Introduction to US Taxation of Mergers
and Acquisitions
Prof. Charlotte Crane
Graduate Tax Program
Northwestern University School of Law
Chicago, Illinois
1
Basic Principles of Taxation of US Corporations
•
Two levels of tax
Shareholders
• Corporation pays tax on earnings
as earned
• Shareholders pay tax when
earnings distributed
•
Corp
Worldwide income of US
corporation taxed by US
• Mitigated by foreign tax credit
•
Tax law not always linked to state
corporate law
US Corp
F assets
US assets
2
Double taxation of Corporate Earnings
Domestic
•
Corporation honored as separate taxable entity
•
Corporation taxed at 35%
$1000 -350= 650
•
Shareholders
Pre-2004 Individual shareholders taxed at 30-35% on
receipt of dividend
Pre-2004
650-195=455
Post-2004 individual shareholders taxed at 15%
Post-2004
Corp
650-97.50=552.50
No shareholder credit for corporate taxes paid
No corporate deduction for dividend paid
No rate difference between income distributed and
income not distributed
•
Except when penalty taxes for accumulations
3
US corporate tax rates
• 2004 stated rates
•
•
•
•
Up to $50,000
Over 50,000 but not over $75,000
Over 75,000 but not over $10,000,000
Over $10,000,000
15%
25%
34%
35%
• 2004 rates including phaseout of lower brackets
•
•
•
•
•
•
•
Up to $50,000
Over 50,000 but not over $75,000
Over 75,000 but not over $100,000
Over 100,000 but not over $10,000,000
Over $10,000,000 but not over $15,000,000
Over $15,000,000 but not over 18,333,333
Over $18,333,333
15%
25%
34%
39%
35%
38%
35%
4
But only double taxation
• Dividends received deduction
With control
100% for 80% or greater ownership
Without control
80% for 20-80% ownership
70% for under 20%
Corp
Corp
Corp
Ind
Share
Corp
But more than double tax not always avoided
5
And not always of single entity
Corp
• Election of affiliated group to file
consolidated returns
– Only US corps may consolidate
Corp
Corp
• And contiguous in some cases
– Only ownership not operation
requirements for eligibility
• Disregarded entities (also called
Tax Nothings)
Foreign
Corp
Corp
Corp
– Partnerships and LLCs when owned
by one shareholder will be treated
as if they did not exist for tax
purposes when box is checked to
treat as pass-through entity
6
Meaning of control
• 1504
vote and value
• 368(c) all voting and stock by class
• Subpart F 50% owned by 10% shs
• All can be subject to their own attribution and look-through rules
7
Disregarded status extends to foreign entities
•
•
•
Regulations specify certain per se entities
Others may be pass-through
Some tension in possibility of market in
foreign entities
German
French
Netherlands
Not eligible AG
for c-the-b
SA
NV
Eligible
Scl
BV
GmBh
8
Tax law not corporate law controls tax treatments
• Corporate law determined primarily by states
– Corporate charters controlling governance and relations with
shareholders
– Relations with creditors
– Procedures for and results of restructuring for non-tax purposes
• Federal law governs access to public capital markets
– Securities offerings (except very small scale)
– Fraud on shareholders (shares with states)
• Federal tax law not tied to state charter or governance law
– “corporation”, “dividend,” “earnings and profits,” “stock,” “debt”
• State law may be necessary for federal tax treatment, but not
determinative-”merger” as one route to tax-free restructuring
• State law may be easiest but not only way-”complete liquidation”
9
Sources of US income tax law
• Internal Revenue Code enacted by Congress
• Regulations promulgated by Treasury Department, written with
Internal Revenue Service
• Published rulings by IRS
• Unpublished rulings by IRS
– Private letter rulings
– Field Service advice, Technical advice memoranda
(designations have changed)
• Court interpretations—only with litigation over actual deficiency
• Treaties
10
What will be taxed as corporation?
• Historically very difficult problem to administer
– Sometimes taxation as corporation preferred, sometimes not
– Previously, if entity provided limited liability to owners, must be
taxed as corporation
– Lawyers found ways to offer effective limited liability
• “Check the box” now allows any entity that does not have a
– Charter as a corporation under state law
– Market made in its interests
– Not available to those corporations that are taxed as bank or
insurance coompanies, or certain foreign entities
Election to be taxed as partnership—called “pass- through”
Cannot change election more often than every 60 months
If “passthrough” single owner, will be disregarded
11
Foreign entities that will be taxed as
corporations
•
•
•
•
•
•
•
•
•
Austria, Aktiengesellschaft
Belgium, Societe Anonyme
France, Societe Anonyme
Germany, Aktiengesellschaft
Italy, Societa per Azioni
Japan, Kabushiki Kaisha
Mexico, Sociedad Anonima
Netherlands, Naamloze Vennootschap
United Kingdom, Public Limited Company
12
Earnings: based on taxable income of corporations
• No general conformity between book income and tax
income
– Schedule M required, but not always useful
– Schedule M may be revised to require more useful information
• Book (financial) income rarely has impact on tax income
•
•
•
•
Cost recovery used as incentive
Costs of many self-developed intangibles deductible
Costs of purchased intangibles amortizable since 1993
Original issue discount
13
Double Tax only applies to earnings
Creates enormous pressure for
debt financing
Without debt
552 after tax to shareholders
•
With debt of 60% at 10%
•
•
•
•
•
•
1000 gross corporate earnings
60 interest
940 net taxable income
329 tax on net
611 earnings to shareholders
91.65 tax by sh
•
•
519.35 after tax to shareholders
39 after tax to creditors
•
558.35 combined after tax
Shareholders
Corp
Shareholders
Creditors
Corp
14
Computation of Earnings and Profits
book
Income from exempt bonds
Gain on installment sales
tax
5000
10000
adjustment to tax for e&p
0
0
5000
10000
original cost book depreciation
tax depreciation
adjustment for e&p
Depreciation on Equipment
Depreciable real estate
Nondepreciable real estate
self-created intangible-patent
Purchased intangible-patent
Federal Income Taxes
50000
50000
20000
15000
17000
5000
8000
0
5000
6000
17000
10000
0
15000
1450
5000
(some as deferred taxes)
11000
16500
15
Distinguishing debt from equity
• Section 385(b) five factors
• (1) whether there is a written unconditional promise to pay, on demand
or on a specified date, a fixed amount in money in return for an
adequate consideration and to pay a fixed rate of interest;
• (2) whether there is a subordination to, or a preference over, other
debt;
• (3) the ratio of debt to equity;
• (4) whether there is convertibility of debt into stock; and
• (5) the relationship between stockholdings and holdings of the interest
in question
• Other factors:
– Whether regular creditor’s remedies are available
– Extent to which participate in corporation gains OR losses
– Participation in governance (rarely determinative)
16
Distinguishing debt from equity other approaches
•
No fixed standards limiting shareholder debt
•
No single statutory or regulatory standard
– Especially difficult when related parties
– Concern about excess debt for non-tax reasons (?)
•
Other limits—deny debt feature
– Section 269 denial of deduction for acquisition indebtedness when
debt and equity stapled
– Section 163(j) denial of deduction
•
“excess interest” to extent more than 50% of income
– (using special definition of income, closer to cash flow)
• Paid to related party (50% common ownership)
• Debt to equity ratio 1.5 to 1 or less
• Can include third party debt guaranteed by related party
– Section 263(l) “payment in kind
•
Other sections may deny equity features of securities
denominated “stock”
17
Debt /Equity Ratio
• In some places statutorily defined, but in others not
• Frequently tax basis of assets (not book or fmv) used for tax
purposes
• Liabilities/Total basis-liabilities
• Not likely to produce same result as bankers or other analysts
would use
• Evidence of problems in structuring Code in which same rules
apply to small closely held as to large publicly-held—common
law nature of evolution of US code
18
Assets of Target Corporation
original cost book depreciation
tax depreciation
tax basis
Certificate of deposit
Accounts receivable
Inventory
Equipment
Depreciable real estate
Nondepreciable real estate
self-created intangible-patent
Purchased intangible-patent
Customer base
Other stock held for investment
Other goodwill
[reserve for tort liability
1000
10000
15000
50000
50000
20000
15000
17000
0
5000
0
183000
Accounts payable
Bank debt
Bonded debt
shareholder equity
100
0
10000
8000
0
5000
6000
0
0
100
0
35000
10000
0
15000
1450
0
0
0
1000
9,900
15000
15000
40000
20000
0
15,550
0
5000
0
29100
61550
121450
0
fmv
Tax gain or lossBook gain or los
1015
9000
22000
38,000
60000
42000
18000
18000
30000
4000
75000
-30000
287015
15
-900
7000
23000
20000
22000
18000
2450
30000
-1000
75000
-30000
15
-900
7000
-2000
18000
22000
8000
7000
30000
-1000
75000
-30000
165565 133115
12000
10000
100000
0
19
Domestic property transactions:
Capital Gains
• Nature of assets involved
• Most stock, financial instruments
• Not inventory, depreciable property
• Land
• All taxable
• unless taxpayer not taxable
– tax-exempt charity
– pension plan
– government
• unless specific transaction not taxable
– tax-free exchanges of certain types of property
– Tax-free corporate restructuring
• unless held by individual at death—stepped up basis to fmv
20
Domestic property transactions:
Capital Gains
• Rate and limitations
– Individuals taxed at favorable rate—15%
– Includes most individual holding of corporate stock
– Except by dealers
– Except in personal retirement accounts
• Dividends now at 15% also
– No special corporate rate for capital gains
– Limitations on losses for both individuals and
corporations
21
Domestic property transactions: depreciable property
• Nature of assets involved
– Machinery and equipment
– Improved real estate
• Special treatment
– Prior deductions may be “recaptured”—1245 and
1250
– Recapture income may be triggered when other
income not
22
Extent of Double Tax Regime
• Alternative regimes
– Passthrough of current income, corporate
level asset gain Subchapter S
– Full pass-through; no entity level tax
• Partnership
• Limited Liability Company
– Full-passthrough entities may “check the box”
• If single owner, become “disregarded entities”
• Not eligible if market made in interests
23
Distributions to Shareholders
Included in income of shareholders to extent of
earnings
• [ignore intricate rules making current e&p available if past
losses]
• No basis offset for receipt of dividend
– Shareholder can have dividend even if holds stock at a loss
– Shareholder can have dividend even if just purchased stock
• No change in shareholder basis as result of income earned
• No shareholder credit for corporate level taxes paid
– Proposal last year was modified version of this, giving
shareholder exemption for fully taxed corporate income
• Only if NO earnings and profits will shareholders have return
of capital
– Return of capital distributions NOT income for US tax
purposes—no withholding
24
Example of treatment of individual
shareholder
• Purchased for $1000
• Now worth $800
• Shareholder receives dividend of $65 from earnings and
profits
– (100 of corporate income)
– 65 of dividend is taxable at 15%
– Leaving shareholder with $55.25 of $100 corporate earnings
• If stock decline in value in connection with dividend to
760
– shareholder basis in stock still 1000
– shareholder recognizes loss of 240 only on sale of stock
• Dividend treatment avoided if sale possible
25
Individual preference for cashing in stock
gains
• Before rate reduction, individual shareholders
sought to avoid dividends—all taxed, highest
rate
• Very low dividend payouts by many US
corporations
• With rate reduction, less concerned unless very
high basis
• Large enough change to effect corporate
behavior??
• Rate reduction set to expire in 2009
26
Distributions to Corporate Shareholders
• Dividends received deduction available for
corporations section 243
• Varies with level of ownership
– 100% if 80% or more
– 80% if 20-80%
– 70% if less than 20%
27
Corporate preference for cashing in stock
gains
• Corporate shareholders may prefer
dividends to sale or exchange
• Corporate shareholder may pay itself
dividend from subsidiary before selling
28
Non-liquidating distributions of property to
shareholders generally taxable
• Treated as dividend received by
shareholders
• Triggers gain to distributing corporations
– No losses triggered
• Losses triggered only on sale
• No losses on sale to related party
• Even to unrelated party, sale not honored if buyer
not take economic risk
• Even of subsidiary stock unless qualifies
as spin-off under reorganization rules
29
Share Repurchases--Redemptions
• Share repurchases in US are legal so long as
shareholders not preferred over others
inappropriately
• “Greenmail”
• Designation of transaction as sale to issuing
corporation will not control
30
Recharacterization of sales of stock to issuing
corporation
• Special rules under section 302 determine when
shareholders have changed position in
corporation enough to have sale not dividend
treatment
• Generally not problem for small shareholders in
publicly held corporations
• When redemption honored as “sale or
exchange” basis allowed
• Of less concern generally with rate reduction in
effect
31
Corporate Liquidations: section 336
• Since 1986 all corporate level gain to be taxed
when leaves “corporate solution” to be held by
individuals
• Prior law ( first set out in ‘General Utilities’ case)
allowed liquidations in any circumstances to
escape corporate level taxation
• Extended by statute to sales made in connection
with liquidation
32
Significance of “repeal of General Utilities”
• General approach to prevent escape of
corporate level gains
• Some implementation rules assume that
corporation should not be able to sell part of its
assets in taxable transaction and other part in
tax-free reorganization
• Removed much of flexibility in corporate
restructuring
• Enormous pressure now on reorganization rules
• Enormous pressure to reduce corporate tax in
33
other ways
Measure of gain in corporate liquidation
• Law still undeveloped
– Too costly to try
– Perhaps more law will develop now that more assets
may be held at loss
– May have difficulty avoiding more gain than actual
gain on sale
• Gain to be computed on each asset as if sold separately
• Separate computation for liabilities in excess of tax basis
• Extent to which unbooked losses will be allowed not clear
34
Assets of Target Corporation
with liability problems on liquidation
tax depreciation
tax basis
fmv
Tax gain or loss
Certificate of deposit
Accounts receivable
Inventory
Equipment
0
100
0
35000
1000
9,900
15000
15000
1015
9000
22000
38,000
Depreciable real estate
10000
40000
60000
Nondepreciable real estate
self-created intangible-patent
Purchased intangible-patent
Customer base
Other stock held for investment
Other goodwill
0
15000
1450
0
20000
0
15,550
0
5000
0
42000
18000
18000
30000
4000
75000
22000
18000
2450
30000
-1000
75000
-30000
-30000
287015
165565
0
[reserve for tort liability
61550
121450
15
-900
7000
23000
80000
20000
Accounts payable
Bank debt
Bonded debt
shareholder equity
35
Liquidations of Controlled subsidiaries:
332 and 337
• Nonrecognition on liquidation if 80% owned by
corporation
• Implementing idea that only Double Tax
• Corporate basis in stock never used
• Controlling corporation takes subsidiary’s basis
in stock
• Controlling corporation inherents other tax
attributes
– In general as if subsidiary never existed
• In minority shareholders, corporate gain as if
336, no loss
36
Nontaxable Transfers to Corporation under
section 351
• Same rules apply whether existing or new corporation
• 80% of corporate stock must be held by control group
after
• Nonvoting stock may be used
– But nonvoting stock that is too much like debt will trigger gain
351(g)
– Debt may be swapped, but possible gain to both corporation and
shareholder
• Control group must retain “immediately after”
– Obligation to transfer will defeat nontaxability unless new
transferee can be counted as transferor
37
A corporation’s dealings in its own stock
•
Under section 1032, corporation not recognize gain or loss in dealings with
own stock
– No difference if “Treasury stock” or repurchased on market
•
Special rules in regulations allow subsidiaries in some circumstances the
same treatment
– Generally subsidiary must dispose of stock promptly
•
Corporation given basis credit for use of stock
– Departure from ordinary expection in US tax law that no basis if no tax paid on
property used as consideration
– Significant visible issue in relation to employee stock options
• Financial accounting treatment different
– Currently being studied
• Other limitations on the deductibility of interest
– Section 269 Acquisition indebtedness
– Section 163(j) anti- “Earnings stripping”
– Section 163(l)
38
Net Operating Loss Carryovers
• Generally, allowed limited carryback and
more generous carryforward of net
operating losses and capital losses
– Character as operating or capital preserved
– Sections 172 and 381
• Change in ownership (whether taxable or
not) can result in limit of use of losses to
present value in hands of old shareholders
– Section 382
39
Consolidated returns
• Affiliated groups (defined in section 1504) may elect
• Only US subsidiaries
– FINANCIAL ACCOUNTING STANDARDS DIFFER FASB 94
•
•
•
•
In general, all US subsidiaries included if election
Gains and losses for transfers within group excluded
Losses of members can offset gains of other members
Intricate rules attempt to limit to losses not incurred while
a member of the group
40
OVERVIEW OF US TAXING
JURISDICTION
41
US taxation of worldwide income of US
taxpayers:
Who is US taxpayer?
– Citizens (wherever they reside)
– Resident aliens
– Corporations with domestic charter
• location of the headquarters, seat of management, place of
operations not matter
• But those not US taxpayers need to compute income
under US rules if earnings will be subject to US tax on
repatriation
42
US worldwide taxation of US taxpayers—
what is taxed?
• All income, without territorial exclusion
– Only territorial exclusion allowed for service income of
individuals
• 911 and 912
– Direct credit for foreign income taxes paid under section 901
– Indirect credit for taxes paid by certain foreign corporations
43
Foreign Tax Credit Section 901
• For taxes paid by taxpayer to foreign
jurisdiction
• Limited under section 904 to otherwise
owed US income on foreign income
– Limit to prevent high rates in foreign
jurisdiction from pulling off US tax on US
income
44
Foreign Tax Credit Limitation 904
• Limited by US tax on “foreign source income”
• Foreign source income is US term of art
– Not income actually subject to foreign tax
– Computed based on US tax concepts
• Currently two types of limits
– Complicated baskets, reduced for future to two
– Overall foreign loss produce resourcing of gain
in later year (2004 new rules)
• Excess credits carryforward but limited
45
Indirect Foreign Tax Credit
902
• Indirect credit allowed when US corporation
receives dividend from 10% owned foreign
corporation
– No dividend received deduction for dividends
paid by foreign corporation
– Dividend grossed up by ratable share of
foreign taxes paid by foreign corporation
under section 78
– Allowed in addition to direct credit for
withholding on dividend
– Allowed for certain deemed dividends as well
Slide
46
US Taxation of Non-US Taxpayers
All foreign persons and foreign corporations
• income “effectively connected” to a trade or
business conducted in the US
• Other income if sourced to US under US
sourcing rules
Slide
47
Trade or business conducted within the
US by foreign taxpayer
• Income computed on net basis, deductions
allowed
• Some income otherwise foreign may be
pulled in if fixed location
– Rents, royalties, dividends, sale of inventory
• Possible branch profits and branch interest
tax if foreign corp
• Effect of treaties on effectively connected
income: permanent establishment may raise
Slide
threshold and affect sourcing
48
Branch profits and branch interest taxes
– To equalize treatment of branches and
subsidiaries of foreign taxpayers
– Section 884 enacted in 1986
– Reduced or eliminated by treaties
Slide
49
Income of Foreign Taxpayers Not
Effectively Connected
• Generally subject to withholding at 30%
– Section 871 for individuals
– Section 881 for corporations
• Rate lowered (sometimes to zero) by treaty
• According to US sourcing rules: section 861
Slide
50
US sourcing rules: interest
• Generally 30% withholding on interest
• Likely to be greatly reduced by treaty
• Since 1984, no withholding on the payment of portfolio interest.
– Section 871(h) and 881(c).
– Portfolio interest not include interest paid to related foreign
taxpayers (10% or more)
• Interest sourced according to the state of incorporation of the
debtor/payor.
• Special source rule for US corporation which has had 80% of
its gross income derived from the active conduct of a foreign
business. Section 861(c).
Slide
51
US sourcing rules: dividends
• Generally 30% withholding
• Treaty provisions alter, but less generous than interest
• Dividends will be treated as US source if distributed by a US
corporation.
• Dividends also US sourced for some foreign corporations
– If 25% of their gross income for three years effectively
connected with the US
– pro rata part of the dividend will be US source.
• Dividends received by a US corporation after restructurings
with corporation with US earnings may also be US sourced.
Section 861(a)(2)(C).
Slide
52
US sourcing rules: Gains on property
• Gains on sales of property generally not US
sourced
• Foreign taxpayers not taxed on sale of US
corporation stock
Slide
53
US sourcing rules:
Gains on certain specific types of property
may be US sourced
• Since 1980 real property in US is US sourced FIRPTA
– 10% withholding or as allowed by IRS
– includes certain interests in entities owning US real
property
• Assets related to assets effectively connected with US
business
• Gains attributable to cost recovery against US income may be
US sourced
• Gains attributable to self-produced property
Slide
54
US sourcing rules:
section 861
Rents and royalties
• Rents from the lease of tangible personal property
will be sourced to the location of the property.
• Royalties from the license of intangible property will
be source according to where the intangibles are
used.
• Sales of Intangibles
– If the terms of the sale are contingent, the source rule
for royalties, location of use, used
– If the terms of the sale are not contingent, gain is
sourced to the country of the seller.
Slide
55
Effect of treaties generally
• Substitution of permanent establishment for
“effectively connected” regime
• Change in source rules
• Reduce or eliminate withholding, especially on
dividends and royalties
• Information reporting
• US more likely to include “limitations on benefits”
provisions to ensure corporation resident in claimed
jurisdiction
Slide
56
Preserving US taxbase and outbound
transactions generally
• If assets transferred outside US to foreign
taxpayers, US loses tax base
• Efforts to make sure that all such transfers
are taxable result in exceptions to some nonrecognition rules Section 367(a)
• Special regime for corporations controlled by
US taxpayers subpart F, sections 951-964
Slide
57
Controlled Foreign Corporations subpart
F, sections 951-964
• Deviation from general rule honoring corporations
as separate entities
– Prompted by fear of “deferral”
– US income tax law generally sensitive to “timing”
problems
• Complex rules aimed at efforts by US taxpayers to
move income offshore
• Usually not interfere when true foreign ownership
not less than 50%
• Rules likely to be changed if “abuses” perceived
Slide
58
Consequences of Being a Controlled
Foreign Corporation
• Some income, if passive, taxed currently
• Special rules trigger dividend income on sale
of stock section 1248
• Special rules apply when earnings of CFC
moved in ways that might make less subject
to US tax in future
– Even if transaction otherwise looks “foreignto-foreign”
Slide
59
When will corporation be CFC?
• foreign corporation more than 50% owned by “US
shareholders”
• since 1986 50% by vote OR value
– may include subjective determinations of influence
• US shareholder only included if own 10% of the
stock
• US partnership will be a “US shareholder” without
regard for the country of its partners
• Attribution rules may look for US owners of foreign
entities
Slide
60
Other anti-deferral regimes
•
Two regimes recently repealed:
–
–
Passive Foreign Investment Companies
•
sections 1291-1297
•
allowing shareholders to elect either to include the foreign corporation’s income in their
income currently or pay interest on the deferral
•
DEFINITIONS REMAIN IMPORTANT FOR CFC REGIME GENERALLY
Foreign Personal Holding Companies
•
•
sections 551-558
Foreign Investment Companies regime remains
–
sections 1246-1247
–
Charges interest on tax deferred through offshore
•
All focus on US taxpayers seeking “deferral” and not at foreign shareholders
•
New 2004 limitation on benefits of inversion prevent normal operation of some nonforeign
favorable attributes
Slide
61
TAXABLE ACQUISITIONS:
STOCK OR ASSETS
Slide
62
Taxable Sales of Business Assets
• Tax rules generally same when seller corporation or individual
• Special rules for situations when assets constitute a “trade or
business”
– Generally to account for “goodwill”
• States will vary about shareholder permission needed
• Tax consequences of taxable sales of business generally not
depend on whether all of corporations assets transferred
– For large enough portion, may require shareholder approval
– If constitutes business, apportionment to goodwill required
63
Taxable Sale of Business Assets
Buyer’s considerations
• Treated as sale of individual assets
• Allocation of purchase price among assets
• Residual purchase price accounted for as
“goodwill”
• No tax attributes conveyed
– NOLs, FTC history stays with seller
64
Allocation issues
• Seller
– Low allocation to ordinary income property
– If to be reported as installment sale, low allocation to recapture
assets
– Avoid capital losses without capital gains to offset
• Buyer
– High allocation to property for which cost recovery allowed
– Concerns greatly lessened by section 197 for purchased
goodwill
• Payments for covenant not to compete treated as
purchased good will
65
Assumption of Seller’s liabilities on sale of
assets
• Generally seller’s gain will be computed
based on all value received
– If seller’s creditors paid as part of transaction,
will count in “amount realized” by seller
– If seller’s creditors to be paid in future by
buyer, will also count in “amount realized” by
seller
• Complications when liabilities of seller are
contingent, but principles remain same
66
Assets of Target Corporation
Assuming all but tort liability to be paid by seller
original cost book depreciation
tax depreciation
tax basis
I
II
Cash
Certificate of deposit
III
IV
II
V
V
V
VI
VI
Accounts receivable
Inventory
Other stock held for investment
Equipment
Depreciable real estate
Nondepreciable real estate
self-created intangible-patent
Purchased intangible-patent
VII Customer base
VII Other goodwill
fmv
Tax gain or loss
500
500
0
0
1000
515
-485
10000
15000
5000
50000
50000
20000
15000
17000
100
0
100
0
10000
8000
0
5000
6000
35000
10000
0
15000
1450
9,900
15000
5000
15000
40000
20000
0
15,550
9000
22000
4000
38,000
60000
42000
18000
18000
-900
7000
-1000
23000
20000
22000
18000
2450
0
0
0
0
0
0
0
0
30000
75000
30000
75000
121450
-150000
166515
-150000
45065
[reserve for tort liability
182500
29100
61550
67
Taxable acquisitions of stock
• Gain not recognized on corporate assets
– NO BASIS TO SELLER FOR PURCHASE PRICE
• Corporate Tax Attributes will survive
– Asset basis
– Accounting methods
– Carryover losses(but limited by 382)
– Earnings and profits
• Unwanted assets can be distributed to shareholders
– IRS position avoids fear of characterization as dividend for
individual shareholders
– Corporate shareholders may prefer dividend treatment to sale
proceeds
• Courts have honored pre-sale dividend distributions if Target
could have funded on its own
68
Borrowing to acquire assets or stock
• Section 279 limits deduction for interest to $5
million per year, but only if
–
–
–
–
Issued to provide consideration in acquisition
Subordinated to trade creditors
Has equity option
debt-to-equity ratio exceeds 2 to 1, or projected
earnings do not exceed three times the interest to be
paid or incurred on the debt
• Not apply to acquisition of foreign business not
subject to US tax
69
Transfers of assets disguised by creation of
a corporation
• Creation of corporation can be tax-free
• Sale of stock may be preferable for seller to sale
of assets
– Judicial doctrines will prevent incorporation
merely to transfer assets
– Generally will be recast as sale of assets
70
Acquisitions of stock treated as acquisitions
of assets
Purchases of stock representing control
followed by 338(a) election (sometimes
called (g ))
• Must acquire 80% of Target
• Acquisition transaction must occur in single 12 month
period
71
History of stock purchase treated as asset
purchase
• Previously result of judicial recasting of transactions
– Now, if would result in increase in basis, only when
statutory election available and made
• Election generally will trigger both corporate and shareholder
level tax
– VERY limited domestic use
» When carryover losses otherwise unavailable
» When corporation 80% owned by another
corporation
» When corporation is Sub S
72
Election to treat sale of stock as sale of
assets under 338(h)(10)
• When subchapter C would excuse a level of tax
• When corporation 80% owned by another corporation
• When corporation is Sub S
– Regulations expanded from original statutory provision for
corporations filing consolidated only
• Election results in no use of seller’s basis in
target stock
– Buyer and seller must agree to election
73
•
•
•
•
Taxable sale of stock
Check-the-box elections: Considerations when
Target to be Sold by US corp is foreign
US CFC regime does not tax business income,
including income on sale of assets, but does tax
sale of stock
If sub of CFC elects to become disregarded
entity, treated as liquidation for US tax purposes,
followed by sale of assets, so business income
for CFC, not stock sale
Honored as sale of stock for foreign purposes
IRS resisted application of “check-the-box” in
such extraordinary situations, but has lost so far
in litigation
74
Taxable sale of Stock:Considerations when
US acquiring buying foreign stock
• Foreign corporation’s tax attributes,
computed using US tax rules, survive
acquisition by US, just as domestic would
• 338 election may be desirable
75
338 elections: Considerations when Target
to be Acquired by US is foreign
• US does not tax not effectively connected
income of foreign corporation
• If election is made on purchase of foreign target
– Basis step-up in assets with no foreign tax cost
– Less income in future for CFC under US tax rules
• Corporation will be CFC if Buyer is US Corp
– Care to avoid being CFC before election—30 days
76
GENERAL CONSIDERATIONS ON
OUTBOUND NONTAXABLE TRANSACTIONS
77
Transfers of assets from US taxing
jurisdiction section 367(a)
• In general, no special rules on transferring
in taxable transactions to foreign
taxpayers
– Except intangibles
– Except some transactions involving US real
estate
• Many exceptions to nonrecognition
provisions
78
Considerations when parties are foreign in
351 transactions
• If assets transferred to foreign corporation
from US taxpayers, leave US tax base
• 367 denies “corporation” status to
transferee
• Regulations indicate result is triggering of
gain but not loss
79
Considerations when parties are foreign in
351 transactions--foreign operations
• Provision not intended to block legitimate
transfers of business assets
• 367(a)(3) provides exception to exception
• Gain still recognized on inventory,
accounts receivable, depreciation
recapture, currency transactions
• 367(a)(3) not available when foreign
branch losses
80
Foreign transferee of Intangibles
• Under section 367(d), all transfers of
intangibles such as patents will be treated
as deemed contingent sales. This
deemed royalty will not, however,
generally attract foreign withholding.
81
Inbound transactions: Foreign shareholders
transferring to US corporation
• No special rules apply when foreign
shareholders contribute property to a US
corporation.
• 2004 legislation may affect basis to
prevent importation of built-in losses from
foreign taxpayers
82
The Idea of a Nontaxable Reorganization
section 368 definitions
• Only route to avoid taxation of corporation
on asset gain and of shareholder on stock
gain
• Originally a very skeletal statute
• Most of interpretation accomplished by
judicial elaboration of statute
• Judicially created doctrines still very
important
83
The Idea of a Nontaxable Reorganization
• Because of notion that involves no change to
corporation
– Generally only available when “substantially all”
corporate assets transferred
– Generally only available when most shareholders
affected
• All in merger (although up to half can be cashed out
• At least 80% in most other types of reorganizations
• Very limited exception to above through 355
spinoff
84
The concept in summary
– The IRS in regulations has summarized the purpose of the
reorganization provisions of the Code:
– “to except from the general rule [of US tax law, that
upon the exchange of property , gain or loss must be
accounted for if the new property differs in a material
particular …from the old property] certain specifically
described exchanges incident to such readjustments
of corporate structures made in one of the particular
ways specified”…as are required by business
exigencies and which effect only a readjustment of
continuing interest in property under modified
corporate forms.”
– Reg. 1.368-1(b).
85
Consequences of Reorganizations
generally
• Target and shareholder consequences tied together
• To extent only stock is used
– To treat old shareholders of Target as if nothing had happened
– To treat Target as if nothing had happened
• To extent other consideration is used
– To tax shareholders on value extracted to extent of gain
– Rarely corporate consequences for cash used
• Acquirer DOES NOT increase basis for cash used
– If Acquirer uses property with fmv greater than basis, gain to Acquirer
• But DOES NOT increase acquirer basis in assets
86
Consequences to the parties: shareholders
generally
• Section 354 allows tax-free receipt
• Section 358 gives shareholders basis in
stock received equal to stock given up
• If non-stock received, shareholders will
have gain (but not loss) under 356
• Gain can be recharacterized as dividend
under 356
87
General corporate consequences of
reorganization: Target
• If stock transferred
– Ordinarily no gain to corporation anyway
• If assets transferred
– Section 361 allows transfer without gain
• Unwanted Assets
• Non-stock consideration
• Dispositions of Acquirer Stock
88
Corporate Consequences: Acquirer
• Acquisition of assets
– Section 362 provides that Acquirer takes basis equal
to Target’s basis in assets
– Use of non-stock consideration may trigger Acquirer
gain but no additional acquirer basis
• Acquisition of stock
– Acquirer takes basis of shareholder from whom
acquired stock
– When Target held publicly, formulaic determination
may be accepted
89
A Reorgs and the Judicially Imposed
Requirements for All Reorganizations
• 368(a)(1)(A) “a statutory merger or
consolidation”
– one of very few places where tax result
conditioned upon state corporate law
provisions actually used
– Continuity of interest
– Continuity of business enterprise
90
Business considerations for A
reorgs/statutory mergers
• Most flexible in terms of consideration
• Most flexible in terms of ability to dispose of
unwanted assets
• Most risky in terms of corporate law
consequences
– Usually no avoidance of any liabilities of Target
• Shareholder approval of both corporations
usually necessary
• Shareholders may have dissenter’s rights
91
Considerations when the parties are foreign
• Under prior law, must be “merger or
consolidation effected pursuant to the
corporation laws of the United States or a State
or Territory or the District of Columbia.” Reg.
1.368-2(b)(1)
• Since Jan 2005 mergers under foreign law will
be honored as mergers for US corporate
purposes
• Use of triangular merger: Foreign Acquirer
creates a US corporation as a merger vehicle
92
Consideration when foreign aspects
• Few special rules when foreign merging into US
with US control
– If corporate law allows
• If US corp merging into foreign
– 367(a) will limit nonrecognition on transfer of nonstock
assets
– 367(b) will apply to extent assets include stock of
subsidiaries of merged corporation
• Foreign to foreign merger may also implicate
367(b)
93
Gain on transfer of foreign operations under 367(a)
original cost book depreciation
tax depreciation
tax basis
Certificate of deposit
Accounts receivable
Inventory
Equipment
Depreciable real estate
Nondepreciable real estate
self-created intangible-patent
Purchased intangible-patent
Customer base
Other stock held for investment
Other goodwill
[reserve for tort liability
Accounts payable
Bank debt
Bonded debt
shareholder equity
1000
10000
15000
50000
50000
20000
15000
17000
0
5000
0
183000
12000
10000
100000
0
100
0
10000
8000
0
5000
6000
0
0
100
0
35000
10000
0
15000
1450
0
0
0
1000
9,900
15000
15000
40000
20000
0
15,550
0
5000
0
29100
61550
121450
0
fmv
1015
9000
22000
38,000
60000
42000
18000
18000
30000
4000
75000
-30000
287015
Tax gain or loss
Book gain or loss
15
-900
7000
23000
20000
22000
18000
2450
30000
-1000
75000
-30000
165565
15
-900
7000
-2000
18000
22000
8000
7000
30000
-1000
75000
-30000
133115
94
Transfers of Assets: “C Reorgs” generally
• “Practical merger” made available first when some states had no
easy statutory merger procedure
• Section 368(a)(1)(C) to “the acquisition by one corporation, in
exchange … for …its voting stock…of substantially all of the
properties of another corporation.”
• 368(a)(2)(G) requires Target to distributes all of its assets—both
what it received from Acquirer and what it did not transfer to
Acquirer—to its shareholders
– regulatory permission to delay liquidation anticipated
• Not tied to any particular transaction under state law
•
target shareholders may have to approve
95
C reorganizations
Stock for assets
A sh
T sh
Acq
T
Assets
•
•
•
•
Acq must use voting stock
Limited other consideration
Acq must acquire
substantially all assets
T must liquidate
96
C reorganizations
*Stock for assets*
A sh
T sh
Acq
T
Assets
•
•
•
•
Acq must use voting stock
Limited other consideration
Acq must acquire
substantially all assets
T must liquidate
97
C reorganizations
*Stock for assets*
T sh
P Acq
Acq
T
Assets
•
•
•
•
•
Acq must use voting stock
Limited other consideration
Acq must acquire substantially
all assets
T must liquidate
May use P Acq stock
98
C reorganizations
**Stock for assets**
T sh
P Acq
Acq
Assets
•
•
•
•
•
Acq must use voting stock
Limited other consideration
Acq must acquire substantially
all assets
T must liquidate
May use P Acq stock
99
“substantially all of the assets”
• Rev. Proc.77-37 70% of gross asset value and 90% of net asset
value is adequate.
– Thus a corporation with assets of $10 million subject to debt of $5.5
million must either transfer at least $7 million of assets and $4 million
worth of net assets.
• Limited non-stock consideration allowed
• Target must distribute value received, as well as any value it did not
transfer, to its shareholders
– This secondary transactions controlled by section 361
• Anticipates non-stock consideration
– Transfers to creditors will be treated as if they were transfers to
shareholders for the purpose of satisfying this requirement
100
Limited usefulness of C with nonstock
consideration
• Liability assumption ordinarily not counted
as “boot”
• But will be to determine adequate
consideration in C
– stock must be used as the consideration to
acquire 80% of the total value of Target
• Thus boot cannot be used whenever boot
and liabilities exceed 20% of fmv of
Target’s assets
101
Business Considerations in C
reorganizations
• Many more liabilities likely to be avoided than
with merger
– But not necessarily all
• Federal environmental liabilities asserted against any owner
of asset involved
• State tort liabilities may go with transfer of line of business
– Acquirer must want “substantially all” of the assets
– Most assets will need to be transferred separately
102
Special considerations when parties are
foreign
• Transfer by US corporation to foreign corp
• 367(a) will trigger gain
• no active foreign business exception available here
– unless transferor corporation is controlled by 5 or fewer US
taxpayers
» Target’s US asset gain may be shifted to Target
shareholder’s basis in stock to extent of non-US
holdings
• Transfer of assets by foreign corporation to US
corporation
• Only problems if CFC
103
Variations: Forward subsidiary mergers
• section 368(a)(2)(D) parent stock may be used,
but only if
– (1) substantially all of the assets of Target must be
acquired
– (2) the transaction would have qualified as an (A)
reorganization if the “merger had been into the
controlling corporation” and
– (3) no stock of acquiring is used in the transaction
• Acquirer may be a new corporation created for
the purposes of facilitating the acquisition.
104
* C reorgs when Target’s old shareholders
left in control
• Section 368(a)(1)(D) provides separate
definition when T’s shareholders in control after
transaction
• For acquisitive domestic transactions, no
difference except when excess liabilities
• Courts have accepted more liberal
interpretation—to keep taxfree when planned to
be taxable
• For foreign transactions, previously difference in
length of gain recognition agreement
105
Transfers of stock: “B reorgs”
• Only voting stock of Acquirer can be used
• Must own 80% control after transaction
– Need not all be acquired in same transaction
– General
106
Solely for Voting stock requirement in B
reorg
• IRS has ruled that some shareholders
may be redeemed if separate transactions
• Dissenter exercise of appraisal right need
not defeat
• Acquirer may pay Target fees (but not
some of Target shareholder’s costs)
•
107
B reorganizations
Stock for stock
A sh
T sh
Acq
T
•
•
Acq can use only voting
stock
Acq must have 80%
control after
108
B reorganizations
*Stock for stock*
A sh
T sh
Acq
T
•
•
Acq can use only voting stock
Acq must have 80% control
after
109
B reorganizations
**Stock for stock**
A sh
T sh
Acq
T
•
•
Acq can use only voting stock
Acq must have 80% control
after
110
Business considerations in B reorgs
• Acquirer is not exposed to Target’s assets
• Target’s debt can survive the transaction without
renegotiation.
• No need to assign contracts, franchises, licenses
• Only Target’s shareholders need to approve the
transaction
111
Concerns when foreign parties:
Foreign acquirer of US Target in B reorg
•
•
•
When a US Target is owned by a Foreign Acquirer the US Target remains generally subject to US
tax
367(a)(2) reflects lower level of concern about erosion of US base.
No gain recognition if
–
–
–
–
–
–
•
if the stock of Foreign Acquirer received by US shareholders is less than 50% of the outstanding stock of
Foreign Acquirer,
if specified US persons own less than 50% of foreign acquirer,
if Foreign Acquirer or a related party have conducted an active trade or business outside the US for at least
three years,
if there are no shareholders of Target that become more than 5% shareholders of Target, or if there are,
these shareholders enter into a Gain Recognition Agreement whereby they agree to recognize their stock
gain if Foreign Acquirer disposes of Target stock,
if the relative fair market value of the Acquirer is substantial (in general, is at least as large as the US Target,
and if Target agrees to follow certain reporting requirements
Above rules aimed at “inversions”
112
Inbound B reorganization situations
• US Acquirer of Foreign Target in B reorg
– neither 367(a) or 367(b) apply
– Corporation will be CFC
113
Foreign to foreign B reorganization
situations
• Foreign Acquirer of foreign corporation
– If not CFC no US concern
– If CFC, will trigger 1248-like dividend
• Deemed dividend will be desirable
114
Foreign B reorganization situations
• Concerns when foreign parties in transfers by controlling
shareholders under section 351
– Outbound transactions: 367(a) generally
– Foreign Transferee/Acquirer of assets denied
status as corporation
Gains triggered
Losses not allowed
Exception for active foreign operations
Inventory, intangibles, recapture not protected
Branch loss exception
115
Variations: Use of Parent Stock
– In B and C reorgs, permitted by parenthetical
in statute
– But only stock of one acquirer side
corporation permitted
– Not stock of grandparent
– In C reorgs permits public-traded stock as
consideration without exposure of Acquirer
assets
116
B reorganizations
*Stock for Parent stock*
P
Acq
T sh
Acq
T
•
•
•
Acq can use only voting stock
Acq must have 80% control
after
Stock of acquirer parent may be
used
117
B reorganizations
Stock for stock with drop
A sh
T sh
Acq
Sub
T
•
•
•
Acq can use only voting stock
Acq must have 80% control
after
Acq may contribute T to sub
118
B reorganizations
**Stock for stock with drop**
A sh
T sh
Acq
Sub
T
•
•
•
Acq can use only voting stock
Acq must have 80% control
after
Acq may contribute T to sub
119
Variations: Reverse subsidiary mergers
• Under section 368(a)(2)(E), an “Acquirer”
can be merged into Target using stock of
Acquirer’s controlling Parent if,
– after the transaction, Target holds
substantially all of the assets of both
corporations, and
– the former shareholders of Target gave up
control of Target in exchange for voting stock
in this transaction
• .
120
Variations: Reverse subsidiary mergers
• “Acquirer” may be a new corporation
created for the purposes of facilitating the
transaction.
• In such cases, it is easiest to see the
reverse subsidiary merger as
accomplishing the same result as a B
reorg using Parent stock and treating
Parent as the Acquirer.
• By far the most useful in most domestic
121
transactions
Multistep transactions
• Transactions may be recast to reflect end results
rather than formal steps taken
– Acquisition of stock followed by liquidation or merger
will be treated as acquisition of stock
• Not if result would render taxable acquisition of assets
• But likely if result would render nontaxable acquisition of
assets
– Merger of transitory corporation can be treated as
acquisition of stock
122
Reorganizations involving less than all
assets
• US affords very limited nonrecognition when less
than all of corporation’s assets involved
• Nonrecognition available only under 355 with
active trade or business requirement
• Limits on ability to use in anticipation of
acquisition of separated business
• Even if nonrecognition not sought, subsidiary
strictly for transfer of part of assets not likely to
be honored
123
Spinoffs under section 355
• Section 355 when met
– Allows a corporation to distribute the stock of a
subsidiary to shareholders without gain at the
corporate level, or at the shareholder level, if certain
conditions are met.
– with section 368(a)(1)(D) allows such transfers even
when the distributed corporation is newly created.
– The distributions to shareholders can be pro rata, but
need not be pro rata.
124
Requirements in section 355 spinoffs
• Relatively strict, sometimes redundant limits
• Both corporations must be engaged in a trade or
business– business separate from the other corporation’s
business at the time of the spinoff—
• for five years before the spinoff.
• cannot have been acquired in a taxable transaction.
• Corporate business purpose,
• the lack of a device to distribute earnings and
profits without dividend treatment.
125
Use of 355 in Acquisition Transactions
• Recent legislation limits useful in acquisition transactions
– Sections 355(d) limits ability to purchase stock to be swapped
for Target stock
– Section 355(e) limits ability to spinoff to separate more generally
• Outsiders cannot acquire more than 50% of stock of Target
• If fail, trigger corporate level gain on distribution of stock
– No basis created
• IRS inconsistent in approach taken to provisions
– Currently relatively lenient
126
355 with foreign aspects:
US distributing corporation
• US distributing to US shs of foreign sub
– If corp distributee, no special rules
– If ind distributee, US distributing recognizes gain
• Presumption to be rebutted that all individuals
• US distributing to foreign shs of foreign sub
– US distributing must recognize gain
• Presumption to be rebutted that all foreign
• No special effect on distributees
127
355 with foreign aspects:
Foreign distributing
• If distributing is CFC
– If 1248 amounts affected, shs must adjust
basis and/or recognize gain
• If distributing is not CFC
– US shareholders have same treatment as if
domestic, if can show 355 standards met
128
Taxable Mergers and Taxable Informal
mergers
– Forward mergers as acquisition of assets
followed by liquidation
– Forward triangular merger as taxable
purchase of assets
– Reverse subsidiary mergers taxable as
purchase of stock
129
Choice of Acquisition Technique:
Taxable or Nontaxable
• Consideration to be used
– Non-tax only available if stock consideration
acceptable
• Corporate law forms available
– Forms usually used for nontaxable may be
used to produce taxable results when planned
to fail
• Tax cost of taxable vs. use of basis
130
Preparing for the acquisition
– Restructuring Target's assets when Target will remain
• US rules tend to be “all-or-nothing”
– 355 allows separation
– clearly only route to two corporations from one in
reorganizations
• If two active trades or businesses, one not wanted
– Target can distribute assets or sell assets and distribute
proceeds
– 302(b)(4) allows treatment as sale or exchange of individual
shareholders stock
131
Assets unwanted by the acquirer when
Target will not remain
• In C, forward triangular and reverse triangular
• no such requirement in a B reorganization.
132
After the acquisition: restructuring involving
Target
– Statutory language allows Target stock (in a
B) or Target assets (in a C) to be dropped
down into Acquirer subsidiary corporations.
133
Disregarded entities in nontaxable
acquisitions
• When the “Target” is the disregarded
entity, there can be no reorganization
• But when the Acquirer is the disregarded
entity, the transaction can be treated as a
reorganization under essentially the same
conditions as would have applied had the
“disregarded entity” actually never existed.
Prop. Reg. 1.368-2(b)(1), Fed. Reg.
(January 2003).
134
Post-acquisitions tax characteristics of the
Target
• Tax characteristics of corporation stay with corporation in taxable
sale of assets
– Disappear if corporation liquidated to individuals
• After nontaxable reorganization or taxable stock most attributes
survive
– earnings and profits account of Target survives
– accounting methods generally survive if not inconsistent with Acquirer
• Section 382 will limit loss carryovers
– Taxable acquisition of stock or
– nontaxable acquisition of assets or stock
• Other limitations may make loss carryovers difficult to use
135
Non-tax considerations in choice of nontaxable or
nontaxable
• Financial accounting for the acquired stock
and assets
– “Pool accounting” no longer available FASB
141
136
Non-merger alternatives
• Using dividend and liquidation equalization agreements
• Dual headed structures have been used with holding company or
“synthetic”with equalization agreement:
• Royal Dutch/Shell Transport
• Reed/Elsevier
• To avoid adverse affect in public markets
• Aversion to foreign stock
• De-indexation affects
• To avoid taxable exchange of shares
• To avoid post-merger withholding taxes
• Not tried in US—perception of base erosion problems
137