ACC 424 Financial Reporting II

1. ACC 424Financial Reporting II Lecture 10 Tax aspects of mergers

2. 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

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

4. Effect of 1986 Tax Act on M&A activity

5. 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

6. 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 stock Shareholders receive cash or notes for their shares A stock acquisition or statutory merger combination type • (2) P’s taxable acquisition of T’s assets T receives taxable consideration (e.g., cash or notes) for the assets An asset acquisition type • (3) P’s tax-free acquisition of T’s stock Shareholders 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 assets Generally 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

7. 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

8. Effect of taxability on acquisition price

9. Effect of taxability on acquisition price & of tax treatment on viability of deal

10. 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

11. 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

12. 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)

13. Tax categories’ tax implications

14. 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?

15. 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 = 3,592PVFA(10%, 26.5) = 3,592  9.2 =33,051 Net cost $466,949

16. Example P’s Preferred strategy • Net cost of tax-free stock acquisition strategy Market value of stock $490,000 Less: PV of depreciation shield Annual depn $10,000 after tax depn shield =  = 3,400 present value = 3,400PVFA(10%,26.5) = 3,4009.2 = $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 = 15,01446,294 Net Cost $443,706 P prefers the tax-free combination

17. 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 distribution Distribution $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

18. Example T’s Preferred strategy • Net benefit of tax-free strategy Market 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?

19. 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

20. 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

21. 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

22. Effects of taxes on recording a business combination • Taxable poolings are not observed so there are only 3 relevant alternatives: • Taxable purchase The asset values are stepped-up and the recorded values become the values for tax basis as well • Tax-free pooling The tax attributes are carried over and hence there are no effects on mechanics • Tax-free purchase Assume 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