Broadcom-VMware Merger Agreement Stock/Cash Election Provides Tax Advantages to VMware Shareholders

By Stuart E. Leblang, Michael J. Kliegman, and Amy S. Elliott

On May 26, Broadcom Inc. (NASDAQ:  AVGO) (Broadcom) and VMware, Inc. (NYSE:  VMW) (VMware) announced^[1]that they had entered into in an agreement for Broadcom to acquire VMware in a cash-and-stock merger valuing VMware at approximately $61 billion, with Broadcom also assuming $8 billion of VMware net debt.  On May 24, we wrote about an important aspect of the then-rumored transaction—its possible effect on the tax-free nature of the October 2021 spin-off of VMware by Dell Technologies Inc. (NYSE:  DELL) (Dell) (that report is appended). ² In this report, we discuss the planned merger and how it addresses the spin-off.

Broadly, the merger is designed to qualify as a tax-free reorganization.  VMware shareholders may elect to exchange a VMware share for either $142.50 in cash or 0.2520 shares of Broadcom common stock.³ However, only half of the exchanged shares will be entitled to receive cash, while the other half will receive stock.  If there is an excess of cash or stock elections, the mix of consideration to a shareholder will be adjusted to achieve the 50-50 ratio.

The acquisition is structured to qualify as a forward merger,⁴ which is necessary to allow for this much cash consideration.⁵There are actually three statutory mergers facilitating the acquisition, involving three separate newly formed merger subsidiaries.  The first merger results in the VMware shareholders exchanging their VMware stock for that of a new Delaware corporation (Holdco) and conversion of VMware to a Delaware limited liability company (LLC) treated as a disregarded entity for U.S. tax purposes.  This first merger is intended to be treated as a so-called “F” reorganization (a mere change in form) of VMware into Holdco.  Immediately following this reorganization, the business combination will be effected via a merger of a Broadcom merger subsidiary (Merger Sub 2) into Holdco and then via a merger of Holdco into another merger subsidiary (Merger Sub 3), with Merger Sub 3 surviving.

There is no indication in the Agreement and Plan of Merger (Merger Agreement)⁶ or other communications from the parties as to why they are restructuring VMware under Holdco.  Our best guess is that, because tax considerations necessitate that the mergers culminate in a Broadcom subsidiary being the surviving entity (a forward merger), such a structure may present some non-tax concerns, particularly if VMware is itself not purely a holding company but holds legal positions that would need to be addressed if it were a nonsurviving participant in a statutory merger.

A VMware shareholder receiving solely stock consideration will not recognize gain or loss and will take a tax basis in the Broadcom stock equal to the shareholder’s basis in the VMware stock exchanged as well as a “tacked” holding period (Broadcom stock holding period includes the pre-merger holding period in the VMware stock exchanged).  Cash received by a VMware shareholder receiving solely cash is treated as proceeds of a redemption of VMware stock.  This redemption should ordinarily qualify for capital gain treatment as a complete termination of interest under Internal Revenue Code (IRC) Section 302(b)(3), and for a foreign investor there should be no dividend withholding tax.

However, where a VMware shareholder receives some stock and some cash consideration, the tax treatment is more interesting.  We instinctively look to the “boot” rules of Section 356 when we see a shareholder receiving both stock and cash in a reorganization.  Generally, under Section 356, a shareholder recognizes gain equal to the lesser of the overall gain realized (cash and value of stock minus tax basis) or the amount of cash received, where no loss may be recognized and the gain might be taxed as either capital gain or as a dividend depending on a modified redemption analysis.

The classic boot situation is where each share of Target stock is exchanged for the mixed consideration.  Here, the parties have apparently taken pains in the Merger Agreement to make clear that, under the shareholder election and also under the proration mechanism, any given share of VMware stock will be exchanged entirely for either stock or cash.⁷Under the generally applicable “specific identification” method with respect to dispositions of stock, the Internal Revenue Service has clearly adhered to the position that arbitrary designations by a taxpayer as to which shares are being sold and which are not will be respected (as long as such designations adequately identify the shares of stock by lot, acquisition date or acquisition price).⁸The IRS has liberally applied this approach in the reorganization area to allow designations of which consideration is being issued for which stock or securities.⁹ The IRS has mainly referred to different classes of stock, but we suspect that the parties in this case have deliberately set the matter up to enable VMware shareholders to obtain redemption/sale treatment (with possible loss recognition) on those shares sold for cash and nonrecognition treatment on those shares exchanged for stock, with results different than under the Section 356 boot rules.

There is little guidance on this point, but determining whether and how to apply these rules on a share-by-share basis, rather than a shareholder-by-shareholder basis, is consistent with the way the statute and regulations are drafted.  This means that a shareholder with blocks of high basis shares and low basis shares may be much better off designating that the former are submitted for the cash election and the latter for the stock election.

In this case, one shareholder owns some 36.8 percent of all VMware stock (the one shareholder being Dell founder, Chairman and CEO Michael S. Dell, according to a May 26 disclosure¹⁰).  Much of Michael Dell’s VMware holding likely has a low historical basis.  But he may also hold shares with a significantly higher basis.  Because of this, it is likely not a coincidence that the Merger Agreement sets up the cash-and-stock process the way it does.

Section 3.4(l) of the Merger Agreement is quite specific as to the mutual intent of the parties with respect to this issue.  It provides that a VMware shareholder’s designation of specifically identified shares for cash consideration is to be respected for tax purposes.¹¹

For a hedge fund or private equity firm shareholder (such as Silver Lake Partners, which holds some 10 percent of all VMware stock through affiliated entities¹²), there is the common concern about dividend withholding tax.  If a cash-only election is fully honored, there should be a clean position for no dividend withholding tax.  However, making a cash-only election is often no guarantee that the investor will not be forced to take both stock and cash due to an over- subscription for cash.  It is possible that this risk is less than usual in this transaction, because Michael Dell might be expected to elect to receive a significant amount of stock.  Just the same, it is worth considering the analysis if a shareholder does receive a combination of stock and cash, especially as there is no indication in the merger documents that Michael Dell has committed to a significant stock election.

Under the boot rule of Section 356 (which, as noted above, may not be applicable), a shareholder receiving stock and cash first determines the amount of gain recognized (lesser of gain realized or the cash received).  Then under Section 356(a)(2), the gain must be tested under modified redemption rules to determine whether it is taxed as a dividend.  Under the so-called Clark test, ¹³ the shareholder is treated as if it received all stock in the merger and then as if it redeemed an amount of Broadcom stock sufficient to yield the amount of cash received.  That notional redemption is then tested under the Section 302 rules.  Assuming the shareholder does not own Broadcom stock before the merger, then this means that the shareholder should qualify for the Section 302(b)(2) 20-percent safe harbor if the cash constitutes more than 20 percent of the consideration it receives.¹⁴In a case where this safe harbor is not met, there are other alternative approaches to avoiding dividend treatment.

If, as discussed above, the boot rules do not apply, and the tax treatment is fully bifurcated between the VMware shares sold for cash and those exchanged for Broadcom stock, then the tax treatment will be different.  Shares subject to the cash election (or forced into it under the proration procedure) must first be tested under the redemption rules of Section 302.  If the redemption passes one of the “capital gain” tests under Section 302(b), then gain or loss will be recognized specifically on the shares sold/redeemed.  If the redemption fails to pass any of these tests, then the entire amount of cash received will be treated as a dividend to the extent of earnings and profits (E&P) and, for a foreign investor, the cash will be subject to dividend withholding of 30 percent unless reduced by an applicable tax treaty.

A VMware shareholder receiving cash in the merger should be considered to completely terminate its interest in VMware, qualifying for capital gain treatment under Section 302(b)(3).  Unlike the boot rule discussed above, the regular redemption rule does not automatically look to the shareholder’s ownership interest in the acquiring corporation (Broadcom).  This should only occur under the terms of the stock attribution rules of Section 318.  Under those rules, a VMware shareholder’s continuing interest in Broadcom (e.g., as a result of receiving Broadcom shares in the merger) should only be taken into account if that shareholder (including certain family and other related parties to that shareholder) owns 50 percent or more of Broadcom. ¹⁵ 

As we have often noted, while the substantive tax rules are important, they are not determinative of whether dividend withholding tax will be imposed in a given transaction.  That ultimately depends on the approach taken by the prime broker (or other withholding agent).  We may not know until a proxy statement is released to the VMware shareholders how Broadcom and VMware are viewing the receipt of cash and stock in the transaction, and consequently, what approach will be taken by the withholding agent.  Given the presumed interest of Michael Dell in the bifurcation/specific identification approach rather than the boot approach (and the presumed interest of Silver Lake in avoiding dividend withholding), we may see helpful clarity on this point.

Finally, revisiting the subject matter of our May 25 report, there are no surprises in the Merger Agreement regarding the issue of whether this merger can potentially cause the Dell spin-off of VMware to result in corporate tax to Dell.  The Merger Agreement contains representations by VMware that it has taken no actions (and that it is not aware of any other person having taken any actions) that would cause the spin-off to be taxable in violation of the Tax Matters Agreement.^[16]Further, the Merger Agreement provides that VMware must receive a tax opinion essentially concluding that the Broadcom merger will not cause the spin-off to be taxable.¹⁷ The validity of the representations and continued validity of the tax opinion are conditions to closing the transaction.¹⁸

^{[1] Joint Press Release, Broadcom And VMware, Broadcom to Acquire VMware for Approximately $61 Billion in Cash and Stock (May 26, 2022) (https://www.sec.gov/Archives/edgar/data/1730168/000119312522160371/d323890dex991.htm).}

^{[2] See “Broadcom:  How to Buy a Company 7 Months Post Spin” (May 24, 2022), which is appended to this report.}

^{[3] According to the press release, the total per-share consideration (taking into account both cash and stock) averages out to $138.23 based on the closing price of Broadcom common stock on May 25, 2022 (which was $531.63, so 0.2520 x $531.63 = $133.97, which averaged with $142.50 = about $138.23).  VMware shareholders that fail to make an election will generally receive stock, assuming the cash election option is oversubscribed (which it may not be given Michael Dell’s interest).}

^{[4] In a forward merger, the target corporation merges into the acquiring corporation (so that the acquiring corporation is the surviving corporation).  In a reverse merger, the target corporation is the surviving corporation.  IRS guidance (Rev. Rul. 2001-46, 2001-2 C.B. 321) allows for back-to-back mergers in certain situations to be treated as an integrated acquisition that qualifies as a single statutory merger.}

^{[5] In general, a forward merger can qualify as a tax-free reorganization if a significant portion (the regulations say 40 percent) of the consideration is stock, which means that as much as 60 percent of the consideration can be cash (see Treas. Reg. § 1.368‐ 1(e)(2)(v), Example 1).  Also, as discussed below, the ultimate surviving corporation in the mergers will be Merger Sub 3, a wholly owned subsidiary of Broadcom.  Merger Sub 3 is an LLC.  If it is treated as a disregarded entity for U.S. tax purposes (which is the default absent an election), then the transaction should qualify as a straight “A” reorganization.  But if the parties elect to treat Merger Sub 3 as a regarded corporation for U.S. tax purposes, then the transaction should be treated as a forward triangular merger under Internal Revenue Code (IRC) §368(a)(2)(D).}

^{[6] Agreement and Plan of Merger dated as of May 26, 2022 by and among VMware and Broadcom, among others (Merger Agreement) (https://www.sec.gov/Archives/edgar/data/1124610/000119312522161168/d362256dex21.htm).}

^{[7] See Sections 3.3 and 3.4 of the Merger Agreement.}

^{[8] See Treas. Reg. §1.1012-1(c); IRS Publication 550, page 40.}

^{[9] See Treas. Reg. §1.356-1(d) Example 4; Treas. Reg. §1.358-2(a).}

^{[10] https://www.sec.gov/Archives/edgar/data/1124610/000119312522161572/d312833dsc13da.htm; Note that Michael Dell’s ownership increases to 40.2% if you include shares owned by the Susan Lieberman Dell Separate Property Trust (Michael Dell’s beneficial ownership of VMware stands at 155,005,746 shares whereas the SLD Trust’s beneficial ownership of VMware stands at 14,272,269 shares.}

^{[11] Section 3.4(l) provides:  “For all purposes of this Article III and for U.S. federal income tax purposes, and in accordance with Treasury Regulations Section 1.358-2(a)(2)(ii), it is intended that a Holder will be treated as having surrendered, in exchange for the Cash Consideration to be paid to such Holder pursuant to this Article III, a number of shares of Company Common Stock (which are specifically identified by such Holder in the Letter of Transmittal to be the shares exchanged for such Holder’s Cash Consideration) equal to the product of (A) the total number of shares of Company Common Stock held by such Holder and converted into the right to receive Merger Consideration pursuant to this Agreement and (B) the Cash Ratio.”}

^{[12] https://www.sec.gov/Archives/edgar/data/0001124610/000119312522161143/d302416dsc13da.htm}

^{[13] See Commissioner v. Clark, 489 U.S. 726 (1989).}

^{[14] IRC §302(b)(2) general provides that a substantially disproportionate redemption requires that the shareholder’s post- redemption percentage interest in the corporation be less than 80% of its pre-redemption percentage.}

^{[15] IRC §318(a)(2)(C).}

^{[16] For the Tax Matters Agreement, scroll down to Exhibit E here:  https://www.sec.gov/Archives/edgar/data/1571996/000119312521116271/d142017dex21.htm}

^{[17] See Section 4.12(m) and Section 8.3(e) of the Merger Agreement.}

^{[18] See Section 8.2(a) of the Merger Agreement.}