The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 6, January 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

It has long been known that a pooling transaction or "pooling of interests" accords favorable accounting treatment. Businesspeople, tax advisors and accountants alike have scratched their collective heads for several years now about just what these requirements mean and how they operate. There is even a kind of awkward silence since no one is quite sure who is supposed to know how these rules work. The pooling rules fall into the realm of accountants (and not tax accountants either, but accountants well-versed with the Financial Accounting Standards Board's rules). The FASB, as it is known, has dickered among itself with the pooling rules and how they may be bettered.

There has been special scrutiny of pooling of interest accounting practices in high-tech mergers, particularly for software companies. It has been pointed out by more than one source that pooling can be particularly important in such cases because of the relative asset value of software companies, which is small compared to that of industrial manufacturers. Industrial manufacturers have a much larger capital base of production facilities. Afficionados of pooling in software deals adamantly assert that a pooling of interests enables software companies to avoid the large goodwill asset categories that would automatically result from acquisitions of a more normal variety. The amortization of a large goodwill would artificially reduce earnings for years, they contend, causing an unacceptable loss of shareholder value.

The primary determinant for the value of a software company's assets, the argument goes, is the cost of development. Development costs, of course, are capitalized and amortized over the anticipated life of the product. This kind of "replacement cost" approach does not take into account the expertise of the software development team that makes the product. This team, representing a kind of "people assets" are generally what is most important to a software company's success, something that cannot accurately be reflected on a balance sheet. Any suggestion that pooling of interest treatment might be eliminated has therefore been most assiduously attacked from the high-tech sector. See "Pooling of Interest is Crucial for High-Tech," Business Week, November 2, 1998, p. 14.

Change in the Offing

In recent years, the FASB has struggled with the pooling rules, and at times talked of abolishing or radically altering them. It may be too soon to predict an outcome for all of this activity. Still, we at The M&A Tax Report find an incredible degree of confusion prevailing. While these are accounting and not tax rules, per se, a review of the current status of the matter seems indicated.

If the FASB project regarding accounting for business combinations goes the way we fear it will (the pooling rules will be amended to incorporate a "relative size" test so that pooling will only be available in cases in which an acquirer cannot be identified), it may not be necessary to have an understanding of the pooling guidelines. Yet, until the time (if ever) that pooling as we know it becomes extinct, it is useful to have a general handle on the requirements set forth in APB 16.

Here, then is a non-accountant's rendition, a kind of horseback review of the principal pooling of interest tests.

1. Only Voting Stock. The target's voting common shareholders must all be offered and receive only voting common stock of the acquiring entity. If the latter entity has multiple classes of common stock outstanding, it must issue the majority class of such stock in the transaction. Although the presence of "tracking" stock in the issuer's capital structure does not preclude a pooling, provided it was not created in contemplation of such pooling, it cannot be used as the currency for a valid pooling. (see EITF Issue No. 96-8). For these purposes, holders of the target's "in-the-money" convertible securities, as well as holders of target options and warrants (whether or not in-the-money and whether or not presently exercisable), must also be offered and receive the acquirer's voting common stock or, alternatively, an acquirer security that is equivalent to the holder's target security.

2. Less Than 10% Cash. The acquirer may pay cash (or other property) for less than 10% of the target's voting common stock but, only, if such cash (or other property) is used to pay for fractional shares or, alternatively, to purchase all the stock held by one or more dissenting shareholders. Moreover, this so-called "10% basket" is reduced to the extent that either of the combining companies hold (a) "tainted" treasury stock, (b) an intercompany investment in the other combining company, or (c) any target stock remains outstanding. Holders of target non-voting common must also be compensated with acquirer voting common stock, whereas target creditors and nonconvertible preferred stockholders may be compensated with cash except in cases in which such debt or preferred stock was issued by the target, in a redemption or a recapitalization, in exchange for its voting common stock during the two-year period preceding the initiation of the pooling.

3. No Subsidiaries. Neither of the combining companies may have been a subsidiary of a division of another entity within the two-year period preceding the initiation of the pooling. A pooling is generally initiated on the date the major terms of the plan are announced. Where an entity is spun off from a parent, like a Lucent or an Allegiance, it cannot initiate a pooling until two years have elapsed form the date of the spinoff.

4. No Reacquisition. Neither of the combining companies may have reacquired shares of its voting common stock during the period commencing two years prior to the initiation of the pooling and extending through its consummation. However, such reacquired stock will not preclude a pooling if it is found to be de minimis that is, the number of reacquired shares does not exceed 10% of the number to be issued in the prospective pooling. Moreover, where an excessive amount of tainted treasury stock exists, such stock can be "purged" via a reissuance of such stock at any time prior to consummation of the pooling. In rare cases, repurchases will not taint a pooling where the stock is reacquired for "recurring" distributions, pursuant to a systematic pattern of reacquisition and, at the time the shares are reacquired, there is a reasonable expectation that they will, in fact, be used for the avowed purpose for which they were reacquired.

What is perhaps most sneaky is that repurchases subsequent to the pooling can, retroactively, taint such pooling if they are connected to the pooling. Repurchases that occur within six months of the pooling are, presumptively, connected thereto, whereas repurchases outside the six-month time frame are not so connected unless evidence exists that a repurchase plan had been "formulated' at the time of the pooling.

5. No Voting Common Changes. Neither combining company may have changed its voting common stock equity interests in contemplation of the pooling. Such an alteration during the period commencing two years prior to the initiation of the pooling is, presumptively, in contemplation thereof. This presumption, which can be triggered by stock issuance, alterations to the terms of outstanding options (including adding an accelerated vesting clause) or, alternatively, by an extraordinary distribution to shareholders (including a spinoff) can, frequently, be rebutted by showing that the alteration transaction was undertaken for business purposes unrelated to the pooling.

6. No Earn-Outs. The consideration must be conclusively resolved at the time the pooling is consummated. "Earn out" or other contingent stock arrangements are forbidden. Nevertheless, something less than 10% of the issuer's stock can be placed in escrow, for up to one year, to secure the target shareholders' liability for breach of general representations and warranties relating to preacquisition facts and claims, and a "reasonable amount" of such stock may escrowed, to secure the issuer against specifically identified contingencies, for a period that is reasonable in light of such contingencies provided any stock returned to such issuer is valued at its "initial negotiated value" its value at the date the acquisition was consummated.

7. No Affiliate Disposition. No "affiliate" (i.e., an officer, director of 10% or greater shareholder) of either combining company may dispose of voting common stock (or reduce its risk with respect to such stock through common hedging strategies) for a period that begins 30 days before the pooling is consummated and lasts until the public issuance of financial results that cover at least 30 days of post-acquisition combined operations.

8. No Disposition of Significant Portion. The combined corporation must not intend or plan to dispose of a "significant portion" of the assets of either of the combining companies, except for dispositions in the ordinary course of business or to eliminate duplicate facilities or excess capacity, within two years of consummation of the pooling. Assets are significant if they represent at least 10% of revenues, operating income or assets (on either a book or fair value basis). A disposal may also be significant if the gain it produces accounts for at least 10% of the disposing party's net income.

The Continued Controversy About Pooling Transactions, Vol. 7, No. 6, The M&A Tax Report (January 1999), p. 1.