The following article is adapted from reprinted from the M&A Tax Report, Vol. 8, No. 2, September 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

Historically, stock rights such as warrants occupied an odd position in the context of a typical reorganization. Notwithstanding their economic approximation of actual equity in one of the constituent companies, warrants have historically been viewed, at least for this purpose, as neither stock nor securities. As a result, when warrants are received by a target shareholder in exchange for his or her stock in an otherwise qualifying reorganization, they have been treated as boot. Boot, as we all know, is a pejorative word. A target shareholder who receives boot is taxed on the lesser of the value of the boot or the amount of gain realized by the shareholder.

The Next Generation

But stock rights may be about to come into a better time, and actually become a much better deal in M&A transactions. Thanks to amendments made to Section 1.354-1(e) of the Regulations, warrants will henceforth be considered securities. Moreover, they are regarded as securities which have no principal amount. This is a kind of double benefit.

In a garden-variety acquisitive reorganization such as a straight A reorganization (a simple statutory merger), this means that a shareholder who receives a combination of stock and warrants will be able to receive the warrants on a tax-free basis. This neat trick is possible because the warrants are regarded as securities, but securities that have no principal amount.

Traditionally of course, where securities are received but no securities are surrendered in a reorganization, the securities will constitute boot subject to tax. The amount of the boot will be equal to the value of the securities' principal amount. Here, the principal amount is presumed to be zero. That means these securities do not produce recognizable boot. (See I.R.C. §356(d)(2)(B).)

Rules and Limits

Despite these concessions, it is important to recognize that the ability to convey warrants in a transaction intended to qualify as a reorganization is not limitless. Most fundamentally, warrants are securities and not stock, so they are not taken into account on the "good side" of the equation in determining whether a merger exhibits sufficient continuity of interest. For a merger to qualify as a reorganization, it must satisfy the continuity of interest requirement. (For recent discussion, see Wood, "One More FSA: This Time, Continuity of Interest," Vol. 7, No. 7, The M&A Tax Report (February 1999), p. 8; and Willens and Wood, "Continuity of Business Enterprise/Continuity of Interest Regs," Vol. 6, No. 8, M&A Tax Report (March 1998), p. 1.)

To satisfy the continuity requirement, a substantial part of the value of the proprietary interests in the target must be preserved in the transaction. A proprietary interest is so preserved only if it is exchanged for a proprietary interest in the issuing corporation. A warrant is not a present proprietary interest. Consequently, an excessive use of warrants in a merger will prevent the transaction from meeting this fundamental requirement for reorganization treatment.

The problem is not restricted to A reorganizaitons either. If a B reorganization is pursued, the target shareholders cannot receive any warrants. This is so because a B reorganization is defined as the acquisition of the stock of a corporation, in exchange solely for voting stock of the acquiring corporation (or its parent), provided that the acquiring corporation has control (within the meaning of Sec. 368(c)) of the acquired corporation immediately after the acquisition. Thus, the use of any consideration other than voting stock will prevent a transaction from qualifying as a B reorganization.

Reverse Mergers and C Reorganizations

There are limits on the use of warrants in triangular mergers and in stock for assets deals, too. A reverse subsidiary merger is similar to a B reorganization in that it preserves the target's corporate entity. This will permit the use of warrants to a limited extent. Reorganization treatment will be available as long as an amount of target stock constituting control is acquired in exchange for voting stock of the issuing corporation. A reverse subsidiary merger can still qualify as a reorganization under Sec. 368(a)(2)(E) so long as no more than 20 percent of the aggregate consideration conveyed consists of property (including warrants) other than voting stock.

Stock for assets deals under Section 368(a)(1)(C) must be watched, too. A C reorganization is an acquisition by a corporation of substantially all of the properties of another corporation in exchange solely for voting stock of the acquiring corporation or its parent. Here, the use of warrants is only permissible if the "boot relaxation" rule, contained in Sec. 368(a)(2)(B), is satisfied. That rule will be met only if at least 80 percent of the gross value of the target's properties are acquired for issuer voting stock.

As a practical matter, though, this rule is rarely availed of. The reason is the 80% control standard. For purposes of the 80 percent standard, liabilities assumed (along with the warrants), are treated as prohibited "other property." As a result, warrants can only be used in a C reorganization if the sum of the warrants and the target liabilities do not exceed 20 percent of the gross value of the target's properties. Since this particular situation is a relatively infrequent occurrence, we won't likely see extensive use of warrants in this context.


Warrants are now a considerably more viable form of acquisition currency in many of the transactions that will qualify under the Code's tax-free reorganization provisions. However, given the definitional limits imposed on some of the more exotic varieties of reorganizations, warrants will be most readily usable in transactions structured as simple statutory mergers and forward triangular mergers.

Stock Rights in Reorganizations: New Bells and Whistles?, Vol. 8, No. 2, The M&A Tax Report (September 1999), p. 1.