With an eye to minimizing taxes, O’Reilly Automotive Inc. and CSK Auto Corp. are taking measured steps to implement an agreement reached in April. If they can secure status as a reorganization, highly appreciated O’Reilly assets can move to CSK without tax consequences and related securities can change hands on a tax-free basis.

The transaction features two crucial steps and a third at O’Reilly’s option. Whether the transaction comprises two steps or three, O’Reilly should achieve its objective, a reorganization with the meaning of Section 368(a) of the tax code.

First, O’Reilly launched a tender offer for CSK shares. In exchange, CSK shareholders were slated to receive some number of shares linked to their trading price in a specified measurement period. For each tendered share accepted for purchase, CSK shareholders will receive fractional shares of O’Reilly, plus $1 in cash if selected deal-related expenses exceed fixed thresholds.

On completion of the tender offer, the O’Reilly subsidiary that launched it (and which will be in possession of a majority of CSK stock) will merge with CSK. Remaining CSK stock will eventually convert into a “merger consideration.”

Tender Offer and Reverse Merger

The O’Reilly transaction closely resembles an example in Internal Revenue Service annals. “Sigma” Corp., a wholly owned, newly created subsidiary of “Psi” Corp., launched a successful tender offer to exchange Psi voting stock for not less than 51 percent of the stock of unrelated “Tau” Corp. Immediately after completing the tender offer, Sigma and Tau merged. Tau holdouts eventually exchanged their remaining 49 percent of outstanding stock for Psi voting stock and cash.

The IRS verdict was hard to predict: qualifications for reorganization apply subject to particular requirements. Questions arose because “in the transaction,” the former shareholders of the surviving Tau corporation must exchange, in return for voting stock of the controlling corporation Psi, an amount of stock in the surviving corporation that constitutes “control” [see Section 368(a)(2)(E)(ii)]. Here, control means ownership of stock possessing at least 80 percent of the total combined voting power of all classes of voting stock plus at least 80 percent of the total number of shares of each class, if any, of the nonvoting stock.

The outcome hinged on contours of the transaction. A transaction comprised solely of the reverse merger (of Sigma with and into Psi) would not have satisfied the “control for voting stock” requirement. In the transaction, the Tau shareholders would have exchanged substantially less than 80 percent of Tau’s stock for voting stock of Psi [see Revenue Ruling 74-564, 1974-2 C.B. 124].

Fortunately, the ruling leaves room to negotiate. “Under general principles of tax law including the step-transaction doctrine, the tender offer and the merger are treated as an integrated acquisition by Psi of all of Tau’s stock.” The ruling cites principles embedded in King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969). That decision treated the tender offer as part of the statutory merger for purposes of the reorganization provisions. Consequently, the ruling concludes that the steps must be evaluated together to determine whether the requirements of Section 368(a)(2)(E) are met. So viewed, the transaction met the requirements of Section 368(a)(2)(E) because, “in the transaction” (comprised of both the tender offer and second step merger), the former Tau shareholders exchanged some 81 percent of Tau stock for voting stock of Psi.

In like fashion, if the CSK/O’Reilly transaction is limited to two steps, the tender offer and subsequent merger, it seems clear that the integrated transaction will qualify as a reorganization. Notwithstanding the cash consideration (as much as $1 per CSK share), well in excess of 80 percent of the CSK stock, a controlling interest, will have been exchanged “in the transaction” for voting stock of O’Reilly.

Potential Third Step

It is possible that the transaction will feature a third step at O’Reilly’s discretion. Once the downstream merger is done and CSK has become a wholly owned subsidiary of O’Reilly, O’Reilly may cause CSK to merge “upstream” with and into an LLC created by O’Reilly for this purpose. The LLC would be treated as a “disregarded entity.” For tax-analysis purposes, this potential third step would be viewed as a direct merger of CSK with and into O’Reilly.

If the third step is executed, it seems likely that each of the tender offers, downstream and upstream, would satisfy expressed intentions of the parties — and be viewed as an integrated transaction. This integrated transaction would be treated as a direct merger of CSK with and into O’Reilly in exchange for a combination of O’Reilly voting stock and cash.

In this event, the preliminary steps, the tender offer and downstream merger, would be ignored. Instead, the transaction would be “telescoped” into a “two-party merger” of CSK with and into O’Reilly [see Revenue Ruling 2001-46, 2001-2 C.B. 321]. The two-party merger would qualify as a reorganization as under Section 368(a)(1)(A). Statutory mergers or consolidations constitute reorganizations when, as here, the transactions exhibit sufficient degree of “continuity of interest” (COI). The COI requirement is met when the potential reorganization preserves a “substantial part” of the value of the proprietary interests in the target company [see Reg. Sec. 1.368-1(e)(1)(i)]. A proprietary interest is so preserved when it is exchanged for a proprietary interest in the issuing corporation. Postmerger, CSK shareholders will exceed the minimum proprietary control in O’Reilly. Thus, the two-party merger that will arise if O’Reilly takes the third step and causes CSK to merge with and into O’Reilly should, without any doubt, constitute a “good” “A” reorganization.

Warning to merger partners that seek status as a reorganization: when taking the third step, structure it as a merger, not a liquidation. Such a misstep would have cost the CSK shareholders the benefits of reorganization. Instead, for reasons that are detailed in Revenue Ruling 2008-25, I.R.B. 2008-21 (May 8, 2008), the CSK shareholders pay a tax on the exchange of their exchange of CSK stock for O’Reilly stock (and cash). O’Reilly would secure a cost basis (rather than a carryover basis) in CSK’s stock but not with respect to CSK’s assets. As a consequence, O’Reilly would sacrifice the enhanced depreciation and amortization deductions that accompany such a basis step-up. Here, however, the provisions of Revenue Ruling 2008-25 should have no application because when companies take the third step, it must take the form of a merger.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

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