The issuance of additional stock by an acquiring corporation is often (though not always) a necessary precondition to qualify a merger or acquisition transaction as a tax-free "reorganization" under Section 368 of the Internal Revenue Code. However, the issuance of additional shares could have a dilutive effect in the simple sense that more shares outstanding means lower earnings per share ("EPS"). For privately held companies, this potentially dilutive effect is not much of a concern. But for public companies, this is a big deal. Indeed, EPS is highly correlated with market rate, and the stock of many public companies trades on that basis.
One option is for the acquiring company to go out into the market and buy back the number of shares issued in connection with the reorganization. Keep in mind, however, that continuity of interest is generally a prerequisite to a valid tax-free reorganization. The tax-free treatment of the reorganization transactions described in Section 368 of the Internal Revenue Code are predicated on the theory that the investment in the target corporation has not changed but rather continues in a different form. Stated more simply, the shareholders of the target corporation have not cashed out their investments insofar as they continue to hold stock in the acquiring corporation. Consequently, there has been no realization event which would trigger tax.
Now, if the acquiring corporation goes out into the market where it repurchases the number of shares that it issued in the reorganization it is conceivable that it could acquire shares that were issued to target shareholders in the reorganization.
The question, therefore, becomes whether this destroys the requisite continuity of interest and, thereby, exposes the merger transaction to tax.
According to the IRS, a market repurchase of shares by an acquiring corporation following reorganization does not destroy continuity. To be sure, it is conceivable (and probably likely) that the acquiring corporation will repurchase shares issued to the target corporation shareholders in the reorganization. However, there is no privity between the buyer and seller in a market transaction. Consequently, a purchase of stock issued to a target shareholder in the reorganization would be purely coincidental.
Note, however, that the holding in Revenue Ruling 99-58 is subject to one mathematical caveat: the acquiring corporation cannot buy back more shares than were outstanding before the reorganization. If you think about it, this makes sense. If the acquiring corporation bought more shares than were outstanding before the reorganization, it would necessarily be purchasing shares issued to target shareholders in the reorganization. And that would destroy continuity.
Structuring a tax-free reorganization is difficult. If you need assistance in this area, please contact me.
