WITH a downward surge in the US economy, the valuations of the US companies have come down. Valuations of Indian companies have also declined, but not in the same proportion, making US companies attractive targets for Indian buyers.

With the size of acquisitions increasing, there has also been a shift towards using equity, GDRs or ADRs of the acquirer as the currency for the acquisition. It would be interesting to study some of the structures followed and the taxation issues involved in structuring US acquisitions by an Indian
company.

Structuring the acquisition:
Once the preliminary due diligence is complete, structuring the transaction is the most crucial step for any acquisition. This can be done in several ways and each could have different tax implications. The basic forms that are used for acquisition in the US are:

Asset/stock acquisition: In an asset acquisition, the buyer would acquire assets of a target for consideration which is normally in cash. In a stock acquisition, the buyer acquires stock of the target from its existing shareholders instead of its assets.

From the buyer’s taxation perspective, it may be better to opt for asset acquisition, where it is expected to realize substantial value from sale of assets. Thus, the buyer can step up the cost basis of the assets to the purchase price.

Stock swap: In a stock swap deal, a buyer would acquire the stock of the target by issuing its own stock to the target’s shareholders. This makes the transaction tax free, if structured appropriately.

Merger: A merger could be a forward merger or a reverse merger. In a forward merger, the target merges into the buyer. For US tax purposes, this transaction is treated as an asset sale by the target to the buyer and subsequent liquidation of the target and distribution of proceeds to the shareholders of the target.

However, in a reverse merger, the buyer merges into the target and the shareholders of the buyer get stock in the target. This is treated as a stock acquisition by the buyer. It is perceived that the merger transactions and in particular, the reverse merger, has the tax advantages of the asset acquisitions and simplicity and convenience of stock acquisitions.

Triangular merger or subsidiary merger: This is the most widely used way of acquiring US companies. Such type of acquisitions/mergers could be structured as an “acquisition” from the Indian legal perspective and “merger” from the US legal perspective.

A triangular merger is said to occur when the buyer sets up an acquisition subsidiary which merges into the target. As a result of the merger, the target would become a wholly-owned subsidiary of the acquirer and shareholders of the target would get shares of the acquirer.

A triangular merger can be structured as forward or reverse triangular merger. In a forward triangular merger, the acquisition subsidiary would survive as a result of the merger between it and the target, while the target would survive as a result of the reverse triangular merger.

Front-end tender offer/back-end merger: An acquisition can not be consummated before all regulatory approvals are obtained. In cases where regulatory approvals may be time-consuming, one may follow this structure as opposed to single step structures as described above, to safeguard against counter bids.

In a front-end tender offer/back-end merger structure the buyer may acquire stock of the target for option to acquire stock in the buyer or for cash. After approvals are in place, the target would merge with the buyer.

Tax planning: Pre-acquisition tax planning may have an impact on the target’s post-acquisition operations. In cross-border acquisitions, especially in US acquisitions, issues like tax-free reorganizations for stock swap deals may be relevant. In a stock swap deal, the shareholders of the target are not distributed any cash but are issued fresh stock of the buyer.

If the share swap results in a taxable event for the shareholders of the target, it could break the deal, as the shareholders of the target would become liable to pay capital gains tax at a point of time when they have not received any cash. Section 368 of the IRC lists certain tax-free reorganizations in case of stock swap, merger or triangular merger deals.

The most commonly used forms are A, hybrid A, B, C and D types of reorganizations. In order to qualify as a tax-free reorganization the target and acquirer should meet the following conditions. The US believes that for a merger to be tax-free, it has to be a merger of equals.

This means that, value of the acquirer should be at least equal to that of the target at the time of merger. As a result of merger, the US resident shareholders of target should not get more than 50% ownership in the acquirer.

The post-acquisition holding of the US resident shareholders of the target (including pre-acquisition holding, if any) in the combined entity should not be more than 50 per cent of the combined entity.

The substantial US resident shareholders of the acquirer will have to sign a “Gain Recognition Agreement” with the IRS, undertaking that in case the acquirer sells the shares in the target within a period of 5 years, the transaction will lose the tax-free status and they will be subject to tax on the merger. The acquirer should be engaged in an active trade or business at least for a period of 36 months before the acquisition.

Compliance with these conditions is not always possible, especially considering the traditional software model that is followed, that of using Indian arm as a development center whereas US arm acting as the marketing unit.

Interpretation of these conditions in light of the interplay between the two diverse legal and tax systems of US and India can be a great challenge to the tax professionals of both countries.