Rentokil to Acquire Terminix for $6.7B Enterprise Value

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

On December 14, Memphis-headquartered pest control company Terminix Global Holdings, Inc. (NYSE:  TMX) (Terminix) and U.K.-based pest control company Rentokil Initial plc (LSE:  RTO) (Rentokil) announced¹ that they had entered into an agreement whereby Rentokil will acquire Terminix in a series of two back-to-back mergers that are intended to qualify as a reorganization under Section 368(a)(1) of the Internal Revenue Code (IRC).^[2]  The obligation of Terminix to close the transaction is conditioned upon obtaining a will-level opinion from counsel that the transaction will so qualify as well as satisfying the requirements under Section 367 discussed below. ³ 

In exchange for their Terminix stock, Terminix shareholders can elect to receive either all stock in the form of Rentokil American depositary shares (ADSs, to be listed on the New York Stock Exchange and representing, in the aggregate, about 643.29 million new Rentokil Initial shares) or all cash (totaling, in the aggregate, about $1.3 billion), subject to proration if oversubscribed.  The transaction is expected to close in the second half of 2022.

It is possible that the first merger, taken by itself, could qualify as a tax-free reverse subsidiary merger under Section 368(a)(2)(E), which requires that Rentokil voting stock constitute at least 80 percent of the consideration.  However, it is clear that the intended reorganization analysis will view the two mergers together and, as such, regard the transaction as a forward subsidiary merger, which does not have this 80 percent rule, leaving much more leeway to qualify. ⁴ 

Inversion Considerations

The proposed acquisition should not trigger the inversion restrictions under Section 7874, because the shareholders of Terminix would only own about 26 percent of the newly combined company.  Under current law Section 7874, if the pre-merger U.S. company shareholders (in this case, Terminix) end up owning at least 60 percent or more of the post-merger foreign company (the combined company), then the post-merger foreign company would constitute a so-called surrogate foreign corporation and certain of the tax benefits of moving offshore would be limited.  Most important, if the pre-merger U.S. company shareholders end up owning at least 80 percent or more of the post-merger foreign company, then the surrogate foreign corporation is treated and taxed as if it is a U.S. corporation (deemed U.S. company rule). ⁵ 

However, both President Joe Biden and former President Barack Obama proposed reducing the deemed U.S. company rule threshold from at least 80 percent to greater than 50 percent.  Many Democrats in Congress (those holding out hope that some form of the Build Back Better Act might eventually be salvaged) are actively contemplating, among other things, something less harsh ⁶ —reducing that threshold from at least 80 percent to at least 65 percent (while the threshold for surrogate foreign corporation status would be reduced from at least 60 percent to more than 50 percent).  While the Rentokil-Terminix transaction (at 26 percent) is not close to any of these thresholds and the chances of any Section 7874 change coming about anytime soon ⁷ are still extremely uncertain, anyone involved in an outbound reorganization needs to be wary of Congressional interest in inversion transactions.

Section 367

For U.S. shareholders of Terminix, this is an outbound transaction, in that they are exchanging their stock in Terminix for stock in a foreign acquirer.  As such, tax-free treatment depends not only on qualifying as a tax-free reorganization under Section 368, but also meeting the requirements under Section 367.

In general, under the Section 367 rules, an outbound exchange of stock in a U.S. corporation can be tax-free to a shareholder as long as:

1. transferors of stock in the U.S. corporation do not acquire more than 50 percent of the stock (tested by both total voting power and total value) of the foreign acquiror, ⁸ 
2. U.S. persons who are officers or directors or 5-percent shareholders of the U.S. company do not own more than 50 percent of the stock (tested by both total voting power and total value) of the foreign acquiror, ^[9] 
3. the U.S. person ends up owning less than 5 percent of the combined company (including stock owned by attribution from certain related parties) after the transaction or, if it will hold 5 percent or more, then such person enters into a gain recognition agreement (GRA) with the Internal Revenue Service (IRS), requiring the original gain be triggered if certain things occur during the 5-year period after the acquisition, ¹⁰ and
4. the foreign acquiror satisfies a rigorous active trade or business test. ¹¹ 

Given the nature of the two companies, the percentage of Rentokil stock that will be held by the Terminix shareholders and the fact that the merger agreement envisions a will-level opinion on the issue, it is fair to assume that counsel has looked at the facts with sufficient detail to be confident that it will be able to come to a tax-free conclusion.

Shareholder Tax Treatment

For U.S. tax purposes, a shareholder of Terminix receiving solely Rentokil stock should not recognize gain or loss and take a basis and holding period based on those of the Terminix stock exchanged.  A shareholder receiving solely cash is technically treated as receiving it in a redemption transaction from Terminix and should generally have sale treatment under the complete termination provision of Section 302(b)(3).  If, however, there is proration such that a shareholder receives both stock and cash, then the shareholder is receiving qualifying stock consideration as well as taxable “boot,” and the treatment is governed by Section 356.

Under the boot rule, a shareholder recognizes gain (but not loss) equal to the lesser of (a) gain in the Terminix stock (value of total consideration less tax basis) or (b) the amount of cash received.  That gain may be taxed as a dividend rather than capital gain if the receipt of the cash has the effect of a dividend, which is determined using the redemption rules.  Under the test set out by the Supreme Court in Commissioner v. Clark, ¹² the shareholder is treated as if it first received solely Rentokil stock and then redeemed an amount corresponding to the cash received.  Depending on whether this notional redemption meets any of the tests under Section 302(b), it is treated as capital gain versus dividend.

Since the total amount of cash in the transaction is 20 percent of the total consideration, if there is proration, then presumably any shareholder receiving stock and cash would receive 20 percent or less of the consideration in cash.  As such, it would not generally satisfy the “substantially disproportionate” safe harbor under Section 302(b)(2), which requires that the shareholder reduce its percentage holding by more than 20 percent in the redemption.  On the other hand, the less precise “meaningful reduction” standard under Section 302(b)(1) should be satisfied by a shareholder owning a relatively small interest in Terminix (for example, less than 1 or 2 percent). ¹³ 

For a U.S. taxpayer, it may not matter whether the boot is taxed as capital gain or dividend.  However, despite the fact that the acquiring corporation here is a U.K. company, because the shareholder is treated as receiving the merger consideration from the U.S. target corporation, there is a risk that withholding tax could be imposed if the redemption test is not comfortably satisfied.  Since this only arises when there is proration, it may be academic.  Further, since proration tends to occur as a result of excessive demand for cash consideration, one safe way to avoid it may be to elect all stock consideration.  But ultimately, if a non-U.S. holder is in a position of receiving stock and cash, both the “small shareholder” rule and the Zenz doctrine ¹⁴ (adopting a plan to sell down the position in Rentokil) should be sustained and prime brokers should be amenable.

^{[1] Joint Press Release, Acquisition of Terminix Global Holdings Inc by Rentokil Initial plc for Stock and Cash Creating the Global Leader in Pest Control and Hygeine & Wellbeing (Dec. 14, 2021) (https://www.sec.gov/Archives/edgar/data/0001428875/000110465921149378/tm2135242d1_ex99-1.htm).}

^{[2] According to the Agreement and Plan of Merger (Merger Agreement), dated as of December 13, 2021, by and among Terminix and Rentokil, among others, the back-to-back mergers (a reverse subsidiary merger followed by a forward subsidiary merger) will be structured as follows:  First, Merger Sub I (Leto Holdings I, Inc., a Delaware corporation and a direct, wholly owned subsidiary of Rentokil) will merge with and into Terminix, with Terminix surviving as a wholly owned direct subsidiary of Rentokil; then, and as part of the same plan, surviving Terminix will merge with and into Merger Sub II (Leto Holdings II, LLC, a Delaware limited liability company and a direct, wholly owned subsidiary of Rentokil) with Merger Sub II surviving as a wholly owned direct subsidiary of Rentokil.  (https://www.sec.gov/Archives/edgar/data/0001428875/000110465921149378/tm2135242d1_ex2-1.htm).}

^{[3] Section 9.03(d) of the Merger Agreement.}

^{[4] See IRC §§368(a)(2)(E) and (a)(2)(D); Rev. Rul. 2001‐46, 2001‐42 IRB 321.}

^{[5] IRC §§7874(a)(2)(B) and (b).}

^{[6] Section 128153 of the Dec. 11, 2021 Senate Finance Committee tax text for the Build Back Better Act (BBB, H.R. 5376) at https://www.finance.senate.gov/imo/media/doc/12.11.21%20Finance%20Text.pdf.}

^{[7] If enacted, the latest Build Back Better Act proposal changing IRC §7874 would be effective for acquisitions completed on or after enactment.}

^{[8] Treas. Reg. §1.367(a)‐3(c)(1)(i).}

^{[9] Treas. Reg. §1.367(a)‐3(c)(1)(ii).}

^{[10] Treas. Reg. §1.367(a)‐3(c)(1)(iii).}

^{[11] Treas. Reg. §1.367(a)‐3(c)(1)(iv).}

^{[12] Commissioner v. Clark, 489 U.S. 726 (1989).}

^{[13] The “meaningful reduction” test for IRC §302(b)(1) was established by the Supreme Court in United States v. Davis, 397 U.S. 301 (1970).  Rev. Rul. 76-385, 1976-2 CB 92, established the rule that a small shareholder with no influence over the corporation can satisfy this standard with any reduction.}

^{[14] Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954).}