Summary of the Ruling
In a reverse subsidiary merger in which contingent stock rights in parent shares were given to target shareholders (“earn out consideration”), the IRS ruled that the post merger integration planning undertaken by the acquiring corporate group would not cause the earn-out consideration to be taxable to the shareholders of the target corporation.
Discussion of the Ruling
PLR 201820002 involves a reverse subsidiary merger under foreign law that occurred between a target corporation (“Target”) and the merger subsidiary (“Merger Sub”) of a publicly traded corporation that is the parent of an affiliated group (“Parent”). Parent wholly owns, either directly or indirectly through disregarded entities, a chain of corporations in which Parent owns 100% of the stock of Corp 1 which in turn owns 100% of the stock of Corp 2, which in turn owns 100% of the stock of Corp 3, which in turn owns 100% of the stock of Corp 4 indirectly through two disregarded entities.
Merger Sub merges into Target under the laws of country A, with Target surviving. The Target shareholders receive Parent stock and cash in exchange for their Target shares. The transaction qualifies as a tax-free merger under Code Section 368(a)(2)(E). After the merger, Parent transfers the shares of Target successively down the chain of its subsidiaries, through Corp 1, Corp 2, and Corp 3 to Corp 4.
As stated in the ruling, the merger agreement provides for the Target shareholders to receive earn out consideration of additional Parent shares and cash if certain achievement milestones are met after the merger. The ruling addresses whether the Target shareholders can receive the additional Parent shares paid as part of the earn out consideration on a tax free basis. The IRS holds that the portion of the earn out consideration made up of additional Parent shares can be received by the Target shareholders tax-free.
Mechanics of a Reverse Subsidiary Merger
A reverse subsidiary merger is a triangular reorganization involving a parent corporation (“P”), a merger subsidiary owned by P (“S”), and a target corporation (“T”). S merges into T in a statutory merger with T surviving. The T shareholders receive P stock in exchange for their T stock.
To qualify as a tax-free merger under 368(a)(2)(E), certain requirements must be met:
1. The merger must otherwise qualify as a section 368(a)(1)(A) reorganization except for the fact that P stock is issued rather than S stock;
2. P must acquire section 368(c) control of T, that is 80% of the voting stock of T and 80% of each other class of T shares, in exchange for P shares;
3. T must retain substantially all of its premerger assets after the merger; and
4. S must be a first-tier subsidiary of P.
Although the use of grandparent stock is not permitted under section 368(a)(2)(E), after the merger of S and T, P is permitted to transfer the shares of T down to its section 368(c) controlled subsidiaries under Treas. Reg. § 1.368- 2(k).
What is Earn Out Consideration
Earn out consideration is a contingent future payment provided for in the merger agreement based on the achievement of agreed upon benchmarks. Earn out consideration can be used in the acquisition of a corporation where the parties disagree about the value of the corporation being acquired. There are many forms that earn out consideration may take. The earn out consideration addressed in the ruling is a contingent right on the part of the Target shareholders to both additional Parent stock and cash. Generally, where earn out consideration takes the form of contingent stock rights, the contingent shares are not issued and outstanding, as a matter of local corporate law, until the milestone that triggers the payment of the earn out consideration is reached.
Implications of the Ruling
As stated above, the ruling permits the portion of the earn out consideration made up of additional Parent shares to be received tax-free by the Target shareholders. This is the case even though at the time the earn out consideration is paid to the Target shareholders, Target is a fifth-tier subsidiary of Parent.
Generally, section 368(a)(2)(E) requires that Target be a first-tier subsidiary of Parent in order to accord the Target shareholder tax-free treatment on the receipt of Parent shares. Thus, the ruling essentially adopts a look back approach in determining whether the Parent shares can be received tax-free by the Target shareholders.
This is a sensible approach so that permissible post merger integration planning under Treas. Reg. § 1.368-2(k) does not cause unintended negative tax consequences for the Target shareholders. If the ruling did not adopt this look back approach, Parent would either have to delay its post merger integration planning until the earn out consideration was paid, potentially a delay of years, or Target shareholders would have to pay tax on the receipt of a portion of their Parent shares in an otherwise tax-free merger.