CHAPTER 4 DEAL STRUCTURING The structuring of M&As often raises complex financing and tax issues in addition to the

accounting issues discussed in Chapter 3. The issues are not only complex, but the regulations and rules can change dramatically, sometimes without much advance notice. Understanding these rules and regulations, and how to structure transactions within these rules in order to maximize the value of the deal, often requires the outside assistance of accounting, financial, and legal advisers. TAXATION AND ACQUISITIONS A considerable amount of literature has been produced on the relation between taxes and takeovers. This section provides a synthesis and assesses the results of the studies to date. The following topics are covered: taxable versus nontaxable or tax-deferred acquisitions; the Tax Reform Act of 1986; and the question of whether tax gains cause acquisitions, which include considerations of early empirical tax effects, later empirical studies of tax effects, and taxes and leveraged buyouts (LBOs). TAXABLE VERSUS NONTAXABLE ACQUISITIONS The basic tax rule with respect to acquisitions is simple. If the merger or tender offer involves exchanging the stock of one company for the stock of the other, it is a nontaxable transaction. If cash or debt is used, it is a taxable transaction. In practice, however, many complications exist. The Internal Revenue Code makes a technical distinction among three types of acquisitive taxfree reorganizations, which are defined in Section 368 of the code. They are referred to as type A, B, and C reorganizations. Type A reorganizations are statutory mergers or consolidations. In a merger, target firm stockholders exchange their target stock for shares in the acquiring firm; in a consolidation, the target and the acquiring firm shareholders turn in their shares and receive stock in the newly created company. Type B reorganizations are similarly stock-for-stock exchanges. Following a type B reorganization, the target can be liquidated into the acquiring firm or maintained as an independent operating entity. Type C reorganizations are stock-for-asset transactions with the requirement that at least 80% of the fair market value of the targets property be acquired. Typically, the target firm sells its assets to the acquiring firm in exchange for voting stock in the acquiring firm; the target then dissolves, distributing the acquiring firms stock to its shareholders in return for its own (nowcanceled) stock. In practice, a three-party acquisition technique is employed. The parent creates a shell subsidiary. The shell issues stock, all of which is bought by the parent with cash or its own stock. The target as the third party is bought with the cash or stock of the parent held by the subsidiary. The advantage of creating the subsidiary as an intermediary is that the parent acquires control of the target without incurring responsibilities for the known and possibly unknown liabilities of the target. The transaction still qualifies as a type A reorganization. The target firm might remain in existence if the stock of the parent is used as the method of payment by the shell subsidiary. Because the parent-acquirer shareholders are not directly involved, they are denied voting and appraisal rights in the transaction. In a reverse three-party merger, the subsidiary is merged into

the target. The parent stock held by the subsidiary is distributed to the targets shareholders in exchange for their target stock. This is equivalent to a type B reorganization. The tax-free reorganization represents only tax deferral for the target firm shareholders. If the target shareholder subsequently sells the acquiring firms stock received in the transaction, a capital gains tax becomes payable. The basis for the capital gains tax is the original basis of the target stock held by the target shareholder. Consider, for example, an individual who purchased 1,000 shares of Texaco in July 2000 at $53 per share. A few months later, in October 2000, Texaco agreed to be acquired by Chevron in a stock exchange merger of 0.77 Chevron shares for each Texaco share. When the merger closed in October 2001, the 1,000 Texaco shares held by the shareholder were converted into 770 Chevron Texaco shares. Assume that the shareholder sold the Chevron Texaco shares at a price of $88 in July 2002. The shareholder would realize a capital gain of $14.76 per each of the original 1,000 Texaco shares purchased. Or the shareholder realizes a capital gain of $19.17 ($88-$53/.77) per each of the 770 Chevron Texaco shares. In either case, the total capital gain is $14,760. Note, however, that if the shareholder dies without selling the shares in Chevron Texaco, the estate tax laws establish the tax basis at the time of death. That is, if the shareholder dies in 2040 and Chevron Texaco stock is trading at $800, then $800 would be the new basis with respect to taxes. Table 4.1 summarizes the main implications of nontaxable versus taxable acquisitions. In a nontaxable (tax-deferred) reorganization, the acquiring firm generally can use the net operating loss (NOL) carryover and unused tax credits of the acquired firm. However, even though the value of the shares paid may be greater than the net book values of the assets acquired, no writeup or step-up of the depreciable values of the assets acquired can be made. For the shareholders of the target firm, taxes are deferred until the common shares received in the transaction are sold. Thus, the shareholders can defer the taxes. TABLE 4.1 Nontaxable vs. Taxable M&As Acquiring Firm Target Firm Nontaxable NOL carryover Tax-credit carryover A. Deferred gains for shareholders reorganizations Carryover asset basis Immediate gain recognition by Stepped-up asset basis Loss of NOLs target shareholders B. Taxable acquisitions and tax credits Depreciation recapture of income In taxable acquisitions, the acquiring firm can assign the excess of purchase price over the book value of equity acquired to depreciable assets, as described under purchase accounting. The acquiring firm, however, is unable to carry over the NOLs and tax credits. The shareholders of the target firm in a taxable transaction must recognize the gain over their tax basis in the shares. In addition, if the target firm has used accelerated depreciation, a portion of any gain that is attributable to excess depreciation deductions will be recaptured to be taxed as ordinary income rather than capital gains, the amount of recapture depending on the nature of the property involved.

Chapter 4. Deal Structuring 4.1 QUESTION: How can personal taxation affect mergers? ANSWER:
Tax considerations in M&As

A. Nontaxable reorganizations

Acquiring Firm NOL carryover Tax-credit carryover Carryover asset basis

Target Firm Deferred gains for shareholders

B. Taxable acquisitions

Stepped-up asset basis Loss of NOLs and tax credits

Immediate gain recognition by target shareholders Depreciation recapture of income

4.2 QUESTION: Discuss the advantages and disadvantages of stock-for-stock versus cash-forstock transactions from the viewpoint of acquired and acquiring firm shareholders. ANSWER: Stock-for-stock transactions: Generally a nontaxable transaction. Acquired firm shareholders deferred gains; still retain ownership in combined firm. Acquiring firm shareholders no cash outlay or borrowing required; carryover of NOLs, tax credits, asset basis. Cash-for-stock transactions: Acquired firm shareholders immediate gain recognition; no longer have ownership interest. Acquiring firm shareholders potential benefits of stepped-up asset basis for future depreciation.

4.3 QUESTION: How do a firms growth prospects affect its potential for being involved in a tax-motivated merger? ANSWER: Particularly for small and/or closely held firms for which there is no active market for the stock, diminished growth prospects may mean the firm can no longer maintain earnings retention without risking a tax on improper accumulation. The prospect of receiving large amounts of earnings paid out and taxable as ordinary income may motivate the sale of such a company, in a tax deferred transaction. Also, shareholders are able to receive a purchase price which capitalizes future earnings. 4.4 QUESTION: A selling company is a regular C corporation. Given the following data, calculate the net proceeds to the shareholders of the selling firm if the buyer makes a stock acquisition versus an acquisition of assets. Purchase price, stock $250

Purchase price, assets Liabilities of seller Basis in assets (seller) Basis in shares (shareholders of seller) Marginal corporate tax rate (federal and state) Individual capital gains tax rate (federal and state)

250 100 150 125 35% 24%

ANSWER:
(1) (2) Acquisition Acquisition of Stock of Assets $ 250 $ 250 100 $ 250 $ 350 (150) 200 35% 70 $ 250 125 375 24% 90 160 180 125 305 24% 73 107

Assumed purchase price Assumed liabilities Total Purchase Price Basis in assets Gain Corporate tax rate* Tax on sale of assets Net to Shareholders Basis in shares Capital gain Tax rate on individual Tax on individual on sale Net proceeds to seller SH

*corporate capital gains rate = corporate ordinary tax rate

4.5 QUESTION: Why are stock mergers the preferred form of payment for large mergers with greater than $1 billion in transaction value? ANSWER: To acquire a target with cash requires that the acquirer either have the cash on hand or access to debt financing. The larger the target firm, especially for the multi-billion dollar targets, there are relatively few acquirers able to make the acquisition with cash. Consider the odds of a firm announcing a $500 billion cash offer for General Electric, Microsoft, or Wal-Mart Stores.