Chapter 12
Structuring the Deal
Tax and Accounting Considerations
In matters of style, swim with the current. In matters of principle, stand like a rock.
—Thomas Jefferson
Inside M&A: continued consolidation in the generic pharmaceuticals industry
Teva Pharmaceutical Industries, a manufacturer and distributor of generic drugs, completed its takeover of Ivax Corp for $7.4 billion in early 2006 to become the world's largest manufacturer of generic drugs. For Teva, based in Israel, and Ivax, headquartered in Miami, the merger eliminated a large competitor and created a distribution chain that spans 50 countries.
To broaden the appeal of the proposed merger, Teva offered Ivax shareholders the option to receive for each of their shares either 0.8471 of American depository receipts (ADRs) representing Teva shares or $26 in cash. ADRs represent the receipt given to U.S. investors for the shares of a foreign-based corporation held in the vault of a U.S. bank. Ivax shareholders wanting immediate liquidity chose to exchange their shares for cash, while those wanting to participate in future appreciation of Teva stock exchanged their shares for Teva shares.
Following the merger, each previously outstanding share of Ivax common stock was canceled. Each canceled share represented the right to receive either of these two previously mentioned payment options. The merger agreement also provided for the acquisition of Ivax by Teva through a merger of Merger Sub, a newly formed and wholly-owned subsidiary of Teva, into Ivax. As the surviving corporation, Ivax would be a wholly-owned subsidiary of Teva. The merger involving the exchange of Teva ADRs for Ivax shares was considered as tax-free under U.S. law.
Chapter overview
While Chapter 11 discussed in detail the first five components of the process, this chapter focuses on the implications of tax and accounting considerations for the deal structuring process. Taxes are an important consideration in almost any transaction, but they seldom are the primary motivation for an acquisition. The fundamental economics of the transaction should always be the deciding factor, and any tax benefits simply reinforce a purchase decision.
Furthermore, recent changes in accounting standards requiring more immediate recognition of changes in the value of acquired assets could have the effect of making acquirers more disciplined in what they are willing to pay for other firms. By substantially overpaying for acquisitions, acquirers condemn themselves to having to improve profitability dramatically to earn the financial returns required by investors. If they have significantly overestimated potential synergy, they will be unable to realize these returns.
A review of this chapter (including practice questions and answers) is available in the file folder entitled “Student Study Guide” on the companion site to this book (www.elsevierdirect.com/companions/9780123854858). The companion site also contains a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.1
General tax considerations and issues
The requirement to pay taxes creates a daunting array of choices for the parties to the transaction. Table 12.1 summarizes the most commonly used taxable and tax-free structures, including both statutory mergers (two-party transactions) and triangular mergers (three-party transactions). The implications of these alternative structures are explored in detail in the following sections.
Table 12.1. Alternative Taxable and Nontaxable Structures
| Taxable Transactions: Immediately Taxable to Target Shareholders | Nontaxable Transactions: Tax Deferred to Target Shareholders |
Taxable transactions
A transaction generally will be considered taxable to the target firm's shareholders if it involves the purchase of the target's stock or assets for substantially all cash, notes, or some other nonequity consideration. Using the term cash or boot to represent all forms of payment other than equity, taxable transactions may take the form of a cash purchase of target assets, a cash purchase of target stock, or a statutory cash merger or consolidation, which commonly includes direct cash mergers and triangular forward and reverse cash mergers.
Taxable Mergers
In a direct cash merger, the acquirer and target boards reach a negotiated settlement, and both firms receive approval from their respective shareholders. The target is then merged into the acquirer or the acquirer into the target, with only one surviving. In a consolidation, the acquirer and the target are merged into a third legal entity, with that entity surviving. Assets and liabilities on and off the balance sheet automatically transfer to the surviving firm in a direct statutory merger or consolidation.
In an effort to protect themselves from target liabilities, acquirers often employ so-called triangular mergers. In a triangular cash merger, the target firm may be merged into an acquirer's operating or shell acquisition subsidiary, with the subsidiary surviving (called a forward triangular cash merger), or the acquirer's subsidiary is merged into the target firm, with the target surviving (called a reverse triangular cash merger). Direct cash mergers and forward triangular mergers (Figure 12.1) are treated as a taxable purchase of assets with cash and reverse triangular mergers (Figure 12.2) as a taxable purchase of stock with cash. The tax consequences of these transactions are discussed in the following sections.
Figure 12.1 A forward triangular cash merger.
Figure 12.2 A reverse triangular cash merger.
Taxable Purchase of Target Assets with Cash
If a transaction involves a cash purchase of target assets, which may involve none, some, or all of the target's liabilities, the target company's tax cost or basis in the acquired assets is increased or “stepped up” to its fair market value (FMV), which is equal to the purchase price (including any assumed liabilities) paid by the acquirer. The additional depreciation in future years reduces the present value of the tax liability of the combined companies. The target firm realizes an immediate gain or loss on assets sold equal to the difference between the FMV of the asset and the asset's adjusted tax basis (i.e., book value less accumulated depreciation).
The IRS views transactions resulting in the liquidation of the target firm as actual sales rather than reorganizations in which the target shareholders have an ongoing interest in the combined firms. Consequently, the target's tax attributes, such as net operating loss carryforwards and carrybacks, capital loss carryovers, and excess credit carryovers, may not be used by the acquirer following closing because they cease to exist along with the target. However, they may be used to offset any gain realized by the target resulting from the sale of its assets.
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 either as a dividend or 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. To compensate the target company shareholders for any tax liability they may incur, the buyer usually will have to increase the purchase price.2
There is little empirical evidence that the tax shelter resulting from the ability of the acquiring firm to increase the value of acquired assets to their FMV is a highly important motivating factor for a takeover.3 However, 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.4
Taxable Purchase of Target Stock with Cash
Taxable transactions often involve the purchase of the target's voting stock, with the acquirer initiating a tender offer for the target's outstanding shares, because the purchase of assets automatically triggers a tax on any gain on the sale and another tax on any payment of the after-tax proceeds to shareholders. In contrast, taxable stock purchases avoid double taxation because the transaction takes place between the acquirer and the target firm's shareholders. Target shareholders may realize a gain or loss on the sale of their stock.
The target firm does not revalue its assets and liabilities for tax purposes to reflect the amount that the acquirer paid for the shares of common stock. Rather, the values of the target's assets and liabilities before the acquisition (i.e., tax basis) are consolidated with the acquirer's financial statements following the acquisition; that is, the historical tax basis of the assets continues, and no step-up or increase in the basis of the assets occurs. The buyer loses the additional tax savings that would result from acquiring assets and writing them up to fair market value. Consequently, the buyer may want to reduce what it is willing to pay to the seller. Furthermore, since from the IRS' viewpoint the target firm continues to exist, the target's tax attributes carry over to the acquirer following the transaction, but their use may be limited by Sections 382 and 383 of the Internal Revenue Service Code (see the section of this chapter entitled “Treatment of Target Tax Attributes in M&A Deals” for more details). Table 12.2 summarizes the key characteristics of the various forms of taxable transactions.
Table 12.2. Key Characteristics of Alternative Taxable (to Target Shareholders) Transaction Structures
a An acquirer may treat a stock purchase as an asset purchase if it and the target agree to invoke a Section 338 election. Such an election would allow a step-up in net acquired assets and result in the loss of the target's tax attributes.
b Contracts, leases, licenses, and rights to intellectual property automatically transfer unless contracts stipulate consent to assignment required.
c The target may choose to liquidate if the sale of assets is substantial and to distribute the proceeds to its shareholders or to continue as a shell.
d May be required by public stock exchanges or by legal counsel if deemed material to the acquiring firm or if the parent needs to authorize new stock. In practice, most big mergers require shareholder approval.
e Target shareholders must accept terms due to merger, although in some states dissident shareholders have appraisal rights for their shares.
Section 338 Election
Section 338 elections are made in connection with a taxable stock sale and apply to C corporations. The acquirer and target firms can jointly elect Section 338 of the Internal Revenue Code and thereby record assets and liabilities at their fair market value 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 if it were an acquisition of assets for tax purposes. The target's tax basis in the net acquired assets are increased to their fair market value and carryover to the buyer when the transaction is completed (i.e., the tax basis to the buyer is the same as for the target). Benefits to the acquirer include the avoidance of having to transfer assets and obtain consents to assignment of all contracts (as would be required in a direct purchase of assets), while still benefiting from the write-up of assets. Asset transfer, sales, and use taxes may also be avoided. Since the tax basis in the target's net acquired assets is increased to reflect the purchase price paid, the acquiring firm must pay the taxes on any gain on the sale.5 Of course, for legal purposes, the sale of the target stock under a 338 election as an asset sale still is treated as a purchase of stock by the buyer. Consequently, the buyer remains responsible for the target's known and unknown liabilities
Section 338 elections are relatively rare because the additional 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. Generally, a 338 election is most advantageous 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. As explained in more detail in the section discussing the tax treatment of target firm tax attributes, these NOLs, capital loss, and tax credit carryforwards are only available for use in reducing the immediate tax liability and do not survive the acquisition if the target firm is liquidated.
In buying Bresnan Communications, Cablevision Systems used the combination of a share repurchase of its stock and tax benefits associated with the acquisition to gain support from its shareholders for the acquisition (see Case Study 12.1).
Case Study 12.1
Cablevision Uses Tax Benefits to Help Justify the Price Paid for Bresnan Communications
During mid-2010, Cablevision Systems announced that it had reached an agreement to buy privately owned Bresnan Communications for $1.37 billion in a cash for stock deal. CVS's motivation for the deal reflected the board's belief that the firm's shares were undervalued and their desire to expand coverage into the western United States.
CVS is the most profitable cable operator in the industry in terms of operating profit margins, due primarily to the firm's heavily concentrated customer base in the New York City area. Critics immediately expressed concern that the acquisition would provide few immediate cost savings and relied almost totally on increasing the amount of revenue generated by Bresnan's existing customers.
CVS saw an opportunity to gain market share from satellite TV operators providing services in BC's primary geographic market. Bresnan, the nation's 13th largest cable operator, serves Colorado, Montana, Wyoming, and Utah. CVS believes it can sell bundles of services, including Internet and phone services, to current Bresnan customers. Bresnan's primary competition comes from DirecTV and DISH Network, which cannot offer phone and Internet access services.
To gain shareholder support, Cablevision Systems announced a $500 million share repurchase to placate shareholders seeking a return of cash. The deal was financed by a $1 billion nonrecourse loan and $370 million in cash from Cablevision. CVS points out that the firm's direct investment in BC will be more than offset by tax benefits resulting from the structure of the deal in which both Cablevision and Bresnan agreed to treat the purchase of Bresnan's stock as an asset purchase for tax reporting purposes (i.e., a 338 election). Consequently, CVS will be able to write up the net acquired Bresnan assets to their fair market value and use the resulting additional depreciation to generate significant future tax savings. Such future tax savings are estimated by CVS to have a net present value of approximately $400 million
Discussion Questions:
1. How is the 338 election likely to impact Cablevision System's earnings per share immediately following closing? Why?
2. As an analyst, how would you determine the impact of the anticipated tax benefits on the value of the firm?
3. What is the primary risk to realizing the full value of the anticipated tax benefits?
Tax-free transactions
As a general rule, a transaction is tax-free if the form of payment is primarily the acquirer's stock. Transactions may be partially taxable if the target shareholders receive some nonequity consideration, such as cash or debt, in addition to the acquirer's stock. This nonequity consideration, or boot, generally is taxable as ordinary income.
Acquirers and targets planning to enter into a tax-free transaction will frequently seek to get an advance ruling from the IRS to determine its tax-free status, which is formal and binding. However, the certainty of the formal letter may diminish if any of the key assumptions underlying the transaction change prior to closing. Moreover, the process of requesting and receiving a letter may take five or six months. Alternatively, acquirers may rely on the opinion of legal counsel.
If the transaction is tax-free, the acquiring company is able to transfer or carry over the target's tax basis to its own financial statements. There is no increase or step-up in assets to fair market value. A tax-free reorganization envisions the acquisition of all or substantially all of a target company's assets or shares, making tax-free structures unsuitable for the acquisition of a division within a corporation.
Qualifying a Transaction for Tax-Free Treatment
According to the Internal Revenue Code Section 368, for a transaction to qualify as tax-free, it must provide for continuity of ownership interest, continuity of business enterprise, a valid business purpose, and satisfy the step-transaction doctrine. Tax-free transactions require substantial continuing involvement of the target company's shareholders. To demonstrate continuity of ownership interests, target shareholders must continue to own a substantial part of the value of the combined target and acquiring firms. To demonstrate continuity of business enterprise, the acquiring corporation must either continue the acquired firm's “historic business enterprise” or use a significant portion of the target's “historic business assets” in a business.6 This continued involvement is intended to demonstrate a long-term commitment on the part of the acquiring company to the target. To meet the continuity of business enterprise requirement, an acquirer must buy “substantially all” of the assets of the target firm. Furthermore, the transaction must demonstrate a valid business purpose, such as maximizing the profits of the acquiring corporation, rather than only be for tax avoidance. Finally, under the step-transaction doctrine, the deal cannot be part of a larger plan that would have constituted a taxable transaction.
Nontaxable or tax-free transactions usually involve mergers, with the acquirer's stock exchanged for the target's stock or assets. Nontaxable transactions also are called tax-free reorganizations. The continuity of ownership interests and business enterprise requirements serve to prevent transactions that more closely resemble a sale from qualifying as a tax-free reorganization.7
Alternative Tax-Free Reorganizations
Section 368 of the Internal Revenue Code covers eight principal forms of tax-free reorganizations. Of these, the most common include type “A” Reorganizations (statutory merger or consolidation, forward triangular mergers, and reverse triangular mergers), type “B” reorganizations (stock-for-stock acquisitions), and type “C” reorganizations (stock-for-assets acquisitions). Type “D” reorganizations may be applied to acquisitions or restructuring. An acquisitive type D reorganization requires that the acquiring firm receive at least 80% of the stock in the target firm in exchange for the acquirer's voting stock. Divisive type D reorganizations are used in spin-offs, split-offs, and split-ups, which are discussed in detail in Chapter 15.
Nontaxable “A” reorganizations involve one corporation acquiring the assets of another in exchange for acquirer stock, cash, and other consideration. A type “B” reorganizations involve one corporation acquiring the stock of another in exchange solely for acquirer voting stock. C reorganizations involve one corporation acquiring “substantially all” of the assets of another in exchange for acquirer voting stock. Finally, divisive “D” reorganizations involve a corporation transferring all or some of its assets to a subsidiary it controls in exchange for subsidiary stock or securities. The remaining tax-free reorganizations contained in Section 368 are less common and are not discussed in this book.
A type A statutory merger or consolidation does not limit the type of consideration involved in the transaction: Target company shareholders may receive cash, voting or nonvoting common or preferred stock, notes, or real property. Nor must target shareholders all be treated equally: Some may receive all stock, others all cash, and others a combination of the two. The acquirer may choose not to purchase all of the target's assets; the deal could be structured so as to permit the target to exclude certain assets from the transaction. Unlike a direct statutory merger in which all known and unknown target assets and liabilities transfer to the buyer by law, a subsidiary merger often results in the buyer acquiring only a majority interest in the target and then carrying the target as a subsidiary of the parent. The target may later be merged into the parent in a back-end merger (discussed in Chapter 11). To ensure that the target does not resemble an actual sale (thereby making the transaction taxable), at least 50% of the purchase price must be acquiring company stock to satisfy the IRS continuity of ownership interests requirement, although in some instances the figure may be as low as 40%.
Type A reorganizations are used widely because of their great flexibility. Because there is no requirement to utilize voting stock, acquiring firms enjoy more options. By issuing nonvoting stock, the acquiring corporation may acquire control of the target without diluting control of the combined or newly created company. Additional flexibility results from the buyer being able to acquire less than 100% of the target's net assets. Finally, there is no maximum amount of cash that may be used in the purchase price, and the limitations articulated by both the IRS and the courts allow significantly more cash than type B and C reorganizations. In fact, this flexibility with respect to cash may be the most important consideration because it enables the acquirer to better satisfy the disparate requirements of the target's shareholders. Some will want cash, and some will want stock.
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 (Figure 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 in a statutory merger. 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), unless the acquiring subsidiary is considered a “disregarded unit.”8
Figure 12.3 A forward triangular stock merger.
Asset sales by the target firm just prior to the transaction may threaten the tax-free status of the deal if it is viewed as a violation of the step doctrine. Moreover, tax-free deals such as spin-offs are disallowed within two years before or after the merger.9 At least 50% of the purchase price must consist of acquirer stock, with the remainder consisting of boot tailored to meet the needs of the target's shareholders. The parent indirectly owns all of the target's assets and liabilities because it owns the subsidiary's entire voting stock.
The advantages of the forward triangular merger may include the avoidance of approval by the parent firm's shareholders. However, public exchanges on which the parent firm's stock trades still may require parent shareholder approval if the amount of the parent stock used to acquire the target exceeds some predetermined percentage of parent 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 recording fees and transfer taxes, because the target's assets go directly to the parent's wholly-owned subsidiary.
With a type A reverse triangular stock merger, the acquirer forms a new shell subsidiary, which is merged into the target in a statutory merger (Figure 12.4). The target is the surviving entity and must hold “substantially all” of the assets and liabilities of both the target and shell subsidiary.10 The target firm's shares are canceled, and the target shareholders receive the acquirer's or parent's shares. The parent corporation, which owned all of the subsidiary stock, now owns all of the new target stock and, indirectly, all of the target's assets and liabilities. Moreover, at least 80% of the total consideration paid to the target must be in the form of the acquirer's voting stock. This stock may be common or preferred equity. The reverse triangular merger is functionally equivalent to a type B reorganization.
Figure 12.4 A reverse triangular stock merger.
The reverse merger may eliminate the need for parent company shareholder approval. Because the target firm remains in existence, the target can retain any nonassignable franchise, lease, or other valuable contract rights. This often is considered the most important advantage of the reverse triangular merger. Also, the target's liabilities are isolated in a subsidiary of the acquirer. By avoiding the dissolution of the target firm, the acquirer avoids the possible acceleration of loans outstanding. Insurance, banking, and public utility regulators may require the target to remain in existence to be granted regulatory approval.
In a type B stock-for-stock reorganization, the acquirer must use its voting common stock to purchase at least 80% of all of the target's outstanding voting and nonvoting stock-outs. Any cash or debt will disqualify the transaction as a type B reorganization. However, cash may be used to purchase fractional shares. Type B reorganizations are used as an alternative to a merger or consolidation. The target's stock does not have to be purchased all at once and allows for a “creeping merger” because the target's stock may be purchased over 12 months or less as part of a formal acquisition plan. Type B reorganizations may be appropriate if the acquiring company wishes to conserve cash or its borrowing capacity. Since shares are being acquired directly from shareholders, there is no need for a target shareholder vote. Finally, contracts, licenses, and so forth, transfer with the stock, thereby obviating the need to receive consent to assignment, unless specified in the contract.
The type C stock-for-assets reorganization is used when it is essential for the acquirer not to assume any undisclosed liabilities. It requires that at least 70% and 90% of the FMV of the target's gross and net assets, respectively, be acquired solely in exchange for acquirer voting stock. Consideration paid in cash or nonequity securities cannot exceed 20% of the fair market value of the target's assets. Any liabilities assumed by the acquirer must be deducted from the 20%, thereby reducing the amount of boot that can be used. Since assumed liabilities frequently exceed 20% of the FMV of the acquired assets, the form of payment, as a practical matter, generally is 100% stock. As part of the reorganization plan, the target subsequent to closing dissolves and distributes the acquirer's stock to the target's shareholders for the now-canceled target stock.
The requirement to use only voting stock is a major deterrent to the use of type C reorganization. While a purchase of assets will allow the acquirer to step up the basis of the acquired assets, asset purchases will result potentially in taxable gains. If the target is liquidated to enable the firm to pay the sale proceeds to its shareholders, target shareholders will then have to pay taxes on these payouts. Table 12.3 summarizes the key characteristics of alternative tax-free deal structures.
Table 12.3. Key Characteristics of Alternative Tax-Free (to Target Shareholders) Transaction Structuresa
a Target shareholders are taxed at ordinary rates on any “boot” received (i.e., anything other than acquiring company stock).
b Asset sales or spin-offs two years prior (may reflect effort to reduce size of purchase) or subsequent to (violates continuity requirement) closing may invalidate tax-free status. Forward triangular mergers do not require any limitations on purchase of target net assets if a so-called “disregarded unit” such as an LLC is used as the acquiring entity and the target is a C corporation that ceases to exist as a result of the transaction.
c Contracts, leases, licenses, and rights to intellectual property automatically transfer with the stock unless contracts stipulate consent to assignment required. Moreover, target retains any nonassignable franchise, lease, or other contract rights as long as the target is the surviving entity as in a reverse triangular merger.
d Acquirer may be insulated from a target's liabilities as long as it is held in a subsidiary, except for liabilities such as unpaid taxes, unfunded pension obligations, and environmental liabilities.
e The parent is responsible for those liabilities conveying with the assets, such as warranty claims.
f May be required by public stock exchanges or by legal counsel if deemed material to the acquiring firm or if the parent needs to authorize new stock.
g Mergers are generally ill-suited for hostile transactions because they require approval of both the target's board and its shareholders.
h While cash may be used to pay for up to 20% of the FMV of net assets, it must be offset by assumed liabilities, making the purchase price usually 100% stock.
Expanding the Role of Mergers in Tax-Free Reorganizations
In late 2006, the IRS finalized regulations11 defining the term statutory merger or consolidation for purposes of using tax-free reorganizations. Under these regulations, only the continuity of interests and continuity of business enterprise tests, and not the more restrictive “substantially all” requirement, must be satisfied. It is now possible for a merger of a corporation into a single-member (i.e., parent) limited liability company established by the parent corporation in a triangular merger to qualify as a two-party type A merger, with no limit on the amount of target net assets the buyer may acquire.12
For years, the IRS had contended that a foreign corporation could not participate in a type A tax-free reorganization because the term statutory merger referred only to a merger completed under the laws of the United States, an individual state, or the District of Columbia. The new regulations make its easier to qualify foreign acquisitions as type A tax-free reorganizations.13 Therefore, if a U.S. firm buys a foreign firm having U.S. shareholders, the transaction can be structured so that the purchase is free of U.S. taxes to the U.S. shareholders.
Treatment of Target Tax Attributes in M&A Deals
Tax attributes, such as net operating loss carryforwards and carrybacks, 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 taxable transactions, the acquirer may benefit from additional depreciation expense generated by increasing the value of net acquired assets to FMV, but not benefit from the target's other tax attributes. In nontaxable transactions, acquirers may benefit from the target's tax attributes other than those resulting from increasing the value of net acquired assets to FMV. Consequently, the target's tax attributes generally will not survive the deal if the acquirer has already stepped up net acquired assets to their fair market value. From the IRS' viewpoint, this prevents the acquirer from realizing “excessive” tax benefits from the transaction—that is, the future tax savings from writing up the net acquired assets plus savings from NOLs, and so on.
In contrast, the target's tax attributes do carry over to the acquirer in tax-free reorganizations, since the tax basis of the net acquired assets is transferred to the acquirer without having been revalued to their fair market value. The tax authorities view a tax-free transaction as a reorganization in which target shareholders retain a significant ownership position in the combined firms rather than as an actual sale of the target firm. In summary, the target's tax attributes survive in nontaxable transactions and taxable purchases of stock (except for stock acquisitions with a 338 election) but not in taxable purchases of assets.
When tax attributes do survive and carry over to the acquirer, their use is limited by Sections 382 (net operating losses) and 383 (tax credit and capital loss carryforwards). When tax attributes do not survive, they may still be used to offset any immediate gain on the sale of target assets.
Tax-Free Transactions Arising from 1031 “Like-Kind” Exchanges
The prospect of being able to defer taxable gains indefinitely is often associated with 1031 exchanges of real estate property. The potential benefits are significant, with capital gains taxes (as of this writing) of 15% at the federal level and between 10% and 15% at the state level. Furthermore, depreciation recapture taxes (i.e., taxes applied to the difference between accelerated and straight-line depreciation) also may be postponed, with applicable federal income tax rates as high as 35% and some state income tax rates approaching 10%.
By postponing the tax payments, investors have more money to reinvest in new properties. For example, assume a property was purchased ten years ago for $5 million and it is now worth $15 million. If the property were sold with no subsequent purchase of a substantially similar property within the required period, the federal capital gains tax bill would be $1.5 million (i.e., ($15 – $5) × 0.15). This ignores the potential for state taxes or depreciation recapture taxes that could be 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. With tax rates likely to rise in the next few years, the value of tax-free exchanges will increase.
News Corp. employed a tax-free 1031 exchange in reaching an agreement in early 2007 to buy Liberty Media's 19%—or $11 billion—stake in the media giant in exchange for News Corp.'s 38.6% stake in satellite TV firm DirecTV Group, $550 million in cash, and three sports TV channels. While the two investments were approximately equal in value, Liberty's management believed that DirecTV's stock was inflated by speculation about the impending deal. The cash and media assets were added to ensure that Liberty Media was exchanging its stake in News Corp. for “like-kind” assets of an equivalent or higher value to qualify as a tax-free exchange. By structuring the deal in this manner, the transaction was viewed as an asset swap rather than a sale of assets, and Liberty Media stood to save billions of dollars in taxes that would have been owed due to its low basis in its investment in News Corp. Had the assets been divested, the two companies would have had to pay an estimated $4.5 billion in taxes due to likely gains on the sale of these assets.14
Other tax considerations affecting corporate restructuring
Many parts of the tax code affect corporate restructuring activities. These include treatment of net operating losses, corporate capital gains taxes, the alternative corporate minimum tax, the treatment of greenmail for tax purposes, and Morris Trust transactions. These are discussed next.
Net Operating Losses
Net operating losses (NOLs) are created when firms generate negative taxable income or losses. NOLs can be carried back 2 years to recover past tax payments and forward 20 years to reduce future taxable income. Losses remaining after 20 years are no longer usable. When the 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 or step-up for tax reporting purposes, the target's NOLs may be used by the acquirer in future years subject to the limitation specified in Section 382 of the IRC code.15 An increase in the ownership of certain shareholders in a corporation by more than 50 percentage points over a three-year period would generally trigger the limitation.
Despite annual limits to carryforwards and carrybacks, NOLs may represent a potentially significant source of value to acquirers that should be considered during the process of valuing an acquisition target. For instance, Lucent Technologies had accumulated numerous losses after the Internet bubble burst in 2000. By acquiring Lucent in 2006, Alcatel obtained $3.5 billion in NOLs that could be used to shelter future income for many years.16 The use of NOLs must be monitored carefully to realize the full value that could potentially result from deferring income taxes. Because the acquirer can never be certain that future income will be sufficient to realize fully the value of the NOLs before they expire, loss carryforwards alone rarely justify an acquisition.17 Table 12.4 illustrates how an analyst might value NOLs on the books of a target corporation. Acquiring Company is contemplating buying Target Company, which has a tax loss carryforward of $8 million. Acquiring Company has a 40% tax rate. Assume the tax-loss carryforward is within the limits of the Tax Reform Act of 1986 and that the firm's cost of capital is 15%.
Table 12.4. Valuing Net Operating Losses
a Tax benefits are equal to earnings before tax times the 40% marginal tax rate of the Acquiring Company. Therefore, the tax benefit in year 1 is $1,800,000 × 0.4 = $720,000.
b The net tax benefit in the fifth year is equal to the $800,000 tax benefit less the $400,000 in tax payments required in the fifth year.
Corporate Capital Gains Taxes
Since both short- and long-term corporate capital gains are taxed as ordinary income and are subject to a maximum federal corporate tax rate of 34%, acquirers often adopt alternative legal structures with more favorable tax attributes for making acquisitions. These include master limited partnerships, Subchapter S corporations, and limited liability companies, in which participants are taxed at their personal tax rates for the profits distributed to them directly.
Alternative Corporate Minimum Tax
Under certain circumstances in which corporate taxes have been significantly reduced, corporations may be subject to an alternative minimum tax with a flat rate of 20%. The introduction of the alternative minimum tax has proven to reduce significantly returns to investors in leveraged buyouts, which—by intent—are highly leveraged and have little (if any) taxable income because of their high annual interest expense.
Greenmail Payments
Greenmail refers to payments made to “corporate raiders” to buy back positions they had taken in target companies (see Chapter 3 for more details). Greenmail has been made more expensive by changes in the tax code that sharply reduced the amount of such payments that can be deducted from before-tax profits.
Morris Trust Transactions
Tax code rules for Morris Trust transactions restrict how certain types of corporate deals can be structured to avoid taxes.18 Assume that Firm A sells an operating unit to Firm B and makes a profit on the transaction on which it would owe taxes. To avoid paying those taxes, Firm A spins off the operating unit as a dividend to its shareholders. The operating unit, still owned by Firm A's shareholders, is subsequently merged with Firm B, and shareholders in Firm A thus become shareholders in Firm B. By spinning off the operating unit, Firm A avoids paying corporate taxes on taxable gains, and Firm A's shareholders defer paying personal taxes on any gains until they sell their stock in Firm B.
To make such transactions less attractive, the tax code was amended in 1997 to require that taxes be paid unless no cash changes hands and Firm A's shareholders end up as majority owners in Firm B. The practical effect of this requirement is that merger partners such as Firm B in these types of transactions must be significantly smaller than Firm A, which reduces significantly the number of potential deal candidates.
The change in the law has had a material impact on the way M&A business is conducted. For example, in 2005, Alltel announced it was getting rid of its local telephone business. Although Alltel had been in talks with phone companies, their size made the prospects of a tax-free transaction more complicated. In the end, Alltel sold the business to a far smaller firm, Valor Communications Group Inc., to meet the tax code requirements.
Financial reporting of business combinations
Since 2001, a company maintaining its financial statements under International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP) needs to account for its business combinations using the purchase method (also called the acquisition method).19 According to the purchase 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 refer to acquired assets less assumed liabilities. Any excess of the purchase price over the fair value 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.
Revised accounting rules (SFAS 141R) have changed the standards covering business combinations to require the acquiring entity to recognize, separately from goodwill, identifiable assets and assumed liabilities at their acquisition date (closing date) fair values and to account for future changes in fair value. The intent was to achieve greater conformity with international accounting standards as applied to business combinations. SFAS 141R applies to transactions with acquisition dates on or after December 15, 2008.
Another recent accounting standard change (SFAS 157) introduces a new definition of fair value, which could have a significant impact on the way mergers and acquisition are done. Previously, the definition of “fair value” was ambiguous, and it often was used inconsistently. The effective date for SFAS 157 for financial assets and liabilities on financial statements was November 15, 2007, and for nonfinancial assets and liabilities November 15, 2008.
SFAS 141R: The Revised Standards
The revised standards in SFAS 141R 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/closing date. Previous guidance had resulted in failure to recognize items on the date of the acquisition, such as acquisition-related expenses. The acquisition date generally corresponds to the closing date rather than the announcement or signing date, as was true under earlier guidelines.
Recognizing Acquired Net Assets and Goodwill at Fair Value
To increase the ability to compare different transactions, SFAS 141R requires recognizing 100% of the assets acquired and liabilities assumed, even if less than 100% of the target's ownership interests are acquired by the buyer. In other words, this results in the recognition of the target's business in its entirety regardless of whether 51%, 100%, or any amount in between of the target is acquired. Consequently, 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 it as well as to the noncontrolling interest. 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 buys 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. Previously, noncontrolling interests were recorded as a liability on the consolidated balance sheet, reflecting their claim on the consolidated firm's assets.
Similarly, 100% of Firm B's earnings are included in Firm A's income statement and added to the retained earnings of the consolidated firms. Firm B will be operated within Firm A as a majority-owned subsidiary with Firm A's investment in Firm B shown at cost, according to the equity method of accounting. The value of this investment will increase with Firm B's net income and decrease with dividends paid to Firm A.
Recognizing and Measuring Net Acquired Assets in Step or Stage Transactions
The revised standards require an acquirer in a business combination undertaken in stages (i.e., a step or stage transaction) 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 fair market value. The acquirer is obligated to disclose gains or losses that arise 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. Under the new standards, the acquirer must report an asset or liability arising from a contingency to be recognized at its acquisition date fair value absent new information about the possible outcome. However, as new information becomes available, the acquirer must revalue the asset or liability to its current fair value reflecting the new information and record the impact of changes in the fair values of these assets or liabilities on earnings. This is likely to encourage more rigorously defined limits on liability in acquisitions, with indemnification clauses that cover specific issues rather than general indemnification clauses.
Contingent consideration or payments are an important component of many transactions and include the transfer of additional equity or cash to the previous owners of the target firm (e.g., earn-outs). Payment of contingent consideration depends on the acquired business achieving certain prespecified performance benchmarks over some period. SFAS 141R treats contingent consideration as part of the total consideration paid (i.e., purchase price) for the acquired business, which is measured at the acquisition date fair value. The revised standard also requires the reporting entity to reestimate the fair value of the contingent consideration at each reporting date until the amount of the payout (if any) is determined, with changes in fair value during the period reported as a gain or loss on the income statement. The potential for increased earnings volatility due to changes in the value of contingent liabilities may reduce the attractiveness of earnouts as a form of consideration.
In-Process Research and Development Assets
Under the new standards, the 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 with an indefinite life until the project's outcome is known. If the specific project is deemed a success, the firm will begin to amortize the asset over the estimated useful life of the technology; if the research project is abandoned, the R&D asset will be considered impaired and expensed.
Expensing Deal Costs
Under the new standard, 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. As such, 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.
SFAS 157: The New Fair Value Framework
The purpose of SFAS 157 is to establish a single definition of fair value and a consistent framework for measuring fair value under GAAP to increase comparability in fair value estimates. The new definition of “fair value” under SFAS 157 is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (i.e., not a forced liquidation or distress sale) between market participants on the date the asset or liability is to be estimated.20
Impact of purchase accounting on financial statements
A long-term asset is impaired if its fair value falls below its book or carrying value. Impairment could occur due to loss of customers, loss of contracts, loss of key personnel, obsolescence of technology, litigation, patent expiration, failure to achieve anticipated cost savings, overall market slowdown, and so on. In a case of asset impairment, the firm is required to report a loss equal to the difference between the asset's fair value and its carrying value. The write-down of assets associated with an acquisition constitutes a public admission by the firm's management of having overpaid for the acquired assets.
In an effort to minimize goodwill, auditors often require that factors underlying goodwill be tied to specific intangible assets for which fair value can be estimated, such as customer lists and brand names. These intangible assets must be capitalized and shown on the balance sheet. Consequently, if the anticipated cash flows associated with an intangible asset, such as a customer list, have not materialized, the carrying value of the customer list must be written down to reflect its current value.
Balance Sheet Considerations
For financial reporting purposes, the purchase price (PP) paid (including the fair value of any noncontrolling interest in the target at the acquisition date) for the target company consists of the fair market value of total identifiable acquired tangible and intangible assets (FMVTA) less total assumed liabilities (FMVTL) plus goodwill (FMVGW). The difference between FMVTA and FMVTL is called net asset value.
These relationships can be summarized as follows:
(12.1)
(12.2)
From Eq. (12.2), it should be noted that as net asset value increases, FMVGW decreases. Also note that the calculation of goodwill can result either in a 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 under SFAS 141R as a “bargain purchase.”21
Table 12.5 provides a simple example of how the purchase method of accounting can be applied in business combinations. Assume Acquirer buys 100% of Target's equity for $1 billion in cash on December 31, 2011. Columns 1 and 2 present the preacquisition book values of the two firms' balance sheets. Column 3 reflects the restatement of the book value of the Target's balance sheet in column 2 to fair market value. As the sum of columns 1 and 3, column 4 presents the Acquirer's balance sheet, which includes the Acquirer's book value of the preacquisition balance sheet plus the fair market value of the Target's balance sheet.
Table 12.5. Example of Purchase Method of Accounting
* In millions of dollars
a The fair market value of the target's equity is equal to the purchase price. Note that the value of the target's retained earnings is implicitly included in the purchase price paid for the target's equity.
b The difference of $100 million between the fair market value of the target's equity plus liabilities less total assets represents the unallocated portion of the purchase price.
c Goodwill = Purchase Price – Fair Market Value of Net Acquired Assets = $1,000 – ($2,600 – $1,000 – $700)
Furthermore, as shown 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 preacquisition and postacquisition equity is equal to the $1 billion purchase price.
Exhibit 12.1 illustrates the calculation of goodwill in a transaction in which the acquirer purchases less than 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.
Exhibit 12.1 Estimating Goodwill
On January 1, 2009, the closing date, Acquirer Inc. purchased 80% of Target Inc.'s 1 million shares outstanding at $50 per share for a total value of $40 million (i.e., 0.8 × 1,000,000 shares outstanding × $50/share). On that date, the fair value of the net assets acquired from Target was estimated to be $42 million. Acquirer paid a 20% control premium, which was already included in the $50 per share purchase price. The implied minority discount of the minority shares is 16.7% (i.e., 1 – (1 / 1 + 0.2)).a What is the value of the goodwill shown on Acquirer's consolidated balance sheet? What portion of that goodwill is attributable to the minority interest retained by Target's shareholders? What is the fair value of the 20% minority interest measured on the basis of fair value per share?
Goodwill shown on Acquirer's balance sheet: From Eq. (12.2), goodwill can be estimated as follows:
where $50,000,000 = $50/share × 1,000,000 shares outstanding.
Goodwill attributable to the minority interest: Note that 20% of the total shares outstanding equals 200,000 shares with a market value of $10 million ($50/share × 200,000). Therefore, the amount of goodwill attributable to the minority interest is calculated as follows:
Fair Value of Minority Interest: $10,000,000
Less 20% fair value of net acquired assets (0.2 × $42,000,000): $ 8,400,000
Equal: Goodwill attributable to minority interest: $ 1,600,000
Fair value of the minority interest per share: Since the fair value of Acquirer's interest in Target and Target's retained interest are proportional to their respective ownership interest, the value of the ownership distribution of the majority and minority owners is as follows:
The fair market value per share of the minority interest is $41.65 (i.e., ($10,000,000/200,000) × (1 – 0.167)). The minority share value is less than the share price of the controlling shareholders (i.e., $50/share) because it must be discounted for the relative lack of influence of minority shareholders on the firm's decision-making process.
aSee Chapter 10 for a discussion of how to calculate control premiums and minority discounts.
Exhibit 12.2 Guidelines for Valuing Acquired Assets and Liabilities
1. Cash and accounts receivable, reduced for bad debt and returns, are valued at their values on the books of the target on the acquisition/closing date.
2. Marketable securities are valued at their realizable value after any transaction costs.
3. Inventories are broken down into finished goods and raw materials. Finished goods are valued at their liquidation value; raw material inventories are valued at their current replacement cost. Last-in, first-out inventory reserves maintained by the target before the acquisition are eliminated.
4. Property, plant, and equipment are valued at fair market value on the acquisition/closing date.
5. Accounts payable and accrued expenses are valued at the levels stated on the target's books on the acquisition/closing date.
6. Notes payable and long-term debt are valued at the net present value of the future cash payments discounted at the current market rate of interest for similar securities.
7. Pension fund obligations are booked at the excess or deficiency of the present value of the projected benefit obligations over the present value of pension fund assets. This may result in an asset or liability being recorded by the consolidated firms.
8. All other liabilities are recorded at their net present value of future cash payments.
9. Intangible assets are booked at their appraised values on the acquisition/closing date.
10. Goodwill is the difference between the purchase price less the fair market value of the target's net asset value. Positive goodwill is recorded as an asset, whereas negative goodwill (i.e., a bargain purchase) is shown as a gain on the acquirer's consolidated income statement.
Firms capitalize (i.e., value and display as assets on the balance sheet) the costs of acquiring identifiable intangible assets. The value of such assets can be ascertained from similar transactions made elsewhere. The acquirer must consider the future benefits of the intangible asset to be at least equal to the price paid. Specifically, identifiable assets must have a finite life. Intangible assets are listed as identifiable if the asset can be separated from the firm and sold, leased, licensed, or rented—such as patents and customer lists. Intangible assets also are viewed as identifiable if they are contractually or legally binding. An example is the purchase of a firm that has a leased manufacturing facility whose cost is less than the current cost of a comparable lease. The difference would be listed as an intangible asset on the consolidated balance sheet of the acquiring firm.22
Table 12.6 illustrates the balance sheet impacts of purchase 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, 2010 (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, 2011, 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.
Table 12.6. Balance Sheet Impacts of Purchase Accounting
| Target Inc. December 31, 2010, Purchase Price (Total Consideration) | $500,000,000 | |
| Fair Values of Target Inc.'s Net Assets on December 31, 2010 | ||
| Current Assets | $ 40,000,000 | |
| Plant and Equipment | 200,000,000 | |
| Customer List | 180,000,000 | |
| Copyrights | 120,000,000 | |
| Current Liabilities | (35,000,000) | |
| Long-Term Debt | (100,000,000) | |
| Value Assigned to Identifiable Net Assets | $405,000,000 | |
| Value Assigned to Goodwill | $95,000,000 | |
| Carrying Value as of December 31, 2010 | $500,000,000 | |
| Fair Values of Target Inc.'s Net Assets on December 31, 2011 | $400,000,000a | |
| Current Assets | $ 30,000,000 | |
| Plant and Equipment | 175,000,000 | |
| Customer List | 100,000,000 | |
| Copyrights | 120,000,000 | |
| Current Liabilities | (25,000,000) | |
| Long-Term Debt | (90,000,000) | |
| Fair Value of Identifiable Net Assets | $310,000,000 | |
| Value of Goodwill | $90,000,000 | |
| Carrying Value after Impairment on December 31, 2011 | $400,000,000 | |
| Impairment Loss (Difference between December 31, 2011, and December 31, 2010, carrying values) | $100,000,000 |
a Note that the December 31, 2011, carrying value is estimated based on the discounted value of projected cash flows of the reporting unit and therefore represents the fair market value of the unit on that date. The fair value is composed of the sum of fair value of identifiable net assets plus goodwill.
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 fair market value, the acquirer records a one-time loss equal to the difference.
International accounting standards
Ideally, financial reporting would be the same across the globe, but at this writing it is not yet the case, although the bodies responsible for setting standards have pledged to work diligently to achieve that objective. The overarching objective of the International Accounting Standards Board (IASB), one of those bodies, 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 across 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 increased litigation, because the IFRS is principles-based and allows more latitude in using professional judgment.
Recapitalization accounting
An acquisition resulting in a change in control (i.e., a change in majority voting power) must use purchase accounting for recording the net assets of the acquired business on the acquirer's financial statements. However, under certain circumstances that arise with a leveraged buyout, control may change without changing the basis of the acquired assets and liabilities. In an LBO, some of the target's shareholders will continue to own stock in the postacquisition firm. If the target's shareholders continue to own more than 20% of the firm, the acquired net assets do not have to be restated to fair market value, avoiding any negative impact on earnings resulting from higher depreciation of assets. Consequently, when the firm is sold at a later date, its financial returns are likely to be more attractive under recapitalization than purchase accounting.
Some things to remember
Taxes are an important but rarely an overarching consideration in most M&A transactions. The deciding factor in any transaction should be whether it makes good business sense. A transaction generally is considered taxable to the seller if the buyer uses mostly cash, notes, or some nonequity consideration to purchase the target's stock or assets. Conversely, the transaction is generally considered tax free if mostly acquirer stock is used to purchase the stock or assets of the target firm. Tax considerations and strategies are likely to have an important impact on how a deal is structured by affecting the amount, timing, and composition of the price offered to a target firm and how the combined firms are organized following closing.
For financial reporting purposes, all M&As (except those qualifying for recapitalization accounting) must be recorded using the purchase method of accounting. The excess of the purchase price, including the fair value of any noncontrolling (i.e., minority) interest in the target on the acquisition date, over the fair market value of acquired net assets is treated as goodwill on the combined firm's balance sheet. If the fair market value of the target's net assets later falls below its carrying value, the acquirer must record a loss equal to the difference. This threat may introduce additional discipline for acquirers when negotiating with target company boards and management, since such an event would be a public admission that management had overpaid for past acquisitions. Furthermore, recent changes in accounting standards requiring business combinations to be valued on the acquisition date may make equity-financed transactions less attractive due to the potential for significant changes in value between signing and closing. However, this concern may be mitigated somewhat by the use of collar arrangements. The requirement to value contingent liabilities at closing and update them over time could contribute to earnings instability and make earn-outs a less attractive form of payment.
Discussion Questions
12.1 When does the IRS consider a transaction to be nontaxable to the target firm's shareholders? What is the justification for the IRS' position?
12.2 What are the advantages and disadvantages of a tax-free transaction for the buyer?
12.3 Under what circumstances can the assets of the acquired firm be increased to fair market value when the transaction is deemed a taxable purchase of stock?
12.4 When does it make sense for a buyer to use a type A tax-free reorganization?
12.5 When does it make sense for a buyer to use a type B tax-free reorganization?
12.6 What are net operating loss carryforwards and carrybacks? Why might they add value to an acquisition?
12.7 Explain how tax considerations affect the deal structuring process.
12.8 How does the purchase method of accounting affect the income statements, balance sheets, and cash-flow statements of the combined companies?
12.9 What is goodwill and how is it created?
12.10 Under what circumstances might an asset become impaired? How might this event affect the way in which acquirers bid for target firms?
12.11 Why do boards of directors of both acquiring and target companies often obtain so-called fairness opinions from outside investment advisors or accounting firms? What valuation methodologies might be employed in constructing these opinions? Should stockholders have confidence in such opinions? Why or why not?
12.12 Archer Daniel Midland (ADM) wants to acquire AgriCorp to augment its ethanol. manufacturing capability. AgriCorp wants the transaction to be tax-free for its shareholders. ADM wants to preserve AgriCorp's significant investment tax credits and tax loss carryforwards so that they transfer in the transaction. Also, ADM plans on selling certain unwanted AgriCorp assets to help finance the transaction. How would you structure the deal so that both parties' objectives could be achieved?
12.13 Tangible assets are often increased to fair market value following a transaction and depreciated faster than their economic lives. What is the potential impact on post-transaction EPS, cash flow, and the balance sheet?
12.14 Discuss how the form of acquisition (i.e., asset purchase or stock deal) could affect the net present value or internal rate of return of the deal calculated postclosing.
12.15 What are some of the important tax-related issues the boards of the acquirer and target companies may need to address prior to entering negotiations? How might the resolution of these issues affect the form of payment and form of acquisition?
Answers to these Chapter Discussion Questions are found in the Online Instructor's Manual for instructors using this book.
Practice Problems and Answers
12.16 Target Company has incurred $5 million in losses during the past three years. Acquiring Company anticipates pretax earnings of $3 million in each of the next three years. What is the difference between the taxes that Acquiring Company would have paid before the merger as compared to actual taxes paid after the merger, assuming a marginal tax rate of 40%? Show your work.Answer: $2 million.
12.17 Acquiring Company buys Target Company for $5 million in cash. As an analyst, you are given the premerger balance sheets for the two companies (Table 12.7). Assuming plant and equipment are revalued upward by $500,000, what will be the combined companies' shareholders' equity plus total liabilities? What is the difference between Acquiring Company's shareholders' equity and the shareholders' equity of the combined companies? Show your workAnswer: The combined companies' shareholders' equity plus total liabilities is $7.1 million, and the change between the combined companies' and Acquiring Company's shareholders' equity is $5 million. Note that the change in the acquirer's equity equals the purchase price.
Table 12.7. Premerger Balance Sheets for Companies ($ million)
| Acquiring Company | Target Company | |
| Current Assets | 600,000 | 800,000 |
| Plant and Equipment | 1,200,000 | 1,500,000 |
| Total Assets | 1,800,000 | 2,300,000 |
| Long-Term Debt | 500,000 | 300,000 |
| Shareholders' Equity | 1,300,000 | 2,000,000 |
| Shareholders' Equity + Total Liabilities | 1,800,000 | 2.300,000 |
Answers to these problems can be found in the Online Instructor's Manual available to instructors using this book.
Chapter business cases
Case Study 12.2
Teva Pharmaceuticals Buys Barr Pharmaceuticals to Create a Global Powerhouse
On December 23, 2008, Teva Pharmaceuticals Ltd. completed its acquisition of U.S.-based Barr Pharmaceuticals Inc. The merged businesses created a firm with a significant presence in 60 countries worldwide and about $14 billion in annual sales. Teva Pharmaceutical Industries Ltd. is headquartered in Israel and is among the top 20 pharmaceutical companies in the world. It also is the world's leading generic pharmaceutical company. The firm develops, manufactures, and markets generic and human pharmaceutical ingredients called biologics, as well as animal health pharmaceutical products. Over 80% of Teva's revenue is generated in North America and Europe.
Barr is a U.S.-headquartered global specialty pharmaceutical company that operates in more than 30 countries. Barr's operations are based primarily in North America and Europe, with its key markets being the United States, Croatia, Germany, Poland, and Russia. With annual sales of about $2.5 billion, Barr is engaged primarily in the development, manufacturing, and marketing of generic and proprietary pharmaceuticals and is one of the world's leading generic drug companies. In addition, Barr also is involved actively in the development of generic biologic products, an area that Barr believes provides significant prospects for long-term earnings and profitability.
Based on the average closing price of Teva American Depository Shares (ADSs) on NASDAQ on July 16, 2008, the last trading day in the United States before the merger's announcement, the total purchase price was approximately $7.4 billion, consisting of a combination of Teva shares and cash. Each ADS represents one ordinary share of Teva deposited with a custodian bank.23 As a result of the transaction, Barr shareholders owned approximately 7.3% of Teva after the merger.
The merger agreement provided that each share of Barr common stock issued and outstanding immediately prior to the effective time of the merger was to be converted into the right to receive 0.6272 ordinary shares of Teva, which trade in the United States as American Depository Shares, and $39.90 in cash. The 0.6272 represents the share exchange ratio stipulated in the merger agreement.
The value of the portion of the merger consideration comprising Teva ADSs could have changed between signing and closing. The share exchange ratio was a fixed ratio agreed to by the parties to the negotiation. The market value of the Teva ADSs that Barr shareholders received in the merger could have increased or decreased as the trading price of Teva's ADSs increased or decreased and, therefore, it could have been different on the closing date than what it was on the signing date. In fact, the differences between signing and closing were minimal.
By most measures, the offer price for Barr shares constituted an attractive premium over the value of Barr shares prior to the merger announcement. Based on the closing price of a Teva ADS on the NASDAQ Stock Exchange on July 16, 2008, the consideration for each outstanding share of Barr common stock for Barr shareholders represented a premium of approximately 42% over the closing price of Barr common stock on July 16, 2008, the last trading day in the United States before the merger announcement.
Since the merger qualified as a tax-free reorganization under U.S. federal income tax laws, a U.S. holder of Barr common stock generally did not recognize any gain or loss under U.S. federal income tax laws on the exchange of Barr common stock for Teva ADSs. A U.S. holder generally would recognize a gain on cash received in exchange for the holder's Barr common stock.
Teva was motivated to acquire Barr because of its desire to achieve increased economies of scale and scope, as well as greater geographic coverage with significant growth potential in emerging markets. Barr's U.S. generic drug offering is highly complementary with Teva's and extends Teva's product offering and product development pipeline into new and attractive product categories, such as a substantial women's healthcare business. The merger also is a response to the ongoing global trend of consolidation among the purchasers of pharmaceutical products as governments are increasingly becoming the primary purchaser of generic drugs.
Under the merger agreement, a wholly-owned Teva corporate subsidiary, the Boron Acquisition Corp. (i.e., the acquisition vehicle) merged with Barr, with Barr surviving the merger as a wholly-owned subsidiary of Teva. Immediately following the closing of the merger, Barr was merged into a newly formed limited liability company (i.e., postclosing organization), also wholly owned by Teva, which is the surviving company in the second step of the merger. As such, Barr became a wholly-owned subsidiary of Teva and ceased to be traded on the New York Stock Exchange.
The merger agreement contained standard preclosing covenants, in which Barr agreed to conduct its business only in their ordinary course of business (i.e., as it has historically in a manner consistent with common practices) and not to alter any supplier, customer, or employee agreements or declare any dividends or buy back any outstanding stock. Barr also agreed not to engage in one or more transactions or investments or assume any debt exceeding $25 million. The firm also promised not to change any accounting practices in any material way or in a manner inconsistent with generally accepted accounting principles. Barr also committed not to solicit alternative bids from any other possible investors between the signing of the merger agreement and the closing.
Teva agreed that from the period immediately following closing and ending on the first anniversary of closing that it would require Barr or its subsidiaries to maintain each Barr compensation and benefit plan in existence prior to closing. All annual base salary and wage rates of each Barr employee would be maintained at no less than the levels in effect before closing. Bonus plans also would be maintained at levels no less favorable than those in existence before the closing of the merger.
The key closing conditions that applied to both Teva and Barr included satisfaction of required regulatory and shareholder approvals, compliance with all prevailing laws, and that no representations and warranties were found to have been breached. Moreover, both parties had to provide a certificate signed by the chief executive officer and the chief financial officer that their firms had performed in all material respects all obligations required to be performed in accordance with the merger agreement prior to the closing date and that neither business had suffered any material damage between the signing and closing.
The merger agreement had to be approved by a majority of the outstanding voting shares of Barr common stock. Shareholders failing to vote or abstaining were counted as votes against the merger agreement. Shareholders were entitled to vote on the merger agreement if they held Barr common stock at the close of business on the record date, which was October 10, 2008. Since the shares issued by Teva in exchange for Barr's stock had already been authorized and did not exceed 20% of Teva's shares outstanding (i.e., the threshold on some public stock exchanges at which firms are required to obtain shareholder approval), the merger was not subject to a vote of Teva's shareholders.
Teva and Barr each filed notification of the proposed transaction with the U.S. Federal Trade Commission and the Antitrust Division of the U.S. Department of Justice in order to comply with the Hart-Scott-Rodino Antitrust Improvements Act of 1976. Each party subsequently received a request for additional information (commonly referred to as a “second request”) from the U.S. FTC in connection with the pending acquisition. The effect of the second request was to extend the HSR waiting period until 30 days after the parties had substantially complied with the request, unless that period was terminated sooner by the FTC. Teva and Barr received FTC and Justice Department approval once potential antitrust concerns had been dispelled. Given the global nature of the merger, the two firms also had to file with the European Union Antitrust Commission as well as with other countries' regulatory authorities.
Discussion Questions
1. Why do you believe that Teva chose to acquire the outstanding stock of Barr rather than selected assets? Explain your answer.
2. Mergers of businesses with operations in many countries must seek approval from a number of regulatory agencies. How might this affect the time between the signing of the agreement and the actual closing? How might the ability to realize synergy following the merger of the two businesses be affected by actions required by the regulatory authorities before granting their approval? Be specific.
3. What is the importance of the preclosing covenants signed by both Teva and Barr?
4. What is the importance of the closing conditions in the merger agreement? What could happen if any of the closing conditions are breached (i.e., violated)?
5. Speculate as to why Teva offered Barr shareholders a combination of Teva stock and cash for each Barr share outstanding and why Barr was willing to accept a fixed share exchange ratio rather than some type of collar arrangement.
Case Study 12.3
Merck and Schering-Plough Merger: When Form Overrides Substance
If it walks like a duck and quacks like a duck, is it really a duck? That is a question Johnson & Johnson might ask about a 2009 transaction involving pharmaceutical companies Merck and Schering-Plough. On August 7, 2009, shareholders of Merck and Company (“Merck”) and Schering-Plough Corp. (Schering-Plough) voted overwhelmingly to approve a $41.1 billon merger of the two firms. With annual revenues of $42.4 billion, the new Merck will be second in size only to global pharmaceutical powerhouse Pfizer Inc.
At closing on November 3, 2009, Schering-Plough shareholders received $10.50 and 0.5767 of a share of the common stock of the combined company for each share of Schering-Plough stock they held, and Merck shareholders received one share of common stock of the combined company for each share of Merck that they held. Merck shareholders voted to approve the merger agreement, and Schering-Plough shareholders voted to approve both the merger agreement and the issuance of shares of common stock in the combined firms. Immediately after the merger, the former shareholders of Merck and Schering-Plough owned approximately 68% and 32%, respectively, of the shares of the combined companies.
The motivation for the merger reflects the potential for $3.5 billion in pretax annual cost savings, with Merck reducing its workforce by about 15% through facility consolidations, a highly complementary product offering, and the substantial number of new drugs under development at Schering-Plough. Furthermore, the deal increases Merck's international presence, since 70% of Schering-Plough's revenues come from abroad. The combined firms both focus on biologics (i.e., drugs derived from living organisms). The new firm has a product offering that is much more diversified than either firm had separately.
The deal structure involved a reverse merger, which allowed for a tax-free exchange of shares and for Schering-Plough to argue that it was the acquirer in this transaction. The importance of the latter point is explained in the following section.
To implement the transaction, Schering-Plough created two merger subsidiaries—that is, Merger Subs 1 and 2—and moved $10 billion in cash provided by Merck and 1.5 billion new shares (i.e., so-called “New Merck” shares approved by Schering-Plough shareholders) in the combined Schering-Plough and Merck companies into the subsidiaries. Merger Sub 1 was merged into Schering-Plough, with Schering-Plough becoming the surviving firm. Merger Sub 2 was combined with Merck, with Merck surviving as a wholly-owned subsidiary of Schering-Plough. The end result is the appearance that Schering-Plough (renamed Merck) acquired Merck through its wholly-owned subsidiary (Merger Sub 2). In reality, Merck acquired Schering-Plough.
Former shareholders of Schering-Plough and Merck become shareholders in the new Merck. The “New Merck” is simply Schering-Plough renamed Merck. This structure allows Schering-Plough to argue that no change in control occurred and that a termination clause in a partnership agreement with Johnson & Johnson should not be triggered. Under the agreement, J&J has the exclusive right to sell a rheumatoid arthritis drug it had developed called Remicade, and Schering-Plough has the exclusive right to sell the drug outside of the United States, reflecting its stronger international distribution channel. If the change of control clause were triggered, rights to distribute the drug outside the United States would revert back to J&J. Remicade represented $2.1 billion or about 20% of Schering-Plough's 2008 revenues and about 70% of the firm's international revenues. Consequently, retaining these revenues following the merger was important to both Merck and Schering-Plough.
The multistep process for implementing this transaction is illustrated in the following steps and figures. From a legal perspective, all these actions occur concurrently.
Step 1: Schering-Plough renamed Merck (denoted in the figures as “New Merck”):
a. Schering-Plough creates two wholly-owned merger subs.
b. Schering-Plough transfers cash provided by Merck and newly issued “New Merck” stock into Merger Sub 1 and only “New Merck” stock into Merger Sub 2.
Step 2: Schering-Plough Merger:
a. Merger Sub 1 merges into Schering-Plough in a reverse merger, with Schering-Plough surviving.
b. To compensate shareholders, Schering-Plough shareholders exchange their shares for cash and stock in “New Merck.”
c. Former Schering-Plough shareholders now hold stock in “New Merck.”
a. Merger Sub 2 merges into Merck, with Merck surviving.
b. To compensate shareholders, Merck shareholders exchange their shares for shares in “New Merck.”
c. Former shareholders in Merck now hold shares in “New Merck” (i.e., a renamed Schering-Plough).
d. Merger Sub 2, a subsidiary of “New Merck,” now owns Merck.
This figure shows the combined company as a result of Steps 1 through 3.
Concluding Comments
In reality, Merck was the acquirer. Merck provided the money to purchase Schering-Plough, and Richard Clark, Merck's chairman and CEO, will run the newly combined firm when Fred Hassan, Schering-Plough's CEO, steps down. The new firm has been renamed Merck to reflect its broader brand recognition. Three-fourths of the new firm's board consists of former Merck directors, with the remainder coming from Schering-Plough's board. These factors would give Merck effective control of the combined Merck and Schering-Plough operations. Finally, former Merck shareholders own almost 70% of the outstanding shares of the combined companies.
J&J initiated legal action in August 2009, arguing that the transaction was a conventional merger and, as such, triggered the change of control provision in its partnership agreement it had with Schering-Plough. Schering-Plough argued that the reverse merger bypasses the change of control clause in the agreement, and that, consequently, J&J could not terminate the joint venture. In the past, courts in the United States have tended to focus on the form rather than the spirit of a transaction. The implications of the form of a transaction are usually relatively explicit, while determining what was actually intended (i.e., the spirit) in a deal is often more subjective.
In late 2010, an arbitration panel consisting of former federal judges indicated that a final ruling would be forthcoming in 2011. Potential outcomes could include J&J receiving rights to Remicade with damages to be paid by Merck; a finding that the merger did not constitute a change in control, which would keep the distribution agreement in force; or a ruling allowing Merck to continue to sell Remicade overseas but providing for more royalties to J&J.
Discussion Questions
1. Do you agree with the argument that the courts should focus on the form or structure of an agreement and not try to interpret the actual intent of the parties to the transaction? Explain your answer.
2. How might allowing the form of a transaction to override the actual spirit or intent of the deal impact the cost of doing business for the parties involved in the drug distribution agreement? Be specific.
3. How did the use of a reverse merger facilitate the transaction?
Answers to these questions are provided in the Online Instructor's Manual for instructors using this book.
1 See Stickney, Brown, and Wahlen (2007) for an excellent discussion of financial reporting and statements analysis. See Carrington (2007) for an in-depth discussion of tax accounting for mergers and acquisitions.
2 Ayers, Lefanowicz, and Robinson, 2003
4 Assets must qualify under Section 197 of the Internal Revenue Service Code. Such assets include goodwill, going concern value, books and records, customer lists, licenses, permits, franchises, and trademarks. A “197” intangible must be amortized over 15 years for tax purposes. Moreover, the current tax code allows operating losses (including those resulting from the write-down of impaired goodwill) to be used to recover taxes paid in the preceding two years and to reduce future tax liabilities up to 20 years.
5 For Section 338(h)(10) elections that apply to acquisitions of corporate subsidiaries or S corporations, the seller bears any incremental tax cost from the stock sale, which is treated as an asset sale for tax purposes, and the selling firm's shareholders may demand a higher purchase price to compensate them for the increased tax liability.
6 The IRS is vague about exactly how it is determined that these criteria are being met. The acquirer must purchase the assets that are key to continuing the operation of the target's business, but such assets may not necessarily represent a majority of the target's total assets. However, acquirers often purchase at least 80% of the target's assets to ensure that they are in compliance with IRS guidelines.
7 An acquirer could merge with another firm in a tax-free transaction and immediately following closing sell the assets acquired in the tax-free transaction. The acquirer's basis in the assets would reflect their fair market value (i.e., the purchase price paid for the assets), and if the assets were resold, there would not be any taxable gain on the sale. Therefore, no taxes would have been paid on either transaction.
8 In 2006, the IRS announced new rules establishing that the “substantially all” requirement may not apply if a so-called “disregarded unit,” such as a limited liability company, is used as the acquiring subsidiary and the target firm (structured as a C corporation) ceases to exist. As such, no limitations would be placed on the amount of target net assets that would have to be acquired in order to qualify as a tax-free reorganization.
9 The IRS imposes these limitations to preclude sellers from engaging in restructuring activities that make them more attractive to potential acquirers that might be willing to consummate a tax-free deal if the target firm were smaller.
10 Note that unlike in a forward triangular merger, the “substantially all” requirement cannot be circumvented by merging a LLC created by a parent corporation with a target C corporation and exchanging parent stock for target stock.
11 Under U.S. Treasury Regulation Section 1.368-2. The new rules apply to transactions taking place on or after January 22, 2006.
12 However, the target firm must be a C corporation that ceases to exist after the transaction is completed. Because three parties are involved in the forward triangular merger, the target firm can be operated as a subsidiary, thereby insulating the parent from its liabilities.
13 With the advent of the new regulations, the merger of a foreign corporation into another foreign corporation (or the creation of a new corporation in a consolidation) in accordance with the host country's laws will qualify as a type A reorganization. As such, the exchange will be tax free for any U.S. shareholders in the target firm receiving acquirer shares or shares in the new company formed as a result of the consolidation.
15 Section 382 of the IRS code was created to prevent acquisitions of companies with substantial NOLs solely to reduce the acquirer's taxable income, without having a valid business purpose other than tax avoidance. Section 382 imposes an annual limit on the use of the target firm's NOLs that do survive the transaction and transfer to the acquirer equal to the minimum of the market value of the target's stock multiplied by the long-term tax-exempt interest rate, taxable income of the combined company, or the amount of unused NOLs remaining. For example, suppose that the target firm has $100 million in NOLs expiring in ten years, an acquirer buys all of the target's stock for $500 million, and the long-term tax-exempt interest rate is 5%. The annual limitation on the use of NOLs is $100 million × 0.05 or $5 million. Consequently, the combined firm can utilize only $5 million annually for ten years or $50 million of the target's $100 million of NOLs.
17 Studies show that it is easy to overstate the value of loss carryforwards because of their potential to expire before they can be fully used. Empirical analyses indicate that the actual tax savings realized from loss carryforwards tend to be about one-half of their expected value (Auerbach and Poterba, 1987).
18 Morris Trust transactions were named after a 1966 court case between the U.S. Internal Revenue Service and the Morris Trust.
19 See IFRS 3 and SFAS (Statements of Financial Accounting Standards) 141, respectively.
20 This new definition introduces the notion that fair value is an “exit” price a market participant would pay the seller for a company, asset, or investment. An asset's “entry” price will always be the price paid, but the asset's exit price can fluctuate dramatically, reflecting changing market, industry, or regulatory conditions.
21 A “bargain” purchase is a business combination in which the total acquisition date fair value of the acquired net assets exceeds the fair value of the purchase price plus the fair value of any noncontrolling interest in the target. Such a purchase may arise due to forced liquidation or distressed sales. SFAS 141R requires the acquirer to recognize that excess on the consolidated income statement as a gain attributable to the acquirer.
22 Many assets, such as intangibles, are not specifically identified on the firm's balance sheet. In the United States, companies expense the cost of investing in intangibles in the year in which the investment is made; the rationale is the difficulty in determining whether a particular expenditure results in a future benefit (i.e., an asset, not an expense). For example, the value of the Coca-Cola brand name clearly has value extending over many years, but there is no estimate of this value on the firm's balance sheet.
23 ADSs may be issued in uncertificated form or certified as an American Depositary Receipt, or ADR. ADRs provide evidence that a specified number of ADSs have been deposited by Teva commensurate with the number of new ADSs issued to Barr shareholders.