Structuring the Deal: Tax and Accounting

Considerations

One person of integrity can make a difference,

a difference of life and death. —

Elie Wiesel

Course Layout: M&A & Other Restructuring Activities

Part IV: Deal Structuring &

Financing

Part II: M&A Process

Part I: M&A Environment

Payment & Legal

Considerations

Public Company Valuation

Financial Modeling

Techniques

M&A Integration

Business & Acquisition

Plans

Search through Closing

Activities

Part V: Alternative Strategies

Accounting & Tax

Considerations

Business Alliances

Divestitures, Spin-Offs & Carve-Outs

Bankruptcy & Liquidation

Regulatory Considerations

Motivations for M&A

Part III: M&A Valuation & Modeling

Takeover Tactics and Defenses

Financing Strategies

Private CompanyValuation

Cross-BorderTransactions

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 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” 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

information.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 liabilities.

• These relationships can be summarized as follows:

– Purchase price: PP = FMVTA– FMVTL+ FMVGW

– Goodwill estimation:2 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 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 GoodwillOn 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 shareholders?

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: $10,000,000Less: 20% fair value of total Target net assets

(.2 x $42,000,000): $ 8,400,000Equal: 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-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 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 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.

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

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 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” Reorganization)

Acquiring FirmTarget Firm (Liquidated as

assets and liabilities merged with acquirer)

Target Shareholders (Receive voting or

nonvoting acquirer stock in exchange for target stock

and boot)

Assets & Liabilities

Acquirer Stock & Boot

Target Stock

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” Reorganization)

Company A (Contributes assets &liabilities to Newco)

Company B(Contributes assets &Liabilities to Newco)

Company A Shareholders

Company BShareholders

New Company(Newco)

Assets/Liabilities

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)

Acquiring Company

Subsidiary (Shell created byparent and funded byparent’s cash or stock)

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

subsidiary)

Target Shareholders (Receive voting or nonvoting stock held by parent’s wholly

owned subsidiary in exchange for target stock)

Parent’s Stock & Boot

Target Assetsand Liabilities

Subsidiary’sStock

Parent’sStock/Cash

“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.

Target Stock

Reverse Triangular Merger (“A” Reorganization)

Acquiring Company

Subsidiary (Shell created byparent and funded by

parent’s voting stock mergedinto target firm)

Target Firm (Receives assetsand liabilities of acquiring

firm’s wholly owned subsidiary)

Target Shareholders (Receive parent’s voting stock

held by parent’s wholly owned subsidiary in

exchange for target stock)

Parent’s Stock & Boot

Subsidiary’s Assetsand Liabilities

Subsidiary’sStock

Parent’sVoting 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.

Target Stock

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

interest– May have minority shareholders if all target shareholders do not

tender their shares

Type “B” Stock for Stock Reorganization

Acquiring Firm (Exchanges voting

shares for at least 80%of target voting & non-

Voting shares”)

Target Shareholders

Wholly-OwnedShell Subsidiary

Target Firm (Merged into acquiring

firm’s subsidiary)

Target Stock

Acquirer Voting Stock (No Boot)

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.

Target Assets and Liabilities

Shell Stock

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, respectively.

• 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

Acquiring Firm(Exchanges voting sharesfor at least 80% of FMV of

Target assets)

Target Firm (Liquidates and transfers

Acquiring Firm shares andany remaining assets

to shareholders)

Target Shareholders

Acquirer Voting

Stock & Boot

Target Assets

Acquirer Voting

Stock & Boot

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.

Target Cancelled Stock

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 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 companies.

• 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 transaction

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 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.)

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