Introduction to US Taxation of Mergers and Acquisitions

Prof. Charlotte Crane Graduate Tax Program Northwestern University School of Law Chicago, Illinois 1

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 Shareholders Corp US Corp F assets US assets 2

Double taxation of Corporate Earnings Domestic • 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=455 Post-2004 individual shareholders taxed at 15% Post-2004 650-97.50=552.50

No shareholder credit for corporate taxes paid No corporate deduction for dividend paid • No rate difference between income distributed and income not distributed Except when penalty taxes for accumulations Shareholders Corp 3

US corporate tax rates •

2004 stated rates

• Up to $50,000 • Over 50,000 but not over $75,000 • Over 75,000 but not over $10,000,000 • Over $10,000,000 15% 25% 34% 35% •

2004 rates including phaseout of lower brackets

• Up to $50,000 15% • Over 50,000 but not over $75,000 • Over 75,000 but not over $100,000 • Over $18,333,333 25% 34% • Over 100,000 but not over $10,000,000 • Over $10,000,000 but not over $15,000,000 35% • Over $15,000,000 but not over 18,333,333 39% 38% 35% 4

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 Ind Share Corp 5

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 6

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 7

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 Eligible GmBh SA Scl NV BV 8

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” 9

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 10

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 11

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 12

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 13

Double Tax only applies to earnings Creates enormous pressure for debt financing

Without debt

552 after tax to shareholders • • • • • • •

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 Shareholders Corp Shareholders Creditors Corp 14

Computation of Earnings and Profits

Income from exempt bonds Gain on installment sales book 5000 10000 tax 0 0 adjustment to tax for e&p 5000 10000 Depreciation on Equipment Depreciable real estate Nondepreciable real estate self-created intangible-patent Purchased intangible-patent Federal Income Taxes 50000 50000 20000 15000 17000 5000 8000 0 5000 6000 17000 10000 0 15000 1450 5000 (some as deferred taxes) 11000 16500 15

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) 16

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” 17

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 18

Assets of Target Corporation Certificate of deposit Accounts receivable Inventory Equipment Depreciable real estate Nondepreciable real estate self-created intangible-patent Purchased intangible-patent Customer base Other stock held for investment Other goodwill [reserve for tort liability Accounts payable Bank debt Bonded debt shareholder equity 1000 10000 15000 50000 50000 20000 15000 17000 0 5000 0 183000 12000 10000 100000 0 0 100 0

10000 8000

0

5000 6000

0 0 29100 0 100 0

35000 10000

0

15000 1450

0 0 61550 1000 9,900 15000 15000 40000 20000 0 15,550 0 5000 0 121450 fmv 1015 9000 22000 38,000 60000 42000 18000 18000 30000 4000 75000 -30000 287015 Tax gain or lossBook gain or loss 15 -900 7000 23000 20000 22000 18000 2450 30000 -1000 15 -900 7000 -2000 18000 22000 8000 7000 30000 -1000 75000 75000 -30000 -30000

165565 133115

19

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 20

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 21

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

22

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 23

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 24

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 25

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 26

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% 27

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 28

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 29

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 30

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 31

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 32

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 33

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 34

Certificate of deposit Accounts receivable Inventory Equipment Depreciable real estate Nondepreciable real estate self-created intangible-patent Purchased intangible-patent Customer base Other stock held for investment Other goodwill [reserve for tort liability Accounts payable Bank debt Bonded debt shareholder equity

Assets of Target Corporation with liability problems on liquidation

0 100 0 35000 10000 0 15000 1450 0 0 61550 1000 9,900 15000 15000 40000 fmv 1015 9000 22000 38,000 60000

80000

Tax gain or loss 15 -900 7000 23000 20000 20000 0 15,550 0 5000 0 42000 18000 18000 30000 4000 75000

-30000

22000 18000 2450 30000 -1000 75000 -30000 121450 287015 165565 35

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 36

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 37

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) 38

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 39

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 40

OVERVIEW OF US TAXING JURISDICTION 41

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 42

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 43

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 44

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 45

Indirect Foreign Tax Credit 902

•

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 46

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 47

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 48

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 49

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 50

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 51

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 52

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 53

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 54

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 55

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 56

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 57

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 58

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 59

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 60

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 61

TAXABLE ACQUISITIONS: STOCK OR ASSETS

Slide 62

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 63

Taxable Sale of Business Assets Buyer’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 64

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 65

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 66

I II Cash Certificate of deposit Assets of Target Corporation Assuming all but tort liability to be paid by seller fmv III IV II V V V VI VI Accounts receivable Inventory Other stock held for investment Equipment Depreciable real estate Nondepreciable real estate self-created intangible-patent Purchased intangible-patent VII VII Customer base Other goodwill 500 10000 15000 5000 50000 50000 20000 15000 17000 0 0 0 100 0 10000 8000 0 5000 6000 0 0 0 100 0 35000 10000 0 15000 1450 0 0 1000 9,900 15000 5000 15000 40000 20000 0 15,550 0 0 500 515 Tax gain or loss -485 9000 22000 4000 38,000 60000 42000 18000 18000 30000 75000 -900 7000 -1000 23000 20000 22000 18000 2450 30000 75000 [reserve for tort liability 182500 29100 61550 121450 -150000 166515 -150000 45065 67

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 68

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 69

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 70

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 71

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 72

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 73

Taxable sale of stock Check-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 74

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 75

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 76

GENERAL CONSIDERATIONS ON OUTBOUND NONTAXABLE TRANSACTIONS 77

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 78

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 79

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 80

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. 81

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 82

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 83

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 84

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 continuing interest in property under modified corporate forms .” – Reg. 1.368-1(b). 85

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 86

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 87

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 88

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 89

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 90

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 91

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 92

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) 93

Gain on transfer of foreign operations under 367(a)

Certificate of deposit Accounts receivable Inventory Equipment Depreciable real estate Nondepreciable real estate self-created intangible-patent Purchased intangible-patent Customer base Other stock held for investment Other goodwill [reserve for tort liability Accounts payable Bank debt Bonded debt shareholder equity 1000 10000 15000 50000 50000 20000 15000 17000 0 5000 0 183000 12000 10000 100000 0 0 100 0 10000 8000 0 5000 6000 0 0 29100 0 100 0 35000 10000 0 15000 1450 0 0 61550 1000 9,900 15000 15000 40000 20000 0 15,550 0 5000 0 121450 fmv 1015 9000 22000 38,000 60000 42000 18000 18000 30000 4000 75000 -30000 287015 15 -900

7000 23000

20000 22000

18000 2450

30000 -1000 75000 -30000 165565 15 -900 7000 -2000 18000 22000 8000 7000 30000 -1000 75000 -30000 133115 94

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 95

T sh C reorganizations Stock for assets A sh

Acq T

Assets • • • • Acq must use voting stock Limited other consideration Acq must acquire substantially all assets T must liquidate 96

T sh C reorganizations *Stock for assets* A sh

Acq T

Assets • • • • Acq must use voting stock Limited other consideration Acq must acquire substantially all assets T must liquidate 97

T sh

T

Assets C reorganizations *Stock for assets* P Acq

Acq

• • • • • Acq must use voting stock Limited other consideration Acq must acquire substantially all assets T must liquidate May use P Acq stock 98

T sh C reorganizations **Stock for assets** P Acq

Acq

Assets • • • • • Acq must use voting stock Limited other consideration Acq must acquire substantially all assets T must liquidate May use P Acq stock 99

“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 100

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 101

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 102

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 corporation shareholder’s basis in stock to extent of non-US holdings • Transfer of assets by foreign corporation to US • Only problems if CFC 103

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.

104

* 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 105

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 106

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) 107

T sh B reorganizations Stock for stock A sh

Acq T

• • Acq can use only voting stock Acq must have 80% control after 108

T sh B reorganizations *Stock for stock* A sh

T Acq

• • Acq can use only voting stock Acq must have 80% control after 109

T sh B reorganizations **Stock for stock** A sh

T Acq

• • Acq can use only voting stock Acq must have 80% control after 110

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 111

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” 112

Inbound B reorganization situations • US Acquirer of Foreign Target in B reorg – neither 367(a) or 367(b) apply – Corporation will be CFC 113

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 114

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 triggered Losses not allowed Exception for active foreign operations Inventory, intangibles, recapture not protected Branch loss exception 115

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 116

T sh B reorganizations *Stock for Parent stock*

P Acq Acq T

• • • Acq can use only voting stock Acq must have 80% control after Stock of acquirer parent may be used 117

T sh B reorganizations Stock for stock with drop A sh

Acq T

Sub • • • Acq can use only voting stock Acq must have 80% control after Acq may contribute T to sub 118

T sh B reorganizations **Stock for stock with drop** A sh

Acq T

Sub • • • Acq can use only voting stock Acq must have 80% control after Acq may contribute T to sub 119

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 120 • .

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 121

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 122

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 123

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. 124

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.

125

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 126

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 127

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 128

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 129

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 130

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 131

Assets unwanted by the acquirer when Target will not remain • In C, forward triangular and reverse triangular • no such requirement in a B reorganization. 132

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. 133

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).

134

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 135

Non-tax considerations in choice of nontaxable or nontaxable • Financial accounting for the acquired stock and assets – “Pool accounting” no longer available FASB 141 136

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 137