Tax-Free Mergers? Life is Good

IRS gives tax blessing to latest wrinkle on triangular mergers
Marie LeoneJanuary 9, 2002

Sometimes the Internal Revenue Service is on your side. Just look what it’s done for mergers lately. In the past year, so-called forward triangular mergers have become very popular. In these multistep transactions, the acquiring company creates a new subsidiary by merging the target with an existing subsidiary, thereby avoiding paying a capital gains tax.

According to tax experts, the IRS grants this exemption because it considers the new company’s stock to represent a continuation of an old investment, with no gain or loss on the investment until the stock is sold.

Some clever souls have been experimenting with a variant on the triangular merger that involves one more step. In this variation, once the initial merger has been completed and the new subsidiary created, the parent company merges its assets with those of an existing subsidiary. Now it looks as if these transactions will also enjoy the tax advantages of triangular mergers.

For a while, says Glen A. Kohl, an M&A tax attorney in Cooley Godward LLP’s Palo Alto, Calif., office, there was some question and confusion about the tax treatment of this second merger. The IRS was not clear on whether the first merger would still qualify for tax-free treatment if its assets were transferred to an existing subsidiary.

Revenue Ruling 2001-46 cleared things up by de-fining the purpose and scope of the tax exemption as it pertains to these multistep transactions. First of all, the rule states that the acquiring company must establish the business purpose for the mergers, as well as the continuity of the business enterprise and continuity of income.

The rule gives companies the opportunity to realize additional strategic and operational benefits, says Mark French, a KPMG tax partner based in Washington, D.C. In particular, the acquiring company may be able to merge its acquisition into a subsidiary located in a low-tax state, or one that shares similar distribution or manufacturing channels.

But this isn’t the only good news. In a related development, the IRS is expected to finalize a proposed rule later this year that will loosen restrictions on tax-free mergers between corporations and non-corporate entities, such as limited liability companies.