INSIGHT: Avon Lady as Helen of Troy?—Natura Acquisition Must Comply With Anti-Inversion Rules

The Brazilian cosmetics and skincare corporation, Natura & Co., announced on May 22 that it is acquiring Avon Products Inc. in an all-stock transaction. For the Avon shareholders to enjoy non-recognition treatment, the transaction must surmount U.S. anti-inversion requirements known as the “Helen of Troy” regulations.

As part of the transaction, a new Brazilian holding company, Natura Holding S.A., has been created. Natura & Co.’s shareholders will own approximately 76% of the stock of the holding company, while Avon’s shareholders will own the remaining 24% of such stock.

As part of one overall plan, the shareholders of Natura & Co. will transfer their Natura & Co. stock to the holding company solely in exchange for stock in the holding company. At the same time, the holding company will create Merger Sub I, and Merger Sub I will create Merger Sub II, each a Delaware corporation. Merger Sub II will be merged with and into Avon. In connection with that first merger, each share of Avon common stock will be converted into the right to receive one share of Merger Sub I stock. Immediately thereafter, Merger Sub I, the owner of all of Avon’s stock, will merge, downstream, with and into Avon.

The holding company will be the surviving corporation in that second merger, and Avon will become a wholly-owned direct subsidiary of the holding company. Each share of Merger Sub I stock will—in connection with the second merger—be converted into the right to receive 0.300 holding company American depository shares (ADSs) or, if the Merger Sub I shareholder prefers, 0.300 holding company shares.

Disregarding, as we must, the transitory existence of Merger Sub I and Merger Sub II, the net effect of the transaction is a transfer by the shareholders of Avon of their Avon stock to the holding company in exchange for the holding company ADSs (or the holding company shares), and a concurrent transfer by the Natura & Co. shareholders of their Natura & Co. stock to the holding company in exchange for the holding company shares.

Immediately after the transfer(s), the transferors of property to the holding company, i.e., the Avon shareholders and the Natura & Co. shareholders, will, collectively, be in control of the holding company. Accordingly, the transaction is described in tax code Section 351 which means, without considering the foreign provenance of the holding company, that no gain or loss will be recognized by the Avon shareholders on the exchange of their Avon stock for the holding company ADSs (or the holding company shares).

Helen of Troy Regulations

An additional hurdle, arising as a result of the fact that Natura & Co. is a foreign corporation, must be surmounted in order for the Avon shareholders to enjoy non-recognition treatment.

Treasury Regulation Section 1.367(a)-3(a) provides that in general, a transfer of stock by a U.S. person to a foreign corporation that is described in Section351 is subject to Section 367(a)(1). Therefore, gain is recognized on such a transfer unless one of the exceptions applies to the transfer. Fortunately, here, such an exception appears eminently applicable.

Thus, Treas. Reg. 1.367(a)-3(c), the so-called “Helen of Troy” regulation, provides that a transfer of stock of a domestic corporation by a U.S. person to a foreign corporation that would otherwise be subject to Section 367(a)(1) will not be so subject if—

• Fifty percent or less of both the total voting power and the total value of the stock of the transferee foreign corporation is received in the transaction by U.S. transferors (all of the stock of Avon is presumed to be owned by U.S. transferors); and 50% or less of both the total voting power and total value of the stock of the foreign transferee is owned, in the aggregate, immediately after the transfer, by U.S. persons that are either officers or directors of the U.S. target or that are “5% target shareholders”;

• Either the U.S. person is not a 5% transferee shareholder, or the U.S. person is such a 5% transferee shareholder and enters into a five-year agreement to recognize gain;

• The transferee or a qualified subsidiary of such transferee is engaged in an active trade or business outside the U.S. for the entire 36-month period immediately before the transfer; and

• The “substantiality” test is satisfied—a transferee foreign corporation will be deemed to satisfy the substantiality test if, at the time of the transfer, the fair market value of the transferee foreign corporation is at least equal to the fair market value of the U.S. target corporation.

It appears that the exception set forth in Treas. Reg. 1.367(a)-3(c) will be easily satisfied in light of the facts that:

• the shareholders of Avon will be receiving only 24% of the stock of the holding company;
• Natura & Co. has a greater than three-year history of active business conduct outside of the U.S.; and
• the value of Natura & Co. appears to dwarf that of Avon.

Accordingly, Section 351’s non-recognition outcome will not be displaced by Section 367(a)(1)’s recognition rule, with the result that no gain or loss will be recognized by the Avon shareholders on their exchange of Avon stock for the holding company ADSs (or the holding company shares).

The merger agreement contemplates (in fact requires) this outcome. The “Intended U.S. Tax Treatment” of the transaction is that it qualifies as a transfer of property described in Section 351 and does not result in gain being recognized due to the application of Section 367(a)(1) (other than for any shareholder that would be a “five percent transferee shareholder” of the holding company immediately after the transaction that does not enter into a five-year gain recognition agreement).“ Technically, the acquisition of Avon’s stock by the holding company also qualifies as a reorganization under Section 368—certainly of the ’B’ variety, and perhaps of the ’A’ variety as well.

The Helen of Troy regulations were added in what turned out to be a futile attempt to reduce the incidence of “inversion” transactions, particularly that most insidious form of inversion known as the “self-inversion.” It was thought that corporations would be loath to invert if, as was frequently the case, the shareholders of the expatriated entity would be required to recognize gain on the exchange of their stock for stock of the foreign acquiring corporation. In fact, the Helen of Troy regulations did not make a noticeable dent in the number of inversion transactions. What stopped inversions was the reduction of the U.S. corporate tax rate and the introduction of “territorial” tax principles, for the first time, into the U.S. tax firmament.

While the Avon/Natura & Co. transaction has the look and feel of an inversion, it technically does not fit that description since the shareholders of Avon, as a result of owning stock therein, will not own 60% or more of the stock of Natura & Co. Moreover, although the instant transaction involves the formation of a holding company, that holding company will be a resident of Brazil, as is the acquired foreign corporation, Natura & Co. Accordingly, this transaction is not a so-called “third country transaction,” a designation that in some cases can render the foreign acquiring corporation, for U.S. tax purposes, a U.S. corporation. See Section 7874(b) and Treas. Reg. 1.7874-9. The designation does not apply here, because the Avon shareholders will not own at least 60% of the stock of the holding company as a result of their ownership of Avon stock.

The merger agreement is available here.

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.