Structuring the Deal: Tax and
Accounting Considerations
One person of integrity can
make a difference,
a difference of life and death.
—Elie Wiesel
Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities
Part I: M&A
Environment
Part II: M&A Process
Part III: M&A
Valuation and
Modeling
Part IV: Deal
Structuring and
Financing
Part V: Alternative
Business and
Restructuring
Strategies
Ch. 1: Motivations for
M&A
Ch. 4: Business and
Acquisition Plans
Ch. 7: Discounted
Cash Flow Valuation
Ch. 11: Payment and
Legal Considerations
Ch. 15: Business
Alliances
Ch. 2: Regulatory
Considerations
Ch. 5: Search through
Closing Activities
Ch. 8: Relative
Valuation
Methodologies
Ch. 12: Accounting &
Tax Considerations
Ch. 16: Divestitures,
Spin-Offs, Split-Offs,
and Equity Carve-Outs
Ch. 3: Takeover
Tactics, Defenses, and
Corporate Governance
Ch. 6: M&A
Postclosing Integration
Ch. 9: Financial
Modeling Techniques
Ch. 13: Financing the
Deal
Ch. 17: Bankruptcy
and Liquidation
Ch. 10: Private
Company Valuation
Ch. 14: Valuing
Highly Leveraged
Transactions
Ch. 18: Cross-Border
Transactions
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). Pooling of interest method was
grandfathered.
•
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.)
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.
2Acquisition
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 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 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 (GWMIN):
FMVGWMIN = .2 x PP1 – .2 x (FMVTA – FMVTL) = .2 x $50,000,000 - .2 x $42,000,000
= $10,000,000 - $8,400,000
= $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
(Assumes Acquirer Pays $1 Billion for Target’s Equity)
Pre-Acquisition Book Value
Acquirer
Target
Col. 1
Current Assets
Long-Term Assets
Goodwill
Total Assets
Current Liabilities
Long-Term Debt
Total Liabilities
Common Equity
Retained Earnings
Total Equity
12,000.00
7,000.00
-19,000.00
10,000.00
3,000.00
13,000.00
2,000.00
4,000.00
6,000.00
Equity + Total Liabilities
19,000.00
1The
Target Fair Market
Acquirer PostValue
Acquisition Value
($Millions)
Col. 2
Col. 3
Col. 4
(= Col. 1 + Col.3)
1,200.00
1,200.00
13,200.00
1,000.00
1,400.00
8,400.00
--100.002
2,200.00
-21,700.00
1,000.00
1,000.00
11,000.00
600.00
700.00
3,700.00
1,600.00
-14,700.00
300.00
1,000.001
3,000.00
300.00
0.00
4,000.00
600.00
-7,000.00
2,200.00
--
21,700.00
fair value of the target's equity is equal to the purchase price; target's retained earnings implicitly included in the purchase price paid.
Note the change in the acquirer's pre-and post-acquisition common equity value equals the purchase price.
2Goodwill
= Purchase price - FMV of Net Acquired Assets = $1000 - ($2600 - $1700) = $1,000 - $900 = $100
Practice Problem:
Purchase Method of Accounting
On January 1, 20XX, Acquirer Inc. purchased 100% of Target Inc.'s outstanding shares for $900
million. Using the data on the following table, fill in the blanks containing question marks to show
how the deal could have been presented for financial reporting purposes.
.
Pre-Acquisition Book Value
Target Current
Acquirer PostAcquirer
Target
Fair Market Value Acquisition Value
($Millions)
Col. 1
Col. 2
Col. 3
Col. 4
Current Assets
4,000.00
1,500.00
1,500.00
???
Long-Term Assets
5,000.00
1,000.00
1,200.00
???
Goodwill
---???
Total Assets
9,000.00
2,500.00
-???
Current Liabilities
3,000.00
1,200.00
1,200.00
???
Long-Term Debt
2,000.00
900.00
800.00
???
Total Liabilities
5,000.00
2,100.00
-???
Common Equity
3,200.00
300.00
???
???
Retained Earnings
800.00
100.00
???
???
Total Equity
4,000.00
400.00
-???
Equity + Total Liabilities
9,000.00
2,500.00
--
???
Discussion Questions
1.
2.
3.
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.
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?
Contingent payments under SFAS
141R must be revalued as new
information becomes available. How
might this 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 (Treated as reorganizations rather than sales):
– 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 generally satisfy the
continuity of interests and business enterprise principles
to avoid being classified as an actual sale
• 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 reverse 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)
How the IRS Views Tax-Free Reorganizations
• “A” reorganizations involve one corporation acquiring
another in exchange for mostly acquirer nonvoting or
voting stock
• “B” reorganizations involve one corporation acquiring the
stock of another in exchange solely for acquirer voting
stock
• “C” reorganizations involve one corporation acquiring
“substantially all” of the assets of another in exchange for
acquirer voting stock
• “D” divisive reorganizations involve a corporation
transferring all or some of its assets to a subsidiary it
controls in exchange for subsidiary stock or securities
Qualifying as a Tax-Free Reorganization
• Four conditions must generally be met:
– Continuity of ownership interest (in certain instances may
be 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)2
– Valid business purpose (other than tax avoidance such as
the sole reason for buying the target is to acquire its
NOLs)
– Step transaction doctrine (must not be part of larger plan
intended to avoid a taxable transaction)
1May
be as low as 40% under some circumstances, if the acquirer has effective control at that level of ownership.
2”Substantially
all” requirement does not apply if the acquiring subsidiary is a so-called disregarded unit such as a limited
liability company.
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 longterm commitment by acquiring company to the target.
1These
principles are intended to require buyers to demonstrate an ongoing commitment to the target firm such that the
transaction is not actual sale but rather a reorganization in which the target shareholders continue to have a
significant ownership stake in the combined firms.
Type A Reorganization
• To qualify as a Type A reorganization, transaction must be a direct
statutory merger or consolidation; forward or reverse triangular merger
• Advantages (applies to all merger types, except as noted):
– Except for reverse triangular mergers, only form of tax free
reorganization in which a substantial portion of the purchase price
can be something other than acquirer equity
– Target assets and liabilities automatically transfer to the acquirer
by “operation of law”
– Target tax attributes automatically transfer subject to limitation
under Sections 382 and 383 of the tax code
• Disadvantages (applies to all merger types):
– 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
– No writeup (step up) in basis of acquired assets as transaction
already tax-free
1As
low as 40% in some circumstances; however, for reverse triangular mergers, the purchase price must consist of at
least 80% acquirer voting common or preferred shares.
Direct Statutory Merger (“A”
Reorganization)
Assets &
Liabilities
Acquiring Firm
Target Firm
(Liquidated as book value
of assets and liabilities merged
with acquirer)
Acquirer Stock &
Boot
Target Stock
Target Shareholders
(Receive voting or
nonvoting acquirer stock
and boot in exchange for
Target stock)
Target merges into acquirer, with acquirer surviving. Acquirer and target shareholder approval required in most
states; dissenting shareholders may have appraisal rights. Flexible form of payment (as little as half of the
purchase price may consist of acquirer non-voting or voting stock).
Statutory Consolidation (“A”
Reorganization)
Company A
(Contributes book
Value assets &
liabilities to Newco)
Assets/Liabilities
Company B
(Contributes book
value of assets &
Liabilities to Newco)
New Company
(Newco)
Company B
Shareholders
Company A
Shareholders
Newco Stock
A & B merge with Newco, with Newco surviving the transaction. A and B’s shareholders must approve the deal
with dissenting shareholders having appraisal rights. Flexible form of payment (as little as half of the purchase
price may consist of acquirer non-voting or voting stock). Structure appropriate for merger of equals.
Forward Triangular Merger (“A” Reorganization)
Target Firm
(Merges book value of
assets and liabilities with
the parent’s whollyowned subsidiary)
Acquiring Company
Parent’s
Stock/Cash
Subsidiary’s
Stock
Subsidiary (Shell created by
parent and funded by
parent’s cash or stock)
Target Assets
and Liabilities
Target Shareholders (Receive
Parent’s Stock voting or nonvoting stock and
& Boot
boot held by parent’s wholly
owned subsidiary in
Target Stock
exchange for target stock)
Viewed by IRS as an asset purchase as target liquidated. Flexible form of payment (as little as half of the
purchase price may consist of acquirer non-voting or voting stock). 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. However, as target eliminated, nontransferable
assets and contracts may be lost.
Reverse Triangular Merger (“A”
Reorganization)
Target Firm (Receives assets
and liabilities of acquiring
firm’s wholly owned
subsidiary)
Acquiring Company
Parent’s
Voting
Stock
Subsidiary’s
Stock
Subsidiary (Shell created by
parent and funded by
parent’s voting stock merged
into target firm)
Subsidiary’s Assets
and Liabilities
Parent’s Stock Target Shareholders (Receive
parent’s voting stock and
& Boot
boot held by parent’s wholly
owned subsidiary in
Target Stock
exchange for target stock)
Viewed by IRS as a purchase of stock since Target survives as acquirer subsidiary. Intellectual property and contracts transfer
automatically; may insulate acquirer from target liabilities and avoid acquirer shareholder approval. Acquirer must buy “substantially
all” of the FMV of the target’s assets and target tax attributes transfer subject to limitation. The major disadvantages are that the
acquirer must purchase at least 80% of the target’s outstanding shares and that purchase price must consist of at least 80% parent
voting common or preferred 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
– No writeup (step up) in basis of acquired assets
Type “B” Stock for Stock Reorganization
Acquiring Firm
(Exchanges voting
shares for at least 80%
of target voting & nonVoting shares”)
Target Stock
Target Shareholders
Acquirer Voting Stock
(No Boot)
Shell
Stock
Wholly-Owned
Shell Subsidiary
Target Assets
and Liabilities
Target Firm
(Merged into acquiring
firm’s subsidiary)
Buyer need not acquire 100% of target shares, shares may be required over time, and may insulate acquirer from
target liabilities. Tax attributes transfer subject to limitation as no asset write-up. 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,
respectively.
• The acquirer must use only voting stock
• Boot cannot exceed 20% of FMV of target’s pre-transaction assets1
• 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
– No writeup in basis of acquired assets
1Value
of assumed liabilities must be deducted from boot and often results in purchase price consisting of all acquirer stock.
Type “C” Stock for Assets Reorganization
Target Firm
Acquiring Firm (Exchanges
Target Assets
(Liquidates and transfers
voting shares for at least
Acquiring Firm shares and
70% & 90% of FMV of
book value remaining
target net & gross assets) Acquirer Voting
assets to shareholders)
Stock & Boot
Acquirer Voting
Target
Cancelled
Stock & Boot
Stock
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; consequently, tax attributes transfer to acquirer subject to limitation.
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 separated 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