Tax Considerations Tax Basis Tax basis is the carrying cost of an asset on a company's tax balance sheet, and

is analogous to book value on a company's accounting balance sheet. In most cases, assets are initially recorded at acquisition cost for both the book and tax purposes. However, book value and tax basis may diverge over time due to different depreciation/amortization methodologies (e.g. straight-line depreciation for accounting purposes versus accelerated depreciation for tax purposes). The taxable gain, if any, recognized by the seller (either individual investors or corporate shareholders) upon the sale of stock or assets is equal to the purchase price less the tax basis in the stock or assets sold. If the tax basis exceeds the sale price, the seller recognizes a loss on the transaction rather than a gain. When the transaction results in a gain, the seller's tax burden is determined by a number of factors, including whether or not the transaction is taxable, whether the seller is taxable or tax-exempt, whether the gain is taxed as ordinary income or a capital gain, the seller's holding period (how long the sold stock/assets were held by the seller before sale), and the applicable tax rate. There are two types of tax basis: inside basis and outside basis. The inside basis is the tax basis that a company has in its assets. The outside basis is the tax basis that a shareholder (which could be corporate entity) has in the shares of a company. The basis to be used in calculating taxes depends on how the transaction is structured. Broadly speaking, acquisitions can be structured as either asset or stock sales. In a taxable stock acquisition, the buyer acquires stock from the target company's shareholders, who are taxed on the difference between the purchase price and their outside basis in the target's stock. In a taxable asset acquisition, the selling corporation is taxed on the excess of the purchase price over its inside basis in the assets sold, and the selling corporation's shareholders are taxed on the distribution of sale proceeds. When a parent company develops a subsidiary internally, rather than through acquisition, the parent's inside and outside bases in the assets and stock of the subsidiary, respectively, are equal. Since most taxable acquisitions are structured as stock purchases without a Section 338 election, the buyer's outside basis in an acquired subsidiary usually exceeds its inside basis in that subsidiary (since the acquirer's basis in the target's stock would be stepped up for tax purposes, while the acquirer's basis in the target's assets would be carried over). If the subsidiary was purchased in a non-taxable transaction, the parent's outside basis in the subsidiary's stock will equal the seller's basis, adjusted for the parent's interest in subsequent taxable income earned by the subsidiary and distributions made by the subsidiary to the parent. As in a regular stock purchase, the parent will assume a carryover basis in the assets acquired, so the parent's outside basis will likely exceed its inside basis. Taxable Stock Acquisition of a Freestanding C Corporation One layer of tax Selling shareholders recognize a taxable gain or loss on their disposition of target stock equal to their cash proceeds less their outside basis in the stock. Since, from the IRS' perspective, no sale of assets has occurred, the target does not incur a tax liability in connection with the transfer of assets. However, if a Section 338 election is made to treat the transaction for tax purposes as an asset sale, the target will recognize a taxable gain or loss. The gain will be taxed as a long-term or short-term capital gain depending on individual shareholders' holding periods. The acquirer assumes a stepped-up cost (FMV) basis in the target's stock and a carryover basis in the acquired net assets, unless a Section 338 election is made. None of the asset write-ups or intangibles recognized in the purchase price allocation for accounting purposes, including goodwill, are tax-deductible. The target's tax attributes survive the acquisition and carry over to the acquirer, but their use is subject to limitation under Section 382.

Example 3.1 Taxable Stock Acquisition

Alpha acquires the stock of freestanding C corporation Tango for $50 in cash. Tango's inside basis in its assets is $25 and Tango's shareholders have an aggregate outside basis of $15. (A) What is Tango's taxable gain? Tango has no taxable gain because this is a stock acquisition. (B) What is the aggregate taxable gain to Tango's shareholders? The taxable gain is the value of consideration received less the shareholders' aggregate basis in the stock sold, or $50 $15 = $35. (C) What is Alpha's resulting basis in Tango's assets? Carryover basis of $25. (D) What is Alpha's resulting basis in Tango's stock? Stepped-up basis of $50. Taxable Asset Acquisition of a Freestanding C Corporation Potentially two layers of tax: Corporate layer Target recognizes a taxable gain or loss on the sale of assets. Shareholder layer Selling shareholders recognize a gain taxed as ordinary income if the target liquidates equal to the after-tax liquidating dividend less shareholders' basis in the stock. The acquirer assumes a stepped-up cost (FMV) basis in the target's net assets. The acquirer allocates the purchase price to the acquired assets and liabilities for tax purposes in the same manner as it does for accounting purposes. The depreciation and amortization of all asset write-ups and intangibles recognized in the transaction, including goodwill, are tax-deductible. The target's tax attributes, such as non-operating losses (NOLs), may be used immediately to offset the target's taxable gain. Any remaining tax attributes are lost if the target liquidates. Example 3.2 Taxable Asset Acquisition Suppose instead that Alpha acquires Tango's assets for $50. Tango is then liquidated and distributes the after-tax cash proceeds from the sale to its shareholders. Tango's tax rate is 35%. (A) What is Tango's taxable gain? The taxable gain equals the consideration received less Tango's inside basis in its assets, or $50 $25 = $25. (B) What is the aggregate taxable gain to Tango's shareholders? The taxable gain equals the after-tax proceeds distributed less the shareholders' aggregate basis in the stock sold, or $50 (1 35%) $15 = $17.5. (C) What is Alpha's resulting basis in Tango's assets? Stepped-up basis of $50. (D) What is Alpha's resulting basis in Tango's stock? Why? Stepped-up basis of $50 because taxes were paid at the shareholder level upon liquidation. An acquisition of a freestanding C corporation will usually be structured as a purchase of stock because an asset purchase usually results in double taxation (i.e. the seller is taxed on the sale of assets, and the seller's shareholders are taxed on any after-tax proceeds from the sale distributed by the seller).

Taxable Acquisition of a Corporate Subsidiary In some situations an asset sale will not result in double taxation. For example, if the target is a corporate subsidiary (with at least 80% ownership by the parent company), the target can generally sell its assets and distribute the proceeds (after the first level of tax on the asset sale) to the parent company without incurring another level of tax on the proceeds so distributed (the distribution of proceeds is a tax-free liquidation of a subsidiary under IRC Section 332). In this case, the parent's decision to whether to sell stock or assets will depend primarily on whether there is a difference between inside and outside basis. [See Chart] When a wholly owned subsidiary is created internally, the parent's inside and outside bases are usually equal. Tax-Free Acquisitions As we have seen, one major determinant of the tax implications of an M&A transaction is the acquisition structure(asset vs. stock purchase). The other major determinant is the form of consideration (cash vs. stock) paid by the acquirer to the seller(s). y y If the consideration is mostly cash or debt, the deal is likely to be taxable. If at least 40% of the consideration is acquirer stock, the deal is more likely to be nontaxable (50% is the technical threshold, but transactions with as little as 40% stock consideration have qualified for tax-free treatment).

Debt as consideration in an acquisition refers to the assumption of a target's debt by the buyer. A transaction in which acquirer stock comprises a significant portion of the total consideration (40% or more) may meet the tax definition of a "reorganization", which is generally not taxable. Such transactions often take the form of "A", "B", or "C" reorganizations, which we will discuss more in our dedicated topic on tax-free acquisitions. Summary There are four basic tax structures whose general tax properties we summarize below: Exhibit 3.1 Comparison of M&A Tax Structures Taxable Non-Taxable

Asset Stock Asset Stock Acquisition Acquisition Acquisition Acquisition

Tax paid by selling shareholders?

Taxed on any liquidating dividend

STCG or LTCG

Taxed to the Taxed to the extent boot extent boot is received is received

Tax paid by target?

Yes

No

No

No

Buyer's inside basis in target's net assets?

Stepped-up

Carryover

Carryover

Carryover

Buyer's outside basis in target's stock?

Stepped-up if target is liquidated

Stepped-up

Carryover

Carryover

Note: "boot" refers to the portion of consideration not paid in acquirer stock. The following framework is redundant to what we have already discussed, but may be helpful in visualizing the buyer's tax basis in net assets acquired from a freestanding C corporation for each of these tax structures:

Keep in mind two points to help you recall whether or not the buyer is entitled to a tax basis step-up in the acquired net assets and/or stock: y y Payment of taxes gives rise to basis step-ups. Non-payment of taxes gives rise to basis carryover.

y y y

Tax Attributes of a Target

Net Operating Losses
Net operating losses (NOLs) are created when the expenses incurred by a company exceed its revenues, generating negative taxable income. NOLs can be carried back 2 years to recover past tax payments, and forward 20 years to reduce future taxable income. After 20 years, any remaining NOL balance expires and the NOLs are no longer usable. NOLs carried forward are recorded on the balance sheet as deferred tax assets (DTA). Loss companies can elect not to carry back their NOLs. However, NOLs should generally be carried back as far as possible and any remaining NOLs should be used at the earliest opportunity in subsequent years to maximize the present value (PV) of the NOLs. Assuming a corporate tax rate of 35%, a $100 NOL is worth $35 today, but will be worth less in the future. The following example illustrates the benefit of an NOL carryback:

[See Chart] The discount rate used to calculate the PV of NOLs should reflect the probability that the loss company can generate pre-tax income in the future that is sufficiently positive to utilize the NOLs; otherwise, the NOLs will be lost. If pre-tax income is expected to be steadily positive in the future, a lower discount rate may be used.

Treatment of NOLs in M&A Transactions

The treatment of a target's tax attributes (e.g. NOLs) in an acquisition depends on the tax structure of the deal. In taxable acquisitions in which the acquired net assets are stepped-up for tax purposes, the target's NOLs may generally be used immediately by the acquirer to offset the gain on the actual or deemed asset sale. Any remaining NOLs of the target do not survive the transaction and are lost. Therefore, when the target has substantial NOLs, the deal is often structured to achieve a step-up in the acquired net assets. For deals in which there is not a step-up for tax purposes, such as a stock acquisition without a Section 338 election, the target's NOLs may be used by the acquirer in future years subject to limitation under Internal Revenue Code (IRC) Section 382, which severely restricts the use of acquired NOLs following a change in ownership.

Section 382
Since NOLs may be one of a target company's most desirable features, the structure of a transaction may be dictated by the target's tax attributes. The IRS created Section 382 to prevent acquisitions of companies with substantial NOLs solely to reduce the buyers' taxable incomes, without any valid business purpose whatsoever other than tax avoidance. Section 382 is triggered when a change in ownership occurs, defined loosely as an increase in ownership interest of at least 50% by shareholders owning 5% or more of the target's stock, over a 3-year period. The precise definition of a qualifying ownership change is complex, but it is sufficient to assume that in

any taxable or non-taxable business combination, a qualifying ownership change under Section 382 occurs. Section 382 imposes an annual limit on the use of NOLs in the hands of the acquirer equal to the minimum of: y y y The market value of the target's stock multiplied by the long-term tax-exempt rate Taxable income of the combined company The amount of unused NOLs remaining

To find the current long-term tax-exempt rate, visit the IRS' web site and search for "Applicable Federal Rate". Download the IRS' most recent revenue ruling on Applicable Federal Rates to find the long-term tax-exempt rate (see image below). The long-term tax-exempt rate for ownership changes in any given month is the highest of the adjusted federal long-term rates for that month and the prior two months.

[See Chart] The buyer must identify the post-transaction period over which it may utilize the target's NOLs subject to limitation under Section 382 in determining the price it is willing to pay for the target, since NOLs that expire before use are worthless. This period is the minimum of: y y y The remaining life of the NOLs The NOL carryforward divided by the Section 382 limitation 20 years

For example, suppose that the target has $20 of NOLs that expire in 6 years. A buyer acquires all of the target's stock for $40, and the long-term tax-exempt rate is 5%. The annual limitation on the use of the NOLs is $40 5% = $2. So, the combined company can only utilize to 6 $2 = $12 of the target's $20 of NOLs. [See Chart] Section 382 requires that the buyer meet the continuity of business enterprise requirement; continuing use of the target's historic business or a significant portion of the target's assets in an existing business for 2 years following the transaction. If the continuity of business requirement is not met, the annual NOL limitation is zero. The continuity of business requirement, together with the annual NOL usage limitation, effectively discourage acquisitions of loss companies for their NOLs alone.

The Section 382 limitation may be circumvented if the target and buyer collaborate to sell unwanted target assets with unrealized built-in gains before the acquisition occurs. The target may then use its NOLs to offset the gain on the sale without limitation. If the unwanted asset disposal occurred after the transaction, on the other hand, the NOLs would be subject to limitation under Section 382 would not go as far in shielding the gain. Companies with unused NOLs seeking new equity financing should be careful not to issue so much new equity as to trigger a change in ownership under Section 382. For example, an IPO of a biotech company that accumulated substantial NOLs during its start-up phase might trigger a qualifying change in ownership. Companies seeking to raise substantial equity financing should consider issuing straight preferred stock (no voting or conversion rights or participation in future earnings) rather than common stock.

Built-in Gains/Losses
If the target's basis in its assets exceeds the enterprise value of the target at the time of a qualifying change in ownership (a "built-in loss"), the excess is treated as a NOL as described above. Likewise, if a target's basis in its asset is less than its enterprise value (a "built-in gain"), the Section 382 limitation for any year following the ownership change is increased by the amount of any such gain realized in that year. So, a buyer planning to divest unwanted assets of the target following the transaction may find the Section 382 limitation less onerous than it at first appears.

Other Tax Attributes

Section 382 limitations also apply to capital loss carryforwards. However, the availability of capital gains is often the primary limitation on the use of capital loss carryfowards/carrybacks, since corporations can deduct capital losses only to the extent of capital gains. Capital losses may be carried back 3 years and forward 5 years. Other tax attributes of the target company, such as [foreign] tax credits and built-in losses, are subject to limitation under other sections of the IRC upon a qualifying change in ownership. Foreign tax credits may be carried back 2 years and forward 5 years.

Section 338 Elections

A buyer is not entitled to a step-up in the tax basis of acquired net assets to fair market value (FMV) in taxable stock acquisitions but, rather, a carryover basis. However, if an Internal Revenue Code (IRC) Section 338 election is made in connection with a taxable stock sale, the transaction is treated as a hypothetical asset deal for tax purposes, and the buyer's basis is accordingly revalued to reflect the purchase price. The depreciation and amortization of all asset write-ups and intangibles, including goodwill, identified in the purchase price allocation then become tax-deductible expenses. Since the transaction is treated as an asset deal, IRC Section 197 applies and all intangible assets, including goodwill, recognized in the transaction are thus amortized over 15 years for tax purposes.

The disadvantage of a Section 338 election is that it triggers a taxable gain on the deemed asset sale. So, the Section 338 election only makes sense when the present value (PV) of future tax savings from tax-deductible depreciation and amortization expenses exceeds the current tax cost of the step-up. Additionally, a stock deal accompanied by a 338 election is still considered a stock deal for legal purposes, so the buyer inherits all of the target's liabilities. There are two types of Section 338 elections: Section 338(g) Election This election applies to acquisitions of freestanding C corporations. The election is made unilaterallyby the acquirer after purchasing stock from the target's shareholders. The acquirer generally bears the incremental tax burden from the gain on the deemed sale of the target's assets. Section 338(h)(10) Election This election applies to acquisitions of corporate subsidiaries or S corporations. The election is made jointly by the acquirer and sellers before the deal is consummated, and the seller bears any incremental tax cost from the deemed asset sale. General requirements for a Section 338 election: y y A Section 338 election cannot be made in a non-taxable stock deal. The buyer must acquire control of the target in a qualified stock purchase (QSP), defined as the purchase of at least 80% of the total voting power and value ("vote and value") of the target's stock within twelve consecutive months of the first purchase of such stock. Preferred stock is not included in computing voting power or value. The "acquisition date" is the date on y which the 80% threshold is reached. The buyer must be a C corporation. For financial sponsors typically organized as LLCs, therefore, the Section 338 election is not usually an option. Individuals and partnerships cannot make a QSP, and are consequently unable to make a 338 election. However, individuals and partnerships can circumvent this restriction by forming a new corporation ("NewCo") to acquire the target's stock. y y Foreign targets are not eligible for the 338(h)(10) election, but are eligible for the 338(g) election. Any Section 338 election must be made by the fifteenth day of the ninth month after the month in which 80% control of the target is acquired (within 8.5 months).

Section 338(g) Election

The tax treatment of the target's shareholders is unaffected by a 338(g) election since the deemed asset sale does not occur until after the transaction is complete and the selling shareholders have already sold their stock. Therefore, a 338(g) election results in two levels of tax: 1) selling shareholders recognize a taxable gain or loss on the actual stock sale and 2) the target entity recognizes a taxable gain on the deemed asset sale, which usually becomes a liability of the acquiring entity. A 338(g) election may be made unilaterally by the acquirer because only the acquirer is affected by the election.

Even though the 338(g) election results in treatment of a stock acquisition as an asset sale, the buyer assumes a stepped-up tax basis in both the acquired net assets and the target's stock. This is because taxes are paid by both the buyer and the target's shareholders on the deemed asset sale and the stock sale, respectively. Section 338(g) elections are rare because the current tax cost of the deemed asset sale usually exceeds the PV of tax savings from the tax basis step-up. Generally, a 338(g) election is only advantageous when the target has substantial net operating loss (NOL) or tax credit carryovers that the acquirer can use to offset any taxable gain triggered by the deemed asset sale. These tax attributes are available only for immediate use and do not survive the acquisition if the target is liquidated.

Section 338(h)(10) Election

To qualify for a 338(h)(10) election, the target must be either 1) a U.S. corporate subsidiary of a selling consolidated group or selling affiliate (a parent company) or 2) an S corporation on the acquisition date. In the acquisition of a subsidiary, the selling group, rather than the buyer, pays tax on the gain from the deemed sale of the target's assets since the target owned by the selling group. As such, the 338(h)(10) election is made jointly by the buyer and seller. Also, the seller will demand a higher purchase price to agree to a 338(h)(10) election as compensation for its tax cost resulting from the election. However, the acquirer will only be able to compensate the seller for its immediate tax cost if the PV of tax savings from the election exceed the tax cost. If the selling group's basis in the target's stock (outside basis) is less than or equal to its basis in the target's assets (inside basis), the 338(h)(10) election is always advantageous. However, if the selling group's outside basis is greater than its inside basis, as is more often the case, the 338(h)(10) election is only advantageous if the PV of tax savings from the election exceed the incremental tax cost. Section 338(h)(10) elections are more common than 338(g) elections for two reasons: y The taxable gain on the deemed sale of the target subsidiary's assets may be offset by any losses in or tax attributes (e.g. NOLs) of other subsidiaries of the selling group (parent company). The proceeds from the liquidation of a subsidiary are tax-free to the subsidiary's shareholders (the parent company) under IRC Section 332, resulting in a single level of tax.

So, no gain or loss is recognized by the selling group on its sale of the target subsidiary's stock, but the target will recognize a gain as if it had sold all of its assets. The tax on this gain is generally paid by the parent (which explains why the 338(h)(10) election is made jointly). If the parent company then distributes the after-tax liquidation proceeds to its shareholders, the parent shareholders are subject to a dividend tax on the distribution. Section 338(h)(10) elections may also be advantageous in the acquisition of S corporations because S corporations are not subject to corporate level tax. Note that since S corporations can have no corporate

shareholders, the QSP does not apply because any stock purchase before the acquisition date would disqualify the target from being a S corporation. The target's tax attributes can be used by the selling group to immediately offset any taxable gain on the deemed asset sale, but any remaining tax attributes vanish if the target is liquidated. Since the tax attributes are used by the selling group, they do not transfer to the acquirer as in a 338(g) election.

Aggregate Deemed Sale Price

When a Section 338(g) election is made in connection with a taxable stock acquisition, the amount for which the target is deemed to have sold its gross assets is known as the aggregate deemed sale price (ADSP), which is calculated as: ADSP = G + L + t (ADSP B N) where: y y y y y G = grossed-up purchase price of target's stock less selling costs L = target's liabilities assumed by acquirer t = corporate tax rate B = target's tax basis in its gross assets N = target's tax attributes (e.g. NOLs) that can be used by the acquirer to offset any taxable gain

"Grossed-up" means that the purchase price is adjusted to reflect the sale of 100% of the target's assets. For example, if the buyer acquires 80% of the target's stock for $800, the grossed-up purchase price would be $800 80% = $1,000. Note that the quantity t(ADSPBN) is the tax liability arising from the deemed asset sale and assumed by the acquirer. If a Section 338(h)(10) election is made in which the selling group, rather than the acquirer, assumes the tax cost of the deemed asset sale, the ADSP is simply: ADSP = G + L The ADSP becomes the buyer's new tax basis in the target's assets. [See Chart] Example 3.7 Stock Acquisition With and Without a 338(h)(10) Election Tango corporation is a wholly owned subsidiary of Sierra corporation. Sierra's basis in Tango's stock is $200 and Tango's inside asset basis is $200. Also, Sierra has NOLs of $500, of which $70 are attributable to Tango. Tango has $150 of liabilities. Alpha corporation has offered to pay $600 to acquire the all of the outstanding stock of Tango. The corporate tax rate is 35%. (A) If Alpha purchases the stock of Tango without a Section 338 election, what are the tax consequences to Sierra?

Sierra realizes a gain on the stock sale of $600 $200 = $400. It cannot use the NOLs attributable to Tango to offset this gain, as they are lost to Alpha in the deal. However, Sierra can use $400 of its other NOLs to completely offset the gain and reduce its taxable income to zero. Therefore, Sierra's after-tax proceeds are $600 35% $0 = $600, and Sierra is left with $500 $70 $400 = $30 of NOLs. (B) What are the tax consequences to Alpha in this scenario? Alpha will assume a stepped-up basis in Tango's stock of $600, and a carryover basis in Tango's assets of $300. Tango's $70 of NOLs carry over to Alpha, but are subject to limitation under Section 382. (C) If Alpha instead purchases the stock of Tango with a Section 338 election, what are the tax consequences to Sierra? Sierra will not recognize a gain on the sale of Tango stock, but Tango will recognize a gain on the deemed asset sale equal to the ADSP less Tango's inside asset basis ($200). If we assume that Sierra bears the tax burden of the deemed asset sale, as would likely be the case in a 338(h)(10) stock sale, the ADSP equals the grossed-up purchase price ($700) plus the amount of liabilities assumed by the acquirer ($150). Sierra's taxable gain is $600 + $150 $200 = $550. But since the deemed asset sale occurs while Tango is still a consolidated subsidiary of Sierra, Sierra can use allof its NOLs ($500), including those attributable to Tango, to offset all but $50 of the gain. Therefore, Sierra's after-tax proceeds are $600 35% $50 = $582.5, and Sierra is left with $50 of NOLs. With a 338(h)(10) election, Sierra will have after-tax cash proceeds that are lower by $17.5, but posttransaction NOLs that are higher by $20. Sierra will only favor a 338(h)(10) election if the PV of tax savings from the incremental post-transaction NOLs adequately compensate it for the lower after-tax proceeds. In this case, even if all of the incremental $20 of NOLs were used immediately, they would generate just 35% $20 = $7 in tax savings. So, Sierra will clearly not agree to a 338(h)(10) election unless Alpha offers a higher purchase price. (D) What are the tax consequences to Alpha in this scenario? Alpha assumes a stepped-up outside basis in Tango's stock of $700, and a stepped-up inside basis in Tango's assets equal to the ADSP, or $850. Tango's NOLs do not carry over to Alpha, since they are used by Sierra. The depreciation and amortization of asset write-ups and intangibles, including goodwill, recognized in the purchase price allocation are tax-deductible expenses. Under Section 197, all intangibles thus recognized are amortized over 15 years. So, even though Alpha loses the PV of tax savings from Tango's NOLs by agreeing to a 338(h)(10) election, it gains the PV of tax savings from stepped-up basis in Tango's assets. Since Tango's NOLs would be subject to limitation under Section 382 anyway, their loss is not a significant disadvantage to Alpha unless the NOLs are substantial. However, as the portion of the step-up allocated to nondepreciable or slowly depreciating assets increases, the PV of tax savings from the step-up decreases and the 338(h)(10) election loses its appeal. Whether or not Alpha prefers a 338(h)(10) election depends on the how much more it must pay Sierra to agree to the election and the relative magnitudes of the PVs of tax savings from Tango's NOLs and the step-up.

Tax-Free Acquisitions
Tax-free M&A transactions are considered "reorganizations" and are similar to taxable deals except that in reorganizations the acquirer uses its stock as a significant portion of the consideration paid to the seller rather than cash or debt. Four conditions must be met to qualify a transaction for tax-free treatment under Internal Revenue Code (IRC) Section 368: y y Continuity of ownership interest At least 50% of the consideration is acquirer stock (although transactions with as little as 40% stock consideration have qualified for tax-free treatment). Continuity of business enterprise The acquirer must either continue the target's historical business or use a significant portion of the target's assets in an existing business for 2 years after the transaction. Valid business purpose The transaction must serve a valid business purpose beyond tax avoidance. Step-transaction doctrine The transaction cannot be part of a larger plan that, taken in its entirety, would constitute a taxable acquisition.

y y

Reorganizations, while not generally taxable at the entity level, are not completely tax-free to the selling shareholders. A reorganization is immediately taxable to the target's shareholders to the extent they receive non-qualifying consideration, or "boot". Also, tax on acquirer stock received by target shareholders as consideration is deferred rather than avoided altogether. Boot Any consideration received by target shareholders other than acquirer stock (e.g. cash or debt). Let's examine how each stakeholder in a non-taxable acquisition is affected from a tax perspective: y Acquiring Entity y y Assumes a carryover basis in the acquired net assets equal to the target's historical tax basis, even when a gain is recognized by the target shareholders on any boot received. Assumes a carryover basis in the stock received from target shareholders equal to the target shareholders' basis, even when a gain is recognized by the target shareholders on any boot received. No gain or loss on the exchange of the acquirer's own stock for stock of the target. The target's tax attributes (e.g. NOLs) survive the acquisition and carry over to the acquirer, but their use is subject to limitation under Section 382.

y y

Target Entity y Target does not recognize a taxable gain on the transfer of assets to the acquirer.

Target Shareholders

y y y

Target shareholders assume a tax basis in the acquirer stock received as consideration equal to their old basis in the target stock. No gain or loss on the exchange of target stock for acquirer stock; rather, any tax on acquirer stock received as consideration is deferred until the target shareholders sell the stock. The transaction is immediately taxable to selling shareholders to the extent boot is received.

Example 3.8 Shareholder Taxes Suppose Alpha acquires Tango in an tax-free reorganization for $60 in cash and $40 in stock. Tango's shareholders' aggregate basis in their stock is $20. So, Tango's shareholders' realized gain is $60 + $40 $20 = $80. Their recognized gain is the lower of the realized gain and the amount of boot received, or $40.

Tax-Free Deal Structures

Section 368 of the Internal Revenue Code recognizes three types of corporate acquisition structures that qualify as tax-free (or tax-deferred) reorganizations: y Type "A" Reorganization (stock-for-assets acquisition) y Statutory merger or consolidation y Forward triangular merger y Reverse triangular merger Type "B" Reorganization (stock-for-stock acquisition) Type "C" Reorganization (stock-for-assets acquisition)

y y

Statutory Merger ("A" Reorganization)

In a statutory merger, target shareholders exchange their shares for acquirer stock and up to 60% boot (continuity of interest requirement applies). Boot is immediately taxable to target shareholders, while payment in acquirer stock is tax-deferred. Stock consideration may be paid in voting and non-voting common or qualified preferred shares of the acquirer. The target is liquidated, and all of the target's assets and liabilities are assumed by the acquirer. Approval of the merger plan is subject to acquirer and target shareholder vote in most states. Also, dissenting shareholders may have their independently appraised and purchase for cash.

Statutory Consolidation ("A" Reorganization)

In a statutory consolidation, two or more corporations contribute all of their assets and liabilities to a new corporation formed to effect the transaction, and the preexisting corporations are dissolved. This structure is appropriate for mergers of equals. Acquirer and target shareholders have the same voting and appraisal rights as in a statutory merger.

Forward Triangular Merger ("A" Reorganization)

In a forward triangular merger, the target is merged into a subsidiary of the acquiring corporation, leaving the subsidiary as the surviving entity. Because the target is eliminated, non-transferrable assets and contracts, such as patents or licenses, may be lost. The buyer must acquire "substantially all" of the target's assets (defined as at least 70% and 90% of the FMV of the target's gross assets and net assets, respectively) for the transaction to qualify for tax-free treatment. Sales of assets not wanted by the acquirer just prior to the merger may jeopardize favorable tax treatment. As in a statutory merger, the form of consideration must meet the continuity of interest requirement and payment in acquirer stock is flexible as to the type of securities used as consideration (payment in subsidiary stock is disallowed). However, this structure has two advantages over a statutory merger: 1) the acquirer is shielded from the target's liabilities because they are isolated in a separate legal entity (the subsidiary) and 2) the acquirer's shareholders need not approve the merger, unless the acquisition is material or more acquirer shares must be authorized to complete the transaction.

Reverse Triangular Merger ("A" Reorganization)

In a reverse triangular merger, a subsidiary of the acquirer is merged into the target, leaving the target as the surviving entity and a subsidiary of the acquirer and eliminating any minority shareholders in the target. This structure allows the acquirer to shield itself from the target's liabilities, as in the forward triangular merger, but with the added benefit that non-transferrable assets and contracts are not lost. For this reason, the reverse triangular merger is a commonly used structure. However, at least 80% of the consideration must be paid in voting common or preferred stock of the acquirer, eliminating some flexibility in the type of equity consideration paid relative to the forward

triangular merger. Other characteristics of this structure are similar to those found in forward triangular mergers, including the "substantially all" and shareholder approval requirements.

Stock-for-Stock Acquisition ("B" Reorganization)

In

"B"

reorganization,

the

acquirer

exchanges

its voting common and/or qualified preferred stock (no boot, except for small amounts paid for fractional shares) for control of the target, defined as ownership of 80% of the "vote and value" of the target's stock. The target survives as a subsidiary of the acquirer, shielding the acquirer from the target's liabilities. The buyer need not acquire the entire 80% of target stock at once, but must own at least 80% upon completion of the acquisition. This allows the buyer to acquire the target's shares gradually in what is known as a "creeping" acquisition. Note that since this structure does not require 100% of the target's shares to be acquired, minority shareholders may retain a stake in the target. The "B" reorganization is similar to the reverse triangular merger, except that the latter allows boot, eliminates minority shareholders, and requires the buyer to acquire "substantially all" of the target's assets. This structure may be useful when the target's shareholders are willing to accept acquirer stock as consideration because, for example, they might have built-in capital gains that would be triggered upon a stock sale for cash. The buyer may also prefer this structure if it does not want to part with a substantial amount of cash to fund the acquisition or seeks to shield itself from the target's liabilities.

Stock-for-Assets Acquisition ("C" Reorganization)

In a "C" reorganization, the acquirer exchanges its voting common and/or preferred stock for "substantially all" of the target's assets. The target liquidates and transfers the acquirer shares and any remaining assets to its shareholders. Consideration paid in cash or securities other than voting common or preferred stock (boot) cannot exceed 20% of the FMV of the target's pre-transaction assets. Any liabilities assumed by the acquirer count toward the 20% boot limit when cash or other non-qualifying consideration is paid. As in taxable asset acquisitions, the buyer can be selective in choosing which, if any, of the target's assets it will assume. Rejecting the certain liabilities altogether affords the acquirer even greater protection than does isolating those liabilities in a subsidiary. However, the acquirer is highly exposed to any assumed liabilities unless a subsidiary is used to shield that exposure as in other structures. Moreover, like taxable asset acquisitions, the "C" reorganization can be mechanically complex, costly, and time consuming. Hence, "C" reorganizations are rare.

Exhibit 3.3 Comparison of Section 368 Tax-Free Structures

Structure Advantages Disadvantages

Statutory Merger or Consolidation

Flexibility in the form of consideration (no voting stock requirement; up to 60% boot can be used) Tax-free status not affected by disposal of unwanted assets Eliminates minority or dissenting shareholders

All target's liabilities assumed Acquirer and target shareholders may be entitled to voting and appraisal rights Transfer of titles, leases, and contracts may be necessary Neither company can be a foreign corporation May lose non-transferrable assets and contracts "Substantially all" requirement Target shareholder vote Acquirer must exchange its voting stock for target stock "Substantially all" requirement Target shareholder vote Acquirer must exchange its votingstock for target stock Inflexible with respect to the form of consideration Minority shareholders not eliminated Acquirer must exchange its votingstock for target stock Inflexible with respect to the form of consideration "Substantially all" requirement Mechanically complex and costly

Forward Triangular Merger

Flexibility in the form of consideration Target's liabilities isolated in a subsidiary

Reverse Triangular Merger

Up to 20% boot can be used Target's liabilities isolated is a subsidiary Non-transferrable assets and contracts are not lost

"B" Target's liabilities isolated in a subsidiary Reorganization Non-transferrable assets and contracts are not lost No "substantially all" requirement

"C" Acquirer can be selective in choosing the Reorganization liabilities it assumes

Section 351 Mergers

IRC Section 351 provides a means to effect a tax-free business combination when the tax-free structures recognized under Section 368 are impractical. The most notable advantage of Section 351 over Section 368 is that the former does not require continuity of ownership interest, which restricts the amount of nontaxable consideration (acquirer stock) that the target's shareholders may receive. Thus, a Section 351 merger may include an unrestricted amount of tax-free consideration, benefiting selling shareholders who value tax deferment over current income. Founding shareholders in a newly formed corporation generally transfer property (e.g. cash and other assets) to the new entity (NewCo) in return for ownership interests (e.g. common or preferred stock).

Under IRC Section 351, this transfer is tax-free, provided that the transferors (in aggregate) assume tax control of NewCo immediately after the transaction, defined as at least 80% ownership of the vote and value of each class of outstanding stock. The conditions required by Section 368 for tax-free treatment do not apply. The following illustration shows one way in which a Section 351 merger might be structured:

Transferors may receive boot (e.g. cash and other property) in addition to NewCo stock in exchange for the property transferred. While the receipt by transferors of NewCo stock is not taxable, transferors who receive boot recognize a taxable gain equal to the lesser of the boot received and the gain realized on the transfer of property. Transferors who receive NewCo stock assume a basis in such stock equal to the basis in the property transferred. However, if the transferors also receive boot in the exchange, their basis in their NewCo stock is reduced by FMV of the boot and any loss they recognize on the exchange. Conversely, the transferors' basis in increased by the amount of anygain recognized on the exchange. NewCo assumes a carryover basis in the property received, increased by the amount of any gain recognized by transferors (recall that when taxes are paid, a step-up is allowed by the IRS). Section 351 mergers are flexible in that they can be tailored to meet the objectives of Target's shareholders. Consideration may consist of cash and/or multiples classes of NewCo stock such as voting and non-voting common and preferred stock. Exhibit 3.4 Example of a Section 351 Merger Delta and Foxtrot are publicly traded corporations. Much of Delta's business consists of supplying raw materials to a manufacturing division of Foxtrot. Delta and Foxtrot agree to a business combination under Section 351 whereby Foxtrot transfers its manufacturing division to Delta in exchange for enough newly issued Delta shares to give Foxtrot 81% ownership of Delta post-transaction. In this case, Delta acquires a new division and Foxtrot acquires tax control of the combined company (Delta) as required by Section 351. The previously issued Delta shares remain outstanding and publicly traded, but now represent just 19% (=181%) of the total Delta shares outstanding. The resulting post-transaction structure would be the same if Foxtrot had instead acquired Delta outright, transferred its manufacturing division into new subsidiary Delta, and carved out 19% of its equity ownership in Delta. Of course, this equivalent series of transactions would be far more complex, potentially tax-inefficient, and impractical. Joint ventures are sometimes structured under Section 351.

Dividends Received Deduction

The Dividends Received Deduction, or DRD, is a tax deduction that C corporations receive on the dividends distributed to them by other companies whose stock they own. As a C corporation's equity interest in a dividend-paying company increases, so does the amount of the DRD as shown below: Exhibit 3.5
Percent Ownership Implied Tax Rate on Dividends*

Dividends Received Deduction

< 20%

70%

10.5% [=35%(1-70%)]

20 - 80%

80%

7.0% [=35%(1-80%)]

> 80%

100%

0.0% [=35%(1-100%)]

* Assumes a 35% tax rate for the corporation receiving the dividend. The DRD is designed to soften the blow of triple taxation on corporate dividends. Triple taxation occurs because the company paying the dividend does so with after-tax money. The C corporation receiving the dividend is then taxed on the dividend. Finally, if the receiving C corporation pays out the dividend to its shareholders, the shareholders are taxed yet again. There are a few limitations to the DRD: y y y y y The DRD is only available to C corporations; not LLCs, S corporations, or individuals. There is a 45-day minimum holding period for common stock. The DRD does not apply to preferred stock. If a corporation is entitled to a 70% DRD, it can deduct dividends only up to 70% of its taxable income. If a corporation is entitled to a 80% DRD, it can deduct dividends only up to 80% of its taxable income.

If a corporation is entitled to a 100% DRD, there is no taxable income limitation. Also, if the DRD creates or increases a net operating loss, the taxable income limitations do not apply. Example 3.9 Corporation X owns 40% of Corporations Y's outstanding stock. Corporation X has taxable income of $900, which includes dividends of $1,000. What is Corporation X's taxable income after the DRD?

At first glance, Corporation X could deduct $800 (=80%$1,000) of dividends based on stock ownership alone. However, the taxable income limitation limits the deduction to 80% of Corporation X's taxable income, or $720 (=80%$900).

Taxable Income Before DRD

$900

Less: DRD

(720)

Taxable Income After DRD

$180

Example 3.10 Use the facts from Example 3.10, except now assume that Corporation X's taxable income is $700. What is Corporation X's taxable income after the DRD? Corporation X can now deduct the full $800 (=80%$1,000) of dividends. The taxable income limitation does not apply because the DRD creates a net operating loss.

Taxable Income Before DRD

$700

Less: DRD

(800)

Taxable Income After DRD

($100)

If a corporation claims both a 70% DRD and an 80% DRD, first calculate the taxable income limit for the 80% DRD. Then, in order to calculate the taxable limit for the 70% DRD, reduce the taxable income by the total amount of the dividends subject to the 80% DRD. Example 3.11 Corporation X has $1,000 of taxable income, inclusive of dividends. It owns 15% of the stock of Corporation Y from which it receives $400 in dividends, and 40% of the stock of Corporation Z from which it receives $700 in dividends. How much can Corporation X deduct? First, calculate the the 80% DRD. The allowable deduction is the smaller of the tentative DRD of $560 (=80%$700) or 80% of its taxable income or $800 (=80%$1,000) taxable income). Next, calculate the 70% DRD. The allowable deduction is the smaller of the tentative DRD of $280 (=70%$400) or 70% of its taxable income after deducting dividends from Corporation Z, or $210 [=70%($1,000$700)].

Taxable Income Before DRD

$1,000

Less: DRD [=$560+$210]

(770)

Taxable Income After DRD

$230