A recent pair of decisions by the California Office of Tax Appeals examined the tax treatment of special dividends paid in connection with the acquisition of a corporate target.
Private company acquisitions are frequently priced on a “cash-free, debt-free” basis. A target company that holds excess amounts of cash shortly before such a sale may be indifferent on a pre-tax basis between receiving a pre-closing distribution and a reduced purchase price and leaving the cash in the company and receiving a corresponding increase in sales proceeds. From an income tax perspective, however, the two are generally treated differently, and in some cases may result in a significant bottom-line difference for different taxpayers.
Although the federal income tax rate for “qualified dividend income” is the same as for long-term capital gains, U.S. shareholders with capital losses may nonetheless prefer capital gains treatment, as capital losses can offset capital gains but not ordinary income (beyond a de minimis annual amount). Likewise, non-U.S. shareholders will generally prefer capital gains on corporate stock, which are ordinarily not subject to withholding, to dividend income, which generally is. Conversely, corporate shareholders may prefer a dividend that is eligible for a dividends received deduction to capital gains (albeit subject to the “extraordinary dividend” rule limits). Lastly, taxpayers seeking tax-free treatment for a sale may be able to increase the limited amount of cash that can be paid in exchange for shares by paying dividends in connection with the transaction funded solely by the target company, rather than the purchaser.
The California Office of Tax Appeals recently affirmed that the distribution-sales proceeds distinction is driven principally by the form chosen by the parties to the transaction, holding that a distribution paid in contemplation of a corporate acquisition would be treated as a separate payment subject to Section 301 of the Internal Revenue Code. It based its ruling on both form and economic substance: the distribution was declared as a dividend, and the cash distributed came from the target, with no indication that it was financed, directly or indirectly, by the acquirer. While the merger agreement permitted the distribution, the agreement neither required the distribution nor contemplated it as part of the merger proceeds.
Although the distinction between distribution and sales proceeds in the decision was ultimately relevant to a specific provision of California state income tax, the ruling follows a long line of federal authorities (both case law and IRS Revenue Rulings) that likewise treat the distinction between sales proceeds and distribution as primarily a matter of form, respecting distributions as such so long as the cash proceeds cannot be traced, directly or indirectly, to the buyer.
If dividend treatment is undesirable and purchase price adjustments are difficult to employ, another possibility may be a part-redemption, part-sale structure frequently called a Zenz transaction. These transactions involve the redemption of some shares by the target corporation in exchange for the target’s cash, combined with a sale of the remaining shares in exchange for the buyer’s cash (or other consideration). The key distinction is one of form: in a Zenz transaction, the cash is not a distribution on the target’s shares, but rather a payment made in exchange for some portion of the target’s shares. Under Zenz, the share repurchase, even if made pro rata, potentially permits sale or exchange treatment under Section 302.
These decisions provide a good reminder that selling shareholders who desire to monetize cash held by a target corporation in the form of capital gains should therefore be careful to adopt a form consistent with that treatment. By the same token, taxpayers desiring dividend treatment must be careful to adopt a form that both avoids any exchange of shares for target cash and clearly establishes that the cash is, indeed, from the target.
