An Introduction to the Taxation of Mergers and Acquisitions

Corporations sometimes purchase stock in other corporations to hold for investment or purchase assets from other corporations for various business reasons. This is commonly referred to as a “corporate acquisition.” This article provides a basic overview of how corporate mergers and acquisitions are taxed. This article does not discuss the various tax-free mergers and acquisitions that fit within one of the precise meanings of the term “reorganization” as defined in Section 368 of the Internal Revenue Code. We have discussed the concepts of tax-free reorganizers and mergers in an article entitled “An Introduction to Basic Tax-Free Corporate Reorganization Principles.” Below is a link to the article.

https://sftaxcounsel.com/blog/basic-tax-free-corporate-reorganization/

Taxable vs. Tax-Free Reorganizations

As discussed above, corporate merger and acquisition may be classified as either a taxable acquisition or a tax-free reorganization. The parties to a corporate acquisition must first decide whether the transaction is to proceed as a taxable acquisition or a tax-free reorganization. The brief material presented in this article on tax-free reorganizations is designed to simply illustrate the key distinctions between taxable and tax-free acquisitions. A taxable acquisition is used simply to indicate that the selling corporation is taxable upon the sale of its assets or that the selling shareholders are taxable upon the sale of their stock. Any particular transaction will be classified as a tax-free reorganization only if it fits within one of the precise meanings of the term “reorganization” as stated in Section 368(a) of the Internal Revenue Code. Under the Internal Revenue Code, a corporate acquisition that does not fall within a nonrecognition provision discussed in Section 368(a) is a taxable acquisition.

The most important difference between a taxable and a tax-free reorganization is that the seller typically recognizes gain or loss in a taxable reorganization, but is eligible for nonrecognition treatment for federal tax purposes in a tax-free reorganization. A second distinction between a taxable acquisition and a tax-free reorganization involves the basis rules. In a taxable asset acquisition transaction, the purchasing corporation is entitled to a Section 1012 cost basis in the assets purchased from the target corporation. On the other hand, in a tax-free asset acquisition, the purchasing corporation is not entitled to a “cost basis,” but instead takes the target corporation’s assets with the same basis as the target corporation.

Stock v. Asset Sale

Once it is decided whether the corporate acquisition will be treated as a tax or tax-free reorganization, it must be decided if the parties to a corporate acquisition will acquire the target corporation’s stock or assets. Both tax and nontax factors will influence how to treat the target corporation’s acquisition. Both the buying and selling corporation will have several tax factors to consider in deciding between a taxable stock or asset sale. A taxable sale of assets results in an immediate taxable gain to the selling corporation. The purchasing corporation’s desire to acquire assets of a target corporation will largely depend upon the extent to which the assets of the target are depreciated. The selling or target corporation’s willingness to sell assets will depend on the extent of the gain or loss reflected in the assets and the possibility of using any offsetting losses to reduce taxable gains. The target or selling corporation may also consider the tax consequences to its shareholders. After an asset sale, the target corporation will distribute cash to its shareholders in a liquidation that will be taxable to its shareholders. Consequently, an asset acquisition will often trigger two layers of tax- a layer of tax at the corporate level and a second layer of tax at the shareholder level.

In contrast to an asset sale, a stock sale by the shareholders generally results in immediate recognition of tax at the shareholder level. Thus, the shareholders of the target corporation only recognize gain or loss upon the sale of their stock while the target corporation’s assets remain with the target corporation and retain their historic basis.

Taxable Asset Acquisition

In a typical taxable, the selling or target corporation transfers all or substantially all of its assets to the purchasing corporation or a subsidiary of the purchasing corporation. As part of the taxable acquisition, the purchasing corporation often will assume some or all of the selling corporation’s liabilities. Generally, the target corporation will liquidate shortly after the exchange, distributing cash, notes, and other considerations received to the target corporation’s shareholders in exchange for their shares. Another form of taxable asset acquisition is a state-law merger of the target corporation into the purchasing corporation or the purchasing corporation’s subsidiary for cash, notes, or other consideration that does not qualify for tax-free reorganization treatment. In this type of transaction, the consideration is transferred by the purchasing corporation to the target corporation and there is no need for the target corporation to liquidate. For tax purposes, the Internal Revenue Code treats this transaction as a taxable asset transfer by the target corporation followed by the target corporation’s complete liquidation.

Tax Consequence to the Target Corporation

In a taxable asset acquisition, the selling target corporation will recognize a taxable gain or loss immediately upon the sale of assets under Sections 61(a)(3) and 1001 of the Internal Revenue Code. Typically, it will be necessary to allocate the purchase price to each asset sold. Since some of the target corporate assets will result in capital gain or loss to its shareholders and other corporate assets will result in ordinary income to the target shareholders, the particular method used for allocating the purchase price of the sale of a target corporation is often important to both the buyer and seller. The Internal Revenue Code requires the “residual allocation method” to be used for purposes of measuring the seller’s gain or loss on the assets sold.

Consistent with these rules, the target corporation must include in its amount realized from the sale any liabilities assumed by the purchaser, and the amount of liability to which any property transferred was subject. In addition, if the purchasing corporation assumes liabilities for accrued, but as yet unpaid operating expenses of a cash basis corporation, the liabilities assumed should be included in the target corporation’s amount realized on the sale.

Tax Consequences to the Target Shareholders

When the target corporation distributes cash or assets to its shareholders in a liquidation following its sale, the shareholders generally will report gain or loss upon the liquidation under Section 331 of the Internal Revenue Code. If, instead of a cash sale, the target corporation sold substantially all of its assets in exchange for notes from the purchasing corporation, the transaction may qualify for the installment method. Under the installment method, the target corporation’s shareholders will report taxable gains only upon receipt of installment payments pursuant to Section 453 of the Internal Revenue Code.

Tax Consequence to Purchasing Corporation

The purchasing corporation in a taxable asset acquisition is entitled to a Section 1012 cost basis in assets purchased from the target corporation. Since the target corporation is typically fully reporting gain or loss on the asset transfer, the purchaser’s cost basis in the assets acquired from the target corporation is the same cost basis of the purchased assets. However, the overall price paid by the purchasing corporation must be allocated among all the assets purchased in order to determine the cost basis of each particular asset.

Allocation of the Purchase Price

Section 1060 of the Internal Revenue Code provides special allocation rules for certain asset acquisitions. Section 1060 mandates that the buyer and the seller use a specific method to allocate the total purchase price among the assets of a corporation. Section 1060 aims to ensure consistency in how buyers and sellers report the tax consequences of a sale, preventing tax avoidance through biased asset valuation. It applies to “applicable asset acquisitions,” which involve the transfer of a group of assets that constitute a trade or business where the buyer’s basis is determined solely by the consideration paid. For this purpose, “consideration” means the buyer’s total cost and the seller’s amount realized, both of which generally include fixed liabilities that the buyer assumes or to which the acquired property is subject. This aggregate consideration is then allocated under the residual method. Specifically, the parties first reduce the consideration by cash and cash equivalents (known as Class I assets) transferred by the seller. Class I assets also include demand deposits, and similar accounts. See Treas. Reg. Section 1.1060-1T(d)(1). The total amount to be allocated is first reduced by the amount of such Class I assets transferred, effectively allocating the purchase price to these assets on a dollar-for-dollar basis. Once the Class I assets are subtracted, the remainder is allocated first to Class II assets (certificates of deposits, federal government securities, and readily marketable stock or securities), then to Class III assets (all tangible and intangible assets not covered by Classes I, II, and IV, including covenants not to compete), and finally to Class IV assets (intangible in the nature of goodwill and going concern value) in proportion to the fair market value of the assets on the purchase date. An allocation to any particular asset cannot exceed the assets’s fair market value. Treas. Reg. Section 1.1060-1T(e)(1); Treas. Reg. Section 1.1060-1T(d)(2).

Section 1060 also includes a reporting requirement. The buyer and seller in an “applicable asset acquisition” must report information about the transaction to the Internal Revenue Service (“IRS”) using Form 8594, Asset Acquisition Statement Under Section 1060. The Section 1060 regulations also require that the parties report any collateral agreements to an acquisition, such as covenants not to compete, employment agreements, licenses, leases, and the like on Form 8594.

Taxable Stock Acquisition

In a typical stock sale, the selling shareholders transfers some or all of their target corporation stock to the purchasing corporation or the purchasing corporation’s subsidiary in exchange for cash or notes. In many cases, the purchasing corporation becomes the parent corporation to its newly acquired subsidiary. In these cases, the target corporation remains intact as a corporate entity. Acquisitions of public companies are almost always in the form of stock acquisitions. Depending on whether the acquisition is friendly or hostile, the next step may be a cash tender offer to the target corporation’s shareholders or a friendly merger is negotiated with the target corporation’s management. A friendly takeover is an agreed-upon acquisition where the target corporation’s board and management cooperate, while a hostile takeover happens when the acquirer bypasses resistant management by appealing directly to the shareholders of the target corporation (using tender offers or proxy fights) to gain control of the target corporation. If the purchasing corporation succeeds in acquiring control of the target corporation, the minority shareholders of the target corporation typically “squeezed out” of the target corporation. A corporate squeeze-out is a maneuver where a majority shareholder uses a merger or other corporate action to force minority shareholders to sell their shares. This often involves the forming of a sub-company that merges with the original company eliminating the minority stakes and voting rights. For a good basic description of the mechanics, dynamics, and economics of modern laws governing “squeeze outs” in corporate takeovers, see e.g., Del.Corp.Law Section 251.

Tax Consequences to the Selling Corporation and its Shareholders

The selling target corporation’s shareholders will recognize gain or loss from the sale of their target corporate shares under Sections 61(a)(3) and 1001 of the Internal Revenue Code. If the shareholders of the target corporation received notes from the purchasing corporation in the acquisition transaction, the shareholders of the target corporation are entitled to report taxable gains under the installment method of Section 453 of the Internal Revenue Code. the target corporation on the other hand recognizes no immediate tax consequences. Each of the target corporation’s assets retains the same basis it had prior to the stock acquisition. If the target corporation liquidates, the corporation will recognize no gain or loss pursuant to Section 337 of the Internal Revenue Code.

Consequences to the Purchasing Corporation

In a taxable stock acquisition, the purchasing corporation is entitled to a Section 1012 cost basis in the target shares acquired. Since the shareholders reported gain or loss on the sale of stock and the purchasing corporation paid full consideration for the shares, the acquiring corporation receives the same basis in the shares of the target corporation’s stock. Absent an election under Section 338 (discussed in more detail below), the target corporation retains the assets of the target corporation with no change in the asset’s basis.

Stock Acquisition treated as Asset Acquisition under Section 338

Congress enacted Section 338 of the Internal Revenue Code that permits an acquiring corporation to elect to treat certain stock purchases as asset purchases. Under Section 338, a corporation that acquires control (i.e., at least 80 percent) of a target corporation may make a Section 338 election and treat the transaction as an asset acquisition under which the acquiring corporation takes a cost basis in the target corporation’s assets and its purged of all of its prior tax attributes. The principal question conforming a purchasing corporation of the stock of a target corporation is whether to take a cost basis or transferred basis of the corporation’s assets. If a stock purchased is treated as an asset acquisition, the target corporation must recognize gain or loss, and the buyer or seller will be subject to corporate tax on any gain. Thus, a Section 338 election in most cases is undesirable from a tax perspective. However, Section 338 remains a viable option in some limited situations.

When a purchasing corporation liquidates a target corporation, the sale may be treated as a “qualified stock purchase” (“QSP”). A QSP is defined as a transaction (or series of transactions) in which the purchasing corporation acquires stock in another corporation that meets a two-part 80% control test under Section 1504(a)(2) of the Internal Revenue Code during a 12-month acquisition period. The “acquisition period” is a 12 month period beginning with the date of the first acquisition by the purchase of stock intended as a QSP. See IRC Section 338(h)(1). A QSP election only applies to stock purchases of control sufficient to meet an 80% control. The purchasing corporation must make a timely Section 338 election and, once made, the election is irrevocable. To be timely, the election must be made “not later than the 15th day of the 9th month beginning after the month in which the acquisition occurs.” See IRC Section 338(g)(1). The “acquisition date” is the “first day on which there is a” QSP, in general, the day on which the purchasing corporation’s stock acquisition during the 12-month period first met the 80% tests. See IRC Section 338(h)(2).

A Section 338 election only applies to QSP purchases. The definition of “purchase” provided in Section 338(h)(3) excludes certain stock acquisitions. For example, target stock in which the purchasing corporation takes a transferred or substituted basis from the transferor or a Section 1014 basis from a decedent is not acquired by purchase. In addition, any stock acquired by purchaser in a tax-free reorganization is not acquired by purpose. Furthermore, any stock acquired from a person the ownership of whose stock would be attributed to purchasers under the Section 318 attribution rules is not acquired by purchase. The idea of a Section 338 election is that it applies only to taxable acquisitions. In an ordinary taxable stock acquisition, the selling shareholders report gain or loss on the sale of stock and the purchasing shareholders take the stock with a cost basis. The Internal Revenue Code permits an elective cost basis in the target’s assets upon a transfer of control that is taxable to the selling shareholders.

In addition to the shareholder level tax reported on the stock sale, a Section 338 election assures corporate level recognition to the target corporation on the appreciation or depreciation in the value of its assets, using a “deemed sale” of the target’s assets as a trigger for recognizing gain or loss. Thus, the tax consequences of the stock acquisition under Section 338 parallels the tax consequences of a direct asset acquisition. In each case, the target corporation recognizes a gain or loss on either the actual or the “deemed sale” of its assets and the target shareholders recognize gain or loss on either the sale of target stock to the purchasing corporation or the receipt of distribution in liquidation of the target corporation. Finally, the purchasing corporation receives the target corporation’s cost basis in its assets.

If the purchasing corporation makes a Section 338 election following a QSP, the target corporation will be deemed to have engaged in two significant transactions. First, under Section 338(a)(1), the target corporation is treated as if it “sold all of its assets at the close of the acquisition date at fair market value in a single transaction.” The sale triggers recognition of gain or loss to the target corporation. Second, under Section 338(a)(2) of the Internal Revenue Code, the target is treated “as a new corporation which purchased all of the assets referred to in paragraph (1)” of the Code on the following day. This deemed repurchase of the target corporation’s assets is the transaction that effectively provides the purchaser with a cost basis in the target’s assets. The statutory language of Section 338(a)(1) provides that “the target shall be treated as having sold all of its assets at the close of the acquisition date at the fair market value in a single transaction. The regulations promulgated under Section 338 elaborate substantially. Rather than adopting a traditional “arm-length buyer and seller” fair market value, the regulations use an aggregate deemed sales price (“ADSP”) as the price at which the target is deemed to have sold all of its assets for purposes of Section 338(a)(1). See Treas. Reg. Section 1.338-3(b)(1).

In a hypothetical asset sale following a Section 338 election, the target corporation is treated as selling its assets for an ADSP. In general, the ADSP for the assets of the target corporation is defined as the sum of the grossed-up basis of the purchasing corporation’s recently purchased stock of the target corporation plus the target corporation’s liabilities, including any tax liabilities associated with the deemed sale. An adjustment is also made for other relevant items, such as a reduction for brokerage commissions paid to acquire the target corporation’s stock. See Treas. Reg. Section 1.338-3(d)(1). Consequently, if the purchasing corporation acquired all of the target corporation’s stock within a 12-month acquisition period, the ADSP is the total purchase price plus any new target corporation’s liabilities. If the purchasing corporation acquired less than 100 percent of the target corporation’s outstanding stock during the 12 month acquisition period, then the concept of “grossed-up basis” must be considered under the ADSP rules. The grossed-up basis is a hypothetical price that the purchasing corporation would have paid for the target corporation’s shares had these shares been purchased at the same average price that it paid for the stock actually purchased during the acquisition period.

The Acquisition of Stock of a Subsidiary and the Section 338(h)(10) Election

A Section 338 election discussed above assumed that the target corporation was not a subsidiary of the purchasing corporation. A Section 338(h)(1) election is available in situations where the target corporation is a wholly owned subsidiary of the seller and the purchasing corporation wishes to acquire the target corporation. For example, let’s assume that purchaser P makes a cash purchase of all of T’s stock from XS. XS will be taxed upon the sale of the T stock. T’s shareholders will report gain or loss for federal tax purposes when cash is received from P. If P makes a Section 338 election, T will report gain or loss from the sale of its assets under Section 338. In this case, the target would be subject to multiple federal tax events. The old target corporation T, XS, and XS shareholders would all be taxed in this example. If T had distributed its assets to XS in a complete liquidation, XS and T would have been entitled to nonrecognition of federal taxes under Sections 332 and 337 of the Internal Revenue Code.

Section 338(h)(10) permits a special election, under which XS will recognize no gain or loss on the sale of its T stock. Under the Section 338(h)(10) regulations, the target corporation is treated as if it sold all of its assets in a single transaction at the close of the acquisition date and subsequently distributed its assets in a complete liquidation. See Treas. Reg. Section 1.338(h)(10)-1(e)(1), (2). This special 338(h)(10) election is available only if the purchasing corporation makes a QSP election election from a member of a selling consolidated group.

The Section 336(e) Election

Section 336(e) is similar in effect to a Section 338(h)(10) election. A Section 336(e) election permits a parent corporation to elect to treat a sale, exchange, or distribution of a subsidiary’s stock as a disposition of the subsidiary’s assets and to ignore any gain or loss on the actual disposition of the stock. Similar to a Section 338(h)(1) election, a Section 336(e) election equates to the sale of a subsidiary’s stock with an actual sale of the subsidiary’s assets followed by a distribution of the sales proceeds in a tax-free Section 332 liquidation.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding of the taxation of corporate acquisitions. It should be evident from this article that this is an extremely complex subject. It is important to note that this area is constantly subject to new development and changes, as Congress continually entertains new tax laws, the Treasury promulgates new regulations, and federal courts issue new opinions that impact the subject matter discussed in this article. As a result, it is crucial that a competent tax attorney be consulted prior to a corporate acquisition transaction.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is the author of a number of published articles addressing cross-border taxation. Anthony also frequently provides continuing educational programs regarding various international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.