Structuring the Deal: Tax and Accounting Considerations

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Structuring the Deal Tax and Accounting
Considerations
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One person of integrity can make a difference, a
difference of life and death.

Elie Wiesel
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Cross-Border Transactions
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Learning Objectives

• Primary Learning Objective To provide students
  with knowledge of how accounting treatment and
  tax considerations impact the deal structuring
  process.
• Secondary Learning Objectives To provide
  students with knowledge of
• Purchase (acquisition method) accounting used for
  financial reporting purposes
• Goodwill and how it is created and
• Alternative taxable and non-taxable transactions.

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Accounting Treatment Background

• Statement of Financial Accounting Standard 141
  (SFAS 141) required effective 12/15/01 purchase
  accounting to be employed for all business
  combinations by allocating the purchase price to
  acquired net assets. Limitations included
  difficulty in comparing transactions (e.g., those
  with minority shareholders to those with none)
  and mixing of historical and current values
  (e.g., staged purchases).
• Effective 12/15/08, SFAS 141R required that
  acquirers must
• Recognize, separately from goodwill,1
  identifiable assets, and assumed liabilities at
  their acquisition date2 fair values3
• Recognize goodwill attributable to
  non-controlling shareholders4
• Revalue acquired net assets in each stage of
  staged transactions to their current fair value
• Compute fair value of contingent payments5 as
  part of total consideration, revalue as new data
  becomes available, and reflect on income
  statement
• Capitalize in-process RD on acquisition date
  with indefinite life until projects outcome is
  known (amortize if successful/write-off if not)
  and
• Expense investment banking, accounting, and legal
  fees at closing capitalize financing related
  expenses
• 1Goodwill is an asset representing future
  economic benefits from acquired assets not
  identified separately (i.e., control, brand name,
  etc.)
• 2Acquisition date is the point at which control
  changes hands (i.e., closing).
• 3Fair value is the amount at which an asset could
  be bought or sold in a current transaction
  between willing parties with access to the same
  information.
• 4An acquirer must recognize 100 of the goodwill
  even if they acquired less than 100 of the
  targets assets, if they have a controlling
  interest giving them effective control over 100
  of the assets.
• 5Recognize as a liability on balance sheet.

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Purchase (Acquisition) Method of Accounting

• Requirements
• Record acquired tangible and intangible assets
  and assumed liabilities at fair market value on
  acquiring firms balance sheet.
• Record the excess of the price paid (PP) plus any
  non-controlling interests1 over the targets net
  asset value (i.e., FMVTA - FMVTL) as goodwill
  (GW) on the consolidated balance sheet, where
  FMVTA and FMVTL are the fair market values of
  total acquired assets and liabilities.
• These relationships can be summarized as follows
• Purchase price PP FMVTA FMVTL
  FMVGW
• Goodwill estimation2 FMVGW PP FMVTA
  FMVTL
• PP - (FMVTA -
  FMVTL)
• 1The balance sheets of acquirers with a
  controlling interest that is less than 100
  ownership must still record 100 of goodwill
  reflecting their effective control over all of
  the target firms assets and liabilities.
• 2Goodwill and net acquired assets must be checked
  annually (or whenever a key event such as the
  loss of a major acquired customer or patent takes
  place impacting value) for impairment.

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Example of Estimating Goodwill

• On January 1, 2009, Acquirer Inc. purchased 80
  percent of Target Inc.s 1,000,000 shares
  outstanding at 50 per share for a total value of
  40,000,000 (i.e., .8 x 1,000,000 x 50). On that
  date, the fair value of total Target net assets
  was 42,000,000. What is value of the goodwill
  shown on Acquirers balance sheet? What portion
  of that goodwill is attributable to the minority
  interest retained by Targets shareholders?
• 100 of Goodwill shown on Acquirers balance
  sheet
• FMVGW PP1 (FMVTA FMVTL) 50,000,000 -
  42,000,000
• 
  8,000,000
• Goodwill attributable to the minority interest
  Note that 20 percent of the total shares
  outstanding equal 200,000 shares with a market
  value of 10,000,000 (50 x 200,000). Therefore,
  the amount of goodwill attributable to the
  minority interest is calculated as follows
• Fair Value of Minority Interest
  10,000,000
• Less 20 fair value of total Target net assets
  
• (.2 x
  42,000,000)
  8,400,000
• Equal Goodwill attributable to minority
  interest 1,600,000
• 1Purchase price as if acquirer purchased 100 of
  target firm (i.e., 50/share x 1,000,000
  50,000,000).

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Example of Purchase Method of Accounting(Assume
Acquirer Pays 1 Billion for Target)
Acquirer Pre-Acquisition Book Value (Millions) Col. 1 Target Pre-Acquisition Book Value (Millions) Col. 2 Target Fair Market Value (Millions) Col. 3 Acquirer Post-Acquisition Value (Millions) Col. 4
Current Assets 12,000 1,200 1,200 13,200
Long-Term Assets 7,000 1,000 1,400 8,400
Goodwill 1003
Total Assets 19,000 2,200 2,600 21,700
Current Liabilities 10,000 1,000 1,000 11,000
Long-Term Debt 3,000 600 700 3,700
Common Equity 2,000 300 1,0001 3,000
Retained Earnings 4,000 300 4,000
Equity Liabilities 19,000 2,200 2,7002 21,700
1The fair value of the targets equity is equal to the purchase price targets retained earnings implicitly included in the purchase price paid for the targets equity. Note that the change in acquirers pre- and post- acquisition common equity value equals the acquisition purchase price. 2The 100 million difference between the fair market value of the targets equity plus liabilities less total assets represents unallocated portion of the purchase price (i.e., the excess of the purchase price over the FMV of net acquired assets). 3Goodwill Purchase price FMV of Net Acquired Target Assets 1,000 (2,600 - 1,000 - 700) 1The fair value of the targets equity is equal to the purchase price targets retained earnings implicitly included in the purchase price paid for the targets equity. Note that the change in acquirers pre- and post- acquisition common equity value equals the acquisition purchase price. 2The 100 million difference between the fair market value of the targets equity plus liabilities less total assets represents unallocated portion of the purchase price (i.e., the excess of the purchase price over the FMV of net acquired assets). 3Goodwill Purchase price FMV of Net Acquired Target Assets 1,000 (2,600 - 1,000 - 700) 1The fair value of the targets equity is equal to the purchase price targets retained earnings implicitly included in the purchase price paid for the targets equity. Note that the change in acquirers pre- and post- acquisition common equity value equals the acquisition purchase price. 2The 100 million difference between the fair market value of the targets equity plus liabilities less total assets represents unallocated portion of the purchase price (i.e., the excess of the purchase price over the FMV of net acquired assets). 3Goodwill Purchase price FMV of Net Acquired Target Assets 1,000 (2,600 - 1,000 - 700) 1The fair value of the targets equity is equal to the purchase price targets retained earnings implicitly included in the purchase price paid for the targets equity. Note that the change in acquirers pre- and post- acquisition common equity value equals the acquisition purchase price. 2The 100 million difference between the fair market value of the targets equity plus liabilities less total assets represents unallocated portion of the purchase price (i.e., the excess of the purchase price over the FMV of net acquired assets). 3Goodwill Purchase price FMV of Net Acquired Target Assets 1,000 (2,600 - 1,000 - 700) 1The fair value of the targets equity is equal to the purchase price targets retained earnings implicitly included in the purchase price paid for the targets equity. Note that the change in acquirers pre- and post- acquisition common equity value equals the acquisition purchase price. 2The 100 million difference between the fair market value of the targets equity plus liabilities less total assets represents unallocated portion of the purchase price (i.e., the excess of the purchase price over the FMV of net acquired assets). 3Goodwill Purchase price FMV of Net Acquired Target Assets 1,000 (2,600 - 1,000 - 700)
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Discussion Questions

1. Acquirer and Target companies reach an agreement
   to merge. Describe how the purchase method of
   accounting would impact the income statement,
   balance sheet, and cash flows statements of the
   combined companies.
2. Goodwill is an accounting entry equal to the
   difference between purchase price and the fair
   market value of net acquired assets. As a
   business manager, what do you believe goodwill
   represents? How could the factors that goodwill
   represents actually contribute to improving the
   combined firms future cash flows?
3. How might the treatment of contingent payments
   under SFAS 141R affect the popularity of earnouts
   from the acquirers perspective?

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Choosing the Right Deal Structure

• Consider the Following Factors
• Tax impact (Immediate or Deferred)
• Acquirer and Target Shareholder Approvals
• Exposure to Target Liabilities
• Payment Flexibility
• Target Survivability
• Limitations on Restructuring Efforts (e.g.,
  tax-free status of spin-offs 2 years before and
  after tax-free deal could be jeopardized)

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Alternative Tax Structures

• Mergers and acquisitions can be structured as
  either tax-free, partially taxable, or wholly
  taxable to target shareholders.
• Taxable Transactions
• The buyer pays primarily with cash, securities,
  or other non-equity consideration for the target
  firms stock or assets
• Absent a special election, tax basis of targets
  assets will not be increased to FMV following a
  purchase of stock
• 338 election Buyer can elect to have a taxable
  stock purchase treated as an asset purchase and
  acquired assets increased to FMV. Taxes must be
  paid on any gains on acquired assets.
• Impact of asset write-up on EPS and potential
  taxable gains must be weighed against improved
  cash flow from tax savings
• Tax-Free Transactions
• Mostly buyer stock used to acquire stock or
  assets of the target
• Buyer must acquire enough of the targets stock
  and assets to ensure that the IRS continuity of
  interests and business enterprise principles are
  satisfied

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Alternative Tax-Free Structures

• A tax-free transaction is also known as a
  tax-free reorganization since it must satisfy the
  continuity of interests and business enterprise
  principles
• Of the 8 different types of tax-free
  reorganizations (Section 368 of the Internal
  Revenue Code), the most common are
• Type A reorganization (incl. statutory direct
  merger or consolidation forward and triangular
  mergers)
• Type B reorganization (stock-for-stock
  acquisition)
• Type C reorganization (stock-for-assets
  acquisition)
• Type D divisive reorganization (spin-offs,
  split-offs, and split-ups)

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Qualifying as a Tax-Free Reorganization

• Four conditions must be met
• Continuity of ownership interest (usually
  satisfied if purchase price at least 50 acquirer
  stock)1
• Continuity of business enterprise (substantially
  all requirement usually satisfied if buyer
  acquires at least 70 and 90 of FMV of target
  gross and net assets)
• Valid business purpose (other than tax avoidance)
• Step transaction doctrine (must not be part of
  larger plan that would have resulted in a taxable
  transaction)

1May be as low as 40 under some circumstances.
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Continuity of Interests and Business Enterprise
Principles1

• Purpose To ensure that subsidiary mergers do not
  resemble sales, making them taxable events
• Continuity of interests A substantial portion of
  the purchase price must consist of acquirer stock
  to ensure target firm shareholders have a
  significant ownership position in the combined
  companies
• Continuity of business enterprise The buyer must
  either continue the acquired firms historic
  business enterprise or buy substantially all
  of the targets historic business assets in the
  combined companies. Continued involvement
  intended to demonstrate long-term commitment by
  acquiring company to the target.
• 1These principles are intended to discourage
  acquirers from buying a target in a tax free
  transaction and immediately selling the targets
  assets, which would reflect the acquirers higher
  basis in the assets possibly avoiding any tax
  liability when sold.

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Type A Reorganization

• To qualify as a Type A reorganization,
  transaction must be a statutory merger or
  consolidation forward or reverse triangular
  merger
• No limits on composition of purchase price
• No requirement to use acquirer voting stock
• At least 50 of the purchase price must be in
  acquirer stock1
• Advantages
• Acquirer can issue non-voting stock to target
  shareholders without diluting its control over
  the combined companies
• Acquirer may choose not to acquire all of the
  targets assets
• Allows use of more cash in purchase price than
  Types B and C reorganizations
• Disadvantages
• Acquirer assumes all undisclosed liabilities
• Requires acquirer shareholder approval if new
  shares are to be issued or number of new shares
  exceeds 20 of the firms shares traded on public
  exchanges.
• Limitations of asset dispositions within two
  years of closing

1As low as 40 in some circumstances.
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Direct Statutory Merger (A Reorganization)
Assets Liabilities
Acquiring Firm
Target Firm (Liquidated as assets and liabilities
merged with acquirer)
Acquirer Stock Boot
Target Stock
Target Shareholders (Receive voting or
nonvoting acquirer stock in exchange for target
stock and boot)
Target liquidated and contracts dissolved.
Contracts need to be assigned or transferred.
Remaining target assets/liabilities assumed by
acquirer acquirer target shareholder approval
required in most states dissenting shareholders
may have appraisal rights. No asset write-up.
Targets tax attributes transfer to acquirer but
are limited by Section 382 and 383 of Internal
Revenue Code (IRC).
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Statutory Consolidation (A Reorganization)
Company B (Contributes assets Liabilities to
Newco)
Assets/Liabilities
Company A (Contributes assets liabilities to
Newco)
New Company (Newco)
Company B Shareholders
Company A Shareholders
Newco Stock
Companies A B liquidated and contracts
dissolved. Contracts need to be transferred or
assigned acquirer and target shareholder
approval required with dissenting shareholders
having appraisal rights. Structure appropriate
for merger of equals. No asset writeup. Acquirer
and target tax attributes transfer to Newco but
are limited by Sections 382 and 383 of IRC.
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Forward Triangular Merger (A Reorganization)
Acquiring Company
Target Firm (Merges assets and liabilities
with the parents wholly-owned subsidiary)
Parents Stock/Cash
Target Assets and Liabilities
Subsidiarys Stock
Subsidiary (Shell created by parent and funded
by parents cash or stock)
Target Shareholders (Receive voting or nonvoting
stock held by parents wholly owned subsidiary
in exchange for target stock)
Parents Stock Boot
Target Stock
Substantially all and continuity of interests
requirements apply. Flexible form of payment.
Avoids transfer taxes and may insulate parent
from target liabilities and eliminate acquirer
shareholder approval unless required by stock
exchange or new shares issued exceed 20 of
acquirers outstanding shares. No asset writeup.
Target tax attributes transfer but subject to
limitation. Target shareholder approval required.
However, as target eliminated, nontransferable
assets and contracts may be lost.
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Reverse Triangular Merger (A Reorganization)
Acquiring Company
Target Firm (Receives assets and liabilities of
acquiring firms wholly owned subsidiary)
Parents Voting Stock
Subsidiarys Assets and Liabilities
Subsidiarys Stock
Subsidiary (Shell created by parent and funded
by parents voting stock merged into target firm)
Target Shareholders (Receive parents voting
stock held by parents wholly owned subsidiary
in exchange for target stock)
Parents Stock Boot
Target Stock
Target survives as acquirer subsidiary. Target
tax attributes and intellectual property and
contracts transfer automatically may insulate
acquirer from target liabilities and avoid
acquirer shareholder approval. At least 80 of
purchase price must be in acquirer voting shares.
No asset writeup. Acquirer must buy
substantially all of the FMV of the targets
assets and target tax attributes transfer subject
to limitation.
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Type B Stock for Stock Reorganization

• To qualify as a Type B Reorganization, acquirer
  must use only voting stock to purchase at least
  80 of the targets voting stock and at least 80
  of the targets non-voting stock
• Cash may be used only to acquire fractional
  shares
• Used mainly as an alternative to a merger or
  consolidation
• Advantages
• Target may be maintained as an independent
  operating subsidiary or merged into the parent
• Stock may be purchased over a 12 month period
  allowing for a phasing of the transaction (i.e.,
  creeping acquisition)
• Disadvantages
• Lack of flexibility in determining composition of
  purchase price
• Potential dilution of acquirers current
  shareholders ownership interest
• May have minority shareholders if all target
  shareholders do not tender their shares

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Type B Stock for Stock Reorganization
Acquiring Firm (Exchanges voting shares for at
least 80 of target voting non- Voting shares)
Target Shareholders
Target Stock
Acquirer Voting Stock (No Boot)
Shell Stock
Target Firm (Merged into acquiring firms
subsidiary)
Wholly-Owned Shell Subsidiary
Target Assets and Liabilities
Buyer need not acquire 100 of target shares,
shares may be required over time, and may
insulate acquirer from target liabilities. May
insulate parent from targets liabilities and tax
attributes transfer subject to limitation.
Suitable for target shareholders with large
capital gains and therefore willing to accept
acquirer shares to avoid capital gains taxes
triggered in a stock for cash sale.
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Type C Stock for Assets Reorganization

• To qualify as a Type C reorganization, acquirer
  must purchase 70 and 90 of the fair market
  value of the targets gross and net assets,
  respectively.
• The acquirer must use only voting stock
• Boot cannot exceed 20 of FMV of targets
  pre-transaction assets (value of any assumed
  liabilities deducted from boot)1
• The target must dissolve following closing and
  distribute the acquirers stock to the targets
  shareholders for their canceled target stock
• Advantages
• Acquirer need not assume any undisclosed
  liabilities
• Acquirer can purchase selected assets
• Disadvantages
• Technically more difficult than a merger because
  all of the assets must be conveyed
• Transfer taxes must be paid
• Need to obtain consents to assignment on
  contracts
• Requirement to use only voting stock potentially
  resulting in dilution of the acquirer
  shareholders ownership interest

1Value of assumed liabilities viewed as part of
purchase price.
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Type C Stock for Assets Reorganization
Acquiring Firm (Exchanges voting shares for at
least 80 of FMV of Target assets)
Target Firm (Liquidates and transfers Acquiring
Firm shares and any remaining assets to
shareholders)
Target Assets
Acquirer Voting Stock Boot
Target Cancelled Stock
Acquirer Voting Stock Boot
Target Shareholders
Enables buyer to be selective in choosing assets
and any liabilities, if at all, it chooses to
assume. Avoids transfer taxes, requires consents
to assignment, and potentially dilutive to
acquirer shareholders. No asset writeup. Tax
attributes transfer to acquirer subject to
limitation.
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Type D Divisive Reorganizations

• Type D Divisive Reorganizations apply to
  spin-offs, split-ups, and split-offs
• Spin-Off Stock in a new company is distributed
  to the original companys shareholders according
  to some pre-determined formula. Both the parent
  and the entity to be spun-off must have been in
  business for at least five years prior to the
  spin-off.
• Split-off A portion of the original company is
  separated from the parent, and shareholders in
  the original company may exchange their shares
  for shares in the new entity. No new firm
  created.
• Split-up The original company ceases to exist,
  and one or more new companies are formed from the
  original business as original shareholders
  exchange their shares for shares in the new
  companies.
• For these reorganizations to qualify as tax-free,
  the distribution of shares must not be for the
  purpose of tax avoidance.

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Implications of Tax Considerations for Deal
Structuring

• In taxable transactions, target generally demands
  a higher purchase price
• Higher purchase price often impacts form of
  payment as buyer tries to maintain PV of
  transaction by deferring some of purchase price
• Buyer may avoid EPS dilution by buying target
  stock or assets using a non-equity form of
  payment in a taxable transaction
• If buyer wants to preserve cash and obtain
  targets tax credits, buyer may use its stock to
  purchase target stock in a non-taxable
  transaction

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Discussion Questions

1. Explain how tax considerations affect the deal
   structuring process? From sellers perspective?
   From buyers perspective?
2. What is a Type A reorganization? When does it
   make sense for a buyer to use a Type A
   reorganization?
3. What is a reverse triangular merger? Under what
   circumstances would a buyer wish to use this type
   of reorganization?
4. How might the buyer structure the transaction in
   order to avoid EPS dilution? (Hint Consider the
   factors that make a transaction taxable or
   non-taxable.)

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Things to Remember

• For financial reporting purposes, all MAs must
  be accounted for using purchase accounting.
• Taxable transactions
• Direct cash merger
• Cash purchase of assets
• Cash purchase of stock
• Tax-free transactions
• Type A reorganization (Incl. direct statutory
  merger or consolidation forward and reverse
  triangular merger)
• Type B stock-for-stock reorganization
• Type C stock-for-assets reorganization