1. Complex Deals: Class 10 M&A Tax Issues and Acquisition Accounting
Tax Basis of net assets versus BVNA and FVINA
When can acquirers revalue the tax basis of the target’s net assets to fair value and access higher depreciation/amortization tax shields?
How does U.S. tax law treat the fair value of acquired intangible assets, including goodwill?

2. Acquires Class Objectives
(Deferred Tax Liability)
What does a deferred tax liability (DTL) represent?
When and why is a DTL created in an M&A deal?
How do tax implications affect the purchase price allocation in a deal?
How to interpret economic implications of tax structure from financial reports.

3. Tax Structure of a Deal and Acquisition Accounting
Tax considerations significantly impact the structure of and accounting for a deal.
Worldwide, financial accounting rules & tax laws are independent of each other:
Two distinct financial statements: financial reporting and tax reporting
Differences between these statements reflect important economic information
Important to understand how differences are reflected in financial statements and how to assess economic implications

4. Fundamental Definitions
Pre-tax Book Income or Income before Income taxes: income reported on financial reporting Income Statement using U.S. GAAP, IFRS or other.
Taxable Income: Income calculated using applicable tax laws. Can vary significantly from pre-tax book income. Income tax currently owed to the taxing authority is based on this quantity.
Tax Expense: Tax expense calculated for financial reporting purposes. Does not necessarily represents amount currently owed to taxing authority.
Pre-tax Book Income  Taxable Income
Pre-tax Book Income*Tax Rate  Taxable Income* Tax Rate
Tax expense  Taxes owed to government

5. Key Definition Underpinning Tax Balance Sheet: Tax Basis
Tax Basis = carrying value of an asset or liability on the tax balance sheet
Analogous to “book value” on the U.S. GAAP/IFRS balance sheet
Represents amount available to shield future income from taxes (i.e.,tax shield)
Tax deductible depreciation expense
Netted against asset sale proceeds to compute taxable gains or losses
Example:
Purchase asset for $100 with tax basis = $100.
Assume tax depreciation expense of $25 => tax basis now = $75.
If this asset sold for $120, the taxable gain = $120 - $75 = $45.

6. Temporary Book-Tax Differences
Financial Reporting
Book Value of Asset (BVA)
Post-Deal Tax Reporting
Tax Basis of Asset
Book-Tax Difference
Temporary book-tax differences:
Result from different methods for financial (U.S. GAAP/IFRS) and tax reporting purposes.
Timing differences reverse over time (e.g., different depreciation schedules for financial and tax purposes).

7. Target Corporation is a Distinct Taxable Entity
Target Entity (T)
Tax Attributes:
Net Inside Basis (NIBT)
Net Operating Losses (NOLs)
Tax Credits
T’s Shareholders
Individuals or Corporations
Outside Basis in T’s shares (OBS)
Outside basis (OBS) applies to target shareholders and not to target entity, T.
Net Inside Basis (NIBT) represents a corporation’s tax basis in its net assets (basically Shareholders’ Equity on the tax balance sheet).

8. An Example to Illustrate Different Tax Concepts
The financial reporting and tax balance sheets of T are as follows:
Financial Reporting Tax
Cash $ 1,000 $ 1,000
PP&E, net 8,000 7,000
Total Assets $ 9,000 $ 8,000
Long-term debt $ 3,600 $ 3,600
Deferred Tax Liability (DTL) 400 –
Equity 5,000 4,400
Total Liabilities & Equity $ 9,000 $ 8,000
BVNA
The difference between the book and tax bases of T ’s PPE is due to the excess depreciation of $1,000 taken for tax purposes but not for book purposes.
T has a statutory tax rate is 40%.
T’s shareholders acquired their stockholdings at an average aggregate cost of $3,000.
Net Inside Basis
(NIB)
T’s shareholders outside basis (OB) in T’s stock

9. Acquirer’s post deal tax basis in T’s net assets:
Carry-over or stepped-up basis?
Purchase Price (allocated to target’s post-deal balance sheet )
Financial Reporting
Pre-Deal Book Value of Net Assets (pre-BVNAT)
Net Asset
Write-up (down)
Acquisition
Goodwill
Book-Tax Difference
Post-Deal Tax Reporting
Pre-deal Net Inside Basis (NIBT)
“Carry-over” old NIBT
Carry-over basis:
Buyer’s tax basis in the property acquired = seller’s tax basis in the property (NIBT )

10. Acquirer’s post deal tax basis in T’s net assets:
Carry-over or stepped-up basis?
Purchase Price (allocated to target’s post-deal balance sheet )
Financial Reporting
Pre-Deal Book Value of Net Assets (pre-BVNAT)
Net Asset
Write-up (down)
Acquisition
Goodwill
No Book-Tax Difference
Post-Deal Tax Reporting
Pre-deal Net Inside Basis (NIBT)
Step-up tax basis to fair value
“Step-up” tax basis to full purchase price
Carry-over basis:
Buyer’s tax basis in the property acquired equals seller’s tax basis in the property (NIBT )
Stepped-up basis:
Buyer’s tax basis in net assets acquired = the purchase price paid for the property.

11. If Acquirer Gets Stepped-up Net Inside Tax Basis
Purchase Price
Financial Reporting
Fair Value of Net Identifiable Assets (FVNIAT)
Goodwill
Post-Deal Tax Reporting
Net Inside Basis (NIBT)
Step-up (down) of Net Identifiable Assets
Goodwill
All acquired assets/liabilities, including intangibles and Goodwill, are stepped up to tax basis = fair value.
A stepped-up tax basis in Target’s net assets allows Acquirer to take larger depreciation & amortization deductions against future taxable income, which reduces future taxes and increases after-tax cash flow.
Section 197 of the U.S. tax code requires acquirers to amortize the tax basis (fair value) of all acquired intangibles (including goodwill) over 15 years

12. What is the value of stepping-up tax basis?
That is, stepped up basis

13. Two Key Determinants of Tax Structure of a Deal
Did the acquirer structure the deal as an asset or a stock acquisition?
What was the mix of consideration used? Cash or acquirer stock used?
Target Company
Tangible assets
Intangible assets
Liabilities
Acquirer
Direct Asset Acquisition
Stock Acquisition
Target’s
Shareholders

14. Acquisition Tax Structures
Primary
Consideration
mostly
Stock
Acquire
Assets
Cash or Debt
Tax Structure of the Deal
Taxable Asset
Acquisition
Taxable Stock
Acquisition
Tax-free Asset
Acquisition
Tax-free Stock
Acquisition
Yes
Section 338 Election No
Acquirer’s NIB in Net Assets Acquired
Stepped-up Basis
Carry-over Basis

15. Taxable Asset Acquisition
Target corporation owes immediate tax on sale:
(Consideration Received – Net Inside Basis) × Tax RateTarget
Acquirer gets to step-up tax basis of assets to purchase price.
Acquirer’s new tax basis in acquired assets (including intangibles and goodwill) = value of consideration paid.
Target shareholders: no effect unless Target distributes after-tax proceeds to shareholders
Cash
Target Company
Tangible assets
Intangible assets
Liabilities
Acquirer
Purchased Assets
Target’s
Shareholders

16. Taxable Asset Acquisition cont’d
Acquirer allocates purchase price to assets purchased. This is analogous to the purchase price allocation performed for financial reporting purposes.
In other words there is a purchase price allocation done for tax purposes!
Allocation of purchase price to intangible assets in U.S. involves Section 197 intangibles assets that are amortized over 15 years for tax purposes.
Target’s tax attributes (e.g., Target’s NOLs*) may be used to offset target’s tax liability from the asset sale.
NOLs = Net operating loss carry-forwards. In the U.S., net operating losses can be carried back and applied against
prior 2 year’s tax returns and forward 20 years (or until exhausted if sooner).

17. Taxable Stock Acquisition (no 338 election)
Target Company
Tangible assets
Intangible assets
Liabilities
Acquirer
Cash
Shares of T’s Stock
Target’s
Shareholders
Purchase Price
Financial Reporting
Fair Value of Net Identifiable Assets (FVNIAT)
Goodwill
Net Inside Basis (NIBT)
Acquirer Gets Carry-Over Tax Basis = T’s Old Net Inside Basis
Post-Deal Tax Reporting

18. Taxable Stock Acquisition
Acquirer receives a carry-over tax basis in Target’s net assets, so Target corporation does not pay any taxes on this type of transaction.
Target shareholders pay immediate tax on gain from sale of shares:
(Consideration Received – Outside Tax Basis) × Tax RateShareholder
Acquirer’s outside basis in T’s stock = purchase price
In addition to carryover basis in the target corporation’s assets, other tax attributes such as NOLs and credits carry over subject to limitations.

19. Taxable Stock Acquisition with 338 Election:
Treated as if it is an asset acquisition
Primary
Consideration
mostly
Stock
Acquire
Assets
Cash or Debt
Tax Structure of the Deal
Taxable Asset
Acquisition
Taxable Stock
Acquisition
Tax-free Asset
Acquisition
Tax-free Stock
Acquisition
Yes
Section 338 Election No
Acquirer’s NIB in Net Assets Acquired
Stepped-up Basis
Carry-over Basis

20. Taxable Stock Acquisition: Section 338 Election
Section 338 election permits the acquirer to treat a taxable stock transaction as if it were a taxable asset acquisition, even though this is a stock sale from the target’s perspective.
Two types of Section 338 elections:
338(g) election: acquisition of “free-standing” Corporation
338(h)(10) election: acquisition of corporate subsidiary

21. Taxable Stock Acquisition: 338(g) Election
Acquirer gets a stepped-up tax basis in net assets acquired.
Section 338(g) election is made unilaterally by the acquirer after purchasing the stock from the target shareholders.
Benefits
A stepped-up tax basis allows buyer to take larger depreciation and amortization deductions, which reduces future taxes and increases after-tax cash flow.
Costs
338 election triggers a taxable gain on the deemed asset sale.
The acquirer (by virtue of owning the target), pays an immediate tax on the amount of tax basis step-up of net assets = (Purchase Price – NIBT) × Tax Rate
Acquirer can use Target’s existing NOLs to offset immediate tax on stepped-up basis.*
Target’s remaining Net Operating Losses (NOLs) are canceled.
* In the U.S., net operating losses can be carried back and applied against the prior 2 year’s tax returns (5 years under certain circumstances) and forward 20 years (or until exhausted if sooner).

22. Should a Section 338(g) Election Be Made?
Generally, a Section 338(g) election is not made for a freestanding C corporation.
Why? Because the immediate tax cost of the gain paid by the acquirer will exceed the present value of tax savings from the stepped-up basis due to the time value of money.
That is, the acquirer pays $1 today to receive $1 far in the future!
Section 338(g) election is advantageous when Target has substantial expiring NOLs or other tax credits that can be used by the acquirer to offset the taxable gain from the step-up.
Time
Acquirer Pays Immediate Tax =
(Purchase Price – NIBT) × Tax Rate
Acquirer Gains Future Tax Savings via depreciation & other tax shield =
(Purchase Price – NIBT) × Tax Rate

23. Taxable Stock Acquisition: 338(h)(10) Election
Like a 338(g) election, a 338(h)(10) election gives the acquirer a stepped-up tax basis in the net assets acquired.
To qualify for Section 338(h)(10) election, the target entity must be a corporate subsidiary in a selling group filing a consolidated U.S. tax return (for those in know, I am ignoring sub-chapter S corps).
Unlike a 338(g) election, the selling shareholder (not the acquirer) bears the incremental tax cost from the sale.
Acquirer and selling group must jointly agree to make a Section 338(h)(10) election.

24. 338(h)(10) Election: Sellers taxable gain measured using net inside basis of Target, rather than its outside basis in Target’s stock

25. (Consideration Received – Net Inside Basis) × Tax RateSeller
338(h)(10) Election: Sellers taxable gain measured using net inside basis of Target, rather than its outside basis in Target’s stock
Without 338(h)(10) election, seller pays tax equal to
(Consideration – Outside basis in stock) × Tax RateSeller
338(h)(10) election allows seller to use net inside basis to compute tax on sale of stock
(Consideration Received – Net Inside Basis) × Tax RateSeller
Note: Outside Basis generally does not = Inside basis
Seller will agree to election if acquirer compensates them for any excess tax cost associated with stepping-up tax basis of assets relative to the tax costs of paying tax on outside tax basis of shares .
Acquirer compensates seller for incremental tax cost if present value of tax savings from stepped-up tax basis to the acquirer exceeds incremental tax cost to the seller.

26. Incremental Tax Costs and Benefits of a Section 338(h)(10) Election
T is a subsidiary of a selling group, SG. SG is contemplating the sale of T via either a taxable stock sale or via a Section 338(h)(10) election (as if taxable asset sale)
Notation:
NIBT = Net Inside Basis of T ’s net assets.
OBSG = SG’s Outside Basis in T ’s stock.
Pno = Purchase price SG would accept for a taxable stock sale of T.
P = Purchase price SG would accept in order to agree to make a joint
338(h)(10) election.
tax = Statutory tax rate.

27. Section 338(h)(10) Election: Incremental Tax Costs
For SG to be indifferent between a stock sale and an asset sale (via a Section 338(h)(10) election), the after-tax proceeds from both must be the same:
Re-arrange this equation to get:
Incremental tax cost to SG from electing 338(h)(10) is:
If OBSG ≤ NIBT, then the Section 338(h)(10) election should always be made.
However, if OBSG > NIBT, then election should only be made if present value of the acquirer’s tax benefits from the stepped-up tax basis exceeds incremental tax cost.
After tax proceeds to SG with 338
After tax proceeds to SG with no 338
Diff between outside
and inside basis

28. OBSG ≤ NIBT OBSG > NIBT
When Does a Section 338(h)(10) Election Make Sense for a Target Subsidiary?
Outside Basis (OBSG) vs.
Net Inside Basis (NIBT)
Optimal Deal Structure
OBSG ≤ NIBT
338(h)(10) election made
OBSG > NIBT
338(h)(10) election made if:

29. Acquisition Tax Structures
Primary
Consideration
mostly
Stock
Acquire
Assets
Cash or Debt
Tax Structure of the Deal
Taxable Asset
Acquisition
Taxable Stock
Acquisition
Tax-free Asset
Acquisition
Tax-free Stock
Acquisition
Yes
Section 338 Election No
Acquirer’s NIB in Net Assets Acquired
Stepped-up Basis
Carry-over Basis

30. Overview of Tax-free Acquisitions (Share for share deals)
Acquiring Entity:
Carry-over basis of assets of target.
Tax attributes, such as NOLs and tax credits, are available for use after the transaction subject to limitations.
Target Entity:
Not taxed on the asset transfer to the acquirer.
Target Shareholders:
Generally, tax-deferral on the gain realized to those who receive all qualifying consideration (e.g., Acquirer’s stock), but taxed on non-qualifying consideration (e.g., cash).

31. Example of How Tax Deferral Work in a Tax-free Deal
Assume T shareholders have old tax basis in T stock =$100.
They receive $150 worth of acquirer’s shares in exchange for their T shares.
To achieve tax deferral:
Tax basis of acquirer’s shares received in the deal set equal to old tax basis in T shares given up = $100.
Former shareholder’s of T now have a tax basis of $100 in their new shares of acquirer, although the shares have a current market value = $150!
Thus seller can defer $50 gain until the stock is sold and gain realized in cash.

32. Merck acquisition of Schering Plough
Each share of Schering Plough receives some cash ($10.50) and shares in New Merck.
Schering Plough (SP) shareholders must
Pay taxes on gains to the extent they received cash
The shares of stock they received in New Merck are treated as a tax free transaction and assume the their old tax basis in Schering Plough shares.
It is determined that
.4233 of each SP share received cash
.5767 of each SP share received New Merck stock

33. .4233 in
cash
Taxable gain =
.5767 in
New Merck
Shares
Total tax basis of New Merck shares = of old tax basis in SP shares