Beware of a Tax Bite In Crafting CVRs; Contingent compensation kickers to help dealmakers bridge a price gap may require holders to pay federal taxes – if they pay off.

Times of uncertainty and turmoil call for drastic measures. In the world of mergers and acquisitions such uncertainty and turmoil may well lead to something of a renaissance for the contingent stock arrangement. It can be employed to “bridge the gap” when the parties to a business combination cannot agree, due to the presence of uncertainty, on the value of the transaction and can’t agree on the amount of acquisition currencies to be exchanged. For example, the acquirer is not sure how the target’s business will perform subsequent to the acquisition and is not willing to pay today for synergies and other advantages that might never materialize. Alternatively, the target shareholders may wish to guard against the possibility that the acquirer’s stock will not hold its value over the period following the business combination. In each case, this uncertainty can be assuaged through the use of a contingent stock arrangement. In the first instance, the buyer agrees to deliver additional stock if the target’s earnings exceed, for a specified period following the merger, certain predetermined levels. In the second case, the target shareholders – to whom certificates of contingent interest, also called contingent value rights (CVRs), are issued – become entitled to additional shares if the acquirer’s stock price, on a date following the merger, dips below the price that existed at the time of the merger. In these cases, the target shareholders are, in effect, guaranteed that the aggregate value of the stock they receive (including the additional shares issued pursuant to the CVRs) will not be less than the value that existed at the time of the business combination. A transaction recently in the market, OSI Pharmaceuticals Inc.’s acquisition of Cell Pathways Inc., presents a textbook case of the utility of contingent stock arrangements. In a business combination structured as a reverse triangular merger, OSI conveyed to Cell Pathway’s shareholders 0.0567 share of OSI’s voting common stock plus a CVR that can ripen into an additional 0.04 share in exchange for each share of Cell Pathways stock. The CVR will give rise to additional OSI stock if, within the five-year period following the consummation of the merger, a new drug application (NDA) covering certain pharmaceutical projects Cell Pathways is currently developing is accepted for filing by the FDA. For tax purposes, what is the nature of a CVR? Can it be received on a tax-free basis the same way outright stock can be received? What happens when the rights “mature” and additional shares are actually delivered? Although, at one time, the IRS took the position that CVRs, in the context of an otherwise qualifying reorganization, were “other property” (or “boot”) and therefore taxable, certain court decisions, most notably the Carlberg and Hamrick cases, found that, generally, CVRs should be not regarded as boot but instead should be accorded a status equivalent to stock. Why? Because, as the courts observed, such CVRs could give rise to nothing but stock. The IRS, grudgingly, now largely agrees with these decisions and generally treats CVRs as “stock” for purposes of complying with Section 354 of the Internal Revenue Code. That allows CVRs to be received on a tax-free basis in an otherwise qualifying reorganization. However, Prof. Martin D. Ginsberg and attorney Jack S. Levin in their treatise, Mergers, Acquisitions & Buyouts, point out that the IRS is not “totally on board” with respect to CVRs that possess anything but “plain vanilla” features. Thus it may well be the IRS position that CVRs that entitle the holders to cash – equal to the dividends they would have received on the delayed shares had they been issued at the inception – may contain an element of boot. The value of the dividend right embedded in the CVR may be so characterized. Moreover, the IRS never did accept the Carlberg case because the rights evidencing the contingent stock arrangement were negotiable. To issue a ruling that CVRs are not boot, the IRS will insist that the arrangement not be assignable or, if it is assignable, that it not be evidenced by a negotiable certificate or be “readily marketable.” Nevertheless, an acquirer or seller should always be aware that the case law is much more liberal than the IRS ruling guidelines and that an opinion based on case law that CVRs are not boot (even when one or more of the IRS’s ruling guidelines are breached) should be easily attainable. In the OSI/Cell Pathways deal, the CVRs are not transferable. Although no ruling was sought, one probably could have been secured because of the non-transferability of the CVRs. From a tax viewpoint, there is one drawback attending the use of CVRs if the additional securities are paid more than a year after the consummation of the business combination. A portion of the additional shares will be treated as taxable interest income under Section 483 of the Internal Revenue Code (IRC). The OSI proxy materials describe how the amount of the interested is computed: *Step One – Calculate the fair value of the additional shares at the time they are delivered to the holders of the CVRs; *Step Two – Discount the fair value from the date of issuance back to the time of the merger using the so-called applicable federal rate (AFR). The difference between the “raw” value of the additional shares and the discounted value measures the amount of imputed interest. Mitigating this detriment is the fact that, symmetrically, the issuing corporation secures an interest expense deduction of equal tenor. The IRS also employs an interesting convention with respect to the computation of a shareholder’s gain or loss from sales of acquirer stock “in the interim,” i.e., the period between the time of the merger and the date on which the CVRs mature. The service, in these cases, assumes that all contingent shares will be earned. Accordingly, the shareholder’s basis in his or her target stock is “spread,” under Section 358, over a greater number of acquirer shares, and the convention therefore minimizes the per-share basis of each acquirer share. Thus, interim sales, all things being equal, will produce a greater gain or a smaller loss than would be the case if the contingent shares were, as seems more proper, simply ignored until the time they were actually delivered. In cases where the imputed interest rules prove unduly burdensome, they can be avoided if the acquirer, in lieu of merely promising to issue additional shares, places the delayed shares in escrow. The rules of Section 483 do not apply to shares deposited in escrow when: *The shares are issued in the names of the former target shareholders; *These shareholders are entitled to vote the delayed shares; and *The shareholders receive dividends on the delayed shares. In these cases, the transaction does not involve a “deferred payment sales contract,” to which the rules of Section 483 apply, because the escrowed shares are considered already issued and outstanding. They are treated as transferred as of the effective date of the reorganization, rather than as a deferred payment. The use of escrowed stock, while avoiding the creation of interest income, is not without its problems. It is possible that the return of the escrowed stock to the issuer (acquirer) because the contingent goals were not achieved can result in a taxable gain measured by the excess of the value of the returned shares over their basis. The shareholder will be taxed on the return of the escrowed shares when: *The number of shares to be returned is based on their value on the return date as opposed to their initial negotiated value; *The shareholder has the right to substitute other collateral for the escrowed shares; and *The escrow account was established to take account of the uncertainties that attend the resolution of a liability that the target had not yet resolved at the time of the merger and was carried forward on a contingent basis. In these cases, the shareholder derives the benefit of postmerger appreciation in value of the escrowed stock, and the use of appreciated property to defray a liability is clearly a taxable event. Nevertheless, because of their utility is resolving good faith disputes regarding values for purposes of exchanging acquisition currencies, we would expect these kinds of CVR arrangements to proliferate in these uncertain times. Sweetening the Deal For the Sellers Another version of a post-closing litigation payoff was hooked to the structure of an agreement by market researcher Information Resources Inc. to be taken private by an investment group. The buyers, Symphony Technology II-A and Tennenbaum Capital Partners will pay $3.30 a share in cash upfront. Information Resources shareholders also received CVRs, which give them a claim on 60% of any proceeds generated by the company’s antitrust suit against information provider rivals ACNielsen, Dun & Bradstreet, and IMS International. – M&A Magazine Robert Willens, CPA, is a Managing Director at Lehman Brothers. Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com