Introduction to US Taxation of Mergers and Acquisitions Prof. Charlotte Crane Graduate Tax Program Northwestern Univers

1. Introduction to US Taxation of Mergers and AcquisitionsProf. Charlotte CraneGraduate Tax ProgramNorthwestern University School of LawChicago, Illinois

2. Shareholders Corp US Corp F assets US assets Basic Principles of Taxation of US Corporations • Two levels of tax • Corporation pays tax on earnings as earned • Shareholders pay tax when earnings distributed • Worldwide income of US corporation taxed by US • Mitigated by foreign tax credit • Tax law not always linked to state corporate law

3. Shareholders Corp Double taxation of Corporate EarningsDomestic • Corporation honored as separate taxable entity • Corporation taxed at 35% $1000 -350= 650 • Pre-2004 Individual shareholders taxed at 30-35% on receipt of dividend Pre-2004 650-195=455 Post-2004 individual shareholders taxed at 15% Post-2004 650-97.50=552.50 No shareholder credit for corporate taxes paid No corporate deduction for dividend paid No rate difference between income distributed and income not distributed • Except when penalty taxes for accumulations

4. US corporate tax rates • 2004 stated rates • Up to $50,000 15% • Over 50,000 but not over $75,000 25% • Over 75,000 but not over $10,000,000 34% • Over $10,000,000 35% • 2004 rates including phaseout of lower brackets • Up to $50,000 15% • Over 50,000 but not over $75,000 25% • Over 75,000 but not over $100,000 34% • Over 100,000 but not over $10,000,000 39% • Over $10,000,000 but not over $15,000,000 35% • Over $15,000,000 but not over 18,333,333 38% • Over $18,333,333 35%

5. Corp Corp Corp Corp Ind Share But only double taxation • Dividends received deduction With control 100% for 80% or greater ownership Without control 80% for 20-80% ownership 70% for under 20% But more than double tax not always avoided

6. Corp Corp Corp Corp Corp Corp Foreign Corp Foreign Corp Corp Corp And not always of single entity • Election of affiliated group to file consolidated returns • Only US corps may consolidate • And contiguous in some cases • Only ownership not operation requirements for eligibility • Disregarded entities (also called Tax Nothings) • Partnerships and LLCs when owned by one shareholder will be treated as if they did not exist for tax purposes when box is checked to treat as pass-through entity Corp Corp

7. Meaning of control • 1504 vote and value • 368(c) all voting and stock by class • Subpart F 50% owned by 10% shs • All can be subject to their own attribution and look-through rules

8. Disregarded status extends to foreign entities • Regulations specify certain per se entities • Others may be pass-through • Some tension in possibility of market in foreign entities

9. Tax law not corporate law controls tax treatments • Corporate law determined primarily by states • Corporate charters controlling governance and relations with shareholders • Relations with creditors • Procedures for and results of restructuring for non-tax purposes • Federal law governs access to public capital markets • Securities offerings (except very small scale) • Fraud on shareholders (shares with states) • Federal tax law not tied to state charter or governance law • “corporation”, “dividend,” “earnings and profits,” “stock,” “debt” • State law may be necessary for federal tax treatment, but not determinative-”merger” as one route to tax-free restructuring • State law may be easiest but not only way-”complete liquidation”

10. Sources of US income tax law • Internal Revenue Code enacted by Congress • Regulations promulgated by Treasury Department, written with Internal Revenue Service • Published rulings by IRS • Unpublished rulings by IRS • Private letter rulings • Field Service advice, Technical advice memoranda (designations have changed) • Court interpretations—only with litigation over actual deficiency • Treaties

11. What will be taxed as corporation? • Historically very difficult problem to administer • Sometimes taxation as corporation preferred, sometimes not • Previously, if entity provided limited liability to owners, must be taxed as corporation • Lawyers found ways to offer effective limited liability • “Check the box” now allows any entity that does not have a • Charter as a corporation under state law • Market made in its interests • Not available to those corporations that are taxed as bank or insurance coompanies, or certain foreign entities Election to be taxed as partnership—called “pass- through” Cannot change election more often than every 60 months If “passthrough” single owner, will be disregarded

12. Foreign entities that will be taxed as corporations • Austria, Aktiengesellschaft • Belgium, Societe Anonyme • France, Societe Anonyme • Germany, Aktiengesellschaft • Italy, Societa per Azioni • Japan, Kabushiki Kaisha • Mexico, Sociedad Anonima • Netherlands, Naamloze Vennootschap • United Kingdom, Public Limited Company

13. Earnings: based on taxable income of corporations • No general conformity between book income and tax income • Schedule M required, but not always useful • Schedule M may be revised to require more useful information • Book (financial) income rarely has impact on tax income • Cost recovery used as incentive • Costs of many self-developed intangibles deductible • Costs of purchased intangibles amortizable since 1993 • Original issue discount

14. Shareholders Shareholders Corp Corp Creditors Double Tax only applies to earnings Creates enormous pressure for debt financing • With debt of 60% at 10% • 1000 gross corporate earnings • 60 interest • 940 net taxable income • 329 tax on net • 611 earnings to shareholders • 91.65 tax by sh • 519.35 after tax to shareholders • 39 after tax to creditors • 558.35 combined after tax Without debt 552 after tax to shareholders

15. Computation of Earnings and Profits

16. Distinguishing debt from equity • Section 385(b) five factors • (1) whether there is a written unconditional promise to pay, on demand or on a specified date, a fixed amount in money in return for an adequate consideration and to pay a fixed rate of interest; • (2) whether there is a subordination to, or a preference over, other debt; • (3) the ratio of debt to equity; • (4) whether there is convertibility of debt into stock; and • (5) the relationship between stockholdings and holdings of the interest in question • Other factors: • Whether regular creditor’s remedies are available • Extent to which participate in corporation gains OR losses • Participation in governance (rarely determinative)

17. Distinguishing debt from equity other approaches • No fixed standards limiting shareholder debt • No single statutory or regulatory standard • Especially difficult when related parties • Concern about excess debt for non-tax reasons (?) • Other limits—deny debt feature • Section 269 denial of deduction for acquisition indebtedness when debt and equity stapled • Section 163(j) denial of deduction • “excess interest” to extent more than 50% of income • (using special definition of income, closer to cash flow) • Paid to related party (50% common ownership) • Debt to equity ratio 1.5 to 1 or less • Can include third party debt guaranteed by related party • Section 263(l) “payment in kind • Other sections may deny equity features of securities denominated “stock”

18. Debt /Equity Ratio • In some places statutorily defined, but in others not • Frequently tax basis of assets (not book or fmv) used for tax purposes • Liabilities/Total basis-liabilities • Not likely to produce same result as bankers or other analysts would use • Evidence of problems in structuring Code in which same rules apply to small closely held as to large publicly-held—common law nature of evolution of US code

19. Assets of Target Corporation

20. Domestic property transactions: Capital Gains • Nature of assets involved • Most stock, financial instruments • Not inventory, depreciable property • Land • All taxable • unless taxpayer not taxable • tax-exempt charity • pension plan • government • unless specific transaction not taxable • tax-free exchanges of certain types of property • Tax-free corporate restructuring • unless held by individual at death—stepped up basis to fmv

21. Domestic property transactions: Capital Gains • Rate and limitations • Individuals taxed at favorable rate—15% • Includes most individual holding of corporate stock • Except by dealers • Except in personal retirement accounts • Dividends now at 15% also • No special corporate rate for capital gains • Limitations on losses for both individuals and corporations

22. Domestic property transactions: depreciable property • Nature of assets involved • Machinery and equipment • Improved real estate • Special treatment • Prior deductions may be “recaptured”—1245 and 1250 • Recapture income may be triggered when other income not

23. Extent of Double Tax Regime • Alternative regimes • Passthrough of current income, corporate level asset gain Subchapter S • Full pass-through; no entity level tax • Partnership • Limited Liability Company • Full-passthrough entities may “check the box” • If single owner, become “disregarded entities” • Not eligible if market made in interests

24. Distributions to Shareholders Included in income of shareholders to extent of earnings • [ignore intricate rules making current e&p available if past losses] • No basis offset for receipt of dividend • Shareholder can have dividend even if holds stock at a loss • Shareholder can have dividend even if just purchased stock • No change in shareholder basis as result of income earned • No shareholder credit for corporate level taxes paid • Proposal last year was modified version of this, giving shareholder exemption for fully taxed corporate income • Only if NO earnings and profits will shareholders have return of capital • Return of capital distributions NOT income for US tax purposes—no withholding

25. Example of treatment of individual shareholder • Purchased for $1000 • Now worth $800 • Shareholder receives dividend of $65 from earnings and profits • (100 of corporate income) • 65 of dividend is taxable at 15% • Leaving shareholder with $55.25 of $100 corporate earnings • If stock decline in value in connection with dividend to 760 • shareholder basis in stock still 1000 • shareholder recognizes loss of 240 only on sale of stock • Dividend treatment avoided if sale possible

26. Individual preference for cashing in stock gains • Before rate reduction, individual shareholders sought to avoid dividends—all taxed, highest rate • Very low dividend payouts by many US corporations • With rate reduction, less concerned unless very high basis • Large enough change to effect corporate behavior?? • Rate reduction set to expire in 2009

27. Distributions to Corporate Shareholders • Dividends received deduction available for corporations section 243 • Varies with level of ownership • 100% if 80% or more • 80% if 20-80% • 70% if less than 20%

28. Corporate preference for cashing in stock gains • Corporate shareholders may prefer dividends to sale or exchange • Corporate shareholder may pay itself dividend from subsidiary before selling

29. Non-liquidating distributions of property to shareholders generally taxable • Treated as dividend received by shareholders • Triggers gain to distributing corporations • No losses triggered • Losses triggered only on sale • No losses on sale to related party • Even to unrelated party, sale not honored if buyer not take economic risk • Even of subsidiary stock unless qualifies as spin-off under reorganization rules

30. Share Repurchases--Redemptions • Share repurchases in US are legal so long as shareholders not preferred over others inappropriately • “Greenmail” • Designation of transaction as sale to issuing corporation will not control

31. Recharacterization of sales of stock to issuing corporation • Special rules under section 302 determine when shareholders have changed position in corporation enough to have sale not dividend treatment • Generally not problem for small shareholders in publicly held corporations • When redemption honored as “sale or exchange” basis allowed • Of less concern generally with rate reduction in effect

32. Corporate Liquidations: section 336 • Since 1986 all corporate level gain to be taxed when leaves “corporate solution” to be held by individuals • Prior law ( first set out in ‘General Utilities’ case) allowed liquidations in any circumstances to escape corporate level taxation • Extended by statute to sales made in connection with liquidation

33. Significance of “repeal of General Utilities” • General approach to prevent escape of corporate level gains • Some implementation rules assume that corporation should not be able to sell part of its assets in taxable transaction and other part in tax-free reorganization • Removed much of flexibility in corporate restructuring • Enormous pressure now on reorganization rules • Enormous pressure to reduce corporate tax in other ways

34. Measure of gain in corporate liquidation • Law still undeveloped • Too costly to try • Perhaps more law will develop now that more assets may be held at loss • May have difficulty avoiding more gain than actual gain on sale • Gain to be computed on each asset as if sold separately • Separate computation for liabilities in excess of tax basis • Extent to which unbooked losses will be allowed not clear

35. Assets of Target Corporation with liability problems on liquidation

36. Liquidations of Controlled subsidiaries: 332 and 337 • Nonrecognition on liquidation if 80% owned by corporation • Implementing idea that only Double Tax • Corporate basis in stock never used • Controlling corporation takes subsidiary’s basis in stock • Controlling corporation inherents other tax attributes • In general as if subsidiary never existed • In minority shareholders, corporate gain as if 336, no loss

37. Nontaxable Transfers to Corporation under section 351 • Same rules apply whether existing or new corporation • 80% of corporate stock must be held by control group after • Nonvoting stock may be used • But nonvoting stock that is too much like debt will trigger gain 351(g) • Debt may be swapped, but possible gain to both corporation and shareholder • Control group must retain “immediately after” • Obligation to transfer will defeat nontaxability unless new transferee can be counted as transferor

38. A corporation’s dealings in its own stock • Under section 1032, corporation not recognize gain or loss in dealings with own stock • No difference if “Treasury stock” or repurchased on market • Special rules in regulations allow subsidiaries in some circumstances the same treatment • Generally subsidiary must dispose of stock promptly • Corporation given basis credit for use of stock • Departure from ordinary expection in US tax law that no basis if no tax paid on property used as consideration • Significant visible issue in relation to employee stock options • Financial accounting treatment different • Currently being studied • Other limitations on the deductibility of interest • Section 269 Acquisition indebtedness • Section 163(j) anti- “Earnings stripping” • Section 163(l)

39. Net Operating Loss Carryovers • Generally, allowed limited carryback and more generous carryforward of net operating losses and capital losses • Character as operating or capital preserved • Sections 172 and 381 • Change in ownership (whether taxable or not) can result in limit of use of losses to present value in hands of old shareholders • Section 382

40. Consolidated returns • Affiliated groups (defined in section 1504) may elect • Only US subsidiaries • FINANCIAL ACCOUNTING STANDARDS DIFFER FASB 94 • In general, all US subsidiaries included if election • Gains and losses for transfers within group excluded • Losses of members can offset gains of other members • Intricate rules attempt to limit to losses not incurred while a member of the group

41. OVERVIEW OF US TAXING JURISDICTION

42. US taxation of worldwide income of US taxpayers: Who is US taxpayer? • Citizens (wherever they reside) • Resident aliens • Corporations with domestic charter • location of the headquarters, seat of management, place of operations not matter • But those not US taxpayers need to compute income under US rules if earnings will be subject to US tax on repatriation

43. US worldwide taxation of US taxpayers—what is taxed? • All income, without territorial exclusion • Only territorial exclusion allowed for service income of individuals • 911 and 912 • Direct credit for foreign income taxes paid under section 901 • Indirect credit for taxes paid by certain foreign corporations

44. Foreign Tax Credit Section 901 • For taxes paid by taxpayer to foreign jurisdiction • Limited under section 904 to otherwise owed US income on foreign income • Limit to prevent high rates in foreign jurisdiction from pulling off US tax on US income

45. Foreign Tax Credit Limitation 904 • Limited by US tax on “foreign source income” • Foreign source income is US term of art • Not income actually subject to foreign tax • Computed based on US tax concepts • Currently two types of limits • Complicated baskets, reduced for future to two • Overall foreign loss produce resourcing of gain in later year (2004 new rules) • Excess credits carryforward but limited

46. Indirect Foreign Tax Credit902 • Indirect credit allowed when US corporation receives dividend from 10% owned foreign corporation • No dividend received deduction for dividends paid by foreign corporation • Dividend grossed up by ratable share of foreign taxes paid by foreign corporation under section 78 • Allowed in addition to direct credit for withholding on dividend • Allowed for certain deemed dividends as well

47. US Taxation of Non-US Taxpayers All foreign persons and foreign corporations • income “effectively connected” to a trade or business conducted in the US • Other income if sourced to US under US sourcing rules

48. Trade or business conducted within the US by foreign taxpayer • Income computed on net basis, deductions allowed • Some income otherwise foreign may be pulled in if fixed location • Rents, royalties, dividends, sale of inventory • Possible branch profits and branch interest tax if foreign corp • Effect of treaties on effectively connected income: permanent establishment may raise threshold and affect sourcing

49. Branch profits and branch interest taxes • To equalize treatment of branches and subsidiaries of foreign taxpayers • Section 884 enacted in 1986 • Reduced or eliminated by treaties

50. Income of Foreign Taxpayers Not Effectively Connected • Generally subject to withholding at 30% • Section 871 for individuals • Section 881 for corporations • Rate lowered (sometimes to zero) by treaty • According to US sourcing rules: section 861