always be feasible for non-tax reasons. For example, if P wishes to acquire T’s assets in a tax-free acquisitive reorganization, it may be unwilling to incur the risk of T’s unknown or contingent liabilities. This risk might continue even if P drops down T’s assets and liabilities to a P subsidiary after a merger of T into P. P also may not wish to incur the expense and delay of securing formal approval of its shareholders to a merger or direct asset acquisition.

The “forward triangular merger” solves many of these non-tax problems. In its simplest form, a forward triangular merger consists of the following steps:

1) P forms a new subsidiary, S by transferring P stock (and perhaps other consideration) for S stock in an exchange that is tax free under Internal Revenue Code Section 351.

2) T is merged into S under state law. T shareholders receive P stock and any other consideration provided by the merger agreement. P ordinarily does not need to secure approval from its shareholders because S is the party to the merger and P is the only shareholder of S. All of T’s assets and liabilities are automatically transferred to S, which remains a wholly owned subsidiary of P.

A forward triangular merger qualifies as a tax-free reorganization under Section 368(a)(2)(D) of the Internal Revenue Code if the following requirements are met:

1) S must acquire substantially all of the properties of T. This is the same requirement imposed on Type C reorganizations, and similar standards are applied.

2) No stock of S may be used as consideration in the merger. The use of S debt securities is also not permitted.

3) The transaction must qualify as a Type A reorganization if T had merged directly into P. This means that the transaction must satisfy the judicial continuity of interest requirement in which T’s shareholders as a group must receive at least 50% of P’s stock. See Treas. Reg. Section 1.368-2(b)(2).

Forward triangular mergers can be classified as Type A forward triangular mergers or Type B forward triangular mergers. Special rules in Section 368(a)(2)(D) of the Internal Revenue Code for a forward Type A triangular merger. In this transaction, the target corporation (T) merges directly into P subsidiary (S). The parent corporation (P) may establish a new subsidiary for this purpose or may use an already existing subsidiary. Several conditions apply to the forward triangular merger under Section 368(a)(2)(D). First, the acquiring subsidiary corporation must receive “substantially all” of the target’s properties. The second requirement for a Type A forward subsidiary merger is that no stock of the acquiring corporation (S) be used in the transaction. Thus, the stock consideration used is limited to P stock; it will not be possible to use a mixture of P and S stock as consideration in a forward subsidiary merger. This restriction only prohibits the use of s stock. Since the Type A reorganization is rather generous with regard to permissible boot, a Type A forward triangular merger may include as consideration cash, debentures, and other types of boot, including S debt. Thus, although it is impermissible to use S stock in the transaction, it is permissible to use S debt. See Treas. Reg. Section 1.368-2(b)(2).

The final requirement for a Type A forward triangular merger is that the transaction would have qualified as a Type A reorganization if it had been a merger of T directly into P. A merger of T into a P subsidiary will be permissible under Section 368(a)(2)(D) of the Internal Revenue Code as long as it meets the business purpose, continuity of proprietary interest, and other tests that would apply in the context of a simple two-part Type A merger.

In a Type B triangular reorganization, T shareholders transfer T stock to P’s subsidiary (S) solely in exchange for P voting stock. In the direct triangular Type B reorganization in which the T shareholder transfers their stock to s in exchange for P stock, all three of the corporations are considered “parties to the reorganization.” T shareholders who receive P stock are entitled to nonrecognition treatment for tax purposes. Resolving the proper treatment for P and S in the Type B triangular reorganization is more difficult. S should be entitled to nonrecognition upon its exchange of P shares for T shares. In the Type B reorganization, s is exchanging its parent’s stock rather than its own. Under the regulations for Section 1032, S will not recognize gain as long as the P stock was provided by P to S or directly to the T shareholders of s pursuant to the plan of reorganization. On the other hand, S will recognize gain or loss to the extent that it uses P stock that it did not receive from P pursuant to the reorganization plan. With regard to basis, since S is entitled to nonrecognition treatment upon the receipt of the T shares, S’s basis in the T stock should be a substituted basis from the T shareholders. 

Forward triangular mergers are not only utilized in domestic transactions. Forward triangular reorganizations are often utilized in cross border transactions.

Below please see Illustration 1 for example of an outbound forward triangular reorganization.

Illustration 1.

Assume that Foreign Parent, a publicly traded corporation, wishes to acquire U.S. Target’s business, but does not want to incur the expense of obtaining its own shareholders’ approval for a straight merger of U.S. Target into Foreign Parent. Further assume that Foreign Parent forms a wholly-owned subsidiary, U.S. Big Fish, for the purpose of obtaining U.S. Target’s business. Finally, assume that U.S. Target merges with and into U.S. Big Fish, with U.S. Target’s shareholders receiving Foreign Parent’s shares as the merger consideration and with U.S. Big Fish surviving the merger. This should qualify as a forward triangular reorganization.

Below please see Illustration 2 for example of an inbound forward triangular reorganization

Illustration 2.

Assume that U.S. Parent, a publicly traded domestic corporation, wishes to acquire Foreign Target’s business, but does not want to incur the expense of obtaining its shareholders’ approval for a Type A merger of Foreign Target into U.S. Parent. Further assume that U.S. Parent owns a wholly-owned subsidiary, U.S. Acquiror, for the purpose of obtaining Foreign Target Business. Finally, assume that Foreign Target merges with and into U.S. Acquiror, with Foreign Target’s U.S. shareholders receiving U.S. Parent shares as the merger consideration and U.S. Acquiror surviving the merger while obtaining Foreign Target’s assets. If the various requirements are satisfied, the merger would qualify as a forward triangular reorganization. See Treas. Reg. Section 1.368-2(b)(1)(iii)(Ex. 13).

Below please see Illustration 3 for example of a foreign to foreign triangular reorganization.

Illustration 3.

Assume that Foreign Parent, a foreign corporation, wants 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 wholly owns a subsidiary, Foreign Acquiror, for purposes 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. Although the forward triangular reorganization rules require a merger that “would have qualified” as a Type a merger, the Internal Revenue Service (“IRS”) has provided guidance that this qualifies as a forward triangular reorganization. See Treas. Reg. Section 1.368-2(b)(1)(iii))Ex.13).

Reverse Triangular Mergers

Before examining the tax consequences of a reverse triangular merger, the transaction itself must be explained. Suppose P desires to acquire the stock of T in a tax-free reorganization and keep T alive as a subsidiary, but P is unable to structure the deal as a Type B reorganization because of the “solely for voting stock” requirement. Neither a merger nor an asset acquisition is feasible because T, as a corporate entity, has a number of assets that would be jeopardized if T were dissolved. A “reverse triangular merger” was developed to accommodate this dilemma. It consists of the following steps:

1) P forms a new subsidiary, S, by transferring P voting stock and other consideration for s stock in an exchange that is tax free under Section 351 of the Internal Revenue Code. (P could also make the transfer to an existing subsidiary).

2) S merges into T under state law. T shareholders receive P voting stock and any other consideration provided by the merger agreement. P exchanges its S stock for T stock. S disappears and T survives as a wholly owned subsidiary of P.

Section 368(a)(2)(E) of the Internal Revenue Code provides that this type of reverse merger will qualify as a tax-free reorganization if: 1) the surviving corporation (T) holds substantially all of the properties formerly held by both corporations (T and S), and 2) the former T shareholders exchange stock consisting “control” (measured by the 80 percent tests in Section 368(c)(1)) for P voting stock).

As with a forward triangular merger, the basic merger of S into T must otherwise qualify as a Type A merger. The reverse subsidiary merger provision also contains a “substantially all” of the assets requirement, which appears in two parts. First, the corporation surviving the merger (T) must hold substantially all of its own properties after the merger. The second part of the “substantially all” test requires that after the transaction T also hold substantially all of the merged corporation’s (S’s) properties (other than P stock distributed in the transaction). Thus, cash or other property contributed by P to s for use as boot consideration to T shareholders or to pay off dissenting T shareholders does not count toward the “substantially all” test and it should not be a problem that T no longer holds these assets. The regulations clarify that “in applying the ‘substantially all’ test to the merged corporation, assets transferred from the controlling corporation to the merged corporation in pursuance of the plan of reorganization are not taken into account.” See Treas. Reg. Section 1.368-2(j)(3)(iii).

One unique quality of the reverse subsidiary merger is the possibility that some of the old T shareholders will dissent and continue to hold T shares as minority shareholders. In the forward subsidiary merger, in contrast, T disappears. The old T shareholders either receive P stock and boot or, as dissenters, are “bought out,” usually with cash. This unique characteristic of the reverse subsidiary merger necessitated a final condition for a successful tax-free reverse triangular merger that the former shareholders of the surviving corporation (T) must have transferred a controlling interest in T in exchange for P voting stock.

As indicated above, a reverse triangular reorganization is similar to a forward triangular reorganization, except that the surviving entity is the target and not the acquiror. In addition, the parent stock issued as merger consideration must be voting stock and must constitute at least 80% of the merger consideration. Moreover, after the transaction, the surviving target holds substantially all of its own and the acquiror’s properties and former shareholders of the surviving target exchange their shares for shares of the acquiror’s parent.

The same concepts that apply in domestic reverse triangular reorganizations apply mergers in cross border transactions.

Below please see Illustration 4 for an example of an outbound reverse triangular reorganization.

Illustration 4.

Assume that Foreign Parent, a publicly traded corporation, wants to acquire U.S. Target’s business, but does not wish to incur the expense of obtaining its own shareholders’ approval for a straight merger of U.S. Target into Foreign Parent. Further assume that Foreign Parent forms a wholly-owned subsidiary, U.S. Big Fish, as an acquisition vehicle. Finally, assume that U.S. Big Fish merges with and into U.S. Target, with U.S. Target’s shareholders receiving Foreign Parent shares as the merger consideration and with U.S. Target surviving the merger. The merger will likely qualify as a reverse triangular reorganization. See Temp. Re. Section 1.367(a)-3(d)(1)(ii); Treas. Reg. Section 1.368-2(b)(1)(iii)(Ex. 13).

Below please see Illustration 5 for an example of an inbound reverse triangular reorganization.

Illustration 5.

Assume that U.S. Parent, a publicly traded corporation wishes to acquire Foreign Target’s business, but does not want to incur the expense of obtaining its shareholders’ approval for a Type A tax-free reorganization of Foreign Target into U.S. Parent. Further assume that U.S. Parent forms a wholly owned subsidiary, U.S. Acquiror, as an acquisition vehicle. Finally, assume that U.S. Acquiror merges with and into Foreign Target, with Foreign Target’s shareholders receiving U.S. Parent shares as the merger consideration and with Foreign Target surviving the merger. Because Foreign Target, with its earnings and profits, remains in existence, any income inclusion is unnecessary.


Below please see Illustration 6 for an example of a foreign to foreign reverse triangular reorganization.

Illustration 6.

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 Type A 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 merges with and into Foreign Target, with Foreign Target’s shareholders receiving Foreign Parent shares as the merger consideration and with Foreign Target surviving the merger. This transaction will likely qualify for a reverse triangular reorganization.

Conclusion

This article was designed to provide the reader with an introduction to cross border forward and reverse triangular mergers. This article does not discuss Internal Revenue Code Section 367 which may also tax cross border forward and reverse triangular transactions. Section 367 must be considered in any international tax transaction. We have written extensively on Section 367 in other articles. The rules governing tax-free cross border forward and reverse triangular mergers can be incredibly complicated. Anyone planning a tax-free cross-border transaction or transactions should consult with a tax attorney who is not only experienced in the tax-free provisions of the Internal Revenue Code, but will also seek to ensure that the cross-border transaction is structured in a way to minimize or eliminate the global tax consequences of the transaction.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.

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