Taxable Mergers

In a direct statutory cash merger (i.e., the form of payment is cash), the acquirer and target boards reach a negotiated settlement, and both firms, with certain exceptions, must receive approval from their respective shareholders. The target is then merged into the acquirer or the acquirer into the target, with only one surviving. Assets and liabilities on and off the balance sheet automatically transfer to the surviving firm. To protect themselves from target liabilities, acquirers often employ triangular mergers. In such deals, the target is merged into an acquirer’s operating or shell acquisition subsidiary, with the subsidiary surviving (called a forward triangular cash merger), or the subsidiary is merged into the target, with the target surviving (called a reverse triangular cash merger). Direct cash mergers and forward triangular mergers are treated as a taxable purchase of assets, with cash and reverse triangular mergers treated as a taxable purchase of stock with cash. Their tax consequences are discussed next.

Taxable Purchase of Target Assets With Cash

If a transaction involves a cash purchase of target assets, with the buyer assuming none, some, or all of the target’s liabilities, the target’s tax cost or basis in the acquired assets is increased, or “stepped up,” to its fair market value (FMV), equal to the purchase price (less any assumed liabilities) paid by the acquirer. The additional depreciation in future years reduces the present value of the tax liability of the combined firms. The target realizes an immediate gain or loss on assets sold equal to the difference between the asset’s FMV and net book value.

The target’s shareholders could be taxed twice—once when the firm pays taxes on any gains and again when the proceeds from the sale are paid to the shareholders as either a dividend or a distribution following liquidation of the corporation. A liquidation of the target firm may occur if a buyer acquires enough of the assets of the target to cause it to cease operations.² To compensate the target company shareholders for any tax liability they may incur, the buyer must increase the purchase price. Taxable transactions have become somewhat more attractive to acquiring firms since 1993, when a change in legislation allowed acquirers to amortize certain intangible assets for tax purposes.³

Taxable Purchase of Target Stock With Cash

Taxable transactions (i.e., those including something other than acquirer stock) involve the purchase of the target’s voting stock to avoid double taxation of gains to the target’s shareholders. An asset purchase automatically triggers a tax on any gain on the sale by the target firm and another tax on any payment of the after-tax proceeds to shareholders. Taxable stock purchases avoid double taxation because the transaction takes place between the acquirer and the target firm’s shareholders. However, target shareholders may realize a gain or loss on the sale of their stock. Assets may not be stepped up to their FMV in these types of transactions. Since from the IRS’s viewpoint the target firm continues to exist, the target’s tax attributes (e.g., investment tax credits and net operating losses) may be used by the acquirer following the transaction, but their use may be limited by Sections 382 and 383 of the Internal Revenue Code. These are explained in more detail later in this chapter. Table 12.2 summarizes the key characteristics of the various forms of taxable deals.

Section 338 Election

Section 338 elections are an option with a taxable purchase of target stock. The acquirer and target firms can jointly elect Section 338 of the Internal Revenue Code allowing the buyer to record acquired assets and liabilities at their FMV for tax purposes. This allows a purchaser of 80% or more of the voting stock and market value of the target to treat the acquisition of stock as an asset purchase. The target’s net acquired assets are increased to their FMV, triggering a taxable gain when the deal is completed.⁴ For legal purposes, the sale of target stock under a 338 election still is treated as a purchase of stock by the buyer, allowing target shareholders to defer the payment of taxes on any gains realized on the sale of their shares. Section 338 elections are rare because the tax liability triggered by the transaction often exceeds the present value of the tax savings from the step-up in the tax basis of the net acquired assets. A 338 election is most useful when the target has substantial net operating losses (NOLs) or tax credit carryovers that the acquirer can use to offset any taxable gain triggered by the transaction.

Qualifying a Transaction for Tax-Free Treatment

To qualify as tax free, a deal must provide for continuity of ownership interests, continuity of business enterprise, a valid business purpose, and satisfy the step-transaction doctrine. To demonstrate continuity of ownership interests, target shareholders must own a substantial part of the value of the combined firms. This requires the purchase price to consist mostly of acquirer stock. Continuity of business enterprise requires the acquirer to use a significant portion of the target’s “historic business assets” in a business⁵ to demonstrate a long-term commitment on the part of the acquirer to the target. This usually means an acquirer must buy “substantially all” of the target’s assets. Further, the transaction must have a valid business purpose, such as maximizing the profits of the acquiring corporation, rather than only for tax avoidance. Finally, under the step-transaction doctrine, the deal cannot be part of a larger plan that would have constituted a taxable deal.⁶ Tax-free deals are also called tax-free reorganizations. The continuity of interests, business enterprise, and step-doctrine requirements are intended to prevent transactions that more closely resemble a sale from qualifying as a tax-free reorganization.

Alternative Tax-Free Reorganizations

The most common is the Type “A” reorganization used in direct statutory mergers or consolidations (mostly acquirer stock for target stock), forward triangular mergers (asset purchases), and reverse triangular mergers (stock purchases). Type “B” reorganizations are stock-for-stock acquisitions, and Type “C” reorganizations are stock-for-assets acquisitions. Type D reorganizations may be applied to acquisitions or restructuring.⁷

For a Type “A” statutory merger (Fig. 12.1) or consolidation (Fig. 12.2), payment can include cash, voting or nonvoting common or preferred stock, notes, or some combination. At least 50% of the purchase price must be acquirer stock to satisfy the IRS requirement of continuity of interests. Type “A” reorganizations are widely used because there is no requirement to use voting stock and acquirers avoid dilution by issuing nonvoting shares. The buyer may acquire less than 100% of the target’s net assets. Finally, there is no limit on the amount of cash used in the purchase price, as is true of Type B and C reorganizations. Since some target shareholders will want cash, some stock, and some both, the acquirer is better able to satisfy the different needs of the target shareholders than in other types of reorganizations.

With a Type “A” forward triangular stock merger, the parent funds the shell corporation by buying stock issued by the shell with its own stock (Fig. 12.3). All of the target’s stock is acquired by the subsidiary with the parent’s stock, the target’s stock is canceled, the acquirer subsidiary survives, and the target’s assets and liabilities are merged into the subsidiary. The IRS views such deals as an asset purchase since the target does not survive. The parent’s stock may be voting or nonvoting, and the acquirer must purchase “substantially all” of the target’s assets and liabilities (defined as at least 70% and 90% of the FMV of the target’s gross and net assets, respectively).⁸ At least 50% of the purchase price must consist of acquirer stock.

The advantages of the forward triangular merger include the flexible form of payment and the avoidance of approval by the parent firm’s shareholders. Public exchanges still may require shareholder approval if the amount of the parent stock used to acquire the target exceeds 20% of the parent’s voting shares outstanding. Other advantages include the possible insulation of the parent from the target’s liabilities, which remain in the subsidiary, and the avoidance of asset transfer taxes, because the target’s assets go directly to the parent’s wholly owned subsidiary. The target’s tax attributes that transfer to the buyer are subject to limitation. Since the target disappears, contract rights do not automatically transfer to the acquirer, which must obtain the consent of the other parties to the contracts to reassign them to the buyer.

With a Type “A” reverse triangular stock merger, the acquirer forms a shell subsidiary, which is merged into the target (Fig. 12.4). As the survivor, the target becomes the acquirer’s wholly owned subsidiary. The target’s shares are canceled, and target shareholders receive the parent’s shares. The parent, who owned all of the subsidiary stock, now owns all of the new target stock and, indirectly, all of the target’s assets and liabilities. At least 80% of the total consideration paid to the target must be acquirer voting common or preferred stock for the transaction to be tax free to target shareholders. The IRS views reverse triangular mergers as a purchase of stock, since the target survives the transaction.

The reverse triangular merger may eliminate the need for parent firm shareholder approval, as the parent is the sole shareholder in the sub. Since the target survives, it retains any nonassignable franchise, lease, or other valuable contract rights. By not dissolving the target, the acquirer avoids accelerating⁹ the repayment of loans outstanding. Insurance, banking, and public utility regulators may require the target to remain in existence. The major drawback is the need to use acquirer voting shares to buy at least 80% of the target’s outstanding shares.

In a Type “B” stock-for-stock reorganization, the acquirer must use voting common or preferred stock to buy at least 80% of the target’s voting and nonvoting stock in a tender offer (Fig. 12.5). Any cash or debt disqualifies the deal as a Type “B” structure.¹⁰ Type “B” deals are used as an alternative to a merger or consolidation. The target’s stock does not have to be purchased all at once, allowing for a “creeping merger” as the target’s stock may be purchased over 12 months or less as part of a formal acquisition plan. Type “B” reorganizations are useful if the acquirer wishes to conserve cash or its borrowing capacity. Since shares are acquired directly from shareholders, there is no need for a target shareholder vote. Finally, contracts and licenses transfer with the stock, which obviates the need to receive consent to assignment, unless specified in contracts. The target firm is either retained as a subsidiary or merged into the parent.¹¹

The Type “C” stock-for-assets reorganization is used when the acquirer does not want to assume any undisclosed liabilities (Fig. 12.6). It requires that at least 70% and 90% of the FMV of the target’s gross and net assets, respectively, be acquired for acquirer voting stock. Consideration paid in cash cannot exceed 20% of the FMV of the target’s assets; any liabilities assumed by the acquirer must be deducted from the 20%. Since assumed liabilities frequently exceed 20% of the FMV of the acquired assets, the form of payment generally is all stock. The target dissolves and distributes the acquirer’s stock to the target’s shareholders. The requirement to use only voting stock discourages the use of Type “C” reorganizations. Table 12.3 summarizes the key characteristics of alternative tax-free deal structures.

Treatment of Target Tax Attributes in M&A Deals

Tax attributes, such as net operating loss carryforwards, capital loss carryovers, excess credit carryovers, tax basis in company assets, and tax basis in subsidiary companies, can represent considerable value to acquiring firms in terms of tax savings. The IRS allows acquirers to realize tax savings from additional depreciation resulting from the revaluation of net acquired target assets to their fair FMV or from the target’s other tax attributes, but not both. Thus, acquirers can use a target’s tax attributes in tax-free reorganizations and in taxable purchases of stock without a Section 338 election, since net acquired assets are not revalued to their FMV. Acquirers cannot use the target’s tax attributes in taxable purchases of assets and taxable purchases of stock undertaken as a 338 election, since net acquired assets are revalued to their FMV.¹²

Tax-Free Transactions Arising From 1031 “Like-Kind” Exchanges

The prospect of being able to defer taxable gains is often associated with 1031 exchanges of real estate property or other income-producing properties. By postponing tax payments, investors have more money to reinvest in new assets. Assume a property was purchased 10 years ago for $5 million and is now worth $15 million. If the property were sold with no subsequent purchase of a similar property within the required period, the federal capital gains tax bill would be $1.5 million [i.e., ($15 − $5) × 0.15], assuming a capital gains tax rate of 0.15. This ignores the potential for state taxes or depreciation recapture taxes owed if the owner took deductions for depreciation. However, by entering into a 1031 exchange, the owner could use the entire $15 million from the sale of the property as a down payment on a more expensive property. If the investor acquires a property of a lesser value, taxes are owed on the difference. Under the Tax Cuts and Jobs Act of 2017, 1031 exchanges completed after January 1, 2018 apply only to real and not personal property. The implications of this change are explored later in this chapter.

Corporate Tax Rates

Beginning on January 1, 2018, the corporate income tax rate on earnings was lowered permanently to 21%. Previously, corporate tax rates consisted of eight brackets ranging from a low of 15% of taxable income of less than or equal to $50,000 to a high of 35% of taxable income over $18.3 million. The lower corporate rate could stimulate greater M&A activity due to the potential for higher future after-tax financial returns.

Pass-Through Income

The new tax law adopts a standard deduction of 20% for pass-through income limited to the greater of 50% of wage income or 25% of wage income plus 2.5% of the cost of tangible depreciable property. Coupled with the reduction in the maximum personal income tax rate to 37%, the 20% deduction creates an effective top tax rate on pass-through income of 29.6% (i.e., 0.37 × (1 − 0.2)). The limitations are intended to discourage the improper classification of wage income as business income. The deduction applies to publicly traded partnerships but does not include certain service providers such as health, law, and professional services. However, joint filers with income below $315,000 and other filers with income below $157,500 can claim the deduction fully on income from service industries. This deduction excludes short-term capital gains, dividends, interest income not allocable to a business, certain other passive income, and income from investment management services. This provision expires on December 31, 2025. The extent to which the changes in the tax law will impact pass-through entities varies by industry, profession, and size of business. This is discussed in more detail in Chapter 15.

Pass-through entities (e.g., S-corps, partnerships, and limited liability companies) must ask if changing their firm’s structure will cut their tax liabilities. A variety of factors must be considered including the size of dividend payments, expectations about what congress might do in the future, whether a business qualifies for the 20% deduction, etc. While it is relatively easy to switch from a pass-through structure to a corporate structure, switching back is more difficult. To avoid double taxation (i.e., at the corporate and individual levels), firms having switched from a pass-through structure to a C corporation must wait 5 years after having made the switch to sell the business to avoid gains resulting from the sale from being taxed twice: once when the sale is completed and again when the proceeds are paid to owners. This waiting period is intended to discourage C corporations from switching to a pass-through entity immediately before they sell to avoid double taxation.

Investment in Capital

Investments in capital equipment can be depreciated over their useful lives for tax purposes. The straight-line method allows for assets to be depreciated evenly, while accelerated methods allow for a larger portion of depreciation to be deducted immediately. Designed to benefit small businesses, Section 179 of the US tax code allows for the immediate expensing of qualifying assets (rather than depreciating them) such as cars, office equipment, business machinery and computers subject to a cap.

The new tax law allows full expensing of short-lived capital investment such as machinery and equipment through 2022. The provision is then phased out between 2023 and 2026: 80%, 60%, 40%, and 20%. The cap on Section 179 business expensing is raised to $1 million from its prior $500,000 limit. The full cost of investment in certain tangible property and computer software will be immediately deductible if acquired and placed in service after September 27, 2017 and before January 1, 2023, even if it is used.

The accelerated depreciation allowed under the new tax law could encourage acquirers to structure deals as asset purchases (or deemed as an asset purchase under a Section 338 election) in a way that is beneficial to both the buyer and seller. This immediate expensing of capital assets also could encourage more acquisitions of pass-through entities. Takeovers of partnerships are treated as asset purchases. For example, hospitality company Aramark’s takeover of hotel management firm Avendra and uniform rental company AmeriPride Services, both partnerships, were treated as asset purchases. The total purchase price for the two businesses was $2.35 billion; however, after the immediate expensing of qualified assets, the net cost of the purchases was $1.86 billion. While stock acquisitions do not benefit from the immediate expensing of revalued net acquired assets, the acquisition of a division of a firm can be structured as an asset purchase to take advantage of the new tax law. Alternatively, a transaction could be structured as a 338 exchange in which both the buyer and seller agree to treat an exchange of shares as a sale of assets.

Alternative Minimum Corporate Income Tax (AMT)

The AMT was originally included in the US tax code in 1969. As part of the Tax Reform Act of 1986, the corporate minimum tax was modified to cover a broader range of preferences. It was an alternative tax because the rules for this minimum tax represent alternative rules to the regular tax system. It was a minimum tax because a corporation must pay the larger of its AMT or its regular tax liability. The 2017 tax law completely eliminates the AMT for corporations so as not to offset the reduction in corporate tax rates. Banks, restaurants, and other companies with operations mostly in the United States that have been paying close to the previous 35% statutory tax rate are likely to benefit the most from the elimination of the 20% AMT. The improvement in their after-tax operating cash flows can make them more active acquirers and attractive target firms.

Deductibility of Interest Expense

The new law limits the tax deductibility of net interest expense to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA) for 4 years, and 30% of earnings before interest and taxes (EBIT) thereafter. As such, for taxable years beginning on or after January 1, 2022, the dollar value of interest deductions will be lower absent an increase in a firm’s EBIT. Interest on debt incurred prior to the new tax law will be limited in the same way as debt incurred after the law was passed. The new rules do not apply to taxpayers with average annual gross revenue for the three-taxable-year period ending with the prior taxable year of less than $25 million. Interest expense in excess of the limitations is deductible indefinitely in future years. The cap on the deductibility of interest expense will spark an increase in equipment leasing and sale-leaseback arrangements¹⁴ making it more important than ever to include leasing expenses in assessing a firm’s ability to finance its ongoing operations.

Unless offset by increasing after-tax cash flow due to the lower corporate tax rate, limitations on the deductibility of interest expense could reduce the degree of leverage for the average firm by as much as five percentage points¹⁵ and possibly the average size of private equity deals. Highly leveraged transactions become less likely because debt financing is more costly. The resulting lessening of the historical bias toward using debt also could reduce the probability of a firm experiencing financial distress. Acquirers with high interest expense and low EBITDA are likely to seek targets with little debt and high EBITDA, as such targets could enable the acquirer (when combined with the target) to deduct a larger percentage of interest expense from pretax income. Firms with large excess cash balances that would allow highly leveraged acquirers to deleverage could become more attractive as targets. Current highly leveraged firms could experience extreme financial distress as the full impact of limits on interest deductibility is phased in. Furthermore, the cap on interest expense deduction could make preferred stock more common as a form of payment as it exhibits some of the characteristics of debt: fixed dividend payment and is paid before common shareholders in liquidation.

Several deal structures make the use of spinoffs more attractive. Spinoffs, if properly structured, enable firms to transfer corporate assets to their shareholders tax-free. Spinoffs followed by an IPO could be structured to allow the former parent to keep much of the proceeds of the newly issued shares enabling the parent to deleverage. In addition, Reverse Morris Trust deals provide a means of increasing the interest rate cap for acquirers. Such deals involve spinning off or splitting off all assets to be combined with a merger partner into a new public company, with the new company combining with the merger partner tax free to shareholders. The merger partner can increase its ability to deduct interest expense if the spun off/split off firm has significant EBITDA and little leverage. See Chapter 16 for more detail on these types of restructuring activities.

Dividends Received Deduction

The size of the deduction depends on the size of the receiving corporation’s ownership stake in the paying corporation. The deduction is equal to100% of the dividend if the two firms are in the same affiliated group (i.e., parent has a controlling interest in its dividend paying subsidiaries). If the receiving corporation owns more than 20% of the paying firm then the deduction is 80%; if it is less than 20%, the deduction is 70%. The new tax law lowers the 80% deduction to 65% and the 70% deduction to 50%, making minority investments less attractive.

Net Operating Losses

For federal tax purposes, NOLs are created when firms lose money. Prior to 2018, such losses could be carried back 2 years to get refunds on prior tax payments and forward 20 years to reduce future tax liabilities, without limits on percent of income. How states treat losses varies widely. Some states don’t allow any deduction while others use the federal standards. States levying a gross receipts tax as their primary corporate tax (i.e., Nevada, Ohio, Texas, and Washington) do not offer NOL deductions. Delaware levies both a gross receipts tax and a corporate income tax.¹⁶ The new law scraps net operating loss carrybacks and caps carryforwards at 90% of taxable income, falling to 80% after 2022. NOLs arising in taxable years ending after December 31, 2017 not deductible in a taxable year can be carried forward indefinitely.

As a result of the new law, targets with large accumulated losses are less attractive as the value of loss carryforwards is reduced. However, NOLs created after January 1, 2018 still represent potential value for acquirers. When acquired net assets are stepped up for tax purposes, the target’s NOLs may be used immediately by the acquirer to offset the gain on an asset sale. For deals not resulting in an asset write-up, the target’s NOLs may be used by the acquirer in future years, subject to the limitation specified in Section 382 of the Internal Revenue Service Code. Because the acquirer can never be sure when future income will be sufficient to realize the value of the NOLs, calculating their present value is problematic. Loss carryforwards alone rarely justify an acquisition.

Section 382 was created to prevent acquisitions of firms with substantial NOLs to reduce acquirer’s taxable income, without having a valid business purpose other than tax avoidance. A firm’s ability to use NOLs to offset current income may be limited if the firm had a 50% change in ownership. An ownership change is one in which shareholders with stakes of 5% or more increase their ownership by more than 50 percentage points at any time during a 3 year period beginning from the date of their initial stock purchase. For example, if a shareholder owning 30% of a firm acquired another 51% within the span of 3 years there would be an ownership change triggering Section 382. The shareholder could still use NOLs in existence prior to the change in ownership but their annual value would be limited to a percentage of the firm’s market value on the date of the change in ownership equal to the market value of the stock times the IRS long-term tax-exempt interest rate.¹⁷

Carried Interest

Carried interest is that portion of profits that general partners of private equity and hedge funds receive as compensation regardless of whether it involves their having contributed their own money to the fund. Historically, general partners often have received a management fee equal to 2% of the fund’s assets plus 20% of any profit generated when the fund is terminated. The management fee is intended to cover the costs of managing the fund and to compensate the fund manager. However, carried interest constitutes the primary source of income for the general partner. Private equity firms argue that carried interest is justified because of the substantial amount of time spent developing strategy, improving firm performance, and exiting the investment through an IPO or sale to a strategic investor or another private equity firm.

Under the new law, carried interest will be subject to a 3-year holding period to qualify as a long-term capital gain for tax years beginning after December 31, 2017. Partnership interests issued before that date are treated in the same manner regardless of any arrangements made under Section 83b of the IRS tax code which deals with deferred income. Previously, carried interest was subject to a 1-year holding period to be treated as a long-term gain. Since most private equity deals are held longer than 3 years, this change in the holding period is expected to have little impact on private equity investors.

Foreign Earnings

Under the prior “worldwide” tax system, overseas taxes were subject to a statutory 35% tax rate less any taxes paid in the country where the profits were earned. The United States allowed the payment of taxes on these earnings to be deferred until they were repatriated. To avoid a current tax bill, multinational firms allowed their cash balances held abroad to accumulate, potentially distorting capital flows. For example, the high cost of repatriating earnings has been associated with lower than would have been expected domestic M&As by US acquirers.¹⁸ The new tax law moves to a “territorial” system where only domestic profits are taxed. To discourage firms from shifting income earned in the United States to lower tax countries two new rules were introduced: the Base Erosion Anti-Abuse Tax (BEAT) and the Global Intangible Low-Taxed Income Tax (GILTI).¹⁹

BEAT applies to large firms with at least $500 million in gross receipts and significant cross-border payments to related parties. Firms subject to BEAT must calculate their tax liabilities with and without cross-border payments to foreign affiliates. If such payments reduce a firm’s tax liability below what it would have been without the payments, the firm must pay the BEAT tax equal to 10% of the difference through 2025 and 12.5% thereafter. Likely to affect most multinationals, BEAT has an impact similar to the alternative minimum tax.

GILTI sets a floor on taxes paid on foreign income, whether to US or foreign tax authorities. Multinational firms paying less than 10.5% of foreign income to foreign tax authorities must pay the difference to the IRS. That minimum tax is applied to foreign income over a threshold based on the firm’s foreign tangible assets, with income over that threshold assumed to have been generated by intangible assets held in low tax countries.²⁰ GILTI also reduces tax on foreign income from goods and services produced in the United States using intellectual property (IP) to 13.1% until the end of 2025 and 16.4% thereafter. Otherwise, royalty income on such property paid to a US based firm would be subject to a maximum 21% tax rate. Multinational firms now have less incentive to hold IP outside the United States.

Multinational firms are now more likely to repatriate foreign profits. Prior to the new tax law, firms would borrow at historically low interest rates to avoid the tax bill on repatriating foreign earnings in order to pay dividends, repurchase shares, and invest (including M&As) in the United States. Now these firms can reduce leverage and use more of their future cash flow for these purposes. Companies likely to benefit most from the movement to a territorial system are those that have maintained large cash balances abroad such as large pharmaceutical, technology, industrial, financial, and consumer product firms.

Deemed Repatriation

Foreign profits on which taxes had been previously deferred are under the new law subject to a one-time tax of 15.5% of cash and cash equivalents and 8% of reinvested foreign earnings when such profits are repatriated to the United States. While firms are not required to repatriate the cash, they are deemed to have done so even if they allow cash to remain abroad. Firms may pay the tax over 8 years. Reinvested earnings are foreign earnings on which taxes have not yet been paid but that have been invested in illiquid assets such as plant and equipment. Future foreign earnings will be treated as described in the previous section. Multinational firms can now more efficiently manage their global cash position, disbursing cash based on financial returns rather than on the desire to defer tax payments. Since most of the overseas cash is invested in commercial paper and other short-term money market investments held by foreign subsidiaries, repatriation is simply a matter of transferring ownership to the parent firms. There is significant empirical evidence that multinational corporations are more likely to engage in domestic acquisitions if the tax cost of repatriation is lower.²¹

1031 “Like-Kind” Exchanges

Used for decades to defer capital gains in real estate deals, like-kind exchanges expanded to apply to exchanges of income producing businesses. The loss of current tax revenue prompted changes in the tax code such that such transfers apply only to real property exchanges occurring after January 1, 2018. Personal property assets that no longer qualify as tax free exchanges include broadband spectrums, fast-food restaurant franchise licenses and patents, aircraft, vehicles, machinery and equipment, railcars, boats, livestock, artwork and collectibles. So-called “self-created property” such as patents, inventions, models or designs (patented or otherwise), and proprietary formulas or processes held by the taxpayer who created the property are included in the definition of personal property. As a result of the new law, 1031 exchanges will be focused on real estate deals.

Tax Cut Expectations and Firm Value

Expectations about tax cuts impact firm values substantially. A recent academic study using cross-sectional data traced stock market reaction from the day prior to the 2016 presidential election through the Trump administration’s first 100 days in office. Values of firms most likely to benefit from a tax cut showed the greatest increase, while those less likely to benefit tended to underperform the overall stock market. Specifically, firms paying substantial amounts of taxes and those with significant deferred tax liabilities tended to outperform the major stock indices; those with large deferred tax assets from NOL carryforwards underperformed, as did those with high leverage and interest expense.²²

Preclosing, Due Diligence, and Postclosing Issues

Issues can be grouped under the heading of preclosing, due diligence, and postclosing. During preclosing negotiations when the form of the transaction (i.e., asset or stock purchase) is determined, it is important for the buyer to consider state and local “transfer taxes” (i.e., those that apply when asset ownership is transferred). Some state or local tax authorities (or jurisdictions) impose sales and use taxes on certain types of tangible personal property transferred from the seller to the buyer according to the terms of the deal. During due diligence, the buyer must determine what if any taxes owed by the target are unpaid. Such tax liabilities must be paid by the acquirer and can include income, sales, use, and employment taxes when the buyer buys all or substantially all of the target’s assets. Moreover, some states impose limitations on the use of net operating losses which may affect the value of target NOLs. Finally, postclosing, the combined acquirer and target firms may have substantially expanded their geographic footprint resulting in a greater presence in more tax jurisdictions than prior to the deal resulting in additional taxes. Prior to the deal both the target and acquirer’s activity in a given jurisdiction may have been minimal resulting in few if any taxes.

Potentially Unforeseen Tax Liabilities

A common problem in takeovers is the likelihood that the target firm is not filing tax returns in all states in which it should be. Each state has different rules for when companies are liable for taxes and many firms often unknowingly create potential tax liabilities in multiple states. States such as Washington and Texas tax gross receipts, others such as Ohio have occupancy taxes; while still others such as Delaware and California have franchise taxes. These taxes are not based on income; as such, firms can still owe taxes even though they are incurring losses.

Pressure on States to Raise Revenue

A combination of shrinking tax bases and upward spiraling spending are forcing some states to seek new sources of revenue. States and local authorities were limited historically on what they could tax. However, this changed when the US Supreme Court ruled on June 20, 2018 that states could tax online commerce in the Wayfair vs. South Dakota decision, reversing the “physical presence rule” in the US Constitution’s “Commerce Clause.” This allowed tax authorities to collect sales taxes on businesses not physically present in the state.

States are likely to become increasingly aggressive in extending their authority to collect taxes from out of state businesses. While in most states sales taxes are paid by the consumer, the seller is obligated to withhold and remit the sales tax proceeds and can be penalized for failing to do so. Acquirers must now determine during due diligence if the target firm has satisfied its obligations to pay taxes that might be owed on sales to customers located in states in which they do not have a physical presence. Therefore, acquirers must be aware of what target products and services might be subject to state and local tax withholding and remittance. If the target firm has failed to do so, the state and local taxing authority may look at past years due to a lack of a statute of limitations resulting in a substantial liability for the acquirer.

Acquisition Method of Accounting

A company maintaining its financial statements under International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP) needs to account for business combinations using the acquisition method.³¹ According to the acquisition method of accounting, the purchase price or acquisition cost is determined and then, using a cost-allocation approach, assigned first to tangible and then to intangible net assets and recorded on the books of the acquiring company. Net assets (or net acquired assets) refer to acquired assets less assumed liabilities. Any excess of the purchase price over the fair value³² of the acquired net assets is recorded as goodwill. Goodwill is an asset representing future economic benefits arising from acquired assets that were not identified individually. Current accounting standards stipulated in Statements of Financial Accounting Standards (SFAS) 141 R require an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the target to be measured at their fair value as of the acquisition date. The acquisition date generally corresponds to the closing date rather than to the announcement or signing date.³³

Who is the Acquirer?

The firm designated as the acquirer is usually the one that has effective control of decision making in the combined firms. However, determining which firm is the acquirer takes on added importance from an accounting perspective as this determines which firm’s assets and liabilities will be revalued on the acquisition date, whether positive or negative good will is created, and the impact of the combined firm’s future earnings.

According to SFAS 141 R, the acquirer usually is the firm retaining the largest share of voting rights following closing and is significantly larger measured in terms of assets, revenue, and earnings. In addition, the acquirer typically is the firm whose former board members make up the largest percentage of the new board, whose former management dominates the senior management of the combined firms, and in an equity exchange is the firm paying a premium for the other firm’s shares.

Determining the acquirer is not always unambiguous. Take for example, the 2008 merger between regional telecom firms CenturyTel and Embarq. Several factors suggested that Century Tel should be viewed as the acquirer, since it issued new shares in exchange for Embarq shares, paid a premium to Embarq shareholders, and its former board members and senior managers comprised a majority of the board and senior management of the combined firm. Yet other factors suggested Embarq should be considered the acquirer since its shareholders had the largest percentage of voting rights and it is the much larger firm. Based on a consideration of these factors, Century Tel was ultimately determined to be the acquirer for financial reporting purposes. This designation resulted in a larger increase in net acquired assets and lower future reported earnings for the combined firms because of larger noncash expenses such as depreciation than would have been the case had Embarq been viewed as the acquirer.

Recognizing Acquired Net Assets and Goodwill at Fair Value

To make comparison of different transactions easier, current accounting rules require recognizing 100% of the assets acquired and liabilities assumed, even if the acquirer buys less than 100% of the target. This results in the recognition of the target’s business in its entirety, regardless of whether 51%, 100%, or any percentage of the target in between is acquired. Thus, the portion of the target that was not acquired (i.e., the noncontrolling, or minority, interest) is also recognized, causing the buyer to account for the goodwill attributable to both it as well as to the noncontrolling interest. Noncontrolling/minority interest is reported in the consolidated balance sheet within the equity account, separately from the parent’s equity. Moreover, the revenues, expenses, gains, losses, net income or loss, and other income associated with the noncontrolling interest should be reported on the consolidated income statement.

For example, if Firm A were to buy 50.1% of Firm B, reflecting its effective control, Firm A must add 100% of Firm B’s acquired assets and assumed liabilities to its assets and liabilities and record the value of the 49.9% noncontrolling, or minority, interest in shareholders’ equity. This treats the noncontrolling interest as simply another form of equity and recognizes that Firm A is responsible for managing all of the acquired assets and assumed liabilities. Similarly, 100% of Firm B’s earnings are included in Firm A’s income statement less that portion attributable to the 49.9% minority owner and added to the retained earnings of the consolidated firms.³⁴

Recognizing and Measuring Net Acquired Assets in Step (or Stage) Transactions

Staged transactions are required to recognize the acquired net assets as well as the noncontrolling interest in the target firm at the full amounts of their fair values. Net acquired assets at each step must be revalued to the current FMV. The acquirer must disclose gains or losses due to the reestimation of the formerly noncontrolling interests on the income statement.

Recognizing Contingent Considerations

Contingencies are uncertainties—such as potential legal, environmental, and warranty claims about which the future may not be fully known at the time a transaction is consummated—that may result in future assets or liabilities. The acquirer must report an asset or liability arising from a contingency to be recognized at its acquisition-date fair value. As new information becomes available, the acquirer must revalue the asset or liability and record the impact of changes in their fair values on earnings, thereby contributing to potential earnings volatility.

In-Process Research and Development Assets

An acquirer must recognize separately from goodwill the acquisition-date fair values of R&D assets acquired in the business combination. Such assets will remain on the books as an asset with an indefinite life until the project’s outcome is known. If the project is a success, the firm will amortize the asset over the estimated useful life; if the research project is abandoned, the R&D asset will be expensed.

Expensing Deal Costs

Transaction-related costs such as legal, accounting, and investment banking fees are recorded as an expense on the closing date and charged against current earnings. Firms may need to explain the nature of the costs incurred in closing a deal and the impact of such costs on the earnings of the combined firms. Financing costs, such as expenses incurred as a result of new debt and equity issues, will continue to be capitalized and amortized over time.

Balance-Sheet Considerations

For financial-reporting purposes, the purchase price (PP) paid, including the fair value of any noncontrolling interest (FMV_NCI) in the target at the acquisition date, for the target company consists of the FMV of total identifiable acquired tangible and intangible assets (FMV_TA) less total assumed liabilities (FMV_TL) plus goodwill (FMV_GW). The difference between FMV_TA and FMV_TL is called net asset value. The purchase price is the total consideration transferred to target firm shareholders for net acquired assets less any interest not owned by the acquirer (i.e., noncontrolling interest). These relationships can be summarized as follows:

$\mathrm{Purchase\; price}\left(\mathrm{total\; consideration}\right)\mathrm{:}\mathrm{PP}={\mathrm{FMV}}_{\mathrm{TA}}-{\mathrm{FMV}}_{\mathrm{TL}}+{\mathrm{FMV}}_{\mathrm{GW}}-{\mathrm{FMV}}_{\mathrm{NCI}}$

$\mathrm{Goodwill:}{\mathrm{FMV}}_{\mathrm{GW}}={\mathrm{PP+FMV}}_{\mathrm{NCI}}-{\mathrm{FMV}}_{\mathrm{TA}}+{\mathrm{FMV}}_{\mathrm{TL}}=\left({\mathrm{PP+FMV}}_{\mathrm{NCI}}\right)-\left({\mathrm{FMV}}_{\mathrm{TA}}-{\mathrm{FMV}}_{\mathrm{TL}}\right)$

From Eq. (12.2), as net asset value increases, FMV_GW decreases, for a given purchase price. Therefore, goodwill can be either positive (i.e., PP > net asset value) or negative (i.e., PP < net asset value). Negative goodwill arises if the acquired assets are purchased at a discount to their FMV and is referred to under SFAS 141R as a “bargain purchase.”⁴¹

Table 12.5 shows how acquisition accounting can be applied in business combinations. Assume Acquirer buys 100% of Target’s equity for $1 billion in cash at yearend. Columns 1 and 2 present the preacquisition book values on the two firms’ balance sheets. Column 3 reflects the restatement of the book value of the Target’s balance sheet in column 2 to their FMV. As the sum of columns 1 and 3, column 4 presents the Acquirer’s postacquisition balance sheet. This includes the Acquirer’s book value of the preacquisition balance sheet plus the FMV of the Target’s balance sheet. In column 3, total assets are less than shareholders’ equity plus total liabilities by $100 million, reflecting the unallocated portion of the purchase price, or goodwill. This $100 million is shown in column 4 as goodwill on the postacquisition Acquirer balance sheet to equate total assets with equity plus total liabilities. Note that the difference between the Acquirer’s pre- and postacquisition equity is equal to the $1 billion purchase price.

Exhibit 12.1 shows the calculation of goodwill in a transaction in which the acquirer purchases < 100% of the target’s outstanding shares but is still required to account for all of the target’s net acquired assets, including 100% of goodwill. Exhibit 12.2 lists valuation guidelines for each major balance-sheet category.

Table 12.6 illustrates the balance-sheet impacts of acquisition accounting on the acquirer’s balance sheet and the effects of impairment subsequent to closing. Assume that Acquirer Inc. purchases Target Inc. on December 31, 2019 (the acquisition/closing date), for $500 million. Identifiable acquired assets and assumed liabilities are shown at their fair value on the acquisition date. The excess of the purchase price over the fair value of net acquired assets is shown as goodwill. The fair value of the “reporting unit” (i.e., Target Inc.) is determined annually to ensure that its fair value exceeds its carrying (book) value. As of December 31, 2020, it is determined that the fair value of Target Inc. has fallen below its carrying value, due largely to the loss of a number of key customers.

In January 2017, the Financial Accounting Standards Board issued revised guidance for goodwill impairment testing to make the process simpler and less expensive. The new guidance found in Accounting Standards Update No. 2017-04 replaces the current two-step process for testing goodwill for a decrease in value with a one-step procedure.

The process for valuing goodwill impairment under GAAP involves the following steps:

1. (1) Calculate the fair value of the business and compare it to the carrying or book value of the business. If the carrying value exceeds fair value, perform the next step. Otherwise, the testing stops.⁴²
2. (2) Estimate the fair value of the identifiable assets and liabilities that support the goodwill and compare to their carrying values on the firm’s balance sheet to determine a new estimate of goodwill. If the new estimate of goodwill is less than the carrying value of goodwill on the firm’s balance sheet, the carrying value must be reduced by the difference and shown as a pretax loss on the firm’s income statement.

The new standard removes Step 2 of the goodwill impairment test, which requires a hypothetical acquisition purchase price allocation. Goodwill impairment will now be the amount by which a business unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. Public companies that file reports with the SEC must adopt the new standard for fiscal years beginning after December 15, 2019. Those that are not SEC filers have until December 15, 2020.

The treatment of impaired goodwill according to international accounting standards is different from GAAP. International standards take into account that some portion of an asset may be recoverable if sold and that the asset may still have some value if used in some portion of the firm’s operations. Therefore, the recoverable amount of an asset is either the asset’s fair value less costs to sell or its value in use, whichever is greater. To measure impairment, the assets carrying amount is compared to its recoverable amount, which is the amount determined for individual assets. The impairment loss is allocated by reducing any goodwill of the business unit and then reducing the carrying value of other assets of the business unit on a pro rata basis.

Income Statement and Cash Flow Considerations

For reporting purposes, an upward valuation of tangible and intangible assets, other than goodwill, raises depreciation and amortization expenses, which lowers operating and net income. For tax purposes, goodwill created after July 1993 may be amortized up to 15 years and is tax deductible. Goodwill booked before July 1993 is not tax deductible. Cash flow benefits from the tax deductibility of additional depreciation and amortization expenses that are written off over the useful lives of the assets. If the purchase price paid is less than the target’s net asset value, the acquirer records a one-time gain equal to the difference on its income statement. If the carrying value of the net asset value subsequently falls below its FMV, the acquirer records a one-time loss equal to the difference.

Rule Changes Affecting the Balance Sheet

Currently, operating leases need only be discussed in footnotes to the balance sheet for financial reporting purposes. For firms using large amounts of leased assets, this often does not give analysts a clear picture of the firm’s total obligations. Under present reporting requirements it is important to value a firm’s operating leases and show their impact on the firm’s balance sheet in calculating a firm’s borrowing capacity as measured by debt to equity or total capital ratios. Once the operating leases are converted to debt, lease expense must be added to EBIT. Why? Because it is a financial expense and EBIT represents operating income before such expenses. An estimate of depreciation expense associated with the leased asset must be deducted from EBIT as is depreciation expense associated with other fixed assets owned by the firm. The resulting “adjusted” EBIT is then used to calculate free cash flow to the firm. For more detail on operating leases and valuation, see Chapter 7.

Beginning in 2019, operating leases must be shown on firm’s balance sheet. While the change does not create new corporate obligations, some firms will look more leveraged than they do currently when evaluated in terms of debt to equity ratios. For purposes of financial analysis, these ratios are generally looked at in terms of the market value of debt and the market value of equity. Consequently, the value of a firm relying heavily on operating leases may show a large increase in the value of its debt relative to equity. The value of equity should be relatively unaffected because the addition of operating leases on the balance sheet has no impact on the firm’s cash flow generation capability and in turn the market value of its equity.

International Accounting Standards

The objective of the International Accounting Standards Board (IASB) is the convergence of accounting standards worldwide and the establishment of global standards, sometimes referred to as “global GAAP.” The IASB issues International Financial Reporting Standards (IFRS), and, since 2005, firms in the European Union have had to conform to IFRS directives. Concerns in the United States about moving to international standards from GAAP include higher taxes (if the conversion results in increases in reported earnings), increased implementation costs, and litigation. In a report issued in mid-2012, the US Securities and Exchange Commission indicated that if the United States ultimately decides to shift to international rules, it will use a hybrid structure incorporating certain IFRS rules into the US system of accounting standards.⁴³ The IASB is currently considering their own guidelines for the treatment of operating leases.

Discussion Questions

1. 1. Speculate as to how J&J’s overseas cash hoard may have influenced the purchase price paid for Actelion.
2. 2. How did the deal structure involving a spin-off of the Actelion’s R&D organization make the takeover of Actelion possible?
3. 3. What is the form of payment in this deal? Why might this form have been selected? What are the advantages and disadvantages of the form of payment used in this deal?
4. 4. What is the form of acquisition used in this deal? Why might this form have been chosen? What are the advantages and disadvantages of the form of acquisition?
5. 5. Assume it is determined by auditors during the next several years that J&J overpaid significantly for Actelion. What is the most likely reason this determination could happen? How could this impact the firm’s reported earnings per share and in turn its share price? Be specific.
6. 6. Did the sale of Actelion require a vote by the firm’s shareholders? Explain your answer.
7. 7. What are the acquisition vehicle and postclosing organization in this transaction?

Solutions to these questions are provided in the Online Instructor’s Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).