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After a corporation acquires all the stock of another corporation in an intended tax-free reorganization, management of the acquiring corporation frequently considers simplifying the corporate entity structure by eliminating the subsidiary corporation. It may be desirable to avoid separate payroll administration, separate company accounting and intercompany contracts. This article discusses how the form of the transaction used to eliminate the subsidiary corporation can adversely affect the intended tax consequences of the initial acquisition.

Structure of the Acquisition
Acquisitions of target corporations frequently involve a “reverse triangular merger” under state corporate law, where an acquiring corporation’s newly formed merger subsidiary (“Merger Sub”) merges into the target corporation (“Target”), with the Target’s shareholders surrendering their Target stock in exchange for merger consideration.

Acquisition Merger:

• Non-Tax Structural Benefits of Reverse Triangular Merger

As a result of the reverse triangular merger, the Target becomes a subsidiary of the acquiring corporation (“Acquirer”), so that the Acquirer’s assets may be insulated from the Target corporation’s liabilities. The Target’s assets (including contracts with third parties) remain owned by the Target and do not need to be assigned to either the Merger Sub or the Acquirer. Also, if the Acquirer later has “buyer’s remorse” as to its acquisition of the Target, it may be easier to dispose of the Target if it is not fully integrated into the Acquirer.

• Tax Structural Disadvantages of a Reverse Triangular Merger Compared to a Direct Merger or a “Forward Triangular Merger”

A reverse triangular merger does not qualify as a Section 368 tax-free reorganization unless, among other requirements, at least 80% of the Target corporation’s voting stock and nonvoting stock is acquired solely for Acquirer voting stock. In other words, consideration other than Acquirer voting stock, such as cash or other property, is limited to 20% of the total merger consideration. This 20% limitation does not apply to a direct merger of a Target into the Acquirer, referred to in this article as a “Direct Merger.” Nor does the 20% limitation apply to a merger of the Target corporation into the Merger Sub, with the Merger Sub being the surviving corporation, known as a “Forward Triangular Merger.” Instead, the merger consideration mix for a Direct Merger or a Forward Triangular Merger may consist of up to 50% cash or other property under an IRS guideline, or up to approximately 55-60% cash or other property under case law.


Form of Subsequent Combination Determines the Tax Consequences
Acquirers often want to avoid separate payroll administration and eliminate the need for intercompany contracts and separate company accounting. After further analyzing the Target’s liabilities and the difficulty of assigning contracts from the subsidiary corporation to the parent corporation, Acquirers frequently determine that the benefits of eliminating the subsidiary outweigh the legal risk and cost of eliminating the subsidiary. When this occurs, tax advisors are often asked about the U.S. federal income tax effect a subsequent liquidation or “Upstream Merger” of the Target into the Acquirer will have on the prior Acquisition Merger. Although the substance is the same, the form of the subsequent combination determines the income tax consequences.

• Liquidation or De Facto Liquidation

If the subsequent entity combination takes the form of a liquidation under state corporate law (rather than a merger under state corporate law), and if the liquidation was part of the overall acquisition plan, the acquisition will be tested under more restrictive income tax requirements of a “C Reorganization.” Under the C Reorganization requirements, if there is any consideration other than stock delivered by the Acquirer to the Target shareholders in consideration for the Target stock, then the Acquirer must acquire at least 80% of the fair market value of all of the property of the Target solely for voting stock. Stated more simply, the sum of the consideration other than stock and liabilities assumed (including contingent or un-booked liabilities) cannot exceed 20% of the fair market value of the Target’s assets. Note that this C reorganization test differs and is more restrictive than the test for a reverse triangular merger, which is based on a 20%/80% measure of total consideration, ignoring Target liabilities.


A corporation may be treated as if it had liquidated (a de facto liquidation) for income tax purposes, even if the corporation is not formally liquidated under state corporate law. If, subsequent to an Acquisition Merger, the Target’s employees are moved to the Acquirer’s payroll, all of the Target’s former products are sold by the Acquirer, and there is no intercompany agreement providing, for example, a chargeback of licensed intellectual property, there is a significant risk that the Target may be viewed as having undergone a de facto liquidation. If the de facto liquidation is integrated with the Acquisition Merger, then the integrated transaction would be tested under the less favorable C reorganization rules rather than the Direct Merger rules.

• Upstream Merger

When the Acquisition Merger is a reverse triangular merger, if the Target is eliminated in the form of a statutory merger, and if the step transaction doctrine applies to treat the Acquisition Merger and the Upstream Merger as an integrated transaction, the integrated transaction should be tested under the requirements of a tax-free Direct Merger. If the Acquisition Merger satisfied all the requirements for a tax-free reverse triangular merger, then there should be no reason why an integrated transaction should not qualify as a tax-free Direct Merger.


Previously, there was some uncertainty caused by a few private letter rulings in which the IRS made the unfortunate statement that a subsequent “liquidation or merger” following a reverse triangular acquisition merger would be treated as a C reorganization. The IRS has subsequently issued numerous private letter rulings and a Revenue Ruling which indicate that provided the acquisition reverse triangular merger and the Upstream Merger are treated as steps in an integrated transaction and the acquisition merger and the Upstream Merger qualify as statutory mergers under applicable state law, then the Acquisition Merger and the Upstream Merger will be treated as if the acquisition had been a Direct Merger. In the Revenue Ruling, the IRS announced that the collapsed Direct Merger can qualify as a Section 368 reorganization even if the Acquisition Merger would not, by itself as a reverse triangular merger, qualify as a Section 368 reorganization.


Although an Acquisition Merger structured as a forward triangular merger followed by an integrated Upstream Merger ought to be treated the same as if the acquisition had been a Direct Merger, IRS rulings test the transaction under the C Reorganization requirements. For this reason, it remains common for Target counsel to require Acquirer to either represent that it does not plan, or agree that it will not, liquidate or merge the subsidiary into the Acquirer until one or two years after a forward triangular merger.


Structural Advantages of Two Step Acquisitions
For corporate law or business reasons (for example, to avoid assignment of contracts at closing), an acquisition may be structured in steps involving either a reverse triangular merger or stock tender offer as the first step and an Upstream Merger or a “sideways merger” of the Target into another subsidiary of the Acquirer as the second step. There is authority which supports the view that a reverse triangular merger followed by a “sideways merger” into another subsidiary of the Acquirer, in an integrated transaction, should be treated as a forward triangular merger of the Target into the subsidiary.


Although two step acquisitions are not the one size fits all preferred acquisition strategy, it may be beneficial to utilize the two step acquisition structure, with a subsequent Upstream Merger or sideways merger as the second step, where there are efficiencies obtainable with an initial reverse triangular merger.


Conclusion
A reverse triangular merger with the Target remaining a subsidiary indefinitely is often the optimal acquisition structure, and there may be no need or desire to merge the Target into the Acquirer. Where it is preferable to eliminate the subsidiary after an Acquisition Merger intended to be a Section 368 tax free reorganization, care should be taken to ensure that the form and timing of elimination of the subsidiary does not adversely affect the prior Acquisition Merger. When “sinking the sub” bear in mind the likely consequences, as set forth in the following chart.

Acquisition	Integrated Second Step	Likely Consequence/Test
Reverse Triangular Merger	Upstream Merger	Direct Merger
Reverse Triangular Merger	Liquidation or Deemed Liquidation	C Reorganization Test
Reverse Triangular Merger	Sideways Merger	Forward Triangular Merger
Forward Triangular Merger	Upstream Merger	Uncertain
Forward Triangular Merger	Liquidation or Deemed Liquidation	C Reorganization Test
Stock Purchase	Upstream Merger	Direct Merger
Stock Purchase	Sideways Merger	Reverse or Forward Triangular Merger
Stock Purchase by Sub	Upstream Merger	Forward Triangular Merger
Stock Purchase by Sub	Downstream Merger	Reverse Triangular Merger

David Plewa is a partner and Eric Swenson is an associate in Gray Cary’s Tax Group.


Copyright © 2002 Gray Cary Ware & Freidenrich LLP