M&A Taxation

yedlu, Winter 2024

Deal Structures

Through acquisition, in general, is defined as the purchase of an existing business, they can be well divided to several categories. In tax treatments, we usually categorize acquisition into:

• asset purchase
• stock purchase
• merger

Asset Purchase

Parties	Actions
Acquirer	Purchase (all or parts of) target’s assets, may assume some liabilities.
Target	Liquidate after deal.

Asset purchase are more commonly found in acquisitions of private companies. During private acquisition, there’s more uncertainty about the liabilities. Hence the buyer can select which assets and liabilities it wants to remain.

Stock Purchase

Parties	Actions
Acquirer	Make offer (often tender offer) to target shareholders to buy their shares (not typically 100%).
Target	Minority shareholders still have rights.

It is hard to achieve full synergies as minority shareholders still have some word to say about company operations.

Merger

Parties	Actions
Acquirer	Buy 100% of the target shares.
Target	Existence vary depends on deal structure.

Merger is defined as the transaction that combines two firms into one. It is relatively easy to achieve synergies in merger.

However, it is relatively more difficult to go through a merger process: it typically needs

• negotiation between managements
• approval of target board of directors
• approval of target shareholders (simple/super majority depends on the company charter, abstain usually counted as against votes)
• approval of acquirer shareholders (if issuing more than 20% of shares through stock purchase)

Types of Mergers

Reverse Triangular

Target merges with a subsidiary of the acquirer, with the target as the surviving corporation to the merger.

This is the most commonly used type of merger, as it provides:

• no change in target’s contracts, titles, leases, etc. to make the deal easier and less costly
• parent company (acquirer) are insulated from target’s liabilities

Forward Triangular

Target merges with a subsidiary of the acquirer, with the acquirer subsidiary as the surviving corporation to the merger.

Statutory Consolidation

A direct merger of two entities into a newly-created entity (only entity continues to exist).

Taxation 101

Transaction Types

Nontaxable if the transaction predominantly involves stock of one company for the stock of the other. Intuition would be that one company is trading its ownership to the ownership of the other company, instead of “cashing out” and realizing gains. We will analyze three types of acquisition deals for nontaxable transactions:

• Merger using stock
  • I.R.C. \(\S\) 368(a)(1)(A): A Reorganization
• Stock purchase using stock
  • I.R.C. \(\S\) 368(a)(1)(B): B Reorganization
• Asset purcahse using stock
  • I.R.C. \(\S\) 368(a)(1)(C): C Reorganization

Taxable if cash/debt is used as consideration. Sellers will recognize monetary income and pay taxes the year of the sale. We will be focusing on using cash to go through three types of acquisition deals:

• Asset purchase using cash
• Stock purchase using cash
  • with \(\S\) 338 election
  • without \(\S\) 338 election
• Merger using cash

Tax Basis

Tax basis is the carrying cost of an asset on a firm’s tax balance sheet. (Analogous but fundamentally different to book value on accounting balance sheet.)

In most cases, asset are initially recorded at the same value for both book/tax purpose. However, they might diverge over time due to different depreciation/amortization standards.

There are two types of tax basis:

• inside basis: a company has in its assets
• outside basis: shareholders have in the equity

The notion of inside/outside tax basis are used in calculating taxes depending on the transaction type.

Tax Calculation

Tax liabilities are calculating with fixing the tax rate on taxable gain, where taxable gain is the difference between:

• purchase price
• tax basis (of asset/stock)

Taxable Purchases

Taxable Asset Purchases (without \(\S\) 338)

In this type of purchases, the acquirer purchases assets and/or assume liabilities, paying with cash.

• Target Firm: recognizes a gain/loss on the asset taxable gain (purchase price - asset tax basis). Net Operating Losses (NOL) can be used to offset this gain for tax purposes and cannot be transfered to acquirer.
• Acquirer Firm:
  • Recognize purchase price as the new tax basis.
  • In turn raises depreciation/amortization expenses (valuable to acquirer).
  • No DTL adjustments because tax/book value are re-aligned.
  • Goodwill is amortized over 15 years for tax purposes (but not for book purposes).
• Target Shareholders: are taxed if proceeds from the asset sale are distributed. If all proceeds are distibuted, the taxable gain is then (value distributed - stock tax basis).
  • *Exception: target subsidiary is more than 80% owned by another corporation.

This creates double taxation on the purchase price by target firm and target shareholder!

Taxable Stock Purchases (without \(\S\) 338)

In this type of purchases, the acquirer purchases shares directly from target shareholders, paying with cash.

Target Shareholder

Seller of target stocks incur capital gains tax (CGT, sale price - outside tax basis) with corresponding tax rate:

• long-term CGT rates: typically 20%
• short-term CGT rates: marginal ordinary income tax rate

Acquirer

Acquirer then establish a new tax basis on the stock equal to the sale price. However, the acquirer cannot step up the tax basis of the target’s assets and cannot attribute any of the purchase price to the tax basis of goodwill.

• this will give rise to a DTL adjustment since book value is stepped-up.

Target Firm

Now as a subsidiary of the bidder, the target does not declare any taxable gain/loss on the sale. Hence, we have avoided double taxation on stock purchases. We will show later that stock purchase dominates asset purchase without electing special tax provisions.

\(\S\) 338 election

If the target is a corporate subsidiary (with at least 80% ownership by a parent) or an S Corp/LLC, an asset sale would not result in double taxation. In this case, stock purchases are no longer dominant strategies.

A Numeric Example

Target (T) corporation has assets with a tax basis of $ 400, liabilities of $ 100. T’s shareholders’ stock basis is $ 500. Acquirer (A) purchases the asset and assumes all liabilities for a total of $ 1,000. T distributes all proceeds to shareholders and then liqudates.

Some additional numerical assumptions:

Item	Assumption
Corporate Tax	25%
Capital Gains Tax	20%
Discount Rate	6%
Straight-Line D/A	5 Years

Now we try to see what would happen under each type of transaction.

Taxable Asset Purchase w/o \(\S\) 338

	($)	Calculation
Purchase Price	1,000	Assumption
Tax Costs
- Paid by T Corp.	175	(1,000-(400-100)) * 0.25
- Paid by T Sh.	65	[(1,000-175)-500] * 0.2
Total Tax	240
Target Shareholder
- Gross Cost	825	1,000 - 175
- (-) Tax	65
- After-Tax Cash	760
Acquirer
- Gross Cost	1,000	Assumption
- (-) PVTS	147	PV(0.06, 10, ((1000-(400-100))/5)*0.25)
- After-Tax Cost	853
Acquirer Tax Basis
- Stock	NA
- Asset	1,000
- Step-Up D/A	700	1,000 - (400-100)

Taxable Stock Purchase w/o \(\S\) 338

	($)	Calculation
Purchase Price	1,000	Assumption
Tax Costs
- Paid by T Corp.	0	Not Involved
- Paid by T Sh.	100	(1,000-500) * 0.2
Total Tax	100
Target Shareholder
- Gross Cost	1,000	1,000 - 0
- (-) Tax	100
- After-Tax Cash	900
Acquirer
- Gross Cost	1,000	Assumption
- (-) PVTS	0
- After-Tax Cost	1,000
Acquirer Tax Basis
- Stock	1,000
- Asset	300	400 - 100
- Step-Up D/A	0	Not Involved

Taxable Stock Purchase w \(\S\) 338

In a taxable acquisition with a \(\S\) 338 election:

• under stock purchase, the target is treated as asset purchase with CGT exempted

	($)	Calculation
Purchase Price	1,000	Assumption
Tax Costs
- Paid by T Corp.	175	(1,000-(400-100)) * 0.25
- Paid by T Sh.	0	Exempt under \(\S\) 338
Total Tax	175
Target Shareholder
- Gross Cost	825	1,000 - 175
- (-) Tax	0
- After-Tax Cash	825
Acquirer
- Gross Cost	1,000	Assumption
- (-) PVTS	147	PV(0.06, 10, ((1000-(400-100))/5)*0.25)
- After-Tax Cost	853
Acquirer Tax Basis
- Stock	NA
- Asset	1,000
- Step-Up D/A	700	1,000 - (400-100)

Summary Table

	Asset	Stock w/o \(\S\) 338	Stock w/ \(\S\) 338
A Pays	Cash	Cash	Cash
A Receives	Assets	Stock	Stock
A Tax	New Tax Basis	Inherent Basis	New Tax Basis
T Corp. Tax	Recognized G/L	No G/L recognized	Recognized G/L
T Sh. Tax	CGT	CGT	CGT waived
NOL	Can offset but expires	Maintain but cannot offset	Can offset but expires

Taxable Mergers

Forward Merger

In a forward merger, the acquirer (or its new subsidiary) is the survivor to the merger. The assets and liabilities are transferred to the survivor, and the target’s shareholders get cash.

For tax purposes, a forward cash-out merger is treated as asset sale transaction.

Reverse Triangular Merger

In a reverse triangular merger, the target merges with a subsidiary of the acquirer, with the target as the surviving corporation to the merger.

For tax purposes, a reverse triangular cash-out merger is treated as stock sale transaction.

Nontaxable Acquisitions

The most common and dominant nontax structures is the A Reorganization. We will introduce three types of nontaxable acquisitions in this section.

To begin with, under nontaxable acquisitions, shares cannot be taxed until capital gains are realized. However, there are parts of offer rendered with cash that constitutes additional tax considerations.

Merger (A Reorganization)

An A Reorganization normally features:

• approval of target shareholders (typically at least simple majority, depends on state laws and company charter)
• tax-free treatment for target shareholders
• target shareholders must receive substantial part consideration for target shares in acquirer stock (of any form, at least 50%)
• target shareholders can also receive boot (taxable cash/debt)

We have to take the taxable boot into account. Under this deal structure, the taxable gain is calculated with:
\[\begin{aligned} \min\{\text{boot}, \text{realized gain}\} \end{aligned}\]

Example. If T shareholder realize a gain of $ 500 on the acquisition, with the boot in cash of $ 400, the tax basis is then: \(\min\{500, 400\} = 400\).

Summary Table

We won’t be discussing other acquisition types in detail, but here’s a summary table for all types of nontaxable acquisitions.

	A Reorg.	B Reorg.	C Reorg.
Acq. Type	Merger	Stock	Asset
A Pays	Stock	Stock	Stock/Cash
A Receive	Stock	Stock	Asset
T Corp. Tax	NA	NA	NA
T Sh. Tax	Boot	NA	NA
NOL	Keep	Keep	Keep
Boot	<50%	0	<20%