The Rules that Launched a Thousand Deals?

A recent cross-border merger met some thorny IRS requirements – including passing the Helen of Troy test – to capture tax-free status as a reorgani...
Robert WillensAugust 18, 2008

Called the merger of “generic giants” by the New Jersey press, Jerusalem-based Teva Pharmaceutical Industries announced a definitive agreement in July to acquire the properties of Barr Pharmaceuticals in a transaction that will be structured as a “forward triangular merger.” A few potential snags could have thwarted the companies’ bid for tax-free treatment — namely clearing the continuity of interest hurdle and the Helen of Troy tests. But it looks like the cross-border union of pharma companies have the right prescription to nab a healthy tax benefit.

Barr, which is based in Montvale, New Jersey, is slated to merge with and into a newly-created domestic subsidiary of Teva, and the merger deal calls for Barr stock to be converted into the right to receive 0.6272 ordinary shares of Teva (to be represented by American Depository Receipts) and $39.60 in cash. What’s more, the merger partners plainly expressed their intent that the deal meet the requirements for treatment as a tax-free reorganization within the meaning of Section 368(a) of the tax code.

By tracking the deal specifics and a few tax code subsections, it becomes clear that the pharmaceutical companies should not have a problem passing muster. To start, under Section 368(a)(1)(A) of the code, an acquisition made by a subsidiary of the properties of a target in exchange for stock of the acquiring corporation’s parent qualifies as a reorganization by reason of another subsection — Section 368(a)(2)(D) — if a few criteria are met.

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For example, the subsidiary must be a first-tier subsidiary of the issuing corporation (Teva); the target must be merged with and into such subsidiary; the subsidiary must acquire “substantially all” of the properties of the target; no stock of the acquiring subsidiary can be used in the transaction (to compensate the target shareholders for their stock); and the transaction would have qualified as an ‘A’ reorganization had the merger been effected directly into the issuing corporation.

The “could have merged” test means only that the general requirements of a reorganization — in addition to the special requirements imposed by Section 368(a)(2)(D) — must be met. It is not relevant under the test, for instance, that a merger of the target and the issuing parent could have been effected under state or federal corporation law. (See Regulation Section 1.368-2(b)(2).) What is relevant, however, is that the general reorganization requirement of the continuity of interest requirement is met. In other words, the merger’s claim to reorganization treatment boils down to whether Teva will be issuing a sufficient amount of its stock to meet the COI requirement.

Continuity of Interest

The merger meets the COI requirement only if a “substantial part” of the value of the proprietary interests in the target corporation are “preserved” in the transaction. (See Regulation Section 1.368-1(e)(1)(i). ) The purpose of the COI requirement is to prevent transactions that “resemble sales” from qualifying for tax-free treatment — that is, qualifying for non-recognition of gain or loss.1 For this purpose, a proprietary interest is preserved when it is exchanged for a proprietary interest in the issuing corporation. Conversely, a proprietary interest is not preserved when, in connection with the potential reorganization, it is acquired by the issuing corporation for consideration other than stock of the issuing corporation.

Regarding the notion of a “substantial part,” the Internal Revenue Service has announced in recently issued regulations that it considers 40 percent to be sufficient. In short, COI will be satisfied if at least 40 percent of the value of the aggregate consideration conveyed in the transaction to the target’s shareholders is comprised of stock in the issuing corporation.

How does timing affect the transaction with respect to COI? In one significant way, especially if COI is measured at the time the merger contract goes into effect. Consider a situation in which the value of the issuing corporation’s stock declines during the period between the transaction’s announcement date and the “effective time.” In that case, the stock consideration value may dip below the 40 percent threshold, calling into question the deal’s status as a reorganization. Fortunately, the regulations (see Regulation Section 1.368-1T(e)(2)) address such a situation.

For purposes of determining whether an appropriate amount of value is preserved, the stock to be exchanged is valued on the last business day before the first date the deal is binding. At least that’s the case if the contract provides for fixed consideration. That means that, as is the case with the Teva/Barr merger, the contract provides both the number of shares of each class of stock of the issuing corporation and the amount of money and other property to be exchanged for all of the proprietary interests in the target.

The fact that the contract features an “anti-dilution” clause does not detract from this conclusion. The regulations expressly provide that “… the presence of a customary anti-dilution clause will not prevent a contract from being treated as providing for fixed consideration …”

Accordingly, the value of the stock consideration on the last business day before the first date on which the Teva/Barr contract was binding was $26.60 (or 0.6272 of Teva’s ordinary shares). That is exactly 40 percent of the aggregate consideration ($66.50) that comprised Teva stock. So the merger, just barely, seems to satisfy the COI requirement — and the merger should, as the partners intend, qualify as an ‘A’ reorganization by reason of Section 368(a)(2)(D).

Helen of Troy

But there is more to the IRS rules than the COI threshold. In the Teva/Barr deal, a U.S. corporation is transferred to a foreign corporation, which means additional requirements must be satisfied for the exchange to be eligible for tax-free reorganization treatment. Indeed, in this cross-border merger, the so-called “Helen of Troy” rules that related to foreign transactions must be addressed.

Under Regulation Section 1.367(a)-3(c), a transfer of stock of a domestic corporation by a U.S. person to a foreign corporation will be eligible to partake of the benefits of reorganization status only if the following conditions are met:
• 50 percent or less of both the total voting power and the total value of the stock of the transferee foreign corporation is, (1) received in the transaction by “U.S. transferors,” and (2) owned immediately after the transaction by U.S. persons who are officers or directors of the U.S. target company or that are five percent target shareholders;
• the U.S. person is not a “five percent transferee shareholder” or, if he is, he enters into a five year “gain recognition agreement;
• the active trade or business test is met — which means that the transferee has to be engaged, outside of the United States, in the active conduct of at least one trade or business for the entire 36 month period immediately before the transfer, and;
• the “substantiality” test is met — which means that at the time of the transfer, the value of the transferee is equal to or greater than the value of the target.

It seems clear that each of these tests will be met here, and the merger will qualify for tax-free treatment. Indeed, Teva satisfies the Helen of Troy tests. What’s more, Barr shareholders should grab the tax benefits because the deal provides for fixed stock consideration, and the merger partners can employ the “signing date” rule to meet the critical COI requirement, which will guard against a drop in Teva’s stock price before the deal is consummated.

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


1 See Revenue Ruling 69-6, 1969-1 C.B. 104.

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