Can companies have their consolidation cake and eat it too? When it comes to having a stock repurchase program and a tax-favorable reorganization status for a merger at the same time, the answer is not obvious.
The tax code at Sec. 368(a)(1)(A) states that a “statutory merger or consolidation” constitutes “reorganization.” However, it is well known that mere compliance with the statutory language is not sufficient; a merger will only constitute a reorganization if, among other things, it satisfies the judicially-inspired continuity of interest requirement. This standard is what distinguishes a transaction entitled to partake of the benefits of reorganization status from a taxable sale.
Qualification as a reorganization is highly desirable; the target shareholders can exchange their stock for stock in the acquiring corporation on a tax-free basis and the target’s assets can be transferred out of its “corporate solution” on that same tax-free basis.
The continuity of interest requirement, which has been memorialized in the regulations (See Reg. Sec. 1.368-1(e)), is satisfied if a “substantial part” of the value of the proprietary interests in the target are preserved in the potential reorganization. For this purpose, a proprietary interest is so preserved when it is exchanged for a proprietary interest in the issuing corporation.
Conversely, a proprietary interest is not preserved when it is exchanged in the merger for cash or other property. Moreover, a proprietary interest is not considered preserved when stock of the issuing corporation furnished in exchange for a proprietary interest in the target is, as part of the plan, repurchased by the issuing corporation or otherwise re-acquired by a person related to such issuing corporation — so continuity of interest is in danger of being flunked.
Other disposals of issuing corporation stock by the shareholders of the target do not detract from continuity even if planned or intended at the time of the merger. In a major concession, which had the effect of largely eliminating the notion of “post-merger continuity,” the Internal Revenue Service has stated that a “mere disposition” of stock of the issuing corporation subsequent to the merger to persons not related to the issuing corporation will, for continuity of interest purposes, be disregarded.
With respect to the notion of a “substantial part,” the I.R.S. has announced that it considers 50 percent continuity of interest to be sufficient. The percentage represents the proportion of equity consideration to aggregate consideration received for the transferred assets. It does not represent the percentage of the issuer’s outstanding stock conveyed to the target’s shareholders.
Although the I.R.S.’s preference for at least 50 percent continuity is well known, the courts have endorsed a lesser standard. Thus, in the landmark 1935 Supreme Court case, Nelson v. Helvering, the Court found a reorganization in a case in which the target’s assets were transferred to the acquirer for the latter’s preferred stock (amounting to 37.5 percent of the aggregate consideration) and cash, representing the balance of such consideration. In light of the Nelson decision, most practitioners feel comfortable rendering opinions at continuity of interest levels of 40 percent and above.
As indicated, repurchases of stock issued in a merger, by the issuing corporation or by a person related to such issuing corporation, which are seen as “part of the plan”, will detract from continuity. However, certain repurchases will not have a deleterious effect on this requirement. Thus, in LTR 200132007, a corporation acquired another corporation in a statutory merger in exchange for an equal mix of its stock and cash.
Therefore, on its face, the merger met the continuity of interest requirement (it exhibited 50 percent continuity) and, hence, constituted a reorganization. However, the issuing corporation had in place a stock repurchase plan at the time of the merger, and its potential impact, with respect to the continuity test, had to be evaluated.
The I.R.S. concluded that the repurchase plan would not have an adverse effect on this requirement for the following reasons:
- It complied with the guidelines set forth in Rev. Rul. 99-58, regarding repurchase plans. Thus, the repurchase plan was in existence prior to the merger and it was not modified in connection with the proposed transaction.
- The repurchases would be made on the open market through a broker. As a result, the issuer would not know the identity of the sellers of its stock nor would a former target shareholder, who chose to liquidate his or her holdings in the issuing corporation, know whether the issuing corporation was the buyer of the stock.
- The issuing corporation’s intention to repurchase stock was not a matter that was negotiated with the target corporation’s shareholders. Accordingly, any sales by the former target shareholders, of their acquiring corporation stock to such acquiring corporation pursuant to the repurchase program, would be “coincidental” and, accordingly, no such sales would detract from continuity.
The merger, therefore, was a valid reorganization. Thus, where a “cash option” merger — as so many are — is structured as a 50/50 cash and stock proposition, a repurchase plan can upset this precarious balance. However, if the guidelines laid out in Rev. Rul. 99-58 are adhered to as is the case in LTR 200132007, the repurchase program will not deprive the merger of its claim to reorganization status.