Canadian Pacific to Acquire Kansas City Southern

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

On March 21, Canada-domiciled Canadian Pacific Railway Limited (TSX:  CP, NYSE:  CP) (CP) and U.S.-domiciled Kansas City Southern (NYSE:  KSU) (KCS), each the operator of a freight transportation network, announced that they had entered into an agreement pursuant to which CP will acquire 100 percent of KCS in exchange for stock and cash consideration.^[1]As described in the Merger Agreement,^[2] each outstanding share of KCS common stock will be exchanged for 0.489 CP share and USD $90 in cash.  Additionally, each share of KCS’s sole class of preferred stock will be exchanged for USD $37.50.

Based on the closing price of CP shares on March 19, the last day of trading before the deal announcement, the aggregate consideration to be paid to the KCS common shareholders is valued at approximately USD $25 billion, and the aggregate cash consideration for the preferred shares is valued at approximately USD $8 million.^[3]

The transaction will take the form of two back-to-back statutory mergers, involving two special purpose subsidiaries of CP—Surviving Merger Sub, a direct wholly owned subsidiary of CP, and First Merger Sub, wholly owned by Surviving Merger Sub.  In the first merger, First Merger Sub will merge with and into KCS, with KCS surviving as a wholly owned subsidiary of Surviving Merger Sub.  KCS shareholders will receive the merger consideration in the first merger.  Immediately following the first merger, KCS will merge with and into Surviving Merger Sub with Surviving Merger Sub surviving.^[4]

The two-merger format has become the norm in mergers involving mixed stock and cash consideration.  With approximately 67 percent stock and 33 percent cash consideration, the first reverse subsidiary merger (with the Target corporation—KCS—surviving), would not qualify as a reorganization,^[5]but with the second, forward merger (with the Target corporation not surviving), the transaction should meet the necessary tests.^[6]

Although the merger should qualify as a tax-free reorganization, the U.S. shareholders of KCS will recognize some amount of taxable gain (but not loss) because of the cash consideration (boot).  Gain recognized by a KCS shareholder will be equal to the value of the total merger consideration minus the shareholder’s tax basis in the KCS stock, but limited to the amount of the cash (boot) received.^[7]

Under Internal Revenue Code (IRC) Section 356, the gain could be treated as a dividend to any KCS shareholder if the receipt of the cash consideration to that shareholder “has the effect of the distribution of a dividend.” Dividend treatment is determined under the so-called Clark^[8]test by (i) treating the shareholder as if it first received solely stock in the acquiring corporation and then received the cash amount in a post-merger redemption and (ii) applying the IRC Section 302 redemption tests to determine whether or not the shareholder experienced a sufficient reduction in its percentage interest in the company to meet one of the tests under the redemption rules.

The “safe harbor” under those rules generally requires a greater-than-20-percent reduction in the shareholder’s percentage interest.^[9]If the boot is treated as a dividend to a foreign investor, it could be subject to U.S. withholding tax of 30 percent, subject to reduction under an applicable tax treaty.  For a KCS shareholder not holding CP stock before the merger, with cash comprising approximately 33 percent of the consideration, the safe harbor test should presumably be met.  It will ultimately be up to the prime broker to determine how to implement the tax rule.

Finally, because the KCS shareholders are exchanging stock in a U.S. corporation for stock in a non-U.S. corporation, the transaction must also satisfy the requirements of Section 367 of the IRC and regulations thereunder.  In general, under those rules, such an outbound exchange of stock in a U.S. corporation can be tax-free to a shareholder as long as (i) the KCS shareholders do not acquire more than 50 percent of the stock of CP,^[10](ii) U.S. persons who are officers or directors CS or 5 percent shareholders of KCS do not own more than 50 percent of the stock of the CP, and (iii) CP satisfies a rigorous active trade or business test, as well as a “substantiality” test comparing the value of the CP’s business to that of the KCS.^[11]

Any U.S. shareholder that owns 5 percent or more of KCS would be fully taxable on the exchange unless it enters into a gain recognition agreement with the Internal Revenue Service under which it agrees to pay tax on any gain realized in the transaction if one of a number of events takes place during the five-year period after the merger.^[12]

Several provisions of the merger agreement make clear that tax-free treatment under the reorganization rules as well as the Section 367 cross-border rules is intended, and a legal opinion to that effect is a condition to KCS’s obligation to close.

^{[1] Press Release, Canadian Pacific and Kansas City Southern Agree to combine to create the first U.S.-Mexico-Canada rail Network (March 19, 2021), the Press Release (https://www.sec.gov/Archives/edgar/data/0000054480/000119312521088557/d114786dex991.htm).}

^{[2] Agreement and Plan of Merger by and among CP, KCS, Merger Sub 1 and Merger Sub 2 dated as of March 21, 2021 (the Merger Agreement) (https://www.sec.gov/Archives/edgar/data/54480/000119312521088557/d114786dex21.htm).}

^{[3] At market close on March 19, a share of CP was trading at CAD $474.27, or about USD $379.23 (at 1.2506 FX rate).  There were 90,936,616 shares of KCS common stock outstanding as of March 17, 2021.  90,936,616 x ($379.23 x 0.489) = about $16,863,601,621 in stock; 90,936,616 x $90 = $8,184,295,440; total stock and cash = about $25.0 billion.  As of March 17, 2021, KCS had 214,542 preferred shares outstanding.  214,542 x $37.50 = about $8,045,325 (total cash = about $8.19 billion)}

^{[4] Id.}

^{[5] IRC §368(a)(2)(E).}

^{[6] See Rev. Rul. 2001‐46, 2001‐42 IRB 321; IRC §368(a)(2)(D).}

^{[7] IRC §356(a)(1).}

^{[8] Clark v. Comm’r, 489 U.S. 726 (1989).}

^{[9] IRC §302(b)(2).}

^{[10] Treas. Reg. §1.367(a)-3(c)(5).}

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

^{[12] Treas. Reg. §1.367(a)-3(c)(1)(iii)(B).}