Preparing for an initial public offering (IPO) is an onerous process and a “health check” of sorts for a company. Multinational companies need to ensure they are in compliance with federal, state, and local tax regulations. An entity should start planning for an IPO approximately 24 months prior to filing and enlist the help of professionals experienced in the IPO process, including valuation experts.
Valuations are required at various stages in the IPO process, typically in the pre-filing stage. Valuation considerations must be managed carefully to minimize the time, effort and costs of the IPO filing process. In this Tax Insight, we address the main valuation issues with respect to going public, as well as some of the areas where tax planning can result in tax benefits.
Step-up in Basis Affords Tax Benefits
The allocation of purchase price is an important task for a company making an acquisition in order to go public, or for a company making acquisitions leading up to an IPO. Depending on the type of purchase, companies can take advantage of a step-up in basis.
Internal Revenue Code (IRC) Section 338 election allows a corporation that makes a “qualified stock purchase” of another corporation to elect to treat such an acquisition as an asset rather than a share acquisition for federal tax purposes. In general, the impact of a Sec. 338 election is that a stock acquisition is treated as an asset acquisition and, therefore, the tax basis of the assets held by the target company is stepped up to the purchase price.
Sec. 338 elections generally take one of two forms: the Sec. 338 (g) election, which is used with foreign acquisitions, and the Sec. 338(h)(10) election, which is commonly used in the case of domestic acquisitions. Both types of Sec. 338 elections require that a purchaser acquire 80 percent of the vote and value of the target company’s stock.
The acquirer receives a step-up basis in the assets and thus obtains the benefit of future increased depreciation and amortization deductions. Therefore, the buyer can have the benefit of the step-up without being required to pay a tax on the full amount of the gain at the time of the election. The buyer also receives the benefit of the increased cash flow.
We recommend engaging an independent valuation provider to contribute a supportable basis of value for allocation of the purchase price for tax reporting purposes to the tangible and intangible assets acquired and to the respective legal entities.
Section 382 Limitation
Companies need to be aware of Section 382 implications after an ownership change. IRC Sec. 382 generally requires a corporation to limit the amount of its income in future years that can be offset by historic losses, such as net operating loss (NOL) carryforwards and certain built-in losses after a corporation has undergone an ownership change.
After an ownership change, the new loss corporation may only deduct its pre-change losses against taxable income in an amount equal to the Sec. 382 limitation amount. There are two components to the Sec. 382 limitation:
- Base limitation, which is driven by the value of the stock, and
- Built-in gain/loss, which is driven by the value of the assets.
The Sec. 382 base limitation amount is calculated using the following equation:
Fair Market Value (FMV) of Old Loss Corporation Stock X Federal Long-term Tax Exempt Rate = Section 382 Base Limitation
The FMV is subject to potential adjustments described in the regulations. The federal long-term tax-exempt rate is published monthly in the Internal Revenue Bulletin. The FMV determination is crucial as it could have a significant impact on the NOL utilization.
Under Notice 2003-65, the IRS provides two approaches for the identification of built-in gains and losses. Both require a FMV assessment of all assets and liabilities prior to the ownership change. A full discussion of recognized and net unrealized built-in gains and losses is beyond the scope of this article, but it is important to note that if you have a built-in loss it is advisable to hold on to it for at least the five-year recognition period. If you don’t, you will be increasing the NOLs subject to Sec. 382.
Migration of intellectual property (IP) is a common practice for multinational corporations. Multinationals will often transfer IP offshore to take advantage of a lower tax jurisdiction. The tax impact will be largely based on the valuation of the IP. Before transferring IP, multinationals should obtain a valuation of the IP. It is critical to have the necessary documentation in place to support the valuation. IP valuations commonly face scrutiny from the IRS when migrating IP to a foreign company. As a result, companies that effectuate an IP migration strategy typically record a tax reserve on the valuation.
Section 409A and Cheap Stock
Companies going public should be cognizant of the “cheap stock” issue, where equity awards at lower than the IPO price resulting in the understatement of equity compensation expense on a company’s income statement. Cheap stock awards can lead to a Section 409A (the IRS code which regulates the taxation of deferred compensation) issue in which a discounted award may result in immediate taxable income for an employee and a potential liability exposure for a corporate board.
Most private companies hire an independent valuation provider to assist with the determination of fair market value of the underlying stock and any options on a grant date to avoid cheap stock issues.
For more information, contact your VRC professional.