The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 5, December 1999, Panel Publishers, New York, NY.


By Robert W. Wood

Citation Corp., a leading independent manufacturer of cast, forged, and machined components for use by automotive and aerospace manufacturers, recently entered into a merger agreement with an affiliate of Kelso & Company. The Kelso affiliate was capitalized with a $190 million equity infusion, is to merge into Citation. Concurrently, Citation is to issue roughly $200 million in senior subordinated notes.

The Citation stock will be converted in the merger into the right to receive $18.10 per share. As is common in a reverse merger, the affiliate's stock will be converted into Citation stock. However, as a condition of the deal, holders of 790,115 shares had to elect to retain their stock in Citation. These retained shares represent roughly 4.4% of the currently outstanding shares of Citation.

After the merger and conversion, this will be 7% of the outstanding shares. The retained shares will be owned by certain Citation executives. Although the opportunity to retain shares is also being provided to other shareholders, that ability is restricted: a retention election can only be executed by shareholders with at least 10,000 shares. Plus, the election can only be made for a comparable amount of Citation stock.

Disregarding Entities

For tax purposes, the merging affiliate of Kelso should be disregarded as a mere transitory entity. The reason? It is both created and extinguished via the merger, part and parcel of an integrated transaction. The transaction is treated as if Citation obtained debt and equity financing and used those funds to redeem the stock owned by its shareholders. (See Revenue Ruling 78-250, 1978-1 C.B. 83.) The parties are taking the position that a shareholder will be viewed as if he sold to Kelso that percentage of his stock that bears the same ratio to his total holdings as the equity infusion bears to the total amount of cash remitted in the transaction. Thus, they say, only the balance of the holder's stock should be properly viewed as if it were redeemed.

A shareholder who completely terminates his interest in Citation should obviously recognize capital gain. (I.R.C. §302(b)(3).) However, for a shareholder who retains a portion of his Citation stock, capital gain treatment is not a slam dunk. A redemption only qualifies for capital gain treatment if the shareholder undergoes a sufficient reduction in his proportionate interest in the corporation. For small minority shareholders in a public corporation, who are neither officers nor directors and who do not exercise control over corporate affairs, any reduction in proportionate interest is sufficient to ensure capital gains treatment. (See Revenue Ruling 76-385, 1976-2 C.B. 92.) But, even here there must be some reduction. If there is no reduction at all, the redemption will be treated as a dividend, no matter how small the shareholder's percentage interest.

For these shareholders (for more on this topic, see Wood, "Redemptions: Gaining Capital Gain Treatment," in this issue), it may be worth considering the use of the Zenz doctrine. A shareholder would sell Citation shares so that his proportionate interest in the corporation is smaller than it was prior to the merger. A shareholder's post-redemption proportionate interest will be measured after the completion of the Zenz sales as long as the redemption and sales are parts of a single transaction. A shareholder using the Zenz doctrine can establish that the redemption and sale are integrated by ensuring that the sale occurs at or about the same time as the redemption, and by maintaining personal records establishing that the two events (redemption and sale), are undertaken to wind up with a diminished proportionate interest in the corporation.

Recap Accounting

When the dust settles, Kelso and its affiliates will own 93% of the post-merger outstanding stock of Citation, and the existing shareholders will hold the balance. This ownership structure is designed to insure that the buyout qualifies for so-called "recap" accounting. The objective is to insure that the transaction is not subject to "push-down" accounting, a technique in which the acquirer's new purchase price for the target's stock is pushed-down to the target's separate financial statements. Push-down accounting is required when the financial statements are included in an SEC filing and the acquirer owns the target. The SEC also requires that the acquirer's debt, interest expense, and debt issuance costs be comparably pushed-down where the target will assume the acquirer's debt or guarantees, or otherwise pledges its assets as collateral for the acquirer's indebtedness.

To avoid push-down accounting, the former target shareholders must continue to own a significant stake in the target's common equity. A stake exceeding 5% is usually considered significant for this purpose. This explains why Kelso is requiring that the existing Citation shareholders continue to own 7% of its stock. Even though there has been a change of control for Citation, purchase accounting does not apply to Citation. The book value of its assets does not change, and its book net worth only changes to reflect the equity infusion provided by Kelso and the amounts paid out by Citation to redeem its stock.

Avoiding purchase accounting is important for Kelso's future plans for Citation. If and when Citation goes public again, it should arguably command an enhanced valuation because its earnings will not need to reflect the amortization of goodwill or other purchase accounting adjustments.

Recap vs. Pooling?

The benefits of recap accounting will be arguably magnified further if the FASB is successful in its efforts to eliminate pooling (as seems to be a foregone conclusion), and to even reduce the maximum goodwill amortization for purchase accounting from 40 years to 20 years. (Regarding pooling, see Wood, "'Pooling of Interests' Accounting To Be Ousted," Vol. 7, No. 11, The M&A Tax Report (June 1999), p. 1.) If the FASB is successful on one or both of these fronts, acquirers unable to utilize recap accounting for an acquisition (this technique is effectively unavailable to a publicly traded acquirer) will suffer by comparison. If both these changes occur, not only will the ability to use pooling for an acquisition be eliminated, but the shorter goodwill amortization period will magnify the dilutive impact of an acquisition.

On the other hand, the FASB is also attempting to introduce its version of "cash earnings" onto corporate income statements. In connection with the above changes, the FASB will evidently also require that corporations depict, on the face of the income statement, a new measure of performance that excludes the impact of goodwill amortization. If this modified version of cash earnings becomes the primary measure of corporate performance - and right now that seems likely — the advantage enjoyed by users of recap accounting will soon evaporate.

Recapitalization Accounting, Vol. 8, No. 5, The M&A Tax Report (December 1999), p. 4.