Corporate acquisitions can be structured in a number of ways. However, buyers should be aware that the method selected can offer certain tax advantages. One of the key tax considerations is whether the acquirer will be entitled to a stepped up tax basis in the assets and thus entitled to future tax deductions through depreciation and amortization. In this Tax Insight, we will look at the various ways to structure an acquisition and the valuation considerations pertaining to each method.
When valuation is important for tax purposes, breakdown by legal entity is key since each legal entity has its own tax identity and related tax consequences. From a tax perspective, acquisitions can be structured as either taxable or tax-free acquisitions.
Taxable acquisitions may be accomplished through the acquisition of the stock or assets of a target company. When stock of a target company is acquired, the acquirer’s purchase price is reflected in the stock basis whereas the tax basis of the assets held by the target carry over, with the result that no future tax deductions are available for any premium paid for the target. In an asset acquisition, the purchase price paid by the acquirer is reflected in the tax basis of the assets, which results in future tax deductions through depreciation and amortization for purchase price paid in excess of tax basis.
Variations on a straight taxable stock acquisition include Sec. 338(g) elections and Sec. 338(h)(10) elections. A corporation which acquires 80% of target company stock within a 12 month period may elect to treat the stock purchase as an asset purchase by making a Sec. 338 election. In the case of a Sec. 338(g) election, the target recognizes gain on the deemed sale of its assets. The tax impact of this gain is borne by the acquirer. The target is then considered a new corporation with a stepped-up basis in the assets. In addition, the seller recognizes gain or loss on the sale of the target company shares. Accordingly, the Sec. 338(g) election results in two levels of tax and thus is generally not beneficial in the case of a domestic acquisition since the acquirer pays tax on the gain immediately and realizes the benefit of the stepped-up basis over time. In the case of an acquisition of a foreign target, a Sec. 338(g) election may be beneficial. The deemed sale of assets by a foreign corporation without U.S.operations generally has no immediate tax impact as the foreign corporation is not subject to U.S. tax. The election results in the elimination of any accumulated earnings and profits of the foreign corporation. Also, the assets of the foreign target would be stepped up for U.S. tax purposes which could result in lower future earnings and profits due to higher depreciation and amortization. The Sec. 338(g) election has no impact on the foreign tax treatment of the company. From a valuation perspective, it is important to perform a purchase price allocation by foreign legal entity and by asset within each legal entity.
The Sec. 338(h)(10) election, in contrast to the Sec. 338(g) election, results generally in a single level of tax. This election is available with respect to acquisitions of S Corporations as well as to subsidiaries within a consolidated group. The target is deemed to have sold all its assets to the new target and to have distributed the proceeds to the old target shareholders. The sale of the shares is in essence ignored. The acquirer receives a stepped-up basis in the assets and thus obtains the benefit of future increased depreciation and amortization deductions. Therefore, the buyer benefits from the stepup without being required to pay a tax on the full amount of the gain up front, at the time of the election. The buyer also receives the benefit of the increased cash flow.
Under Sec. 1060, the purchase price must be allocated to the assets under the residual method per Sec. 338(b)(5). The purchase price is allocated, in order, to each of the following classes (listed below with examples of the types of assets included in the class), based on the value of the assets:
- Class I: Cash and cash equivalents
- Class II: Actively traded personal property (or Sec. 1092(d)), certificates of deposit, and foreign currency
- Class III: Accounts receivables, mortgages, and credit card receivables
- Class IV: Inventory
- Class V: All assets not in classes I – IV, VI and VII (equipment, land, building)
- Class VI: Sec. 197 intangibles, except goodwill and going concern
- Class VII: Goodwill and going concern
Performing the allocation above is also useful for any future restructuring, as well as tax planning, as the allocation may have implications related to movement of assets around the group, transfer pricing and/or the implementation of cost sharing structures.
Tax-free reorganizations are transactions which may be accomplished in full or part in a tax-free manner. As a general matter, in order for a transaction to be characterized as a tax-free reorganization, there must be a continuing ownership interest by the shareholders of the target company and stock of the acquirer must represent a significant portion of the consideration paid. There are generally three types of acquisitive tax-free reorganizations:
- A reorganization: statutory merger
- B reorganization: stock of target constituting control is acquired in exchange solely for voting stock
- C reorganization: substantially all of the assets of Target are acquired in exchange for voting stock
Tax-free organizations must meet continuity of interest, business purpose, and continuity of business enterprise requirements, in addition to any requirements for the specific type of reorganization. Valuation considerations are the same as those for taxable acquisitions of stock. Valuations may be required to support various requirements of tax-free acquisitive reorganizations including support for substantially all of the assets, continuity of interest, and solvency of an entity. For more information, contact your VRC representative.