March 16, 2009

“You’re Going the Wrong Way!”

– by John Jenkins, Calfee Halter & Griswold

Remember the scene in “Planes, Trains and Automobiles” where John Candy and Steve Martin are driving the wrong way down an interstate highway? A couple driving in the adjacent lane roll down their window and repeatedly scream “you’re going the wrong way!!” in an effort to get them to turn around. Candy and Martin ignore their warnings, only to eventually look up and see two semi-trucks bearing down on them at high speed. Hilarity ensues.

I am frequently reminded of this scene when I look at the initial draft of a merger agreement for a taxable acquisition and find the deal structured as a forward subsidiary merger (i.e., one in which the target merges into the buyer’s merger sub, with merger sub as the surviving corporation). I’m sure there may be some tax or non-tax reasons to structure a taxable transaction in this manner from time to time, but a forward merger usually is not the preferred way to structure a taxable corporate acquisition. In fact, it is usually the worst possible structure for such a transaction.

That’s because – in the strange universe presided over by the IRS – there are no such things as taxable “mergers.” There are taxable stock acquisitions, and taxable asset acquisitions. If the IRS thinks your deal looks like a taxable asset acquisition, you get hit with double taxation (gain is taxed at the corporate and shareholder level).

For the past 40 years, the IRS has taken the position that a forward merger is an asset acquisition subject to double taxation. (If you’re interested, the pertinent authority is Rev. Rul. 69-6, 1969-1 C.B. 104). In contrast, a reverse subsidiary merger (i.e., one in which merger sub is merged into the target, with the target surviving) is treated as a stock acquisition. This is the classic trap for the unwary – and some scholars have argued that the IRS should do away with distinction between forward and reverse mergers, and treat all cash mergers as stock purchases.

It should be noted that when you’re dealing with a tax-free reorganization under Section 368 of the Internal Revenue Code, forward mergers frequently make quite a bit of sense, particularly because you can issue a lot more cash or other non-stock consideration in these transactions than you can in tax-free reverse subsidiary merger.

Putting aside the tax issues, a reverse subsidiary merger structure is often preferable to a forward merger because this structure tends to trigger a lot fewer change of control clauses and consent requirements than does a forward merger structure. Yet despite these tax and non-tax considerations, it’s remarkable how frequently the first draft of deal documents contemplates a forward merger.

Going the wrong way was pretty funny when John Candy and Steve Martin did it, but it’s a lot less amusing if the parties to a merger agreement for a taxable deal do it.