This article considers the intersection of the corporate law tool known as the “top up option” with the Internal Revenue Code’s section 338, which permits an election that can be favorable after certain corporate stock purchases.
The Top Up Option under Delaware Law. Two step taxable stock acquisitions by tender offer and follow-on squeeze out merger frequently employ what are called top up options. These are best explained by the Delaware Chancery Court opinion that approved their use, Olson v. ev3, Inc., 2011 Del. Ch. LEXIS 34 (Feb. 21, 2011):
A top-up option is a stock option designed to allow the holder to increase its stock ownership to at least 90 percent, the threshold needed to effect a short-form merger under Section 253 of the Delaware General Corporation Law (the “DGCL”), 8 Del. C. § 253. A top-up option typically is granted to the acquirer to facilitate a two-step acquisition in which the acquirer agrees first to commence a tender offer for at least a majority of the target corporation’s common stock, then to consummate a back-end merger at the tender offer price if the tender is successful.
In that case a shareholder contested the use of a top up option and its effect on the appraisal of the shares under Delaware law, arguing also that the directors failed to follow state law in the agreed issuance of the shares. The suit was settled in the shareholder’s favor and the matter before the court was the fee to be awarded the shareholder/plaintiff. Because the court found the top up option not to have affected the appraisal, a minimal fee was awarded with respect to that part of the claim. However, a substantial fee was awarded as to the directors’ noncompliance with the statute.
The noncompliance was the failure of the acquisition agreement to specify the terms of the note to be paid for the top up shares. Without those terms it was impossible for the directors to perform their statutory duty to determine that proper consideration would be received for the shares. Moreover, the shareholder’s suit settlement resulted in the top up agreement being changed to provide for payment in cash, which evidently was required by Delaware law during the year in issue.
The defendant (the corporation) argued that the top up shares and the terms of the note were of little significance because the shares were outstanding only one day. The court rejected that argument, stating that the issuance of shares is “an an act of fundamental legal significance having a direct bearing upon questions of corporate governance, control and the capital structure of the enterprise. The law properly requires certainty in such matters.” The opinion of the court did not indicate that if a note had been issued it would be meaningless; rather it considered the note important, which is why it required that the note terms be specified.
Federal Tax Consequences. What is the effect on a qualified stock purchase (“QSP”) for section 338 purposes if a top up option is used and the acquirer purchases a significant amount of target stock from the target for a note? Section 338 allows certain favorable elections when a stock acquirer purchases 80% of the vote and value of a target corporation within a year, under certain circumstances. Meeting the definition of “purchase” used in “qualified stock purchase” is very important to obtaining the favorable section 338 election results.
Example: P buys 50 of T’s 100 outstanding shares in a tender offer for $50. Pursuant to a top up option it buys 400 shares from T, giving it 450/500 shares or 90% of T, before the squeeze out merger (and 100% after). This stock issuance is respected by Delaware law and permits P to cause a short form merger to occur to effectuate the squeeze out. This could not occur (or would be harder to effectuate) if P did not own 90% of the T stock. If the qualified stock purchase analysis is done on the basis of T having 500 shares outstanding, then P has not made a QSP unless the purchase of the 400 shares from T counts. Alternately, if the 400 shares can be ignored for QSP purposes, P has made a QSP because it has bought 100% of the outstanding T stock for cash from unrelated parties. It may not be entirely clear that the 400 shares can be ignored, or that if they are regarded that they count as purchased stock, although the best analysis is that the 400 shares be ignored.
Analysis. The problem is the definition of a stock purchase in section 338(h)(3). It excludes purchases from related persons and stock acquired in section 351 exchanges. T would be a related person but for a special exception for purchases from a related corporation at least 50% of the stock of which P had purchased. That exception would apply to the example, and indeed the exception sounds like it was written for this very case. However, early commentary on the 1984 act that created the exception described the provision not in terms of a two step tender offer but rather in terms of buying 50% of X and then buying stock of Y from X. Deloitte Haskins & Sells, Analysis of the Tax Reform Act of 1984, 24 Tax Notes 67 (July 2, 1984); New York State Bar Assoc. Report on Temporary Section 338 Regulations, 30 Tax Notes 137 (Jan. 13, 1986).
Nevertheless, the terms of that exception literally apply, so the related party seller rule should not be a problem, but that leaves the rule that excludes a stock acquisition in a section 351 exchange. An exchange of cash or a note for stock after which the purchaser owns 80% of the stock is literally subject to section 351, even though the nonrecognition results provided by section 351 are not needed on these facts. Moreover, an early commentary also observed that a section 351 exchange could be excluded from the purchase category even if the exchange was of cash for target stock. New York State Bar Report (expressing disagreement with this result). There does not appear to have been any published rulings or private guidance on either of these subjects.
The foregoing analysis of the definition of purchase leaves the matter somewhat up in the air if the 400 shares in the example must be counted. The most reasonable analysis is that the 400 shares should not be counted, just as they were ignored by the Delaware law in valuing the target corporation through appraisal. This is the type of disregarding of a transitory event that the IRS normally would go along with, but for one unsettling fact: at least in Delaware, and under the cited case, the stock was not simply disregarded for all purposes. Indeed, the Delaware court could hardly disregard it since that stock was the statutory key to allowing the short form merger.
Conclusion. If the facts of the example are that the top up option stock is issued for a note and the note is immediately canceled when P obtains ownership of all of T, and if the state law is ok with that purposeful transitoriness, then the tax law normally would allow the taxpayer to disregard the 400 shares and the note as transitory and to treat P as purchasing all of the stock of T, the 100 shares.
To insure this result the parties should make clear in their agreement the transitory nature of the top up shares and any payment therefore. However, if the corporate law makes such treatment problematic, then perhaps a ruling should be sought from the IRS.
For additional information call Jack Cummings, Alston & Bird LLP, 919-862-2302