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M&A involving Foreign Corporations

Being on the west coast, much of my work has an international component. Foreign and international tax transactions can be particularly complex. There are many “gotchas” that make these transactions difficult to manage. Non-tax lawyers often deal with foreign tax-sensitive transactions but sometimes the client would be much better served if a tax lawyer is contacted and gets involved in the deal. Here is a snap shot of some of the caveats that make international tax transactions difficult to manage.

Outbound transactions (foreign acquirer and domestic target). In an outbound transaction, a foreign acquirer is engages with a domestic target. This can be done on a tax deferred or tax free basis if there is compliance with numerous requirements. Generally, the acquirer must have been engaged in an active trade or business for at least 36 months and it must be larger than the target so that less than 50% of the acquiror stock is changing hands.

The company’s accountant plays a vital role in these deals and should be heavily involved. Many reporting requirements must be complied with because the failure to comply could result in turning a non-taxable transaction into a taxable one.

Inbound transactions. In a 367(b) inbound transaction, a domestic acquirer acquires a foreign target. Generally, this can be done on a tax-free basis. Nevertheless, it is important to be cautious when the target is a “controlled foreign corporation” (CFC). A transfer of stock of a CFC may trigger an income inclusion (the “1248 Amount”) when the foreign corporation is more than 50% owned by US persons. Section 1248 re-characterizes stock gains as ordinary to the extent of the earnings that are attributable to the US shareholders.

Classic inversion. Years ago, there was a lot of press about U.S. companies exporting jobs, inverting, going offshore and forming Bermuda holding companies and not paying taxes ever again. Whole industries seem to have simply got up and left California for tax reasons via the inversion. An example of a classic inversion is as follows: A US semiconductor company forms a foreign company (maybe in the Cayman Islands). Then the foreign company acquires the US company in a stock for stock exchange. When the deal is done, shareholders of the U.S. company own shares of a Cayman company which owns the U.S. target. Under old law, that inversion would have been taxable because, among other things, the Cayman acquiror had no 36-month active trade or business. The company or its shareholders might have paid a tax on that transaction (based on value, which may have been depressed at the close of the transaction) or possibly no tax being paid because the company was able to offset the gains with its net operating losses (NOLs).

Now, there are a whole set of anti-inversion rules to prevent this transaction. Eventually, Congress caught on and passed new laws to govern outbound stock deals. Now, if the shareholders of the U.S. target own more than 80% of the foreign acquirer, the foreign acquirer is treated as if it were a U.S. corporation. Consequently, it does the company no good to do a tax motivated migration.

If ownership continuity is between 60% to 80% meaning that the shareholders of the U.S. target own more than 60% of the foreign company but less than 80%, the foreign company will not be treated as a U.S. company but the company will not be able to use its NOLs to offset the gain on the transaction. Also, if there is a stock based compensation in an inversion, the IRS will impose an excise tax. These rules have pretty much shut down the whole strategy although there are still ways to accomplish those goals.

When a company is sold, section 1248 taxes the sellers as though the earnings were distributed as a dividend. Section 1248 is important to consider when drafting the acquisition agreements because the 1248 inclusion amount is determined at the end of the year and allocated day by day among the year. Thus, post close events can impact the seller’s tax consequences.

Next, foreign joint ventures…

For more information on mergers and acsuisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. 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. See M&A slides at SlideShare.

 

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An inbound “flip” transaction (“flip”)morphs a foreign entity (usually a startup) into a US entity, typically to receive US angel or venture capital funding.  Consider the most common scenario:

Forco, a foreign startup, has filled a market need and has accelerating year-over-year growth. Without proper funding, Forco remains highly vulnerable to emerging, funded competitors.  Forco has identified Investor, a US-based angel investor or venture capital firm interested in investing.  However, Investor has expressed discomfort with Forco’s foreign entity structure and foreign governing law.  As a condition to funding, Investor requires Forco to reincorporate in the US.

A willingness to flip opens the world’s top venture capital market to foreign startups.  The Global Venture Capital and Private Equity Country Attractiveness Index ranks the US as #1 in venture capital overall[1] and in five distinct categories:  size of the economy ($15.1 trillion GDP in 2011),[2] size of the stock market ($15.6 trillion stock market cap in 2011),[3] stock market liquidity ($4.7 billion daily trading volume on October 11, 2012),[4] IPO market activity (71 IPOs in the first half of 2012),[5] and mergers and acquisitions (“M&A”) market activity (3,159 M&A deals in the first half of 2012).[6]  Of the $48.7 billion in global venture capital in 2011, the US venture capital market comprised 67%.

Foreign startups should generally not flip before securing US investors:  first, the flip eventually subjects the worldwide operation to US tax because the new US parent is taxed on its worldwide income.  Second, as with Forco and US investors in the scenario above, a US parent would prevent some foreign VCs from investing in the operation.

Once US investment is secured, legal counsel flips the foreign startup.  In a flip, Forco’s shareholders create a new US entity (“Domco”), and exchange their Forco stock for Domco stock.  After the exchange, the shareholders will own Domco, and Domco will own Forco.  Investor invests into Domco.

[Insert Fig. 1 – Flip Transaction, with caption “Fig. 1:  Flip Transaction”]

[Insert Fig. 2 – Post Flip, with caption “Fig. 2:  Post-Flip Transaction”]

In conjunction with a flip, foreign startups should consider a physical relocation to Silicon Valley.  The Silicon Valley venture capital market is the most vibrant in the world, comprising 41% of the US’s venture capital.[7]  Silicon Valley offers exposure to flagship startups and a uniquely experienced and innovative workforce, as well as to Silicon Valley acquirors and customers.

Royse Law Firm, a tax, business and corporate law firm headquartered in Palo Alto, California, regularly connects startups with compatible investors in the stages prior to the flip.  Royse Law Firm has been performing flip transactions since 2006, and the transaction is typically executed tax-free within about 3–4 weeks.  See our Recent Transactions for prior representations.


[1] Alexander Groh, Heinrich Liechtenstein and Karsten Lieser, The Global Venture Capital and Private Equity Country Attractiveness Index 2012, http://blog.iese.edu/vcpeindex/unitedstates (last visited Oct. 11, 2012).

[2] International Monetary Fund, World Economic Outlook Database, http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx (last visited Oct. 11, 2012).

[3] The World Bank, Market Capitalization of Listed Companies, http://data.worldbank.org/indicator/CM.MKT.LCAP.CD (last visited Oct. 11, 2012).

[4] WSJ, Market Data Center, http://online.wsj.com/mdc/page/marketsdata.html (last visited Oct. 11, 2012).

[5] PriceWaterhouseCoopers, After Strong Start to 2012, IPO Market Sees Pullback, PwC Says, http://www.pwc.com/us/en/press-releases/2012/q2-ipo-watch-press-release.jhtml (last visited Oct. 11, 2012).

[6] MarketWatch, Ernst & Young:  U.S. M&A Activity Falling, http://www.marketwatch.com/story/ernst-young-us-ma-activity-falling-2012-07-02 (last visited Oct. 11, 2012).

[7] Ernst & Young, Globalizing Venture Capital:  Global Venture and Insights and Trends Report, https://www.pwcmoneytree.com/MTPublic/ns/nav.jsp?page=historical (last visited Oct. 11, 2012).

Tax Free Mergers and Reorganizations in California: Continuity of Interest

Tax Free Mergers and Reorganizations in California: Continuity of Interest.

Tax Free Mergers and Reorganizations in California: Continuity of Interest

As noted in an earlier post, some types of acquisitions can be tax free or tax deferred to the sellers. In order to determine whether the tax-free reorganization provisions are available, the type of currency being given to the sellers in exchange for their stock or assets must meet certain requirements. The “currency” could be in the form of buyer stock, cash, compensation, debt or contingent and deferred payments.  Of that currency, some portion must be in the form of buyer equity. The amount of equity in the deal will drive the rest of the analysis.

A seller must retain a sufficient equity stake in the acquirer in order for a transaction to be treated as a tax-free reorganization. That “stake” is commonly referred to as the “continuity of interest” requirement and according to the IRS, there should be at least 50% continuity to meet the IRS safe harbor.  By “at least 50% continuity,” we mean that at least 50 % of the value of the consideration to be received by the seller will be equity of the buyer.  Fifty percent is considered safe. Case law goes as low as 25% but most tax lawyers will not accept such a low amount as sufficient continuity for the transaction to be tax-free. 

Traditionally, the IRS will rule on a transaction if there is at least 50% continuity (e.g. 50% of the consideration is Buyer stock). Escrowed shares tend to count for continuity purposes and relatively recent developments in the law are more tax friendly towards transactions with less than 50% equity.  Under current law, buyer stock is valued the day immediately before the signing of the definitive acquisition agreement.  Fluctuations in value between the day of signing and the day of closing are less of a concern.   Additionally, if there is other property that has a specified value (e.g. $100,000 worth of stock), that specified value will be used. 

The percentage of equity in a tax-free merger is important because the shareholders in a tax-free merger realize gain only to the extent of boot.  “Boot” includes non-stock property and securities.  Selling shareholders will not recognize taxable gain or pay tax on the value of stock received in a transaction.  They will take a low “exchange” basis in the buyer stock received in the merger and recognize a gain when they eventually sell the buyer stock, but they will not recognize that gain at the time of the merger. 

In our next post, I will discuss the different types of tax free reorganizations.

For more information on mergers and acsuisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. 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. See M&A slides at SlideShare.

Buying and Selling a Business: Mergers and Acquisitions: Tax Issues

A sale or acquisition of a company may take the form of a tax free reorganizations or a taxable transactions. How should we analyze, structure, and negotiate the tax provisions when a client wants to sell a company?

The first question will almost always be whether the seller can avail itself of the tax-free provisions of the Internal Revenue Code of 1986, as amended.  “Chunking up” a bit, the bigger issue to be considered is the tax sensitivity of the buyers and sellers.  As odd as that sounds at first, a seller may have substantial losses available to offset any gains. It may be a sale at a loss. The seller may be foreign. Similarly, on the buy side, the business deal might totally overshadow any tax consequences. The size of the target might be inconsequential to the buyer, or the buyer simply might not care about getting extra tax basis. In those cases, there is not much for a tax lawyer to do but sit on the sidelines and avoid penalties to wholly avoidable taxes on the transaction. The vast majority of sale transactions however will require a determination of whether the deal can be structured to be wholly or partially tax-free.

Although the tax-free reorganization provisions are not elective, it is possible to change the economics and structure of a transaction to fit within the tax-free provisions if that provides the best result to the parties.  Often, getting the business to fit within the tax-free provisions will greatly increase the complexity of the transaction, so a client’s desire to reduce taxes must be balanced against their tolerance for complexity.  If the buyers and sellers are more sensitive to avoiding complexity than to tax concerns, and the reorganization will make the transaction complex, the analysis stops there.  If tax is more of an issue than complexity, the use of the tax-free reorganization provisions must be considered.

For more information on mergers and acsuisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. 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. See M&A slides at SlideShare.