Friday, January 3, 2014
The Sysco Merger and the Double Dummy
Recently a financial advisor called me to discuss investments and, more specifically, Sysco’s acquisition of U.S. Foods. I had to read up on what he was talking about.
The Sysco deal is a reverse triangular merger. It is not hard to understand, although the terms the tax attorneys and CPAs throw around can be intimidating. Let’s use an example with an acquiring company (let’s call it Big) and a target company (let’s call it Small).
· Big creates a subsidiary (Less Big).
· Less Big merges into Small.
· Less Big ceases to exist after the merger.
· Small survives.
· Big now owns Small.
This merger is addressed in the tax Code under Section 368, and the reverse triangular is technically a Section 368(a)(2)(E) merger. Publicly traded companies use Section 368 mergers extensively to mitigate the tax consequences to the companies and to both shareholder groups.
In an all-stock deal, for example, the shareholders of Small receive stock in Big. Granted, they do not receive cash, but then again they do not have tax to pay. They control the tax consequence by deciding whether or not to receive cash (up to a point).
Sysco used $3 billion of its stock to acquire U.S. Foods. It also used $500 million in cash.
And therein is the problem with the Section 368 mergers.
It has to do with the cash. Accountants and lawyers call it the “basis” issue. Let’s say that Sysco had acquired U.S. Foods solely for stock. Sysco would acquire U.S. Foods' “basis” in its depreciable assets (think equipment), amortizable assets (think patents) and so on. In short, Sysco would take over the tax deductions that U.S. Foods would have had if Sysco had left it alone.
Now add half a billion dollars.
Sysco still has the tax deductions that U.S. Foods would have had.
To phrase it differently, Sysco has no more tax deductions than it would have had had it not spent the $500 million.
Then why spend the money? Well… to close the deal, of course. Someone in the deal wanted to cash-out, and Sysco provided the means for them to do so. Without that means, there may have been no deal.
Still, spending $500 million and getting no tax-bang-for-the-buck bothers many, if not most, tax advisors.
Let’s say you and I were considering a similar deal. We would likely talk about a double dummy transaction.
The double dummy takes place away from Section 368. We instead are travelling to Section 351, normally considered the Code section for incorporations.
Let’s go back to Big and Small.
· Big and Small together create a new holding company.
· The holding company will in turn create two new subsidiaries.
· Big will merge into one of the subsidiaries.
· Small will merge into the other subsidiary.
In the end, the holding company will own both Big and Small.
How did Small shareholders get their money? When Big and Small created the new holding company, Small shareholders exchanged their shares for new holding company shares as well as cash. Was the cash taxable to them? You bet, but it would have been taxable under a Section 368 merger anyway. The difference is that – under Section 362 – the holding company increases its basis by any gain recognized by the Small shareholders.
And that is how we solve our basis problem.
The double dummy solves other problems. In a publicly traded environment, for example, a Section 368 merger has to include at least 40% stock in order to meet the continuity-of-interest requirement. That 40% could potentially dilute earnings per share beyond an acceptable level, thereby scuttling the deal. Since a double dummy operates under Section 351 rather than Section 368, the advisor can ignore the 40% requirement.
The double dummy creates a permanent holding company, though. There are tax advisors who simply do not like holding companies.
Sysco included $500 million cash in a Section 368 deal. Assuming a combined federal and state tax rate of 40%, that mix cost Sysco $200 million in taxes. We cannot speak for the financial “synergies” of the deal, but we now know a little more about its tax implications.