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Taxable Acquisitions

Taxable Acquisitions. The transaction is taxable because most, if not all, consideration is cash. Consequently, the deal will not qualify as non-taxable under I.R.C. Sec. 368. There are many reasons why cash is used as consideration rather than stock Value of acquiring companies stock too low

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Taxable Acquisitions

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  1. Taxable Acquisitions • The transaction is taxable because most, if not all, consideration is cash. Consequently, the deal will not qualify as non-taxable under I.R.C. Sec. 368. • There are many reasons why cash is used as consideration rather than stock • Value of acquiring companies stock too low • Dilution • Target’s shareholders don’t want stock: the stock may be too risky, the shareholders may not care about tax deferral. • LBO firms always use cash.

  2. Items to Consider inan Acquisition • The tax consequences of the transaction for target shareholders • The incremental tax costs and tax benefits if the buyer changes the basis in the target’s assets • The effect on the target company’s tax attributes

  3. PRACTICE CASES 1-4:Given Information Given Asset purchase price $2,000 Stock purchase price $1,370 ADSP $2,000 T's net asset basis $200 T shareholder's stock basis $200 Corporate tax rate 35% Individual investor capital-gains tax rate 20% After-tax discount rate 10% Amortization/depreciation period 10 Depreciation method straight-line Step-up $1,800 Annual incremental amort./deprec. $180 T has no liabilities, NOLs, tax-credit carryforwards, or loss carryforwards. T’s shareholders are individual investors, not corporate or tax-exempt entities. In all cases, the method of payment is cash and purchase accounting is used.

  4. Problem--Comparison of Tax Effects of Various Taxable Acquisition Structures Transaction Structure Asset Acquisition Stock Acquisition No With a Without a Liquidation Liquidation 338 Election 338 Election Purchase Price $ $ $ $ Tax Costs: Tax paid by T Tax paid by A--from 338 election Tax paid by T's shareholders Total Tax Paid $ $ ) $ $ T Shareholder Consequences: Gross cash received n/a Less: Shareholder taxes n/a After-tax cash to T's shareholders n/a $ $ $ A Net After-tax Cost: Gross cost $ $ $ $ Less: Present value of tax benefits Net after-tax cost of the acquisitions $ $ $ $ A's Tax Basis in the T's: Stock n/a n/a $ $ Assets $ $ $ $

  5. Case 1—Taxable Asset Acquisition w/o a Complete Liquidation of the Target • No change in the identity of the target’s shareholders--they retain control of the target firm • Taxable gain at target corporation level • No taxable gain recognized by target shareholders • Step-up in tax basis of the target’s assets • Target’s tax attributes survive • Possibility of tax-based goodwill • Possibility of financial-accounting-based goodwill

  6. Case 1—Taxable Asset Acquisition w/o a Complete Liquidation of the Target • To determine how both the seller and buyer allocate the selling price to the assets sold and purchased, must use residual method (see I.R.C. Sec 1060). • Under the residual method, sale price is allocated first to cash and cash equivalents, then to FMV of investment securities (CDs, marketable securities, etc.), then to FMV of tangible assets( receivables, inventory, fixed assets), then to FMV of specific intangible assets (customer lists, formulas, covenants not to compete). Remainder of purchase price allocated to goodwill. • Amounts allocated to goodwill, covenants not to compete are amortizable over 15 years under I.R.C. Sec 197.

  7. Case 1—Taxable Asset Acquisition w/o a Complete Liquidation of the Target: Non-Tax Issues • Acquiring firm may avoid unrecorded liabilities • Cost’s of transferring title to assets may be high • Some assets may be difficult to transfer or assign: certain contracts, licenses, government permits, etc.

  8. Problem--Comparison of Tax Effects of Various Taxable Acquisition Structures Transaction Structure Asset Acquisition No Liquidation Purchase Price $ 2,000.00 Tax Costs: Tax paid by T (630.00) Tax paid by A--from 338 election 0.00 Tax paid by T's shareholders 0.00 Total Tax Paid $ (630.00) T Shareholder Consequences: Gross cash received n/a Less: Shareholder taxes n/a After-tax cash to T's shareholders n/a A Net After-tax Cost: Gross cost $ 2,000.00 Less: Present value of tax benefits (387.10) Net after-tax cost of the acquisitions $ 1,612.90 A's Tax Basis in the T's: Stock n/a Assets $ 2,000.00

  9. Estimation of Tax Benefits From Stepping-up the Tax Basis of a Target’s Assets

  10. Taxable Asset Acquisition w/o a Subsequent Liquidation Target: Receives $2,000 in cash in return for all of its assets (basis = $200). Recognizes a gain of $1,800 and pays tax of $630. Has $1,370 of cash after-tax. Acquirer: Purchases the assets of the target for $2,000 cash. Takes a basis in the target’s assets equal to the price paid ($2,000). $2,000 cash All of the target’s assets Target Shareholders: No direct tax effect. Acquirer Shareholders: No direct tax effect.

  11. Case 2—Sale of the Target Firm’s Assets Followed by a Liquidation • T distributes the after-tax proceeds of the asset sale to its shareholders in return for their shares • Taxable gain at target corporation level • Taxable gain recognized by target shareholders • Step-up in the tax basis of the target’s assets • Target’s tax attributes do not survive • Possibility of tax-based goodwill • Possibility of financial-accounting-based goodwill

  12. Case 2—Sale of the Target Firm’s Assets Followed by a Liquidation • Buyer and seller use Section 1060 approach to allocate purchase price. Amount of purchase price allocated to goodwill is amortizable over 15 years by the acquiring corporation. • Non-tax issues are the same as in Case 1.

  13. Problem--Comparison of Tax Effects of Various Taxable Acquisition Structures Transaction Structure Asset Acquisition No Liquidation Liquidation Purchase Price $ 2,000.00 $ 2,000.00 Tax Costs: Tax paid by T (630.00) (630.00) Tax paid by A--from 338 election 0.00 0.00 Tax paid by T's shareholders 0.00 (234.00) Total Tax Paid $ (630.00) $ (864.00) T Shareholder Consequences: Gross cash received n/a 1,370.00 Less: Shareholder taxes n/a (234.00) After-tax cash to T's shareholders n/a $ 1,136.00 A Net After-tax Cost: Gross cost $ 2,000.00 $ 2,000.00 Less: Present value of tax benefits (387.10) (387.10) Net after-tax cost of the acquisitions $ 1,612.90 $ 1,612.90 A's Tax Basis in the T's: Stock n/a n/a Assets $ 2,000.00 $ 2,000.00

  14. Taxable Asset Acquisition with Subsequent Liquidation of the Target Target: Receives $2,000 in cash in return for all of its assets (basis = $200). Recognizes a gain of $1,800 and pays tax of $630. Distributes $1,370 of cash after-tax. Acquirer: Purchases the assets of the target for $2,000 cash. Takes a basis in the target’s assets equal to the price paid ($2,000). $2,000 cash All of the target’s assets $1,370 cash All of the target’s stock Target Shareholders: Receive $1,370 in cash, recognize a gain of $1,170 ($1,370 - $200 basis) and pay tax of $234. Cash after-tax is $1,136. Acquirer Shareholders: No direct tax effect.

  15. Case 3—Purchase of the Target’s Stock Followed by a § 338 Election • Under § 338, the acquirer can elect to treat a stock purchase of a freestanding C corporation as a taxable asset purchase if it acquires at least 80% of T’s stock within 12 months in a taxable manner. • Taxable gain at target corporation level • Taxable gain recognized by target shareholders • Step-up in the tax basis of the target’s assets • Target’s tax attributes do not survive • Possibility of tax-based goodwill • Possibility of financial-accounting-based goodwill

  16. Case 3—Purchase of the Target’s Stock Followed by a § 338 Election • Target corp is treated, for tax purposes, as if it sold its gross assets to the new target for what is known as the aggregate deemed sale price (ADSP). • ADSP = P + L + t(ADSP-BASIS) where P is the price paid for target stock, L is the liabilities of the target (assumed by acquirer), t is the corporate tax rate, and BASIS is the adjusted basis of the gross assets. • The ADSP is allocated to assets deemed sold and purchased under Sec. 1060 approach. Goodwill is amortizable over 15 years.

  17. Case 3—Purchase of the Target’s Stock Followed by a § 338 Election:Non-tax Issues • Transactions cost of obtaining stock lower than for obtaining assets-no asset transfer costs. • Problem of non-transferable assets avoided. • Unknown liabilities of target still present, although acquirer only liable up to the value of assets in new subsidiary.

  18. Problem--Comparison of Tax Effects of Various Taxable Acquisition Structures Transaction Structure Asset Acquisition Stock Acquisition No With a Liquidation Liquidation 338 Election Purchase Price $ 2,000.00 $ 2,000.00 $ 1,370.00 Tax Costs: Tax paid by T (630.00) (630.00) 0.00 Tax paid by A--from 338 election 0.00 0.00 (630.00) Tax paid by T's shareholders 0.00 (234.00) (234.00) Total Tax Paid $ (630.00) $ (864.00) $ (864.00) T Shareholder Consequences: Gross cash received n/a 1,370.00 1,370.00 Less: Shareholder taxes n/a (234.00) (234.00) After-tax cash to T's shareholders n/a $ 1,136.00 $ 1,136.00 A Net After-tax Cost: Gross cost $ 2,000.00 $ 2,000.00 $ 2,000.00 Less: Present value of tax benefits (387.10) (387.10) (387.10) Net after-tax cost of the acquisitions $ 1,612.90 $ 1,612.90 $ 1,612.90 A's Tax Basis in the T's: Stock n/a n/a $ 1,370.00 Assets $ 2,000.00 $ 2,000.00 $ 2,000.00

  19. Taxable Stock Acquisition of the Target w/ a § 338 Election Target: Target corporation’s owners change. The target’s assets are deemed sold to a hypothe- tical buyer after the stock acquisition for ADSP ($2,000). The asset sale gives rise to a gain of $1,800 and tax of $630. The tax is payable by the acquirer since the target is a subsidiary of the target at the time of the deemed asset sale. The tax attributes of the target vanish after the deemed asset sale. Acquirer Shareholders: No direct tax effect. Acquirer: Purchases the stock of the target for $1,370 cash. After the 338 election, takes a stepped-up basis in the target’s assets ($2,000). Target Shareholders: Receive $1,370 in cash, recognize a gain of $1,170 ($1,370 - $200 basis) and pay tax of $234. Cash after-tax is $1,136. $1,370 cash All of the target’s stock

  20. Taxable Stock Acquisition of the Target w/ a § 338 Election--Post-acquisition Acquirer: Owns 100% of the target’s stock. Has a basis in the target’s stock of $1,370 and a basis in the target’s net assets of $1,370. Target: Now a wholly owned subsidiary of the acquirer. Net asset basis is $1,370 and gross asset basis is $2,000.

  21. Case 4—Purchase of the Target’s Stock w/o a § 338 Election • Same as Case 3, except the acquirer does not make the § 338 election • No taxable gain at corporation level • Taxable gain recognized by the target shareholders • No step-up in the tax basis of the target’s assets • Target’s tax attributes survive • No possibility of tax-based goodwill • Possibility of financial-accounting-based goodwill • Non-tax issues the same as in Case 3

  22. Problem--Comparison of Tax Effects of Various Taxable Acquisition Structures Transaction Structure Asset Acquisition Stock Acquisition No With a Without a Liquidation Liquidation 338 Election 338 Election Purchase Price $ 2,000.00 $ 2,000.00 $ 1,370.00 $ 1,370.00 Tax Costs: Tax paid by T (630.00) (630.00) 0.00 0.00 Tax paid by A--from 338 election 0.00 0.00 (630.00) 0.00 Tax paid by T's shareholders 0.00 (234.00) (234.00) (234.00) Total Tax Paid $ (630.00) $ (864.00) $ (864.00) $ (234.00) T Shareholder Consequences: Gross cash received n/a 1,370.00 1,370.00 1,370.00 Less: Shareholder taxes n/a (234.00) (234.00) (234.00) After-tax cash to T's shareholders n/a $ 1,136.00 $ 1,136.00 $ 1,136.00 A Net After-tax Cost: Gross cost $ 2,000.00 $ 2,000.00 $ 2,000.00 $ 1,370.00 Less: Present value of tax benefits (387.10) (387.10) (387.10) 0.00 Net after-tax cost of the acquisitions $ 1,612.90 $ 1,612.90 $ 1,612.90 $ 1,370.00 A's Tax Basis in the T's: Stock n/a n/a $ 1,370.00 $ 1,370.00 Assets $ 2,000.00 $ 2,000.00 $ 2,000.00 $ 200.00

  23. Taxable Stock Acquisition of the Target w/o a § 338 Election Target: Target corporation’s owners change. Target tax attributes are limited under I.R.C. § 382. The tax basis of the target’s assets do not change. Acquirer Shareholders: No direct tax effect. Acquirer: Purchases the stock of the target for $1,370. Takes a carryover basis in the target’s assets ($200). Target Shareholders: Receive $1,370 in cash, recognize a gain of $1,170 ($1,370 - $200 basis) and pay tax of $234. Cash after-tax is $1,136. $1,370 cash All of the target’s stock

  24. Taxable Stock Acquisition of the Target w/o a § 338 Election--Post-acquisition Acquirer: Owns 100% of the target’s stock. Has a basis in the target’s stock of $1,370 and a basis in the target’s assets of $200. Target: Now a wholly owned subsidiary of the acquirer. Net asset basis is $200.

  25. Tax Consequences of Taxable Acquisition Structures (C Corps)

  26. Taxable Acquisition Case Summary • Do the target firm’s shareholders care which type of acquisition strategy is used to acquire target? Why or Why not? • To determine target shareholders indifference price for either an asset sale or stock sale use the following formula: Passet = Pstock + tc(Passets - Basis) where Passet is price paid for asset acquisition, Pstock is price paid for stock acquisition, tc is the tax rate of the target, and Basis is the tax basis of the target’s assets. • Intepretation: Acquiring firm can pay less if the deal is done as a stock acquisition because the target (and target shareholders indirectly) avoid one layer of tax.

  27. Taxable Acquisition Case Summary • If target shareholders are indifferent, which deal structure is best for the acquirer? Why? • To get step-up in basis, acquirer must compensate the target shareholders now for the additional tax incurred at the target level. Benefits of the step-up only accrue over time. • Consequently, most taxable deals of free-standing corporations (not subsidiaries) are done as stock acquisitions. Benefits of step-up overrated. • With stock deals, acquirer will have to book goodwill but no tax goodwill.

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