For lawyers, figuring out tax codes, international tax implications, and how to mitigate a client’s tax burden can be…well, taxing. However, a carefully drafted purchase agreement will ensure that tax questions are a central part of any plan of acquisition, especially when these involve multinational mergers and reorganizations.
By examining an Agreement and Plan of Merger and Reorganization for a U.S. company buying two merging Israeli entities, we can learn a lot about the tax implications of multinational M&A deals. Keep reading to get answers on how technical tax requirements are often an important part of large-scale business transactions, and discover how contracts can help your clients navigate their tax responsibilities in a global economy.
Questions in this Episode
- What is the impact of disqualifying factors in a tax-free reorganization?
- What is the relationship between the timing of this transaction and the timing of the taxation?
- How are related and unrelated party transactions different from each other?
- How does a merger affect the company’s obligations?
- How can you use contracts to solve tax implications?
What is the Agreement and Plan for Merger and Reorganization?
This agreement and plan for merger and reorganization is an intra-company merger between different entities in Israel. The parent company is based in the United States. There are two Israeli subsidiaries that are looking to merge.
Recital B appears very early in the contract and the intention behind it is really important to indicate the purpose of the contract. The Internal Revenue Code tries to ensure that every transaction is done for a business or non-tax purpose.
| B. It is intended that, for United States federal income tax purposes, the Merger shall qualify as (i) a transaction described in Section 351 of the Code or (ii) a reorganization within the meaning of Section 368(a) of the Code. The parties to this Agreement adopt this Agreement as a “plan of reorganization” within the meaning of Treasury Regulation Sections 1.368-2(g) and 1.368-3(a). |
Understanding Tax Codes and Timing
The two fundamental corporate reorganization codes in the Internal Revenue Code are 351 and 368. 351 says that it does not regard a transaction if it doesn’t meet certain qualifications like ownership stock. This means that the transfer of property must be made in exchange for stock in the corporation. 368 gives an exemption that allows tax-free reorganizations where there are merging companies. It qualifies as reorg when the acquiring company gives a substantial amount of its own stock as consideration to the acquired company.
| 1.1 The Merger. Upon the terms and subject to the conditions set forth in this Agreement, at the Effective Time (as defined in Section 1.3), Merger Sub shall be merged with and into the Company. By virtue of the Merger, at the Effective Time, the separate existence of Merger Sub shall cease and the Company shall continue as the surviving corporation in the Merger (the “Surviving Corporation”); all, in accordance with the applicable provisions of the Israeli Companies Law. 1.2 Effects of the Merger. The Merger shall have the effects set forth in this Agreement and in the applicable provisions of the Israeli Companies Law. 1.3 Closing; Effective Times of the Merger. (a) The consummation of the Contemplated Transactions (the “Closing”) shall take place at the offices of Law Offices of Xxxxx X. Xxxxxx, 000 Xxxxxxxx Xxxxxx Xxxxx, Xxxxx 000, Xxxxxx, Xxxxxxxxxx, immediately following the delivery of the Company Written Consent and the Merger Sub Written Consent by the Company and the Merger Sub, respectively. The date on which the Closing actually takes place is referred to as the “Closing Date.” (b) Without derogating from any other provision of this Agreement pertaining to the preconditions required to give effect of the Merger, the Merger shall not be in effect until such time as the parties have complied with all conditions pursuant to the law of the State of Israel, and all parties have executed and transferred their signatures to this Agreement, and all deliverables required hereunder the “Effective Time”). |
When it comes to deferring the taxes, very large corporations want to save 100 million dollars for 5 years so those can be reinvested to create more markets and assets. Timing is a complicated issue. If the transaction is going to be taxable after the deferral is over, laying out the dates, the income category, and the closing are all very different things. It’s important to understand the relationship between the timing of this transaction and the timing of the taxation. We may have a transaction close in 2022. But due to certain tax reorganizations or other tax rules, we may not actually recognize that income until 2025. For example, on the sale of an asset. This is what we call the “built in-game.”
Timing is critical, and tax codes 368 and 351 have timing requirements. You’re likely to see language like ‘immediately following’ or ‘immediately before’. - Tyler Stone #ContractTeardown Click To Tweet
International Tax Implications
When you have a foreign country and the U.S., you have two jurisdictions with two different taxing systems, legal systems, and different governments. If we can get the two tax systems to fit, where we’re not double taxing the income in both jurisdictions, that’s the perfect situation for an international tax planner.
| 1.8 Tax Consequences. For federal income tax purposes, to the extent (i) not in contrary with the Israeli Companies Law and/or (ii) that no additional tax liabilities are imposed on the Company and/or its shareholders pursuant to the following, the Merger is intended to constitute (a) a transaction described in Section 351 of the Code or (b) a “reorganization” within the meaning of Section 368 of the Code, and the parties will report the Merger as such for U.S. federal, state and local income tax purposes. None of the parties will knowingly take any action, or fail to take any action, which action or failure to act would cause the Merger neither to qualify as a transaction described in Section 351 of the Code nor to qualify as a reorganization within the meaning of Section 368 of the Code. The parties to this Agreement adopt this Agreement as a “plan of reorganization” within the meaning of Treasury Regulation Sections 1.368-2(g) and 1.368-3(a). |
You have to be really careful when dealing with foreign countries. There’s a lot in the international tax realm, but this is an example of many different laws. We have company laws, corporate laws in the U.S., U.S. tax laws, Israeli tax laws, and tax treaties. It’s not a simple section. You have to work through all these.
Related vs Unrelated Party Transactions
In a related party transaction, your departments are speaking to each other, and it’s easy to figure out who is responsible for which tax filing obligations in which country.
In unrelated transactions, it becomes much more tricky because the seller wants to get rid of all of the liability and responsibility for filing any taxes anywhere in the world, whereas the buyer wants them to stick around for a while.
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3.8 Tax Matters.
(a) Each of the Tax Returns required to be filed by or on behalf of Parent with any Governmental Body with respect to any taxable period ending on or before the Closing Date (the “Parent Returns”): (i) has been or will be filed on or before the applicable due date (including any extensions of such due date); and (ii) has been, or will be when filed, prepared in all material respects in compliance with all applicable Legal Requirements. All Taxes of Parent, whether or not shown on the Parent Returns, due on or before the Closing Date, have been or will be paid on or before the Closing Date. (b) Schedule 3.7(b) sets forth the amount and kind of all unpaid Taxes of Parent as of the Closing (whether or not such Taxes are due or payable) that are attributable to a taxable period or portion thereof occurring prior to the Closing. (c) Neither Parent nor any Parent Return is currently being (or since April 28, 2015 has been) audited by any Governmental Body. No extension or waiver of the limitation period applicable to any of the Parent Returns has been granted (by Parent or any other Person), and no such extension or waiver has been requested from Parent. (d) No claim or Legal Proceeding is pending or, to the knowledge of Parent, has been threatened against or with respect to Parent in respect of any material Tax. There are no unsatisfied liabilities for material Taxes (including liabilities for interest, additions to tax and penalties thereon and related expenses) with respect to any notice of deficiency or similar document received by Parent with respect to any material Tax (other than liabilities for Taxes asserted under any such notice of deficiency or similar document which are being contested in good faith by Parent and with respect to which adequate reserves for payment have been established on the Parent September 30, 2016 Balance Sheet). (e) There are no liens for material Taxes upon any of the assets of Parent except liens for current Taxes not yet due and payable. (f) Parent has not been, and will not be, required to include any adjustment in taxable income for any tax period (or portion thereof) pursuant to Section 481 or 263A of the Code (or any comparable provision of state or non-U.S. Tax laws) as a result of transactions or events occurring, or accounting methods employed, prior to the Closing. (g) Schedule 3.7(g) sets forth all jurisdictions in which Parent has filed a Tax Return since December 31, 2015 and the Tax Returns filed in each such jurisdiction. Parent has delivered or otherwise made available to the Company accurate and complete copies of all Tax Returns of Parent for all Tax years or other relevant periods.(h) No written claim has ever been received by Parent from any Governmental Body in a jurisdiction where Parent does not file a Tax Return that Parent is or may be subject to taxation by that jurisdiction which has resulted or would reasonably be expected to result in an obligation by Parent to pay material Taxes. (i) Parent is not now and has never been a member of an “affiliated group of corporations” within the meaning of Section 1504 of the Code. Parent is not now and has never been a member of any combined, unitary or consolidated or similar group for state, local or non-U.S. Tax purposes or within the meaning of any similar Legal Requirement to which Parent may be subject. (j) There are no Contracts relating to allocating or sharing of Taxes to which Parent is a party or is otherwise bound. Parent is not liable for Taxes of any other Person. Parent is not under any contractual obligation to indemnify any Person with respect to any amounts of such Person’s Taxes. Parent is not a party to any Contract providing for payments by Parent with respect to any amount of Taxes of any other Person. For the purposes of this Section 3.7(j), the following Contracts shall be disregarded: (i) commercially reasonable Contracts providing for the allocation or payment of real property Taxes attributable to real property leased or occupied by Parent and (ii) commercially reasonable Contracts for the allocation or payment of personal property Taxes, sales or use Taxes or value added Taxes with respect to personal property leased, used, owned or sold in the ordinary course of business. (k) Parent has not constituted either a “distributing corporation” or a “controlled corporation” within the meaning of Section 355(a)(1)(A) of the Code. (l) Parent is not, and never has been, a “United States real property holding corporation” within the meaning of Section 897(c)(2) of the Code. (m) Parent has taken no position on any U.S. federal income Tax Return (whether or not such position has been disclosed on any such U.S. federal income Tax Return) that would reasonably be expected to give rise to a material understatement penalty within the meaning of Section 6662 of the Code or any similar Legal Requirement. (n) Parent is not now participating in and has never participated in a “Listed Transaction” or a “Reportable Transaction” within the meaning of Treasury Regulation Section 1.6011-4(b). (o) The Merger will be effected for bona fide non-Tax business reasons and will be carried out strictly in accordance with the Agreement. The terms of the Agreement and all other agreements entered into in connection therewith (the “Transaction Documents”) are the product of arm’s length negotiations. The Transaction Documents represent the entire agreement among the stockholders of the Company (the “Company Stockholders”), Parent, Merger Sub and the Company with respect to the Merger, and there are no other written or oral agreements regarding the Merger (or any transaction related thereto) other than those expressly referred to in the Transaction Documents. (p) In connection with the Merger, the Company Shareholders will not receive in exchange for Company Capital Stock, directly or indirectly, any consideration other than the Parent Common Stock and cash for fractional shares, if any, received in the Merger. No shares of Merger Sub have been or will be used as consideration or issued to the Company Shareholders in the Merger. (q) Neither Parent nor any person related to Parent within the meaning of Treasury Regulation Section 1.368-1(e)(3), (e)(4) and (e)(5) (a “Parent Related Person”) has any plan or intention to directly or indirectly purchase, redeem, or otherwise acquire or reacquire, any of the Parent Common Stock that will be issued in exchange for Company Share Capital pursuant to the Merger. In connection with the Merger, no Parent Related Person and no person acting as an intermediary for Parent or such a Parent Related Person will acquire any of the Parent Common Stock issued in the Merger.(r) Parent and Merger Sub have paid and will pay only their respective expenses, if any, incurred in connection with or as part of the Merger. (s) Merger Sub is a newly-formed, wholly-owned subsidiary of Parent that was created for the sole purpose of facilitating the Merger. Merger Sub has not conducted and is not conducting any business activities, and has had no assets prior to the Effective Time (other than nominal assets contributed upon the formation of Merger Sub, which assets will be treated in accordance with the provisions of Section 323 of the Israeli Companies Law. Prior to the Effective Time, Parent owns all of the equity interests of Merger Sub, and other than the said equity interests, there are no outstanding obligations regarding the Merger Sub’s securities (including without limitations, with respect to any options, warrants, debentures and/or any other commitments and/or contingencies in connection with the Merger Sub’s security interests). (t) Neither Parent nor Merger Sub is an investment company as defined in Sections 368(a)(2)(F)(iii) and (iv) of the Code. (u) The fair market value of the assets of Parent exceeds and will exceed the sum of its liabilities, plus (without duplication) the amount of liabilities, if any, to which those assets are subject. (v) Neither Parent nor Merger Sub is or will be under the jurisdiction of a court in a Title 11 or similar case within the meaning of Section 368(a)(3)(A) of the Code. (w) Prior to the Effective Time, neither Parent, Merger Sub, nor any of their respective affiliates will take or agree to take any action that would reasonably be likely to prevent the Merger from qualifying as a reorganization under Section 368 of the Code. (x) Merger Sub will have no liabilities assumed by the Company and will not transfer to the Company any assets subject to liabilities in the Merger. (y) All Parent Common Stock exchanged in the Merger for Company Share Capital will be voting stock. (z) To the knowledge of Parent and Merger Sub without independent verification thereof: (i) At the Effective Time, the fair market value of the consideration received by each Company Shareholder will be approximately equal to the fair market value of the Company Share Capital surrendered in exchange therefor, and the aggregate consideration received by the Company Shareholders in exchange for their Company Share Capital will be approximately equal to the fair market value of all of the outstanding shares of Company Share Capital immediately prior to the Merger. (ii) Following the Merger, neither Parent nor any Parent Related Person has any plan or intention to make any dividend or other distribution to the Company Shareholders other than regular, normal dividends or distributions made to all holders of Parent Common Stock. (iii) The Company Shareholders will surrender their Company Share Capital solely in exchange for the Parent Common Stock to be issued pursuant to the Merger under similar terms and conditions regarding their issuance and/or grant (as applicable), unless otherwise prescribed herein, the SPAs and/or the Assumption Agreement (if applicable). No liabilities of the Company Shareholders will be assumed by Parent or Merger Sub, nor will any shares of Company Share Capital be acquired subject to any liabilities. (iv) Parent has no present plan or intention: (A) to liquidate the Company or to merge the Company into another entity; (B) to sell or otherwise dispose of any share in the Company held by Parent except in connection with a transaction described in Section 368(a)(2)(C) of the Code; or (C) to sell or otherwise dispose of, or to cause the Company to sell or otherwise dispose of, any of the Company’s assets (including any of the assets of Merger Sub acquired in the Merger), except for (x) dispositions in connection with a transaction described in Section 368(a)(2)(C) of the Code or (y) dispositions in the ordinary course of business consistent with past practices, provided that, after such dispositions in the ordinary course of business consistent with past practices, the representations set forth in Section 3.7(z)(v) would continue to be accurate. (v) Parent does not and Parent will not at the Effective Time have a plan or intention to substantially dispose of or discontinue the Company’s trade or business in a manner that would cause the requirements of Treasury Regulation Section 1.368-1(d) to fail to be satisfied. Following the Merger, Parent, or a member of Parent’s “qualified group,” will continue the Company’s historic business or use a “significant portion” of Company’s “historic business assets” within a business (as such terms are used in Treasury Regulation Section 1.368-1(d)). (vi) Parent will own all outstanding ownership interests of the Company immediately after the Merger. Parent has no plan or intention to cause or permit the Company to issue additional ownership interests (including options, warrants and convertible securities) to any person or entity (other than Parent or pursuant to a transaction described in Section 368(a)(2)(C) of the Code). Immediately after the Merger, the Company will have no outstanding warrants, options, convertible securities or any other type of right pursuant to which any person could acquire interests in the Company that, if exercised or converted, would result in Parent losing control of the Company within the meaning of Section 368(c) of the Code. (vii) Neither Parent nor Merger Sub has any plan or intention to sell or otherwise dispose of any of the assets of the Company acquired in the Merger, except for dispositions made in the ordinary course of business or transfers described in Section 368(a)(2)(C) of the Code. Parent has no plan or intention to sell or otherwise dispose of any equity interest in the Company, except for a transfer (or successive transfers) of at least 80% of the equity of the Company to a corporation controlled (within the meaning of Section 368(c) of the Code) in each case by the transferor corporation. |
We often see escrow accounts being created where the buyer and the seller agree to put money into an account and no one can touch it for six months or a year.
Assumption of Company Obligations
This is going to get a little tax techie, but it’s worth considering.
Code sections 351 and 368 give favorable tax treatment and are often going to allow the exchange of shares or stock in a company for stock in a company. Otherwise, it might not be tax-free because the whole point is that if you’re passing cash along with it, then you’re making a payment.
To get around that, the tax code says that it’s not going to disqualify your entire tax-free status or tax-deferred status, but will look at the consideration you have paid for this company.
When this happens, if there’s anything that’s not accounted for in the shares, that is essentially going to be treated as “boot.” Typically, you can think of it as $100 of shares in company A plus ten dollars of cash in company A and those ten dollars of cash is your boot. That does not qualify for the tax-free treatment because it doesn’t stick with the equity portion.
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1.9 Assumption of Company Obligations. Company is a party to Securities Purchase and Registration Rights Agreements dated December 29, 2016 (the “SPAs”) with a number of investors investing approximately $10 Million in connection with the Closing. Pursuant to the terms of the SPA, Parent shall automatically assume all of Company’s post-Closing obligations under the SPAs, and the warrants being issued therewith, immediately following the Closing as defined herein. To that end, Parent is executing an Agreement for the Transfer and Assumption of Obligations under the Securities Purchase and Registration Rights Agreements, in form attached hereto as Exhibit F, to be delivered at Closing (the “Assumption Agreement”). |
Yet another twist in this interesting section is C’s assumption of liabilities. They want to make it clear that they have an obligation of liability or debt of some kind. If they transfer the obligations in the sale where the seller wants to unload that position and give it to the buyer, the buyer needs to consider everything transferred and check whatever was given outside of shares.
Big Picture of Using Contracts For Tax Purposes
Tax is probably the most critical and the easiest way to tell a court, adversary, target, or buyer what the situation is going to be. If you’re uncertain about tax, which almost everybody is, especially in today’s changing economy, it’s good to have guarantees put in place.
There’s nothing wrong with having tax compliance checklists because so many contracts go through IRS audits, accounting firm audits, and law firm scrutiny and they always seem to be okay. There is authority telling us that the avoidance of taxation itself could be a business purpose in some cases.
Tax is extremely complicated and it doesn't need to be, but it is. - Tyler Stone #ContractTeardown Click To Tweet
Show Notes
Lawyers aren’t accountants, but when drafting corporate purchase agreements, they often have to deal with tax questions. Watch as Tyler Stone, international business law expert, tears down a multinational plan of merger and reorganization and tells us all about the complex tax codes within these contracts. Stone offers an insider understanding of the taxation rules behind global M&A deals, explaining how the system works to incentivize investment and ensure tax responsibilities fall where they should.
THE CONTRACT: AGREEMENT AND PLAN OF MERGER AND REORGANIZATION
THE GUEST: Tyler Stone spent the past 15 years working on international and domestic transactional tax matters at Big 4 and second tier accounting firms. International M&A involving dealing with tax consequences across multiple jurisdictions.
THE HOST: Mike Whelan is the author of Lawyer Forward: Finding Your Place in the Future of Law and host of the Lawyer Forward community. Learn more about his work for attorneys at www.lawyerforward.com.
If you are interested in being a guest on Contract Teardown, please email us at community@lawinsider.com.
Interview Transcript
Mike Whelan [00:00:02] Tyler Stone, welcome to The Contract Teardown. How are you today?
Tyler Stone [00:00:11] I’m doing well, thank you, Mike.
Mike Whelan [00:00:12] I am excited to rehab this conversation with you. We have had this conversation before and you know that it had to happen again because it’s about tax law. The most fun subject in the contracting world. I mean, we deserve to have this conversation twice. What we’re going to do is dig into the tax implications of a document. It’s this document. I will share it with the folks at home. It is an agreement and plan of merger and reorganization as titled. Tyler, before we dig into it, what is this document?
Tyler Stone [00:00:41] So basically, this is a—it’s going to be an intercompany merger between different entities in Israel and the United States. The parent company is a U.S. company and we have two Israeli subsidiaries that are looking to merge.
Mike Whelan [00:00:55] Great. And there’s a bit of a theme to this, which is “let’s play reindeer games with tax codes.” And it’s basically as we’ll talk about toward the end, you know, it’s this question of can you use contracts to solve other purposes, specifically tax implications? Can we signal intentions with it? And so we’re going to go through this thing in some specific sections, as we do. I want you to sort of, you know, key in for us, where are those sections where they’re trying to play those reindeer games and whether you think it’s working or not. So to do that, we’ll start with the recitals. We’ll start with Recital B. It is intended that for United States federal income tax purposes, the merger shall qualify as a transaction in Section 351. We’re laying out intentions. I mean, it’s explicitly saying we’re trying to do X relative to the tax code. What do you think of this section coming up so early in the recitals? Do you think it’s effective in communicating those expectations?
Tyler Stone [00:01:52] Yeah, I mean, that’s a very good question. So the IRS and the Internal Revenue Code is going to want to see that every transaction was done for some sort of business purpose or, in other words, a non tax purpose. So to put this in the front is kind of…kind of you scratch your head and say, well, if it’s the second recital, is it really not the purpose of the contract? Nevertheless, the intent is really important. And this is—I’ve seen thousands of times where we want to try to put the tax code rules upfront and lay them out and say, this is what we’re doing, this is our intention. And you should probably enter into the contract section somewhere about the business purpose of the contracts.
Mike Whelan [00:02:35] Right, like does having it this early actually call attention to, “Hey, tax stuff!” When you know, to your point, you’ve got to show a business purpose. Well, let’s go to the description of the transaction. So this is in section one. And specifically, we’re going to target 1.1 to 1.3 because I wanted to ask you about timing. There’s stuff in here where obviously it describes the merger and who’s in existence after the merger, but it also talks about closing and effective times of the merger. Talk to us about these sections and the relationship between the timing of this transaction and the timing of the taxation.
Tyler Stone [00:03:11] Right, okay, so very good questions. Going back real quick to Rectial B, we see that reference to 351 and 368. So these are sort of the two fundamental corporate reorganizational code sections in the Internal Revenue Code. Three fifty one is going to say that we don’t regard a transaction if it’s certain—it meets certain qualifications, meaning ownership, stock, things like that. Three sixty eight deals with tax free reorganizations, where we’re merging companies or we’re doing some sort of activity that’s not quite exactly just a contribution in three fifty one, but actually more of a reorganization under three sixty eight. So the beauty of this is, and it’s a tricky question, and Mike got right to it. What is the advantage to doing this for tax reasons? So a lot of people are going to say, “tax free reorg, that sounds great!” But in reality, it’s not really a tax-free reorg. It’s a tax-deferred reorg. So you’re really only getting the benefit of the time-valued money. That being said, with large corporations, that benefit is very large.
Mike Whelan [00:04:14] Yeah, and to think of the timing in the description, the transaction in 1.1, 1.3 they are laying out explicitly when we think this is going to happen. And so, you know, to repeat a tax question that is a basic tax question for somebody I can’t remember if I passed federal tax or not, what is the difference between that tax savings and tax deferred? There seems to be, to your point, a lot of effort to make this transaction be in a different year. I don’t know if they’re trying to put it in the year before or the year after or how that works. But like, if you’re making the taxation decision, are you trying to give yourself the flexibility to pick which year this thing goes in? Or do these timing statements make it so we’re saying through the contract, we’re going to peg this transaction in this year for the purposes of taxes.
Tyler Stone [00:05:04] I mean, that’s a great question. There’s a lot there. So first and foremost, I’d say that when we say that we have gone ahead and deferred the taxes again, what I want to reiterate is think of a very large corporation that’s going to save a hundred million dollars for five years, that million dollars is going to be reinvested and create more gains, more assets. So, you know, it’s a plus and a minus on that aspect. And then as far as timing goes, it also is kind of a complicated issue because we want the—if the transaction is going to be a taxable transaction eventually, after the deferral is over, we’re going to want to lay out which dates we want to see the income fall into, which dates we want the transaction to close in. These are very different things, so we may have a transaction close in 2022, but due to certain tax reorganizations or other tax rules that come into play, we may not actually recognize that income until 2025, on let’s say, a sale of an asset that was related to—that has that what we call built in gain. So timing is critical, and 368 and 351 are going to have timing requirements. So it’s—you’re going to see language like “immediately following,” “immediately before,” things like that.
Mike Whelan [00:06:28] Well and again, they’re trying to repeat on a theme I think in 1.8, this section titled Tax Consequences. And it points to something that is not unique but interesting about this conversation, which is that we’re not just dealing with U.S. federal income tax. It does say for federal income tax purposes to the extent not in contract with Israeli companies, law, et cetera. Again, repeats this point about 351 and 368. What do you think about Section 1.8 and particularly the reference to Israeli law and how these, you know, without digging into international tax, which is a whole area, sort of how, you know, when you’re drafting a contract, you need to be mindful of the fact that you’ve got international tax implications.
Tyler Stone [00:07:13] Certainly. So, yes, like you said, international tax is quite complicated. It’s something I’ve focused on, but I’m not going to dig into it here because I don’t think it’s relevant to this conversation. But you’re absolutely right, Mike. When you have a foreign country and you’re dealing with the U.S., you have two jurisdictions with two different taxing systems, two different legal systems, two different governments. There’s an aspect of you could call it comparative law, possibly, or something along those lines where it’s going to take somebody who kind of has an understanding of accounting, finance and economics that can take the tax rules in the United States, look at the tax rules in another country and kind of somehow get to that same meeting. And if we can get the two tax systems to fit, where we’re not double-taxing the income in both jurisdictions, that’s the perfect ideal situation for an international tax planner, other than, of course, putting everything in the Cayman Islands, which is not advised. So, yeah, I mean, I think you make it—you make a really good point about that, Mike, we have to be really careful when we’re dealing with foreign countries. Again, there’s a lot in the international tax realm, but I would just say this is an example of many different laws. We have company’s laws, corporate laws in the U.S., U.S. tax laws, Israeli tax laws. We have tax treaties. So there’s a lot that goes in here. So it’s not just…it’s not just a simple section. You really got to work through all these.
Mike Whelan [00:08:43] Yeah. And it’s tough because it feels almost prohibitive, right? Like if you’re one of these big companies and you can go hire one of the big four accounting firms who you worked for for a while and get all of this stuff figured out—at the same time, you know, we’ve got all of these very international transactions now. I mean, we’re very connected. And so you have even small transactions significantly smaller than this who are, you know, trying to work together. And it’s just, you know, crazy to think of the cost structure of figuring this stuff out that’s associated with what might not be that big of a transaction.
Tyler Stone [00:09:18] Yeah, that comes up—yeah, I mean, one other thing to think about just anecdotally is if we’re doing a merger like this across borders, the US company may want to send some of its employees to Israel for a year or two, maybe a month or two, maybe forever. That’s when we get into our expatriate talk and get into all that stuff, so definitely not going to touch that today. But I mean, it’s just an example, a couple paragraphs in this contract that seem pretty—pretty benign, actually have quite a bit in them.
Mike Whelan [00:09:50] Yeah. Again, an interesting thing that we’re trying to do with the contract, something that reflects what we’re trying to do in compliance, right? So speaking of 3.8, this is a really long section. 3.8 really is going multiple pages covering all kinds of things, and some of them are, you know, to your point, fairly benign. They’re trying to state what—they’re trying to lay out what the state of the two companies are beforehand and afterwards and in our conversation before I referred to this as a prenup, right, that this agreement where you’re laying out, “here are my obligations, here are your obligations.” I’m making representations that I’m not being sued right now, that I’m not messing around on my taxes. What do you think of Section 3.8 and tax matters for that purpose?
Tyler Stone [00:10:35] So this is critical when you’re dealing, especially—you know, I didn’t say this last time, and it occurred to me just now—but especially when you’re dealing with the unrelated party transaction, this becomes very critical; in a related party transaction it’s hopefully not as critical, because your departments are speaking to each other, and it would be pretty easy to figure out who is responsible for what tax filing obligations in which country. In an unrelated transaction that becomes much more tricky because the seller wants to probably get rid of all of the liability, all of the responsibility for filing any taxes anywhere in the world. Whereas the buyer is going to want them to stick around for a little while and wait. So we’ll often see these escrow accounts created where the buyer and the seller agree that they’re just going to put money into an account, no one can touch it for six months, a year, something like that. But these tax matter issues really are, who is going to file what returns? And when you have different companies with different interests and they’re, you know, they’re working toward a merger—and I’ve seen this happen the day the merger happens—those two people never talk again. They might spend, you know, a month talking every day for five hours. They’ll never talk again. So when it comes to figuring out who’s responsible for filling out the tax forms, this section is critical. It’s important.
Mike Whelan [00:12:00] Speaking of nerdy things that I don’t know what you’re talking about, you introduced me to a term when we spoke before, which is “the boot.” Pirate’s Boot—Booty, obviously. We’re going to talk about Section 1.9 and it’s titled Assumption of Company Obligations. Tell us about Section 1.9, what it’s trying to do and specifically what this boot is that you were referring to.
Tyler Stone [00:12:24] Sure. So this is going to get a little tax techy, but I think it’s worth it here, I think it’s definitely called for in this case. So the assumption—so basically when we have 351, 368, these different code sections that are giving us favorable tax treatment, they’re often going to be these rules that say, you can only exchange shares. You can only exchange stock in a company for a stock in a company. Otherwise, it might not be tax free because the whole point is, if you’re passing cash along with it, then you’re kind of making a payment, or you could be making a payment, in any kind of—in a hidden manner. So to get around that, what the tax code says is, we’re not going to disqualify your entire tax free status or tax deferred status, but we are going to look at the consideration that you have paid for this company. And in doing so, if there’s anything that’s not accounted for in the shares, that is essentially going to be treated as what we call boot. Typically, you think of it as $100 of shares in company A, plus ten dollars of cash in company A: that ten dollars of cash is your boot. That does not qualify for the tax free treatment. The tax free treatment sticks only with the equity portion. So putting yet another twist on that, this is a really interesting section because it’s saying the assumption of contingencies—the assumption of liabilities. What they’re really getting at, of course, here is that they want to make it clear—let me just pull the language itself—they want to make it clear, yeah, that they have an obligation, essentially a liability or debt of some kind, it could even be a tax debt, but that the obligation is out there and if they transfer that obligation in the sale—so if the seller wants to essentially unload that position with me and give me as the buyer the potential for this—then essentially I’m going to have to look at everything they’ve given me and anything outside of shares, which is cash and then assumption of liability. This is now the big one. So that’s why I really wanted to pull this section out, sorry I was kind of long- winded there. But basically, boot is consideration paid that it’s not in equity and it doesn’t have to necessarily be a positive rate. It can be a liability. So you have to look into these things.
Mike Whelan [00:15:00] Got it, and I’m thinking sort of big picture as we close, as we often do. I can’t be the only lawyer who was like, “man, tax law,” right? We all, you know, there’s the cliche we didn’t go to law school to do math. And I think for a lot of us, that’s true. But these people are doing something purposeful, which is using the contract to check some boxes on some tax compliance issues. It sounds like from what you said before, there’s a risk to that, that the IRS might feel like that’s literally all you’re trying to do with this document and with this transaction. But also, I assume there’s an opportunity here. There’s a way for businesses to use contract drafting to make sure that they satisfy the client and to get out of or, you know, adjust some of those taxes to their advantage. What do you think about that? What do you think about the big picture of using contracts for these tax purposes?
Tyler Stone [00:15:59] You know, I think it’s probably the most critical—the easiest way to tell a court or to tell an adversary or a target or a buyer of what the situation really is going to be. If you’re uncertain about tax, which almost everybody is, especially in today’s economy, as it’s changing around the world at rates we’ve never seen, if you’re not sure about tax, it’s good to have those sort of guarantees put in place. So you have those checklists put in place. I don’t think there’s anything wrong with it. And I’m saying that mostly from experience, just because I’ve seen so many of these contracts go through IRS audit, other accounting firm audit, law firm scrutiny, etc. and they always seem to be okay. So, yeah, I mean, I would stick with that. And one other anecdote, and I didn’t want to point this out, but I will say it. There is some ruling, some sense and some authority that is telling us that the avoidance of taxation actually itself could be a business purpose in some cases. So I’ll leave it there and just say the tax is extremely complicated and it doesn’t need to be, but it is. And I think that’s a perfect example of it that, you know, we have to have a non tax business purpose. Okay, the non tax business purpose is to save taxes. Well, what is it?
Mike Whelan [00:17:22] Yeah, it’s interesting because obviously, you know, politicians use the tax code to do all kinds of social engineering, really. And so they’re favoring an activity, and the activity that the code is trying to favor is, you know, economic movement, the movement of money. And so these kinds of deals are actually within their purpose. But you know, if people start playing too many reindeer games, it makes sense that it starts to undermine the initial social engineering.
Tyler Stone [00:17:50] Yeah. No, I think I think you said it really well. I think that’s a very good way to put it.
Mike Whelan [00:17:55] Well, I’ll tell you what, Tyler, I never want to talk to you again about taxes. I want this to be the last time that we talk about it. [Both laugh.] But other people who are watching this might love talking to you about the tax implications of these documents. If people want to chat with you, what’s the best way to reach out?
Tyler Stone [00:18:09] Sure. So please, you can reach out to me by phone if you like nine four nine four six six seven four two nine. Alternatively, and probably better, would be by my personal email, which is stone tyler zero three at Yahoo dot com. Look forward to any questions you have. Feel free to reach out to me.
Mike Whelan [00:18:32] Perfect. We’ll have that information, a link to this contract over at the blog post on lawinsider dot com slash resources. And if you want to be a guest on The Contract Teardown Show to beat up contracts like this, just email us. We are at Community at Law Insider dot com. We will see you all next time, Tyler. Thank you again, again. We’ll see you guys next time!