Accounting Treatment and Tax Considerations

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Accounting Treatment and Tax Considerations
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Learning Objectives

• Primary Learning Objective To provide students
  with knowledge of how accounting treatment and
  tax considerations impact the deal structuring
  process.
• Secondary Learning Objectives To provide
  students with knowledge of
• Purchase accounting used for financial reporting
  purposes
• Goodwill and how it is created and
• Alternative taxable and non-taxable transactions.

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Accounting Treatment Background

• Historically, either purchase or pooling of
  interests accounting treatment could be used for
  financial reporting of business combinations.
• Purchase accounting considers the actual price
  paid for a target firm while pooling of interest
  does not.
• Historically, any transaction not satisfying all
  12 criteria required to qualify as a pooling of
  interest was accounted for using purchase
  accounting.
• Financial Accounting Standards Board announced on
  12/15/01 that all business combinations
• Must use the purchase method for financial
  reporting purposes
• All business combinations accounted for using the
  pooling method prior to that date would be
  grandfathered and
• Goodwill arising from business combinations
  should not be amortized but should be reviewed
  for impairment when appropriate

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Purchase Method of Accounting

• Requirements
• Record target firms tangible and intangible
  assets and assumed liabilities at fair market
  value on acquiring firms balance sheet.
• Record the excess of the price paid (PP) over the
  targets net asset value (i.e., FMVTA - FMVTL) as
  goodwill (GW) on the acquirers balance sheet,
  where FMVTA and FMVTL are the fair market value
  of total acquired assets and liabilities.
• These relationships can be summarized as follows
• Purchase price distribution PP FMVTA FMVTL
  FMVGW
• Goodwill estimation FMVGW PP FMVTA FMVTL
• PP - (FMVTA - FMVTL)

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Purchase Method of Accounting Example

• Assume Acquiring Company pays 26 million for all
  of the outstanding stock in Target Company. The
  FMV of the Target Companys tangible assets is
  9.00 million and intangible assets is 5
  million. The FMV of assumed liabilities is 1
  million. Estimate the value of goodwill that must
  be shown on the balance sheet of the combined
  companies.

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Alternative Tax Structures

• Mergers and acquisitions can be structured as
  either tax-free, partially taxable, or wholly
  taxable.
• Taxable Transactions
• The buyer pays primarily with cash, securities,
  or other non-equity consideration for the target
  firms stock or assets
• Absent a special election, tax basis of targets
  assets will not be increased to FMV following a
  purchase of stock
• 338 election An acquirer can elect to have a
  taxable stock purchase treated as an asset
  purchase and acquired assets increased to FMV
• Impact of asset write-up on EPS must be weighed
  against the improvement in cash flow from tax
  savings
• Tax-Free Transactions
• Mostly buyer stock used to acquire stock or
  assets of the target
• Buyer must acquire enough of the targets stock
  to ensure that the IRS continuity of interests
  principle is satisfied

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Alternative Tax-Free Structures

• A tax-free transaction is also known as a
  tax-free reorganization
• Of the 8 different types of tax-free
  reorganizations (Section 368 of the Internal
  Revenue Code), the most common are
• Type A statutory merger
• Type B stock-for-stock merger
• Type C stock-for-assets merger
• Type D divisive reorganization

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Type A Reorganization

• To qualify as a Type A reorganization,
  transaction must be either a statutory merger or
  consolidation
• No limits on composition of purchase price
• No requirement to use acquirer voting stock
• No limit on amount of target assets that may be
  acquired
• At least 50 of the purchase price must be in
  acquirer stock
• Advantages
• Acquirer can issue non-voting stock to target
  shareholders without diluting its control over
  the combined companies
• Acquirer may choose not to acquire all of the
  targets assets
• Allows use of more cash in purchase price than
  Types B and C reorganizations
• Disadvantages
• Acquirer assumes all undisclosed liabilities
• Requires shareholder approval

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Type B Stock for Stock Reorganization

• To qualify as a Type B Reorganization, acquirer
  must use voting stock to purchase at least 80 of
  the targets voting stock and at least 80 of the
  targets non-voting stock
• Cash may be used only to acquire fractional
  shares
• Used mainly as an alternative to a merger or
  consolidation
• Advantages
• Target may be maintained as an independent
  operating subsidiary or merged into the parent
• Stock may be purchased over a 12 month period
  allowing for a phasing of the transaction
• Disadvantages
• Lack of flexibility in determining composition of
  purchase price
• Potential dilution of combined company EPS

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Type C Stock for Assets Reorganization

• To qualify as a Type C reorganization, acquirer
  must purchase at least 80 of the fair market
  value of the targets assets as well as certain
  specified liabilities.
• The acquirer must use only voting stock
• The target must dissolve following closing and
  distribute the acquirers stock to the targets
  shareholders for the canceled target stock
• Advantages
• Acquirer does not assume any undisclosed
  liabilities
• Acquirer can purchase selected assets
• Disadvantages
• Technically more difficult than a merger because
  all of the assets must be conveyed
• Transfer taxes must be paid
• Need to obtain consents to assignment on
  contracts
• Requirement to use only voting stock

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Type D Reorganizations

• Type D Divisive Reorganizations apply to
  spin-offs, split-ups, and split-offs
• Spin-Off Stock in a new company is distributed
  to the original companys shareholders according
  to some pre-determined formula. Both the parent
  and the entity to be spun-off must have been in
  business for at least five years prior to the
  spin-off.
• Split-off A portion of the original company is
  separated from the parent, and shareholders in
  the original company may exchange their shares
  for shares in the new entity. No new company is
  created.
• Split-up The original company ceases to exist,
  and one or more new companies are formed from the
  original business.
• For these reorganizations to qualify as tax-free,
  the distribution of shares must not be for the
  purpose of tax avoidance.

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Forward Triangular Merger
Acquiring Company
Target Firm (Merges assets and liabilities
with the parents wholly-owned subsidiary)
Parents Stock/Cash
Target Assets and Liabilities
Subsidiarys Stock
Subsidiary (Shell created by parent and funded
by parents cash or stock)
Target Shareholders (Receive voting or nonvoting
stock held by parents wholly owned subsidiary
in exchange for target stock)
Parents Stock
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Reverse Triangular Merger
Acquiring Company
Target Firm (Receives assets and liabilities of
acquiring firms wholly owned subsidiary)
Parents Voting Stock
Subsidiarys Assets and Liabilities
Subsidiarys Stock
Subsidiary (Shell created by parent and funded
by parents voting stock merged into target firm)
Target Shareholders (Receive parents voting
stock held by parents wholly owned subsidiary
in exchange for target stock)
Parents Stock
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Summary of Alternative Tax Free Structures
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Implications of Tax Considerations for Deal
Structuring

• If a transaction is taxable, it is likely that
  the target firm will demand an increase in
  purchase price to compensate shareholders for
  their tax liability.
• The increase in the purchase price may impact
  form of payment since buyer may maintain PV of
  transactions total cost by deferring some
  portion of the purchase price.
• If buyer wants to avoid EPS dilution by issuing
  stock, the buyer will desire to structure the
  transaction as taxable by buying stock or assets
  for cash, notes, or some other form of payment
• If buyer is more concerned about preserving cash
  and the targets favorable tax attributes, the
  buyer may want to structure the transaction as
  non-taxable by acquiring stock or assets for
  stock.
• Buyer may be willing to pay a somewhat higher
  price if the target has net operating loss and
  tax credits carryovers.

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Things to Remember

• For financial reporting purposes, all MAs must
  be accounted for using purchase accounting.
• Taxable transactions
• Taxable purchase of assets
• Taxable purchase of stock
• Tax-free transactions
• Type A reorganization
• Type B stock-for-stock reorganization
• Type C reorganization
• Forward and reverse triangular mergers