Alexion Pharmaceuticals Inc. is acquiring Achillion Pharmaceuticals Inc. for cash and contingent value rights (CVRs), which will entitle the former Achillion shareholders to additional cash based on clinical and regulatory thresholds.
Under the merger agreement, Achillion will merge into a newly formed, wholly-owned subsidiary of Alexion.
In this “reverse subsidiary merger,” each share of Achillion common stock will be converted into the right to receive: (1) $6.30 in cash, without interest, and (2) one CVR. Each CVR represents the right to receive (1) $1 upon the achievement of a “clinical trial milestone” relating to the development of ACH-5528 prior to the fourth anniversary of the closing of the merger, and (2) $1 upon Alexion’s first receipt of approval by the Food and Drug Administration with respect to ACH-4471 prior to the date that is 54 months after the closing of the Merger.
This is, of course, a fully taxable transaction. The transitory existence of Merger Sub will be disregarded and the transaction will be treated as a direct sale by the Achillion shareholders of their Achillion stock to Alexion in exchange for the cash and CVRs. At issue, however, is the manner in which the CVRs are likely to be taxed. In computing gain or loss from the sale of the Achillion stock are the CVRs taken into account as an element of consideration?
Open or Closed Transaction?
In Revenue Ruling 58-402, the Internal Revenue Service noted that “the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis.” The amount realized, it went on to say, shall be “the sum of any money received plus the fair market value of the property (other than money) received.” CVRs constitute property. Do they have a “fair market value?”
The IRS position is that the amount of the fair market value of property of property is a question of fact, but only in rare and extraordinary cases will property be considered to have no fair market value. In other words, the IRS construes the landmark “open transaction” case, Burnet v. Logan, in the narrowest possible way.
The IRS believes that the open transaction approach can lead to abuse. If a sale or exchange remains an open transaction then the subsequent payments received under the contract will be subject to the appropriate capital gains provisions in the statute; but, if not, then the sale or exchange is a closed transaction, by reason of valuation of the contract or claim to receive indefinite amounts of income, and the subsequent payments in excess of basis received under the contract or claim constitute ordinary income.
Therefore, it is necessary, according to the IRS, in order to prevent escape from the ordinary income tax by converting income payments into capital gains, to ascertain the value of the property in the prior sale or exchange and to close the transaction, except in rare and extraordinary cases. Otherwise, the ordinary income tax on the income collected from the contract or claim after the sale or exchange will inevitably be “converted” into a tax on capital gains.
In light of the IRS’s strong preference for “closing” transactions that entail as an element of consideration contracts and claims to receive indefinite amounts of income, it is probably appropriate to assume that the amount realized from the sale of the Achillion stock will include not only the cash consideration, but the fair market value of the CVR as well. An Achillion shareholder, therefore, will have a basis in the CVR equal to the amount taken into account in determining the amount realized from the sale of his or her Achillion stock.
Does Section 1234A Change the Landscape?
The IRS, based on the reasoning it employed in Rev. Rul. 58-402 to justify an exceedingly narrow window for open transaction treatment, seems to assume that the “gain” arising from the collection of a CVR (i.e., the amount, if any, by which the CVR payout exceeds the recipient’s basis in the CVR) will be classified as ordinary income. This view, no doubt, is informed by the fact that the extinguishment of a CVR, upon its maturation, does not constitute a “sale or exchange” of that financial instrument.
However, it is certainly conceivable that this ordinary income result is not proper in light of the provisions of tax code Section 1234A. Section 1234A, in pertinent part, provides that “[g]ain or loss attributable to the termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset shall be treated as gain or loss from the sale of a capital asset.” Accordingly, it is necessary to determine exactly what a CVR pertains to.
If, for example, the CVR represents a “right” with respect to the developmental drugs the approval of which triggers a payment under the CVR, which drugs would certainly be capital assets in the hands of the holders of the CVRs, then, arguably, the termination of that right should be treated, under Section 1234A “as gain or loss from the sale of a capital asset.” In other words, the necessary predicate for capital gains treatment may well be supplied by Section 1234A which, in effect, treats the payment in respect of a CVR as a payment “in exchange” for such CVR.
Ironically, if Section 1234A properly applies here, the rationale for narrowing the occasion for open transaction treatment, i.e., that open transaction treatment leads to the conversion of ordinary income into capital gains, would itself disappear and, perhaps, the IRS would become more amenable to concluding that contracts or claims to receive indefinite amounts of income do not, in many cases, have an ascertainable fair market value.
Further, we have noted that some issuers of CVRs are taking the position that payments with respect to CVRs, that are made to foreign holders thereof, are subject to withholding taxes, i.e., that the payments are fixed, determinable, annual, or periodical (FDAP) income. If Section 1234A were applicable to the termination of a CVR, such that the pay outs in respect thereof were treated as distributions in full payment “in exchange” therefor, the withholding tax rationale would also be belied.
It is, in our estimation, high time the IRS revisited Rev. Rul. 58-402 and seriously considered the role that Section 1234A may very well play in characterizing the income or gain arising from the maturation or ripening of a CVR.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.