Sysco Deal Leaves Money on the Food Table

The Sysco Corporation’s deal to acquire its chief rival, US Foods, would put food on the table at a wide swath of restaurants, schools and hospitals. But it may have left money on the table as well.

The concern is the less-than-creative tax structure of the $3.5 billion deal, which would create the largest food distributor in North America with clients, including the celebrity chef Daniel Boulud and public schools.

Under the merger, Sysco would use $3 billion of its stock to acquire the bulk of US Foods’ shares and would pay $500 million in cash for the rest. Some tax experts say that the cash part of the deal is the Wall Street equivalent of throwing away perfectly good food â€" in this case, perhaps $200 million. That is because the steps that Sysco is taking in the merger do not allow it to use a lucrative tax benefit involving extra value, in the form of lower future tax bills, embedded in that cash.

The upshot of the steps, known in the tax world as a reverse triangular merger followed by a forward merger, is that for the cash portion of the deal, Sysco inherits the relatively low value, for tax purposes, of the assets of US Foods, which include machinery, equipment, vehicles and the like. That value, known as cost basis, reflects the fact that US Foods had to depreciate and amortize those assets over time. A lower cost basis typically translates into higher tax bills.

Had Sysco structured its deal differently, it could have increased its cost basis and created perhaps $200 million in future tax savings, said Robert Willens, a tax and accounting expert in New York. If Sysco had instead set up a structure known as a horizontal double dummy, it would have been able to include that $500 million in cash in its cost-basis calculations, in turn lowering the combined company’s tax bills.

Mr. Willens said that “$500 million in basis is worth 35 percent in tax savings somewhere along the line, so that’s nearly $200 million in value that’s being forfeited by the combined new company.”

That value is forfeited in part by the two private equity firms, Clayton, Dubilier & Rice and Kohlberg Kravis Roberts, that own US Foods. The firms will end up with about 13 percent in the combined company.

Charley Wilson, a spokesman for Sysco, did not respond to requests for comment. Lisa Lecas, a spokeswoman for US Foods, was not available for comment.

Horizontal double dummies may sound like two guys stretched out on sofas watching Sunday football, but they have played a starring role in some significant deals, including Kmart’s $11 billion purchase of Sears, Roebuck in 2004 and Oracle’s $5.8 billion acquisition of Siebel in 2005. The structure is legal under the tax code.

The tax structure involves two companies, an acquiring firm and a target firm, setting up a permanent holding company and below it two temporary subsidiaries â€" the “dummies.” The acquiring firm and the target firm merge separately into the subsidiaries. Stock in both subsidiaries is transferred to the holding company, and the dummies are dissolved. The holding company pays shareholders of the target firm for their equity, leaving the acquiring firm, through the holding company, in control.

Michael L. Schler, a tax lawyer at Cravath, Swaine & Moore in New York, said that one deterrent to using double dummies was the complexity of the structure and the need to reregister and list the merged entity as a public company. But “if it is done correctly, the tax rules are clear cut and there is no reason for the Internal Revenue Service to challenge it,” he said.

US Foods’ shareholders have to pay capital gains taxes on any cash they receive for their shares, regardless of the tax structure used in the merger. So there is no compelling reason to use any structure other than a horizontal double dummy, said Crawford Moorefield, an energy, oil and gas and corporate tax lawyer at Strasburger & Price in Houston who has done such deals.

Mr. Willens added that in any acquisition involving stock and cash, the horizontal double dummy structure “should be standard operating procedure.”

“It’s a mystery to me why they don’t get done more often,” he added.