February 9, 2018

M&A Tax: IRS Adopts New “Safe Harbor” for Valuing Stock Consideration

Companies have to jump through quite a few hoops in order for an acquisition to qualify as a tax-free reorganization. One of these is the “continuity of interest” (COI) requirement. The IRS says that in order for a deal to qualify for tax free treatment, there must be sufficient continuity of the target’s pre-deal shareholders’ proprietary interest in the corporation – and that’s been interpreted to mean that at least 40% of the deal’s value must be in the form of the buyer’s stock.

Determining the value of a buyer’s stock issued as consideration for a merger can sometimes get a little dicey. The IRS used to look to the closing date values in order to determine whether the COI test was met – and fluctuations in the market price sometimes made for a wild ride. In 2005, it changed its approach for fixed price deals, and looked at the signing date value in making the COI call.

That made things easier for deals with a fixed price – but can still make the pre-signing period a bumpy ride for deals that are close to the line. What’s more, deals in which the consideration isn’t fixed – i.e., those where the number of shares delivered or the value of the cash will be adjusted to offset changes in value between signing and closing – are still evaluated at the closing date.

Now, this King & Spalding memo reports that the IRS has adopted a “safe harbor” that will allow companies to determine compliance with COI by reference to the average trading price of the buyer’s shares over a measuring period, which should help smooth out some of the effects of short-term market volatility on the COI calculation. Here’s an excerpt:

Under the Revenue Procedure, if taxpayers use one of three safe harbor valuation methods (a “Safe Harbor Valuation”) to determine the value of acquirer stock for purposes of setting “the number of shares of each class of [acquirer] stock, the amount of money, and any other property” to be included in the consideration mix, then the Safe Harbor Valuation can also be used to value the stock for COI purposes in lieu of the value that would normally apply under the Signing Date Rule or the Closing Date Rule.

The three permitted Safe Harbor Valuation methods are: (1) the average of the daily volume weighted average prices of a stock, (2) the average of the daily average high-low trading prices for a stock, or (3) the average of the daily closing prices of a stock. Each of these three methods must be applied over a “Measuring Period” of between five and 35 consecutive trading days. If the Signing Date Rule applies, the Measuring Period must end no earlier than three trading days before the day prior to signing and no later than the day prior to signing (or, if earlier, the last pre-signing trading day). Similarly, if the Closing Date Rule applies, the Measuring Period must end no earlier than three trading days before closing and no later than the closing date (or the last pre-closing trading day).

John Jenkins