The transaction involved a so-called reverse subsidiary merger -- the merger of a newly-formed US subsidiary of British Petroleum into Amoco, with Amoco surviving. Under the merger agreement and pursuant to US corporation law, the common shares of Amoco were converted into ordinary shares of British Petroleum, and the shares of the newly-formed merger subsidiary were converted into shares of Amoco. Amoco, as a result, became a direct subsidiary of BP.
While cross-border tax-free mergers have always been possible in the US, recent amendments to the applicable regulations have made the structuring of these transactions even more intricate. Success depends on compliance with a laundry list of technical requirements, most of which can only be explained as the product of antiquated statutes and the blunderbuss response of the US Internal Revenue Service (IRS) to a number of notorious transactions.
An initial question is why in a merger of equals is it often the foreign corporation that acquires the US target and not vice versa? Obviously, factors other than tax affect these determinations, but tax considerations are a very important part of the calculus. The US is not a friendly tax home for multinational enterprises. The US taxes foreign income without granting a participation or similar exemption for foreign dividends and, under its subpart F and similar regimes, often imposes US tax on foreign income before it is repatriated to the US.
The US foreign tax credit regime addresses some of these issues, but relevant credit limitations, the complexity of the system and the relatively high effective rate of US corporation tax prevent the problem from being eliminated. There is also no headquarter or foreign income dividend regime in the US, with the result that dividends paid by a US corporation are subject to a 30% withholding tax (reduced but not eliminated by treaty) without regard to whether the dividends are paid out of US or foreign source income.
The US also employs a ?classical? tax system ? the shareholder and corporation income taxes are not integrated. Consequently, moving the top-tier holding company outside the US does not result in US shareholders of the target company losing the ability to claim imputation credits or similar relief, since no such relief is available to US shareholders of US companies.
There are two sets of hurdles to overcome in making these transactions tax-free to the US shareholders of US target corporations. The first set applies to all transactions (whether or not cross-border) ? the transaction must be a reorganization under section 368 of the Internal Revenue Code. The second set involves compliance with section 367 of the Code, which limits the circumstances in which US shareholders can receive shares of a foreign corporation in a reorganization without recognizing a gain. Finally, going forward after these acquisitions, at least one peculiar shareholder-level tax issue may arise that may be of concern to US investors.
Universal requirements
There is an enumerated set of transaction structures that constitute reorganizations, and which are therefore generally tax-free under section 368 of the Code. (Possibilities under section 351 of the Code, which are also relevant in the cross-border context, are not covered in this article).
Of the set of potential transaction structures, two are unusable in the cross-border context. A direct merger of the target into the acquirer (a so-called ?A? reorganization because the relevant Code provision permitting the transaction is section 368(a)(1)(A)), is thought not to be available because it requires that the merger be ?effected pursuant to the corporation laws of the United States or a State or Territory or the District of Columbia,? and a merger involving a foreign entity is effected (at least partially) pursuant to foreign law.
Similarly, although there is no direct legal impediment, a transaction in which the acquirer or its first-tier subsidiary acquires substantially all of the assets of the target in exchange for voting stock of the acquirer (a so-called ?C? reorganization because the relevant Code provision is section 368(a)(1)(C)) is generally unworkable from a non-tax perspective. Even if a bulk sale of assets for stock could be arranged, these transactions involve a number of difficult tax issues at the corporate level. As a result they are not used. This leaves three potential acquisition structures: a stock-for-stock exchange, a forward subsidiary merger, and a reverse subsidiary merger.
In a stock-for-stock exchange (a so-called ?B? reorganization because the relevant provision is section 368(a)(1)(B) of the Code), the acquirer or its first-tier subsidiary acquires stock that leaves it in control of the target solely for voting shares of the acquirer. These are difficult transactions because the use of any other type of consideration is forbidden (except for limited exceptions with respect to fractional shares and certain payments that are deemed to come from the target rather than from the acquirer). The payment or assumption of shareholder-level liabilities (including in some cases shareholder transfer taxes) will cause a transaction to fail as a ?B? reorganization.
The remaining two structures ? transactions in which the target merges with a US subsidiary of the acquirer ? are the most favoured. These are called forward subsidiary mergers if the merger subsidiary survives, and reverse subsidiary mergers if the target survives.
Given the foregoing constraints, the BP/Amoco transaction was structured so as to qualify as a reverse subsidiary merger, tax-free under sections 368(a)(1)(A) and (a)(2)(E) of the Code. A reverse subsidiary merger must satisfy the following four constraints to be tax-free under section 368 of the Code.
First, the merger subsidiary must be ?controlled? by the acquirer, meaning that the acquirer must own the merger subsidiary directly. Indirect ownership does not satisfy the control test. In BP/Amoco, the merger subsidiary was a newly-formed, direct wholly-owned subsidiary of BP. Secondly, the merger subsidiary must be a US corporation, so that the merger is effected under domestic law. In BP/Amoco, the merger subsidiary was an Indiana corporation and the merger was effected under Indiana law.
Thirdly, the target must hold ?substantially all? of its assets after the merger. The IRS has provided a safe harbour that allows reductions of up to 10% of the target's net assets and/or 30% of the target's gross assets without violating this rule. Pre-closing reductions are counted if they are in contemplation of the merger; post-closing reductions are counted unless the transaction has aged to a sufficient degree.
In general, the items that reduce assets for this purpose are pre-closing redemptions, or special dividends (including payments by the target to dissenting shareholders), or payments by the target of its reorganization expenses. Target assets may also be depleted by post-closing intra-group assets transfers from the target subgroup to the acquirer subgroup, under the theory that the target has paid an in-kind dividend to the acquirer. (In the cross-border context, intra-group asset transfers that cause a ?substantially all? problem might also trigger a US withholding tax.) In BP/Amoco, the ?substantially all? safe harbour test was met.
Finally, target shareholders must exchange in the merger an amount of the target stock constituting control of target for the voting stock of the acquirer. The definition of control for this purpose is stock ?possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock.? Thus, the acquirer may acquire just under 20% of the target's stock for cash.
Usually issues arise under this test only if the target has non-voting preferred stock outstanding, or the acquirer wants to use a significant amount of cash in the acquisition. If the acquirer merely substitutes its non-voting preferred stock for the target non-voting preferred stock, control has not been acquired for voting stock. Alternatively:
the target could redeem any such stock (but this would count against the ?substantially all? test);
the target could transform the non-voting stock into voting stock prior to the merger; or
the acquirer could substitute its voting preferred stock for target non-voting preferred stock.
In BP/Amoco, this question did not arise since Amoco did not have outstanding any non-voting preferred stock and BP did not contemplate paying cash for Amoco stock.
Requirements peculiar to cross-border transactions
In a domestic acquisition, a transaction that meets the requirements of section 368 of the Code is treated as a tax-free reorganization without any further scrutiny. In a cross-border acquisition, the transaction must also meet the requirements of section 367 to avoid the recognition of gain. In the merger-of-equals context, certain of these tests may, as noted below, be more difficult to satisfy.
The 367 rules differ depending on whether the foreign party is the acquirer or the target. Where the foreign party is the acquirer, as in the BP/Amoco structure, under recently adopted amendments to the applicable regulations the transaction must satisfy the following four constraints to be tax-free under section 367 of the Code.
First, US persons that are target shareholders must not receive in the transaction more than 50% (by vote or value) of the stock of the acquirer. All target shareholders are presumed to be US persons for this purpose; the presumption can be rebutted only to the extent that shareholders execute and deliver affidavits stating their non-US status (a requirement that makes it very difficult to rebut the presumption). Unlike the second test set forth below:
each target shareholder that is a US person must be counted without regard to the size of its stake in the target; and
only acquirer stock received in the transaction (as opposed to previously owned by target shareholders) is required to be counted.
It should be noted as well that this test depends not only on the relative sizes of the two companies, but also on the portion of the consideration package delivered in the form of acquirer stock (as opposed to cash). In BP/Amoco, the Amoco shareholders received approximately 40% of BP's stock in the merger, and this test was therefore satisfied.
Secondly, US persons that are members of the target control group must not own, in the aggregate, more than 50% (by vote or value) of the stock of the acquirer immediately after the merger. The control group consists, for this purpose, of each US shareholder of the target that is an officer or director of the target, or an owner of at least 5% of the target's stock (by vote or value) immediately prior to the merger.
Unlike the first test set forth above, not all target shareholders must be counted, and acquirer stock previously owned by the relevant target shareholders must be included in the computation. Where the target is a large public company, as in the case of Amoco, this test is easily met since the control group owns a relatively small percentage of the target.
Thirdly, the transaction will not be tax-free to any US shareholder of the target that will own (together with certain affiliates and other related persons) at least 5% of the acquirer's stock (by vote or value) immediately after the merger, unless that shareholder enters into an agreement to recognize its deferred gain in certain circumstances (generally the taxable disposition by the acquirer, within 60 months of the merger, of the target stock acquired in the merger). The failure to satisfy this test affects only the 5% shareholder in question; the remaining shareholders continue to enjoy tax-free status.
Once again, in the case of a merger of equals, this test is not likely to affect many shareholders. In the BP/Amoco transaction, it does not appear that any Amoco shareholder became a 5% shareholder of BP.
Finally, the active trade or business test must be satisfied. This test is really two tests rolled into one. The first part of the test is that the acquirer, either directly or through at least 80%-owned subsidiaries, has conducted an active trade or business outside the US for the entire 36-month period immediately preceding the merger, and has no intention to dispose of or discontinue such business. This part is easily satisfied where, as in the case of BP, the foreign acquirer is a very large, active corporation.
The second part of the test is that the fair market value of the acquirer must be at least equal to the fair market value of the target at the time of the merger. A few points should be noted about this second test.
First, the moment at which the value comparison is made is at the closing of the merger, rather than at the signing of the merger agreement or the moment before the merger becomes public knowledge. Thus, the fair market value of the target will be the deal value, which may include a premium to the market value of the target immediately before the announcement of the acquisition. Additionally, variations in relative value between signing and closing (either by reason of a variable exchange ratio or a cash component to the consideration) can cause the test to be violated, even if it was satisfied based on the relative values of the companies at the time of signing.
Secondly, because the test looks at the relative values of the companies and not the relative amounts of acquirer stock held by the two shareholder groups, the test cannot be satisfied (unlike the first two tests set forth above) by increasing the amount of cash paid by the acquirer to former target shareholders. Thirdly, the test cannot be manipulated by artificially bulking up the size of the acquirer prior to the measurement date (the so-called ?anti-stuffing? rule). In the BP/Amoco transaction, BP was large enough to satisfy this test.
A peculiar shareholder-level tax issue
A cross-border merger of equals may also result in an otherwise obscure foreign tax credit rule coming into play for US shareholders after the deal closes.
If any withholding tax is imposed on dividends paid by the foreign acquirer to US shareholders, those shareholders will be subject to double taxation unless a tax credit is allowable in the US for the foreign tax withheld. Under the new UK withholding regime, applicable under the US-UK income tax treaty, a withholding tax on dividends that is otherwise invisible to shareholders is deemed to be imposed. An amount of UK tax is deemed withheld equal to the UK imputation tax credit that otherwise would be allowed to a UK shareholder with respect to the dividend. Thus, the foreign tax credit analysis remains relevant even under the new UK regime.
In general, withholding taxes on dividends from a foreign corporation would be eligible for a full foreign tax credit. However, if the foreign corporation is a US-owned foreign corporation, special rules may apply to limit the allowable tax credit.
A foreign corporation is US-owned if 50% or more of its stock, by vote or value, is owned directly or indirectly by US persons. A foreign acquirer in a cross-border merger could be US-owned for this purpose, notwithstanding that it met all of the section 367 tests, if the foreign corporation already had a significant US shareholder base prior to the acquisition. In the BP/Amoco case, for instance, BP may be (or may become) US-owned, notwithstanding that Amoco represented only 40% of the value of the combined entity, because BP already had a significant number of US shareholders.
Solely for foreign tax credit purposes, shareholders of a US-owned foreign corporation that receives more than a minimum threshold amount (ie 10%) of US source income will be required to treat a proportional amount of the dividends they receive as US source income. This will have the effect, all other things being equal, of denying a foreign tax credit to the US shareholder in respect of that portion of the dividend. A shareholder may elect to turn off this rule (and would invariably so elect) if the dividend is treated as foreign source income under the relevant tax treaty.
In the case of BP/Amoco, the US-UK treaty provides the basis for making such an election. This is not true for all treaties, however. The US-Germany treaty, for example, does not provide the basis for the desired election. Moreover, the US-UK treaty is being renegotiated, and it is possible that a revised treaty would look more like the German one, which is of more recent vintage.
Andrew P Solomon
Ronald E Creamer
Sullivan & Cromwell
