Corporate Acquisitions

1. Corporate Acquisitions • Acquisition form • Asset Acquisition • Direct acquisition of selected assets of target corporation • Merger with target corporation dissolved into acquiring corporation • Stock Acquisition

2. Acquisitions Decision Model

3. Five Major Tax Issues • Will the transaction result in a taxable gain or loss to the target firm’s shareholders? • Will the transaction result in a taxable gain or loss to the target firm? • How will the transaction affect the target firm’s tax attributes (NOLs, credit carryovers)? • Will the transaction affect the tax basis of the target firm’s assets? • Will the use of leverage generate tax savings?

4. Taxable Asset Acquisitions • If direct asset acquisition • Target recognizes gain or loss on sale of assets • No tax consequences to target shareholders, unless target liquidates (then shareholders recognize gain or loss on disposition of their stock) • If structured as a merger • Target recognizes gain or loss as if assets were sold at FMV • Target shareholders recognize gain or loss on the disposition of their target stock

5. Taxable Asset Acquisitions continued • If merger, or target liquidates after acquisition, target firm’s tax attributes, including NOL and credit carryovers, are lost • Cannot ‘buy’ tax attributes • Acquiring corporation takes a cost basis (FMV) in assets acquired • Debt financing is common in taxable asset acquisitions, often resulting in increased leverage

6. Example: Taxable Asset Acquisition • ABC Inc. wishes to acquire the business of Target Corporation, whose stock is owned by Mr. Smith. ABC is willing to pay $2 million for all of Target’s assets. • If Target’s assets have a tax basis of $800,000, what are the tax consequences of the sale? • Mr. Smith’s tax basis in his target stock is $500,000. If Target liquidates and distributes the after-tax proceeds of the asset sale to Mr. Smith, what are the tax consequences of the liquidation?

7. Taxable Stock Acquisitions • Target shareholders recognize gain or loss on disposition of their target stock • Target does not recognize gain or loss (unless Sec. 338 election) • Tax attributes survive the acquisition, but their future use is subject to limitations • Acquiring corporation takes a cost (FMV) basis in the target stock acquired • No impact on basis of target’s assets (unless Sec. 338 election)

8. Taxable Stock Acquisitions continued • Debt financing is common in taxable stock acquisitions, often resulting in increased leverage • If 80% control acquired, acquiring corporation and target may file a consolidated tax return

9. Example: Taxable Stock Acquisition • Refer to previous example. • Suppose that ABC is willing to pay Mr. Smith $2 million for his Target stock. What are the tax consequences of this sale? • Why might ABC not be willing to pay $2 million for the stock? • At what stock purchase price would Mr. Smith be indifferent between a stock sale and an asset sale followed by a liquidation of Target?

10. Special Issues in Taxable Stock Acquisitions • Section 338 Election • Election to treat a stock purchase as an asset purchase for tax purposes • Advantage: Acquiring corporation gets to adjust the tax basis of target’s assets to FMV • Cost: Target must recognize gain or loss as though assets were sold for FMV

11. Nontaxable Acquisitions (Reorganizations) • Qualified reorganizations are treated as nontaxable exchanges • Judicial requirements for acquisitive reorgs: • Original owners of target must maintain continuity of proprietary interest in target’s business - satisfied if at least 50% of consideration is acquiring corporation stock • Continuity of business enterprise - acquirer must continue target’s business or use target’s assets in an existing business • Business purpose, beyond tax avoidance

12. Tax Consequences of Nontaxable Acquisitions • Most basic case: No boot (all consideration is acquiring corporation stock) • No gain or loss recognized by target corporation, or target’s shareholders • Target tax attributes survive • Acquiring corporation takes a carryover basis in the assets or stock acquired • If asset acquisition, target distributes stock received to its shareholders and (usually) liquidates

13. Nontaxable Acquisitions continued • Target shareholders take a carryover basis in the acquiring corporation stock received • Debt financing cannot occur directly in this case (since it would be considered boot), so increased leverage not possible as part of the acquisition transaction • Acquirer corporation debt can be issued to replace target corporation debt. No gain or loss will occur if principal amounts are equal

14. Boot in Acquisitive Reorganizations • Any property transferred by the acquiring corporation other than its own stock or securities is considered boot • Gain (but not loss) recognized by the acquirer if FMV of boot transferred > adjusted tax basis • No gain or loss if the boot is cash • Target corporation recognizes gain (but not loss) if boot not distributed to shareholders, or if target distributes its own assets (not acquired in the reorganization) to its shareholders

15. Boot in Acquisitive Reorganizations continued • Target shareholders receiving boot and stock or securities recognize gain (but not loss) equal to the lesser of the gain realized or the FMV of the boot received • Target shareholders receiving only boot recognize any gain or loss realized • Gain recognized by target shareholders is treated as a dividend (ordinary income) to the extent of each shareholder’s proportionate share of target’s AEP. Any remaining gain is capital gain.

16. Boot in Acquisitive Reorganizations continued • Target security holders recognize gain if the principal value of the securities received is greater than the principal value of the securities given up • The basis of assets transferred to the acquirer is increased by any gain recognized by the target • The basis of stock or securities received by target shareholders is increased by any gain recognized and decreased by the FMV of boot received

17. GAAP Treatment of Mergers and Acquisitions • Purchase accounting • All assets and liabilities of acquired target recorded at FMV, including goodwill • SEC-preferred method of accounting for acquisitions • Pooling-of-interests accounting • Assets and liabilities of combined firms recorded at historical book cost • Typically results in little or no recorded goodwill • No longer allowed under GAAP

18. Tax versus Financial Statement Goodwill • For tax purposes, goodwill is recorded only when the tax basis of target assets is stepped up to FMV • Taxable asset acquisitions • Taxable stock acquisitions with Sec. 338 election • Purchased goodwill amortizable over 15 years for tax purposes • Many nontaxable acquisitions are recorded using the purchase method for GAAP purposes, resulting in GAAP goodwill that is not amortizable for tax purposes

19. Corporate Divisions • Spin-off: Parent corporation distributes controlling interest in stock of a subsidiary corporation to parent’s shareholders • Split-off: Parent corporation distributes controlling interest in stock of a subsidiary to a group of shareholders in exchange for their parent stock • Split-up: Parent corporation distributes stock of two (or more) subsidiaries to its shareholders in complete liquidation of the parent

20. Corporate Divisions continued • Such transactions are nontaxable to the parent and participating shareholders if undertaken for a corporate business purpose and requirements of Sec. 355 are met • Parent must distribute at least 80% of subsidiary stock • Subsidiary and parent (spin-off or split-off) must continue to engage in a business that had been conducted for at least 5 years before the distribution • Parent must have held the stock of the subsidiary for at least 5 years before the distribution (unless acquired in a nontaxable transaction)