Following up on my previous post, Dell's Use Of Tracking Stock In Acquisition Of EMC Will Save $10 Billion In Taxes: Re/code, Dell’s EMC Deal Could Fall Apart on Tax Rule:
Michael Dell’s ambitious $67 billion plan to take over storage giant EMC may face a big tax burden that could complicate or derail the deal entirely.
Dell insiders are worried the company could end up being on the hook for a tax bill of up to $9 billion following a regulatory review, sources familiar with the matter told Re/code. The worries stem from Dell’s unusual proposal to use a new type of stock share to help pay for the acquisition. Their concerns are also rooted in EMC’s wildly successful investment in the software company VMware, the value of which has risen by tens of billions of dollars since EMC acquired it in 2003.
The combination of factors has some Dell execs concerned, sources said, that certain key aspects of the deal may not qualify for the sort of tax treatment they consider essential for the transaction — the biggest tech acquisition ever proposed — to succeed.
In order to offer EMC shareholders $33.15 a share for the company, Dell plans to pay them $24.05 per share in cash. The remaining $9.10 is to be made up by offering EMC shareholders tracking stock linked to VMware. (EMC owns an 81 percent stake in VMware, while 19 percent of its shares trade on the New York Stock Exchange; those shares have declined by about a third since the deal was announced last month.) The tracking stock is intended to offset the amount of debt Dell would have to take on; it is also meant to help Dell avoid a heavy tax liability.
Dell’s plan to create tracking shares in a company it does not yet own (that’s VMware) would, if successful, amount to a clever threading of a needle in U.S. tax laws: It is intended as neither a distribution of shares nor the spinoff of a subsidiary, both of which are typically taxable events. Instead, EMC shareholders will face taxes in the range of 20 percent to 40 percent for the gains on the cash and the value of the tracking shares.
Tracking stocks are a popular financial device used during the Internet stock boom of the late 1990s. Creating tracking stocks allowed shareholders to invest in the performance of a specific business unit of a larger publicly traded company without the parent giving up any ownership or voting control.
Dell insiders are concerned that the creation of the tracking stock will invite scrutiny by the Internal Revenue Service. The agency could deem it a taxable distribution in part because the new shares are linked to EMC’s subsidiary, VMware, in the context of EMC’s acquisition by Dell.
Their concerns are centered on a portion of the U.S. tax law, Section 355, and specifically a subsection that governs “certain distributions of stock or securities in connection with acquisitions.” In some circumstances, when a parent company distributes shares in a subsidiary within two years before or after being acquired itself, any gains in value on those distributed shares can be taxable. Simply put, the law is intended to prevent corporate spinoffs or share distributions from helping pay for an acquisition, which appears to be what Dell is attempting to do. ...
“This is a very complicated deal, and there will be a lot of nuance to sort through,” said Michael Solomon, a tax lawyer with the Silicon Valley law firm of Fenwick and West, which is not involved in the deal. “If you believe in this deal, then you’ve got to believe that it can only happen in a tax-free manner. If this deal turns out to be taxable, it becomes substantially more expensive to Dell.”
Dell’s best chance in winning over the IRS, Solomon said, will be to convince the agency that the tracking shares in VMware are more closely linked to Dell itself. “The deal raises a factual question as to whether or not the EMC shareholders are basically getting stock in Dell as the result of this merger,” he said. “If yes, then I expect the IRS would approve it. If it’s deemed to be a constructive distribution of the VMware subsidiary, in that case the deal fails. … This is taking things right up to the edge.”
A key development, he said, will be a review by a law firm — Dell has hired the New York firm of Simpson Thacher & Bartlett — to examine the deal and reassure Dell that the IRS is likely to rule in its favor. “If you’re Dell, you go in with a strong opinion from counsel that you’re likely to get the tax treatment that you want and why,” Solomon said. But a strong opinion is no guarantee. “There’s clearly a reason that Dell should be worried about this,” he said.