M&A II: Sec. 338 Basis Step-Up Election and Comparison of Taxable Asset and Stock Purchases

Question 1

Timing of corporate level tax in a taxable asset purchase? Taxable stock purchase?

Answer 1

• Taxable asset purchase: current (time of sale)

- Taxable stock purchase: Deferred

Question 2

Acquisition date corporate level tax in a taxable asset purchase? Taxable stock purchase?

Answer 2

• Taxable asset purchase = Gain * Corporate tax rate

- Taxable stock purchase = Gain is postponed

Question 3

Tax basis in Target’s assets in a taxable asset purchase? Taxable stock purchase?

Answer 3

• Taxable asset purchase: FMV

- Taxable stock purchase: Carryover basis

Question 4

Future tax savings from expensing (depreciating) Target’s assets in a taxable asset purchase? Taxable stock purchase?

Answer 4

• Taxable asset purchase = Tax Basis (FMV) * Corporate tax rate
• Taxable stock purchase = Tax Basis (c/o) * Corporate tax rate

Question 5

Purchase price allocation can generate tax-based goodwill in taxable asset purchase? Taxable stock purchase?

Answer 5

• Taxable asset purchase: YES, if Acquisition Price > FMV of identifiable assets. Can only have tax basis goodwill if transaction is taxable at corporate level.
• Taxable stock purchase: NO, unless Sec. 338 election is made. Taxable stock acquisition results in a c/o tax basis so there will not be tax-basis goodwill created. If 338 election made, then corporate level tax is pad and tax basis goodwill can be created.

Question 6

When is the corporate level tax that is deferred in a taxable stock purchase paid?

Answer 6

• In the future through lower tax savings from depreciating the c/o basis compared to the step-up basis

Question 7

Most acquisitions are what kind of acquisitions?

Answer 7

Taxable stock acquisitions (and don’t generate tax basis goodwill)

Question 8

Following a taxable stock purchase, what can the acquiring company elect to do?

Answer 8

• Make a 338 election to step up Target’s asset basis to FMV

Question 9

What is the cost of achieving the basis step up in a taxable stock purchase?

Answer 9

• Cost is the corporate level tax paid upon election on a hypothetical sale of Target’s assets

Question 10

When can a 338 election be made in a taxable stock acquisition?

Answer 10

• Can only be made if 80% or more of Target’s stock is acquired
• Election must be filed within 8.5 months of acquisition
• Only available if gain will be recognized

Question 11

Why is a 338 election rare in a taxable stock acquisition? Expand.

Answer 11

• Rare b/c you’re paying tax to get basis step-up
• Benefits of election is that basis step-up will give you higher basis for depreciation (more depreciation deductions in the future)
• If tax rate is same in year of election as in future year where you’ll take extra depreciation deductions, then PV of tax savings from basis step up will be lower than tax you pay to get basis step up
• So election may hurt you rather than help you

Question 12

What is ADSP a function of?

Answer 12

ADSP =
Price paid for stock
+ Liabilities assumed
+ Tax paid to make 338 election

Question 13

What is ADSP used for?

Answer 13

To compute gain on hypothetical asset sale (amount realized = ADSP)

Question 14

When would a basis step up make sense?

Answer 14

• Assets have short depreciation lives (PP gain is recognized sooner with shorter asset lives)
• Underlying assets of Target will be sold shortly after acquisition
• Tax rates expected to increase (rather pay tax at lower current tax rate and receive future depreciation benefits on higher future tax rate)
• Target has expiring NOLs

Question 15

The Seller prefers more of the sales price to be allocated to what? Why?

Answer 15

• Goodwill

- B/c it will be taxed as capital gain

Question 16

The Buyer prefers more of the sales price to be allocated to what? Why?

Answer 16

• Shorter-lived assets

- B/c larger near term tax deductions

Question 17

What does indifference imply?

Answer 17

• Both alternatives have same ATCF (BTCF - Tax)

Question 18

For the Acquiring Co., if the price to acquire Target is the same regardless of acquisition type, what type of acquisition will it prefer?

Answer 18

• Asset acquisition (as long as purchase price > c/o tax basis of assets)
• I.e. There is a built in gain
• Preferred b/c of future tax savings from depreciating/amortizing basis step up from asset purchase

Question 19

Why won’t an acquiring co pay as much for a taxable stock acquisition as a taxable asset acquisition?

Answer 19

• B/c w/ a taxable stock acquisition, Acquiring Co. is responsible for deferred corporate level tax on Target’s built in gain

Question 20

When is the corporate level tax that is deferred using a taxable stock acquisition recognized?

Answer 20

• When assets sold or through lower depreciation

Question 21

The longer deferral period of a postponed corporate level tax increases the preference for what?

Answer 21

• Taxable stock acquisition (relative to taxable asset acquisition)
• Therefore indifference price increase

Question 22

Generally, do buyers prefer to buy assets or stock? Why?

Answer 22

• Assets

- B/c of tax benefits they receive in asset deal

Question 23

Generally, do sellers prefer to sell assets or stock? Why?

Answer 23

• Stock
• B/c individual S/Hs are generally taxed only once on any gain they recognize on the sale of their stock, while corporation bears no immediate tax consequence at all
• B/c gain from stock sale will generally be taxed at individual capital gain tax rates instead of corporate tax rates (which tend to be higher)

Question 24

What is a non-tax detriment an acquiring corporation might inquire by purchasing target co. stock?

Answer 24

Assumption of contingent liabilities

Question 25

Why does acquiring co. generally prefer to buy target co. assets as opposed to its stock?

Answer 25

B/c of tax benefits they receive (e.g. stepped up basis in assets, additional depreciation and amortization deductions)

Question 26

Acquiring Co. has a tax adjusted basis in the Target’s assets equal to their FMV if acquisition is structured as an asset purchase or if a 338 election is made subsequent to taxable stock purchase. What factors make a basis step up relatively more desirable?

Answer 26

• Higher tax rates in the future than today
• When target has substantial NOLs
• When tax credit carryovers that acquirer can use to offset any taxable gain triggered by “deemed credit sale”

Question 27

In the SH_ATAX(tax asset) equation why is there a TSTOCKB(tcg) term at the end?

Answer 27

Need to adjust for fact that the basis is not subject to tax

Question 28

What is the equation to find the price for a taxable asset acquisition to make target’s S/H indifferent to a taxable stock acquisition at a given price?

Answer 28

Price (tax asset) =

[Price(tax stock) - (TASSETB)tc] / (1-tc)

Question 29

What is the equation to find the price for a taxable stock acquisition to make target’s S/H indifferent to a taxable asset acquisition at a given price?

Answer 29

Price (tax stock) =

Price(tax asset) - (Price(tax asset) - TASSETB)tc

Question 30

What is the key difference b/w the amount an acquiring co. is wiling to pay for a taxable asset purchase vs. taxable stock purchase attributed to?

Answer 30

• Difference due to tax paid today and PV of tax paid in future (through lower depreciation)

Question 31

If the price to acquire the Target is the same regardless of the type of acquisition, then what will he Acquiring co. prefer?

Answer 31

Asset acquisition (as long as purchase price exceeds c/o tax basis of the assets - i.e. there is a built in gain)

Question 32

Why won’t Acquiring Co. pay as much for a taxable stock acquisition as a taxable asset acquisition?

Answer 32

• B/c basis is lower (c/o as opposed to stepped up basis in a taxable asset acquisition)
• This lower basis results in lower depreciation

Question 33

What is the difference b/w corporate level tax paid today in a taxable asset acquisition vs. PV of corporate level tax to be paid in a taxable stock acquisition attributed to?

Answer 33

Cash savings from corporate level tax deferral

Question 34

What is the Acquiring Co.’s present value after tax cost to acquire Target Co. via a taxable stock purchase equal to?

Answer 34

ACQ_ATAX(tax stock) =

Price(tax stock)

Question 35

What is the Acquiring Co.’s present value after tax cost to acquire Target Co. via a taxable asset purchase equal to?

Answer 35

ACQ_ATAX(tax asset) =
Price (tax asset) -
[{(Price(tax asset) - TASSETB) / n } * tc * PVANN]

Question 36

Why would the acquiring co. not pay as much to purchase Target’s stock vs. Target’s assets?

Answer 36

B/c not as large of depreciation related tax shield with taxable stock acquisition

Question 37

Who determines the min. in the negotiation range for a taxable stock acquisition that will make both parties better off relative to a benchmark taxable asset acquisition?

Answer 37

Target S/H indifference point

Question 38

Who determines the max in the negotiation range for a taxable stock acquisition that will make both parties better off relative to a benchmark taxable asset acquisition?

Answer 38

Acquiring co. indifference point

Question 39

What are the mechanics of a 338 election (3 steps)?

Answer 39

(1) Pretend sale of Target’s assets to pretend New Target Co. for ADSP
(2) One day real tax return is filed for pretend sale. Generates real tax liability. Target’s NOLs and capital loss c/f can offset income from pretend sale. Target’s tax attributes disappear post-election.
(3) New Target Co. has tax basis in assets equal to ADSP. ADSP allocated to assets following 1060 allocation rules. Given this is treated as an asset sale for tax purposes, tax basis goodwill can be created.