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Acquisitions of Subsidiaries of Freestanding Companies Tax-free Subsidiary Sales Taxable Subsidiary Sales –Taxable asset sale –Taxable stock sale –Taxable.

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Presentation on theme: "Acquisitions of Subsidiaries of Freestanding Companies Tax-free Subsidiary Sales Taxable Subsidiary Sales –Taxable asset sale –Taxable stock sale –Taxable."— Presentation transcript:

1 Acquisitions of Subsidiaries of Freestanding Companies Tax-free Subsidiary Sales Taxable Subsidiary Sales –Taxable asset sale –Taxable stock sale –Taxable stock sale with an IRC §338(h)(10) election

2 Tax-free Subsidiary Sales The divesting parent exchanges the stock or assets of the subsidiary for the stock of the acquiring firm. No gain is recognized. The sold subsidiarys NOLs remain with the subsidiary but are limited by §382. The acquirer takes a carryover basis in the subsidiarys assets and stock. The divesting parent takes a substituted basis in the acquiring stock received equal to its basis in the sold subsidiarys stock.

3 Undesirable Aspects of Tax- free Subsidiary Sales The seller has not truly divested its holding in the sold subsidiary. The seller will hold a relatively illiquid block of the acquirer. The acquirer and the seller may both hold financial positions with a built-in gain after consummation of the transaction.* *If the FMV of the subsidiary is greater than the sellers tax basis in the subsidiarys stock.

4 Given Information for Examples and Cases

5 Example: Tax-Free Subsidiary Stock Sale Under IRC §368(a)(1)(B) Divesting Parent Shareholders: No direct tax effect. Acquirer Shareholders: No direct tax effect. Divesting Parent: Receives $10,000 of acquirer stock in return for the divested subsidiarys stock. Realizes a gain of $8,000. No gain is recognized. Takes a substituted basis in the acquirer stock received ($2,000). Acquirer: Purchases the stock of the target (subsidiary) for $10,000 of its stock. Takes a carryover basis in the stock of the acquired subsidiary ($2,000). Acquired subsidiary becomes a subsidiary of the acquirer and its asset basis carries over. All of the subsidiarys stock $10,000 of acquirer stock Sold Subsidiary: The owners of the subsidiary corporation change. The tax attributes of the subsidiary are limited but stay with the subsidiary. The tax basis of the subsidiarys assets carryover ($2,000).

6 Example: Post-Acquisition Ownership Structure Acquirer: Owns 100% of the sold subsidiarys stock. Has a basis in the targets stock of $2,000 and a basis in the targets assets of $2,000. Sold Subsidiary: Now a wholly owned subsidiary of the acquirer. Net asset basis is $2,000.

7 Taxable Subsidiary Sales Taxable Asset Sale--the acquirer purchases the assets of the subsidiary (target) corporation (usually for cash) from the divesting parent. Taxable Stock Sale--the acquirer purchases the stock of the target corporation from the parent for cash. Taxable Stock Sale w/ an IRC §338(h)(10) election--completed as a stock sale but taxed like an asset sale.

8 Taxable Asset Sales A gain or loss is recognized and computed as price less basis in subsidiarys net assets. The portion of the gain that arises from recaptured depreciation is ordinary income; the difference between the purchase price and the historical cost of the assets is a capital gain. The sold subsidiarys NOLs remain w/ the divesting parent, can offset a gain on sale, and are not limited by §382. Continued....

9 Taxable Asset Sales...Continued Generally, the divesting parent corporation liquidates the sold subsidiary; no gain or loss is recognized on the liquidation under IRC §332. The acquirer steps-up to a basis in the subsidiarys assets equal to the purchase price paid. There are tax benefits from additional depreciation and amortization deductions.

10 Taxable Subsidiary Asset Sale Divesting Parent Shareholders: No direct tax effect. Divesting Parent: Receives $7,200 from the sold subsidiary in liquidation. There is no tax associated with the liquidation under IRC § 332. $7,200All of the subsidiarys stock Sold Subsidiary: Subsidiary receives $10,000 for all of its assets. Recognizes a gain of $8,000 and incurs a tax liability of $2,800. After-tax, it has $7,200 that is distributed to the parent corporation in liquidation. Acquirer: Purchases the assets of the target (subsidiary) for $10,000 cash. Takes a basis in the targets assets equal to the price paid ($10,000). All of the targets assets $10,000 cash Acquirer Shareholders: No direct tax effect.

11 Tax Implications of a Taxable Asset Sale Taxable Asset Sale $10, $8, $10, , $7, $10, , $8, n/a $10, ,000.00

12 Taxable Subsidiary Stock Sale w/o a §338(h)(10) Election A capital gain is recognized and computed as price less basis in subsidiarys stock. The sold subsidiarys NOLs remain with the subsidiary but are limited by §382. The acquirer takes a carryover basis in the subsidiarys assets. The acquirer takes a basis in the targets (subsidiarys) stock equal to the purchase price.

13 Taxable Subsidiary Stock Sale w/o a §338(h)(10) election Divesting Parent Shareholders: No direct tax effect. Acquirer Shareholders: No direct tax effect. Divesting Parent: Receives $10,000 cash in return for the divested subsidiarys stock. Recognizes a capital gain on the stock sale of $8,000 and incurs a tax liability of $2800. After-tax, divesting parent has $7,200. Acquirer: Purchases the stock of the target (subsidiary) for $10,000 cash. Takes a carryover basis in the targets assets ($2,000). Acquired subsidiary becomes a subsidiary of the acquirer. All of the subsidiarys stock $10,000 cash Sold Subsidiary: The owners of the subsidiary corporation change. The tax attributes of the subsidiary are limited but stay with the subsidiary. The tax basis of the subsidiarys assets carryover ($2,000).

14 Post-Acquisition Ownership Structure Acquirer: Owns 100% of the sold subsidiarys stock. Has a basis in the targets stock of $10,000 and a basis in the targets assets of $2,000. Sold Subsidiary: Now a wholly owned subsidiary of the acquirer. Net asset basis is $2,000.

15 Tax Implications of a Taxable Stock Sale w/o a §338(h)(10) Election Taxable Stock Sale w/o a Sec. 338(h)(10) Election $10, $8, $10, , $7, $10, $10, ,

16 Taxable Stock Sale w/ a §338(h)(10) Election §338(h)(10) allows for the potentially favorable tax treatment of an asset sale without incurring the non-tax costs of an asset sale. A subsidiary stock sale can be taxed as an asset sale under §338(h)(10) only if both the acquirer and the divesting parent jointly make the election.

17 Taxable Stock Sale w/ a §338(h)(10) Election A gain is recognized and computed as price less basis in the subsidiarys net assets. The portion of the gain that arises from recaptured depreciation is ordinary income; the difference between the purchase price and the historical cost of the assets is a capital gain. The sold subsidiarys NOLs remain w/ the divesting parent, can offset a gain on sale, and are not limited by §382. Continued....

18 Taxable Stock Sale w/ a §338(h)(10) Election... Continued The acquirer steps-up to a basis in the subsidiarys assets equal to the purchase price paid. The acquirer takes a basis in the targets (subsidiarys) stock equal to the purchase price. There are tax benefits from additional depreciation and amortization deductions.

19 Taxable Subsidiary Stock Sale w/ a §338(h)(10) election Divesting Parent Shareholders: No direct tax effect. Acquirer Shareholders: No direct tax effect. Divesting Parent: Receives $10,000 cash in return for the divested subsidiarys stock. Recognizes a gain of $8,000 (purchase price less subsidiarys net asset basis). Divesting parent pays tax of $2,800. After-tax, divesting parent has $7,200. Acquirer: Purchases the stock of the target (subsidiary) for $10,000 cash. Takes a stepped-up basis in the targets assets ($10,000 basis; $8,000 step-up) as a result of the deemed asset sale under §338(h)(10). Acquired subsidiary becomes a subsidiary of the acquirer. All of the subsidiarys stock $10,000 cash Sold Subsidiary: The owners of the subsidiary corporation change. The tax attributes of the subsidiary remain with the divested parent. The tax basis of the subsidiarys assets carryover ($2,000).

20 Post-Acquisition Ownership Structure Acquirer: Owns 100% of the sold subsidiarys stock. Has a basis in the targets stock of $10,000 and a basis in the targets assets of $10,000. Sold Subsidiary: Now a wholly owned subsidiary of the acquirer. Net asset basis is $10,000.

21 Tax Implication of a Taxable Stock Sale w/ a §338(h)(10) Election Taxable Stock Sale w/ a Sec. 338(h)(10) Election $10, $8, $10, , $7, $10, , $8, $10, , ,000.00

22 Review of Various Subsidiary Sale Tax Structures

23 Tax Implications of Various Taxable Subsidiary Sale Structures

24 Indifference Price Equation The seller is indifferent if: PRICE 338h10 - t c (PRICE 338h10 - ASSET) = PRICE NO338h10 - t c (PRICE NO338h10 -STOCK) where PRICE 338h10 is the price when an election is made PRICE NO338h10 is the price if the election is not made ASSET is the sellers basis in the net asset STOCK is the sellers basis in the sold subsidiarys stock t c is the corporate tax rate

25 Minimum Price Equation The minimum price demanded by the seller to make the §338(h)(10) election is: PRICE 338h10 = PRICE NO338h10 + [t c /(1 - t c )](STOCK - ASSET) where PRICE 338h10 is the price when an election is made PRICE NO338h10 is the price if the election is not made ASSET is the sellers basis in the net asset STOCK is the sellers basis in the sold subsidiarys stock t c is the corporate tax rate

26 Maximum Price Equation The maximum price that the acquiring firm will pay in a §338(h)(10) transaction is: ACQPRICE 338h10 = PRICE NO338h10 + t c * PVANN*[(ACQUPRICE 338h10 - ASSET)/N] where ACQPRICE 338h10 is the maximum purchase price the acquiring firm is willing to pay in a §338(h)(10) transaction PRICE NO338h10 is the price if the election is not made ASSET is the sellers basis in the net asset t c is the corporate tax rate N is the average useful life of the acquired subsidiarys assets PVANN is the present value of an annuity

27 A §338(h)(10) election will be made in a subsidiary sale when ACQPRICE 338h10 - PRICE 338h10 > 0 or, put another way, when [t c /(1/FACTOR) - t c ][PRICE NO338h10 - ASSET] - [t c /(1 - t c )][STOCK - ASSET] > 0 where FACTOR is PVANN/N The other variables are as previously defined

28 Factors Determining a Parents Basis in a Subsidiarys Stock and Net Assets The parents tax basis in the stock and net assets will be equal if the subsidiary was internally generated. When the sold subsidiary was previously acquired by the divesting parent, the parents tax basis in the subsidiarys stock and assets is determined by the tax structure used to acquire the target.

29 Subsidiary Sales vs. Sales of Freestanding C Corporations With subsidiary sales, the seller is a corporation--not an individual shareholder or a group of various sorts of shareholders Subsidiary sales often result in a step-up in the tax basis of the targets assets; in acquisitions of freestanding C corporations, the targets assets usually carry over.

30 Conditions When a §338(h)(10) Election is Optimal When the target subsidiarys stock basis = asset basis and purchase price > net asset basis. Also, when the tax basis of the targets assets > the tax basis of the targets stock.

31 Conditions When a §338(h)(10) Election is Sub-optimal When the divesting parents tax basis in the sold subsidiarys stock substantially exceeds the net tax basis of the subsidiarys assets. This situation is likely to arise if the divested subsidiary was previously acquired in a taxable stock acquisition.


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