Acquisitions of Subsidiaries of Freestanding Companies

• Tax-free Subsidiary Sales

• Taxable Subsidiary Sales– Taxable asset sale

– Taxable stock sale

– Taxable stock sale with an IRC §338(h)(10) election

Tax-free Subsidiary Sales• The divesting parent exchanges the stock or assets of the

subsidiary for the stock of the acquiring firm.

• No gain is recognized.

• The sold subsidiary’s NOLs remain with the subsidiary but are limited by §382.

• The acquirer takes a carryover basis in the subsidiary’s assets and stock.

• The divesting parent takes a substituted basis in the acquiring stock received equal to its basis in the sold subsidiary’s stock.

Undesirable Aspects of Tax-free Subsidiary Sales

• The seller has not truly divested its holding in the sold subsidiary.

• The seller will hold a relatively illiquid block of the acquirer.

• The acquirer and the seller may both hold financial positions with a built-in gain after consummation of the transaction.*

* If the FMV of the subsidiary is greater than the seller’s tax basis in the subsidiary’s stock.

Given Information for Examples and Cases

Purchase Price $10,000.00Target's Tax Net Asset Basis* $2,000.00Divesting Parent's Tax Basis in Target's Stock $2,000.00Corporate Tax Rate 35.00%Discount Rate 10.00%Amortization Period 10.00

-The subsidiary is 100% owned by the parent. -Neither the subsidiary nor the divesting parent have NOLs. -The sold subsidary is liquidated by the parent after the sale.

*Historical cost of $2,000 with $0 of accumulated depreciation.

Example: Tax-Free Subsidiary Stock Sale Under IRC §368(a)(1)(B)

Divesting Parent Shareholders:No direct tax effect.

Acquirer Shareholders:No direct tax effect.

Divesting Parent:Receives $10,000 of acquirer

stock in return for the divestedsubsidiary’s stock. Realizes a

gain of $8,000. No gain isrecognized. Takes a substituted

basis in the acquirer stockreceived ($2,000).

Acquirer:Purchases the stock of the target(subsidiary) for $10,000 of itsstock. Takes a carryover basis

in the stock of the acquiredsubsidiary ($2,000). Acquired

subsidiary becomes a subsidiaryof the acquirer and its asset

basis carries over.

All of thesubsidiary’s stock

$10,000 ofacquirer stock

Sold Subsidiary:The owners of the subsidiary corporation change.The tax attributes of the subsidiary are limited but

stay with the subsidiary. The tax basis of thesubsidiary’s assets carryover ($2,000).

Example: Post-Acquisition Ownership Structure

Acquirer:Owns 100% of the sold subsidiary’s stock.Has a basis in the target’s stock of $2,000and a basis in the target’s assets of $2,000.

Sold Subsidiary:Now a wholly owned

subsidiary of the acquirer.Net asset basis is $2,000.

Taxable Subsidiary Sales

• Taxable Asset Sale--the acquirer purchases the assets of the subsidiary (target) corporation (usually for cash) from the divesting parent.

• Taxable Stock Sale--the acquirer purchases the stock of the target corporation from the parent for cash.

• Taxable Stock Sale w/ an IRC §338(h)(10) election--completed as a stock sale but taxed like an asset sale.

Taxable Asset Sales• A gain or loss is recognized and computed as price

less basis in subsidiary’s net assets.

• The portion of the gain that arises from recaptured depreciation is ordinary income; the difference between the purchase price and the historical cost of the assets is a capital gain.

• The sold subsidiary’s NOLs remain w/ the divesting parent, can offset a gain on sale, and are not limited by §382.

Continued. . . .

Taxable Asset Sales. . .Continued

• Generally, the divesting parent corporation liquidates the sold subsidiary; no gain or loss is recognized on the liquidation under IRC §332.

• The acquirer steps-up to a basis in the subsidiary’s assets equal to the purchase price paid.

• There are tax benefits from additional depreciation and amortization deductions.

Taxable Subsidiary Asset Sale

Divesting Parent Shareholders:No direct tax effect.

Divesting Parent:Receives $7,200 from the sold subsidiary inliquidation. There is no tax associated with

the liquidation under IRC § 332.

$7,200 All of the subsidiary’s stock

Sold Subsidiary:Subsidiary receives $10,000 for all of itsassets. Recognizes a gain of $8,000 and

incurs a tax liability of $2,800. After-tax, ithas $7,200 that is distributed to the parent

corporation in liquidation.

Acquirer:Purchases the assets ofthe target (subsidiary)

for $10,000 cash. Takesa basis in the target’s

assets equal to the pricepaid ($10,000).

All of thetarget’s assets

$10,000 cash

Acquirer Shareholders:No direct tax effect.

Tax Implications of a Taxable Asset Sale

GivenPurchase Price $10,000.00Target's Tax Net Asset Basis* $2,000.00Divesting Parent's Tax Basis in Target's Stock $2,000.00Corporate Tax Rate 35.00%Discount Rate 10.00%Amortization Period 10.00

-The subsidiary is 100% owned by the parent. -Neither the subsidiary nor the divesting parent have NOLs. -The sold subsidary is liquidated by the parent after the sale.

*Historical cost of $2,000 with $0 of accumulated depreciation.

Purchase Price

Tax Effect for Divesting Parent: Gain on Sale

Cash Received Tax on Gain After-tax Cash

Acquirer Cost: Purchase Price Less: Incremental Tax Savings Net After-tax Cost

Acquirer's Tax Basis in Target's: Stock Net Assets Step-up in the Tax Basis of T's Assets

Taxable Asset Sale

$10,000.00

$8,000.00

$10,000.002,800.00

$7,200.00

$10,000.001,720.48

$8,279.52

n/a$10,000.00

8,000.00

Taxable Subsidiary Stock Sale w/o a §338(h)(10) Election

• A capital gain is recognized and computed as price less basis in subsidiary’s stock.

• The sold subsidiary’s NOLs remain with the subsidiary but are limited by §382.

• The acquirer takes a carryover basis in the subsidiary’s assets.

• The acquirer takes a basis in the target’s (subsidiary’s) stock equal to the purchase price.

Taxable Subsidiary Stock Sale w/o a §338(h)(10) election

Divesting Parent Shareholders:No direct tax effect.

Acquirer Shareholders:No direct tax effect.

Divesting Parent:Receives $10,000 cash in return

for the divested subsidiary’sstock. Recognizes a capital gainon the stock sale of $8,000 andincurs a tax liability of $2800.After-tax, divesting parent has

$7,200.

Acquirer:Purchases the stock of the target(subsidiary) for $10,000 cash.Takes a carryover basis in the

target’s assets ($2,000).Acquired subsidiary becomes a

subsidiary of the acquirer.

All of thesubsidiary’s stock

$10,000 cash

Sold Subsidiary:The owners of the subsidiary corporation change.The tax attributes of the subsidiary are limited but

stay with the subsidiary. The tax basis of thesubsidiary’s assets carryover ($2,000).

Post-Acquisition Ownership Structure

Acquirer:Owns 100% of the sold subsidiary’s stock.Has a basis in the target’s stock of $10,000and a basis in the target’s assets of $2,000.

Sold Subsidiary:Now a wholly owned

subsidiary of the acquirer.Net asset basis is $2,000.

Tax Implications of a Taxable Stock Sale w/o a §338(h)(10) Election

Taxable Stock Sale w/o aSec. 338(h)(10) Election

$10,000.00

$8,000.00

$10,000.002,800.00

$7,200.00

$10,000.000.00

$10,000.00

$10,000.002,000.00

0.00

Taxable Asset SalePurchase Price $10,000.00

Tax Effect for Divesting Parent: Gain on Sale $8,000.00

Cash Received $10,000.00 Tax on Gain 2,800.00 After-tax Cash $7,200.00

Acquirer Cost: Purchase Price $10,000.00 Less: Incremental Tax Savings 1,720.48 Net After-tax Cost $8,279.52

Acquirer's Tax Basis in Target's: Stock n/a Net Assets $10,000.00 Step-up in the Tax Basis of T's Assets 8,000.00

Selected Given InformationPurchase Price $10,000.00Target's Tax Net Asset Basis $2,000.00Divesting Parent's Tax Basis in Target's Stock $2,000.00Corporate Tax Rate 35.00%Discount Rate 10.00%Amortization Period 10.00

Taxable Stock Sale w/ a §338(h)(10) Election

• §338(h)(10) allows for the potentially favorable tax treatment of an asset sale without incurring the non-tax costs of an asset sale.

• A subsidiary stock sale can be taxed as an asset sale under §338(h)(10) only if both the acquirer and the divesting parent jointly make the election.

Taxable Stock Sale w/ a §338(h)(10) Election

• A gain is recognized and computed as price less basis in the subsidiary’s net assets.

• The portion of the gain that arises from recaptured depreciation is ordinary income; the difference between the purchase price and the historical cost of the assets is a capital gain.

• The sold subsidiary’s NOLs remain w/ the divesting parent, can offset a gain on sale, and are not limited by §382.

Continued. . . .

Taxable Stock Sale w/ a §338(h)(10) Election. . . Continued

• The acquirer steps-up to a basis in the subsidiary’s assets equal to the purchase price paid.

• The acquirer takes a basis in the target’s (subsidiary’s) stock equal to the purchase price.

• There are tax benefits from additional depreciation and amortization deductions.

Taxable Subsidiary Stock Sale w/ a §338(h)(10) election

Divesting Parent Shareholders:No direct tax effect.

Acquirer Shareholders:No direct tax effect.

Divesting Parent:Receives $10,000 cash in return

for the divested subsidiary’sstock. Recognizes a gain of$8,000 (purchase price less

subsidiary’s net asset basis).Divesting parent pays tax of$2,800. After-tax, divesting

parent has $7,200.

Acquirer:Purchases the stock of the

target (subsidiary) for$10,000 cash. Takes astepped-up basis in thetarget’s assets ($10,000basis; $8,000 step-up)

as a result of the deemedasset sale under §338(h)(10).

Acquired subsidiarybecomes a subsidiary of the

acquirer.

All of thesubsidiary’s stock

$10,000 cash

Sold Subsidiary:The owners of the subsidiary corporation change. The tax

attributes of the subsidiary remain with the divested parent.The tax basis of the subsidiary’s assets carryover ($2,000).

Post-Acquisition Ownership Structure

Acquirer:Owns 100% of the sold subsidiary’s stock.Has a basis in the target’s stock of $10,000and a basis in the target’s assets of $10,000.

Sold Subsidiary:Now a wholly owned

subsidiary of the acquirer.Net asset basis is $10,000.

Tax Implication of a Taxable Stock Sale w/ a §338(h)(10) Election

Taxable Stock Sale w/ aSec. 338(h)(10) Election

$10,000.00

$8,000.00

$10,000.002,800.00

$7,200.00

$10,000.001,720.48

$8,279.52

$10,000.0010,000.008,000.00

Selected Given InformationPurchase Price $10,000.00Target's Tax Net Asset Basis $2,000.00Divesting Parent's Tax Basis in Target's Stock $2,000.00Corporate Tax Rate 35.00%Discount Rate 10.00%Amortization Period 10.00

Taxable Stock Sale w/o aTaxable Asset Sale Section 338(h)(10) Election

Purchase Price $10,000.00 $10,000.00

Tax Effect for Divesting Parent: Gain on Sale $8,000.00 $8,000.00

Cash Received $10,000.00 $10,000.00 Tax on Gain 2,800.00 2,800.00 After-tax Cash $7,200.00 $7,200.00

Acquirer Cost: Purchase Price $10,000.00 $10,000.00 Less: Incremental Tax Savings 1,720.48 0.00 Net After-tax Cost $8,279.52 $10,000.00

Acquirer's Tax Basis in Target's: Stock n/a $10,000.00 Net Assets $10,000.00 2,000.00 Step-up in the Tax Basis of T's Assets 8,000.00 0.00

Review of Various Subsidiary Sale Tax Structures

Tax StructureTaxable stock Taxable stock

Tax-free Taxable sale w/o a 338 sale w/ a 338Factors influenced by stucture stock sale asset sale (h)(10) election (h)(10) electionWhat is acquired? Stock Assets Stock StockConsideration used: Acquirer stock Usually cash Usually cash Usually cashEffect on the Divesting Parent: Gain or loss recognized: No Yes Yes Yes Gain computed as: No gain Price less basis Price less basis Price less basis

recognized in subsidiary's in subsidiary's in subsidiary'snet assets stock net assets

Character of gain: n/a Ordinary income Capital gain Ordinary incomeand capital gain and capital gain

Sold Subsidiary's NOLs Remain w/ Remain w/ Remain w/ Remain w/subsidiary but divesting parent subsidiary but divesting parentlimited by 382 and can offset limited by 382 and can offset

gain on sale; not gain on sale; notlimited by 382 limited by 382

Effect on the acquirer: Basis in subsidiary's assets: Carryover Step-up to Carryover Step-up to

purchase price purchase pricepaid paid

Basis in subsidiary's stock: Carryover n/a Purchase price Purchase price Tax benefits from additional No Yes No Yes depreciation and amortization deductions

Tax Implications of Various Taxable Subsidiary Sale Structures

Susidiary Sale Structure Tax Benefit SplitTaxable Stock Taxable Stock Mid-point Price

Sale w/o a Sec. Sale w/ a Sec. w/ a Sec. Incremental338(h)(10) Election 338(h)(10) Election 338(h)(10) Election Difference

Purchase Price--Base Case $10,000.00Acquirer Indifference Price $12,191.86Purchase Price--Tax Benefit Split $11,095.93

Tax Effect for Divesting Parent: Gain on Sale $8,000.00 $10,191.86 $9,095.93 Cash Received $10,000.00 $12,191.86 $11,095.93 Tax on Gain 2,800.00 3,567.15 3,183.58 After-tax Cash $7,200.00 $8,624.71 $7,912.35 $712.35

Acquirer Cost: Purchase Price $10,000.00 $12,191.86 $11,095.93 Less: Incremental Tax Savings 0.00 2,191.86 1,956.16 Net After-tax Cost $10,000.00 $10,000.00 $9,139.77 $860.23

Acquirer's Tax Basis in Target's: Stock $5,000.00 $12,191.86 $11,095.93 Net Assets 2,000.00 12,191.86 11,095.93 Step-up in the Tax Basis of T's Assets 0.00 10,191.86 9,095.93

Indifference Price Equation

The seller is indifferent if:

PRICE338h10 - tc(PRICE338h10 - ASSET) =

PRICENO338h10 - tc(PRICENO338h10 -STOCK)

where• PRICE338h10 is the price when an election is made

• PRICENO338h10 is the price if the election is not made

• ASSET is the seller’s basis in the net asset

• STOCK is the seller’s basis in the sold subsidiary’s stock

• tc is the corporate tax rate

Minimum Price Equation The minimum price demanded by the seller to make

the §338(h)(10) election is:

PRICE338h10 = PRICENO338h10 + [tc/(1 - tc)](STOCK - ASSET)

where• PRICE338h10 is the price when an election is made• PRICENO338h10 is the price if the election is not made• ASSET is the seller’s basis in the net asset• STOCK is the seller’s basis in the sold subsidiary’s stock• tc is the corporate tax rate

Maximum Price Equation The maximum price that the acquiring firm will pay in

a §338(h)(10) transaction is:

ACQPRICE338h10 = PRICENO338h10 + tc* PVANN*[(ACQUPRICE338h10 - ASSET)/N]

where• ACQPRICE338h10 is the maximum purchase price the acquiring firm is willing to

pay in a §338(h)(10) transaction• PRICENO338h10 is the price if the election is not made• ASSET is the seller’s basis in the net asset• tc is the corporate tax rate• N is the average useful life of the acquired subsidiary’s assets• PVANN is the present value of an annuity

A §338(h)(10) election will be made in a subsidiary sale when

ACQPRICE338h10 - PRICE338h10 > 0

or, put another way, when

[tc/(1/FACTOR) - tc][PRICENO338h10 - ASSET] - [tc/(1 - tc)][STOCK - ASSET] > 0

where• FACTOR is PVANN/N• The other variables are as previously defined

Factors Determining a Parent’s Basis in a Subsidiary’s Stock and Net Assets

• The parent’s tax basis in the stock and net assets will be equal if the subsidiary was internally generated.

• When the sold subsidiary was previously acquired by the divesting parent, the parent’s tax basis in the subsidiary’s stock and assets is determined by the tax structure used to acquire the target.

Subsidiary Sales vs. Sales of Freestanding C Corporations

• With subsidiary sales, the seller is a corporation--not an individual shareholder or a group of various sorts of shareholders

• Subsidiary sales often result in a step-up in the tax basis of the target’s assets; in acquisitions of freestanding C corporations, the target’s assets usually carry over.

Conditions When a §338(h)(10) Election is Optimal

• When the target subsidiary’s stock basis = asset basis and purchase price > net asset basis.

• Also, when the tax basis of the target’s assets > the tax basis of the target’s stock.

Conditions When a §338(h)(10) Election is Sub-optimal

• When the divesting parent’s tax basis in the sold subsidiary’s stock substantially exceeds the net tax basis of the subsidiary’s assets.

• This situation is likely to arise if the divested subsidiary was previously acquired in a taxable stock acquisition.