Invesco Ltd., a Bermuda corporation, entered into a definitive agreement to acquire Morgan Stanley’s retail investment business, Van Kampen Investments, on October 19. The consideration for the acquisition consists of some $500 million in cash and an amount of Invesco common stock that can equal not more than 4.9% of Invesco’s total common stock.
Any difference between the amount of stock that New York–based Morgan Stanley can receive in accordance with the “common-stock cap” and the amount of stock to which it would otherwise be entitled will be represented by shares of Invesco’s newly created, nonvoting convertible preferred stock. This latter stock will automatically convert to common stock once it is transferred by Morgan Stanley to a person who is not an affiliate of the New York investment house.
In a nutshell, Invesco agreed to purchase from Morgan Stanley — and Morgan Stanley agreed to sell to Invesco — the “purchased assets.” In addition, Invesco agreed to take on the “assumed liabilities.” As a result, the merger may be structured as follows: Invesco will pay the “asset consideration” of $500 million in cash. The Morgan Stanley subsidiary, Van Kampen Investments, will be merged with and into a newly created Delaware subsidiary of Invesco (AlphaSub, we’ll call it for illustrative purposes). The merger consideration will consist solely of Invesco’s stock, as described above, and the asset consideration will consist solely of cash, according to the agreement.
It is intended that the merger qualify as a “tax-free reorganization,” meaning that the transaction will result in an “A” reorganization under the tax code by reason of Section 368(a)(2)(D). The transaction qualifies for tax-free status because it meets several key criteria, including:
• Van Kampen will be merged with and into AlphaSub;
• AlphaSub is a corporation controlled by Invesco (AlphaSub will be a first-tier subsidiary of Invesco);
• AlphaSub will be acquiring “substantially all” of the assets of Van Kampen;
• No stock of AlphaSub will be used in the transaction; and
• The transaction exhibits continuity of interest (the sole consideration to be conveyed in the merger to Morgan Stanley is Invesco stock, with the result that a substantial part of the value of the proprietary interests in Van Kampen will be preserved).
The transaction exhibits continuity of business enterprise (AlphaSub will be continuing Van Kampen’s historic business). As a result, the transaction “would have qualified” as an “A” reorganization even if the merger had been effected directly into the controlling corporation.
“Because Invesco is a foreign corporation, additional requirements must be complied with to maintain the transaction’s tax-free status.” — Robert Willens
However, because Invesco is a foreign corporation, additional requirements must be complied with to maintain the transaction’s tax-free status. Indeed, Morgan Stanley’s exchange of Van Kampen stock for Invesco stock would constitute a taxable exchange unless an exception applies. That’s because a taxable transaction is triggered if a transfer of stock or securities is made by a U.S. person (Morgan Stanley) to a foreign corporation under the tax code; specifically, Section 354 that is subject to Section 367(a)(1).
For purposes of the rule, when a U.S. person exchanges domestic shares of the so-called Section 354 stock for shares in a foreign corporation, as is the case in the Invesco/Van Kampen deal, the person shall be treated as having made an indirect transfer of such stock to a foreign corporation that is subject to the rules of this section.1
Further, the Invesco/Van Kampen deal entails the exchange by a U.S. person of stock in a corporation for stock in a foreign corporation that controls the acquiring corporation (AlphaSub) in a reorganization described in Section 368(a)(1)(A) and Section 368(a)(2)(D).2
Therefore, the exchange, otherwise rendered tax-free by Section 354, will be taxable unless an exception applies. In the case of Invesco/Van Kampen, the exception set forth in Regulation Section 1.367(a)-3(c) appears to be available. That section provides that a transfer of stock of a domestic corporation by a U.S. person to a foreign corporation shall not be subject to Section 367(a)(1) if:
• 50% or less of both the total voting power and total value of the stock of the transferee (Invesco) is received in the transaction by U.S. transferors;
• 50% or less of each of the total voting power and the total value of the stock of the transferee is owned immediately after the transfer by U.S. persons that are officers or directors of the U.S. target or that are 5% target shareholders;
• The U.S. person is not a “5% transferee shareholder” or will become such a 5% transferee shareholder and enters into a “five year gain recognition agreement” (it would appear that here Morgan Stanley will be constrained to execute such an agreement);
• The active trade or business test is met. It will be so met if, as here, the transferee (Invesco) is engaged in the active conduct of at least one trade or business outside of the United States for the entire 36-month period immediately before the transfer; and
• The “substantiality” test is met. It will be so met if, as here, at the time of the transfer, the fair-market value of the transferee is at least equal to the fair-market value of the U.S. target.
Thus, Morgan Stanley should be positioned to receive the Invesco stock provided for in the agreement on a tax-free basis.
However, the agreement also contains a provision that permits Morgan Stanley to opt out of the merger structure and, instead, to “sell” the Van Kampen stock to Invesco (or to AlphaSub) in exchange for the merger consideration. In that case, the parties acknowledge that the sale will be fully taxable.
The transaction, if this alternative structure is adopted, cannot qualify as a “B” reorganization because a portion of the consideration to be received by Morgan Stanley for the Van Kampen stock will consist of nonvoting stock. A “B” reorganization is defined as an acquisition by a company in which the company’s voting stock3 is exchanged for the stock of another corporation, provided that immediately after the acquisition, the acquiring corporation has control within the meaning of Section 368(c) of the target.
In this case, the nonvoting convertible preferred stock that Morgan Stanley is slated to receive — and that automatically converts into voting stock once it is transferred by Morgan Stanley outside of its affiliated group — does not convert the stock into voting stock for purposes of Section 368(a)(1)(B).4 If Morgan Stanley does avail itself of this option, the agreement, oddly, provides that Invesco is absolutely precluded from making a regular Section 338 election with respect to its “qualified stock purchase”5 of Van Kampen and that Morgan Stanley and Invesco are barred from executing a joint election under Section 338(h)(10) with respect to such qualified stock purchase.
As a result, Invesco will secure a “cost” basis only with respect to the “purchased assets” and will be saddled with a carryover basis with respect to the assets owned by Van Kampen and its subsidiaries even if Morgan Stanley elects the alternative transaction structure.
Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 The transaction must be the same as described in Regulation Section 1.367(a)-3(d)(1)(i) through (v), which is the case with the Invesco/Van Kampen deal.
2 See Regulation Section 1.367(a)-3(d)(1)(i).
3 Or in exchange solely for the voting stock of a corporation in control of the acquiring corporation.
4 See Rev. Rul. 72-72, 1972-1 C.B. 104; X Corp. (X) desired to acquire all of the stock of Y Corp. (Y). Mr. A owned all of the stock of X. In order to acquire all of the stock of Y, X would have to issue additional voting common stock so that after the transaction the Y shareholders would own some 55% of X’s outstanding stock. Mr. A was concerned about relinquishing control of X. Therefore, X and the shareholders of Y agreed to an arrangement whereby Mr. A would retain an irrevocable right, for five years, to vote the stock to be received by the shareholders of Y. The voting restriction imposed by the agreement was printed on the stock certificates to be issued. On termination of the five-year period, the shareholders of Y would receive the right to vote their stock without restriction. The ruling observes that the arrangement prevented the shareholders of Y from voting their stock on their own behalf for a period of five years and perpetuated Mr. A’s voting control over all of the outstanding stock of X. The arrangement, the ruling notes, is the same as if X issued nonvoting stock that automatically converted to voting common stock after five years: in either case, the ruling concludes, the stock is not voting stock within the meaning of Section 368(a)(1)(B).
5 A qualified stock purchase means any transaction or series of transactions in which stock meeting the requirements of Section 1504(a)(2) (at least 80% of the stock measured by both voting power and value excluding, for this purpose, stock described in Section 1504(a)(4)) of one corporation is acquired by another corporation by purchase during the 12-month acquisition period. See Section 338(d)(3). The term, purchase, includes any acquisition of stock but only if, among other things, the stock is not acquired in an exchange to which Section 354 applies. See Section 338(h)(3)(A)(ii). In the instant case, the exchange of VK for I stock would not be an exchange to which Section 354 applies because the transaction in connection with which the exchange takes place is not, ab initio, a reorganization within the meaning of Section 368. See in this regard Turnbow v. Commissioner, 286 F.2d 669 (9th Cir. 1960), aff’d on other issues, 368 US 337 (1961).