Last October, Dell offered to buy EMC for $67 billion, making it the largest tech merger ever. This merger will create a new technology giant that will sell both consumer and IT products, ranging from personal computers to data storage gear for corporate data centers.
To finance this acquisition, Dell will use a combination of borrowed cash up to $49.5 billion and tracking stocks in an EMC subsidiary called VMware. The offer valued EMCat $33.15 a share, for which Dell will pay $24.05 in cash per share and give EMC shareholders a special stock that tracks the share price in VMware. Intended to offset the amount of debt Dell will take on, those tracking stocks seriously threaten the feasibility of the deal because of a possible $9 billion tax bill.
Tracking stocks are a popular financial device used during the Internet stock boom of the late 1990s. They enable shareholders to own a stake in a company without the parent giving up voting control or any ownership. In the Dell-EMC merger, the tracking stocks will simply reflect the performance of VMware. If the deal closes, investors will be able to buy either the tracking stock, or part of the 20% of VMware that EMC doesn’t own and that is traded on the New York Stock Exchange.
The problem is that under U.S. tax law, Section 355, 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. This provision is aimed at preventing the acquirer from using corporate spinoffs or share distributions to pay for an acquisition without creating a tax event. As a result, Dell fears the Internal Revenue Service (IRS) will rule that the tracking stock is a taxable distribution of shares. The IRS could reasonably do so because the new shares are linked to EMC’s subsidiary, in the context of EMC’s acquisition by Dell.
According to the tax specialist Michael Solomon, Dell’s best chance in winning over the IRS will be to convince the agency that the tracking shares in VMware are more closely linked to Dell itself. If the IRS considers that EMC shareholders are simply receiving stocks in Dell as a result of the merger, the deal will easily go through. However, if the agency looks at the tracking stocks as distribution of shares of the subsidiary, the deal will probably fail because of a $9 billion tax liability.
As a consequence, the IRS’ decision regarding the tax treatment of tracking stocks in a merger context will be crucial for the deal and will define a new line for other future transactions. If the distribution of tracking stocks is considered taxable, Dell will either have to borrow more money to pay EMC’s shareholders or kill the deal.