M&A in 2014: Tax considerations Optimizing after-tax returns in acquisitive transactions

William P. Bowers - Norton Rose Fulbright

Patrick L. O’Daniel- Norton Rose Fulbright

September 4, 2014

Speaker William P. BowersNorton Rose Fulbright

Bill Bowers rejoined the Dallas location as a partner in the Fall of 2008, following two years as Senior Counsel in the Office of Tax Policy of the Treasury Department. In the Office of Tax Policy, he was responsible for the development of administrative guidance and legislative initiatives for pass-through entities. He played an important role in formulating the Administration's response to proposed legislation regarding the taxation of carried interests and the treatment of publicly traded hedge funds and private equity funds as corporations. Also, in his position with the Treasury, he worked closely with the IRS to develop administrative guidance on a number of matters including non-compensatory options, compensatory options, debt-for-equity exchanges, varying interests rules and the application of mixing bowl rules to partnership mergers.

As a member of tax practice group, he focuses on federal income tax planning for complex business transactions involving corporations, partnerships and real estate investment trusts. Additionally, Bill co-authored a Treatise on Texas LLCs with Patrick O'Daniel and George Coleman and is an active speaker and author on federal tax issues, partnerships and LLCs.

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Speaker Patrick L. O’DanielNorton Rose Fulbright

Patrick O'Daniel has served for many years as a trusted business and tax advisor to clients efficiently solving their legal problems as part of their business team. A large portion of his practice is dedicated to the tax and public law aspects of municipal finance and structured and project finance.

He advises on a wide variety of international and domestic issues concerning the formation, operation, acquisition, merger, combination, liquidation and disposition of partnerships, limited liability companies and corporations, as well as various funding structures.

Patrick served as a clerk for US Supreme Court Justice Clarence Thomas and US Court of Appeals for the Fifth Circuit Judge Will Garwood.

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Continuing education information

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Topics For Discussion

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• Taxable Acquisitions of Corporations• Tax-free Mergers and Acquisitions of Corporations• Transaction Documents – Tax Components• Tax Due Diligence

Tax Considerations of Taxable Corporate Asset Acquisition

1. S Corporation may have corporate level tax liability per Section 1374 IRC.2. C Corporation subject to same tax rate for ordinary and capital gain.3. Subject to possible application of Section 1374 IRC.4. Special rules in corporation part of consolidated group.

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– Seller: (C Corporation)

• Taxable Entity: Fully Taxable to C Corporation

• Character of Gain: Ordinary or Capital Based on Character of Assets Sold2

• Double Tax: Yes; Once to Corporation and Again When Proceeds Distributed4

– Buyer

• Step-Up in Tax Basis: Yes

• Fresh Start: Does Not Inherit Federal Income Tax Profile of Seller

– State and Local Taxes: Possible Transfer Taxes and Successor Tax Liability

– Seller: (S Corporation)

• Flow-Through: Fully Taxable to Shareholders1

• Character of Gain: Ordinary or Capital Based on Character of Assets Sold

• Double Tax: No; Income and Gain Taxable Once on Shareholders Return3

– Buyer

• Step-Up in Tax Basis: Yes

• Fresh Start: Does Not Inherit Federal Income Tax Profile of Seller

– State and Local Taxes: Possible Transfer Taxes and Successor Tax Liability

Tax Considerations of Taxable Stock Acquisition

1. Collapsible corporation rules repealed. 2. If Seller is or he’s been a member of consolidated group tax return, Seller has joint and several

liability for group tax liability. Under Texas Gross Margin Tax, Seller retains liability for Controlled Group.

3. Acquisition may terminate S Corporation status of purchase not an eligible Shareholder. 8

– Target (C Corporation)

• Fully Taxable to Shareholders

• Character of Gain: Capital Gain1

– Buyer

• Carry-Over Target’s Tax Basis: Yes

• Fresh Start: No2 –Target Retains Federal Income Tax Profile

• Carry-over Target’s NOLS: Yes (Subject to Section 382 Limitations)

– Target (S Corporation)

• Fully Taxable to Shareholders

• Character of Gain: Capital Gain1

– Buyer

• Carry-over Target’s Tax Basis: Yes

• Fresh Start: No3 – Target Retains Federal Income Tax Profile

• Carry-over Target’s NOLS: Generally No

Taxable stock acquisition – Section 338(h)(10) election: Stock Sale for State Law But Taxable Asset Sale for FIT• Important to both Buyer and Seller!

• Buyer gets a “stepped up” basis in the assets, but avoids the expense and complication of

an asset acquisition from a corporate perspective (e.g., pref. rights and consents)

• Seller may seek indemnity for increased taxes resulting from the 338(h)(10) election (e.g.,

state taxes; capital gain v. ordinary income)

• Buyer must be a corporation (C or S Corporation) that makes a qualified stock purchase at

least 80% of the stock of the Target corporation

• Target corporation must be either (i) an S corporation or (ii) a C corporation that is a

domestic corporation and subsidiary in consolidated or affiliated group

• Election made on IRS Form 8023. Form 8023 must be signed by both Buyer and Seller and

filed within 15th day of the ninth month following the month of acquisition.

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Taxable stock acquisition – Section 336(e) IRC

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• Tax consequences similar to Section 338(h)(10) election.

• Available for acquisitions subsequent to May 14, 2013.

• Section 336(e) applies to certain instances in which Section 338(h)(10) election is unavailable.

– Applies to “qualified stock dispositions” of target stock

– Applies even though the purchaser is not a corporation

• Section 336(e)

– Selling shareholders must enter into binding agreement to make the election.

– Election must be attached to the relevant timely filed (including extensions) FIT Return for taxable year of disposition.

– Unlike Section 338(h)(10) election, purchaser is not party to election.

Summary of tax considerations in an M&A deal

Seller wants to increase after-tax return• Avoid double taxation• Defer taxes when possible

(time value of money)• Individuals: Capital gain

(20%) v. ord. income (39.5%)• Consider federal, state, and

foreign tax consequences (income, franchise, transfer and employment taxes)

Buyer wants to increase after-tax return on investment• Step-Up in Depreciable /

Amortizable assets• Retain favorable tax benefits

of target (e.g. NOL)• Consider federal, state, and

foreign tax consequences of acquisition structure (income, franchise, transfer and employment taxes)

• Limit exposure to pre-closing tax liabilities

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Tax-free Mergers & Acquisitions

• Acquisitive Asset Reorganization

• Acquisitive Stock Reorganization

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Tax consideration of Tax-free Mergers & Acquisitions

1. Amount of boot generally lesser of the boot or gain realized on transaction. The amount is taxed as capital gain or dividend depending on whether boot results in dividend distribution.

2. Buyer generally takes carry-over tax basis even when gain recognized to shareholders on receipt of boot per Section 362(b) IRC. Special rules apply in a reorganization described in Section 368(a)(1)(B) and Section 368(a)(2)(E) IRC.

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– Shareholder

• Taxable / Tax-free? Tax-free Except for “Boot”

• Character of Gain on Boot? Generally Capital Gain1

– Buyer

• Carry-over Target’s Tax Basis? Yes2

• Carry-over Target’s NOLS? Yes (Subject to Section 382 limitations)

• Inherit Target’s Tax Attribution in Acquisitive Asset Reorganization? Yes; Tax Attribution Listed in Section 381(c)

− Tax Year of Target? Generally, Pre-closing Tax Year in Seller’s Group Return or Separate Year Returned and Post-closing Tax Year in the Buyer’s Group Return

Acquisitive Asset Reorganizations

• “A” Reorganization (Section 368(c)(1)(A) IRC)

• Forward Triangular Merger (Section 368(a)(2)(D) IRC)

• “C” Reorganization (Section 368(a)(1)(C))

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“A” Reorganization

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“A” Reorganization Highlights:• “Statutory merger or consolidation” of the Target with and into the Acquiror with the Acquiror surviving.• All Target assets and liabilities transfer to Acquiror by operation of law.• Under recently issued Treasury Regulations, “continuity of interest” (“COI”) will be met if at least 40% of the value of the merger consideration is comprised of Acquiror stock (voting or non-voting, common or preferred). The remaining consideration can be cash or other property (i.e., “boot”). • An “A” reorganization that fails to meet the requirements for tax-free treatment will be treated as a taxable sale of the Target’s assets, followed by a taxable liquidation of the Target. Acquirorliable for corporate level tax of Target in deemed taxable sale of Target’s assets as a result of the state law merger.

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“Forward Triangular Merger”

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Parent

Parent &Former TargetShareholders

Acquisition Steps End Result

Parent

Target

ParentShareholders

TargetShareholders

AcquirorMerger Acquiror

(w/ all of Target’s assets & liabilities)

“Forward Triangular Merger” Highlights:• Parent must “control” Acquiror, which means that Parent must own 80% or more of Acquiror’s total combined voting power and at least 80% of the total number of shares of each other class of stock (i.e., non-voting stock). Acquiror is usually a newly formed, wholly-owned subsidiary of Parent.• Acquiror must acquire “substantially all” of the Target’s assets (generally 90% of the FMV of the Target’s “net assets” and 70% of the FMV of the Target’s “gross assets”).• To meet the COI requirement, at least 40% of the value of the merger consideration must be comprised of Parent stock (voting or non-voting, common or preferred) and the remaining merger consideration can be cash or other property; provided, that no Acquiror stock may be used as merger consideration.• A forward triangular merger that fails to meet the requirements for tax-free treatment will be treated as a taxable sale of the Target’s assets, followed by a taxable liquidation of the Target. Acquiror may be liable for corporate level tax of Target in deemed taxable sale of Target’s assets as a result of the state law merger.

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“C” Reorganization

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Acquiror Target Acquiror(w/ certain of Target’s

assets & liabilities)CertainAssets &Liabilities

AcquirorShareholders

TargetShareholders Acquiror &

Former TargetShareholders

Acquisition Steps End Result

TargetLiquidates

AcquirorVoting Stock

“C” Reorganization Highlights:• Acquiror must acquire “substantially all” of the Target’s assets “solely” in exchange for Acquiror voting stock.

• “Solely” means that at least 80% of the value of the merger consideration must be comprised of voting stock of Acquiror and the remaining 20% may be cash or other property. However, assumed liabilities are treated as money for purposes of this 80/20 rule.

• “Substantially all” generally means 90% of the FMV of the Target’s “net assets” and 70% of the FMV of the Target’s gross assets.

• Target’s assets and liabilities do NOT transfer by operation of law so Acquiror may select the liabilities it is willing to assume.

• Target must liquidate and distribute the merger consideration and all remaining Target assets to its shareholders.

• A “C” reorganization that fails to meet the requirements for tax-free treatment will be treated as a taxable sale of the Target’s assets, followed by a taxable liquidation of the Target.

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Acquisitive Stock Reorganizations

• “B” reorganization (Section 368(a)(1)(B) IRC)

• Reverse triangular merger (Section 368(a)(2)(E) IRC)

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“B” Reorganization

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Acquiror Target

Acquiror

AcquirorShareholders

TargetShareholders

Acquiror &Former TargetShareholders

Acquisition Steps

Target

“B” Reorganization Highlights:

• Acquiror must acquire “control” of Target “solely” in exchange for voting stock.

• Merger consideration must be voting stock of Acquiror. There can be no boot in a “B” reorganization.

• “Control” means stock possessing at least 80% of the combined voting power of all Target stock and 80% of the total number of shares of each other class of Target stock (i.e., non-voting stock).

• A “B” reorganization that fails to meet the requirements for tax-free treatment will be treated as a taxable stock sale by the Target’s shareholders.

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“Reverse Triangular Merger”

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Parent

Target

ParentShareholders

TargetShareholders

Merger Sub Merger

Parent

Parent &Former TargetShareholders

Target

Acquisition Steps End Result

“Reverse Triangular Merger” Highlights:• Merger Sub merges with and into the Target with the Target surviving.

• Parent must “control” Merger Sub (i.e., generally 80%). Merger Sub usually a newly formed subsidiary of Parent.

• After the merger, Target must hold “substantially all” of its assets and “substantially all” of Merger Sub’s assets (generally means 90% of the FMVof each entity’s “net assets” and 70% of the FMV of each entity’s “gross assets”).

• At least 80% of the value of the merger consideration must be comprised of Parent voting stock and the remaining 20% may be cash or other property.

• A reverse triangular merger that fails to meet the requirements for tax-free treatment will be treated as a taxable sale of the Target’s stock by the Target’s shareholders.

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Acquisitive Section 351 Transaction

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Target Structures

Target FV

$10 M

Other Shareholders

A

100 shares

900 shares

First Step of Transaction

NEWCO

AAcquiror

$9 M

90 shares

100 Target shares

10 shares

Acquisitive Section 351 Transaction Continued

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NEWCO

AAcquiror

$9 M

mergerMerger-Sub$9 M Target

Other Shareholders

Second Step of Transaction

Section 351 Acquisition Transaction Highlights:

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• First Step must satisfy the requirement of Section 351 IRC

– Transfer of property (including stocks) to a corporation (generally, newly formed) (“NEWCO”)

– Transferor Group receive NEWCO stock alone or with “boot”

– Immediately after exchange the Transferor Group “controls” NEWCO (80/80 Test)

– If multiple property transferors, a transferor is included in the control group only if the transferor gets NEWCO stock (vs. boot) of more than small value in relation to the transferor’s NEWCO stock already owned or received for services.

• Often used with management roll-over of shares in Target where Acquiror is Private Equity Fund

• Generally, carryover basis transaction for assets of Target

• Transferor receiving “boot” as well as NEWCO stock is taxed to the extent of lesser of “boot” or realized gain

Transaction Documents – Tax

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• Generally, same component parts of transaction documents for either taxable or tax-free acquisition

• Basic Transaction documents

– Purchase and Sale Agreement

– Merger Agreement

• Tax Components

– Tax representation and warranties of Seller

i. Materiality Qualifiers

ii. Knowledge Qualifiers

iii. Disclosure Schedules

– Tax covenants regarding operations between signing of definitive agreement and closing; generally more important in entity acquisition

Transaction Documents – Tax Continued

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– Tax filing responsibility where entities acquired

i. Pre-closing tax period (period ends prior to or at the close of the closing date)

ii. Post-closing tax period (period begins after closing)

iii. Straddle tax period (period begins prior to closing and ends after closing)

iv. Control over audits / litigation

– Tax indemnity from Seller to Buyer

i. Dollar one tax indemnity for all pre-closing taxes / working capital adjustments

ii. Tax indemnity normally survives as long as statute of limitations

iii. Tax indemnity normally not subject to “deductibles,” “caps,” or “baskets”

iv. Public target likely no tax indemnities

– Taxable asset acquisitions or taxable stock acquisition with Section 338(h)(10) or Section 336(e) election

– Purchase price allocation (IRS Form 8594 taxable asset acquisition or Form 8883 in an 338(h)(10) or 336(e) election); non-compete covenants

– State tax clearance certificate

– Withholding obligations of Buyer

i. FIRPTA

Tax Due Diligence of Target

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• Critical in entity acquisition.

• Normally, starts with tax due diligence request, or in many deals (particularly public targets) tax information provided in data room.

• Accounting firm heavily involved in reviewing target data.

“Tax Take-Aways”1. Since different acquisition/sale structures could result in

substantially different tax consequences, the letter of intent and the acquisition agreement should be reviewed by the in-house tax department or outside tax counsel before execution (e.g., 338(h)(10) or Section 336(e) election, tax-free merger, tax representations and indemnity, etc.)

2. The tax classification of the target will impact the structure of the transaction, and the tax classification of the target cannot be assumed based on the form of organization (e.g., “Check-the-Box regulations)

3. Before a structure can be determined, multiple taxes need to be considered: Federal, State (e.g., income, sales tax, etc.), and possibly foreign taxes. Do not forget FIRPTA employment taxes and ERISA liabilities.

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“Tax take-aways”

4. The form of a transaction matters. For example, a “forward merger” and a “reverse merger” could have substantially different tax consequences, including the buyer being responsible for a significant tax liability of the target corporation

5. Proposed changes to the tax reps, tax covenants, and the tax indemnity in an acquisition agreement should always be reviewed by the in-house tax department or outside tax counsel before being agreed to in negotiations with the other party

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