On the surface, the public bidding war between Boston Scientific and Johnson & Johnson to buy Guidant Inc., was a fairly routine merger story: two industry giants with multi-line businesses slugging it out to win the right to acquire a coveted target company.
Boston Scientific emerged as the official victor last week when Guidant’s board approved the $27 billion offer at $80 per share. If Guidant’s shareholders approve the deal in the coming months they will receive $42 in cash and $38 in Boston Scientific common stock for each Guidant share they own. As of Monday’s close, Guidant’s share price was $72.26.
More interesting than the battle, however, is the reason Boston Scientific chose the merger structure that it did. The company used the “reverse triangular” technique, so called because it creates a new paper subsidiary—a “third company”—that’s merged into the target company.
The method is usually deployed to create a tax-free transaction for target shareholders. In this case, however, the approach would produce a taxable transaction for Guidant shareholders because the merger fails to meet the requirements for a non-taxable reorganization under Section 368 of the U.S. Tax Code.
To qualify as a tax-free reorganization, the transaction either must be solely a stock-for-stock deal, or in this case consist of at least 80 percent of Boston Scientific stock. The deal fails on both counts.
Indeed, it’s likely that Boston Scientific failed the test on purpose, contends Lehman Brothers tax expert Robert Willens. (Boston Scientific could not be reached for comment at press time.) Here’s why.
Under its status as a taxable transaction, the deal would enable Boston Scientific to boost the basis in Guidant stock on which it can be taxed if it sells the company. Essentially, the basis becomes what Boston Scientific paid for Guidant—in this case, $27 billion. That’s a considerable step-up compared to what the basis would have been if the acquisition had been a tax-free transaction.
Indeed, if the merger qualified as a tax-free reorganization, Boston Scientific would have been burdened with a comparatively low basis in Guidant’s stock of about $3 billion, figures Willens.
The basis calculation becomes important if the merger goes sour and Boston Scientific decides to sell Guidant in the future. Essentially, the smaller the basis that Boston has in Guidant, the greater is Boston Scientific’s capital gain, and the higher is its tax bill. Corporations are taxed at a 40 percent capital gains rate.
Consider that if Boston Scientific’s step-up in Guidant stock is about $24-billion (the $27 billion purchase price minus the $3 billion basis in Guidant’s stock) the company could save nearly $10 billion in taxes on a future sale of Guidant. The math is straightforward: Boston Scientific would have to pay 40 percent in capital gains tax if it sells Guidant. Forty percent of a $24-billion step up is $9.6 billion in tax savings.
While a traditional forward merger would not give Boston Scientific the opportunity for a basis step-up, neither would a tax-free reorganization. But under the current law, engaging in a reorganization that fails the tax-free test does allow the step-up to occur, according to Willens.
Gaining a basis step-up in this way is often referred to as “divorce insurance,” the tax lawyer notes. The concept was first gained prominence in 2004, when Johnson & Johnson made its first bid for Guidant, but the merger never went through. (Johnson & Johnson would have used the technique again if it had won the bidding war to buy Guidant, according to its regulatory filings.)
The divorce-insurance technique was used last year by Maytag in its acquisition of Whirlpool, and again when Oracle bought Siebel Systems Inc.
The Oracle/Siebel merger had an added twist. The target company’s chairman, Tom Siebel, who would have been hit with a considerable tax bill if the reverse merger failed the reorganization test, would not sanction the deal unless it was a tax-free transaction. Oracle, on the other hand, wanted the coveted basis step-up. To accomplish both goals, and keep the merger on track, investment bankers suggested the seldom used “reverse double dummy” which satisfied both merger partners.