Acquisitions of Subsidiaries of
Freestanding Companies
• Tax-free Subsidiary Sales
• Taxable Subsidiary Sales
– Taxable asset sale
– Taxable stock sale
– Taxable stock sale with an IRC
§338(h)(10) election
Tax-free Subsidiary Sales
• The divesting parent exchanges the stock or assets
of the subsidiary for the stock of the acquiring
firm.
• No gain is recognized.
• The sold subsidiary’s NOLs remain with the
subsidiary but are limited by §382.
• The acquirer takes a carryover basis in the
subsidiary’s assets and stock.
• The divesting parent takes a substituted basis in
the acquiring stock received equal to its basis in
the sold subsidiary’s stock.
Undesirable Aspects of Tax-free
Subsidiary Sales
• The seller has not truly divested its holding
in the sold subsidiary.
• The seller will hold a relatively illiquid
block of the acquirer.
• The acquirer and the seller may both hold
financial positions with a built-in gain after
consummation of the transaction.*
* If the FMV of the subsidiary is greater than the
seller’s tax basis in the subsidiary’s stock.
Given Information for
Examples and Cases
Purchase Price
Target's Tax Net Asset Basis*
Divesting Parent's Tax Basis in Target's Stock
Corporate Tax Rate
Discount Rate
Amortization Period
$10,000.00
$2,000.00
$2,000.00
35.00%
10.00%
10.00
-The subsidiary is 100% owned by the parent.
-Neither the subsidiary nor the divesting parent have NOLs.
-The sold subsidary is liquidated by the parent after the sale.
*Historical cost of $2,000 with $0 of accumulated depreciation.
Example: Tax-Free Subsidiary Stock
Sale Under IRC §368(a)(1)(B)
Divesting Parent Shareholders:
Acquirer Shareholders:
No direct tax effect.
No direct tax effect.
Divesting Parent:
Receives $10,000 of acquirer
stock in return for the divested
subsidiary’s stock. Realizes a
gain of $8,000. No gain is
recognized. Takes a substituted
basis in the acquirer stock
received ($2,000).
Acquirer:
$10,000 of
acquirer stock
All of the
subsidiary’s stock
Sold Subsidiary:
The owners of the subsidiary corporation change.
The tax attributes of the subsidiary are limited but
stay with the subsidiary. The tax basis of the
subsidiary’s assets carryover ($2,000).
Purchases the stock of the target
(subsidiary) for $10,000 of its
stock. Takes a carryover basis
in the stock of the acquired
subsidiary ($2,000). Acquired
subsidiary becomes a subsidiary
of the acquirer and its asset
basis carries over.
Example: Post-Acquisition
Ownership Structure
Acquirer:
Owns 100% of the sold subsidiary’s stock.
Has a basis in the target’s stock of $2,000
and a basis in the target’s assets of $2,000.
Sold Subsidiary:
Now a wholly owned
subsidiary of the acquirer.
Net asset basis is $2,000.
Taxable Subsidiary Sales
• Taxable Asset Sale--the acquirer purchases
the assets of the subsidiary (target)
corporation (usually for cash) from the
divesting parent.
• Taxable Stock Sale--the acquirer purchases
the stock of the target corporation from the
parent for cash.
• Taxable Stock Sale w/ an IRC §338(h)(10)
election--completed as a stock sale but
taxed like an asset sale.
Taxable Asset Sales
• A gain or loss is recognized and computed
as price less basis in subsidiary’s net assets.
• The portion of the gain that arises from
recaptured depreciation is ordinary income;
the difference between the purchase price
and the historical cost of the assets is a
capital gain.
• The sold subsidiary’s NOLs remain w/ the
divesting parent, can offset a gain on sale,
and are not limited by §382.
Continued. . . .
Taxable Asset Sales. . .Continued
• Generally, the divesting parent corporation
liquidates the sold subsidiary; no gain or
loss is recognized on the liquidation under
IRC §332.
• The acquirer steps-up to a basis in the
subsidiary’s assets equal to the purchase
price paid.
• There are tax benefits from additional
depreciation and amortization deductions.
Taxable Subsidiary Asset Sale
Divesting Parent Shareholders:
No direct tax effect.
Divesting Parent:
Receives $7,200 from the sold subsidiary in
liquidation. There is no tax associated with
the liquidation under IRC § 332.
$7,200
Acquirer Shareholders:
No direct tax effect.
All of the subsidiary’s stock
Acquirer:
Sold Subsidiary:
Subsidiary receives $10,000 for all of its
assets. Recognizes a gain of $8,000 and
incurs a tax liability of $2,800. After-tax, it
has $7,200 that is distributed to the parent
corporation in liquidation.
$10,000 cash
All of the
target’s assets
Purchases the assets of
the target (subsidiary)
for $10,000 cash. Takes
a basis in the target’s
assets equal to the price
paid ($10,000).
Tax Implications of a Taxable
Asset Sale
Given
Purchase Price
Target's Tax Net Asset Basis*
Divesting Parent's Tax Basis in Target's Stock
Corporate Tax Rate
Discount Rate
Amortization Period
$10,000.00
$2,000.00
$2,000.00
35.00%
10.00%
10.00
-The subsidiary is 100% owned by the parent.
-Neither the subsidiary nor the divesting parent have NOLs.
-The sold subsidary is liquidated by the parent after the sale.
*Historical cost of $2,000 with $0 of accumulated depreciation.
Purchase Price
Tax Effect for Divesting Parent:
Gain on Sale
Cash Received
Tax on Gain
After-tax Cash
Taxable Asset Sale
$10,000.00
$8,000.00
$10,000.00
2,800.00
$7,200.00
Acquirer Cost:
Purchase Price
Less: Incremental Tax Savings
Net After-tax Cost
$10,000.00
1,720.48
$8,279.52
Acquirer's Tax Basis in Target's:
Stock
Net Assets
Step-up in the Tax Basis of T's Assets
n/a
$10,000.00
8,000.00
Taxable Subsidiary Stock Sale
w/o a §338(h)(10) Election
• A capital gain is recognized and computed
as price less basis in subsidiary’s stock.
• The sold subsidiary’s NOLs remain with the
subsidiary but are limited by §382.
• The acquirer takes a carryover basis in the
subsidiary’s assets.
• The acquirer takes a basis in the target’s
(subsidiary’s) stock equal to the purchase
price.
Taxable Subsidiary Stock Sale
w/o a §338(h)(10) election
Divesting Parent Shareholders:
Acquirer Shareholders:
No direct tax effect.
No direct tax effect.
Divesting Parent:
Receives $10,000 cash in return
for the divested subsidiary’s
stock. Recognizes a capital gain
on the stock sale of $8,000 and
incurs a tax liability of $2800.
After-tax, divesting parent has
$7,200.
$10,000 cash
All of the
subsidiary’s stock
Sold Subsidiary:
The owners of the subsidiary corporation change.
The tax attributes of the subsidiary are limited but
stay with the subsidiary. The tax basis of the
subsidiary’s assets carryover ($2,000).
Acquirer:
Purchases the stock of the target
(subsidiary) for $10,000 cash.
Takes a carryover basis in the
target’s assets ($2,000).
Acquired subsidiary becomes a
subsidiary of the acquirer.
Post-Acquisition Ownership
Structure
Acquirer:
Owns 100% of the sold subsidiary’s stock.
Has a basis in the target’s stock of $10,000
and a basis in the target’s assets of $2,000.
Sold Subsidiary:
Now a wholly owned
subsidiary of the acquirer.
Net asset basis is $2,000.
Tax Implications of a Taxable Stock
Sale w/o a §338(h)(10) Election
Selected Given Information
Purchase Price
Target's Tax Net Asset Basis
Divesting Parent's Tax Basis in Target's Stock
Corporate Tax Rate
Discount Rate
Amortization Period
$10,000.00
$2,000.00
$2,000.00
35.00%
10.00%
10.00
Taxable Asset Sale
$10,000.00
Taxable Stock Sale w/o a
Sec. 338(h)(10) Election
$10,000.00
$8,000.00
$8,000.00
$10,000.00
2,800.00
$7,200.00
$10,000.00
2,800.00
$7,200.00
Acquirer Cost:
Purchase Price
Less: Incremental Tax Savings
Net After-tax Cost
$10,000.00
1,720.48
$8,279.52
$10,000.00
0.00
$10,000.00
Acquirer's Tax Basis in Target's:
Stock
Net Assets
Step-up in the Tax Basis of T's Assets
n/a
$10,000.00
8,000.00
$10,000.00
2,000.00
0.00
Purchase Price
Tax Effect for Divesting Parent:
Gain on Sale
Cash Received
Tax on Gain
After-tax Cash
Taxable Stock Sale w/ a
§338(h)(10) Election
• §338(h)(10) allows for the potentially
favorable tax treatment of an asset sale
without incurring the non-tax costs of an
asset sale.
• A subsidiary stock sale can be taxed as an
asset sale under §338(h)(10) only if both the
acquirer and the divesting parent jointly
make the election.
Taxable Stock Sale w/ a
§338(h)(10) Election
• A gain is recognized and computed as price
less basis in the subsidiary’s net assets.
• The portion of the gain that arises from
recaptured depreciation is ordinary income;
the difference between the purchase price
and the historical cost of the assets is a
capital gain.
• The sold subsidiary’s NOLs remain w/ the
divesting parent, can offset a gain on sale,
and are not limited by §382.
Continued. . . .
Taxable Stock Sale w/ a
§338(h)(10) Election. . . Continued
• The acquirer steps-up to a basis in the
subsidiary’s assets equal to the purchase
price paid.
• The acquirer takes a basis in the target’s
(subsidiary’s) stock equal to the purchase
price.
• There are tax benefits from additional
depreciation and amortization deductions.
Taxable Subsidiary Stock Sale
w/ a §338(h)(10) election
Divesting Parent Shareholders:
Acquirer Shareholders:
No direct tax effect.
No direct tax effect.
Divesting Parent:
Receives $10,000 cash in return
for the divested subsidiary’s
stock. Recognizes a gain of
$8,000 (purchase price less
subsidiary’s net asset basis).
Divesting parent pays tax of
$2,800. After-tax, divesting
parent has $7,200.
$10,000 cash
Acquirer:
Purchases the stock of the
target (subsidiary) for
$10,000 cash. Takes a
All of the
stepped-up basis in the
subsidiary’s stock
target’s assets ($10,000
basis; $8,000 step-up)
as a result of the deemed
asset sale under §338(h)(10).
Sold Subsidiary:
Acquired subsidiary
The owners of the subsidiary corporation change. The tax
attributes of the subsidiary remain with the divested parent. becomes a subsidiary of the
acquirer.
The tax basis of the subsidiary’s assets carryover ($2,000).
Post-Acquisition Ownership
Structure
Acquirer:
Owns 100% of the sold subsidiary’s stock.
Has a basis in the target’s stock of $10,000
and a basis in the target’s assets of $10,000.
Sold Subsidiary:
Now a wholly owned
subsidiary of the acquirer.
Net asset basis is $10,000.
Tax Implication of a Taxable Stock
Sale w/ a §338(h)(10) Election
Selected Given Information
Purchase Price
Target's Tax Net Asset Basis
Divesting Parent's Tax Basis in Target's Stock
Corporate Tax Rate
Discount Rate
Amortization Period
$10,000.00
$2,000.00
$2,000.00
35.00%
10.00%
10.00
Taxable Asset Sale
$10,000.00
Taxable Stock Sale w/o a
Section 338(h)(10) Election
$10,000.00
Taxable Stock Sale w/ a
Sec. 338(h)(10) Election
$10,000.00
$8,000.00
$8,000.00
$8,000.00
$10,000.00
2,800.00
$7,200.00
$10,000.00
2,800.00
$7,200.00
$10,000.00
2,800.00
$7,200.00
Acquirer Cost:
Purchase Price
Less: Incremental Tax Savings
Net After-tax Cost
$10,000.00
1,720.48
$8,279.52
$10,000.00
0.00
$10,000.00
$10,000.00
1,720.48
$8,279.52
Acquirer's Tax Basis in Target's:
Stock
Net Assets
Step-up in the Tax Basis of T's Assets
n/a
$10,000.00
8,000.00
$10,000.00
2,000.00
0.00
$10,000.00
10,000.00
8,000.00
Purchase Price
Tax Effect for Divesting Parent:
Gain on Sale
Cash Received
Tax on Gain
After-tax Cash
Review of Various Subsidiary
Sale Tax Structures
Factors influenced by stucture
What is acquired?
Consideration used:
Effect on the Divesting Parent:
Gain or loss recognized:
Gain computed as:
Character of gain:
Sold Subsidiary's NOLs
Effect on the acquirer:
Basis in subsidiary's assets:
Basis in subsidiary's stock:
Tax benefits from additional
depreciation and amortization
deductions
Tax-free
stock sale
Stock
Acquirer stock
No
No gain
recognized
n/a
Remain w/
subsidiary but
limited by 382
Carryover
Carryover
No
Tax Structure
Taxable stock
Taxable
sale w/o a 338
asset sale
(h)(10) election
Assets
Stock
Usually cash
Usually cash
Yes
Price less basis
in subsidiary's
net assets
Ordinary income
and capital gain
Remain w/
divesting parent
and can offset
gain on sale; not
limited by 382
Yes
Price less basis
in subsidiary's
stock
Capital gain
Step-up to
purchase price
paid
n/a
Yes
Carryover
Remain w/
subsidiary but
limited by 382
Purchase price
No
Taxable stock
sale w/ a 338
(h)(10) election
Stock
Usually cash
Yes
Price less basis
in subsidiary's
net assets
Ordinary income
and capital gain
Remain w/
divesting parent
and can offset
gain on sale; not
limited by 382
Step-up to
purchase price
paid
Purchase price
Yes
Tax Implications of Various
Taxable Subsidiary Sale Structures
Purchase Price--Base Case
Acquirer Indifference Price
Purchase Price--Tax Benefit Split
Tax Effect for Divesting Parent:
Gain on Sale
Cash Received
Tax on Gain
After-tax Cash
Acquirer Cost:
Purchase Price
Less: Incremental Tax Savings
Net After-tax Cost
Acquirer's Tax Basis in Target's:
Stock
Net Assets
Step-up in the Tax Basis of T's Assets
Susidiary Sale Structure
Taxable Stock
Taxable Stock
Sale w/o a Sec.
Sale w/ a Sec.
338(h)(10) Election
338(h)(10) Election
$10,000.00
$12,191.86
Tax Benefit Split
Mid-point Price
w/ a Sec.
Incremental
338(h)(10) Election
Difference
$11,095.93
$8,000.00
$10,191.86
$9,095.93
$10,000.00
2,800.00
$7,200.00
$12,191.86
3,567.15
$8,624.71
$11,095.93
3,183.58
$7,912.35
$712.35
$10,000.00
0.00
$10,000.00
$12,191.86
2,191.86
$10,000.00
$11,095.93
1,956.16
$9,139.77
$860.23
$5,000.00
2,000.00
0.00
$12,191.86
12,191.86
10,191.86
$11,095.93
11,095.93
9,095.93
Indifference Price Equation
The seller is indifferent if:
PRICE338h10 - tc(PRICE338h10 - ASSET) =
PRICENO338h10 - tc(PRICENO338h10 -STOCK)
where
•
•
•
•
•
PRICE338h10 is the price when an election is made
PRICENO338h10 is the price if the election is not made
ASSET is the seller’s basis in the net asset
STOCK is the seller’s basis in the sold subsidiary’s stock
tc is the corporate tax rate
Minimum Price Equation
The minimum price demanded by the seller to
make the §338(h)(10) election is:
PRICE338h10 =
PRICENO338h10 + [tc/(1 - tc)](STOCK - ASSET)
where
•
•
•
•
•
PRICE338h10 is the price when an election is made
PRICENO338h10 is the price if the election is not made
ASSET is the seller’s basis in the net asset
STOCK is the seller’s basis in the sold subsidiary’s stock
tc is the corporate tax rate
Maximum Price Equation
The maximum price that the acquiring firm
will pay in a §338(h)(10) transaction is:
ACQPRICE338h10 = PRICENO338h10 + tc*
PVANN*[(ACQUPRICE338h10 - ASSET)/N]
where
• ACQPRICE338h10 is the maximum purchase price the acquiring
firm is willing to pay in a §338(h)(10) transaction
• PRICENO338h10 is the price if the election is not made
• ASSET is the seller’s basis in the net asset
• tc is the corporate tax rate
• N is the average useful life of the acquired subsidiary’s assets
• PVANN is the present value of an annuity
A §338(h)(10) election will be made in
a subsidiary sale when
ACQPRICE338h10 - PRICE338h10 > 0
or, put another way, when
[tc/(1/FACTOR) - tc][PRICENO338h10 - ASSET] [tc/(1 - tc)][STOCK - ASSET] > 0
where
• FACTOR is PVANN/N
• The other variables are as previously defined
Factors Determining a Parent’s Basis
in a Subsidiary’s Stock and Net Assets
• The parent’s tax basis in the stock and net
assets will be equal if the subsidiary was
internally generated.
• When the sold subsidiary was previously
acquired by the divesting parent, the
parent’s tax basis in the subsidiary’s stock
and assets is determined by the tax structure
used to acquire the target.
Subsidiary Sales vs. Sales of
Freestanding C Corporations
• With subsidiary sales, the seller is a
corporation--not an individual shareholder
or a group of various sorts of shareholders
• Subsidiary sales often result in a step-up in
the tax basis of the target’s assets; in
acquisitions of freestanding C corporations,
the target’s assets usually carry over.
Conditions When a §338(h)(10)
Election is Optimal
• When the target subsidiary’s stock basis =
asset basis and purchase price > net asset
basis.
• Also, when the tax basis of the target’s
assets > the tax basis of the target’s stock.
Conditions When a §338(h)(10)
Election is Sub-optimal
• When the divesting parent’s tax basis in the
sold subsidiary’s stock substantially
exceeds the net tax basis of the subsidiary’s
assets.
• This situation is likely to arise if the
divested subsidiary was previously acquired
in a taxable stock acquisition.