Private Equity Investment: Tax Considerations to The Target Company October 17, 2006

1. Private Equity Investment:Tax Considerations to The Target Company October 17, 2006

2. Company Recapitalization Tax Implications to Company Advantages • Company’s tax attributes and tax basis in its assets remain unchanged. This may be advantageous if the assets have a tax basis greater than fair market value or the Company has tax attributes that may be utilized post acquisition. • Minimal transfer taxes may be imposed. Disadvantages • Consideration received in the transaction may be less as the Company maintains a carry-over tax basis in its assets (no step-up). • The tax basis in the assets remains unchanged. If the assets have appreciated or intangibles created, no additional tax basis will be created. • Tax attributes may be limited. • Company remains liable for all its pre-acquisition liabilities.

3. Debt vs. Equity Debt • Included in debt section of balance sheet, earnings charge for interest cost • Taxable income to Creditor regardless whether Company has net income or E&P • Fully taxable – No dividends received deduction for corporate investors • Generally, Company deduction for interest paid. Equity • Included in equity section of balance sheet (generally) • Taxable income to Equity Holder is limited to Company’s E&P • Dividends received deduction to corporate investors • No deduction to Company for dividends paid

4. Section 382: The Loss Corporation • After an ownership change occurs under Section 382, the Loss Company’s taxable income that can be offset by pre-change losses cannot exceed the Section 382 limit for such year. • In general, the Section 382 limit equals the value of the stock of the Company immediately before the ownership change multiplied by a prescribed percentage rate. • The value of a loss corporation is generally the fair market value of all of the corporation’s stock immediately before the ownership change as adjusted.

5. Section 382: The Loss Corporation (Cont’d) • The equity value of the loss corporation is: • reduced by acquisition indebtedness borne by the loss corporation. • reduced by equity contributions to loss corporation (e.g., IPO) within prior two years, with certain exceptions. • reduced if loss corporation has significant non-business assets (one-third threshold). • If the company is private, the determination of value is more difficult where an ownership change occurs other than by a purchase of 100% of the stock. • Items such as control premiums and minority interest discounts complicate the valuation process. • The valuation of the loss corporation’s stock includes “plain vanilla” preferred stock, even though such classes of stock are not considered in testing for an ownership change. • Special rules exist under Section 382 for corporations upon emergence from bankruptcy.

6. Applicable High-Yield Debt Obligations (AHYDOs) • A debt instrument with the following characteristics is considered an AHYDO: • Obligation issued by a C Corporation • Maturity date more than 5 years from issuance • Yield to maturity equals or exceeds applicable federal rate (AFR) plus 5% • The obligation is issued with significant OID

7. AHYDOs (Cont'd) • If a debt instrument is classified as an AHYDO: • The Company deducts interest only when paid • The Holder accrues interest into income ratably over the life of the instrument

8. AHYDOs (cont’d) • If YTM > AFR + 6%, deductibility of a portion of interest is permanently disallowed (treated as a dividend). • Example: AFR = 14% Term: 10 yrs. YTM = 25 - Maturity date > 5 yrs. from issuance? Yes - YTM > AFR + 5%? Yes - Significant OID? Yes

9. AHYDOs (cont’d) • Example (cont’d): • YTM > AFR + 6%? Yes • Disallowed Interest = YTM - [AFR + 6%] x Interest • AFR + 6%= 25% - [14% + 6%] = 5% = 25% • 14% + 6% 20% • Therefore, 25% of annual interest will be treated as a dividend.

10. Managing AHYDO • Through careful planning it may be possible to mitigate the application of the AHYDO provisions • All accrued interest is paid in cash before the end of the first accrual period ending 5 years after issuance and • Terms of debenture require yearly cash payments of interest thereafter.

11. Corporate Acquisition Indebtedness (CAI) A debt instrument is classified as CAI when all of the following conditions are met: • The obligation is issued to provide consideration for the acquisition of stock or assets of another corporation • The obligation is subordinated to (i) the claims of trade creditors or (ii) a substantial amount of unsecured indebtedness • The obligation is convertible directly or indirectly into stock of the issuing corporation or is part of an investment unit that includes an option to purchase stock • The Company has a debt-equity ratio in excess of 2:1 or the Company’s average earnings do not exceed three times the annual interest to be paid or incurred • Once debt is CAI, interest deductions are lost permanently • Refinancing of CAI will not likely cure problem

12. Debt Payable In Or By Reference To Company Equity A debt instrument is classified as Disqualified Debt when all of the following conditions are met: • The debt is issued by a corporation • The debt is payable in, or by reference to the value of, equity (“equity-linked”) • The above equity is equity of the issuer or any other person

13. Debt Payable In Or By Reference To Company Equity Where a debt instrument is classified as Disqualified Debt: • Any deduction for interest paid or accrued is permanently disallowed • The holder must still include in income, interest paid on disqualified debt

14. Structuring of TransactionsStock Acquisitions with a Section 338 (h)(10) Election Requirements • There must be a “qualified stock purchase” (“QSP”) of Target. • Acquirer must be a corporation • At least 80% of the vote and value of the stock of target must be acquired within a 12 month period • Acquisition must be a taxable transaction • The Section 338 (h)(10) election is available if the target is: • A subsidiary member of an affiliated group of corporations (seller must be a domestic corporation); • A subsidiary member of a consolidated group of corporations; or • An S corporation • The acquiring corporation and the target shareholders must jointly make a Section 338 (h)(10) election. • The election must be filed within 9 ½ months of acquisition and must be signed by both parties. Allocation of purchase price must be tentatively agreed to. Treatment • Stock acquisition treated as a deemed asset acquisition for tax purposes followed by a deemed liquidation of Target. The purchase price for the assets is the consideration paid plus the assumption of liabilities. • Legal and all other treatment is generally a stock acquisition. • Purchaser receives a fair market value tax basis in the assets deemed acquired. A Section 338(h)(10) election should almost always be considered when acquiring an S corporation or a subsidiary of a consolidated group.

15. Stock Acquisitions with a Section 338 (h)(10) Election Flow of purchase consideration Deemed liquidation (treated as full payment in exchange for stock under Sec.331 if S-Corp or Sec 332) Seller Shareholder Target Stock Private Equity Fund Cash, notes or other consideration Buyer Corporation Target (“Old” Target) Target (“New” Target) Deemed asset sale Legal structure post transaction Private Equity Fund Legal Form Buyer Corporation Tax Form Target (“New” Target)

16. Preferred Stock Potential Phantom Income Issue Often times an investment by a private equity group is made in the form of preferred stock. For some or all of the intended holding period, the preferred will generally not pay dividends in cash. Instead the value will be distributed in kind or through an accretion of value. General Rule: Section 305/taxation of phantom income • Stock dividends that are issued on preferred stock is taxable • Holder is taxable to the extent that the issue price is less that redemption price under general OID principals. Issue price accretes to redemption price over the term of the preferred. • Taxed as ordinary income to the extent that the Company has E&P • To the extent there is no E&P it is a return of capital.

17. Preferred Stock Potential Phantom Income Issue What happens when there is OID as a result of preferred stock issued as part of an investment unit? • When warrants are issued with preferred, the issue price is typically reduced by the value of the warrants which creates OID • Section 305(c) now applies to cause the investor to have phantom income • Income is recognized over the term of the preferred under general OID principals • May adversely impact the ability of the Company to raise capital efficiently

18. “Strips of Stock” to Provide Incentives for Management Private Equity Investor Company Mgmt 10% Class B 100% Class A 90% Class B Newco Example (for illustrative purposes only): Class A Class B Current Value 90% 10% Future Appreciation 10% 90% Company Intended Results • Provide incentives for management • Favorable exit strategy for management

19. Company Mgmt Investor Capital & Profits Interest P/S Company Management IncentivePartnership Profits Interest Private Equity Investor Company Mgmt Profits Interest (Vesting) Intended Results • Provide incentives for management • Investor recovers investment prior to Company Mgmt receiving funds • May prove tax efficient to Company Mgmt

20. Private Equity Partnership Investment P Private Equity Investor Unwanted assets Cash Partnership Step 1: P contributes unwanted assets to partnership in exchange for partnership interest Step 2: Investor contributes cash to partnership in exchange for partnership interest

21. Private Equity Partnership Investment P Private Equity Investor Cash distribution Non-recourse bank loan Partnership Step 3: Partnership borrows on a non-recourse basis and distributes the cash proceeds to P Step 4: Step up in tax basis of Partnership assets as P recognizes gain

22. Contact Details

23. Howard B. Steinberg Partner KPMG, LLP (212) 872-6562 hbsteinberg@kpmg.com www.kpmg.com