United States: Achieving Tax-Free ‘Rollover' Treatment for Certain Shareholders in Acquisition of Publicly Traded Target Company

Introduction

A common issue that arises when structuring a corporate acquisition of a public company is that a tax-sensitive shareholder of the target corporation (T) requires tax-free treatment while the remaining shareholders do not. For example, assume that an acquiring corporation (P) seeks to purchase T (which has fair market value of $100), that 60 percent of the T stock is widely held by the public and that 40 percent of T is owned by a single family or individual (Individual).  P would prefer to acquire all of T for cash, and the public shareholders may generally be indifferent to tax considerations (e.g., where T stock is held primarily by tax-exempt pension funds), but Individual demands tax-free rollover treatment of his/her T shares. This article addresses four methods for structuring P's acquisition of T to achieve taxable treatment for the public and tax-free treatment for Individual. In the discussion below, P and T are domestic corporations, but a similar analysis frequently applies when P and T are foreign. 

Reorganization Under Section 368(a)(1)(A)

The simplest structure from a U.S. federal tax perspective for providing Individual with tax-free rollover treatment under the scenario presented above is a reorganization under section 368(a)(1)(A) (an "A" reorganization) of the Internal Revenue Code. The A reorganization can be accomplished through a direct statutory merger of T into P or a merger of T into a disregarded entity or subsidiary of P. In order for the reorganization to be tax-free, at least 40 percent of the value of the total consideration paid to T shareholders must be in the form of P stock (the "continuity of interest" requirement). Thus, T can merge directly into P, with the T shareholders collectively receiving a total of $40 of P stock and $60 of cash.

In the example above, all tax objectives will be achieved if the $40 of P stock can be directed to Individual (who will receive tax-free rollover treatment on the exchange of T stock for P stock) and the $60 cash can be directed to the public T shareholders. Depending on the jurisdiction, securities and corporate law may or may not prevent P from effectively ensuring that the public receives solely cash and Individual receives solely the P stock. For example, certain states permit the P stock to be offered to shareholders that tender the most T stock (i.e., Individual). Other jurisdictions impose stricter protections for public shareholders, which may necessitate P offering potentially costly financial incentives to obtain the necessary cooperation from the T shareholders.

Meeting the 40 percent continuity of interest requirement can also pose practical issues. The parties will typically want to negotiate the major economic terms of the reorganization, but fluctuations in the value of T or P before closing can impact whether the amount of P stock and cash intended to be delivered at closing will actually meet the 40/60 ratio on that date. Treasury regulations provide a helpful "signing date" rule for measuring continuity of interest that allows the parties to agree to an exchange ratio that satisfies the 40/60 test when the original merger agreement is signed (so that subsequent value fluctuations do not disqualify the merger on the closing date). However, the signing date rule can prove difficult to satisfy, particularly where disparate consideration must be offered to different groups of T shareholders (as described above). 

The 'Double Dummy' Structure

A second structure for combining P and T with tax-free rollover treatment is known as the "double dummy" structure. In a double dummy structure, P may acquire T using a larger percentage of cash consideration than 60 percent because the transaction is not geared to satisfy the requirements of an A reorganization, but rather the more flexible requirements for a tax-free section 351 exchange. Note that section 351(a) provides that a transfer of property (including stock) to a corporation in exchange for stock will be tax-free if one or more transferors own at least 80 percent of the stock (within the meaning of section 368(c) of the transferee corporation immediately after the exchange (the "control" requirement). The double dummy structure thus commonly is used when P seeks to issue more than 60 percent cash in the exchange (e.g., where Individual owns only 25 percent of T and P wants to purchase the remaining 75 percent of T for cash).

A double dummy structure involves P or T forming a new holding corporation (New Holdco), which in turn forms two wholly owned merger subsidiaries (the "double dummy" corporations).  Dummy One merges into P (the P merger) and Dummy Two merges into T (the T merger), with P and T each surviving the merger as wholly owned subsidiaries of New Holdco. In the P merger, the P shareholders receive solely New Holdco stock in exchange for their P stock; in the T merger, Individual receives $25 of New Holdco stock and the T public shareholders receive $75 cash in exchange for their T stock.

Because T and P survive the reverse mergers, the transitory existence of the dummy corporations is disregarded for federal tax purposes and the transaction is treated as if the P and T shareholders transferred their stock to New Holdco in exchange for New Holdco stock (or $75 cash in the case of the T public). Treating the reverse mergers as stock transfers ensures that there is no risk of a corporate level tax on the assets of P and T. In addition, the P and T stock exchanges are designed to qualify for tax-free treatment at the shareholder level under section 351. That is, the shareholders of P and Individual constitute a section 351 "control group" who own in the aggregate 100 percent of the stock of New Holdco following the exchanges. Thus, the P shareholders and Individual should each obtain tax-free treatment under section 351(a). 

As stated above, this structure is frequently useful for a merger of equals where Individual owns less than 40 percent of T or the continuity of interest requirement is otherwise difficult to satisfy.  Drawbacks of this structure include the fact that the P shareholders generally must participate in and vote for the exchanges (although under Delaware law, the vote by P shareholders can sometimes be avoided) and that P, which may be a much larger publicly traded company than T, will end up as a subsidiary of a new public holding company.  If it is undesirable for P to become a subsidiary of New Holdco, the "single dummy" structure (discussed below) is a viable alternative. 

The 'Single Dummy' Structure

A single dummy structure is a variation of the double dummy structure where P merges directly into New Holdco rather than becoming a subsidiary of New Holdco, thus enabling P's business to continue in the top-tier public company. In a single dummy structure, P forms New Holdco and New Holdco, in turn, forms a single new subsidiary (Dummy One).  Dummy One then merges into T, with T surviving as a wholly owned subsidiary of New Holdco. Here, the T public receives $75 of cash and Individual receives $25 of New Holdco stock. Immediately after T's merger, P merges into New Holdco, with New Holdco surviving and the P shareholders receiving New Holdco stock. Once again, the combination of T and P into New Holdco is designed to qualify as an overall section 351 exchange, so that Individual can obtain rollover treatment, but the technical tax analysis differs slightly.  Specifically, Individual and P will be considered co-transferors in a section 351 exchange, with Individual obtaining section 351 treatment and the P shareholders obtaining tax-free reorganization treatment under section 354.

To reach a good comfort level for a single dummy acquisition, it is important that (i) the transaction be structured so that the merger of P into New Holdco cannot qualify as a reorganization under section 368(a)(1)(F) (which is achieved by completing the T merger before the P merger), and (ii) the incorporation of New Holdco or the P merger achieves some business objective beyond satisfying section 351 (which is usually the case).

Convertible Stock

A fourth alternative is for P to form a new subsidiary (S) with cash and cause S to acquire the T stock. In this alternative, S buys out the T public shareholders with the cash and acquires Individual's T stock in exchange for S stock; P and Individual are treated as co-transferors in the section 351 exchanges with S, with Individual obtaining tax-free treatment.  Although Individual will initially hold a less liquid minority interest in S stock, Individual will also be given a conversion right so that he/she can exchange the S stock for a more liquid interest in P's publicly traded common stock after a period of time (e.g., one year after the acquisition).

Due to the issues presented by the conversion feature, this structure is less desirable, but it has been used when the alternatives listed above are not workable (for example, News Corporation acquired all of the shares of Dow Jones & Company using this structure in 2007). Crucially, the subsequent conversion of S stock into P stock will be a taxable exchange for Individual. Other planning considerations also should be kept in mind when structuring the transaction (e.g., the S stock should participate to some extent in corporate growth to avoid potential concerns under section 351(g)) in order to successfully defer the recognition of Individual's gain until the time of conversion.

Thus, while this structure has the advantage that P does not have to merge or be contributed to a holding company, the additional tax complexities of the conversion arrangement mean that the tax treatment is somewhat less assured.

Achieving Tax-Free 'Rollover' Treatment for Certain Shareholders in Acquisition of Publicly Traded Target Company

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions