Structuring the Deal Tax and Accounting ElsevierDirect

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

        —Elie Wiesel
                                    Course Layout: M&A & Other
                                      Restructuring Activities

 Part I: M&A        Part II: M&A           Part III: M&A         Part IV: Deal       Part V:
 Environment         Process               Valuation &           Structuring &     Alternative
                                            Modeling              Financing        Strategies

Motivations for      Business &          Public Company           Payment &        Business
     M&A             Acquisition            Valuation                Legal         Alliances
                       Plans                                     Considerations

 Regulatory        Search through            Private              Accounting &    Divestitures,
Considerations        Closing               Company                   Tax         Spin-Offs &
                     Activities             Valuation            Considerations   Carve-Outs

Takeover Tactics   M&A Integration          Financial              Financing      Bankruptcy &
 and Defenses                               Modeling               Strategies      Liquidation

               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.
               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 values;3
       – Recognize goodwill attributable to non-controlling shareholders;4
       – Revalue acquired net assets in each stage of staged transactions to their current fair
       – 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” R&D on acquisition date with indefinite life until project’s
          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
4An acquirer must recognize 100% of the goodwill even if they acquired less than 100% of the target’s assets, if they have a controlling interest giving
       them effective control over 100% of the assets.
5Recognize as a liability on balance sheet.
       Purchase (Acquisition) Method of Accounting
• Requirements:
   – Record acquired tangible and intangible assets and assumed
     liabilities at fair market value on acquiring firm’s balance sheet.
   – Record the excess of the price paid (PP) plus any non-controlling
     interests1 over the target’s 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
• These relationships can be summarized as follows:
   – Purchase price:              PP = FMVTA– FMVTL+ FMVGW
   – Goodwill estimation:2        FMVGW = PP – FMVTA + FMVTL
                                            = PP - (FMVTA - FMVTL)

    1Thebalance 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 firm’s 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.
                            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 Acquirer’s balance sheet? What
   portion of that goodwill is attributable to the minority interest retained by Target’s

100% of Goodwill shown on Acquirer’s 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).
            Example of Purchase Method of Accounting
            (Assume Acquirer Pays $1 Billion for Target)
                                   Acquirer Pre-                    Target Pre-                  Target Fair Market                Acquirer Post-
                                  Acquisition Book                Acquisition Book                Value ($Millions)               Acquisition Value
                                  Value ($Millions)               Value ($Millions)                                                  ($Millions)
                                       Col. 1                          Col. 2                             Col. 3                       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 target’s equity is equal to the purchase price; target’s retained earnings implicitly included in the purchase price paid for the
target’s equity. Note that the change in acquirer’s pre- and post- acquisition common equity value equals the acquisition purchase price.
2The $100 million difference between the fair market value of the target’s 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)
              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 firm’s future cash flows?
3.   How might the treatment of contingent payments under
     SFAS 141R affect the popularity of earnouts from the
     acquirer’s perspective?
   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)
                  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 firm’s stock or assets
   – Absent a special election, tax basis of target’s 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 target’s stock and assets to
     ensure that the IRS’ continuity of interests and business
     enterprise principles are satisfied
      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)
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
   – 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.
    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 firm’s “historic business
  enterprise” or buy “substantially all” of the target’s
  “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 target’s assets, which would reflect the acquirer’s higher basis in the assets possibly avoiding any tax
    liability when sold.
                        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 target’s assets
   – Allows use of more cash in purchase price than Types B and C
• 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 firm’s shares
      traded on public exchanges.
   – Limitations of asset dispositions within two years of closing

  1As   low as 40% in some circumstances.
                     Direct Statutory Merger (“A”

                                                 Assets &
                                                 Liabilities         Target Firm (Liquidated as
                Acquiring Firm                                      assets and liabilities merged
                                                                           with acquirer)

                                                Acquirer Stock &

                     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. Target’s tax attributes transfer to acquirer but are
limited by Section 382 and 383 of Internal Revenue Code (IRC).
                     Statutory Consolidation (“A”

                                                Assets/Liabilities                  Company B
             Company A
        (Contributes assets &                                                  (Contributes assets &
         liabilities to Newco)                                                  Liabilities to Newco)

                                                 New Company

             Company A                                                                Company B
             Shareholders                                                            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.
  Forward Triangular Merger (“A” Reorganization)

                                                                       Target Firm (Merges assets
                                                                         and liabilities with the
               Acquiring Company
                                                                         parent’s wholly-owned

      Parent’s                    Subsidiary’s                             Target Assets
      Stock/Cash                  Stock                                    and Liabilities

                                                                      Target Shareholders (Receive
                                                  Parent’s Stock
         Subsidiary (Shell created by                                   voting or nonvoting stock
                                                     & Boot
           parent and funded by                                          held by parent’s wholly
           parent’s cash or stock)                                         owned subsidiary in
                                                  Target Stock          exchange for 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 acquirer’s 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.
                 Reverse Triangular Merger (“A”
                                                                      Target Firm (Receives assets
                                                                       and liabilities of acquiring
              Acquiring Company
                                                                         firm’s wholly owned

     Parent’s                     Subsidiary’s                            Subsidiary’s Assets
     Voting                       Stock                                   and Liabilities

        Subsidiary (Shell created by             Parent’s Stock Target Shareholders (Receive
                                                    & Boot          parent’s voting stock
           parent and funded by
                                                                   held by parent’s wholly
        parent’s voting stock merged
                                                                     owned subsidiary in
              into target firm)                  Target Stock     exchange for 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 target’s assets and target tax attributes transfer subject to limitation.
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 target’s voting stock
  and at least 80% of the target’s 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 acquirer’s current shareholders’ ownership
   – May have minority shareholders if all target shareholders do not
      tender their shares
     Type “B” Stock for Stock Reorganization
              Acquiring Firm
           (Exchanges voting                         Target Stock
         shares for at least 80%                                                    Target Shareholders
         of target voting & non-
             Voting shares”)                 Acquirer Voting Stock
                                                 (No Boot)


                                                                                        Target Firm
               Wholly-Owned                                                        (Merged into acquiring
               Shell Subsidiary                     Target Assets
                                                                                     firm’s subsidiary)
                                                    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 target’s 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.
     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 target’s gross and net assets,
• The acquirer must use only voting stock
• Boot cannot exceed 20% of FMV of target’s pre-transaction assets (value
  of any assumed liabilities deducted from boot)1
• The target must dissolve following closing and distribute the acquirer’s
  stock to the target’s 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.
Type “C” Stock for Assets Reorganization

                                                                           Target Firm
            Acquiring Firm
                                            Target Assets           (Liquidates and transfers
     (Exchanges voting shares
                                                                    Acquiring Firm shares and
     for at least 80% of FMV of
                                                                      any remaining assets
            Target assets)                 Acquirer Voting
                                                                        to shareholders)
                                            Stock & Boot
                                                         Acquirer Voting                 Target
                                                          Stock & Boot                   Cancelled

                                                                         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.
         Type D Divisive Reorganizations

• Type D Divisive Reorganizations apply to spin-offs, split-ups, and
• Spin-Off: Stock in a new company is distributed to the original
  company’s 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
• For these reorganizations to qualify as tax-free, the distribution of
  shares must not be for the purpose of tax avoidance.
     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
  target’s tax credits, buyer may use its stock to
  purchase target stock in a non-taxable
         Discussion Questions
1. Explain how tax considerations affect the deal
   structuring process? From seller’s
   perspective? From buyer’s perspective?
2. What is a Type A reorganization? When does
   it make sense for a buyer to use a Type A
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
            Things to Remember
• For financial reporting purposes, all M&As 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

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