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Chapter 12: Structuring the Deal-Tax and Accounting Considerations

Chapter Summary and Learning Ob ecti!es


"hile Chapter 11 discussed in detail the #irst #i!e components o# the process$ this chapter %ill #ocus on the implications o# tax considerations #or the deal structuring process& Tax considerations can a##ect the amount$ timing$ and composition o# the purchase price& '# a transaction is taxable$ target shareholders %ill demand a higher purchase price to o##set the anticipated tax liability& The increase in the purchase price may cause the ac(uirer to de#er some portion o# the purchase price by altering the terms to include more debt or installment payments to maintain the same purchase price in present !alue terms& )oreo!er$ the decision as to the appropriate organi*ational structure o# the combined businesses is a##ected by such #actors as the desire to minimi*e taxes and to pass through losses to o%ners& 'n addition$ this chapter addresses ho% transactions are recorded #or #inancial reporting purposes& Since the elimination o# pooling o# interests as an alternati!e to purchase accounting in 2++1$ ac(uirers$ %hose stoc, is publicly traded$ are increasingly !ulnerable to massi!e %rite o##s o# good%ill$ o#ten resulting #rom excessi!e prices paid #or target companies& This e!er-present threat may exert some discipline into the negotiating process$ a##ecting both the amount and timing o# o##er prices& Chapter 12 Learning Objectives: Providing students with an understanding of 1& 2& .& Tax considerationsAlternati!e tax structure- and )/A accounting treatment&

Learning Objective 1: Tax considerations 0usiness combinations can be tax-#ree$ partially taxable$ or %holly taxable transactions to the target company shareholders& A non-taxable transaction occurs %hen the ac(uirer1s stoc, is used to purchase substantially all o# either the target1s stoc, or assets& A taxable transaction occurs %hen cash$ debt$ or some non-e(uity consideration is used to purchase the target1s stoc, or assets&

Learning Objective 2: Alternative tax structures Taxable Transactions --The buyer pays %ith cash$ securities$ or other non-e(uity consideration 2or some combination o# the three3 #or substantially all o# the target company1s stoc, or assets& --Absent a special election$ the tax basis o# the target company1s assets %ill not be increased to #air mar,et !alue #ollo%ing a purchase o# its stoc, purchase& --..4 election: An ac(uirer can elect to ha!e a taxable stoc, purchase treated as an asset purchase and ta,e a stepped-up basis in the ac(uired assets& Tax 5ree Transactions --The buyer uses its stoc, to ac(uire substantially all o# the stoc, or assets o# the target #irm --0uyer must ac(uire enough o# the target stoc, to ensure that the '6S1 continuity o# interests principle is satis#ied A tax-#ree transaction is also ,no%n as a tax-#ree reorgani*ation& Type A 6eorgani*ation: --To (uali#y as a Type A 6eorgani*ation$ transaction must be either a statutory merger or consolidation --7o limits on composition o# purchase price --7o re(uirement to use ac(uirer !oting stoc, --7o limit on amount o# target assets that may be ac(uired --At least 8+9 o# the purchase price must be in ac(uirer stoc, Ad!antages: --Ac(uirer can issue non-!oting stoc, to target shareholders %ithout diluting its control o!er the combined companies --Ac(uirer may choose not to ac(uire all o# the target1s assets --Allo%s use o# more cash in purchase price than Types 0 and C 6eorgani*ation Disad!antages: --Ac(uirer assumes all undisclosed liabilities --6e(uires shareholder appro!al Types 0 Stoc, #or Stoc, 6eorgani*ation --To (uali#y as a Type 0 6eorgani*ation$ ac(uirer must use !oting stoc, to purchase at least 4+9 o# the target1s !oting stoc, and at least 4+9 o# the target1s non-!oting stoc, --Cash may be used only to ac(uire #ractional shares --:sed mainly as an alternati!e to a merger or consolidation

Ad!antages --Target may be maintained as an independent operating subsidiary or merged into the parent --Stoc, may be purchased o!er a 12-month period allo%ing #or a phasing o# the transaction Disad!antages: --Lac, o# #lexibility in determining composition o# purchase price --;otential dilution o# combined company <;S Type C Stoc, #or Assets 6eorgani*ation --To (uali#y as a Type C reorgani*ation$ ac(uirer must purchase at least 4+9 o# the #air mar,et !alue o# the target1s assets as %ell as certain speci#ied liabilities --The ac(uirer must use only !oting stoc, --The target must dissol!e #ollo%ing closing and distribute the ac(uirer1s stoc, to the target1s shareholders #or the canceled target stoc, Ad!antages: --Ac(uirer does not assume any undisclosed liabilities --Ac(uirer can purchase selected assets Disad!antages: --Technically more di##icult than a merger because all o# the assets must be con!eyed --Trans#er taxes --7eed to obtain consents to assignments on contracts --6e(uirement to use only !oting stoc, Type D Di!isi!e 6eorgani*ation=Spin-o##s$ Split-ups$ and Split-o##s --Spin-o##: Stoc, in a ne% company is distributed to the original company1s shareholders according to some pre-determined #ormula& 0oth the parent and the entity to be spun-o## must be in business #or at least #i!e years prior to the spin-o##& --Split-o##: A portion o# the original company is separated #rom the parent$ and shareholders in the original company may exchange their shares #or shares in the ne% entity& 7o ne% company is created& --Split-up: The original company ceases to exist$ and one or more ne% companies are #ormed #rom the original business& --5or these reorgani*ations to (uali#y as tax-#ree$ the distribution o# shares must not be #or the purpose o# tax a!oidance& 5or%ard Triangular )erger 2Tax 5ree Asset ;urch a s e 3

--)ost com m o nly used #orm o# reorg a ni* a tio n #or tax- #ree ass e t ac(uisitions $ 2i&e&$ #orm o#

paym e n t is ac(uir er stoc,3& 't is consid e r e d as a purch a s e o# targ e t ass e t s bec a u s e the targ e t is mer g e d into ac(uir er1s sub and cea s e s to exist& --'n!ol!es thre e partie s: the ac(uiring #irm$ the targ e t #irm$ and a shell subsidiary o# the ac(uiring #irm& --;aren t #unds shell corpor a tio n by buying stoc, issu e d by the shell %ith its o%n !oting or non- !oting stoc,& --Targ e t1s stoc, ac(uire d by the subsidiary %ith the stoc, o# the pare n t$ and the targ e t1s stoc, is canc elle d --Targ e t comp a n y1s ass e t s and liabilities are merg e d into the ac(uir er1s subsidiary in a stat u t o r y merg e r --Ac(uirer mus t purch a s e subs t a n ti ally all o# the targ e t1s ass e t s and liabilities& Subst a n ti ally > ?+9 o# 5)@ o# targ e t1s gross ass e t s & --Trans a c tio n (uali#ies as a Type A tax- #ree reorg a ni* a tio n& --;aren t indirectly o%ns all targ e t ass e t s and liabilities since it o%ns all o# the subsidiary1s !oting stoc, Ad!ant a g e s : --A!oidanc e o# appro! al by the pare n t #irm1s shar e h old e r s - ho% e! e r$ public exch a n g e s o#ten still re(uire shar e h old e r s appro! al --;ote n tial insulation o# par e n t #rom the targ e t1s liabilities$ %hich rem ain in the subsidiary --A!oidanc e o# ass e t recording #ees and tran s# e r taxe s since the targ e t1s ass e t s go directly to the pare n t1s %holly o%ne d subsidiary& 6e!ers e Triangular )erger 2Tax 5ree Stoc, ;urch a s e 3

--)ost com m o nl y use d to e##ect tax- #ree stoc, ac(uisitions & 't is consid er e d as an ac(uisition o# stoc, in that the ac(uir er sub is mer g e d into the targ e t %ith the targ e t sur!i!ing& Cons e ( u e n tl y$ it is not consid e r e d an actu al sale as targ e t shar e h old e r s simply exch a n g e their o%ner s hip inter e s t s in the targ e t #or pare n t stoc,& --'n!ol!es thre e parties : ac(uiring #irm$ targ e t #irm$ and shell subsidiary o# ac(uiring #irm

--Ac(uirer #orms a ne% shell subsidiary$ %hich is merg e d into the targ e t comp a n y in a stat u t o r y mer g e r --Targ e t sur!i!e s$ mus t hold subs t a n ti ally all ass e t s Bliabilities o# both targ e t and shell subsidiary- targ e t shar e s canc elled --Targ e t shar e h ol d e r s recei!e the ac(uir er1s or par e n t1s shar e s & --;aren t$ %hich o%ne d all o# the subsidiary stoc,$ no% o%ns all o# the ne% targ e t stoc, and indirectly all o# targ e t1s ass e t s and liabilities& --Targ e t shar e h ol d e r s mus t exch a n g e at leas t 4+9 o# their stoc, #or the par e n t1s !oting stoc, --Trans a c tio n (uali#ies as a Type 0 tax- #ree reorg a ni* a tio n& Ad!ant a g e s : --"hile re!er s e triang ul ar mer g e r similar to a Type 0 reorg a ni* a tio n$ it per mits the ac(uir er to use up to 2+9 cas h --)ay also a!oid the nee d #or par e n t comp a n y shar e h ol d e r appro! al$ since targ e t rem ai n s in exist e n c e --Targ e t retain s any non a s sig n a bl e #ranchis e$ leas e$ or other !alua bl e contr a c t rights --0y a!oiding dissolution o# targ e t #irm$ ac(uirer a!oids the possible acceler a tio n o# loans outs t a n di n g --5acilitat e s regula t o r y appro! al 2insur a n c e $ ban,ing$ and public utility3 %hen such appro! al re(uire s that targ e t rem ain s in exist e n c e & Type o# 6eorgani*ation A Summary o# Alternati!e Tax-5ree Structures )aximum Cash 6e(uirement to Type o# Stoc, ;ayment ;urchase 6e(uirement Substantially All the Assets 8+9 under 7o @oting or ad!ance ruling non!oting #rom '6S +9 #or ad!ance ruling 7o @oting only @oting only Commonly :sed "hen Substantial portion o# purchase price is cash Ac(uirer %ants to limit use o# cash or le!erage Ac(uirer %ants to a!oid undisclosed and

0 C

2+9 reduced by Ces any target liabilities

5or%ard Triangular )erger 6e!erse Triangular )erger

assumed by ac(uirer Same as Type A 2+9

Ces Ces

@oting or non!oting @oting only

contingent liabilities Tax-#ree asset ac(uisitions Tax-#ree stoc, ac(uisitions

6elating Common )/A Legal Structures to Tax 5ree 6eorgani*ations Common Tax 5ree Type A Type 0 Type C 6eorgani*ations Common )/A Legal Structures Statutory )erger1 D 2 Consolidation D Stoc,-#or-Stoc, D . <xchange Stoc, #or Assets D <xchangeA 5or%ard Triangular D )erger8 6e!erse Triangular D )ergerE 1 Target shareholders exchange stoc, #or ac(uirer1s shares& 2 0oth target and ac(uirer1s shareholders exchange their stoc, #or stoc, in the ne%ly created company& . Target is either li(uidated or maintained as a subsidiary o# the ac(uiring #irm& A Target #irm sells at least 4+9 o# #air mar,et !alue o# its assets to ac(uirer and dissol!es and distributes ac(uirer stoc, #or target stoc,& The target stoc, then is cancelled& 8 ;arent creates a shell subsidiary that issues stoc, purchased by the parent %ith cash or its o%n stoc,& The target is ac(uired %ith cash or parent stoc, held by the subsidiary and merged %ith the subsidiary& E ;arent1s subsidiary merged into target& ;arent1s stoc, held by the subsidiary is distributed by target shareholders in exchange #or their target stoc,& Learning Objective : !"A accounting treat#ent Fistorically$ either purchase or pooling o# interests accounting could be used #or reporting business combinations 2i&e&$ one #irm ac(uires all or a portion o# the net assets o# another #irm and obtains control o!er that #irm3 #or purposes o# reporting such in#ormation to the public and regulatory agencies& Any transaction$ that did not satis#y all o# the t%el!e criteria re(uired to (uali#y as a pooling o# interests$ must ha!e been accounted #or using the purchase method o# accounting& ;ooling o# interests accounting presumed that the ac(uirer and target %ere comparable in si*e$ re(uired

summing the #inancial statements o# the t%o #irms$ and did not result in the creation o# good%ill& The 5inancial Accounting Standards 0oard has announced that e##ecti!e December 18$ 2++1 that all business combinations --)ust use the purchase method o# accounting #or #inancial reporting purposes--All business combinations accounted #or using the pooling o# interests method prior to that date %ould be Ggrand#athered-H and --Iood%ill arising #rom business combinations should not be amorti*ed but should be re!ie%ed #or impairment annually or %hene!er an e!ent occurs indicating that the !alue o# good%ill may ha!e been reduced& This applies to all good%ill %hether created be#ore or a#ter June 2++1& ;urchase )ethod o# Accounting --5or #inancial reporting purposes$ the purchase price 2;;3 paid #or the target company consists o# the #air mar,et !alue o# total identi#iable re(uired assets 25)@TA3$ total ac(uired liabilities 25)@TL3$ and good%ill 25)@I"3& The di##erence bet%een 5)@TA and 5)@TL is called net asset !alue& Chapter 12 $tud% Test TrueB5alse Kuestions: 1& 2& .& Tax considerations can a##ect the amount$ timing$ and composition o# the purchase price&
True or 5alse '# a transaction is taxable$ target shareholders %ill demand a higher purchase price to o##set the anticipated tax liability& True or 5alse

Ac(uirers$ %hose stoc, is publicly traded$ are increasingly !ulnerable to massi!e %rite o##s o# good%ill$ o#ten resulting #rom excessi!e prices paid #or target companies& This e!erpresent threat o# asset impairment may exert some discipline into the negotiating process$ a##ecting both the amount and timing o# o##er prices& True or 5alse Tax considerations are al%ays extremely important in )/A transactions& True or 5alse The use o# anything other than the ac(uirer1s stoc, to ac(uire substantially all o# the target1s stoc, renders the transaction taxable to the target #irm1s shareholders& True or 5alse Taxable transactions ha!e been made some%hat more attracti!e since 1LL.$ %hen a change in the legislation allo%ed ac(uirers to amorti*e intangible assets$ including good%ill$ o!er 18 years #or tax purposes& True or 5alse

A& 8&

E&

?&

According to Section ..4 o# the :&S& tax code$ a purchaser o# 4+9 or more o# the stoc, o# the target may elect to treat the ac(uisition as i# it %ere an ac(uisition o# the target1s assets& True or

5alse 4& L& 1+& 11& 12& 1.& Transactions may be partially taxable i# the target shareholders recei!e some none(uity consideration$ such as cash or debt$ in addition to the ac(uirer1s stoc,& True or 5alse 7et operating loss carry #or%ards are pro!isions in the tax la%s allo%ing #irms to use 7OLs generated in the past to o##set #uture taxable income& True or 5alse &;ooling o# interests accounting remains a popular #orm o# reporting business combinations& True or 5alse
A #or%ard triangular merger is the most commonly used #orm o# reorgani*ation #or tax-#ree asset ac(uisitions in %hich the #orm o# payment is ac(uirer stoc,& True or 5alse

The '6S generally !ie%s #or%ard triangular cash mergers as a purchase o# target assets$ since the ac(uiring subsidiary sur!i!es& True or 5alse A transaction generally %ill be considered taxable to the seller i# it in!ol!es the purchase o# the target1s stoc, 2but not i# it in!ol!es a purchase o# assets3 #or substantially all cash$ notes$ or some other none(uity consideration& True or 5alse '# a transaction in!ol!es a purchase o# assets$ the target company1s tax cost or basis in the ac(uired stoc, or assets is increased or Gstepped upH to their #air mar,et !alue& True o# 5alse Transactions may be partially taxable i# the target shareholders recei!e some none(uity consideration$ such as cash or debt$ in addition to the ac(uirer1s stoc,& True or 5alse T

1A&

18&

)ultiple Choice Kuestions: 1E& "hich o# the #ollo%ing is not true o# a taxable transactionM a& b& c& d&
1?&

Ac(uiring #irm steps up the basis #or the ac(uired assets to their #air mar,et !alue 'mmediate recognition o# a gain by target shareholders 7et operating losses o# the target are trans#erred to the ac(uiring #irm The ac(uiring #irm losses the target1s net operating losses and tax credits

"hich phrase best completes the #ollo%ing statement& 5or #inancial reporting purposes$ an up%ard !aluation o# tangible and intangible assets$ other than good%ill$

a& b& c& d&

6aises depreciation but lo%ers amorti*ation expenses Lo%ers depreciation and amorti*ation expenses 'ncreases operating and net income 6aises depreciation and amorti*ation expenses$ %hich lo%ers operating and net income&

14&

As a general rule$ a transaction is tax-#ree to the target1s shareholders i#: a& b& c& d& The buyer uses cash to ac(uire the target1s stoc, The buyer uses mostly stoc, to ac(uire substantially all o# the target1s stoc, or assets The buyer uses cash to buy the target1s assets The buyer uses debt to buy the target1s stoc,

1L&

"hich o# the #ollo%ing is not true o# good%illM a& b& c&


d&

't must be amorti*ed o!er A+ years& 't represents the excess o# the purchase price o!er the net asset !alue o# ac(uired assets& 't must be %ritten do%n i# its net asset !alue #alls belo% its carrying !alue&
The loss o# ,ey customer contracts$ patent protection expiration$ or the #ailure to achie!e anticipated cost-sa!ing synergies could a##ect the !alue o# good%ill on the #irm1s balance sheet&

2+&

"hich o# the #ollo%ing is not true o# purchase accountingM a& b& c& d& The ac(uiring #irm records the target at the actual purchase price& Ac(uired assets and assumed liabilities are re!alued to their #air mar,et !alue on the date o# ac(uisition The purchase price is #irst allocated to tangible and then to intangible assets& The excess o# the purchase price o!er the target #irm1s net asset !alue is ignored& Answers to Test &uestions

TrueB5alse

)ultiple Choice

1& True 2& True .& True A& 5alse 8& True E& True ?& True 4& True L& True 1+& 5alse 11& True 12& True 1.& 5alse 1A& True 18& True 1E& C 1?& D 14& 0 1L& A
L

2+& D

1+