Certain Tax and Regulatory Considerations in Acquisition Financings

By: Linda Curtis and Andrew Cheng, Gibson, Dunn & Crutcher LLP.

TAX CONSIDERATIONS—FEDERAL, STATE, LOCAL, AND foreign income taxes, as well as other types of taxes such as transfer and property taxes—are a major consideration when determining the optimal structure of any business acquisition. A stock purchase, asset purchase, or merger may each have different tax implications to consider in light of the tax implications of the acquisition financing terms and structure. The following discussion describes generally two federal tax issues that may be of particular importance in acquisition financings. In all cases, however, tax counsel should be consulted early in the process of structuring the acquisition itself as well as the relevant financing, since tax laws vary by jurisdiction and are constantly changing.

AHYDO Issues

One key tax consideration in structuring the acquisition financing is to ensure that interest on the acquisition debt is deductible—an area that potentially implicates, on the federal income tax level, the AHYDO rules. I.R.C. § 163(e)(5). In sum, the AHYDO rules apply to any debt instrument that: (a) is issued by a corporation, (b) has a term of more than five years, (c) has significant original issue discount (OID), and (d) has a yield to maturity that equals or exceeds the applicable federal rate for the month of issuance (the AFR) plus 500 basis points. The AHYDO rules are not limited to debt issued as part of acquisition financings.

A debt instrument generally has significant OID if the terms of the debt permit more than one year’s yield to be accrued and unpaid for any accrual period ending after five years. AHYDO issues often arise in financings where the borrower is either permitted or required to pay interest “in kind” (PIK). Notably, OID may be deemed significant where the borrower has the option to elect PIK interest even if the borrower actually determines to pay it in cash.

If the AHYDO rules are applicable, then the interest deduction for the borrower may be deferred and, in some cases, even disallowed. The AHYDO rules also impact the tax treatment of the payments to the lender, although typically in a less draconian way. One approach to mitigating the risk that an instrument will be deemed subject to the AHYDO rules is to include in the instrument a so-called AHYDO catch-up payment. Essentially, this is a formula-based required payment to be made on or about the fifth anniversary of the original issuance of the debt in an amount sufficient to avoid significant OID. For more information on AHYDO issues, see Applicable High-Yield Discount Obligation (AHYDO) Rules.

Section 956 (Deemed Dividend) Issues

An acquisition target company may have significant foreign operations, some or all of which may be conducted through foreign subsidiaries. However, if a foreign subsidiary provides credit support (through either guarantees or granting security) for a loan to a U.S. parent company, then the federal tax rules may treat the foreign subsidiary as having paid a deemed dividend to the U.S. parent company. In addition, in certain circumstances, the issue can arise if domestic subsidiaries that own foreign subsidiaries provide such credit support, or if intercompany debt or other liabilities owed by foreign subsidiaries is pledged. The consequences of such a deemed dividend can involve significant tax liability under I.R.C. § 956 (Section 956).

The federal tax rules permit a pledge of less than 2/3 of the voting stock of a foreign subsidiary, and many acquisition financings take this approach (sometimes with a 65% threshold). Note that the stock of second-tier foreign subsidiaries is an asset of the first-tier foreign subsidiaries, which makes such stock subject to the general rule that no pledge is permitted. Also, note that the 2/3 limitation does not apply to non-voting stock.

The reach of Section 956 and the types of entities and assets lenders will agree to exclude from the credit group due to these issues is an unclear and constantly evolving area of the law. Whether or not certain subsidiaries are disregarded or are pass-through entities for applicable tax purposes may impact the tax analysis. In transactions with significant foreign operations, the borrower and lenders may consider digging deeper into the Section 956 rules to determine the practical impact of a deemed dividend.

For example, if a foreign subsidiary does not have earnings and profits, or the applicable borrower has significant net operating losses, then the practical impact of a deemed dividend may be minimal. In such cases, it may make sense from a business perspective for the borrower to provide the lender with the additional security. Such a move is clearly in the lender’s interest, and may also be in the borrower’s interest if it can negotiate lower pricing or other more favorable terms in exchange for the foreign credit support. However, borrowers nevertheless still tend to resist the requirement to provide additional security from their non- U.S. subsidiaries based on the argument that those entities in the future may or will generate earnings during the life of the loans, and therefore guarantees and pledged collateral by those entities may now inadvertently trigger the negative tax impacts on the borrower in the future. For additional information on deemed dividend issues, see Security Structures and Controlled Foreign Corporations Rules.

Margin Regulations

The margin regulations—Regulations T, U, and X—promulgated by the Federal Reserve Board, are a set of complex and technical rules intended to limit speculative lending based on publicly traded securities. The margin regulations were initially adopted as a response to the perception that margin lending contributed to the stock market crash of 1929. They have been amended in the many years since their initial adoption, and the Federal Reserve has also issued numerous interpretive rulings for issues that are not immediately clear on the face of the regulations. The margin regulations require lenders to register and maintain certain records and reports regarding margin lending. Most importantly, the margin rules impose substantive requirements (described generally below) on lenders and borrowers through restrictions upon specified types of loans secured directly or indirectly by publicly traded securities.

The substantive aspects of the margin regulations generally apply only to purpose credits, which are defined in the regulations as any credit for the purpose, whether immediate, incidental, or ultimate, of buying or carrying margin stock. Margin stock can be:

• Any equity security trading on a national securities exchange
• Any Over-the-Counter (OTC) security trading in the NASDAQ Stock Market’s National Market
• Any debt security convertible into a margin stock or carrying a warrant or right to subscribe to or purchase a margin stock
• Any warrant or right to subscribe to or purchase a margin stock
• Any security issued by an investment company registered under Section 8 of the Investment Company Act of 1940 (15 U.S.C.S. § 80a-8) (with certain exceptions).

Accordingly, the prototypical situation where a borrower and its lenders need to consider the potential application of the margin regulations is in the case of a debt financed public company acquisition.

Regulation U (12 C.F.R. 221) sets out certain requirements for bank and nonbank lenders, other than securities brokers and dealers, who extend purpose credit secured directly or indirectly by margin stock. This regulation covers any entity that is not a broker or dealer, including but not limited to commercial banks and savings and loan associations. Regulation T (12 C.F.R. 220) is the corresponding regulation that applies only to securities brokers and dealers. Regulation X (12 C.F.R. 221.6) applies to borrowers and essentially prohibits any borrower from willfully causing credit to be extended to it in violation of Regulations T or U. Accordingly, the major focus of compliance with the margin regulations for a typical acquisition financing is Regulation U.

The basic prohibition in Regulation U is that no lender shall extend any purpose credit, secured directly or indirectly by margin stock, in an amount that exceeds the maximum loan value of the collateral securing the credit. A classic example of purpose credit is a bank financing for a company’s tender offer to purchase public equity securities of another company. However, a purpose credit also includes a credit for the purpose of carrying margin stock. Carrying is a concept designed to prevent the weakening of the margin regulations through later refinancings. If the proceeds of a loan are used to pay off another lender, and the proceeds of the loan being paid off were used to purchase margin stock, the new loan is being used to carry the margin stock and is subject to Regulation U.

What does it mean for a loan to be secured directly or indirectly by margin stock?

Direct security is relatively clear cut—a loan is secured directly by margin stock when margin stock is included as a part of the collateral for the loan. Indirect security is a more complicated analysis, which includes any arrangement with a borrower under which (1) the borrower’s right or ability to sell, pledge, or otherwise dispose of margin stock owned by the borrower is in any way restricted while the credit remains outstanding; or (2) the exercise of such right is or may be cause for accelerating the maturity of the credit. Asset disposition and negative pledge covenants, for example, can be a means of indirectly securing a loan with margin stock.

It is important to note, however, that the Federal Reserve has issued guidance saying that if, after applying the proceeds of the credit, margin stock represents 25% or less of the value (as determined by any reasonable method) of the assets that are subject to the negative pledge or similar arrangement, then such credit is not indirectly secured by the margin stock.

What is the maximum loan value of the collateral securing the credit?

Since 1974, the Federal Reserve Board has set the maximum loan value of margin stock at 50% of its current market value. Options, including puts, calls, and combinations thereof, have no loan value unless they are publicly traded. Publicly traded options qualify as margin stock. All other collateral has good faith loan value, which means the amount that a lender, exercising sound banking judgment, would lend on such collateral.

Violations of the margin regulations constitute violations of securities laws and can expose the offender to enforcement actions, civil monetary penalties, and injunctive relief. Credit agreements generally contain representations and warranties from borrowers intended to give lenders assurance that their loan is not in violation of the substantive aspects of the margin regulations. The content of the representations and warranties for any particular deal will depend on the specifics of the type of credit as well as whether or not the credit is secured or unsecured. In order to ensure compliance with the margin rules, the lenders and borrower may agree to exclude margin stock from the collateral package and from the coverage of certain negative covenants such as the lien, asset sale, and negative pledge covenants.

It is important to note that the margin regulation compliance representation is usually present not only in acquisition financing credit agreements, but in all credit agreements, because of the carrying aspect of the regulations. Note also that the credit agreement often requires the borrower to represent that it is not engaged principally, or as one of its important activities, in the business of extending credit for the purpose of purchasing or carrying margin stock. This representation is included because the Federal Reserve has taken the position that credit extended to any borrower engaged in such business can itself be deemed purpose credit. For further discussion of the margin regulations, see Margin Lending Regulations and Margin Lending and Inter-BankFinancing.

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