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Dell's EMC Deal Could Fall Apart on Tax Rule

There are worries inside Dell that the VMware tracking stock designed to avoid paying taxes may instead trigger them.

Justin Sullivan / Getty

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.

Representatives of Dell and EMC declined to comment.

If the IRS were to rule that the tracking stock qualifies as a taxable distribution of shares as defined in Section 355, it would remove a key plank of Dell’s financing for the transaction. At minimum it would require Dell to borrow more money to pay EMC shareholders for the full value of the company. As it is, Dell is expected to have an astounding $50 billion worth of debt on its books after the deal closes sometime next year.

At worst, sources said, the added tax expense could derail the deal entirely. These sources point to a few lines of text in the merger agreement between Dell and EMC stating as much. The document, on file with the Securities and Exchange Commission, requires that “neither the company [EMC] nor any of its subsidiaries has been a ‘controlled corporation’ or a ‘distributing corporation’ in any distribution occurring during the two-year period ending on the date hereof that was purported or intended to be governed by Section 355 of the code.” Essentially, that text means that if Section 355 applies, the deal is off.

Instead, Dell is hoping the IRS will see the creation of the VMware tracking shares as a tax-free exchange, which is covered by a different portion of the tax laws — Section 351. One hint at the importance of this distinction can be found in the text of the 76-page merger agreement, which mentions Section 351 nine times versus once for Section 355. One section requires that all parties to the transaction take “any action necessary” to ensure it qualifies for Section 351 or the “intended tax treatment.”

“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.

The transaction is expected to come under review by federal regulators under the Hart-Scott-Rodino Act. That process is led by the Federal Trade Commission and the Department of Justice, which can then ask for help from other government agencies, including the IRS, to review specific details of the deal.

Sources familiar with the matter offered differing views on how likely the tax questions are to cause a problem for Dell as the transaction proceeds toward closing. As one source put it: “They’re in unexplored territory concerning how they’ve proposed to use tracking stock. Someone is going to have to bless it with a ruling, and that ruling is going to permanently change how tracking stocks are viewed.”

Another source with similar knowledge of the discussions had a less extreme view: “You have to believe that both parties had the best tax lawyers in the world advising them on this. Yes, it’s a concern, but it’s one the lawyers would have foreseen and considered unlikely to cause a problem, or they wouldn’t have rolled the dice.”

And even if the IRS ignores the entire question — a distinct possibility — questions about EMC’s tax liabilities may come up in court. There are at least a dozen shareholder lawsuits seeking to unwind the deal. One filed last week in federal and state courts in Massachusetts alleges that the transaction is “designed to shield Dell from a multi-billion dollar tax burden.”

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