P&G, Coty And A Unicorn Named Morris

You may know that P&G is streamlining, selling off non-core lines of business. It just concluded a deal to sell 43 beauty brands, including Clairol and Max Factor, to Coty, Inc. The deal appears to be good for Coty, as it will double sales and transform Coty into one of the largest cosmetic companies in the world. P&G in turn receives $12.5 billion.

What makes it interesting to the tax planners is the structure of the deal: P&G is using a “reverse-Morris” structure. It combines a carve-out of unwanted assets (unwanted, in this case, by P&G) with a prearranged merger. The carve-out is nontaxable, but if you err with the merger the carve-out becomes taxable. This is a high stakes game, and woe unto you if the IRS determines that the merger was prearranged. The reverse Morris is designed to directly address a prearranged merger.

Let’s walk through it.

First, what is a “regular” Morris?

Let’s say that you own a successful and publicly-traded company (say Jeb). You have a line of business, which we shall call Lindsey. Someone (“Donald”) wants to buy Lindsey. Jeb could flat-out sell Lindsey, but the corporate taxes might be outrageous. Jeb could alternatively spinoff Lindsey to you, and you in turn could sell to Donald. That would probably be preferable.

Why?

Front and center is the classic tax issue with C corporations: double taxation. If Jeb sells, then Jeb would have corporate taxes. Granted, Jeb would distribute the after-tax proceeds to you, but then you would have individual taxes. The government might wind up being the biggest winner on the deal.

Forget that. Let’s spinoff Lindsey tax-free to you, and you sell to Donald. There would be one tax hit (yours), which is a big improvement over where we were a moment ago.

But you cannot do that.

You see, under regular corporate tax rules a tax-free merger with Donald within two years of a spinoff would trigger BAD tax consequences. We are talking about the spinoff being retroactively taxable to Jeb. Jeb will have to amend its tax return and write a big check. That is BAD.

I suppose you could tell Donald to take a hike for a couple of years while you reset the clock. Good luck with that.

You talk to your accountant (“Hillary”). She recommends that you have Jeb borrow a lot of money. You then drop Lindsey into a new subsidiary and spinoff new Lindsey to you. You leave the debt in Jeb. You then sell Jeb to Donald. Donald takes over the debt. He doesn’t care. Donald just offsets whatever he was going to pay you by that debt.

This is a Morris deal and Congress did not like it. It looked very much like a payday.

• The cash is in Lindsey
• The debt is in Jeb
• You sell Jeb
• You keep Lindsey
• You keep the money that is in Lindsey
• The government doesn’t get any money from anybody

The government was not getting its vig. Congress in response wrote a new section into the tax Code (Section 355(e)) which triggers gain if more than 50% control of either the parent or subsidiary changes hands. 

Yep, that pretty much will shut down a Morris deal. Donald wants more than 50% control. Donald is like that.

Now, Section 355(e) presented a challenge to the tax attorneys and CPAs. Think of it as an epic confrontation between a chromatic Great Wyrm and your 28th level paladin at the weekly Saturday night D&D game. The players were not backing down. No way.

So someone said “the deal will work if the buyer will accept less than 50% control.”

Eureka!

Let’s take our example above and introduce a different buyer (let’s call him Bernie). Bernie wants to buy Lindsey. Bernie is willing to accept less than 50%, as contrasted to that meanie Donald. Same as before, let’s drop Lindsey into a new subsidiary. New Lindsey borrows a lot of money and ships it to Jeb. New Lindsey, now laden with debt, is sold to Bernie. Bernie takes over the debt as part of the deal. When the dust settles, Bernie will own less than 50% of new Lindsey, which gets us out of the Section 355(e) dilemma.

You in turn keep Jeb and the cash.

And that is the reverse Morris. We sidestep Section 355(e) by not allowing more than 50% of either Jeb or Lindsey to change hands.

Why do we not see reverse Morris deals more often? There are three key reasons:

1. It requires a buyer that is smaller than the target, but not so small that it cannot do the deal. 
2. There will be new debt, likely significant. This raises the business risk associated with the deal, as the bank is going to want its money back.
3. The new company’s management and board may be an issue. After all, the buyer BOUGHT the company. It is not unreasonable that Bernie wants to control what he just bought. I would want to drive the new car I just bought and paid for.

The Reimann family of Germany owns approximately two-thirds of Coty. Even though Coty is acquiring less than 50% of the P&G subsidiary, the Reimann’s will own a large enough block of stock to have effective control. That must have helped make the reverse Morris attractive to Coty.

Reverse Morris deals are not unicorns, but there have been less than 40 of them to-date. That makes them rare enough that the tax specialists look up from their shoes when one trots out. P&G by itself has had three of them over the last ten or so years. Someone at P&G likes this technique.

Pfizer Wants To Decrease Its Taxes By Moving To Britain

I am reading the following headline at Bloomberg Businessweek: “Pfizer’s $99 Billion Bid for AstraZeneca Is a Tax Shelter.”

No, it is not. This is a tax shelter the same way I am Floyd Mayweather Jr.’s next opponent.

It is sign of a problem, though.

Pfizer is based in New York City. AstraZeneca is based in London. Pfizer has proposed the deal, but AstraZeneca has not yet accepted. The deal may fall yet fall through. There are any number of reasons why a drug company would buy another drug company, but this one would move one of the largest U.S. multinationals to London. The term for this is “inversion.”

Mind you: the Pfizer executives are not moving. They will remain in New York, and Pfizer research facilities will remain in Connecticut. Pfizer will however go from being a U.S.-based multinational to a U.K.-based one. How? There will be a new parent company, and that parent will be based in London. Voila!

Inversions are more complicated than they used to be. In 2004 Congress passed IRC Section 7874, which denies tax benefits to an inversion unless certain thresholds are met. For example,

·       If the former shareholders of the former U.S. parent own 80% or more of the foreign corporation after the inversion, then the inverted company will continue to be considered – and taxed – as a U.S. company.

You can quickly assume that new – and non-U.S. shareholders – will own more than 20% of the new Pfizer parent.

What if you own Pfizer stock? In addition to owning less than 80% of the new parent, code Section 367 is going to tax you when Pfizer inverts. This is considered an “outbound” transaction, and there is a “toll” tax on the outbound. What does that tell you? It tells you that there has to be cash in the deal, otherwise you are voting against it. There has to be at least enough cash for the U.S. shareholders to pay the toll.

Let’s say the deal happens. Then what?

I cannot speak about the drug pipeline and clinical trials and so forth. I can speak about the tax part of the deal, however.

As a U.S. multinational, Pfizer has to pay taxes on its worldwide income. This means that that it pays U.S. taxes on profits earned in Kansas City, as well as in Bonn, Cairo, Mumbai and Sydney. To the extent that a competitor in Germany, Egypt, India or Australia has lower tax rates, Pfizer is at an immediate disadvantage. In the short term, Pfizer would be less profitable than its overseas competitor. In the long term, Pfizer would move overseas. Congress realized this and allowed tax breaks on these overseas profits. Pfizer doesn’t have to pay taxes until it brings the profits back to the United States, for example. Clever tax planners learned quickly how to bend, pull and stretch that requirement, so Congress passed additional rules saying that certain types of income (referred to as “Subpart F” income) would be immediately taxed, irrespective of whether the income was ever returned to the United States. The planners responded to that, and the IRS to them, and we now have an almost incomprehensible area of tax Code.

Take a moment, though, and consider what Congress did. If you made your bones overseas, you could delay paying taxes until you brought the money back to the U.S. Then you would have to pay tax – but at a higher rate than your competitor in Germany, Egypt, India or Australia. You delayed the pain, but you did not avert it. In the end, your competitor is still better off than you, as he/she got to keep more of his/her profit.

What do you do? Well, one thing you cannot do is ever return the profit to the United States. You will expand your overseas location, establish new markets, perhaps buy another – and foreign – company. What you will not do is ship the money home.

How much money has Pfizer stashed overseas? I have read different amounts, but $70 billion seems to be a common estimate.

When Pfizer inverts, it may be able to repatriate that money to the U.S. without paying the inbound toll. That is a lot of money to free up. I could use it.

The U.S. also has one of the highest – in truth, maybe the highest – corporate tax rate in the world. The U.K. taxes corporate profits at 20%, compared to the U.S. 35%. The U.K. also taxes profits on U.K. patents at 10%, an even lower rate. This is a pharmaceutical company, folks. They have more patents than Reese’s has pieces. And the U.K. taxes only the profits generated in the U.K., which is a 180 degree turn from Washington’s insistence that it can tax profits of an American company anywhere on the planet.

Now, Pfizer does not get to avoid U.S. taxes altogether. It will still pay U.S. tax on profits from its U.S. sales and activities. The difference is that it will not pay U.S. taxes on sales and activities occurring outside the United States.

Since 2012 approximately 15 large U.S. companies have moved or announced plans to move offshore. Granted, there are numerous reasons why, but a significant – and common – reason has to be the benighted policy of U.S. multinational taxation. What has the White House proposed to stem the tide? Increase the ownership threshold from 20% to 50% before the company will be deemed based outside the U.S.

Brilliant.  To think that Washington at one time pulled off the Manhattan Project, Hoover Dam and landing a man on the moon. How far the apple has fallen.

The issue of corporate inversion has been swept up as part of the larger discussion on tax reform. That discussion is all but dead, unfortunately, although perhaps it may resurrect after the Congressional elections. The Camp tax proposal wants to move the U.S. to a territorial tax system rather than the existing worldwide system, which is an acknowledgement of the problem and a very good first step. It will not stop Pfizer, but we may able to stop the next company to follow.

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.

Voila!

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.