TAX PRACTICE. tax notes. Blown B Acquisitions of Foreign Targets by U.S. Public Companies. By Michael Kosnitzky, Ivan Mitev, and Keith J.

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1 Blown B Acquisitions of Foreign Targets by U.S. Public Companies By Michael Kosnitzky, Ivan Mitev, and Keith J. Blum Michael Kosnitzky Ivan Mitev Keith J. Blum Michael Kosnitzky and Keith J. Blum are with Boies, Schiller & Flexner LLP in Miami, and Ivan Mitev is with the firm s New York office. This article discusses some notable benefits and detriments a U.S. public company should consider in acquiring a foreign target in a blown B taxable acquisition. All merger and acquisition tax professionals are quite familiar with the tax consequences of a stockfor-stock acquisition involving a domestic target corporation. This familiarity takes root early in most professionals tax careers because domestic corporate mergers and reorganizations are part of the curriculum of every LLM and MAcc program around the country. For U.S. tax purposes, these purely domestic stock-for-stock acquisitions are typically structured as nonrecognition transactions. One of the principal reasons to structure a domestic corporate acquisition as a U.S. nonrecognition transaction is to defer any realized gain on the acquisition to the target s U.S. shareholders. Thereby, in a purely domestic nonrecognition transaction, the selling shareholders will not need to immediately pay U.S. income tax on the realized gain from the disposition of their shares. This in turn means that those shareholders would not have phantom income and would not be faced with selling acquisition company shares to cover taxes. This benefit to the selling shareholders is offset by a tax detriment borne by the acquirer and its shareholders. The cost to the acquiring corporation in such a nonrecognition transaction is substituted basis in the hands of the acquirer of the target s TAX PRACTICE tax notes stock and the carryover basis in its assets. In other words, the acquirer does not get the benefit for federal income tax purposes of the full fair market value of the consideration paid for the target stock, and thus, it does not get to step up the basis in the acquired shares or underlying assets of the target. The practical implication of this lack of a step-up is that the acquirer loses the potential additional tax benefit resulting from increased depreciation and amortization of the target s assets or the benefit of recognizing smaller gain from low basis stock in the event of a future stock sale of target. Now let s compare the standard domestic stockfor-stock transaction with the following crossborder transaction. A U.S. corporation whose stock is traded on a U.S. public exchange (U.S. PublicCo) is contemplating the acquisition of all the outstanding stock of a foreign publicly traded corporation (Foreign TargetCo) (the transaction). For reasons that may not necessarily be driven by tax considerations, the transaction is structured as a stock exchange or stock tender offer 1 of U.S. PublicCo s voting stock for all the stock of Foreign TargetCo so that U.S. PublicCo will own 100 percent of the equity of Foreign TargetCo after the transaction. 2 The first thing that is important under these hypothetical facts is that the traditional economic impetus to structure the transaction as a nonrecognition acquisition for U.S. tax purposes likely does not exist because the target is a public foreign entity. In that case, the shareholders of the target are typically non-u.s. persons and are not subject to U.S. tax absent some direct or indirect connection to the United States such as a U.S. trade or business. Considering the potential tax benefit to U.S. Public- Co and the lack of U.S. tax detriment to target or its shareholders, U.S. tax advisers usually suggest adding some element to the transaction that will cause 1 This type of a stock-for-stock acquisition could often be viewed as more convenient; and, more importantly, it does not deplete the cash reserves of the acquirer or force the acquirer to borrow funds to implement the transaction. 2 The ultimate structure flowing from the transaction will result in Foreign TargetCo being a controlled foreign corporation wholly owned by U.S. PublicCo. Generally, U.S. corporations are not entitled to receive a dividends received deduction from an investment in a foreign corporation except in very limited circumstances. See sections 243 and TAX NOTES, March 18, 2013

2 it to be taxable for U.S. tax purposes without materially altering the intended economics. As discussed in more detail below, this element may, for example, be introduced by offering some small cash consideration as part of the overall stock-for-stock transaction. Notably, however, structuring the transaction as a taxable acquisition for U.S. tax purposes in all likelihood will have corresponding tax consequences for foreign tax purposes that may be the same as the U.S. tax consequences of the transaction. Thus, the specific steps of accomplishing this taxable status for U.S. tax purposes need to be carefully discussed with local tax counsel. This discussion could produce several outcomes. If we assume that the U.S. taxability is accomplished by offering some cash as part of the acquisition consideration, local counsel may advise that the local jurisdiction has rules that overlap with U.S. law, and thus, for example, a stock-for-stock acquisition does not permit any boot, in which case a taxable U.S. acquisition will likely be taxable for local law purposes as well. Alternatively, counsel may advise that local law is not as restrictive as U.S. law and it permits up to, say, 10 percent boot or has a provision whereby dissenting shareholders could be cashed out by the acquirer, in which case the transaction may be structured as taxable for U.S. tax purposes but tax free for local tax purposes. Lastly, the target and majority of its shareholders may be located in a jurisdiction that has no, or very low, income tax; conversely, the target may be in a jurisdiction where there are no tax-free reorganization provisions or there are very restrictive tax-free reorganization provisions. 3 If U.S. tax counsel receives a confirmation from local tax counsel that the transaction would have nominal negative tax consequences under foreign law or that the transaction will be taxable in any event because, for example, there are no local tax-free reorganization of provisions, U.S. counsel has something to work with and can focus on introducing some element that makes the transaction taxable for U.S. tax purposes. If U.S. counsel takes this course of action, it is important to make sure that the contemplated taxable transaction does not inadvertently fall within the requirements of another U.S. nonrecognition provision. That would clearly obviate the U.S. client s goals. If that were to happen, U.S. PublicCo would not be able to 3 For example, in Thailand, corporate reorganizations are generally taxable. See Thai Revenue Code sections In other countries, such as Japan, tax-free reorganization provisions may be difficult to meet because of special requirements such as continuity of employees. Also, local counsel needs to determine whether any such structuring would cause any negative consequences other than tax. COMMENTARY / TAX PRACTICE take advantage of the benefits of a taxable transaction, which include an increase in the tax basis of the Foreign TargetCo shares acquired. It is also very important to make sure that by structuring the transaction as taxable, the client is not somehow whipsawing its foreign tax credit position. Some of these considerations are described in more detail below. U.S. Tax Consequences The transaction could possibly fall within the purview of two nonrecognition provisions, section or section 368(a)(1)(B) (a B reorg ). Section 351 is less likely to pose a problem. Foreign TargetCo stock should in all likelihood not be considered to be acquired in an exchange to which section 351 applies because control, one of the fundamental requirements of section 351, will likely not be met. 5 Thus, the following discussion will focus primarily on the B reorg provisions and their application to the transaction. A B reorg is defined as an acquisition of stock of one corporation (here Foreign TargetCo) in exchange solely for voting stock of the acquiring corporation (here U.S. PublicCo) or in exchange solely for voting stock of a corporation in control of the acquiring corporation. If U.S. Public- Co acquires more than 80 percent of Foreign TargetCo in exchange solely for stock, the transaction will comply with the requirements of section 368(a)(1)(B) and be considered a tax-free reorganization for U.S. tax purposes. As discussed above, there are advantages to having the transaction structured as a taxable transaction for U.S. tax purposes, and thus, U.S. tax counsel has been tasked with finding ways to make the transaction taxable. For abreorg, this generally means that U.S. PublicCo should structure the transaction so as to include elements that will disqualify the transaction as abreorgforu.s. tax purposes (commonly referred to as a blown B ). For example, the use of voting stock plus some other variety of consideration in connection with the acquisition of the stock of another corporation will violate the solely-for-voting-stock requirement ingrained in section 368(a)(1)(B). 6 One way to 4 The deemed transaction that can potentially result in section 351 treatment is a contribution of Foreign TargetCo to U.S. PublicCo in exchange for U.S. PublicCo treasury or newly issued acquisition shares. 5 The transfers of the stock of U.S. PublicCo to the Foreign TargetCo shareholders are not the types of transfers described in section 351 because the Foreign TargetCo shareholders will not be in control of U.S. PublicCo after the transaction. Rev. Rul , C.B Turnbow v. Commissioner, 368 U.S. 337 (1961). There are potential stock exchange restrictions on the use of nonvoting or reduced voting shares as consideration. TAX NOTES, March 18,

3 COMMENTARY / TAX PRACTICE achieve this result would be to purchase some of the minority or dissenting shares in a tender offer for cash as part of the overall transaction. 7 Including even a small amount of cash would violate the B reorg solely-for-voting-stock requirement and result in a blown B. 8 In U.S. PublicCo s case, a blown B would be a positive result in that all participants should then be afforded sale or exchange treatment regarding the entire transaction. 9 That is, U.S. PublicCo should receive a tax basis in the Foreign TargetCo shares equal to the total of the cash consideration paid for the shares and the FMV of the U.S. PublicCo shares exchanged for the Foreign TargetCo shares. 10 Thus, 7 Note, however, that a pre-reorganization redemption of the minority shareholders with Foreign TargetCo cash would not violate the B reorg requirements. See, e.g., reg. section (e)(7), Example 9. Compare Rev. Rul , C.B. 110, in which the funds could be traced to the acquirer; in this ruling, target redeemed the shareholders with borrowed funds and then repaid the loan with funds from the acquirer. 8 See Chapman v. Commissioner, 618 F.2d 856 (1st Cir. 1980) (no cash is permissible in a reorganization described in section 368(a)(1)(B)), cert. denied, 451 U.S. 1012; Rev. Rul , C.B. 115 (acquisition of 80 percent of target for stock and 20 percent for cash under the same plan violates solely-for-votingstock requirement of section 368(a)(1)(B)). 9 Turnbow v. Commissioner, 368 U.S. 337 (1961), aff g 286 F.2d 669 (9th Cir. 1960). The argument that a blown B causes a transaction to be partially viewed as a sale or exchange to the effect that the acquirer shareholders are taxed only on the amount of boot received was rejected in Turnbow. There the appeals court summarized the issue as follows: This case presents the following question: whether gain realized by a taxpayer upon the transfer of his stock in a whollyownedcorporationinconsiderationforvotingstock in another corporation plus cash is recognizable in its entirety or only to the extent of the cash received. The Tax Court, following Howard v. Commissioner of Internal Revenue, 7 Cir., 1956, 238 F.2d 943, has ruled that the gain is recognizable only to the extent of the cash received. Grover D. Turnbow, 32 T.C We have concluded that this was error and that the gain is recognizable in its entirety. Note that even in a failed or blown B, the issuing corporation, here U.S. PublicCo, never recognizes taxable income under the general principles of section Section 367, which under many circumstances may cause the U.S. parties to an international M&A transaction to recognize gain or enter into a gain recognition agreement with Treasury, does not directly implicate section Because section 1032(b) cross-references only section 362 (the tax basis rules applicable to tax-free reorganizations), one may be led to believe that no step-up in U.S. tax basis would be available to U.S. PublicCo if the transaction is subject to section However, reg. section (d) (second sentence) clearly states that if section 1032 is applicable regarding an otherwise taxable transaction, tax basis is computed under the principles of section Section 1012 provides that the basis of acquired property is its cost. For these purposes, courts have held that when a corporation acquires property in exchange for its own stock, the cost basis of the property is the value of the stock given up in the exchange. See, e.g., FX Sys. Corp. v. Commissioner, 79 T.C. 957 (1982). for example, if U.S. PublicCo was to eventually sell Foreign TargetCo, it will potentially have less gain, or more loss, for U.S. federal tax purposes. This would generally translate to less U.S. federal income tax at the time Foreign TargetCo is sold. Also, a blown B can give U.S. PublicCo the opportunity to step up the inside tax basis of Foreign TargetCo s assets, a step-up that would otherwise be unavailable in a purely tax-free transaction. 11 U.S. PublicCo could accomplish this by making a section 338(g) election regarding the acquired Foreign TargetCo s stock. 12 A section 338(g) election will treat the transaction as a deemed sale of assets of the target, 13 as well as a sale of stock of the target. 14 To qualify for the election, U.S. PublicCo must meet the requirements of a qualified stock purchase. 15 If the transaction is restructured as a blown B, it will likely meet this requirement. 16 This election may be made for an acquired foreign target 11 The definition of a purchase for section 338 purposes excludes all basis carryover transactions and specifically excludes exchanges to which section 351, 354, 355, or 356 applies. See section 338(h)(3). 12 In contrast, a foreign corporation cannot be the target corporation in the case of a section 338(h)(10) election. See reg. section 1.338(h)(10)-1(b)(1), (2), and (3). Therefore, this section is inapplicable to the transaction and will not be discussed. 13 U.S. PublicCo will also need to evaluate whether to make section 338(g) elections for the 80-percent-owned subsidiaries of Foreign TargetCo. In most cases, U.S. PublicCo would want to make this election for the Foreign TargetCo subsidiaries in order to obtain the step-up in basis of the assets of the subsidiaries. 14 In U.S. PublicCo s case, U.S. PublicCo would receive an FMV tax basis in the Foreign TargetCo shares and Foreign TargetCo would receive an FMV tax basis in its assets. 15 A qualified stock purchase is an essential predicate for an election under section 338. Section 338(d)(3) defines a qualified stock purchase as a transaction or series of transactions within a 12-month period, in which a purchasing corporation purchases the amount of stock in another corporation specified in section 1504(a)(2) that is, at least 80 percent of the stock, measured by both voting power and value. Section 338(d)(3). 16 If restructured as suggested, the acquisition of the Foreign TargetCo stock by U.S. PublicCo should satisfy all three statutory requirements for a purchase listed in section 338(h)(3). First, as discussed above and if restructured, the basis of the stock would be based on the amount of cash paid for the stock and the FMV of the U.S. PublicCo stock exchanged therefore. Thus, U.S. PublicCo s basis in the Foreign TargetCo stock is not determined in whole or in part on the tax basis in the hands of the selling shareholders. See LTR for an all-stock transaction that qualified for section 338(g) purposes as long as the transaction was not a tax-free reorganization under section 368. Second, as also discussed above, the only nonrecognition provisions that could possibly apply to the transaction are section 351, which does not apply, and section 368(a)(1)(B). Section 368(a)(1)(B), based on the restructured transaction as discussed herein, should not apply either because the acquisition of the Foreign TargetCo stock will not be solely for voting stock of U.S. PublicCo. Third, the facts do not suggest that there is a relationship between U.S. PublicCo and the selling shareholders of Foreign TargetCo that would implicate any person the (Footnote continued on next page.) 1348 TAX NOTES, March 18, 2013

4 corporation even though the seller is foreign, and it has no immediate U.S. tax consequence. 17 U.S. PublicCo can make this election by simply filing a form by the 15th day of the ninth month beginning after the month in which the acquisition date occurs. 18 If the section 338(g) election is made, then: historical earnings and profits and foregoing U.S. taxes of the Foreign TargetCo are eliminated; and the Foreign TargetCo takes an FMV basis in its assets for the purposes of computing future income for U.S. income tax purposes. Making the section 338(g) election is beneficial under most circumstances and matches well with a blown B. However, U.S. tax counsel must be aware not only of the positives of making such an election but also with some of the possible detriments that the election may have to its clients. The principal pros and cons of the section 338(g) election are discussed below. Benefits Since the inside basis of Foreign TargetCo will be stepped up, the associated amortization or depreciation has the potential of reducing post-acquisition U.S. E&P, and thus reducing subpart F income. This increases the opportunity for deferral and the distribution of earnings tax free as a return of capital. For example, if Foreign TargetCo earns $100 postacquisition income but has only $50 of E&P due to depreciation on account of the stepped-up assets, it could distribute the entire $100 and pay tax only on $50, because its outside basis is stepped up in the transaction, and the remaining $50 is therefore a return of capital. The increase in amortization and depreciation could also increase the availability of FTCs. 19 ownership of whose stock would be attributed to the person acquiring the stock under section 318(a). 17 See AM (Feb. 23, 2007). 18 Section 338(g)(1). This is contrasted with a section 338(h)(10) election, which must be made by both the acquiring corporation and the selling shareholder. Section 338(h)(10)(C). 19 The formula for determining deemed-paid FTC is based on the accumulated post-1986 E&P of the entity; this E&P serves as the denominator in the formula. In basic terms, the formula is (dividends divided by post-1986 E&P pool) x post-1986 foreign taxes = FTC. Thus, because the increased amount of depreciation on account of the section 338(g) election reduces E&P, it also reduces the denominator, and thus, it increases the available FTC. However, this amount could further be limited by section 904. That said, note that in 2010, Congress limited some of the U.S. tax benefits a U.S. acquirer received by making a section 338(g) election, among others that resulted in the stepped-up tax basis of the target company s assets, by enacting section 901(m). Section 901(m) denies FTCs for foreign income not subject to U.S. taxation by reason of a covered asset acquisition. A covered asset acquisition is an acquisition of assets that have in the aggregate a higher tax basis for U.S. tax purposes than for (Footnote continued in next column.) COMMENTARY / TAX PRACTICE U.S. PublicCo will not have to expend significant resources to ascertain the historical U.S. E&P or U.S. tax basis of Foreign TargetCo or its assets. Foreign TargetCo is currently not a CFC. This means that in all likelihood no historical U.S. E&P or U.S. tax basis records exist. Foreign TargetCo will be a CFC after the transaction, and thus, the importance of the historical E&P to the post-acquisition target will be important for U.S. reporting purposes. By making the election, U.S. PublicCo eliminates the need for these pre-acquisition calculations. A section 338(g) election wipes out low-tax E&P. This is E&P associated with income for which there has been paid low or no foreign income tax. This kind of E&P may pose a problem for a U.S. acquirer because it can cause future distributions to be subject to tax in the United States as dividends without a commensurate FTC. Making the section 338(g) election will also obviously eliminate any negative balances in E&P. Typically, before a foreign target can generate deemed FTCs, it must have a positive accumulated E&P account. This is the so-called trapped taxes problem. The foreign taxes are trapped because dividends and subpart F inclusions pull up foreign taxes only pro rata to E&P. Possible Detriments The election wipes out E&P, and thus, possibly wipes out high-tax E&P. This negative is the reverse of the low-tax benefit point above. If a foreign target has high-tax E&P, that is, E&P associated with income for which taxes have been paid in a foreign country in excess of the U.S. tax rate, the U.S. acquirer forfeits the possibility of taking out dividends that will pull up credits in excess of the U.S. tax associated with the dividend. The increase in amortization and depreciation from the section 338(g) election could cause postacquisition negative E&P. This generally can create a trapped taxes problem and limit FTC. Conclusion The above discussion outlines the principal U.S. tax considerations for adopting a blown B structure for the transaction and making a section 338(g) election. As illustrated, this planning could have significant benefits for a U.S. corporate taxpayer. If U.S. PublicCo adopts this strategy, it needs to consider the effect on its overall FTC strategy, the effect on foreign taxes, and other nontax corporate implications, including the impact on the selling foreign tax purposes, such as may occur as a result of a qualified section 338(d)(3) stock purchase to which section 338(a) applies. Counsel should carefully examine the application of section 901(m) if FTCs are a material factor for making the election. TAX NOTES, March 18,

5 COMMENTARY / TAX PRACTICE shareholders. As alluded to above, a threshold issue for this planning is the introduction of cash or other unpermitted types of consideration and their effect on the foreign tax consequences of the transaction. While the blown B and section 338(g) election structure may not have any U.S. tax implications for the selling shareholders as long as they are not U.S. persons, the payment of cash may have adverse tax consequences to those shareholders under the laws of their respective countries, in which case the U.S. planning may not be feasible from the outset TAX NOTES, March 18, 2013