Tax and Corporate Law Considerations in M&A Transactions (transcript)
This is a transcript from a speaking engagement presented by Roger Royse and Harpreet Walia on 21 June 2012 to the Bar Association of San Francisco.Additional materials on mergers and acquisitions can be found at our blog posts at Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction, Corporate Reporting of Transactions Affecting Basis, M&A Trends and Qualified Small Business Stock
Roger: Alright, I guess we will get started. Thank you, folks, for coming here today! We have a nice small group, so we can turn this into an interactive workshop as well as a webinar. I am Roger Royse and I am the founder of the Royse Law Firm. We are a business tax and corporate law firm with offices in Northern and Southern, California – Palo Alto, San Francisco, and Los Angeles. I have been practicing in this area, the Silicon Valley, primarily since 1991 and before that was on the East Coast and in the mid-West.
Now, I am primarily a tax lawyer and I have a presentation I have given many times on tax aspects of M&A to Tax Section of the State Bar as well as a lot of accounting and CPA groups. We decided for today to expand this topic, and although we are going to talk about some high level tax issues, we will also include corporate law considerations since after all we are lawyers, not accountants, and we have to deal with the legal and corporate aspects as well as the tax aspects.
So joining me for this presentation and webinar is Harpreet Walia who is a corporate law attorney here in our San Francisco office. He has been with us a couple of years, has a substantial amount of experience on corporate transactions. Harpreet and I have double teamed quite a few M&A deals in the last couple of years, so I thought what we would do is go through the set of slides that again are primarily tax-based but talk about the corporate aspects as we do that.
Now, we have a handout which is in the back. It is the set that I am going to go through on the PowerPoint. And if you like a soft copy of that, please just leave me your card or an email address and I am happy to send that to you or you can find it posted eventually on both Slideshare and royseuniversity.com. So I guess by way of background coincidentally, this has been a busy week for me. I have done a couple of panels, actually six of them by the time the week is done, on six different topics.
This morning it was equity compensation in Palo Alto and as we were talking about different equity compensation plans, somebody asked when they should start thinking about exits. And I said, “You should start thinking about that about the time you file your Articles of Incorporation.” It is never too early to start this kind of planning. We should always be cognizant of some of these issues and as we go through this in the next hour I think we are going to hit on some of the places where good planning is really, really important and I want to make this very practical since we are practitioners and give you some real nuts and bolts about it.
But in my mind when a client comes to me and says “Gee, I’d like to sell my company” – and we are most often on the sell side, sometimes on the buy side – I have to consider the source here. My focus generally is sell side and that is what I am going to spend most of my time thinking about here. But when they come to me and say “Gee, I want to sell my company,” the first thing I think of is, well, (1) is it going to be taxable or non-taxable and (2) do we care?
We will typically walk into my office and hopefully they have just started to think about the process and have not hired any brokers yet. God forbid, they have not signed a letter of intent. They just have a company and they know that they are in a state of pre-transaction readiness. So I guess the first thing I want to just put out there as a practice item is, Harpreet, what do you typically see? When do you generally get involved in this process? And when should the lawyer be brought into the sale of a business transaction?
Harpreet: We always like to say as early as possible; hopefully as early as when you are, as Roger mentioned, founding the company. One of the questions we always ask when we found the company is “What is your exit strategy?” because as Roger mentioned, the way you set up your company can have lasting consequences and I do not think companies give that a lot of thought. So I guess in an ideal world we would like to be with them from the day they started incorporation, but if we are not we certainly would like to be there prior to the negotiation of the term sheet.
There are real practical consequences for doing this, I mean we had been involved both in the buy and sell side where unfortunately clients have come to us after they have signed the term sheet and then start asking us “Well, what are the ramifications of this?,” and sometimes it’s a bit too late. Of course, we may have to go back and negotiate both with the buyer and seller but that has real world consequences.
We were engaged by a client after they had negotiated the term sheet before consulting with us. And this buyer was a European buyer that wanted to acquire assets in the US and we determined that the most effective way for post transaction closing was for these assets to be held offshore.
Unfortunately, the buyer had negotiated a stock purchase agreement and so it kind of cuts our legs off before we got started here in terms of being able to structure something that is very tax efficient. I would say certainly if you’re representing a buyer, you need to be involved as early as possible before they even identify a target to try to understand what they want to do, how they want to grow, how they want to achieve this inorganic growth and the strategies behind it, so you want to be there early on. For the sellers, unfortunately you typically get to them after they have signed the term sheet but they have a little bit more flexibility in negotiations.
But a buyer should really be coming into a transaction with a very clear understanding. And I will tell you in this particular case we had been struggling along trying to actually have this transaction completed because the sellers had a certain expectation upon signing that term sheet and then we had it essentially turned upside down. So this has real world consequences – the earlier you get involved, the better.
Roger: Okay, great. So my checklist when somebody comes to me. Well, first of all, we would rather they have not signed a term sheet because odds are they got it wrong. There is something in it that is not right – the structure is not right, sometimes it does not make sense, sometimes they give it away (usually in my case a tax item they would not have to give away), sometimes they did not say enough about indemnification, and sometimes they have said too much. My preference is please I hope they did not sign the term sheet just so we can get the structure right before we go into it.
Secondly, it is a diligence issue. I really would like to get to a company long before they talk to a buyer, maybe long before they have had a buyer do any diligence on them, a selling company in any case, because there are problems that we can fix. And if the company has not been very diligent about keeping its legal counsel up to date, it may have legal issues that need to be straightened out – the cap table might not be right, they might have employment agreements and proprietary information agreements they need to gather up, there might be claims that they can make go away, and there might be mis-tax filings.
Almost every company messes up on nexus issues if they are doing business in other states. We can fix that really easily early on in the game, but if we wait until the buyer tells us about it we have the potential of a valuation issue or a delay in closing, or something like that. So I like to start getting in really early in cleaning up those issues.
The third thing is a tax matter and it is individual personal tax planning for the shareholders. And it is really easy sometimes for us to forget as company counsel that the ultimate constituents and beneficiaries of the transaction are the shareholders and often times there is nobody around to tell the shareholders that they ought to be talking to their estate planning people. Pre-transaction might be a good time to do some gifting, to do some leverage gifting, to establish some trust, to do some things that they are just not going to be able to do because the value is going to go up very quickly once they get into play that they are not going to do post transaction or very close to a transaction. So I like to get in very early for that reason.
The final reason is my thinking – I would like to get Harpreet’s view on this – my thinking has change dramatically in the last ten years on whether a selling company should use a broker or not. If you asked me ten years ago, I would have said, “Of course not, these are people that just try to insert themselves into a transaction that’s going to happen anyway and get a big fee.”
But over the last few years I have decided that I think it might be prudent for a seller to consult with these folks to make sure that they have gone out into the market and tested the waters and they have gotten as much exposure as any to get the higher value. As a result, I have seen a lot more business brokers and bankers in this place now than there were ten years ago, a lot more. It is hardly ever that we do a deal that does not have a banker in it. And the consequence for us is that they are going to have to sign an engagement letter with the banker or broker.
I really want to get to them before they do that because those letters are always outrageously one-sided. They have provisions in there that often times double count. They have provisions that just simply do not deal with earn-outs and deferred payments which I see in almost every deal now. They always have to be tweaked and modified. But we cannot do that when the client has hired the banker and then has come to see us because now they figured out they need a lawyer. Harpreet, what is your view?
Harpreet: I agree with you. I think it is all a relation of the M&A market itself. Ten years ago, I think we had a lot of domestic buyers buying small-to mid-cap companies which we typically represent. And they could not seek them out because there were a lot of things that larger companies needed. A lot or our clients tend to be in the technology or technology-enabled space and a lot of them have some sort of international operation.
For example, if you have an off-shoring capability in India, you would have large buyers that were out there, that had not gone there that were new to these territories and they thought the easiest way of entry was to acquire someone that had this capability. So at that point, I think companies saw the value. Now obviously, since 2008 the M&A market has really come crashing down and I think also the buyers are becoming more sophisticated. They have understood the difficulties of digesting companies, even smaller companies.
So now they are reluctant to do it. If you are out there and you want to sell your company, you need to find a strategic buyer; you need to find someone who is going to value you. And typically company shareholders or officers do not have that ability amongst all the other things that we do to be able to really extract and show they are valuable and find the types of buyers that will value them for various pieces.
I think that is where a good banker or broker can show their stuff. Now certainly not all of them are created equal but once you have experience in the domain that your clients are, certainly they have these connections and I can see the strategic value and push that value. I think they are fantastic frankly. And so I agree, I think in more recent times they certainly add a lot more value. Of course, now when we see their bill compared to ours we always have second thoughts but I have to say they do add value.
Roger: Thank you. So now that we have gotten the preliminary matters out of the way, the client just came to us, we have their corporate compliance up to date, they are all cleaned up. We have dressed the baby and now the baby does not look quite so ugly and we are ready to put it out there onto the market. They have their broker; we have to decide what the deal is going to look like.
So, number one, is it going to be tax-free or is it going to be taxable? And that is the first question often times is a question of what the currency for the transaction is. Are they going to sell for cash? Are they going to sell for stock or some other sort of equity interest so that we could do a tax-free deal?
And then, number two, do we care? It may be that we do not care about taxes because we have a foreign seller that is not taxable in the US or maybe we have our company that is distressed and has lots of NOL’s which often happens down in my neighborhood. They expect to be able to shelter any of the gain by their net operating losses (NOL’s).
So it is important to kind of take a step back before we jump right in through all these hoops and bend in over backwards to make our transaction nontaxable. He may not care. In fact, it may be better to be taxable because the buyer will get a better result in a taxable deal because they get a fair market value basis and there are some arbitrageurs that might be willing to pay a little bit more for that and the seller might not care.
Sometimes I have seen that happen where people just assumed that you would rather have a nontaxable deal – that is not so. Similarly, the deal might trigger losses. You might be selling not often, but a seller could be selling at a lost and they might want it to be taxable. I have seen that happen, where what we wanted to be taxable was nontaxable just because the reorganization provisions of the Internal Revenue Code are not elective – you just deem them or not.
Then finally I want to talk a little bit before we leave about pass-through entities because I do not know about you but in the last ten years, I am seeing far more limited liability companies and I am seeing a lot of S corporations. I always have it but mostly LLC’s as remedies and that is somewhat of a whole different ball game on the legal side when we do a sale or even an acquisition. So again taxable versus tax-free, we talked about the nature of the buyers and the seller, whether they care, and the type of acquisition currency.
If it is stock, we can fit within the tax-free provisions. If it is cash, we probably cannot. So the question is what happens if we have some combination of cash and stock. And that is where in tax parlance we come up with different types. We have a merger which is just a statutory merger. It means that the companies have combined under a state law statute that allows a combination where one company goes out of existence and the other company continues in existence.
Type B is a stock-for-stock deal. We just trade stock for stock. Type C is stock-for-assets, in other words, selling company transfers its assets to acquiring company in exchange for acquiring company stock and then distributes that acquiring company stock up to its shareholders in liquidation. In Type D, we will not talk about a lot because these are not really offered. They can be acquisitive but Type D reorganizations are most often thought of when we split a company up.
If we do have some cash and some stock, we are either in a Type A or a Type C scenario, usually a merger. And the question comes up: “Well, how much cash can I get away with before the stock component is taxable?” And this is what we call continuity of interest and what I mean by that, because you will hear this term thrown around a lot by tax people, is that the shareholders of the target company have to continue interest in the buying company in order for it to be a tax-free transaction to the extent of stock. It is never tax-free to the extent of cash. They are going to be taxed to the extent they are receiving cash but they can avoid tax to the extent they receive stock if it fits within the merger requirements; the biggest one is that they not have too much cash in a deal.
The IRS safe harbor is 50%. There is a regulation that goes down to 40%. There are cases that go lower but very few lawyers will be comfortable going below 40% continuity.
So this is how it looks. Two of our corporations combined and only one survives and the assets move over. In my practice this is almost always how it happens with a couple of little variations just because it is so easy. I know when I started practicing I tried to avoid doing mergers. I would rather do asset transfers or stock blocks just to avoid having to deal with the California Secretary of State’s Office.
Again, my thinking has changed on that and I would much rather just have things happen by operation of law as opposed to trying to force them by doing the actual physical transfer of assets in exchange of stock in liquidation, even though we can get the same tax result.
Harpreet, what percentage of the transactions you do would you say now are actually statutory mergers as opposed to stock sales, stock transfer, asset sales, or asset transfers?
Harpreet: I think in the last year there has been a lot of strategic kind of reorganization and acquisitions of companies where they are combining to create value. So in those particular situations we certainly see a lot more mergers happening. Those are good merger candidates. Typically, it is a pooling of the resources to do that.
So I would say now we are probably at 25-30% to do that and I think the statutory merger works well especially if the goal down the road is also to look at some kind of outside financing because I think the venture capital community and the private equity community are more assured of having all the assets transfer through a merger. It is cleaner for them too and we are just going through one now, and that is actually one of the requirements by the VC’s. They said they were going to be funding this after we did the merger. And they said, “We want a statutory merger because we can ensure that everything transfers over.”
Roger: Right. And we also have the benefit of not having to get a 100% shareholder vote in a merger, correct?
Harpreet: That is right. What happens sometimes is when you are starting a company and you are out there and you give pieces of equity to perhaps employees over time or people that were initially founders but are no longer, and you do not have any sort of buyback right and the shares have vested. They may have different interests. They want a liquidity event in the truest sense. They want cash and they will try to holdout a transaction to the extent that they feel they have some leverage. And so in those particular situations certainly a merger is a good way to resolve those issues.
Roger: Now, let me pause for just a minute on the stock-for-stock idea because it just seems so easy, doesn’t it? Let us assume we get 100% shareholders to agree to it. We have one shareholder maybe, maybe a handful of them, and they all agree. So we do not need a merger statute to force the minorities to go along with the deal because that is one of the reasons I think we use mergers statutes. We only need more than 50% approval to make the deal happen. In stock deals, you need 100% because an acquirer wants 100% of the company they are buying.
But let us suppose we have that. An acquirer comes along and says, “Gee, it would be so much easier if I just give you some of my stock and you give me your stock and I’ve heard about these type B transactions that are tax-free.” The problem with that and the reason we hardly ever do it that way is because the rule of type B organizations is “No boot in B.”
It is easy to remember. It means one dollar of non-stock consideration makes the entire deal taxable and it is taxable to the target shareholders even though they have gotten one dollar of cash out of it. So, everybody will be tempted at some point to want to just do what should be a merger as a type B and if you are lucky you will resist that temptation because it is easy to inadvertently trip up and have some consideration moving around that you might not even know about as counsel to the companies.
For example, the acquirer organization might be paying the selling shareholders legal expenses or something like that or giving bonuses on the side or some sort of control premium. So it is really a risk that we will not often take.
Now, getting back to the ideal, there is another way to do that and I understand why we want to do the merger. But let us suppose that I as a buyer am a little nervous about that selling company and I am a little concerned that they might not even be running this company as carefully as I would have and maybe they have some liabilities out there that they don not know about and I do not know about.
Then, yes, I know we can get escrows, reps and warranties, and holdbacks but it might be something kind of big. So, Harpreet, what would you do in that scenario if you are a little worried about taking on liabilities that you do not know about of a selling target?
Harpreet: Well, if you wanted to still buy the stock, you would probably want to set up some kind of subsidiary to do the acquisition.
Roger: Good. Alright, we are going to get to that. What I was getting at, what I was trying to bait you into saying, is to do an asset deal where we can cherry pick the assets as well as theoretically the liabilities. Now, there are some liabilities you just cannot get out of, there is successor liability for some things, but for the most part we are trying to take assets but not take all the liabilities. That is why we might do it this way, right?
Roger: Now the problem with that, of course, is it is not a merger. And suppose that for our consideration of stock we do not want to be taxed on the value of the stock because it is not cash; we want to do it in a tax-free manner. Well, the Internal Revenue Code quite generously allows us to do it that way through what they call a type C reorganization. That is substantially all the target’s asset both on a gross basis and net basis in exchange solely for acquirer stock but that has some wiggle room. We can have some cash in the deal and some liability assumptions subject to some very complex limitations if the target then liquidates immediately after the transaction.
I do that once in a while whenever I see the assets are relatively easily movable and it is a big hassle because now we have a different company and there has to be a physical transfer of the asset, bills of sale and assignments, and all of those trademark assignments, etc. But you see that when you do worry a little bit about the big unknown claim out there, and I can tell you even in my career I have seen companies wiped out by things that came way out of left field like sexual harassment claims or environmental liabilities. So it could be a real concern.
But I want to go to what you just said a minute ago about using a subsidiary because that is another technique that is much more elegant if we are worried about liabilities of a company and this is a scenario, the triangular or subsidiary merger, where a parent merges with the acquirer. By operation of law it picks up all of its liabilities. It has corporate law succession to its liabilities, known or unknown, etc. So again in my world almost every deal I do is through this structure. Harpreet, maybe you can talk a little bit about what that should look like?
Harpreet: Essentially what we do is we have set up a subsidiary that essentially merges with the target. You will notice here that we have 80% and that is because of the 80% rule that Roger can fill us in on. But essentially what happens is the target merges into the subsidiary and the shareholders of target will have P stock as you can see and the surviving entity is S and it’s a wholly-owned subsidiary of P or at least 80% owned subsidiary of P. The reason to do it as we had mentioned is, well, there could be a number of reasons.
One is that you are just not ready to do integration and frankly if you look at larger companies, they typically do it this way. They are not ready to fully bring in somebody within the walls of their company. They kind of keep them outside the walls, probe at them a little bit, do the integration over time, and then slowly you will see that maybe the subsidiary level disappears and they will merge back into the company.
This is very common for acquisitions. That used to happen before because I think people got burned about having everything come up to the corporate parent level. I think this is a very good way for a buyer who still wants to have some distance of this company.
The great part is compared to an asset transfer, now you have all these assets, maybe contracts that are extremely important that transfer over to the subsidiary, and you have a merger that happens. You hope depending on these contracts it would be much easier for them to remain without going back to the customers and seeking consent unless they have some kind of changing control clause in the contracts. You have seen them more often but it is just an easier way to make sure all the assets transfer over without having to go back and get consent from various parties that are involved.
Roger: Okay. So that is why we use the subsidiary – that is the corporate law reason. So there are two kinds. Now, you will notice in the slide on your screen that we refer to that as a forward triangular meaning that S, our merger sub, is going to survive. T is going to merge into S which prior to the transaction is owned by P, parent or the acquiring company.
The other way they might do it is they merge these two companies and let the target survive. And that is usually a lot easier as a corporate law matter because the target has all the employees, it has its tax ID number, it has its contracts. It is just like a stock deal. At the end of the day, before the transaction, T shareholders owned T stock; after the transaction P owns T stock. So it’s a lot less of a hassle as a corporate law matter; there is a difference as a tax matter.
In both of these transactions, if structured properly, you get identical tax consequences. The transaction is tax-free except to the extent of vote or cash.
Now, if it fails for some reason you get drastically different consequences. If the reverse subsidiary merger fails that fails to qualify as a tax-free deal for a number of reasons that I will tell you about. That would be treated as a taxable stock sale. So there would be one level of tax at the shareholder level because it looks a lot like a stock sale. We have got just a change in shareholders.
On the other hand, if the forward were to fail or be treated as taxable because we blew one of these tax rules, we have a much worse result because that looks a lot like an asset sale, followed by liquidation. If that is taxable, there are two levels of tax – one on the asset sale and again on the stock sale.
You might be thinking “Well, gee, given that, we always do the reverse just to avoid the result?” Well, you might except it is much easier to qualify as a forward merger than it is as a reverse merger. And to be a forward merger we only have to satisfy that continuity of interest rule that I told you about earlier. Remember 50% continuity?
To qualify as a reverse triangular merger, the acquiring company has to acquire more than 80% of all classes of stock of the target. Now, that might sound easy to do but here is where it comes up and here is another practice pointer for you to take away because it is one of those not really very intuitive things. But most of the startup and small companies that I work with, they have cash flow problems when they get started.
Maybe the founders will put additional funds in and take stock back when they do it. But sometimes they will put additional funds in and they do not take anything back. They put it in an open account. If you ask them what it is, they might say it was a loan, they might say it is equity, or they might not even really have thought too much about it.
As a corporate law matter, we can clean that up. As a tax law matter, that is a problem because if they have a poorly drafted or an open account type of account somebody might say “Well, that looks like another class of stock. In fact, it looks like a non-voting stock and if that’s the case and they get paid out in the transaction, then the parent, the acquirer company, has not traded its stock for control, control being more than 80% of all classes of stock.”
It is kind of a hyper-technical, arcane, not something you would expect reason to blow the reverse manager but I can tell you tax lawyers worry about that in almost every deal. We have to look at that and I can tell you how many deals I have seen that have been recast from a reverse to a forward because of that.
Now, there are some very advance techniques for getting around this problem but for now that is the basic issue and that is why you might see one structure preferred over another.
Let us talk a little bit about contingent stock escrows and earn-outs. So to set the stage for the tax rules, I guess, Harpreet, I would like you to comment on what you typically see in terms of consideration and deferred compensation, escrows, earn-outs, contingencies.
Harpreet: Sure. To understand, essentially you have a transaction and the seller will either get cash or stock in the company. In order to sell their company, a seller or shareholders of the seller will have to make certain warranties and representations in your purchase agreement. And those warranties and representations are as to how things are in the company at the time of the acquisition and the warranties are certain representations that the company makes as to things that would happen potentially with the company’s post closing.
So the buyer, in order to ensure that these representations and warranties are true, will sometimes say “I want a certain amount of money held back in escrow to guarantee the performance or the truthfulness of these warranties and representations. And so you see in lots of transactions, I would say probably on the transactions that we do, probably about at least 40-50% will have escrow components to it or if they do not it will probably be because there is some sort of earn-out component attached.
And so the funds are held in escrow from closing proceeds for a certain period of time, typically it is between one to two years, and if the warranties and representations hold to be true then those funds in escrow are returned or given to the shareholders or the sellers and if they are not, then a claim is made by the buyer against those bonds. So the question is, from a tax perspective, how does the Code deem the funds that are held in escrow? Are they part of the consideration that you will have to pay taxes on or is it somehow deferred?
Roger: We almost always defer it. We have some flexibility here and we will always report this on the installment basis to defer and not take these amounts into income until they are actually received. And we are allowed to do that. You can change that result, of course, by contract and treat escrows as owned by the seller but I never actually seen that done. It would not really make sense.
The only place it would make some sense, and this is another gotcha that I hear about around April 15th every year, is that whenever you have deferred payments and you want to report those on the installment method. The installment method means for a cash-basis taxpayer that they pick up income as amounts are paid on an installment obligation, not before, and they don’t pay tax until then.
Well, there is a rule that if a taxpayer has more than $5 million of installment obligations in any year, then they have to pay an interest charge as if they had paid tax during the year. It takes the benefit of the obligation away.
There are planning opportunities and ways around that rule that are very easy to do but you have to be aware of the rule. Oftentimes in bigger deals you will find shareholders who thought they were not going to be taxed handsome amounts or thought that they qualify for installment method only to find out that they owe this interest charge and they could have avoided it.
So just be aware of more than $5 million of aggregate obligations for any one individual in a year and we have 453(a) issues to deal with. In the tax reorganization area, the real issue with deferred payments is how that affects this continuity analysis and discussion and we certainly have ruling guidelines on this as to how we would value those amounts.
Where it really becomes difficult is with earn-outs because with deferred payments you can present value. With the earn-out, depending on how fancy it is drafted, you do not know if you are going to hit those or not. So an earn-out in a tax-free deal could be really problematic and I am seeing it in almost every deal I see. I do not know about you, Harpreet, on earn-outs.
It is just five years ago we used to tell people to just “Don’t do it. You’re going to litigate if you do an earn-out.” I do not really tell people that anymore because I know they are going to do it anyway. Do you know what I mean by earn-out? Is everybody on the same page? Supposed I am a seller. I think my company is worth $100 because it is going to do so great. You are a buyer and you only think it is worth $50, so we decide “Well, tell you what, we’ll just defer the decision. We’ll value it based on how well it does post-transaction.”
It is hard to draft as a corporate matter I think because there are lots of issues and it is always heavily negotiated. But as a tax matter it is just basically an installment sale reporting so it’s relatively easy to deal with as a tax matter.
Harpreet: I would say even, to just elaborate on the earn-out issues, even when you draft a great document and you put in the terms that you need, you find oftentimes that the buyer has a change in strategy. I am working with a client right now. We had very clearly defined earn-out goals and targets and definitions and we spent a lot of time and we thought this is going to be great and this earn-out here is definitely not going to be a problem because we have put in all the parameters. But the buyer chose to just simply ignore the terms and conditions of the earn-out.
Now, our clients are part of this company and obviously they do not want to get into a lawsuit. And so there are always challenges no matter how well-drafted these provisions are. Companies can change strategies.
In our particular case, our client for example is selling a widget and we had very clearly defined terms of what the minimum requirements were and how many widgets had to be sold and what the minimum purchase price had to be and we have provisions that said that the buyer cannot try to circumvent the earn-out capabilities of the seller and all these things. And the buyer just decided “Well, you know what, we’re going to add this as a cog now to a bigger product. So now no one can buy this product standalone and they’re going to buy it as part of this larger product.”
So, of course, our clients have a claim. But now do they bring it? They are in the middle of this company. They have other earnings and other earn-outs tied to this. So these are really big issues regardless of how you draft them. I think the buyer controls some of that and I think the sellers need to understand that no matter what, there is a risk inherent in that and I know I always speak to a lot of CPA’s and they said, “We’re not even going to count that until we actually see it,” because I think people have seen so many issues related to them.
Roger: Okay. I just want to pause briefly to let you know again about the rise of the LLC, which you are seeing used in more and more acquisitions. We have regulations from a few years ago that say that an acquirer, instead of forming a corporation to do an acquisition, can form an LLC and do an acquisition provided that the LLC survives (because that is very much like a merger), followed by dropping the business down into a wholly-owned LLC. That works. It might not work if the target survives, so it is a subtle but important difference because in that case the acquirer is transferring the assets if the target survives and it is not transferring all of its assets because it would not qualify under the merger statutes.
I do want to get into the foreign corporations because these days the Valley is so international that almost at least half of the deals I think we are doing have an international component to it – a foreign buyer or a foreign seller or a foreign affiliate – and everybody now has to consider the foreign issues.
With the rise of the increased foreign presence in this area there has also been an increase by Congress and the Obama Administration to really tighten the screws on foreigners who cannot vote as well as foreign transactions which are viewed as potentially abusive. We are talking about assets leaving US taxing jurisdictions for the last time.
The basic rules are contained in Code Section 367 which provides that foreign corporations are not treated as corporations, except as provided in regulations. So it is kind of an odd way to word this but what it comes down to is that there is an overlay of regulation whenever you try to do a tax-free deal with foreign corporations. The overlay typically requires that the buying company has been in business for 36 months and that it is bigger than the acquired company, meaning that the acquired company shareholders are going to own less than 50% of the buying company and that we comply with fairly extensive disclosure information and sometimes what they call game-recognition agreements. So if we can satisfy all of these technical requirements we can have tax-free foreign transfers.
Now, what I really want to pause on is supposed we fail those rules for one reason or another. The biggest reason we fail is because if you have been reading the papers in the last 10 years, you have heard about a company setting up in Bermuda, moving/migrating to Bermuda or some other tax haven solely to save taxes. They were headquartered here and they moved someplace else.
I myself had a rush of semiconductor that just opted to move to Taiwan many years ago. That was not for taxes as much as it was for business reasons, but nevertheless they did it. They did not satisfy these rules that I just told you about – that the acquiring company has to be bigger and it has to have 36 months of operating history because they formed it on Monday and then merged on Tuesday. The whole objective was just to move the company and not change the shareholder base.
So they would come to my office and I would say “Well, you can do that but you’re going to violate this rule and your transaction is going to be fully taxable.” And they would say, “Well, gee, break my heart. I mean I’m a startup company. I’ve got three years of net operating losses. I can shelter all the taxable income on this and when the dust clears I’m just about to get profitable and I will have taken the deductions in the US. I’m going to take the income and outside the US so we’re going to do this anyway.”
Congress caught on to that and now we have these additional anti-inversion rules which basically provides for what they call a surrogate form of corporation. If you do that just pure migration, the one I just talked about, where you started out with Delaware in your corporate charter and you ended up with Cayman Islands on your corporate charter, the IRS will tax that corporation still as a US corporation if you have more than 80% common ownership.
If you fall below a 60% threshold, in other words if you do have a real acquirer and you only have 60% common ownership, the target shareholders ended owning more than 60% but less than 80% of the acquiring company, we w would not treat the acquiring company as a US shareholder. We will, however, deny the use of net operating losses and other tax attributes so they will base the tax on the exit.
Let us just say the IRS has pretty much shut that down subject to an exception that you could drive a MACK truck through which is foreign trade or business. So if the foreign company is actually conducting a foreign trade or business then we do not have these draconian consequences.
Joint-venture structures. So in the market in the foreign area, again this whole area is getting so international. I mean tomorrow I am speaking to a Panamanian delegation. Last week I spoke to Swiss, next week is Uruguay and Belgium, the week before was a Russian delegation. But I will just tell you it is very, very international and coming inbound, and we are seeing a lot of joint ventures where the foreign party and the US party often have much different objectives and much different issues when they do a foreign deal. The biggest overriding issue for us, when we see these deals put together, is that there is a corporate issue and a tax matter.
As a corporate matter, Harpreet, if you are representing the US company in one of these joint ventures with a foreign company and I am the foreign company, I am going to say, “Gee, I want to be in Cayman Islands or British Virgin Islands or someplace that doesn’t pay any US tax.” As a US party, what is your preference going to be as the choice of jurisdiction for the joint venture entity.
Harpreet: Well, I think we would certainly like to keep it in the US.
Roger: Absolutely, we want to keep it in the US. We want it under California or Delaware Law or something that we all understand. Well, that is a problem for the foreign company. It creates no problems for us because we can drop assets into a US LLC or corporation tax-free. The foreign company can also (a) put cash or assets tax-free, but it subjects them to US tax and regulations on their joint venture. Now, let us suppose that we give in and we decide we want to do a foreign entity to joint venture at as we often do especially if we are going to exploit this business offshore.
The problem for the US company is that we have what they call the super royalty provisions in tax parlance. What it means is that when a US company transfers intangible property, not intellectual property but intangible property which is a much broader definition, to a foreign corporation, that transaction basically is either going to be fully taxable on grant, well-structured so it’s fully taxable, or not fully taxable because we have done it under one of the tax re-contribution provisions.
The US party has to recognize and take an annual income inclusion equal to “the income attributable to the intangible,” whatever that means, and we think it means a transfer pricing concept. In either case, it means the US Company is going to be taxed on an annual basis if that foreign venture is successful. And that is usually not a result that anybody is willing to accept. We will either sell the intangible to the foreign company so that we trigger the tax today or we will have an actual license that I just described. We can get actual cash instead of pretend cash from the foreign company. So that is one gotcha to watch out for.
Speaking of gotchas, let us talk a little bit about 338 because it is just so important. So here is our scenario that I see all the time. A client comes to me. They have engaged the banker who is smart enough to put together a term sheet and a letter of intent and the term sheet says “We’re going to _______ (Whoever you’re representing, it doesn’t matter). The buyer is going to buy all the stock of selling company. It is an all-cash deal or maybe cash in installment notes.” And then they sign it and then the banker exits the stage, left, and turns it over to the lawyers to clean up the mess.
The first question eventually the buyer is going to ask once they talk to their lawyers or their accountants is “Well, gee, this doesn’t look very efficient. You’re going to pay $10 million for the stock in a company that has $10 of basis.” So you have a lot of money in stock that you cannot amortize or depreciate and you have this low basis inside the company. You know what we should do is we should have bought assets but we cannot because you said you are going to buy stock and there are lots of good business reasons.
If the selling company is an S Corporation or a member of a consolidator group, or in other words it is one corporation selling another corporation, we can do a 338(h)(10) election.
338 generally is an election that treats a stock sale as an asset sale for tax purposes. 338G basically means that the buying group is going to pick up the gain so you would do it if you had lots of built down loses in a company or if you are a foreign company – those two scenarios.
338(h)(10) says that the selling group is going to pick up the income, is going to be treated as though the corporation sold its assets and then re-incorporated into a new company. So we have an asset sale instead of a stock sale. An S Corporation is only taxed once so it is not a problem and a consolidator group will file a consolidator return so they will only pay one level of tax also so it makes sense.
That sounds like a really elegant answer and that is something that the lawyers will then ask for. So let me pause on that again. I want to make sure we all got it. It is an asset sale but for tax purposes the seller basically treats it as a stock sale, one level of tax, but because an S Corp. is a pass-through the buyer treats it as an acquisition instead of a stock acquisition. So they get a fair market value basis in the assets that they can amortize going forward. It is very tax-efficient.
As I said, that unfortunately is not the end of the inquiry because if it is not in the term sheet now we have to negotiate it if you are a buyer and the first thing the seller ought to be asking is “Well, gee, is this going to cost me anything?” Well, it is. It is going to cost him a little bit almost always and it is two things.
Number one is character of gain because gain on the sale of stock is capital taxed at 15% Federal currently. Gain on the sale of assets may be capital or it may not; it depends on the asset. If it is goodwill held for more than a year then it is capital. If it is appreciated inventory, if it is cash-basis accounts receivable, or if it is what we call a depreciation recapture, then it is not capital. It is ordinary and we have increased the tax on that component to 20%. That is number one – it is the character issue and you just have to get your accountants involved to kind of do numbers and figure out if you have that problem.
Then number two is the state of California will impose a 1½% income tax on that 338(h)(10) election. So it is not a big number but it is a number. So then when that happens, Harpreet, I expect that people are going to try to figure out who has to pay that additional tax and who is going to win.
Harpreet: Yes, that is the challenge. That is part of the negotiating process. But hopefully you understand as lawyers and you need to understand the ramifications, as Roger has explained, of 338(h) because oftentimes we find the client certainly will not because they just feel like “Hey, this is a stock deal and I’m getting the benefit of that?” So this is a matter that is negotiated.
I have found in practice that we are typically able to negotiate this on behalf of the sellers to say that we should be essentially reimbursed for the amount of this allocation and our argument typically is “Hey, you get a step-up basis on the stock. There’s a benefit for you and so it can’t come as a detriment to us. So we need to be compensated for this.” Generally you will find after some push and pull that a buyer will agree at least to some degree of this.
The issue then kind of dissipates to another level of determining what that amount is and that I think comes in a bit of an overlay on the allocation issue on how we are allocating the purchase price amongst various assets.
When you are looking at it, you have got to make sure from a drafting perspective that you (a) address the cost associated with 338(h) if you are representing a seller, and then (b) make sure you have language around the purchase price allocation because too often than not what you see is a seller will just acquiesce to a buyer and say “You determine the allocation of this purchase price.” You know of course they are going to allocate in terms of what is favorable to them and that may have some ramifications certainly for you.
So you certainly as a by-product of 338(h) also want to have some leverage in negotiating or have some say in how the purchase price is allocated for this company. So you would draft provisions where essentially you could give a buyer the right to give you an allocation that is a draft allocation, and you will then have the ability to counter that. If the parties cannot agree, then you hire a third-party firm who will actually do an allocation for you. Typically, when you have that kind of language in there people are pretty good about the purchase price allocation issues.
But at the very minimum these are two things, I think, if you are representing the seller that you want addressed. If you are representing the buyer, this is an option that if you are caught in a stock deal and you realized that there are benefits to do an asset, you still have this way out – the 338(h) election is there for you to make. Just know that the sellers, if they have good lawyers, they are not going to just roll over and say “Okay, you take it and we bear the cost of that.”
Roger: Okay. So to stay on time, I want to jump ahead to hopefully give you a sense of some of the things that we have seen in the market – some takeaway, some tips and trends, and interesting aspects of things that have changed.
One of the big ones for me is it used to be that in the document, of course, there is oftentimes a working capital adjustment. We are buying a company that says it had this balance sheet. If that closed you deliver something that has a different balance sheet or, if we find out we didn’t get the balance sheet you represented, there is going to be an adjustment to the purchase price, usually down but sometimes up or down.
It used to be we would just say “We’re going to determine your balance sheet according to GAAP, Generally Accepted Accounting Principles.” Well, what a lot of us have discovered sometimes the hard way over the last few years is that GAAP can mean a lot of things. Whose GAAP is it? Is it buyer’s GAAP? Is it seller’s GAAP? And these days I always make sure I drag the accountants into the deal to make sure we all understand what we mean by GAAP. Harpreet, do you have a comment?
Harpreet: I agree. I think this last point that you made is extremely important. For me as a corporate lawyer who is drafting these things, I have the luxury of going next door and going to our tax group and saying “Help” in terms of structuring and language around some of the tax pieces. That is great to have.
But at the end of the day, we are not going to be the ones that file those returns for either the buyer or the seller. Somebody else is going to and I think strategically as a lawyer you need to have people on board who will say “Yes, we’re on board with this,” because the last thing you want to do is have a transaction that is done and then you have an accountant somewhere saying “Wow, I only wish someone had come to me and asked me this” or “I wish you had done this.”
And the client is going to look to you because you are the advisor, the professional, and say “Hey, what happened here?” So I think you need, as Roger mentioned, to have a buy-in. I know when I go to Roger and he says, “Well, have you spoken to their finance team – their accountants, their CPA’s – because we want them to sign off on this thing?” I think that is extremely crucial to do, extremely crucial to do.
Roger: Okay. So with that, I believe we’ll conclude the formal part of the program. I want to thank you, folks, again for spending your lunch hour with us. If there are any questions, Harpreet and I can stick around for a little while as well. Thanks.