ACC 424Financial Reporting II

Lecture 10

Tax aspects of mergers

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Reasons for discussing tax aspects

• Taxes can motivate a business combination

• Even if taxes are not the motivation, tax effects are an important determinant of a combination’s structure

• A combination’s structure determines its accounting (purchase/pooling)

• Tax effects may have to be traded off against accounting effects and contracting & information costs

• The objective is to introduce the tax effects & provide a structure for thinking about them

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Effects of 1981 & 1986 Tax Acts, 1968 Williams Act & APB Opinions on M&A activity

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Effect of 1986 Tax Act on M&A activity

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Business combination types & accounting

• Text’s 4 business combination types:– Asset acquisitions– Stock acquisitions– Statutory mergers– Statutory consolidations

• Asset acquisitions use the purchase method only

• Stock acquisitions and statutory mergers & consolidations depending on circumstances use the purchase or pooling accounting methods

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Business combination types & tax categories

• Combinations can be classified into 4 tax categories: P is purchaser & T target, taxable refers to the seller’s gains being taxable

– (1) P’s taxable acquisition of T’s stockShareholders receive cash or notes for their shares

A stock acquisition or statutory merger combination type

– (2) P’s taxable acquisition of T’s assetsT receives taxable consideration (e.g., cash or notes) for the assets

An asset acquisition type

– (3) P’s tax-free acquisition of T’s stockShareholders are not taxed to the extent they receive shares

Stock acquisition and statutory merger & consolidation combination types

– (4) P’s tax-free acquisition of T’s assetsGenerally T receives P’s stock for substantially all of its assets

Usually an asset acquisition type

• Taxable transactions always have purchase accounting treatment

• Tax-free transactions often have pooling treatment, but not always

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Tax goals in structuring combination

• Both parties would like to minimize PV of their taxes arising from the combination

• These objectives clash as there are tax tradeoffs in combination structure choice– you can structure the combination to reduce

one party’s taxes (e.g., the seller) at the expense of the other party (e.g., the buyer)

• Ceteris paribus, both parties would agree, however, to – minimize the present value of the total taxes of

both parties and

– share the reduction in taxes via the price

• Expect taxable combinations, ceteris paribus, to have higher prices

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Effect of taxability on acquisition price

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Effect of taxability on acquisition price & of tax treatment on

viability of deal

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Tradeoffs in the taxable/tax-free choice

• Taxable combinations – allow the purchaser a step-up in the basis of

depreciable assets (except taxable stock acquisition w/o s338 election)

– at the expense of the target shareholder and/or target incurring taxable gains

– typically result in the loss of target’s tax loss & tax credit carryforwards (except taxable stock acquisition w/o s338 election)

• Tax-free combinations– do not allow a step-up

– avoid taxable gains for shareholder and/or target

– typically allow transfer of target’s tax loss & tax credit carryforwards with limitations

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Tradeoffs in the taxable/tax-free choice

• Note that the benefits of the step-up come in the future, while the gains are taxed immediately

• This makes the following factors important– interest rates

– whether taxes are expected to increase or decrease

– whether you have a step-up and gain or a step-down and loss

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Tax categories’ tax implications

• Scholes & Wolfson’s table 24.1 (next slide) details the tradeoffs

• Taxable purchases of T’s stock (referenced as a taxable stock acquisition in table 24.1) can, at P’s election under s. 338, be treated as if P bought the assets directly. (thus there are 2 cases for this category in the following table - cases 3 & 4)

• Taxable purchases of T’s assets are not taxable at the shareholder level unless the sale is followed by a liquidation (s.336) (thus there are 2 cases for this category in the following table - cases 1 & 2)

• Tax-free purchases of T’s stock & assets can occur under both sections 368 & 351. Most occur under 368 which is illustrated in table 24.1 (case 5)

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Tax categories’ tax implications

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Example

In early 1998, P Co. was considering acquiring the assets of T Co. P has formulated two strategies:

1. buy the assets for $500,000 cash (or have a taxable stock acquisition of T with a s.338 election);

2. exchange P stock worth $490,000 for 100% of T’s stock (tax-free combination)

T has two assets (and no liabilities):

Land acquired 5 years ago for $100,000 that has a $120,000 current market value; and

Buildings also acquired 5 years ago for $315,000 have a current book value of $265,000 and a $280,000 market value. For tax they are being depreciated on a straight-line basis over 31.5 years. Under the tax-free combination the depreciation would not change. Under the alternative the depreciation would be on a straight-line basis over 26.5 years but on the restated basis

T has a net operating loss carryforward of $50,000.

The long-term tax-exempt federal interest rate is 7%

P’s marginal tax rate is 34%, the capital gains tax rate is 20% and the relevant cost of capital is 10%

Which strategy would P prefer? Which strategy would S prefer?

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Example P’s Preferred strategy

• Net cost of taxable asset acquisition strategy

Cash outlay $500,000

Less: PV of depreciation shield

Step-up to $280,000 over 26.5 years st. line

annual depreciation = 280,000/26.5 = $10,566

after-tax depn shield = 10,566 .34 = $3,592

present value = 3,592PVFA(10%, 26.5)

= 3,592 9.2 = 33,051

Net cost$466,949

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Example P’s Preferred strategy

• Net cost of tax-free stock acquisition strategyMarket value of stock $490,000

Less: PV of depreciation shield

Annual depn $10,000

after tax depn shield = = 3,400

present value = 3,400PVFA(10%,26.5)

= 3,4009.2 = $31,280

PV of NOL tax shield

Annual limitation under s.382

MV of stock before acquisition long term tax exempt rate published by IRS gives the tax deduction per year until the NOL is eliminated

$490,000 7% = 34,300 per year

tax shield first year = 34,300 =$11,662

tax shield 2nd year = 15,700 = $5,338

PV= 11,662/1.1 + 5,338/1.21 = 15,014 46,294

Net Cost $443,706

P prefers the tax-free combination

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Example T’s Preferred strategy

• Net benefit of taxable strategy

Cash received $500,000

Less: tax on capital gain

Sale $500,000

Less: tax basis 365,000

Capital gain & depn rec. 135,000

Less: NOL (=depn rec.) 50,000

Taxable capital gain $ 85,000

Tax on capital gain (.2) 17,000

Net cash received by T Co. $483,000

Personal taxes assuming distributionDistribution $483,000

Less: basis (assume shareholders

just happen to have contributed

bv of assets) 415,000

Capital gain $ 68,000

Tax at 20% 13,600

Net liquidation benefit $469,400

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Example T’s Preferred strategy

• Net benefit of tax-free strategyMarket value of shares $490,000

Less: tax if liquidate

market value $490,000

basis 415,000

capital gain $ 75,000

Tax at 20% 15,000

Net liquidation benefit $475,000

• So tax-free strategy is preferred by both P Co. and T Co.’s shareholders– P Co. by $466,949 - 443,706 = $

23,243

– T Co. shareholders by 475,000-469,400 = 5,600

Total net benefit is $ 28,843

• Where does this extra $28,843 come from?• How much less could P have paid T?

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Example Source of the gains

• The answer is the IRS loses $28,843• Advantages of stock acquisition

– Limited transfer of NOL $15,014

• Disadvantage of asset purchase– Corporate tax on gain on sale of assets

(after deducting NOL) 17,000

$32,014

• Less advantage of asset purchase– Step-up - difference in PV of tax shields

($33,051-31,280) $ 1,771

$30,243

• Less higher personal capital gains tax($15,000-13,600) $ 1,400

• Net advantage to stock acquisition $28,843

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ExampleMinimum tax-free deal

• The minimumP could have offered T in a tax-free deal depends on the best deal any other purchasers might offer

• If we assume the best deal would be the taxable offer (i.e., $469,400 after taxes) we can calculate the minimum stock value P could have offered and still consummated the deal

• The formula for the benefits of the tax-free deal is: Stock value-.20(stock value-415,000) = $469,400

.8 stock value = $386,400

stock value = $483,000

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Caveats on tax effects of business combinations

• Be careful about business combinations motivated by tax benefits:– The tax benefits can often be obtained by alternative

mechanisms

– Other contracting & information costs may offset the tax benefits. For example, NOLs have remained on the books of some firms (e.g., Penn Central, Chrysler, Lockheed & US Steel) so costs to eliminate NOLs must be great

• Examples of other costs that should be considered in choosing combination structure:– Asset acquisition could involve legal costs for property

transfers & some assets such as patents may be very difficult to transfer, property taxes could be increased, consents of other parties may be required etc.

– Stock acquisitions may be difficult to consummate because of approval requirements

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Effects of taxes on recording a business combination

• Taxable poolings are not observed so there are only 3 relevant alternatives:

– Taxable purchaseThe asset values are stepped-up and the recorded values become the

values for tax basis as well

– Tax-free poolingThe tax attributes are carried over and hence there are no effects on

mechanics

– Tax-free purchaseAssume assets of $200 fair value with a book value (equal to tax basis)

of $150 are acquired for $250

Our normal journal entry would be:

Assets $200

Goodwill 50

Shareholders equity $250

The $50 difference between fair value & book value basis is assumed to flow through as income in the future and generates a deferred tax liability of $20 ($50 tax rate of .40)

Altered journal entry

Assets $200

Goodwill 70

Shareholders equity $250

Deferred liability 20