Print this article | Return to Article | Return to CFO.com
The reverse merger between Merck and Schering-Plough was not done to garner tax-free status - although it will - but to maintain a business relationship with J&J.
Robert Willens, CFO.com | US
March 16, 2009
Merck's acquisition" of its rival, Schering-Plough is being structured in an unusual manner. Despite the relative sizes of the two companies (Merck is vastly larger than Schering and has, by far, the higher market capitalization), Schering will function as the "issuing" corporation in the transaction.
Merck will become a wholly-owned subsidiary of Schering and the latter will change its name to Merck. Thus, the transaction can best be described as a "reverse merger," one in which the smaller company acquires the larger.
This technique is being used primarily for the purpose of insuring that Schering's joint venture with Johnson & Johnson is not imperiled by the Merck acquisition. Apparently, the joint venture agreement's termination provision (which is premised on a change in control of either party) will not be triggered by a business combination in which Schering is the surviving corporation.
That will be the case in the Merck/Schering combination even though, for financial accounting purposes, Schering will be regarded as the acquired entity1. As a result, the parties are hoping that the merger structure will foreclose any ability on Johnson & Johnson's part to abrogate agreements with Schering with respect to important products such as Remicade and Golimumab, both used in the treatment of rheumatoid arthritis as well as other conditions.
Interestingly, the reverse merger is not being used for the usual reason - to "finesse" the continuity of interest (COI) requirement. For a merger, or other acquisitive transaction, to qualify as a tax-free reorganization, it must exhibit, among other things, COI.2 Specifically, the tax code notes that "Requisite to a reorganization...are a continuity of business enterprise...and (except as otherwise provided in Sec. 368(a)(1)(D)) a continuity of interest."
A merger exhibits COI if, and only if , a substantial part of the value of the proprietary interests in the target corporation are preserved in the potential reorganization.3 A proprietary interest is preserved when it is exchanged for a proprietary interest in the issuing corporation. Conversely, the interest is not preserved when it is acquired by the issuing corporation for consideration other than stock in the issuing company.
However, it is well-settled that the COI test does not apply to the acquired corporation or its shareholders.4 So in cases in which the issuing corporation is not offering sufficient stock to meet the COI test, the path of least resistance is to reverse the "direction" of the merger.5 (For a proprietary interest in the target company to be considered preserved, at least 40 percent of the aggregate consideration must consist of such stock.)6
Essentially, in cases in which not enough stock is offered, COI is satisfied because it only applies to the (technical) acquired corporation and its shareholders. In the Merck/Schering case, the acquiring corporation is the corporation whose shareholders will be "cashed out" in excessive numbers.Alternatively, the parties may wish, through the "horizontal double dummy" structure, to bring the case under the more permissive provisions of Section 351, which has no COI requirement.7
However, a merger of Schering with and into Merck would have met the COI test since fully 56 percent of the consideration conveyed to Schering shareholders would have consisted of Merck stock. Therefore, it seems safe to say that, in the instant case, the reverse merger format is being used exclusively for non-tax reasons.
The Merck/Schering transaction features the following steps. Schering will form two subsidiaries (MS1 and MS2) for the sole purpose of completeing the merger. As part of an overall plan:
When the dust settles, Merck will be a wholly-owned subsidiary of Schering, and the latter will have changed its name to Merck. The former shareholders of Merck will emerge with approximately 68 percent of the stock of Schering. Meanwhile, Schering shareholders will have received $10.50 per share in cash and retained Schering stock representing some 32 percent of its post-merger outstanding stock.
For tax purposes, it seems certain that the transitory existence of MS1 will be disregarded (MS1 is, after all, both created and extinguished in the course of an integrated transaction). The transaction, therefore, will be treated as if Schering had redeemed 44 percent of its stock from its shareholders, and those shareholders retained the remaining 56 percent of their stock.8
Under Section 302(a) of the tax code, the redemption element of the transaction should be treated as a distribution, in part or full payment, in exchange for the stock redeemed. That's because each redeemed shareholder will suffer a "sufficient" reduction of his or her proportionate interest in Schering.
In making this determination, we would compare the shareholder's proportionate interest in Schering - before any steps of the integrated transaction are undertaken - with proportionate interest after all of the steps have been completed. In doing so, consider an IRS revenue ruling, that uses a redemption transaction that is similar to the Schering case (See Rev. Rul. 75-447, 1975-2 C.B. 113). In the ruling, the redemption is accompanied by an issuance of new stock (or by a sale of stock), and both steps are clearly part of an integrated plan to reduce a shareholder's proportionate interest. As a result, effect will be given only to the overall result for purposes of Section 302(b) of the tax code, and the sequence in which the events occur will be disregarded.
Moreover, there is little doubt that the Merck merger will qualify as a tax-free reorganization. In fact, the transaction appears to qualify, concurrently, as both an "A" reorganization as well as a "B" reorganization. The transaction should qualify as an A reorganization (by reason of Section 368(a)(2)(E)) because the former shareholders of Merck will be exchanging, for voting stock of Schering, an amount of Merck stock constituting control. After the transaction, Merck will hold substantially all of its properties and those of MS2.
Furthermore, the transaction - if we disregard the transitory existence of MS2 - should also qualify as a B reorganization because: (1) the stock of Merck will have been acquired by Schering solely in exchange for voting stock of Schering; and (2) immediately after the acquisition, Schering will be in control (within the meaning of Section 368(c)) of Merck.9 In short, there does not appear to be any tax impediment whatever to the expeditious completion of this historic transaction.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com
1See SFAS No. 141(R), Business Combinations. In a business combination completed primarily by exchanging equity interests, the acquirer is usually the entity that issues its equity interests. However, in some business combinations, called reverse acquisitions, the issuing entity is the acquiree. That will be the case where the owners of acquired entity will own, as a group, the largest portion of the voting rights in the combined entity. The instant transaction seems to be the textbook reverse acquisition. In addition, Merck will not be entitled to write-off, in the period in which the deal is completed, the amount attributable to Schering "in-process" R&D. Accordingly, the amounts ascribed to this asset will have to be capitalized and amortized (or written off if earlier found to be impaired) in the same manner that amounts allocated to other "identifiable intangible assets" must be.
2 See Regulation Section 1.368-1(b) of the U.S. Tax Code.
3 See Regulation Section 1.368-1(e)(1)(i).
4 See Revenue Ruling 70-223, 1970-1 C.B. 79.
5 See Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, paragraph 12.21.
6 See Regulation Section 1.368-1T(e)(2)(v), Example 1.
7 See Revenue Ruling 84-71, 1984-1 C.B. 106; the Service has concluded that the fact that the larger acquisitive transaction fails to meet the requirements for tax-free treatment under the reorganization provisions of the Code does not preclude the application of Sec. 351 to transfers that may be described as part of such larger transaction but also, either alone or in combination with other transfers, meet the requirements of Sec. 351.
8 See Revenue Ruling 78-250, 1978-1 C.B. 270.
9 See Revenue Ruling 67-448, 1967-2 C.B. 144.