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Latest SPAC Deal Features Eclectic Mix of Merger Consideration

Oct. 16, 2020, 8:01 AM

Hims Inc., a telemedicine company, will be “going public” by means of a business combination with Oaktree Acquisition Corp., a special purpose acquisition company (SPAC) sponsored by an affiliate of Oaktree Management LP.

Oaktree is currently a Cayman Islands exempted company, but, as part of the plan, Oaktree intends to “domesticate” as a Delaware company. Such domestication is necessary to ensure that the shareholders of Hims can receive the merger consideration to which they will become entitled on a tax-free basis. If Oaktree remained a Cayman entity, the shareholders of Oaktree would be taxed on their receipt of the merger consideration because, collectively, such shareholders will be receiving well in excess of 50% of the stock of Oaktree, and an “outbound” reorganization is taxable to the shareholders of the acquired corporation where such shareholders, in the aggregate, receive more than 50% (by vote or value) of the foreign acquirer’s stock. See Reg. Section 1.367(a)-3(a) and (c).

In addition, under the “inversion” rules, because the shareholders of Hims will acquire more than 80% of Oaktree’s stock, by reason of their ownership of Hims’s stock, Oaktree, were it not preemptively domesticating, would be treated, for U.S. federal income tax purposes, as a U.S. corporation. See tax code Section 7874(b).

The domestication will constitute a reorganization under Section 368(a)(1)(F). However, because of the “direction” of the transaction, i.e., the fact that it entails an acquisition by a domestic corporation of the assets of a foreign corporation in a transaction described in Section 368(a)(1), the shareholders of Oaktree (who are not “U.S. shareholders” thereof) will be constrained to either recognize gain on the exchange or, if they choose, include in gross income, as a deemed dividend, the so-called “all earnings and profits” amount with respect to Oaktree. See Treasury Regulation 1.367(b)-3(b) and (c).

The U.S. shareholders do not have an option. They are required to include in gross income, as a deemed dividend, the all-earnings and profits amount with respect to their stock. An exchanging shareholder whose stock in the foreign acquired corporation has a fair market value of less than $50,000 on the date of the exchange experiences neither income inclusion nor gain recognition from the exchange. The good news is that Oaktree, a recently minted SPAC, almost certainly has minimal, if any, earnings and profits, such that the deemed dividend the “inbound” reorganization will produce should certainly be de minimis.

Consistent with the manner in which the vast majority of SPAC acquisitions are structured, the instant transaction will take the form of a “reverse triangular merger.” Thus, Oaktree will create a Delaware “newco” (merger subsidiary), and, at the effective time of the merger, the merger subsidiary will be merged with and into Hims. Hims will be the surviving corporation in such merger and shall continue as a wholly-owned subsidiary of Oaktree. What sets this deal apart from the others is the varied mix of merger consideration to which the Hims shareholders will become entitled.

Thus, at the effective time, the Hims common stock will be converted into the right to receive:

  • a number of shares of Oaktree’s Class A (low vote) common stock,
  • a number of Class A warrants to purchase Oaktree’s Class A (low vote) common stock,
  • “earn out” shares, and
  • Class V (high vote) Oaktree common stock.

The parties intend that the merger “shall constitute a reorganization” within the meaning of Section 368(a) and/or the merger and the PIPE financing (private investment in public equity) “shall be considered part of an overall plan in which the Hims shareholders exchange their shares of Hims common stock for the merger consideration in an exchange described” in Section 351. Contemporaneously with the merger, certain institutional investors will be purchasing shares directly from Oaktree. The former shareholders of Hims, and the institutional investors, are each ”transferors“ of property (as used in Section 351, the term, property, includes money) to Oaktree in exchange for its stock and such transferors, collectively, will own, immediately after their exchanges, at least 80% of the total combined voting power of all classes of Oaktree stock entitled to vote. Accordingly, the transaction appears to satisfy the requirements of Section 351(a).

It seems likely that the merger will qualify as an “A” reorganization, by reason of Section 368(a)(2)(E). A reverse triangular merger qualifies as such an “A” reorganization where, as seems to be the case here, the merging subsidiary of the issuing corporation is a first-tier subsidiary thereof; after the transaction, the surviving corporation holds substantially all of its properties and those of the merging subsidiary; and in the transaction the former shareholders of the surviving corporation exchanged, for voting stock of the controlling corporation, an amount of stock constituting control of the surviving corporation. See Section 368(a)(2)(E)(ii). It appears that this so-called “control for voting stock” requirement will be met here, so long as the non-voting stock consideration, i.e., the warrants to be issued do not represent, by value, more than 20% of the aggregate merger consideration.

Contingent Stock

In the case of a reorganization, the target shareholders can exchange their target stock for stock of the issuing corporation on a tax-free basis. See Section 354(a)(1). Although warrants constitute “securities,” rather than stock, and Section 356(d) provides that the term “other property” includes securities (such that the receipt of the warrants would be taxable), the Hims shareholders should, nonetheless, be in a position to receive the warrants on a tax-free basis. Treasury Regulation 1.356-3(b) tells us that “a right to acquire stock that is treated as a security…has no principal amount.” Thus, such right is not other property when received in a transaction to which Section 356 applies. Accordingly, as a practical matter, where, as here, a target shareholder exchanges his or her target stock for a combination of stock and warrants of the acquiring corporation in an otherwise qualifying reorganization, the target shareholders will recognize no gain on the exchange.

It is a rare SPAC deal that does not prominently feature a contingent stock element. Usually, the contingent stock will be “earned” if the acquiring corporation’s stock trades at certain reasonably attainable levels at different points in time during the five-year period beginning on the date of the consummation of the business combination. The better the stock trades, the more contingent shares will be earned.

The right to receive contingent stock is, for purposes of Section 354 , equivalent to outright stock and, thus, can be received on a tax-free basis, but only if the rights are not assignable and can give rise to the receipt of only additional stock of the acquirer and no more than 50% of the maximum number of shares which can be issued in the transaction are contingent shares. See e.g., Revenue Ruling 66-112.

However, if the contingent stock is delivered more than six months after closing (and at least one contingent payment is due more than one year after closing), a portion of each contingent share so delivered will be treated as “imputed” interest income. Only the remainder of the contingent share can be received on a tax-free basis under the auspices of Section 354.

These “imputed interest” rules can be reliably avoided if the contingent stock is actually issued at the effective time, and is subject to repossession should the stock price not perform in the manner envisioned. See Rev. Rul. 70-120. That is what is taking place here. The agreement explicitly provides that Oaktree “shall issue Earn Out Shares, subject to vesting and forfeiture conditions.” Each Hims shareholder issued earn out shares “shall be entitled to the voting and dividend rights generally granted to holders of Oaktree’s Class A common stock.” The earn out shares shall be treated as issued and outstanding (i.e., transferred as of the effective date of the reorganization); and any forfeiture thereof shall be treated as nothing more than an adjustment to the merger consideration for tax purposes. (The return of the earn out shares should not entail any gain recognition for the Hims shareholders since the number of shares to be so returned is based on their initial negotiated value).

Accordingly, it appears that the “release” of the earn out shares will not entail any imputed interest income consequences to the Hims shareholders. This transaction, unlike the case where the contingent shares are not actually issued at closing, is not a “deferred payment sales contract” to which the imputed interest rules of Section 483 are applicable. This SPAC deal breaks a lot of new ground when it comes to the components of the merger consideration; and, even better, with obvious attention to detail, it appears to allow each of the elements of such merger consideration to be received by the acquired corporation’s shareholders on a tax-free basis.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

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.