1 Introduction to US Taxation of Mergers and Acquisitions Prof. Charlotte Crane Graduate Tax Program Northwestern University School of Law Chicago, Illinois.

1

Introduction to US Taxation of Mergers and Acquisitions

Prof. Charlotte CraneGraduate Tax Program

Northwestern University School of LawChicago, Illinois

2

Basic Principles of Taxation of US Corporations

• Two levels of tax• Corporation pays tax on earnings

as earned

• Shareholders pay tax when earnings distributed

• Worldwide income of US corporation taxed by US

• Mitigated by foreign tax credit

• Tax law not always linked to state corporate law

Corp

Shareholders

US Corp

US assets

F assets

3

Double taxation of Corporate EarningsDomestic

• Corporation honored as separate taxable entity

• Corporation taxed at 35%$1000 -350= 650

• Pre-2004 Individual shareholders taxed at 30-35% on receipt of dividend

Pre-2004 650-195=455Post-2004 individual shareholders taxed at 15%

Post-2004 650-97.50=552.50

No shareholder credit for corporate taxes paidNo corporate deduction for dividend paidNo rate difference between income distributed and

income not distributed • Except when penalty taxes for accumulations

Corp

Shareholders

4

US corporate tax rates• 2004 stated rates • Up to $50,000 15%• Over 50,000 but not over $75,000 25%• Over 75,000 but not over $10,000,000 34%• Over $10,000,000 35%

• 2004 rates including phaseout of lower brackets• Up to $50,000 15%• Over 50,000 but not over $75,000 25%• Over 75,000 but not over $100,000 34%• Over 100,000 but not over $10,000,000 39%• Over $10,000,000 but not over $15,000,000 35%• Over $15,000,000 but not over 18,333,333 38%• Over $18,333,333 35%

5

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%

But more than double tax not always avoided

Corp

Corp

Corp

Corp

IndShare

6

And not always of single entity

• Election of affiliated group to file consolidated returns– Only US corps may consolidate

• And contiguous in some cases

– Only ownership not operation requirements for eligibility

• Disregarded entities (also called Tax Nothings)– 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

Corp

CorpCorp

Corp

Foreign Corp

Corp

Corp

CorpCorp

Corp

Foreign Corp

Corp

7

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

8

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 for c-the-b

AG SA NV

Eligible GmBh Scl BV

9

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”

10

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

11

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

12

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

13

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

14

Double Tax only applies to earnings

• 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

Corp

Shareholders

Corp

Shareholders

Creditors

Creates enormous pressure for debt financing

Without debt

552 after tax to shareholders

15

book tax adjustment to tax for e&p

Income from exempt bonds 5000 0 5000Gain on installment sales 10000 0 10000

original cost book depreciationtax depreciationadjustment for e&p

Depreciation on Equipment 50000 5000 17000 11000Depreciable real estate 50000 8000 10000Nondepreciable real estate 20000 0 0self-created intangible-patent 15000 5000 15000Purchased intangible-patent 17000 6000 1450

Federal Income Taxes 5000 16500(some as deferred taxes)

Computation of Earnings and Profits

16

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)

17

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”

18

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

19

original cost book depreciationtax depreciationtax basis fmv Tax gain or lossBook gain or loss

Certificate of deposit 1000 0 0 1000 1015 15 15Accounts receivable 10000 100 100 9,900 9000 -900 -900Inventory 15000 0 0 15000 22000 7000 7000Equipment 50000 10000 35000 15000 38,000 23000 -2000Depreciable real estate 50000 8000 10000 40000 60000 20000 18000Nondepreciable real estate 20000 0 0 20000 42000 22000 22000self-created intangible-patent 15000 5000 15000 0 18000 18000 8000Purchased intangible-patent 17000 6000 1450 15,550 18000 2450 7000Customer base 0 0 0 0 30000 30000 30000Other stock held for investment 5000 5000 4000 -1000 -1000Other goodwill 0 0 0 0 75000 75000 75000[reserve for tort liability -30000 -30000 -30000

183000 29100 61550 121450 287015 165565 133115Accounts payable 12000Bank debt 10000Bonded debt 100000shareholder equity 0

Assets of Target Corporation

20

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

21

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

22

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

23

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

24

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

25

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

26

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

27

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%

28

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

29

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

30

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

31

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

32

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

33

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 other

ways

34

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

35

tax depreciationtax basis fmv Tax gain or loss

Certificate of deposit 0 1000 1015 15Accounts receivable 100 9,900 9000 -900Inventory 0 15000 22000 7000Equipment 35000 15000 38,000 23000

Depreciable real estate 10000 40000 60000 80000 20000

Nondepreciable real estate 0 20000 42000 22000self-created intangible-patent 15000 0 18000 18000Purchased intangible-patent 1450 15,550 18000 2450Customer base 0 0 30000 30000Other stock held for investment 5000 4000 -1000Other goodwill 0 0 75000 75000

[reserve for tort liability -30000 -30000

61550 121450 287015 165565Accounts payableBank debt Bonded debtshareholder equity

Assets of Target Corporation with liability problems on liquidation

36

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

37

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

38

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)

39

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

40

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

41

OVERVIEW OF US TAXING JURISDICTION

42

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

43

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

44

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

45

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

Slide 46

Indirect Foreign Tax Credit902

• 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 47

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 48

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 threshold and affect sourcing

Slide 49

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 50

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 51

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 52

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 53

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 54

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 55

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 56

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 57

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 non-recognition rules Section 367(a)

• Special regime for corporations controlled by US taxpayers subpart F, sections 951-964

Slide 58

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 59

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 “foreign-to-foreign”

Slide 60

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 61

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 62

TAXABLE ACQUISITIONS:STOCK OR ASSETS

63

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

64

Taxable Sale of Business AssetsBuyer’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

65

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

66

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

67

original cost book depreciationtax depreciationtax basis fmv Tax gain or loss

I Cash 500

II Certificate of deposit 500 0 0 1000 515 -485

III Accounts receivable 10000 100 100 9,900 9000 -900IV Inventory 15000 0 0 15000 22000 7000II Other stock held for investment 5000 5000 4000 -1000V Equipment 50000 10000 35000 15000 38,000 23000V Depreciable real estate 50000 8000 10000 40000 60000 20000V Nondepreciable real estate 20000 0 0 20000 42000 22000VI self-created intangible-patent 15000 5000 15000 0 18000 18000VI Purchased intangible-patent 17000 6000 1450 15,550 18000 2450

VII Customer base 0 0 0 0 30000 30000VII Other goodwill 0 0 0 0 75000 75000

[reserve for tort liability -150000 -150000182500 29100 61550 121450 166515 45065

Assets of Target Corporation

Assuming all but tort liability to be paid by seller

68

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

69

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

70

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

71

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

72

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

73

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

74

Taxable sale of stockCheck-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

75

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

76

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

77

GENERAL CONSIDERATIONS ON OUTBOUND NONTAXABLE TRANSACTIONS

78

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

79

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

80

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

81

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.

82

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

83

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

84

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

85

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 which effect only a readjustment of continuing interest in property under modified continuing interest in property under modified corporate formscorporate forms.”

– Reg. 1.368-1(b).

86

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

87

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

88

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

89

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

90

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

91

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

92

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

93

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)

94

original cost book depreciationtax depreciationtax basis fmv Tax gain or lossBook gain or loss

Certificate of deposit 1000 0 0 1000 1015 15 15Accounts receivable 10000 100 100 9,900 9000 -900 -900Inventory 15000 0 0 15000 22000 7000 7000Equipment 50000 10000 35000 15000 38,000 23000 -2000Depreciable real estate 50000 8000 10000 40000 60000 20000 18000Nondepreciable real estate 20000 0 0 20000 42000 22000 22000self-created intangible-patent 15000 5000 15000 0 18000 18000 8000Purchased intangible-patent 17000 6000 1450 15,550 18000 2450 7000Customer base 0 0 0 0 30000 30000 30000Other stock held for investment 5000 5000 4000 -1000 -1000Other goodwill 0 0 0 0 75000 75000 75000[reserve for tort liability -30000 -30000 -30000

183000 29100 61550 121450 287015 165565 133115Accounts payable 12000Bank debt 10000Bonded debt 100000shareholder equity 0

Gain on transfer of foreign operations under 367(a)

95

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

96

C reorganizationsStock for assets

• Acq must use voting stock• Limited other consideration• Acq must acquire

substantially all assets• T must liquidate

T

T sh

A sh

Acq

Assets

97

C reorganizations*Stock for assets*

• Acq must use voting stock• Limited other consideration• Acq must acquire

substantially all assets• T must liquidate

T

T sh

A sh

Acq

Assets

98

C reorganizations*Stock for assets*

• Acq must use voting stock• Limited other consideration• Acq must acquire substantially

all assets• T must liquidate• May use P Acq stock

T

T sh P Acq

Acq

Assets

99

C reorganizations**Stock for assets**

• Acq must use voting stock• Limited other consideration• Acq must acquire substantially

all assets• T must liquidate• May use P Acq stock

T sh P Acq

Acq

Assets

100

“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

101

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

102

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

103

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

104

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.

105

* 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

106

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

107

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)

•

108

B reorganizationsStock for stock

• Acq can use only voting stock

• Acq must have 80% control after

T

T sh

A sh

Acq

109

B reorganizations*Stock for stock*

• Acq can use only voting stock• Acq must have 80% control

afterT

T sh

A sh

Acq

110

B reorganizations**Stock for stock**

• Acq can use only voting stock• Acq must have 80% control

afterT

T sh

A sh

Acq

111

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

112

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”

113

Inbound B reorganization situations

• US Acquirer of Foreign Target in B reorg

– neither 367(a) or 367(b) apply– Corporation will be CFC

114

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

115

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 triggeredLosses not allowed Exception for active foreign operationsInventory, intangibles, recapture not protectedBranch loss exception

116

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

117

B reorganizations*Stock for Parent stock*

• Acq can use only voting stock• Acq must have 80% control

after• Stock of acquirer parent may be

used

T

T sh

Acq

P Acq

118

B reorganizationsStock for stock with drop

• Acq can use only voting stock• Acq must have 80% control

after• Acq may contribute T to sub

T

T sh

A sh

Acq

Sub

119

B reorganizations**Stock for stock with drop**

• Acq can use only voting stock• Acq must have 80% control

after• Acq may contribute T to sub

T

T sh

A sh

Acq

Sub

120

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

• .

121

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 transactions

122

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

123

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

124

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.

125

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.

126

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

127

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

128

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

129

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

130

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

131

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

132

Assets unwanted by the acquirer when Target will not remain

• In C, forward triangular and reverse triangular • no such requirement in a B reorganization.

133

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.

134

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).

135

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

136

Non-tax considerations in choice of nontaxable or nontaxable

• Financial accounting for the acquired stock and assets– “Pool accounting” no longer available FASB

141

137

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