Presentation on theme: "Structuring the Deal: Tax and Accounting Considerations"— Presentation transcript:
1 Structuring the Deal: Tax and Accounting Considerations
2 One person of integrity can make a difference, a difference of life and death.—Elie Wiesel
3 Course Layout: M&A & Other Restructuring Activities Part IV: Deal Structuring & FinancingPart II: M&A ProcessPart I: M&A EnvironmentPayment & Legal ConsiderationsPublic Company ValuationFinancial Modeling TechniquesM&A IntegrationBusiness & Acquisition PlansSearch through Closing ActivitiesPart V: Alternative StrategiesAccounting & Tax ConsiderationsBusiness AlliancesDivestitures, Spin-Offs & Carve-OutsBankruptcy & LiquidationRegulatory ConsiderationsMotivations for M&APart III: M&A Valuation & ModelingTakeover Tactics and DefensesFinancing StrategiesPrivate CompanyValuationCross-BorderTransactions
4 Learning ObjectivesPrimary 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 ofPurchase (acquisition method) accounting used for financial reporting purposes;Goodwill and how it is created; andAlternative taxable and non-taxable transactions.
5 Accounting Treatment Background Statement of Financial Accounting Standard 141 (SFAS 141) required effective 12/15/01 purchase accounting to be employed for all business combinations by allocating the purchase price to acquired net assets. Limitations included difficulty in comparing transactions (e.g., those with minority shareholders to those with none) and mixing of historical and current values (e.g., staged purchases).Effective 12/15/08, SFAS 141R required that acquirers mustRecognize, separately from goodwill,1 identifiable assets, and assumed liabilities at their acquisition date2 fair values;3Recognize goodwill attributable to non-controlling shareholders;4Revalue acquired net assets in each stage of staged transactions to their current fair value;Compute fair value of contingent payments5 as part of total consideration, revalue as new data becomes available, and reflect on income statement;Capitalize “in-process” R&D on acquisition date with indefinite life until project’s outcome is known (amortize if successful/write-off if not); andExpense investment banking, accounting, and legal fees at closing; capitalize financing related expenses1Goodwill is an asset representing future economic benefits from acquired assets not identified separately (i.e., control, brand name, etc.)2Acquisition date is the point at which control changes hands (i.e., closing).3Fair value is the amount at which an asset could be bought or sold in a current transaction between willing parties with access to the same information.4An acquirer must recognize 100% of the goodwill even if they acquired less than 100% of the target’s assets, if they have a controlling interest giving them effective control over 100% of the assets.5Recognize as a liability on balance sheet.
6 Purchase (Acquisition) Method of Accounting Requirements:Record acquired tangible and intangible assets and assumed liabilities at fair market value on acquiring firm’s balance sheet.Record the excess of the price paid (PP) plus any non-controlling interests1 over the target’s net asset value (i.e., FMVTA - FMVTL) as goodwill (GW) on the consolidated balance sheet, where FMVTA and FMVTL are the fair market values of total acquired assets and liabilities.These relationships can be summarized as follows:Purchase price: PP = FMVTA– FMVTL+ FMVGWGoodwill estimation: FMVGW = PP – FMVTA + FMVTL= PP - (FMVTA - FMVTL)1The balance sheets of acquirers with a controlling interest that is less than 100% ownership must still record 100% of goodwill reflecting their effective control over all of the target firm’s assets and liabilities.2Goodwill and net acquired assets must be checked annually (or whenever a key event such as the loss of a major acquired customer or patent takes place impacting value) for impairment.
7 Example of Estimating Goodwill On January 1, 2009, Acquirer Inc. purchased 80 percent of Target Inc.’s 1,000,000 shares outstanding at $50 per share for a total value of $40,000,000 (i.e., .8 x 1,000,000 x $50). On that date, the fair value of total Target net assets was $42,000,000. What is value of the goodwill shown on Acquirer’s balance sheet? What portion of that goodwill is attributable to the minority interest retained by Target’s shareholders?100% of Goodwill shown on Acquirer’s balance sheet:FMVGW = PP1 – (FMVTA – FMVTL) = $50,000,000 - $42,000,000= $8,000,000Goodwill attributable to the minority interest: Note that 20 percent of the total shares outstanding equal 200,000 shares with a market value of $10,000,000 ($50 x 200,000). Therefore, the amount of goodwill attributable to the minority interest is calculated as follows:Fair Value of Minority Interest: $10,000,000Less: 20% fair value of total Target net assets(.2 x $42,000,000): $ 8,400,000Equal: Goodwill attributable to minority interest: $ 1,600,0001Purchase price as if acquirer purchased 100% of target firm (i.e., $50/share x 1,000,000 = $50,000,000).
8 Example of Purchase Method of Accounting (Assume Acquirer Pays $1 Billion for Target) Acquirer Pre-Acquisition Book Value ($Millions)Col. 1Target Pre-Acquisition Book Value ($Millions)Col. 2Target Fair Market Value ($Millions)Col. 3Acquirer Post-Acquisition Value ($Millions)Col. 4Current Assets12,0001,20013,200Long-Term Assets7,0001,0001,4008,400Goodwill1003Total Assets19,0002,2002,60021,700Current Liabilities10,00011,000Long-Term Debt3,0006007003,700Common Equity2,0003001,0001Retained Earnings4,000Equity + Liabilities2,70021The fair value of the target’s equity is equal to the purchase price; target’s retained earnings implicitly included in the purchase price paid for the target’s equity. Note that the change in acquirer’s pre- and post- acquisition common equity value equals the acquisition purchase price.2The $100 million difference between the fair market value of the target’s equity plus liabilities less total assets represents unallocated portion of the purchase price (i.e., the excess of the purchase price over the FMV of net acquired assets).3Goodwill = Purchase price – FMV of Net Acquired Target Assets = $1,000 – ($2,600 - $1,000 - $700)
9 Discussion QuestionsAcquirer and Target companies reach an agreement to merge. Describe how the purchase method of accounting would impact the income statement, balance sheet, and cash flows statements of the combined companies.Goodwill is an accounting entry equal to the difference between purchase price and the fair market value of net acquired assets. As a business manager, what do you believe goodwill represents? How could the factors that goodwill represents actually contribute to improving the combined firm’s future cash flows?How might the treatment of contingent payments under SFAS 141R affect the popularity of earnouts from the acquirer’s perspective?
10 Choosing the Right Deal Structure Consider the Following Factors:Tax impact (Immediate or Deferred)Acquirer and Target Shareholder ApprovalsExposure to Target LiabilitiesPayment FlexibilityTarget SurvivabilityLimitations on Restructuring Efforts (e.g., tax-free status of spin-offs 2 years before and after tax-free deal could be jeopardized)
11 Alternative Tax Structures Mergers and acquisitions can be structured as either tax-free, partially taxable, or wholly taxable to target shareholders.Taxable Transactions:The buyer pays primarily with cash, securities, or other non-equity consideration for the target firm’s stock or assetsAbsent a special election, tax basis of target’s assets will not be increased to FMV following a purchase of stock338 election: Buyer can elect to have a taxable stock purchase treated as an asset purchase and acquired assets increased to FMV. Taxes must be paid on any gains on acquired assets.Impact of asset write-up on EPS and potential taxable gains must be weighed against improved cash flow from tax savingsTax-Free Transactions:Mostly buyer stock used to acquire stock or assets of the targetBuyer must acquire enough of the target’s stock and assets to ensure that the IRS’ continuity of interests and business enterprise principles are satisfied
12 Alternative Tax-Free Structures A tax-free transaction is also known as a tax-free reorganization since it must satisfy the continuity of interests and business enterprise principlesOf the 8 different types of tax-free reorganizations (Section 368 of the Internal Revenue Code), the most common are:Type A reorganization (incl. statutory direct merger or consolidation; forward and triangular mergers)Type B reorganization (stock-for-stock acquisition)Type C reorganization (stock-for-assets acquisition)Type D divisive reorganization (spin-offs, split-offs, and split-ups)
13 Qualifying as a Tax-Free Reorganization Four conditions must be met:Continuity of ownership interest (usually satisfied if purchase price at least 50% acquirer stock)1Continuity of business enterprise (“substantially all requirement” usually satisfied if buyer acquires at least 70% and 90% of FMV of target gross and net assets)Valid business purpose (other than tax avoidance)Step transaction doctrine (must not be part of larger plan that would have resulted in a taxable transaction)1May be as low as 40% under some circumstances.
14 Continuity of Interests and Business Enterprise Principles1 Purpose: To ensure that subsidiary mergers do not resemble sales, making them taxable eventsContinuity of interests: A substantial portion of the purchase price must consist of acquirer stock to ensure target firm shareholders have a significant ownership position in the combined companiesContinuity of business enterprise: The buyer must either continue the acquired firm’s “historic business enterprise” or buy “substantially all” of the target’s “historic business assets” in the combined companies. Continued involvement intended to demonstrate long-term commitment by acquiring company to the target.1These principles are intended to discourage acquirers from buying a target in a tax free transaction and immediately selling the target’s assets, which would reflect the acquirer’s higher basis in the assets possibly avoiding any tax liability when sold.
15 Type A ReorganizationTo qualify as a Type A reorganization, transaction must be a statutory merger or consolidation; forward or reverse triangular mergerNo limits on composition of purchase priceNo requirement to use acquirer voting stockAt least 50% of the purchase price must be in acquirer stock1Advantages:Acquirer can issue non-voting stock to target shareholders without diluting its control over the combined companiesAcquirer may choose not to acquire all of the target’s assetsAllows use of more cash in purchase price than Types B and C reorganizationsDisadvantages:Acquirer assumes all undisclosed liabilitiesRequires acquirer shareholder approval if new shares are to be issued or number of new shares exceeds 20% of the firm’s shares traded on public exchanges.Limitations of asset dispositions within two years of closing1As low as 40% in some circumstances.
16 Direct Statutory Merger (“A” Reorganization) Assets & LiabilitiesAcquiring FirmTarget Firm (Liquidated asassets and liabilities mergedwith acquirer)Acquirer Stock &BootTarget StockTarget Shareholders(Receive voting ornonvoting acquirer stockin exchange for target stockand boot)Target liquidated and contracts dissolved. Contracts need to be assigned or transferred. Remaining target assets/liabilities assumed by acquirer; acquirer & target shareholder approval required in most states; dissenting shareholders may have appraisal rights. No asset write-up. Target’s tax attributes transfer to acquirer but are limited by Section 382 and 383 of Internal Revenue Code (IRC).
17 Statutory Consolidation (“A” Reorganization) Assets/LiabilitiesCompany B(Contributes assets &Liabilities to Newco)Company A(Contributes assets &liabilities to Newco)New Company(Newco)Company BShareholdersCompany AShareholdersNewco StockCompanies A & B liquidated and contracts dissolved. Contracts need to be transferred or assigned; acquirer and target shareholder approval required with dissenting shareholders having appraisal rights. Structure appropriate for merger of equals. No asset writeup. Acquirer and target tax attributes transfer to Newco but are limited by Sections 382 and 383 of IRC.
18 Forward Triangular Merger (“A” Reorganization) Acquiring CompanyTarget Firm (Merges assetsand liabilities with theparent’s wholly-ownedsubsidiary)Parent’sStock/CashSubsidiary’sStockTarget Assetsand LiabilitiesSubsidiary (Shell created byparent and funded byparent’s cash or stock)Target Shareholders (Receivevoting or nonvoting stockheld by parent’s whollyowned subsidiary inexchange for target stock)Parent’s Stock& BootTarget Stock“Substantially all” and “continuity of interests” requirements apply. Flexible form of payment. Avoids transfer taxes and may insulate parent from target liabilities and eliminate acquirer shareholder approval unless required by stock exchange or new shares issued exceed 20% of acquirer’s outstanding shares. No asset writeup. Target tax attributes transfer but subject to limitation. Target shareholder approval required. However, as target eliminated, nontransferable assets and contracts may be lost.
19 Reverse Triangular Merger (“A” Reorganization) Acquiring CompanyTarget Firm (Receives assetsand liabilities of acquiringfirm’s wholly ownedsubsidiary)Parent’sVoting StockSubsidiary’sStockSubsidiary’s Assetsand LiabilitiesSubsidiary (Shell created byparent and funded byparent’s voting stock mergedinto target firm)Target Shareholders (Receiveparent’s voting stockheld by parent’s whollyowned subsidiary inexchange for target stock)Parent’s Stock& BootTarget StockTarget survives as acquirer subsidiary. Target tax attributes and intellectual property and contracts transfer automatically; may insulate acquirer from target liabilities and avoid acquirer shareholder approval. At least 80% of purchase price must be in acquirer voting shares. No asset writeup. Acquirer must buy “substantially all” of the FMV of the target’s assets and target tax attributes transfer subject to limitation.
20 Type “B” Stock for Stock Reorganization To qualify as a Type B Reorganization, acquirer must use only voting stock to purchase at least 80% of the target’s voting stock and at least 80% of the target’s non-voting stockCash may be used only to acquire fractional sharesUsed mainly as an alternative to a merger or consolidationAdvantages:Target may be maintained as an independent operating subsidiary or merged into the parentStock may be purchased over a 12 month period allowing for a phasing of the transaction (i.e., “creeping acquisition”)Disadvantages:Lack of flexibility in determining composition of purchase pricePotential dilution of acquirer’s current shareholders’ ownership interestMay have minority shareholders if all target shareholders do not tender their shares
21 Type “B” Stock for Stock Reorganization Acquiring Firm(Exchanges votingshares for at least 80%of target voting & non-Voting shares”)Target ShareholdersTarget StockAcquirer Voting Stock(No Boot)Shell StockTarget Firm(Merged into acquiringfirm’s subsidiary)Wholly-OwnedShell SubsidiaryTarget Assetsand LiabilitiesBuyer need not acquire 100% of target shares, shares may be required over time, and may insulate acquirer from target liabilities. May insulate parent from target’s liabilities and tax attributes transfer subject to limitation. Suitable for target shareholders with large capital gains and therefore willing to accept acquirer shares to avoid capital gains taxes triggered in a stock for cash sale.
22 Type “C” Stock for Assets Reorganization To qualify as a Type C reorganization, acquirer must purchase 70% and 90% of the fair market value of the target’s gross and net assets, respectively.The acquirer must use only voting stockBoot cannot exceed 20% of FMV of target’s pre-transaction assets (value of any assumed liabilities deducted from boot)1The target must dissolve following closing and distribute the acquirer’s stock to the target’s shareholders for their canceled target stockAdvantages:Acquirer need not assume any undisclosed liabilitiesAcquirer can purchase selected assetsDisadvantages:Technically more difficult than a merger because all of the assets must be conveyedTransfer taxes must be paidNeed to obtain consents to assignment on contractsRequirement to use only voting stock potentially resulting in dilution of the acquirer shareholders’ ownership interest1Value of assumed liabilities viewed as part of purchase price.
23 Type “C” Stock for Assets Reorganization Acquiring Firm(Exchanges voting sharesfor at least 80% of FMV ofTarget assets)Target Firm(Liquidates and transfersAcquiring Firm shares andany remaining assetsto shareholders)Target AssetsAcquirer VotingStock & BootTarget Cancelled StockAcquirer VotingStock & BootTarget ShareholdersEnables buyer to be selective in choosing assets and any liabilities, if at all, it chooses to assume. Avoids transfer taxes, requires consents to assignment, and potentially dilutive to acquirer shareholders. No asset writeup. Tax attributes transfer to acquirer subject to limitation.
24 Type D Divisive Reorganizations Type D Divisive Reorganizations apply to spin-offs, split-ups, and split-offsSpin-Off: Stock in a new company is distributed to the original company’s 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 firm created.Split-up: The original company ceases to exist, and one or more new companies are formed from the original business as original shareholders exchange their shares for shares in the new companies.For these reorganizations to qualify as tax-free, the distribution of shares must not be for the purpose of tax avoidance.
25 Implications of Tax Considerations for Deal Structuring In taxable transactions, target generally demands a higher purchase priceHigher purchase price often impacts form of payment as buyer tries to maintain PV of transaction by deferring some of purchase priceBuyer may avoid EPS dilution by buying target stock or assets using a non-equity form of payment in a taxable transactionIf buyer wants to preserve cash and obtain target’s tax credits, buyer may use its stock to purchase target stock in a non-taxable transaction
26 Discussion QuestionsExplain how tax considerations affect the deal structuring process? From seller’s perspective? From buyer’s perspective?What is a Type A reorganization? When does it make sense for a buyer to use a Type A reorganization?What is a reverse triangular merger? Under what circumstances would a buyer wish to use this type of reorganization?How might the buyer structure the transaction in order to avoid EPS dilution? (Hint: Consider the factors that make a transaction taxable or non-taxable.)
27 Things to RememberFor financial reporting purposes, all M&As must be accounted for using purchase accounting.Taxable transactions:Direct cash mergerCash purchase of assetsCash purchase of stockTax-free transactions:Type A reorganization (Incl. direct statutory merger or consolidation; forward and reverse triangular merger)Type B stock-for-stock reorganizationType C stock-for-assets reorganization