SJSU TEI High Technology Tax Institute

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SJSU / TEIHigh Technology Tax Institute
Current Developments in Mergers and Acquisitions

• November 7, 2006Palo Alto, CA

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LLC Mergers
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Tax-Free LLC A Reorganizations

• Treas. Reg. Section 1.368-2 allows the merger of
  a corporation into a disregarded entity to
  qualify as a tax free A reorganization provided
  certain conditions are met.
• However, the merger of a disregarded entity into
  a corporation cannot qualify as an A
  reorganization.

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Tax-Free LLC A Reorganizations

• The regulations establish three new definitions
  for purposes of determining whether a disregarded
  entity merger qualifies as a valid A
  reorganization.
• A disregarded entity is defined as a business
  entity that is disregarded as an entity separate
  from its owner for Federal tax purposes, such as
  a domestic single member limited liability
  company that does not elect to be classified as a
  corporation. Other disregarded entities include a
  corporation that is a qualified REIT subsidiary
  within the meaning of Section 856(i)(2) and a
  corporation that is a qualified subchapter S
  subsidiary within the meaning of Section
  1361(b)(3)(B).
• A "combining entity" is defined as a business
  entity that is a corporation that is not a
  disregarded entity.
• A "combining unit" is comprised solely of a
  combining entity and all disregarded entities, if
  any, the assets of which are treated as owned by
  such combining entity.

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Tax-Free LLC A Reorganizations

• Under the regulations, a valid A reorganization
  requires that "All of the assets (other than
  those distributed in the transaction) and
  liabilities (except to the extent satisfied or
  discharged in the transaction)" of each member of
  one of more combining units (each a transferor
  unit) become the assets and liabilities of one or
  more members of one other combining unit ... and
  ... the combining entity of each transferor
  unit ceases its separate legal existence for all
  purposes ... ." Every merger will involve at
  least two combining units, the 'transferor unit
  and the transferee unit.
• With respect to a disregarded entity merger, all
  of the assets and all of liabilities of T, a
  corporation, (and any of its disregarded
  entities) generally must become the assets and
  liabilities of a disregarded entity of P, a
  corporation, by operation of a merger law.
• Since a combining unit must include a combining
  entity that is a corporation, T cannot merge into
  a disregarded entity owned by a partnership.
• T's shareholders must not receive any interest in
  the surviving disregarded entity or such entity.

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Type A Statutory MergerDisregarded Entities

• Ts assets and liabilities are acquired by LLC in
  the merger in exchange for P stock
• T ceases to exist
• Qualifies as a Type A reorganization

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Type A Statutory MergerDisregarded Entities
(contd)

• Ts assets and liabilities are acquired by LLC in
  exchange for P/S interests
• T ceases to exist
• Does not qualify as a Type A reorganization
• Considered a taxable sale of Ts assets and
  liquidation of T under Rev. Rul. 69-6

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Type A Statutory MergerDisregarded Entities
(contd)

• LLCs assets and liabilities are acquired by P in
  exchange for P stock
• LLC ceases to exist
• T retains its assets and remains in existence
• Does not qualify as a Type A reorganization

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Type A Statutory MergerDisregarded Entities
(contd)

• P acquires all the stock of T for 50 A voting
  stock, 50 cash
• T converts to LLC (disregarded for tax purposes)
• Does not qualify as Type A reorg because Ts
  legal existence does not cease with conversion,
  as required by the 2003 temporary regs (TD 9242)

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Expanded Reorganization Rules
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Expansion of Merger Definition in Foreign Context

• Section 368(a)(1)(A) provides that the term
  reorganization means (A) a statutory merger or
  consolidation.
• Prior regulations interpreted Section
  368(a)(1)(A) as a statutory merger or
  consolidationeffected pursuant to the laws of
  the United States or a State or the District of
  Columbia in which, as a result of the operation
  of such laws
• All of the assets and liabilities become the
  assets and liabilities of the transferee, and
• The combining entity ceases its separate legal
  existence.
• The current regulations (adopted January 23,
  2006) do not contain a reference to federal,
  state or District of Columbia law.
• The new reference is to the statute or statutes
  necessary to effect the merger or consolidation.
• The change is particularly significant because
  the requirements of Section 368(a)(1)(A) are the
  most relaxed of the reorganization categories,
  i.e., only need meet continuity of interest and
  continuity of business enterprise tests.

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Application to Amalgamations

• Facts Country Q entities Z and V amalgamate in
  which pursuant to the Country Q statutes, all of
  the assets and liabilities of Z and V become the
  assets and liabilities of R an entity created in
  the transaction. Z and V shareholders receive
  stock of Y, the parent entity of R.
• Analysis With respect to each of Z and V, the
  transaction meets the requirements of Treas. Reg.
  1.368-2(b)(1)(ii), and is therefore a statutory
  merger or consolidation qualifying in this case
  as a reorganization under Section 368(a)(1)(A) by
  reason of Section 368(a)(2)(D), i.e., a forward
  triangular merger.

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Some Implications of Expanded Definition

• The expanded definition may make it easier to
  qualify foreign acquisitions, both unrelated
  party transactions and internal restructurings,
  and reorganizations.
• Each transaction under foreign law must be
  carefully analyzed to determine its potential for
  qualifying under the A rules.
• The government has asked for comments as to
  whether a stock acquisition followed by a
  conversion should qualify as an A reorganization.
• Although generally positive for U.S. stockholders
  of acquired foreign entities, the new rules
  present potential traps for the unwary acquirer.
• Often U.S. acquirors in unrelated party
  acquisitions seek taxable status to achieve
  favorable U.S. tax results.
• The primary planning technique involves a Section
  338 election following a taxable stock purchase,
  sometimes with a check the box election for the
  target and sometimes with a restructuring under
  foreign law.
• The step transaction analysis of Rev. Rul.
  2001-46 and its predecessor Rev. Rul. 67-274,
  further complicates this analysis, since
  post-acquisition restructuring may often result
  in reorganization status.

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Continuity of Interest UpdateMeasuring Value of
Consideration
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Continuity of Interest UpdateMeasuring Value of
Consideration

• General Rule COI tested based on aggregate
  consideration actually paid/received (subject to
  Max Min exception), but under circumstances
  defined in new regulations, value of
  consideration is measured as of signing, rather
  than as of closing (signing date rule)
• Principle where binding contract provides for
  fixed consideration in the form of acquirer
  shares, target shareholders are generally subject
  to the economic fortunes of the acquirer as of
  signing
• 40 Threshold Whether or not the signing date
  rule applies, the COI requirement is satisfied
  where 40 of the target shares are exchanged for
  acquirer shares

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Continuity of Interest Update Measuring Value of
Consideration

• General Signing Date Rule Consideration valued
  on last business day before the first date a
  contract is a binding contract, if the contract
  provides for fixed consideration
• Binding Contract
• Tender offers made without binding contracts
  date that amount and type of consideration is
  first announced (or date of last announced
  modification) is treated as binding contract date
• Pre-closing binding contract modification
  Resets the value date if the modification relates
  to the amount or type of consideration
• EXCEPT if modification results only in issuance
  of additional acquirer shares to target
  shareholders and, absent the modification,
  continuity of interest would have been preserved
• NOTE No exception if modification results in a
  change to non-share consideration, even if ratio
  of acquirer shares to non-share consideration (in
  original contract) increases

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Continuity of Interest Update Measuring Value of
Consideration

• Fixed Consideration General Rules
• Fixed number of acquirer shares fixed amount of
  cash or other property for all target shares or
  for each target share or
• Provided that a proration mechanism preserves the
  fixed acquirer stock and cash pools, shareholders
  may elect cash or stock
• Fixed percentage of (i) the number or value of
  target shares, or (ii) each target share, to be
  exchanged for acquirer shares (provided that the
  exchanges for stock and cash are economically
  reasonable)
• Provided that a proration mechanism preserves the
  fixed percentage of target shares (or each target
  share) to be exchanged for acquirer shares,
  shareholders may elect cash or stock and certain
  symmetric collars may be used for price
  protection
• Accommodates flexibility given to target to issue
  more shares pre-closing (e.g., exercise of stock
  options)

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Continuity of Interest Update Measuring Value of
Consideration

• Shareholder elections that could affect (i) pools
  of acquirer stock/cash or (ii) percentage of
  target shares to be exchanged for acquirer stock
• If binding contract does not provide fixed
  consideration, as specifically defined in the
  General Rules, and target shareholders can elect
  stock or cash, fixed consideration will exist if
  contract provides
• Minimum number of acquirer shares and maximum
  amount of cash to be exchanged for all target
  shares, or
• Minimum percentage of the number or value of
  target shares to be exchanged for acquirer shares
  (provided that the exchanges for stock and cash
  are economically reasonable)
• Max Min Exception - Continuity of interest tested
  without regard to actual consideration received
• Assuming minimum number of acquirer shares and
  maximum amount of cash are exchanged for all
  target shares, or
• Assuming minimum percentage of target shares (by
  number or by value) are exchanged for acquirer
  stock

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Continuity of Interest Update Measuring Value of
Consideration

• Contingent Consideration will prevent a contract
  from being treated as providing fixed
  consideration (e.g., a collar, cash top-up
  arrangement)
• Except if contingent consideration consists
  solely of acquirer shares and COI requirements
  would be satisfied if the contingent shares were
  never delivered
• Escrow Consideration placed in escrow to secure
  targets performance of pre-closing covenants or
  reps/warranties will not prevent a contract from
  providing for fixed consideration, but to the
  extent escrowed consideration is ultimately
  forfeited, it will not be taken into account in
  testing for COI (purchase price adjustment)
• Anti-Dilution Customary anti-dilution clause
  will not preclude fixed consideration however,
  in the absence of such a clause, no fixed
  consideration will exist if the acquirer alters
  its capital structure in a manner that materially
  alters the deal economics
• Dissenters rights Will not preclude contract
  from being treated as fixed consideration, but
  any consideration paid to dissenters could be
  taken into account in testing for COI
• New Issuances If fixed consideration exists,
  new acquirer shares, securities or debt to be
  issued in the reorganization are valued as if
  issued at date of signing

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Transaction Costs and the Final Regulations
under 263(a)
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Scope of Treas. Reg. 1.263(a)-5

• Amounts paid to facilitate
• The acquisition of a trade or business
• A change in the capital structure of a business
  entity
• Certain other transactions
• Distinction between listed transactions and
  covered transactions

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Listed Transactions Treas. Reg. 1.263(a)-5(a)

• Acquisition of assets that constitute a trade or
  business
• Acquisition of an ownership interest in a
  business entity if taxpayer and business entity
  are related following the acquisition
• Acquisition of an ownership interest in the
  taxpayer

• Reorganization of the capital structure
• A transfer described in 351 or 721
• A formation or organization of a disregarded
  entity
• An acquisition of capital
• A stock issuance
• A borrowing
• Writing an option

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Facilitate Standard for Listed Transactions
Treas. Reg. 1.263(a)-5(b)

• Amounts paid in the process of investigating or
  otherwise pursuing the transaction
• Based on facts and circumstances
• The fact that an amount would (or would not) have
  been paid but for is relevant but not
  determinative
• Special rules for borrowing, asset sales,
  mandatory stock distributions, bankruptcy, stock
  issuance, integration, registrar/transfer agent,
  termination payments

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Covered Transactions Treas. Reg. 1.263(a)-5(e)

• Taxable acquisition of assets that constitute a
  trade or business
• Taxable acquisition of an ownership interest in a
  business entity if, immediately after the
  acquisition, parties are related
• Reorganization described in 368(a)(1)(A), (B),
  or (C), or a reorganization described in
  368(a)(1)(D) in which stock or securities of the
  corporation to which the assets are transferred
  are distributed in a transaction that qualifies
  under 354 or 356

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Facilitate Standard for Covered Transactions
Treas. Reg. 1.263(a)-5(e)

• Amounts are facilitative (paid in the process of
  investigating or otherwise pursuing the
  transaction) only if
• Amount is inherently facilitative, or
• Amount relates to activities performed on or
  after the bright line date

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Inherently Facilitative Treas. Reg.
1.263(a)-5(e)(2)

• All inclusive list
• Certain activities require capitalization,
  regardless of when incurred, including
• Fairness opinion
• Structure of transaction
• Merger agreement
• Regulatory approval
• Shareholder approval
• Conveying property

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Bright-Line Date Treas. Reg. 1.263(a)-5(e)(1)

• The date on which a letter of intent, exclusivity
  agreement, or similar written communication
  (other than a confidentiality agreement) is
  executed by representatives of the acquirer and
  target or
• The date on which the material terms of the
  transaction (as tentatively agreed to by
  representatives of the acquirer and the target)
  are authorized by the taxpayers board of
  directors

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Simplifying Conventions Treas. Reg.
1.263(a)-5(d)

• Capital transaction costs do not include
• Employee compensation including salary, bonus and
  commissions
• Fixed overhead (rent, utilities, depreciation)
• De minimis costs (less than 5,000)

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Transaction Costs Special Rules

• Rebuttable presumption that success-based fees
  are facilitative
• A success-based fee is an amount paid to
  facilitate the acquisition except to the extent
  that taxpayer maintains sufficient documentation
  to establish that a portion of the fee is
  allocable to activities that do not facilitate.
• Above exception requires contemporaneous
  documentation (prepared on or before the due date
  of the taxpayers return for the year in which
  the transaction closes).

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Transaction Costs Special Rules (Cont.)

• Borrowing costs
• Amounts paid to facilitate a borrowing do not
  facilitate another transaction.
• Thus, costs to finance a transaction are
  capitalized to the notes and not the transaction.
• Integration costs
• Does not facilitate the acquisition
• May be capitalized for other reasons

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Transaction Costs Special Rules (Cont.)

• Asset sales
• Amounts paid to facilitate a sale of assets are
  not capitalized but reduce the amount realized on
  the sale of assets
• Break-up fees
• An amount paid to terminate a contract/arrangement
  is not facilitative unless transactions are
  mutually exclusive

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Accounting Method Changes for Treas. Reg.
1.263(a)-5

• Change in method of accounting versus amended
  return
• No definitive IRS guidance or case law whether
  change in treatment of transaction costs is a
  change in accounting method

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Misc. Diligence Issues
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Diligence Issues

• Section 195
• Transfer pricing
• Permanent establishment
• State income and sales tax nexus
• Section 409A discount options
• Historic Section 382 limitations

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Developments Under theAnti-Inversion Rules
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Background of Anti-Inversion Rules

• Prior to 1994, the Code and Regulations were
  largely ineffective in deterring the inversion of
  U.S. corporations
• While outbound asset transfers were taxable,
  outbound stock transfers were often not, and were
  becoming more common.
• Since 1994, inversions of U.S. corporations have
  been discouraged under the Section 367(a)
  regulations, which require gain recognition on
  certain outbound stock transfers
• The existing Section 367(a) rules generally
  preserve tax-free status on outbound transfers
  where an unrelated foreign acquiror is larger and
  has been engaged in an active trade or business
  outside of the U.S. for three years.
• Congress, nevertheless became concerned about
  taxable inversions becoming widespread and
  depleting the U.S. corporate tax base.
• The result was Section 7874, added by the 2004
  Act, a statute that is designed to penalize the
  classic tax haven inversion, but by its terms can
  apply quite broadly.

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Basics of Section 7874

• Applies to Foreign Corporation Acquiring U.S.
  Corporation or Partnership where
• After the transaction shareholders or partners in
  U.S. entity own 60 (or 80) or more of a foreign
  corporation by reason of their ownership of the
  U.S. entity
• The foreign corporation directly or indirectly
  acquires substantially all the assets of the U.S.
  entity and
• The foreign corporation does not have a
  substantial presence in its country of
  incorporation.
• Acquisitions of U.S. corporations by foreign
  corporations that do not result in the foreign
  corporation being treated as a domestic
  corporation under 80 test of Section 7874 must
  still run the gauntlet of the Section 367(a)
  regulations.
• Notwithstanding Section 7874, interest in
  inversions remains high, in part because of the
  perceived burdens of being a public company in
  the U.S. (e.g., the effect of Sarbanes-Oxley).

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Impact of Section 7874

• Foreign corporations meeting the 80 threshold
  are treated as domestic corporations for U.S. tax
  purposes.
• Shareholders not taxable under Section 367(a)
  because no transfer to foreign corporation.
• Considerable uncertainty over the impact of dual
  characterization, outside of tax haven setting.
• Some companies wishing to list on non-U.S. stock
  exchanges have considered inverting to low-tax
  jurisdictions and accepting domestic tax status.
• Foreign corporations meeting the 60 threshold
  are treated as foreign corporations, but lose the
  ability to use tax attributes to offset income or
  gain from the transfer or license of property or
  to deduct certain compensation.
• Shareholders may also be liable for tax on gain
  recognized under Section 367(a) regulations.

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Issues Under Section 7874

• ISSUES
• Treatment of related party interests for purposes
  of the 60 (and 80) test
• What constitutes substantial presence in
  country of incorporation?
• Calculation of 60 and 80 tests in context of
  contemporaneous or related stock issuances
• Treatment of options
• Transactions involving foreign partnerships

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December 2005 Regulations RelatedParty
Interests

• In general, stock of the foreign acquirer held by
  one or members of the expanded affiliated group
  (EAG) is disregarded (i.e. not included in the
  numerator or denominator) for purposes of
  determining whether the 60 or 80 test is met.
• The effect of this rule is the prevent so-called
  hook stock (i.e., stock of the foreign parent
  owned by a subsidiary) from affecting the
  application of the 60 or 80 tests.
• Special rules allow for the inclusion of
  affiliate owned stock (other than hook stock) in
  the denominator, but not the numerator, if
• Either the common parent owns directly or
  indirectly at least 80 of the domestic entity
  before the transition and continuing owners that
  are not members of the EAG hold no more than 20
  of the acquiring foreign corporation, or
• The former owners of the domestic entity do not
  own directly or indirectly more than 50 of any
  member of the EAG.

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June 2006 Regulations - Definition of substantial
presence

• Regulation Section 1.7874-2T provides guidance on
  substantial business activities in foreign
  country of incorporation.
• The temporary regulations provide a facts and
  circumstances test and a safe harbor test.
• The facts and circumstances test compares
  business activity in the country of
  incorporation, taking into account only the
  relevant factors, to the total business
  activities of the EAG. The relevant factors are
• Historical presence in the foreign country,
• Operational activities, indicated by property,
  services or sales,
• Substantial management activities,
• Substantial degree of ownership by investors
  resident in the foreign country, and
• Strategic business activities in the foreign
  country.
• Will the IRS issue private letter rulings under
  the facts and circumstances test?

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Substantial Business Activity Safe Harbor

• Under the safe harbor test of Treas. Reg. Section
  1.7874-2T(d)(2), the EAG will have substantial
  business activities if all of the following tests
  are met
• Employees based in the foreign country account
  for at least 10 percent (by number and
  compensation) of total employees,
• The total sales of tangible assets in the foreign
  country is at least 10 percent of the groups
  total assets, and
• Sales within the country (over a prescribed
  12-month period) account for at least 10 percent
  of total group sales.
• Intangible assets are excluded from the asset
  test, in part because of the uncertainty related
  to the location of such assets.
• A number of examples are provided under both the
  facts and circumstances test and the safe harbor
  test and the guidance clearly suggests that
  inversions may still be possible under the right
  circumstances, most likely to a non-tax haven
  jurisdiction.

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Other Aspects of June 2006 Regulations

• Acquisition of stock of domestic corporation by a
  foreign corporation is an indirect acquisition of
  properties unless stock of domestic corporation
  already owned by foreign corporation
• Acquisition of interest in partnership holding
  stock of domestic corporation is an indirect
  acquisition of a proportionate amount of the
  assets held by the domestic corporation
• Acquisition of stock in domestic corporation by
  corporation controlled (more than 50) by a
  foreign corporation is an indirect acquisition.
• Stock in the acquiring foreign corporation by
  reason of holding stock in the domestic
  corporation will be determined on the basis of
  relative values, when, for example, the
  exchanging shareholders are also receiving stock
  in exchange for other property.
• This could include stock issued for cash or other
  property as part of a new financing
• The preamble notes that this rule is subject to
  the application of Section 7874 (c)(4) which
  requires that transfers will be disregarded if
  they occur as part of a plan to avoid Section 7874

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Other Aspects of June 2006 Regulations (contd)

• Options and similar interests held by reason of
  holding stock in the domestic corporation or
  partnership are treated as exercised, if the
  effect is to treat the foreign entity as a
  surrogate foreign corporation
• Where a surrogate foreign corporation is treated
  as a domestic corporation (other than from
  inception such as in the case of a newly-formed
  foreign corporation), the conversion is treated
  as an F reorganization, subject to all of the
  relevant provisions of the Code, including the
  Section 367(b) regulations.
• Treatment of Publicly-Traded Foreign Partnerships
  (PTPs)
• Treated as foreign corporations for purposes of
  Sec. 7874 tests.
• If meet 80 test, foreign PTP is taxed as a
  domestic corporation.
• Comments requested on extending treatment to
  foreign non-PTPs.
• Impact of any regulations potentially
  far-reaching given extensive use of foreign
  partnerships as investment vehicles