It was recently announced that Dow and DuPont plan to merge, and then split into three separate companies – focusing on agriculture, materials, and specialty products. The move has been described as a victory for activist shareholders, and doubts have been raised about the practical viability of the plan.

But the aspect that intrigues me is the tax planning.

Now, I’m not a tax lawyer – I just play one on the internet – but after consultation with my colleague, Shu-Yi Oei, here’s my understanding of how this works.

Ordinarily, if a company spins off an aspect of its business and distributes the shares to existing shareholders, it can be treated as tax free under 26 U.S.C. § 355. The idea is that the existing shareholders once held shares in a single company, but now hold shares in two companies, there has been no substantive change, and the entire transaction is not treated as a realization event. If, however, a company simply sells off a business line to a third party, that is treated as a realization event, and it is taxed.

As a result, companies have tried to structure sales as tax free spinoffs. For example, a target company might spin off one business line tax-free, then sell remaining business lines to an acquirer, rather than have the acquirer buy the entire target (with attendant taxes).

The tax code therefore has a series of provisions designed to distinguish between the two scenarios. In particular, it provides that if a company spins off a business to its shareholders, that will be treated as taxable if 50% of the voting or economic interest in either the original company or the spinoff is acquired in the period immediately preceding or following the spinoff.

The question, then, is whether DuPont and Dow merging “counts” as an acquisition of 50% of the voting/economic interest in either company prior to the three-way split.

Dow and DuPont maintain that it does not. They are structuring the deal as a “merger of equals” – two companies of approximately equal size, combining, so that shareholders of the former DuPont and Dow will each own 50% of the combined new entity. But to avoid tripping the 50% threshold that the IRS treats as an acquisition of one or the other, they’re relying on the significant overlap between the two companies’ shareholders. Specifically, Vanguard Group, State Street, Capital World, and BlackRock own something like (I hope my math is right) 17% of Dow Chemical, and 18% of DuPont. The theory goes, due to this overlap, when these shareholders receive stock in the combined post-merger entity, they have not actually acquired any new interests – they’ve simply consolidated their existing interests. Therefore, their interests don’t count when determining whether there’s been an acquisition of 50% immediately preceding the spinoff.

The fascinating thing here, of course, is that these shareholders – and a handful of others – are the top shareholders of lots of publicly traded companies.

Some literally random examples that I just thought to look up:

Delta.  Among the top investors are Vanguard, Capital World, State Street, and BlackRock.

Whole Foods, whose top investors include Vanguard, State Street, and BlackRock.

Microsoft, whose top investors you will be shocked to learn include Vanguard, Capital World, State Street, and BlackRock.

First Energy, whose top investors include – wait for it! – State Street, Vanguard, and BlackRock.

Everyone who’s surprised by the news that some of the top shareholders of Activision are Vanguard, State Street, and BlackRock, stand on your head.

And – hey, look! Vanguard, Capital World, State Street, and BlackRock are also sharing a Coke.

Now, many institutional investors, like Vanguard, hold shares through mutual funds or other types of entities, all of which are legally distinct.  So if the argument is that all of these funds count as a single “owner” for tax purposes, Dow and DuPont may (I guess?) be relying on 26 U.S.C. § 355(d)(4), which defines “interest” to mean either voting power or economic interest. Vanguard’s mutual funds may be the “owners” of the shares, but Vanguard has broad control over their votes across its fund holdings, which it appears may be enough for the IRS.*

In any event, if overlapping shareholders is the test, that’s one hell of a tax loophole.

*I gather that there are also special attribution rules for determining whether the 50% threshold has been reached; Skadden (as the tax advisor) clearly thinks they’ve got it covered.